r

fl

The Time Value of Mo"eif

f
F

i
E

r
I

DOLLAR TODAY is worth more rhan a doilar in the furure becau:e

we can invest
the dollar elsewhere and earn a return on it. Most people
can grasp ,rr* ,.**."a
wirhout the use of moders and mathematics. In this chapter,
r". ur. ,rr" ."ri.*, .i ,
yf .jmonfy to calculate exactly how much . do[r. received .. ,.
:::
time in the future is worth today, or vice versa, nrra ,'.*.
what makes the time varue of money compening is the fact that
it has apprica-
biliry in a range of personal decisions, f.o,. ,r,ri.rg for retirement
or tuition to buy_
ing a house or a car. we consider a variety of such examples
in this chapter. The
measurement of the time value of monev is arso centrar
to corporate finance. In
investment analysis, we are often cailed opon to anaiyze
investments spread out over
ti,e' Thus, the managers at Boeing, when anaryzing the
Superl.rmbo invesrment,
have to consider whar rhey wiII have ro spend not
onry today but also in the future,
and measure this against what they expect to earn
today and far into the future. The
principles that we learn in this chapter arso become
cruciar when wevalue assers or
entire businesses, whose earnings rvil be generated
over extended time periods.
Given that our objective in corporate finance is to maximize
value, it i, .Lr. rhrt
rve cannot do so without an understanding of
how to compare donars at different
points in time.

The Intuitive Basis for the Time Value of Money

why is a dollar today worth more to you than a donar a year from
now? The sim_
plest way to explain the inruition is to note that you
courd have invested the dollar
elsewhere and ear*ed a returr on it, in rhe form
of interest, dividends, or price
appreciation. Thus, ifyou could earn 5yo in a savings
account in a bank, the dollar
today would be worth $1.05 a year from today.
Although we often take the interest rare we can earn
on our savings as a given,
it worth considering what goes into this interest rate. fusuming
is
that you are guar-
anteed this return by the borrower, there are rwo
reasons why you need to earn the
interest rate to save. The first is that the presence
of infration means that the dorlar
today will buy more in terms of real goods th.r,
th. s-arne dollar . y... to,. ,o*.
consequently, you would demand an interest rate to compensate
for the loss in pur_
chasing power that comes with inflation. The second
reason is that rike most indi_
viduals, yo,t prefer present cottsum7ttion tofuture cgnsumption.
Thus, even if there were
44
 CASH FLOWS AND TIME LINES 45

no inflarion and the doliar today and the dolar

a year from now purchased exacrry the
quantiry of goods, you wourd prefer to spend
same
the dorar anJ consume the goods
today' Therefore' to get you to postpone the
consumption, the borrower m'st offer
you some compensation in the form of an inter
a real interesr rate. How much would you
":::'::';#::il";lti;*11:Jff3
upon how strong your preference for current consumption
is, with sffonger prefer_
ences leading to higher real interest rates. The
inrerest rate that includes the expected
inflarion in addirion to the real interest rate is called
a norninal interest rate.
Thus far,we have assumedyou are guaranteed
the return on your savings. If there
is uncertainty about whether you will earn the rerurn,
there is , ,t ira .o."ponenr to
the return that you would need to make on your
investment. rrri, ,iri.i component
is compensation for the uncertainry that you
... .*por.d ,o, .J i, ,rr.Jo u. greater
as the uncertainry increases.'w'hen there is no
certainry about what you-win make on
your investment, we measure the return not as an interest rate but as.an expected
le return.
In summary then, when we tark about the return
you can make by investinga,lor_
\ar today e)sewhere, there are three compohents
l- of this return: the expected inflation
rate, a real interest rate, and a premium
for unccrta.inry.
central to the notion of the time varue of money
is the idea that the money can
be invested eisewhere to earn a return. This
I return is what we car a discount rate.
Note rhat the incerest ,rr: yol can make on
a guaranreed invesrment, say a
ment securiry can be used as the discoun, ,rr. ;;";;
i,h..,;;;; i;;;,t*Jr,r'rr'.*p..r.o ,o
yield a guaranreed return. when rhere is uncertainry
.u.r, ,rr. fi.iJln ,r, ,n r.rr,n..,r,
the discount rate is the rate of return that you
can expect to make on an investment
with a similar amount of uncertainry in which
..r. r, *nt h;.;; ;;;rare a pre_
mium for uncertainry. The "discount rate" is
therefore a more g.r..d terrrr than
"interest rates" when it comes to time
varue,, and that is the ,"r- *l will
use through
the rest of this chapter. In examples in which
the amount we will receive orpay out
is known with a fair degree of certainry
the interest rate will be the discount rate. In
other examples, where there is uncertainry about
the futurri, we will use the expected
return on invesrments of similar risk as the
discounr rate.

cr 3'1: Economists and government officiars have

been wringing their hands over
the desire for current consumption that has
red American families to save ress
consume more of their income. what are and
the imprication, to, air."rnt ,it"rr
Cash Flows and Time Lines
In addition to discount rates, the other variable
rhar we wrr calk abour in rhis chapter
is cash flows' A cash flow is either cash
that we expecr to receive (a cash inflow) or
cash that wc expect to pay out (a cash
outflow). Since this chapter is all about the
nificance of comparing cash flows a.ros sig-
ti-., we will present cash flows on a tirne
Iine that shows both the timing and the amount
of each cash flow. Thus, cash flows
of$100 received at the end ofeach ofthe next
four years can be
vv svrrvLls
depicted vr
on a rime
line like the one depicted in Figure 3.1.
In the figure, tiarp 0 refers to the present. A cash
flow that occurs at time 0 does
not need to be adjusted for time ',rrl,r.. I., this
we have no cash flows ar time 0,
case,
but we ha'ze $400 in nominal cash flows
over the next four years. However, the fact

.:

i
 .+6 CHAPTER THREE I THE l-iivii vALUE (-)F MONEY

Figure 3.1 .A Time

Cash.Flows
Line for Cash Flows:
$100 in Cash Flows $1 00 $1oo $100 $1 00
Received at the End
of Each of the Next 4
Years
0 1 2 3-._ 4
. year

that they occur at different points in time means that the cash flows really cannot be
compared to each other. That is, $10C in one year should be worth less than g100
today but more than $100 in fwo years. In sum, $400 over rhe next four years should
be worth less rhan g400 today.
Notc rhe difference berween a period of time and a point in time in Figure 3.1.
The portion of the tirne line berween 0 and 1 refers to period 1, which, in this exam-
ple, is the first year. The cash flow that we receive at the point in time "1" refers to
the cash flow that occurs at the end of period 1.Had the cash flows occurred at the
beginning of each year instead of at rhe end of each year, the rime line would have
been redrawn as ir appears in Figure 3.2.

,,,J[:,'.]il:l:fr ?$T#il1;i*,-,1T,]:il:?T:;',JI, j3111'ffff ";::

ing that while we receive $400 in this case, as in the previous one, these cash flows
worth more because we get each g100 one year earlier than in the previ-
*::i;1,
,..j;;l;;,'1,T.::nT:ffi :.:ri;il:ilrr::1,1Hl}#::"'#::":ili.::;
flows today. yield a ptesent value (PV).'We will also reverse this process and ask a dif-

IJI.:ff '::l?il,"ffi :,-"",'Hiil'##Ll.'".ff '*;lTJ,-#H:ff ['ilj

future is called cornpounding and the resulting value is called a future value (FV).

