T6.

1 Chapter Outline

Discounted Cash Flow Valuation
Chapter Organization
6.1 Future and Present Values of Multiple Cash Flows
6.2 Valuing Level Cash Flows: Annuities and Perpetuities
6.3 Comparing Rates: The Effect of Compounding
6.4 Loan Types and Loan Amortization
6.5 Summary and Conclusions
M ZAHID KHAN
T6.1 Chapter Outline

Discounted Cash Flow Valuation
FUTURE VALUE WITH MULTIPLE CASH FLOW:
So far we have restricted our attention to either the cash
flow of a lump-sum present amount or the present value of
some single future cash flows. In this section , we begin to
study ways to value multiple cash flows.
M ZAHID KHAN
T6.1 Chapter Outline

Discounted Cash Flow Valuation
FUTURE VALUE WITH MULTIPLE CASH FLOW:
Suppose that you have deposited 100 today in account
paying 8 % . In one Year , you will be deposited another
100. How much you will paid in two years?
208*1.08=224.64
M ZAHID KHAN
T6.1 Chapter Outline

Discounted Cash Flow Valuation
FUTURE VALUE WITH MULTIPLE CASH FLOW:
There are two ways to calculate the future values for Multiple cash
Flows:
1 Compound the accumulated balance forward one year at a
time
2 Calculate the future value of each cash flow first and then
add these up.
M ZAHID KHAN
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 5
T6.2 Future Value Calculated (Fig. 6.3-6.4)
Future value calculated by compounding forward one period at a time
Future value calculated by compounding each cash flow separately
T6.1 Chapter Outline

Discounted Cash Flow Valuation
FUTURE VALUE WITH MULTIPLE CASH FLOW:
If you deposit 100$ in one Year.200$ in two year ,and 300$ in
three year . How much will you have in three years ? How much
of this interest ? How much will you have in five year if you dont
have additional amounts? Assume 7 percent interest rate
through out?
M ZAHID KHAN
T6.1 DCFM

Discounted Cash Flow Valuation:

FUTURE VALUE WITH MULTIPLE CASH FLOW:
If you deposit 100$ in one Year.200$ in two year ,and 300$ in
three year . How much will you have in three years ? How much
of this interest ? How much will you have in five year if you dont
have additional amounts? Assume 7 percent interest rate
through out?
Ans: 100$ * 1.07^2 = 114.49$
200$ * 1.07 = 214.00
300$ * = 300.00
628.49

Future Value = 628.49-( 100+200+300)= 28.49

M ZAHID KHAN
T6. DCFM

Discounted Cash Flow Valuation:

FUTURE VALUE WITH MULTIPLE CASH FLOW:

Ans: 100$ * 1.07 = 114.49$
200$ * 1.07 = 214.00
300$ * = 300.00
628.49
Future Value = 628.49-( 100+200+300)= 28.49

5 Years amount ?
We know we have 628.49*1.07^2 = 628.49*1.1449=719.56

M ZAHID KHAN
T6.1 Chapter Outline

Discounted Cash Flow Valuation

PRESENT VALUE WITH MULTIPLE CASH FLOW:

There are 2 ways :

We can either discount back one period at a time

We can calculate the present values individually and then add
them up.
M ZAHID KHAN
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 10
T6.3 Present Value Calculated (Fig 6.5-6.6)
Present value
calculated by
discounting each
cash flow separately
Present value
calculated by
discounting back one
period at a time
T6.1 Chapter Outline

Discounted Cash Flow Valuation

PRESENT VALUE WITH MULTIPLE CASH FLOW:

Suppose you need 1,000$ in one year and 2000$ more in two
years . If we can earn 9 % on your money , how much do you
have to put up today to exactly cover these amount in the future
? In other words , what is the present value of the cash flows at
9%?
M ZAHID KHAN
T6.1 DCFM PV MULTIPLE CF
Discounted Cash Flow Valuation:

PRESENT VALUE WITH MULTIPLE CASH FLOW:

Suppose you need 1,000$ in one year and 2000$ more in two
years . If we can earn 9 % on your money , how much do you
have to put up today to exactly cover these amount in the future
? In other words , what is the present value of the cash flows at
9%?
The PV of 2000 in two yrs at 9% is :
2000/1.09^2 = 1,683.36
The PV of 1000 in one yrs at 9% is :
1000/1.09=917.43
Total 1683.36+917.43=2600.79
To checking :
2600.79*1.09=2834.86 almost 3000

