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After studying this chapter, you should be able to understand the following: Financial Decision Making Present Value Of Annuities Future Value Of Annuities Simple And Compound Interest Discounting Applicable Interest Rate Perpetuities Inflation and the time value of money
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We regard Chapter 3 as the most important chapter in this Manual, so we spend a good bit of time on it. We approach time value in three ways. First, we try to get students to understand the basic concepts by use of time lines and simple logic. Second, we explain how the basic formulas follow the logic set forth in the time lines. Third, we show how time value tables can be used to solve various time value problems in an efficient manner. Once we have been through the basics, we have students work problems and become proficient with the calculations and also get an idea about the sensitivity of output, such as present or future value, to changes in input variables, such as the interest rate or number of payments. Some instructors prefer to take a strictly analytical approach and have students focus on the formulas themselves. Others prefer to use the Present Value Tables, which have for many years been supplied with the text. In both cases, the argument is made that students treat their calculators as “black boxes,” and that they do not understand where their answers are coming from or what they mean. We disagree. We think that our approach shows students the logic behind the calculations as well as alternative approaches, and because calculators are so efficient, students can actually see the significance of what they are doing better if they use a calculator. We also think it is important to teach students how to use the type of technology they must use when they venture into the real world. In the past, the biggest stumbling block to many of our students has been time value, and the biggest problem there has been that they did not know how to use their calculator when we got into time value. Therefore, we strongly encourage students to get a calculator early, learn to use it, and bring it to class so they can work problems. The relationship between time and money provides the foundation for virtually every financial decision financial managers have to make. Whether they are saving money for a future event or considering a loan to pay for a current financial need, financial managers will be greatly impacted by the time value of money. This is true for two main reasons. First, a Kwacha received today can earn interest or appreciate in an investment account, thus increasing its value with
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time. Second, inflation impacts the value of that Kwacha. As the price of goods increases with time due to inflation, the value (or purchasing power) of the Kwacha decreases implying that a Kwacha is not able to buy the same amount of goods it would have bought if there was no inflation in the world. And as you may imagine, such a world, without inflation, can only exist in our dreams. Thus, the scope of business decisions covers a considerable period of time in which inflation will almost certainly take its toll. The values of cash flows related to those decisions occurring over this wide time period are accordingly and imperatively affected by the time value of money. As most decisions focus on doing something today, such as making an investment, with returns flowing over future time periods, it is important for students to understand that cash flows in such different time periods may not be comparable and must, therefore, be adjusted to a common time period, usually to the present, before comparison and analyses can be performed. This adjustment reflects the opportunity cost of alternative investment and the adjustment focus in most decisions is the current period. The concepts in this and the next two chapters are based on one of the most important ideas in financial management, which is, the dividend valuation model. This says that the price which shareholders are willing to pay for a security equals the future cash receipts expected to be generated by the security, discounted at the shareholders' required rate of return. The concepts learnt in these three chapters will prove handy as you tackle advanced topics such as investment appraisal, company valuation and risk management in later chapters. Time Value of Money (“TVM”) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities. TVM is based on the concept that a Kwacha that you have today is worth more than the promise or expectation that you will receive a Kwacha in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your Kwacha for one year at a 6% annual interest rate and accumulate K1.06 at the end of the year. You can say that the future value of the Kwacha is K1.06 given a 6% interest rate and a one-year period. It follows that the present value of the K1.06 you expect to receive in one year is only K1.00. Some skillful observer of the laws of physics as well as economics once said that the two most powerful forces in the world are gravity and the time value of money. It would be hard to argue that point. And since the time value of money is the foundation of all financial planning, we need to establish a thorough understanding of this powerful concept if we are to achieve financial security throughout life. There are several elements that can enter into the Time Value of Money - that magical concept that allows you to quantify your goals in Kwacha amounts - including five "variables" that interact in any given situation, namely: Present Value (PV); Future Value (FV); Number of compounding periods (N) or sometimes (T); Interest Rate (I) or sometimes (R); and Periodic Payment Amount (PMT). Working with these variables and a good financial calculator, or just plain old annuity tables, found at the back of this Manual, one can use the known factors to determine the unknown quantities through the use of standard formulas. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value.
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In the end. or how you handle the risks associated with these financial decisions. 000 in some future period (T). where utility is simply a measure of the happiness or satisfaction gained from a good or service. One of the cornerstones of modern finance assists us in understanding which decisions to make. according to economists. and your financing policy. Think of it this way. or cease to exist. roughly defined to be the minimum number of Kwacha that you would have to give up today in return for receiving K100. financial decisions influence your quality of life.Suppose someone promises to pay you K100. Business is about creating value. you'll be forced to do one of two things. whether it is revenue and growth for business. and a present value (sometimes referred to as a present discounted value). and a bit differently. could create more value themselves using other means. To get more. which is simply a measure of the number of Kwacha that you will receive in period (T). Successful strategic management. . It’s known as the Time Value of Money. and your ability to enjoy the things you want. we all want more. we return to the decisions mentioned earlier. the present value of the future K100. For business the value question is rather important. it's maximum utility. Change how you do things. Life is about making decisions. Personally. and the fact that a little interdisciplinary thinking can go a long way. or old-fashioned utility in our personal lives. especially when other people want or need the same thing. and it is equally applicable to business and personal finance. Once again we are back looking at the study of incentives . People have it a little easier in some respects. which is the direction you want to take the business. choosing which projects to undertake.55 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . In this case. as all the decisions we make have a direct impact on both value creation and utility maximization.if you don't create value in today's economy. K1 today is worth more to you than K1 received in the future. let’s take a note about value and utility. Simply put.000 payment is the value of this future K100. either owners or investors. why bother running or investing in a business? Assuming we don't all have a perpetual income stream it comes back to this . The concept of present value permits financial assets with different associated payment streams to be compared with each other by calculating the value of these payment streams in terms of a single common unit: namely. current Kwacha. 000. Our personal lives. can you look me in the eye and deny that Life is about making decisions? Indeed you can’t. We have already alluded to this in the preceding section. is supported by your investment policy. are about maximizing our utility. 000 in period (T). The income from the investment will in turn. Creating maximum utility is an incentive in and of itself.how people get what they want. This amount of money actually has two different values: a nominal value of K100. how you fund everything. or need. business or personal life. no matter how measly. Often ignored is the interplay between all these areas. This might sound obtuse. If shareholders. making K1 today more valuable than K1 received at some time in the future because it can be invested today to provide a return. in particular those related to finance. A specific procedure for the calculation of present value for future payments will now be developed. Before we go any further. PKN == cfk^k`f^i=ab`fpflk=j^hfkd= Think for a moment.000 payment measured in terms of current (or present) Kwacha. but many important decisions can be made easier by thinking simply. and business is considered first. Linked to all of this is risk management. Stated somewhat differently. whether they relate to your work. make the K1 you get today worth more than the one promised to you in the future. Why? Money has a time value because of interest rates.
