FUNDAMENTALS OF

MANAGERIAL
ECONOMICS
CHAPTER 1, (CONT’D), MICHEAL BAYE

RECOGNIZING THE TIME VALUE OF MONEY

IN THE LAST LECTURE OF THIS MODULE WE
COVERED THE TOPICS
• What is managerial Economics
• Qualities required in an effective manager
• Identifying goals and constraints
• Recognize the nature and importance of profits
• Accounting vs Economic Profits
• Implicit, Explicit and Opportunity Cost
• Porter’s Five Forces for Industry Profitability
• Understanding Market
• Three main types of rivalaries
• Understanding Incentives
DISCUSSION IN THIS LECTURE

• Time value of money

• Present value & Future Value
• Net Present Value
• Annutiy & Perpetuity
• NPV of indefinitely lived assets
• Profit Maximization using NPV
TIME VALUE OF MONEY

• Effective Managers must have a good idea about the time value for money,
since timing are important in many decision, when the investment is done
or the cost is incurred and when benefits of the project will be received.
• If you were offered $100 today or $100 a year from now, which
would be the better option and why?
• First and the foremost, inflation, which reduces the buying power of money
• Investment lost has opportunity cost
• Risk of not receiving the dollar in future, the company might go bankrupt
• Consumption forgone has opportunity cost
TIME VALUE OF MONEY

• Time Value of Money is a concept that recognizes the relevant worth of future
cash flows arising as a result of financial decisions by considering the opportunity
cost of funds.
• The time value of money is also known as the Present Value.
• The present value (PV) of an amount received in the future is the amount that
would have to be invested today at the prevailing interest rate to generate the given
future value.
• In evaluating the PV two elements are very important
• What interest rate (opportunity cost, discount rate, expected rate of return) do want to
evaluate the cashflow based on
• At what time do these the cash flows occur and at what time do you need to evaluate
them?
TIME VALUE OF MONEY

• Present Value (tells you the current worth of a future sum of money)
• Future Value (gives you the future value of cash that you have now)

future value  present value  (1  i ) n

• Say someone asks you, which would you prefer: $100,000 today or
$120,000 a year from now, given interest rate is 20%? The $100,000 is the
"present value" and the $120,000 is the "future value" of your money after
one year. So in this case both scenarios are equal.
• Now if we have to calculate the future value of $100,000, after 3 years at
an interest rate of 20%?
• $172,800
FORMULA FOR CALCULATING PRESENT VALUE

Mostly in business situation we are interested in calculating the PV for a given FV,
then the above equation can be rearranged to give the following formula:

FV
PV 
Where
(1  i ) n

i is the interest rate

n the no. of years taken into consideration
DEMONSTRATION PROBLEM 1

For example, what is the present value of $100.00 in 10 years if the discount
rate is at 7 percent.

100
PV   50.83
(1  0.07)10

This essentially means that if you invested $50.83 today at a 7 percent

interest rate, in 10 years your investment would be worth $100.
 FV
TIME VALUE OF MONEY PV 
(1  i ) n

• Notice that the interest rate appears in the denominator of the formula. This
means that the higher the interest rate, the lower the present value of a future
amount, and conversely.
• The present value of a future payment reflects the difference between the future
value (FV) and the opportunity cost of waiting (OCW):
PV = FV – OCW
• Intuitively, the higher the interest rate, the higher the opportunity cost of waiting
to receive a future amount and thus the lower the present value of the future
amount.
• For example, if the interest rate is zero, the opportunity cost of waiting is zero,
and the present value and the future value coincide.
TIME VALUE OF MONEY

The present or future value of cash flows are calculated using a discount rate,
which depends on several factors

●   Rate of Higher the rate of inflation, higher the return that investors
inflation would require on their investment.

Higher the interest rates on deposits and debt securities,

●   Interest Rates greater the loss of interest income on future cash inflows
causing investors to demand a higher return on investment.

Greater the risk associated with future cash flows of an

●   Risk Premium investment, higher the rate of return required by an
investors to compensate for the additional risk.
PRESENT VALUE FOR A SERIES OF FUTURE
PAYMENTS
• The basic idea of the present value of a future amount can be extended
to a series of future payments. For example, if you are promised FV1
one year in the future, FV2 two years in the future, and so on for n
years, the present value of this sum of future payments is
FV1 FV2 FVn
PV    ... 
(1  i ) (1  i )
1 2
(1  i ) n

• Formula (Present Value of a Stream). When the interest rate is i, the

present value of a stream of future payments of FV1, FV2, . . . , FVn is
n
FVn
PV  
t 1 (1  i ) n
 DEMONSTRATION PROBLEM 2

• A person wins a state lottery. The terms of the lottery are that the winner will receive
annual payments of $20,000, at the end of this year and for the next 3 years. If the
winner could invest this money today at a rate of 8 percent per year, compounded
annually, what is the present value of annuity?

