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Chapter 4

The Time Value


of Money

Chapter Outline
4.1 The Timeline

4.2 The Three Rules of Time Travel


4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5 Perpetuities and Annuities

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4-2

Chapter Outline (contd)


4.6 Solving Problems with a Spreadsheet or
Calculator
4.7 Non-Annual Cash Flows
4.8 Solving for the Cash Payments
4.9 _The Internal Rate of Return

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Learning Objectives
1. Draw a timeline illustrating a given set of
cash flows.
2. List and describe the three rules of time
travel.
3. Calculate the future value of:
4. A single sum.
5. An uneven stream of cash flows, starting
either now or sometime in the future.
6. An annuity, starting either now or
sometime in the future.
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Learning Objectives
7. Several cash flows occurring at regular
intervals that grow at a constant rate
each period.
8. Calculate the present value of:
9. A single sum.
10. An uneven stream of cash flows, starting
either now or sometime in the future.
11. An infinite stream of identical cash flows.
12. An annuity, starting either now or
sometime in the future.
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Learning Objectives
13. Given four out of the following five inputs
for an annuity, compute the fifth: (a)
present value, (b) future value, (c)
number of periods, (d) periodic interest
rate, (e) periodic payment.
14. Given three out of the following four
inputs for a single sum, compute the
fourth: (a) present value, (b) future
value, (c) number of periods, (d) periodic
interest rate.
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4-6

Learning Objectives
15. Given cash flows and present or future
value, compute the internal rate of
return for a series of cash flows.

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4-7

Learning Objectives
1. Draw a timeline illustrating a given set of
cash flows.
2. List and define three rules of time travel.
3. Calculate the future value of:
a. A single sum.
b. An uneven stream of cash flows, starting either
now or sometime in the future.
c. An annuity, starting either now or sometime in
the future.
d. A growing annuity.
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4-8

Learning Objectives
4. Calculate the present value of:
a. A single sum.
b. An uneven stream of cash flows, starting either
now or sometime in the future.
c. An infinite stream of identical cash flows.
d. An annuity, starting either now or sometime in
the future.
e. A growing perpetuity
f. A growing annuity.

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4-9

Learning Objectives
5.

6.

Given four out of the following five inputs


for an annuity, compute the fifth: (a)
present value, (b) future value, (c)
number of periods, (d) periodic interest
rate, (e) periodic payment.
Given three out of the following four
inputs for a single sum, compute the
fourth: (a) present value, (b) future
value, (c) number of periods, (d) periodic
interest rate.

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4-10

Learning Objectives
7.

Given cash flows and an interest rate,


compute the Net Present Value for a
series of cash flows.
8. Solve problems with a spreadsheet or
calculator.
9. Evaluate time value of money problems
when cash flows are not annual.
10. Given cash flows and present or future
value, compute the Internal Rate of
Return for a series of cash flows.
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4.1 The Timeline


A timeline is a linear representation of the
timing of potential cash flows.
Drawing a timeline of the cash flows will
help you visualize the financial problem.

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4.1 The Timeline (contd)


Assume that you made a loan to a friend.
You will be repaid in two payments, one at
the end of each year over the next two
years.

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4.1 The Timeline (contd)


Differentiate between two types of cash
flows
Inflows are positive cash flows.
Outflows are negative cash flows, which are
indicated with a (minus) sign.

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4.1 The Timeline (contd)


Assume that you are lending $10,000 today and that the loan
will be repaid in two annual $6,000 payments.

The first cash flow at date 0 (today) is represented as a


negative sum because it is an outflow.
Timelines can represent cash flows that take place at the end
of any time period a month, a week, a day, etc.

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Textbook Example 4.1

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4-16

Textbook Example 4.1 (contd)

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4.2 Three Rules of Time Travel


Financial decisions often require combining
cash flows or comparing values. Three rules
govern these processes.
Table 4.1 The Three Rules of Time Travel

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The 1st Rule of Time Travel


A dollar today and a dollar in one year are
not equivalent.
It is only possible to compare or combine
values at the same point in time.
Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
To answer this, you will have to compare the
alternatives to decide which is worth more. One
factor to consider: How long is later?

