CH04 PPT

Fundamentals of Corporate Finance
Fourth Edition, Global Edition
Chapter 4
Time Value
of Money:
Valuing Cash
Flow Streams
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Chapter Outline
4.1 Valuing a Stream of Cash Flows
4.2 Perpetuities
4.3 Annuities
4.4 Growing Cash Flows
4.5 Solving for Variables Other Than Present Value or
Future Value
4.6 Non-Annual Cash Flows

Learning Objectives
• Value a series of many cash flows
• Value a perpetual series of regular cash flows called a
perpetuity
• Value a common set of regular cash flows called an
annuity
• Value both perpetuities and annuities when the cash flows
grow at a constant rate
• Compute the number of periods, cash flow, or rate of
return of a loan or investment
• Value cash flow streams with non-annual payments
4.1 Valuing a Stream of Cash
Flows (1 of 11)
• Rules developed in Chapter 3:
– Rule 1: Only values at the same point in time can be
compared or combined.
– Rule 2: To calculate a cash flow’s future value, we must
compound it.
FVn  C  1  r 
n
– Rule 3: To calculate the present value of a future cash

flow, we must discount it.
C
PV  C  1  r  
n
1  r 
n

Flows (2 of 11)
Applying the Rules of Valuing Cash Flows
• Suppose we plan to save $1,000 today, and $1,000 at
the end of each of the next two years
• If we earn a fixed 10% interest rate on our savings,
how much will we have three years from today?

Flows (3 of 11)
• We can do this in several ways
• First, take the deposit at date 0 and move it forward to
date 1
• Combine this amount with the deposit at date 1 and
move the combined total forward to date 2

Flows (4 of 11)
• Continuing in the same fashion, we can solve the
problem as follows:

Flows (5 of 11)
• Another approach is to compute the future value in
year 3 of each cash flow separately
• Once all amounts are in year 3 dollars, combine them

Flows (6 of 11)
• Consider a stream of cash flows: C0 at date 0, C1 at
date 1, and so on, up to CN at date N
• We compute the present value of this cash flow

stream in two steps
• First, compute the present value of each individual
cash flow

Flows (7 of 11)
• Then combine the present values
• This timeline provides the general formula for the

present value of a cash flow stream:
C1 C2 CN
PV  C0     
1  r  1  r 2
1  r 
N

Example 4.1 Present Value of a
Stream of Cash Flows (1 of 6)
Problem
• You have just graduated and need money to buy a new
car. Your rich Uncle Henry will lend you the money as long
as you agree to pay him back within four years, and you
offer to pay him the rate of interest that he would otherwise
get by putting his money in a savings account. Based on
your earnings and living expenses, you think you will be
able to pay him $5000 in one year, and then $8000 each
year for the next three years. If Uncle Henry would
otherwise earn 6% per year on his savings, how much can
you borrow from him?

Solution
Plan
• The cash flows you can promise Uncle Henry are as
follows:

• How much money should Uncle Henry be willing to give
you today in return for your promise of these payments?
He should be willing to give you an amount that is
equivalent to these payments in present value terms. This
is the amount of money that it would take him to produce
these same cash flows. We will (1) solve the problem using
Eq. 4.3 and then (2) verify our answer by calculating the
future value of this amount.

Execute
1. We can calculate the PV as follows:
5000 8000 8000 8000

PV    
1.06 1.06 1.06 1.06 4
2 3
 4716.98  7119.97  6716.95  6336.75

 $24,890.65
• Now suppose that Uncle Henry gives you the money, and
then deposits your payments to him in the bank each year.
How much will he have four years from now? We need to
compute the future value of the annual deposits. One way
to do this is to compute the bank balance each year:
2. To verify our answer, suppose your uncle kept his

$24,890.65 in the bank today earning 6% interest. In four
years he would have:
FV = $24,890.65  1.06   $31,423.87 in 4 years
4
We get the same answer both ways (within a penny, which is

due to rounding).
Evaluate
• Thus, Uncle Henry should be willing to lend you
$24,890.65 in exchange for your promised payments.
This amount is less than the total you will pay him
1$5000 + $8000 + $8000 + $8000 = $29,0002 due to
the time value of money.

Example 4.1a Present Value of a
Problem:
• You have just graduated and need money to pay the
deposit on an apartment.
• Your aunt will lend you the money so long as you
agree to pay her back within six months.
• You offer to pay her the rate of interest that she would
otherwise get by putting her money in a savings
account.

Problem:
• Based on your earnings and living expenses, you
think you will be able to pay her $70 next month, $85
in each of the next two months, and then $90 each
month for months 4 through 6.
• If your aunt would otherwise earn 0.5% per year on
her savings, how much can you borrow from her?

Solution:
Plan:
• The cash flows you can promise your aunt are as
follows:
• She should be willing to give you an amount equal to

these payments in present value terms.

