Chapter 2: Time Value of Money

Decision Rules for Capital Investment Delay in cash ows decreases the PV ( = Market Price) Increased riskiness implies higher opportunity cost of capital (since you have to consider the rate of return on equally risky investments) decreases the PV ( = Market Price) T Ct NPV = C0 + ! t t =1 (1 + r )
NPV = Net Present Value of the investment Co is the cost of the investment today (how much you have to pay for the apartment block. The sigma is the Discounted Cash Flow of the Investment (the present value) If NPV > 0 carry out the investment

Return =

Profit ( = Sale Price - C 0 ) ! Investment ( = C 0 )

If Return > Opportunity Cost of Capital carry out the investment Cash Flows and Shortcuts

The PV of a t-year annuity at t is the difference between a perpetuity starting at 0 and a perpetuity starting at t. E.g. if payments start at the end of year 1 for the rst perpetuity and at the end of year 4 for the second perpetuity, t = 3. An annuity due is worth (1+r) times the value of an ordinary annuity Future Value of an Annuity = PV of an annuity of $1 x (1 + r)^t (r is the return you earn on your savings) Explaining the formulae: For an annuity we know that:

PV =

C ! r

But since I only get my rst C at t, the PV of that C will have to be discounted. Hence:

1 C PV = ! r (1 + r )t
If C = 1, this is known as the t-year annuity factor

Discrete vs. Continuous Compounding An amount A is invested for n years at annual interest rate r per annum If the rate is compounded once per year, the nal amount will be A(1 + r )n ! If the rate is compounded m times per year, the nal amount will be mn ! r$ A #1 + & ! " m% When m, the nal amount will be rn Ae ! To pass from continuous to a discrete (with a given number of m yearly payments), we must equate the nal amounts: ! r $ rc = m ln #1 + m & ! " m%