Present Value

AswathDamodaran

Aswath Damodaran

Intuition Behind Present Value

Therearethreereasonswhyadollartomorrowisworthlessthanadollartoday

Individualspreferpresentconsumptiontofutureconsumption.Toinducepeople
togiveuppresentconsumptionyouhavetoofferthemmoreinthefuture.

Whenthereismonetaryinflation,thevalueofcurrencydecreasesovertime.The
greatertheinflation,thegreaterthedifferenceinvaluebetweenadollartodayanda
dollartomorrow.

Ifthereisanyuncertainty(risk)associatedwiththecashflowinthefuture,the
lessthatcashflowwillbevalued.

Otherthingsremainingequal,thevalueofcashflowsinfuturetimeperiods
willdecreaseas
thepreferenceforcurrentconsumptionincreases.
expectedinflationincreases.
theuncertaintyinthecashflowincreases.

Aswath Damodaran

Discounting and Compounding

Themechanismforfactoringintheseelementsisthediscountrate.
DiscountRate:Thediscountrateisarateatwhichpresentandfuturecash
flowsaretradedoff.Itincorporates
(1)Preferenceforcurrentconsumption(Greater....HigherDiscountRate)
(2)expectedinflation (Higherinflation
....
HigherDiscountRate)
(3)theuncertaintyinthefuturecashflows(HigherRisk....HigherDiscountRate)

Ahigherdiscountratewillleadtoalowervalueforcashflowsinthefuture.
Thediscountrateisalsoanopportunitycost,sinceitcapturesthereturns
thatanindividualwouldhavemadeonthenextbestopportunity.
Discountingfuturecashflowsconvertsthemintocashflowsinpresent
valuedollars.Justadiscountingconvertsfuturecashflowsintopresentcash
flows,
Compoundingconvertspresentcashflowsintofuturecashflows.

Aswath Damodaran

Present Value Principle 1

Cash flows at different points in time cannot be compared and

aggregated. All cash flows have to be brought to the same point in
time,beforecomparisonsandaggregationsaremade.

Aswath Damodaran

Cash Flow Types and Discounting Mechanics

Therearefivetypesofcashflows

Aswath Damodaran

simplecashflows,
annuities,
growingannuities
perpetuitiesand
growingperpetuities

I.Simple Cash Flows

Asimplecashflowisasinglecashflowinaspecifiedfuturetime
period.
CashFlow:
CFt

_______________________________________________|
TimePeriod:
t
Thepresentvalueofthiscashflowis
PVofSimpleCashFlow=CFt/(1+r)t

Thefuturevalueofacashflowis
FVofSimpleCashFlow=CF0(1+r)t

Aswath Damodaran

Application 1: The power of compounding Stocks, Bonds and Bills

IbbotsonandSinquefield,inastudyofreturnsonstocksandbondsbetween
192692foundthatstocksontheaveragemade12.4%,treasurybondsmade
5.2%andtreasurybillsmade3.6%.
The following table provides the future values of $ 100 invested in each
categoryattheendofanumberofholdingperiods1,5,10,20,30and40
years.
HoldingPeriod
Stocks
T.Bonds
T.Bills
1 $112.40
$105.20
$103.60
5 $179.40
$128.85
$119.34
10 $321.86
$166.02
$142.43
20 $1,035.92
$275.62
$202.86
30 $3,334.18
$457.59
$288.93
40 $10,731.30
$759.68
$411.52

Aswath Damodaran

Concept Check

Mostpensionplansallowindividualstodecidewheretheirpensions
fundswillbeinvestedstocks,bondsormoneymarketaccounts.
Wherewouldyouchoosetoinvestyourpensionfunds?
Predominantlyorallequity
Predominantlyorallbondsandmoneymarketaccounts
AMixofBondsandStocks
Willyourallocationchangeasyougetolder?
Yes
No

