CHAPTER 6

D I S C O U N T E D C A S H F L O W V A L U AT I O N

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 LEARNING OBJECTIVES
• Determine the future and present value of investments
with multiple cash flows.
• Explain how loan payments are calculated and how to
find the interest rate on a loan.
• Describe how loans are amortized or paid off.
• Show how interest rates are quoted (and misquoted).

© McGraw Hill 3-2

 CHAPTER OUTLINE
• Future and Present Values of Multiple Cash Flows.
• Valuing Level Cash Flows: Annuities and Perpetuities.
• Comparing Rates: The Effect of Compounding.
• Loan Types and Loan Amortization.

© McGraw Hill 3-3

 FUTURE VALUE WITH MULTIPLE CASH
FLOWS
Suppose you deposit $100 today in an account paying 8 percent interest. In one year,
you will deposit another $100. How much will you have in two years?
• At the end of the first year, you will have $108 plus the second $100 you deposit,
for a total of $208. You leave this $208 on deposit at 8 percent for another year. At
the end of this second year, it is worth: $208 × 1.08 = $224.64

© McGraw Hill
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3-4
 FUTURE VALUE WITH MULTIPLE CASH
FLOWS (ALTERNATE SOLUTION)
The first $100 is on deposit for two years at 8 percent, so its future value is:
• $100 × 1.082 = $100 × 1.1664 = $116.64.

The second $100 is on deposit for one year at 8 percent, and its future value is thus:
• $100 × 1.08 = $108

The total future value, as we previously calculated, is equal to the sum of these two
future values:
• $116.64 + 108 = $224.64

• Based on this example, there are two ways to calculate future values for multiple
cash flows, both giving the same answer:

1. Compound the accumulated balance forward one year at a time.

2. Calculate the FV of each cash flow first and then add them up.

© McGraw Hill 3-5

 SAVING UP REVISITED
• You think you will be able to deposit $4,000 at the end of each of the next three
years in a bank account paying 8 percent interest. You currently have $7,000 in the
account. How much will you have in three years? In four years?

At the end of the first year, you will have:

• $7,000 × 1.08 + 4,000 = $11,560
At the end of the second year, you will have:
• $11,560 × 1.08 + 4,000 = $16,484.80

Repeating this for the third year gives:

• $16,484.80 × 1.08 + 4,000 = $21,803.58
Therefore, you will have $21,803.58 in three years. If you leave this on deposit for one
more year (and don’t add to it), at the end of the fourth year, you’ll have:
• $21,803.58 × 1.08 = $23,547.87

© McGraw Hill 3-6

 ILLUSTRATING TWO DIFFERENT WAYS
OF CALCULATING FUTURE VALUES 1

• Consider the future value of $2,000 invested at the end of each of the next five
years. The current balance is zero, and the rate is 10 percent. The time line is
presented below:

• Notice that nothing happens until the end of the first year, when we make the first
$2,000 investment.
• If we compound the investment one period at a time, the future value is
$12,210.20.

© McGraw Hill
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3-7
 ILLUSTRATING TWO DIFFERENT WAYS
OF CALCULATING FUTURE VALUES 2

• We can solve the problem from the previous slide using the second technique,
where we calculate the future value of each cash flow first and then add them up

• The answer is the same, regardless of the technique used, with the future value
being $12,210.20

© McGraw Hill
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3-8
 PRESENT VALUE WITH MULTIPLE CASH
FLOWS
• Suppose you need $1,000 in one year and $2,000 more in two years. If
you can earn 9 percent on your money, how much do you have to put up
today to exactly cover these amounts in the future? In other words, what
is the present value of the two cash flows at 9 percent?
The PV of $2,000 in two years at 9 percent is:
• $2,000/1.092 = $1,683.36.
The PV of $1,000 in one year at 9 percent is:
• $1,000/1.09 = $917.43.
• Therefore, the total PV is: $1,683.36 + 917.43 = $2,600.79

© McGraw Hill 3-9

 PV WITH MULTIPLE CASH FLOWS (CALCULATE PV
INDIVIDUALLY AND ADD THEM UP)
• As with future values, there are two ways to determine the present value of a
series of future cash flows:
1. Discount back one period at a time.
2. Calculate the present values individually and add them up.
• Suppose we had an investment that was going to pay $1,000 at the end of every
year for the next five years. To find the present value, we could discount each
$1,000 back to the present separately and then add them up.

