The Time Value Of Money

Introduction

This module introduces the concepts and skills necessary to understand the time value of money and its applications.

Learning Objectives
1. Construct cash flow timelines to organize your analysis of time value of money problems and learn three techniques for solving time value of money problems. 2. Understand compounding and calculate the future value of cash flow using mathematical formulas, financial tables and an Excel worksheet.
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Learning Objectives (cont.)

3. Understand discounting and calculate the present value of cash flows using mathematical formulas, financial tables and an Excel spreadsheet. 4. Understand how interest rates are quoted and how to make them comparable.

Learning Objectives
5. Distinguish between an ordinary annuity and an annuity due, and calculate present and future values of each.

6. Calculate the present value of a level perpetuity and a growing perpetuity.

7. Calculate the present and future values of complex cash flow streams.

The Time Value Concept

We know that receiving $1 today is worth more than $1 in the future. This is due to opportunity costs. The opportunity cost of receiving $1 in the future is the interest we could have earned if we had received the $1 sooner.
Today Future

If we can measure this opportunity cost, we can:

Translate $1 today into its equivalent in the future (compounding).

Today Future

Translate $1 in the future into its equivalent today (discounting).

Today

Future

Using Timelines to Visualize Cashflows

A timeline identifies the timing and amount of a stream of cash flows along with the interest rate.

A timeline is typically expressed in years, but it could also be expressed as months, days or any other unit of time.

Time Line Example

i=10%

0
Years Cash flow

1
$30 $20

2
-$10

3
$50

-$100

The 4-year timeline illustrates the following:

The interest rate is 10%. A cash outflow of $100 occurs at the beginning of the first year (at time 0), followed by cash inflows of $30 and $20 in years 1 and 2, a cash outflow of $10 in year 3 and cash inflow of $50 in year 4.

Checkpoint 5.1
Creating a Timeline Suppose you lend a friend $10,000 today to help him finance a new Jimmy Johns Sub Shop franchise and in return he promises to give you $12,155 at the end of the fourth year. How can one represent this as a timeline? Note that the interest rate is 5%.

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Checkpoint 5.1

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Checkpoint 5.1

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The Time Value of Money

Compounding and Discounting Single Sums

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Simple Interest and Compound Interest

What is the difference between simple interest and compound interest?

Simple interest: Interest is earned only on the principal amount. Compound interest: Interest is earned on both the principal and accumulated interest of prior periods.
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Simple Interest and Compound Interest (cont.)

Example 5.1: Suppose that you deposited $500 in your savings account that earns 5% annual interest. How much will you have in your account after two years using (a) simple interest and (b) compound interest?
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Simple Interest and Compound Interest (cont.)

Simple Interest Interest earned = 5% of $500 = .05500 = $25 per year Total interest earned = $252 = $50 Balance in your savings account: = Principal + accumulated interest = $500 + $50 = $550
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Simple Interest and Compound Interest (cont.)

Compound interest Interest earned in Year 1 = 5% of $500 = $25 Interest earned in Year 2 = 5% of ($500 + accumulated interest) = 5% of ($500 + 25) = .05525 = $26.25 Balance in your savings account: = Principal + interest earned = $500 + $25 + $26.25 = $551.25
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Present Value and Future Value

Time value of money calculations involve Present value (what a cash flow would be worth to you today) and Future value (what a cash flow will be worth in the future). In example 5.1, Present value is $500 and Future value is $551.25.

18

COMPOUNDING AND FUTURE VALUE

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Future Value Equation

Value at the end of year n for a sum compounded at interest rate i is: FVn = PV0 (1 + i)n

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Future Value Equation (cont.)

We can apply equation 5-1a to example 5.1 FV2 = PV(1+i)n 500(1.05)2 = = $551.25
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Future Value Equation (cont.)

Continue example 5.1 where you deposited $500 in savings account earning 5% annual interest. Show the amount of interest earned for the first five years and the value of your savings at the end of five years.
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Future Value Equation (cont.)

YEAR PV or Beginning Value Interest Earned (5%) FV or Ending Value

1
2 3 4 5

$500.00
$525.00 $551.25 $578.81 $607.75

$500*.05 = $25
$525*.05 = $26.25 $551.25*.05 =$27.56 $578.81*.05=$28.94 $607.75*.05=$30.39

$525
$551.25 $578.81 $607.75 $638.14

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Future Value Equation (cont.)