Plan:
• We will:
– Solve the problem using equation 4.3
– Verify our answer by calculating the future value of this
amount.

Execute:
• We can calculate the PV as follows:
70 85 85 90 90 90
PV      
1.005 1.005 1.005 1.005 1.005 1.005 6
2 3 4 5
 $69.65  $84.16  $83.74  $88.22  $87.78  $87.35

 $500.90

Execute:
• Now, suppose that your aunt gives you the money,
and then deposits your payments in the bank each
month.
• How much will she have six months from now?

Execute:
• We need to compute the future value of the monthly
deposits.
• One way is to compute the bank balance each month.

Execute:
• To verify our answer, suppose your aunt kept her
$500.90 in the bank today earning 0.5% interest.
• In six months she would have:
FV = $500.90  1.005   $516.11 in 6 months

6

Evaluate:
• Thus, your aunt should be willing to lend you $500.90
in exchange for your promised payments.
• This amount is less than the total you will pay her
($70+$85+$85+$90+$90+$90=$510) due to the time
value of money.

Flows (8 of 11)
Using a Financial Calculator: Solving for Present and Future Values
of Cash Flow Streams
• Financial calculators and spreadsheets have the formulas pre-
programmed to quicken the process
• There are five variables used most often:
– N = Number of periods
– PV = Present value
– PMT = Payment
– FV = Future value
– I/Y = Interest rate
• Each function takes four variables as inputs and returns the value
of the fifth
Flows (9 of 11)
Example 1:
• Suppose you plan to invest $20,000 in an account
paying 8% interest.
• How much will you have in the account in 15 years?
• To compute the solution, we enter the four variables
we know and solve for the one we want to determine,
FV.

Flows (10 of 11)
Example 1:
• For the HP-10BII or the TI-BAII Plus calculators:
– Enter 15 and press the N key.
– Enter 8 and press the I/Y key (I/YR for the HP)
– Enter −20,000 and press the PV key.
– Enter 0 and press the PMT key.
– Press the FV key (for the TI, press “CPT” and then
“FV”).

Flows (11 of 11)
Excel Formula: = FV(0.08,15,0,-20000)
• Notice that PV (the amount we’re putting in to the bank)is

entered as a negative number and FV (the amount we take out
of the bank)is shown as a positive number.
• It is important to enter the signs correctly to indicate the
direction the cash flows are moving. It is also important to note
that an interest rate of 8% is entered as “8” in a financial
calculator, but as “0.08” in Excel.
Example 4.2 Computing the Future
Value (1 of 4)
Problem
• Let’s revisit the savings plan we considered earlier:
We plan to save $1000 today and at the end of each
of the next two years. At a fixed 10% interest rate,
how much will we have in the bank three years from
today?

Value (2 of 4)
Solution
Plan
• We’ll start with the timeline for this savings plan:
• Let’s solve this problem in a different way than we did in

the text, while still following the rules we established. First,
we’ll compute the present value of the cash flows. Then,
we’ll compute its value three years later (its future value).
Value (3 of 4)
Execute
• There are several ways to calculate the present value of
the cash flows. Here, we treat each cash flow separately
and then combine the present values.
• Saving $2735.54 today is equivalent to saving $1000 per

year for three years. Now let’s compute future value in
year 3 of that $2735.54:
Value (4 of 4)
Evaluate
• This answer of $3641 is precisely the same result we
found earlier. As long as we apply the three rules of valuing
cash flows, we will always get the correct answer.

Example 4.2a Computing the Future
Value (1 of 4)
Problem:
• We plan to save $1,000 today and at the end of each
of the next two years.
• At a fixed 6% interest rate, how much will we have in
the bank three years from today?

Value (2 of 4)
Solution:
Plan:
• We’ll start with the timeline for this savings plan:
0 1 2 3
$1,000 $1,000 $1,000 ?
• Next, we’ll compute the present value of the cash

flows.
• Then we’ll compute its value three years later (its
future value).
Value (3 of 4)
Execute:

Value (4 of 4)
Evaluate:
• The answer of $3,374.62 and we can get the same
result no matter which way we solve the problem.

