ACC209 Lecture 2

Financial Management Time Value of Money

 At the end of the lecture, students are expected
to:
1. Define compound interest and present /
future value of cash flows.
2. Calculate both future value and the
Objectives present value of a mixed stream of cash
flows.
3. Understand and perform calculations of
annuity and perpetuity.
4. Evaluate projects based on techniques
that use time value of money (e.g. NPV,
IRR,…etc.)
5. Understand the concept of sunk cost and
relevant cash flows 2
 • Simple interest versus compound interest
• Time value of money and its impact
Contents • Return on capital employed calculations
• NPV and IRR calculations
• Payback period method and Discounted Cash
Flow (DCF) methods

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 • The time value of money refers to the
observation that it is better to receive money
sooner than later.
• Money that you have in hand today can be
invested to earn a positive rate of return,
The Role of producing more money tomorrow. For that
reason, a dollar today is worth more than a
Time Value dollar in the future.
in Finance • In business, managers constantly face trade-offs
in situations where actions that require outflows
of cash today may produce inflows of cash later.
• Because the cash that comes in the future is
worth less than the cash that firms spend up
front, managers need a set of tools to help them
compare cash inflows and outflows that occur at
different times. 4
 • Future Value: compounding or growth over time
Basic • Present Value: discounting to today’s value
• Single cash flows & series of cash flows can be
Concepts considered
• Timelines are used to illustrate these relationships

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Example
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 1 $3,000
Year 2 $5,000
Year 3 $4,000
Year 4 $3,000
Year 5 $2,000
Is this a wise investment?

It might seem that the obvious answer is yes because the firm spends $15,000 and receives
$17,000.

Remember, though, that the value of the dollars the firm receives in the future is less than the value
of the dollars that they spend today.

Therefore, it is not clear whether the $17,000 inflows are enough to justify the initial investment.
Time-value-of-money analysis
• Time-value-of-money analysis helps managers answer questions like these.
• The basic idea is that managers need a way to compare cash today versus cash
in the future.
• There are two ways of doing this.
1. One way is to ask the question,
• What amount of money in the future is equivalent to $15,000 today? In
other words, what is the future value of $15,000?
2. The other approach asks,
• What amount today is equivalent to $17,000 paid out over the next 5 years
as outlined above? In other words, what is the present value of the stream
of cash flows coming in the next 5 years?
Timelines
• A horizontal line on which time zero appears at the leftmost end and future
periods are marked from left to right; can be used to depict investment cash
flows.

• To make the right investment decision, managers need to compare the cash
flows at a single point in time. Typically, that point is either the end or the
beginning of the investment’s life.
Compounding & Discounting
• The future value technique uses
compounding to find the future value
of each cash flow at the end of the
investment’s life and then sums these
values to find the investment’s future
value.
• the present value technique uses
discounting to find the present value
of each cash flow at time zero and
then sums these values to find the
investment’s value today.
• In practice, when making investment
decisions, managers usually adopt the
present value approach.
Basic Patterns of Cash of Flow
• Single amount: A lump-sum amount either
currently held or expected at some future
date. Examples include $1,000 today and
$650 to be received at the end of 10 years.
• Cash flow—both inflows
and outflows—of a firm • Annuity: A level periodic stream of cash flow.
Examples include either paying out or
can be described by its receiving $800 at the end of each of the next
general pattern. 7 years.

• Mixed stream: A stream of cash flow that is

not an annuity; a stream of unequal periodic
cash flows that reflect no particular pattern.
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.
• The future value depends on the rate of interest earned and the
length of time the money is left on deposit.
• The future value of a present amount is found by applying
compound interest over a specified period of time.
Simple & Compound Interest

• There are two types of interest! Simple and Compound.

• With simple interest, you don’t earn interest on interest.

• Year 1: 5% of $100 = $5 + $100 = $105
• Year 2: 5% of $100 = $5 + $105 = $110
• Year 3: 5% of $100 = $5 + $110 = $115
• Year 4: 5% of $100 = $5 + $115 = $120
• Year 5: 5% of $100 = $5 + $120 = $125

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Compound Interest

• With compound interest, a depositor earns interest on interest!

• Year 1: 5% of $100.00= $5.00 + $100.00 = $105.00
• Year 2: 5% of $105.00= $5.25 + $105.00 = $110.25
• Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
• Year 4: 5% of $115.76= $5.79 + $115.76 = $121.55
• Year 5: 5% of $121.55= $6.08 + $121.55 = $127.63

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The Future Value Formula

Where
• PV: Present Value
• FV: Future Value
• R: rate of return
(borrowing or deposit rate – this
assumes that both are equal)
• T –Time Period
 • Jane Farber places $800 in a savings account paying 6%
Future Value of a Single Amount: interest compounded annually. She wants to know how much
The Equation for Future Value money will be in the account at the end of five years.

FV5 = $800 X (1 + 0.06)5 = $800 X (1.33823) = $1,070.58

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Graphical View of Future Value
The graph illustrates how the future value depends on
the interest rate and the number of periods that
money is invested.

The figure shows that:

1. the higher the interest rate, the higher the
future value, and
2. the longer the period of time, the higher the
future value.

