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Time Value of Money Chapter 5
Time Value of Money Chapter 5
Introduction to
Valuation: The
Time Value of
Money
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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More on Present and Future Values
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Why TIME?
Basic Definitions
• Present Value –
The current value of future cash flows
discounted at the appropriate discount rate.
earlier money on a time line
• Future Value –
The amount an investment is worth after one
or more periods
later money on a time line
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Future Values
• Suppose you invest $1,000 for one year at
5% per year. What is the future value in one
year?
– Interest = $1,000(.05) = $50
– Value in one year = principal + interest =
$1,000 + 50 = $1,050
– Future Value (FV) = $1,000(1 + .05) = $1,050
• Suppose you leave the money in for another
year. How much will you have two years from
now?
FV = $1,000(1.05)(1.05) = $1,000(1.05)2 =
$1,102.50
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Effects of Compounding
• Simple interest (interest is earned only on
the original principal)
• Compound interest (interest is earned on
principal and on interest received)
• Consider the previous example
– FV with simple interest = $1,000 + 50 + 50 =
$1,100
– FV with compound interest = $1,102.50
– The extra $2.50 comes from the interest of .
05($50) = $2.50 earned on the first interest
payment
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Figure 4.1
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Present Values
• How much do I have to invest today to have
some amount in the future?
FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t
(1 + r)t or PVIF present value interest Factor
(Table)
• When we talk about discounting, we mean finding
the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.
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PV – One-Period Example
• Suppose you need $10,000 in one year for
the down payment on a new car. If you can
earn 7% annually, how much do you need to
invest today?
• PV = $10,000 / (1.07)1 = $9,345.79
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Present value:
Important relationship I
For a given interest rate:
– The longer the time period,
the lower the present value.
FV
PV
(1 r ) t
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Present value:
Important relationship II
For a given time period:
– The higher the interest rate,
the smaller the present value.
FV
PV
(1 r ) t
Single-Period PV
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Discount Rate
• Often, we will want to know what the
implied interest rate is in an investment
• Rearrange the basic PV equation and
solve for r
FV = PV(1 + r)t
r = (FV / PV)1/t – 1
• If you are using formulas, you will want
to make use of both the yx and the 1/x
keys
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Saving Up
You would like to buy a new
automobile. You have $50,000 or so,
but the car costs $68,500.
•If you can earn 9%, how much do
you have to invest today to buy the
car in two years?
•Do you have enough?
•Assume the price will stay the same.
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Evaluating Investments
To give you an idea of how we will be
using present and future values,
considering the following simple
investment. Your company proposes to
buy an asset for $335. This investment
is very safe. You would sell off the
asset in three years for $400. You know
you could invest the $335 elsewhere at
10% with very little risk. What do you
think of the proposed investment?
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Examples of Annuities
Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3
Parts of an Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3
0 1 2 3
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
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Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
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Annuity
Example 5.5
• You can afford $632
per month.
1
• Going rate = 1
(1.01)48
PV 632 23,999.54
1%/month for 48 .01
months.
• How much can you
borrow?
• You borrow money
TODAY so you
need to compute
the present value.
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Annuity—Sweepstakes example
• Suppose you win the Publishers
Clearinghouse $10 million. The money is
paid in equal annual instalments of $333
333.33 over 30 years. If the appropriate
discount rate is 5%, how much is the
sweepstakes actually worth today?
– PV = 333 333.33[1 – 1/1.0530] / .05 =
$5 124 150.29
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Solving for r
• Suppose you borrow $1,000 and loan
arrangement requires you to pay $282 per
year for the next 4 years.If the payment
made at the end of each year, what
interest rate are you paying on the loan?
• Ans r=5%
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Annuity due
• An annuity for which the cash flows occur at the
beginning of the period.
• You are saving for a new house and you put $10 000 per
year in an account paying 8%. The first payment is made
today. How much will you have at the end of 3 years?
(1 r )t 1
FVAD PMT (1 r )
r
(1.08) 3 1
FVAD 10000 (1.08) 35,061.12
.08
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Perpetuities—
Example 5.7
• An annuity in which the cash flows continue
forever.
• Perpetuity formula: PV = C / r
• If $100 receives each year forever and
interest rate is 8% pv of perpetuity?
• Ans:$1,250.
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Quick quiz
• You are considering preferred stock that
pays a quarterly dividend of $1.50. If your
desired return is 3% per quarter, how
much would you be willing to pay?
– $1.50/0.03 = $50
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“Piece-At-A-Time”
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
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“Group-At-A-Time” (#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow
6. Solve the problem
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Frequency
Frequency of
of
Compounding
Compounding
General Formula:
FVn = PV0(1 + [r/m])mn
n: Number of Years
m: Compounding Periods per Year i:
Annual Interest Rate FVn,m:
FV at the end of Year n
PV0: PV of the Cash Flow today
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Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2 Years
at an annual interest rate of 12%.
Annual FV2 = 1,000(1
1,000 + [0.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1
1,000 + [0.12/2])(2)(2)
= 1,262.48
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Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1
1,000 + [0.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1
1,000 + [0.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1
1,000 + [0.12/365])(365)(2)
= 1,271.20
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Continuous Compounding
With continuous compounding the number
of compounding periods per year approaches infinity.
Through the use of calculus, the equation thus becomes:
Continuing with the previous example, find the future value of the
$100 deposit after 5 years if interest is compounded continuously.
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Future values
with monthly compounding
• Suppose you deposit $50 a month into an
account that has an interest rate of 9%,
based on monthly compounding. How
much will you have in the account in 35
years?
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Computing APRs
• What is the APR if the monthly rate is .5%?
– .5(12) = 6%
• What is the APR if the semi-annual rate is .5%?
– .5(2) = 1%
• What is the monthly rate if the APR is 12%, with
monthly compounding?
– 12 / 12 = 1%
– Can you divide the above APR by 2 to get the semi-
annual rate? NO!!! You need an APR based on semi-
annual compounding to find the semi-annual rate.
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Things to remember
• You ALWAYS need to make sure that the
interest rate and the time period match:
– If you are looking at annual periods, you need an
annual rate.
– If you are looking at monthly periods, you need a
monthly rate.
• If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the interest
rate appropriately if you have payments other
than monthly.
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EAR formula
m
APR
EAR 1 1
m
• APR = the quoted rate
• m = number of compounds per year
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Decisions, decisions… II
• Which savings accounts should you
choose:
– 5.25%, with daily compounding
– 5.30%, with semiannual compounding
• First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
• Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
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APR m (1 EAR)
1
m
-1
m = number of compounding periods per year
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APR—Example
• Suppose you want to earn an effective rate of
12% and you are looking at an account that
compounds on a monthly basis. What APR
must they pay?
APR 12 (1 .12)1/ 12 1 .113 8655 or 11.39%
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EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
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Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t – 1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.
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Usefulness of Amortization
1. Determine Interest Expense – Interest
expenses may reduce taxable income
of the firm.
2. Calculate Debt Outstanding – The
quantity of outstanding debt may be
used in financing the day-to-day
activities of the firm.