Discounted Cash Flow

Valuation
BASIC PRINCIPAL
 Would you rather have $1,000 today or
$1,000 in 30 years?
Why?

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Present and Future Value
 Present Value: value of a future payment today
 Future Value: value that an investment will
grow to in the future
 We find these by discounting or compounding
at the discount rate
 Also know as the hurdle rate or the opportunity
cost of capital or the interest rate

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One Period Discounting
 PV = Future Value / (1+ Discount Rate)
 V0 = C1 / (1+r)
 Alternatively
 PV = Future Value * Discount Factor
 V0 = C1 * (1/ (1+r))
 Discount factor is 1/ (1+r)

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PV Example
 What is the value today of $100 in one year, if
r = 15%?

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FV Example
 What is the value in one year of $100, invested
today at 15%?

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Discount Rate Example
 Your stock costs $100 today, pays $5 in
dividends at the end of the period, and then
sells for $98. What is your rate of return?
 PV =
 FV =

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NPV
 NPV = PV of all expected cash flows
Represents the value generated by the project
To compute we need: expected cash flows &
the discount rate
 PositiveNPV investments generate value
 Negative NPV investments destroy value

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Net Present Value (NPV)
 NPV = PV (Costs) + PV (Benefit)
 Costs:are negative cash flows
 Benefits: are positive cash flows
 One period example
 NPV = C0 + C1 / (1+r)
 For Investments C0 will be negative, and C1 will be
positive
 For Loans C0 will be positive, and C1 will be
negative
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Net Present Value Example
 Suppose you can buy an investment that
promises to pay $10,000 in one year for
$9,500. Should you invest?

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Net Present Value
 Sincewe cannot compare cash flow we
need to calculate the NPV of the
investment
If the discount rate is 5%, then NPV is?

 At what price are we indifferent?

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Coffee Shop Example
 If you build a coffee shop on campus, you can
sell it to Starbucks in one year for $300,000
 Costs of building a coffee shop is $275,000

 Should you build the coffee shop?

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Step 1: Draw out the cash flows

Today Year 1

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Step 2: Find the Discount Rate
 Assume that the Starbucks offer is guaranteed
 US T-Bills are risk-free and currently pay 7%
interest
 This is known as rf
 Thus, the appropriate discount rate is 7%
 Why?

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Step 3: Find NPV
 The NPV of the project is?

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If we are unsure about future?
 Whatis the appropriate discount rate if
we are unsure about the Starbucks offer
rd = rf
rd > rf
rd < rf

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The Discount Rate
 Should take account of two things:
1. Time value of money
2. Riskiness of cash flow
 The appropriate discount rate is the
opportunity cost of capital
 This is the return that is offer on comparable
investments opportunities

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Risky Coffee Shop
 Assume that the risk of the coffee shop is
equivalent to an investment in the stock
market which is currently paying 12%

 Should we still build the coffee shop?

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Calculations
 Need to recalculate the NPV

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Future Cash Flows
 Since future cash flows are not certain, we
need to form an expectation (best guess)
 Need to identify the factors that affect cash flows
(ex. Weather, Business Cycle, etc).
 Determine the various scenarios for this factor (ex.
rainy or sunny; boom or recession)
 Estimate cash flows under the various scenarios
(sensitivity analysis)
 Assign probabilities to each scenario

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Expectation Calculation
 The expected value is the weighted average of
X’s possible values, where the probability of
any outcome is p
 E(X) = p1X1 + p2X2 + …. psXs
 E(X) – Expected Value of X
 Xi − Outcome of X in state i
 pi – Probability of state i
s – Number of possible states
 Note that = p1 + p2 +….+ ps = 1
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Risky Coffee Shop 2
 Now the Starbucks offer depends on the state
of the economy

Recession Normal Boom

Value 300,000 400,000 700,000
Probability 0.25 0.5 0.25

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Calculations
 Discount Rate = 12%
 Expected Future Cash Flow =

 NPV =

 Do we still build the coffee shop?