We will obtain the same answer using equation 5-1 i.e. FV = PV(1+i)n = 500(1.05)5 = $638.14 So the balance in savings account at the end of 5 years will equal $638.14. The total interest earned on the original principal amount of $500 will equal $138.14 (i.e. $638.14 minus $500.00).
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Tables have Three Variables

Interest factors (IF)

Time periods (n)

Interest rates per period (i) If you know any two, you can solve algebraically for the third variable.
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Solving By Table:

FV3 = PV0 (FVIF5%,5) = $500(1.2763) = $638.15

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Power of Time
Figure 5.1 Future Value and Compound Interest Illustrated

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Power of Interest Rate

Figure 5.1 Future Value and Compound Interest Illustrated

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What Do We Learn from Panel B and C of Figure 5-1?

1.

Power of Time: Future value of original investment increases with time. However, there will be no change in future value if the interest rate is equal to zero. Power of Rate of Interest: An increase in rate of interest leads to an increase in future value.
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2.

Checkpoint 5.2 - Calculating the Future Value of a Cash Flow

You are put in charge of managing your firms working capital. Your firm has $100,000 in extra cash on hand and decides to put it in a savings account paying 7% interest compounded annually. How much will you have in your account in 10 years?

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Checkpoint 5.2

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Checkpoint 5.2

32

Checkpoint 5.2

33

Checkpoint 5.2: Check Yourself

What is the future value of $10,000 compounded at 12% annually for 20 years?

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FV Applications in Other Areas

Example 5.2 A DVD rental firm is currently renting 8,000 DVDs per year. How many DVDs will the firm be renting in 10 years if the demand for DVD rentals is expected to increase by 7% per year? Using Equation 5-1a,

FV = 8000(1.07)10 = $15,737.21

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FV Applications in Other Areas (cont.)

Example 5.3 Your annual tuition at a State University is currently $20,000. If the tuition increases by 6% annually, what will be the annual cost of attending the State University in 25 years? FV =$20,000 (1.06)25
=

$85,837.41 per year

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Compound Interest with Shorter Compounding Periods

Banks frequently offer savings account that compound interest every day, month, or quarter.

More frequent compounding will generate higher interest income for the savers if the APR is the same.

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Compound Interest with Shorter Compounding Periods (cont.)

Example 5.4 You invest $500 for seven years to earn an annual interest rate of 8%, and the investment is compounded semi-annually. What will be the future value of this investment? We will use equation 5-1b to solve the problem. This equation adjusts the number of compounding periods and interest rate to reflect the semi-annual compounding.
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Compound Interest with Shorter Compounding Periods (cont.)

FV = PV(1+i/2)m*2 = 500(1+.08/2)7*2 = 500(1.7317) = $865.85

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Checkpoint 5.3 - Calculating Future Values Using Non-Annual Compounding Periods

You have been put in charge of managing your firms cash position and noticed that the Plaza National Bank of Portland, Oregon, has recently decided to begin paying interest compounded semi-annually instead of annually. If you deposit $1,000 with Plaza National Bank at an interest rate of 12%, what will your account balance be in five years?
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Checkpoint 5.3

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Checkpoint 5.3

43

Checkpoint 5.3: Check yourself

If you deposit $50,000 in an account that pays an annual interest rate of 10% compounded monthly, what will your account balance be in 10 years?

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DISCOUNTING AND PRESENT VALUE

Copyright 2011 Pearson Prentice Hall. All rights reserved.

The Key Question

What is value today of cash flow to be received in the future?

The answer to this question requires computing the present value i.e. the value today of a future cash flow, and the process of discounting, determining the present value of an expected future cash flow.

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PV Equation

The term in the bracket is known as the Present Value Interest Factor (PVIF).
PV = FVn PVIF

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PV Equation (cont.)

Example 5.5 How much will $5,000 to be received in 10 years be worth today if the interest rate is 7%?

PV = FV (1/(1+i)n )
= 5000 (1/(1.07)10) = 5000 (.5083) = $2,541.50

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Impact of Interest Rates on PV

If the interest rate (or discount rate) is higher (say 9%), the PV will be lower.

