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29 visualizzazioni50 paginepowerpoint on time value of money

Oct 26, 2017

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Basic Definitions

Present Value earlier money on a time line

Future Value later money on a time line

Interest rate exchange rate between earlier

money and later money

Discount rate

Cost of capital

Opportunity cost of capital

Required return

Future Values and Present Values

Future Value of Rs.100 =

FV ` 100 (1 r ) t

Example: FV

What is the future value of Rs. 100 if interest is

compounded annually at a rate of 7% for two

years?

FV ` 100 (1.07) (1.07) ` 114.49

FV ` 100 (1 .07) ` 114.49

2

Effects of Compounding

Simple interest

Compound interest

Consider the previous example

FV with simple interest = 100 + 7 + 7 = 114

FV with compound interest = 114.49

The extra 0.49 comes from the interest of .07(7)

= 0.49 earned on the first interest payment

4

Future values and compounding

For a given present value, future value

increases with increases in interest rate, r

Future Values with Compounding

Future values and compounding

The effect of compounding is small for a small

number of periods, but increases as the

number of periods increases.

Present Values

How much do I have to invest today to have some amount in

the future?

FV = PV(1 + r)t

Rearrange to solve for PV = FV / (1 + r)t

When we talk about discounting, we mean finding the present

value of some future amount.

When we talk about the value of something, we are talking

about the present value unless we specifically indicate that

we want the future value.

8

Present Value One Period Example

payment on a new car. If you can earn 7% annually, how

much do you need to invest today?

PV = 10,000 / (1.07)1 = 9,345.79

9

Present Values

=

= 1

Present Values

Discount factor = DF = PV of Rs. 1

1

= (1+)

present value of any cash flow

2-1 Future Values and Present Values

can solve for the remaining variable

PV when discount factor and FV is given.

PV DF2 C 2

PV 1

114.49 100

(1.07 ) 2

Present Value Important Relationship

I

For a given interest rate the longer the time

period, the lower the present value

What is the present value of Rs.500 to be received in 5

years? 10 years? The discount rate is 10%

5 years: N = 5; I/Y = 10; FV = 500

CPT PV = 310.46

10 years: N = 10; I/Y = 10; FV = 500

CPT PV = 192.77

13

Present Value Important Relationship

II

For a given time period the higher the interest rate,

the smaller the present value

What is the present value of Rs.500 received in 5 years if

the interest rate is 10%? 15%?

Rate = 10%: N = 5; I/Y = 10; FV = 500

CPT PV = 310.46

Rate = 15%; N = 5; I/Y = 15; FV = 500

CPT PV = 248.59

14

Present Values

Valuing an Office Building

Step 1: Forecast Cash Flows

Cost of building = C0 = Rs. 700,000

Sale price in year 1 = C1 = Rs. 800,000

If equally risky investments in the capital market

offer a return of 7%, then cost of capital = r = 7%

2-1 Future Values and Present Values

Valuing an Office Building

Step 3: Discount future cash flows

PV C1

(1 r ) ` 800,000

(1.07) ` 747, 664

Step 4: Go ahead if PV of payoff exceeds

investment

` 47, 664

Present Values

Net Present Value

C1

NPV = C0

1 r

Present Values

Risk and Present Value

Higher risk projects require a higher rate of return

Higher required rates of return cause lower PVs

PV of C1 ` 800,000 at 7%

$800,000

PV ` 747, 664

1 .07

Present Values

Risk and Present Value

Higher risk projects require a higher rate of return

Higher required rates of return cause lower PVs

PV of C1 ` 800,000 at 7%

$800,000

PV ` 747, 664

1 .07

Present Values

Risk and Net Present Value

NPV= ` 747,664 ` 700,000

` 47,664

Present Values

Net Present Value Rule

Accept investments that have positive net present

value

Using the original example: Should one accept the

project given a 10% expected return?

$800,000

NPV= ` 700,000+ ` 27, 273

1.1

Present Values

Rate of Return Rule

Accept investments that offer rates of return in

excess of their opportunity cost of capital

In the project listed below, the opportunity cost of

capital is 12%. Is the project a wise investment?

Return .143, or 14.3%

investment ` 700,000

Present Values

Multiple Cash Flows

Discounted Cash Flow (DCF) formula:

C1 C2 Ct

PV0 ....

(1 r )1

(1 r ) 2

(1 r ) t

T

NPV0 C0 t 1

Ct

(1 r ) t

Net Present Values

Discount Rate

Often we will want to know what the implied interest

rate is on an investment

Rearrange the basic PV equation and solve for r

FV = PV(1 + r)t

r = (FV / PV)1/t 1

25

Discount Rate Example 1

You are looking at an investment that will pay

Rs.1,200 in 5 years if you invest Rs.1,000 today.