If someone interested in purchasing your investment offered you K105 for it today.56 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . allowing people to work out. a bond typically pays interest periodically until maturity at which time the face value of the bond is also repaid. where an annuity factor represents the value of K1 received or paid in each period over a specified number of periods. The problem is. like lease rentals. Think of large personal assets you might have. they don't want you to have all your money now because they understand the time value of money. the present value of that payment is K100. Its worth more to them. Remember the time value of money can be used both for and against you. Lease pricing also uses the present value of annuities. depends upon what these future cash flows are worth in today's Kwacha."A bird in the hand is worth two in the bush". and Stock Valuation. Why? Because that Kwacha can be invested in order to earn interest. PKO == mobpbkq=s^irbp= You must remember the old saying . If a payment received today is not worth the same as one received next year because of the lost investment opportunity. just look to which party has the larger incentives. Let’s look at what really motivated your bank or the National Housing Authority to extend the facility to you. interest rates and spread over different periods of time. hmm? Let's look at the incentives. thus. . Interest rates are paid because someone else can use your money now. at the risk of sounding a broken record. Bond Valuation. The agreements reached in setting up the settlement left you with a sense of security for the future and continuing. If you were to receive a payment of K110 next year and your investment opportunity is l0%. and they bank on the fact that you haven't given it a second thought. this comes back to the incentives mentioned earlier. then what is it worth? What is its present value? Let's look at an example. we need to look at things the other way round and get a handle on the incentives of everyone involved. this concept is part of what is known as the Sharpe-Lintner Capital Asset Pricing Model (“CAPM” for short). and it's slightly more personal. The concept of present value is very useful in comparing investment alternatives that have different cash flows. compared with maximizing your utility? How much utility is your monthly settlement cheque going to provide you in 10 years? Just think about increases in the cost of living over the next fifteen years. Comfortable. dependable payments over time. we must repeat that a Kwacha received today is worth more than a Kwacha received tomorrow or a year from now. The time value of money can apply to you. Well.Again. There is another side to this discussion. This factor is used to determine the present value of a stream of payments. And find out which way it is being used. your utility. For example. and how the monthly cheque stands up. which is in truth a premium for taking the risk of giving your money to someone else. in today's terms. With business. it would be a good deal because it would increase your present value by K5. To understand how. This topic is discussed in detail in Chapter 6 where we discuss the Capital Asset Pricing Model. The Time Value of Money has applications in many areas of Corporate Finance including Capital Budgeting. To be able to really understand what is going on. The value of the bond today. you have to think like they do. and they are prepared to pay you a return for the privilege of doing so. How much value is there for you in holding first-mortgage on a property for 20 years. the value of future cash flows on any project or decision requiring investment. like a House bought through a structured settlement plan. and specifically. The illusion is that you will be better off down the track with the settlement.
43 150.00 .97 8. that has been discounted by an appropriate interest rate.000 i =.509. how much should she invest today to yield K150.PKOKN== mobpbkq=s^irb=lc=m^vjbkqp=Ó=pfkdib=mboflap= We have already alluded to the fact that “Present Value” is an amount today that is equivalent to a future payment.000 [1 / (1 + .57 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .89 133.57 8.128.499.89 133.942. 000. The relationship between the present value and future value can be expressed as: PV = FV [ 1 / (1 + i)n ] Where: PV = Present Value FV = Future Value i = Interest Rate per Period n = Number of Compounding Periods bu^jmibJ=N= j^kab=t^jrkafi^= Mande wants to buy a house 5 years from now for K150. Since money has time value. The difference between the two depends on the number of compounding periods involved and the interest or discount rate.06)5] = 150.725.088.000 (1 / 1.84 7556.57 118. 000.509.942. the present value of a promised future amount is worth less the longer you have to wait to receive it.46 141.05 125.000.000.000.43 6.730 Tabular presentation (K’000) End of Year Principal Interest Total 1 2 3 4 5 112. or series of payments.46 141.3382255776) = K112.814. 000.814.06 n=5 PV = 150.499.05 125.009.32 7. Assuming a 6% interest rate compounded annually. 088.000 in 5 years? ANSWER: FV =K 150.73 118.490.000.
K150.000. FV = K150. use the following two steps: Step 1: Calculate the present value of each of the individual payments in the payment stream. K150. Step 2: Sum the separate present value calculations obtained in Step 1 to obtain the present value of the payment stream as a whole. Similarly.000. and K200 to be received over the next three years? To calculate the present value of the payment stream (K100.000 i = . it follows that the present value of the K100 payment to be received at the end of the first year is K100/ (1+i). it follows that the present value of the K200 payment to be received at the end of the third year is K200 ---------- . you must multiply the number of years by two to obtain the total number of periods. K200) consisting of the three separate payments K100.343916379) = K 111. to be received at the end of the third year. 000. Since there are two compounding periods per year. what is the present value of the payment stream (K100.03)10] = 150.06 / 2 = .090 PKOKO== mobpbkq=s^irb=lc=^=pqob^j=lc=^o_fqo^ov=m^vjbkqp= Now suppose one will be receiving a sequence of three payments over the next three years.000 (1 / 1.03 n = 5 * 2 = 10 PV = 150. it follows that the present value of the K150 payment to be received at the end of the second year is: K150 ---------(1+i) 2 Finally. K150. and K200). 000 [1 / (1 + . How much less can she deposit today to yield K150. and the nominal value of the third payment is K200.= bu^jmib=J=O= If Mande Wamundila finds another financial institution that offers an interest rate of 6% compounded semi annually. the nominal value of the second payment is K150. to be received at the end of the first year. taking care to note how many years into the future each payment is going to be received. to be received at the end of the second year. 000 in five years? ^kptboW= Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a rate per period of 3%. Given a fixed annual interest rate i. The nominal value of the first payment is K100. Carrying out Step 1.58 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .614. 000.