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4-19

The 2nd Rule of Time Travel


To move a cash flow forward in time, you
must compound it.
Suppose you have a choice between receiving
$1,000 today or $1,210 in two years. You
believe you can earn 10% on the $1,000 today,
but want to know what the $1,000 will be worth
in two years. The time line looks like this:

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The 2nd Rule of Time Travel


(contd)

Future Value of a Cash Flow

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Using a Financial Calculator: The


Basics
TI BA II Plus
Future Value

FV

Present Value

PV

I/Y

I/Y

Interest Rate per Year


Interest is entered as a percent, not a decimal
For 10%, enter 10, NOT .10

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Using a Financial Calculator:


The Basics (cont'd)
TI BA II Plus

Number of Periods

2nd CLR TVM

2ND

FV

Clears out all TVM registers


Should do between all problems

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Using a Financial Calculator:


Setting the keys
TI BA II Plus
2ND P/Y

2ND

I/Y

Check P/Y

2ND P/Y # ENTER


Sets Periods per Year to #

2ND

I/Y

ENTER

ENTER

2ND FORMAT # ENTER


Sets display to # decimal places

2ND
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Using a Financial Calculator


TI BA II Plus
Cash flows moving in opposite directions must
have opposite signs.

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Financial Calculator Solution


Inputs:
N=2
I = 10
PV = 1,000

Output:

10

I/Y

1,000

PV

CPT

FV

FV = 1,210

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-1,210

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Figure 4.1 The Composition of


Interest Over Time

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Textbook Example 4.2

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Textbook Example 4.2 (contd)

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Textbook Example 4.2 Financial


Calculator Solution for n=7 years
Inputs:
N=7
I = 10
PV = 1,000

Output:
FV = 1,948.72

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10

I/Y

1,000

PV

CPT

FV

-1,948.72

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Alternative Example 4.2


Problem
Suppose you have a choice between receiving
$5,000 today or $10,000 in five years. You
believe you can earn 10% on the $5,000 today,
but want to know what the $5,000 will be worth
in five years.

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Alternative Example 4.2 (contd)


Solution
The time line looks like this:
1

$5,000

x 1.10

$5, 500

x 1.10

$6,050

x 1.10

$6,655

x 1.10

$7,321

x 1.10

$8,053

In five years, the $5,000 will grow to:


$5,000 (1.10)5 = $8,053
The future value of $5,000 at 10% for five years
is $8,053.
You would be better off forgoing the gift of $5,000 today and
taking the $10,000 in five years.
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Alternative Example 4.2


Financial Calculator Solution
Inputs:
N=5
I = 10
PV = 5,000

Output:
FV = 8,052.55

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10

I/Y

5,000

PV

CPT

FV

-8,052.55

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The 3rd Rule of Time Travel


To move a cash flow backward in time, we
must discount it.
Present Value of a Cash Flow

C
P
V

(
1

r
)
n
(
1

r
)
n

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Textbook Example 4.3

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Textbook Example 4.3

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Textbook Example 4.3


Financial Calculator Solution
Inputs:
N = 10
I=6

FV = 15,000

10

I/Y

15,000 FV

Output:
PV = 8,375.92

Copyright 2014 Pearson Education, Inc. All rights reserved.

CPT

PV

-8,375.92

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Alternative Example 4.3


Problem
Suppose you are offered an investment that
pays $10,000 in five years. If you expect to earn
a 10% return, what is the value of this
investment today?

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Alternative Example 4.3 (contd)


Solution
The $10,000 is worth:
$10,000 (1.10)5 = $6,209

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Alternative Example 4.3:


Financial Calculator Solution
Inputs:
N=5

I = 10

10

I/Y

FV = 10,000

Output:
PV = 6,209.21

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10,000 FV
CPT

PV

-6,209.21

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Applying the Rules of Time Travel


Recall the 1st rule: It is only possible to
compare or combine values at the same
point in time. So far weve only looked at
comparing.
Suppose we plan to save $1000 today, and
$1000 at the end of each of the next two years.
If we can earn a fixed 10% interest rate on our
savings, how much will we have three years from
today?