What is the implied rate of interest?

r = (1,200 / 1,000)1/5 1 = .03714 = 3.714%

26

Finding the Number of Periods

Start with basic equation and solve for t

(remember your logs)

FV = PV(1 + r)t

t = ln(FV / PV) / ln(1 + r)

27

Number of Periods Example

per year and you currently have Rs.15,000,

how long will it be before you have enough

Rs.20000?

t = 3.02 years

28

Spreadsheet Example

Use the following formulas for TVM calculations

FV(rate,nper,pmt,pv)

PV(rate,nper,pmt,fv)

RATE(nper,pmt,pv,fv)

NPER(rate,pmt,pv,fv)

29

Multiple Cash Flows FV

today and Rs.600 in one year. If the fund

pays 9% annually, how much will you have in

two years?

FV = 500(1.09)2 + 600(1.09) = 1,248.05

30

Multiple Cash Flows PV

Rs.1,000 in one year, Rs.2,000 in two years and

Rs.3000 in three years. If you want to earn 10% on

your money, how much would you be willing to pay?

PV = 1000 / (1.1)1 = 909.09

PV = 2000 / (1.1)2 = 1,652.89

PV = 3000 / (1.1)3 = 2,253.94

PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92

31

Annuities and Perpetuities Defined

Annuity finite series of equal payments that occur

at regular intervals

32

Perpetuities

Perpetuity

cash flow

Return

present value

C

r

PV

Perpetuities

Perpetuity

cash flow

PV of cash flow

discount rate

C1

PV0

r

Perpetuities

Present Value of Perpetuities

What is the present value of Rs. 1 billion every

year, for eternity, if the perpetual discount rate is

10%?

PV ` 1 bil

0.10 ` 10 billion

Perpetuities

Present Value of Perpetuities

What if the investment does not start making

money for 3 years?

PV ` 1 bil

0.10 ` 7.51 billion

1

1.103

Annuities

1 1

PV of annuity C t

r r 1 r

Annuities

Annuity

Example: The state lottery advertises a jackpot

prize of $365 million, paid in 30 yearly

installments of $12.167 million, at the end of each

year. Find the true value of the lottery prize if

interest rates are 6%.

1 1

Lottery Value 12.167 30

.06 .061 .06

Value $167,500,000

Annuities

Future Value of an Annuity

1 r t 1

FV of annuity C

r

Annuities

Future Value of an Annuity

What is the future value of Rs. 20,000 paid at the

end of each of the following 5 years, assuming

investment returns of 8% per year?

1 .08 1 5

FV 20, 000

.08

` 117,332

Growing Perpetuities and Annuities

Constant Growth Perpetuity

C1 g = the annual growth

PV0

rg rate of the cash flow

This formula can be used to value a perpetuity

at any point in time

Ct 1

PVt

rg

Growing Perpetuities

Constant Growth Perpetuity

What is the present value of Rs. 1 billion paid at

the end of every year in perpetuity, assuming a

rate of return of 10% and constant growth rate of

4%?

1

PV0

.10 .04

` 16.667 billion

Growing Annuities

Golf club membership is Rs. 5,000 for 1 year, or

Rs. 12,750 for three years. Find the better deal

given payment due at the end of the year and 6%

expected annual price increase, discount rate

10%.

How Interest is Paid and Quoted

Interest rate annualized using compound

interest

Interest rate annualized using simple

interest

How Interest is Paid and Outlaid

Given a monthly rate of 1%, what is the

(EAR)? What is the (APR)?

EAR = (1 + .01) 1 = r

12

12

Computing APRs from EARs

If you have an effective rate, how can you

compute the APR? Rearrange the EAR

equation and you get:

APR m (1 EAR)

1

m

-1

APR - Example

Suppose you want to earn an effective rate of 12%

and you are looking at an account that compounds

on a monthly basis. What APR must they pay?

APR 12 (1 .12) 1 / 12

1 .1138655152

or 11.39%

47

Future Values with Monthly

Compounding

Suppose you deposit $50 a month into an account

that has an APR of 9%, based on monthly

compounding. How much will you have in the

account in 35 years?

Monthly rate = .09 / 12 = .0075

Number of months = 35(12) = 420

FV = 50[1.0075420 1] / .0075 = 147,089.22

48

Present Value with Daily Compounding

can deposit money into an account that pays an

APR of 5.5% based on daily compounding, how

much would you need to deposit?

Daily rate = .055 / 365 = .00015068493

Number of days = 3(365) = 1,095

FV = 15,000 / (1.00015068493)1095 = 12,718.56

49

Continuous Compounding

Sometimes investments or loans are figured based

on continuous compounding

EAR = eq 1

The e is a special function on the calculator normally

denoted by ex

Example: What is the effective annual rate of 7%

compounded continuously?

EAR = e.07 1 = .0725 or 7.25%

50

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