Aswath Damodaran

The Frequency of Compounding

Thefrequencyofcompoundingaffectsthefutureandpresentvalues
ofcashflows.Thestatedinterestratecandeviatesignificantlyfrom
thetrueinterestrate
Forinstance,a10%annualinterestrate,ifthereissemiannual
compounding,worksoutto
EffectiveInterestRate=1.0521=.10125or10.25%

Frequency
Annual
SemiAnnual
Monthly
Daily
Continuous
Aswath Damodaran

Rate
10%
10%
10%
10%
10%

t
1
2
12
365

Formula
r
(1+r/2)21
(1+r/12)121
(1+r/365)3651
expr1

EffectiveAnnualRate
10.00%
10.25%
10.47%
10.5156%
10.5171%
9

II. Annuities

Anannuityisaconstantcashflowthatoccursatregularintervalsfora
fixedperiodoftime.DefiningAtobetheannuity,

Aswath Damodaran

A
|
1

A
|
2

A
|
3

A
|
4

10

Present Value of an Annuity

Thepresentvalueofanannuitycanbecalculatedbytakingeachcash
flowanddiscountingitbacktothepresent,andaddingupthepresent
values.Alternatively,thereisashortcutthatcanbeusedinthe
calculation[A=Annuity;r=DiscountRate;n=Numberofyears]
1

(1 + r)n
PVofanAnnuity = PV(A, r, n) = A

Aswath Damodaran

11

Example: PV of an Annuity

Thepresentvalueofanannuityof$1,000forthenextfiveyears,
assumingadiscountrateof10%is
1
1

(1.10) 5
PVof$1000eachyearfornext5years = $1000

.10

Thenotationthatwillbeusedintherestoftheselecturenotesforthe
presentvalueofanannuitywillbePV(A,r,n).

Aswath Damodaran

12

Annuity, given Present Value

Thereverseofthisproblem,iswhenthepresentvalueisknownand
theannuityistobeestimatedA(PV,r,n).

AnnuitygivenPresentValue = A(PV, r,n) = PV

1
1
(1 + r)n

Aswath Damodaran

13

Future Value of an Annuity

Thefuturevalueofanendoftheperiodannuitycanalsobe
calculatedasfollows
n

FV

ofanAnnuity

FV

Aswath Damodaran

14

An Example

Thus,thefuturevalueof$1,000eachyearforthenextfiveyears,at
theendofthefifthyearis(assuminga10%discountrate)

5
(1.10)

1
FVof$1, 000eachyearfornext5years = $1000

.10

Thenotationthatwillbeusedforthefuturevalueofanannuitywill
beFV(A,r,n).

Aswath Damodaran

15

Annuity, given Future Value

ifyouaregiventhefuturevalueandyouarelookingforanannuity
A(FV,r,n)intermsofnotation

AnnuitygivenFutureValue = A(FV, r,n) = FV

(1 + r)n 1

Aswath Damodaran

16

Application 2: Saving for College Tuition

Assumethatyouwanttosendyournewbornchildtoaprivatecollege
(whenhegetstobe18yearsold).Thetuitioncostsare$16000/year
nowandthatthesecostsareexpectedtorise5%ayearforthenext18
years.Assumethatyoucaninvest,aftertaxes,at8%.
Expectedtuitioncost/year18yearsfromnow=16000*(1.05)18=$38,506
PVoffouryearsoftuitioncostsat$38,506/year=$38,506*PV(A,8%,4
years)=$127,537

Ifyouneedtosetasidealumpsumnow,theamountyouwouldneed
tosetasidewouldbe
Amountoneneedstosetapartnow=$127,357/(1.08)18=$31,916

Ifsetasideasanannuityeachyear,startingoneyearfromnow
Ifsetapartasanannuity=$127,537*A(FV,8%,18years)=$3,405

Aswath Damodaran

17

Application 3: How much is an MBA worth?

