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Time Value of Money

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What is Time Value of Money?
• A dollar received today is worth more than a dollar received
tomorrow
• This is because a dollar received today can be invested to earn interest
• The amount of interest earned depends on the rate of return that can be
earned on the investment
• Time value of money quantifies the value of a dollar through time

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Uses of Time Value of Money
• Time Value of Money, or TVM, is a concept that is used in all aspects
of finance including:
• Bond valuation
• Stock valuation
• Accept/reject decisions for project management
• Whether to acquire a new equipment or not?
• Financial analysis of firms
• And many others!

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Intuition Behind Present Value
There are three reasons why a dollar tomorrow is worth less than a dollar
today
 Individuals prefer present consumption to future consumption. To induce people to
give up present consumption you have to offer them more in the future.
 When there is monetary inflation, the value of currency decreases over time. The
greater the inflation, the greater the difference in value between a dollar today and a
dollar tomorrow.
 If there is any uncertainty (risk) associated with the cash flow in the future, the less
that cash flow will be valued.
Other things remaining equal, the value of cash flows in future time periods
will decrease as
the preference for current consumption increases.
expected inflation increases.
the uncertainty in the cash flow increases.
Discounting and Compounding
The mechanism for factoring in these elements is the discount rate. The
discount rate is a rate at which present and future cash flows are traded off.
It incorporates
(1) Preference for current consumption (Greater ....Higher Discount Rate)
(2) Expected inflation(Higher inflation .... Higher Discount Rate)
(3) Uncertainty in the future cash flows (Higher Risk....Higher Discount Rate)

A higher discount rate will lead to a lower value for cash flows in the future.

The discount rate is also an opportunity cost, since it captures the returns
that an individual would have made on the next best opportunity.
 Discounting future cash flows converts them into cash flows in present value dollars.
 Just as discounting converts future cash flows into present cash flows, Compounding
converts present cash flows into future cash flows.
Time lines for cash flows
• The best way to visualize cash flows is on a time line,
where you list out how much you get and when.
• In a time line, today is specified as “time 0” and each
year is shown as a period.
Present Value Principle 1
• Cash flows at different points in time cannot be compared or aggregated.

• All cash flows have to be brought to the same point in time, before
comparisons and aggregations are made.

• That point of time can be today (present value) or a point in time in the future
(future value).
Cash Flow Types and Discounting Mechanics
There are five types of cash flows -
 simple cash flows,
 annuities,
 growing annuities
 perpetuities and
 growing perpetuities
 Most assets represent combinations of these cash
flows. Thus, a conventional bond is a combination of
an annuity (coupons) and a simple cash flow (face
value at maturity). A stock may be a combination of
a growing annuity and a growing perpetuity.
I.Simple Cash Flows
A simple cash flow is a single cash flow in a specified future time period.
Cash Flow: CFt
_______________________________________________|
Time Period: t
The present value of this cash flow is
PV of Simple Cash Flow = CFt / (1+r)t

• Present value calculations determine what the value of a cash flow received in the
future would be worth today (time 0)
• The process of finding a present value is called “discounting”
• The interest rate used to discount cash flows is generally called the discount rate

The future value of a cash flow is


FV of Simple Cash Flow = CF0 (1+ r)t
Example of PV of a Lump Sum
How much would $100 received five years from now be worth today if the interest rate is 10%?
1. Draw a timeline
The arrow represents the flow of money and the
numbers under the timeline represent the time period.

i = 10%
? $100

0 1 2 3 4 5
2. Write out the formula using symbols:
PV = CFt / (1+r)t
3. Insert the appropriate numbers:
PV = 100 / (1 + .1)5
4. Solve the formula:
PV = $62.09 10
Future Value of a Lump Sum
• You can think of future value as the opposite of present value
• Future value determines the amount that a sum of money invested
today will grow to in a given period of time
• The process of finding a future value is called “compounding”

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Example of FV of a Lump Sum
• How much money will you have in 5 years if you invest $100 today at a 10% rate of
return?
1. Draw a timeline
2. Write out the formula using symbols:
FVt = CF0 * (1+r)t
i = 10%
$100 ?

