A SIMPLE APPROACH TO DISCOUNTED CASH FLOW VALUATION

Cha-am Jamal, Thailand,, 2002

All rights reserved
ABSTRACT
The mathematics of continuous compounding is simpler than that for discrete step
wise compounding; and contrary to conventional wisdom its application is not lim
ited to continuously discounted financial instruments but rather it is a versati
le and robust model that may be used for valuation of all financial contracts no
rmally encountered. Further, this model offers a more effective tool for teachin
g discounting to students of finance as it consists of a simple, consistent, and
coherent set of equations that apply without modification to the complete range
of applications normally covered in college courses. The discrete stepwise mode
l of compounding, by contrast, is a redundant innovation that is more complicate
d and it is often a barrier to learning.
INTRODUCTION
Exponential growth is a natural phenomenon and is understood colloquially as the
“snowball effect”. It occurs whenever the instantaneous rate of growth is direc
tly proportional to accumulation. For example, bacterial population in fermentin
g wine behaves in this manner. The more bacteria there are, the greater are the
number undergoing reproduction and therefore the greater the rate of growth. In
finance we understand this behavior as “compounding”. <
But mathematical models of bacterial systems may not apply directly to financial
systems because bacterial reproduction – or “compounding” – occurs at random bu
t financial compounding is synchronized with the calendar. The bacterial system
is akin to a portfolio of many zero coupon bonds that mature at random while the
financial system is similar to a bacterial population in which the reproductive
activities of the bacteria are synchronized. It is this distinction that has pr
evented financial analysts from applying the relatively simple mathematical mode
ls of exponential growth in natural systems to the same phenomenon in financial
systems.
The effect of randomness is that interest payment and compounding occurs at smal
l increments of time throughout the year; but financial contracts specify discre
te interest payments only on certain dates of the calendar. Although this behavi
or is easily accommodated mathematically within the exponential model for natura
l systems, the calculus of financial compounding has been developed on an entire
ly different premise. It is this development that has produced the mathematics o
f discrete stepwise compounding we teach in business schools today as the “time
value of money” or the discounted cash flow method of valuation.
In this paper we present an alternative to conventional discounting mathematics
in finance by making a synchronization correction to the exponential mathematics
for natural systems. In comparing this model of compounding to the conventional
stepwise mathematics in finance textbooks we find that the textbook approach is
a redundant innovation that adds unnecessary complexity and limitations to mode
ling and understanding the compounding process in finance.
We conclude that both in teaching finance and in carrying out valuation of secur
ities in practice the exponential model offers an advantage over the stepwise co
mpounding model. Contrary to the conventional wisdom that the exponential model
only applies to securities with continuous compounding we find that the exponent
ial model with a “synchronization correction” is a simple and robust tool that m
ay be used for valuation of a real financial contracts including continuously co
mpounded instruments. Most finance textbooks do not present the exponential mode
l at all. Those that do, present it as a model that is limited to the treatment
of financial contracts that are continuously compounded. We show that this is no
t the case.
THE BASICS OF EXPONENTIAL GROWTH
Lump Sum Contracts
Suppose we start with a fixed sum of $Wo and allow it to grow exponentially to W
t in t years at a continuously compounded rate of c% per year. Exponential growt
h occurs when the instantaneous rate of growth is not constant but is proportion
al to the current level of funds accumulated at any given time t. Algebraically
we may state that
Equation 1
zt = e-ct
That is, we would pay z dollars today for each dollar to be delivered t years fr
om now if we expect or require our investment to grow at c percent per year. Thi
s is the foundation relationship for valuation in all of finance.
Various algebraic forms of this equation are used in practice. For example, Wt/W
o = ect may be used to explicitly describe Wt, the value to which an investment
of Wo dollars today would grow in t years if the rate of return is c percent per
year. In fact, all valuation relationships in finance are derived from equation
1. Two useful forms are shown below.
1/z = ect, and ln(1/z) = ct
Flow Annuity Contracts
In the exponential model of compounding, cash flow streams may be thought of as
a continuous flow of funds. An annuity is a cash flow stream that flows at a con
stant rate.If the constant rate is $d per year then, applying equation 2, the di
scounted value at time zero of an incremental amount of flow during dt years may
be written as
dWo = e-ct*d*dt
Wo is then computed as the sum of all of these incremental values by integration
.
