5.1

Chapter

5Discounted Cash Flow Valuation

5.2

Key Concepts and SkillsBe able to compute the future value of multiple

cash flowsBe able to compute the present value of

multiple cash flowsBe able to compute loan paymentsBe able to find the interest rate on a loanUnderstand how loans are amortized or paid

offUnderstand how interest rates are quoted

5.3

Chapter Outline

Future and Present Values of Multiple Cash Flows

Valuing Level Cash Flows: Annuities and Perpetuities

Comparing Rates: The Effect of Compounding Periods

Loan Types and Loan Amortization

5.4

Multiple Cash Flows –Future Value Ex 5.1 You invest $7,000 today, and $4,000 a year for the next three. Given

an 8% rate of return, find the sum value at year 3 of the cash flows.

Today (year 0 CF): 3=N; 8=I/Y; -7000=PV; FV = ?= Year 1 CF: N= ; I/Y= ; PV= ; FV = ? = Year 2 CF: N= ; I/Y= ; PV= ; FV = ? = Year 3 CF: value = Total value in 3 years =

Value at year 4=?: N= ; I/Y= ; PV= FV=? =

5.5

Multiple Cash Flows – FV Example 2Suppose you invest $500 in a mutual fund now

and $600 in one year. If the fund pays 9% annually, how much will you have in 2 years?

Year 0 CF: N=2; PV=<500>; I/Y=9; FV =?= 594.05Year 1 CF: N=1; PV=<600>; I/Y=9; FV =? = 654.00Total FV =

5.6

Multiple Cash Flows – Example ContinuedHow much will you have in 5 years if you

make no further deposits?First way:

Year 0 CF: N= ; PV= ; I/Y= ; FV =? Year 1 CF: N= ; PV= ; I/Y= ; FV =? Total FV = Second way – use value at year 2: N= ; PV= ; I/Y= ; FV = ?

5.7Multiple Cash Flows – FV Example 3Suppose you plan to deposit $100 into an account

in one year and $300 into the account in three years. How much will be in the account in five years if the interest rate is 8%?

Year 1 CF: N= ; PV= ; I/Y= ; FV = ?Year 3 CF: N= ; PV= ; I/Y= ; FV = ?

Total FV = OR:CF 0 = ; CF 1= ; CF2= ;CF3= ; i=

NPV =? ; then :: NPV=PV= ; N= I/Y= ; FV=?=

5.8

Multiple Cash Flows – P.V. Example 5.3You deposit $200, $400, $600, $800, at the end of

each of the next four years. Find the PV of each cash flow and net them.

Year 1 CF: N= ; I/Y= ; FV= ; PV=? Year 2 CF: N= ; I/Y= ; FV= ; PV=? Year 3 CF: N= ; I/Y= ; FV= ; PV=? Year 4 CF: N= ; I/Y= ; FV= ; PV=? Total PV =

OR:: Using Cash Flow Function?

5.9

Example 5.3 Timeline0 1 2 3 4

200 400 600 800178.57

318.88

427.07

508.41

1432.93

5.10

Multiple Cash Flows – PV Another ExampleYou are considering an investment that pays

$1000 in one year, $2000 in two years, and $3000 in three years. If you want to earn 10% on the money, how much would you be willing to pay?

N= ; I/Y= ; FV= ; PV=N= ; I/Y= ; FV= ; PV=N= ; I/Y= ; FV= ; PV=PV =

5.11

5.12

Multiple Uneven Cash Flows – Using the CalculatorAnother way to use the financial calculator for uneven

cash flows is you use the cash flow keys Type the CF amount then press CF to enter the cash flows

beginning with year 0. The “Nj” is the number of times a given cash flow occurs in

consecutive years Enter the interest rate into I/YR Use the shift (second or orange function key) and NPV key to

compute the present value Clear the cash flow keys by pressing shift (second or orange

function key) and then CLEAR ALL

5.13

Multiple Uneven Cash Flows – Using the CalculatorAnother way to use the financial calculator for uneven

cash flows is you use the cash flow keys Texas Instruments BA-II Plus

Press CF and enter the cash flows beginning with year 0. You have to press the “Enter” key for each cash flow Use the down arrow key to move to the next cash flow The “F” is the number of times a given cash flow occurs in

consecutive years Use the NPV key to compute the present value by entering the

interest rate for I, pressing the down arrow and then compute Clear the cash flow keys by pressing CF and then CLR Work

