Discounted Cash Flow and Valuation (Read Moles et al Chapter 6)

1. PV of multiple cash flows: Riesenrad GmbH has borrowed from their bank at a rate of 8
per cent and will repay the loan with interest over the next five years. Their scheduled
payments, starting at the end of the year are as follows—€450 000, €560 000, €750 000, €875
000 and €1 000 000. What is the present value of these payments? (Round to the nearest
euro.)

a. €2 735 200
b. €2 615 432
c. €2 431 224
d. €2 815 885

Solution:
0 1 2 3 4 5
├───────┼────────┼───────┼────────┼───────┤
€450 000 €560 000 €750 000 €875 000 €1 000 000
n = 5; i = 8%

€ 450 000 € 560 000 € 750 000 € 875 000 € 1 000 000
PV = + + + +
(1 . 08) (1 . 08)2 (1 .08 )3 (1. 08 )4 (1 . 08)5
¿€ 416 666. 67+€ 480 109 .74 +€ 595 374 . 18+€ 643 151 .12+€ 680 583 . 20
¿€2 815 884 . 91
2. Present value of an annuity: Transit Insurance Company has made an investment in
another company that will guarantee it a cash flow of €37 250 each year for the next five
years. If the company uses a discount rate of 15 per cent on its investments, what is the
present value of this investment? (Round to the nearest euro.)

a. €101 766
b. €124 868
c. €251 154
d. €186 250

Solution:
0 1 2 3 4 5
├───────┼────────┼───────┼────────┼───────┤
€37 250 €37 250 €37 250 €37 250 €37 250
n = 5; i = 15%

Annual payment = PMT = €37 250

No. of payments = n = 5
Required rate of return = 15%
Present value of investment = PVA5

1
 [ ]
1
1−
(1+i )n
PVA n=PMT ×
i

[ ]
1
1−
(1. 15)5
¿€ 37 250× =€ 37 250×3.3522
0 .15
¿€124 867 . 78

3. Annuity given PV Moles et al Chapter 6 Problem 36. The Sundarams are buying a new
house and will borrow €237 000 from a bank at a rate of 6.375 per cent for 15 years.
a. What is their monthly loan payment? b. Prepare an amortisation table using Excel.

Solution: Home loan amount = €237 000

Interest rate on loan = i = 6.375%
Term of loan = n = 15 years
Frequency of payment = m = 12
Monthly payment on loan = PMT

4. Perpetuity: Your father is 60 years old and wants to set up a cash flow stream that would
be forever. He would like to receive €20 000 every year, beginning at the end of this year. If
he could invest in account earning 9 per cent, how much would he have to invest today to
receive his perpetual cash flow? (Round to the nearest euro.)

a. €222 222
b. €200 000
c. €189 000
d. €235 200
Solution:
Annual payment needed = PMT = €20 000

2
 Investment rate of return = i = 9%
Term of payment = Perpetuity
Present value of investment needed = PV
PMT € 20 000
PV of Perpetuity = =
i 0. 09
=€222 222 . 22

5. Growing perpetuity: Jack Benny is planning to invest in an insurance company product.

The product will pay €10 000 at the end of this year. Thereafter, the payments will grow
annually at a 3 per cent rate forever. Jack will be able to invest his cash flows at a rate of 6.5
per cent. What is the present value of this investment cash flow stream? (Round to the nearest
euro.)

a. €326 908
b. €312 766
c. €285 714
d. €258 133

Solution:
Cash flow at t=1 = CF1 = €10 000
Annual growth rate = g = 3%
Discount rate = i = 6.5%
Present value of growing perpetuity = PVA∞
CF 1 € 10 000
PVA ∞= =
(i−g ) (0 . 065−0 . 03 )
¿ €285 714 . 29

6. Growing annuity: Hill Unternehmen is expecting tremendous growth from its newest
boutique store. Next year the store is expected to bring in net cash flows of €675 000. The
company expects its earnings to grow annually at a rate of 13 per cent for the next 15 years.
What is the present value of this growing annuity if the firm uses a discount rate of 18 per
cent on its investments? (Round to the nearest euro.)

