Time Value of Money (Valuation of risk free cash flows) (LN # 2) Discounting You just got your first

job. The salary is $80,000, which will be paid at the end of the year. But you need money for the expenses during the year. A bank is willing to lend you $0.909091 now if you will pay back $1 a year later. $0.826446 now if you will pay back $1 two years later. $0.751315 now if you will pay back $1 three years later. How much can you borrow now, if you are willing to pay the loan back at the end of the first year?

If you will pay $80,000 two years from now, how much can you borrow now?

If you will pay $80,000 at the end of three years, how much can you borrow now?

$72,727.27 is the present value of $80,000 a year from now, if the interest rate is 10% per year. 72,727.27 = 80,000 x 0.909091 0.909091 is called the Present Value Interest Factor at 10% for a year. PVIF(10%,1) $66,115.70 is the present value of getting $80,000 two years from now, if the interest rate is 10% per year. $66,115.70 = 80,000 x 0.826446 0.826446 is called the Present Value Interest Factor at 10% for two years. PVIF(10%,2)

$60,105.18 is the present value of getting $80,000 three years from now, if the interest rate is 10% per year. $60,105.18 = $80,000 x 0.751315 0.751315 is called the Present Value Interest Factor at 10% for three years. PVIF(10%,3) Just like future value interest factors, present value interest factors also depend on the interest rate and the number of time-periods. Unlike future value interest factors, present value interest factors are smaller if the interest rate is higher and the number of time-periods is more. The following diagram show the relationship between PVIF and FVIF.
$1.00

$0.909091

Based on the future value problems, we can write the relationship between the cash flows shown above as 0.909091 x FVIV (10%,1) = 1.00 Therefore, 0.909091 = 1.00 / FVIF(10%,1) But 0.909091 is defined as the PVIF(10%,1) Therefore, PVIF(10%,1) = 1 / FVIF(10%,1) The PVIF is the reciprocal of the FVIF. The above relationship is valid for other interest rates and time-periods. That is, PVIF (i, n) = 1 / FVIF(i, n) Example 1 How much will you lend me now if I promise to pay you $5,000 a. one year from now

b. two years from now c. three years from now d. ten years from now if the interest rate is 8% per year. Example 2 You will be able to save $5,000 at the end of each year for five years and use it for payment on a loan. How much can you borrow now if the interest rate is 8% per year? Solution: Assume that you can get $ Z1 now in exchange for $5,000 a year from now. The interest rate is 8% per year. The amount you can borrow now Z1 = 5,000 / (1+0.08) Z1 = 5,000 x PVIF (8%,1) Similarly, the amount you can borrow now in exchange for $5,000 two years from now Z2 = 5,000 x PVIF(8%,2) And so on. The total amount you can borrow now in exchange for $5,000 per year for the next five years is Z1 + Z2 + Z3 + Z4 + Z5 = 5,000 [PVIF(8%,1) + PVIF(8%,2) + PVIF(8%,3) + + PVIF(8%,4) + PVIF(8%,5) ] = 5,000 x PVIFA(8%,5) = 5,000 (1/0.08) [ 1- 1/ (1+0.08)5] = 5,000 x 3.992710 = $19,963.55 The PVIFA (8%,5) = 3.992710 Instead of taking a loan now, if you invest the annual savings at the same interest rate and collect the savings and interest at the end of five years, you will have 5,000 x FVIF(8%,4) + 5,000 x FVIF (8%,3) + 5,000 x FVIF(8%,2)

5,000 x FVIF(8%,1) + 5,000 x FVIF(8%,0) = 5,000 x FVIFA(8%,5) = $29,333 Does it mean that it is better to save and invest instead of taking a loan now? The values of both $19,963.55 and $29,333 are the same after adjusting for the time. In fact you can verify that the value of $19,963.55 when compounded five times at the rate of 8% per year is the same as $29,333. The formula for PVIFA (8%,5) = (1/0.08) [ 1- 1/ (1+0.08)5] The formula for FVIFA (8%, 5) = (1/0.08) [ (1+0.08)5 1] Note that, although PVIF(i,n) = 1/ FVIF(i,n), such a relationship does not exist between the PVIFA and the FVIFA. However, you can get the FVIFA formula by multiplying the PVIFA by FVIF. That is FVIFA (i,n) = PVIFA (i,n) x FVIF (i,n)

