Question to the class:
“What do you think is more valuable
– one rupee today or one rupee a
year from now? And why?”
Chapter
Fundamental 4
s of
Corporate The Time
Finance Value of
Money
Fifth Edition
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights
Topics Covered
Simple and Compound Interest
Future Values
Present Values
Multiple Cash Flows
Level Cash Flows Perpetuities and Annuities
Inflation & Time Value
EAR and APR
Simple and Compound Interest
Simple Interest: Interest earned only on the
original investment; no interest is earned on
interest
Compound Interest: Interest earned on interest
Compounding: The process of earning interest
on interest
Exercise: What would be the value of $100
today after 5 years at r=10%:
Under simple interest
Under compound interest
Timeline
A line that puts cash flows and periods together
Always draw a timeline when you are dealing with problems involving
time value of money, bond valuation, stock valuation or any other asset
valuation that involves cash flows in different periods of time. Always!
Exercise: A dealer is offering an escalating pay program under which,
you can pay for a car in three years by paying $500 today, $700 in year
1, $800 in year 2 and $1000 in year 3. Interest rate stands at 4%. Draw a
timeline to reflect the above data.
Exercise: Your cash inflows from a “Lifetime jackpot” you just won will
be five $1000 payments starting from today, $2500 after that and finally
$3000 after that forever. The appropriate discount rates are: 5% in the
next 4 years and 6% after that forever.
Draw a timeline to reflect the above data
Future Values
Future Value - Amount to which an investment will
grow after earning interest.
Formula: FV = PV * (1+r)^n
Also,
FV = PV * FVIFr,n
Sensitivity to interest rate (r) and time (t):
FVIF increases with increase in both “r” and “n”
Exercise: Find out the Future value of $100 today for
the following:
r = 7%; n = 9 years (using the FVIF table)
r = 5.2%; n= 60 years (using the formula given above)
Present Values
Present Value – Value today of a future cash flow. Also
can be defined as amount of money that has to be
invested today so that it can grow to specified sum
in the future.
Formula: PV = FV/ (1+r)^n
Also,
PV = FV * PVIFr,n
Sensitivity to interest rate (r) and time (t):
PVIF decreases with increase in both “r” and “n”
Exercise: Find out the Present value of $100 for the
following:
r = 7%; n = 9 years (using the PVIF table)
r = 5.2%; n= 60 years (using the formula given above)
Exercises
Finding FV (Pg 103, Question 3)
Finding PV (Pg 103, Question 7)
Finding interest rate “r” (Pg 103, Question
8)
Finding time “n” (Pg 103, Question 10)
Doubling one’s money (Pg 108, Question
70)
Doubling period: Rule of 72
Rule of 72: Time it will take for an investment to
double in value equals approximately “72/r”, where
“r” is expressed as a percentage.
Example: If a savings account offers interest rate
of 9% per year, the time in which it doubles money
is:
= 72/9 = 8 years
Rule of 72 is only an approximation formula.
The precise doubling period can be found by
solving the following:
$2 = $1 * (1+0.09)^n
=> n = 8.0432 years (which is very close to the
result given by our approximation formula)
Multiple Cash Flows
Present and future values of multiple cash flows can be found
by compounding/discounting each cash flow at the appropriate
discount rate
To find the value at some future date of a stream of cash flows,
calculate what each flow will be worth at that future date, and
then add up these future values.
To find the present value of a stream of cash flows, calculate
what each flow will be worth today, and then add up these
present values.
Exercise: A rising young Nepali cricketer has been offered 5
year contracts by two clubs – Baneswor Cricket Club and
Gairidhara Cricket Club. Baneswor Cricket Club offers to pay
him $3 million a year for the upcoming 5 years while
Gairidhara Cricket Club offers him $4 million today and $2
million a year for the upcoming 5 years. Which club is making
a better offer to the Cricketer if the interest rate is 10%? (ACE
Spring 2012, midterm)
Level cash flow: Perpetuities and
Annuities
Annuity: Equally spaced level stream of
cash flows with a finite maturity period
Perpetuity: Stream of level cash payments
(annuity) that never ends
Valuing Annuities
PV of a perpetuity = C/r
FV for a perpetuity cannot be calculated as it has a non-
ending life
PV of an annuity = C * PVIFAr,n
Where, PVIFAr,n = (1-1/(1+r)^n)/r = (1-PVIFr,n)/r
FV of an annuity = C* FVIFAr,n
Where, FVIFAr,n = (((1+r)^n)-1)/r = (FVIFr,n- 1)/r
Note: Using the PV formulae given above, PV of perpetuities as well as
annuities are obtained at one period before the first cash flow, i.e. for a cash
flow stream that begins on year 1, the formulae calculate PV at year 0 and for
a cash flow stream that begins on year 4, the formulae calculate PV on year
3.
Also, the FV formula given above calculates FV of an annuity at the period of
the last cash flow, i.e. for a cash flow stream that ends on year 7, the annuity
formula calculates FV at year 7.
Annuity Due
Level stream of cash flows (annuity)
starting immediately or from period zero
PV of annuity due = PV of a normal annuity
* (1+r)
FV of annuity due = FV of a normal annuity
* (1+r)
Can you derive these formulas from a simple
timeline? Its easy if you try!
Inflation and Time Value of Money
Nominal cash flows: Normal cash flows
reported (unadjusted for inflation)
Real cash flows: Cash flows adjusted for
inflation (reported at constant dollars)
Nominal interest rate: Rate at which money
invested grows
Real interest rate: Rate at which the
purchasing power of an investment
increases
Inflation and Time Value of
Money….
(1+real int rate) = (1+nominal int
rate)/(1+inflation rate)
Loosely, one could approximate:
Real int rate = Nominal int rate – inflation rate
However, this is valid only for small values of real
rates and inflation rates
Real cash flow = Nominal cash flow n /
(1+inflation)^n
Important: Always discount nominal cash flows
by nominal int rate and real cash flows by real
int rate. Results from both are the same!
APR and EAR
APR: Annual Percentage Rates are interest
rates that are annualized using simple
interest
APR = Periodic int rate * no. of periods in a year
EAR: Effective Annual Rates are interest
rates that are annualized using compound
interest
(1+EAR) = (1+Periodic rate)^(no. of periods in
a year)
=(1+APR/n)^n; where n = no. of
periods in a year
Exercises
Annuity and annuity due: Pg 105, Question
33
Perpetuities: Pg 106, Question 47
Annuities and interest rate: Pg 104,
Question 23
APR and EAR: Pg 104, Question 15
Real versus nominal annuities: Pg 107,
Question 67
Exercises
When Anuja got her first job 40 years ago
in the year 1972, her monthly salary was
Rs. 500. Forty years later in the year 2012,
Anuja’s son landed up with his first job
which paid Rs. 22,000 per month. If the
average rate of inflation over last 40 years
were 10%, what is the real value (or
purchasing power) of the salary of Anuja’s
son in terms of the price level in the year
1972?
Consider a four-year amortizing loan. You
borrow Rs. 1,000 initially and repay it in
four equal annual year-end payments. If the
