Present Value

Present value is the value today of a future cash flow or series of cash flows.
That is, present value is a future amount discounted to the present by some
required rate.

The present value is also dependent on three things :

(i) future value,
(ii) period and
(iii) rate of interest.

As for example, if future value is Tk.115, period is one year and rate of
interest is 15 percent; then present value will be Tk. 100 only.
 PRESENT VALUE OF A SINGLE AMOUNT

• It is often useful to determine the value today of a future amount of money. For
example, how much would I have to deposit today into an account paying 7 percent
annual interest to accumulate $3,000 at the end of 5 years?
• Present value is the current dollar value of a future amount, or the amount of money
that would have to be invested today at a given interest rate over a specified period to
equal the future amount. Like future value, the present value depends largely on the
interest rate and the point in time at which the amount is to be received.
• The Concept of Present Value
• The process of finding present values is often referred to as discounting cash flows. It is
concerned with answering the following question:
• If I can earn r percent on my money, what is the most I would be willing to pay now for
an opportunity to receive FVn dollars n periods from today?
• This process is actually the inverse of compounding interest. Instead of finding the
future value of present dollars invested at a given rate, discounting deter- mines the
present value of a future amount, assuming an opportunity to earn a certain return on
the money. This annual rate of return is variously referred to as the discount rate,
required return, cost of capital, and opportunity cost
Calculating the Present Value

• So far, we have seen how to calculate the future

value of an investment
• But we can turn this around to find the amount
that needs to be invested to achieve some desired
future value:
• Using the Present Value Table
• Present value interest factor (PVIF):
a factor multiplied by a future value to determine the present
value of that amount (PV = FV(PVIFA)
• Notice that PVIF is lower as the number of years increases
and as the interest rate increases
• It can also be calculated using a financial calculator
PV = [FV/(1+r)n]
Cash Flow Types and Discounting Mechanics
• There are five types of cash flows -
• single cash flows (Lump sum cash flows),
• Cash flows stream
• annuities,
• growing annuities and
• perpetuities
• BASIC PATTERNS OF CASH FLOW
• The cash flow—both inflows and outflows—of a firm can be described by its general pattern. It can
be defined as a single amount, an annuity, or a mixed stream.
• Single amount: A lump-sum amount either currently held or expected at some future date.
Examples include $1,000 today and $650 to be received at the end of 10 years.
• Annuity: A level periodic stream of cash flow. For our purposes, we’ll work primarily with annual
cash flows. Examples include either paying out or receiving $800 at the end of each of the next 7
years.
• Mixed stream: A stream of cash flow that is not an annuity; a stream of un- equal periodic cash
flows that reflect no particular pattern. Examples include the following two cash flow streams A and
B.
Mixed cash flow stream
• End of year A B
• 1 $ 100 −$ 50
• 2 800 100
• 3 1,200 80
• 4 1,200 −60
• 5 1,400
• 6 300
• Note that neither cash flow stream has equal, periodic cash flows and that A is a 6-year mixed stream and B is
I. Single Cash Flows
• A single cash flow is a single cash flow in a
specified future time period.
• Cash Flow: CFt
_______________________|
Time Period: t
• The present value of this cash flow is-
PV of Single Cash Flow =

 CFt 
PV   
t 
 1  r  
Example: Present Value of a single cash flow:

• You would like to accumulate Birr 50,000 in five

years by making a single investment today. You
believe you can achieve a return from your
investment of 8% annually.
• What is the amount that you need to invest today to
achieve your goal?
 50,000
PV  5
 34029.16
(1.08)
Or
We can use table

PV = 50,000(PVIF)5,8%
=50,000 x 0.681

= 34050
Paul Shorter has an opportunity to receive $300 one year from now. If he can earn 6% on his
investments in the normal course of events, what is the most he should pay now for this opportunity?
To answer this question, Paul must determine how many dollars he would have to invest at 6% today
to have $300 one year. Letting PV equal this unknown amount and using the same notation as in the
future value discussion, we have
• PV * (1 + 0.06) = $300
• Future Value of One Dollar ($)
• Interest rates, time periods, and future value of one dollar
• FIGuRE 5.4
• Solving for PV gives us
• PV = $300
• (1 + 0.06)
• = $283.02
• The value today (“present value”) of $300 received 1 year from today, given an interest rate of 6%,
is $283.02. That is, investing $283.02 today at 6% would result in $300 at the end of 1 year.
II. Valuing a Stream of Cash Flows
• Valuing a lump sum (single) amount is easy to evaluate because there
is one cash flow.
• What do we need to do if there are multiple cash flow?
• Equal Cash Flows: Annuity or Perpetuity
• Unequal/Uneven Cash Flows