4.2 Perpetuities (1 of 7)
• The formulas we have developed so far allow us to
compute the present or future value of any cash flow
stream
• Now we will consider two types of cash flow streams:
– Perpetuities
– Annuities

Perpetuities
– A perpetuity is a stream of equal cash flows that occur
at regular intervals and last forever
– Here is the timeline for a perpetuity:
– the first cash flow does not occur immediately; it

arrives at the end of the first period

• Using the formula for present value, the present value
of a perpetuity with payment C and interest rate r is
given by:
C C C
PV =    ......
(1  r) (1  r) (1  r)
2 3
• Notice that all the cash flows are the same

• Also, the first cash flow starts at time 1 (there is no
cash flow at time 0)

• Let’s derive a shortcut by creating our own perpetuity
• Suppose you can invest $100 in a bank account
paying 5% interest per year forever
• At the end of the year you’ll have $105 in the bank −
your original $100 plus $5 in interest

• Suppose you withdraw the $5 and reinvest the $100
for another year
• By doing this year after year, you can withdraw $5
every year in perpetuity:

• To generalize, suppose we invest an amount P at an
interest rate r
• Every year we can withdraw the interest we earned,
C = r × P, leaving P in the bank
• Because the cost to create the perpetuity is the
investment of principal, P, the value of receiving C in
perpetuity is the upfront cost, P
• Rearranging C = r × P to solve for P, we have P = C
r

Present Value of a Perpetuity
C
PV C in Perpetuity  
r

Example 4.3 Endowing a
Perpetuity (1 of 3)
Problem
• You want to endow an annual graduation party at your
alma mater. You want the event to be memorable, so
you budget $30,000 per year forever for the party. If
the university earns 8% per year on its investments,
and if the first party is in one year’s time, how much
will you need to donate to endow the party?

Perpetuity (2 of 3)
Solution
Plan
• The timeline of the cash flows you want to provide is:
• This is a standard perpetuity of $30,000 per year. The

funding you would need to give the university in perpetuity
is the present value of this cash flow stream.

Perpetuity (3 of 3)
Execute
• Use the formula for a perpetuity:
C
PV  ,
r
$30,000
  $375,000 today
0.08
Evaluate
• If you donate $375,000 today, and if the university invests
it at 8% per year forever, then the graduates will have
$30,000 every year to fund their graduation party.
Example 4.3a Endowing a
Perpetuity (1 of 4)
Problem:
• You just won the lottery, and you want to endow a
professorship at your alma mater.
• You are willing to donate $4 million of your winnings
for this purpose.
• If the university earns 5% per year on its investments,
and the professor will be receiving her first payment in
one year, how much will the endowment pay her each
year?

Perpetuity (2 of 4)
Solution:
Plan:
• The timeline of the cash flows you want to provide is:
• This is a standard perpetuity. The amount she can

withdraw each year and keep the principal intact is the
cash flow when solving equation 4.4.
Perpetuity (3 of 4)
Execute:
• From the formula for a perpetuity,
C
PV  , so C  PV  r
r
C  $4,000,000  .05  $200,000

Perpetuity (4 of 4)
Evaluate:
• If you donate $4,000,000 today, and if the university
invests it at 5% per year forever, then the chosen
professor will receive $200,000 every year.

4.3 Annuities (1 of 8)
• Annuities
– An annuity is a stream consisting of a fixed number of
equal cash flows paid at regular interval
– The difference between an annuity and a perpetuity is

that an annuity ends after some fixed number of
payments

Present Value of An Annuity
• Note that, just as with the perpetuity, we assume the
first payment takes place one period from today
C C C C
PV =    ......
(1  r) (1  r)2 (1  r)3 (1  r)N
• To find a simpler formula, use the same approach as

we did with a perpetuity: create your own annuity

• With an initial $100 investment at 5% interest, you can
create a 20-year annuity of $5 per year, plus you will
receive an extra $100 when you close the account at
the end of 20 years:

• The Law of One Price tells us that because it only
took an initial investment of $100 to create the cash
flows on the timeline, the present value of these cash
flows is $100:
$100  PV  20  year annuity of $5 per year   PV $100 in 20 years 

• Rearranging:
PV  20  year annuity of $5 per year   $100  PV $100 in 20 years 

100
 100 
1.05 
20
 $100  $37.69  $62.31

• We usually want to know the PV as a function of C, r,
and N
• Since C can be written as $100(0.05) = $5, we can
further re-arrange:

In general:
1  1 
PV  Annuity of C for N periods with Interest Rate r   C  1  
r  1  r N 
 

Lottery Prize Annuity (1 of 7)
Problem
• You are the lucky winner of a $30 million state lottery.
You can take your prize money either as (a) 30
payments of $1 million per year (starting today), or (b)
$15 million paid today. If the interest rate is 8%, which
option should you choose?

Solution
Plan
• Option (a) provides $30 million in prize money but paid
over time. To evaluate it correctly, we must convert it to a
present value. Here is the timeline:

• Because the first payment starts today, the last
payment will occur in 29 years (for a total of 30
payments). The $1 million at date 0 is already stated
in present value terms, but we need to compute the
present value of the remaining payments. Fortunately,
this case looks like a 29-year annuity of $1 million per
year, so we can use the annuity formula.

