Graduate School of Business Administration 548 - Corporation Finance MBA.

PM
Spring 2012 Semester - J. K. Dietrich
Present Value Analysis and Formulas
(1) Any single future cash flow can be discounted or its present value calculated using
the general formula (Text, p. 98):
. Example:
8384 $.
) 0316 . 1 (
1 $
PV
665 . 5

+

A U.S. Treasury strip (zero-coupon bond) yielding (2/18/03)

3.16% maturing in November 2008 (T=5.665) has a present
value of $. 8384 (actual price = 83:17 = .8353). You can
use a calculator or Excel to calculate this answer.
(2) The present value of any sequence of future cash flows can be discounted or its
present value calculated using the general formula (Text, p. 101, without initial cost):
Example:
A mortgage-backed bond is expected to pay $1220 in year one, $1500 in year two,
$1720 in year 3, $1550 in year 4, and $1200 and is priced to yield (2/18/03) 250
basis points over the 5-year Treasury, or 2.90%+2.50% = 5.40% = .054. The
present value is $6,155.15
(3) If a cash flow is paid annually (or periodically) forever then the present value of the
payments can be calculated using the perpetuity formula (Text, p. 110):

Example:
Duke Energy 6.375%A preferred ($25 par) pays $.3944 dividend
per quarter yielding 6.22% or 1.555% = .01555 per quarter.
Graphical representation of perpetuity cash flows:
[2/24/2012]
C
a
s
h

F
l
o
w
0
Time
T
T
) r 1 (
C
PV
+

r
C
PV
Single Cash Flow
Sequence of Cash Flows
Perpetuity
15 . 155 , 6 $
) 054 . 1 (
1200 $
) 054 . 1 (
1550 $
) 054 . 1 (
1720 $
) 054 . 1 (
1500 $
) 054 . 1 (
1220 $
PV
5 4 3 2 1

+
+
+
+
+
+
+
+
+

62 . 25 $
01555 .
39844 $.
PV

+
+ +
+
+
+
+
+

T t
1 t
i
i
T
T
3
3
2
2
1
1
) r 1 (
C
) r 1 (
C
) r 1 (
C
) r 1 (
C
) r 1 (
C
PV
(4) If you can assume that a beginning (first period) cash flow will grow after the first
period at a constant rate g, the present value of the cash flows can be calculated using the
growing perpetuity formula (Text, p. 108):
Example:
A building has first-month after tax cash flow (rental income net of
operating costs) of $10,500 and are expected to increase at the
assumed annual inflation rate of 2%, while real estate is currently
being capitalized at 10%, yielding a value of $1.5 million.
Graphical representation of cash flows for a growing perpetuity:
(5) If a cash flow is paid annually (or periodically) for T periods the present value of the
payments can be calculated using the annuity formula (Text, p. 111):
Example:

You require $10,000 per year at the end of each year for
tuition and have a savings account paying 2.5% = .025
interest. You must have $37,620 in the account one-year
before first payment is due.
(6) If you can assume that a beginning (first period) cash flow will grow after the first
period at a constant rate g for T periods, the present value of the cash flows can be
calculated using the growing annuity formula (Text, p. 115):

Example:
You plan to start saving $2,000 next year expecting
an 8% = .08 return and you plan that your annual
saving will grow at 2.5% = .025 after the first year.
Graphical representation of annuity and growing annuity:
Graduate School of Business Administration 548 - Corporation Finance MBA.PM
[2/24/2012]
0
Time
C
a
s
h

F
l
o
w
1
]
1

+

T
) r 1 ( r
1
r
1
C PV
1
1
]
1

,
_

+
+

T
r 1
g 1
x
g r
1
g r
1
C PV
0
C
a
s
h

F
l
o
w
Time
T
620 , 37 $
) 025 . 1 ( 025 .
1
025 .
1
000 , 10 $ PV
4

1
]
1

+

000 , 575 , 1 $
12 / ) 02 . 10 (.
500 , 10 $
PV

g r
C
PV

1
1
]
1

,
_

+
+

25
08 . 1
025 . 1
x
025 . 08 .
1
025 . 08 .
1
000 , 2 $ PV
520 , 26 $ PV
Growing Perpetuity
Annuity
Growing Annuity
Annuity
Spring 2012 Semester - J. K. Dietrich
Summary of Present Value Formulas
.
.
GENERAL FORMULAS


.
PERPETUAL CASH FLOWS FOR QUICK CALCULATIONS


CASH FLOWS OVER LIMITED TIME HORIZON PRACTICAL


[2/24/2012]
0
Time
C
a
s
h

F
l
o
w
1
]
1

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T
) r 1 ( r
1
r
1
C PV
1
1
]
1

,
_

+
+

T
r 1
g 1
x
g r
1
g r
1
C PV
0
C
a
s
h

F
l
o
w
Time
T
T
T
) r 1 (
C
PV
+

r
C
PV
g r
C
PV

Single Cash Flow

Perpetuity
Growing Perpetuity
Annuity
Growing Annuity
Annuity

+
+ +
+
+
+
+
+

T t
1 t
i
i
T
T
3
3
2
2
1
1
) r 1 (
C
) r 1 (
C
) r 1 (
C
) r 1 (
C
) r 1 (
C
PV
Growing Annuity
C
a
s
h

F
l
o
w
0
Sequence of Cash Flows