Chapter 5

Discounted Cash
Flow Valuation

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Future and Present Values of Multiple
Cash Flows
• Valuing Level Cash Flows: Annuities
and Perpetuities
• Comparing Rates: The Effect of
Compounding Periods
• Loan Types and Loan Amortization

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Annual Percentage Rate (APR)

• This is the annual rate that is quoted by law
• By definition APR = period rate times the numbers
of compounding per year
– Monthly rate = 1%
– Quarterly rate = 2%
• Period rate = APR / numbers of compounding per
year
– APR = 12% compounded monthly

– APR = 10% compounded semiannually

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Numbers of Compounding per year

(m)
• Compounded annually

• Compounded semi-annually

• Compounded quarterly

• Compounded monthly

• Compounded daily

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Effective Annual Rate (EAR)

• This is the actual rate paid (or received)
after accounting for compounding effect.
• If you want to compare two alternative
investments with different compounding
periods you need to compute the EAR and
use that for comparison.

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Computing EARs - Example

• Suppose you can earn 1% per month on $1
invested today.

• Suppose if you put it in another account, you earn

3% per quarter.

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EAR - Formula
m
 APR 
EAR = 1 +  − 1
 m 
APR = Annual Percentage Rate (quoted rate)
m = No. of compounding in a year

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Decisions, Decisions II
• You are looking at two savings accounts.
One pays 5.25%, with daily compounding.
The other pays 5.3% with semiannual
compounding. Which account should you
use?

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Computing APRs from EARs

• Rearrange the EAR equation and you get:


APR = m (1 + EAR)
1
m
-1
 

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APR - Example
• Suppose you want to earn an effective
rate of 12% and you are looking at an
account that compounds on a monthly
basis. What APR must they pay?

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Things to Remember

• You ALWAYS need to make sure that the interest

rate (r), cash flows (c) and the time period (t)
match.
– If you are looking at annual periods, you need an
annual rate and annual cash flows
– If you are looking at monthly periods, you need a
monthly rate and monthly cash flows

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Future Values with Monthly

Compounding
• Suppose you deposit $50 a month into an
account that has an APR of 9%, based on
monthly compounding. How much will you
have in the account in 35 years?

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Quick Quiz: Part 5

• What is the definition of an APR?
• What is the effective annual rate?
• Which rate should you use to compare
alternative investments or loans?
• Which rate do you use to derive period
rate, to calculate the PV and FV?

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Loan Types
• 1. Pure Discount Loan
• 2. Interest Only Loan
• 3. Amortized Loan

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1. Pure Discount Loan

• Loans that sell at the price lower than par.
• Treasury bills - principal amount is repaid
at some future date, without any periodic
interest payments.
• If a T-bill promises to repay $10,000 in 12
month and the market interest rate is 7
percent, how much will the bill sell for in
the market?

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2. Interest Only Loan

• Pay periodic interest payments and
principal at maturity
• A 5-year, interest only loan with a 7%
interest rate. The principal amount is
$10,000. Interest is paid annually.
– What would the stream of cash flows be?

• This cash flow stream is similar to the

cash flows on corporate bonds (chap-6).
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3. Amortized Loan with Fixed
Payment
• Each payment covers the interest expense
plus portion of principal, eg: home loan
• Consider a 4 year loan with annual
payments, the interest rate is 8% and the
principal amount is $5000.
– What is the annual payment?

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Amortization Table for Example

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Quick Quiz: Part 6

• What is a pure discount loan? What is a
good example of a pure discount loan?
• What is an interest only loan? What is a
good example of an interest only loan?
• What is an amortized loan? What is a
good example of an amortized loan?

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Tutorial
• Q1: Bank-A charges 12.6% compounded monthly on
its loan. Bank-B charges 12.8% compounded
semiannually. As a borrower, which bank would you
go for?

• Q2. You found a dream home. The selling price is

RM220,000; you will put RM50,000 down payment and
obtain a 30-year fixed-rate mortgage at 7.5% APR for
the balance. Assume that monthly payments begin in
one month, how much interest will you pay (in Ringgit)
over the lifetime of the loan?

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Tutorial
• Q3:Your brother-in-law borrowed RM3,000 from you
5 years ago and then disappeared. Yesterday he
returned and expressed a desire to pay back the
loan, including the interest accrued. Assuming that
you had agreed to charge him 12%, and assuming
that he wishes to make five equal annual payments
beginning from now, how much would your brother-
in-law have to pay you annually in order to pay off
the debt?

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