Execute
• We use the annuity formula:
1  1 
PV  29  year of $1 million at 8% annual int erest   $1 million   1  
0.08  1.08 29 
 $1 million  11.16
 $11.16 million today
• Thus, the total present value of the cash flows is $1 million

+ $11.16 million = $12.16 million. In timeline form:

• Option (b), $15 million upfront, is more valuable—even

though the total amount of money paid is half that of option
(a). Financial calculators or Excel can handle annuities
easily—just enter the cash flow in the annuity as the PMT:

Excel Formula: PV(RATE,NPER,PMT,FV)PV(0.08,29,1000000,0)
• Both the financial calculator and Excel will give you the PV
of the 29 payments ($11,158,406, or 11.16 million), to
which you must add the first payment of $1 million just as
shown.
Evaluate
• The reason for the difference is the time value of money. If
you have the $15 million today, you can use $1 million
immediately and invest the remaining $14 million at an 8%
interest rate. This strategy will give you $14 million × 8% =
$1.12 million per year in perpetuity! Alternatively, you can
spend $15 million −$11.16 million = $3.84 million today,
and invest the remaining $11.16 million, which will still
allow you to withdraw $1 million each year for the next 29
years before your account is depleted.

Example 4.4a Present Value of an
Annuity Starting Today (1 of 7)
Problem:
• Your parents have made you an offer you can’t refuse.
They’re planning to give you part of your inheritance early.
• They’ve given you a choice.
• They’ll pay you $10,000 per year for seven year (beginning
today) or they’ll give you their 2015 BMW M5 Convertible,
which you can sell for $61,000 (guaranteed) today.
• If you can earn 7% annually on your investments, which
should you choose?

Solution:
Plan:
• Option (a) provides $10,000 paid over time. To
evaluate it correctly, we must convert it to a present
value. Here is the timeline:
0 1 2 3 4 5 6
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

Plan:
• The $10,000 at date 0 is already stated in present
value terms, but we need to compute the present
value of the remaining payments.
• Fortunately, this case looks like a 6-year annuity of
$10,000 per year, so we can use the annuity formula.

Execute:
• From the formula for a annuity,
1  1 
PV (6-year annuity)  $10,000  1 
0.07  1.076 
PV (6-year annuity)  $47,665

Execute:
• Thus, the total present value of the cash flows is
$10,000 + $47,665. In timeline form:
0 1 2 3 4 5 6
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000
+$47,665
$57,665

Execute:
• Financial calculators or Excel can handle annuities
easily—just enter the cash flow in the annuity as the
PMT:
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.07,6,10000,0)

Evaluate:
• Lucky you!
• Even if you don’t want to keep it, the fact that you can
sell it for more than the annuity is worth means you’re
better off taking the BMW.

Future Value of an Annuity
FV  Annuity   PV  1  r 
N
C  1 
 1  r 
N
 1
r  1  r  
N
 
1

 C  1  r   1
r
N


Example 4.5 Retirement Savings Plan
Annuity (1 of 5)
Problem
• Ellen is 35 years old and she has decided it is time to
plan seriously for her retirement. At the end of each
year until she is 65, she will save $10,000 in a
retirement account. If the account earns 10% per year,
how much will Ellen have in her account at age 65?

Annuity (2 of 5)
Solution
Plan
• As always, we begin with a timeline. In this case, it is
helpful to keep track of both the dates and Ellen’s age:

Annuity (3 of 5)
• Ellen’s savings plan looks like an annuity of $10,000
per year for 30 years. (Hint : It is easy to become
confused when you just look at age, rather than at
both dates and age. A common error is to think there
are only 65 − 36 = 29 payments. Writing down both
dates and age avoids this problem.) To determine the
amount Ellen will have in her account at age 65, we’ll
need to compute the future value of this annuity.

Annuity (4 of 5)
Execute
1
FV  $10,000 
0.10
1.1030  1
 $10,000  164.49
 $1.645 million at age 65
Using a financial calculator or Excel:
Excel Formula: FV(RATE,NPER, PMT, PV) = FV(0.10,30,−10000,0)

Annuity (5 of 5)
Evaluate
• By investing $10,000 per year for 30 years (a total of
$300,000) and earning interest on those investments,
the compounding will allow Ellen to retire with $1.645
million.

Example 4.5a Retirement Savings
Plan Annuity (1 of 6)
Problem:
• Adam is 25 years old, and he has decided it is time to
plan seriously for his retirement.
• He will save $10,000 in a retirement account at the
end of each year until he is 45.
• At that time, he will stop paying into the account,
though he does not plan to retire until he is 65.
• If the account earns 10% per year, how much will
Adam have saved at age 65?

Solution:
Plan:
• As always, we begin with a timeline. In this case, it is
helpful to keep track of both the dates and Adam’s
age:

• Adam’s savings plan looks like an annuity of $10,000
per year for 20 years.
• The money will then remain in the account until Adam
is 65 − 20 more years.
• To determine the amount Adam will have in the bank
at age 45, we’ll need to compute the future value of
this annuity.
• Then we’ll compound the future value into the future
20 more years to see how much he’ll have at 65.

