CHAPTER
2 2-1
HOW TO CALCULATE
PRESENT VALUES
Brealey, Myers, and Allen
Principles of Corporate Finance
13th Edition
Slides by Matthew Will
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Topics Covered
2-2
• Future Values and Present Values
• Looking for Shortcuts—Perpetuities and
Annuities
• More Shortcuts—Growing Perpetuities
and Annuities
• How Interest Is Paid and Quoted
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Present Value and Future Value
2-3
• Future Value
oAmount to which an investment will grow
after earning interest
• Present Value
oValue today of a future cash flow
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Future Values
2-4
Future Value of $100 = FV
FV $100 (1 r) t
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Future Values Continued
2-5
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) = $114.49 2
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Figure 2.1 Future Values with Compounding
2-6
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Present Value
2-7
Present value = PV
PV = discount factor C1
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Present Value Continued
2-8
Discount factor = DF = PV of $1
DF 1
(1 r ) t
Discount factors can be used to compute
the present value of any cash flow
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Present Value Concluded
2-9
• 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.
PV = DF2 ´C2
PV = (1+.07)
1
2 ´ $114.49 = $100
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Figure 2.2 Present Values with
Compounding
2-10
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Valuing an Investment Opportunity
2-11
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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Valuing an Investment Opportunity
Continued
2-12
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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Net Present Value
2-13
NPV = PV – required investment
C1
NPV = C0 +
1+ r
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Figure 2.4 NPV Calculation
2-14
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Risk and Present Value
2-15
PV of C1 $800,000 at 12%
800,000
PV 714,286
1 .12
PV of C1 $800,000 at 7%
800,000
PV 747,664
1 .07
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Risk and Net Present Value
2-16
NPV = PV – required investment
NPV = 714,286 – 700,000
= $14,286
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Net Present Value Rule
2-17
• Accept investments that have positive net
present value
Example
Use the original example. Should we accept
the project given a 10% expected return?
800,000
NPV = –700,000 + = $27,273
1.10
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Rate of Return Rule
2-18
• 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?
profit 800,000 700,000
Return .143 or 14.3%
investment 700,000
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Calculating Present Values When There
Are Multiple Cash Flows
2-19
For multiple periods we have the discounted
cash flow (DCF) formula
C1 C2 Ct
PV = (1+r)1 + (1+r)2 +...+ (1+r)T
T
NPV = C0 + å (1+r )t
Ct
t=1
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Figure 2.5 NPV Calculation
2-20
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How to Value Perpetuities
2-21
• 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.
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Shortcuts
2-22
Perpetuity: Financial concept in which a cash
flow is theoretically received forever.
cash flow
Return
present value
C
r
PV
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Shortcuts Continued
2-23
Perpetuity: Financial concept in which a cash
flow is theoretically received forever.
cash flow
PV of cash flow =
discount rate
C
PV =
r
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Present Values
2-24
Example
What is the present value of $1 billion every
year, for all eternity, if you estimate the
perpetual discount rate to be 10%?
PV $1 bil
0.10 $10 billion
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Present Values Continued
2-25
Example continued
What if the investment does not start making
money for 3 years?
PV $1 bil
0.10 $7.51 billion
1
1.10 3
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How to Value Annuities
2-26
Annuity: An asset that pays a fixed sum each
year for a specified number of years
1 1
PV of annuity C t
r r 1 r
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Perpetuities & Annuities
2-27
PV Annuity Factor (PVAF): The present value
of $1 a year for each of t years
é ù
PVAF = ë r - r (1+r )t û
1 1
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Figure 2.7 Annuity
2-28
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Figure 2.8 Costing an Installment Plan
2-29
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Valuing Annuities Due
2-30
Annuity due: Level stream of cash flows starting
immediately
How does it differ from an ordinary annuity?
PVAnnuity due PVAnnuity (1 r )
How does the future value differ from an ordinary annuity?
FVAnnuity due FVAnnuity (1 r )
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Example 2.3 Paying off a Bank Loan
2-31
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Table 2.1 Amortizing Loan Example
2-32
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Future Value of an Annuity
2-33
FVAD FVAnnuity (1 r )
Example: Suppose you invest $429.59 annually at
the beginning of each year at 10% interest. After 50
years, how much would your investment be worth?
é 1 1 ù
FVAD = $429.59 ´ ê – 50 ú
´1.10 2
ë .10 .10(1+.10) û
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Future Value of an Annuity Continued
2-34
Future Value of an Annuity: The future value of
an asset that pays a fixed sum each year for a
specified number of years.
1 r 1 t
FV of annuity C
r
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Future Value of an Annuity Concluded
2-35
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?
1 .085 1
FV 20,000
.08
$117,332
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Growing Perpetuities
2-36
Present value of growing perpetuity
C1
PV0
rg
g = the annual growth rate of the cash flow
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Growth Perpetuity Example
2-37
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%?
1
PV0
.10 .04
$16.667 billion
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How Interest is Paid and Quoted
2-38
Annual Percentage Rate: Interest rate
that is annualized using simple interest
Effective Annual Interest Rate: Interest
rate that is annualized using compound
interest
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EAR & APR Formulas
2-39
Annual Percentage Rate (APR):
APR = MR ´12
Effective Annual Interest Rate (EAR):
EAR (1 MR ) 1 12
*where MR = monthly interest rate
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Effective Interest Rates
2-40
Example:
Given a monthly rate of 1%, what is the effective
annual rate (EAR)? What is the annual
percentage rate (APR)?
12
EAR = (1 + .01) -1 = r
EAR = (1 + .01)12 -1 = .1268 or 12.68%
APR = .01 12 = .12 or 12.00%
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