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Valuing a Project Summary
 Step 1: Forecast cash flows
 Step 2: Draw out the cash flows
 Step 3: Determine the opportunity cost of
capital
 Step 4: Discount future cash flows
 Step 5: Apply the NPV rule

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Reminder
 Important to set up problem correctly
 Keep track of
• Magnitude and timing of the cash flows
• TIMELINES
 You cannot compare cash flows @ t=3 and @
t=2 if they are not in present value terms!!

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General Formula
PV0 = FVN/(1 + r)N OR FVN = PVo*(1 + r)N

 Given any three, you can solve for the fourth

 Present value (PV)
 Future value (FV)
 Time period
 Discount rate

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Four Related Questions
1. How much must you deposit today to have $1
million in 25 years? (r=12%)
2. If a $58,823.31 investment yields $1 million in 25
years, what is the rate of interest?
3. How many years will it take $58,823.31 to grow to
$1 million if r=12%?
4. What will $58,823.31 grow to after 25 years if
r=12%?

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FV Example
 Suppose a stock is currently worth $10, and is
expected to grow at 40% per year for the next five
years.
 What is the stock worth in five years?
$10

0 1 2 3 4 5

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PV Example
 How much would an investor have to set aside
today in order to have $20,000 five years from
now if the current rate is 15%?
PV $20,000

0 1 2 3 4 5

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Historical Example
 From Fibonacci’s Liber Abaci, written in the year
1202: “A certain man gave 1 denari at interest so that
in 5 years he must receive double the denari, and in
another 5, he must have double 2 of the denari and
thus forever. How many denari from this 1denaro
must he have in 100 years?”
 What is rate of return? Hint: what does the investor
earn every 5 years

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Simple vs. Compound Interest
 Simple Interest: Interest accumulates only on
the principal
 Compound Interest: Interest accumulated on the
principal as well as the interest already earned
 What will $100 grow to after 5 periods at 35%?
• Simple interest
 FV = (PV * (r) + PV *(r)) + PV = PV (1 + 2r) =
2 0 0 0 0
• Compounded interest
 FV = PV (1+r) (1+r)= PV (1+r)2 =
2 0 0

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Compounding Periods
We have been assuming that compounding
and discounting occurs annually, this does not
need to be the case

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Non-Annual Compounding
 Cash flows are usually compounded over
periods shorter than a year
 The relationship between PV & FV when
interest is not compounded annually
 FVN = PV * ( 1+ r / M) M*N
 PV = FVN / ( 1+ r / M) M*N
 M is number of compounding periods per year
 N is the number of years

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Compounding Examples
 What is the FV of $500 in 5 years, if the
discount rate is 12%, compounded monthly?

 What is the PV of $500 received in 5 years, if

the discount rate is 12% compounded
monthly?

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Another Example
 An investment for $50,000 earns a rate of
return of 1% each month for a year. How
much money will you have at the end of the
year?

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Interest Rates
 The 12% is the Stated Annual Interest Rate
(also known as the Annual Percentage Rate)
 This is the rate that people generally talk about
 Ex. Car Loans, Mortgages, Credit Cards

 However, this is not the rate people earn or

pay
 The Effective Annual Rate is what people
actually earn or pay over the year
 The more frequent the compounding the higher the
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Effective Annual Rate
Compounding Example 2
 If you invest $50 for 3 years at 12%
compounded semi-annually, your investment
will grow to:

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Compounding Example 2: Alt.
 If you invest $50 for 3 years at 12%
compounded semi-annually, your investment
will grow to: $70.93
 Calculate the EAR: EAR = (1 + R/m)m – 1

 So, investing at compounded annually

is the same as investing at 12% compounded
semi-annually 38
EAR Example
 Find the Effective Annual Rate (EAR) of an 18% loan
that is compounded weekly.