© McGraw Hill
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3-10
 PRESENT VALUE WITH MULTIPLE CASH FLOWS
(DISCOUNT BACK ONE PERIOD AT A TIME)
Alternatively, we could discount the last cash flow back one period and add it to the
next-to-the-last cash flow:
• ($1,000/1.06) + 1,000 = $943.40 + 1,000 = $1,943.40

We could then discount this amount back one period and add it to the Year 3 cash
flow:
• ($1,943.40/1.06) + 1,000 = $1,833.39 + 1,000 = $2,833.39

• Process can be repeated as necessary, as shown below:

© McGraw Hill
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3-11
 HOW MUCH IS IT WORTH?
You are offered an investment that will pay you $200 in one year, $400 the next year,
$600 the next year, and $800 at the end of the fourth year. You can earn 12 percent
on very similar investments. What is the most you should pay for this one?
We need to calculate the present value of these cash flows at 12 percent. Taking
them one at a time gives:
$200  1 1.121  $200 1.1200  $178.57
$400  1 1.122  $400 1.2544  318.88
$600  1 1.123  $600 1.4049  427.07
$800  1 1.124  $800 1.5735  508.41
Total present value  $1,432.93

If you can earn 12 percent on your money, then you can duplicate this investment’s
cash flows for $1,432.93, so this is the most you should be willing to pay.

© McGraw Hill 3-12

 CALCULATE PV WITH MULTIPLE FUTURE CASH
FLOWS USING A FINANCIAL CALCULATOR
• We will use Example 6.3 (from the previous slide) to illustrate.
• From Example 6.3, the first cash flow is $200 to be received in one year and the
discount rate is 12%, so we do the following:

• You could write down the answer (above), but a more efficient method is to store
the number in your calculator’s memory.
• Next, value the second cash flow by changing N to 2 and FV to 400.

• You save this number (above) by adding it to the one you saved in your
first calculation, and so on for the remaining two calculations.

© McGraw Hill 3-13

 HOW MUCH IS IT WORTH?
PART 2 1

• You are offered an investment that will make three $5,000 payments. The first
payment will occur four years from today. The second will occur in five years, and
the third will follow in six years. If you can earn 11 percent, what is the most this
investment is worth today? What is the future value of the cash flows?
• We will answer the questions in reverse order to illustrate a point. The future
value of the cash flows in six years is:

( $5,000 × 1.11 2 ) + ( $5,000 × 1.11) + $5,000 = $6,160.50 + 5,550 + 5,000 =

$16,710.50.

The present value must be:

$16,710.50 1.116  $8,934.12

© McGraw Hill 3-14

 HOW MUCH IS IT WORTH?
PART 2 2

Let’s check this. Taking them one at a time, the PVs of the cash flows are:
$5,000 × 1 / 1.11 6 = $5,000 / 1.8704 = $2,673.20
$5,000 × 1 / 1.11 5 = $5,000 / 1.6851 = 2,967.26
$5,000 × 1 / 1.11 4 = $5,000 / 1.5181 = 3,293.65
Total present value = $8,934.12

This is as we previously calculated. The point we want to make is that we can calculate
present and future values in any order and convert between them using whatever way
seems most convenient. The answers will always be the same as long as we stick with
the same discount rate and are careful to keep track of the right number of periods.

© McGraw Hill 3-15

 PRESENT VALUE FOR ANNUITY CASH
FLOWS 1

In many situations, multiple cash flows will all be for the same amount (for
example, consumer loans and home mortgages)
An annuity is a level stream of cash flows for a fixed period
Suppose we were examining an asset that promised to pay $500 at the end
of each of the next three years. The cash flows from this asset are in the
form of a three-year, $500 annuity. If we wanted to earn 10 percent on our
money, how much would we offer for this annuity?
• One way to solve this problem is to discount each of these $500
payments back to the present at 10% to determine the total P V.
Present value  $500 1.11  $500 1.12  $500 1.13
 $500 1.1  $500 1.21  $500 1.331
 $454.55  413.22  375.66
 $1, 243.43
© McGraw Hill 3-16
 PRESENT VALUE FOR ANNUITY CASH
FLOWS 2

P V of an annuity of C dollars per period for t periods when the rate of return or
interest rate, r, is given by:
• Term in parentheses on first line is called the present value interest factor for
annuities and abbreviated PVIFA(r, t).
 1  Present value factor 
Annuity present value  C   
 r 
1  1 1  r t  
 
 C   
 r 
 
• From the example in the previous slide, the usual PV factor is:

Present value factor  1 1.13  1 1.331  .751315

© McGraw Hill 3-17

 PRESENT VALUE FOR ANNUITY CASH
FLOWS 3

• To calculate the annuity PV factor, we simply plus this in:

Annuity present value factor = ( 1 − Present value factor ) / r
= ( 1 − .751315 ) / .10
= .248685 / .10 = 2.48685
• PV of $500 annuity is therefore: $500 × 2.48685 = $1,243.43.