Many finance situations involve more than one cash flow.59 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . adding together these three separate present value calculations in accordance with Step 2. they are referred to as a stream of cash flows.(1+i) 3 Consequently. The Present Value of an Ordinary Annuity could be solved by calculating the present value of each payment in the series using the present value formula and then summing the results. regardless how different the payment streams associated with different financial assets might be. Annuity refers to equal. Calculating the present value of a unequal series of future cash flows is determined by summing the present values of each discounted single future cash flow. the original principal and all accumulated interest will be completely exhausted at the end of the annuity. K200) is given by: PV(i) = K100 + K150 + K200 (1 + i)1 (1 + i)2 (1 + i)3 More generally.. one can calculate the present values for these payment streams in current Kwacha terms and hence have a way to compare them. It is extremely useful for comparing two separate cash flows that differ in some way.(1 / (1 + i)n)) / i] Where: PVoa = Present Value of an Ordinary Annuity PMT = Amount of each payment i = Discount Rate Per Period n = Number of Periods . the present value PV (i) of the payment stream (K100. given any fixed annual interest rate.. K150. Consequently. PKOKP== mobpbkq=s^irb=lc=^k=loafk^ov=^kkrfqv= The Present Value of an Ordinary Annuity (PV-oa) is the value of a stream of expected or promised future payments that have been discounted to a single equivalent value today. consecutive payments. an annuity due assumes they are paid at the beginning of the period. Whether they are equal. given any fixed annual interest rate i. PV-oa can also be thought of as the amount you must invest today at a specific interest rate so that when you withdraw an equal amount each period. consecutive payments or irregular. the present value of this payment stream can be found by following the two steps outlined above.V3.V2. annual (or every period) cash flows is the future value of an annuity. then. Cash flows in a period are assumed to occur at the end of the period... A more direct formula is: PVoa = PMT [(1 . Accumulating a future sum via unequal. An ordinary annuity assumes cash flows occur at the end of each period. and given any payment stream paid out on a yearly basis to the owner of some financial asset. unequal cash flows over time. In particular. the present (current Kwacha) value of this payment stream can be found by following Steps 1 and 2 outlined above.VN) consisting of individual payments to be received over the next N years. periodic payments entails a combination of a series of single future value cash flows. and given any payment stream (V1. The future value of a sum of equal.
000 1.061.01 Interest per period (12% annual rate / 12 payments per year) n = 24 number of periods .325.00 17.325.06] = 5.000 .716.06 9.= bu^jmib=Ó=P= cilobk`b=aÛkdfib=kaeilsr= What amount must Florence invest today at 6% compounded annually so that she can withdraw K5.96 4.(1/(1 + .06 n=5 PVoa = 5.263. 200 cash.53 13.365.96 4. The present value of an ordinary annuity of 24 payments at K25 per monthly period Plus 2.212364) = 21.716. PMT = 50 per period i = .000 (4. 000 at the end of each year for the next 5 years? ^kptboW= PMT = 5.53 -5.000 801.166. a computer dealer offers to lease a system to you for K50 per month for two years. She will sell the same system to you for K1.90 -5.039.98 = bu^jmib=Ó=Q= fklkdb=ilqf= Inonge Loti. If the going interest rate is 12%.365.53 13. The present value of K500 paid as a single amount in two years.02 -5.000 i = .60 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .82 17.06 9.71 -5.061.06)5)) / . which is the better offer? ^kptboW= You can treat this as the sum of two separate calculations: 1. At the end of two years.166. you have the option to buy the system for K500.000 283.12 /12 = .98 1.000 [(1 .82 Year Begin Interest Withdraw End 1 2 3 4 5 21. You will pay at the end of each month.02 -5.000 550.
01] = 50 [(1.17 + 393.95 better off paying cash right now if you have it. Since each payment occurs one period earlier. you would be K255.78).062.( 1/(1.78 The present value (cost) of the lease is K1.( 1 / 1.062.01 Interest per period n = 24 Number of periods PV = FV [1 / (1 + i) n] = 500 (1 / 1. So if taxes are not considered.17 PLUS FV = 500 Future value (the lease buy out) i = .01] = 1. 000 at the beginning of each year for the next 5 years? ^kptboW= PMT = 5.06 n=5 . 455.61 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .26973)) /.000 i = .95 (1.26973) = 393. PKOKQ== mobpbkq=s^irb=lc=^k=^kkrfqv=arb= The Present Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end.01)24)) / . PVad = PVoa (1+i) Where: PV-ad = Present Value of an Annuity Due PV-oa = Present Value of an Ordinary Annuity i = Discount Rate Per Period = bu^jmib=Ó=R= j^tfi^=`efct^k^hbkf= What amount should Mawila Chifwanakeni invest today at 6% interest rate compounded annually so that she would be able to withdraw K5. we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i).PVoa = 50 [ (1 .
716.PVoa = 21.02 5 5.1) / i] Where: FVoa = Future Value of an Ordinary Annuity PMT = Amount of each payment i = Interest Rate Per Period n = Number of Periods bu^jmib=Ó=S= alo`^p=jrqfqf= What amount will accumulate if Dorcas were to deposit K5.000.00 Begin 22.00 550.000.53 -5.00 9.82 (1.325. The difference between the two depends on the number of compounding periods involved and the going interest rates.000.325.000.96 PKP crqrob=s^irbp=lc=^kkrfqfbp= Future Value describes the process of finding what an investment today will grow to in the future.90 -5.53 18.06 14.166. A more direct formula is: FVoa = PMT [((1 + i)n .166.96 Interest Withdraw 1.716.00 -5. The Future Value of an Ordinary Annuity could be solved by calculating the future value of each individual payment in the series using the future value formula and then summing the results.365. 000 at the end of each year for the next 5 years? Assume an interest of 6% compounded annually.00 801.00 . ^kptboW= .62 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .53 Year 1 2 3 4 9.000. It is the amount of money that an investment made today (the present value) will grow to by some future date.00 End 18.000.06 14. we naturally expect the future value to be greater than the present value.98 283.06) = 22. Since money has time value.000.365.02 -5.061.00 -5.98 5.039. PKPKN== crqrob=s^irb=lc=^k=loafk^ov=^kkrfqv= The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or promised future payments will grow to after a given number of periods at a specific compounded interest.