5.14

Decisions, DecisionsYour broker calls you and tells you that he has this

great investment opportunity. If you invest $100 today, you will receive $40 in one year and $75 in two years. If you require a 15% return on investments of this risk, should you take the investment? Use the CF keys to compute the value of the investment

CF; CF0 = 0; CF1 = 40; CF2 = 75; I = 15; 2nd NPV = ?=91.49

No – the broker is charging more than you would be willing to pay.

5.15

Saving For Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

The cash flows years 1 – 39 are 0 (CF1 = 0; Nj = 39

The cash flows years 40 – 44 are 25,000 (CF2 = 25,000; Nj = 5)

5.16

Saving For Retirement

You are offered the opportunity to put some money away for retirement. You will receive five annual payments of $25,000 each beginning in 40 years. How much would you be willing to invest today if you desire an interest rate of 12%?Use cash flow keys:

CF0= ; CF1= ; 2nd Nj= ; CF2= ; Nj= I= ; NPV= ?

5.17

Quick Quiz – Part 1

Suppose you are looking at the following possible cash flows: Year 1 CF = $100; Years 2 and 3 CFs = $200; Years 4 and 5 CFs = $300. The required discount rate is 7%

What is the value of the cash flows at year 5?What is the value of the cash flows today?What is the value of the cash flows at year 3?

5.18

Annuities and Perpetuities Defined

Annuity – finite series of equal payments that occur at regular intervalsIf the first payment occurs at the end of the period, it

is called an ordinary annuityIf the first payment occurs at the beginning of the

period, it is called an annuity due

Perpetuity – infinite series of equal payments

5.19

Annuities and Perpetuities – Basic FormulasPerpetuity: PV = C / rAnnuities:

r

rCFV

rr

CPV

t

t

1)1(

)1(1

1

5.20

Annuities and the Calculator

You can use the PMT key on the calculator for the equal payment

The sign convention still holdsOrdinary annuity versus annuity due

You can switch your calculator between the two types by using 2nd (shift) BEG

If you see “BGN” or “Begin” in the display of your calculator, you have it set for an annuity due

Most problems are ordinary annuities

5.21

Annuity – Example 5.5

You want to buy a car and your budget allows you to make payments of $632 a month. You obtain a car loan charging 12% interest with monthly payments over the 4 year loan life. What’s the most you can borrow today to stay within your budget? N= ; I/Y= ; PMT=

PV =?

5.22

Annuity – Sweepstakes Example

Suppose you win the Publishers Clearinghouse $10 million sweepstakes. The money is paid in equal annual installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how much is the sweepstakes actually worth today?N= ; I/Y= ; PMT= PV =?=

5.23

Buying a HouseYou are ready to buy a house and you have $20,000

for a down payment and closing costs. Closing costs are estimated to be 4% of the loan value. You have an annual salary of $36,000 and the bank is willing to allow your monthly mortgage payment to be equal to 28% of your monthly income. The interest rate on the loan is 6% per year with monthly compounding for a 30-year fixed rate loan. How much money will the bank loan you? How much can you offer for the house?

5.24

Buying a House - ContinuedBank loan

Monthly income = Maximum payment = =$840

N= I/Y= PMT= PV = ? =

Total Price Closing costs = = 5,604 Down payment = = 14,396 Total Price = = 154,501

5.25

Quick Quiz – Part 2You know the payment amount for a loan and

you want to know how much was borrowed. Do you compute a present value or a future value?

You want to receive 5000 per month in retirement. If you can earn .75% per month and you expect to need the income for 25 years, how much do you need to have in your account at retirement?

