Principles of

Chapter 2 Corporate Finance

Tenth Edition

How to Calculate
Present Values

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2-2

Topics Covered
Future Values and Present Values
Looking for Shortcuts—Perpetuities and
Annuities
More Shortcuts—Growing Perpetuities
and Annuities
How Interest Is Paid and Quoted
 2-3

Present and Future Value

Future Value
Amount to which
an investment will
grow after earning
Present Value interest

Value today of
a future cash
flow.

2-4

Future Values

Future Value of $100 = FV

FV  $100  (1  r ) t
 2-5

Future 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

2-6

Future Values with Compounding

1800
1600 0%
1400 5%
10%
1200
FV of $100

15%
1000
Interest
800
Rates
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
 2-7

Present Value

Present Value = PV

PV = discount factor  C1

2-8

Present Value

Discount Factor = DF = PV of $1

1
DF  ( 1 r ) t

Discount Factors can be used to compute the present

value of any cash flow.
 2-9

Present Value
 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
1
PV  (1.07 ) 2
114.49  100

2-10

Present Values with Compounding

120
Interest
100 Rates 0%
5%
80
PV of $100

10%
60 15%

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
 2-11

Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 370,000
Sale price in Year 1 = C1 = 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

C
PV  (1r1 )  420 ,000
(1 .05)  400,000

Step 4: Go ahead if PV of payoff exceeds

investment

NPV  400 ,000  370 ,000

 30 ,000
 2-13

Net Present Value

NPV = PV - required investment

C1
NPV = C0 
1 r

2-14

Risk and Present Value

Higher risk projects require a higher
rate of return
Higher required rates of return cause
lower PVs

PV of C1  $420,000 at 5%
420,000
PV   400,000
1  .05
 2-15

Risk and Present Value

PV of C1  $420,000 at 12%
420,000
PV   375,000
1  .12

PV of C1  $420,000 at 5%
420,000
PV   400,000
1  .05

2-16

Risk and Net Present Value

NPV = PV - required investment

NPV = 375,000 - 370,000

 $5,000
 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?

420,000
NPV = -370,000 +  $30,000
1.05

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?
profit 420,000  370,000
Return    .135 or 13.5%
investment 370,000
 2-19

Multiple Cash Flows

For multiple periods we have the
Discounted Cash Flow (DCF) formula

PV0  C1
(1 r ) 1  (1Cr2 ) 2  ....  (1Crt )t

T
NPV0  C0   (1Crt )t
t 1

2-20

Net Present Values

- $370,000

$20,000 $
420,000

Present Year
Value 0 1 2

Year 0
-
$370,000
= $17,900
= $334,800
20,000/1.12
= - $17,300
420,000/1.12
2

Total
 2-21

Short Cuts
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

Short Cuts
Perpetuity - Financial concept in which a
cash flow is theoretically received
forever.

cash flow
Return 
present value
C
r
PV
 2-23

Short Cuts
Perpetuity - Financial concept in which a
cash flow is theoretically received
forever.

cash flow
PV of Cash Flow 
discount rate
C
PV0  1
r

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%??

$1 bil
PV  0.10  $10 billion
 2-25

Present Values
Example - continued
What if the investment does not start making money
for 3 years?

PV  $10.10bil     $7.51 billion

1
1.103

2-26

Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.

Asset Year of Payment Present Value

1 2…..t t+1
Perpetuity (first C
payment in year r
1)
C  1
Perpetuity (first   t
payment in year t + 1)  r  (1  r )

Annuity from year  C   C  1 

     
t 
1 to year t  r   r  (1  r ) 
 2-27

Present Values
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?
5,000 5,000 5,000 5,000 5,000
Year
Present 0 1 2 3 4 5
Value at year
0
5,000 / 1.07  4,673
2
5,000 / 1.07   4,367
3
5,000 / 1.07   4,081
4
5,000 / 1.07   3,814
5
5,000 / 1.07   3,565
Total NPV  20,501

2-28

Short Cuts
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  
 2-29

Annuity Short Cut

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?

 1 1 
Lease Cost  300    48 
 .005 .0051  . 005 
Cost  $12,774.10
 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?
 1 1 
Lottery Value  11.828    25 
 .059 .0591  .059  
Value  $152,600,000

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.

 1  r t  1
FV of annuity  C   
 r 
 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?

 1  .085  1
FV  20,000   
 .08 
 $117,332

2-34

Constant Growth Perpetuity

C1
PV0 
rg

g = the annual growth

rate of the cash flow
 2-35

Constant Growth Perpetuity

NOTE: This formula can

be used to value a
perpetuity at any point in
time.
C t 1
C1 PVt 
PV0 
rg rg

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%?

1
PV0 
.10  .04
 $16.667 billion
 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

Effective Annual Interest Rate - Interest

rate that is annualized using compound
interest.

Annual Percentage Rate - Interest rate

that is annualized using simple 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)?

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

APR = .01 x 12 = .12 or 12.00%

 2-41

Web Resources
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www.smartmoney.com
http://finance.yahoo.com
www.in.gov/ifa/files/TollRoadFinancialAnalysis.pdf
www.mhhe.com/bma