BADM 7090 Financial Management: Basic Concepts: The Time Value of Money

BADM 7090
Financial Management
Unit I.B
Basic Concepts:
The Time Value of Money
Text material: GSM, Ch. 3
D. Chance
Questions
• How do we calculate the future value of
money invested today?
• How do we calculate the value today of
money to be received in the future?
• How do these problems differ when there
are multiple payments?
Version: 1/3/11 D. Chance – BADM 7090 – Unit IB p. 2 of 43

Present Value and Future Value
• Present value is the amount of money at
one point in time that is equivalent in
value, given a rate of interest, to an
amount of money at a later point in time.
• Future value is the amount of money at a
later point in time that is equivalent in
value, given a rate of interest, to an
amount of money at an earlier point in
time.

The Interest Rate
• The rate that should be used to discount
cash flows is a central focus of this
course. At its most fundamental level, it
must reflect the concept of an opportunity
cost:
– The amount that you could earn by investing
your money at the same risk.
– When we discuss discounting equity claims,
we will not call this an interest rate.
Future Value Calculation
• Value of $1 today invested at rate r per
period one period later:
FV  $1(1  r )
This is called the compound factor.
$1 $1(1 + r)
0 1

Future Value Calculation (cont.)
• Example Problem I.B(1): What is the value
of $100,000 compounded for one year at
6%?
$100,000(1.06)  $106,000

• The result extends to multiple periods, t.
FV  $1(1  r ) t
$1 $1(1 + r)t
0 1 2 t

• Example Problem I.B(2): What is the value of
$100,000 compounded for two years at 6% per
year?
$100,000(1.06)  $112,360
2
• With multiple periods, interest compounds on

itself. More on that later.

Present Value Calculation
• Value today of $1 to come in one period at the
rate r
$1
PV   (1  r )1
(1  r )
This is called the discount factor .
$1(1 + r)-1 $1
0 1

Present Value Calculation (cont.)
today of $100,000 in one year at 6%?
$100,000
 $94,340
(1.06)

• The result extends to multiple periods, t.
$1 t
PV   (1  r )
(1  r )t
$1(1 + r)-t $1
0 1 2 t

today of $100,000 to be received or paid in two
years at 6% per year?
$100,000
2
 $89,000
(1.06)
• You can think of this like putting down $89,000
at 6% to fund a payment of $100,000 in 2 years.

Discount Factors and Present
Value
• DF =1/(1 + r)t = (1 + r)-t
• Discount factors further away in time must
always be less than earlier ones, even if the rate
for the later period is lower. Otherwise, parties
can trade to earn infinite profits at no risk. This
type of trade is called arbitrage and is not
permitted in well-functioning financial markets,
as covered later in this course.
• The relationship between interest rates and
maturity is called the term structure of interest
rates. We will look at this relationship later.
Multiperiod Cash Flows and
Value Additivity
• Present (and future) values are additive,
meaning that the present value of a series
of cash flows equals the sum of their
respective present values. CF1 CF2 CF3 CF4 CF5
0 1 2 3 4 5
PV1
PV2
PV3
PV4
PV5

Value Additivity (cont.)
• Example Problem I.B(5): Consider the
following series of cash flows. Find the
present value of the entire series if 5% is an
appropriate discount rate.
– C1 = $10,000
– C2 = $12,500
– C3 = -$3,500 (note < 0)
– C4 = $9,000
$10,000 $12,500 $3,500 $9,000
PV   2
 3

1.05 (1.05) (1.05) (1.05) 4
 $9,524  $11,338  $3,023  $7,404  $25,243

Value Additivity (cont.)
• In general, the present value of a series of cash
flows can be written as follows:
n
Ct
PV  
t 1 (1  r )t
• The notion of finding present value by discounting

cash flows is also referred to as the discounted
cash flow method.
• Note also that the future value of a stream of
unequal payments follows a similar approach.
See your book for details.
Annuities
• An annuity is a series of equivalent cash flows. Here C1
= C2 = … = Cn = C. The present value formula simplifies
to (see optional MBATN07-03 for details):
C C C C
PV     ... 
1  r (1  r ) (1  r )
2 3
(1  r )n
n
C  1  (1  r ) n  1 1   1 n 
  C   or C    or C   1  (1  r )  
t 1 (1  r )  r r (1  r )
t n
 r    r 
• The term in large parentheses is often called the annuity

