Chapter 5: Discounted Cash Flow Valuation

& Effective Annual Rates

FV Multiple Cash Flows
1
1. Suppose you invest $500 in a Fidelity Spartan mutual
fund today and $600 in one year. If you expect that the
fund will pay 9% annually, how much will you have in two
years?
How much will you have in 5 years if you make no further
deposits?
There are 2 ways to solve the problem.
What are the two ways?
2. Suppose you plan to deposit $100 into an account in one
year and $300 into the account in three years. How much
will be in the account in five years if the interest rate is 8%?


PV Multiple Uneven Cash Flows
2
1. You are considering an investment that will pay you $200
in one year, $400 in two years, $600 in three years, and
$800 in four years. If you want to earn 12% on your money,
how much would you be willing to pay?

2. Your broker calls you and tells you that he has this great
investment opportunity. If you invest $100 today, you will
receive $40 in one year and $75 in two years. If you require
a 15% return on investments of this risk, should you take
the investment?
What is the highest price you would be willing to
pay?

Annuities and Perpetuities
3
Annuity finite series of equal payments that occur at regular
intervals
If the first payment occurs at the end of the period, it is called an
ordinary annuity
If the first payment occurs at the beginning of the period, it is called an
ANNUITY DUE
Perpetuity infinite series of equal payments
Perpetuity: PV = C / r
Annuities:





(

+
=
r
r
C AFV
t
1 ) 1 (
(
(
(
(

=
r
t
r
C APV
) 1 (
1
1
Annuities Sweepstakes Winnings
4
1. Suppose you win the Publishers Clearinghouse $10 million
sweepstakes. The money is paid in equal annual
installments of $333,333.33 over 30 years beginning one
year from today. If the appropriate discount rate is 5%, how
much is the sweepstakes actually worth today?
a. Suppose there is a lump sum option to receive $5 million
dollars today. Will you choose the installments or lump sum?
2. Assume that you choose the installments and invest each
installment at 5%. How much will you have at the end of 30
years?
a. Suppose instead that you chose the lump sum. How much
will you have at the end of 30 years if you invest at 5%?
Annuities: Finding the Payment (C) -
5
1. Suppose you want buy a new car that costs $20,000. You
can borrow at 8% per year, compounded monthly. If you
take a 4 year loan, what is your monthly payment?
What if you wanted to borrow more money, but this is
the maximum payment you can afford. What changes
can be made to the loan to make this possible?
2. Subsidized Stafford. You will have a accumulated $30,000
in student loans by the time you graduate in 2010. The
interest rate on the loan is 6.8%. What will be your monthly
payment for a term of 30 years?





Finding t the number of payments
You will not need to solve for t or r in this
class



Finding r the interest rate
r can not be solved directly, so you must use
a financial calculator, a computer, or trial and
error.
| |
) 1 ln(
) / ( 1 1 ln
r
C PV r
t
+

=
Annuity Due Definition and Example
7
An ordinary annuity assumes payments begin one period
from today (at t=1)
An annuity due is an annuity with cash flows that begin
today (at t=0)
You are saving for a new house and you put three
payments of $10,000 per year in an account paying 8%.
The first payment is made today. How much will you have
at the end of 3 years?
Annuity Due Timeline
8
0 1 2 3
10K 10K 10K
10K 10K 10K
Ordinary
Annuity
Annuity
Due
Notice: Because the payments begin one
period earlier, the annuity due cash flow
earn an extra period of interest. That is why
we multiply our answer by 1+r.
Practice Problem
You are going to lease a car and can afford to pay $350
per month for a 3 year lease. The interest rate is 7% and
your first payment is to be made today. If you will be
putting down $2000 today, how much are you paying to
lease the car? Alternatively, you can purchase the same
car for $15,000. If you plan to keep the car for only 3
years no matter how you decide to pay for the car, would
you prefer to lease or buy the car?
9
Perpetuity: Defined and Example
10
Perpetuity an annuity in which the cash flows continue
forever
Perpetuity formula: PV = C / r
Most common perpetuities - Preferred Stock which often
pay a dividend in perpetuity
A company currently pays preferred shareholders a $0.75
dividend per quarter. If the dividend is expected to
continue forever, and the required rate of return on
stocks of similar risk is 7.5% per year, what is the fair price
of the stock?