Wo = d*(1- e-ct
Expressing Wo/d as v(t) and e-ct as z(t) we may write
Equation 2
vt = (1- zt)/c
That is, we would pay v dollars today for continuous flow payments of $1 per yea
r over a contract period of t years. Equations 1 and 2 may now be used as the ba
sic building blocks for the pricing of all patterned streams of cash flows.
Stepwise Annuity Contracts
Suppose that an annuity pays $1 per payment m times a year in chunks at equal in
tervals rather than as a continuous flow. It can be shown that an equivalent “fl
ow annuity” exists and its value may be derived from equation 1 as
Equivalent “Flow Annuity” = c/(ec/m-1)
That is, discrete stepwise payments of $1 per period m times a year has the same
wealth effect as a continuous flow annuity of $c/(ec/m-1) per year. The proof f
or this equality is provided in the Appendix. Substituting this value into the f
low equation we get
Equation 3
ut = (1- zt)/(ec/m-1)
Here we define u(t) as the value of discrete stepwise payments of $1 to be paid
m times a year for t years. We may now use this relationship to price all patter
ned “chunky” cash flows that may be modeled as discrete stepwise annuities.
For example, coupon bond contracts may be priced as a complex security that cons
ists of an ordinary annuity and a zero coupon bond and the bond price as a fract
ion of face value may be written in terms of equations 1 and 4 as
Bo = z + u*(period coupon rate)
Perpetuities are annuities in which t is not bounded. Since z approaches zero as
t goes to infinity, the value of perpetuity may be expressed as
u = 1/(ec/m-1)
That is, we would pay u dollars today for each dollar to be delivered m times a
year forever. Preferred stocks may be valued as perpetuity as they are like the
annuity portion of bonds but the contract does not expire and there is no balloo
n payment pending at any time in the future.
Contracts with Increasing Annuity Payments
Consider a flow annuity in which the annuity paid per year grows at a constant r
ate of g% per year. That is, the annuity at time t is given by
d(t) = d*egt
Substituting this relationship for d we may re-write the differential equation f
or flow annuities as
dWo = d*egt * e–ct * dt
Collecting terms we may re-write this relationship as
dWo = d* e–(c-g)t * dt
Integration yields
Equation 4
vt = (1-e-(c-g)t)/(c-g)
Here vt is the value of a flow annuity with an initial rate of $1 per year but g
rowing at g% per year. The valuation is similar to equation 2 but with (c-g) rat
her than c as the discount rate. The “equivalent flow annuity” term may then be
written as
EFA = (c-g)/( e(c-g)/m)
Therefore the value of a chunky annuity in which the payment amount grows at g%
per year is given by
Equation 5
ut = (1 - e-(c-g)t)/( e(c-g)/m)
We would pay u dollars today to receive $1 next period and further payments m ti
mes a year growing at g% per year for a contract term of t years.
Common stock valuation differs from preferred stock valuation by virtue of the i
nvestor’s ability to participate in the growth of the firm. Its valuation theref
ore represents perpetuity of constant growth dividends that may be expressed as
u = 1/(e(c-g)/m-1)
The equation states that if the next dividend payment is expected to be $1, and
if there are m dividend payments per year, and if dividends grow at g percent pe
r year continuously forever, then we would pay u dollars today for the common st
ock.
STEPWISE COMPOUNDING
The rate of return c in equations 1 through 5 may be interpreted as a “continuou
sly compounded” rate; that is, growth of funds due to interest earnings occurs a
t every interval of time however small. In real financial contracts, for various
spurious reasons, this is not the case. Each contract arbitrarily specifies a “
step” size in time during which growth is not permitted to occur. The typical st
ep size is one month, three months, six months, or one year. At the end of each
step, an accumulated growth amount is instantaneously added. For our model of ex
ponential growth to be directly applicable to these types of financial contracts
, it must be faithful to this start-stop nature of compounding.
A simple method of modeling the stepwise growth behavior is to develop and apply
a generalized relationship between the stepwise rate of return r and the contin
uous rate of return c so that for any quoted stepwise rate an equivalent continu
ous rate may be computed. Once the equivalent continuous rate is available the c
ontinuous exponential model may be used for valuation purposes.
