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Topic 3: Valuation of Multi Payment Cashflows

In the previous topic we considered the tradeoff between money today and
money at some future time and we looked at interest rates as a way of measuring
this tradeoff. We covered simple and compound interest, and interest rates
expressed as nominal or effective annual rates. This was in the context of single
payment cashflows.

Now we shall start looking at more complex tradeoffs such as those involving
exchanging
• a single payment made at time s
for
• a series of n other payments made at various times t1 , t2 ,..., tn

or exchanging
• a series of m payments made at times s1 , s2 ,..., sm
for
• a series of n other payments made at various times t1 , t2 ,..., tn

home loan example

You take out a home loan with a bank. Suppose you borrow $1m over a 25 year
term with monthly repayments of principal and interest.
In this case you have done a deal with the bank to exchange a single payment of
+$1,000,000 at time 0 months for a series of monthly payments for 300 months.

example: superannuation / retirement savings

You make regular payments into your superannuation fund of a fixed percentage
of your salary. On retirement, you wish to be paid a pension from your
superannuation fund. In this case you are exchanging one series of payments
(your contributions) for another series of payments (the pension payments).

In each of the above examples we would like to be able to assess whether the
tradeoff is a fair arrangement from the perspective of both parties to the
arrangement.
There are many examples of such tradeoffs in finance and financial decision
making. This includes decisions about loans / finance, superannuation /
retirement, investments, savings plans, leases and various other long term
contracts.
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Special Multi Payment Cashflows

In analysing these tradeoffs it is worthwhile to identify particular standard

payment patterns and develop valuation formulae for these using the assumption
that the interest rate is constant over the term of the contract / financial
arrangement.

This is what we do next. We shall look at the following specific payment

patterns. These occur in many valuation / financial decision problems.
1. The ordinary annuity
2. The annuity due
3. Payment patterns where the payment frequency differs from the interest
compounding frequency
4. The perpetuity
5. The increasing annuity where payments increase exponentially
6. The perpetuity where payments increase exponentially

For these payment patterns, when the interest rate is constant over the term of the
contract, we can derive some nice simple mathematical formulae for the value of
the payment stream.

We can compute the present value of the payment stream, or the future value of
the payment stream, or the value of the payment stream at some specified time.

Sometimes the payment stream is defined by some parameter(s). For instance,

the monthly repayment on a home loan is such a parameter. The growth rate in
the superannuation contributions is another example of such a parameter that
defines the size or other features of the payment stream.

Often these parameters are part of the negotiation of the deal between the lender
and the borrower or, the provider and the receiver of the cashflow. This leads to
the need to develop and solve what is known as “an equation of value”.

We create an equation of value when we equate the time value of the two sets of
payments at any convenient date called the focal date. By the time value of the
payments we mean the value of the payments allowing for the effect of interest.
It doesn’t matter which focal date is chosen as long as all payments are valued at
the chosen focal date.

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Recall from lecture 2 for compound interest and a single sum of money:

P is the present value

S is the accumulated value
i is the rate of interest per time period and
T is the number of time periods

The accumulated value is

S  P 1  i 
T

The present value is

S 1
 S 1  i 
T
P  SvT where v 
1  i  1 i
n

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VALUATION OF ANNUITIES

An annuity is a series of payments of money at regular intervals. There are

various different types of annuities. For example, if the annuity is guaranteed to
be payable for a fixed period of time it is called a term certain annuity. If the
payment depends on a person being alive (e.g. a pension is payable only while
the pensioner is alive) it is called a life annuity or “contingent annuity”.
We will look at term certain annuities.

Level Ordinary Annuity Payable For n Periods.

The cashflow for a level ordinary annuity is a payment of amount R paid at the
end of each period for n periods. The word ordinary tells us that the annuity is
paid at the end of each time period or in arrears. The word level tells us that
each payment is the same size.