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Credit Card
 A bank quotes you a credit card with an interest rate
of 14%, compounded daily. If you charge $15,000 at
the beginning of the year, how much will you have to
repay at the end of the year?
 EAR =

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Credit Card
 A bank quotes you a credit card with an interest rate
of 14%, compounded daily. If you charge $15,000 at
the beginning of the year, how much will you have to
repay at the end of the year?
 EAR =

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Present Value Of a Cash Flow Stream

C1 C2 C3 CN
PV = + + +...+
(1 + r1 ) (1 + r2 ) (1 + r3 )
2 3
(1 + rN ) N

N
Ct
=∑
t =1 (1 + rt ) t

 Discount each cash flow back to the present

using the appropriate discount rate and then
sum the present values.

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Insight Example
r = 10%
Year Project A Project B
1 100 300
2 400 400
3 300 100

PV

Which project is more valuable? Why?

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Various Cash Flows
 A project has cash flows of $15,000, $10,000, and
$5,000 in 1, 2, and 3 years, respectively. If the
interest rate is 15%, would you buy the project if it
costs $25,000?

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Example (Given)
 Consider an investment that pays $200 one
year from now, with cash flows increasing by
$200 per year through year 4. If the interest
rate is 12%, what is the present value of this
stream of cash flows?
 If the issuer offers this investment for $1,500,
should you purchase it?

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Multiple Cash Flows (Given)
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93

Don’t buy
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 Various Cash Flow (Given)
 A project has the following cash flows in periods 1
through 4: –$200, +$200, –$200, +$200. If the prevailing
interest rate is 3%, would you accept this project if you
were offered an up-front payment of $10 to do so?
 PV = –$200/1.03 + $200/1.032 – $200/1.033 + $200/1.034
 PV = –$10.99.
 NPV = $10 – $10.99 = –$0.99.
 You would not take this project

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Common Cash Flows Streams
 Perpetuity, Growing Perpetuity
 A stream of cash flows that lasts forever
 Annuity, Growing Annuity
 A stream of cash flows that lasts for a fixed
number of periods
 NOTE: All of the following formulas assume the
first payment is next year, and payments occur
annually

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Perpetuity
 A stream of cash flows that lasts forever
C C C

0 1 2 3 …
C C C
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

 PV: = C/r
 What is PV if C=$100 and r=10%:

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Perpetuity Example
 What is the PV of a perpetuity paying $30
each month, if the annual interest rate is a
constant effective 12.68% per year?

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Perpetuity Example 2
 What is the prevailing interest rate if a
perpetual bond were to pay $100,000 per year
beginning next year and costs $1,000,000
today?

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Growing Perpetuities
 Annual payments grow at a constant rate, g
C1 C2(1+g) C3(1+g)2
…
0 1 2 3

PV= C1/(1+r) + C1(1+g)/(1+r)2 + C1(1+g)2(1+r)3 +…

 PV = C1/(r-g)
 What is PV if C1 =$100, r=10%, and g=2%?

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Growing Perpetuity Example
 What is the interest rate on a perpetual bond that pays
$100,000 per year with payments that grow with the
inflation rate (2%) per year, assuming the bond costs
$1,000,000 today?

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Growing Perpetuity: Example (Given)
 The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever.
 If the discount rate is 10%, what is the value of this
promised dividend stream?
$1.30×(1.05) $1.30 ×(1.05) 2
$1.30 = $1.43
= $1.37
…
0 1 2 3

PV = 1.30 / (0.10 – 0.05) = $26

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Example
An investment in a growing perpetuity costs
$5,000 and is expected to pay $200 next year.
If the interest is 10%, what is the growth rate
of the annual payment?

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Annuity
A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) T

C 1 
PV = 1 − T 
r  (1 + r ) 
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 Annuity Formula
C
C
PV = − r T
r (1 + r )
C C C C C C C

0 1 2 3 T T+1 T+2 T+3

 Simply subtracting off the PV of the rest of the

perpetuity’s cash flows
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Annuity Example 1
 Compute the present value of a 3 year ordinary
annuity with payments of $100 at r=10%
 Answer:

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Alternative: Use a Financial Calculator
 Texas Instruments BA-II Plus, basic
N = number of periods
 I/Y = periodic interest rate
 P/Y must equal 1 for the I/Y to be the periodic rate
 Interest is entered as a percent, not a decimal
 PV = present value
 PMT = payments received periodically
 FV = future value
 Remember to clear the registers (CLR TVM) after each
problem
 Other calculators are similar in format

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 Annuity Example 2
 You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of
capital is 0.5% per month, what is the cost of the lease?
Work through on your financial calculators

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Annuity Example 3
 What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
 What do the payments look like?