Execute:
FV  a t a ge 45  = $10,000 × 1.10 20 - 1
= $572,750
Using Financial calculators or Excel:
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.10,20, −10000,0)

Execute:
FV  a t a ge 65  = $572,750 × 1.10 20 
= $3,853,175
Using Financial calculators or Excel:
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.10,20,0, −572750)

Evaluate:
• By investing $10,000 per year for 20 years (a total of
$200,000) and earning interest on those investments,
the compounding will allow him to retire with $3.85
million.
• Even though he invested for 10 fewer years (and
$100,000 less) than Ellen did, Adam will end up with
more than twice as much money because he’s
starting his retirement plan ten years earlier than she
will.

4.4 Growing Cash Flows (1 of 5)
• A growing perpetuity is a stream of cash flows that
occur at regular intervals and grow at a constant rate
forever
• For example, a growing perpetuity with a first payment
of $100 that grows at a rate of 3% has the following
timeline:

Present Value of a Growing Perpetuity
C
PV Growing perpetuity  
r g

Example 4.6 Endowing a Growing
Perpetuity (1 of 3)
Problem
• In Example 4.3, you planned to donate money to your alma mater
to fund an annual $30,000 graduation party. Given an interest rate
of 8% per year, the required donation was the present value of:
$30,000
PV   $375,000 today
0.08
• Before accepting the money, however, the student association
has asked that you increase the donation to account for the effect
of inflation on the cost of the party in future years. Although
$30,000 is adequate for next year’s party, the students estimate
that the party’s cost will rise by 4% per year thereafter. To satisfy
their request, how much do you need to donate now?
Perpetuity (2 of 3)
Solution
Plan
• The cost of the party next year is $30,000, and the cost
then increases 4% per year forever. From the timeline, we
recognize the form of a growing perpetuity and can value it
that way.

Perpetuity (3 of 3)
Execute
• To finance the growing cost, you need to provide the
present value today of:
$30,000
PV   $750,000 today
0.08  0.04 
Evaluate
• You need to double the size of your gift!

Example 4.6a Endowing a Growing
Perpetuity (1 of 3)
Problem:
• In Example 4.3a, you planned to donate $4 million to
your alma mater to fund an endowed professorship.
• Given an interest rate of 5% per year, the professor
would be able to collect $200,000 per year from your
generosity.
• The inflation rate is expected to be 2% per year.
• How much can the professor be paid in the first year in
order to allow her annual salary to increase by 2% each
year and keep the principal intact?
Perpetuity (2 of 3)
Solution:
Plan:
• The salary needs to increase 2% per year forever.
From the timeline, we recognize the form of a growing
perpetuity and can value it that way.

Perpetuity (3 of 3)
Evaluate:
• She can only withdraw $120,000 in her first year.
CF = $4,000,000 ×( 0.05 - 0.02) = $120,000
• In the second year, her payment will be $120,000 ×

1.02 = $122,400 and the payments will continue to
increase each year.

Present Value of a Growing Annuity
• A growing annuity is a stream of N growing cash
flows, paid at regular intervals
• It is a growing perpetuity that eventually comes to an
end

• The following timeline shows a growing annuity with
initial cash flow C, growing at a rate of g every period
until period N:

• Present Value of a Growing Annuity:
1   1 g  
N
PV = C  1   
r - g   1 r  

Example 4.7 Retirement Savings with
a Growing Annuity (1 of 5)
Problem
• In Example 4.5, Ellen considered saving $10,000 per
year for her retirement. Although $10,000 is the most
she can save in the first year, she expects her salary
to increase each year so that she will be able to
increase her savings by 5% per year. With this plan, if
she earns 10% per year on her savings, how much
will Ellen have in her account at age 65?

Solution
Plan
• Her new savings plan is represented by the following
timeline:

• This example involves a 30-year growing annuity, with a
growth rate of 5%, and an initial cash flow of $10,000. We
can use Eq. 4.8 to solve for the present value of this
growing annuity. Then we can use Eq. 4.1 to calculate the
future value.

Execute
• The present value of Ellen’s growing annuity is given by
1   1.05 30 
PV = $10,000  1    
0.10 - 0.05   1.10  
 $10,000  15.0463
 $150,463 today
• Ellen’s proposed savings plan is equivalent to having
$150,463 in the bank today. To determine the amount she
will have at age 65, we need to move this amount forward
30 years:
FV = $150,463  1.10
30
 $2,625 million in 40 years

Evaluate
• Ellen will have $2.625 million at age 65 using the new
savings plan. This sum is almost $1 million more than
she had without the additional annual increases in
savings. Because she is increasing her savings
amount each year and the interest on the cumulative
increases continues to compound, her final savings is
much greater.

with a Growing Annuity (1 of 5)
Problem:
• In Example 4.5a, Adam considered saving $10,000
per year for his retirement.
• Although $10,000 is the most he can save in the first
year, he expects his salary to increase each year so
that he will be able to increase his savings by 4% per
year.
• With this plan, if he earns 10% per year on his
savings, how much will Adam have saved at age 65?