PV = 5000*(1/(1.09)10) = 5000*(0.4224) =$2,112.00

If the interest rate (or discount rate) is lower (say 2%), the PV will be higher.

PV = 5000*(1/(1.02)10) = 5000*(0.8203) = $4,101.50

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Checkpoint 5.4 - Solving for the Present Value of a Future Cash Flow
Your firm has just sold a piece of property for $500,000, but under the sales agreement, it wont receive the $500,000 until ten years from today. What is the present value of $500,000 to be received ten years from today if the discount rate is 6% annually?

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Checkpoint 5.4

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Checkpoint 5.4

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Checkpoint 5.4

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Checkpoint 5.4: Check Yourself

What is the present value of $100,000 to be received at the end of 25 years given a 5% discount rate?

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Solving for the Number of Periods

Key Question: How long will it take to accumulate a specific amount in the future?
It is easier to solve for n using the financial calculator or Excel rather than mathematical formula.

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Solving for the Number of Periods (cont.)

Example 5.6 How many years will it take for an investment of $7,500 to grow to $23,000 if it is invested at 8% annually?

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Solving for the Number of Periods (cont.)

Using a Financial Table

FVn = PV0 (FVIF8%,n)

23,000 = 7,500 (FVIF8%,n) FVIF8%,n = 23,500 / 7,500 = 3.1333 n = between 14 and 15 years

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Solving for the Number of Periods (cont.)

Using an Excel Spreadsheet

N = NPER(rate,pmt,pv,fv)
= NPER(0.08,0,-7500,23000) = 14.56

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Checkpoint 5.5 - Solving for the Number of Periods, n

Lets assume that the Toyota Corporation has guaranteed that the price of a new Prius will always be $20,000, and youd like to buy one but currently have only $7,752. How many years will it take for your initial investment of $7,752 to grow to $20,000 if it is invested so that it earns 9% compounded annually?
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Checkpoint 5.5

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Checkpoint 5.5

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Checkpoint 5.5: Check Yourself

How many years will it take for $10,000 to grow to $200,000 given a 15% compound growth rate?

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Rule of 72

Rule of 72 is an approximate formula to determine the number of years it will take to double the value of your investment.

Rule of 72 N = 72/interest rate

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Rule of 72 (cont.)

Example 5.7 Using Rule of 72, determine how long it will take to double your investment of $10,000 if you are able to generate an annual return of 9%. N = 72/interest rate N = 72/9 = 8 years

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Solving for Rate of Interest

Key Question: What rate of interest will allow your investment to grow to a desired future value?

We can determine the rate of interest using mathematical equation, the financial calculator or the Excel spread sheet.

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Solving for Rate of Interest (cont.)

Example 5.8 At what rate of interest must your savings of $10,000 be compounded annually for it to grow to $22,000 in 8 years?

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Solving for Rate of Interest (cont.)

Using Mathematical Formula:

I = (FV/PV)1/n - 1 = (22000/10000)1/8 - 1 = (2.2).125 - 1 = 1.1035 1 = .1035 or 10.35%

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Solving for Rate of Interest (cont.)

Using a Financial Table

FVn = PV0 (FVIFi%,8)

22,000 = 10,000 (FVIFi%,8) FVIFi%,8 = 22,000 / 10,000 = 2.2 i = between 10% and 11%

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Solving for Rate of Interest (cont.)

Using an Excel Spreadsheet =Rate(nper,pmt,pv,fv) =Rate(8,0,-10000,22000) =10.36%

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Checkpoint 5.6 - Solving for the Interest Rate, i

Lets go back to that Prius example in Checkpoint 5.5. Recall that the Prius always costs $20,000. In 10 years, youd really like to have $20,000 to buy a new Prius, but you only have $11,167 now. At what rate must your $11,167 be compounded annually for it to grow to $20,000 in 10 years?
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Checkpoint 5.6

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Checkpoint 5.6

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Checkpoint 5.6

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Checkpoint 5.6: Check yourself

At what rate will $50,000 have to grow to reach $1,000,000 in 30 years?