Assumethatyouwereearning$40,000/yearbeforeenteringprogram
andthattuitioncostsare$16000/year.Expectedsalaryis$
54,000/yearaftergraduation.Youcaninvestmoneyat8%.
Forsimplicity,assumethatthefirstpaymentof$16,000hastobemadeatthe
startoftheprogramandthesecondpaymentoneyearlater.
PVOfCostOfMBA=$16,000+16,000/1.08+40000*PV(A,8%,2
years)=$102,145

Assumethatyouwillwork30yearsaftergraduation,andthatthe
salarydifferential($14000=$54000$40000)willcontinuethrough
thisperiod.
PVofBenefitsBeforeTaxes=$14,000*PV(A,8%,30years)=$157,609
Thishastobediscountedbacktwoyears$157,609/1.08 2=$135,124
ThepresentvalueofgettinganMBAis=$135,124$102,145=$32,979

Aswath Damodaran

18

Some Follow-up Questions

1.Howmuchwouldyoursalaryincrementhavetobeforyoutobreak
evenonyourMBA?
2.Keepingtheincrementconstant,howmanyyearswouldyouhaveto
worktobreakeven?

Aswath Damodaran

19

Application 4: Savings from Refinancing Your

Mortgage

Assumethatyouhaveathirtyyearmortgagefor$200,000thatcarries
aninterestrateof9.00%.Themortgagewastakenthreeyearsago.Since
then,assumethatinterestrateshavecomedownto7.50%,andthatyou
arethinkingofrefinancing.Thecostofrefinancingisexpectedtobe
2.50%oftheloan.(Thiscostincludesthepointsontheloan.)Assume
alsothatyoucaninvestyourfundsat6%.
Monthlypaymentbasedupon9%mortgagerate(0.75%monthlyrate)
=$200,000*A(PV,0.75%,360months)
=$1,609
Monthlypaymentbasedupon7.50%mortgagerate(0.625%monthlyrate)
=$200,000*A(PV,0.625%,360months)
=$1,398

MonthlySavingsfromrefinancing=$1,609$1,398=$211

Aswath Damodaran

20

Refinancing: The Trade Of

Ifyouplantoremaininthishouseindefinitely,
PresentValueofSavings(at6%annually;0.5%amonth)
=$211*PV(A,0.5%,324months)
=$33,815

Thesavingswilllastfor27yearstheremaininglifeoftheexistingmortgage.
Youwillneedtomakepaymentsforthreeadditionalyearsasaconsequenceof
therefinancing
PresentValueofAdditionalMortgagepaymentsyears28,29and30
=$1,398*PV(A,0.5%,36months)/1.0627
=$9,532

RefinancingCost=2.5%of$200,000=$5,000
TotalRefinancingCost=$9,532+$5,000=$14,532
NetEffect=$33,815$9,532$14,532=$9,751:Refinance

Aswath Damodaran

21

Follow-up Questions
1.Howmanyyearswouldyouhavetoliveinthishouseforyoubreak
evenonthisrefinancing?
2.We'veignoredtaxesinthisanalysis.Howwoulditimpactyour
decision?

Aswath Damodaran

22

Application 5: Valuing a Straight Bond

Youaretryingtovalueastraightbondwithafifteenyearmaturityanda
10.75%couponrate.Thecurrentinterestrateonbondsofthisrisklevelis
8.5%.
PVofcashflowsonbond=107.50*PV(A,8.5%,15years)+1000/1.085 15=$
1186.85

Ifinterestratesriseto10%,
PVofcashflowsonbond=107.50*PV(A,10%,15years)+1000/1.10 15=
$1,057.05
Percentagechangeinprice=10.94%

Ifinterestratefallto7%,
PVofcashflowsonbond=107.50*PV(A,7%,15years)+1000/1.07 15=$1,341.55
Percentagechangeinprice=+13.03%

Thisasymmetricresponsetointerestratechangesiscalledconvexity.

Aswath Damodaran

23

Application 6: Contrasting Short Term and Long

Term Bonds

20.00%

15.00%

10.00%

5.00%

0.00%

%Changeifrate

increasesto10%

5.00%

10.00%

15.00%

Aswath Damodaran

15

30

24

Bond Pricing Proposition 1

Thelongerthematurityofabond,themoresensitiveitistochanges
ininterestrates.