Solution:
Plan:
His new savings plan is represented by the following timeline:
This example involves a 20-year growing annuity with a

growth rate of 4% and an initial cash flow of $10,000. We
can use Eq. 4.8 to solve for the present value of a growing
annuity.

Execute:
The present value of Adam’s growing annuity is given
by:
1   1.04 20 
PV = $10,000  1    
0.10 - 0.04   1.10  
 $10,000  11.2384
 $112,384 today

Execute:
• Adam’s proposed savings plan is equivalent to having
$112,384 in the bank today. To determine the amount
he will have at age 65, we need to move this amount
forward 40 years:
FV = $112,384  1.10 40
 $5,086,416 in 40 years

Evaluate:
• Adam will have saved $5.086 million at age 65 using
the new savings plan. This sum is over $1 million
more than he had without the additional annual
increases in savings.
• Because he is increasing his savings amount each
year and the interest on the cumulative increases
continues to compound, his final savings is much
greater.

4.5 Solving for Variables Other Than
Present Value or Future Value (1 of 10)
• In some situations, we use the present and/or future
values as inputs, and solve for the variable we are
interested in.
• We examine several special cases in this section.

Solving for Cash Flows in an Annuity (Loan Payment)
P
C
1 1 
1  N 
r (1  r) 

Example 4.8 Computing a Loan
Payment (1 of 4)
Problem
• Your firm plans to buy a warehouse for $100,000. The
bank offers you a 30-year loan with equal annual
payments and an interest rate of 8% per year. The
bank requires that your firm pays 20% of the purchase
price as a down payment, so you can borrow only
$80,000. What is the annual loan payment?

Payment (2 of 4)
Solution
Plan
• We start with the timeline (from the bank’s perspective):
Using Eq. 4.9, we can solve for the loan payment, C,

given N = 30, r = 0.08, and P = $80,000.

Payment (3 of 4)
Execute
• Equation 4.9 gives the following payment (cash flow):
P 80,000
C   $7106.19
1 1  1  1 
1 1
r  (1  r )  0.08  (1.08)30 
 N  
Using a financial calculator or Excel:

Payment (4 of 4)
Excel Formula: PMT(RATE,NPER,PV,FV)PMT(0.08,30,−80000,0)

Evaluate
• Your firm will need to pay $7106.19 each year to repay the
loan. The bank is willing to accept these payments
because the PV of 30 annual payments of $7106.19 at 8%
interest rate per year is exactly equal to the $80,000 it is
giving you today.
Example 4.8a Computing a Loan
Payment (1 of 5)
Problem:
• Suppose you accept your parents’ offer of a 2007 BMW M6
convertible, but that’s not the kind of car you want.
• Instead, you sell the car for $61,000, spend $11,000 on a
used Corolla, and use the remaining $50,000 as a down
payment for a house.
• The bank offers you a 30-year loan with equal monthly
payments and an interest rate of 6% per year, and requires
a 20% down payment.
• How much can you borrow, and what will be the payment on
the loan?
Payment (2 of 5)
Solution:
Plan:
• To calculate the amount we can borrow, we need to
find out what amount $50,000 is 20% of:
$50,000  0.2  Value
$50,000
Value   $250,000
0.2
• Because you’ll be putting $50,000 down, your loan

amount will be $250,000 − $50,000 = $200,000.
Payment (3 of 5)
Solution:
Plan:
• We start with the timeline:
Note, we need to use the monthly interest rate. Since the

quoted rate is an APR, we can just divide the annual rate by 12:
0.06
r   0.005
12
Payment (4 of 5)
Execute:
• Eq. 4.8 gives the payment (cash flow) as follows:
P 200,000
C   $1,199.10
1 1  1  1 
1  1 
r  (1  r )N  0.005  (1.005)365 

Payment (5 of 5)
Execute:
• Using a financial calculator or Excel:
Excel Formula: =PMT(RATE,NPER, PV, FV) =

PMT(0.005,360,200000,0)

• Rate of Return
– The rate of return is the rate at which the present
value of the benefits exactly offsets the cost

• Suppose you have an investment opportunity that
requires a $1000 investment today and will pay $2000
in six years
• What interest rate, r, would you need so that the
present value of what you get is exactly equal to the
present value of what you give up?
2000
1000 
(1  r)6

• Rearranging:
1000  (1  r)6  2000

1
 2000  6
1 r   
 1000 
 1.1225,or
r  12.25%

• Suppose your firm needs to purchase a new forklift
• The dealer gives you two options:
1. A price for the forklift if you pay cash ($40,000)
2. The annual payments if you take out a loan from the
dealer (no money down and four annual payments of
$15,000)