In fact the relationship between c and r is a simple one. In general, if there a
re n steps per year, and the rate of return is r per step then the relationship
between r and c may be written as
Equation 6
c = n*ln(1+r) and r = ec/n
For any conventional stepwise rate of return quoted as r or as APR = n*r, an equ
ivalent continuous rate c may be inferred using equation 6 and the continuous co
mpounding model shown in Table 1 may be applied directly for all valuation purpo
ses. No additional complexity is necessary to accommodate stepwise compounding.
THE PROPOSED DISCOUNTING MODEL
Based on the arguments presented above we propose a wholly new approach to compo
unding models in finance. We demonstrate that the new model is easier to use tha
n conventional discrete compounding and that it is general in scope since it app
lies directly to all forms of financial contracts including those that use flow
annuities and continuous compounding.
Summary of the Proposed Model
The working equations of the proposed model are summarized in Table 1 and the no
tation used in the model is summarized in Table 2. The model is compact and simp
le and yet versatile in its application to real financial contracts. It requires
the additional rate conversion step in all cases and this step is not always ne
cessary in conventional stepwise compounding models but there is a significant p
ayoff in coherence and comprehension.
TABLE 1: Working Equations of the Model
Lump Sum Contracts zt = e-ct
Annuity Contracts ut = (1- zt)/(ec/m-1
Growing Annuities ut = (1 - e-(c-g)t )/( e(c-g)/m)
Perpetuities u = 1/(ec/m-1
Growing Perpetuities u = 1/(e(c-g)/m-1)
Rate Conversion c = n*ln(1+r) and r = ec/n-1
TABLE 2: Notation
c = continuously compounded rate of return in % per year
r = periodically compounded rate of return in % per period
n = compounding periods per year
m = periodic payments per year
t = time in years
z(t) = value of a dollar to be paid t years from now
u(t) = value of an annuity of $1 per period m times a year for t years
v(t) = value of a flow annuity of $1 per year for t years
By way of contrast, the conventional and therefore the textbook approach to step
wise compounding is altogether different. It begins by re-writing equation 1 for
stepwise growth as W(step x) = W(step x-1)*(1+r). The resulting equations are m
ore difficult to apply in practice particularly when m and n are not both equal
to one year or to each other or when the financial contract specifies continuous
compounding or continuous flow annuities
The continuous exponential compounding model presented in Table 1 is simple and
robust. In these equations we see that m and n are independent of each other and
any combination is possible without increasing the complexity of the model and
without the need for case specific equations. Values of m and n that are less th
an one are also easily accommodated. The resultant model is completely general i
n scope and the equations are easily rendered explicit in a number of different
variables that are often the object of financial analysis. We now demonstrate th
e simplicity and lucidity of the model in pricing an assortment of financial ins
truments.
Application of the Proposed Discounting Model
Example 1: Lump Sum Contracts
We wish to price a T-Bill that pays $10,000 in 70 days and yields 5% per year wi
th annual compounding. First we compute c = ln(1.05) = 0.04879 and t in years as
t = 70/365 = 0.19178 years. We can now evaluate Wo = 10,000*e-0.04879*0.19178 =
$9906.87
But what if the compounding period were, say, 90 days instead of one year? There
are 365/90 or 4.0555 of these periods per year so n=4.0555. If the quoted 5% ra
te is the APR then the 90-day rate is 5%/4.0555 or 0.012329 and the equivalent c
ontinuous rate is c = 4.0555*ln(1.012329) or 0.04969. The T-Bill pricing may the
refore be computed as 10,000*e-.04969*0.19178 or $9905.16
Alternately, we might want to know what rate of return we would earn if the T-Bi
ll were quoted at $9900. The rate is c = ln(9900/10000)/t = 0.0524. The equivale
nt 90-day compounded rate is r = e0.0524/4.055-1 or 0.013 and so the correspondi
ng APR quote would be 4.055*0.013 or 5.274% and the APY quote is given by r = e.
0524-1 or 5.38%.
Example 2: Ordinary Annuities
A $20,000 car loan is to be paid over a period of 5 years in 60 equal monthly pa
yments. The interest on the loan is quoted as 9% APY. The value of c is ln(1.09)
or 8.6177%, t is 5 years, and m is 12; so we may compute e-ct = 0.64993 and ec/
m = 1.007207. Wo/d = 0.35007/0.007207 or 48.5736. Therefore the payment is 20,00
0/48.5736 or 411.7462 or $411.75.
