Discounted Cash Flow Valuation Techniques by Tanvir Mohammad Hayder Arif

Discounted cash flow valuation
Chapter 5
Key concepts and skills
• Be able to compute the future value of
multiple cash flows
• Be able to compute the present value of
multiple cash flows
• Be able to compute loan payments
• Be able to find the interest rate on a loan
• Understand how loans are amortised or paid
off
• Understand how interest rates are quoted
Copyright © 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al. 5-2
Slides prepared by David E. Allen and Abhay K. Singh
Chapter outline
• Future and present values of multiple cash
flows
• Valuing level cash flows: Annuities and
perpetuities
• Comparing rates: The effect of
compounding periods
• Loan types and loan amortisation
Copyright ©2011 McGraw-Hill Australia Pty Ltd

Future value with multiple cash
flows—Drawing and using a time line
• Suppose you deposit $100 today in an account paying
8%. In one year, you will deposit another $100. How
much will you have in two years?
– At the end of first year = 100* (1.08)+100=208
– At the end of second year = 208*(1.08)=224.64
Copyright ©2011 McGraw-Hill Australia Pty Ltd 5-4

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Future value: Multiple cash flows
Example 5.1
• You think you will be able to deposit $4000
at the end of each of the next 3 years in a
bank account paying 8% interest.
• You currently have $7000 in the account.
• How much will you have in 3 years?
• How much in 4 years?

Example 5.1—Formulas
• Find the value at year 3 of each cash flow
and add them together
– Year 0: FV = $7000(1.08)3 = $ 8 817.98
– Year 1: FV = $4000(1.08)2 = $ 4 665.60
– Year 2: FV = $4000(1.08)1 = $ 4 320.00
– Year 3: value = $ 4 000.00
– Total value in 3 years = $21 803.58
• Value at year 4 = $21 803.58(1.08)= $23 547.87

Example 5.1—Calculator
• Calculator keys:
– Today (year 0 CF): 3 N; 8 I/Y; -7000 PV; CPT FV =
8817.98
– Year 1 CF: 2 N; 8 I/Y; -4000 PV; CPT FV = 4665.60
– Year 2 CF: 1 N; 8 I/Y; -4000 PV; CPT FV = 4320
– Year 3 CF: value = 4000
– Total value in 3 years = 8817.98 + 4665.60 + 4320
+ 4000 = 21 803.58
• Value at year 4: 1 N; 8 I/Y; -21 803.58 PV; CPT
FV = 23 547.87
Example 5.2
• You deposit $100 in one year, $200 in two
years and $300 in three years.
• How much will you have in 3 years at 7%
interest?
– Year 1: FV = $100(1.07)2 = $ 114.49
– Year 2: FV = $200(1.07) = $ 214.00
– Year 3: FV = $300 = $ 300.00
– Total value in 3 years = $628.49

Example 5.2 (cont.)
• How much in 5 years if you don’t add

additional amounts?
– Amount in three years = 628.49
– Year 5: FV=628.49(1.07)2 = $719.56
– This can also be calculated by calculating the
future value of each amount separately.
– Year 1: FV= 100(1.07)4 = 131.08
– Year 2: FV= 200(1.07)3 = 245.01
– Year 3: FV=300(1.07)2 = 343.47
– Total = 719.56
Example 5.2—Formulas and time line
TIMELINE
0 1 2 3 4 5
7%
-$100.00 -$200.00 -$300.00
$300.00
200*(1.07) = $214.00
100*(1.07)^2 = $114.49
$628.49
Total interest = $628.49-600=28.49
* (1.07)^2 = $719.56

Example 5.2 (cont.)
– Year 3 CF: value = 300
– Total value in 3 years = 114.49+214.00+300.00
= 628.49
– Total FV in 5 years = 628.49*(1.07)2 = 719.56

Future value: Multiple cash flows:
Another example
• Suppose you plan to deposit $100 into an
account in one year and $300 into the account
in 3 years. How much will be in the account in
5 years if the interest rate is 8%?
– FV = 100(1.08)4 + 300(1.08)2 = 136.05 + 349.92 =
$485.97
– Year 1 CF: 4 N; -100 PV; 8 I/Y; CPT FV = 136.05
– Year 3 CF: 2 N; -300 PV; 8 I/Y; CPT FV = 349.92
– Total FV = 136.05 + 349.92 = 485.97
Example—Time line
0 1 2 3 4 5
100 300
136.05
349.92
$485.97
Present value: Multiple cash flows
Example 5.3
You are offered an investment that will pay:

– $200 in year 1;
– $400 the next year;
– $600 the following year; and
– $800 at the end of the 4th year.
You can earn 12% on similar investments.
What is the most you should pay for this
one?
Example 5.3—Formula
Find the PV of each cash flow and add them:

– Year 1 CF: $200 / (1.12)1 = $ 178.57
– Year 2 CF: $400 / (1.12)2 = $ 318.88
– Year 3 CF: $600 / (1.12)3 = $ 427.07
– Year 4 CF: $800 / (1.12)4 = $ 508.41
– Total PV = $1432.93

Example 5.3—Calculator
• Calculator:
– Year 1 CF: N = 1; I/Y = 12; FV = 200; CPT PV = -
178.57
318.88
427.07
508.41
– Total PV = 178.57 + 318.88 + 427.07 + 508.41 =
1432.93

Example 5.3—Time line
0 1 2 3 4
Time
(years)
200 400 600 800

178.57
= 1/(1.12)2 x
318.88
= 1/(1.12)3 x
427.07
= 1/(1.12)4 x
508.41
1,432.93
Example 5.4
You are offered an investment that will pay:

– 3 payments of $5000
• the first $5000 in four years from today
• the second $5000 in five years
• the third $5000 in six years
You can earn 11%.
What is the future value of cash flows?

Example 5.4 (cont.)
• First method:
– Year 4: FV= 5000(1.11)2 =6160.50
– Year 5: FV= 5000(1.11) =5550
– Year 6: Value =5000
– Total =16710.50
– PV = 16710.50/(1.11)6 =8934.12
• Second method—using PV one at a time:
– Year 6: CF: 5000/(1.11)6 =2673.20
– Year 5: CF: 5000/(1.11)5 =2967.26
– Year 4: CF: 5000/(1.11)4 =3293.65
– Total PV =8934.12
Another example—Formula solution
• You are considering an investment that will
pay you $1000 in one year, $2000 in two
years and $3000 in three years. If you want
to earn 10% on your money, how much
would you be willing to pay?
 PV = $1,000 / (1.1)1 = $ 909.09
 PV = $2,000 / (1.1)2 = $1652.89
 PV = $3,000 / (1.1)3 = $2253.94
 PV = $4815.92

Another example—Calculator solution
• Calculator:
– N = 1; I/Y = 10; FV = 1000; CPT PV = -909.09
– N = 2; I/Y = 10; FV = 2000; CPT PV = -1652.89
– N = 3; I/Y = 10; FV = 3000; CPT PV = -2253.94
– Total PV= $4815.92

Calculator hints
• Use the internal memory of the calculator
to store cash flows.
• Use of cash flow or CF key
– Clear all
• [CF]-[2nd]-[CLR WORK]
– Enter period 0 cash flow (use [+/-] to change
the sign)
– Press [ENTER] to enter the figure in cash flow
register

Example: Spreadsheet strategies
• You can use the PV or FV functions in Excel to
find the present value or future value of a set
of cash flows.
• Setting the data up is half the battle—once it
is set up properly, you can simply copy the
formulas.
• Click on the Excel icon for an example.

Decisions, decisions…
• Your broker calls you and tells you that he has a great investment
opportunity for you. If you invest $100 today, you will receive $40 in one
year and $75 in two years. If you require a 15% return on investments of
this risk, should you take the investment?
– Use the CF keys to compute the value of the

investment:
• CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
• NPV; I = 15; CPT NPV = $91.49
– No: the broker is charging more than you
would be willing to pay.

Saving for retirement
• You are offered the opportunity to put
some money away for retirement. You will
receive 5 annual payments of $25 000
each, beginning in 40 years. How much
would you be willing to invest today if you
desire an interest rate of 12%?
– Use cash flow keys:
• CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25000; F02 =
5; NPV; I = 12; CPT NPV = $1084.71
Saving for retirement time line
0 1 2 … 39 40 41 42 43 44
0 0 0 … 0 25K 25K 25K 25K 25K
Notice that the year 0 cash flow = 0 (CF0 = 0)

