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Principles of Finance

Time value of money


Key Learning Points

 Compounding

 Discounting

 Calculating Present Value of a single cash flow

 Calculating the Present Value of an annuity

 Calculating the Present Value of a perpetuity

 Use of Present Value table and Annuity tables


Capital Investment Decisions

Capital investment decisions normally represent the most important


decisions that an organisation makes, since they commit a substantial
proportion of a firm’s resources to actions that are likely to be irreversible.

Many different investment projects exist including; replacement of assets,


cost-reduction schemes, new product/service developments, product/service
expansions, statutory, environmental and welfare proposals, etc.

One characteristic of all capital expenditure projects is that the cash flows
arise over the long term (a period usually greater than 12 months). Under this
situation it becomes necessary to carefully consider the time value of money.
Compounding (Compound Interest)
Interest is a payment to the investors of capital, for the use of the funds.
Compound interest is where interest generated in one period will earn
interest itself in future periods.

Exercise 1

$100 is invested in an account for five years. The interest rate is 10%
per annum. What is the value of the account after five years?

Formula for compounding:

F = P.(1 + r) n

Where:

F = Future value
P = Initial investment (present value)
r = Interest rate (expressed as a decimal)
n = Number of time periods
Answer to Exercise 1

F = P.(1 + r) n

F = 100 x (1 + 0.10)5

F = 100 x (1.10)5 = $161.05

F = 100 x 1.6105 = $161.05


Exercise 2

$450 is invested in an account earning 6.25% interest p.a.

Calculate the account value after 12 years.

Answer to Exercise 2

F = P.(1 + r) n

F = 450 x (1.0625)12 = $931.45

F = 450 x (2.06989) = $931.45


Discounting

• Discounting performs the opposite function to compounding

• Compounding finds the future value of a sum invested now

• Discounting considers a sum receivable in the future and establishes


its equivalent value today

This value in today’s terms is known as the Present Value (PV).

Formula for discounting:

The formula is simply a rearrangement of the compounding formula:

 Compounding: F = P. (1+r)n

 Discounting: P = F / (1+r)n
Exercise 1 - continued

If you were to receive $161.05 in 5 years time, what would it be worth to


you today, i.e. what is the PV (Present Value) if interest rate is 10%?

P = F / (1+r)n

P = $161.05 / (1.10)5

P = $161.05 / 1.6105

P = $100
Discount Factors

You also need to know that:


 
Present value (PV) = Future value (FV) x Discount factor (DF)
 
Where:

Discount factor = 1 / (1+ r)n

Using Exercise 1

Discount factor = 1 / (1+ r)n

Discount factor = 1 / (1.10)5 = 1 / 1.6105 = 0.621

Present Value

PV = FV x DF

PV = $161.05 x 0.621 = $100


Using the Discount Tables (Present Value Tables)
Annuities

An annuity is a constant cash flow that occurs for ‘n’ periods or years.

To calculate the PV of an annuity we use the annuity tables or cumulative


present value tables.

Exercise 3

You will receive an annuity of $1,250 for the next three years. The
current discount rate is 10%. The first cash flow will be received in 1
years’ time.

What is the PV of the annuity?


Exercise 3 Answer

Using PV tables:

CF$ DF 10% PV$


YR1 1,250 0.909 1,136
YR2 1,250 0.826 1,033
YR3 1,250 0.751 939

NPV* 3,108

(*Net Present Value) The addition of the


individual DFs is
equal to the 2.487
OR - Alternatively discount factor!!!...

Using Annuity Tables (Cumulative Discount Tables):

CF$ DF 10% NPV$


YR1 - 3 1,250 2.487 3,109
Using the Annuity Tables (Cumulative Present Value Tables)
Perpetuities

An perpetuity is a constant cash flow that occurs indefinately.

To calculate the PV of a perpetuity we use the following formula:

PV Perpetuity = CF$ x 1 / r (where r is the discount rate)

Exercise 4

You will receive a perpetuity of $2,000 starting one year from now. The
current discount rate is 10%.

What is the PV of the perpetuity?


Exercise 4 Answer

PV Perpetuity = $CF x 1 / r

PV = $2,500 x 1 / 0.10

PV = $2,500 x 10

PV = $25,000

i.e. $2,500 received indefinitely is worth $25,000 at a current interest


rate of 10%
Further Learning

Delayed Annuity

i.e. the cash flow does not begin in the first year!!!...

Exercise – Jarvis Cocker Ltd

An investment will generate cash flows of $1,800 each year in years 3 – 7


(i.e. the first amount to be received 3 years from now). The discount rate is
15% per annum.

What is the present value of the cash flows?


Answer to Exercise – Jarvis Cocker Ltd

Using PV tables:

CF$ DF 15% PV$


YR1 0 0.870 0
YR2 0 0.756 0
YR3 1,800 0.658 1,184
YR4 1,800 0.572 1,030
YR5 1,800 0.497 895
YR6 1,800 0.432 778
YR7 1,800 0.376 677

NPV 4,564
The addition of the
individual DFs is
OR: - equal to the 2.535
CF$ DF 15% PV$ discount factor!!!...
YR3-7 1,800 2.535 4,563
OR Answer to Exercise – Jarvis Cocker Ltd

Using cumulative PV (annuity) tables:

We require the 15% discount factor for years 3-7

Cumulative DF for years 1-7 at 15% 4.160


Less: Cumulative DF for years 1-2 at 15% (1.626)
= Cumulative DF for years 3-7 at 15% 2.534

Present Value = $1,800 x 2.534 = $4,561


Further Learning

Advanced Annuity

i.e. the cash flow begins immediately (now)!!!...

Exercise – Jarvis Cocker Ltd

An investment will generate cash flows of $1,800 each year beginning now
and for 4 further years. The discount rate is 15% per annum.

What is the present value of the cash flows?


Answer to Exercise – Jarvis Cocker Ltd

Using PV tables:

CF$ DF 15% PV$


YR0 1,800 1.000 1,800
YR1 1,800 0.870 1,566
YR2 1,800 0.756 1,361
YR3 1,800 0.658 1,184
YR4 1,800 0.572 1,030
NPV 6,941

The addition of the


individual DFs is
OR: - equal to the 3.856
CF$ DF 15% PV$ discount factor!!!...
YR0-4 1,800 3.856 6,941
OR Answer to Exercise – Jarvis Cocker Ltd

Using cumulative PV (annuity) tables:

We require the 15% discount factor for years 1-4

Cumulative DF for years 1-4 at 15% 2.855


Add: 1.00 for the CF at YR0 1.000
= Cumulative DF for years 0-4 at 15% 3.855

Present Value = $1,800 x 3.855 = $6,939


Key Learning Points

 Compounding

 Discounting

 Calculating Present Value of a single cash flow

 Calculating the Present Value of an annuity (delayed and advanced)

 Calculating the Present Value of a perpetuity

 Use of Present Value table and Annuity tables


Further Reading

Arnold, G. Corporate Financial Management, 5th Edition. – Pages. 49 - 55


Corporate Finance
Compounding and Discounting

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