Time 0 1 2 … n
Payment 0 R R R R

The standard ordinary annuity has R = 1 so the payment is 1 per period

Present value level ordinary annuity

The present value at time 0, that is one time period before the first payment, of
an ordinary annuity of n level payments of size R, assuming an interest rate of i
per period is
1  (1  i )  n
 , if i  0
P  R  a(n, i ) where a ( n, i )   i
 n, if i  0


a(n, i) is the “annuity factor”. This factor gives the economic value (or present
value) of the standard annuity cashflow.

n.b. we can also calculate the annuity factor as

t
 
a ( n, i )  v  v 2  ...  v n    
n
1

t 1  1  i 

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There are lots of examples of ordinary annuities. This is a very commonly

occurring cashflow pattern. The interest income stream from a Government
Bond is an example. The monthly repayments on an amortizing home loan is
another.

Numerical example:

Suppose i  25%, n  4

1
Then v   0.80, v 2  0.64, v 3  0.512, v 4  0.4096
1  0.25
a  4, 25%   v  v 2  v3  v 4  0.8  0.64  0.512  0.4096  2.3616
1  v 4 1  0.4096 0.5904
a  4, 25%      2.3616
i 0.25 0.25

Numerical example / scenario:

You have just retired (aged 55) and received a superannuation payout of $1m
You don’t feel confident about being able to invest the money so you decide to
buy an income stream (also known as a term certain annuity) for a term of 30
years with monthly payments from a life insurance company. The annuity
payments will go for exactly 30 years, regardless of whether you are alive or
dead at the time of the payments. If you die before the end of the 30 year term,
the payments will be paid to your estate / surviving relatives. If you survive
beyond the 30 year term, the payments will cease after 30 years so you will need
other money / income to survive on.

The insurance company will give you an annuity calculated at an interest rate of
9% p.a. convertible monthly (i.e. i12  9% )

Question: what would be the amount of the regular monthly payments?

From the perspective of the insurance company the economic value of the
payments they are making to you must equal the economic value of the
payments they receive from you. Otherwise they make a loss on the deal

The economic value of the payments you make to them is $1, 000, 000
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The economic value means the present value of the payments.

The economic value of the payments they make to you is given by the expression
 1  vn 
P  R  a  n, j   R    where
 j 
1 0.09
j  i12   0.0075 interest rate per period
12 12
1 1
v   0.99255583 discount factor per period
1  j 1.0075

n  30 12  360 # periods (months)

Using excel we get a  n, j   a  360,0.0075   124.281866

Use excel function PV(0.0075,360,-1)

For each $1 of monthly pension spread over 30 years the economic value of the
pension is $124.281866

The economic value of the payments being exchanged must be the same.

This leads to an “equation of value”

 1  vn 
This is 1000000  R     R  124.281866
 i 

The left hand side is the value of the payment stream given up by the customer
The right hand side is the value of the payment stream the customer is buying
R is one of the parameters defining the value of the payment stream on the right
hand side of the equation

Solving the equation we get

 1  vn  1000000
1000000  R     R  124.281866  R   $8,046.23
 i  124.281 86 6

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So the retiree has swapped a payment of $1m for an income stream of $8046.23
per month for 30 years.
The income stream is financially equivalent to a single payment of $1m at time 0
In excel PMT(0.0075,360,-1000000) would have given the same result.

Note that in this example we have introduced two excel functions:

The PV function and the PMT function. Explore these functions in excel and
become familiar with them. You will get more practice with them in later
weeks.
Annuity Due

If the payments start immediately but there are still n payments, then the annuity
is called an “annuity due” with payment R and the cash flow is

Time 0 1 2 … n-1 N
Payment R R R R R 0

The standard annuity due has R = 1

The difference from an ordinary annuity is that the payments are made in
advance, at the start of each period instead of at the end of each period.

Examples of this include

• rents on a unit or flat,
• insurance premiums,
• rents on a car lease and so on.

The financial contracts for these things usually involve payment in advance of
when the service (i.e. accommodation, insurance cover etc.) is provided for the
period.

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The present value of an annuity due is given by either of the following

formulae

P  R 1  a ( n  1, i ) 
P  R 1  i  a ( n, i )

Proof: Looking at the payment stream

Time 0 1 2 … n-1 N
Payment R R R R R 0

• We see that the payments at times 1 to n-1 are the same as the payments on an
ordinary annuity of term n-1. This has value R  a(n  1, i )
• We also receive an additional payment of amount R at time 0. This has value
R
• Hence the total value is P  R 1  a ( n  1, i ) 

Numerical example:

Suppose we have signed a lease to rent an apartment for a year. The lease
requires us to make payments of $2000 per month, payable at the start of each
month, for 12 months. The first rental payment is due immediately.