 What is the discount rate?

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Annuity Example 3
 What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
 What do the payments look like?
PV $600 $600 $600 $600 $600

0 2 4 6 8 10

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Annuity Example 3
 What is the value today of a 10-year annuity
that pays $600 every other year? Assume that
the stated annual discount rate is 10%.
 What is the discount rate?

63
Annuity Example 4
 What is the present value of a four payment
annuity of $100 per year that makes its first
payment two years from today if the discount
rate is 9%?
 What do the payments look like?

0 1 2 3 4 5

64
Annuity Example 5
 What is the value today of a 10-pymt annuity
that pays $300 a year if the annuity’s first
cash flow is at the end of year 6. The interest
rate is 15% for years 1-5 and 10% thereafter?

65
Annuity Example 5
 What is the value today of a 10-pymt annuity that
pays $300 a year (at year-end) if the annuity’s first
cash flow is at the end of year 6. The interest rate is
15% for years 1-5 and 10% thereafter?
 Steps:
1. Get value of annuity at t= 5 (year end)

2. Bring value in step 1 to t=0

66
Annuity Example 6
 You win the $20 million Powerball. The lottery
commission offers you $20 million dollars today or
a nine payment annuity of $2,750,000, with the first
payment being today. Which is more valuable is
your discount rate is 5.5%?

67
Alt: Annuity Example 6
 You win the $20 million Powerball. The lottery
commission offers you $20 million dollars today or
a nine payment annuity of $2,750,000, with the first
payment being today. Which is more valuable if
your discount rate is 5.5%?

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Delayed first payment: Perpetuity
 What is the present value of a growing
perpetuity, that pays $100 per year, growing at
6%, when the discount rate is 10%, if the first
payment is in 12 years?

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Growing Annuity
A growing stream of cash flows with a fixed maturity

C C×(1+g) C ×(1+g)2 C×(1+g)T-1


0 1 2 3 T
T −1
C C × (1 + g ) C × (1 + g )
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) T

C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
  70
Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3% each
year. What is the present value at retirement if the discount rate
is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40

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 Growing Annuity: Example (Given)
You are evaluating an income generating property. Net rent is received at the end of each year. The first year's
rent is expected to be $8,500, and rent is expected to increase 7% each year. What is the present value of the
estimated income stream over the first 5 years if the discount rate is 12%?

PV = (8,500/(.12-.07)) * [ 1- {1.07/1.12}5] = $34,706.26

0 1 2 3 4 5

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Growing Perpetuity Example
 What is the value today a perpetuity that makes
payments every other year, If the first payment is $100,
the discount rate is 12%, and the growth rate is 7%?
 r:

 g:

 Price:

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Valuation Formulas
FVn
PV = FVn = PV * (1 + r ) n
(1 + r ) n

C C1
PV = PV =
r−g
r
C 1 
PV = 1 −   1+ g  
T
r  (1 + r )T  PV =
C1
1 −   
r − g   (1 + r )  
 

74
Remember
 That when you use one of these formula’s or
the calculator the assumptions are that:
 PV is right now
 The first payment is next year

75
What Is a Firm Worth?
 Conceptually, a firm should be worth the
present value of the firm’s cash flows.
 The tricky part is determining the size, timing,
and risk of those cash flows.

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Quick Quiz
1. How is the future value of a single cash flow
computed?
2. How is the present value of a series of cash flows
computed.
3. What is the Net Present Value of an investment?
4. What is an EAR, and how is it computed?
5. What is a perpetuity? An annuity?

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Why We Care
 The Time Value of Money is the basis for all
of finance
 People will assume that you have this down
cold

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