5/23/2019

Single Cash-flow
Structures: A
Simple Problem
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

Time Value of Money-Outline

Why should you care?
• Commonly occurring
concept in finance
• Extremely useful for
valuation – stocks and
bonds as well as business
ideas
 Corporate investments,
new product ideas,
acquisitions etc.

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Time Value of Money-Outline

Fundamental tenet
• Financial decisions often
involve valuing multiple
cash flows occurring at
different points in time

Time Value of Money-Outline

• One cannot simply ignore
timing differences.
• The value of $1 received
next year is less than $1
received now.
• But how much less?
• Time Value of Money
(TVM) concepts.

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A Motivational Problem
Q: Would you pay $100
now, to receive $110
one year from now?
Wrong answer:
Yes, because I will make $10
in a year.

A Motivational Problem
Q: Would you pay $100
now, to receive $110
one year from now?
A: It depends on the
interest rate one can
earn elsewhere.

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A Motivational Problem
Q: Would you pay $100
now, to receive $110
one year from now? Principle Interest
If interest rate = 20%? $100 + $100*20%
A: No! You can turn $100 = $100*(1+20%)
into $120 by investing = $100*1.2 = $120
elsewhere.

A Motivational Problem
Q: Would you pay $100
now, to receive $110
one year from now?
If interest rate = 5%?
A: Of course! $100*(1 + 0.05)
The next best scenario: $105 = $100*1.05
= $105

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A Motivational Problem
Major takeaways
1. Same reference point is
required to make a
meaningful comparison.
2. Interest rate
3. Compounding

Single Cash-flow
Structures: Present
Value
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

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Same Problem, Different Approach

Q: Would you pay $100 Approach:
now, to receive $110 How much to set aside
one year from now? today (?) to accumulate
Assume that the $110 in a year?
interest rate is 20%?
? * (1 + 20%) = 110
A: No!
? = 110 / (1.2) = $91.67
An immediate
investment of $91.67
will do the same.

Same Problem, Different Approach

Q: Would you pay $100
now, to receive $110
one year from now?
What if the interest
rate were 5%? Approach:
A: Yes! ? * (1 + 5%) = 110
Need to set aside ? = 110 / (1.05) = $104.76
$104.76 immediately to
accumulate $100.

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Same Problem, Different Approach

Major takeaways
1. Same result when our
reference point is
chosen at the present.
2. Present value is useful.
3. Discounting

Let Us Modify the Problem

Approach: Figure out how
Q: Would you pay $80 now, much I need to set aside
to receive $130 in two today (?) so that I accumulate
years? Assume that the $130 in two years?
interest rate is 20%.
@ the end of the 2nd year
A: Yes! @ the end of
the 1st year
It makes perfect sense ? *(1.2)*(1.2) = 130
to pay $80 for an
?*(1.2)2 = 130
investment opportunity
that is worth $90.28. ?*1.44 = 130
? = 130 / 1.44 = $90.28

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Let Us Modify the Problem

A closer examination of
$90.28
CF
Present Future PV =
(1 + r)t
Time frame
value cash flow (t=2)
(PV) (CF=$130)
$90.28 = 130 / (1.2)2
Interest rate (1+r);
r=0.2

Some Numerical Examples

Q1: What is the present
value of $150 received in
three years? Assume that $150
the interest rate is 10%?
150
1 1 10%
0 3
150 150
$112.70
1.1 1.331
How to calculate 1.103 ?

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Some Numerical Examples

1.103 y x or
^
Input:
1.10 yx 3 =
1.10 ^ 3 =

Some Numerical Examples

Q2: What is the present
value of $220 received in
eight years? Assume that $220
the interest rate is 8%?
220
1 1 8%
0 8
220 220
$118.86
1.08 1.8509

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Multiple Cash-flow
Structures
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

Some Numerical Examples

Q: What is the present value of the following cash flow series?
Assume interest rate as 5%?
• $100 received one year from now
• $150 received two years from now
• $200 received three years from now
A: Split the problem into three single-cash flow problems and
sum the present values.
$100 $150 $200 $100 $150 $200
= + +
0 1 2 3 0 1 0 2 0 3

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Some Numerical Examples

$100 $150 $200 $100 $150 $200
= + +
0 1 2 3 0 1 0 2 0 3

100 150 200

= 1 5%
+ +
1 5% 1 5%
100 150 200
= 1.05
+ +
1.1025 1.1576
= 95.24 + 136.05 + 172.77
= .