Note that for an interest rate of 0 percent, the future

value always equals the present value ($1.00). But for
any interest rate greater than zero, the future value is
greater than the present value of $1.00.
Present Value of a Single Amount
• Present value is the current dollar value of a future amount of money.
• It is based on the idea that a dollar today is worth more than a dollar tomorrow.
• It is the amount today that must be invested at a given rate to reach a future
amount.
• Calculating present value is also known as discounting cash flows.
• 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 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%.

𝐹𝑉
𝑃𝑉 =
( 1 + 𝑟 )𝑡

PV = $1,700/(1 + 0.08)8
= $1,700/1.85093 = $918.46
OR if you round off to 3 decimal places,
= $1,700/1.851 = $918.42

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Graphical View of Present Value

The graph clearly shows that, everything else

being equal,
1. the higher the discount rate, the lower
the present value, and
2. the longer the period of time, the
lower the present value.

Also note that given a discount rate of 0

percent, the present value always equals the
future value ($1.00). But for any discount
rate greater than zero, the present value is
less than the future value of $1.00.
Reading Financial
Tables

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 PV of 1 =

Present Value
tables

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 PV of 1 =

Present Value
tables

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 Annuity
• An annuity is a stream of equal
periodic cash flows, over a specified
time period.
• Types of Annuity
• Ordinary Annuity - An annuity for
which the cash flow occurs at the
end of each period.
• Annuity Due - An annuity for
which the cash flow occurs at the
beginning of each period.
Present Value
of an
Ordinary
Annuity: The
Long Method

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 Present Value
PVA = $700 (PVIFA,8%,5)
of an Ordinary = $700 (3.993)
Annuity: Using = $2,795.10
PVIFA Tables

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 PV of annuity of 1 =

Annuity Tables

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 PV of annuity of 1 =

Annuity Tables

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 • A perpetuity is a special kind of annuity.
• With a perpetuity, the periodic annuity or cash
flow stream continues forever.
Present Value PV = Annuity/Interest Rate
of a Perpetuity
• For example, how much would I have to deposit
today in order to withdraw $1,000 each year
forever if I can earn 8% on my deposit?

PV = $1,000/.08 = $12,500
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 ✔Discounting
▪ Present value of 1 =
Discounting, ✔Annuity
annuity, ▪ Present value of annuity of 1 =
✔Perpetuity
perpetuity ▪ Present value of cash flows in perpetuity of 1 =

Where r is discount rate and n is number of periods

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 • With continuous compounding the number of
compounding periods per year approaches
infinity.
• Through the use of calculus, the equation
thus becomes:
Continuous
Compounding FVn (continuous compounding) = PV x (er × n) where
“e” has a value of 2.7183.

• Find the Future value of the $100 deposit at 8%

after 2 years if interest is compounded
continuously.

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Continuous Compounding (cont.)
• With continuous compounding the number of compounding periods per year
approaches infinity.

FVn (continuous compounding) = PV x (er × n) where

“e” has a value of 2.7183.

FVn = 100 x (2.7183).08x2 = $117.35

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 • The nominal interest rate is the stated or
contractual rate of interest charged by a
lender or promised by a borrower.
Nominal & • The effective interest rate is the rate actually
Effective paid or earned.
• The effective annual rate reflects the effects of
Annual Rates compounding frequency, whereas the nominal
of Interest annual rate does not.
• In general, the effective rate > nominal rate
whenever compounding occurs more than
once per year
Nominal & Effective
Annual Rates of Interest (cont.)
Fred Moreno wishes to find the effective m equals the number of times per
annual rate associated with an 8% nominal year interest is compounded
annual rate (r = .08) when interest is
compounded
1. annually (m=1);
2. semiannually (m=2)
3. quarterly (m=4).
Special Applications of Time Value: Interest
or Growth Rates
• At times, it may be desirable to determine the compound interest rate or growth
rate implied by a series of cash flows.

• Examples include finding the interest rate on a loan, the rate of growth in sales,
and the rate of growth in earnings.

Ray Noble wishes to find the rate of interest or growth

reflected in the stream of cash flows he received from a real
estate investment over the period from 2002 through 2006 as
shown in the table on the following slide.
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Special Applications of
Time Value: Interest or
Growth Rates (cont.)

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 • Net present value (NPV)
Net Present Value • Internal rate of return (IRR)
& Other • Payback period
• Return on capital employed method
Investment Criteria or ARR
 Discounted cashflow method
• Discounted cash flow (DCF) refers to a
valuation method that estimates the value of
an investment using its expected future
cash flows.
• DCF analysis attempts to determine the
value of an investment today, based on
projections of how much money that
investment will generate in the future.
• It can help those considering whether to
acquire a company or buy securities make
their decisions.
• Discounted cash flow analysis can also assist
business owners and managers in making
capital budgeting or operating expenditures
decisions.
 Cash flows incurred at beginning
of project occur in year 0

Conventions Cash flows occurring during time

of DCF period assumed to occur at
period-end
analysis
Cash flows occurring at
beginning of period assumed to
occur at end of previous period
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Advantages of • The time value of money is taken into
account.
DCF over • The method takes account of all of a project's
cash flows.
other • It allows for the timing of cash flows.
methods: • There are universally accepted methods of
calculating the NPV and IRR

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 • Two methods: Net Present Value (NPV) and
Internal Rate of Return (IRR)
• NPV: the value obtained by discounting all cash
DCF Methods flows of project by target rate of return or cost
of capital.
• Decision
• Positive - Accept
• Negative - Reject

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NPV Example
•Cosine Co. is planning to invest $90,000 in a three year project that is expected to
generate cash inflows of $40,000 per year for the first two years and $50,000 in the
third year. Current Weighted Average Cost of Capital of Cosine Co. is 12%.
Determine the NPV of the project.

