EQUATIONS OF VALUE
CFI 1102
INTRODUCTION
By now we should be comfortable working with the various
formulae for compounding and discounting that we have
introduced so far.
The formulae would be of little practical value if they could
not be used to solve daily financial problems.
The purpose of this lecture is to introduce you to equations
of value, which are in effect, a demonstration of how to
use both the formulae we have learned so far, an other
formulae we are going to learn in future lectures, to solve
daily financial problems.
WHAT ARE EQUATIONS OF VALUE?
From time to time, a debtor (the guy who owes money)
may wish to replace his set of financial obligations with
another set. On such occasions, he must negotiate with
his creditor (the guy who is owed money) and agree
upon a new due date, as well as a new set of
conditions (including a new interest rate).
This is generally achieved by evaluating each
obligation in terms of the new due date, and equating
the sum of the old and the new obligations on the new
date.
WHAT ARE EQUATIONS OF VALUE?
The resultant equation of value is then solved to obtain
the new future value that must be paid on the new due
date.
We need to appreciate that only amounts that are at the
same date can be either added to, or subtracted from
each other. We achieve this by either moving our money
forward in time (compounding), backward in time
(discounting).
We will demonstrate this concept with the aid of an
example.
EXAMPLE 1
A car manufacturer announces that they will be making a
special 10 year addition of their hybrid hatchback that has
been in the market for 6 years. The special addition will be
available in 4 years’ time for $16 000.00. Mr Nare promises
to buy the hatchback for his daughter Shirley, a first year
finance student at a local university on two conditions:
She has to graduate before the special edition is released; and
•She also has to calculate how much he has to deposit in a
fixed deposit account today to have enough to pay for the car
in 4 years’ time.
EXAMPLE 1
Required
Image that you are Shirley, and determine how
much Mr Nare should invest today if the interest
rates are 16% converted monthly.
EXAMPLE 1 SOLUTION
Mr Nare should invest $ 8472.43 today.
EXAMPLE 2
A car manufacturer announces that they will be making a special 10
year addition of their hybrid hatchback that has been in the market
for 6 years. The special addition will be available in 4 years’ time for
$16 000.00. Mr Nare promises to buy the hatchback for his daughter
Shirley, who is a first year finance student at a local university, as her
graduation present, on three conditions:
She has to graduate before the special edition is released;
His insurance policy that matured in 3 years’ time from now, and will pay
$9 000 will be the main source of funds, and
She also has to calculate how much he has to deposit in a fixed deposit
account today to cover the shortfall (if any) after the insurance gratuity,
so that they will be enough to pay for the car in 4 years’ time.
EXAMPLE 2
Required
Image that you are Shirley, and determine how
much Mr Nare should invest today if the interest
rates are 16% converted monthly, and if the
insurance gratuity will be deposited into the same
fixed deposit account under the same terms and
conditions.
EXAMPLE 2 SOLUTION
EXAMPLE 2 SOLUTION
Mr Nare will only require the difference
between the 16000 and the value of the
gratuity to have enough to buy Shirley the car.
Since the gratuity from the insurance will be
worth $10 550.44 after 4 years:
EXAMPLE 2 SOLUTION
Mr Nare will only require the present value of 5449.56 today,
for him to have enough in 4 years:
Mr Nare should invest $ 2885.69 today.
EXAMPLE 2 SOLUTION
It should be apparent from the examples that we have
already looked at so far that equations of value can be
solved one step at a time, or by coming up with a single
comprehensive equation.
Drawing up time lines also becomes more important as the
problem at hand becomes more complicated.
We conclude our topic on equations of value by looking at a
further example.
EXAMPLE 3
Val Makhalima borrowed $13 000 one year ago at
15% per annum, compounded semi-annually and
due six months from now.
He also owes $5 500, borrowed six months ago at
18% per annum, compounded quarterly and due
nine months from now.
He foresees cash flow problems ahead because he
will not be able to repay such a large amount of
money this year.
EXAMPLE 3
Required
Val wishes to renegotiate his debt so that he will repay the larger
portion of the debt after graduation when he expects to be working.
If his creditor agrees, Val will pay $4 000 now and reschedule his
remaining debt so as to settle his obligations 18 months from today.
His creditor agrees to this, provided that the old obligations are subject
to 19% per annum compounded monthly for the extended period.
It is also agreed that the $4 000 paid now will be subject to this same
rate of 19% per annum compounded monthly for evaluation purposes.
What will his payment be in 18 months’ time?
EXAMPLE 3 SOLUTION
The best way to easily visualise what is happening is to
come up with a time line.
EXAMPLE 3 SOLUTION
We know exactly how much the $13 000, $5 500, and
$4 000 are worth on the day the cash flow occurred,
but we will need to account for the changes in value as
a result of the changes in time. Therefore we do not
yet know the value of the cash flows represented by X,
Y and Z.
Cash flows can only be added to, or subtracted from
each other if they occurred on the same day. In this
case they did not, but we are already equipped with
the means to move them to the same day.
EXAMPLE 3 SOLUTION
There are many ways to do this, but two of the
most convenient ways would be:
to either first move all the cash flows to the
present value, or
to first move all of them to a future value 18 month
from today, when the rest of the debt is expected
to be repaid.
In our case, we will use the approach of first
moving all the cash flows to their present value.
EXAMPLE 3 SOLUTION
EXAMPLE 3 SOLUTION
The future value of the $13,000, after 6 months will
be”
EXAMPLE 3 SOLUTION
The future value of the $5 500 after 9 months will
be:
EXAMPLE 3 SOLUTION
Bringing these amounts to the present, they then
become:
EXAMPLE 3 SOLUTION
Now that all the amounts are in their present
values, we can now net them:
= 14,697.18 + 5,950.34 -4 000.00
= 16,647.52
Finally, we can now move all the net cash flow to
the future date where the loan repayment will be
made in 18 months’ time:
EXAMPLE 3 SOLUTION
= 22,087.87
Therefore, if Val manages to restructure his loan, he
will be liable to repay $22,087.87 after 18 months.
EXAMPLE 3 SOLUTION
In fact, we could have squashed some of the steps
to reduce the number of steps, for example finding
the present values of the 13 000 and the 5 500 in a
single step for each:
EXAMPLE 3 SOLUTION
Or finding the whole future value in a single
elaborate equation:
