40 Part One

Value

Net present value is

present value plus any immediate cash flow
Net present value (NPV) = Co + Py

e m d e r that Co is negative if the immediate cash flow is an investment, that is, if it is a cash outflow.
ne discount rate r is determined by rates of return prevailing in financial markets. If the future cash flow is
absutely safe, then the discount rate is the interest rate on safe securities such as U.S. government debt. If the
fu I1ow is uncertain. then the
expected cash flow should be discounted at the expected rate of return
d D y equivalent-risk securities. (We talk more about risk and the cost ofcapital in Chapters 7 to 9.)
asn TiowS are discounted for two simple reasons: because (1) a dollar today is worth more than a dollar tomor.
o and 2) a safe dollar is worth more than a risky one. Formulas for PV and NPV are numerical expressions of
these ideas.
a n c i a l markets, including the bond and stock markets, are the markets where safe and risky future cash

OWs are traded and valuced. That is why we look to rates of return prevailing in the financial markets to determine
Dow much to discount for time and risk. By calculating the present value of an asset, we are estimating how much
people will pay for it if they have the altemative of investing in the capital markets.
ou can always work out any present value using the basic formula. but shortcut formulas can reduce the
Ledium. We showed how to value
investment that makes a level stream of cash flows forever (a perpetuitry) and
an

onethat produces a level stream for a limited period (an annuity). We also showed how to value invesuments that
produce growing streams of cash flows.
When someone offers to lend you a dollar at a quoted interest rate, you should always check how frequently the
interest is to be paid. For
example, suppose that a T100 loan requires six-month payments of 3. The total yearidy
interest payment is T6 and the interest will be
quoted as a rate of 6% compounded semiannualiy. The equivalent
annually compounded rate is (1.03) l .061, or 6.1%. Sometimes it is convenient to assume that interest is paid
-
=

evenly over the year, so that interest is quoted as a continuously compounded rate.

PROBLEM SETS
BASIC
1. Future values If you invest 100 at an interest rate of 15%, how much will
you have at the end of eight
years?
2. Discount factors If the PV of T139 is 125, what is the discount factor?
3. Present values f the cost of capital is 9%, what is the PV of {374 paid in year 9?
4. Present values A project produces a cash flow of R432 in year 1, R137 in
year 2. and 797 in year 3. If the
cost of capital is 15%, what is the project's PV? If the project requires an investment of T1,200. what is its
NPV?
5. Opportunity cost of capital Which of the following statements are true? The
opportunity cost of capital:
a. Equals the interest rate at which the company can borrow.
b. Depends on the risk of the cash flows to be valued.
C. Depends on the rates of return that shareholders can expect to earn by investing on their own.
d. Equals zero if the firm has excess cash in ius bank account and the bank account pays no interest.
6. Perpetuities An investment costs 71,548 and pays R138 in perpetuity. If the interest rate is 9%. what is the
NPV?
7. Growing perpetuities A common stock will pay a cash dividend of R4 next year. After that, the dividends
are expected to increase indefinitely at 4% per year. If the discount rate is 14%, what is the PV of the stream
of dividend payments?
 Chapter 2 How to Calculate Present Values 41

8. Perpetuities and annuities The interest rate is 10%.

a. What is the PV of an asset that pays I a year in perpetuity?
b. The value of an asset that appreciates at 10h per annum approximately doubles in seven years. What is
the approximate PV of an asset that pays ?1 a year in perpetuity beginning in year 8?
What is the approximate PV of an asset that pays 71 a year for each of the next seven years?
d. A piece of land produces an income that grows by 5% per annum. If the first year's income is ]0,0),
what is the value of the land?
9. Present values What is the PV of 7I00 received in:
aYear 10 (at a discount rate of I%)?
b. Year 10 (at a discount rate of 13%)?
C. Year 15 (at a discount rate of 25%)?
d. Each of years 1 through 3 (at a discount rate of 12A?
10. Continuous compounding The continuously compounded interest rate is 12%.
a. You invest i,000 at this rate. What is the investment worth after five years?
b.What is the PV of 75million to be received in eight years?
What is the PV of a continuous stream of cash flows, amounting to 2,000 per year, starting immediately
and continuing for 15 years?
11. Compounding intervals You are quoted an interest rate of 6% on an investment of R10 million. What is
the value of your investment after four years if interest is compounded:
a. Annually?
b. Monthly? or
c. Continuously?