• Setting the present value of the cash flows equal to
zero requires that the present value of the payments
equals the purchase price:
1 1 
40,000  15,000   1 
r  (1  r)4 
• The solution for r is the interest rate charged by the

dealer, which you can compare to the rate charged by
your bank

• There is no simple way to solve for the interest rate
• The only way to solve this equation is to guess at
values for r until you find the right one
• An easier solution is to use a financial calculator or a
spreadsheet

Excel Formula: =RATE(NPER,PMT,PV,FV)=Rate(4,-15000,40000,0)

Example 4.9 Computing the Rate of
Return with a Financial Calculator (1 of 6)
Problem
• Let’s return to the lottery prize in Example 4.4. How
high of a rate of return do you need to earn by
investing on your own in order to prefer the $15 million
payout?

Solution
Plan
• Recall that the lottery offers you the following deal: take
either (a) 30 payments of $1 million per year starting
immediately, or (b) a $15 million lump sum payment
immediately. The first option is an annuity of 29 payments
of $1 million plus an initial $1 million payment.

• We need to solve for the rate of return that makes the
two offers equivalent. Anything above that rate of
return would make the present value of the annuity
lower than the $15 million lump sum payment, and
anything below that rate of return would make it
greater than the $15 million payment.

Execute
• We set the present value of option (a) equal to option
(b), which is already in present value since it is an
immediate payment of $15 million:
1  1 

$15 million = $1 million + $1 million × 1-
r  1+ r 29 
 
1  1 

$14 million = $1 million× 1-
r  1+ r 29 
 
Using a financial calculator to solve for r :

Excel Formula: RATE(NPER,PMT,PV,FV)RATE(29,1000000,−14000000,0)
The rate of return equating the two options is 5.72%.

Evaluate
• 5.72% is the rate of return that makes giving up the
$15 million payment and taking the 30 installments of
$1 million an even trade in terms of present value. If
you could earn more than 5.72% investing on your
own, then you could take the $15 million, invest it and
generate 30 installments that are each more than $1
million. If you could not earn at least 5.72% on your
investments, you would be unable to replicate the $1
million installments on your own and would be better
off choosing the installment plan.
Example 4.9a Computing the Internal Rate
of Return with a Financial Calculator (1 of 4)
Problem:
• Let’s return to the BMW example (Example 4.4a).
• What rate of return would make you indifferent
between the car and the $10,000 per year payout
(even if the car is your favorite color and has HD
radio)?

Solution:
Plan:
• We need to solve for the rate of return that makes the
two offers equivalent.
• Anything above that rate of return would make the
present value of the annuity lower than the $61,000
car and
• Anything below that rate of return would make it
greater than the $61,000.

Execute:
Excel Formula: = RATE(NPER, PMT, PV,FV) = RATE(6,10000, − 51000,0)
The rate equating the two options is 4.85%. (Note: The

PV is −51,000 not −61,000 because the first $10,000
payment happens at date 0.)

Evaluate:
• 4.85% is the rate of return that makes giving up the
$61,000 car and taking the 7 installments of $10,000
exactly a zero NPV action.
• If you can earn more than 4.85% investing on your own,
then you can take the $61,000, invest it and generate
seven installments that are each more than $10,000.
• If you can not earn at least 4.85% on your investments,
you would be unable to replicate the $10,000 installments
on your own and would be better off taking the generous
payments your parents have offered.
• Solving for the Number of Periods
– In addition to solving for cash flows or the interest rate,
we can solve for the amount of time it will take a sum of
money to grow to a known value
– In this case, the interest rate, present value, and future
value are all known
– We need to compute how long it will take for the
present value to grow to the future value

Example 4.10 Solving for the Number
of Periods in a Savings Plan (1 of 6)
Problem
• Let’s return to your savings for a down payment on a
house. Imagine that some time has passed and you
have $10,050 saved already, and you can now afford
to save $5000 per year at the end of each year. Also,
interest rates have increased so that you now earn
7.25% per year on your savings. How long will it take
to reach your goal of $60,000?

Solution
Plan
• The timeline for this problem is:

• We need to find N so that the future value of your current
savings plus the future value of your planned additional
savings (which is an annuity) equals your desired amount.
There are two contributors to the future value: the initial
lump sum of $10,050 that will continue to earn interest,
and the annuity contributions of $5000 per year that will
earn interest as they are contributed. Thus, we need to find
the future value of the lump sum plus the future value of
the annuity.