Aswath Damodaran

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Application 7: Contrasting Low-coupon and

High-coupon Bonds

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
%Changeifrate

increasesto10%
5.00%

10.00%

15.00%

20.00%

0%

Aswath Damodaran

5%

10.75%

12%

26

Bond Pricing Proposition 2

Thelowerthecouponrateonthebond,themoresensitiveitisto
changesininterestrates.

Aswath Damodaran

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III. Growing Annuity

Agrowingannuityisacashflowgrowingataconstantratefora
specifiedperiodoftime.IfAisthecurrentcashflow,andgisthe
expectedgrowthrate,thetimelineforagrowingannuitylooksas
follows

...........

Aswath Damodaran

28

Present Value of a Growing Annuity

Thepresentvalueofagrowingannuitycanbeestimatedinallcases,
butonewherethegrowthrateisequaltothediscountrate,usingthe
followingmodel:
1
1

(1 + r)n
PVofanAnnuity = PV(A, r, n) = A

Inthatspecificcase,thepresentvalueisequaltothenominalsumsof
theannuitiesovertheperiod,withoutthegrowtheffect.

Aswath Damodaran

29

Appendix 8: The Value of a Gold Mine

Considertheexampleofagoldmine,whereyouhavetherightstothe
mineforthenext20years,overwhichperiodyouplantoextract
5,000ouncesofgoldeveryyear.Thepriceperounceis$300
currently,butitisexpectedtoincrease3%ayear.Theappropriate
discountrateis10%.Thepresentvalueofthegoldthatwillbe
extractedfromthisminecanbeestimatedasfollows
20

(1.03)
1

(1.10)20
PVofextractedgold = $300 * 5000 * (1.03)
.10 .03

Aswath Damodaran

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PV of Extracted Gold as a Function of Expected

Growth Rate

$50,000,000

$45,000,000

$40,000,000

$35,000,000

$30,000,000

$25,000,000

$20,000,000

$15,000,000

$10,000,000

$5,000,000

$-

Aswath Damodaran

31

PV of Extracted Gold as a Function of Expected

Growth Rate

$50,000,000

$45,000,000

$40,000,000

$35,000,000

$30,000,000

$25,000,000

$20,000,000

$15,000,000

$10,000,000

$5,000,000

$-

Aswath Damodaran

32

Concept Check

Ifboththegrowthrateandthediscountrategoupby1%,willthe
presentvalueofthegoldtobeextractedfromthismineincreaseor
decrease?

Aswath Damodaran

33

IV. Perpetuity

Aperpetuityisaconstantcashflowatregularintervalsforever.The
presentvalueofaperpetuityis
PVofPerpetuity =

Aswath Damodaran

A
r

34

Application 9: Valuing a Console Bond

Aconsolebondisabondthathasnomaturityandpaysafixed
coupon.Assumethatyouhavea6%couponconsolebond.Thevalue
ofthisbond,iftheinterestrateis9%,isasfollows
ValueofConsoleBond=$60/.09=$667

Aswath Damodaran

35

V. Growing Perpetuities

Agrowingperpetuityisacashflowthatisexpectedtogrowata
constantrateforever.Thepresentvalueofagrowingperpetuityis
PVofGrowingPerpetuity =

CF1
(r g)

where
CF1istheexpectedcashflownextyear,
gistheconstantgrowthrateand
risthediscountrate.

Aswath Damodaran

36

Application: Valuing a Stock with Growing

Dividends

SouthwesternBellpaiddividendspershareof$2.73in1992.Its
earningsanddividendshavegrownat6%ayearbetween1988and
1992,andareexpectedtogrowatthesamerateinthelongterm.The
rateofreturnrequiredbyinvestorsonstocksofequivalentriskis
12.23%.
CurrentDividendspershare=$2.73
ExpectedGrowthRateinEarningsandDividends=6%
DiscountRate=12.23%
ValueofStock=$2.73*1.06/(.1223.06)=$46.45

Aswath Damodaran

37