Tiure Value ct'Money: Compounding

and Discounting
we consider how to discount and compound a simple .rrfi flerr, and
;flj:.:?;,

Compounding
Assume that vou are the owner of InfoSoft, a private business that manufacture: soft-
ware, and that you have $50,000 in the bank earning 6010 interesr for the foreseeable

Figure 3.2 A Time

Line for Cash Flows: Cash Flows
$100 in Cash Received $100 $100 $100
at the Beginning of
Each Year for the
'2
llext 4 Y. ears
Year
 TIME V'ALUE OF MONEY COMPOUNDING
AND DISCOUNTING 47
future.over rime' that investment wil increase
in value. Thus, at the erid of cine yeir,
rhe $50,000 win be worth 953,000 ($50,000
* inrerest of 6yo on$50,000). ihrs rs the
furure v-alue at the end of the first ye?r.v/e
can write trri, urt,r. *or. formally as:
Furure Value at end ofyear 1
= $50,000(1.06) = $53,000
At the end.of year2,the deposit would have,grown
further ro $56,1g0 ($53,000 +
inrerest of 6yo on $53,000). This can
also be writren ** for*rUy ,r,
or be.:
Furure Value at end ofyear 2
= g50,000(1.06Xi.06) = $50,000(1.06)2 = 56,180
$100 . $
ou.ld' Note that the future value at the end of 10
years would then be:
Future Value at end
of10 years = $5,000(1.06;ro = $g9,542
3.L.
In addition to the inirial investmenr of
lrn- $50,000 earningo ----vrvwL'
interest, rrrw
the ,'
interest earned in
each year imelf earns interest in future
ito years.
why do we eare about the furure varue of an investment?
the
measure that we can us:_to g-ornpare-{terq4.rives
It provides us with a
tye to reaving the money in the bank.
For insrance, if you could irru.rrifr.-gSqOOi
.tr.*t.r. and end up with more than
$89,542iat the eiid of 10 years,you courd argue
2 for taking this invesrment, assum_
ing this investment,is just as safe as leaving
t- your money in. the bank. If it were riskier,
you would need io end up with more
r's thangS9,5a2'ro .o*p..rr"r. fo, tt. uncer_
tainry, which is equivalent to saying
that you would need a higher rate ofreturn
6%. rhan
In general' the value.ofa cash flow tqday (cF,)
at the end of a future period (r).
when the discount rate is given (as r),
can U" *rln." .,
Futu.r.e Value of Cash Flow = CFo (l + /)r
The future value will increase with time
and increase as the discount rate increases.
y' CC g.t: ln computing the future
value of g50.000 qn if,i above, we assumed
that interest earned was arowed a pr"in "*"*ple
i, the accgunt and earn more interest. -
what wourd the ruture var,e re ir;;;
from the account each year?
ir";il;;;ffiff5 ,"il'ln,"r"r, income

Brl Frmutims $"!: Ihe powst' ol Csmpoundin$ _ $loclrs, Build$,

and Bilts
ln the preceding example, the future
value increased as we incre.ased the
for which we invested our rnoney; we number of years
ca, this the compounding period. As the
the compounding period is exte;ded, rength of
rr"rr Jir".un.es in discorlnt rates can lead to large
differences in future varue. rn a study
of returns on stocks and bonds between
1 998' rbbotson Associates r926 and
found that sto.t, on it," .r"rage made
government bonds on average_made. about 1 1 % a year, whire
about 5% a year.,Assuming that these
tinue into the future, Figure 3.3 provides returns con-
tire future vJiues of $.100 invested in
bonds for periods extending. up io ao yea.s. stocks and
ing at these different rates oJ return ur"
ri"1lt"r"n.", i^ trirr" ,rL" ;#;'r::i:
,r"ir to, Jort compounding periods (such as one
year) but become larger as the
compoundint p.rta is extended. For instance,
vear time horizon, the future varue of inr.rirns-in with a 40-
,to.kr, or 1.to/o, is_
more than nine times rarger than the future ";
.i.rr" of rn*rtrng ";;;";;;ft;"
ii ir;s,f
uonas at an
average return of 5%.

.'l

.:

.L
48 CT{APTER THR.EE / THE TIMi VATUE OF MONEY

Figure 3.3 Effect of

Compounding
Periods: Stocks versus
T. Bonds

.:t ..,,

r r.:rt'i-r-i:',1 rr!

3,,5 :r7;,.9 J1r13 15 17.19 21 2g 25 27 29 31 33 95 37,'39

'.,,' ,. . ,' CompgundinglPeqigds .

Discounting

::iii: *:rir
.,-,,-a ."^,

a_f <5:=
-l

Figure 3.4 Present

Value of a Cash Flow

Discounting converts $2 billion in cash flows in year I into cash flow tcday
 TlA,lE VALUE OF MONEy: COMPOUNDING AND
DISCOUNTING 49
Solving for the cash flow today, we ger:

.", = $:,ol']l:"
(1.10)s
= $qir ,riirion

Thus, g2 billion in eighr years is i,vorth g933 minion

in prese,r value rerms. whar
exacdy does that mean? with a 10% discour-rt rare,
::i tsoeing rvourd be indifferenr
berr'veen receiving g933 ,rilrio, today and
$2 bi-nron in eighr-ye:rrs.
Generalizing, if cF, is the cash florv at the end. of ,o.rr.
f,,r,r.. y.,,. r and ris rhe
discour-rt rate, the present varue of a crsh flow can
be r,vritten as forlor,vs:
present Value of a Cash Flo-, Ci
= (1 + ,),
:

The present value will decrease the further into rhe future
a cash tlow is expectecl ro
be received and as the discount .rr-. i.,.r.rr.r.
Why do rve discourtt? Discotrnting rllorvs us to convert crsh
florvs in thc futr,re
into crsh flolvs today, so that we can compare them and aggregate
them for purposes
of analysis. To illustrate, the Boeing SuperJumbo investnrenr
mrghr have cash inflr:rvs
and outflows occurring each year for the nexr 30 years.
Although these cash flows, bv
thettrselves cf,nllot be contpalecl to erch other. rhe
presenr valr.re ol.cac6 of chesc casl,
.:95:3:;; florvs can be aggregated or curnulated. we coulcl,
for instance, answer the question o[
r'vhether the present value of the cash inflows
:, *=@+,,..-
r55E;-:, value of the cash outflo.,rrs.
on this project r,vilr exceed rt p..r.",
"
lookjj ';-.isffi.j i"'
hat ai
*ffi,*l-
:=-€i-.*-
It is also interesting ro look at presenr value frorl the perspective
lines. Singapore Airlines, after entering into a conrracr
of Si,gapore Air-
uuc[! z,=a;l;*:
ro pay g2 billion in eighr years,
,-...:i;.ffi_" rvi11 have an expected cash ourflorv of rhar
amolurt at rhe end of rhe eighth year.
Assume that it lvants to set asicle the nroney todav
- *c€'J;1?1--'
: ro ensure rh.rt rc will have $2 t,ii_
,.-';;ii,'ffi.st' r',, lion at the end of the eighth year ancl that it can earn |yo
on ttsinvestments. The pres-
ent value of g2 billjon in eight years can be r,vriten as:

$l't]0O
Present V.rlr.re of pavnrent
. = = $1'164 nlillion
(1 07f
Singapore Airlines rvould have to set aside
loh $i,164 million toda.v, earning 7,% ayear,to
D'. ensure rhat it had g2 billion at the end ofeighr years.

ce
m.
lfi Pnaclice 8.2: T$* Fres*rlE $mllg* fffs*{s r{ l{l$lls*, I}isssrint Batar
ln the preceding example, we assumed that singapore
Airlines could make 7o/o on its
investments and calculate_d that it would need.to-5et
a.sidg $t,rca million t.O.V t. irrir"
at a value of $2 bilrion in eight years. what if it courd
if the rate of return *"ru ,iu.h i.*"'i ri" r.'Li* irr.
Li" rrrgi";';""1./,? or what
""r, " ii.;;;;;;;"
,"*r, Airrines can
earn on its investments, the rower is the present varue
firm woutd need to set aside to set g2 biilion at th"
and the ress i, ti"lr"r^t
that the
,."rrl in,, is iilustrated
"nJ;i
in Egure 3.5. At a 14o/o rate of.rerurn, for instance, singapore-niir1;;r;;;rd "i;ii
aside only $201 million to reach $Z billion at the to set
end oi year g. ""ed

