NPV, Annuities, Perpetuities and Finance Project Evaluation

Faculty of Economics and SECCF
University of Belgrade
IMQF
Mathematics and Modeling for Finance
NPV, Annuities,
Perpetuities
Irena M. Jankovic
Belgrade, November 2015
Irena Jankovic, Faculty of Economics, Belgrade, November 2015
SUMMARY
Introduction
Time Value of Money
Interest Rates
Future Value
FV of an Annuity
Present Value
PV of an Annuity and Perpetuity
Net Present Value
Internal Rate of Return
Conclusions
Time Value of Money
Present vs future consumption

Do 1000Euros today have the same
value as 1000 Euros received one or
more years from now?
How to deal with cash flows occurring
on different dates?
Interest rate
Rate of return that reflects the

relationship between differently dated
cash flows
Required rate
Discount rate
Opportunity cost
1.
2.
3.
Investors perspective
Real risk-free interest rate
+Inflation premium
+Default risk premium
+Liquidity premium
+Maturity premium
Nominal riskfree interest

rate
=r
Future value
Relationship between Present value

(PV) which earns a rate of return (r) and
its Future Value (FV) which will be
received N years from now
For N=1, FV1=PV(1+r)
Simple interest, FVN=PV(1+Nr)
Compound interest, interest on
interest, FVN=PV(1+r)N
Simple interest
Compound interest
Year
Balance
Year
Balance
0
1
2
PV
PV+r*PV
PV+r*PV+r*PV
0
1
2
PV
PV+r*PV
(PV+r*PV)+r*(PV+r*PV)
FV=PV(1+Nr)
FV=PV(1+r)N
Example 1. (Excel)
Suppose you deposit 1000Eur in an
account leaving it there for 10 years
at interest rate of 10% p.a. How
much will you have at the end of 10
years? Compare simple vs
compound interest calculations
results and graph them.
Example 2. (Excel)
Person is 58 years old and intends to retire
at age 63. She starts retirement account:
At the beginning of each year 0, 1, 2, 3, 4
she makes deposit into account and
expects it will earn 10% interest per
annum.
After retirement she expects to withdraw
$20,000 each year for 8 years.
How much should she deposit each year
in the account?
Frequency of compounding
When interest is compounded several

times a year (biannual, quarterly, daily,
hourly, every minute)
The periodic rate and the number of
compounding periods must be
compatible.
FVN=PV(1+r/m)mN
As the number of compounding periods
increases, the future value increases
Continuous compounding
If the number of compounding periods

per year becomes infinite m
FVN=PVerN
e 2.7182818
The more frequent compounding, the

larger the FV
Used for portfolio return calculations
and options valuations
Example 3. (Excel)
You deposit $1000 in a bank that pays

5% p.a. How much will you have after a
year if the compounding is done 1, 2,
10, 20, 50, 100, 150, 300, 800 times a
year or continuously? Graph the effect
of changing compounding frequency.
Effective annual rate

Discrete:
EAR= (1+r/m)m-1
Continuous:
EAR= er-1
e.g. A $1 would at 5%p.a. in a year grow
to:
m=1, 1(1+0.05)=$1.05, EAR=r
1.
m=2, 1(1+0.05/2)2=1.050625,
2.
EAR=(1+0.05/2)2-1=0.050625=5.0625%
Continuous compounding,
3.
EAR=e0.05-1=0.051271=5.1271%
The future value of an annuity
Annuity a finite set of level sequential

cash flows
1.
Ordinary annuity (t=1)

Annuity due (t=0)
Perpetuity a set of level never-ending
sequential cash flows (t=1)
2.
3.
Ordinary annuity
FVN = A (1+ r)
N 1
+ (1+ r)
(1+ r) 1
FVN = A
N 2
+ ...+ (1+ r) + (1+ r)

1
Example 4. (Excel)
Suppose we have 5 separate deposits of
$1000 occurring at the end of the next five
years. Find the future value of this annuity
after the last deposit at t=5. r=5%p.a.
Example 5. (Excel)
Two years from now a client will receive
first of three annual payments of $20,000. If
he can invest them at 9%p.a., how much
will they worth after 6 years?
Present value
Given a future
cash flow that is
to be received in
period N, and an
interest rate per
period r, we can
calculate the
present value
PV=FVN(1+r)-N
PV=FVN(1+r/m)-mN
PV=FVN/erN
Example 6. (Excel)
Suppose you own liquid asset that will
pay you $100,000 in 10 years from today.
Given an 8% discount rate, what will the
asset be worth 4 years from today, and
what will be its value today? What would
be the value today in the case of monthly
compounding?
The present value of an ordinary

annuity
A
A
A
A
PV =
+
+ ... +
+
N 1
2
(1 + r ) (1 + r )
(1 + r )
(1 + r ) N
1
1 (1 + r ) N
PV = A
r
Mortgages, auto loans and retirement savings

plans are classic examples of application of
annuity formulas.
Example 7. (Excel)
Pension fund manager anticipates that

