6th Presentation

BF06: Time will Tell

Time Value of Money
 Specific Learning Objectives
• Explain Time value of money (TVM) concept.
• Differentiate between the concepts of discounting
and compounding.
• Compute present / future value of multiple cash
flows and annuities.
• Apply TVM concept to financial decision-making and
investment decisions.
 Problem Analysis
Alabama Tigers
4 Options :
• Nikey Ltd
• Reeback Ltd
Sponsorship • Xtreme Ltd
Rights
• Embro Ltd

Sell exclusive
rights to sponsor
for a period of
3 years How to evaluate these
options with different
methods of payment &
decide which is best?
If you could choose…
Option A Option B

Get $1 Or Get $1
Today in a year’s time

Obviously, you would opt for Option A.

One dollar in hand today is worth more than a

dollar promised some time in the future because of
the returns that could be earned while waiting.
Recap on Simple Interest
Simple interest is calculated only on the beginning
principal.
For instance, if you invest $100 at a simple interest rate of
3% per annum, the values of the investment at the end of
each period are as follows (assuming no further inflow or
outflow of the initial amount invested):
Interest earned per Interest earned per Value of investment at
Year
period period end of period
Year 1 P x R x T = I1 $100 x 0.03 x 1= $3 P + I1 = $103

Year 2 P x R x T = I2 $100 x 0.03 x 1= $3 P + I1 + I2 = $106

Year 3 P x R x T = I3 $100 x 0.03 x 1= $3 P + I1 + I2 + I3= $109

Year 4 P x R x T = I4 $100 x 0.03 x 1 = $3 P + I1 + I2 + I3 + I4 = $112

Year 5 P x R x T = I5 $100 x 0.03 x 1= $3 P + I1 + I2 + I3 + I4 + I5 = $115

 Recap on Compound Interest
Compound interest is calculated on the beginning principal
AND the interest accumulated as well.

Using the earlier example with the difference of a

compound interest of 3% instead of a simple interest, our
investment of $100 will look like this instead.

Value of investment at
Year Interest earned per period Interest earned per period
end of period

Year 1 P x R x T = I1 $100 x 0.03 x 1 = $3 P + I1 = $103

Year 2 (P + I1) x R x T = I2 $103 x 0.03 x 1 = $3.09 P + I1 + I2 =$106.09

Year 3 (P + I1 + I2) x R x T = I3 $106.09 x 0.03 x 1 = $3.18 P + I1 + I2 + I3 =$109.27

P + I1 + I 2 + I 3 + I 4
Year 4 (P +I1+I2+I3) x R x T = I4 $109.27 x 0.03 x 1= $3.28
=$112.55

P + I1 + I2 + I3 + I4+ I5
Year 5 (P + I1+I2+I3+I4) x R x T = I5 $112.55 x 0.03 x 1 = $3.38 =$115.93
Compound Interest
Using EXCEL function:
Step 1 : Click ‘fx’ on menu bar

Step 2 : Type ‘FV’ on Search for a function

Step 2 : Or Click on ‘FV’

Step 3 : Click ‘OK’

Compound Interest
Using EXCEL function:

Step 4: Enter Rate, No. of periods and PV

Step 5 : Click ‘OK’

If you could choose again…

Option A Option B

Get $1 Or Get $1.50

Today in a year’s time

How will you decide? Will the $0.50 be enough to

compensate you for the 1 year wait?
Future Value
One way to look at this problem is to see whether you are
able to invest the $1 today and get back more than $1.50
after a year.

Assuming we could invest the money at 3%, after 1 year we

will be getting:

$1 x (1+r) = $1 x (1.03)
= $1.03
r = interest rate/rate of return/discount rate

Since $1.50 is much more than $1.03, we should choose

option B.
Future Value
Using EXCEL function:
Present Value
We could also look at how much the $1.50 we will be
getting in a year’s time is worth to us today.

Assuming we could invest the money at 3%, the 1.50 is worth:

1.50 = 1.46 today

(1+0.03)

Since $1.46 is much more than the $1, we should choose

option B.
Present Value
Using EXCEL function:
Basic Present Value Equation
These are the equations we have been using:
Compounding

PV FV
Discounting

FVt = PV (1+r)t

FVt
PV =
(1+r)t
PV – Present Value. What future cash flows are worth today.
FVt – Future Value. What cash flows are worth in the future.
r - interest rate, rate of return, discount rate per period
t - number of periods
Types of Cash Flows
An annuity is a stream of constant
cash flows that occur at regular
intervals for a fixed period of time.
Annuities
Examples include:
Unequal Cash Flows
Student Loan Payments
Insurance Premiums
Perpetuities
Types of Cash Flows
To Calculate Present Value/Future Value,
we can consider each individual Cash Flow
and discount/compound it to the
present/future value before adding it all
together.
Annuities
Unequal Cash Flows

Ordinary Annuity: Payments or receipts

Perpetuities occur at the end of each period.