a. €6 448 519
b. €6 750 000
c. €7 115 449
d. €5 478 320

Solution:
Time of growth = n = 15 years
Next year’s expected net cash flow = CF1 = €675 000
Expected annual growth rate = g = 13%
Firm’s required rate of return = i = 18%
Present value of growing annuity = PVAn

3
 CF 1
[ ( )]
1+g n € 675 000
[ ( )]
15
1. 13
PVA n= × 1− = × 1−
(i−g) 1+i (0 .18−0 .13 ) 1. 18
¿€ 13 500 000×0. 477668
¿€6 448 519 .47
7. Effective annual rate: Largent Distribution has borrowed to invest in a project. The loan
calls for a payment of €17 384 every month for three years. The lender quoted Largent a rate
of 8.40 per cent with monthly compounding. At what rate would you discount the payments
to find amount borrowed by Largent? (Round to two decimal places.)

a. 8.40%
b. 8.73%
c. 8.95%
d. None of the above.
Solution:
Loan amount = PV
Interest rate on loan = i = 8.4%
Frequency of compounding = m = 12
Effective annual rate = EAR

[ ]i m×1
[ ]
12
0 .084
EAR= 1+ −1= 1+ −1
m 12
¿ 1. 0873−1=8 .73 %

To discount present or future value of cash flows, the most appropriate rate is the
EAR, that is, 8.73 per cent.

8.
(a) Using a discount rate of 6%, calculate the present value of the following cash flows:
When received: 1 year from now 2 years from now 3 years from now
Cash flow: $1 $1 $1
(b) Using the same discount rate of 6%:
(i) Calculate the present value of a perpetuity of $1 starting one year from now.
(ii)Calculate the present value of a perpetuity of $1 starting four years from now.
(ii) Calculate the difference between your answers to (i) and (ii) above and explain why this
is the same as your answer to part (a).

(a) The present value is calculated below:

1 1 1
------- + ------- + ------ = 0.9434 + 0.8900 + 0.8396 = 2.673
1.061 1.062 1.063

(b) The required calculations are provided below:

(i) Time line of a perpetuity starting one year from now:

PV of perpetuity at year 0 = 1 ÷ 0.06 = 16.667

4
(ii) Time line of a perpetuity starting four years from now:

PV of perpetuity at year 3 = 1 ÷ 0.06 = 16.667

1
PV of cash flows at year 0 = 16.667 x ---------- = 13.994
1.063
(iii) Difference between answers to (i) and (ii):
16.667 – 13.994 = 2.673
This is the same as the answer to part (a) because, if you take away the PV of a perpetuity of
$1 starting four years from now from the PV of perpetuity of $1 starting one year from now,
you will be left with the PV of an annuity of $1 received for the first three years.

9. Chandler and Monica, who are planning to buy a small apartment, are trying to estimate
their affordable purchase price. A mortgage company is offering 25-year loans at an annual
interest rate of 6.6% for young people of their income group, and they reckon they could
afford an approximate monthly payment of £550 towards repayment of the loan with interest.

(a) Calculate the approximate value of the mortgage loan that they would be able to
obtain on the terms stated.

(b) Based on the joint income of Chandler and Monica, the mortgage company are
prepared to offer a loan of £100,000. If they accepted this offer from the mortgage company,
what would be the approximate amount of monthly mortgage payment they would have to
make?

Answer
If P is the principal of the mortgage loan, and PMT the monthly payment, P = PMT x PVIFAi
%,n

i = 6.6% per annum = 6.6 ÷ 12 = 0.55% per month

n = 25 x 12 = 300 months

1 -1.0055-300
PVIFA0.55%,300 = ------------------ = 146.7418
0.0055

 P = 550 x 146.7418 = £80,708.

(c) If P = PMT x PVIFAi%,n, then PMT = P ÷ PVIFAi%,n

 if P is £100,000,

PMT = 100,000 ÷ 146.7418 = £681.50 approx.