© McGraw Hill 3-18

 ANNUITY TABLES
Just as there are tables for ordinary PV factors, there are tables for annuity
factors, as well
To find the annuity PV factor we calculated in the previous slide, look for the
row corresponding to three periods and then find the column for 10 percent.
• The number you see at that intersection should be 2.4869 (rounded to
four decimal places), as we calculated.
Interest Rate
Number of Periods 5% 10% 15% 20%
1 .9524 .9091 .8696 .8333
2 1.8594 1.7355 1.6257 1.5278
3 2.7232 2.4869 2.2832 2.1065
4 3.5460 3.1699 2.8550 2.5887
5 4.3295 3.7908 3.3522 2.9906

© McGraw Hill 3-19

 FIND ANNUITY PRESENT VALUES WITH
A FINANCIAL CALCULATOR
• To find annuity present values with a financial calculator, we need to use
the PMT key.
• Compared to finding the present value of a single amount, there are two
important differences:
1. We enter the annuity cash flow using the PMT key.
2. We don’t enter anything for the future value (FV).
• The problem we have been examining is a three-year, $500 annuity. If the
discount rate is 10 percent, we need to do the following (after clearing out
the calculator!):

© McGraw Hill 3-20

 HOW MUCH CAN YOU AFFORD?
After carefully going over your budget, you have determined you can afford to pay
$632 per month toward a new sports car. You call your local bank and find out that
the going rate is 1 percent per month for 48 months. How much can you borrow?
To determine how much you can borrow, we need to calculate the present value of
$632 per month for 48 months at 1 percent per month. The loan payments are in
ordinary annuity form, so the annuity present value factor is:
Annuity PV factor  1  Present value factor  r

 1  1 1.0148  0.1

 1  .6203 0.1  37.9740
With this factor, we can calculate the present value of the 48 payments of $632 each
as:
Present value = $632 × 37.9740 = $24,000
Therefore, $24,000 is what you can afford to borrow and repay.
© McGraw Hill 3-21
 FINDING THE PAYMENT 1

• Suppose you wish to start up a new business that specializes in the latest of health
food trends, frozen yak milk. To produce and market your product, the Yakkee
Doodle Dandy, you need to borrow $100,000. Because it strikes you as unlikely
that this particular fad will be long-lived, you propose to pay off the loan quickly
by making five equal annual payments. If the interest rate is 18 percent, what will
the payment be?
Annuity present value  $100,000  C  1  Present value factor  r 

 
 C  1  1 1.185  .18

 C  1  .4371 .18

 C  3.1272
C  $100,000 3.1272  $31,977.78
• You will make five payments of just under $32,000 each.

© McGraw Hill 3-22

 FINDING THE PAYMENT 2

• Solving the problem from the previous slide using a financial

calculator is quite simple
• In our yak milk example, the PV is $100,000, the interest rate
is 18 percent, and there are five years
• We find the payment as follows:

© McGraw Hill
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3-23
 FINDING THE NUMBER OF PAYMENTS 1

You ran a little short on your spring break vacation, so you put $1,000
on your credit card. You can afford only the minimum payment of $20
per month. The interest rate on the credit card is 1.5 percent per
month. How long will you need to pay off the $1,000?
What we have here is an annuity of $20 per month at 1.5 percent per
month for some unknown length of time. The present value is $1,000
(the amount you owe today). We need to do a little algebra (or use a
financial calculator):
$1,000 = $20 × [ ( 1 − Present value factor ) / .015 ]
( $1,000 / 20) × .015 = 1 − Present value factor

Present value factor  .25  1 1  r 

t

© McGraw Hill
1.015t  1 .25  4
3-24
 FINDING THE NUMBER OF PAYMENTS 2

At this point, the problem boils down to asking: How long does
it take for your money to quadruple at 1.5 percent per month?
Based on our previous chapter, the answer is about 93 months:
1.01593  3.99  4

• It will take you about 93/12 = 7.76 years to pay off the $1,000
at this rate. If you use a financial calculator for problems like
this, you should be aware that some automatically round up to
the next whole period.