Alternately we might compute how much the buyer would have in the bank in five y
ears if she saves 411.7462 per month for 5 years and earns 9% APY. Wt = 20,000/0
.64993 or $30,772.54.
Suppose that the buyer wishes to pay weekly at a rate of $100 per week. How long
will it take to pay off the car at the same rate of interest and without changi
ng the compounding period? We set Wo/d to 20000/100 or 200 and m to 52. Since c*
t must equal 0.377445 and so t must be 4.6212 years or 240.3 weeks.
Example 3: More on Ordinary Annuities
This example is used to illustrate the utility of this model in the valuation of
cash flows with complex compounding and payment streams. Suppose that a consume
r with a $10,000 credit card balance makes weekly purchases of $100 and makes mo
nthly payments of $500. The issuer charges 14% APR compounded every 25 days. Wha
t is the balance on the account after 3 years? First, we compute the 25-day peri
od rate as 0.14*25/365 = 0.009589. Setting n=365/25=14.6 we find c = 14.6*ln1.00
9589 = 0.13933.
With the value of c in hand we can now set up the credit card problem as a sum o
f two annuities and one lump sum. At t=3 years, the lump sum of $10,000 is worth
10,000*e3*0.13933 = $15,189. The purchases form an annuity of $100 with m=52 an
d its value at t=3 years is 100*(e3*0.13933 –1)/ (e0.1393/52 –1) or $19,341. The
monthly payments at m=12 are worth 500*(e3*0.13933 –1)/ (e0.1393/12 –1) or $22,
221. The year 3 balance is 15,189+19,341-22,221 or $12,309.
To maintain her $10,000 balance, the consumer’s monthly payments must be 500*(22
,221+2309)/22,221 or $551.96. For a zero balance she must pay 500*34530/22221 =
$776.97. The solution is simple and clear in the exponential model but not so in
the stepwise textbook model.
Example 4: Coupon Bond Pricing
A Treasury makes coupon payments of $4 every six months and yields 5% APY. It ha
s 10.75 years to maturity at which time a redemption value of $100 will be paid
in addition to the coupon payment. First we note that the 5% APY corresponds to
a c-value of ln(1.05) or 0.04879. The corresponding z and u values are z = e-10.
75*0.04879 = 0.591855, u = (1-z)/(e0.04879/2 –1) = 16.5274
Since the coupon rate per period is 4% the price of the bond is Bo = 0.591855 +
0.04*16.5274 = 1.25295 times $100 or $125.395.
Bond yield computations require an iterative procedure. Suppose that the bond ab
ove is available for $120. Since the coupon rate is 4% twice a year, the bond pr
ice will be $100 at c= 2*ln1.04 or 7.844%. Interpolating between 7.844% and 4.87
9%, our first guess is 4.879+0.1172*(125.2951-120) = 5.5 %. At c=5.5% we compute
bond price = 120.755. Our second guess is 5.5% + 0.1172*0.755 = 5.588% and the
computed bond price is 119.98.
Example 5: A Coupon Bond with Flow Annuities
Suppose that the bond in Example 4 makes the 8% annual coupon payment as a flow
annuity. In that case we compute v = (1-z)/0.04879 = 8.36534. The bond price is
0.591855 + 8.36534*0.08 or 1.26108 times face value or $126.108.
Example 6: Growing Annuities
A young couple wishes to take out a $300,000 home mortgage at an APY of 7.5%. Pa
yments are to be made monthly for 30 years. We compute n=1, c = ln1.075 or 0.072
32, m=12, z= 0.114221, ec/m = 1.00604486, and u = 146.534. Therefore the payment
is 300,000/146.534 = 2047.303 per month.
Suppose they agree to increase the payment by say 2.5% per year. The equivalent
continuous rate of growth in payments is g = 0.0246926 and g-c=0.047627 and u =
0.760406/0.0039768 = 191.211. The first year payments will be 300,000/191.211 =
1568.947 per month. In the 30th year, when the couple’s income is expected to be
higher, their payments will be 1568.947*e0.0246926*30 = 3290.97per month.
