ECONOMICS 357 (01)

Winter 2014
Some Notes on Present Discounted !"ue
I# Present Discounted !"ue C!"cu"!ted !t t$e %orro&in' (!te o) Interest
Assume that you have been offered an amount equal to $30,000 plus 4 percent, one year
from now; that is, you have been offered
$30,000 + $30,000 x 4 ! $30,000 x "#04 ! $3",$00
Assume also that you have no money, but that you can borrow money at % interest#
&hat is the maximum amount you would be willin' to pay for the opportunity to receive
that $3",$00 one year from now( )conomists answer this question by as*in' how much
you could borrow today and repay that amount out of $3",$00 one year from now# +hat
is, they solve for , in the followin' equation-
, ."#0%/ ! $3",$00
0% # 433 , $0 $
0% # "
$00 , 3" $
= = X
+hat is, if you had to pay $$0,433#0% for the ri'ht to receive $3",$00 one year from now,
you could borrow that amount from the ban*, at %, and that $3",$00 would be exactly
the amount you would need in order to repay the loan# +hus, if it costs you anythin' less
than $$0,433#0% to obtain the opportunity to 'et $3",$00 a year from now, you will be
able to borrow that amount, repay it a year from now out of the $3",$00, and still have
money left# 1or example, if you had to pay $$0,000 for the ri'ht to receive $3",$00 a year
from now, you could borrow that $$0,000 .to pay for the opportunity/ and at the end of a
year you would owe the ban* $$0,000 x "#0% ! $30,240# 3nce you had repaid that out of
the $3",$00 promised to you, you would have $4%0 left over#
&hen you calculate the maximum amount you can borrow today, and repay that amount
out of an amount received in the future, the fi'ure you have calculated .$$0,433#0%, in
this case/ is called the present value of the future amount, discounted at the borrowing
rate of interest - or just the present discounted value#
+he same *ind of calculation can be done for an amount to be received two years from
now# 1or example, assume that you have been promised an amount equal to $30,000
increased by 4 per year two years from now# +hat is, assume you have been promised
$30,000 x ."#04/
$
! $3$,444# +he maximum amount you could borrow from the ban*, at
)conomics 352 $ 6resent 7iscounted 8alue
%, and repay that loan out of $3$,444 two years from now can be found from the
formula-
( ) 444 , 3$ $ 0% # "
$
= X
( )
%0 # 424 , $4 $
0% # "
444 , 3$ $
$
= = X
9f you were to be char'ed anythin' less than $$4,424#%0 for the ri'ht to receive $3$,444
two years from now, you could borrow the amount required, repay it out of $3$,444
.when you received it/ and still have some money left over#
:ow, assume that you receive the followin' offer- you will be paid $30,000."#04/ one
year from now and $30,000."#04/
$
two years from now# ;ow much is that worth to you
today( 3ne way to answer this is to divide the question into two parts# ;ow much could
you borrow today and repay that loan out of the first amount, plus how much could you
borrow today and repay that loan out of the second amount( +hat is, simply ima'ine that
you could ma*e two loans, one a'ainst each amount promised in the future# <ou can see
easily that the answer is
$$0,433#0% + $$4,424#%0 ! $54,3"$#5%
1inally, ima'ine that the promised amount is $30,000 today, $3",$00 one year from now,
and $3$,444 two years from now# &hat is the maximum amount you would be willin' to
pay to receive that stream of benefits( &e have already seen that you would be willin' to
pay $54,3"$#5% for the second two components of this stream; and you would be willin'
to pay $30,000 for the first component# .<ou pay for the three components added
to'ether and are immediately paid $30,000# =o, you are willin' to pay $30,000 for the
first component#/ =o, now we have that the present discounted value of the stream of
benefits, $30,000 + $3",$00 + $3$,444, calculated at the borrowing rate of interest is-
( )
( )
5% # 3"$ , 44 $ %0 # 424 , $4 $ 0% # 433 , $0 $ 000 , 30 $
0% # "
04 # " 000 , 30 $
0% # "
/ 04 # " . 000 , 30 $
"
000 , 30 $
"
$
$
"
= + + =
+ + =
PDV
PDV
>ompare this stream of income with a stream that is $33,000 today, $33,000."#05/ one
year from now, plus $33,000."#05/
$
two years from now# +he 678 of this stream,
calculated at the borrowing rate of interest, is-
( )
( )
04 # 0%4 , 04 $ 30 # 340 , 3$ $ %4 # %44 , 3$ $ 000 , 33 $
0% # "
05 # " 000 , 33 $
0% # "
/ 05 # " . 000 , 33 $
"
000 , 33 $
$
$
$
$
= + + =
+ + =
PDV
PDV
)conomics 352 3 6resent 7iscounted 8alue
&e can also calculate the maximum amount you would pay today in order to receive the
second income stream above instead of the first one# 1or example, assume that the first
income stream represents your income from your current ?ob and the second stream
represents your potential income from a second ?ob .e#'# in another city/# ;ow much
would you be willin' to pay to obtain that second ?ob .instead of your first one @ you
canAt have both/# Bsin' the 678 formula, you could answer this question by deductin'
the income in the first ?ob from the income in the second ?ob in each year .producin' a
stream of C'ainsD of $3,000 + $3,450 + $3,034#50/ and then calculatin' the 678 of that
stream .by dividin' by ", "#0% and ."#0%/
$
, respectively/# ;owever, you should be able to
see that that will 'ive you exactly the same result as if you had simply deducted 678
"