© McGraw Hill 3-25

 FINDING THE NUMBER OF PAYMENTS 3

• To solve Example 6.6 (from the previous slide) on a financial calculator, do the
following:

Notice that we put a negative sign on the payment you must make, and we have
solved for the number of months; You still must divide by 12 to get our answer!
• 93.11 / 12 = 7.76 years
Some financial calculators won’t report a fractional value for N; they automatically
round up to the next whole period
With a spreadsheet, use the function =NPER(rate,pmt,pv,fv)
• Be sure to put in a zero for F V (or leave it blank) and to enter −20 as the payment

© McGraw Hill 3-26

 FINDING THE RATE 1

• An insurance company offers to pay you $1,000 per year for 10 years if you will
pay $6,710 up front. What rate is implicit in this 10-year annuity?
$6,710  $1,000  1  Present value factor  r 


$6,710 $1,000  6.71  1  1 1  r  

10

 r
As shown above, the annuity factor for 10 periods is equal to 6.71, and we need to
solve this equation for the unknown value of r.
• This is mathematically impossible to do directly; the only way to do it is to use a
table or trial and error to find a value for r.

Solving with annuity table

• If you look across the row corresponding to 10 periods in Table A.3, you will see a
factor of 6.7101 for 8%, so the insurance company is offering just about 8%

© McGraw Hill 3-27

 FINDING THE RATE 2

• Suppose a relative wants to borrow $3,000. She offers to repay you $1,000 every
year for four years. What interest rate are you being offered?
• Finding the answer by trial and error
1. At 10%, the annuity PV factor is: [1 − (1/1.104)] /.10 = 3.16987.

• PV of the cash flows at 10% is thus: $1,000 × 3.16987 = $3,169.87

2. Is 10% too high or too low? PVs and discount rates move in opposite directions:
Increasing the discount rate lowers the PV and vice versa. PV here is too high, so
discount rate is too low.
3. Let’s try 12%: $1,000 × {[1 − (1/1.124)] / .12} = $3,037.35.

• We are still a low on the discount rate (because PV is a little high)

4. Let’s try 13%: $1,000 × {[1 − (1/1.134)] / .13} = $2,974.47
• This is less than $3,000, so we now know that the answer is between 12% and
13%, and it looks to be about 12.5%
© McGraw Hill 3-28
 FINDING THE RATE (CONCLUDED)
• Suppose a relative wants to borrow $3,000. She offers to repay you
$1,000 every year for four years. What interest rate are you being
offered?
• Finding the answer using a financial calculator

Notice that we put a negative sign on the present value

With a spreadsheet, use the function =RATE(nper,pmt,pv,fv);
• Be sure to put in a zero for FV (or leave it blank) and to enter 1,000 as the
payment and −3,000 as the PV
© McGraw Hill 3-29
 FUTURE VALUE FOR ANNUITIES 1

• Here is the future value factor for an annuity:

Annuity FV factor   Future value factor  1 r

 1  r   1 r
t

 
• Suppose you plan to contribute $2,000 every year to a retirement account paying 8
percent. If you retire in 30 years, how much will you have?
• We can calculate the annuity future value factor as:
Annuity FV factor   Future value factor  1 r
 1.0830  1 .08
 10.0627  1 .08
 113.2832
• Future value of this 30-year, $2,000 annuity is thus:
Annuity future value = $2,000 × 113.2832
© McGraw Hill = $226,566.42 3-30
 FUTURE VALUE FOR ANNUITIES 2

You could solve the problem from the previous slide using a financing
calculator by doing the following:

Notice that we put a negative sign on the payment.

With a spreadsheet, use the function =FV(rate,nper,pmt,pv)
• Be sure to put in a zero for PV (or leave it blank) and to enter −2,000 as the
payment

© McGraw Hill 3-31

 FUTURE VALUE FOR ANNUITIES
(CONCLUDED)
• Sometimes we need to find the unknown rate, r, in the context of an annuity
future value.
• If you had invested $100 per month in stocks over the 25-year period ended
December 1978, your investment would have grown to $76,374. This period had
the worst stretch of stock returns of any 25-year period between 1925 and 2019.
How bad was it?
• To find the implicit rate, r:

• $76,374  $100  Future value factor  1 r 

• $763.74  1  r   1 r

300

Because this is the worst period, let’s try 1 percent:

• Annuity future value factor = (1.01300 − 1)/.01 = 1,878.85.
We see that 1 percent is too high; from here, it’s trial and error!
© McGraw Hill 3-32
 A NOTE ABOUT ANNUITIES DUE
Ordinary annuities are annuities in which the cash flows occur at the end of
each period
An annuity due is an annuity for which the cash flows occur at the beginning
of each period
There are several different ways to calculate the value of an annuity due:
• With a financial calculator, switch it into “due” or “beginning” mode
• Treat number of payments in annuity due as equivalent to number of
payments less one in ordinary annuity (That is, five-year annuity due
equals four-year ordinary annuity) and add the cash flow at Time 0
• Calculate the PV or FV as though it were an ordinary annuity and then
multiply your answer by (1 + r)
Annuity due value  Ordinary annuity value  1  r 

© McGraw Hill 3-33

 SUMMARY OF ANNUITY AND PERPETUITY
CALCULATIONS 1

I. Symbols:
PV = Present value, what future cash flows are worth today.
FVt = Future value, what cash flows are worth in the future.
r = Interest rate, rate of return, or discount rate per period—typically, but not always,
one year.
t = Number of periods—typically, but not always, the number of years.
C = Cash amount.

II. Future Value of C per Period for t Periods at r Percent per Period:


FVt  C  1  r   1 r

t

 
A series of identical cash flows is called an annuity, and the term

called the annuity future value factor.

© McGraw Hill 3-34
 SUMMARY OF ANNUITY AND PERPETUITY
CALCULATIONS 2

III. Present Value of C per Period for t Periods at r Percent per Period:


PV  C  1  1 1  r  

t
r


The term 1  1 1  r  

t
r

is called the annuity present value factor.

IV. Present Value of a Perpetuity of C per Period:

PV  C r

A perpetuity has the same cash flow every year forever.

© McGraw Hill 3-35

 PERPETUITIES
Perpetuities are annuities in which the cash flows continue forever
• Also referred to as consols, particularly in Canada and the U.K.

Present value of a perpetuity is:

PV for a perpetuity  C r

For example, an investment offers a perpetual cash flow of $500 every year.
The return you require on such an investment is 8 percent. What is the value
of this investment?
The value of this perpetuity is:

Perpetuity PV  C r  $500 .08  $6, 250

© McGraw Hill 3-36

 PREFERRED STOCK 1

• Preferred stock (or preference stock) is an important example of a perpetuity.

When a corporation sells preferred stock, the buyer is promised a fixed cash
dividend every period (usually every quarter) forever. This dividend must be paid
before any dividend can be paid to regular stockholders—hence the term
preferred.
Suppose the Fellini Co. wants to sell preferred stock at $100 per share. A similar issue
of preferred stock already outstanding has a price of $40 per share and offers a
dividend of $1 every quarter. What dividend will Fellini have to offer if the preferred
stock is going to sell?
The issue that is already out has a present value of $40 and a cash flow of $1 every
quarter forever. Because this is a perpetuity:

Present value  $40  $1  1 r 

r  .025, or 2.5%

© McGraw Hill 3-37

 PREFERRED STOCK 2

To be competitive, the new Fellini issue will also have to offer 2.5 percent
per quarter; so if the present value is to be $100, the dividend must be such
that:

Present value  $100  C  1 0.25 

C=$2.50  per quarter 

© McGraw Hill 3-38

 GROWING ANNUITIES AND
PERPETUITIES 1

• Annuities commonly have payments that grow over time

• Suppose we are looking at a lottery payout over a 20-year period. The first
payment, made one year from now, will be $200,000. Every year
thereafter, the payment will grow by 5%, so the payment in the second
year will be $200,000 × 1.05 = $210,000. The payment in the third year
will be $210,000 × 1.05 = $220,500, and so on. What’s the PV if the
appropriate discount rate is 11%?
• If we use the symbol g to represent the growth rate, we can calculate the
value of a growing annuity using a modified version of our regular annuity
formula:
  1  g t 
1    
 1  r  
Growing annuity present value  C  
 rg 
 
© McGraw Hill
  3-39
 GROWING ANNUITIES AND
PERPETUITIES 2

• Plugging in the numbers from our lottery example (and letting g = .05), we
get:
  1  .05  20 
1    
1  11
PV  $200, 000       $200, 000  11.18169  $2, 236,337.06
 .11  .05 
 
 
• There is also a formula for the PV of a growing perpetuity:
 1  C
Growing perpetuity present values  C    
r  g  r  g
• Returning to our lottery example, now suppose the payments continue
forever. In this case, the present value is:
1
PV=$200,000   $200, 000  16.6667  $3,333,333.33
© McGraw Hill .11  .05 3-40
 EFFECTIVE ANNUAL RATES AND
COMPOUNDING
Rates are quoted in many ways.
If a rate is quoted as 10 percent compounded semiannually, this means the
investment actually pays 5 percent every six months.
• Is 5% every six months the same thing as 10% per year? No!
• If you invest $1 at 10% per year, you will have $1.10 at year end.
• If you invest at 5% every six months, then you’ll have the FV of $1 at 5% for
two periods: $1 × 1.052 = $1.1025.