M ZAHID KHAN
T6.1 Chapter Outline

ANNUITIES AND PERPETUTIES :
A series of constant , or level , cash flows that occur at the end of
each period for some fixed number of years, is called ordinary
annuity or more correctly , the cash flows are said to in ordinary
annuity form.
Present value of an annuity of C $ per period for t period when
the rate of return , or the interest rate , is r is given by:
Annuity present Value = C * ( 1- Present Value Factor / r)
= C * ( 1- (1-(1/1+r) ^ t ) / r
Notice that 1 / 1+r ^ t is the same present value Interest factor.
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 14
T6.10 Summary of Annuity and Perpetuity Calculations (Table 6.2)
I. Symbols
PV = Present value, what future cash flows bring today
FV
t
= Future value, what cash flows are worth in the future
r = Interest rate, rate of return, or discount rate per period
t = Number of time periods
C = Cash amount
II. FV of C per period for t periods at r percent per period:
FV
t
= C {[(1 + r )
t
- 1]/r}
III. PV of C per period for t periods at r percent per period:
PV = C {1 - [1/(1 + r )
t
]}/r
IV. PV of a perpetuity of C per period:
PV = C/r

( )
r
r
C PV
t
)
`

=
1
1
1
( ) { }
r
r
C FV
t
t
1 1 +
=
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 15
T6.5 Annuities and Perpetuities -- Basic Formulas
Annuity Present Value
PV = C {1 - [1/(1 + r )
t
]}/r

Annuity Future Value
FV
t
= C {[(1 + r )
t
- 1]/r}

Perpetuity Present Value

PV = C/r

The formulas above are the basis of many of the calculations
in Corporate Finance. It will be worthwhile to keep them in
mind!

( )
r
r
C PV
t
)
`

=
1
1
1
( ) { }
r
r
C FV
t
t
1 1 +
=
Examples: Annuity Present
Value (continued

PRESENT VALUE FOE ANNUITY CASH FLOWS:
Suppose an Asset that promised to pay 500 $ at the end of each
of the nest three years. The cash flow from this asset of a three
years is Ordinary annuity . If would like to earn 10% on our
money , how much we offer for this annuity?

Present Value Factor=

=1/1.1^3 = 1/1.331 =.75131

To calculate the Annuity Present Value Factor=
= (1 - Present Value Factor) / r
= (1 - .75131) / .10
= .248685 / .10 = 2.48685
The Present value of our Annuity is then :
Annuity Present Value = 500 * 2.48685 = 1,243.43



M ZAHID KHAN
( )
r
r
C PV
t
)
`

=
1
1
1
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 17
T6.6 Examples: Annuity Present Value
Annuity Present Value
Suppose you need $20,000 each year for the next three
years to make your tuition payments.
Assume you need the first $20,000 in exactly one year.
Suppose you can place your money in a savings
account yielding 8% compounded annually. How much
do you need to have in the account today?
(Note: Ignore taxes, and keep in mind that you dont
want any funds to be left in the account after the third
withdrawal, nor do you want to run short of money.)
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 18
T6.6 Examples: Annuity Present Value (continued)
Annuity Present Value - Solution
Here we know the periodic cash flows are $20,000
each. Using the most basic approach:
PV = $20,000/1.08 + $20,000/1.08
2
+ $20,000/1.08
3
= $18,518.52 + $_______ + $15,876.65
= $51,541.94
Heres a shortcut method for solving the problem using the
annuity present value factor:
PV = $20,000 [____________]/__________
= $20,000 2.577097
= $________________
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 19
T6.6 Examples: Annuity Present Value (continued)
Annuity Present Value - Solution
Here we know the periodic cash flows are $20,000
each. Using the most basic approach:
PV = $20,000/1.08 + $20,000/1.08
2
+ $20,000/1.08
3
= $18,518.52 + $17,146.77 + $15,876.65
= $51,541.94
Heres a shortcut method for solving the problem using the
annuity present value factor:
PV = $20,000 [1 - 1/(1.08)
3
]/.08
= $20,000 2.577097
= $51,541.94
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 20
T6.6 Examples: Annuity Present Value (continued)
Annuity Present Value
Lets continue our tuition problem.
Assume the same facts apply, but that you can only
earn 4% compounded annually. Now how much do you
need to have in the account today?

Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 21
T6.6 Examples: Annuity Present Value (concluded)
Annuity Present Value - Solution
Again we know the periodic cash flows are $20,000
each. Using the basic approach:
PV = $20,000/1.04 + $20,000/1.04
2
+ $20,000/1.04
3
= $19,230.77 + $18,491.12 + $17,779.93
= $55,501.82
Heres a shortcut method for solving the problem using the
annuity present value factor:
PV = $20,000 [1 - 1/(1.04)
3
]/.04
= $20,000 2.775091
= $55,501.82
PER AND ANNUITY

FINDING THE PAYMENT:
Finding C;
Suppose you wish to start up a new Business , You need to
borrow 100,000. You want to make 5 equal installment and the
interest rate is 5 percent.

Present Value = 100,000/=
Annuity Present Value =

100,000 = C * ( 1 Present Value Factor) / r
100,000 = c * (1 1/ 1.18^ 5 ) / .18
100,000 = C * ( 1 - .4371 ) / .18
100,000 = C * 3.1272
C = 100,000 / 3.1272 = 31,978
Just under 32,000/=



M ZAHID KHAN
( )
r
r
C PV
t
)
`

=
1
1
1
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 23
T6.4 Chapter 6 Quick Quiz: Part 1 of 5 (concluded)

Example: Finding C
Q. You want to buy a Mazda Miata to go cruising. It costs $25,000.
With a 10% down payment, the bank will loan you the rest at
12% per year (1% per month) for 60 months. What will your monthly
payment be?
A. You will borrow .90 $25,000 = $22,500 . This is the amount today, so
its the present value. The rate is 1%, and there are 60 periods:

$ 22,500 = C {1 - (1/(1.01)
60
}/.01
= C {1 - .55045}/.01
= C 44.955
C = $22,500/44.955
C = $500.50 per month
PER AND ANNUITY

FINDING THE RATE :
Suppose that Insurance Co offer to pay you 1,000/= per year for
10 yrs if you pay 6,710 up front . What rate is implicit in this for
10 yrs.

Present Value = 6,710/=
Cash Flows = 1,000/= per years
6,710 = 1,000 * ( 1 Present Value Factor) / r
(6,710 / 1000 ) =6.71 = 1- Present Value Factor / r

If you look across the row 10 periods in Table A.3 . You will see a
factor of 6.7101 for 8 percent , so we are right away that
insurance co is just offering 8 %
Or Just Use TRIAL AND ERROR
M ZAHID KHAN
( )
r
r
C PV
t
)
`

=
1
1
1
PER AND ANNUITY

FUTURE VALUE OF ANNUITIES:
There are Future Value Factor for annuities as well as present
factor.
The Future Value Factor of Annuity is :

Annuity FV Factor = ( Future Value Factor 1) / r
= ( ( 1 + r ) ^ t - 1) / r
Suppose you plan to Contribute 2,000 per yr into the retirement
account paying 8 % . If you retire in 30 yrs , how much will you
have ?
Annuity FV Factor = ( Future Value Factor 1) / r
= (1.08 ^ 30 1) / .08
= (10.0627 1) / .08
= 113.2832
Thus the FV of this 30 yrs , 2000 annuity is :
Annuity Future Value = 2,000 * 113.2832
= 226,566.40


M ZAHID KHAN
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 26
T6.7 Chapter 6 Quick Quiz -- Part 2 of 5
Example 2: Finding C
21-year old could accumulate $1 million by age 65 by investing
$15,091 today and letting it earn interest (at 10%compounded
annually) for 44 years.
Now, rather than plunking down $15,091 in one chunk, suppose
she would rather invest smaller amounts annually to accumulate
the million. If the first deposit is made in one year, and deposits
will continue through age 65, how large must they be?
Set this up as a FV problem:
$1,000,000 = C [(1.10)
44
- 1]/.10
C = $1,000,000/652.6408 = $1,532.24
Becoming a millionaire just got easier!
( ) { }
r
r
C FV
t
t
1 1 +
=
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 27
T6.8 Example: Annuity Future Value
Previously we found that, if one begins saving at age 21,
accumulating $1 million by age 65 requires saving only
$1,532.24 per year.
Unfortunately, most people dont start saving for retirement
that early in life. (Many dont start at all!)
Suppose Bill just turned 40 and has decided its time to get
serious about saving. Assuming that he wishes to accumulate
$1 million by age 65, he can earn 10% compounded annually,
and will begin making equal annual deposits in one year and
make the last one at age 65, how much must each deposit be?
Setup: $1 million = C [(1.10)
25
- 1]/.10
Solve for C: C = $1 million/98.34706 = $10,168.07
By waiting, Bill has to set aside over six times as much money
each year!
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 28
T6.9 Chapter 6 Quick Quiz -- Part 3 of 5
Consider Bills retirement plans one more time.
Again assume he just turned 40, but, recognizing that he has
a lot of time to make up for, he decides to invest in some
high-risk ventures that may yield 20% annually. (Or he may
lose his money completely!) Anyway, assuming that Bill still
wishes to accumulate $1 million by age 65, and will begin
making equal annual deposits in one year and make the last
one at age 65, now how much must each deposit be?
Setup: $1 million = C [(1.20)
25
- 1]/.20
Solve for C: C = $1 million/471.98108 = $2,118.73
So Bill can catch up, but only if he can earn a much higher
return (which will probably require taking a lot more risk!).
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 29
T6.10 Summary of Annuity and Perpetuity Calculations (Table 6.2)
I. Symbols
PV = Present value, what future cash flows bring today
FV
t
= Future value, what cash flows are worth in the future
r = Interest rate, rate of return, or discount rate per period
t = Number of time periods
C = Cash amount
II. FV of C per period for t periods at r percent per period:
FV
t
= C {[(1 + r )
t
- 1]/r}
III. PV of C per period for t periods at r percent per period:
PV = C {1 - [1/(1 + r )
t
]}/r
IV. PV of a perpetuity of C per period:
PV = C/r