The Frequency of Discounting and Compounding

In the preceding examples, the cash flo.,rslwere discounted
and compounded a*uany
that is, interesr paylncnrs anc i;iconrc lvcie Lol,rfJrLc.i
- rt rhe .rJ;i;;.; ,."r. Urr"i

,.
50 CHAPTER THREE / THE TIME VALUE OF MONEY

Figure 3.5 Present

Value of $? Billion in
8 Years

on the balance at the beginning of the year. In some cases, however, the interest may
be computed more frequendy, such as on a monthly or semiannual basis. In these:i
cases,the present and future values may be very different &om those computed on an.,
annual basis.
To illustrate, consider the investment of $50,000 in the bank earning 6Yo ayear that 'i ::
we considered in the secrion on compounding. The furure value of $89,542 was based
on the assumption that rhe bank computed interest income on the income at the end .].:

of each of the next 10 years. Assume instead that the bank computed interest every ::
..
l

,.
six months.'We can then compute the future value of the investrnent at the end of 10 :

years as follows: i

Future Yalue at end of year 10 = $50,000h * 0':6 :,

\ tl )20 = Sso,roo :
,}:
i ::
The interest rate every six months is now 3% (6%/2),b:ut there are 20 six-month com-
pounding periods io 10 years. Where does the increase in value from $89,542 to
$90,306 come from? It arises &om the fact that the interest income is now computed a-
:i: ,'

at the end of six months to be $1,500; this interest income now earns interest over the
remaining six months of the first year. A similar compounding benefit occurs with
each interest payment from the bank. If the compounding were done every month
instead of every six months, the future value would be: ::':t

.,i :
oi:U :1 :':
Future Value at end ofyear 10 (monthly compounding) = $50,000(1 - = $90,970
)"t a::
:.i ,,,:

In general, then, the future value of a cash flow, where there are I compounding peri- :l.i :

ods each year and rz is the number of years, can be written as follows: ::
Stated Annual Interest Rate
Furure Value of Cash Fiow = Cash Flow todav +
[t ]*'
 TIME VAIUE OF MONEY COMPOUNDING
AND DISCOUNTING 51

This anaiysis can be re&amed in terms of the

interest rate that you earn on your invest_
ment' Although the stated annuar rate on the
investment in our example is 6yo, tite
effective annual rate is much higher when compounding
occurs every six months. It
can be computed as follows:

Effective Interesr nrr. = [1 *

0 06
L z 1'
I
-, = u.onu

In general, the eft-ective annual interest rate, given

that there are , compounding peri_
ods every year, can be computed as follows

Stated Annua] Interest Rate

Effecrive Interesr Rare - [, *
L, ]'-,
The bank can compute interest on a weekry or
daily basis, in which case the future
value and the efFecrive inrerest rate wourd be
even high"r. ai*. rr*rrJ"*.ver, the
bank could-compougd at every instant in time,
in which case it is caled
compounding. As compounding becomes conrinuous, trr. "r"ri;;;;
.ft-..tiu. i*;r*;;;
be computed as follows:

Stated Annual Interest Rate

Effecdve Inreresr nrt. = +
l- -1 =
expstated mle _1
[l
tey In our example above, for instance, the effective interest
rate when a 6% annuar rate is
)se compounded continuously would be:
ln
, Efi'ective Interest Rate = exp0.06 _1 = 6.1g%
The future value of $50,000 at the end of 10 years
at with continuous compounding
d would then be:
d Future Vaiue of $50,000 with continuous compounding = $50,000 exp(0.06)(r0)= $91,106
Y
In the context of discounting, more frequent compounding,
) by increasing the effec-
tive discount rate, reduces the present varue. It
shourd .o,,. ,, ,o ,rrrprii then that
loan sharks use daily compounding to keep track
of the amounts owed to them.

ln Pnactice 3.8: [stimating tffestiue lilterg$t Ratos

0r Montuaue
toans
Most home mortgage loans in the united states
iequire monthry payments and conse_
quently have monthry compounding. Thus,
the annuar interest ,",";i;i;-;n roans can
be deceptive because they are actuaily too row.
A roan with an annuar interest rate of
8'00%, for exampre, when adjusted ftr monthry
compounding. wiil have an effective
interest rate of

Effective tnterest n"t" = + Jlx -r = s.sx

[r ]"

lm Prartice $.4: Ap[ Legislation

Prior to 1 968, banks in the United states were ailowed
to advertise using any interest rate
.h.:y on.both deposits il;;;;e;l;;;r'.
t::"
with a blizzard of rates, some stated, rorni.tr".ti"",
:o,.,"ouentty, consumers were faced
and some adjusted, which courd not
. 52 CHAPTER THREE / THE TIME VAIUE OF MONEY

t-l:j::.;i ::;;; :)ii,:: iii:ai-+J

*rb .':-:'.i:r-+.i,::::-j-1 *r::
+*+r-;:ih*:*:" i;ail*:' a :i
Time

t. zi.: y-+r.!jyr

#rc
-ft
.1+

l:.:,

?Y,

Future Value of.$5;000.invested in year 2 = $5,000 (1.06)8 = $7,969

Figure 3.6 Annuity of

$5,000 each Year for 10
Years
5 b
Year
 TIME VALUE OF MONEY ANNUITIES AND PERPETUITIES 53

Lend- Computing the future values of all 10 investments and then adding them up, we
ng to obtain:
been
I per- Cumulated Future Value = $5,000(1.06)e + $5,000(1.06)8 + $5,000(1.06)7 + g5,000 (1.06)6
per- + $5,000 (1.06)s + $5,000 (1.06)4 + $s,000 (1.06)3 + $5,000 (1.06)2 + $5,000 (1.06)
:ront
=
$5,000 (1.06e+ 1.068+ 1.067+ 1.066+ 1.06s+ 1.064+ 1.063+ 1.062+ 1.06 + 1)
ould
This can be simplified ro yield the following:

cumurated Future value = $s,000

0lj1l
ff 0.06 = $6s.e04
dif-
ate
[ J

ted In general, the future value ofan annuiry (A), received or paid, at the end ofeach year
1as for r years with a discount rate / can be calculated as follows:
rp-

t---
---*.
FV of ay Aanuity = FV (As,n) =4!:21]
Thus, the notition we will use throughout this book for the futur-e value of an annu-
iry will be FV (A,r,n).
This analysis is based on the assumption that the cash flows occur at the end of

ffi,
:i'Ei'*r*,'*'-=
each year. Ifthey occu-rred at the beginning ofeach year instead, each cash flow would
earn an additional year of interest. This wouid result in a future value for the annuity
that is greater by this factor:
:ffi.-6*'
.:.rii FV of tBeginning-of-the-Period Annuiry = A (1 +,
*4.i+::ir.:;:
iii.i*:i::.i , [Jt{1]
This future value will be higher than the furure value of the same annuiry at the end
ofeach period.
**i- :-.
is *.. l
Im Prarti*m $"$: lndiuiilual Relirsmsnt f,ccoultts flnf,)
lndividual retirement accounts (lRAs) allow some taxpayers to set aside $2,000 a year for
-i:-:i:.:: i
retirement, and the interest earned on these accounts ii exempt tr., t.*.ii"". lf an indi-
-
.il:-:; vidual starts setting aside money in an IRA early in her working life, its value at retirement
can be substantially higher than the amount actually put in. For instance, assume that an
individual sets aside $2,000 at the end of every year; starting when she is 25 years old, for
an expected retirement at the age of 55, and that she expects to make g% i year on her
investments. The expected value of the account on her retirement date can be calculated
.:-,:,'.
as follows:

Expected Value of tRA set aside at 6s = g2,0oo = $s18,113

tffiL]
The tax exemptionradds substantially to the vdlue because it ailoli.e the investor to keep
the pre-tax return of 87o made on lbe IEA invest[ent. lf the income had been taxed at
40%, the after-tax return would have dropped to 4.gyo, resulting in a much lower
expected value:

Expected vatue of tRA set aside at 65 if taxed = 52,000 = 1230,127

tffi]
As you can see, with the loss of the tax exemption. the funds available at retirernent drop
by more than 5570.