Execute
• We can solve this problem using a financial calculator or
Excel:
Excel Formula: NPER(RATE,PMT,PV,FV)NPER(0.0725,−5000,−10050,60000)

• There is also a mathematical solution. We can calculate
the future value of the initial cash flow by using Eq. 4.1 and
the future value of the annuity using Eq. 4.6:
1
10,050  1.0725N  5000 
0.0725

1.0725N  1  60,000
Rearranging the equation to solve for N,
60,000  0.0725  5000
1.0725N   1.632
10,050  0.0725  5000
we can then solve for N :

In 1.632 
N  7 years
In 1.0725 
Evaluate
• It will take seven years to save the down payment.

Example 4.10a Solving for the Number
Problem:
• Let’s return to Ellen and Adam.
• Suppose Ellen decides she will continue working until
she has as much at retirement as her brother, Adam,
will have when he retires.
• She will continue to contribute $10,000 each year to
her retirement account.
• How much longer will she need to work to tie the
competition with her brother?

Solution:
Plan:
• The timeline for this problem is

Plan:
• We need to find N so that the FV of the $1,645,000
she’ll have at age 65 plus the $10,000 she’ll contribute
each year is equal to $3,850,000.
• Remember, she’s earning 10% on her investments.

Execute:
Excel Formula: =NPER(RATE,PMT, PV, FV) =

NPER(0.10,−10000,−1645000,3850000)

Evaluate:
1
• Ellen will have to work until 73 years old.
2
she’s

4.6 Non-Annual Cash Flows
• Everything we have learned about annual cash flow
streams applies to monthly cash flow streams as long
as:
1. The interest rate is specified as a monthly rate
2. The Number of periods is express in months

Example 4.11 Evaluating an Annuity
with Monthly Cash Flows (1 of 4)
Problem
• You are about to purchase a new car and have two
payment options. You can pay $20,000 in cash
immediately, or you can get a loan that requires you to
pay $500 each month for the next 48 months (four
years). If the monthly interest rate you earn on your
cash is 0.5%, which option should you choose?

Solution
• Let’s start by writing down the timeline of the loan
payments:

The timeline shows that the loan is a 48-period annuity.
Using the annuity formula, the present value is
1  1 
PV  48  period annuity of $500   $500   1  
0.005  1.00548 
 $21,290
Alternatively, we may use the annuity spreadsheet to

solve the problem:

Excel Formula: PV(0.005,48,500,0)
Evaluate
• Thus, taking the loan is equivalent to paying $21,290
today, which is costlier than paying cash. You should
pay cash for the car.

Example 4.11a Evaluating an Annuity
with Weekly Cash Flows (1 of 4)
Problem:
• You have just won the Publisher’s Clearing House
drawing and you have two payment options.
• You can receive a $5,000 a week for next 75 years or
you can receive a lump sum of $5,000,000.
• If the weekly interest rate you can earn is 0.096%,
which option should you choose?

Solution:
• The timeline for this problem is
Week 0 1 2 3 4 5 3,900
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000
• Using the annuity formula, the present value is:

1  1 
PV (3,900  period annuity of $5,000)=$5,000  1  3,900 
 $5,084,886
0.00096  1.00096 

Solution:
• Alternatively, we may use the annuity spreadsheet to
solve the problem:
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.00096,3900,5000,0)

Evaluate:
• Taking the weekly payments is equivalent to receiving
$5,084,866 today, which is more than receiving the
lump sum.
• Thus, you should take the weekly payments.

Chapter Quiz
1. How do you calculate the present value of a cash flow
stream?
2. What is the intuition behind the fact that an infinite stream of
cash flows has a finite present value?
3. What are some examples of annuities?
4. What is the difference between an annuity and a perpetuity?
5. What is an example of a growing perpetuity?
6. How do you calculate the cash flow of an annuity?
7. How do you calculate the rate of return on an investment?

CH04 PPT

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH04 PPT

Uploaded by

Copyright:

Available Formats

Fundamentals of Corporate Finance

Fourth Edition, Global Edition

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

– Rule 3: To calculate the present value of a future cash

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• We compute the present value of this cash flow

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• This timeline provides the general formula for the

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

5000 8000 8000 8000

 4716.98  7119.97  6716.95  6336.75

2. To verify our answer, suppose your uncle kept his

We get the same answer both ways (within a penny, which is

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• She should be willing to give you an amount equal to

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

 $69.65  $84.16  $83.74  $88.22  $87.78  $87.35

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

FV = $500.90  1.005   $516.11 in 6 months

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Excel Formula: = FV(0.08,15,0,-20000)

• Notice that PV (the amount we’re putting in to the bank)is

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• Let’s solve this problem in a different way than we did in

• Saving $2735.54 today is equivalent to saving $1000 per

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

$1,000 $1,000 $1,000 ?

• Next, we’ll compute the present value of the cash

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

– the first cash flow does not occur immediately; it

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• Notice that all the cash flows are the same

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• This is a standard perpetuity of $30,000 per year. The

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• This is a standard perpetuity. The amount she can

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.