(discount) factor.
• You should always use the annuity factor rather than
discount each cash flow. There may be many cash
flows. The annuity factor is faster.
Annuities (cont.)
• Example Problem I.B(6): What is the value of a
four year scholarship of $5,000 per year if the
opportunity cost is 5% and the first payment
starts in one year?
 1  (1.05)4 
PV  $5,000    $17,730
 0.05 

Annuities (cont.)
• Normally we think of an annuity problem as
being one in which the first payment occurs one
period later. This is called an ordinary annuity.
If the first payment occurs today, it is called an
annuity due. To obtain its present value, we
multiply everything by 1 + r. Or change n to n -
1 and add C.

Annuities (cont.)
• Example Problem I.B(7): What is the value of a
four-year scholarship of $5,000 per year if the
opportunity cost is 5% and the payments occur
at the beginning of the year?
$5,000 $5,000 $5,000
PV  $5,000     $18,616
(1.05) (1.05)2 (1.05)3
 1  (1.05)3 
 $5,000  $5,000    $18,616
 0.05 
 1  (1.05)4 
 $5,000   (1.05)  $18,616 or
 0.05 

Annuities (cont.)
• What about the future value of an annuity?
 (1  r )n  1 
FV  C  
 r 
• This formula assumes the first payment starts
one period later. The term in parentheses is
called the annuity compound factor.

Annuities (cont.)
• Example Problem I.B(8): Save $100 at the
end of each year for 20 years, starting in one
year. The rate is 6%. How much will you have
in 20 years?
 (1.06)20  1 
FV  $100    $3,679
 0.06 

Compound Interest
• When interest compounds on itself, it
grows much faster.
• That is, in one period, interest is paid on
the principal, and in the next interest is
paid on the principal and the previously
paid interest.

Compound Interest (cont.)
• Example Problem I.B(9): Find the future
value of $100 at 10% simple interest and
10% compound interest over a period of 2
years
– Simple: $100 + $100(0.10)*2 = $120
– Compound: $100(1.10)2 = $121

• Example Problem I.B(10): Consider $100
invested for one year at 6%. How much would
you have after one year for different
compounding intervals?
– Simple (annual): $100(1.06) = $106
– Semiannual: $100(1 + 0.06/2)2 = $106.09
– Quarterly: $100(1 + 0.06/4)4 = $106.14
– Monthly: $100(1 + 0.06/12)12 = $106.17
– Weekly: $100(1 + 0.06/52)52 = $106.18
– Daily: $100(1 + 0.06/365)365 = $106.1831
– Continuously: $100e0.06 = $106.1837

• Here are the effects over a long period of time.
Future Value of $100 at 10%

20,000
15,000
10,000
$
5,000
0
0 10 20 30 40 50
Year
Annual Semiannual Quarterly Monthly

Weekly Daily Continuous

Constant Growth
• (Note: This material is not covered in GSM until
the next chapter.)
• If the cash flows grow at the rate g forever, the
formula simplifies (optional MBATN07-03 for
details):
C1 C1(1  g ) C1(1  g )2 C1(1  g )1
PV     ... 
1 r (1  r )2
(1  r )3
(1  r )

C1(1  g )t 1 C1
 
t 1 (1  r )t r g

Constant Growth (cont.)
• Example Problem I.B(11): If C1 is $5,000 and
the cash flows grow at 4%, what is the present
value if the opportunity cost is 7%.
$5,000
PV   $166,667
0.07  0.04
• This formula assumes that the first cash flow
occurs in one year. (This is a critical assumption
that will cause you many problems if you forget
it.)

Perpetuities
• A perpetuity is an infinite annuity, as in C1 = C2 =
C3 = . . . = C∞ = C (g = 0 in the growth formula)

C C
PV   
t 1 (1  r )
t
r

Perpetuities (cont.)
• Example Problem I.B(12): What is the value of
$10,000 a year forever at 4%.
$10,000
PV   $250,000
0.04
• That is, $250,000 will generate $10,000 per year
forever. (Consider endowing a scholarship!)