20000 20000 20000 20000

PV    
(1  0.08) (1  0.08)
1 2
(1  0.08) (1  0.08)
3 4

PV  $66,242.60
NET PRESENT VALUE

• Given the present value of the income stream that arises from a project, one can easily
compute the net present value of the project.
• The net present value (NPV) of a project is simply the present value (PV) of the
income stream generated by the project minus the current cost (C0) of the project
NPV = PV - C0
• If the net present value of a project is positive, then the project is profitable because
the present value of the earnings from the project exceeds the current cost of the
project.
• On the other hand, a manager should reject a project that has a negative net present
value, since the cost of such a project exceeds the present value of the income stream
that project generates.
FORMULA FOR NET PRESENT VALUE

FV1 FV2 FVn

NPV    ...   C0
(1  i ) (1  i )
1 2
(1  i ) n

• Where FV1, FV2 and FVn are future payments in respective time periods
• C0 is the sinking cost for the project at the current time
• i is the discount (or interest) rate
DEMONSTRATION PROBLEM 3

• The manager of Automated Products is contemplating the purchase of

a new machine that will cost $300,000 and has a useful life of five
years. The machine will yield (year-end) cost reductions to Automated
Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3,
and $90,000 in years 4 and 5. What is the present value of the cost
savings of the machine if the interest rate is 8 percent? Should the
manager purchase the machine?
PRESENT VALUE AND FUTURE VALUE
• Now consider a situation when all future payments are equal
FV1 = FV2 = …= FVn = FV
• Then the PV is given by
n FV
PV  
t 1 (1  i ) n
• Mathematically speaking this type of series is called a geometric
progression (with FV as a constant) the sum of this series can be written as:

PV  FV 
1  1  i  
n

i
• Hence the NPV can be calculated by subtracting the initial setup cost from
this Present value formula
DEMONSTRATION PROBLEM 4

• For Example an initial investment of $50,000 is expected to generate a

net return of $15,000 at the end of 1 year and for the next three
years. Let's assume that the desired rate of return for the project is 8
percent per year. Is the project profitable for the company or not?
SOLUTION TO DEMOSNTRATION PROBLEM 4

PV  FV 
1  1  i  
n

• So using the formula for present value of annuity, putting n = 4, i = 0.08,

PV = $15000 x (3.31213)
= $49,681.95

• So
NPV = PV – C0
= $49681.8 – 50,000
= -$318.2
• An annuity is a series of equal payments or receipts that occur at evenly spaced
intervals.
• Eg. loan, rental payment, regular deposit to saving account, monthly home mortgage
payment, monthly insurance payment
• A Perpetuity is a constant stream of identical cash flows with no end.
• perpetuity is similar to Annuity which will last till infinity.
• The closest example of a true perpetuity is a type of bond from the British government
known as a consol. These bonds have no maturity date and keep making interest
payments forever – or at least as long as the British government is in existence.
• Another real-life example is preferred stock; the perpetuity calculation assumes the
company will continue to exist indefinitely in the market and keep paying dividends.
APPLICATIONS OF ANNUITY & NET PRESENT
VALUE
Below is a list of the most common areas in which people use net present value calculations to
help them make financial decisions.
• Mortgage payments
• Student loans
• Savings for college
• Home, auto, or other major purchases
• Credit cards
• Money management
• Retirement planning
• Investments
• Financial planning (both business and personal)
PRESENT VALUE OF INDEFINITELY LIVED
ASSETS
Some decisions generate cash flows that continue indefinitely.
For instance, consider an asset that generates a cash flow of CF0 today, CF1 one year from
today, CF2 two years from today, and so on for an indefinite period of time.
If the interest rate is i, the value of the asset is given by the present value of these cash
flows:

