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Future Value versus Present Value (cont.) Future Value versus Present Value (cont.)
When making investment decisions, managers usually
To make the right investment decision, managers calculate present value.
need to compare the cash flows at a single point in
time. Figure 5.2 Compounding and Discounting
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The three basic patterns of cash flows include: Future value is the value at a given future date of
A single amount: A lump sum amount either held an amount placed on deposit today and earning
currently or expected at some future date. interest at a specified rate. Found by applying
compound interest over a specified period of time.
An annuity: A level periodic stream of cash flow.
Compound interest is interest that is earned on a
A mixed stream: A stream of unequal periodic
given deposit and has become part of the principal
cash flows.
at the end of a specified period.
Principal is the amount of money on which interest
is paid.
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Finding the Present Value of an Ordinary Finding the Present Value of an Ordinary
Annuity Annuity (cont.)
You can calculate the present value of an ordinary Braden Company, a small producer of plastic toys, wants
annuity that pays an annual cash flow equal to CF to determine the most it should pay to purchase a
by using the following equation: particular annuity. The annuity consists of cash flows of
$700 at the end of each year for 5 years. The firm requires
the annuity to provide a minimum return of 8%.
This situation can be depicted on a time line as follows:
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Table 5.2 Long Method for Finding the Finding the Future Value of an Annuity
Present Value of an Ordinary Annuity Due
You can calculate the present value of an annuity
due that pays an annual cash flow equal to CF by
using the following equation:
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A perpetuity is an annuity with an infinite Ross Clark wishes to endow a chair in finance at his
life, providing continual annual cash flow. alma mater. The university indicated that it requires
$200,000 per year to support the chair, and the
If a perpetuity pays an annual cash flow of endowment would earn 10% per year. To determine
CF, starting one year from now, the present the amount Ross must give the university to fund the
value of the cash flow stream is chair, we must determine the present value of a
$200,000 perpetuity discounted at 10%.
PV = CF r
PV = $200,000 0.10 = $2,000,000
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Shrell Industries, a cabinet manufacturer, expects to If the firm expects to earn at least 8% on its
receive the following mixed stream of cash flows over investments, how much will it accumulate by the end
the next 5 years from one of its small customers. of year 5 if it immediately invests these cash flows
when they are received?
This situation is depicted on the following time line.
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Frey Company, a shoe manufacturer, has been If the firm must earn at least 9% on its investments,
offered an opportunity to receive the following mixed what is the most it should pay for this opportunity?
stream of cash flows over the next 5 years. This situation is depicted on the following time line.
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Table 5.4 Future Value from Investing $100 at Table 5.5 Future Value at the End of Years 1 and
8% Interest Compounded Quarterly over 24 2 from Investing $100 at 8% Interest, Given
Months (2 Years) Various Compounding Periods
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Fred Moreno wishes to find the effective annual rate The following equation calculates the annual cash payment (CF)
associated with an 8% nominal annual rate (r = 0.08) that wed have to save to achieve a future value (FVn):
when interest is compounded (1) annually (m = 1);
(2) semiannually (m = 2); and (3) quarterly (m = 4).
Suppose you want to buy a house 5 years from now, and you
estimate that an initial down payment of $30,000 will be
required at that time. To accumulate the $30,000, you will wish
to make equal annual end-of-year deposits into an account
paying annual interest of 6 percent.
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Special Applications of Time Value: Loan Special Applications of Time Value: Loan
Amortization Amortization (cont.)
Loan amortization is the determination of the The following equation calculates the equal periodic loan
equal periodic loan payments necessary to provide payments (CF) necessary to provide a lender with a specified
a lender with a specified interest return and to interest return and to repay the loan principal (PV) over a
repay the loan principal over a specified period. specified period:
The loan amortization process involves finding the
future payments, over the term of the loan, whose
present value at the loan interest rate equals the
amount of initial principal borrowed. Say you borrow $6,000 at 10 percent and agree to make
A loan amortization schedule is a schedule of equal annual end-of-year payments over 4 years. To find the
size of the payments, the lender determines the amount of a
equal payments to repay a loan. It shows the
4-year annuity discounted at 10 percent that has a present
allocation of each loan payment to interest and value of $6,000.
principal.
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