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Internal Rate • The internal rate of return (IRR) of an
investment project is the cost of capital or
of Return (IRR) required rate of return which, when used to
discount the cash flows of a project, produces
a net present value of zero.

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Internal Rate of return (IRR)

•The IRR method of investment appraisal is to accept projects whose IRR (the rate
at which the NPV is zero) exceeds a target rate of return.
• The IRR is calculated using interpolation.

Where
•a is lower of two rates of return used
•b is higher of two rates of return used
•NPVa is NPV obtained using rate a
•NPVb is NPV obtained using rate b

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 Find the IRR of the project given below
and states whether the project should be
accepted if the company requires a
minimum return of 17%.

Time Cash flow ($)

IRR - Example 0 (4,000)

1 1,200
2 1,410
3 1,875
4 1,150

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Solution to IRR Example

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 46

IRR – Graphical Representation

The closer our NPVs are to zero, the closer our estimate will be to the true IRR.
 • The amount of time required for a firm to
recover its initial investment in a project, as
calculated from cash inflows.
• When the payback period is used to make
accept–reject decisions, the following decision
criteria apply:
Payback period • If the payback period is less than the
maximum acceptable payback period, accept
the project.
• If the payback period is greater than the
maximum acceptable payback period,
reject the project.
• payback period is generally viewed as an
unsophisticated capital budgeting technique,
because it does not explicitly consider the
time value of money. 47
Payback period Example
We can calculate the payback period for Bennett Company’s
projects A and B.
For project A, which is an annuity, the payback period is 3.0 years
Project B generates a mixed stream of cash inflows, the calculation of
its payback period is not as clear-cut.
In year 1, the firm will recover $28,000 of its
$45,000 initial investment. By the end of year 2, $40,000 ($28,000 from
Year 1 $12,000 from year 2) will have been recovered. At the end of
year 3, $50,000 will have been recovered. Only 50% of the year-3
cash inflow of $10,000 is needed to complete the payback of the
initial $45,000. The payback period for project B is therefore 2.5 years
(2 years + 50% of year 3).

If Bennett’s maximum acceptable payback period were 2.75 years, project A

would be rejected and project B would be accepted. If the maximum
acceptable payback period were 2.25 years, both projects would be rejected.
If
the projects were being ranked, B would be preferred over A because it has a
shorter payback period.
 • Ratio of Profit Before Interest and Tax (PBIT) to
Capital Employed(CE)
• Normally expressed as a %
• The most important profitability ratio
Return on • also called return on investment (ROI) or
• ARR (Accounting Rate of Return)
Capital
Employed

Either beginning or average capital employed

can be used.
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 Even if a project has a positive NPV, or an
Other factors acceptable IRR, a company may not go ahead if
matter too! the profits are felt to be too marginal, and the risk
of loss too great.

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 • To evaluate investment opportunities, financial
managers must determine the relevant cash
flows associated with the project.
• Relevant costs are future incremental cash
flows.
Relevant cash • Avoidable costs are costs which would not
be incurred if the activity to which they
flows relate did not exist.
• Differential cost is the difference in relevant
cost between alternatives.
• Opportunity cost is the benefit which has
been given up, by choosing one option
instead of another.

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 Any costs incurred in the past, or any committed
costs which will be incurred regardless of whether
or not an investment is undertaken, are not
relevant cash flows.
• Sunk costs are already incurred and hence
Non-relevant should not be taken account of in decision
making.
cash flows • Committed costs are future cash outflows
that will be incurred anyway, whatever
decision is taken now about alternative
opportunities.
• Notional costs are hypothetical accounting
cost to reflect the use of a benefit for which
no actual cash expense is incurred.
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Impact of inflation on DCF
• Nominal rate of return measures return in terms of the (falling in value) currency
• Real rate of return measures return in constant price level terms

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NPV layout

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 • Calculation of ROCE, NPV, IRR and payback
period are useful in evaluating projects.
• Decision also depends on risk and sensitivity
• EAR > Nominal Rate whenever compounding
Summary occurs more than once a year
• Cash / non-cash items and sunk cost need to be
identified
• Annuity and perpetuity helps in investment
planning, especially for individuals

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References

Gitman, L. J., & Zutter, C. J. (2014). Principles of Managerial Finance, 14th Edition.
Prentice Hall.
(Chapter 5)

BPP Publishers (2016) ACCA - F9: Financial Management: Study Text

(Chapter 8)
Questions?