$1 million per year must be paid to
retirees starting at year 11. The benefits
will be paid until t=39 for a total of 30
payments. What is a PV of pension
liability if the appropriate discount rate
is 5% compounded annually?
The PV of a Perpetuity
1
A
A
A
PV =
+
+
+ ... = A
2
3
t
(1 + r ) (1 + r ) (1 + r )
(
1
)
r
+
t =1
r>0
A
PV =
r
Some government bonds and preferred

stocks are typical examples of assets that
make level payments for an indefinite period
of time.
Example 8.
A perpetual preferred stock pays
quarterly dividends of $1000 forever. If
the required rate of return is 12%p.a. on
this type of investment, how much
would you pay for this stock?
Example 9.
Consider a level perpetuity of $100 p.a.
with its first payment beginning at t=5.
What is its PV today given a 5%
discount rate?
Example 10.
How long it will take for an investment of
1,000,000 to double in value? The interest
rate is 8%p.a.
Example 11.
En is 22 years old and is planning retirement
at age 63. She plans to save $2,000 per year
next 15 years. She wants to have retirement
income of 100,000 per year for 20 years
starting at t=41. How much must she save
each year from t=16 to t=40 in order to achieve
her goal? She plans to invest her money in
investment fund earning on average 8%p.a.
Net Present Value (NPV)
A method for choosing among

alternative investments
Present value of investment cash
inflows (benefits) minus the present
value of its cash outflows (costs)
Decisions concerning capital budgeting
and capital structure
NPV rules
1.
2.
3.
4.
5.
Identify all cash inflows and outflows

associated with the investment
Determine appropriate discount rate for
particular project (e.g. WACC)
Sum all present values=NPV
If NPV>0, undertake investment
If you are choosing between two projects
(mutually exclusive) undertake the one with
higher positive NPV
NPV formula
N
CFt
NPV =
t
t = 0 (1 + r )
CFt = net cash flow at time t

r = the discount rate or opportunity cost of
capital
N = the projected life of the investment
When NPV is positive, the investment adds
value!
Example 12.
Management of the Corporation plans to
invest $1 million in R&D. Incremental net
cash flows are forecasted to be $150,000
per year in perpetuity. Corporations
opportunity cost of capital is 10%p.a.
Should shareholders accept the plan?
What would be their decision if the
opportunity cost of capital is 15%?
Example 13. (Excel)

Company is planning joint
venture that requires
investment of $13 million.
Expected cash flows are
given below. Discount rate
calculated for this proposal
is 12%p.a.
a) Calculate investments NPV
b) Make a recommendation to
the management
Year Cash flow

0
-13,000,000
3,000,000
3,000,000
3,000,000
3,000,000
10,000,000
Internal Rate of Return (IRR)
A single number that represents the rate of

return generated by an investment
The discount rate that makes NPV=0
PV of outflows=PV inflows
In the study of bonds IRR is called Yield to
Maturity
CFN
CF1
CF2
+
+ ... +
=0
NPV = CF0 +
1
2
N
(1 + IRR) (1 + IRR)
(1 + IRR)
IRR rule
Accept project or investment for

which the IRR is greater than the
opportunity cost of capital
When the opportunity cost is equal to

IRR, NPV=0
Caution: When the project after initial
investment has positive and negative
cash flows, it can have more than one
IRR.
Example 14.
Use Example 12 data and calculate IRR.
Example 15.
Bank gives a $1000 loan to a customer
and makes a 5 year payment plan (300,
200, 150, 600, 900). Each payment
consists of the principal and the interest.
Find the IRR for this loan schedule.
NPV vs IRR
1.
2.
NPV and IRR give the same accept or reject

decision when the projects are independent
When projects are mutually exclusive, we
have to rank them.
Rankings according to NPV and IRR may
differ when:
The size of the projects differs
The timing of the projects cash flows
differs
IRR and NPV for Mutually

Exclusive Projects of Different
Size
Project Investment
at t=0
A
-10,000
Cash Flow IRR NPV at

8%
at t=1
15,000
50% 3,888.9
42,000
-30,000
40% 8,888.9
IRR and NPV for Mutually

Exclusive Projects with Different
Timing of Cash Flows
Pro CF0
ject
A
B
CF1
-10,000 15,000
-10,000
0
CF2 CF3
IRR
NPV at
8%
0
0 50% 3,888.9
0 21,220 28.5% 6,845.12
When you have this kind of conflicts, choose the

project with higher NPV because it would lead to
higher increase in shareholders wealth!!!

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Faculty of Economics and SECCF

Mathematics and Modeling for Finance

Belgrade, November 2015

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Time Value of Money

Present vs future consumption

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Rate of return that reflects the

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Nominal riskfree interest

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Relationship between Present value

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

When interest is compounded several

If the number of compounding periods

The more frequent compounding, the

You deposit $1000 in a bank that pays

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Effective annual rate

The future value of an annuity

Annuity a finite set of level sequential

Ordinary annuity (t=1)

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

+ ...+ (1+ r) + (1+ r)

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

The present value of an ordinary

Mortgages, auto loans and retirement savings

Pension fund manager anticipates that

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Some government bonds and preferred

Net Present Value (NPV)

A method for choosing among

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Identify all cash inflows and outflows

CFt = net cash flow at time t

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Example 13. (Excel)

Year Cash flow

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

Internal Rate of Return (IRR)

A single number that represents the rate of

Accept project or investment for

When the opportunity cost is equal to

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

NPV and IRR give the same accept or reject

IRR and NPV for Mutually

Cash Flow IRR NPV at

Irena Jankovic, Faculty of Economics, Belgrade, November 2015

IRR and NPV for Mutually

When you have this kind of conflicts, choose the

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