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Chapter 2

Principles of
Corporate Finance,
Concise
Second Edition
How to Calculate
Present Values
Slides by
Matthew Will
Copyright 2011 by The McGraw-Hill Companies, I nc. All rights reserved. McGraw-Hill/I rwin
2- 2
Topics Covered
Future Values and Present Values
Looking for ShortcutsPerpetuities and
Annuities
More ShortcutsGrowing Perpetuities and
Annuities
How Interest Is Paid and Quoted
2- 3
Present and Future Value
Present Value
Value today of a future cash flow.
Future Value
Amount to which an investment will grow
after earning interest
2- 4
Future Values
Future Value of $100 = FV


FV r
t
= + $100 ( ) 1
2- 5
Future Values
FV r
t
= + $100 ( ) 1
Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 7% for two years?


49 . 114 $ ) 07 . 1 ( 100 $
49 . 114 ) 07 . 1 ( ) 07 . 1 ( 100 $
2
= + =
= =
FV
FV
2- 6
0
200
400
600
800
1000
1200
1400
1600
1800
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
F
V

o
f

$
1
0
0
0%
5%
10%
15%
Future Values with Compounding
Interest Rates
2- 7
Present Value
1
factor discount = PV
PV = Value Present
C
2- 8
Present Value
Discount Factor = DF = PV of $1




Discount Factors can be used to compute the present value of
any cash flow.
DF
r
t
=
+
1
1 ( )
2- 9
100 49 . 114
2
) 07 . 1 (
1
2 2
= =
=
+
PV
C DF PV
The PV formula has many applications. Given
any variables in the equation, you can solve for the
remaining variable. Also, you can reverse the prior
example.
Present Value
2- 10
0
20
40
60
80
100
120
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
P
V

o
f

$
1
0
0
0%
5%
10%
15%
Present Values with Compounding
Interest Rates
2- 11
Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C
0
= 370,000
Sale price in Year 1 = C
1
= 420,000

Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%

2- 12
Valuing an Office Building
Step 3: Discount future cash flows



Step 4: Go ahead if PV of payoff exceeds investment

000 , 400
) 05 . 1 (
000 , 420
) 1 (
1
= = =
+ +r
C
PV
000 30
000 370 000 400
,
, , NPV
=
=
2- 13
Net Present Value
r
C
+
+
1
C = NPV
investment required - PV = NPV
1
0
2- 14
Risk and Present Value
Higher risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
2- 15
Risk and Present Value
000 , 400
.05 1
420,000
PV
5% at $420,000 C of PV
1
=
+
=
=
000 , 375
.12 1
420,000
PV
12% at $420,000 C of PV
1
=
+
=
=
2- 16
Risk and Net Present Value
$5,000
370,000 - 75,000 3 = NPV
investment required - PV = NPV
=
2- 17
Net Present Value Rule
Accept investments that have positive net
present value
Example
Use the original example. Should we accept the
project given a 10% expected return?


000 , 30 $
1.05
420,000
+ -370,000 = NPV =
2- 18
Rate of Return Rule
Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?
13.5% or .135
370,000
370,000 420,000
investment
profit
Return =

= =
2- 19
Multiple Cash Flows
For multiple periods we have the
Discounted Cash Flow (DCF) formula

t
t
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 (
0
....
2
2
1
1
+ + +
+ + + =

=
+
+ =
T
t
r
C
t
t
C NPV
1
) 1 (
0 0
2- 20
Net Present Values
Present Value
Year 0

20,000/1.12
420,000/1.12
2
Total



= $17,900
= $334,800
= - $17,300
$20,000
- $370,000
Year
0 1 2
$ 420,000
-$370,000
2- 21
Shortcuts


Sometimes there are shortcuts that make it
very easy to calculate the present value of
an asset that pays off in different periods.
These tools allow us to cut through the
calculations quickly.
2- 22
Shortcuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
PV
C
r =
=
lue present va
flow cash
Return
2- 23
Shortcuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
r
C
PV
1
0
rate discount
flow cash
Flow Cash of PV
=
=
2- 24
Present Values
Example
What is the present value of $1 billion every year, for all
eternity, if you estimate the perpetual discount rate to be
10%??



billion 10 $
10 . 0
bil $1
= = PV
2- 25
Present Values
Example - continued
What if the investment does not start making money for 3
years?