:.
54 CHAPTER THR-EE,/ THE TIME VAIIIE OF MONEY

consider also the effect of setting aside the savings at the beginning
of each year inst
of the end of each year, for the next 40 years. th! future value of this annuity wourd
Expected value of tRA (besinnins of year) = $2,ooo(1.08)
= $sss,s62
,
,'
,': 'l : ::
.
.'a , ' I{}1]
ot,r:u see, the gains from making payments at the beginning of each period can be
substantial.
:3i
a final example, consider a different scenario, in which
.As an investor or a company is
)ovrrg
saving to meei a goar
Lo meer goal and wants to estimate how much to save in each period
oeriod to reach
rea.h ir
it.
The analysis can be modified fairry simpry to answer this question.
ror instance, lr;;; i;
the example jug! described that the injiviauat can save money at the
end ;;fi;;;;;;
"f accumutated
a:co-ur.'t, earnins 8.% a year, and wants to
:f,l:I:9.r^"::r^:
savings of $400,000 atil,lRA
rv have
rsus qLLurttutoLc{J
the end of the fortieth y""r. io estimate how much ilr;;;;i
r

ings would need to be, we can do the following:

;
Expecred Value of lM set aside at g4OO,0O0
5.r;no, [.0#o
- ,i
G5 = = Annual
I o.oa J

Solving for the anrlual savings,

Annual savinss = $400,000

r 0.08 I
tAffi -rl = il,sa4
Annual savings of $1,sM at the end of each year for the
next 40 years and an annuar
return of 870 a year produce a future ,alue of S+OO,OOO. ln gen"rai
to arrive at a required future value can be calculated as followsi
i;;;.y;.* needed

Annual Cash Flow given Future Value A(FVr;n)=

= ,, [. _ I
[(1+r)'-1i

Discounting an Annuity rn 1997 and 199g, there was'discusion of a comprehen-

sive seftlement berween cobacco
frms in rhe United Sutes and tn. r.a..ri goverrunenr,
whereby the,robacco firms wourd pay approximately
$zo brrr.;; ;;r 25 years in
exchange for immuniry from lawsuits on smoking-related
deaths. a.lthough the agree_
ment was never rauified by Congress, ler us consider how much
.orrtor,t; ,t. ;;;;
ment would have been ro tobacco firms, in present value dollars,
if it hri i.., approved.
Assume that the tobacco firms coliecrively would have to g;r.r"*.
,h. o'J;;;
and that rhe discount rare is 6%o.The present val".
by taking each payment and discounring it back to rhe "r,i.-pffi;;':;;;. .;;;;
present. Thus, the present value
of $20 billion in one year, * a 6yo discounr rate, is g1g.g7 billion,.o,'pu,"d
*, foxo*r,
Present Value of $20 billion in one year = torht.t = $18.87 billion

The present value of each of the remaining24 payments

can be computed similarly
and then added up to yield the following:

cumurared present varue =::::,*", (#.|#.;o_. _

*r)
= $255.67 brltion
 TIME VAIUE OF MONEY ANNUITIES AND PERPETUITIES 55

This can be simplified to yield a shortcut to compuring the present value of an

annuitlt:

PV of $20 billion for 25 years = $20 bllion

[ '-#tr.|= $255.67 bilrron
lon6
LI I

In general, the present value ofan annual cash flow (,,{) each year for a years, with a
discount rate r, can be calcuiated as follows:
)any
ach
ime
i
in: PVof anAnnuiry = PV(A,r,n) =
[,- t
Al' 0+r)"
I
I
ar for l--l
lated L'l
Accordingly, rhe notarion we wiil use in the rest of this book for the present value
I sav-,
of
an annuiry will be PV(A,an).

ln Praclice 8.fi: fstimatin$ ille pnesenl uatue ol flnnuities

Assume again that you are the owner of lnfosoft and that you have a choiie. of buying a
copier for $11,000 cash down or paying g3,000 a year for five years for the sime
copier. lf
the discount rate is 12o/o, which would you rathei do?
,.con-si{er the.present,value of paylng $3,ooo, a year for fiye,ygars. Each payment can
be discounted back:to the present to yield the vqlqei in. qliiurd':.i, art"rn.tiily,
ttre pres-
ent value of the payments can be calculated using the shortcut described earlier.

pv ot 13,000 each year for next five years = g3,oo! -

[, #l= ,.,0,r,,o

t 'r,
The present valueof the installment payments is less than,the cash-dorin price; therefore,
j
you would want to buy the copier on the installment plan.
' In this'case,,we assumed that the payments were made at:the end of each year. lf,
howeveq the payments were due at the beginning of each year, the present value
wouli
be much higher since each payment would be discounted back one less year (Figure
3.ii.
The present value of $3,000 at the beginning oJ each of the next five years can be cal-
.
culated to be:

py of $3,000 each year for next five years g3;-000

::. =
']
+ $3,000
[
tru1
:&]= fi2,1 12

Figure 3.7 payment

$3,000 $3,000 $3,000 $3,000 $3,ooo
of i3,000 at the End
of Each of Next 5
Years

PV
$2,679
$2,392
$2,135
$1,906
#,-|
$1,702
$10,814

::

1.:
56 CHAPTER THRIE / THE TIME VALUE OF MONEY

Figure 3.8 Payment $3,000 $3,ooo $3,ooo $3,000 $3,000 $3,000

of$3,000 at the
Beginning of Each of
Next 5 Years
PV

$3,000
$2,679
.dl
(t
$2,392
$2,135
$1.906
.:'
$12,112

ln general, the present value of an annuity where the cash flows are at the beginning of
each period for the next n periods can be written as follows:

PV of Beginning of Period Annuities over n years = A +A

Is: PrssElue &.?: l$aftln$ $altse 0l $p$rt$ $snlrasls

Sports contracti foi big-name:players often' invotve mind-boggting amounts of money.
Although the contracts are undoubtedly large, the use of nominal dollars in estimating
the size of these contracts is actually misleading bgcause the contracts are generally mul-
tiyear contracts. Consider, {or instance, the $105 miiiion contract signed by Kevin Brown
to play baseball for the Los Angeles Dodgers on December 12, 1998. As the first ptalrrir to'
crack the $100 million barrier, he clearly will not be pleading poverty in the near future.
The contraCt;.-however, requires the'payment of approiimately.$15 million a year for
seven.years. ln present value terms, assuming a discount rateof 670, the contract is worth
.,,
$83.74 million. '.1
,I
[,_(t.oo;z
Pyof $15 million each yearfor nextseven years = $15 million I' l= 583.74 million
ILJ 0^06 I

The use of norninal values for cgntracts does serue a useful purpose. Both the player
and the team signing him up can declare victory in terms of getting the best deal. The
player's ego is satisfied by the size of the nominal contract, while the team's financial pain
can be minimized by spreading the payments over more time, thus reducing the present
value of the contract.

