Lecture Time Value of Money

Time Value of Money

Used for valuing: Evaluate investment alternatives Plan for retirement Estimate estate needs Make credit decisions Planning Insurance purchases

TIME VALUE OF MONEY

BASIC PROBLEM FACED BY FINANCIAL MANAGER IS

HOW TO VALUE FUTURE CASH FLOWS?

For example:

I HAVE TO SPEND MONEY TODAY TO BUILD A PLANT WHICH WILL GENERATE CASH FLOWS IN THE FUTURE

Time Value of Money An Important Concept

Even if we did not have inflation, a dollar received in the future is worth less than a dollar received today. An obligation to pay a dollar in the future is less costly than paying a dollar today.

Why TIME?
TIME allows one the opportunity to postpone consumption and earn INTEREST. NOT having the opportunity to earn interest on money is called OPPORTUNITY COST.

WHAT DETERMINES TRADE - OFF BETWEEN CURRENT DOLLARS AND FUTURE DOLLARS? HOW MUCH I CAN EARN ON THE MONEY DURING THE YEAR
The opportunity cost of capital (k)

How can one compare amounts in different time periods?

One can adjust values from different time periods using the opportunity cost of capital (k). Remember, one CANNOT compare numbers in different time periods without first adjusting them using the opportunity cost of capital (k).

The opportunity cost of capital (k)

Measure the time value of money Take also into consideration the risk of the investment decision alternatives Basic Formula: K = Rf + premium risk
Rf = nominal risk-free rate

The opportunity cost of capital (k)

Depend on the type of investment alternatives: Bank deposits interest rate; A company stocks company or activity sector returns and so forth.

Taking into consideration the time value of money. FUTURE VALUE PRESENT VALUE
COMPOUND PRINCIPAL AMOUNT FORWARD INTO THE FUTURE DISCOUNT A FUTURE VALUE BACK TO THE PRESENT

Future Value
The amount to which a cash flow or series of cash flows will grow over a period of time when compounded at a given opportunity cost .

Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest. FV = Principal + (Principal x Interest) = PV (1 + k) = 2000 (1 + k) = 2000 + (2000 x .06)

Note: PV refers to Present Value or Principal

Future Value (Graphic)

If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

6%

$2,000
FV

Future Value (Formula)

FV1 = PV (1+k)n = $2,000 (1.06)2 = $2,247.20
FV = PV = k = n = future value, a value at some future point in time present value, a value today which is usually designated as time 0 rate of interest per compounding period number of compounding periods

FUTURE VALUE OF $1
20 18
16

15

14 12 10

Year 1 2 5 10 20

FUTURE VALUE 10% 5% 1.100 1.050 1.210 1.103 1.331 1.276 2.594 1.629 6.727 2.653

15% 1.150 1.323 2.011 4.046 16.37

10 8
6

k = 15% k = 10%

k = 5%

00
0 0

5 4

10 8

10

15 12

14

20 16

18

25 20

Year YEARS

Frequency of Compounding
General Formula: FVn = PV0(1 + [k/m])mn
n: m: k: FVn,m: PV0: Number of Years Compounding Periods per Year Annual Interest Rate FV at the end of Year n PV of the Cash Flow today

Frequency of Compounding Example

Suppose you deposit $1,000 in an account that pays 12% interest, compounded quarterly. How much will be in the account after eight years if there are no withdrawals? PV = $1,000 k = 12%/4 = 3% per quarter n = 8 x 4 = 32 quarters Answer: FV= PV (1 + k)n = 1,000(1.03)32 = 2,575.10

Compounding Annually vs. Semi-Annually

0 100 133.10 Annually: FV3 = 100(1.10)3 = 133.10. 0 1 2 0 5% 1 2 3 4 5 3 6 10% 1 2 3

100

134.01

Semi-annually: FV6/2 = 100(1.05)6 = 134.01.

Distinguishing Between Different Interest Rates

kSIMPLE = Simple (Quoted) Rate used to compute the interest paid per period EAR = Effective Annual Rate the annual rate of interest actually being earned APR = Annual Percentage Rate = kSIMPLE periodic rate X the number of periods per year

How do we find EAR for a simple rate of 10%, compounded semi-annually?

m

k SIMPLE EAR = 1 + m
2

-1

0.10 = 1 + - 1.0 2 =  1.05 - 1.0 = 0.1025 = 10.25%

2

FV of $100 after 3 years if interest is 10% compounded semi-annual? Quarterly?

k SIMPLE FVn = PV1 + m
FV3v2 FV3v4 0.10 = $1001 + 2
2v3

mvn

! $100(1.34010) ! $134.01
4v3

0.10 = $1001 + 4

! $100(1.34489) ! $134.49

Future Value of an Annuity

Annuity: A series of payments of equal amounts at fixed intervals for a specified number of periods. Ordinary (deferred) Annuity: An annuity whose payments occur at the end of each period. Annuity Due: An annuity whose payments occur at the beginning of each period.

Ordinary Annuity Versus Annuity Due

Ordinary Annuity 0 k% 1 PMT Annuity Due 0 k% PMT 1 2 PMT 2 3 PMT 3

PMT

PMT

Whats the FV of a 3-year Ordinary Annuity of $100 at 10%?