The cash flows for years 1 – 39 are 0 (C01 = 0; F01
= 39)
The cash flows for years 40 – 44 are 25 000 (C02 =
25 000; F02 = 5)
Quick quiz: Part 1
• Suppose you are looking at the following
possible cash flows:
– Year 1: CF = $100
– Years 2 and 3: CFs = $200
– Years 4 and 5: CFs = $300
– The required discount rate is 7%.
• What is the value of the CFs at year 5?
• What is the value of the CFs today?
Quick quiz: Part 1
Solution: Calculator
• Use the uneven cash flow keys and find the
present value first, then compute the
others based on that (easiest solution):
– CF0 = 0; C01 = 100; F01 = 1; C02 = 200; F02 = 2;
C03 = 300; F03 = 2; I = 7; CPT NPV = 874.17
– Value in year 5: PV = 874.17; N = 5; I/Y = 7; CPT
FV = 1226.07

Quick Quiz: Part 1
Solution: Formula
• Using formulas and one CF at a time:
– Year 1 CF: FV5 = 100(1.07)4 = 131.08; PV0 = 100 / 1.07 = 93.46; FV3 =
100(1.07)2 = 114.49
– Year 2 CF: FV5 = 200(1.07)3 = 245.01; PV0 = 200 / (1.07)2 = 174.69; FV3 =
200(1.07) = 214
– Year 3 CF: FV5 = 200(1.07)2 = 228.98; PV0 = 200 / (1.07)3 = 163.26; FV3 =
200
– Year 4 CF: FV5 = 300(1.07) = 321; PV0 = 300 / (1.07)4 = 228.87; PV3 = 300 /
1.07 = 280.37
– Year 5 CF: FV5 = 300; PV0 = 300 / (1.07)5 = 213.90; PV3 = 300 / (1.07)2 =
262.03
– Value at year 5 = 131.08 + 245.01 + 228.98 + 321 + 300 = 1226.07
– Present value today = 93.46 + 174.69 + 163.26 + 228.87 + 213.90 = 874.18

Quick quiz: Part 1
Solution: Excel
A B C D E
1 Chapter 5 - Quick Quiz 1
2 Rate 7%
3 Year Nper CF PV Formula
4 1 1 100 $93.46 =-PV($C$2,A4,0,C4)
5 2 2 200 $174.69 =-PV($C$2,A5,0,C5)
6 3 3 200 $163.26 =-PV($C$2,A6,0,C6)
7 4 4 300 $228.87 =-PV($C$2,A7,0,C7)
8 5 5 300 $213.90 =-PV($C$2,A8,0,C8)
9 Total PV $874.17 =SUM(C4:C8)
10
11 Year Nper CF FV Year

12 1 4 100 $131.08 =-FV($C$2,B12,0,C12)
13 2 3 200 $245.01 =-FV($C$2,B13,0,C13)
14 3 2 200 $228.98 =-FV($C$2,B14,0,C14)
15 4 1 300 $321.00 =-FV($C$2,B15,0,C15)
16 5 0 300 $300.00 =-FV($C$2,B16,0,C16)
17 Total FV $1,226.07 =SUM(C12:C16)
Copyright © 2011 McGraw-Hill Australia Pty Ltd 5-30
Quick quiz: Part 1
Timeline
$ 874.12 PV
$ 213.90
$ 228.87
$ 163.26
$ 174.69
$ 93.46
7%
Period 0 1 2 3 4 5
CFs 0 100 200 200 300 300
$ 300.00
$ 321.00
$ 228.98
$ 245.01
$ 131.08
FV = $ 1,226.07

Valuing level cash flows
Annuities and perpetuities
• Annuity—finite series of equal payments
that occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of
the period, it is called an annuity due
• Perpetuity—infinite series of equal
payments

Annuities and perpetuities
Basic formulas
• Perpetuity: PV = C/r
• Annuities:
 1 
1 
(1  r ) t 
PV  C  
 r 

 

 (1  r ) t  1 
FV  C  
 r 

Annuities and the calculator
• The [PMT] key on the calculator is used for
the equal payment.
• The sign convention still holds.
• Ordinary annuity versus annuity due
– You can switch your calculator between the two
types by using the [2nd] [BGN] [2nd] [SET] on the
TI BA-II Plus.
– If you see ‘BGN’ or ‘Begin’ in the display of your
calculator, you have it set for an annuity due.
– Most problems arise with ordinary annuities.

Annuities present value
Spreadsheet strategy
• The present value and future value
formulas in a spreadsheet include a place
for annuity payments.
• Double-click on the Excel icon to see an
example.