lt: Prm#Ere ffi.$: $etu Ba They Eo Ths?? Lsttsng Priees

State-run lotteries have proliferated in recent years, as states recognlze their potential
to create revenues for a variety of causes. The New York State lottery, for instance, was
generated from
expected to generate funds for education
- since 50% of the revenue
the lottery was supposed to go toward education. lt is therefore surprising sometimes
to see iottery prizes that exceed the revenues from ticket sales. HoW for instance, can a
lottery pay oui $40 millibn in prizes on ticket sales of $35 million and still claim to gen-
erate revenues for education? The answer is that while the sales are in current dollars,
the prizes are paid out as annuities over very long time periods, resulting in a present
value that is much lower than the announced prize. The present value of $2 million paid
 TIME VALUE OF MONEY ANNUITIES AND PERPETUITIES 57

out each year for 20 years is significantly lower than the $35 million that the state
receives todaY.

y' CC E.g:Assume thatyou run the lottery and you wantto ensure that 50% of ticket
revenues go toward education, while preserving the nominal prizes at $40 million.
How much can you afford to pay out each year, assuming a discount rate of
'10%?

f* Pnacriffi &.$: Prssnul llalu* sl Muttl$la finnuitius

-SE suppose you are the pension fund consultant to The Home Depot and that you are trying
to estimate the present value of its pension obligations, which are expected to be the fol-
lowing:
Years Annual Cash Flow
1-5 $200.0 million
6-10 $300.0 million
1 1-20 $400.0 million

lf the discount rate is 10%, the present value of these three annuities can be calculated as
follows:

Present Value of first annuity = $200 million x PV (A = $1, 10%, 5) = $758 million
(A = $1, l0%o, 5)
Present value of second annuity = $300 million x PV = $706 million
1.10s

(A = $1, 1o%, 10)

present Value of third annuity = $400 million y Py = 5948 miilion
1l0ro

The present values of the second and third annuities can be calculated in two steps. First,
the standard present value of the annuity is computed over the period that the annuity is
received. Second, that present value is brought back to the present. Thus, for the second
annuity. the present value of $300 million each year for five years is computed to be $1,137
million; this present value is really as of the end of the fifth year.l it is discounted back five
more years to arrive at today's present value, which is $706 million'
presentvalue= $258 million + $706 million + $948 million = $2,412 million

Estirnating an dnnual Cash Flow In some cases, the plesent value of the cash
flows is known, and the annual cash flow needs to be estimated. This is often the case
with home and automobile loans, for example, where the borrower receives the ioan
today (present value) and pays it back in equal monthly installments over an extended
period of time. In these cases. the payment can be calculated from the equation we
developed for estimating the present value of an annuiry in the last section:

I rl
PV ot anAmruiry = PL'(A,r,n) = -' II-l'- (* rf I

Lrl

year, the
1 A comnron error is to assunc thar since the tirst paynlent in this annuiry is at the end of the sixth
prescnt value is also at that point. The process of conrputing the present value, however, noves the
cash florvs

back one year prior to the first cash tlorv, which in this case is the end ofthe trtih year.
58 C}IAPTER THREE / THE TIME VALuE oF MoNEY

If we know the present value, the discount rate r, andthe number of years for
the annuity is to be paid or received, the annual cash fow can be calculated as f

Annual Cash Flow given Presenc Vaiue = A(p(r,n) = ,rl , '-l

To illustrate, suppose you borrow $200,000 to buy a house on a 30_year
['-,,." ]
with monthly payments. The annual percenrage i"t" oo the loan is g%. The *o.rtili,
paymenrs on this loan, with the payments occurring at the end of each month, can
be
calculated using this equation:

Monthly Interest Rate on Loan = =

# +F = 0.oo67

Monthry paymenr on Mortgage = uoo,o*[;ft1= rr,oru.r,

(1-006?160
t'-
This monthly payment will be higher if the loan has a higher iriterest rate.
.1

In recent years, mortgage holders have been provided the option of making their
payments at the beginning of each month rather than the end of the month.
As was
the case wlth the future vdue of annuities, there is an effect on the required monthly
payment. To esrimate.the,monthly payment at the beginning of each month rather
than the end, we modify the equation to allow for the fact that each payment, will
be
discounted back one less period (month).

Monthrv pavmenr on Mortgage = $200,000

hry-l
r- L*^
(1oo6a36o \
(1'oo6a /t=
$1,463.31

t J
The homeowner:can save $9.80 every month by making th. p.yrrr"rrt at the begin_
ning of the month rather than the end of the month.

In Pracliss $.1l!: Gasft [iscuril uer'$u$ a Lotruer !ilhro${ fiate

ff fflomo[ile loan -
Now supDose you are trying to buy a new car that has a sticker price of g15,000.
The
dealer offers you two deals:
r You can borrow $15,000 at a special annual percentage rate of 3oh tor 36 months.
. You can reduce the sticker price by $t,ooo and borrow $14ooo at the normal
-.-- -- financing
rate of 12o/o per annum. t*:S ,onttri.'
To determine which is the better deal, you must calculate the monthly payments
on each
one. On the special financing deal,

Monthly Rate of lnterest =,.,!*

12
=
g.25yo

Monthly Payment on Special Financing Deal g15,ggg

t o.oozs I
,
= L l= $+fe.ZZ
t
'- (t*,'l* I
 TIME VALUE OF MONEYANNUITIES

On the normal financing,

Monthly Rate of lnterest 12Vl

= 12
= p/o

:tgage $46s.00
nthly
rn be' The monthly payments are lower on the special financing deal, making it the
better one.
Another way of looking at these thoices is to compare the presenl value of the
sav-
ings you get from the lower rate against the dollar value of the discount. ln
this case, for
instance, the monthly payment on a $'15,000 loan at an aiinual rate of zrt is
$ls6.zz:,
while the monthly payment on the same loan at an annual rate of rzrz" is
$+gg.zr. rh-;
monthly savings h $61.99, yielding a present value of savings of

[,_ , I
Present Vatue of Monthty Savings = $61.99
I '- t,"rpt I= ir,AOo.S+

The present value of the savings is greater anr, ,n"

lol*In{
of $r,ooo. The dearer
etr would therefore-have to offer a much larger discount (>$i,g66.34) for you to take the
sec-
/as ond deal.
Iy
-'a optioas for computing Tirne value of Money In the chapter so far, we have
re computed present value through equations. Although these equations are not parric-
$
':1
ularly complicated, two alternatives are widely used for compound.ing and discount-
ing. One alternalive is the use of time value tables. These tables summarize what are
called present value and future value factors that can be used to compute. the present
r+ or future value of a single cash flow or an annuity. To illustrate how such tables are
r- constructed, consider the earlier example in which we computed the present value
of
\ll Kevin Brown's conrract with the Los Angeles Dodgers for $15 million a year for seven
t -'
lC, y"rs, ri a 6% discount rate.

$\ = $83.74 million

J
i) If we had isolated only the second term in the equarion, we would have obtained the
C present value factor for 6% and seven years:
6) pz of $1 each 6%)=[ -
,
ft year for nexr seven years (at
#t l= ,.urrn
O t016 I
t.o This factor, which could also be found in the table summarizing
orlr"rr, r,alue facrors
for annuities under 6Yo and seven years, can then be mulriplied by the annuiry of
$15
million to yield a vilue of $83.74 million.Although tables are convenienr (they are
O
,., available in the appendix to this book), they are restrictive because they usually report
factors only for certain discount ntes (6%o but not 6.og%,for irutance) arrd fo.ipecific
q
\j The sec.ond akerlarive is to use a financial calculator. Financial calculators today
4L are powerful enorrgh to compute the time value of almost any rype of cash flow.
Many of them have the present v-alue and future value of annuiry equations
.built
 60 CHAPTER THREE i THE TIME VALUE oF MOI.JEY

into thern and thus require the user to inp*t only the key variables.
For the exarn
above, for instance, using my_Hp-178 calculator, we
would har,-e input the paym
($15 nnlion), the tirae period (seven years), rnd rhe
discounr r-ate (6%) ,"d ;;;-
present value burton on the calculator to arrive ar the
value of$g3.74 nrillion. The o
note of caution that we would add is that most rrnanciar calculators
now a11ow for rnf
iad options, including whether the payment is ar the begi,ning
or end of each peric
and hor'v ,rany periods of co,rpoundi,g and discounting ther-e
are i, each y.r.. It
important to keep track of these opdons and ensure that they are correctiy
set.