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MAKING INTEREST RATES COMPARABLE

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Annual Percentage Rate (APR)

The annual percentage rate (APR) indicates the amount of interest paid or earned in one year without compounding. APR is also known as the nominal or stated interest rate. This is the rate required by law.

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Comparing Loans using EAR

We cannot compare two loans based on APR if they do not have the same compounding period. To make them comparable, we calculate their equivalent rate using an annual compounding period. We do this by calculating the effective annual rate (EAR)

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Comparing Loans using EAR (cont.)

Example 5.9 Calculate the EAR for a loan that has a 5.45% quoted annual interest rate compounded monthly.

EAR = [1+.0545/12]12 - 1 = 1.0558 1 = .05588 or 5.59%

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Checkpoint 5.7 - Calculating an EAR or Effective Annual Rate

Assume that you just received your first credit card statement and the APR, or annual percentage rate listed on the statement, is 21.7%. When you look closer you notice that the interest is compounded daily. What is the EAR, or effective annual rate, on your credit card?

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Checkpoint 5.7

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Checkpoint 5.7

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Checkpoint 5.7: Check yourself

What is the EAR on a quoted or stated rate of 13% that is compounded monthly?

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Continuous Compounding

When the time intervals between when interest is paid are infinitely small, we can use the following mathematical formula to compute the EAR. EAR = (e quoted rate ) 1

Where e is the number 2.71828

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Continuous Compounding (cont.)

Example 5.10 What is the EAR on your credit card with continuous compounding if the APR is 18%?

EAR = e.18 - 1 = 1.1972 1 = .1972 or 19.72%

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Annuities

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Ordinary Annuities

An annuity is a series of equal dollar payments that are made at the end of equidistant points in time such as monthly, quarterly, or annually over a finite period of time. If payments are made at the end of each period, the annuity is referred to as ordinary annuity.
87

Ordinary Annuities (cont.)

Example 6.1 How much money will you accumulate by the end of year 10 if you deposit $3,000 each for the next ten years in a savings account that earns 5% per year? We can determine the answer by using the equation for computing the future value of an ordinary annuity.
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The Future Value of an Ordinary Annuity

FVn = FV of annuity at the end of nth period. PMT = annuity payment deposited or received at the end of each period i = interest rate per period n = number of periods for which annuity will last
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The Future Value of an Ordinary Annuity (cont.)

FV = $3000 {[ (1+.05)10 - 1]

(.05)}

= $3,000 { [0.63] (.05) } = $3,000 {12.58} = $37,740

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The Future Value of an Ordinary Annuity (cont.)

Using a Financial Table FV = $3000 (FVIFA5%,10)

= $3,000 (12.5779) = $37,734

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The Future Value of an Ordinary Annuity (cont.)

Using an Excel Spreadsheet

FV of Annuity

= FV(rate, nper,pmt, pv) =FV(.05,10,-3000,0) = $37,733.68

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Solving for PMT in an Ordinary Annuity

Instead of figuring out how much money you will accumulate (i.e. FV), you may like to know how much you need to save each period (i.e. PMT) in order to accumulate a certain amount at the end of n years. In this case, we know the values of n, i, and FVn in equation 6-1c and we need to determine the value of PMT.
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Solving for PMT in an Ordinary Annuity (cont.)

Example 6.2: Suppose you would like to have $25,000 saved 6 years from now to pay towards your down payment on a new house. If you are going to make equal annual end-of-year payments to an investment account that pays 7 per cent, how big do these annual payments need to be?
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Solving for PMT in an Ordinary Annuity (cont.)

Here we know, FVn = $25,000; n = 6; and i=7% and we need to determine PMT.

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Solving for PMT in an Ordinary Annuity (cont.)

$25,000 = PMT

{[ (1+.07)

- 1]

(.07)}

= PMT{ [.50] (.07) } = PMT {7.153}

$25,000 7.153 = PMT = $3,495.03

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Checkpoint 6.1 - Solving for an Ordinary Annuity Payment

How much must you deposit in a savings account earning 8% annual interest in order to accumulate $5,000 at the end of 10 years? Lets solve this problem using the mathematical formulas, a financial calculator, and an Excel spreadsheet.
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Checkpoint 6.1

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Checkpoint 6.1

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Checkpoint 6.1

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Checkpoint 6.1: Check Yourself

If you can earn 12 percent on your investments, and you would like to accumulate $100,000 for your childs education at the end of 18 years, how much must you invest annually to reach your goal?