FV1 FV2 FVN

PV     
1  i  1  i 
1 2
1  i N

N FVt
PV  
t 1 1  i 
t
 Valuing a Stream of Cash
Flows
? 1000 2000 3000

0 1 2 3
• Uneven cash flows exist when there are
different cash flow streams each year
• Treat each cash flow as a Single Sum
problem and add the PV amounts together.
 • What is the present value of the preceding cash flow
stream using a 12% discount rate?

n FVt n 3 100 200 300 

PV  
t  0 1  r 
n = PV      3
t  0  1  0.12  1  0.12 1  0.12 
1 2

PV   893  1594  2135

PV  4622

Yr 1 $1,000 / (1.12)1 = $ 893

Yr 2 $2,000 / (1.12)2 = 1,594
Yr 3 $3,000 / (1.12)3 = 2,135
$4,622
III. Annuities
• The present value of an annuity is the value now of a
series of equal amounts to be received (or paid out) for
some specified number of periods in the future.
• It is computed by discounting each of the equal periodic
amounts.
• An annuity is a series of nominally equal payments
equally spaced in time
• The timeline shows an example of a 5-year, $100 annuity

100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity
• The present value of an annuity can be calculated by taking
each cash flow and discounting it back to the present, and
adding up the present values.
• We can use the principle of value additivity to find the
present value of an annuity, by simply summing the present
values of each of the components:


Pmt Pmt 1 Pmt 2 Pmt
PVA  t
     N

1  i 1  i 1  i 1  i
t 1 2 N
t 1
Present Value of an Annuity (cont.)
• Alternatively, there is a short cut that can be used in the
calculation [A = Annuity; r = Discount Rate; n =
Number of years]
• Thus, there is no need to take the present value of each
cash flow separately
• The closed-form of the PVA equation is:

1  1 
 (1  r ) N 
PV  FV  
 r 

 

Present Value of an Annuity (cont.)
• Using the example, and assuming a discount rate of
10% per year, we find that the present value is:
100 100 100 100 100
PV       379.08
1.10 1.10 1.10 1.10 1.10
A 1 2 3 4 5

62.0
68.3
9
75.1
0
82.6
3
90.9
4
1
379.08 100 100 100 100 100

0 1 2 3 4 5
 • We can use this equation to find the present value of our
annuity example as follows:
 1 
1 
 (1  0.1)5 
PV  100  
 0.1 
 1  
1  (1.1)5 
PV  100  
 0.1 
 

PV  100 
0.3791
PV  1003.791
 0.1 
PV  379.1
 This equation works for all regular (ordinary)
annuities, regardless of the number of payments
Annuities Due
• The annuities that we begin their payments at the end
of period 1 are referred as regular annuities (ordinary
annuities)
• An annuity due is the same as a regular annuity, except
that its cash flows occur at the beginning of the period
rather than at the end

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity Due
• The formula for the present value of an annuity due, sometimes referred to
as an immediate annuity, is used to calculate a series of periodic payments,
or cash flows, that start immediately
• We can find the present value of an annuity due in the same way as we did
for a regular annuity, with one exception
• Note from the timeline that, if we ignore the first cash flow, the annuity due
looks just like a four-period regular annuity
• Therefore, we can value an annuity due with:

1  1 
 (1  i ) n1 
PV  CF    CF
 i 
 
Present Value of an Annuity Due (cont.)
• Therefore, the present value of our example annuity
due is:

 1 
1  1  0.151 
PVAD  100    100  416.98
 0.1 
 
 Note that this is higher than the PV of the
regular annuity
Deferred Annuities
• A deferred annuity is the same as any other annuity,
except that its payments do not begin until some later
period
• The timeline shows a five-period payment deferred
annuity