Growing Annuities
In the iast section, we looked at ways in which we can compound and discount
an
annuiry. A growing annuity is a cash flow that grows
at a consranr rlre for a speci-
fied period of time. As an example, assume that you rent your otTice
space and
the rent currenrlv is g20,000 a vear. Assume also that there is
an inflation clause in
agreenlenr that allows the owner of the otlice building
to increase yonr rent at the
of inflation, which is expected to be 3yoa year. The expected
renrar cost for rhe r
five years, for instance, can then be written as sho'uvn in Figure
3.9. To co'1pure
of these rental pavmetlts, we can discount each cash flow back sepa
l.:tjt",',*1"t,
and add up rhe disco.nred values. Thus, if the discount
- -r ___ -'--/
rate is i0%, the presenc value
of che rental payment in year 1 can be written as:

Present Value of year 1 rental payr.nenr = $10,U0{l l'()3

sur-,ming up the values across arl five years then, we obtain

the foilorvir-rg:

CunruLredPresenrV.rlucofrencal paynrcnrs=$lu.ugnIt.n:nto:t*1rr]'nLrrit-I.uli''l
11.10 Ll0r Ll0' t.l0r I.lrr:,]

=sio,u611p31 | *]
lr:o_*,
In general, if,4 is the current florv andg is the expecred grorvth rate, the present
cash
value of a growing annuiry can be calculated by using
the follor,ving equation:

f _ (r*s1,,
PV of a Grorving Annuin* *e)l' ,
ft*,1,,1
1

[ '-.e ]
The present val-re of a growing annuirv can be carcuiated
in all cases except the one,
for which the grorvth rate is equar to'the cliscount rate. In
that clse, the present value
is equai to the sum of rhe nonri,al annuities over
rhe period. The growch effecc is
exactly ot*et by rhe discor.rnting effect. Thr-rs, in the above
exarnple, if iorh the grcwth

Figure 3.9 Rent of

20,000(1.03) 20,000(1.03)2 20,OOO(1.03)3 20,OOO(1.03)4
$20,000 Growing at 3% l.
20,OOO(1.03)s
a Year for Next 5 years
o12iii
Year
 _l

TIME VALUE OF MONEY: ANNUITIES AND PERPETUITIES 61

rate in rental payments and the discount rate were l2%,the present value of $20,000
a year for the next five years would be $100,000 ($20,000 x 5).
sed
allows You to
PV of a Growing Annuiry for m years (when r = g) = nA
1e(
'ihe Present
,rrf Note also that the growing annuity equation works even when the growth rate is
gre^til than the discount rate.2

lm Frsutles ff"lt:Ihe Ualue 0l a $old Mlne

suppose you have the rights to a gold mine for the next 20 years, during which you plan
hta
tg. extract 5,000 ounces of gold every year. The current price per ounce is $300, but it is
"expected
.oeci to increase 3o/o a lea,- Assume that the discount rate is 10%. The present value
can be computed as follows:
rth
[, (r.og)'o I
r PVof extracted gold = $300 x 5,000 x r.o: l '-- (,rt), | = $to,t+s,seo
t-l
text 0.10-0.03 I
|.
the:j
The present value of thergold.expected to be extracted from this mine is $15.145 million;
tely, it is an increasing function of the expected growth rate in gold prices. Figure 3.10 illus-
lue, trates the present value as a function of the expected growth rate.

y' cc g.g; $ bs\h rhe grssl\h rale arrd the d\:qsssl. \d(e i(\cteBse by 1K, st(( the ites-
ent value of the gold to be extracted from this mine increase or decrease? Why?

Figure 3.10 Present

Value of Extracted
Gold as a Function of ^,$60
o
GroMh Rate
e
Es0
E
s,
E
E+o
E The present value of $1.5 million
o growing al x7" ayear increases as
o
g30
x
IJ

;20
TBE
t!
E10 EgEgE il
o
ID
-o
L0 tr3 g' n
!
3 4 5 6 7 I 9 1011
GrowthRaie in Gold Prices (6) .

2
When g is greater than r, the denominator becomes negative, but so dos the numerator. The net effect is that
the present value can still be computed it will not become negative.
-
 .t

62 CI-IAPTER THRI,E / TFIE TIME VALL,E oF MoNEY

Perpetuities
An annuity is a corutant cash flow for a specific rime period. lfhat if you *.r. .
to receive a constant cash flow forever? Ari annuiry that lasts forever is called a pr
petuity. To compute the present value of a perpetuiry we can use the annuity
tion that we developed earlier and look at the present value as the number of p
approach infiniry (*).

pvoraperpetuiry=,
i, #* 1= +
L,J
As an example, consider an investment where you will make income of
$60 a year
in perpetuiry. The present value of this investmenr, assuming that the interest rate
today is 9Yo,can be computed to be g667.

$60
Present Value = = fi667

This approach is usefirl in at least two cases. one is the case ofa consol bond.-unlike
traditional bonds that repay the principal at the end ofa specified period (called the
maturity date), a consol-never matures and pays a fixed coupon forever. Ia-thelatb
1800s and early 1900s, the Brirish and canadian governments issued such bonds,
and
a few are still in existence. The other case is preferred stock. The owner
ofpreferred
stock gets a fixed dollar payment; called a preferred dividend, every period; preGrrpd
stock also has an infinite'liG. i ,

Growing Perpetuities
In corporate finance, we are often called upon to value publicly traded fums, which
at least in theory have infinite lives and could conceivably keep growing over these
'Iives. In some cases, we have to analyze projects that codj u.t r". *ry long periods,
if not forever, again with increasing earnings each period. In both scenarios, we have
to value notjust an infinite stream of cash flows, but a stream of cash flows that grows
over that period.-A g.rouring perpetuity is a cash flow that is e4pected to grow
ar a
constant raieforever. To estimate the value of a growing pe.per,riry,
- - i. can draw on the
equation for a growing annuiry and set , to - ,grirr.

