FINC 3330 – Chapter 5 (Discounted Cash Flow Valuation)

I. Valuation of Uneven Series of Cash Flows

II. Valuation of Even Series of Cash Flows
A. Annuity
B. Perpetuity
III. Comparison of Interest Rates
A. Annual Percentage Rate (APR)
B. Effective Annual Rate (EAR)

I. Valuation of Uneven Series of Cash Flows

The future (or present) value of an uneven series of cash flows is simply the sum of all future (or
present) values of individual cash flows.

II. Valuation of Even Series of Cash Flows

A. Annuities
An annuity is a series of constant payments (A) made at equal intervals throughout an
investment horizon. An annuity can be: (1) ordinary (cash flows fall at the end of the time
periods); (2) due (cash flows fall at the beginning of the time periods).

(1) Valuation of Ordinary Annuities

FV = A {[1 + (r / m)] – 1}(r / m)
mxn –1
PV = A {1 – [1 + (r / m)] -mxn
}(r / m) -1

(2) Valuation of Annuities Due

Calculate the PV or FV as for an ordinary annuity, and then multiply the result by [1 + (r / m)].

B. Perpetuities
A perpetuity is a series of equal cash flows (P) occurring at fixed intervals of time forever.
Thus, only present values can be calculated for perpetuities – future values cannot be calculated.
If the cash flow occurs at the end of the time period, then PV = P (r / m) . If the cash flow
– 1

occurs at the beginning of the time period, then PV = P [1 + (r / m)] (r / m) . –1

VI. Comparison of Interest Rates

A. The Annual Percentage Rate (APR)
The term APR refers to the annual simple interest rate. The APR allows comparisons between
interest rates with the same compounding frequency, but different fees and charges. If there are
no additional fees and charges, the APR equals the stated rate.

B. The effective (or equivalent) annual rate (EAR)

The term EAR refers to the actual annual interest rate paid (or earned) after taking into account
any compounding of interest. The EAR allows comparisons between interest rates with different
compounding frequencies. When comparing investment, one should choose the highest EAR if
lending, and the lowest EAR if borrowing. The EAR is calculated as: EAR = [1 + (r / m)] – 1. m