3- 1

Present Values





Discount Factors can be used to compute
the present value of any cash flow.
DF
r
t
=
+
1
1 ( )
1
1
1
1 r
C
C DF PV
+
= =
3- 2
Present Values
Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money, how much money should you set aside today
in order to make the payment when due in two years?
572 , 2 $
2
) 08 . 1 (
3000
= = PV
3- 3
Present Values
Example
You have the opportunity to purchase the baseball hit by
Barry Bonds to break Hank Arrons home run record
(home run # 756). You estimate this baseball will be worth
$2,000,000 when you retire at the end of twenty years. If
you expect a 12% return on your investment, how much
will you pay for the baseball ?
334 , 207 $
20
) 12 . 1 (
000 , 000 , 2
= = PV
3- 4
Present Values





Replacing 1 with t allows the formula
to be used for cash flows that exist at any
point in time
t
t
t
r
C
C DF PV
) 1 ( +
= =
3- 5
Present Values
Example
You will receive $200 risk free in two years. If the annual
rate of interest on a two year treasury note is 7.7%, what is
the present value of the $200?



42 . 172 $
2
) 077 . 1 (
200
= = PV
3- 6
Present Values
PVs can be added together to evaluate
multiple cash flows.
PV
C
r
C
r
= + +
+ +
1
1
2
2
1 1 ( ) ( )
....
3- 7
Present Values
PVs can be added together to evaluate
multiple cash flows.
88 . 265
2 1
) 077 1 (
200
) 07 . 1 (
100
= + =
+ +
PV
3- 8
Present Values
Present Value
Year 0

100/1.07
200/1.077
2
Total



= $93.46
= $172.42
= $265.88
$100
$200
Year
0 1 2
3- 9
Present Values
Given two dollars, one received a year from now
and the other two years from now, the value of
each is commonly called the Discount Factor.
Assume r1 = 20% and r2 = 7%.
87 .
83 .
2
1
) 07 . 1 (
00 . 1
2
) 20 . 1 (
00 . 1
1
= =
= =
+
+
DF
DF
3- 10
Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building is as
follows. Given a 5% required
rate of return, create a present
value worksheet and show the
net present value.
000 , 320 000 , 100 000 , 170
2 Year 1 Year 0 Year
+
3- 11
Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
( )
011 , 25 $
249 , 290 000 , 320 907 . 2
238 , 95 000 , 100 952 . 1
000 , 170 000 , 170 0 . 1 0
Value
Present
Flow
Cash
Factor
Discount
Period
2
05 . 1
1
05 . 1
1
= =
+ + =
=

Total NPV
3- 12
Present Values
Present Value
Year 0
-170,000
-100,000/1.05
320,000/1.05
2
Total = NPV
-$170,000


= -$170,000
= $95,238
= $290,249
= $25,011
-$100,000
+$320,000
Year
0 1 2
Example - continued
Assume that the cash flows from the construction and sale of an office
building is as follows. Given a 5% required rate of return, create a
present value worksheet and show the net present value.
3- 13
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
PV
C
r =
=
lue present va
flow cash
Return
3- 14
Short Cuts
Perpetuity - Financial concept in which a cash
flow is theoretically received forever.
r
C
PV
1
0
rate discount
flow cash
Flow Cash of PV
=
=
3- 15
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%??



billion 10 $
10 . 0
bi l $1
= = PV
3- 16
Short Cuts
Annuity - An asset that pays a fixed sum each year for
a specified number of years.
r
C
Perpetuity (first
payment in year 1)
Perpetuity (first payment
in year t + 1)
Annuity from year
1 to year t
Asset Year of Payment
1 2..t t + 1
Present Value
t
r r
C
) 1 (
1
+
|
.
|

