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Chapter 2

HOW TO CALCULATE
PRESENT VALUES

Brealey, Myers, and Allen


Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
2-1 FUTURE VALUES AND PRESENT VALUES

Calculating Future Values


Future Value
Amount to which investment will grow
after earning interest
Present Value
Value today of future cash flow

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2-1 FUTURE VALUES AND PRESENT VALUES

Future Value of $100 =

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
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FIGURE 2.1 FUTURE VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

Present va lue = PV
PV = discount factor C1

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2-1 FUTURE VALUES AND PRESENT VALUES

Discount factor = DF = PV of $1

Discount factors can be used to compute


present value of any cash flow

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2-1 FUTURE VALUES AND PRESENT VALUES

Given any variables in the equation, one


can solve for the remaining variable
Prior example can be reversed

PV DF2 C2
PV 1
(1.07) 2
114.49 100

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FIGURE 2.2 PRESENT VALUES WITH
COMPOUNDING

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2-1 FUTURE VALUES AND PRESENT VALUES

Valuing an Office Building


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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2-1 FUTURE VALUES AND PRESENT VALUES

Valuing an Office Building


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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2-1 FUTURE VALUES AND PRESENT VALUES

Net Present Value

NPV = PV required investment


C1
NPV = C0
1 r

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2-1 FUTURE VALUES AND PRESENT VALUES

Risk and Present Value


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

PV of C1 $800,000 at 7%
$800,000
PV $747,664
1 .07

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2-1 FUTURE VALUES AND PRESENT VALUES

Risk and Net Present Value

NPV = PV required investment


NPV = $747,664 $700,000
$47,664

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2-1 FUTURE VALUES AND PRESENT VALUES

Net Present Value Rule


Accept investments that have positive net
present value
Using the original example: Should one accept
the project given a 10% expected return?

$800,000
NPV = $700,000 + $27,273
1.1

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2-1 FUTURE VALUES AND PRESENT VALUES

Rate of Return Rule


Accept investments that offer rates of return in
excess of their opportunity cost of capital
In the project listed below, the opportunity cost
of capital is 12%. Is the project a wise
investment?
profit $800,000 $700,000
Return .143, or 14.3%
investment $700,000

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2-1 FUTURE VALUES AND PRESENT VALUES

Multiple Cash Flows


Discounted Cash Flow (DCF) formula:

PV0 (1r )1 (1r )2 .... (1r )t


C1 C2 Ct

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FIGURE 2.5 NET PRESENT VALUES

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2-2 PERPETUITIES AND ANNUITIES

Perpetuity
Financial concept in which cash flow is
theoretically received forever

cash flow
Return
present va lue
C
r
PV
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2-2 PERPETUITIES AND ANNUITIES

Perpetuity

cash flow
PV of cash flow
discount rate
C1
PV0
r

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2-2 PERPETUITIES AND ANNUITIES

Present Value of Perpetuities


What is the present value of $1 billion
every year, for eternity, if the perpetual
discount rate is 10%?

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2-2 PERPETUITIES AND ANNUITIES

Present Value of Perpetuities


What if the investment does not start
making money for 3 years?

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2-2 PERPETUITIES AND ANNUITIES

Annuity
Asset that pays fixed sum each year for
specified number of years
Asset Year of Payment Present Value
1 2..t t+1
Perpetuity (first
payment in year 1)

Perpetuity (first
payment in year t + 1)

Annuity from C C 1

t
year 1 to year t r r (1 r )

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2-2 PERPETUITIES AND ANNUITIES
Example: Tiburon Autos offers 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?

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2-2 PERPETUITIES AND ANNUITIES

1 1
PV of annuity C t
r r 1 r

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2-2 PERPETUITIES AND ANNUITIES

Annuity
Example: The state lottery advertises a jackpot
prize of $365 million, paid in 30 yearly
installments of $12.167 million, at the end of
each year. Find the true value of the lottery
prize if interest rates are 6%.
1 1
Lottery Value 12.167 30
.06 .061 .06
Value $167,500,000

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2-2 PERPETUITIES AND ANNUITIES

Future Value of an Annuity

1 r 1
t
FV of annuity C
r

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2-2 PERPETUITIES AND ANNUITIES

Future Value of an Annuity


What is the future value of $20,000 paid at the
end of each of the following 5 years, assuming
investment returns of 8% per year?

1 .085 1
FV 20,000
.08
$117,332

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2-3 GROWING PERPETUITIES AND ANNUITIES

Constant Growth Perpetuity


C1 g = the annual growth
PV0
rg rate of the cash flow

This formula can be used to value a perpetuity


at any point in time

Ct 1
PVt
rg

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2-3 GROWING PERPETUITIES AND ANNUITIES

Constant Growth Perpetuity


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 constant growth rate
of 4%?

1
PV0
.10 .04
$16.667 billion

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2-3 GROWING PERPETUITIES AND ANNUITIES

Growing Annuities
Golf club membership is $5,000 for 1 year, or
$12,750 for three years. Find the better deal
given payment due at the end of the year and
6% expected annual price increase, discount
rate 10%.

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2-4 HOW INTEREST IS PAID AND QUOTED

Effective Annual Interest Rate (EAR)


Interest rate annualized using compound
interest
Annual Percentage Rate (APR)
Interest rate annualized using simple
interest

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2-4 HOW INTEREST IS PAID AND OUTLAID

Given a monthly rate of 1%, what is the


(EAR)? What is the (APR)?

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

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

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