0 1 2 3 4 5

3. Substitute the numbers into the formula:


FV = $100 * (1+.1)5
4. Solve for the future value:
FV = $161.05
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Some Points to Note
• In both the examples, note that if you were to perform the
opposite operation on the answers (i.e., find the future
value of $62.09 or the present value of $161.05) you will
end up with your original investment of $100.
• This illustrates how present value and future value
concepts are intertwined. In fact, they are the same
equation . . .
• Take PV = FVt / (1+r)t and solve for FVt. You will get FVt = PV *
(1+r)t.
• As you get more comfortable with the formulas and
calculations, you may be able to do the calculations on
your calculator alone. Be sure you understand WHAT you
are entering into each register and WHY.

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Sometimes we need to find how long it
will take a sum of money (or anything
else) to grow to some specified amount.
For example, if a company’s sales are
growing at a rate of 20% per year, how
long will it take sales to double?
Finding the Time to Double
0 1 2 ?
20%

-1 2

FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8018
If you want an investment to double in
3 years, what interest rate must it earn?
Finding the Interest Rate
0 1 2 3
?%

-1 2
FV = PV(1 + i)n
$2 = $1(1 + i)3
(2)(1/3) = (1 + i)
1.2599 = (1 + i)
i = 0.2599 = 25.99%.
Present Value of a Cash Flow Stream
• A cash flow stream is a finite set of payments that an investor will
receive or invest over time.
• The PV of the cash flow stream is equal to the sum of the present
value of each of the individual cash flows in the stream.
• The PV of a cash flow stream can also be found by taking the FV of
the cash flow stream and discounting the lump sum at the
appropriate discount rate for the appropriate number of periods.

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Example of PV of a Cash Flow Stream
• X made an investment that will pay $100 the first year, $300 the second year, $500 the third
year and $1000 the fourth year. If the interest rate is ten percent, what is the present value of
this cash flow stream?
1. Draw timeline:
2. Write out the formula using symbols: PV = [CF1/(1+r)1]+[CF2/(1+r)2]+[CF3/(1+r)3]+[CF4/(1+r)4]
3. PV = [100/(1+.1)1]+[$300/(1+.1)2]+[500/(1+.1)3]+[1000/(1.1)4]
4. PV = $90.91 + $247.93 + $375.66 + $683.01 = $1397.51

$100 $300 $500 $1000

0 1 2 3 4

?
? i = 10%
?
?
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Future Value of a Cash Flow Stream
• The future value of a cash flow stream is equal to the sum of the
future values of the individual cash flows.
• The FV of a cash flow stream can also be found by taking the PV of
that same stream and finding the FV of that lump sum using the
appropriate rate of return for the appropriate number of periods.

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Example of FV of a Cash Flow Stream
• Assume X has the same cash flow stream from his investment but wants to know what it will
be worth at the end of the fourth year
1. Draw a timeline:

$100 $300 $500 $1000

0 1 2 3 4
$1000
i = 10% ?
?
?
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Example of FV of a Cash Flow Stream
2. Write out the formula using symbols
n
FV = S [CFt * (1+r)n-t]
t=0
OR
FV = [CF1*(1+r)n-1]+[CF2*(1+r)n-2]+[CF3*(1+r)n-3]+[CF4*(1+r)n-4]

3. Substitute the appropriate numbers:


FV = [$100*(1+.1)4-1]+[$300*(1+.1)4-2]+[$500*(1+.1)4-3] +[$1000*(1+.1)4-4]

4. Solve for the Future Value:


FV = $133.10 + $363.00 + $550.00 + $1000
FV = $2046.10

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Annuities
• An annuity is a cash flow stream in which the cash flows are all equal
and occur at regular intervals.
• Note that annuities can be a fixed amount, an amount that grows at a
constant rate over time, or an amount that grows at various rates of
growth over time. We will focus first on fixed amounts.

