Chapter 6

Discounted Cash Flow

Valuation

1
Annual Percentage Rate (APR)
• Annual Percentage Rate is the annual rate that is
quoted by law

• Effective Annual Rate (EAR) actual rate accounts 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.

2
 EAR - Formula

Remember that the APR is the quoted rate

m is the number of compounding periods per year

3
 Decisions
• You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays 5.3%
with semiannual compounding. Which account should
you use?
– First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
– Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
• Which account should you choose and why?

4
 Amortized Loan

• Suppose a business takes out a $5,000, five-

year loan at 9 percent. The loan agreement
calls for the borrower to pay the interest on the
loan balance each year and to reduce the loan
balance each year by $1,000.

• Interest in the first year will be $5,000 multiply

by .09 equals $450. The total payment will be
$1,000 plus 450 equals $1,450.

5
 Amortized Loan-First Type
• In the second year, the loan balance is
$4,000, so the interest is $4,000 multiply
by .09 equals $360,

6
 Amortized Loan – Second Type

Suppose in second type of loan, the loan agreement calls for the borrower to
pay equal amount

7
Amortized Loan – Second Type (Continued)

The interest in the second year is $4,164.54*0.09= $374.81

The interest in the third year is 3,253* 0.09= 292.85