\
|
|
|
.
|

\
|
+
|
.
|

\
|

|
.
|

\
|
t
r r
C
r
C
) 1 (
1
3- 17
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?
Present Values
5,000
Year
0 1 2 3 4 5
5,000 5,000 5,000 5,000
( )
( )
( )
( )
20,501 NPV Total
565 , 3 07 . 1 / 000 , 5
814 , 3 07 . 1 / 000 , 5
081 , 4 07 . 1 / 000 , 5
367 , 4 07 . 1 / 000 , 5
673 , 4 07 . 1 / 000 , 5
5
4
3
2
=
=
=
=
=
=
Present Value at
year 0
3- 18
Short Cuts
Annuity - An asset that pays a fixed sum each
year for a specified number of years.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
3- 19
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?
3- 20
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?
( )
10 . 774 , 12 $
005 . 1 005 .
1
005 .
1
300 Cost Lease
48
=
(

+
=
Cost
3- 21
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.
( )
(

+
=
r
r
C
t
1 1
annuity of FV
3- 22
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?
( )
332 , 117 $
08 .
1 08 . 1
000 , 20 FV
5
=
(

+
=
3- 23
Constant Growth Perpetuity
g r
C
PV

=
1
0
g = the annual growth rate of the
cash flow
3- 24
Constant Growth Perpetuity
g r
C
PV

=
1
0
NOTE: This formula can be used
to value a perpetuity at any point
in time.
g r
C
PV
t
t

=
+1
3- 25
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%?
billion 667 . 16 $
04 . 10 .
1
0
=

= PV
3- 26
Perpetuities
A three-year stream of cash flows that grows at the rate g is
equal to the difference between two growing perpetuities.
3- 27
Compound Interest
i ii iii iv v
Periods Interest Value Annually
per per APR after compounded
year period (i x ii) one year interest rate

1 6% 6% 1.06 6.000%

2 3 6 1.03
2
= 1.0609 6.090

4 1.5 6 1.015
4
= 1.06136 6.136

12 .5 6 1.005
12
= 1.06168 6.168

52 .1154 6 1.001154
52
= 1.06180 6.180

365 .0164 6 1.000164
365
= 1.06183 6.183
3- 28
Simple and Compound Interest
The value of a $100 investment earning 10% annually.
3- 29
Compound Interest
Compound interest versus simple interest. The top two ascending lines show the
growth of $100 invested at simple and compound interest. The longer the funds
are invested, the greater the advantage with compound interest. The bottom line
shows that $38.55 must be invested now to obtain $100 after 10 periods.
Conversely, the present value of $100 to be received after 10 years is $38.55.
3- 30
Compound Interest
0
2
4
6
8
10
12
14
16
18
0 3 6 9
1
2
1
5
1
8
2
1
2
4
2
7
3
0
Number of Years
F
V

o
f

$
1
10% Simple
10% Compound
3- 31
Compound Interest
Example
Suppose you are offered an automobile loan at an APR of
5% per year. What does that mean, and what is the true
rate of interest, given monthly payments?
3- 32
Compound Interest
Example - continued
Suppose you are offered an
automobile loan at an APR of 5% per
year. What does that mean, and what
is the true rate of interest, given
monthly payments? Assume $10,000
loan amount.

% 1678 . 6
78 . 616 , 10
) 005 . 1 ( 000 , 10 Pmt Loan
12
=
=
=
APR
3- 33
Assumptions in Valuation
An Ideal Capital Market:
1. Capital markets are frictionless
2. All market participants share
homogenous expectations
All market participants are atomistic
Firms investment program is fixed and
known
The financing is fixed
3- 34
Worked Example
Your father is 50 years old and will retire in 10 years. He expects to
live for 25 years after he retires, until he is 85. He wants a fixed
retirement income that has the same purchasing power at the time he
retires as RM40,000 has today. (The real value of his retirement
income will decline annually after he retires.)
His retirement income will begin the day he retires,10 years from
today; and he will then receive 24 additional annual payments. Annual
inflation is expected to be 5 percent. He currently has RM100,000
saved, and he expects to earn 8 percent annually on his savings. How
much must he save during each of the next 10 years (end of year
deposits) to meet his retirement goal?
3- 35
Worked Example
1. Will save for 10 years, and then receive payments for 25 years. How much
must he deposit at the end of each of the next 10 years?