Delayed Cash Flow Stream - Example
11
Suppose that you are offered an investment that will pay
you $1000 per year forever beginning 2 years from now.
How much should you pay today if your required return is
15%?
t 0 1 2 3.
1000 1000
$
Delayed Cash Flow Stream
The annuity and perpetuity formulas provide the PV of
the cash flow stream as of the time period before the first
cash flow is paid.
To find PV of a delayed cash flow stream it is a Two-step
process: Find PV of cash flow stream and then discount
PV back to today.
The Two-Step Process
1. Find the PV of the perpetuity.
Cash flow stream begins at t=2 so this gives PV as of t=1
2. Discount the PV of the cash flow stream back to today
13
t 0 1 2 3.
1000 1000
$
PV=$1000/.15=

PV Annuity: Saving For Retirement
14
You are offered the opportunity to put some money away
for retirement. You will receive five annual payments of
$25,000 each beginning in 40 years. How much would you
be willing to invest today if you desire an interest rate of
12%?

Chapter 5, Part 2: Effective Annual Rates
Comparing Rates: The Effect of Compounding
Is 5% every six months the same as 10% per year?
Which account is better an account that earns 15.5%
compounded quarterly or one that earns 16% compounded
annually?
When number of compounding periods differ you must
determine the Effective Annual Rate (EAR) to compare rates.
The EAR captures the effect of compounding periods
throughout the year.
An Annual Percentage Rate (APR) or quoted rate does not
reflect the number of compounding periods per year.
EAR - Formula
16
APR is the quoted rated you may see Q in place of
APR in this equation
Assume (unless noted otherwise) that the rate given in
problems is the APR (quoted rate).
1
m
APR
1 EAR
m

+ =
Annual Percentage Rate (APR)
17
This is the ANNUAL rate that is quoted by law
By definition APR = period rate times the number of
periods per year
Consequently, to get the period rate we rearrange the
APR equation:
Period rate = APR / number of periods per year

Number of Periods Per Year
18
Annual - 1
Semiannual 2
Quarterly 4
Monthly 12
Weekly 52
Daily - 365
Computing APRs
19
What is the APR if the monthly rate is .5%?

What is the APR if the semiannual rate is .5%?

What is the monthly rate if the APR is 12% with monthly
compounding?
Remember
20
You ALWAYS need to make sure that the interest rate and
the time period match.
If you are looking at annual periods, you need an annual rate.
If you are looking at monthly periods, you need a monthly rate.
If you have an APR based on monthly compounding, you
have to use monthly periods for lump sums. (Remember
this when pricing bonds!)
EARs - Example
21
Suppose you can earn 1% per month on $1 invested
today.
What is the APR?
How much are you effectively earning?
Suppose if you put it in another account, you earn 3% per
quarter.
What is the APR?
How much are you effectively earning?

EAR Example 2
22
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?
Computing APRs from EARs
23
Rearrange the EAR equation to solve for APR:
(

+ = 1 - EAR) (1 m APR
m
1
APR - Example
24
Suppose you want to earn an effective rate of 12% and you
are looking at an account that compounds on a monthly
basis. What APR must they pay?


Remember
25
Use EAR
When comparing interest rates with different
compounding periods.
Use APR (Quoted rate)
When calculating PV and FV.
Or If you use EAR when calculating PV and FV, use EAR (do
not divide by number of periods per year) and use t=the
number of years.
Homework/Practice Problems
Read Chapter 5
Part I: Do 5.1 to 5.5; 2, 7, 9, 10, 11, 24, 25, 30, 35, 36, 38,
46 (a only), 47, 49
Part II: Do 14, 15, 19, 43