Some Other Applications of
Time Value of Money
• How interest rates are expressed
– Stated rate vs. effective rate
• Example Problem I.B(13): You take out a $1 loan at a rate
of 5%. What is the effective annual rate for the different
compounding periods below, one of which will be specified
by the bank as applicable to this loan?
– If compounded annually, (1 + 0.05/1)1 – 1 = 0.05
– If compounded semiannually, (1 + 0.05/2)2 – 1 = 0.050625
– If compounded quarterly, (1 + 0.05/4)4 – 1 = 0.050945
– If compounded monthly, (1 + 0.05/12)12 – 1 = 0.051162
– If compounded weekly, (1 + 0.05/52)52 – 1 = 0.051246
– If compounded daily, (1 + 0.05/365)365 – 1 = 0.051267
– If compounded continuously, e0.05(1) – 1 = 0.051271

Time Value of Money (cont.)
• How interest rates are expressed (cont.)
– Stated rate vs. effective rate (cont.)
• Note how the effective annual rate increases the more
frequently interest is compounded.
• This concept often leads to confusion in understanding how
much a borrower is really paying.
• Consumer lending laws require specification of the effective
annual rate.

• Amortizing a loan
– A loan with a series of equal payments is paid
off over its specified life. Each payment is
comprised of interest applied to the remaining
balance and an amount that pays down the
principal or amount owed.
– Example Problem I.B(14): Suppose you take
out a three-year loan of $1,000 at a rate of 10%
with annual payments. Determine the payments
and show how the loan is amortized.
• Amortizing a loan (cont.)
– Annual payments:
$1,000
Payment  3
 $402.11
1  (1.10)
0.10
– Amortization schedule
• Each period the interest is 10% times the beginning
of period balance.
• The contribution to principal is the total payment
minus the interest.

– Amortization schedule (cont.)
The Interest is the interest rate
applied to the beginning balance.
Beginning of
Year Beginning Balance Payment Interest Principal Ending Balance
0 $1,000.00
1 $1,000.00 $402.11 $100.00 $302.11 $697.89
2 $697.89 $402.11 $69.79 $332.33 $365.56
3 $365.56 $402.11 $36.56 $365.56 $0.00
The
Beginning
Balance is
carried
forward as
The Principal is the Payment The Ending Balance is the
the previous
minus the Interest Beginning Balance minus the
period
Principal
ending
balance.

• Implied interest rate
– Given a number of periods, an amount today,
and an amount at a later date, what is the rate
implied by these numbers?
• Example Problem I.B(15): Suppose you invested
$100 in a stock and 10 years later, your portfolio was
worth $150 (This assumes no further investments).
What rate did you earn? (Typically we want the
annual rate but other compounding periods could be
of interest.)

• Implied interest rate (cont.)
$150  $100(1  r )10
$150
(1  r )10   1.5
$100
10ln(1  r )  ln(1.5)
ln(1.5)
ln(1  r )   0.040547
10
(1  r )  e 0.040547  1.04138
r  0.04138

• Implied number of periods (years)
– Given a rate, an amount today, and an amount
at a later date, what is the number of periods it
took for this to occur?
• Example Problem I.B(16): Suppose you put $100 in
an investment that would earn 6% a year. How many
years would it take to accumulate $300? (This
assumes no further investments.)

• Implied number of periods (cont.)
$300  $100(1.06)n
$300
(1.06) 
n
 3.00
$100
n ln(1.06)  ln(3.00)
ln(3.00)
n  18.85
ln(1.06)

• Note that when these problems involve
annuities, you simply use the annuity
formulas instead of the lump sum present or
future value formulas.
• Also, when these problems involve unequal
amounts, the solutions are far more difficult
and are similar to the concept of the internal
rate of return, which we will cover later.

What Does the Discount Rate, r,
Stand For?
• r is comprised of
– The risk-free rate, which is
• the opportunity cost of investing without risk.
– A premium to compensate for the risk
– A premium to compensate for expected inflation
• The rate r used to evaluate any present or future
cash flow should be the rate on alternatives with
equivalent risk.
• In general, it is an opportunity cost for
investments of equivalent risk.
Look at the Following
• See MBATN08-01 for how to use present
value analysis to determine how much you
are worth.
• See MBATN09-01 for a review of present
value

Coming up in Unit I.C
• How to determine the values of stocks and
bonds

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BADM 7090

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• With multiple periods, interest compounds on

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• The notion of finding present value by discounting

• The term in large parentheses is often called the annuity

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Future Value of $100 at 10%

Annual Semiannual Quarterly Monthly

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