08

Fall

Dr. Rafiqul Bhuyan
[Type the abstract of the document here. The abstract is typically a short summary of the
contents of the document.]


Time Value of Money
2

Introduction: Discounted Cash Flow Valuation

Chapter 4 discusses topics on the time value of money in different cases, for example the single
period case, and multiple period case. Cash flows can be broken down into different cases as
shown in the diagram below.
i



In discussing the valuation of money, Ch.4 introduces the Future Value and Present Value
concepts. Future value can be described as the value of an investment at the end of a specified
period of time, at a given interest rate. Present value is the current value of a future cash flow
that is discounted at a given interest rate.
ii


One-Period with Ending Single Cash Flow


PV
0
= Present Value
CF
t
= Cash flow at future date,t
r = discount/interest rate
t = future date, t

The equation to find the present value is:

PV
0
=
CF
t
1+ r ( )
t


PV
0
=
CF
1
1+ r ( )
1
=
350
1.10
= $318.18
t=0 t=1

CF
1
=$350
Time Value of Money 3

As you can see in the diagram on the previous page, there is only one period, and the cash flow
is received at the end, at t=1. At interest rate r=10%, the present value of the future cash received
is $318.18. As a real world example, imagine the previous scenario in the following form: If I
want $350 in my account one year from now, how much do I need to save today, if my account
has a 10% interest rate?
Example with a change in future date, t = 4:


PV
0
=
CF
4
1+ r ( )
4
=
350
1.10 ( )
4
= $239.05


Example with a change in future date, t = 8:



PV
0
=
CF
8
1+ r ( )
8
=
350
1.10 ( )
8
= $163.28



t=0 t=4

CF
4
=$350
t=0 t=8

CF
8
=$350
4
The chart above demonstrates the relationship between the present value and time. We can see
that given the same discount rate and cash flow, as time increases the present value decreases.
Also, given the same t and cash flow, the present value will decrease as the discount rate
increases


One Period with Beginning Single Cash Flow

Here, we can determine the future value, at a given time T and with cash flow received at the
beginning of the period.

FV
T
= CF
t
1+ r ( )
Tt
FV
T
= Future Value at time T
CF
t
= Cash Flow at time T
r = interest rate


FV
1
= CF
0
1+ r
( )
10
FV
1
= 250 1.15
( )
1
FV
1
= $287.50











0
200
400
600
800
1000
1200
1400
1600
1800
1 2 3 4 5 6 7 8 9 10 11 12 13
t=0 T=1 r=15%

CF
0
=$250

FV
1
=287.50

Time Value of Money 5


The chart on the previous page shows us the relationships between the future value and time T.
As time T increases, the Future Value also increases.



Also, given the same time T and cash flow, Future Value will increase as the interest rate
increases.

Multiple Period with Ending Unequal Cash Flow


PV
0
=
t=1
T

CF
t
1+ r
( )
t



In the end-multiple case, we have multiple periods with cash flows taking place at the end of
each period. In the illustration above, we have five different cash flows starting at the end of
each year and in unequal amounts.
To solve for the present value, given r=15%, we do the following:
t=0 1 2 3 4 5

CF
1
=25

CF
3
= 75

CF
4
=100

CF
5
=125

CF
2
=50
6

PV
0
=
CF
1
1+ r ( )
1
+
CF
2
1+ r ( )
2
+
CF
3
1+ r ( )
3
+
CF
4
1+ r ( )
4
+
CF
5
1+ r ( )
5
PV
0
=
25
1.15 ( )
1
+
50
1.15 ( )
2
+
75
1.15 ( )
3
+
100
1.15 ( )
4
+
125
1.15 ( )
5
PV
0
= 21.74 + 37.80+ 49.31+ 57.17+ 82.19
PV
0
= 248.21

When we solve for the future value we use the following equation:

FV
T
= CF
t
1+ r ( )
Tt
t=1
T

In this particular example, the future value, with a given 15%, we solve for FV as follows:

FV
5
= CF
1
1+ r
( )
51
+ CF
2
1+ r
( )
52
+ CF
3
1+ r
( )
53
+ CF
4
1+ r
( )
54
+ CF
5
1+ r
( )
55
FV
5
= 25(1.15)
4
+ 50(1.15)
3
+ 75(1.15)
2
+100(1.15)
1
+125(1.15)
0
FV
5
= 43.72+ 76.04 + 99.18+115+125
FV
5
= 458.94


