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Time value of money

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
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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

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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.

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Present Value One Period Example

Suppose you need Rs.10,000 in one year for the down


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

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Present Values

=
= 1
Present Values
Discount factor = DF = PV of Rs. 1

1
= (1+)

Discount factors can be used to compute


present value of any cash flow
2-1 Future Values and Present Values

Given any variables in the equation, one


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

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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

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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

Step 2: Estimate Opportunity Cost of Capital


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

NPV ` 747, 664 ` 700 , 000


` 47, 664
Present Values
Net Present Value

NPV = PV required investment


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=PV required investment


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?

profit ` 800, 000 ` 700,000


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

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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%

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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)

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Number of Periods Example

You need Rs.20,000. If you can invest at 10%


per year and you currently have Rs.15,000,
how long will it be before you have enough
Rs.20000?
t = 3.02 years

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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)

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Multiple Cash Flows FV

Suppose you invest Rs.500 in a mutual fund


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

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Multiple Cash Flows PV

You are considering an investment that will pay you


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

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Annuities and Perpetuities Defined
Annuity finite series of equal payments that occur
at regular intervals

Perpetuity infinite series of equal payments

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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

Effective Annual Interest Rate (EAR)


Interest rate annualized using compound
interest

Annual Percentage Rate (APR)


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

EAR = (1 + .01) 1 = .1268, or 12.68%


12

APR = .01 12 = .12, or 12.00%


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%

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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

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Present Value with Daily Compounding

You need $15,000 in 3 years for a new car. If you


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

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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%

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