Example 7: Common Stock Pricing
A common stock pays dividends of $1 every quarter and we expect these dividends
to grow at a rate of 1.5% per quarter. Our required rate of return from this sto
ck is 16% APY. To price this stock we first compute c = ln(1.16) or 14.842% and
the continuous growth rate in dividends as g=4*ln(1.015) = 5.955%. The stock pri
ce is = 1/(exp(0.08887/4)-1) = $44.51. At zero growth rate and a perpetuity of $
1/quarter dividends, the price would be 1/exp(0.14842/4 –1) = $26.45
Example 8: Yield Curve Effects
When the yield curve is not flat coupon bond pricing must be consistent with the
strip market to reach a state of equilibrium where no arbitrage is possible bet
ween the coupon market and the strip market (Varian 1987). To check for equilibr
ium, each coupon must be priced according to the yield curve. Equation 3 does no
t apply in this case and Equation 1 must be used repeatedly for each payment in
the cash flow stream.
Suppose a Treasury with a face value of $100 matures in 5 years and makes annual
coupon payments of $10. The yield curve is upward sloping. Strip maturing in [1
, 2, 3, 4, 5] years yield [2, 3, 4, 5, 6]% APY. Equation 2 must be applied to ea
ch payment. First we compute c = [0.0198, 0.02956, 0.03922, 0.04879, 0.05827] an
d use Equation 2 to compute the value of $1 delivered under each of the 5 condit
ions as z = [0.9804, 0.9426, 0.8890, 0.8227, 0.74725]. For payments of $[10, 10,
10, 10, 110], equilibrium price of the bond is 118.5445.
Example 9: Interest Rate Futures
The equilibrium values of interest rate futures quotations are determined by the
yield curve because any divergence between these values provides arbitrage oppo
rtunities (Taggart 1996). Suppose that the yield curve is given by strip yields
of [c1, c2, c3]% for terms of [t1, t2, t3] years and interest rate futures are q
uoted at continuously compounded rate of f% for term = (t3-t2) years for strips
to be delivered t2 years from now. We set up the arbitrage as shown below:
Spot leg: invest $1 in t3 strips for t3 years for W(t3) = $ ec3*t3
Futures leg: go short $1 in t2 strips for t2 years and at the same time sell (t3
-t2) year futures for delivery t2 years from now for an obligation in year 3 of
W(t3) = $ ec2*t2 * ef*(t3-t2)
Here f is the continuously compounded interest rate on the futures contract. We
find the equilibrium value of f by setting arbitrage profits to zero and solving
for f.
ec2*t2 * ef*(t3-t2) = ec3*t3
c2*t2 + f*(t3-t2) = c3*t3
f = (c3*t3 – c2*t2)/(t3-t2)
As a numerical example consider the yield curve given by r = [4.0, 4.5, 5.0]% AP
Y for term = [1, 2, 5] years respectively. The equilibrium futures quotation f f
or a 3-year strip to be delivered 2 years from now may be computed as follows:
The equivalent continuous rates are given by ln(1+r) as c = [0.03922, 0.04402, 0
.04879] and so f = (0.24395 – 0.088034)/3 = 0.05197. The equivalent APY quote is
ec/n –1 = e0.05197 - 1 = 0.05334
Example 10: Non-Constant Payments
When learning the principles of NPV analysis for capital budgeting purposes, the
student is faced with a stream of cash flows that do not follow a given pattern
. No shortcut algebraic solution exists in these cases. These cash flows may be
priced one at a time by repeatedly applying Equation 1. We show in the example b
elow that both NPV and IRR may be easily computed using the valuation model pres
ented in this paper.
A project with a life of 5 years requires an initial investment of $100 and offe
rs net cash flows of $[20, 25, 25, 30, 30] in years [1, 2, 3, 4, 5]. Our term-de
pendent required rate of return from projects of this nature are [10, 10, 11, 11
, 12]% APY. To evaluate this project we first compute c = [0.0953, 0.0953, 0.104
4, 0.1044, 0.1133]. The corresponding z-values are [0.9091, 0.82646, 0.7311, 0.6
586, 0.5675]. The value of the cash flows is therefore = 18.02+20.66+18.278+19.7
58+17.025 = 93.74. The NPV is -6.26.