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Applying the Rules of Time Travel


(cont'd)
The time line would look like this:

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Applying the Rules of Time Travel


(cont'd)

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Applying the Rules of Time Travel


(cont'd)

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Applying the Rules of Time Travel


(cont'd)

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Table 4.1 The Three Rules of


Time Travel

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Textbook Example 4.4

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Textbook Example 4.4 (contd)

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Textbook Example 4.4


Financial Calculator Solution
CF

1,000

ENTER

1,000

ENTER

ENTER

NPV

10

ENTER

CPT

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2,735.54

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Alternative Example 4.4


Problem
Assume that an investment will pay you
$5,000 now and $10,000 in five years.
The time line would like this:
0

$5,000

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$10,000

4-50

Alternative Example 4.4 (cont'd)


Solution
You can calculate the present value of the combined
cash flows by adding their values today.
0

$5,000
$6,209
$11,209

1.105

$10,000

The present value of both cash flows is $11,209.

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Alternative Example 4.4 (cont'd)


Solution
You can calculate the future value of the
combined cash flows by adding their values
in Year 5.
1

$5,000

x 1.105

$10,000
$8,053
$18,053

The future value of both cash flows is $18,053.


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4-52

Alternative Example 4.4 (cont'd)


Present
Value
0

$11,209

$18,053

1.105

$11,209

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x 1.105

Future
Value
5

$18,053

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4.3 Valuing a Stream of Cash


Flows
Based on the first rule of time travel we can
derive a general formula for valuing a
stream of cash flows: if we want to find the
present value of a stream of cash flows, we
simply add up the present values of each.

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4-54

4.3 Valuing a Stream of Cash


Flows (contd)

Present Value of a Cash Flow Stream


N

C
n
P
V

P
V
(
C
)

n
n
(
1

r
)
n

0
n

0
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4-55

Textbook Example 4.5

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4-56

Textbook
Example 4.5
(contd)

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4-57

Textbook Example 4.5


Financial Calculator Solution
CF

ENTER

5,000

ENTER

8,000

ENTER

ENTER

NPV

ENTER

CPT

24,890.66

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4-58

Alternative Example 4.5


Problem
What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0

$2,000

$2,000

$2,000

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4-59

Alternative Example 4.5 (cont'd)


Solution

$2,000

$2,315
x 1.05

x 1.05

x 1.05

x 1.05

x 1.05

$2,000

$2,205
$2,000

Or

x 1.05

$2,000

$2,000
$2,100
$4,100

$2,000

x 1.05

x 1.05

$4,305
$6,305
x 1.05

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$2,100
$6,620

$6,620
4-60

Future Value of Cash Flow


Stream
Future Value of a Cash Flow Stream with a
Present Value of PV
n
F
V

P
V

(
1

r
)
n

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4-61

4.4 Calculating the Net Present


Value
Calculating the NPV of future cash flows
allows us to evaluate an investment
decision.
Net Present Value compares the present
value of cash inflows (benefits) to the
present value of cash outflows (costs).

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Textbook Example 4.6

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Textbook Example 4.6 (cont'd)

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4-64

Textbook Example 4.6


Financial Calculator Solution
CF

-1,000

ENTER

500

ENTER

ENTER

NPV

10

ENTER

CPT

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243.43

4-65

Alternative Example 4.6


Problem
Would you be willing to pay $5,000 for the
following stream of cash flows if the discount
rate is 7%?
1

$3,000

$2,000

$1,000

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4-66

Alternative Example 4.6 (contd)


Solution
The present value of the benefits is:
3000 / (1.05) + 2000 / (1.05)2 + 1000 / (1.05)3 =
5366.91

The present value of the cost is $5,000, because


it occurs now.
The NPV = PV(benefits) PV(cost)
= 5366.91 5000 = 366.91

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4-67

Alternative Example 4.6


Financial Calculator Solution
CF

-5,000

ENTER

3,000

ENTER

2,000

ENTER

1,000

ENTER

NPV

ENTER

CPT

366.91

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On a present value
basis, the benefits
exceed the costs by
$366.91.