Multiple Period with Beginning - Unequal Cash Flow


PV
0
=
t=0
T

CF
t
1+ r
( )
t




PV
0
=
CF
0
1+ r ( )
0
+
CF
1
1+ r ( )
1
+
CF
2
1+ r ( )
2
+
CF
3
1+ r ( )
3
+
CF
4
1+ r ( )
4
PV
0
=
25
1.15 ( )
0
+
50
1.15 ( )
1
+
75
1.15 ( )
2
+
100
1.15 ( )
3
+
125
1.15 ( )
4
PV
0
= 25+ 43.48+ 56.71+ 65.75+ 71.47
PV
0
= 262.41

t=0 1 2 3 4 5

CF
0
=25

CF
2
= 75

CF
3
=100

CF
4
=125

CF
1
=50
Time Value of Money 7



FV
T
= CF
t
1+ r ( )
Tt
t= 0
T

FV
5
= CF
0
1+ r
( )
50
+ CF
1
1+ r
( )
51
+ CF
2
1+ r
( )
52
+ CF
3
1+ r
( )
53
+ CF
4
1+ r
( )
54
FV
5
= 25(1.15)
5
+ 50(1.15)
4
+ 75(1.15)
3
+100(1.15)
2
+125(1.15)
1
FV
5
= 50.28+ 87.45+114.06+132.25+143.75
FV
5
= 527.79


Perpetuity (Infinite)
A perpetuity is a series of cash flow that go on forever. A British bond called a consol yields
interest annually forever. How can the price of a consol be determined? Consider a consol that
pays a coupon of C dollars each year and will do so forever. Simply applying the PV formula
gives us:
( ) ( ) ( )
t
r
C
r
C
r
C
r
C
PV
+
+ +
+
+
+
+
+
=
1
. . .
1 1
1
3 2

therefore: PV=
r
C

For example,
A perpetuity paying $100 a year. If the relevant interest rate is 8%, what is the value of the
consol?
1250 $
08 .
100 $
= = PV
Suppose the interest rate falls to 5%.
2000
05 .
100 $
= = PV

The value of the perpetuity rises with a drop in the interest rate, and the value of the perpetuity
falls with a rise in the interest rate.
8
Growing Perpetuity
Imagine, an apartment building where cash flows to the landlord after expenses will be $100,000
next year. These cash flows are expected to rise at 5% per year. If one assumes that this rise will
continue indefinitely, the cash flow stream is termed a growing perpetuity. The relevant interest
rate is 11% and the present value of the cash flow can be represented as:
( ) ( ) ( )
T
T
r
g C
r
g C
r
g C
r
C
PV
+
+
+ +
+
+
+
+
+
+
+
=

1
) 1 ( *
. . .
1
) 1 ( *
1
) 1 ( *
1
1
3
2
2

Therefore:
g r
C
PV

=
667 , 666 , 1 $
05 . 11 .
000 , 100 $
=

= PV

Annuity (Finite)
An annuity is a level stream of regular payments that lasts for a fixed number of periods. The
pensions that the people receive when they retire are often in form of annuity. Leases and
mortgages are often annuities.
Formula for Present Value of Annuity:
(
(
(
(

=
|
|
.
|

\
|
+
=
r
r
C PV
r r r
C PV
T
T
) 1 (
1
1
) 1 (
1 1

Example 1
Mark has just won a lottery, paying $50,000 a year for 20 years. He receives his first payment a
year from now. The state advertises this as the Million Dollar Lottery. If the interest rate is 8%,
what is the true value of the lottery?
Time Value of Money 9

( )
905 , 490 $ 8181 . 9 * 000 , 50 $
08 .
08 . 1
1
1
* 000 , 50 $
2 0
= =
(
(
(
(

= PV

Mark supposes to get $1,000,000, but he only get $490,905 in today money.

FV =
C
r
1+ r
( )
T
1
| |
For example, if you make 30 payments of $100 at the end of each period at 5% per period. How
much will be in your account after the last payment?
| | 8 8 . 6 6 4 3 $ 1 0 5 . 1
0 5 .
1 0 0
30
= = FV


Annuity Due
Annuity due is similar to annuity but the first payment occurs at the beginning of the period
instead of the end.


The equations for annuity due are:
( )
( ) r
r
r
C
PV
t
+
(

+
= 1
1
1
1

FV =
C
r
1+ r
( )
t
1
| |
1+ r
( )


For example, what is the present value of an annuity due of ten $ 1,000 annual payments at 5%
discounted rate?

PV =
1,000
.05
1
1
1.05
10



(

(
1.05 ( )= $8,107.82
t=0 1 2 3 4
$1,000 $1,000 $1,000 $1,000
10
What is the future value if you make ten $1,000 payments at the beginning of each period at 15%
discounted rate?

FV =
1,000
.15
1.15
10
1
| |
1.15
( )
= $4,821.53


Growing Annuity
Cash flows in businesses are likely to grow over time, due either to real growth, or inflation. The
growing perpetuity, which assume the infinite number of cash flows, provides one formula to
handle this growth. We now consider a growing annuity, which is a finite number of growing
cash flows. Because perpetuity of any kind are rare, a formula for a growing annuity would be
useful:
Formula for Present Value of Growing Annuity
(
(
(
(
(

|
.
|

\
|
+
+

=
(
(

|
.
|

\
|
+
+

=
g r
r
g
C
r
g
g r g r
C PV
T
T
1
1
1
1
1
*
1 1


Example 1,
John has been offer a job at $120,000 a year. He anticipates his salary increasing by 7% a year
until his retirement in 30 years. Given the interest rate of 10%, what is the present value of his
lifetime salary?
71 . 010 , 255 , 2 $
07 . 10 .
10 . 1
07 . 1
1
000 , 120 $
30
=
(
(
(
(
(

|
.
|

\
|

= PV

Compounding Periods
Up until this point weve been assuming that the compounding and discounting are done on a
yearly basis. However, there are situations where compounding can happen more than once
Time Value of Money 1
1

within the year. For example, bonds pay interest semiannually, stocks pay dividends quarterly,
most mortgages and loans require monthly payment and banks compound interest daily.