Annuity
Example 5.5
• You can afford $632 48 [N]
per month. 1 [I/Y]
• Going rate = 632 [+/-][PMT]
0 [FV]
1%/month for 48 [CPT][PV]= 23,999.54
months. ($24,000)
• How much can you

borrow?  1 
 1 
(1.01)48 
• You borrow money PV  632    23,999.54
 .01 
TODAY so you need to  
compute the present
value. =PV(0.01,48,-632,0)
Annuity—Sweepstakes example
• Suppose you win the Publishers
Clearinghouse $10 million sweepstakes.
The money is paid in equal annual
instalments of $333 333.33 over 30 years.
If the appropriate discount rate is 5%, how
much is the sweepstakes actually worth
today?
– PV = 333 333.33[1 – 1/1.0530] / .05 =
$5 124 150.29

Annuity—Sweepstakes example
Calculator and Excel solution
30 [N]
5 [I/Y]
[CPT] $ (5,124,150.29) [PV]
$ 333,333.33 [PMT]
0 [FV]
=PV(5, 30, 333333.33, 0) = ($5,124,150.29)

Buying a house
• You are ready to buy a house and you have $20 000 for
a down payment and closing costs.
• Closing costs are estimated to be 4% of the loan value.
• You have an annual salary of $36 000.
• The bank is willing to allow your monthly mortgage
payment to be equal to 28% of your monthly income.
• The interest rate on the loan is 6% per year with
monthly compounding (.5% per month) for a 30-year
fixed-rate loan.
• How much money will the bank loan you?
• How much can you offer for the house?

Buying a house (cont.)
• Bank loan
– Monthly income = 36 000 / 12 = 3000
– Maximum payment = .28(3000) = 840
– Present value= = 840[1 – 1/1.005360] / .005 = $140 105
• 360 [N] (30*12) =PV(.005,360,-840,0)
• 0.5 [I/Y]
• 840 [+/-][PMT]
• [CPT][PV]= 140 105
• Total Price
– Closing costs = .04(140 105) = 5604
– Down payment = 20 000 – 5604 = 14 396
– Total price = 140 105 + 14 396 = 154 501
Quick quiz: Part 2
• You know the payment amount for a loan
and you want to know how much was
borrowed.
– Do you compute a present value or a future
value?

Quick quiz: Part 2 (cont.)
• You want to receive $5000 per month in
retirement. If you can earn .75% per month
and you expect to need the income for 25
years, how much do you need to have in
your account at retirement?
– 300 [N]  Months
– 0.75 [I/Y]  Monthly rate
– 5000 [PMT]  Monthly Payment
– 0 [FV]
– [CPT][PV] -595 808.11
=PV(0.0075,300,5000,0)
Finding the payment
• Suppose you want to
borrow $20 000 for a
new car. 4(12) = 48 [N]
0.66667 [I/Y]
• You can borrow at 8% 20,000 [PV]
per year, compounded 0 [FV]
monthly (8/12 = [CPT][PMT]= - 488.26
.66667% per month).
• If you take a 4-year
loan, what is your =PMT(0.006667,48,20000,0)
monthly payment?
Example: Spreadsheet strategies—
Annuity payment
• Another TVM formula that can be found
in a spreadsheet is the payment formula:
– PMT(rate, nper, pv, fv)
– The same sign convention holds as for the PV
and FV formulas
• Click on the Excel icon for an example.

Finding the number of payments
Example 5.6
• $1000 is due on a credit card
• Payment = $20 month minimum
• Rate = 1.5% per month
– How long would it take to pay off the $1000?
– Formula solution:
• 1000 = 20(1 – 1/1.015t) / .015
• .75 = 1 – 1 / 1.015t
• 1 / 1.015t = .25
• 1 / .25 = 1.015t
• t = ln(1/.25) / ln(1.015) = 93.111 months = 7.75 years
– And this is only if you don’t charge anything more
on the card!
Finding the number of payments
Example 5.6 (cont.)
Calculator solution:
– Sign convention is important
1.5 [I/Y]
1000 [PV]
20 [+/-][PMT]
0 [FV]
[CPT][N]= 93.111 months
= 7.75 years
Spreadsheet solution =NPER(0.015,-20,1000,0)

