Chapter 6
Discounted Cash Flows and Valuation
Learning Objectives
1.
Explain why cash flows occurring at different times must be discounted to a
common date before they can be compared, and be able to compute the present
value and future value for multiple cash flows.
2.
Describe how to calculate the present value of an ordinary annuity and how an
ordinary annuity differs from an annuity due.
3.
Explain what a perpetuity is and how it is used in business, and be able to calculate
the value of a perpetuity.
4.
Discuss growing annuities and perpetuities, as well as their application in business,
and be able to calculate their value.
5.
Discuss why the effective annual interest rate (EAR) is the appropriate way to
annualize interest rates, and be able to calculate EAR.
I.
Chapter Outline
6.1
Multiple Cash Flows
A.
Future Value of Multiple Cash Flows
•
In contrast to Chapter 5, we now consider situations in which there are multiple
cash flows. Solving future value problems with multiple cash flows involves a
simple process.
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•
First, draw a time line to make sure that each cash flow is placed in the correct
time period.
•
Second, calculate the future value of each cash flow for its time period.
•
Third, add up the future values.
B.
Present Value of Multiple Cash Flows
•
Many situations in business call for computing the present value of a series of
expected future cash flows. This could be to determine the market value of a
security or business or to decide whether a capital investment should be made.
•
The process is similar to determining the future value of multiple cash flows.
•
First, prepare a time line to identify the magnitude and timing of the cash flows.
•
Next, calculate the present value of each cash flow using Equation 5.4 from the
previous chapter.
•
Finally, add up all the present values.
•
The sum of the present values of a stream of future cash flows is their current
market price, or value.
6.2
Level Cash Flows: Annuities and Perpetuities
•
There are many situations in which both businesses and individuals would be faced
with either receiving or paying a constant amount for a length of period.
•
When a firm faces a stream of constant payments on a bank loan for a period of time,
we call that stream of cash flows an
annuity
.

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