LECTURE 3
TIME VALUE OF MONEY
Ross, S. A., Westerfield, R. W. & Jordan B.D. (2013): Ch 5
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Key Concepts and Skills
Be able to compute the future value of an investment made
today
Be able to compute the present value of cash to be received at
some future date
Be able to compute the return on an investment
Be able to compute the number of periods that equates a
present value and a future value given an interest rate
Be able to use a financial calculator and a spreadsheet to solve
time value of money problems
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Lecture Outline
Future Value versus Present Value
Future Value of a Single Amount
Basic Patterns of Cash Flow
Future Value of a Single Amount
Present Value of a Single Amount
Annuities
Finding the Future Value of an Ordinary Annuity
Finding the Present Value of an Ordinary Annuity
Finding the Future Value of an Annuity Due
Finding the Present Value of an Annuity Due
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Lecture Outline
Finding the Present Value of a Perpetuity
Future Value of a Mixed Stream
Present Value of a Mixed Stream
Compounding Interest More Frequently Than Annually
Continuous Compounding
Nominal and Effective Annual Rates of Interest
Special Applications of Time Value
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Future Value versus Present Value
Suppose a firm has an opportunity to spend $15,000 today on
some investment that will produce $17,000 spread out over the
next five years as follows:
Year Cash flow
1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000
Is this a wise investment?
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Future Value versus Present Value (cont.)
To make the right investment decision, managers need to
compare the cash flows at a single point in time.
Figure 3.1 Time Line
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Future Value versus Present Value (cont.)
When making investment decisions, managers usually
calculate present value.
Figure 3.2 Compounding and Discounting
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Basic Patterns of Cash Flow
The three basic patterns of cash flows include:
• A single amount: A lump sum amount either held
currently or expected at some future date.
• An annuity: A level periodic stream of cash flow.
• A mixed stream: A stream of unequal periodic cash
flows.
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Future Value of a Single Amount
Future value is the value at a given future date of an
amount placed on deposit today and earning interest at
a specified rate. Found by applying compound interest
over a specified period of time.
Compound interest is interest that is earned on a
given deposit and has become part of the principal at
the end of a specified period.
Principal is the amount of money on which interest is
paid.
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Personal Finance Example
If Fred Moreno places $100 in a savings account paying 8%
interest compounded annually, how much will he have at
the end of 1 year?
Future value at end of year 1 = $100 (1 + 0.08) = $108
If Fred were to leave this money in the account for another
year, how much would he have at the end of the second
year?
Future value at end of year 2= $100 (1 + 0.08) (1 + 0.08)
= $116.64
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Future Value of a Single Amount: The
Equation for Future Value
We use the following notation for the various inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial
calculators, I is typically used to represent this rate.)
– n = number of periods (typically years) that the
money is left on deposit
The general equation for the future value at the end of
period n is
FVn = PV (1 + r)n
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Future Value of a Single Amount: The Equation
for Future Value
Jane Farber places $800 in a savings account paying 6% interest
compounded annually. She wants to know how much money will be in the
account at the end of five years.
FV5 = $800 (1 + 0.06)5 = $800 (1.33823) = $1,070.58
This analysis can be depicted on a time line as follows:
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Figure 3.3
Future Value Relationship
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Present Value of a Single Amount
Present value is the current dollar value of a future
amount—the amount of money that would have to be
invested today at a given interest rate over a specified
period to equal the future amount.
It is based on the idea that a dollar today is worth more
than a dollar tomorrow.
Discounting cash flows is the process of finding
present values; the inverse of compounding interest.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return,
or the cost of capital.
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Present Value of a Single Amount: The
Equation for Present Value
The present value, PV, of some future amount, FVn, to be
received n periods from now, assuming an interest rate
(or opportunity cost) of r, is calculated as follows:
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Present Value of a Single Amount: The Equation
for Future Value
Pam Valenti wishes to find the present value of $1,700 that will
be received 8 years from now. Pam’s opportunity cost is 8%.
PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
This analysis can be depicted on a time line as follows:
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Annuities
An annuity is a stream of equal periodic cash flows, over
a specified time period. These cash flows can be inflows of
returns earned on investments or outflows of funds
invested to earn future returns.
– An ordinary (deferred) annuity is an annuity for
which the cash flow occurs at the end of each period
– An annuity due is an annuity for which the cash
flow occurs at the beginning of each period.