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4.5 Perpetuities and Annuities


Perpetuities
When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.

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4-69

4.5 Perpetuities and Annuities


(contd)
The value of a perpetuity is simply the cash
flow divided by the interest rate.
Present Value of a Perpetuity

C
P
V
(
C
i
n
p
e
r
p
e
t
u
i
t
y
)

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Textbook Example 4.7

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Textbook Example 4.7 (contd)

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4-72

Alternative Example 4.7


Problem
You want to endow a chair for a female
professor of finance at your alma mater. Youd
like to attract a prestigious faculty member, so
youd like the endowment to add $100,000 per
year to the faculty members resources (salary,
travel, databases, etc.) If you expect to earn a
rate of return of 4% annually on the
endowment, how much will you need to donate
to fund the chair?

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4-73

Alternative Example 4.7 (contd)


Solution
The timeline of the cash flows looks like this:

This is a perpetuity of $100,000 per year. The


funding you would need to give is the present
value of that perpetuity. From the formula:
C
$
1
0
0
,
0
0
0
P
V

$
2
,
5
0
0
,
0
0
0
r .
0
4

You would need to donate $2.5 million to endow


the chair.
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4-74

4.5 Perpetuities and Annuities


(contd)
Annuities
When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is
called an annuity.

Present Value of an Annuity


N
C
C
CC
C
PV

...

2
3
N
n
n

1
(
1

r
)
(
1

r
)
(
1

r
)
(
1

r
)
(
1

r
)

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4-75

Present Value of an Annuity


To find a simpler formula, suppose you
invest $100 in a bank account paying 5%
interest. As with the perpetuity, suppose
you withdraw the interest each year.
Instead of leaving the $100 in forever, you
close the account and withdraw the
principal in 20 years.

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4-76

Present Value of an Annuity


(contd)
You have created a 20-year annuity of $5
per year, plus you will receive your $100
back in 20 years. So:

$
100

PV
(
20

yea
ann
of
$
5
pe
ye
)

PV
($
1
in
2
y
)

Re-arranging terms:

PV
(
20

year
annuity
of
$
5
per
year
)

$
100

PV
($
100
in
20
yea
)
100

100
20

$
62
.
31
(
1
.
05
)

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4-77

Present Value of an Annuity


For the general formula, substitute P for the
principal value and:
P
V
(a
n
n
u
ityo
fC
fo
rN
p
e
rio
d
s)
PP
V
(P
inp
e
rio
dN
)

P
1
P
P1

N
(1r)
(
1

r
)

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4-78

Textbook Example 4.8

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4-79

Textbook
Example
4.8

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4-80

Textbook Example 4.8


Financial Calculator Solution
Since the payments begin today, this is an
Annuity Due.
First, put the calculator on Begin mode:

2ND

PMT

2ND

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ENTER

2ND

CPT

4-81

Textbook Example 4.8 Financial


Calculator Solution (cont'd)
Then:
30

I/Y

1,000,000
CPT

PMT
PV

-12,158,406

$15 million > $12.16 million, so take the lump sum.

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4-82

Future Value of an Annuity


Future Value of an Annuity
N
F
V
(
a
n
n
u
i
t
y
)P
V

(
1
r
)

C
1
N

1

(
1

r
)

N
r
(
1
r
)
1
N
C

(
1
r
)

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4-83

Textbook Example 4.9

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Textbook Example 4.9 (contd)

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4-85

Textbook Example 4.9


Financial Calculator Solution
Since the payments begin in one year, this
is an Ordinary Annuity.
Be sure to put the calculator back on End
mode:
2ND

PMT

2ND

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ENTER

2ND

CPT

4-86

Textbook Example 4.9 Financial


Calculator Solution (cont'd)
Then
30

10

I/Y

10,000
CPT

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PMT
FV

-1,644,940

4-87

Growing Cash Flows


Growing Perpetuity
Assume you expect the amount of your
perpetual payment to increase at a constant
rate, g.

