DISCOUNTED CASH FLOWS AND

VALUATION
Learning outcomes
 
1) compute the present value and future value for multiple cash
flows, the present value of an ordinary annuity and perpetuity,
and effective annual interest rate;
2) discuss their application in business.
 Why should we find the Present Value of
future cash flows?
• Since we can not compare or add/subtract cash flows at
different point in time together we need to convert cash flow
to a common point in time.
• Financial decisions are made in the present time.
• Your investment is being made in the present, but the cash
flows you get back will be in the future. Because of the time
value of money, future cash flows are not comparable with a
present cash flow (i.e. your investment). To make them
comparable, the present value of the future cash flows has to
be found
Cash Flow Types and Discounting Mechanics

There are five types of cash flows -

· simple cash flows,
· perpetuities
· annuities
· growing annuities
· growing perpetuities
I . Simple Cash Flows

 A simple cash flow is a single cash flow in a specified future time

period.
Cash Flow: CFt

__________________________________________________________
________|
CFt
Time Period: PV of Simple Cash Flow 
t
(1 + r) t
 The present value of this cash flow is-

FV of Simple Cash Flow  CF0 * (1 + r) t

 The future value of a cash flow is
 Present Value of Simple Cash Flow
E.g. An investment of £1000 today would get back £1200 after 3
yrs. If your opportunity cost is 9%, you could appraise this
investment in two different ways:

1. FV of £1000 invested at the opportunity cost of 9% would be

1000 x 1.093 = £1295. This is greater than £1200, so the
investment is not worthwhile.

2. PV of £1200 received 3 years from now, discounted at the

opportunity cost of 9%, would be 1200/1.093 = 926.62. This
is less than the investment of £1,000, so the investment is
not worthwhile.

The second method is useful when evaluating investments

that generate multiple cash flows over many future periods –
the PVs of all future cash flows can be added up and
compared with the investment.
Present Value of Multiple Cash Flows

 First, prepare timeline to identify magnitude

and timing of cash flows.
 Next, calculate present value of each cash
flow
 Finally, add up all present values.
 Sum of present values of stream of future
cash flows is their current market price, or
value.

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 PROJECT APPRAISAL WITH MULTIPLE CASH FLOWS
Suppose you invest £950 today and are repaid:
Year0_______Year 1_________Year 2_________Year 3
-950 300 400 500
The time value of money is accounted for by discounting
the future cash inflows at your opportunity cost (10%) to
determine the Present Value (PV) of the cash inflows:

Although the total cash returns are 300 + 400 + 500 =

£1,200, the Present Value of the returns is only £979.
This is still more than your investment of £950, so the
investment will increase your present wealth by £29.
II. Annuity: A level stream of equal cash flows received or
paid over a number of periods is called an annuity.
The formula for the Present Value Interest Factor for an
Annuity (PVIFA) is a little more complicated.
Let Annuity = A, Discount Rate = i, and Period = n yrs
PV of Annuity =

The bracketed sum is the Present Value Interest Factor

for an Annuity (PVIFA) at i% for n periods. It simplifies
to:
Example of an Annuity
Suppose you invest £950 today and are repaid:
Year0 Year 1_______Year 2 _______Year 3
382 382 382
At discount rate of 10%, the PV of these cash flows would be:

The above calculation can be simplified as follows:

2.4868 is the present value interest factor for an annuity at

10% for 3 years (i.e. PVIFA10%,3) – this can be found from
Annuity Tables or by using the PVIFA formula.
 Application: Amortised Investment
An amortised investment is one that is repaid, together
with compound interest, in equal periodic payments over
the life of the investment.
Mortgage loans are typically amortised investments
made by the mortgage lender. The loan is equal to the
present value of the periodic mortgage payments,
discounted at the lender’s rate of interest. E.g.:
P = Principal amount of loan given today
PMT = Periodic payment to be made in future
n = Number of periods
i = Interest rate
P = PMT x PVIFAi,n  PMT = P ÷ PVIFAi,n
Mortgage payments are generally monthly, so the number
of compounding periods in a year are usually 12.
Example of Amortised Investment
A lender offers a mortgage loan of £140,000 to be repaid in
equal monthly instalments over 20 years, with interest at
6% per annum. What will be the monthly payment?
P = 140,000; n = 20 x 12 = 240 periods
i = 6 ÷ 12 = 0.5% per period
0.5
[Note: 0.5% = ------ = 0.005]
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III. Perpetuity
• A perpetual annuity or perpetuity is a stream of
equal cash flows that continues forever, without
any termination date. The formula for finding the
present value of a perpetuity is very simple:

Perpetual Cash Flow

PV of a Perpetuity = ----------------------------
i
 In addition to constant cash flow streams, one
may have to deal with cash flows that grow at a
constant rate over time.
 These cash-flow streams called growing
annuities or growing perpetuities.

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 IV Growing Annuity
 Business may need to compute value of multiyear product or
service contracts with cash flows that increase each year at a
constant rate.
 These are called growing annuities.
 Example of growing annuity: valuation of growing business
whose cash flows increase every year at a constant rate.
 Use this equation to value the present value of growing
annuity (equation 6.5) when the growth rate is less than
discount rate.
CF1   1  g  
n

PVA n   1     (6.5)
 i - g    1  i  

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V. Growing Perpetuity
 When cash flow stream features constant growing
annuity forever.
 Can be derived from equation 6.5 when n tends to
infinity and results in the following equation:
CF1
PVA  = (6.6)
i-g

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Discounted Cashflow Valuation:
Basis for Approach
t = n CF
Value =  t
(1 + r)t
t =1

– where,
– n = Life of the asset
– CFt = Cashflow in period t
– r = Discount rate reflecting the riskiness of the estimated cashflows
Effective Annual Interest Rate
 Interest rates can be quoted in financial
markets in variety of ways.
 Most common quote, especially for a loan,
is annual percentage rate (APR).
 APR represents simple interest accrued on
loan or investment in a single period;
annualised over a year by multiplying it by
appropriate number of periods in a year

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 Effective Annual Interest Rate
Calculating the Effective Annual Rate (EAR)

 Correct way to compute annualised rate is to

reflect compounding that occurs; involves
calculating effective annual rate (EAR).
 Effective annual interest rate (EAR) is defined as
annual growth rate that takes compounding into
account.

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Effective Annual Interest Rate
Calculating the Effective Annual Rate
(EAR)
EAR = (1 + Quoted rate/m)m – 1 (6.7)

m is the number of compounding periods during a

year.

 EAR conversion formula accounts for

number of compounding periods, thus
effectively adjusts annualised interest rate
for time value of money.
 EAR is the true cost of borrowing and
lending.
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