Alternatively, you could pay an upfront rent for the whole 12 months of $23000.
Which of these is the better deal? Assume the interest rate is 12% p.a.
convertible monthly.

Solution: you have been offered a tradeoff between

A cashflow of $2000 paid at each of the times 0,1,2,3,4,5,6,7,8,9,10,11

AND
A single payment of $23000 at time 0

The economic value of the first cashflow is P  R 1  a ( n  1, i ) 

where R  $2000, n  12, i  1% per month

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1
1  1.0111 
a ( n  1, i )  a (11,0.01) 
0.01
1  0.8963237 0.1036763
   10.367628
0.01 0.01

The payments at times 1,2,3,4,5,6,7,8,9,10,11 constitute an ordinary annuity for

a term of 11 periods

The value of the annuity with payments in advance, at the start of each month for
12 months is a(n  1, i)  1  10.367628  1  11.367628
So the value of the rental cashflow is P  R  11.367628  $22, 735.26

This is a bit cheaper than the 23000 alternative.

Excel: You can calculate the present value of an annuity due using the PV
function. However, you must set the type to 1.
PV(0.01,12,-2000,0,1)

If the interest rate were 6% p.a. convertible monthly, then the value of the rental
payments would be $23,354.05 which means the alternative of $23,000 would be
cheaper.

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Valuation of payment streams where the payment frequency does not match
the interest compounding frequency of the interest rate used for valuation:

Such a situation may arise where we believe that the appropriate interest rate to
use in our valuation is one which is usually quoted with a specific compounding
frequency but where the payment pattern we want to value has payments with a
different frequency.

This situation is best dealt with by computing the equivalent interest rate
convertible with the same frequency as the payments and then valuing the
payments using that interest rate.

Remember to convert nominal rate with frequency m to nominal rate with

frequency n use
m n
 1   1 
 1  im    1  in 
 m   n 

 1 
m n

Or re-arranged in  n   1  im   1
 m  

1  1 
m n

in    1  im   1
n   m  

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Numerical example
We have observed the Commonwealth Government bond yield for a term of 5
years to be i2  4% per year

What is the financially equivalent annual nominal rate compounding with

frequency 12 per year? (i.e. compounding monthly)

Solution: we are given i2  4% and we want to compute i12

 1 
m n

Apply the formula in  n   1  im   1
 m  
Where n  12, m  2, im  0.04

We have
 1 
2 12
  1 
16

in  12   1  i2   1  12   1  0.04   1
 2    2  
 i12  12  1.02   1  12  1.003306  1  0.039671  3.9671% p.a.
16

 

The rate of interest per month is thus

1
i12  1.02   1  1.003306  1  0.3306%
16

12  

Example / Scenario

You have leased a building to a federal government department and you receive
a rental of $120,000 per year after tax, paid monthly at the end of each month
over a 5 year period.

You want to estimate the economic value of this income stream. As the federal
government is a very reliable tenant, you believe the 5 year bond yield is the
appropriate rate of interest to use for computing the present value. This yield is
i2  4%

The government tenant makes you an offer. You’ve been offered an opportunity
to exchange this income stream for a single up front payment of $500,000. In
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other words they offer to pay you $500,000 today in return for no monthly rent
over the next 5 years.

Question: Is this a good deal for landlord?

Solution:

• The rental income you would be giving up is an annuity with

1
R  $120,000   $10,000; n  5  12  60 monthly periods
12
• The economic value of this income stream today is P  R  a(n, j ) where R is
the periodic payment, n is the number of periods and j is the interest rate per
period
• The interest rate for the valuation is a rate per year compounding twice a year.
The payments are made 12 times a year. We need to convert the interest rate
to an equivalent rate compounding 12 times a year.
• The valuation interest rate equivalent to the observed market yield to maturity
on a 5 year government bond is i12  3.9671% p.a. so that the rate of interest
1
per month is j  i12  0.33059% (see previous example for where this rate
12
comes from)

The economic value of the income stream is

1  1  0.33059%  60 
10000     10000  $54.342910  $543, 429.10
 0.33059% 

We are being offered the opportunity to give up (ie. sell) something worth
$543,429 in exchange for $500,000.
This is not a worthwhile arrangement for the landlord, it is a loss making
proposition.