Some Numerical Examples

$324.26 $190.48
Deposit $100 $150 $200
$404.06 $424.26 $340.48 $200

Today Year 1 Year 2 Year 3

t=0 t=1 t=2 t=3
$404.06 ∗ 1.05 $324.26 ∗ 1.05 $190.48 ∗ 1.05
$424.26 $340.48 $200

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Some Numerical Examples

$324.26 $190.48
Deposit $100 $150 $200
r = 0.05 $404.06 $424.26 $340.48 $200

Today Year 1 Year 2 Year 3

Fair t=0 t=1 t=2 t=3
amount
$420? Too much
$380? Go for it!

Some Numerical Examples

Major Takeaways:
1. Splitting is very useful.
2. PV is a robust concept
meaningful comparison.

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One More Practice Question

Q: What is the present value of the cash flow stream shown
below? Assume that the interest rate is 10%.
Hint: Split $140 $75 $300 $400

0 3 5 17 21
140 75 300 400
1 10% 1 10% 1 10% 1 10%
140 75 300 400
1.331 1.610 5.054 7.400
105.18 46.57 59.35 54.05 265.15

Special Cash-flow
Structures
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

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Perpetuity
What defines a
perpetual cash-flow
structure?
• Cash flows that are
occurring periodically
forever.
• Each period the cash flow
grows relative to the
previous year’s amount.

Perpetuity
Why do you care?
• Useful to model cash
flows of entities that are
assumed to have really
long lives (i.e. firms).

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Perpetuity
An example?
 t=1 $100
5% growth
 t=2 $105
5% growth
 t=3 $110.25
5% growth
 t=4 $115.7625
… $110.25 $115.76
$100 $105
…
0 1 2 3 4

Perpetuity
How to calculate the
present value? Assume
that the interest rate is
10%.
• Splitting
• Formula method to deal
with the computational
burden.

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Perpetuity
What does the formula
do?
• Simplifies the problem
into a WHOLE LOT
simpler problem.
• Bundles all of the cash
flows into a theoretically
equivalent single cash
flow.

Perpetuity
$110.25 $115.76
$100 $105
… $2,200

0 1 2 3 4 1
1
0.1
∗ 1
$2,200
2,200
100 ∗ 1 10% 100 ∗ 1.1 $2,000
1.1
10% 5% 0.05
$2,200
0 1

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Perpetuity
Does the present value
still maintain its meaning in
this setting?
• ABSOLUTELY!
Indifferent between:
Getting a Getting a perpetual
one-time series of cash flows
$2,000 starting with $100
now and growing at a
rate of 5%

Perpetuity
$110.25 $115.76
$100 $105
…
0 1 2 3 4

$ ,
Why is it not infinitely large?

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Perpetuity
Due to discounting the
present value of VERY large
future cash flows becomes
Check using the PV of
negligibly small. single-cash flow:
$227,399,612
… 227,399,612
1.1
0 300
227,399,612
2,379,100,905,625
!
$0.0096

Perpetuity
Major takeaway:
• When dealing with a
perpetuity simplify the
problem into a single-
cash flow problem.
• The meaning of PV
remains robust.

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More Practice on
Perpetuities
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

One More Practice Question

Q: What is the present value of
the shown cash flow stream?
Assume that the interest rate is
7%.
$75
… g = 3%

0 5

Hint: Convert the problem.

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One More Practice Question

What do we need for
conversion?
• First cash-flow of the
perpetuity ($75)
• Interest rate (7%)
• Growth rate (3%)
• The conversion formula
∗ 1 75 ∗ 1 7% 75 ∗ 1.07
$2,006
7% 3% 0.04

One More Practice Question

Converted problem:
$2,006

0 5

2,006 2,006
1 7% 1.4025
$1,430.25

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An Ultimately Challenging Problem

Q: What is the present value of
the shown cash flow stream?
Assume that the interest rate is
9%.
$20 $60 $80 $120
… g = 4%
0 1 2 3 4
∗ 1
Hint: Convert the problem.

