Time Value of Money

All time lines were drawn and discussed in class Removal of errors and omissions, if any, in this ppt are your responsibility

Agenda
Timeline Present Value - Future Value One period PV, NPV PV - different rates and time periods FV - different rates and time periods Multi-Period Case (incl. power of compounding) Annuities, Perpetuities - Simplifications Special Cases Effective Annual Rate APR and Loan Balance Risk and CF
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Timeline
Main issue is what value to place on a cash flow

When or time component (early part of the course) Uncertainty (risk-return latter part)

Importance is because we need to make apples-to-apples comparisons It is only possible to compare or combine values at the same point in time
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Timeline
A timeline is a linear representation of the timing of potential cash flows Drawing a timeline of the cash flows will help you visualize the financial problem Usually cash flows are assumed to be at the end of the period unless o/w stated By convention, inflows are positive and outflows are negative
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Present Value
Key insight is that a Rupee today is worth more than a Rupee tomorrow the Rupee today can be invested to earn interest which can be obtained along with the original Rupee invested (tomorrow)

Conversely one could ask how much is it worth to me today to have a Rupee tomorrow or How much do I have to put away today to get a Rupee tomorrow
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Present Value
The PV of a delayed payment is obtained by multiplying the payoff by the discount factor
Consider the following example

Suppose you receive Rs.1 tomorrow and the bank pays an interest rate of 15% (reward for waiting) , what is the PV? r is the rate of return, X (1+r)1 = 1 hurdle rate,

X = 1/(1+r)1 = 1/(1.15) = 0.869

Discount factor (DF)

opportunity cost of capital

PV = Discount factor * payment to be received

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Future Value
If I had a Rupee today what is it worth tomorrow?
Consider the following example

Suppose you have Rs.1 today, the bank pays an interest rate of 15% (rate of return), what is the FV? 1* (1+r)1 = 1*(1.15)1 = 1.15
Discount rate (also called future value factor,
compound factor)

FV = Initial payment + accumulated interest

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PV & FV
Present Value Value today of a future cash flow Future Value Amount to which an investment will grow after earning interest

Discount Factor Present value of a Rs.1 future payment

Discount Rate Interest rate used to compute present values of future cash flows

One Period: PV
Consider the following example

Suppose you are offered an investment that pays Rs.12,000 in three years. If you expect to earn a 13% return, what is the value of this investment?

One Period: PV
Consider the following example

John Doe wishes to find the present value of Rs.1,700 that will be received 8 years from now; Johns opportunity cost is 8%

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One Period: FV
Consider the following example

Jane Farber places Rs.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

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One Period: Net Present Value (NPV)

The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less the cost of the investment.
Consider the following example

Suppose an investment that promises to pay Rs.15,500 in one year is offered for sale for Rs.12,500. Your interest rate is 8%. Should you buy?

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PV- different rates and time periods

Interest rate, time period and PV
100 90 80 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 5% 10% 15% 20%

0%

As t increases PV decreases As r increases PV decreases

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FV- different rates and time periods

Interest rate, time period and FV
1000 900 800 700 600 500 400 300 200 100 0 1 3 0% 5 7 5% 9 11 13 10% 15 17 15% 19 21 20% 23 25

As t increases FV increases As r increases FV increases

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Multi-period Case
What happens when the number of period increases? FV = X* (1+r)t PV = X/(1+r)t

FV = PV * (1+r)t or PV = FV /(1+r)t
Consider a simple example

Suppose r = 10% & you want to compare two plan

A: receive Rs.400 4 years from now B: Receive Rs.600 12 years from now

Which one would you prefer?

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Multi-period Case
Consider the following example

Suppose you have a choice between receiving Rs.5,000 today or Rs.10,000 in five years. You believe you can earn 10% on the Rs.5,000 today. What should you do?

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Multi-period Case
Consider the following example

Suppose that Brealey invested in the initial public offering of the Myers company. Myers pays a current dividend of Rs.1.15, which is expected to grow at 40% per year for the next five years. What will the dividend be in five years?

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Multi-period Case
Consider the following example

Suppose we plan to save Rs.1000 today, and Rs.1000 at the end of each of the next two years. If we can earn a fixed 10% interest rate on our savings, how much will we have three years from today?