( ) billion 51 . 7 $
3
1.10
1
10 . 0
bil $1
= = PV
2- 26
Short Cuts
Annuity - An asset that pays a fixed sum each year for
a specified number of years.
r
C
Perpetuity (first
payment in year 1)
Perpetuity (first payment
in year t + 1)
Annuity from year
1 to year t
Asset Year of Payment
1 2..t t + 1
Present Value
t
r r
C
) 1 (
1
+
|
.
|

\
|
|
|
.
|

\
|
+
|
.
|

\
|

|
.
|

\
|
t
r r
C
r
C
) 1 (
1
2- 27
Example
Tiburon Autos offers you easy 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?
Present Values
5,000
Year
0 1 2 3 4 5
5,000 5,000 5,000 5,000
( )
( )
( )
( )
20,501 NPV Total
565 , 3 07 . 1 / 000 , 5
814 , 3 07 . 1 / 000 , 5
081 , 4 07 . 1 / 000 , 5
367 , 4 07 . 1 / 000 , 5
673 , 4 07 . 1 / 000 , 5
5
4
3
2
=
=
=
=
=
=
Present Value
at year 0
2- 28
Shortcuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
2- 29
Annuity Shortcut


Example
You agree to lease a car for 4 years at $300 per month.
You are not required to pay any money up front or at the
end of your agreement. If your opportunity cost of capital
is 0.5% per month, what is the cost of the lease?
2- 30
Annuity Short Cut
Example - continued
You agree to lease a car for 4 years at $300 per
month. You are not required to pay any money up
front or at the end of your agreement. If your
opportunity cost of capital is 0.5% per month,
what is the cost of the lease?
( )
10 . 774 , 12 $
005 . 1 005 .
1
005 .
1
300 Cost Lease
48
=
(

+
=
Cost
2- 31
Annuity Short Cut
Example
The state lottery advertises a jackpot prize of $295.7
million, paid in 25 installments over 25 years of $11.828
million per year, at the end of each year. If interest rates
are 5.9% what is the true value of the lottery prize?
( )
000 , 600 , 152 $
059 . 1 059 .
1
059 .
1
828 . 11 Value Lottery
25
=
(

+
=
Value
2- 32
FV Annuity Short Cut
Future Value of an Annuity The future value of
an asset that pays a fixed sum each year for a
specified number of years.
( )
(

+
=
r
r
C
t
1 1
annuity of FV
2- 33
Annuity Short Cut
Example
What is the future value of $20,000 paid at the end of each
of the following 5 years, assuming your investment returns
8% per year?
( )
332 , 117 $
08 .
1 08 . 1
000 , 20 FV
5
=
(

+
=
2- 34
Constant Growth Perpetuity
g r
C
PV

=
1
0
g = the annual growth
rate of the cash flow
2- 35
Constant Growth Perpetuity
g r
C
PV

=
1
0
NOTE: This formula can be
used to value a perpetuity at
any point in time.
g r
C
PV
t
t

=
+1
2- 36
Constant Growth Perpetuity
Example
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 a constant growth rate of 4%?
billion 667 . 16 $
04 . 10 .
1
0
=

= PV
2- 37
Perpetuities
A three-year stream of cash flows that grows at
the rate g is equal to the difference between two
growing perpetuities.
2- 38
Effective Interest Rates
Annual Percentage Rate - Interest rate that is
annualized using simple interest.
Effective Annual Interest Rate - Interest rate
that is annualized using compound interest.
2- 39
Effective Interest Rates
Example
Given a monthly rate of 1%, what is the Effective
Annual Rate (EAR)? What is the Annual
Percentage Rate (APR)?


2- 40
Effective Interest Rates
example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?


12.00% or .12 = 12 x .01 = APR
12.68% or .1268 = 1 - .01) + (1 = EAR
r = 1 - .01) + (1 = EAR
12
12
2- 41
Additional Web Resources
Click to access web sites
Internet connection required
www.smartmoney.com
http://finance.yahoo.com
www.in.gov/ifa/files/TollRoadFinancialAnalysis.pdf
www.mhhe.com/bma

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