000.300.873.000 (1.000.000 Present value (the amount you have today) i = . a person may wish to calculate both the future value of an annuity .22 After 20 years Janja will have accumulated K211. .204.46 In practical problems.510.06 ] = 5.08 28.22 (46.00 955.000.22).00 618. Will he have enough money to retire in 20 years? ANSWER: You can treat this as the sum of two separate calculations: The future value of 240 monthly payments of K100 Plus the future value of the K50.300.204 + PV = 50.918.005 Interest per period (6% annual rate / 12 payments per year) n = 240 periods FVoa = 100 [ (3.38 5.637092) = 28.00 Deposit 5.00 5. 714.63 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .000.PV = 5.185.1) /.3102 .918.06 /12 = .46 Year Begin Interest 1 0 0 2 3 4 5 5.a stream of future periodic payments and the future value of a single amount that they have today.000.000 i = .00 10.00 15.005)240 = 165. 000 in his savings account.00 21.00 10.00 1.000 (5.005 Interest per period n = 240 Number of periods FV = PV (1+i)240 = 50.873. He can add K100 at the end of each month to his account which pays an interest rate of 6% per year.08 300.1) /.00 21. 000 now in his account.00 End 5.3382255776 . PMT = K100 per period i = .185.005 ] = 46.00 5.000.312.000 [ (1.06 n=5 FVoa = 5.510.00 15.00 + 165. = bu^jmib=Ó=T= g^kg^=jrpq^cbo= Janja Mustafer is 40 years old and has accumulated K50.000.08 5.
000.64 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .873.PKPKO== crqrob=s^irb=lc=^k=^kkrfqv=arb= The Future Value of an Annuity Due is identical to an ordinary annuity except that each payment occurs at the beginning of a period rather than at the end. ^kptboW= PV = 5.38 5.185.00 1.000.000 i = .00 16.13 Deposit 5.00 5.000.46 (1.00 618.691.000.873.46 29.00 955.185.46 5.918.300.06) = 29.876.00 10.00 Interest 300.185.300. we can calculate the present value of an ordinary annuity and then multiply the result by (1 + i).59 .59 Year Begin 1 0 2 3 4 5 5.00 1.000.00 End 5.00 16.06 n=5 FVoa = 28.08 5.876.918. 000 at the beginning of each year for the next 5 years? Assume an interest of 6% compounded annually. Since each payment occurs one period earlier.08 23.08 23.00 10. FVad = FVoa (1+i) Where: FVad = Future Value of an Annuity Due FVoa = Future Value of an Ordinary Annuity i = Interest Rate Per Period = bu^jmib=Ó=U= j^m^il=jribkd^= What amount will accumulate if Mapalo were to deposit K5.312.
Simple Interest = p * i * n Where: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods = bu^jmib=Ó=V= g^_ri^kf=jribkd^== Suppose that Mr. suppose that K200. PKQKN== páãéäÉ=fåíÉêÉëí= This is where any interest earned is NOT added back to the principal amount invested.65 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . For example. 000 is invested at 20% simple interest per annum.000 320. Accumulated interest from prior periods is not used in calculations for the following periods. 000 for 3 years at 5% simple annual interest.000 200.000) 40.000 Simple interest is calculated on the original principal only. such as 30 or 60 days.000 200. Simple interest is normally used for a single period of less than a year.000 (20% of 200.500 .000) Cumulative 240.000 (20% of 200.05 * 3 = 1. The following table shows the state of the investment.000) 40. the interest earned can be dealt with in two ways. year by year: Year 1 2 3 Principal 200.PKQ pfjmib=^ka=`ljmlrka=fkqbobpq== When an amount of money is invested over a number of years.000 280.000 * .000 Interest earned 40. Jabulani Mulenga decides to borrow K10.000 (20% of 200. == ^kptboW= Interest = p * i * n = 10.
the compounding periods can be yearly. or even continuously.109.000 345. interest is earned on interest.000 280. The interest earned in each period is added to the principal of the previous period to become the principal for the next period. mortgages. Compounding is the arithmetic process of determining the final value of a cash flow or series of cash flow or series of cash flows when compound interest is applied. PKR== afp`lrkqfkd= Discounting is nothing more than the flip side of compounding! The time value of money is a two-way street.500 + 525) *.600 The difference between the two methods can easily be seen by comparing the above two tables.25.000 + 500) * .) But as you might rightly guess inflation is just as real and .25 Total interest earned over the three years = 500 + 525 + 551. present value of an annuity.000) 48. you borrow K10. This table shows the results of making a one-time investment of K10. quarterly. 000 for 30 years using 12% simple interest.25 = 1.576.000 * .000 Interest earned 40.22 Compounded Quarterly 347.000) 57.599.87 You can solve a variety of compounding problems including leases. 000 for three years at 5% annual interest compounded annually: Interest year 1 = p * i * n = 10. The term itself merely implies that interest paid on loan or an investment is added to the principle.05 * 1 = 500 Interest year 2 = (p2 = p1 + i1) * i * n = (10.000.000) Cumulative 240. because you can invest today's Kwacha and earn interest on it starting today. Year 1 2 3 Principal 200.000 (20% of 200. Compare this to 1.66 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .000 288.000 240.05 * 1 = 525 Interest year 3 = (p3 = p2 + i2) * i * n = (10. You start with the premise that a Kwacha you get today is worth more than a Kwacha you'll get at some point down the road. As a result.000 (20% of 240. Compound interest is calculated each period on the original principal and all interest accumulated during past periods. (And add to that the thought that inflation hasn't had a chance to erode today's Kwacha yet.05 * 1 = 551. semiannually.600(20% of 288. Type of Interest Simple Compounded Yearly Principal Plus Interest Earned 46. and 12% interest compounded yearly and quarterly. The power of compounding can have an astonishing effect on the accumulation of wealth. For example. Notice that the amount on which simple interest is calculated is always the same.500 earned over the same number of years using simple interest.00 299. loans.PKQKO== `çãéçìåÇ=fåíÉêÉëí= The notion of compound interest is central to understanding the mathematics of finance. and annuities by using the present value. You can think of compound interest as a series of back-to-back simple interest contracts. and future value of annuity formulae. Although the interest may be stated as a yearly rate. future value.