Finding the number of payments—
Another example
• Suppose you borrow $2000 at 5% and you
are going to make annual payments of
$734.42. How long before you pay off the
loan?
– 2000 = 734.42(1 – 1/1.05t) / .05
– .136161869 = 1 – 1/1.05t
– 1/1.05t = .863838131
– 1.157624287 = 1.05t
– t = ln(1.157624287)/ln(1.05) = 3 years
Finding the number of payments—
Another example (cont.)
Calculator solution:
5 [I/Y]
2000 [PV]
734.42[+/-][PMT]
0 [FV]
[CPT][N]= 3 years
Spreadsheet solution:
=NPER(0.05,-734.42,2000,0)
Finding the rate
• Suppose you borrow $10 000 from your parents
to buy a car. You agree to pay $207.58 per
month for 60 months. What is the monthly
interest rate?
60 [N]
• Calculator keys
10000 [PV]
207.58[+/-][PMT]
0 [FV]
[CPT][I/Y]=.75%
• Spreadsheet function =RATE(60,-207.58,10000,0)
Annuity—Finding the rate without a
financial calculator
• Trial and error method:
– Choose an interest rate and compute the PV of
the payments based on this rate.
– Compare the computed PV with the actual loan
amount.
– If the computed PV > loan amount, then the
interest rate is too low.
– If the computed PV < loan amount, then the
interest rate is too high.
– Adjust the rate and repeat the process until the
computed PV and the loan amount are equal.
Quick quiz: Part 3
• You want to receive $5000 per month for
the next 5 years. How much would you
need to deposit today if you can earn .75%
per month?
60 [N]
0.75 [I/Y] =PV(0.0075,60,5000,0)
5000 [PMT]
0 [FV]
[CPT][PV]= -240866.87
• You want to receive $5000 per month for
the next 5 years.
• What monthly rate would you need to earn
if you only have $200 000 to deposit?
60 [N]
200000 [+/-][PV] =RATE(60,5000,-200000,0)
5000 [PMT]
0 [FV]
[CPT][I/Y]= 1.4395%
• Suppose you have $200 000 to deposit and
you can earn .75% per month.
– How many months could you receive the
$5000 payment?
0.75 [I/Y]
200000 [+/-][PV] =NPER(0.0075,5000,-200000,0)
5000 [PMT]
0 [FV]
[CPT][N]= 47.73 months
≈ 4 years
• Suppose you have $200 000 to deposit and you
can earn .75% per month.
– How much could you receive every month for 5
years?
60 [N] =PMT(0.0075,60,-200000,0)
0.75[I/Y]
200000[+/-][PV]
0 [FV]
[CPT][PMT]= 4151.67
Future values for annuities
• Suppose you begin saving for your retirement by
depositing $2000 per year in a superannuation
fund. If the interest rate is 7.5%, how much will
you have in 40 years?
40 [N] =FV(0.075,40,-2000,0)
7.5[I/Y]  (1  r ) t  1
FV  PMT  
0 [PV]  r 
2000[+/-][PMT]  (1.075) 40  1
FV  2000    454,513.04
[CPT][FV]=  .075 
454513.04
Annuity due
• An annuity for which the cash flows occur at the beginning
of the period.
• You are saving for a new house and you put $10 000 per
year in an account paying 8%. The first payment is made
today. How much will you have at the end of 3 years?
[2nd][BGN][2nd][SET]
3 [N] =FV(0.08,3,-10000,0,1)
8[I/Y]  (1  r ) t  1
0 [PV] FVAD  PMT   (1  r )
 r 
10000[+/-][PMT]  (1.08)3  1
FVAD  10000   (1.08)  35,061.12
[CPT][FV]= 35061.12  . 08 
Annuity due time line
0 1 2 3
$10 000 $10 000 $10 000
$32 464
$35 061.12

Perpetuities—
Example 5.7
• An annuity in which the cash flows continue
forever.
• Perpetuity formula: PV = PMT / r
• Current required return:
– 40 = 1 / r
– r = .025 or 2.5% per quarter
• Dividend for new preferred:
– 100 = PMT / .025
– PMT = 2.50 per quarter
Summary of annuity and
perpetuity calculations
Table 5.2

Example: Work the Web
• <www.moneychimp.com> is one of the sites that has
a financial calculator.
• Click on the information icon, and work out the
following example using the website calculator.
• Suppose you retire with $1 000 000. The growth rate
is 9%.
• How much you can withdraw for next 30 years.
• Do the calculation with a calculator and compare the
results.