5.26

Finding the Payment

Suppose you want to borrow $20,000 for a new car. You can borrow at 8% per year, compounded monthly ( =? % per month). If you take a 4 year loan, what is your monthly payment?N= ; PV= ; I/Y=PMT = ? =

5.27

Finding the Number of Payments – Ex. 5.6You max out your new18% credit card, charging

$1,000 worth at BEER ‘N THINGS. If you make only the minimum monthly payments of $20, how long will it take to pay off the card? I/Y = PV = PMT= N = ? = The sign convention matters!!!

And this is only if you don’t charge anything more on the card!

5.28

Finding the Number of Payments – Another ExampleSuppose you borrow $2000 at 5% and you are

going to make annual payments of $734.42. How long before you pay off the loan?Sign convention matters!!!I/Y=PV=PMT= N = ? =

5.29

Finding the Rate

Suppose you borrow $10,000 from your parents to buy a car. You agree to pay $207.58 per month for 60 months. What is the monthly interest rate?Sign convention matters!!!N=PV=PMT=I/Y = ? =

5.30

Quick Quiz – Part 3You want to receive $5000 per month for the next 5

years. How much would you need to deposit today if you can earn .75% per month?

What monthly rate would you need to earn if you only have $200,000 to deposit?

Suppose you have $200,000 to deposit and can earn .75% per month. How many months could you receive the $5000

payment? How much could you receive every month for 5 years?

5.31

Future Values for Annuities

Suppose you begin saving for your retirement by depositing $2000 per year in an IRA. If the interest rate is 7.5%, how much will you have in 40 years?Remember the sign convention!!!N=I/Y=PMT=FV = ? =

5.32

Annuity DueYou are saving for a new house and you put $10,000

per year in an account paying 8%. The first payment is made today. How much will you have at the end of 3 years? 2nd BEG (you should see BEGIN in the display) N= PMT= I/Y= FV=? = 2nd END (to change back to an ordinary annuity)

5.33

Annuity Due Timeline

0 1 2 3

10000 10000 10000

32,464

35,016.12

5.34

Perpetuity – Example 5.7Perpetuity’s Present Value =

Fixed $ Pmt / Int. rateor PV=C / r

Current required return:40 = 1 / rr = .025 or 2.5% per quarter

Dividend for new preferred:100 = C / .025C = 2.50 per quarter

5.35

Quick Quiz – Part 4You want to have $1 million to use for retirement in

35 years. If you can earn 1% per month, how much do you need to deposit on a monthly basis if the first payment is made in one month?

What if the first payment is made today?You are considering preferred stock that pays a

quarterly dividend of $1.50. If your desired return is 3% per quarter, how much would you be willing to pay?

5.36

Effective Annual Rate (EAR)This is the actual rate paid (or received) after

accounting for compounding that occurs during the year

If you want to compare two alternative investments with different compounding periods you need to compute the EAR and use that for comparison.

5.37

Annual Percentage Rate (Nominal)This is the annual rate that is quoted by lawBy definition APR = periodic rate times the

number of periods per yearConsequently, to get the periodic rate we

rearrange the APR equation:Periodic rate = APR / number of periods per year

You should NEVER divide the effective rate by the number of periods per year – it will NOT give you the period rate

5.38

Computing APRs (Nominal Rates)What is the APR if the monthly rate is .5%?

.5% monthly x 12 months per year = 6%What is the APR if the semiannual rate is .5%?

.5% semiannually x 2 semiannual periods per year = 1%What is the monthly rate if the APR is 12% with

monthly compounding? 12% APR / 12 months per year = 1% Can you divide the above APR by 2 to get the semiannual

rate? NO!!! You need an APR based on semiannual compounding to find the semiannual rate.