120 ∗ 1 9% 130.8
$2,616
9% 4% 0.05

An Ultimately Challenging Problem

The converted problem:
$2,616 $2,616
$20 $60 $80 $20 $60 $80
= + + +
0 1 2 3 4 0 1 0 2 0 3 0 4

20 60 80 2,616
1 9% 1 9% 1 9% 1 9%

18.35 50.50 61.77 1,853.24

1983.86

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Summary
• Good news!
• What should you
remember by heart?

Summary
Single-cash flow
• Easy, apply the single c-f
formula.

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Summary
Multiple cash flow
• Split the problem into
single c-f structures and
sum up the PV using the
single c-f formula.

Summary
Perpetuity
1. Convert the problem
into single c-f structure
using the bundling
formula. ⠀
∗ 1

2. Find the PV using the

single c-f formula. ⠀

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Summary
Ultimate combos
• Take care of perpetuity
first by converting into
multiple cash-flow
structures and then split.

Is it Worth to Go to
Grad School
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

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Is It Worth to Go to Grad School?

A simple analysis of the
decision to attend a
2-year MBA program

Is It Worth to Go to Grad School?

Costs
Tuition $20,000 per year
(first payment is due
in a year)
Opportunity Given up annual
cost salary of $50,000 for
the next two years
Benefits
Higher $20,000 per year
salary averaged over the
rest of the career

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Is It Worth to Go to Grad School?

Other info
Remaining years in 35 years
the work force
Interest rate 5%

Is It Worth to Go to Grad School?

Costs 70 70
0 1 2 1 5% 1 5%
66.67 63.49 $130
-$70K -$70K

Benefits
20 20 20
$20K $20K $20K ⋯
1 5% 1 5% 1 5%
…
$297
0 3 4 37

Net PV $297 130 Given the assumptions, YES

$167

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A New Inventory
Processing System
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

A New Inventory Processing System

Future benefits and Immediate benefits
costs and costs
• Lower order -$90,000 • Cost of purchasing
processing costs +$5,000 • Salvage value of the
• Lower spoilage Net after-tax existing machine
• Faster delivery, cash flow effect
thus improved + $25,000 per year
sales (first one due in a Other information
year)
• More frequent • Obsolete in 5 years
maintenance 12% • Interest rate
(cost of capital)

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A New Inventory Processing System

Costs Benefits Net PV = $90.12 - $85
0 $25K $25K $25K $25K $25K = +5.12K

-$85K 0 1 2 3 4 5

$85
25 25 25 25 25
1 12% 1 12% 1 12% 1 12% 1 12%

$90.12

Value of a Business
Time Value of Money
Emre Unlu, PhD, CFA
Associate Professor of Finance
Paul C. Burmeister Professor of Investments

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Value of a Business
How to calculate the
fundamental value of a
firm?

Value of a Business
Ingredients
Future cash flows and Cost of capital (closely
growth related to risk)
Expected future = 12%
cash flows
• First year $100,000
• Second year $150,000
• Third year $200,000
• Fourth year $225,000
with 3% thereafter

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Value of a Business Hints:

1. Convert the perpetuity
2. Split the multiple cash flows
$100K $150K $200K $225K
$100K $150K $200K $2,800K
… g = 3% =
0 1 2 3 4 0 1 2 3 4

Convert
225 ∗ 1 12% 225 ∗ 1.12 100 150 200 2,800
$2,800
12% 3% 0.09 1 12% 1 12% 1 12% 1 12%

89.29 119.58 142.36 1,779.45

$2,130

Why Important? – Useful Decision Tool

• How much is my company
worth?
• How much would the
value change if growth
declines?
• Is it worth to invest
$400K now so that we
can grow 4% perpetually
starting at t=4?
Nice bump!

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Value of a Business
$100K $150K $200K $225K
$100K $150K $200K $3,150K
… g = 4% =
0 1 2 3 4 0 1 2 3 4

Convert
225 ∗ 1 12% 225 ∗ 1.12 100 150 200 3,150
$3,150
12% 4% 0.08 1 12% 1 12% 1 12% 1 12%
$2,353 New value
$2,130 Old value
Difference = $223K
Immediate cost = $400K Not worth investing!

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