• In this example, the 10% is a stated, or quoted, interest rate.

• The 10.25%, which is actually the rate you will earn, is called the effective annual
rate (EAR).
• Anytime we have compounding during the year, we need to be concerned about
what the rate really is .
• To compare different investments or interest rates, we will always need to convert
to effective rates.
© McGraw Hill 3-41
 CALCULATING AND COMPARING
EFFECTIVE ANNUAL RATES 1

Suppose you’ve shopped around and found the following rates:

• Bank A: 15 percent compounded daily
• Bank B: 15.5 percent compounded quarterly
• Bank C: 16 percent compounded annually

• Which of these is the best if you are thinking of opening a savings account? Which
is best if they represent loan rates?
• Bank C is offering 16% per year. Because there is no compounding during the year,
the EAR is 16%.
• Bank B is paying .155/4 = .03875, or 3.875% per quarter. An investment of $1 for
four quarters would grow to: $1 × 1.038754 = $1.1642. The EAR, therefore, is
16.42%.
• Bank A is compounding every day. The daily interest rate is: .15/365 = .000411,
or .0411%. An investment of $1 for 365 periods would grow to: $1 × 1.000411365 =
$1.1618 and the EAR is 16.18%
© McGraw Hill 3-42
 CALCULATING AND COMPARING
EFFECTIVE ANNUAL RATES 2

The EARs from the previous slide are as follows:

• Bank A – 16.18%
• Bank B – 16.42%
• Bank C – 16.00%

• Which rate is best?

• For a borrower, Bank C offers the best rate.
• For a saver, Bank B offers the best rate.

• EAR may be calculated as follows, where m is the number of times the

interest is compounded:
m
EAR  1   Quoted rate m   1

© McGraw Hill 3-43

 WHAT’S THE EAR? 1

A bank is offering 12 percent compounded quarterly. If you put $100 in an account,

how much will you have at the end of one year? What’s the EAR? How much will you
have at the end of two years?
The bank is effectively offering 12%/4 = 3% every quarter. If you invest $100 for four
periods at 3 percent per period, the future value is:

Future value  $100  1.034

 $100  1.1255
 $112.55
The EAR is 12.55 percent: $100 × (1 + .1255) = $112.55.
We can determine what you would have at the end of two years in two different ways.
One way is to recognize that two years is the same as eight quarters. At 3 percent per
quarter, after eight quarters, you would have:

© McGraw Hill 3-44

 WHAT’S THE EAR? 2

$100 1.038  $100 1.2668  $126.68

Alternatively, we could determine the value after two years by using an EAR
of 12.55 percent; so after two years you would have:

$100 1.12552  $100  1.2668  $126.68

Thus, the two calculations produce the same answer. This illustrates an
important point. Anytime we do a present or future value calculation, the
rate we use must be an actual or effective rate. In this case, the actual rate is
3 percent per quarter. The effective annual rate is 12.55 percent. It doesn’t
matter which one we use once we know the EAR.

© McGraw Hill 3-45

 EARS AND APRS
Truth-in-lending laws in the U.S. require lenders to disclose an APR on virtually all
consumer loans
• Annual percentage rate (APR) is the interest rate charged per period multiplied by
the number of periods per year.
• Is APR an EAR? In other words, if a bank quotes a car loan at 12% APR, is the
consumer actually paying 12% interest? No!
• For example, an APR of 12% on a loan calling for monthly payments is really 1% per
month
• However, the EAR on such a loan is the following:
12
EAR  1   APR 12   1  1.0112  1  .126825, or 12.6825
• There are also truth-in-saving laws that require banks and other borrowers to
quote an “annual percentage yield,” or APY, on things like savings accounts
• Unlike APR, an APY is an EAR; rates quoted to borrowers (APRs) and those quoted
to savers (APYs) are not computed the same way
© McGraw Hill 3-46
 A NOTE ABOUT CONTINUOUS
COMPOUNDING 1

There is no upper limit to the number of times your money

could be compounded during the year.
• We have seen daily compounding, but compounding (in
theory) could occur every hour or minute or second.
Compounding Period Number of Times Compounded Effective Annual Rate
Year 1 10.00000%
Quarter 4 10.38129
Month 12 10.47131
Week 52 10.50648
Day 365 10.51558
Hour 8,760 10.51703
Minute 525,600 10.51709

© McGraw Hill 3-47

 A NOTE ABOUT CONTINUOUS
COMPOUNDING 2

How high will the EAR get?