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Perpetuity

If the term of the annuity is infinite, we call it a “perpetuity”.

With a level ordinary perpetuity, the cashflow starts in period 1, and is of

amount R every period thereafter, going on forever.

Time 0 1 2 3 etc
Payment 0 R R R R

• The standard ordinary perpetuity has R = 1 so the regular payment is 1 per

period
• The valuation formula for the present value of a perpetuity is simpler than that
for an ordinary annuity:

The present value of a level ordinary perpetuity of R per period, with first
payment starting at time 1, valued at rate i is
1
P  R
i
provided that the interest rate i is strictly positive ( i  0 )

if the first payment is at time 0 instead of at time 1 then the value is

1  1
P  R  R   R  1  
i  i

This formula and variants of it is the basis of various methods for valuation of
shares and other assets.

Proof
We showed above that the value of a standard annuity with a term of n periods
valued at rate i is P  a  n, i    1  v n  where v 
1 1
i 1 i
Noting that i  0  0  v  1  0  v  1 and that n    v n  0
n

1 1
We see that n    a  n, i    1  0  
i i
Hence it follows that the pv of the perpetuity is as stated above

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Example

The British Government, at the turn of the 20th century, issued some special
Bonds known as “consols”.

These were long term Government bonds with a “coupon rate” of 2.5% p.a. and
a Face Value of 1,000,000 which are “redeemable” at the option of the British
Government. Since the time these were issued the UK Government never
decided to redeem them. Redeeming them means paying back the principal on
the loan to the bond holder.

These securities are effectively a perpetuity of the annual coupon payment.

Assuming the yield to maturity (valuation interest rate) is 3%, compute the
value of one of these consol bonds.

Solution
using the perpetuity valuation formula, the value of these bonds is
1 $25,000
P   $1,000,000  0.025     $833,333.33
0.03 0.03

Some corporations also issue securities which are effectively a perpetuity.

These are debt type securities with no maturity date.

Examples include
• “perpetual subordinated debt” and
• “perpetual preference shares”.

These types of corporate securities can be valued in the same way as above.

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REAL INTEREST RATES

Economists distinguish between “nominal” and “real” interest rates. The nominal
rate of interest is the interest rate quoted on some investment or loan. However,
whenever there is any level on inflation in the economy, the purchasing power of
money is eroded over time. “A real interest rate is an interest rate that has been
adjusted to remove the effects of inflation to reflect the real cost of funds to the
borrower, and the real yield to the lender.” (Investopedia)

Suppose that the inflation rate is j per annum and the nominal interest rate is i per
annum.

Over a 1 year time frame, the price of $1.00 worth of goods today will increase
to (1  j ) .

The present value of (1  j ) at rate i is

1
1 j   1 i 
  1  r 
1
 
 1 i  1 j 

1 i
The “real interest rate” on your investment is r where 1  r 
1 j

This real rate measures the return on your investment after making allowance for
the effect of inflation.

The real interest rate in terms of the nominal rate and the inflation rate is
1 i i j
r 1 
1 j 1 j

Example: Compute the real interest rate r when the nominal rate is i = 10% and
the inflation rate is j = 5%.

1  0.10 0.10  0.05

Solution: r  1   4.762%
1  0.05 1.05
(Note that r is just slightly less than the approximation (10% -5%) = 5%. This
approximation provides a quick check of the value of r).
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Increasing annuity where the payments increase exponentially

Suppose we have a cashflow / payment pattern where

• The payment starts at $R at time 1,
• increases by a factor of (1+j) in each period,
• up to and including time n.

