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# Chapter 2

HOW TO CALCULATE
PRESENT VALUES

## Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
CLASS ACTIVITY

## This is a revision chapter, covering:

PVs and FVs
NPV rule, NPV and risks
IRR rule
Valuation of cash flows
Perpetuities and growing perpetuities
Annuities and growing annuities

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2-1 FUTURE VALUES AND PRESENT VALUES

FV \$100 (1 r) t

Example: FV

## What is the future value of \$100 if interest is

compounded annually at a rate of 7% for two
years?
FV \$100 (1.07) (1.07) \$114.49
FV \$100 (1 .07) 2 \$114.49
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FIGURE 2.1 FUTURE VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

Present va lue = PV
PV = discount factor C1

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2-1 FUTURE VALUES AND PRESENT VALUES

Discount factor = DF = PV of \$1

## Discount factors can be used to compute

present value of any cash flow

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2-1 FUTURE VALUES AND PRESENT VALUES

## Given any variables in the equation, one

can solve for the remaining variable
Prior example can be reversed

PV DF2 C2
PV 1
(1.07) 2
114.49 100

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FIGURE 2.2 PRESENT VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

## Valuing an Office Building

Step 1: Forecast Cash Flows
Cost of building = C0 = \$700,000
Sale price in year 1 = C1 = \$800,000
Step 2: Estimate Opportunity Cost of
Capital
If equally risky investments in the capital
market offer a return of 7%, then cost of
capital = r = 7%
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2-1 FUTURE VALUES AND PRESENT VALUES

## Valuing an Office Building

Step 3: Discount future cash flows

PV C1
(1r ) \$800, 000
(1.07) \$747,664
Step 4: Go ahead if PV of payoff exceeds
investment
NPV \$747,664 \$700,000
\$47,664

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2-1 FUTURE VALUES AND PRESENT VALUES

## Risk and Present Value

Higher risk projects require a higher rate of
return. Why?
Higher required rates of return cause lower PVs

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ACTIVITY 1

## Risk and Net Present Value

Calculate NPV for C0= -700,000 and
C1=800,000 if required rate of return
is:
10%, 15%, 20%
Explain how risk is related to the required rate
of return.

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2-1 FUTURE VALUES AND PRESENT VALUES

## Internal Rate of Return (IRR) Rule

Accept investments that offer IRR in excess of
the required rate of return (or the WACC)
In the project listed below, the opportunity cost
of capital is 12%. Is the project a wise
investment?
profit \$800,000 \$700,000
Return .143, or 14.3%
investment \$700,000

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2-1 FUTURE VALUES AND PRESENT VALUES

## Multiple Cash Flows

Discounted Cash Flow (DCF) formula:

## PV0 (1r )1 (1r )2 .... (1r )t

C1 C2 Ct

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FIGURE 2.5 NET PRESENT VALUES

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2-2 PERPETUITIES AND ANNUITIES

Perpetuity

cash flow
PV of cash flow
discount rate
C1
PV0
r

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2-2 PERPETUITIES AND ANNUITIES

## Present Value of Perpetuities

What is the present value of \$1 billion
every year, for eternity, if the perpetual
discount rate is 10%?

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2-2 PERPETUITIES AND ANNUITIES
Example: Tiburon Autos offers payments of \$5,000 per year,
at the end of each year for 5 years. If interest rates are 7%,
per year, what is the cost of the car?

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2-2 PERPETUITIES AND ANNUITIES

1 1
PV of annuity C t
r r 1 r

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2-2 PERPETUITIES AND ANNUITIES

Annuity
Example: The state lottery advertises a jackpot
prize of \$365 million, paid in 30 yearly
installments of \$12.167 million, at the end of
each year. Find the true value of the lottery
prize if interest rates are 6%.
1 1
Lottery Value 12.167 30
.06 .061 .06
Value \$167,500,000

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2-2 PERPETUITIES AND ANNUITIES

## Future Value of an Annuity

1 r 1
t
FV of annuity C
r

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2-2 PERPETUITIES AND ANNUITIES

## Future Value of an Annuity

What is the future value of \$20,000 paid at the
end of each of the following 5 years, assuming
investment returns of 8% per year?

1 .085 1
FV 20,000
.08
\$117,332

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2-3 GROWING PERPETUITIES AND ANNUITIES

## Constant Growth Perpetuity

C1 g = the annual growth
PV0
rg rate of the cash flow

## This formula can be used to value a perpetuity

at any point in time

Ct 1
PVt
rg

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2-3 GROWING PERPETUITIES AND ANNUITIES

## Constant Growth Perpetuity

What is the present value of \$1 billion paid at
the end of every year in perpetuity, assuming a
rate of return of 10% and constant growth rate
of 4%?

1
PV0
.10 .04
\$16.667 billion

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2-3 GROWING PERPETUITIES AND ANNUITIES

Growing Annuities
Golf club membership is \$5,000 for 1 year, or
\$12,750 for three years. Find the better deal
given payment due at the end of the year and
6% expected annual price increase, discount
rate 10%.

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2-4 HOW INTEREST IS PAID AND QUOTED

## Effective Annual Interest Rate (EAR)

Interest rate annualized using compound
interest
Annual Percentage Rate (APR)
Interest rate annualized using simple
interest

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2-4 HOW INTEREST IS PAID AND OUTLAID

## Given a monthly rate of 1%, what is the

(EAR)? What is the (APR)?

EAR = (1 + .01)12 1 = r
EAR = (1 + .01) 1 = .1268, or 12.68%
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