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Example of PV of an Annuity
• Assume that X owns an investment that will pay him $100 each year for 20
years. The current interest rate is 15%. What is the PV of this annuity?
1. Draw a timeline

$100 $100 $100 $100 $100

0 1 2 3 …………………………. 19 20

?
i = 15%
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Present Value of an Annuity
• The present value of an annuity can be calculated by
taking each cash flow and discounting it back to the
present, and adding up the present values.

é1 - 1 ù
ê (1 + r) ú
n
PV of an Annuity = PV(A,r, n) = A
ê r ú
ë û
Example of PV of an Annuity
2. Write out the formula using symbols:
PVA = PMT * {[1-(1+r)-t]/r}
3. Substitute appropriate numbers:
PVA = $100 * {[1-(1+.15)-20]/.15}
4. Solve for the PV
PVA = $100 * 6.2593
PVA = $625.93

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Example of FV of an Annuity
• Assume that X owns an investment that will pay him $100 each year for 20
years. The current interest rate is 15%. What is the FV of this annuity?
1. Draw a timeline

$100 $100 $100 $100 $100

0 1 2 3 …………………………. 19 20

?
i = 15% 28
Future Value of an Annuity
• The future value of an end-of-the-period annuity can
also be calculated as follows-
é (1 + r)n - 1 ù
FV of an Annuity = FV(A,r,n) = A ê úû
ë r

• This is the equation you would use to determine how


much money you will accumulate at a future point in
time if you set aside a constant amount each period.
Example of FV of an Annuity
2. Write out the formula using symbols:
FVAt = PMT * {[(1+r)t –1]/r}
3. Substitute the appropriate numbers:
FVA20 = $100 * {[(1+.15)20 –1]/.15
4. Solve for the FV:
FVA20 = $100 * 102.4436
FVA20 = $10,244.36

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Annuity, given Present Value
• The reverse of this problem, is when the present
value is known and the annuity is to be estimated -
A(PV,r,n).
é ù
ê r ú
Annuity given Present Value = A(PV, r,n) = PV
ê1 - 1 ú
ë (1 + r)n û

• This, for instance, is the equation you would use to


determine your monthly payments on a home
mortgage.
Annuity, given Future Value
• if you are given the future value and you are looking
for an annuity - A(FV,r,n) in terms of notation -

é r ù
Annuity given Future Value = A(FV,r,n) = FV ê
ë (1+ r) - 1 úû
n
Computing Monthly Payment on a Mortgage

• Suppose you borrow $300,000 to buy a house on a 25-year


mortgage with annual payments. The annual percentage rate on
the loan is 8%. The annual payments on this loan, with the
payments occurring at the end of each year, can be calculated
using this equation:
Application : Saving for College Tuition
• Assume that Mr X want to send his newborn child to a private college (when he gets to be 18
years old—for 4 years). The tuition costs are $ 16000/year now and that these costs are
expected to rise 5% a year for the next 18 years.
• Assume:
• Mr X can invest, after taxes, at 8%.
• Tuition fee per year remains same for four years, once admitted to college.
• Tuition fee need to be paid at the beginning of the year

• Expected tuition cost/year 18 years from now = 16000*(1.05)18 = $38,506


• PV of four years of tuition costs at $38,506/year = 38506+$38,506 * PV(A ,8%,3 years)= $137739.81
• If X need to set aside a lump sum now, the amount X would need to set aside would be -
• Amount one needs to set apart now = $137739/(1.08)18 = $34,462