from 678
$
above# +hat is, the 678 of the future stream- $3,000 + $3,450 + $3,034#50 is
?ust the difference between $04,0%4#04 and $44,3"$#5$, or $0,25%#4$# +he maximum
amount you would be willin' to pay to enter the second ?ob, if you had to borrow funds at
% to ma*e that payment, would be $0,25%#4$# =o, for example, if you could only obtain
the second ?ob by payin' $"0,000 to move from one city to another, you would not be
willin' to do that#
+he method used above to calculate 678 is useful as lon' as the stream of income does
not extend very many years into the future# Eut ima'ine that each of the two ?obs in my
example, above, extended forty years into the future# 9n that case, you would have to
ma*e 40 calculations for each 678, a rather len'thy, tedious ?ob# 9nstead of doin' that, it
is possible to use the followin' technique#
678
"
, above was calculated to be-
( )
( )
$
$
"
0% # "
04 # " 000 , 30 $
0% # "
/ 04 # " . 000 , 30 $
"
000 , 30 $
+ + = PDV
Fultiply both sides of this formula by "#04G"#0%# +he result is-
( )
( )
( )
3
3
$
$
"
0% # "
04 # " 000 , 30 $
0% # "
/ 04 # " . 000 , 30 $
0% # "
/ 04 # " . 000 , 30 $
0% # "
04 # "
+ + = PDV
:ow, if you subtract the second of these formulas from the first you 'et-
( )
( )
3
3
" "
0% # "
04 # " 000 , 30 $
"
000 , 30 $
0% # "
04 # "
= PDV PDV
or
( )
( )

3
3
"
0% # "
04 # "
" 000 , 30 $
0% # "
04 # "
" PDV
( )
( )

3
3
"
0% # "
04 # "
" 000 , 30 $
0% # "
04 # "
0% # "
0% # "
PDV
)conomics 352 4 6resent 7iscounted 8alue
( )
( )

3
3
"
0% # "
04 # "
" 000 , 30 $
0% # "
04 # " 0% # "
PDV
( )
( )

=
04 # " 0% # "
0% # "
0% # "
04 # "
" 000 , 30 $
3
3
"
PDV
"
PDV ! $30,000.0#05554/.53/ ! $30,000.$#04325$/
! $44,3"$#5%
:ote that this is exactly the answer that was obtained at the be'innin' of this section#
:ote also, that if you were to repeat the process above with a series that ran for 40 years,
instead of 3, the 678 would be found to be-
( )
( )

=
04 # " 0% # "
0% # "
0% # "
04 # "
" 000 , 30 $
40
40
"
PDV
+his can easily be calculated, in only a few seconds on your hand calculator, to be-
"
PDV ! $30,000.0#404440/.53/ ! $30,000.42#%4"""3/
! $",4$0,$33#40
:ote that what this says is that if- you start earnin' $30,000 per year at a'e $5 .probably
too low in $0"4/, your income 'rows at 4 percent per year .also reasonable if, say,
inflation is 3 percent/, the rate at which you can borrow funds is % percent, and your
planned retirement a'e is %5, the present discounted value of your lifetime income is
approximately $",430,000# +hat is, followin' the assumptions employed up to this point,
what that says is that you could borrow almost one and a half million dollars today, use
that money however you li*ed, and you would be able to repay your loan out of your
annual income# .3f course, you would have no annual income left, after ma*in' your
loan payments#/
<ou should be able to see that, in 'eneral, the 678 of a stream of benefits paid over :
years will be
( )
( )