100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity

• We can find the present value of a deferred annuity in

the same way as any other annuity, with an extra step
required
PV deferred annuity formula
1  1  1   1  
 1  i n  m    1  i m  
PVDA  CF   
 i   i 
   
 
OR
  1 
1   1  i n  
PVDA  CF    1 
 i  m
  1  i  
 
 
PV of a Deferred Annuity (cont.)
• To find the PV of a deferred annuity, we can first
calculate the ordinary PVA equation, and then discount
that result back to period 0
• Here we are using a 10% discount rate

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity (cont.)
  1 
1  
 1  0.15 

  1 
PVDA  100

2 
 0.1  1  0.1 
 
 
1  0.6209   1 
PVDA  100   2
 0.1   1.1 
 0.3791  1 
PVDA  100 
 0.1   1.21
PVDA  1003.7910.8264

PVAD  379.10.8264 
PVAD  313.29
Or we can calculate with two steps

  1 
1    
1  0.1 5

PV2  100  
Step 1:  0.1 
 
 
1  0.6209 
PV2  100 
 0.1
 0.3791
PV2  100
 0.1 
PV2  379.1
379.1 379.1
PV0   2   313.29
Step 2:  1.1  1.21
Uneven Cash Flows
• Very often an investment offers a stream of cash flows which are not
either a lump sum or an annuity
• We can find the present or future value of such a stream by using the
principle of value additivity
Uneven Cash Flows: An Example (1)
• Assume that an investment offers the following cash
flows. The required return is 7%, what is the
maximum price that you would pay for this
investment?

100 200 300

0 1 2 3 4 5

100 200 300

PV     513.04
1.07  1.07  1.07 
1 2 3
Uneven Cash Flows: An Example (2)
• Suppose that you need to deposit the following amounts
in an account paying 5% per year. What should be the
balance of the account at the end of the third year?

300 500 700

0 1 2 3 4 5
300 .05 500 .05
2 1
FV 1  1  700  1,555.75
Present value of a Growing Annuity
• A cash flow that grows at a constant rate for a specified period of time
is a growing annuity
• A time line of a growing annuity is as follows

A1  g  A1  g  A1  g 

2 n
.....
0 1 2 ...... n
• The present value of a growing annuity can be calculated using
the following formula
 1  g   n

1  1  r n 
PVga  A1  g  
 rg 
 

• The above formula can be used when

• The growing rate is less than the discount rate (g<r) or
• The growing rate is more than the discount rate (g>r)
• However, it doesn’t work when the growing rate is equal
to the discount rate (g=r)
Example:

• Suppose you have the right to harvest a tea

plantation for the next 20 years over which you
will get 100,000 tons of tea per year. The current
price per ton of tea is Birr 500, but it is expected to
increase at a rate of 8% per year. The discount rate
is 15% per year.

• Then, how much is the present value of the tea that

you can harvest?
Solution:

 1  0.08  20

1  1  0.1520 
PVga  Birr 500 X 100,0001  0.08 
 0.15  0.08 
 
PVga  Birr 551,736,683
IV. Present value of perpetuity annuity
• A perpetuity is an annuity of with an infinite duration.
• Hence the present value of perpetuity may be expressed as follows
PV∞ = CF x PVIFA
• Where PV∞ = present value of a perpetuity
• CF = constant annual cash flows
• PVIFA = present value interest factor for
perpetuity (an annuity of infinite duration)

• The value of PVIFA is

 1 1
PVIFA   t 
t 1 1  r  r
• Ross Clark wishes to endow a chair in finance at his alma mater. The university
indicated that it requires $200,000 per year to support the chair, and the endowment
would earn 10% per year. To determine the amount Ross must give the university to
fund the chair, we must determine the present value of a $200,000 perpetuity discounted
at 10%. Using Equation we can determine that the present value of a perpetuity paying
$200,000 per year is $2 million when the interest rate is 10%:
• PV = $200,000 , 0.10 = $2,000,000
• In other words, to generate $200,000 every year for an indefinite period requires ,
$2,000,000 today if Ross Clark’s alma mater can earn 10% on its investments the
university earns 10% interest annually on the $2,000,000, it can
withdraw $200,000 per year indefinitely.