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Solving for Interest Rate in an Ordinary Annuity

You can also solve for interest rate you must earn on your investment that will allow your savings to grow to a certain amount of money by a future date. In this case, we know the values of n, PMT, and FVn in equation 6-1c and we need to determine the value of i.

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Solving for Interest Rate in an Ordinary Annuity

Example 6.3: In 20 years, you are hoping to have saved $100,000 towards your childs college education. If you are able to save $2,500 at the end of each year for the next 20 years, what rate of return must you earn on your investments in order to achieve your goal?

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Solving for Interest Rate in an Ordinary Annuity (cont.)

Using the Mathematical Formula

$100,000 = $2,500

{[ (1+i)
(i)}

20

- 1]

(i)}]

40 =

{[ (1+i)

20

- 1]

The only way to solve for i mathematically is by trial and error.

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Solving for Interest Rate in an Ordinary Annuity (cont.)

We will have to substitute different numbers for i until we find the value of i that makes the right hand side of the expression equal to 40.

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Solving for Interest Rate in an Ordinary Annuity (cont.)

Using a Financial Table

FV = PMT (FVIFAi%,20)

100,000 = 2,500 (FVIFAi%,20) FVIFAi%,20 = 40 i = 6% to 7%

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Solving for Interest Rate in an Ordinary Annuity (cont.)

Using an Excel Spreadsheet

i = Rate (nper, PMT, pv, fv) = Rate (20, 2500,0, 100000) = 6.77%

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Solving for the Number of Periods in an Ordinary Annuity

You may want to calculate the number of periods it will take for an annuity to reach a certain future value, given interest rate.

It is easier to solve for number of periods using financial calculator or excel, rather than mathematical formula.

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Solving for the Number of Periods in an Ordinary Annuity (cont.)

Example 6.4: Suppose you are investing $6,000 at the end of each year in an account that pays 5%. How long will it take before the account is worth $50,000?

109

Solving for the Number of Periods in an Ordinary Annuity (cont.)

Using a Financial Table FV = PMT (FVIFA5%,n)

50,000 = 6,000 (FVIFA5%,n) FVIFA5%,n = 8.3333 i = 7 to 8 years

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Solving for the Number of Periods in an Ordinary Annuity (cont.)

Using an Excel Spreadsheet n = NPER(rate, pmt, pv, fv) n = NPER(5%,-6000,0,50000) n = 7.14 years
Thus it will take 7.13 years for annual deposits of $6,000 to grow to $50,000 at an interest rate of 5%
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The Present Value of an Ordinary Annuity

The present value of an ordinary annuity measures the value today of a stream of cash flows occurring in the future.

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The Present Value of an Ordinary Annuity (cont.)

For example, we will compute the PV of ordinary annuity if we wish to answer the question: what is the value today or lump sum equivalent of receiving $3,000 every year for the next 30 years if the interest rate is 5%?
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The Present Value of an Ordinary Annuity (cont.)

Figure 6-2 shows the lump sum equivalent ($2,106.18) of receiving $500 per year for the next five years at an interest rate of 6%.

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115

The Present Value of an Ordinary Annuity (cont.)

PMT = annuity payment deposited or received at the end of each period. i = discount rate (or interest rate) on a per period basis. n = number of periods for which the annuity will last.
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The Present Value of an Ordinary Annuity (cont.)

Note , it is important that n and i match. If periods are expressed in terms of number of monthly payments, the interest rate must be expressed in terms of the interest rate per month.

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Checkpoint 6.2 - The Present Value of an Ordinary Annuity

Your grandmother has offered to give you $1,000 per year for the next 10 years. What is the present value of this 10-year, $1,000 annuity discounted back to the present at 5 percent? Lets solve this using the mathematical formula, a financial calculator, and an Excel spreadsheet.
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Checkpoint 6.2

119

Checkpoint 6.2

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Checkpoint 6.2: Check Yourself

What is the present value of an annuity of $10,000 to be received at the end of each year for 10 years given a 10 percent discount rate?

121

Amortized Loans

An amortized loan is a loan paid off in equal payments consequently, the loan payments are an annuity.