INTERMEDIATE
12. Future values and annuities
a. The cost of a new automobile is T300,000. If the interest rate is 5%, how much would you have to set aside
now to provide this sum in five years?
b. You have to pay T600,000 a year in school fees at the end of each of the next six years. If the interest rate
is 8%. how much do you need to set aside today to cover these bills?
c. You have invested T3,000.000 at 8%. After paying the above school fees, how much would remain at the
end of the six years?
13. Discount factors and present values
a. If the one-year discount factor is 905, what is the one-year interest rate?
b. If the two-year interest rate is 10.5%. what is the two-year discount factor?
C. Given these one- and two-year discount factors. calculate the two-year annuity factor.

d. If the PV of 10 a yeàr for three years is 24.65. what is the three-year annuity factor?
e. From your answers to (c) and (d). calculate the three-year discount factor.
14. Present values A factory costs 4,000,000. You reckon that it will produce an inflow after operating costs
of 7900.000 a year for 10 years. If the opportunity cost of capital is 14%, what is the net present value of the
factory? What will the factory be worth at the end of five years?
 42 Part One Value
to produce the following cash flows
esent values A machine costs 20.000.000 and is expected

8 9 10
5 6
Year 2 3
4000 3400 2500
4250 4600 4600
Cash flow (RO00S) 2500 2850 3750 4000

If the cost of capital is 12%, what is the machine's NPV?

1. Opportunity cost of capital Explain why we refer to the opportunity cost of capilal, instead of just "coNt a
statement: "The opportunity cost of capital
capital discount rate." While you're at it, also explain the following
or
depends on the proposed use of cash, not the source of financing.
17. Present values A factory costs 20,000,000. It will produce an inflow after operating costs of R5,000,000 in
year 1, Rl0,000.000 in year 2. and 15,000,000 in year 3. The opportunity cost of capital is l5%. Calculate the

NPV.
18. Present values and opportunity cost of capital Halcyon Lines is considering the purchase of a new bulk
carrier for $8 million. The forecasted revenues are $5 million a year and operating costs are $4 million, A
major refit costing $2 million will be required after both the fifth and tenth years. After 15 years, the ship is
expected to be sold for serap at $1.5 million.
a. What is the NPV if the opportunity cost of capital is 86?
b. Halcyon could finance the ship by borrowing the entire investment at an interest rate of 4.5%. How does
this borrowing opportunity affect your calculation of NPV?
19. Present values As winner of a breakfast cereal competition, you can choose one of the following prizes
a. 100,000 now.
b.T180,000 at the end of five years.
c. F11,400 a year forever.
d. 719,000 for each of 10 years.
e. T6,500 next year and increasing thereafter by 5% a year forever.
If the interest rate is 12%, which is the most valuable prize?
20. Annuities Parminder Kaur is 65 years of age and has a life expectancy of 12 more years. She wishes to invest
T10 lakhs in an annuity that will make a level payment at the end of each year until her death. If the interest rale
is 9.5%, what income can Mrs. Kaur expect to receive each year?
21. Annuities David and Helen Zhang are saving to buy a boat at the end
of five years. If the boat co
$20,000 and they can earn 10% a year on their savings, how much do of
years I through 5?
they need to put aside at the Cnd

22. Annuities Autos is offering free credit on a new $10,000 car.

Kangaroo You pay $1,000 down and tn
$300 a month for the next 30 months. Turtle MotorS next door does not offer free
credit but will give
$1,000 off the list price. If the rate of interest is .85% a month, which company is
offering the better dea
23. Present values Recalculate the NPV of the
office building venture in 10,
and 15%. Plot the points on a graph with NPV on the vertical axis and the
Example 2.1 at interest rates ol

axis. At what discount rate (approximately) wouid the project have zero
discount rates on the horizon
NPV? Check your answer.
24. Perpetuities and continuous compounding the interest rate is
7%, what is the value of the follow
three investments?
a. An investment that offers you $100 a year in perpetuity with the payment at the end of each
year.
b.A similar investment with the
payment at the beginning ofeach year.
C. A similar investment with the
payment spread evenly over each year.
 Chapter 2 How to Calculate Present Values 43

25. Perpetuities and annuities Refer to Sections 2-3 through 2-4. If the rate of interest is 8% rather than 10%
how much would you need to set aside to provide each of the following?
a. I billion at the end of each year in perpetuity.
b. A perpetuity that pays ?I billion at the end of the first year and that grows at 4% a year.

c.I billion at the end of each year for 20 years.

