Discounted Cash Flow Valuation

2 BASIC PRINCIPAL Would you rather have $1,000 today or $1,000 in 30 years?  Why?

Present and Future Value Present Value: value of a future payment today Future Value: value that an investment will grow to in the future We find these by discounting or compounding at the discount rate  Also know as the hurdle rate or the opportunity cost of capital or the interest rate 3

4 One Period Discounting PV = Future Value / (1+ Discount Rate)  V 0 = C 1 / (1+r) Alternatively PV = Future Value * Discount Factor  V 0 = C 1 * (1/ (1+r))  Discount factor is 1/ (1+r)

5 PV Example What is the value today of $100 in one year, if r = 15%?

6 FV Example What is the value in one year of $100, invested today at 15%?

7 NPV NPV = PV of all expected cash flows  Represents the value generated by the project  To compute we need: expected cash flows & the discount rate Positive NPV investments generate value Negative NPV investments destroy value

8 Net Present Value (NPV) NPV = PV (Costs) + PV (Benefit)  Costs: are negative cash flows  Benefits: are positive cash flows One period example  NPV = C 0 + C 1 / (1+r)  For Investments C 0 will be negative, and C 1 will be positive  For Loans C 0 will be positive, and C 1 will be negative

9 Net Present Value Example Suppose you can buy an investment that promises to pay $10,000 in one year for $9,500. Should you invest?

10 Net Present Value Since we cannot compare cash flow we need to calculate the NPV of the investment  If the discount rate is 5%, then NPV is? At what price are we indifferent?

11 Net Present Value Since we cannot compare cash flow we need to calculate the NPV of the investment  If the discount rate is 5%, then NPV is? At what price are we indifferent?

12 Coffee Shop Example If you build a coffee shop on campus, you can sell it to Starbucks in one year for $300,000 Costs of building a coffee shop is $275,000 Should you build the coffee shop?

13 Step 1: Draw out the cash flows

14 Step 2: Find the Discount Rate Assume that the Starbucks offer is guaranteed US T-Bills are risk-free and currently pay 7% interest  This is known as r f Thus, the appropriate discount rate is 7%  Why?

15 Step 3: Find NPV The NPV of the project is?

16 If we are unsure about future? What is the appropriate discount rate if we are unsure about the Starbucks offer  r d = r f  r d > r f  r d < r f

17 The Discount Rate Should take account of two things: 1. Time value of money 2. Riskiness of cash flow The appropriate discount rate is the opportunity cost of capital  This is the return that is offer on comparable investments opportunities

18 Risky Coffee Shop Assume that the risk of the coffee shop is equivalent to an investment in the stock market which is currently paying 12% Should we still build the coffee shop?

19 Calculations Need to recalculate the NPV

20 Future Cash Flows Since future cash flows are not certain, we need to form an expectation (best guess)  Need to identify the factors that affect cash flows (ex. Weather, Business Cycle, etc).  Determine the various scenarios for this factor (ex. rainy or sunny; boom or recession)  Estimate cash flows under the various scenarios (sensitivity analysis)  Assign probabilities to each scenario

21 Expectation Calculation The expected value is the weighted average of X’s possible values, where the probability of any outcome is p E(X) = p 1 X 1 + p 2 X 2 + …. p s X s  E(X) – Expected Value of X  X i  Outcome of X in state i  p i – Probability of state i  s – Number of possible states Note that = p 1 + p 2 +….+ p s = 1

22 Risky Coffee Shop 2 Now the Starbucks offer depends on the state of the economy

23 Calculations Discount Rate = 12% Expected Future Cash Flow = NPV = Do we still build the coffee shop?

24 Valuing a Project Summary Step 1: Forecast cash flows Step 2: Draw out the cash flows Step 3: Determine the opportunity cost of capital Step 4: Discount future cash flows Step 5: Apply the NPV rule

25 Reminder Important to set up problem correctly Keep track of Magnitude and timing of the cash flows TIMELINES You cannot compare cash t=3 t=2 if they are not in present value terms!!

26 General Formula PV 0 = FV N /(1 + r) N OR FV N = PV o *(1 + r) N Given any three, you can solve for the fourth  Present value (PV)  Future value (FV)  Time period  Discount rate

27 Four Related Questions 1. How much must you deposit today to have $1 million in 25 years? (r=12%) 2. If a $58, investment yields $1 million in 25 years, what is the rate of interest? 3. How many years will it take $58, to grow to $1 million if r=12%? 4. What will $58, grow to after 25 years if r=12%?

28 FV Example Suppose a stock is currently worth $10, and is expected to grow at 40% per year for the next five years. What is the stock worth in five years? $

29 PV Example How much would an investor have to set aside today in order to have $20,000 five years from now if the current rate is 15%? $20,000 PV

30 Simple vs. Compound Interest Simple Interest: Interest accumulates only on the principal Compound Interest: Interest accumulated on the principal as well as the interest already earned What will $100 grow to after 5 periods at 35%? Simple interest FV 2 = (PV 0 * (r) + PV 0 *(r)) + PV 0 = PV 0 (1 + 2r) = Compounded interest FV 2 = PV 0 (1+r) (1+r)= PV 0 (1+r) 2 =

31 Compounding Periods We have been assuming that compounding and discounting occurs annually, this does not need to be the case

32 Non-Annual Compounding Cash flows are usually compounded over periods shorter than a year The relationship between PV & FV when interest is not compounded annually  FV N = PV * ( 1+ r / M) M*N  PV = FV N / ( 1+ r / M) M*N M is number of compounding periods per year N is the number of years

33 Compounding Examples What is the FV of $500 in 5 years, if the discount rate is 12%, compounded monthly? What is the PV of $500 received in 5 years, if the discount rate is 12% compounded monthly?

34 Interest Rates The 12% is the Stated Annual Interest Rate (also known as the Annual Percentage Rate)  This is the rate that people generally talk about Ex. Car Loans, Mortgages, Credit Cards However, this is not the rate people earn or pay The Effective Annual Rate is what people actually earn or pay over the year  The more frequent the compounding the higher the Effective Annual Rate

35 Compounding Example 2 If you invest $50 for 3 years at 12% compounded semi-annually, your investment will grow to:

Compounding Example 2: Alt. If you invest $50 for 3 years at 12% compounded semi-annually, your investment will grow to: Calculate the EAR: EAR = (1 + R/m) m – 1 So, investing at compounded annually is the same as investing at 12% compounded semi-annually 36

37 EAR Example Find the Effective Annual Rate (EAR) of an 18% loan that is compounded weekly.

38 Present Value Of a Cash Flow Stream Discount each cash flow back to the present using the appropriate discount rate and then sum the present values.

39 Insight Example r = 10% YearProject AProject B PV Which project is more valuable? Why?

40 Example (Given) Consider an investment that pays $200 one year from now, with cash flows increasing by $200 per year through year 4. If the interest rate is 12%, what is the present value of this stream of cash flows? If the issuer offers this investment for $1,500, should you purchase it?

41 Multiple Cash Flows (Given) ,432.93

42 Common Cash Flows Streams Perpetuity, Growing Perpetuity  A stream of cash flows that lasts forever Annuity, Growing Annuity  A stream of cash flows that lasts for a fixed number of periods NOTE: All of the following formulas assume the first payment is next year, and payments occur annually

43 Perpetuity A stream of cash flows that lasts forever PV: = C/r What is PV if C=$100 and r=10%: … 0 1 C 2 C 3 C

44 Growing Perpetuities Annual payments grow at a constant rate, g PV= C 1 /(1+r) + C 1 (1+g)/(1+r) 2 + C 1 (1+g) 2 (1+r) 3 +… PV = C 1 /(r-g) What is PV if C 1 =$100, r=10%, and g=2%? … 0123 C1C1 C 2 (1+g)C 3 (1+g) 2

45 Growing Perpetuity: Example (Given) The expected dividend next year is $1.30, and dividends are expected to grow at 5% forever. If the discount rate is 10%, what is the value of this promised dividend stream? 0 … 1 $ $1.30×(1.05) = $ $1.30 ×(1.05) 2 = $1.43 PV = 1.30 / (0.10 – 0.05) = $26

46 Example An investment in a growing perpetuity costs $5,000 and is expected to pay $200 next year. If the interest is 10%, what is the growth rate of the annual payment?