For instance, a bank pays a 10% interest rate compound semiannually. This means that a $1,000
deposit in a bank would be worth $1,000*1.05= $1,050 after 6 months, and $1050*1.05=
$1102.50 at the end of the year. The equation can be written as

FV = CF 1+
r
m
( )
m

where FV= Future Value CF= Cash Flow
r= Interest rates m=compounding investment m times a year.
( )
2
2
10 .
1 000 , 1 50 . 102 , 1 + =
Example 2, Quarterly compounding at 10% yield wealth at the end of the year of
1,103.81 = 1,000
4
4
10 .
1 |
.
|

\
|
+
The Annual Percentage Rate (APR) is the contracted or stated annual rate, but the Effective
Annual Rate (EARs) is the annual rate of interest actually being earned.
Effective Annual Rate equation is: 1 1 |
.
|

\
|
+
m
m
r

Interest rate is 10% semiannually:
1
2
10 .
1
2
|
.
|

\
|
+ = 10.25%
Interest rate is 10% quarterly:
% 38 . 10 1
4
10 .
1
4
= |
.
|

\
|
+
The APR for example 1 is 10%, but the EARs is 10.25%. The APR for example 2 is also
10%, but the EARs is 10.38%
12

Exercises
iii

Simple Interest
Ex 1:
Jim invests $5,500 in an account that pays 8 percent simple interest. How much money will he
have at the end of four years?
Answer: $5,500 + ($5,500 x .08 x 4) = $7,260
Compound Interest
Ex 2:
Mark just started a new job and his current annual salary is $40,000. If the rate of
inflation is approximately 5% annually for the next 50 years, and he receives annual
cost-of-living increases tied to the inflation rate. What will be his ending salary?
Answer:
$40,000(1.04)
50
= $284,267.33

Simple Interest vs. Compound Interest

Ex 3:

If Julie invests $3,500 in an account that pays 5 percent simple interest, how much more could
she have earned over a 10-year period if the interest had compounded annually?

Ending value at 5 percent simple interest = $3,500 + ($3,500 x .05 x 10) = $5,250
Ending value at 5 percent compounded annually = $3,500 x (1 + .05)
10
= $5,701.13
Difference = $5,701.13 - $5,250 = $451.13

As we can see, Julie could have earned $451.13 more if the interest had compounded annually.

Present Value
Ex 4:
How much do you need to invest at 9% per year, in order to have $15,000 in:
a. One year: PV = $15,000 / 1.09 = $13,761.47; so you need $13,761.47 today at 9% to
get $15,000 after one year.

Time Value of Money 1
3

b. Two years: PV = $15,000 / (1.09)
2
= $12,625.20; You need $12,625.20 today at 9% to
get $15,000 after two years.
c. Ten years: PV = $15,000 / (1.09)
10
= $6,336.16; You need $6,336.16 today at 9% to
get $15,000 after 10 years.
Ex 5:
Kevin wants to have $80,000 in her investment account 20 years from now. How much does she
have to deposit today to reach her goal, if she earns 9.5 percent compounded annually?
PV = $80,000 / (1.095)
15
= $20,505.87
Ex 6:
What is the present value of $40,800 to be received 5 years from today if the discount rate is 10
percent?
PV = $40,800 / (1.01)
5
= $38,819.80

Finding the Interest Rate, r

Ex 8:

What interest rate makes a PV of $200 become a FV of $250 in 6 periods?
r = (250 / 150)
1/6
1 = 8%
or PV = -200; FV = 250; N = 6; CPT I/Y = 8%.

Ex 9:
Fifty years ago, your father invested $21,000. Today, that investment is worth $287,047. What is
the average annual rate of return your father earned on his investment?

$287,047 = $21,000 x (1 + r)
50
-1; r = (287,047/21,000)
1/50
-1= 5%

Finding the Number of Periods, t

FV = PV(1 + r)
t
rearrange and solve for t. Remember your logs!
t = ln(FV / PV) / ln(1 + r).
14

Ex 8:
Some time ago, Richard purchased five acres of land costing $250,000. Today, that land is
valued at $400,500. How long has he owned this land if the price of land has been increasing at
4.5 percent per year?

T = ln(400,500 / 250,000) / ln(1+.045) = 10.7


i
.
ii
Stephen A. Ross, Corporate Finance 9e (NY: McGraw-Hill/Irwin 2010), 87.
iii
Chapter 5 Time Value of Money. http://blackboard.csusb.edu/bbcswebdav/xid-1641786_1.
[Numerical references where changed]