d. 71 billion a year spread evenly over 20 years.
today 15%
How much will you have at the end of 20 years if you invest R100 at
26. Continuous compounding
annually compounded? How much will you have if you invest at 15% continuously compounded?
will pay
You have just read an advertisement stating, "Pay us 100 a year for 10 years and
we
27. Perpetuities
what is the rate of interest?
you 100 a year thereafter in perpetuity." If this is a fair deal,
28. Compounding intervals Which would you prefer?
a. An investment paying interest of 12% compounded annually.
b. An investment paying interest of 11.7% compounded semiannually.
C. An investment paying 11.5% compounded continuously.
Work out the value of each of these investments after I, 5, and 20 years.
of F100,000 and nine
29. Compounding intervals A leasing contract calls for an immediate payment
What is the PV of these payments if the
subsequent R100,000 semiannual payments at six-month intervals.
annual discount rate is 8%?
State
30. Annuities Several years ago The WalI Street Journal reported that the winner of the Massachusetts
for fraud. The prize was $9.420.713. to
Lottery prize had the misfortune to be both bankrupt and in prison
be paid in 19 equal annual installments. (There were 20 installments, but the winner had already received
the first payment.) The bankruptcy court judge ruled that the prize should be sold off to the highest bidder

and the proceeds used to pay off the creditors.

a. If the interest rate was 8%, how much would you have been prepared to bid for the prize?
b. Enhance Reinsurance Company was reported to have offered $4.2 million. Use Excel to find the return
that the company was looking for.
31. Amortizing loans A mortgage requires you to pay R70,000 at the end of each of the next eight years. The
interest rate is 8%.

a. What is the present value of these payments?

the loan. and
b. Calculate for each year the loan balance that remains outstanding, the interest payment on

the reduction in the loan balance.

32. Growing annuities You estimate that by the time you retire in 35 years. you will have accumulated savings
of 2 million. If the interest rate is 8% and you live 15 years after retirement. what annual level ofexpenditure
will those savings support?
Unfortunately, inflation will eat into the value of your retirement income. Assume a 4T inflation rate and
work out a spending program for your 2 million in retirement savings that will allow you to increase your

expenditure in line with inflation.

33. Annuities The annually compounded discount rate is 5.5%. You are asked to calculate the preseni value of
a 12-year annuity with payments of 50,000 per year. Caleulate PV for each of the following cases.

a. The annuity payments arrive at one-year intervals. The first pay ment arrives one year from now
b. The first payment arrives in six months. Following payments arrive at one-ycar intervals (i.e.. at 18

months, 30 months, etc.).

 44 Part One
Value
34. Annuities Dear Financial
Adviser
yspouse and I are each 62 and hope to retire in three years. After retirement we will receive S7 s
month after 500 p
taxes from our
employers' pension plans and $1,500 per month after taxes from Social Se
ntortunately our monthly living expenses are $15.000. Our social obligations preclude further economia curity
We have
$i.000,000 invested in a high-grade, tax-free municipal-bond mutual fund. The return onmies.
Tund is 3.5%
per year. We plan to make annual withdrawals from the mutual fund to cover the the
between our pension and Social differen
erence
out of money?
Security income and our living expenses. How many years before we r
run

Sincerely,
Luxury Challenged
Marblehead. MA
You can assume that
the withdrawals (one will sit in
The
per year) a checking account (no interest) until
couple will use the account to cover the
spent
35. Present values Your
monthly shortfalls.
firm's geologists have discovered a small oil field in New York's Westchester
The field is forecasted to
produce a cash flow of C $2 million in the first =
You estimate that
County
earn an
expected return of r =12% from investing in stocks with a similaryear. you could
Therefore, 12% is the degree of risk to your oil field.
opportunity cost of capital.
What is the present value? The
answer, of course,
year. Calculate present value for the depends on what happens to the cash flows after the first
following cases:
a. The cash flows areforecasted to continue forever, with no
expected growth or decline.
b. The cash flows are forecasted to
continue for 20 years only, with
that period. no
expected growth or decline during
c. The cash flows are forecasted to continue forever., increasing
d. The cash flows by3% per year because of
inflation.
are forecasted to continue for 20 years
36. only, increasing by 3% per year because of inflation.
Amortizing loans Suppose that
you take out a
interest rate on the loan is
R200,000, 20-year mortgage loan to buy
6o, and payments on the loan are made
a condo. The
a. What is your annual annually at the end of each
year
payment on the loan?
b. Construct a mortgage amortization table in
Excel similar to Table 2.1,
amortization of the loan, and the loan balance showing the interest
for each year. payment, the
c. What fraction of
your initial loan payment is interest?
loan has been paid off after 10 What about the last
years? Why is the fraction less than half? payment? What fraction of tne

CHALLENGE
37. Future values and continuous
that with discrete
compounding Here are two useful rules of
compounding
the time it takes for an thumb. The
investment to double in value is "Rule 72
of Says
rate (in percent). The "Rule of
69 says that with continuous roughly 72/interest
exactly 69.3/interest rate (in percent). compounding the time that it takes to double d
a. If theannually compounded interest rate is 12%, use the Rule of 72
before your money doubles. Now work it to calculate roughly how long it takes
out exactly.
b. Can you prove the Rule of 69?

38. Annuities Use Excel to construct your own set of

of interest rates and years. annuity tables showing the annuity
factor for a selection