Alternately, one may compute the value of the cash flows at time t = Wt = [20, 2
5, 25, 30, 30] * [e4*0.1044, e3*0.1044,e2*0.0953, e0.0953*1,1] = 30.366+34.196+3
0.25+33+30 = 157.8117.
The computation of IRR requires an iterative procedure. As a first guess we may
use c = ln(157.8117/100)/5 = 0.09123. The corresponding 1/z-values are [1.4404,
1.3148, 1.200, 1.0955, 1.00]. The new Wt value is 154.543 and our next guess is
c=ln(154.543/100)/5 = 0.08706. The corresponding z-values are [0.91662, 0.84018,
0.77014, 0.70593, 0.64707]. The computed investment amount is 99.18. The target
is 100.
Example 11: Negative Interest Rates
The exponential model accommodates negative interest rates in a simple and symme
trical manner. For example if c is a negative 5%, t is 10 years, and m is 12, th
en the value of z is e-(-0.05)*10 = e0.5 = 1.648, that is, you must invest $1.64
8 today to receive $1 ten years from now.
The value of u is (1-1.648)/(e-0.05/12) = 0.648/-0.004158 = 156.844, that is we
must pay $156.844 today to receive 10*12 = 120 monthly payments of $1. At zero i
nterest the value of the annuity would be m*t or $120.
SUMMARY AND CONCLUSIONS
Because financial contracting involves stepwise compounding and discrete cash fl
ow streams it is thought that the exponential model does not apply because it su
bsumes continuous compounding. Conventional wisdom is that an entirely new appro
ach to valuation is necessary.
We show in this paper that this is not so because for any financial contract tha
t offers a stepwise rate of return r, there exists an equivalent continuous rate
of return c, and for any discrete annuity there exists an equivalent flow annui
ty; and there are simple relationships between the continuous compounding parame
ters and the discrete compounding parameters.
The continuous compounding model is not limited to pricing continuously compound
ed securities but in fact the model is more general in scope than the discrete m
odel. We show that the continuous exponential model is robust and simple and is
easily applied to all forms of financial contracting for valuation purposes.
The simple and consistent set of equations presented here apply without modifica
tion under all combinations of payment and compounding periods and may be used t
o price a wide variety of financial contracts.
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Black, Fisher and Myron Scholes, The pricing of options and corporate liabilitie
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Brealey, Myers, and Marcus, Fundamentals of corporate finance, 3rd edition, Irwi
n McGraw Hill, 2000
Brigham and Gapenski, Intermediate financial management, 5th Edition, Dryden Pre
ss, 1996
Finnerty, John, An overview of corporate securities innovation, Continental Bank
Journal of Applied Corporate Finance, Winter 1992
Rubenstein, Mark, Derivative assets analysis, Journal of Economic Perspectives,
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Sundaresan, Suresh, Fixed income markets and their derivatives, South Western Co
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APPENDIX
The Equivalent Flow Annuity
Consider a chunky annuity that pays $1 per period m times a year at equal interv
als of time. After the first period, 1/m years have passed and $1 has been recei
ved. Using equation 1 we compute the value of this payment as z = e-ct = e-c/m.
Using equation 2 we may price a flow annuity of EFA dollars per year for 1/m yea
rs as v = EFA*(1-e-c/m)/c
For equal wealth we set z = v and solve for EFA = c/(1-e-c/m).
The Equivalent Continuous Rate
Equate the value of Wt at any value of t say t=1 with n compounding periods per
year and a period rate of r.
ec = (1+r)n
Take the natural logarithm of both sides
c = n*ln(1+r)
The Bounded-ness of z and u
As x approaches zero from the positive side, i.e., as x becomes a smaller and sm
aller positive number, the function ex approaches 1+x; and as x becomes infinite
ly large ex also goes to infinity and therefore e-x goes to zero. Applying these
limits to equation 2 and 3 we find that
Limit (c->zero): z -> 1+ct -> 1
Limit (c->infinity): z -> 0
Limit (c->zero): u -> (1-1+ct)/(1+c/m –1) = ct/(c/m) = mt
Limit (c->infinity): u -> (1-0)/(infinity) = 0
That is, as long as interest rates have positive values, z is bounded by 0 and 1
and u is bounded by 0 and m*t. These results are consistent with our intuition.