not future. If the job you want pays better. then pay it out during the following summer. An appraiser can verify investor assumptions directly by interviewing the parties to comparable sales transactions or indirectly by estimating the income expectancy and likely reversion for a comparable property and deriving a prospective yield rate. making correct rate selection crucial.certain as death. there is a market for loanable funds. Historical yield rates derived from comparable sales may be relevant. benefits in the mind of the investor and may not be reliable indicators of current yield. and investment management expenses. you'll be better off borrowing money to buy a car now. the amount of risk that the cash will not be tendered when due and the rate of return available from other comparably risky investments. The appraiser calculates the present worth of the forecast revenue stream by multiplying the projected net income (cash flow) for each year by the calculated discount factor for that year. The Discount rate is the rate of return on investment. sellers. The amount investors discount the future cash flows depends on the length of time until the cash is due. and here is why: Life is short. To select an appropriate rate an appraiser must verify and interpret the attitudes and expectations of market participants. The discount rate is a key variable in discounted cash flow analysis.67 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . and the process is known as discounted cash flow (DCF) analysis. The existence of these bank accounts in turn means that even if you don't have a pressing need for money now. advisers. This makes investors. Although the actual yield on an investment cannot be calculated until the investment is sold. the selection of yield rates for discounting cash flows should focus on the prospective or forecast yield rates anticipated by typical buyers and sellers of comparable investments. . Cash preference is preferring income today to getting the same income in the future. including buyers. Suppose you are broke (for many students. an investor may set a target yield for the investment before or during ownership. The discount factor for each successive year declines to reflect the reduced value of revenue received in the future. The market's expectations are critical when estimating a discount rate. This discounting procedure converts future income to present value usually using annual discount factors. even though you'll have to pay interest to the lender. Because there are always people in this circumstance. you're still better off getting it now than getting it later. the rate an investor requires to discount future income to its present worth. These discount factors are derived from the discount rate (also known as the yield rate). lack of liquidity. Economists assume that pretty much everybody has cash preference. Therefore. It is made up of an interest rate and an equity yield rate. This is called Cash or liquidity preference. Working and saving to buy a car someday may not be your best option. The discount rate is most often estimated by band-of-investment analysis or a sales comparison analysis that estimates typical internal rates of return. Because investors prefer immediate cash returns over future cash returns. or any person for that matter to be more inclined to having money now rather than later. This someone doesn’t trust himself to save for the summer on his own. For instance someone who get paid only from August to May might ask the payroll office to take a slice out of each pay cheque and hold it. investors pay less for future cash flows--they "discount" them. and that's why there are bank accounts that pay interest. The selection of a yield [discount] rate is critical to DCF analysis. and brokers. for whom borrowing is a good idea. Theoretical factors considered in setting a discount rate are the safe rate earned from a completely riskless investment (this rate may reflect anticipated loss of purchasing power due to inflation) and compensation for risk. One exception to the cash preference rule is that some people like to have their future money held for them so they don't spend it foolishly now. that's not too hard to imagine) and you need a car today to be able to drive to the job you want. but they reflect past.
bi-annual or annual.68 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .5)) Where: PWFMY = mid-year present worth factor. This component can also be defined as the risk-free rate minus the inflation rate. The risk-free rate is made up of the inflation rate plus a return to reimburse the investor for a loss of liquidity and is measured by the yield to maturity on Government securities with a maturity period comparable to the investment under consideration. qÜÉ=êáëâJÑêÉÉ=ÅçãéçåÉåí= A return to compensate the investor for a loss of liquidity. The number of periods. The DCF equation is expressed as follows: PV = CF1 x (PWF1) + CF2 x (PWF2) + . daily. The formulas vary based on the time the money is received. . Many oil properties are evaluated using an annual mid-period discounting variation of the DCF formula.PKRKN== aáëÅçìåíÉÇ=`~ëÜ=cäçï=^ééê~áë~ä== The DCF method is versatile and widely used to appraise income producing property. beginning of period. These include: qÜÉ=áåÑä~íáçå=ê~íÉ== The annual rate of price change for a basket of consumer goods. equals 1/((1+i)n) i = discount rate (the period compound interest rate) n = the period for the present worth factor being calculated.. Each annual cash flow is discounted to present value. The period may be continuous. monthly. (usually years) used in the analysis is determined by the number of years that the mineral property is expected to produce a positive net income. An appraiser using DCF first projects an anticipated net income for each year of the property's remaining economic life. To estimate the present value (PV).e. Inflation is normally measured by the Consumer Price Index for All Urban Consumers (CPI-U). The market perceives these securities as risk-free for all practical purposes since they are issued by the Zambian Government. and then all the present values are added to obtain the total market value of the real property interest being appraised. The appropriate present worth factor for mid-year DCF analysis is: PWFMY = 1/ ((1+i)(n-. An investor's rate of return must equal the rate of inflation just to break even in real Kwacha terms. CFn x (PWFn) Where: PV = present value CF = the cash flow or income for the period specified PWF = the end of period present worth factor. n. continuously. calculated by the Central Statistics Office and the Catholic Centre for Theological Reflection. PKRKO== aáëÅçìåí=o~íÉ=`çãéçåÉåíë== The discount rate used in discounted cash flow analysis has several components.. i. quarterly. There are many variations on the DCF formula. an estimate of the income (cash flow) to be received in each period is necessary. middle of period or end of period. The inflation rate is the most basic component of a discount rate.
compounded annually. and Implicit Rate . The weighted average cost of capital (WACC) minus the risk-free rate is the general risk premium. This method equates leasing to an equivalent loan transaction. Here's a table that shows how much K1. For certain high-risk investments. The implicit rate is also called the lessee's incremental borrowing rate or IBR. weighing each according to its proportion of total capital. Then find the horizontal row corresponding to the number of years it will take to receive the . with interest at different rates. this premium can be quite high. péÉÅáÑáÅ=êáëâ=éêÉãáìã== A return that compensates the investor for assuming the unique risks associated with a particular investment.= = dÉåÉê~ä=êáëâ=éêÉãáìã== A return to compensate the investor for assuming diversified company-wide risk. Here are four common methods for determining the discount rate: Opportunity Cost . The Investment-specific risk premium may be derived from available data in some cases. is currently worth. Companies also have the option to analyze their investments on a pre-tax or post-tax basis. Investors demand a premium above the WACC to compensate them for this individual investment risk. and then adding the weighted costs. If one were appraising companies. `çãéçåÉåí=ëìãã~êó== These discount rate components can be summarized: == fkci^qflk=o^qb= H=ofph=cobb=`ljmlkbkq= H=dbkbo^i=ofph=mobjfrj= H=pmb`fcf`=ofph=mobjfrj= = Z=afp`lrkq=o^qb= There are other ways to "build up" a discount rate.many companies use their actual return on investment calculated from historical investment transactions. The WACC is measured by weighting the typical company debt and equity costs by the typical company debt and equity capital structure percentages.to arrive at this rate. Some companies use Return on Assets (ROA). find the vertical column under your interest rate (your cost of capital). Return On Investment (ROI) . at the end of various periods in the future. As you can see. To use the table.It represents the highest yield available on investment opportunities at the time a decision is made. Return on Equity (ROE) or Return on Capital (ROC).69 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . Weighted Cost of Capital .this is the rate that makes the present value of the lease payments plus the present value of the unguaranteed residual equal to the cost of the asset. there are various approaches to determining the proper discount rate. This method's advantage is that the first three components are quantifiable from public data. the WACC would be the discount rate since it reflects the market's expected yields from the stock and debt of a company. but in general the appraiser must estimate it. a company calculates its cost of both debt and equity. Calculation of a WACC will be explained in more detail later in this study manual. The discount rate minus the WACC is the Investment-specific risk premium.