• If set aside as an annuity each year, starting one year from now -
• If set apart as an annuity = $137739 * A(FV,8%,18 years) = $3,677
How much is an MBA worth?
Assume that you were earning $40,000/year before entering program and
that tuition costs are $16000/year. Expected salary is $ 54,000/year after
graduation. You can invest money at 8%.
For simplicity, assume that the first payment of $16,000 has to be made at the start of the
program and the second payment one year later.
PV Of Cost Of MBA = $16,000+16,000/1.08 + 40000 * PV(A,8%,2 years) = $102,145
Assume that you will work 30 years after graduation, and that the salary
differential ($14000 = $54000-$40000) will continue through this period.
PV of Benefits = $14,000 * PV(A,8%,30 years) = $157,609
This has to be discounted back two years - $157,609/1.082 = $135,124
The net present value of getting an MBA is = $135,124 - $102,145 = $32,979

1. How much would your salary increment have to be for you to break even on
your MBA?
2. Keeping the increment constant, how many years would you have to work to
break even?
Perpetuity
• A perpetuity is a constant cash flow at regular
intervals forever. The present value of a perpetuity is-
A
PV of Perpetuity =
r

• Forever may be a tough concept for human beings to


grasp, but it makes the mathematics much simpler.
Valuing a Console Bond
• A console bond is a bond that has no maturity and
pays a fixed coupon. Assume that you have a 6%
coupon console bond. The value of this bond, if the
interest rate is 9%, is as follows -
Value of Console Bond = $60 / .09 = $667
III. Growing Annuity
• A growing annuity is a cash flow growing at a
constant rate for a specified period of time. If A is the
current cash flow, and g is the expected growth rate,
the time line for a growing annuity looks as follows –
Present Value of a Growing Annuity
 The present value of a growing annuity can be estimated
in all cases, but one - where the growth rate is equal to
the discount rate, using the following model:

é (1+g)

ê1 - ú
ê (1+r) ú
n
PV of an Annuity = PV(A, r, g,n) = A(1 +g) ê ú
ê (r - g) ú
êë úû

 In that specific case, the present value is equal to the


nominal sums of the annuities over the period, without
the growth effect.
The Value of a Gold Mine
• Consider the example of a gold mine, where you have the
rights to the mine for the next 20 years, over which period you
plan to extract 5,000 ounces of gold every year. The price per
ounce is $300 currently, but it is expected to increase 3% a
year. The appropriate discount rate is 10%. The present value
of the gold that will be extracted from this mine can be
estimated as follows –

é (1.03) ù
20
1 -
ê (1.10) ú
20
PV of extracted gold = $300 * 5000 * (1.03) = $16,145,980
ê .10 - .03 ú
êë úû
Growing Perpetuities
A growing perpetuity is a cash flow that is expected
to grow at a constant rate forever. The present value
of a growing perpetuity is -
CF1
PV of Growing Perpetuity =
(r - g)

where
 CF1 is the expected cash flow next year,
g is the constant growth rate and
r is the discount rate.
What’s the difference between an
ordinary annuity and an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT


Annuity Due
0 1 2 3
i%

PMT PMT PMT


PV FV
Ordinary Annuity due
(deferred)
Annuity
Mortgages Insurance
premiums
Car loans Rental payments

Student loans
You are in negotiations to make a 7-year loan of Rs. 25,000 to DeVille Corporation. To repay you, DeVille will pay Rs. 2,500 at the
end of Year 1, Rs. 5,000 at the end of Year 2, and Rs. 7,500 at the end of Year 3, plus a fixed but currently unspecified cash flow, X,
at the end of each year from Year 4 through Year 7. You are confident the payments will be made, since DeVille is essentially
riskless. You regard 8% as an appropriate rate of return on a low risk but illiquid 7-year loan. What cash flow must the investment
provide at the end of each of the final 4 years, that is, what is X?

Interest rate 8%

Time line:

0 1 2 3 4 5 6 7

- Rs. 25,000 Rs. 2,500 Rs. 5,000 Rs. 7,500 X X X X

Step 1: First find the present value of cash flows from t0 to t3. = - Rs 12,444.75

Step 2: Calculate the future value of this amount, calculated in step 1, at the end of t3 = -Rs.15, 676.80

Step 3: Now calculate the annual payment to be made for a 4 year annuity that equals the value calculated in step 2. = Rs 4733.15