Examples: Home mortgage loans, Auto loans

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Amortized Loans (cont.)

In an amortized loan, the present value can be thought of as the amount borrowed, n is the number of periods the loan lasts for, i is the interest rate per period, future value takes on zero because the loan will be paid of after n periods, and payment is the loan payment that is made.

123

Amortized Loans (cont.)

Example 6.5 Suppose you plan to get a $9,000 loan from a furniture dealer at 18% annual interest with annual payments that you will pay off in over five years. What will your annual payments be on this loan?

124

Amortized Loans (cont.)

Using a Financial Table PV = PMT (PVIFA18%,5)

9,000 = PMT (3.1272) PMT = $2,878

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The Loan Amortization Schedule

Year Amount Owed on Principal at the Beginning of the Year (1) Annuity Payment (2) Interest Portion of the Annuity (3) = (1) 18% Repayment of the Principal Portion of the Annuity (4) = (2) (3) $1,258.00 $1,484.44 Outstanding Loan Balance at Year end, After the Annuity Payment (5) =(1) (4) $7,742.00 $6,257.56

1 2

$9,000 $7,742

$2,878 $2,878

$1,620.00 $1,393.56

3
4 5

$6257.56
$4,505.92 $2,438.98

$2,878
$2,878 $2,878

$1,126.36
$811.07 $439.02

$1,751.64
$2,066.93 $2,438.98

$4,505.92
$2,438.98 $0.00

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The Loan Amortization Schedule (cont.)

We can observe the following from the table:

Size of each payment remains the same. However, Interest payment declines each year as the amount owed declines and more of the principal is repaid.

127

Amortized Loans with Monthly Payments

Many loans such as auto and home loans require monthly payments. This requires converting n to number of months and computing the monthly interest rate.

128

Amortized Loans with Monthly Payments (cont.)

Example 6.6 You have just found the perfect home. However, in order to buy it, you will need to take out a $300,000, 30year mortgage at an annual rate of 6 percent. What will your monthly mortgage payments be?

129

Amortized Loans with Monthly Payments (cont.)

Mathematical Formula

Here annual interest rate = .06, number of years = 30, m=12, PV = $300,000
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Amortized Loans with Monthly Payments (cont.)

1- 1/(1+.06/12)360
.06/12

$300,000= PMT x

$300,000 = PMT [166.79] $300,000 166.79 = $1798.67

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Checkpoint 6.3 - Determining the Outstanding Balance of a Loan

Lets say that exactly ten years ago you took out a $200,000, 30-year mortgage with an annual interest rate of 9 percent and monthly payments of $1,609.25. But since you took out that loan, interest rates have dropped. You now have the opportunity to refinance your loan at an annual rate of 7 percent over 20 years. You need to know what the outstanding balance on your current loan is so you can take out a lowerinterest-rate loan and pay it off. If you just made the 120th payment and have 240 payments remaining, whats your current loan balance?
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Checkpoint 6.3

133

Checkpoint 6.3

134

Checkpoint 6.3

135

Checkpoint 6.3: Check Yourself

Lets assume you took out a $300,000, 30-year mortgage with an annual interest rate of 8%, and monthly payment of $2,201.29. Since you have made 15 years worth of payments, there are 180 monthly payments left before your mortgage will be totally paid off. How much do you still owe on your mortgage?
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Annuities Due

Annuity due is an annuity in which all the cash flows occur at the beginning of the period. For example, rent payments on apartments are typically annuity due as rent is paid at the beginning of the month.
137

Annuities Due: Future Value

Computation of future value of an annuity due requires compounding the cash flows for one additional period, beyond an ordinary annuity.

138

Annuities Due: Future Value (cont.)

Recall Example 6.1 where we calculated the future value of 10-year ordinary annuity of $3,000 earning 5 per cent to be $37,734. What will be the future value if the deposits of $3,000 were made at the beginning of the year i.e. the cash flows were annuity due?
139

Annuities Due: Future Value (cont.)

FV = $3000 {[ (1+.05)10 - 1] (.05)} (1.05)

= $3,000 { [0.63] (.05) } (1.05) = $3,000 {12.58}(1.05) = $39,620

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Annuities Due: Present Value

Since with annuity due, each cash flow is received one year earlier, its present value will be discounted back for one less period.