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Multi-period Case
Consider the following example (PV case)

You have an opportunity to invest in a business that will pay Rs.200,000 in year one, Rs.400,000 in year two, Rs.600,000 in year three and Rs.800,000 in year four. You can earn 12% per year compounded annually on a mutual fund that has similar risk. If it costs Rs.1.2 million to start this business, should you invest?
0 1 2 3 4

| 1.2 mil

| 200K

| 400K

| 600K

800K

Discount rate = 12%

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Multi-Period Case

In general when you have multiple cash flows C0 ..CN, the PV of those Cash flows is

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Multi-period Case

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PV & FV
Only values at the same point in time can be combined or compared (time travel) When cash flows occur at different points in time they must be discounted or compounded appropriately To move cash flow forward compound it To compound cash flows, multiply the amount by (1 + r)n where r is the periodic interest rate and n is the number of compounding periods To move cash flow backward discount it To discount cash flows, divide the amount by (1 + r)n where r and n are as defined previously
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Annuities, Perpetuities - Simplifications

Annuity - A stream of constant cash flows that lasts for a fixed number of periods Growing annuity - A stream of cash flows that grows at a constant rate for a fixed number of periods Perpetuity - A constant stream of cash flows that lasts forever

Growing perpetuity - A stream of cash flows that grows at a constant rate forever.
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Annuities, Perpetuities - Simplifications

Annuity - A constant stream of cash flows with a fixed maturity

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Annuities, Perpetuities - Simplifications

Consider the following example

If you can afford a Rs.400 monthly car payment, what is the maximum price of the car you can buy if the interest rates is 7% on 36-month loan

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Annuities, Perpetuities - Simplifications

Consider the following example

What is the present value of a four-year annuity of Rs.100 per year that makes its first payment two years from today if the discount rate is 9%?

297.05

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Annuities, Perpetuities - Simplifications

Consider the following example (spreadsheet)

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 Rs.1000 at the end of each year for 10 years. The required return is 9%.

6417.66

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Annuities, Perpetuities - Simplifications

Future Value of an Annuity

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Annuities, Perpetuities - Simplifications

Consider the following example

Ellen is 35 years old today and wants to begin saving for retirement from next year. At the end of each year until she is 65 she will save Rs.10,000 each year in a retirement account. If the account earns 10% per year how much would Ellen have saved at age 65?

1644940.27

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Annuities, Perpetuities - Simplifications

Growing annuity - A growing stream of cash flows with a fixed maturity

The PV of a growing annuity with the initial cash flow c, growth rate g, and interest rate r is

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Annuities, Perpetuities - Simplifications

Consider the following example

In the Ellen example Suppose Ellen expects to salary to increase and so she plans to save 5% more each year - how much will she have saved by at age 65? All other details remain the same

2625491.98

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Annuities, Perpetuities - Simplifications

Consider the following example PV of a lottery

You have won the Rs. 30 Million state lottery. You have two options to claim the prize (a) 30 payments of 1 million starting today or (b)15 million lump-sum paid today If the interest rate is 8% which is the option you should choose (you are rational!)

a 11.26

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Annuities, Perpetuities - Simplifications

In an annuity due all that happens is that the timeline changes. So how does the value change.. An annuity due is worth (1+r) times an ordinary annuity

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Annuities, Perpetuities - Simplifications

Perpetuity - A constant stream of cash flows that lasts forever

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Annuities, Perpetuities - Simplifications

Consider the following example

What is the value of a British consol that promises to pay 15 each year, every year until the sun turns into a red giant and burns the planet to a crisp? The interest rate is 10-percent

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Annuities, Perpetuities - Simplifications

Consider the following example

How much would I have to deposit today in order to withdraw Rs.2,500 each year forever if I can earn 9% on my deposit?

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Annuities, Perpetuities - Simplifications

Consider the following example

You want to endow a graduation party at IIMK. You want the event to be memorable and plan Rs.5,000 per year for ever for the party. If IIMK can invest at 7% year and the first party is a year from now how much will you need to donate to endow the party?

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Annuities, Perpetuities - Simplifications

Growing perpetuity - A growing stream of cash flows that lasts forever

The PV of a growing perpetuity with the initial cash flow c, growth rate g, and interest rate r is

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Annuities, Perpetuities - Simplifications

Consider the following example

The expected dividend next year is Rs.1.30 and dividends are expected to grow at 5% forever; If the discount rate is 10%, what is the value of this dividend stream?

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Annuities, Perpetuities - Simplifications

Consider the following example

If in the MBA graduation party endowment case you realize that the inflation rate will be 4% per year after the first year and that will also need to be factored in in your original donation amount what do you now have to donate. All other details remain the same.

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Annuities, Perpetuities - Simplifications

Consider the following example

Your firm is about to make its initial public offering of stock and your job is to estimate the correct offering price. Forecast dividends are as follows

If investors demand a 10% return on investments for stocks of similar risk, what price will they be willing to pay? 32.81
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Annuities, Perpetuities - Simplifications

Conceptually, a firm should be worth the present value of the firms cash flows. The tricky part is determining the size, timing and risk of those cash flows.

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Special Cases
So far, we have computed either the PV or the FV of a stream of CF (unequal or equal) for a given number of time periods and interest rate Sometimes we know the present value or future value, but do not know one of the other variables we have previously been given as an input

For example, when you take out a loan you may know the amount you would like to borrow, but may not know the loan payments that will be required to repay it

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Special Cases
Consider the following example

Your firm plans to buy a warehouse for Rs.500,000. The bank requires you to pay 20% down payment and will lend Rs.400,000 to you for a 30-year time period at 9% annual rate of interest. What is your annual payment amount?

38934.54
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Special Cases
At times it may be necessary to compute the r (also called IRR) more on this later in the session but let us do an example Jane has just graduated and is offered a fantastic job at ABC investment corporation. She ponders but decides to set up her own business and asks them for funding. ABC lends her Rs.2 million with the agreement that she will pay back Rs.200,000 at the end of each year for the next 30 years. Assuming she fulfills her agreement what is the rate at which ABC has lent Jane the money? 9.5%

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Special Cases
Suppose ABC corporation gives Jane another option pay 200,000 in the first year and 4% more in perpetuity all other details remain the same. What is the rate that ABC is lending at (IRR)?

14%

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Special Cases
Consider the following example

Assume the total cost of a college education will be Rs.100,000 when Ms.Xs child enters college in 12 years. She has Rs.50,000 to invest today. What rate of interest must she earn on the investment to cover the cost of her childs education?

6%

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Special Cases
Calculating time T (or N) If we deposit Rs.20,000 today in an account paying 10%, how long does it take to grow to Rs.100,000?

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Effective Annual Rate

Compounding an investment m times a year for T years provides for future value of wealth

C0 = initial investment or PV of the CF

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Effective Annual Rate

Consider the following example

You invest Rs.100 for 3 years at 12% compounded semi-annually, what will your investment grow to at the end of that period

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Effective Annual Rate

A reasonable question to ask in the above example is what is the effective annual rate of interest on that investment The Effective Annual Interest Rate (EAR) is the annual rate that would give us the same end-ofinvestment wealth after 3 years

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Effective Annual Rate

So, investing at 12.36% compounded annually is the same as investing at 12% compounded semiannually

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Effective Annual Rate

Find the Effective Annual Rate (EAR) of an 18% APR (annual % rate) loan that is compounded monthly.

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Effective Annual Rate

What is the difference between the EAR of interest and stated rate of interest in the following cases: Case A: Stated rate of interest is 8 percent and the frequency of compounding is six times a year. Case B: Stated rate of interest is 10 percent and the frequency of compounding is four times a year. Case C: Stated rate of interest is 12 percent and the frequency of compounding is twelve times a year.
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Effective Annual Rate

The general formula for the future value of an investment compounded continuously over many periods is FV = C0erT Where C0 is cash flow at date 0 r is the stated annual interest rate T is the number of periods over which the cash is invested, and e is a transcendental number approximately equal to 2.718
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Effective Annual Rate

The nominal interest rate is the stated or contractual rate of interest charged by a lender or promised by a borrower The effective interest rate is the rate actually paid or earned In general, the effective rate > nominal rate whenever compounding occurs more than once per year

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Effective Annual Rate

Example of an actual automobile loan agreement The ad says

12 month car loans - Only 9%!

What is actually happening.

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APR and Loan Balance

Ten years ago your firm borrowed $3 million to purchase an office building using a loan with a 7.80% APR, and monthly payments for 30 years How much do you owe on the loan today How much interest was paid on the loan in the last year C = 21596 Owe(10) = 2,620,759 Owe(9) = 2,673,247 Interest = 215896*12 - 52488
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Problem Solving
Mini case see word doc

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Problem Solving
Mini case see word doc

What are the four questions to be answered

How much money would Vikas need 20 years from now? How much money should Vikas save each year for the next 20 years to be able to meet his investment objective? How much money would Vikas need when he reaches the age of 60 to meet his donation and bequeathal objective? What is the present value of Vikass life time earnings?
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Problem Solving
Ms. Ann Chen receives an annuity of $550,payable once every two years The annuity stretches out over 20 years. The first payment occurs at date 2, that is, two years from today. The annual interest rate is 8%

2596

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Risk and CF
A safe Rupee is worth more than a risky one

Generally, investors do not like risk

In order to induce the investors to invest in risky projects, a higher rate of return is needed Higher rate of return causes lower PVs Consider a Lottery vs. bank deposit
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How do you master this

Practice, practice, practice

It is also easy to watch what is done in class and convince yourself that you can do it, if needed There is no substitute for getting out the calculator, paper and pen and working out many, many problems from the book until you can do them correctly and quickly

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Thank you !

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