Chapter 2

How to Calculate Present

Values
Examples - Future Cash-Flows

“A dollar tomorrow worth less than a dollar today ”.

Exercise set 0:

1. Suppose that the annual interest rate is 8%. How much do

you get in 1 year if you invest 100 today?

2. Suppose that the annual interest rate is 8%. How much do

you get in 2 years if you invest 100 today?

3. Suppose that the annual interest rate is 8%. How much do

you get in 3 years if you invest 100 today?
General Formula - Future Cash-Flows

Your cash-flow in t years is:

CFt = PV0 ∗ (1 + r )t

Where,
I CFt = the cash-flow in t years.

I PV0 = value invested today.

I r = annual rate of return.

I t = time measured in years.

Examples - Future Cash-Flows

Exercise set 1:

1. Suppose that you want a 8% annual return. How much

should you get in 1 year if you invest 100 today?

2. Suppose that you want a 8% annual return. How much

should you get in 2 years if you invest 100 today?

3. Suppose that you want a 8% annual return. How much

should you get in 3 years if you invest 100 today?
Examples - Future Cash-Flows

Exercise set 1:

1. Suppose that you want a 8% annual return. How much

should you get in 1 year if you invest 100 today?

2. Suppose that you want a 8% annual return. How much

should you get in 2 years if you invest 100 today?

3. Suppose that you want a 8% annual return. How much

should you get in 3 years if you invest 100 today?

CFt = PV0 ∗ (1 + r )t
Present Value - flip the question

Exercise set 2. Let’s flip the questions made in Exercise 1:

1. Suppose that you want a 8% annual return. What value do

you need to invest today to get 108 in 1 year?

2. Suppose that you want a 8% annual return. What value do

you need to invest today to get 116.64 in 2 year?

3. Suppose that you want a 8% annual return. What value do

you need to invest today to get 125.97 in 3 year?
General Formula - Present Value

The present value (value today) of a “cash-flow” in t years is:

CFt
PV0 =
(1 + r )t

I CFt = the cash-flow in t years.

I PV0 = present value.

I r = annual rate of return.

I t = time measured in years.

Interpretation 1: the amount you need to invest today to obtain

a certain annual return r .
Present Value ≡ Market Price

I You wonder what is the market price of a project.

I Investors would invest in the project to obtain a return.
I Same annual return they obtain from similar risk investments.
I How much should they invest today to obtain such return?
I ANSWER: The present Value, with “r ” being the annual
return of similar risk investments

Interpretation 2: The present value is the investment amount or

project price that would give investors the same return they could
earn in the financial markets for similar risk investments.
I Present value ≡ market value
Present Value - Example and Exercises
Exercise Set 3: You want to find the present value of a project.
Similar risk investments yield an 8% annual return. What is the
present value if...?
I the project makes one payment of 10M in one year and no
other payments thereafter.
(a) the project makes one payment of 10M in 2 years and no
other payments thereafter.

(b) the project makes one payment of 10M in 3 years and no

other payments thereafter.

(c) the project makes one payment of 10M in 4 years and no

other payments thereafter.

(d) the project makes one payment of 10M in 5 years and no

other payments thereafter.
Present Value of Multiple Cash-Flows - Exercises
I Projects make multiple payments, not just one. What’s the
present value of multiple cash-flows?
I The present value of multiple cash-flows is equal to the
sum of the present value of the individual cash-flows:

CF1 CF2 CF3 CFT

PV0 = + + + ... +
(1 + r )1 (1 + r )2 (1 + r )3 (1 + r )T

I CFt = the cash-flow in t years.

I PV0 = present value.

I r = annual rate of return.

I T = final year years.

Present Value of Multiple Cash-Flows - Exercises

Exercise Set 4:
I Suppose that the market-appropriate rate of return is 8% per
year. What is the present value if...?
(a) the project makes multiple payouts, 10M in year 1, 10M in
year 2, 10M in year 3, 10M in year 4, 10M in year 5, and no
other payments thereafter.

(b) the project makes multiple payouts, 10M in year 1, and

payouts that grow at a 10% rate in year 2, year 3, year 4, and
year 5, and no other payments thereafter.
Formulas - Annuity & Growing Annuity
Constant finite annuity (starting in 1 year):

1
1− (1+r )T
PV0 = CF ∗
r

Constant-growth finite annuity (starting in 1 year):

 T
1+g
1− 1+r
PV0 = CF ∗
r −g

I CF = cash-flow in one year, i.e., next year.