Quick quiz: Part 4
• You want to have $1 million to use for retirement in 35
years.
• Q1: If you can earn 1% per month, how much do you
need to deposit on a monthly basis if the first payment
is made in one month?
420 [N]
1 [I/Y]
=PMT(0.01,420,0,1000000)
0 [PV]
1000000 [FV]
[CPT][PMT]= -155.50

• Q2: If you can earn 1% per month, how
much do you need to deposit on a monthly
basis if the first payment is made today?
420 [N]
=PMT(0.01,420,0,1000000,1)
1 [I/Y]
0 [PV]
1000000 [FV]
[CPT][PMT]= -153.96
• You are considering preferred stock that
pays a quarterly dividend of $1.50. If your
desired return is 3% per quarter, how much
would you be willing to pay?
– $1.50/0.03 = $50

Effective annual rate (EAR)
• This is the actual rate paid (or received)
after accounting for compounding that
occurs during the year.
• If you want to compare two alternative
investments with different compounding
periods, you need to compute the EAR and
use that for comparison.

Annual percentage rate (APR)
• This is the annual rate that is quoted by
law.
• By definition APR = period rate times the
number of periods per year.
• So, to get the period rate we rearrange the
APR equation:
– Period rate = APR/number of periods per year
• You should NEVER divide the effective rate
by the number of periods per year—it will
NOT give you the period rate.
Computing APRs
• What is the APR if the monthly rate is .5%?
– .5(12) = 6%
• What is the APR if the semi-annual rate is .5%?
– .5(2) = 1%
• What is the monthly rate if the APR is 12%, with
monthly compounding?
– 12 / 12 = 1%
– Can you divide the above APR by 2 to get the semi-
annual rate? NO!!! You need an APR based on semi-
annual compounding to find the semi-annual rate.

Things to remember
• You ALWAYS need to make sure that the
interest rate and the time period match:
– If you are looking at annual periods, you need an
annual rate.
– If you are looking at monthly periods, you need a
monthly rate.
• If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the interest
rate appropriately if you have payments other
than monthly.
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al 5-67
Slides prepared by David E Allen and Abhay K Singh
EAR formula
m
 APR 
EAR  1   1
 m 
• APR = the quoted rate
• m = number of compounds per year

Computing EARs—Example
• Suppose you can earn 1% per month on $1 invested
today.
– What is the APR? 1(12) = 12%
– How much are you effectively earning?
• FV = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%
• Suppose you put it in another account, where you
earn 3% per quarter.
– What is the APR? 3(4) = 12%
– How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%

EAR and APR on calculator
• [2nd][ICONV]
• [2nd][CLR WORK]
• 3 fields in worksheet:
– NOM (Nominal rate-APR)
– EFF (Effective annual rate)
– C/Y (Compounding periods/yr)
– Enter any 2 values, move to the 3rd and press [CPT]

EAR and NOM (APR) in Excel
• 2 functions:
=EFFECT(Nom, Nper)
=NOMINAL(Eff, Nper)
• All rates entered as decimals

• Nper = number of compounding periods
per year

Decisions, decisions… II
• Which savings accounts should you
choose:
– 5.25%, with daily compounding
– 5.30%, with semiannual compounding
• First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
• [2nd][ICONV]:NOM=5.25; C/Y=365 EFF=5.3899
• =EFFECT(0.525,365)
• Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
• [2nd][ICONV]: NOM=5.3; C/Y=2 EFF=5.3702
• =EFFECT(0.53,2)
Decisions, decisions… II (cont.)
• Let’s verify the choice. Suppose you invest
$100 in each account. How much will you
have in each account in one year?
– First account:
• Daily rate = .0525 / 365 = .00014383562
• FV = 100(1.00014383562)365 = $105.39
– Second account:
• Semiannual rate = .0539 / 2 = .0265
• FV = 100(1.0265)2 = $105.37
• You will have more money in the first account.
Computing APRs from EARs
• If you have an effective rate, how can you
compute the APR? Rearrange the EAR
equation and you get:

APR  m (1  EAR)
1
m
-1
 
m = number of compounding periods per year

APR—Example
• Suppose you want to earn an effective rate of
12% and you are looking at an account that
compounds on a monthly basis. What APR must
they pay?