The number j is the rate of growth in the payments.

the cashflow for an increasing annuity of this type is

Time 0 1 2 3 … n
Payment 0 R R(1+j) R(1+j)2 … R(1+j)(n-1)

This is a commonly occurring cashflow pattern in finance.

The present value at rate i of this annuity is

t
 t 1  1 
n
PV   R 1  j   
t 1 1 i 
Note the form of the expression for the PV:
t
n
 1 
PV   Ct  
t 1 1 i 
 t 1
• Ct  R 1  j  is the cashflow at time t
t
 1 
•   is the discount factor to discount payments from time t to time 0
1 i 

It can be shown that this PV can be valued more simply by the shortcut formula:
1
PV  R   a ( n, r )
1 j
(i  j )
where r is the “real interest rate” r 
1 j

This valuation formula is often used in valuation of shares and other investment
projects, as we shall see later on in the course when we deal with share
valuation.

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This valuation formula can also be used to compute the value of an indexed
pension payable for a fixed number of years. An indexed pension is a pension
where the payments are linked to inflation so they grow exponentially as above.

Example

You work for an insurance company which is considering investment in a high

rise building in the C.B.D. of Sydney. The rent is paid annually in arrears. You
have estimated that rent at the end of the first year will be $2.5 million. Rental
escalation clauses written into various lease contracts will mean this rental
income will increase at a guaranteed 4% p.a.

Find the present value of the first 10 years of rent.

Solution:

The rental income stream constitutes an increasing annuity for a term of 10 years
where the payments start at $2.5m and increase as a geometric progression with
a growth rate of 4% p.a. in the payments.

Using the formula:

1 0.10  0.04
P  2.5m   a (10, r ) where r  =5.7692%
1  0.04 1.04

2,500,000  1  1.057692 10 

The value is thus   = $17,887,572.88
1.04  0.057692 

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Perpetuity where the payments increase in geometric progression

The cashflow we are considering here is

• The payment starts at $R at time 1, and
• increases by a factor of (1+j) in each period,
• going on forever.
• The number j is the rate of growth in the payments.

The cashflow for an increasing annuity of this type is

Time 0 1 2 3 …
Payment 0 R R(1+j) R(1+j)2 …

This is a commonly encountered cashflow in finance and it is often used in

conjunction with the valuation of shares, as we shall see in the next topic.

The present value of this perpetuity is

1 1 R
PV  R   
1 j r i  j
Note that here we are assuming the first payment is R, not R(1+j)

This valuation formula is also frequently used in the valuation of shares.

This valuation formula is true if and only if i  j and if not then the valuation
formula is not valid and produces an infinite or negative valuation.

If we are valuing a perpetual cashflow that increases exponentially (like a

Geometric Progression) where the first cashflow at time 1 is R(1+j), then the
1 1 R (1  j )
valuation formula becomes PV  R 1  j    
1 j r i j

Proof
From the formula for the annuity with exponentially growing payments and term
R R 1
of n periods we have n    PV   a ( n, r )  
1 j 1 j r
1 i j R 1 j R
We also have  so that PV   
r 1 j 1 j i  j i  j
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Example / case study

You are an equity analyst and you are trying to estimate the value of the shares
of a firm which wants to list on the stock exchange. The firm is expected to
produce earnings of $10,000,000 in the next year and you believe that it will
experience growth in earnings of 3.5% p.a. compound for ever. The firm intends
to issue 5,000,000 shares.

The valuation interest rate to use for valuing the earnings of other similar firms
in the market is 12% p.a. You decide to value the firm as a perpetuity where the
cashflows increase by 3.5% p.a. and the valuation interest rate is 12%.

Compute the estimated value of the firm and the price per share

Solution:

Assuming that this year’s income will be received at the end of the year, we
value the firm as the present value of the future earnings, allowing for both
growth and discounting, using formula 15.

$10,000,000
The value is = $117,647,058.82
0.12  0.035

$117,647,058.82
The price per share is therefore: $23.53 =
5,000,000

Example
Assume the same information as above except that the earnings of $10m is last
year’s earnings (assumed paid at the end of the year) instead of this year’s
earnings. What difference will this make to the valuation?