– An annuity due will always be greater than an
otherwise equivalent ordinary annuity because
interest will compound for an additional period.
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Table 3.1 Comparison of Ordinary Annuity and Annuity
Due Cash Flows ($1,000, 5 Years)
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Finding the Future Value of an Ordinary Annuity
You can calculate the future value of an ordinary
annuity that pays an annual cash flow equal to CF by
using the following equation:
As before, in this equation r represents the interest rate
and n represents the number of payments in the
annuity (or equivalently, the number of years over
which the annuity is spread).
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Personal Finance Example
Fran Abrams wishes to determine how much money she will have at
the end of 5 years if he chooses annuity A, the ordinary annuity and
it earns 7% annually. Annuity A is depicted graphically below:
This analysis can be depicted on a time line as follows:
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Finding the Present Value of an Ordinary
Annuity
You can calculate the present value of an ordinary
annuity that pays an annual cash flow equal to CF by
using the following equation:
As before, in this equation r represents the interest rate
and n represents the number of payments in the
annuity (or equivalently, the number of years over
which the annuity is spread).
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Finding the Present Value of an Ordinary
Annuity (cont.)
Braden Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of $700 at the end
of each year for 5 years. The firm requires the annuity to
provide a minimum return of 8%.
This situation can be depicted on a time line as follows:
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Table 3.2 Long Method for Finding the Present
Value of an Ordinary Annuity
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Finding the Future Value of an Annuity Due
You can calculate the present value of an annuity due
that pays an annual cash flow equal to CF by using the
following equation:
As before, in this equation r represents the interest rate
and n represents the number of payments in the
annuity (or equivalently, the number of years over
which the annuity is spread).
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Personal Finance Example
Fran Abrams now wishes to choose between an ordinary annuity and
an annuity due, both offering similar terms except the timing of cash
flows. We have already calculated the value of the ordinary annuity,
but need to calculate the value of an annuity due.
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Personal Finance Example (cont.)
Future value of ordinary Future value of annuity
annuity due
$5,705.74 $6,153.29
The future value of an annuity due is always higher than the
future value of an ordinary annuity.
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Finding the Present Value of an Annuity
Due
You can calculate the present value of an ordinary
annuity due that pays an annual cash flow equal to CF
by using the following equation:
As before, in this equation r represents the interest rate
and n represents the number of payments in the
annuity (or equivalently, the number of years over
which the annuity is spread).
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Matter of Fact
Kansas truck driver, Donald Damon, got the surprise of his
life when he learned he held the winning ticket for the
Powerball lottery drawing held November 11, 2009. The
advertised lottery jackpot was $96.6 million. Damon could
have chosen to collect his prize in 30 annual payments of
$3,220,000 (30 $3.22 million = $96.6 million), but
instead he elected to accept a lump sum payment of
$48,367,329.08, roughly half the stated jackpot total.
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Finding the Present Value of a Perpetuity
A perpetuity is an annuity with an infinite life,
providing continual annual cash flow.
If a perpetuity pays an annual cash flow of CF,
starting one year from now, the present value
of the cash flow stream is
PV = CF ÷ r
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Personal Finance Example
Ross Clark wishes to endow a chair in finance at his alma
mater. The university indicated that it requires $200,000
per year to support the chair, and the endowment would
earn 10% per year. To determine the amount Ross must
give the university to fund the chair, we must determine
the present value of a $200,000 perpetuity discounted at
10%.
PV = $200,000 ÷ 0.10 = $2,000,000
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Future Value of a Mixed Stream
Shrell Industries, a cabinet manufacturer, expects to receive
the following mixed stream of cash flows over the next 5 years
from one of its small customers.
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Future Value of a Mixed Stream
If the firm expects to earn at least 8% on its investments,
how much will it accumulate by the end of year 5 if it
immediately invests these cash flows when they are
received?
This situation is depicted on the following time line.
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Present Value of a Mixed Stream
Frey Company, a shoe manufacturer, has been offered an
opportunity to receive the following mixed stream of cash
flows over the next 5 years.
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Present Value of a Mixed Stream
If the firm must earn at least 9% on its investments, what
is the most it should pay for this opportunity?
This situation is depicted on the following time line.