' FV of a Growing perpetuiry

Perpetuity = z{(1
A(1 + s) ['-fi+#-]
As lonq ls g is less thai n, this equation simplifies to the following:
t,=.I
I 1 of nGrowing perpe*r.y
l$
PV = f-8{4
where the numeratoi is the expected cash flow next year,g is the constant growth
rate,
and r is the discount rate.
'when
the growth,rate is equal to or exceeds the discount rate, the present value
of- a growing perperuiil,is infinite and thus cannot be computed. ahirough there is a
mathematica] possibility of the growth rate exceeding the dis.iount
rate, we can rule
it out by making sure th1 we are reasonable in our estimates of the constant growth
 TIME VALUE OF MoNEY: ANNUITIES
AND PERPETUITIES (I]

' rate.'since any asset that grows at a rate higher

than the growth rate of.rhe econorlry

*;":l';J::"':iiY"t::"::":t:'-;'"'i'r,,.i,q.o*oi, g.;,n",," this eq,ra-

:: tron has to be less than or equal to the growrh .rr" ',
;f;";;;;._ril:'L"'irJ; v 11rIuu
States, for instance, q,hen using
usinq rhi" f^"-",,r- :,
,.*.
this fbrmu]a, ir r^ _r.
is at,lost
,..,., ,- :::r:j::::ll.-l,'-Ili"
..",o,r,ble ro assume
eonstant growth rates that exceed 5 to 6yn_j

.,
*', l.t:. ..
+:;=-,$s$ Ffl'*st**e&gff: ualuinil a pFoi*rt sEitk &r'sIuilr$ gasfi
flows
the present varue or the expected
:1t1liliX'J:i[i: T:l;:ii"i,:r:'-'.:?'p:1"
j:r'.ll'y* of ;;;;;;.;:i*^: ;n'i;:: ;;$:ffj"";:
f: H:",AT,i.':::", :::
ffi : I"j# H r.x l?l:: 1:* :: :l-r":l;;' ;;; ;;:;J ;il""ilii:
"
il:. ;il#.::' ffi H ;
:

Iff :, ::H,1'lr'. :ri J:",x l: : :: :t I ":i ri,,1 ; ;il ; ir;;;i;; ; ili'::? :i: ffi :II
::.1 ;1 fl::t:l : :::i li*l,:: -".",.1",, ;J *" i"Xi L,i H,,i,ll, if H1ffi
rate thai o,,*, ;;,; ;;1:.;:'i#",;:J.:,T
flir:,:li":ll"",i:li"^1,::::nt ffi#;
; liJJ*:..::"^:T.::::.111
Disneyland
atio n rate L i% ;
can be calculated: " ;" * ;",",J:?l;: lil#il l.".T
iC $100 million (1'03)
Present value of Cash Ftnrn,. - = $1'1214 million
to'rz -loJl-
Two points are worth repeating. First,
the.numerator is the expected cash frow in the next
year and thus refrects the expected
infration of 3zo. second, *,i, pr"r"ni r]ue is a fairry
good approximation for a long_lived
inves_tmentl even though it might
For instance, if we assumed lo-y".r, not last forever.
rite tor ilre iurk. *" would estimate
$100 million growing at3o/o a" year for 50 years the value of
to be g1,127 million:

formula provides a shortcut to estimatins

I}T:,H1r:ltrT€rpetuitv
long-term investment. the vatue of any

cr 3'3: Assume that you have a cash frow that

is expected to grow at different
rates each year over time, but the
average growth rate.forever iJsy".
the growing perpetuity formula? WfrV c"r, you use
*iV .i ,*l

The time vaiue of money is a central factor

ir.r .".;.;; ;;;;:.: ,.. .ru"o
rhat generate cash flow.s over mulripie ";:.';
:::.::
with the ::::\:p."J..r.'
same characterisrics.'w'hy do we prefer-a
years and value assets
dolrar today to a ciolrar in the future?
The first reason is that the presence of infladon
reduces the purchasing power of
dollar over time; the second is the desire the
for consumptron nolv orr.. .l.rrur-,ption in
the future; the final conlponenr is rhe
uncerrainry rssociate( rcitt\
feceive the dollar in the firrure- The-se sr\tr\tr lqt. ru\\
tbree.tzt:torcarc arcasurecrrh a dls.O,nf
\Xre can take t'uvo basic rate.
actions in con-rputing the tinre value
of money-The first is
compounding, by which we examine
how much a doilar roday wilr be worth
in rhe

I Thisis approximately the nomill

Srorllr rate (rncruding inflation) of the U.S. economy, The
srows at f, siightiy higher nte (5.59/o to 6.59/"). *.r*--*
64 CHAPTER THR-EE / THE TIME VALUE oF }.4oIiE T

:-..alr::

:4jr*4ri.i ,3il: i.; srl;,;

!'; .:Aj jj:*:; ),1j ij,..;
;:: ii- : lfi
''::.:: J.3*?ltrt :
Iast forever.
A ,\umunn, nf Drocoqt l,/.1,," E^,*.,1-.
i,,!ra:i jj;i:-r ,"i,::3.il *:!1$t
i:!,:-,: ..',s$i: :it*: +j: irilylie_rOfcrrih",ftlerrr] .r,i ; e,€,: g+i${}rii * Formula

-PV of
;:..r4:l:i:i r::ila: : ._'j

rii:o 1"1

r- ,l'
' (1+r)'
I

,)
:)i : :, :.,: i., t,..W,!4 nfrfr,).,.,
"[*5]
-l

Annuiry given preient Value

;r:i:*:fiji ]: Fj?"e+
St:j 1i**: i:I.3 ,r'i;* I f1
+r)'-11

Present Value of Growing Annuiry

1,,rrii;; ,'!;,. 1,'r,.

i:,:;;':11:ii; i::

Present Vaiue of a Growing Perpetuiry A(1+ s)

r-g

.4

\
)
 PROBLEMS 6J

nnn
- - of$100'000
a loa, -r6rnn corrring due in 6ve years. 5. You
are valuing real estate. The building
that you can earn 6% on your invesrments, valt llng that you art
ls expected to generate $25,000 rn renta,
. rrrorrl, vo, nee,,:l r^ (pi aside
r"*x::1j"" ;^J^.- .^
repav
I dis_
ftcuts l#:lit
rn' w,crr rr Lurrrs) qlrtr:
.c;r6 toclav ro
1:G ;;;;;,;":?:T:ff'H".I,
a discount rate of g%, what is rhe
present,ralue of the
nnu- ,uy a new Porsche convertible, put no nonev rental income?
The
";ilI
l. 6' You have just been rert an inheritance org1 million,
;i:,,:ffi:,,:'#:1i"'i:"i?;'n:,i: ;1I:
ities r costs 1zo-, :li*"currentlyearninganinterestrateof5%.
1o.z^^
$60,000 and the car dearer.hrrge, yo,.,
;ts$60,000andthecardealercheroc<rrn,,
;;.rt'rrfurl:.T-;irHtJil:rrri*ffiIfyou
:nth irrteresQ, estimate your monthly payments.
(as
that fron, th. i.rfr.rirrrr." iow long will it last?

f:j#,rl[,T:i:i":J1,".,:r,,
-^+^)
on a loan, whar is 7. you have been
ussrr utereo ,n,J;;;.J"uu,i.,.*.
offered a, snare of a new business. The
rr,.
your annual effecrive inra.A.r
rate?
interest L,.-;_ . . rs expected
.

. :uslness to generate cash flows of$1 nil_

4. r{yott save $i5,000 each year for the next 40 years and 1ion, growing at 3% ayeit forever.
wirh a discounr rare
eern a 5Yo interest rate on your savings, how niuch will oi 750/o,*hrl i, th. value of rhe business?
you expecr to have ar the end ofthe fortieth vear?