Solution: the first payment in the payment stream is

R 1  j   $10 m  1.035  $10.35 m instead of $10m as in the previous example

$10,000,000
The value of the firm will become  1.035 = $121,764,705.88,
0.12  0.035

and the price per share will become $24.35

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Computing Future Values from Present Values

Most of the formulae given above are for the present value (at time 0) of some
future cashflow.

To compute the equivalent economic value as at some future time n (relative to

time 0) we only need to compute the present value and multiply it by the factor
(1+i)n.

Accumulated value level ordinary annuity

The accumulated value at time n, that is at the time of the last payment, of an
ordinary annuity of n level payments of size R, assuming an interest rate of i per
period is
 (1  i ) n  1
 , if i  0
P  R  s(n, i ) where s ( n, i )   i
 n, if i  0


s(n, i) is the “accumulation factor”. This factor gives the value of the standard
annuity cashflow at the time of the last payment.

Note that:

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Appendix: (The proofs in the appendix are NOT examinable)

Deriving the valuation formula for a Level Ordinary Annuity Payable For
N Periods.

The present value at time 0 of a level ordinary annuity, assuming an interest rate
of i per period is
1  (1  i )  n
 , if i  0
P  R  a(n, i ) where a ( n, i )   i
 n, if i  0


Deriving the valuation formula for the annuity:

The value at time 0 of a single payment of 1 due at time t in the future is:
t
 1  1
PV     v t
where v  at rate i per period
1 i  1 i

Note that i  0  1  i   1  1 1  i   1  v  1

The value at time 0 of an ordinary annuity of $1 per period for n periods is

a ( n, i )  v  v  ...  v   v
n
2 n t

t 1
n
Note that i  0  v t  1   v t  1  1  ...  1  n So a(n, i)  n for i  0
t 1 n 1's here

Note that i  0  0  vt  1
Let S  v  v 2  ...  v n 
Then vS  v v  v 2  ...  v n1  v n   v 2  v 3  ...  v n  v n 1

It follows that
  
S  vS  v   v 2  ...  v n    v 2  ...  v n   v n 1 
(1  v ) S  v  v n1  v 1  v n 

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So that 1  v  S  v 1  v n   S  1  vn 
v
1 v

v 1
But  since
1 v i
v 1 1  i  1 1  i  1 i 1 1
v  1 1  i       
1  v 1  1 1  i  1  1 1  i  1  i 1  i  1 i

Hence S  a  n, i  
1
i
1  vn  for i  0

Deriving the formula for an increasing annuity where the payments

increase exponentially
Suppose we have a cashflow / payment pattern where
• The payment starts at $R at time 1,
• increases by a factor of (1+j) in each period,
• up to and including time n.

The number j is the rate of growth in the payments.

the cashflow for an increasing annuity of this type is

Time 0 1 2 3 … n
Payment 0 R R(1+j) R(1+j)2 … R(1+j)(n-1)

It can be shown that this PV can be valued by the shortcut formula:

1
PV  R   a ( n, r )
1 j
(i  j )
where r is the “real interest rate” r 
1 j

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Proof

 t 1
• The cashflow / payment to be received at time t is Ct  R 1  j 
• The present value at time 0 of this cashflow is
1  j 
t 1
1  j 
t t
R R 1 j 
PV  Ct   R    
1  i  (1  j ) 1  i t (1  j )  1  i 
t

1 j   1 i 
• The factor   is the reciprocal of  ,
 1  i   1  j 
1
1 j   1 i   1 i 
or in other words  
    1 1 j 
 1 i  1 j   
 1 i 
• we showed earlier that    1  r  where r is the “real rate of interest”
 1  j 
i.e. the rate of interest i adjusted for inflation at rate j
R
it follows that PV  Ct   1  r  which is the present value of a payment
t
•
1 j
R
of amount received at time t and valued at rate r
1 j
• hence it follows that the present value of the overall cashflow / income stream
n n
R R  n t  R
is  PV  Ct    1  r       1  j  a  n, r  
t
 1  r 
t 1 t 1 1  j 1  j  t 1 
• this means we can value the growing income stream by changing the payment
R
per period to and valuing it as an annuity with this fixed payment at the
1 j
“real rate” r

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