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Compounding Interest More Frequently
Than Annually
Compounding more frequently than once a year results
in a higher effective interest rate because you are
earning on interest on interest more frequently.
As a result, the effective interest rate is greater than the
nominal (annual) interest rate.
Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.
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Table 3.3 Future Value from Investing $100 at 8% Interest
Compounded Semiannually over 24 Months (2 Years)
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Table 3.4 Future Value from Investing $100 at 8% Interest
Compounded Quarterly over 24 Months (2 Years)
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Table 2.5 Future Value at the End of Years 1 and 2 from
Investing $100 at 8% Interest, Given Various
Compounding Periods
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Compounding Interest More Frequently
Than Annually (cont.)
A general equation for compounding more frequently
than annually
Recalculate the example for the Fred Moreno example
assuming (1) semiannual compounding and (2) quarterly
compounding.
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Continuous Compounding
Continuous compounding involves the compounding
of interest an infinite number of times per year at
intervals of microseconds.
A general equation for continuous compounding
where e is the exponential function.
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Personal Finance Example
Find the value at the end of 2 years (n = 2) of Fred
Moreno’s $100 deposit (PV = $100) in an account paying
8% annual interest (r = 0.08) compounded continuously.
FV2 (continuous compounding) = $100 e0.08 2
= $100 2.71830.16
= $100 1.1735 = $117.35
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Nominal and Effective Annual Rates of
Interest
The nominal (stated) annual rate is the contractual
annual rate of interest charged by a lender or promised
by a borrower.
The effective (true) annual rate (EAR) is the annual
rate of interest actually paid or earned.
In general, the effective rate > nominal rate whenever
compounding occurs more than once per year
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Personal Finance Example
Fred Moreno wishes to find the effective annual rate
associated with an 8% nominal annual rate (r = 0.08)
when interest is compounded (1) annually (m = 1); (2)
semiannually (m = 2); and (3) quarterly (m = 4).
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Special Applications of Time Value: Deposits Needed to
Accumulate a Future Sum
The following equation calculates the annual cash payment (CF) that
we’d have to save to achieve a future value (FVn):
Suppose you want to buy a house 5 years from now, and you estimate
that an initial down payment of $30,000 will be required at that time.
To accumulate the $30,000, you will wish to make equal annual end-
of-year deposits into an account paying annual interest of 6 percent.
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Special Applications of Time Value: Loan
Amortization
Loan amortization is the determination of the equal
periodic loan payments necessary to provide a lender
with a specified interest return and to repay the loan
principal over a specified period.
The loan amortization process involves finding the
future payments, over the term of the loan, whose
present value at the loan interest rate equals the
amount of initial principal borrowed.
A loan amortization schedule is a schedule of equal
payments to repay a loan. It shows the allocation of
each loan payment to interest and principal.
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Special Applications of Time Value: Loan
Amortization (cont.)
The following equation calculates the equal periodic loan
payments (CF) necessary to provide a lender with a specified
interest return and to repay the loan principal (PV) over a
specified period:
Say you borrow $6,000 at 10 percent and agree to make equal
annual end-of-year payments over 4 years. To find the size of the
payments, the lender determines the amount of a 4-year annuity
discounted at 10 percent that has a present value of $6,000.
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Table 3.5 Loan Amortization Schedule
($6,000 Principal, 10% Interest, 4-Year Repayment
Period)
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Special Applications of Time Value: Finding
Interest or Growth Rates
It is often necessary to calculate the compound annual
interest or growth rate (that is, the annual rate of
change in values) of a series of cash flows.
The following equation is used to find the interest rate
(or growth rate) representing the increase in value of
some investment between two time periods.
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Personal Finance Example
Ray Noble purchased an investment four years ago for
$1,250. Now it is worth $1,520. What compound annual
rate of return has Ray earned on this investment?
Plugging the appropriate values into Equation 5.20, we
have:
r = ($1,520 ÷ $1,250)(1/4) – 1 = 0.0501 = 5.01% per year
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Special Applications of Time Value: Finding
an Unknown Number of Periods
Sometimes it is necessary to calculate the number of
time periods needed to generate a given amount of
cash flow from an initial amount.
This simplest case is when a person wishes to
determine the number of periods, n, it will take for an
initial deposit, PV, to grow to a specified future amount,
FVn, given a stated interest rate, r.
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