$500 $500 $500 $500 $500

Now Year 1 Year 2 Year 3 Year 4 Year 5

Annuity Due: Payments or receipts occur

at the beginning of each period.
Ordinary Annuity (at end of each period)
Using EXCEL function:

Note:
The default
value of “Type”
= 0.
Where the
payment is
made at the
end of each
period.
Annuity Due (at the beginning of each period)
Using EXCEL function:

Enter „1‟ for Type

Types of Cash Flows

For unequal Cash Flows,

Annuities $500 $300 $200 $400 $100

Unequal Cash Flows Now Year 1 Year 2 Year 3 Year 4 Year 5

To Calculate Present Value/Future Value,

Perpetuities
we can consider each individual Cash Flow
and discount it to the present value/future
value before adding it all together.
Unequal cash flows
Using EXCEL function:
Unequal cash flows
Using EXCEL function:
Types of Cash Flows
A perpetuity is an annuity that
lasts forever.
Annuities $500 $500 $500 $500 $500

Unequal Cash Flows Now Year 1 Year 2 Year 3 Year 4 Year 5

Perpetuities PV of Perpetuity =
C
r
C – cash flow
r - interest rate, rate of return, discount rate
Summary - Types of Cash Flows
Application to Problem
Statement
 Solving the Problem
• We will determine the present value and future value of each of
the options.
Nikey Ltd
One time present payment (upfront payment of $20,000,000)
Reeback Ltd
Ordinary Annuity (pay $4,100,000 at the end of every six months)
Xtreme Ltd
One time future payment (pay at the end of three years)
Embro Ltd
Unequal cash flows (different payments as shown in Table 1)

• To decide which option is more attractive, we have to make

assumptions about the rate of return.
• To assume interest to be compounded semi-annually
FV Calculation
FV Calculation
FV Calculation
PV Calculation
PV Calculation
PV Calculation
 Comparing the Options using
different discount rates
Future Value

Present Value

Different assumptions of discount rate made will result in different conclusions.

But using either FV or PV will give the same conclusion for the same discount
rate.
Other Considerations
• Other factors affecting the cash flow such as the need to pay
off loans that are due soon.

• Other needs, especially since the company is a young one,

options that provide a cash flow upfront early may be more
attractive.

• Consider the uncertainty of the cash flow i.e. the risks

involved for each option especially for the sales forecast
probability.

• Consider the current distribution channels, stability and

financial reputation of the four companies.
 Concept Diagram
Simple or
Compound?
Cash flows

Time Value
Interest •Annuities
Of Money •Unequal cash
flows
•Perpetuity

Present Future
Value Value
References
Recommended Textbooks
•Ross, S.A., Westerfield, R.W., & Jordan, B.D. (2008). Corporate Finance Fundamentals (8th ed.) [Chapter 5,
pp.122-140 & Chapter 6, pp. 146-170]. New York: McGraw-Hill Irwin

Reference Textbooks
•Brealey, R.A., Myers, S.C., & Marcus A.J. (2007). Fundamentals of Corporate Finance, Time Value of Money
(5th ed.) New York: McGraw-Hill Irwin. [Chapter 4]
•Block, S.B., Hirt, G.A. (2008). Foundations of Financial Management, Time Value of Money (12th ed.) New
York: McGraw-Hill Irwin. [Chapter 9]
•Brigham, E.F. & Houston, J.F. (2007). Fundamentals of Financial Management, Time Value of Money
(Concise 4th ed.). Thomson South-Western. [Chapter 6]

Websites
•The Time Value of Money. (n.d.) Retrieved October 10, 2010, from TeachMeFinance.com website:
http://teachmefinance.com/timevalueofmoney.html
•Understanding the Time Value of Money. (n.d.) Retrieved October 10, 2010, from Investopedia.com
website: http://www.investopedia.com/articles/03/082703.asp
•NetMBA Business Knowledge Center. (n.d.) Retrieved October 10, 2010 from netmba.com website:
http://www.netmba.com/finance