+
+
=
g i
i
i
g
B PDV
N
N
"
"
"
"
when E is the benefit in year " .i#e# is an amount that is paid CtodayD/, g is the annual rate
of 'rowth of E, and i is the borrowin' rate of interest# .:ote- 9 have substituted .i@g/ for
."+i/ ."+g/#/
)conomics 352 5 6resent 7iscounted 8alue
:ote also that all of the terms in brac*ets on the ri'htHhand side of the last equation above
are constants# =o, we can calculate the 678 of any stream that has a startin' value of E
by multiplyin' E by the term in brac*ets# 9n the example ?ust 'iven, for 45 years, that
value was 42#%4"""3# +his value is often called the multiplier# =o, now assume that
instead of E bein' your startin' salary, ima'ine that it is the difference between the
startin' salary of a hi'h school 'raduate and the startin' salary of a university 'raduate#
1or example, this mi'ht be $"0,000# :ow, we can calculate the difference between the
lifetime income of a university 'raduate and that of a hi'h school 'raduate by multiplyin'
$"0,000 by 42#%4"""3, to 'et $42%,4""#"3# 9f university cost you, say $50,000, you could
borrow that amount and repay it out of your 'ains and still have $4$%,4""#"3 left over#
II# Present Discounted !"ue C!"cu"!ted !t t$e *endin' (!te o) Interest
9n the precedin' discussion, 9 assumed that you would have to borrow money in order to
pay for the opportunity to obtain the assumed future amounts# ;ow would the analysis
differ if you had money of your own to invest .so you didnAt need to borrow/( >onsider
a'ain the very first scenario in =ection 9# <ou have been offered the opportunity to
receive $3",$00 one year from now# +he question now becomes, how much would you
be willin' to remove from your own investment portfolio, to purchase this opportunity(
Assume that you have money invested in bonds that have been earnin' 5 # .:ote- 9
assume that the rate at which you can lend or invest money is less than the rate at which
you can borrow it @ in my examples above, this was % H because ban*s cannot afford to
lend money at a lower rate than the rate they pay to their depositors#/ ;ow much would
you need to invest in such bonds to 'enerate $3",$00 one year from now( >allin' this
amount, <, the answer is-
< ."#05/ ! $3",$00
$0 # 2"4 , $0 $
05 # "
$00 , 3" $
= = Y
+hat is, if you were to invest $$0,2"4#$0 in bonds at 5 percent, you would receive
$3",$00 one year from now# =o, if someone was to char'e you less than $$0,2"4#$0 in
return for the ri'ht to $3",$00 one year from now, you would be better off puttin' your
money into that opportunity than investin' it in bonds .assumin' that both investments
had the same level of ris*/#
+he value that is obtained in this case is called the present value of the future amount,
discounted at the lending rate of interest or, again, just the present discounted value#
All of the other results obtained above apply, mutatis mutandis, to this interpretation of
678, with the borrowin' rate of interest replaced by the lendin' rate# 1or example, we
could as*, how much would you be willin' to spend to obtain the ri'ht to a stream of
income from year 0 to year 30 .i#e# 40 years/, equal to $30,000 + $30,000."#04/ +
)conomics 352 % 6resent 7iscounted 8alue
$30,000."#04/
$
+ I## + $30,000."#04/
30
# 9f the lendin' rate of interest is 5 percent, the
answer is-
( )
( )
( )( )
%0 # 4"$ , 00" , " $
"05 3"4 # 0 000 , 30 $
04 # " 05 # "
05 # "
05 # "
04 # "
" 000 , 30 $
40
40
=
=

=
x
x
x
PDV
PDV
PDV
+his, $",00",4"$#%0, fi'ure is the amount you would be willin' to pay to buy the stream
of income above, if you had to ta*e that money away from investments earnin' you 5
percent# 3r, put another way, it is the amount you would have to invest at 5 percent in
order to 'enerate the stream of income identified above# 1or example, assume that you
were in?ured at a'e $5 and, as a result, lost your ability to earn an income# +o replace
your lifetime income stream, of $30,000 + $30,000."#04/ + $30,000."#04/
$
+ I## +
$30,000."#04/
30
, you would have to be paid $",00",4"$#%0# .+his is how dama'es are
calculated in personal in?ury lawsuits#/
J:ote also, from the formula above, that as the number of years increases, the fraction
."#04/
n
."#05/
n
'ets smaller and smaller, so the term in the first brac*et approaches "# +hus,
for example, when the number of years approaches infinity, the 678 is determined by
multiplyin' $30,000 by "05# +here is a type of bond, called a consu", that ma*es annual
payments in perpetuity# +his is how the value of such bonds is calculated#K
III# Intern!" (!te o) (eturn
Assume, that you have been offered the income stream $30,000 + $30,000."#04/ +
$30,000."#04/
$
+ I## + $30,000."#04/
30
# Assume also that the CpriceD for this stream is
$",00",4"$#%0# &e can now answer the question- At what interest rate would you have
had to invest $",00",4"$#%0 in order to 'enerate that stream( 1rom the analysis above, we
*now that the answer to the question is 5 percent# &hen you calculate the interest rate
that you would have to earn on an investment, in order to 'enerate a particular income
stream, you are said to be calculatin' the internal rate of return.