After all the factors are considered (including initial costs. kÉí=mêÉëÉåí=s~äìÉ=çÑ=~=hï~ÅÜ~= VKRB= NMKMB= MKVNPOQO= MKVMVMVN= MKUPQMNN= MKUOSQQS= MKTSNSRQ= MKTRNPNR= MKSVRRTQ= MKSUPMNP= MKSPROOU= MKSOMVON= MKRUMNNT= MKRSQQTQ= MKROVTUT= MKRNPNRU= MKQUPUOQ= MKQSSRMT= MKQQNUQU= MKQOQMVU= MKQMPRNQ= MKPURRQP= MKPSURMS= MKPRMQVQ= MKPPSRPR= MKPNUSPN= vÉ~ê= N= O= P= Q= R= S= T= U= V= NM= NN= NO= VKMB= MKVNTQPN= MKUQNSUM= MKTTONUP= MKTMUQOR= MKSQVVPN= MKRVSOST= MKRQTMPQ= MKRMNUSS= MKQSMQOU= MKQOOQNN= MKPUTRPP= MKPRRRPR= NMKRB= MKVMQVTT= MKUNUVUQ= MKTQNNSO= MKSTMTPR= MKSMTMMM= MKRQVPON= MKQVTNOP= MKQQVUUR= MKQMTNPS= MKPSUQQV= MKPPPQPU= MKPMNTRQ= For example. Let's say he needs five years for this.payment.620921 to be precise. Go to the 10-percent column and slide down to the 5-year row and be dismayed to learn that your today's Kwacha will only be worth 62 ngwee in 5 years (or K00. in order to find the present value of the amount you expect. and let's also say you think you could be earning 10 percent interest on your money if you got your fees upfront. You can multiply this value by the number of Kwachas you expect to receive. And here's an example of how the table can be used to compute the net present value of a major project by discounting the cash flow. tax savings from depreciation. The point at which the column and the row intersect is your present value of K1. suppose you are designing a building for a big client who wants you to agree to wait for payment of your fees until the building is built and rented out. Let's say you're considering the acquisition of a new machine. you project the following cash flows from the machine: `~ëÜ=cäçï=^ÑíÉê=mìêÅÜ~ëÉ= EhNMIMMMF== h=PIMMM== h=PIRMM== h=PIRMM== h=PIMMM= vÉ~ê=N== vÉ~ê=O== vÉ~ê=P== vÉ~ê=Q== vÉ~ê=R== Assume that your cost of capital is 9 percent. the Net Present Value Table shows whether the new machine would at least cover its financial costs: kÉí=mêÉëÉåí=s~äìÉ=~ÑíÉê=mìêÅÜ~ëÉ= q~ÄäÉ=c~Åíçê= NKMMMMMM=Z= MKVNTQPN=Z= MKUQNSUM=Z= MKTTONUP=Z= MKTMUQOR=Z= vÉ~ê= `~ëÜ=cäçï= N= EhNMIMMMF=ñ= O= h=PIMMM=ñ= P= h=PIRMM=ñ= Q= h=PIRMM=ñ= R= h=PIMMM=ñ= kms=Z=hROSKMV= mêÉëÉåí=s~äìÉ= EhNMIMMMKMMF= hOITROKOV= hOIVQRKUU= hOITMOKSQ= hOINORKOU= .70 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . revenue from additional sales. and taxes on additional revenues).
first multiply each side by (1+g)/ (1+i): PV (1+g) = C (1+g) + C (1+g) 2 + …… (1+i) (1+i) 2 (1+i) 3 Then subtract the second equation from the first: . a usable present value formula can be determined by first dividing each side by (1+i). but let’s stop here for now. (1+i)3 To simply this expression. We will discuss this further in Chapter 11 when we look at Capital Investment Appraisal.71 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .. From this infinite series. subtract the second equation from the first equation: PV – PV/ (1+i) = C/ (1+i) Solving for PV. why not turn the pages? PKS== ibsbi=`^pe=ciltp=J=mbombqrfqfbp= PKSKN== bèì~ä=é~óãÉåíë= A perpetuity is a series of equal payments over an infinite time period into the future. the purchase of the new machine looks like it might be a good decision. In order to eliminate most of the terms in the series. PV = C/ (1+i) + C/ (1+i)2 + C/ (1+i)3 + ………. Consider the case of a cash payment “C” made at the end of each year at interest rate “i” as shown in the following time line: 0 PV 1 C 2 C 3 C Because the cash flow continues forever. But if you feel hungry for it. the PV is given by an infinite series.Since the net present value of the discounted cash flow is positive.. PV / (1+i) = C / (1+i)2 + C/ (1+i)3 + C/ (1+i)4 +……. increase at a certain growth rate “g” as depicted in the following time line: 0 1 2 3 PV C C+ (1+g) C+ (1+g)2 The PV of a growing perpetuity can be written in the following infinite series: PV = C (1+i) + C (1+g) (1+i)2 +C(1+g)2 +……. the present value of a perpetuity is given by: PV = C/ i PKSKO== dêçïáåÖ=éÉêéÉíìáíáÉë= Sometimes the payments in a perpetuity are not constant but rather.