I g = cash-flows’ growth rate.
I PV0 = present value.
I r = annual rate of return.
I T = years to final payment.
Present Value of Infinite Cash-Flows

Constant infinite annuity (starting in 1 year):

CF
PV0 =
r

Constant-growth infinite annuity (starting in 1 year):

CF
PV0 =
r −g

I CF = cash-flow in one year, i.e., next year.

I g = cash-flows’ growth rate (g < r ).
I PV0 = present value.
I r = annual rate of return.
Present Value of Infinite Cash-Flows - Exercises

Exercise Set 5:
I Suppose that the market-appropriate rate of return is 8% per
year. What is the present value if...?
(a) the project makes payments of 10M every year forever, starting
in 1 year.
(b) the project makes a first payment of 10M in year 1, and
payments growing at 5% per year forever.
PV of (In)finite Annuity Starting in “n” Years

I What’s the present value of (in)finite annuity starting in “n”

years instead of 1 year?
1. Apply ‘annuity formula’ as if it started next year.
2. Divide your result by (1 + r )n−1 .

I Step 1 gives the ‘project’s value in year n-1’. Step 2 gives the
present value of the ‘project’s value in year n-1’.
PV (In)finite Annuity Starting in t Years - Exercise

Exercise Set 6:
I Suppose that the market-appropriate rate of return is 8% per
year. What is the present value if...?
(a) the project makes five consecutive annual payments of 10M
each starting in year 4.
(b) the project makes five consecutive annual payments growing at
a 10% rate, starting with 10M in year 5.
(c) the project makes infinite annual payments of 10M each
starting in year 6.
(d) the project makes infinite annual payments growing at a 5%
rate, starting with 10M in year 7.
PV of (In)finite “Annuity Due”

I What’s the present value of (in)finite annuity starting today,

n=0 (i.e., an “annuity due”)?
1. Apply ‘annuity formula’ as if it started next year.
2. Divide your result by (1 + r )n−1 .
I It’s the same as multiplying by (1 + r ) when n=0

I Step 1 gives the ‘project’s value in year -1’. Step 2 gives the
present value of the ‘project’s value in year -1’.
PV (In)finite Annuity Starting in t Years - Exercise

Exercise Set 7:
I Suppose that the market-appropriate rate of return is 8% per
year. What is the present value if...?
(a) the project makes five consecutive annual payments growing at
a 10% rate, starting with 10M today.
(b) the project makes infinite annual payments growing at a 5%
rate starting with 10M today.
Definitions & Exercises

I Discounted value: present value is called discounted value

I Discount rate: the rate “r” is called the discount rate.

I t-year discount factor≡ 1
(1+r )t

I Measures the present value of one euro received in year t

I Present Value (CFt )= CFt × t-year discount factor.
I Exercises: calculate the discount factors for years 1 to 5 in
Exercise set 3. Calculate PV using the above formula.
1
1−
(1+r )T
I T-year annuity factor≡ r
I Present value of one euro a year for T years.
I Present Value (annuity) = CF × T-yr annuity factor
I Exercises: calculate the 5-year annuity factor in Exercise set
4(a), and calculate PV using the above formula.
Definitions & Exercises

I Opportunity cost of capital: the rate “r” is also called like this
because it’s the return that investors could get by investing in
other financial assets with the same risk as the project.
I Exercise. The return on US bonds is 2%. The average return
on US stocks is 10%. The average return of tech-stocks is
16%. Find the cost of capital if:
(a) Your project has no risk.
(b) You plan to buy a conglomerate firm.
(c) You plan to develop a new software.

I Net Present Value (NPV)=Present value - Investment cost

I Investment decision rule: invest only if NPV ≥ 0.
It increases shareholder’s value.
Useful Applications 1: NPV & Value maximization

Exercise Set 8:
I Which of the following projects increase value for
shareholders?
1. Exercise 4(a) if investment cost is 45M.
2. Exercise 4(b) if investment cost is 45M.
3. Exercise 5(a) if investment cost is 125M.
4. Exercise 5(b) if investment cost is 125M.
5. Exercise 6(a) if investment cost is 45M.
6. Exercise 6(b) if investment cost is 45M.
7. Exercise 6(c) if investment cost is 125M.
8. Exercise 6(d) if investment cost is 125M.
9. Exercise 7(a) if investment cost is 45M
10. Exercise 7(b) if investment cost is 125M.
Useful Applications 2: Mortgage payments

I Most bank loans are paid off in equal installments.