In the problems below' you can use a market risk premium of 5.5%
and a tax rate of 40% where none rs specified.

l' You have an expected liabiliry (cash outflow) of a. how much money wourd the company need
$500,000 in 10 years, and you use a discount rate of to set
aside at the end ofeach year for,h..r.*,
10%' 10 years
to be able ro repay the bonds when they conre
a. How much would you need rieht now as savings to due?
cover the expected liabiliry?
b. how
would your answer change if the money
b. How much would vou need to ser aside at the end were
set aside at the beginning of.;.h y.".1
of each lear for the next 10 vears to cover the
6. You are revierving an advertisement by a finance
expected liabiliry? pany oftering loans at an annuar percentage
com-
rate of 99/o.
2' You are exarnining r'vhether your savings will
be ade- If the interesiis compouncled rveekly,what
is the effec-
quate to meedng your retirement needs.
saved
You rive interest rate on rhis loan?
$1'500 last year' and you expect vour annual savings
to 7. you have a reladve who has accumulated
grow 5Yn a year for the next 15 years savings of
lfyou can invest $250,000 over his working liiltime and now plans
your money at 8%' how much would to
you expect ro retire. Assuming that he *irh., ,o withdraw
have at the end of the fifteenth year? equal
ffil#ffijii, rhese savings for the next 25 years of
3' You have.just taken a 30-year mortgage loan hislife,howmuchrviileachinstallmentamountroifhe
for
$200,000. The annual percenrage rare on i, earmng 5% on his savings?
rhe loan i,
ot made -o"thly' Estimate your 8. You are
Y.-*tJ;r;:ljir** offered a special set of annuities by your insur-
ance company, whereby you will receive
4' Ytuareplanningtobuyacarworrh$20,000.whichof fo. the next $20,000 a year
10 y."., and g30,000 a year for the fol-
the trvo deals-described next would you
choose? lowing 10 years. How much would you be
willing ro
' The dealer offers to take 10% off rhe price and lend pay for these annuities, if your discount
rate is 9yo and
you the balance at thl regular financing the annuities are paid at the end of each
rate (which year? How
is an annual
Percentage rate of 9Yo). much would you be rvilling to pay if they
*... th.
. The dealer ofers to lenci you beginning of each year? "t
$20,000 (with no dis_ ^
count) at a speciai financins rate of 3')/0. 9' A bill that is designed to reduce the nation,s
budget

' f,;;Tfir.1,,'i}f;:?#;T,il.:#r;H: ,T',.; *'ill',',"i,tr11::;:'.?;:ffi-ffiffi1:ii*

F.,. ,l'.
If it does not tell us is the timing
9%i
appropriare discount rate is
.'J'rJil'j;rlt"
of the

)
66 CHAPTER,THREE / THE TIME VALUE OF IVIONEY

Year Deficit Rciurrion The houses are roughly equivalent

1 $25 Billion a. Estimate the toral p4rments (mortgage and
2 $30 Billion erry taxes) vou would have on each house.
3 $35 Billion one is less expensive?
4 $40 Billion
b. Are mortgage payments and properry taxes directly
5 $45 Billion
comparable? Why or why nor?
6 $55 Billion
7 $60 Billion
c. If properry raxes are expected to grow 3Vo a year
8 $65 Billion
forever, which house is less expensive?
9 $70 Billion 13. You bought a house a year ago for $250,000, borrow--
10 $75 Billion ing $300.000 ar [006 on a 30-year rerrn loan (wirh
If the federal government can borrow at 8%, what is monthly payments). Interest rates have since come
the rrue deflrcit reducrion in the bil]? down to 9ol0. You can refinance your mortgage at this
rate. wirh a ciosing cosr that will be 3% of the loan.
10. New York Srate has a pension ftrnd liabiliry ot$25 bil-
Your opporruniry cosr is 8%. Ignore rax effects.
lion, due in 10 years. Each year the legislature is sup-
posed co set aside an annuiry to arrive )t rhis furure a. Hor.v much are your monthly payments on your
val-re. This annuiry is based on rvhat the legislarure current loan (at 10%)?
:.:
believes it can earn on this mone\,. b. How much would your monthly payments be if
a. Estinlate the amruiw needed each year for the next you could refinance your morrgege at 9% (with a,

10 years, assuming that the interest rate that can be 3O-year term loan)?
earned on the rnoney is 6%. c. You plan to stay in this house for the next five
b. The legislature years. Given the refinancing cost (39/o of rhe loan),
changcs the investment rate to 89/u
and recalculates the annuity needed to arrive at the lvould you refinance this loan?
future vaiue. It claims the difference as.budget sav- d. How nruch would interesr rates have to go down
ings this year. Do you agree? before it would make
sense to refinance this loan
11. Poor Bobby Bonillal The nervspapers claim that he (assuming that you are going to stay in the house
is
making $5.7 million a vear. He clairns thar this is not lor five vears)?

true in a present value sense and that he vvill really be 14. You are 35 years old roday and are considering your
nraking the following anlounrs for the next live years: retirement needs. You expect to retire ar age 65, and
Year Anrtttutt your actuarial tables suggest that you will live to be
100. You want ro move to the Bahamas when you
0 (now) 55.5 nrillion lSign-up tsonus)
retlre. lbu esrimare that it will cosr you $300,000 to
1 $4 million
make the move (on your 65th birthday) and that your
2 $-l milLion
living expenses w-ill be $30,000 a year (starting at the
3 $4 million
ofyear 66 and continuing through the end ofyear
er-rd
4 $4 million
100) after that.
5 $7 million
a. How much rvill you need to have saved by your
a. Assunring that Bonilla can make 7% on his invest-
retiremenr date to be able to afford this course of
ments, what is the present value of his contract?
action?
b. If you wanted to raise the non-rinal value o[ his b. You already have $50,000 in savings. If you can
contracr to 930 rnillion, rvhile preserving the pres_
invest mone-y, tax-free, at 8yo e year, how much
ent value, how rvould you do it? fou can adjust
rvould you need to save each year for the next 30
oniy rhe sign-up bonus and the fina1 year! cash
years to be able to afford this retirement pian?
flow.)
c. Ifyou did not have any current savings and do not
You are comparing houses in fwo towns in NewJer-
expect to be able to start saving money for the next
sey. You have $100,000 ro put as a down payment, and
five years, horv much would you have to set aside
30-year mortgage rates are at 8%.
each year afier thar to be able to afford this retire-
Chathatn Sorth Orange ment plan?
Price ofthe hous,- $400,000 $300,000 15. Assume that you are the manager of a professional
Annual properry rax $6,000 $12,000 soccer team and that you are negotiating a contract
with vour 6:a.p6'3 s6ar player. You can afford to pay the
 REFER-ENCES 67

:frg fiA of his contracQ. The player's agent to be able to withdraw

that the player will not accePt a contract with a
vaiue les than $5 million. Can you rieet the
demand without relaxing your financial con-
on how much you can afford to pay him?
have been hired to run a pension fund for TelDet
small manufacturing firm. The firm currendy
g5 million in the fund and expects to have cash
of g2 million a year for the first five years fol-
by cash oudows of $3 million a year for the
6ve years. Assume that interest €tes-'are at 8olo.
How much money will be left in the fund at the
end ofthe tenth year?
you were required to pay a perpetuiry after the
nrh year (starring in year 1 1 and going through
out of the balance left in the pension fund,
:if much could you afford to pay?
1a are an investment advisor who has been
to be 90 years old.) How
the bank 10 years from
each year for the next 10 years to be able to afford
these planned withdrawals ($80,000 a year) after
the tenth year?
c. Assume that interest rates decline to 4% 10 years
&om now. How much, if any, would your client
hle to lower h* annual withdraual, assuming that he
still pians to withdraw cash each year for the next
z) yexs(
18. You are trying to assess the vaiue of a small retail store
that is up for sale. The store generated a cash flow to
its owner of $100,000 in the most profitable year of
operation and is expected to have growth ofabout 51/o
a year in perpetutiry.

by a client for help on his financial strat- a. If the rate of rerurn required on this store is 107r,
ve $250,000 in savings in the bank. He is 55
ras what would your assessment be of the value of the
,, and expects to work for 10 more years, mak- store?
(He expec* to make a return of
b. What would the growth rare need to be to jusrif.r
n rts for the foreseeable future. You a price ur
d yrrLs of $2.5 million for this store?
$L-J L\l
n
e

books referenced in the chapter 'Cissell, R., H. Cissell, and D. C. Flaspholer, 1990, The Mathematics
rciates, Sror&s, Bionds, Bills antl lnjationYcarbook, 1998, of Finance, Bostonl Houghton Miffin.
Associates.
Related Veb Sites
trces . htrp :,2 /m. wiley. com/colle geldamodaran
present value facton and derilarions of present