BITS Pilani

presentation
BITS Pilani Dr. Nivedita Sinha
Hyderabad Campus Department of Economics & Finance
Agenda

 Foundation building for Valuation

Time Value of money
 Present value
 Future value
 Effective annual rate and Annual percentage rate
 Valuing perpetual stream of cash flows & growing perpetual stream of cash flows
 Valuing annuity stream of cash flows & growing annuity stream of cash flows

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BITS Pilani, Hyderabad Campus
 Time Value of Money

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BITS Pilani, Hyderabad Campus
For the purpose of this session

 The forecasted Cash Flows are already given

 The timing of the Cash flows are also provided

 The discount factor or the hurdle rate is also known

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Net Present Value (The Investment
decision)
The Net Present Value (NPV) of an investment is the present value of
the expected cash flows, less the initial investment.

Accept Investments that have positive NPV

NPV = -C0 + PV of expected Cash Flows

Where C0 is the initial investment incurred (mostly the Capital
expenditure incurred at t=0)

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BITS Pilani, Hyderabad Campus
Present Value concept

Present Value (PV)

The current value of a future sum of money or stream of cash

flows discounted by an appropriate interest rate *or the hurdle
rate*

The hurdle rate is the minimum acceptable rate of return on a

capital investment project given its risk and it is the opportunity
cost of forgoing other projects of similar risk.

* Opportunity cost of capital/ cost of capital / required rate of

return / discount rate/ Hurdle rate

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Present Value Formula - General
Timeline for the Cash Flows:

Discount rate : r per period and Discount Factort = 1/(1+r)t . Assumption : r

is stated annual rate discounted annually

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BITS Pilani, Hyderabad Campus
Compounding periods – more than
once a year (m periods)
The general formula for FV at the end of year t where interest is paid m
times a year and the interest amount is reinvested every period is

FVt = C0(1+r/m)mt

Where
C0 = Cash to be invested at date 0
r : is Stated annual interest rate (or APR) compounded m times a year
t: No. of years over which cash is invested

Now m can be = 2 (semi-annual compounding) ;

4 (quarterly compounding) ; 12 (monthly compounding) ; 52 (weekly
compounding) or infinity (continuous compounding)

When m tends to infinity , the term (1+r/m)mt approaches ert

FVt = C0ert where e is 2.71828 with continuous compounding
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BITS Pilani, Hyderabad Campus
Compounding periods – more than once a
year (m periods)
Present Value (PV) = Ct/(1+r/m)mt
With r being stated annual interest rate compounded m times in a year
T is no. of years

Present Value (PV)= Cte-rt

Where r is stated annual interest rate continuously compounded
Ct is the CF at the end of tth year

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BITS Pilani, Hyderabad Campus
Effective Annual Rate (EAR),
Effective Annual Yield (EAY) or Effective
Interest Rate
r
EAR  [(1  )^ m]  1
m
Where r is the stated annual interest rate or Annual Percentage Rate (APR)
compounded m times in year

•EAR is a way of restating the APR so that it takes into account the effects
of compounding

•APR should always be stated with periods of compounding otherwise

APR has no meaning

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 EAR and APR example

Given : APR (Annual Percentage rate) or SAIR (Stated Annual

Interest rate) is equal to 10% compounded monthly

What is the equivalent EAR (Effective annual rate)?

EAR =[ (1+10%/12)^12] -1 = 10.471%

An APR of 10% compounded monthly is equivalent to

An EAR of 10.471% which is again equivalent to
An APR of 10.471% compounded annually

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Conventions to refer time

Date Date Date Date

0Few follow the exact
1 2 treat CFs being
time rule as they 3 received on exact
dates and there is a gap of one period (say a year) between any two
dates. Date 0 is the present time

End of End of Year 1 End of End of Year

Year 0 = Year 2 3
Now Most follow the end of year rule (or an end of a period rule). Under this
convention a beginning of year 0 has already passed and is not referred
to. Beginning of Year 1 is End of Year 0 and so on....

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Perpetuity
A constant stream of cash flow forever .

PV of Perpetuity = C/r where r is not equal to zero

Where C is the Cash flow received one period hence and every year, r is
the appropriate discount rate.
Sum of Geometric Series (Finite)

Sum of Geometric Series (Infinite)

As n goes to infinity, the absolute value of r must be less than one for the series to converge. The sum then becomes

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BITS Pilani, Hyderabad Campus
Problem 2 on Perpetuity

Given an interest rate of 6.1% per year, what is the value at date t = 7
of a perpetual stream of $2,500 annual payments that begin at date t =
15?

C C C..........
PV

T =7 T =9 .......... T =14 T =15 T =16 ..........

PV at (t = 14 ) = C/r = 2500/0.061 = $40983.61

PV (t = 7) = PV (at t =14)/(1+r)7 = $40983.61/(1.061)7 = $27077.121

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BITS Pilani, Hyderabad Campus
Thank you!

5/19/2020
BITS Pilani, Hyderabad Campus