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Chapter 2

HOW TO CALCULATE
PRESENT VALUES

Brealey, Myers, and Allen
Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2-1 FUTURE VALUES AND PRESENT VALUES

• Calculating Future Values
• Future Value
• Amount to which investment will grow
after earning interest
• Present Value
• Value today of future cash flow

2-2

2-1 FUTURE VALUES AND PRESENT VALUES

• Future Value of $100 =

FV  $100  (1  r) t

• Example: FV

• What is the future value of $100 if interest is
compounded annually at a rate of 7% for two
years?
FV  $100  (1.07)  (1.07)  $114.49
FV  $100  (1  .07) 2  $114.49
2-3

1 FUTURE VALUES WITH COMPOUNDING 2-4 .FIGURE 2.

2-1 FUTURE VALUES AND PRESENT VALUES Present va lue = PV PV = discount factor  C1 2-5 .

2-1 FUTURE VALUES AND PRESENT VALUES • Discount factor = DF = PV of $1 • Discount factors can be used to compute present value of any cash flow 2-6 .

one can solve for the remaining variable • Prior example can be reversed PV  DF2  C2 PV  1 (1.49  100 2-7 .07) 2 114.2-1 FUTURE VALUES AND PRESENT VALUES • Given any variables in the equation.

2 PRESENT VALUES WITH COMPOUNDING 2-8 .FIGURE 2.

000 • Sale price in year 1 = C1 = $800. then cost of capital = r = 7% 2-9 .2-1 FUTURE VALUES AND PRESENT VALUES • Valuing an Office Building • Step 1: Forecast Cash Flows • Cost of building = C0 = $700.000 • Step 2: Estimate Opportunity Cost of Capital • If equally risky investments in the capital market offer a return of 7%.

664 • Step 4: Go ahead if PV of payoff exceeds investment NPV  $747.000  $47.664 2-10 .07)  $747.2-1 FUTURE VALUES AND PRESENT VALUES • Valuing an Office Building • Step 3: Discount future cash flows PV  C1 (1r )  $800.664  $700. 000 (1.

2-1 FUTURE VALUES AND PRESENT VALUES • Net Present Value NPV = PV  required investment C1 NPV = C0  1 r 2-11 .

000 at 7% $800.2-1 FUTURE VALUES AND PRESENT VALUES • Risk and Present Value • Higher risk projects require a higher rate of return • Higher required rates of return cause lower PVs PV of C1  $800.000 PV   $747.07 2-12 .664 1  .

664  $700.000  $47.2-1 FUTURE VALUES AND PRESENT VALUES • Risk and Net Present Value NPV = PV  required investment NPV = $747.664 2-13 .

000 NPV = $700.2-1 FUTURE VALUES AND PRESENT VALUES • Net Present Value Rule • Accept investments that have positive net present value • Using the original example: Should one accept the project given a 10% expected return? $800.273 1.000 +  $27.1 2-14 .

3% investment $700.143. Is the project a wise investment? profit $800. the opportunity cost of capital is 12%.000 Return    .000 2-15 . or 14.000  $700.2-1 FUTURE VALUES AND PRESENT VALUES • Rate of Return Rule • Accept investments that offer rates of return in excess of their opportunity cost of capital • In the project listed below.

 (1r )t C1 C2 Ct 2-16 .2-1 FUTURE VALUES AND PRESENT VALUES • Multiple Cash Flows • Discounted Cash Flow (DCF) formula: PV0  (1r )1  (1r )2  ....

FIGURE 2.5 NET PRESENT VALUES 2-17 .

2-2 PERPETUITIES AND ANNUITIES • Perpetuity • Financial concept in which cash flow is theoretically received forever cash flow Return  present va lue C r PV 2-18 .

2-2 PERPETUITIES AND ANNUITIES • Perpetuity cash flow PV of cash flow  discount rate C1 PV0  r 2-19 .

for eternity. if the perpetual discount rate is 10%? 2-20 .2-2 PERPETUITIES AND ANNUITIES • Present Value of Perpetuities • What is the present value of $1 billion every year.

2-2 PERPETUITIES AND ANNUITIES • Present Value of Perpetuities • What if the investment does not start making money for 3 years? 2-21 .

2-2 PERPETUITIES AND ANNUITIES • Annuity • Asset that pays fixed sum each year for specified number of years Asset Year of Payment Present Value 1 2…..t t+1 Perpetuity (first payment in year 1) Perpetuity (first payment in year t + 1) Annuity from  C   C  1        t  year 1 to year t  r   r  (1  r )  2-22 .

2-2 PERPETUITIES AND ANNUITIES • Example: Tiburon Autos offers payments of $5. what is the cost of the car? 2-23 . If interest rates are 7%.000 per year. at the end of each year for 5 years. per year.

2-2 PERPETUITIES AND ANNUITIES 1 1  PV of annuity  C    t   r r 1  r   2-24 .

167 million.061  .06  Value  $167.500. at the end of each year.000 2-25 . paid in 30 yearly installments of $12.2-2 PERPETUITIES AND ANNUITIES • Annuity • Example: The state lottery advertises a jackpot prize of $365 million.06 .167    30   . Find the true value of the lottery prize if interest rates are 6%.  1 1  Lottery Value  12.

2-2 PERPETUITIES AND ANNUITIES • Future Value of an Annuity  1  r   1 t FV of annuity  C     r  2-26 .

000     . assuming investment returns of 8% per year?  1  .000 paid at the end of each of the following 5 years.085  1 FV  20.332 2-27 .08   $117.2-2 PERPETUITIES AND ANNUITIES • Future Value of an Annuity • What is the future value of $20.

2-3 GROWING PERPETUITIES AND ANNUITIES • Constant Growth Perpetuity C1 g = the annual growth PV0  rg rate of the cash flow • This formula can be used to value a perpetuity at any point in time Ct 1 PVt  rg 2-28 .

10  .04  $16. assuming a rate of return of 10% and constant growth rate of 4%? 1 PV0  .2-3 GROWING PERPETUITIES AND ANNUITIES • Constant Growth Perpetuity • What is the present value of $1 billion paid at the end of every year in perpetuity.667 billion 2-29 .

or $12.2-3 GROWING PERPETUITIES AND ANNUITIES • Growing Annuities • Golf club membership is $5. Find the better deal given payment due at the end of the year and 6% expected annual price increase. discount rate 10%.750 for three years.000 for 1 year. 2-30 .

2-4 HOW INTEREST IS PAID AND QUOTED • Effective Annual Interest Rate (EAR) • Interest rate annualized using compound interest • Annual Percentage Rate (APR) • Interest rate annualized using simple interest 2-31 .

00% 2-32 . what is the (EAR)? What is the (APR)? EAR = (1 + .01)  1 = .68% 12 APR = .2-4 HOW INTEREST IS PAID AND OUTLAID • Given a monthly rate of 1%.01)12  1 = r EAR = (1 + . or 12.1268. or 12.01  12 = .12.