APR  12 (1 .12)1/ 12  1  .1138655 or 11.39% 
[2nd][ICONV]: EFF = 12
C/Y = 12
NOM[CPT] = 11.3866
=NOMINAL(0.12,12)
Computing payments with APRs
• Suppose you want to buy a new computer system and
the store is willing to allow you to make monthly
payments. The entire computer system costs $3500.
The loan period is for 2 years and the interest rate is
16.9%, with monthly compounding. What is your
monthly payment?
• Calculator
• 2(12) = 24[N]
• 16.9 / 12 = 1.40833 [I/Y]
• 3500 [PV]
• 0 [FV]
• [CPT][PMT] = -172.88
• Spreadsheet =PMT(0.0140833,24,3500,0)

Future values
with monthly compounding
• Suppose you deposit $50 a month into an
account that has an APR of 9%, based on
monthly compounding. How much will you
have in the account in 35 years?
– Calculator:
• 420 [N] (35*12)
• 0.75 [I/Y] (9/12)
• 0 [PV]
• -50 [PMT]
• [CPT][FV]= 147,089.22
– Spreadsheet: =FV(0.0075,420,-50,0)
Present value with daily compounding
• You need $15 000 in 3 years for a new car. If you

can deposit money into an account that pays an
APR of 5.5% based on daily compounding, how
much would you need to deposit?
– Calculator:
• 1095 [N] (3*365)
• .015068493[I/Y] (5.5/365)
• 0 [PMT]
• 15 000 [FV]
• [CPT][FV] = -12 718.56
– Spreadsheet: PV(0.00015,1095,0,15000)

Quick quiz: Part 5
• What is the definition of an APR?
• What is the effective annual rate?
• Which rate should you use to compare
alternative investments or loans?
• Which rate do you need to use for the time
value of money calculations?

Loan types and loan amortisation
Pure discount loans—Example 5.11
• Bank bills are excellent examples of pure discount
loans.
– Principal amount is repaid at some future date.
– No periodic interest payments are paid.
• If a promissory note promises to repay $10 000 in 90
days and the market interest rate is 7%, how much
will the bill sell for in the market?
– Calculator:
– 1 [N]; 10,000 [FV]; (7*90/365) [I/Y]; [CPT][PV] = -
9830.33
– =PV(.07,1,0,10000) (spreadsheet formula)
Interest only loan—Example
• Consider a 5-year, interest only loan with a
7% interest rate. The principal amount is
$10 000. Interest is paid annually.
– What would the stream of cash flows be?
• Years 1–4: Interest payments of .07(10 000) =
$700
• Year 5: Interest + principal = $10 700
• This cash flow stream is similar to the cash
flows on corporate bonds; we will talk
about them in greater detail later.
Amortised loan with fixed payment—
Example
• Each payment covers the interest expense
plus reduces principal.
• Consider a 5-year loan with annual
payments. The interest rate is 9% and the
principal amount is $5000.
– What is the annual payment?
• 5000 = PMT[1 – 1 / 1.095] / .09 PMT = 1285.46
• =PMT(0.09,5,5000,0) = 1285.46
• 5 [N]; 9 [I/Y]; 5000 [PV], 0 [FV] , [CPT][PMT] =
1285.46

Amortised loan with fixed payment
Example: Amortisation table
• Spreadsheet strategies
• Click on the spreadsheet icon to see the
example.
Quick quiz: Part 6
• What is a pure discount loan? What is a
good example of a pure discount loan?
• What is an interest only loan? What is a
good example of an interest only loan?
• What is an amortised loan? What is a good
example of an amortised loan?
• The amount of the loan is $250 000. You
will repay the loan over the next 30 years
at 6.5%. What are your monthly payments?

Discounted Cash Flow Valuation Techniques by Tanvir Mohammad Hayder Arif

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Discounted cash flow valuation

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Copyright ©2011 McGraw-Hill Australia Pty Ltd 5-4

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• Value at year 4 = $21 803.58(1.08)= $23 547.87

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• How much in 5 years if you don’t add

-$100.00 -$200.00 -$300.00

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You are offered an investment that will pay:

Find the PV of each cash flow and add them:

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200 400 600 800

You are offered an investment that will pay:

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– Use the CF keys to compute the value of the

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0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)

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11 Year Nper CF FV Year

CFs 0 100 200 200 300 300

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• How much can you

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=PV(5, 30, 333333.33, 0) = ($5,124,150.29)

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Spreadsheet solution =NPER(0.015,-20,1000,0)

$10 000 $10 000 $10 000

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– Enter any 2 values, move to the 3rd and press [CPT]

• All rates entered as decimals

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• You need $15 000 in 3 years for a new car. If you

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Copyright © 2011 McGraw-Hill Australia Pty Ltd

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