0 1 2 3

10%

100

100

100 110 121

FV

= 331

Numerical Solution:
(1  k) n  1 n1 t FVA n ! PMT (1  k) ! PMT k t !0 (1.10) 3  1 FVA 3 ! $100 0.10 ! $100(3.31000) ! $331.00

Present Value
Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given opportunity cost.

Present Values
How much do I have to invest today to have some amount in the future? FV = PV(1 + k)t Rearrange to solve for PV = FV / (1 + k)t When we talk about discounting, we mean finding the present value of some future amount. When we talk about the value of something, we are talking about the present value unless we specifically indicate that we want the future value.

Present Value (Graphic)

Assume that you need to have exactly $4,000 saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?

6%

10

$4,000
PV0

Present Value (Formula)

PV0 = FV / (1+k)10 = $2,233.58 = $4,000 / (1.06)10

6%

10

$4,000
PV0

PRESENT VALUE OF $1 1,2

1 0,8 0,6

PRESENT VALUE Year 1 2 5 10 20 5% .952 .907 .784 .614 .377 10% .909 .826 .621 .386 .149 15% .870 .756 .497 .247 .061

k = 5%

0,4 0,2 0 0 2

k = 15% k = 10%

10

12

14

16

18

20

YEARS

Present Value of an Annuity

PVAn = the present value of an annuity with n payments. Each payment is discounted, and the sum of the discounted payments is the present value of the annuity.

What is the PV of this Ordinary Annuity?

0 10% 100 100 100 1 2 3

90.91 82.64 75.13 248.69 = PV

Numerical Solution
1 - 1 n 1 (1k) PVA n ! PMT ! PMT t k t !1 (1  k)
n

1 - 1 3 (1.10) PVA 3 ! $100 0.10 ! $100(2.48685) ! $248.69

Short Cuts
Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly.

SHORTCUTS FOR

1. PERPETUITIES 2. GROWING PERPETUITIES 3. ANNUITIES

PVAn =

PMT 1 PMT2 PMTn   .......  2 (1  k ) (1  k ) (1  k )n

1. PERPETUITIES

PMT PVAn = k

2. GROWING PERPETUITIES 3. ANNUITIES

1 1 n (1  k ) PVAn ! PMT k

PMT1 PVAn ! kg

Quick Quiz (I)

 All other things being equal, I'd rather have $1,000 today than to receive $1,000 in 10 years. A.True B.False  Comparing the values of undiscounted cash flows is analogous to comparing apples to oranges. A.True B.False  Compound interest pays interest for each time period on the original investment only. A.True B.False

Quick Quiz (II)

 Finding the present value is simply the reverse of compounding. A.True B.False  For a given amount, the greater the discount rate, the less the present value. A.True B.False  If you would like to double your money in 8 years, the approximate compound annual return you need is 9 percent A.True B.False

Quick Quiz (III)

A How much must you deposit today in a bank account paying interest compounded quarterly: If you wish to have $6,000 at the end of 12 months, if the bank pays 9.0% APR? Answer: $5,489 A How much must you deposit today in a bank account paying interest compounded monthly: If you wish to have: 6,000 at the end of 6 months, if the bank pays 9.0% APR ? Answer: 5,737

Quick Quiz (IV)

 Suppose you make an investment of $1,000. This first year the investment returns 12%, the second year it returns 6%, and the third year in returns 8%. How much would this investment be worth, assuming no withdrawals are made? Answer: 1000*(1.12) x (1.06) x (1.08) = $1,282  How much would you need to deposit every month in an account paying 6% a year to accumulate by $1,000,000 by age 65 beginning at age 20? Answer: PMT = $362.85

Quick Quiz (V)

As a winner of a local competition, you can choose one of the following prizes: (a) $100,000 now (b) $180,000 at the end of 4 years (c) $11,400 a year forever (d) $19,000 for each of 10 years (e) $6,500 next year and increasing thereafter by 5% a year forever
If the interest rate is 12%, which is the most valuable prize?

Quick Quiz (VI)

Your firm has a retirement plan that matches all contributions on a one to two basis. That is, if you contribute $1,000 per year, the company will add $500 to make it $1,500. The firm guarantees 8% return on the funds. Alternatively, you can do it yourself; you think you can earn 11% on your money by doing it yourself. The first contribution will be made one year from today. At that time, and every year thereafter, you will put $1,000 into the retirement account. If you want to retire in 25 years, which way are you better off?

Quick Quiz (VII)

 A typical mortgage problem. You borrow $80,000 to be repaid in equal monthly installments for 30 years. The APR is 9%. What is the monthly payment? Answer: PMT = $643.70  You will receive $100,000 dollars when you retire, forty years from today. If inflation averages 3% per year for the next forty years, how much would that amount be worth measured in today's dollars? (Note, this is not a time value of money problem, but it solved with a similar calculation. Such adjustments are necessary to overcome money illusion] Answer: $100,000 (1.03)^40 =100,000 3.26204 = $ 30,655

Quick Quiz (VIII)

 You will receive $100,000 dollars when you retire, forty years from today. If inflation averages 3% per year for the next forty years, how much would that amount be worth measured in today's dollars? (Note, this is not a time value of money problem, but it solved with a similar calculation. Such adjustments are necessary to overcome money illusion] Answer : $100,000 (1.03)40 =100,000 3.26204 = $ 30,655