141

Annuities Due: Present Value (cont.)

Recall checkpoint 6.2 Check yourself problem where we computed the PV of 10year ordinary annuity of $10,000 at a 10 percent discount rate to be equal to $61,446. What will be the present value if $10,000 is received at the beginning of each year i.e. the cash flows were annuity due?
142

Annuities Due: Present Value (cont.)

PV = $10,000 { 1-(1/(1.10)10]

(.10)} (1.1)

= $10,000 {[ 0.6144] (.10)}(1.1) = $10,000 {6.144) (1.1) = $ 67,590

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Annuities Due

The examples illustrate that both the future value and present value of an annuity due are larger than that of an ordinary annuity because, in each case, all payments are received or paid earlier.
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Perpetuities

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Perpetuities

A perpetuity is an annuity that continues forever or has no maturity. For example, a dividend stream on a share of preferred stock. There are two basic types of perpetuities:

Growing perpetuity in which cash flows grow at a constant rate, g, from period to period. Level perpetuity in which the payments are constant rate from period to period.
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Present Value of a Level Perpetuity

PV = the present value of a level perpetuity PMT = the constant dollar amount provided by the perpetuity i = the interest (or discount) rate per period
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Present Value of a Level Perpetuity

Example 6.6 What is the present value of $600 perpetuity at 7% discount rate?

PV = $600 .07 = $8,571.43

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Checkpoint 6.4
The Present Value of a Level Perpetuity What is the present value of a perpetuity of $500 paid annually discounted back to the present at 8 percent?

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Checkpoint 6.4

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Checkpoint 6.4

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Checkpoint 6.4: Check Yourself

What is the present value of stream of payments equal to $90,000 paid annually and discounted back to the present at 9 percent?

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Present Value of a Growing Perpetuity

In growing perpetuities, the periodic cash flows grow at a constant rate each period. The present value of a growing perpetuity can be calculated using a simple mathematical equation.
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Present Value of a Growing Perpetuity (cont.)

PV = Present value of a growing perpetuity PMTperiod 1 = Payment made at the end of first period i = rate of interest used to discount the growing perpetuitys cash flows g = the rate of growth in the payment of cash flows from period to period
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Checkpoint 6.5 - The Present Value of a Growing Perpetuity

What is the present value of a perpetuity stream of cash flows that pays $500 at the end of year one but grows at a rate of 4% per year indefinitely? The rate of interest used to discount the cash flows is 8%.

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Checkpoint 6.5

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Checkpoint 6.5

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Checkpoint 6.5: Check Yourself

What is the present value of a stream of payments where the year 1 payment is $90,000 and the future payments grow at a rate of 5% per year? The interest rate used to discount the payments is 9%.

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Complex Cash Flow Streams

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Complex Cash Flow Streams

The cash flows streams in the business world may not always involve one type of cash flows. The cash flows may have a mixed pattern. For example, different cash flow amounts mixed in with annuities. For example, figure 6-4 summarizes the cash flows for Marriott.

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Complex Cash Flow Streams (cont.)

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Complex Cash Flow Streams (cont.)

In this case, we can find the present value of the project by summing up all the individual cash flows by proceeding in four steps: 1. Find the present value of individual cash flows in years 1, 2, and 3. 2. Find the present value of ordinary annuity cash flow stream from years 4 through 10. 3. Discount the present value of ordinary annuity (step 2) back three years to the present. 4. Add present values from step 1 and step 3.
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Checkpoint 6.6 - The Present Value of a Complex Cash Flow Stream

What is the present value of cash flows of $500 at the end of years through 3, a cash flow of a negative $800 at the end of year 4, and cash flows of $800 at the end of years 5 through 10 if the appropriate discount rate is 5%?
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Checkpoint 6.6

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Checkpoint 6.6

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Checkpoint 6.6

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Checkpoint 6.6

Step 3 cont.

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Checkpoint 6.6

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Checkpoint 6.6

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Checkpoint 6.6: Check Yourself

What is the present value of cash flows of $300 at the end of years 1 through 5, a cash flow of negative $600 at the end of year 6, and cash flows of $800 at the end of years 7-10 if the appropriate discount rate is 10%?
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