I Example: you take a five-year loan of e1000 at 8%.
I Bank requires you to pay back in 5 equal installments:
year 1 year 2 year 3 year 4 year 5
CF CF CF CF CF
I If the bank pays you 1000 and wants an 8% return, what
should be the value of the constant payments CF?
I In 4(a) we asked the opposite question. If investors get 5
constant CF, what should they pay to get 8% return?
I Answer: the Present value: = CF × 5-yr annuity factor.

I If we flip the question, we flip the answer:

I Answer: CF= Present value / 5-yr annuity factor.
= 1000 / 3.9927 = $250.45
Useful Applications 2: Mortgage payments

Mortgage payments (CF):

Loan value
CF =
T-year annuity factor

I r = annual rate of return.

I T = loan length (years)

Exercise Set 9:

(a) Verify that you pay the loan after 5 years, and calculate the
annual amortization of the loan.

(b) You take a e250,000 house mortgage at 12% rate to be

repaid over 30 years. What are your mortgage payments?
Useful Applications 3: Saving for the future

I Example: you are saving to buy a car. You estimate that once
you graduate you could save 10K a year and earn an 8%
return. How much will you have after five years?
I Long way: calculate the future value of every cash flow (using
future value formula) and sum them.
I Short way: calculate the present value of the cash flows, then
calculate the future value of the present value.

Future Valuet = present value × (1 + r )t

I Why the short way is shorter? Because we have short-cuts for

calculating present value.
Useful Applications 3: Saving for the future

I In the example we want to find the value of a T-year annuity

at the end of year T. The short way formula is:
1
1 − (1+r )T
Future value of an Annuity = CF × × (1 + r )T
r
(1 + r )T − 1
= CF ×
r
T
I Future value T-annuity factor ≡ (1+rr) −1
I Useful for calculating savings for retirement.

Exercise Set 10:

(a) Use the short method to find out how much will you be able
to spend on the car. (hint: T=5, CF=10K)
How Interest is Paid and Quoted

I Example 1: Bond A pays 10% interest every year, bond B 5%

interest every six months. Which one do you prefer?

I Both pay the same simple interest. Simple interest is the

annual interest paid on the initial investment.

I Example 2: Bond C pays 12% interest every year, bond D 1%

interest every month. Which one do you prefer?

I Both pay the same simple interest.

How Interest is Paid and Quoted

I Example 1 cont’: bond B is the correct answer. The sooner

you get the money the sooner you can invest it an earn
interest on interest (compound interest).
I To observe this, calculate how much you would obtain by
investing 100 at 5% interest compounded semiannually.
I After 2 semesters (1 year): 100 × (1 + 5%)2 = 110.25
I A 5% interest compounded semiannually is equivalent to a
10.25% interest compounded annually, which is called the
effective annual interest rate (EAR).

I Example 2 cont’: bond D is the correct answer because you

can earn interest on the monthly interest.
I To observe this, calculate how much you would obtain by
investing 100 at 1% interest compounded monthly.
I After 12 months (1 year): 100 × (1 + 1%)12 = 112.68
I A 1% interest compounded monthly is equivalent to a 12.68%
interest compounded annually. EAR=12.68%.
How Interest is Paid and Quoted

I People use the effective annual interest rate (EAR) to

compare interest rates that have different payment frequency
to take into account the time value of money.
I Convention: the quoted rate is the simple interest rate.
I It would be 10% for bonds B and 12% for bond D.

EAR = [1 + (r /m)]m − 1

I m = number of payments per year (compounding frequency).

Exercise Set 11:

(a) Calculate the EAR of 10% compounded every 4 months.

(b) Calculate the EAR of 10% compounded quarterly.
Continuous Compounding

I In theory, the compounding frequency can be as high as

infinite. In this case interest is continuously compounded
I [1 + (r /m)]m = e r when m is infinite.
I The EAR of a continuously compounded interest is:

EARcont = e r − 1

Exercise Set 11 cont’:

(c) Calculate the EAR of 10% compounded continuously.