Finance Calculator Functions Example 3 You will be able to save $5,000 at the end of each year for the next five years, starting from this year. You would like to use your annual savings for making payments on a loan you want to take now. How much can you borrow if the interest rate is 8% per year. In order to understand calculator functions it is best to use a time line diagram:

PV PMT

$5,000

$5,000

$5,000

$5,000

$5,000

FV= 0

In the above diagram, we need to find the value of the cash flows as of time t = 0.

First you have to enter the information from the time line diagram in the calculator. (Calculators differ. Therefore you must consult the appropriate manual to find out how the entries have to be made. However, the following entries must be ok for most calculators.) 1. The equal periodic payment of $5000 is entered in the register PMT. 2. As there are 5 such payments, enter 5 for n. 3. There is no payment in addition to the last periodic payment. Therefore you must enter zero for FV. 4. The appropriate interest rate, which here is 8%, must be entered for i. 5. Now all the relevant information has been fed into the calculator. We have to find the value of all these cash flows as of nowi.e., t = 0. To get this, press the keys CPT and then PV. Note that the answer is -$19,963.55. The negative sign can be interpreted as the cash flow opposite to the ones you entered. Example 4 In addition to the payments described in example 3, you will make a $6,000 payment five years from now. What is the value of all the payments as of now (t=0)? The time line diagram for this problem is as follows:
0 1 2 3 4 5

PV PMT

$5,000

$5,000

$5,000

$5,000

$5,000

FV=6,000

The only difference is in the cash flows at t=5. For this problem, you need to enter 6,000 in FV in addition to the previous entries and then enter CPT and PV. The answer to the above problem is $24,047.05. (Note the negative sign.) When you enter a number in the FV register, the calculator interprets it as a cash flow at the end of the time line, in addition to the periodic paymentsPMT. (On the other hand, if you enter CPT + FV, it will be interpreted as the value you want to find.)

Example 5 You will be able to make $5,000 end-of-the-year deposits, for the next five years. The first payment will be at t=1. The bank pays 8% interest per year. In addition to these savings, you will also deposit $6,000 now. What will be the value of this investment five years from now?

In the previous problems we computed the value as of t =0. In contrast, in the present problem we have to compute the value as of t = 5, which is the terminal value. The time line diagram is

PV= $6,000 PMT $5,000

$5,000

$5,000

$5,000

$5,000

FV

The calculator entries are as follows: 1. The equal periodic payment of $5000 is entered in the register PMT. 2. As there are 5 such payments, enter 5 for n. 3. There is a $6,000 payment at t = 0 in addition to the periodic payments. Therefore you must enter $6,000 for PV. (Note that it does not mean it is the present value.) 4. The appropriate interest rate, which here is 8%, must be entered for i. 5. Now all the relevant information has been fed into the calculator. We have to find the value of all these cash flows as of five years from nowi.e., t = 5. To get this, press the keys CPT and then FV. Answer: -$38,148.97 (note the negative sign.)

Problems to be done in class: You are a manager of a finance company that makes loans to individuals and firms. Currently the shares of your firm are trading at $100/share. The total number of shares outstanding is 100,000. The company has $10 millions cash. Three companies--A,B, and C--have approached you for a $10 million loan. Because of he unique circumstances of the firms, the repayment patterns of the loan are different as indicated below. (The figures are in millions of dollars.)
Firm A B C year 1 4 3 2 year 2 3 5 6 year 3 3 3 4 year 4 3 3 2

The market rate of interest for this type of loan is 10%. 1. You have to decide to whom you will make the loan. 2. After you make the loan, you inform the decision to the shareholders. What will be the effect of this announcement on the share price?

You need $10,000 in five years to buy a boat. At present you have $2,000 in a savings account that pays 8% per year. If you intend making equal end-of-the-year deposits in the next five years in the same savings account and leave, what must the annual deposits be in order to have a total of $10,000 in five years to buy the boat? The first annual payment will be a year from now.