2. Wants payments of $40,000 per year in todays dollars for first payment
only. Real income will decline. Inflation will be 5%. Therefore, to find the
inflated fixed payments, we have this time line:
0 5 10
| | |
40,000 FV = ?

Enter N = 10, I/YR = 5, PV = -40000, PMT = 0, and press FV to get FV =
$65,155.79.
3. He now has $100,000 in an account that pays 8%, annual compounding.
We need to find the FV of the $100,000 after 10 years. Enter N = 10, I/YR = 8,
PV = -100000, PMT = 0, and press FV to get FV = $215,892.50.




4. He wants to withdraw, or have payments of, $65,155.79 per year for 25
years, with the first payment made at the beginning of the first retirement year.
So, we have a 25-year annuity due with PMT = 65,155.79, at an interest rate of
8%. Set the calculator to BEG mode, then enter N = 25, I/YR = 8, PMT =
65155.79, FV = 0, and press PV to get PV = $751,165.35. This amount must
be on hand to make the 25 payments.
5. Since the original $100,000, which grows to $215,892.50, will be
available, we must save enough to accumulate $751,165.35 - $215,892.50 =
$535,272.85.
So, the time line looks like this:
Retires
50 51 52 59 60 61
83 84 85
| | | | | |
| | |
$100,000 PMT PMT PMT PMT
-65,155.79 -65,155.79
-65,155.79 -65,155.79
+ 215,892.50
- 751,165.35 = PVA(due)
Need to accumulate -$535,272.85 = FVA10

6. The $535,272.85 is the FV of a 10-year ordinary annuity. The payments
will be deposited in the bank and earn 8% interest. Therefore, set the
calculator to END mode and enter N = 10, I/YR = 8, PV = 0, FV =
535272.85, and press PMT to find PMT = $36,949.61.





3- 36
Worked Example
4. He wants to withdraw, or have payments of, $65,155.79 per year for 25 years,
with the first payment made at the beginning of the first retirement year. So, we have a
25-year annuity due with PMT = 65,155.79, at an interest rate of 8%. Set the calculator
to BEG mode, then enter N = 25, I/YR = 8, PMT = 65155.79, FV = 0, and press PV to
get PV = $751,165.35. This amount must be on hand to make the 25 payments.
5. Since the original $100,000, which grows to $215,892.50, will be available, we
must save enough to accumulate $751,165.35 - $215,892.50 = $535,272.85.
So, the time line looks like this:
Retires
50 51 52 59 60 61
83 84 85
| | | | | |
| | |
$100,000 PMT PMT PMT PMT
-65,155.79 -65,155.79 -65,155.79 -
65,155.79
+ 215,892.50
- 751,165.35 = PVA(due)
Need to accumulate -$535,272.85 = FVA10

3- 37
Worked Example
The $535,272.85 is the FV of a 10-year ordinary annuity.
The payments will be deposited in the bank and earn 8%
interest. Therefore, set the calculator to END mode and
enter N = 10, I/YR = 8, PV = 0, FV = 535272.85, and
press PMT to find PMT = $36,949.61.
3- 38
Cases & Readings
Case: The Battle for Value, 2004: Fed EX Corp. versus United Parcel
Services, Inc.,
(Refer to Pages 53-73 of the Book, Case Studies in Finance: Managing
for Corporate Value Creation, by Robert F. Bruner, Kenneth M. Eades
and Michael J. Schill, 6
th
Edition, McGraw-Hill International Edition,
2010).
Articles: 1. An Islamic Perspective on the economics of Discounting in project
evaluation, Muhamad Anas Al Zarqa, Chapter 6, in the book, An Introduction
to Islamic Economics & Finance, Edited by Sheikh Ghazali Sheikh Abod,
Syed Omar Syed Agil, and Aidit Ghazali, CERT Publications, 2005
2. Time value from Islamic Perspective, Muhamad Akram Khan, Chapter 7, in
the book, An Introduction to Islamic Economics & Finance, Edited by Sheikh
Ghazali Sheikh Abod, Syed Omar Syed Agil, and Aidit Ghazali, CERT
Publications, 2005.