5.39

Things to RememberYou ALWAYS need to make sure that the interest

rate and the time period match. If you are looking at annual periods, you need an annual

rate. If you are looking at monthly periods, you need a

monthly rate.If you have an APR based on monthly compounding,

you have to use monthly periods for lump sums, or adjust the interest rate appropriately if you have payments other than monthly

5.40

Computing EARs - Example Suppose you can earn 1% per month on $1 invested today.

What is the APR? 1% x 12 monthly periods per year = 12% How much are you effectively earning?

APR=NOM=12%; P/YR=12 (since Monthly) EFF= ? =

Suppose if you put it in another account, you earn 3% per quarter.

What is the APR? How much are you effectively earning?

APR=NOM= ; P/YR= EFF= ? =

5.41

EAR - Formula

1 m

APR 1 EAR

m

Remember that the APR is the quoted rate

5.42

Decisions, Decisions II

You are looking at two savings accounts. One pays 5.25%, with daily compounding. The other pays 5.3% with semiannual compounding. Which account should you use?First account:

APR= ; P/YR= ; EAR=? = Second account:

APR= ; P/YR= ; EAR=? =

Which account should you choose and why?

5.43

Decisions, Decisions II ContinuedLet’s verify the choice. Suppose you invest

$100 in each account. How much will you have in each account in one year?First Account:

N= ; I/Y= ; PV= FV=?=

Second Account: N= ; I/Y= ; PV= FV=? =

You have more money in the first account.

5.44

Computing APRs from EARs

If you have an effective rate, how can you compute the APR? Rearrange the EAR equation and you get:

1 - EAR) (1 m APR m

1

5.45

APR - Example

Suppose you want to earn an effective rate of 12% and you are looking at an account that compounds on a monthly basis. What APR must they pay?

EAR=EFF=12%; P/YR=12 (since monthly);APR=NOM=?=11.39%

11.39%or

8655152113.1)12.1(12 12 APR

5.46

Computing Payments with APRs

Suppose you want to buy a new computer system and the store is willing to sell it to allow you to make monthly payments. The entire computer system costs $3500. The loan period is for 2 years and the interest rate is 16.9% with monthly compounding. What is your monthly payment?N= ; I/Y=PV= ; PMT =?=

5.47

Future Values with Monthly CompoundingSuppose you deposit $50 a month into an

account that has an APR of 9%, based on monthly compounding. How much will you have in the account in 35 years?N=I/Y=PMT=FV=? =

5.48

Present Value with Daily CompoundingYou need $15,000 in 3 years for a new car. If

you can deposit money into an account that pays an APR of 5.5% based on daily compounding, how much would you need to deposit?N=I/Y=FV=PV =?=

5.49

Quick Quiz – Part 5

What is the definition of an APR?What is the effective annual rate?Which rate should you use to compare

alternative investments or loans?Which rate do you need to use in the time

value of money calculations?

5.50

Pure Discount Loans – Example 5.11

Treasury bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments.

If a T-bill promises to repay $10,000 in 12 months and the market interest rate is 7 percent, how much will the bill sell for in the market?N= ; FV= ; I/Y= PV=? =

5.51

Interest Only Loan - ExampleConsider a 5-year, interest only loan with a 7%

interest rate. The principal amount is $10,000. Interest is paid annually.

What would the stream of cash flows be? Years 1 – 4: Interest payments of .07(10,000) = 700 Year 5: Interest + principal = 10,700

This cash flow stream is similar to the cash flows on corporate bonds and we will talk about them in greater detail later.

5.52

Amortized Loan with Fixed Payment - ExampleEach payment covers the interest expense plus

reduces principalConsider a 4 year loan with annual payments.

The interest rate is 8% and the principal amount is $5000.What is the annual payment?

4= N 8= I/Y 5000= PV PMT=? = -1509.60

5.53

Amortization Table for ExampleYear Payment Interest Paid Principal

PaidBalance

1

2

3

4

Totals

5.54

Quick Quiz – Part 6

What is a pure discount loan? What is a good example of a pure discount loan?

What is an interest only loan? What is a good example of an interest only loan?

What is an amortized loan? What is a good example of an amortized loan?