CF1 CF2 CFn

PVAsset  CF0    ...   ...
(1  i ) (1  i )
1 2
(1  i ) n
 PERPETUITY CASH FLOW
• While this formula contains terms that continue indefinitely, for certain patterns of future
cash flows one can readily compute the present value of the asset. For instance, suppose
that the current cash flow is zero (CF0 = 0) and that all future cash flows are identical
(CF1 = CF2 =...).
• In this case the asset generates a perpetual stream of identical cash flows at the end of
each period. If each of these future cash flows is CF, the value of the asset is the present
value of the perpetuity:

CF CF CF CF
PV perpetuity    ...   ...  
(1  i ) (1  i )
1 2
(1  i ) n
n 1 (1  i )
n

• Using properties of infinite geometric series this can be written as:

CF
PV perpetuity 
i
PRESENT VALUE OF INDEFINITELY LIVED
ASSETS
• Examples of such an asset include perpetual bonds and preferred
stocks. Each of these assets pays the owner a fixed amount at the end
of each period, indefinitely. Based on the above formula, the value of a
perpetual bond that pays the owner $100 at the end of each year when
the interest rate is fixed at 5 percent is given by

CF 100
PVPerpetual Bond    $2000
i 0.05
PRESENT VALUE OF THE STREAM OF PROFITS

• Present value analysis is also useful in determining the value of a

firm, since the value of a firm is the present value of the stream
of profits (cash flows) generated by the firm’s physical, human, and
intangible assets. In particular, if π0 is the firm’s current level of profits,
 1and so on.Therefore,
π1 is next year’s profit,  nof the firm
then
PV firm   0   2
 ... 
the value
 ...
is:
(1  i )1
(1  i ) 2
(1  i ) n

• In other words, the value of the firm today is the present value of its
current and future profits.
PROFIT MAXIMIZATION IN TERMS OF PV AND
FV

Profit Maximization:: Maximizing profits means maximizing the value of

the firm, which is the present value of current and future profits.
VALUE OF FIRM WITH CONSTANT GROWTH
RATE
• Suppose a firm’s current profits are π0, and that these profits have not
yet been paid out to stockholders as dividends.

• Imagine that these profits are expected to grow at a constant rate of g

percent each year
• profit growth is less than the interest rate (g < i)

• In this case, profits one year from today will be (1 + g) π0, profits two
years from today will be (1 + g)² π0, and
1 so on.
 (1  g )  (1  g ) 2
PV firm  
0
0
  .....
0
(1  i ) (1  i )
1 2
VALUE OF FIRM

• The above series is also a geometric series since g < i

• Hence this gives
 1 i 
PV firm   0  
ig 
• For a given interest rate and growth rate of the firm, it follows that
maximizing the lifetime value of the firm (long-term profits) is
equivalent to maximizing the firm’s current (short-term) profits of π0
PV OF FIRM WHEN PROFITS PAID AS
DIVIDEND
• if current profits have already been paid out as dividends. In this case,
the present value of the firm is the present value of future profits (since
current profits have already been paid out).
• The value of the firm after its current profits have been paid out as
dividends (called the ex-dividend date) may be obtained by simply
subtracting π0 from the above equation, i.e.
EX  dividend
PV firm  PV firm   0

• This simplifies to
1 g 
PV Ex  dividend
firm   0  
ig 
MAXIMIZING SHORT-TERM PROFITS MAY
MAXIMIZE LONG-TERM PROFITS

If the growth rate in profits is less than the interest rate and
both are constant, maximizing long-term profits is the same
as maximizing current (short-term) profits.
DEMONSTRATION PROBLEM 5

• Suppose the interest rate is 10 percent and the firm is expected to

grow at a rate of 5 percent for the foreseeable future. The firm’s
current profits are $100 million.
• (a) What is the value of the firm (the present value of its current and
future earnings)?
• (b) What is the value of the firm immediately after it pays a dividend
equal to its current profits?
SUMMARY

• Discussed the time value of money in terms of future value and present value
• While making decision involving returns on investment in future it is important
to consider the present values of total cash flows.
• While deriving the value of an Annuity, it's required to compound cash flow and
interest rate which is earned every year, till the life of Annuity. Whereas
Perpetuity has an infinite time period, it uses simple interest rate or stated
interest rate only.
• Company’s Profit maximization means maximizing the value of the firm, which is
the present value of current and future profits. This can be calculated using the
current interest rate and growth rates for profits
“Investing is a simple process of taking into account the present value and future
value. The other major factor to understand here, is what you lose as a result of
inaction. Consider what you can gain and what you can lose in your decision.”
― J.R. Rim