47 Annuity A constant stream of cash flows with a fixed maturity 0 1 C 2 C 3 C T C

48 Annuity Formula Simply subtracting off the PV of the rest of the perpetuity’s cash flows 0 1 C 2 C 3 C T C T+1 C T+2 C T+3 C

49 Annuity Example 1 Compute the present value of a 3 year ordinary annuity with payments of $100 at r=10% Answer: Or

50 Alternative: Use a Financial Calculator Texas Instruments BA-II Plus, basic  N = number of periods  I/Y = periodic interest rate P/Y must equal 1 for the I/Y to be the periodic rate Interest is entered as a percent, not a decimal  PV = present value  PMT = payments received periodically  FV = future value  Remember to clear the registers (CLR TVM) after each problem  Other calculators are similar in format

51 Annuity Example 2 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? Work through on your financial calculators

52 Annuity Example 3 What is the value today of a 10-year annuity that pays $600 every other year? Assume that the stated annual discount rate is 10%.  What do the payments look like?  What is the discount rate?

53 Annuity Example 4 What is the present value of a four payment annuity of $100 per year that makes its first payment two years from today if the discount rate is 9%?  What do the payments look like?

54 Annuity Example 5 What is the value today of a 10-pymt annuity that pays $300 a year if the annuity’s first cash flow is at the end of year 6. The interest rate is 15% for years 1-5 and 10% thereafter?

Annuity Example 6 You win the $20 million Powerball. The lottery commission offers you $20 million dollars today or a nine payment annuity of $2,750,000, with the first payment being today. Which is more valuable is your discount rate is 5.5%? 55

Alt: Annuity Example 6 You win the $20 million Powerball. The lottery commission offers you $20 million dollars today or a nine payment annuity of $2,750,000, with the first payment being today. Which is more valuable if your discount rate is 5.5%? 56

57 Delayed first payment: Perpetuity What is the present value of a growing perpetuity, that pays $100 per year, growing at 6%, when the discount rate is 10%, if the first payment is in 12 years?

58 Growing Annuity A growing stream of cash flows with a fixed maturity 0 1 C 2 C×(1+g) 3 C ×(1+g) 2 T C×(1+g) T-1

59 Growing Annuity: Example A defined-benefit retirement plan offers to pay $20,000 per year for 40 years and increase the annual payment by 3% each year. What is the present value at retirement if the discount rate is 10%? 0 1 $20,000 2 $20,000×(1.03) 40 $20,000×(1.03) 39

60 Growing Annuity: Example (Given) You are evaluating an income generating property. Net rent is received at the end of each year. The first year's rent is expected to be $8,500, and rent is expected to increase 7% each year. What is the present value of the estimated income stream over the first 5 years if the discount rate is 12%? PV = (8,500/( )) * [ 1- {1.07/1.12} 5 ] = $34,

61 Growing Perpetuity Example What is the value today a perpetuity that makes payments every other year, If the first payment is $100, the discount rate is 12%, and the growth rate is 7%?  r:  g:  Price:

62 Valuation Formulas

63 Remember That when you use one of these formula’s or the calculator the assumptions are that: PV is right now The first payment is next year

64 What Is a Firm Worth? Conceptually, a firm should be worth the present value of the firm’s cash flows. The tricky part is determining the size, timing, and risk of those cash flows.

65 Quick Quiz 1. How is the future value of a single cash flow computed? 2. How is the present value of a series of cash flows computed. 3. What is the Net Present Value of an investment? 4. What is an EAR, and how is it computed? 5. What is a perpetuity? An annuity?

Why We Care The Time Value of Money is the basis for all of finance People will assume that you have this down cold 66