Topic 2.

Discounting
Future Value
Future value of $100 after t years:

Example: What is the future value of $100,000 after one year if interest is
paid annually at a rate of 5% per year?
 FV=$100,000*(1+0.05)=$105,000
What is its future value after 2 years?
 FV=$100,000*(1+0.05)2=$110,250

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 Present Value
Present value (PV) is the value of future cash flows today:

PV=Discount factor*Ct
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PV  Ct
(1  r ) t

Discount factor is the PV of $1.

Discount rate is the interest rate used to calculate the discount factor.
Calculating present value (converting future value to present) is called
‘discounting’.

Example: What is the present value of $110,250 received in two years if

the interest rate is 5% pa?
 PV=1/1.052*$110,250=$100,000
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 Discount Rate
 Discount rate is the reward investors demand for accepting
delayed payments.
 Investors demand what they could receive from risk-
equivalent alternatives.
 Hence, discount rate is also called the opportunity cost of
capital because it is the return forgone by investing in an asset
rather than in an alternative asset.

Net Present Value (NPV)

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Example:

- this is the value of the project.

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 Net Present Value Rule

Accept investments that have positive net present value

Example:

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Solution:

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 Multiple Cash Flows
Present values can be added together to evaluate multiple cash flows:

or

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 Return Definitions
 Realized return – return earned in the past
 Discount rate – rate used to calculate the present value of future cash
flows
 Required return (fair return, hurdle rate) – rate that you require
from your investments given their level of risk
 Expected return – return that you expect from your investments in
the future
 Opportunity cost of capital – expected return that is foregone by
investing in a project rather than in a comparable financial securities
Required return, expected return and opportunity cost of capital are
different names for the same concept. You discount your cash flows
with the fair return or your hurdle rate which is equal to the opportunity
cost of capital that you could get from alternative investments.
 Weighted average cost of capital (WACC) – cost of debt and equity
financing for a company – used to value projects of a corporation.
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 Shortcuts for Valuing Perpetuities and Annuities
Perpetuity – an asset that pays a level stream of cash flows until infinity

C C
PV   
t 1 (1  r ) t r
Annuity – an asset that pays a level stream of cash flows for a specified period

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Perpetuity with growth: Consider a security which pays C1 next period,
and then the payment grows at a constant rate g forever

C1 (1  g ) t 1 C1
PV   
t 1 (1  r ) t rg

Annuity with growth: Consider a security which pays C1 next period, and
then the payment grows at a constant rate g until period T after which it
terminates
 1  g  C1
T
C
PV  1   
r  g  1 r  r  g

Annuities are often used to value fixed-income securities (e.g. bonds, loans,
mortgages)

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Example: Amortization of a loan: $226,236 par value, 6% pa, 30 years.

PV(payments)=$226,236
Total repayment: $488,304

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 Compound and Simple Interest Rates

Example:

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 Nominal and Real Interest Rates
Inflation: Rate at which the general price level increases
Nominal interest rate: Rate at which the value of an investment grows in money
terms
Real interest rate: Rate at which the purchasing power of an investment grows

Literature: BMA, ch.2

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