( )
r
r
C PV
t
)
`

=
1
1
1
( ) { }
r
r
C FV
t
t
1 1 +
=
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 30
T6.11 Perpetuity:
An important special case of an annuity arises when the level
stream of cash flows continuous forever, since the cash
flows are perpetual. Perpetuities are also called console.
Since a perpetuity has a infinite number of cash flows , we
obviously cant compute its value by discounting each one.
Fortunately , valuing a perpetuity turn out be the easiest possible
case.
The PV of Perpetuity is simply = C/r
Example :
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 31
T6.11 Example: Perpetuity Calculations
Suppose we expect to receive $1000 at the end of each of the
next 5 years. Our opportunity rate is 6%. What is the value
today of this set of cash flows?
PV = $1000 {1 - 1/(1.06)
5
}/.06
= $1000 {1 - .74726}/.06
= $1000 4.212364
= $4212.36
Now suppose the cash flow is $1000 per year forever. This is
called a perpetuity. And the PV is easy to calculate:
PV = C/r = $1000/.06 = $16,666.66
So, payments in years 6 thru have a total PV of $12,454.30!
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 32
T6.12 Chapter 6 Quick Quiz -- Part 4 of 5
Consider the following questions.
The present value of a perpetual cash flow stream has a finite value
(as long as the discount rate, r, is greater than 0). Heres a question
for you: How can an infinite number of cash payments have a finite
value?
Heres an example related to the question above. Suppose you are
considering the purchase of a perpetual bond. The issuer of the
bond promises to pay the holder $100 per year forever. If your
opportunity rate is 10%, what is the most you would pay for the bond
today?
One more question: Assume you are offered a bond identical to the
one described above, but with a life of 50 years. What is the
difference in value between the 50-year bond and the perpetual
bond?
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 33
T6.12 Solution to Chapter 6 Quick Quiz -- Part 4 of 5
An infinite number of cash payments has a finite present
value is because the present values of the cash flows in the
distant future become infinitesimally small.
The value today of the perpetual bond = $100/.10 = $1,000.
Using Table A.3, the value of the 50-year bond equals
$100 9.9148 = $991.48
So what is the present value of payments 51 through infinity
(also an infinite stream)?
Since the perpetual bond has a PV of $1,000 and the
otherwise identical 50-year bond has a PV of $991.48, the
value today of payments 51 through infinity must be
$1,000 - 991.48 = $8.52 (!)
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 34
T6.13 Compounding Periods, EARs, and APRs
Compounding Number of times Effective
period compounded annual rate
Year 1 10.00000%
Quarter 4 10.38129
Month 12 10.47131
Week 52 10.50648
Day 365 10.51558
Hour 8,760 10.51703
Minute 525,600 10.51709
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 35
T6.13 Compounding Periods, EARs, and APRs
Compounding Number of times Effective
period compounded annual rate
Quarter 4 10.38129
10 PERCENT COMPOUND QUARTERLY
10 % OR .10 /4 = .025 OR 2.5 % PER QUARTER
1 $ Investment for 4 qtr
1*1.025^ 4= 1.103812891 $
The EAR is 10.38122 PERCENT

Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 36
T6.13 Compounding Periods, EARs, and APRs (continued)
EARs and APRs
Q. If a rate is quoted at 16%, compounded semiannually,
then the actual rate is 8% per six months. Is 8% per six
months the same as 16% per year?
A. If you invest $1000 for one year at 16%, then youll
have $1160 at the end of the year. If you invest at
8% per period for two periods, youll have
FV = $1000 (1.08)
2
= $1000 1.1664
= $1166.40,
or $6.40 more. Why? What rate per year is the
same as 8% per six months?
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 37
T6.13 Compounding Periods, EARs, and APRs (concluded)
The Effective Annual Rate (EAR) is _____%. The 16%
compounded semiannually is the quoted or stated rate,
not the effective rate.
By law, in consumer lending, the rate that must be quoted
on a loan agreement is equal to the rate per period
multiplied by the number of periods. This rate is called the
_________________ (____).
Q. A bank charges 1% per month on car loans. What is the
APR? What is the EAR?
A. The APR is __ __ = ___%. The EAR is:
EAR = _________ - 1 = 1.126825 - 1 = 12.6825%

Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 38
T6.13 Compounding Periods, EARs, and APRs (concluded)
The Effective Annual Rate (EAR) is 16.64%. The 16%
compounded semiannually is the quoted or stated rate,
not the effective rate.
By law, in consumer lending, the rate that must be quoted
on a loan agreement is equal to the rate per period
multiplied by the number of periods. This rate is called the
Annual Percentage Rate (APR).
Q. A bank charges 1% per month on car loans. What is the
APR? What is the EAR?
A. The APR is 1% 12 = 12%. The EAR is:
EAR = (1.01)
12
- 1 = 1.126825 - 1 = 12.6825%
The APR is thus a quoted rate, not an effective rate!
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 39
T6.13 AMORTIZED LOAN
The process of paying off a loan by making regular
principal reductions is called amortizing loan.

Suppose you take out a loan of 5000/= 5 yrs loan at 9% .
The loan agreement call for a borrower to pay interest on
the loan balance each year and to reduce the loan balance
each year by 1000 . Since the loan is declined by 1000 each
year it will be paid in 5 yrs completely ?
Make the Amortization Schedule ?
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 40
T6.13 AMORTIZED LOAN
Suppose you take out a loan of 5000/= 5 yrs loan at 9% .
The loan agreement call for a borrower to pay interest on
the loan balance each year and to reduce the loan balance
each year by 1000 . Since the loan is declined by 1000 each
year it will be paid in 5 yrs completely ?
Make the Amortization Schedule ?
1
st
Year Interest = 5000*.09 = 450
Total Payment = 1000+450=1450
2
nd
Year Interest = 4000*.09=360
Total Payment 2
nd
Year = 1000+360=1360
Since the Principal amount is declining the Interest
Charges are declining each year.
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 41
T6.14 Example: Amortization Schedule - Fixed Principal
Beginning Total Interest Principal Ending
Year Balance Payment Paid Paid Balance
1 $5,000 $1,450 $450 $1,000 $4,000
2 4,000 1,360 360 1,000 3,000
3 3,000 1,270 270 1,000 2,000
4 2,000 1,180 180 1,000 1,000
5 1,000 1,090 90 1,000 0
Totals $6,350 $1,350 $5,000
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 42
T6.13 AMORTIZED LOAN FIXED PAYMENT
The Most common way of amortizating a loan is to have
the borrower make a single , fixed payment every period.
Suppose our 5 yrs , 9 % , 5000 loan was amortized this way
5000 = C*(1 -1/1.09^5) / .09
= c* (1 1-.6499) / .09
C= 5000 / 3.8897
= 1285.46
The Interest is = 450 ( from the previous sheet)
1285-450= 835.46 ( The Principal amount )
450+835.46=1285.46
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 43
T6.15 Example: Amortization Schedule - Fixed Payments
Beginning Total Interest Principal Ending
Year Balance Payment Paid Paid Balance
1 $5,000.00 $1,285.46 $ 450.00 $ 835.46 $4,164.54
2 4,164.54 1,285.46 374.81 910.65 3,253.88
3 3,253.88 1,285.46 292.85 992.61 2,261.27
4 2,261.27 1,285.46 203.51 1,081.95 1,179.32
5 1,179.32 1,285.46 106.14 1,179.32 0.00
Totals $6,427.30 $1,427.31 $5,000.00
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 44
How to lie, cheat, and steal with interest rates:
RIPOV RETAILING
Going out for business sale!
$1,000 instant credit!
12% simple interest!
Three years to pay!
Low, low monthly payments!
T6.16 Chapter 6 Quick Quiz -- Part 5 of 5
Assume you buy $1,000 worth of furniture
from this store and agree to the above credit
terms. What is the APR of this loan? The
EAR?
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 45
T6.16 Solution to Chapter 6 Quick Quiz -- Part 5 of 5 (concluded)
Your payment is calculated as:
1. Borrow $1,000 today at 12% per year for three years, you
will owe $1,000 + $1000(.12)(3)

