Ch 6.

Discounted cash flow

valuation
 1. FV and PV with multiple cash flows
1) FV with multiple cash flows: Two methods

(1) Rolling over FV year by year

(2) FV=FV1+FV2+FV3….

Ex) Deposit $100 every year for 3 yrs. And 10%

interest rate. FV?
 2) PV with multiple cash flows: Two
method

(1) Rolling back year by year

(2) PV=PV1+PV2+…..

Ex) You are supposed to need $1000 in one year

and $2000 in the second year. If you can
earn 9% on your money, how much you have
to put up today?
 2. Annuities and Perpetuities
1) Def of Annuity:
Constant cash flows for a fixed period of time
Ex) car loan

Ex) Assets with promised to pay $500 at the end

of the each of the next three years. What is
the price of the asset now if a discount rate
is 10%?
Answer:

500/(1.1)+500/(1.1^2)+500/(1.1^3)= 1243.43

2) Formula for Annuity Present Value

C  [1  1 /(1  k ) t ]
PV 
k
 C C C
PV   2
 ..... 
(1  k ) (1  k ) (1  k ) t
C C C
PV  (1  k )  C   2
 ..... 
(1  k ) (1  k ) (1  k ) t 1
C
PV  PV  (1  k )  t
C
(1  k )
1
PV ( k )  C[ t
 1]
(1  k )
1
C[1  t
]
(1  k )
Therefore PV 
k
Ex) You stop by a car dealer shop and find a really
good car. The sticker price of the car is $15000.
But you don’t have money now. So, want
installment payment over 4 yrs. Over
conversation, the dealer suggests $632 per
month for 48 month at 1% per month.

How much is going to be your PV of total

installments?
2-2) Finding C
Ex) You stop by a car dealer shop and find a
really good car. The sticker price of the car is
$15000. But you don’t have money now. So, if
you want installment payment over 4 yrs, how
much you have to pay monthly? (Here interest
rate is 12%)
2-3) Finding rate
Ex) an insurance company offers to pay you
$1000 per year for 10 years if you pay $6710
up front. What rate is used in this annuity?

3) Def of perpetuities:
An annuity in which the cash flow continues
forever
4) Formula for PV of perpetuities

PV=C/k

Ex) Preferred stock – promised fixed dividend every

period forever.

A company want to sell preferred stock at $100 per

share. How much of dividend it has to pay. Currently
the similar preferred stock is sold at $40 with $1
dividend.
i) Calculate r:
R= 1/40 = 0.025
ii) Calculate C:
100 = C/0.025. Then, C=2.5

5) FV for Annuities
t
FV  C  [(1  k )  1] / k
 2 t 1
FV  C  C (1  k )  C (1  k )  ......  C (1  k )
FV  (1  k )  C (1  k )  C (1  k ) 2  C (1  k )3  .....  C (1  k )t
FV  FV (1  k )  C  C (1  k )t
t
FV (k )  C[1  (1  k ) ]
C[(1  k )t  1]
FV 
k
Ex) $2000 annuity for 30 years and k= 0.08. What is the
annuity future value?

6) Annuities due

Def: annuity for which the cash flows occur at the beginning
of the period

Annuity due value =

ordinary annuity value * (1+k)
7) Uneven Cash Flows;
• Summing PV and FV of each cash flows
• Using the cash flow patterns to apply formula

8) Growing annuities: payment growth by g%.

1 g t
1[ ]
PV  C  [ 1 k ]
kg
• E.g) lottery payout over a 20 year period. The
first payment, made one from now, will be
$200,000. Every year thereafter, the payment
will grow by 5% so on during 20 years.
Discount rate is 11%.
• PV = 200000 * (1-(1.05/1.11)^20)/(0.11-0.05)
• = 2236337.06
9) Growing perpetuity: payment grows by g%
forever.
PV  C /( k  g )
3. Rate
Q1. 10% compounded semi-annually is the same as 10%
per year in compounding?

No! here, 10% is APR, (annual percentage rate) and

actually, 10.25% (=(1+0.05)*(1+0.05)-1) is the effective
annual rate.

To compare to other rates, we need to convert APR into

the effective rates
3-1) APRs (Annual Percentage Rate)
Def: interest rate charged per period (periodic rate)
multiplied by the number of periods per year

APR =EAR?
No!!!!

So, APR is a quoted rate and need to be converted to

the EAR
EAR(Effective Annual Rate)
 [1  (APR/m)]m  1

unlimited interest calculatio n

EAR  e k  1
e  2.71828
Ex)
One credit card company selling a card by tele-
marketing. The company said the card will
benefit its cardholders with semi-annual
15%APRs, compared to the other credit card
with 16% EAR.

Do you agree or not?

 6. Loan types and Amortized loan
1) Pure discount loan:
• Receive money today and repay a single lump sum in future

• What is the price of loan that you will pay $25,000 in 5 years? A
lender wants to apply 12% interest rate.

• 14,186 = 25000/(1.12)^5

2) Interest only loan:

• Pay interest each period and repay the entire principal at some
point in the future
A three year, 10% interest only loan of $1000.

A borrower has to pay $100 at the end of first

and second year. At the end of third year, he or
she has to pay $100 and $1000.

3) Amortized loan:
Repay parts of the loan amount over time
Borrow $5000 for 5 years. An interest rate is 9%.
Annual payment happens.

3-1) constant principal payment

Year Begin Pay Interest Principa End

paid l
1 5000 1450 450 1000 4000
2 4000 1360 360 1000 3000
3 3000 1270 270 1000 2000
4 2000 1180 180 1000 1000
5 1000 1090 90 1000 0
total 6350 1350 5000
 3-2. Fixed payment
• 5000 = c*[1-1/(1+0.09)^5]/0.09
• C=1285.46