are real interest rates. which is often called "core inflation". inflation is a rise in the general level of prices.PV – PV (1+g) = (1+i) C (1+i) Finally. That means the Kwachas you receive today will be worth less in the future. or the rate at which the purchasing power of an investment increases. disinflation which is the reduction of the rate of inflation. The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. interest rates were assumed to be "real" rates. Finally. or broadly speaking.Pick a lot prize. Over 20 years.72 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= .44. interest and output dominate over other effects. With inflation the purchasing power of cash flows over a time line declines at the rate of inflation. As with many economic numbers. An inflation rate of 4 percent might not seem like much until you consider its effect on the purchasing power of your money over the long term. as measured against some baseline of purchasing power. when looking at inflation. the structured payment will never increase to meet inflation. the growth rate must be less than the interest rate. and those who believe that the interaction of money. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases. Related terms include deflation which is a falling general level of prices. The real rate of interest is calculated as follows: . adjusted for inflation in a period. or in the way in which goods from the present are compared with goods from the past. loans. Bonds. In today's economy. Nominal rates. solving for PV yields the expression for the present value of a growing perpetuity as follows: PV = C/ (1-g) For this expression to be valid. In the time value of money analysis above. insurance settlement or trust. either for the relative weight of goods in the basket. Inflation measures are often modified over time. and the cash flows over the time line were assumed to have the same purchasing power. inflation's easy to overlook when planning your financial future. Yet in most cases. In general mainstream economists divide into two camps: those who believe that monetary effects dominate all others in setting the rate of inflation. hyper inflation which is an out of control inflationary spiral and reflation which is an attempt to raise prices to counter act deflationary pressures. that is g < i== PKT== fkci^qflk=^ka=qeb=qfjb=s^irb=lc=jlkbv= Inflation doesn't sleep. no matter what the source. economic institutions sometimes only look at subsets or "special indexes". One common set is inflation ex-food and energy. If those Kwachas are part of a structured payment. inflation will make the value of today's payments shrink in the coming years. monetarists. 4 percent inflation annually would drive the value of a Kwacha down to K0. In mainstream economics. and most financial contracts are quoted in nominal interest rates. PKSKN== oÉ~ä=îÉêëìë=kçãáå~ä=`~ëÜ=cäçïë= Actual Kwacha prices or interest rates are called nominal Kwachas or interest rates. versus changes in the economy. or broadly speaking Keynesians.
tuition savings plans. In order to convince an individual to postpone that consumption (and to save or invest the money). For Kwacha amounts at some point in the future. people are given some compensation. That compensation usually comes in the form of an investment return or interest earnings. This is because individuals have a preference for current consumption since they gain satisfaction from consuming goods and services. PKSKO== s~äìáåÖ=oÉ~ä=`~ëÜ=m~óãÉåíë= Since nominal rates include real rates plus expected inflation. the realized real rate may be negative.73 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . do not mix nominal and real or you will have garbage! PKT== lsbosfbt=afp`rppflk== PKTKN== tÜó=açÉë=jçåÉó=e~îÉ=~=qáãÉ=s~äìÉ\= Money has a time value. . then nominal cash flows and rates must be adjusted to compare. the associated future value (FV) will be larger. Current Kwacha cash flows must be discounted by the nominal interest rate. When one set of cash flows are presented in real term. PKTKO== cìåÇ~ãÉåí~ä=oÉä~íáçåëÜáéë= The fundamental relationship is as follows: For a specific Kwacha amount today (the present value or PV). discounting nominal future cash flows by nominal rates will give the same answer as discounting real. The actual purchasing power rate of return (real rate) on an investment is the nominal expected rate of return. and mix the cash flows. As noted above.1 + real interest rate = 1 + nominal rate/1+ inflation rate The approximate realized real rate is the nominal rate minus the inflation rate for the period. PKSKQ= oÉ~ä=çê=kçãáå~ä\= Most financial analyses in this text will assume nominal rates and will discount nominal cash flows. Nominal rates include expected real rates of return plus expected inflation rates. given a positive rate of return (or a positive interest rate). PKSKP== mêçîáÇáåÖ=Ñçê=oÉíáêÉãÉåí= Expected inflation is a significant variable in retirement planning. 1+r. contrast. such as the social security cash flows. divided by 1 + the expected inflation rate. real cash flows must be discounted by the real interest rate. we use the term "Future Value" or the initials "FV". or any long-term financial planning. a Kwacha amount invested today becomes a greater Kwacha amount in the future. Even a low rate of inflation can have a major negative effect on people who will receive relatively fixed nominal income or returns. With high inflation. Investors and lenders include expected inflation rates in nominal rates to compensate for the loss of purchasing power. choice of vocation. we use the term "Present Value" or the initials "PV". expected inflation adjusted cash flows by the real interest rate. For Kwacha amounts in the present. Since a Kwacha that is saved or invested has the power to increase over time (if the earnings are reinvested).
insurance programming problems. Furthermore. the associated present value of that amount will be less than K100. . PKTKQ== qsj=`~äÅìä~íáçåë== Time value of money calculations are used to shift Kwacha values through time. These four types of calculations provide the basis for most of the financial calculations preformed by financial managers.74 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . 1. all the calculations become simple. Once the methods of restating money values through time is mastered. We do this by restating money values through time with Time Value of Money Calculations. given a positive rate of return (or a positive interest rate). the Annuity problems are shown to be nothing more than a series of the simpler FV and PV problems. that K100 will grow to a greater amount in the future. They can be used to state future Kwacha flows in present value terms or to restate current Kwachas into future Kwacha values. 2. They allow numerous calculations related to the earning of interest. The calculation of present values is the foundation for many financial decision making processes including the area of capital budgeting. If we consider a K100 payment that is made 3 years from today (a FV). =PKTKP== fãéçêí~åÅÉ=çÑ=pí~íáåÖ=`~ëÜ=cäçïë=áå=mêÉëÉåí=s~äìÉ=qÉêãë= The fact that money has a time value means we must take this time value of money into consideration when we are making financial decisions. and almost any asset purchase decision. the earning of non-interest returns on investments. In reality. the present value today (or PV) will be smaller. The calculations are the most powerful tool available for making financial and business decisions. once the first and most fundamental type of time value calculation is mastered. There are just four fundamental time value of money calculations. they can be used for restating cash flows in such a way as to make them comparable in the financial decision making process. 3. 4. By stating all future cash flows in terms of present values. loan related problems. They also provide the foundation for some of the most widely used valuation concepts and valuation models employed in finance. Future Value of a Kwacha calculation (FV) Present Value of a Kwacha calculation (PV) Future Value of an Ordinary Annuity (FV oa) Present Value of an Ordinary Annuity (PV oa) PKTKR== oÉä~íáçåëÜáé=ÄÉíïÉÉå=íÜÉëÉ=Ñçìê=`~äÅìä~íáçåë= Once the FV problem and the related equation is understood. we can compare them. capital budgeting decision processes. If we consider K100 invested today (a PV) in an account that pays interest. PKTKS== qóéÉë=çÑ=cáå~åÅá~ä=`~äÅìä~íáçåë=rëáåÖ=qsj== Even the most complicated financial modeling problems can be broken down into component parts and can be addressed with these four types of time value of money problems.For a specific Kwacha amount at some point in the future (a future value or FV). it is found that the PV problem and its equation is just the opposite (the inverse) of the FV process.