• There is an upper limit to the EAR
• If we let q stand for the quoted rate, then as the number of
times interest is compounded gets extremely large, EAR
approaches:
EAR  e q  1

© McGraw Hill 3-48

 WHAT’S THE LAW?
At one time, commercial banks and savings and loan associations (S&Ls) were restricted
in the interest rates they could offer on savings accounts. Under what was known as
Regulation Q, S&Ls were allowed to pay at most 5.5 percent, and banks were not
allowed to pay more than 5.25 percent (the idea was to give the S&Ls a competitive
advantage; it didn’t work). The law did not say how often these rates could be
compounded, however. Under Regulation Q, then, what were the maximum allowed
interest rates?
The maximum allowed rates occurred with continuous, or instantaneous, compounding.
For the commercial banks, 5.25 percent compounded continuously would be:

EAR  e.0525  1
 2.71828.0525  1
 1.0539026  1
 .0539026, or 5.39026%
This is what banks could actually pay. Check for yourself to see that S&Ls could
effectively pay 5.65406 percent.
© McGraw Hill 3-49
 LOAN TYPES AND LOAN AMORTIZATION:
PURE DISCOUNT LOANS
Pure discount loans are those in which the borrower receives money today and
repays a single lump sum at some time in the future.
• Simplest form of loan.
• Common when the loan term is short – say a year or less.

Suppose a borrower was able to repay $25,000 in five years. If we, acting as the
lender, wanted a 12% interest rate on the loan, how much would we be willing to
lend? Put another way, what value would we assign today to that $25,000 to be repaid
in five years?
• Answer is the present value of $25,000 at 12 percent for five years:

Present value  $25, 000 1.125

 $25, 000 1.7623
 $14,185.67

© McGraw Hill 3-50

 TREASURY BILLS
When the U.S. government borrows money on a short-term
basis (a year or less), it does so by selling what are called
Treasury bills, or T-bills for short. A T-bill is a promise by the
government to repay a fixed amount at some time in the future
—for example, in 3 months or 12 months.
Treasury bills are pure discount loans. If a T-bill promises to
repay $10,000 in 12 months, and the market interest rate is 7
percent, how much will the bill sell for in the market? Because
the going rate is 7 percent, the T-bill will sell for the present
value of $10,000 to be repaid in one year at 7 percent:
Present value = $10,000/1.07 = $9,345.79

© McGraw Hill 3-51

 LOAN TYPES AND LOAN AMORTIZATION:
INTEREST ONLY LOANS
Interest-only loans call for the borrower to pay interest each period and to
repay the entire principal (the original loan amount) at some point in the
future.
• Most corporate bonds have general form of an interest-only loan

For example, with a three-year, 10 percent, interest-only loan of $1,000, the

borrower would pay $1,000 × .10 = $100 in interest at the end of the first and
second years.
• At the end of the third year, the borrower would return the $1,000 along
with another $100 in interest for that year.
• Likewise, a 50-year interest-only loan would call for the borrower to pay
interest every year for the next 50 years and then repay the principal

© McGraw Hill 3-52

 LOAN TYPES AND LOAN AMORTIZATION:
AMORTIZED LOANS 1

If the lender requires the borrower to repay parts of the loan over time, it is an
amortized loan; process of providing for a loan to be paid off by making regular
principal reductions is called amortizing the loan
Simple way of amortizing a loan is to have the borrower pay the interest each period
plus some fixed amount
• Suppose a business takes out a $5,000, 5-year loan at 9%. The loan agreement
calls for the borrower to pay the interest on the loan balance each year and to
reduce the loan balance each year by $1,000. Because the loan amount declines
by $1,000 each year, it is fully paid in 5 years.
Year Beginning Balance Total Payment Interest Paid Principal Paid Ending Balance
1 $ 5,000 $ 1,450 $ 450 $ 1,000 $ 4,000
2 4,000 1,360 360 1,000 3,000
3 3,000 1,270 270 1,000 2,000
4 2,000 1,180 180 1,000 1,000
5 1,000 1,090 90 1,000 0
Totals $ 6,350 $ 1,350 $ 5,000

© McGraw Hill 3-53

 LOAN TYPES AND LOAN AMORTIZATION:
AMORTIZED LOANS 2

• Most common way of amortizing a loan is to have the borrower make a single,
fixed payment every period.
• Suppose our five-year, 9 percent, $5,000 loan was amortized this way. How would
the amortization schedule look?

