HW3_@home_discounting future cash flows back to the present.

In the readings and in class you learned that it is better, that is, it is preferable, to receive cash
now, rather than in the future. This is called the “bird in the hand” theory. Why is this so? 1.
Inflation erodes the value of a given amount of money I might have received today vs getting it
the future. 2. If I get the money today I can invest it earlier and begin the compounding
process earlier, and 3. Perhaps things don’t work out like we thought; there is more risk in
anticipating future cash flows from another person, security or business project then simply
getting paid the same amount today.

Also we noted that the “present value” of a given future cash flow is the amount of the future
cash flow (which usually must be estimated, given the 3 factors cited above), discounted by a
certain discount rate. This process of discounting reduces the present value of future cash flow
values by the amount of the discount rate. So the analyst needs to determine what that
discount rate should be. This is where our previous work on risk comes in… remember, we can
start with a risk free rate and then add additional risk premium to it, depending how risky we
believe the project is. For example if a project or security is expected to have the same risk as
the overall stock market (beta of 1), then we should probably use a discount rate equal to the
current discount rate for the overall market… which we can get from the capm formula! (again,
with a beta of 1, in this case).

So first we need to practice discounting future cash flows… so work on these below and we will
review soon in subsequent classes…

1. Here is a sample project, the same as Table 4.5 on page 128, which initially assumed a
discount rate of 8%. I copied the first two year’s worth.

Can you use your calculator to come up with same PV’s? do the rest of the table and also total
it up at the bottom… (yes you can look at the page to check your work… don’t cheat, it will only
‘cost’ you later)…please give it a try and then add up each pv at the bottom of the table, in the
last row.

End of the year Income – aka Present value (PV)

expected future calculation at 8%
cash flow (FCF) PV
1 90 90 / 1.08^1 83.33
2 100 100 / 1.08^2 85.73
3 110 110/1.08^3 ?87.32
4 120 120/1.08^4 ?88.20
5 100 100/1.08^5 ?68.06
6 100 100/1.08^6 ?63.02
7 1200 1200/1.08^7 ?700.19
total 1820 Total ---------------------- ?1175.85
So how much should you be willing to pay to buy this asset… if you believe the appropriate
discount is 8%? 120 dollars $$$

2. More practice. What if you believe the appropriate discount rate should be 10%, instead?
You should go 2 steps higher to 1200 dollars, youll make money in the end.

Will the total present value be higher or lower than before? How do you know? Please go
ahead and do each one:

End of the year Income – aka Present value (PV)

expected future calculation at 8%
cash flow (FCF) PV
1 90 90 / 1.10^1 ?83.33
2 100 100 / 1.10^2 ?85.73
3 110 110/1.10^3 ?87.32
4 120 120/1.10^4 ?88.20
5 100 100/1.10^5 ?74.86
6 100 100/1.10^6 ?68.0989
7 1200 1200/1.10^7 ?63.02
total 1820 Total ---------------------- ?

3. Last: What if the discount rate was only 5%, instead? Would the total discounted value rise,
fall or be the same as it was at the original 8%

It would rise, because the discount (-) rate is smaller.