75 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . The types of questions answered are: What price do I think is fair for that share of stock? What am I willing to pay for that bond? What is the true value of that franchise package? Is it worth it to invest in rental property? PKTKNM== oÉíáêÉãÉåí=éä~ååáåÖW== Whether an individual is saving through a pension fund.PKTKT== iç~å=êÉä~íÉÇ=éêçÄäÉãëW== All automobile loans. nothing more than PV of an Annuity problem. will we increase the economic value of our firm? Are the incremental benefits of the project greater than the incremental costs? PKTKV== mÉêëçå~ä=áåîÉëíãÉåí=ÇÉÅáëáçåëW== Personal decisions to invest in securities such as bonds and stocks create the problem of how to decide what the security might be worth. home mortgage loans. The questions answered with capital budgeting decisions are: Does the project have a positive Net Present Value? Does the project have a percentage return that is greater than our cost of capital? If we undertake this project. . equipment loans. an understanding of how future wealth is created is essential for proper decision making. These models rely on the PV calculations to arrive at these values. All retirement planning is based on FV and FV of Annuity problems. and credit card loans that require a periodic payment (such as a monthly payment) that contains both interest due and a payment on the loan principal are often called loan amortization problems. how much of a home mortgage will I qualify for? PKTKU== `~éáí~ä=ÄìÇÖÉíáåÖ=ÇÉÅáëáçåë=~åÇ=çíÜÉê=ÄìëáåÉëë=áåîÉëíãÉåíëW== All business investment decisions should be based on Discounted Cash Flow (DCF) decision tools such as Net Present Value (NPV). They are. There are a number of different valuation methods that are used to determine what the economic value of the cash flows associated with an investment are. the basis of many fundamental financial decisions is Time Value calculations. The types of questions answered with this calculation include: How much is the monthly payment? When will the loan be paid off? What is the mortgage interest expense deduction for tax purposes? Given my monthly gross salary. The main questions answered are: How much money do I need to retire? How much of an annual income will that provide to me? How much do I need to save now every year if I am to meet my goals? As you can see. Once the incremental after-tax cash flows associated with an investment project are identified. in reality. the process of calculating the NPV is nothing more than a series of PV and PV of Annuity calculations. or a life insurance policy.
the higher the discount rate and longer the term. It was devoted to the TVM principle. and time. a fair deal or a bad deal by the National Housing Authority? This chapter has taught you how to answer such questions. r.76 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . The expression. The cash flows must be time adjusted at an appropriate discount rate. The value today of a future cash flow is called the present value. The present value is the reciprocal of the future value calculation. the lower the PV. how to value at one point in time cash flows that actually occur at other points in time. to be successful. This will be an important variable when value determination is studied in a later chapter. t. 1/ (1+r) t is called a discount factor. Financial decisions are measured by their NPV – the present value of the expected future cash flows minus the cost. Present value (1+r) t = future value. usually to the "present" for comparison. or other analysis. which is the PV of a K1 future payment. Discount factors for whole number discount rates and years are calculated and available for use. = . The higher the future cash flows. The NPV is the value created or lost by a decision. the higher the PV.PKU== `e^mqbo=prjj^ov= Have you ever paid for something with monthly payments? Suppose you wanted to buy a K90 million house in PHI and were told the payments would be K7 million for 48 months. Cash flows occurring at different time periods are not comparable for financial decision making. summation. You have learnt how to determine the PV of future cash flows and more generally. Present values are directly related to the future cash flows and inversely related to the discount rate. The interest rate used to compute present values of future cash flows is called the discount rate. while the present value (PV) = 1/ (1+r) t x future value. firms must find positive NPV opportunities and avoid negative NPV choices. How would you know whether you were being offered a good deal. Therefore. The present value computation solves for the original investment at a certain rate when one knows the future value. A time line presentation helps students visualize the concept.
24%.= PKT== bu^jfk^qflk=pq^ka^oa=nrbpqflk= = = wfmmlo^e=j_btb= Assume that it is now 1 January 2007. Assuming that the bank compounds interest annually. Zipporah intends to deposit K1.5061) = K1. Suppose Zipporah deposited the K1.56 Therefore.56 each to have a balance of K1. K1. 2010 and 2011. On 1 January 2008. How large would each of her payments have to be for Zipporah to obtain the same ending balance as the one calculated in part (a) above? ^kptboW= a. 259. PMT (FVIFA 8%.71. 259. Required: a. 2010 and 2011. 126.0 = (1. What would Zipporah’s 1 January 2011 balance be if the bank used quarterly compounding rather than annual compounding? c. 000 is being compounded for three years so Zipporah’s balance on 1 January 2011 is calculated to be K1.0 = 0.5061) = K1. c. 4 years) = FV PMT (4.02) 4 – 1. ************************************************************* .71 / 4. This is arrived at as follows: FV = PV (1+i) t = K1.08) 3 = K1. Therefore.77 = `Ü~éíÉê=P= qáãÉ=î~äìÉ=çÑ=ãçåÉó= . based on 8% annual compounding? d. 000 in 4 payments of K250 each on 1 January 2008. n) = K250 (4. 2009.2681) = K1. FV = K1. i = 8%. PMT (FVIFA k.53 d. 259. As you work this problem.0824 = 8. Zipporah would have to make 4 payments of K279. 000 (1+ 0. 259.08/4) 4 – 1. 259. The effective annual interest rate for 8%.71 PMT = K1. t=4. compounded quarterly is calculated as: EAR = (1 + 0. the FV = K1.10.5061 = K279.71 on 1 January 2011. 259. keep in mind that the tables assume that payments are made at the end of each period. you must solve this problem by finding the future value of an annuity of K250 for years at 8%. 000 (1. 2009. 000 into a savings account at one of the local commercial banks paying an 8% interest rate. How much would she have in her savings account on 1 January 2011.71 b. Therefore. 000 (1.71.0824) 3 = K1. how much will Zipporah have in her savings account on 1 January 2011? b. Suppose Zipporah deposited 4 equal payments in her savings account on 1 January 2008. 268.