Present Value of a Growing Perpetuity


C
P
V
(
g
r
o
w
i
n
g
p
e
r
p
e
t
u
i
t
y
)

rg

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4-88

Textbook Example 4.10

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4-89

Textbook Example 4.10 (contd)

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4-90

Alternative Example 4.10


Problem
In Alternative Example 4.7, you planned to
donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University has
asked you to increase the donation to account
for the effect of inflation, which is expected to
be 2% per year. How much will you need to
donate to satisfy that request?

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4-91

Alternative Example 4.10


(contd)
Solution
The timeline of the cash flows looks like this:

The cost of the endowment will start at $100,000, and


increase by 2% each year. This is a growing perpetuity.
From the formula:
C
$
1
0
0
,
0
0
0
P
V

$
5
,
0
0
0
,
0
0
0
r.
0
4

.
0
2

You would need to donate $5.0 million to endow the chair.


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4-92

Growing Cash Flows


Growing Annuity
The present value of a growing annuity with the
initial cash flow c, growth rate g, and interest
rate r is defined as:
Present Value of a Growing Annuity
N

1
1

P
V

(
rg

)
(
1

r
)

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Textbook Example 4.11

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Textbook Example 4.11

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4-95

Alternative Example 4.11


Problem
You want to begin saving for your retirement.
You plan to contribute $12,000 to the account at
the end of this year. You anticipate you will be
able to increase your annual contributions by 3%
each year for the next 45 years. If your
expected annual return is 8%, how much do you
expect to have in your retirement account when
you retire in 45 years?

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Alternative Example 4.11


(contd)

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4-97

4.6 Solving Problems with a


Spreadsheet or Calculator
Spreadsheets simplify the calculations of
TVM problems

NPER
RATE
PV
PMT
FV

These functions all solve the problem:

1
F
1
V
N
P
V

P
V

P
M
T

N
P
E
R
N
P
E
R
R
A
T
E
(
1

R
A
T
E
)
(
1

R
A
T
E
)

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Textbook Example 4.12

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Textbook Example 4.12 (contd)

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Textbook Example 4.13

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Textbook Example 4.13 (contd)

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4.7 Non-Annual Cash Flows


The same time value of money concepts
apply if the cash flows occur at intervals
other than annually.
The interest and number of periods must be
adjusted to reflect the new time period.

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Textbook Example 4.14

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Textbook Example 4.14 (contd)

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4.8 Solving for the Cash


Payments
Sometimes we know the present value or
future value, but do not know one of the
variables we have previously been given as
an input.

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4.8 Solving for the Cash


Payments
For example, when you take out a loan you
may know the amount you would like to
borrow, but may not know the loan
payments that will be required to repay it.

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Textbook Example 4.15

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Textbook Example 4.15 (contd)

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4.9 The Internal Rate of Return


In some situations, you know the present
value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the
interest rate that sets the net present value
of the cash flows equal to zero.

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Textbook Example 4.16

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Textbook Example 4.16 (contd)

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Textbook Example 4.17

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Textbook Example 4.17 (contd)

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Chapter 4
Appendix

Appendix: Solving for the Number of


Periods
In addition to solving for cash flows or the
interest rate, we can solve for the amount
of time it will take a sum of money to grow
to a known value.

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Textbook Example 4A.1

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Textbook Example 4A.1 (contd)

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Discussion of Data Case Key


Topic
Would your answer change if the
certification job would require her to stay
in Seattle but an MBA would allow her to
move to New York City, where Natasha has
always wanted to live?
Hint: Consider the cost of living differences
between Seattle and New York. Would her
salary be different in Seattle versus New York?
http://cgi.money.cnn.com/tools/costofliving/cos
tofliving.html

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Chapter Quiz
1. Can you compare or combine cash flows at
different times?
2. How do you calculate the present value of a cash
flow stream?
3. What benefit does a firm receive when it accepts
a project with a positive NPV?
4. How do you calculate the present value of a
a.
b.
c.
d.

Perpetuity?
Annuity?
Growing perpetuity?
Growing annuity?

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