= $1,360.
2. To make it easy on you, make 36 low, low payments of
$1,360/36 = $37.78.
3. Is this a 12% loan?
$1,000 = $37.78 x (1 - 1/(1 + r )
36
)/r
r = 1.767% per month
APR = 12(1.767%) = 21.204%
EAR = 1.01767
12
- 1 = 23.39% (!)
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 46
T6.17 Solution to Problem 6.10
Seinfelds Life Insurance Co. is trying to sell you an
investment policy that will pay you and your heirs $1,000
per year forever. If the required return on this investment is
12 percent, how much will you pay for the policy?
The present value of a perpetuity equals C/r. So, the most a
rational buyer would pay for the promised cash flows is
C/r = $1,000/.12 = $8,333.33
Notice: $8,333.33 is the amount which, invested at 12%,
would throw off cash flows of $1,000 per year forever.
(That is, $8,333.33 .12 = $1,000.)
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 47
T6.18 Solution to Problem 6.11
In the previous problem, Seinfelds Life Insurance Co. is
trying to sell you an investment policy that will pay you
and your heirs $1,000 per year forever. Seinfeld told you
the policy costs $10,000. At what interest rate would this
be a fair deal?
Again, the present value of a perpetuity equals C/r. Now
solve the following equation:
$10,000 = C/r = $1,000/r
r = .10 = 10.00%
Notice: If your opportunity rate is less than 10.00%, this is
a good deal for you; but if you can earn more than 10.00%,
you can do better by investing the $10,000 yourself!
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 48
T6.18 Solution to Problem 6.11
Congratulations! Youve just won the $20 million first prize in
the Subscriptions R Us Sweepstakes. Unfortunately, the
sweepstakes will actually give you the $20 million in $500,000
annual installments over the next 40 years, beginning next
year. If your appropriate discount rate is 12 percent per year,
how much money did you really win?
How much money did you really win? translates to, What is
the value today of your winnings? So, this is a present value
problem.
PV = $ 500,000 [1 - 1/(1.12)
40
]/.12
= $ 500,000 [1 - .0107468]/.12
= $ 500,000 8.243776
= $4,121,888.34 (Not quite $20 million, eh?)
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 49
PER AND ANNUITY

FINDING THE NUMBER OF PAYMENTS:
Suppose you PUT 1,000/= on your credit card . You can only
make payment of 20 per month . Interest Rate is 1.5 % per
month . How long it would take to pay of 1000.?

Present Value = 1000/=

1000 = 20 * ( 1 Present Value Factor) / .015
(1000 / 20 ) / 0.015 = 1- Present Value Factor / . 015
Present Value Factor = 0.25 = 1 ( 1+ r ) ^ t
1.015^ t = 1/.25 = 4
The question is How long does it take for your money to quadruple
at 1.5 % per month ? The answer is about ( Use F Calculator)
1.015 ^ 93 = 3.99 = 4
It will take you about 93 / 12 = 7.75 years at this rate.


M ZAHID KHAN
( )
r
r
C PV
t
)
`

=
1
1
1
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 50
T6.7 Chapter 6 Quick Quiz -- Part 2 of 5
Q. Suppose you owe $2000 on a Visa card, and the
interest rate is 2% per month. If you make the
minimum monthly payments of $50, how long will it
take you to pay off the debt? (Assume you quit
charging stuff immediately!)
Example 1: Finding t
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd Slide 51
T6.7 Chapter 6 Quick Quiz -- Part 2 of 5
Q. Suppose you owe $2000 on a Visa card, and the
interest rate is 2% per month. If you make the
minimum monthly payments of $50, how long will it
take you to pay off the debt? (Assume you quit
charging stuff immediately!)

Example 1: Finding t
A. A long time:

$2000 = $50 {1 - 1/(1.02)
t
}/.02

.80 = 1 - 1/1.02
t
1.02
t
= 5.0

t = 81.3 months, or about 6.78 years!