1. We can solve for the payment as follows:


$5, 000  C  1  1 1.095  .09 
 C  1  .6499  .09 

• This gives us:

C = $5,000 / 3.8897 = $1,285.46
• Borrower will therefore make five equal payments of $1,285.46.

© McGraw Hill 3-54

 LOAN TYPES AND LOAN AMORTIZATION:
AMORTIZED LOANS 3

2. We will calculate the interest and then subtract it from the total payment to
calculate the principal portion in each payment

• Interest paid in the first year if $5,000 x .09 = $450

• Principal paid in first year = $1,285.46 – 450 = $835.46
• Ending loan balance = $5,000 – 835.46 = $4,164.54

© McGraw Hill 3-55

 LOAN TYPES AND LOAN AMORTIZATION:
AMORTIZED LOANS (CONCLUDED)
• All remaining calculations are summarized in the following
schedule:
Year Beginning Balance Total Payment Interest Paid Principal Paid Ending Balance

1 $ 5,000.00 $ 1,285.46 $ 450.00 $ 835.46 $ 4,164.54

2 4,164.54 1,285.46 374.81 910.65 3,253.88

3 3,253.88 1,285.46 292.85 992.61 2,261.27

4 2,261.27 1,285.46 203.51 1,081.95 2,261.27

5 1,179.32 1,285.46 106.14 1,179.32 0.00

Total $ 6,427.31 $ 1,427.31 $ 5,000.00

• Because the loan balance declines to zero, the five equal

payments pay off the loan
© McGraw Hill 3-56
 PARTIAL AMORTIZATION, OR
“BITE THE BULLET” 1

• common arrangement in real estate lending might call for a 5-

year loan with, say, a 15-year amortization. What this means
is that the borrower makes a payment every month of a fixed
amount based on a 15-year amortization. However, after 60
months, the borrower makes a single, much larger payment
called a “balloon” or “bullet” to pay off the loan. Because the
monthly payments don’t fully pay off the loan, the loan is said
to be partially amortized.
• Suppose we have a $100,000 commercial mortgage with a 12
percent APR and a 20-year (240-month) amortization. Further
suppose the mortgage has a five-year balloon. What will the
monthly payment be? How big will the balloon payment be?
© McGraw Hill 3-57
 PARTIAL AMORTIZATION, OR
“BITE THE BULLET” 2

• The monthly payment can be calculated based on an ordinary annuity

with a present value of $100,000. There are 240 payments, and the
interest rate is 1 percent per month. The payment is:
$100, 000  C  1  1 1.01240  .01
 C  90.8194
C  $1,101.09
• Now, there is an easy way and a hard way to determine the balloon
payment. The hard way is to actually amortize the loan for 60 months to
see what the balance is at that time. The easy way is to recognize that after
60 months, we have a 240 − 60 = 180-month loan. The payment is still
$1,101.09 per month, and the interest rate is still 1 percent per month.
The loan balance is thus the present value of the remaining payments:

© McGraw Hill 3-58

 PARTIAL AMORTIZATION, OR
“BITE THE BULLET” 3

Loan balance  $1,101.09  1  1 1.01180  .01

 $1,101.09  83.321
 $91, 744.33

The balloon payment is a substantial $91,744.33. Why is it so large? To get

an idea, consider the first payment on the mortgage. The interest in the first
month is $100,000 × .01 = $1,000. Your payment is $1,101.09, so the loan
balance declines by only $101.09. Because the loan balance declines so
slowly, the cumulative “pay down” over five years is not great.

© McGraw Hill 3-59

 SELECTED CONCEPT QUESTIONS
• Describe how to calculate the future value of a series of cash
flows.
• Describe how to calculate the present value of a series of
cash flows.
• In general, what is the present value of a perpetuity?
• If an interest rate is given as 12 percent compounded daily,
what do we call this rate?
• What is an APR? What is an EAR? Are they the same thing?
• What is a pure discount loan? An interest-only loan?
• What does it mean to amortize a loan?
© McGraw Hill 3-60
 END OF CHAPTER
CHAPTER 6

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