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Chapter 5

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

Time Value of years as follows:

Money Year Cash flow

1 $3,000

2 $5,000

3 $4,000

4 $3,000

5 $2,000

Future Value versus Present Value (cont.) Future Value versus Present Value (cont.)

When making investment decisions, managers usually

To make the right investment decision, managers calculate present value.

need to compare the cash flows at a single point in

time. Figure 5.2 Compounding and Discounting

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The three basic patterns of cash flows include: Future value is the value at a given future date of

A single amount: A lump sum amount either held an amount placed on deposit today and earning

currently or expected at some future date. interest at a specified rate. Found by applying

compound interest over a specified period of time.

An annuity: A level periodic stream of cash flow.

Compound interest is interest that is earned on a

A mixed stream: A stream of unequal periodic

given deposit and has become part of the principal

cash flows.

at the end of a specified period.

Principal is the amount of money on which interest

is paid.

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Personal Finance Example

Equation for Future Value

If Fred Moreno places $100 in a savings account We use the following notation for the various

paying 8% interest compounded annually, how much inputs:

will he have at the end of 1 year? FVn = future value at the end of period n

Future value at end of year 1 = $100 (1 + 0.08) = $108 PV = initial principal, or present value

If Fred were to leave this money in the account for r = annual rate of interest paid. (Note: On financial

calculators, I is typically used to represent this rate.)

another year, how much would he have at the end of

the second year? n = number of periods (typically years) that the money is

left on deposit

The general equation for the future value at the

= $116.64 end of period n is

FVn = PV (1 + r)n

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Equation for Future Value Future Value Relationship

Jane Farber places $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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Present Value of a Single Amount

Equation for Present Value

Present value is the current dollar value of a The present value, PV, of some future amount, FVn, to

future amountthe amount of money that would be received n periods from now, assuming an interest

have to be invested today at a given interest rate rate (or opportunity cost) of r, is calculated as

over a specified period to equal the future amount. follows:

It is based on the idea that a dollar today is worth

more than a dollar tomorrow.

Discounting cash flows is the process of finding

present values; the inverse of compounding

interest.

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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Equation for Future Value Present Value Relationship

Pam Valenti wishes to find the present value of

$1,700 that will be received 8 years from now.

Pams opportunity cost is 8%.

follows:

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Annuities Annuity Due Cash Flows ($1,000, 5 Years)

over a specified time period. These cash flows can be

inflows of returns earned on investments or outflows

of funds invested to earn future returns.

An ordinary (deferred) annuity is an annuity for which

the cash flow occurs at the end of each period

An annuity due is an annuity for which the cash flow

occurs at the beginning of each period.

An annuity due will always be greater than an otherwise

equivalent ordinary annuity because interest will compound

for an additional period.

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Personal Finance Example

Annuity

You can calculate the future value of an ordinary Fran Abrams wishes to determine how much money she

annuity that pays an annual cash flow equal to CF will have at the end of 5 years if he chooses annuity A, the

by using the following equation: ordinary annuity and it earns 7% annually. Annuity A is

depicted graphically below:

rate and n represents the number of payments in This analysis can be depicted on a time line as follows:

the annuity (or equivalently, the number of years

over which the annuity is spread).

Pearson Education Limited, 2015. 5-17 Pearson Education Limited, 2015. 5-18

Finding the Present Value of an Ordinary Finding the Present Value of an Ordinary

Annuity Annuity (cont.)

You can calculate the present value of an ordinary Braden Company, a small producer of plastic toys, wants

annuity that pays an annual cash flow equal to CF to determine the most it should pay to purchase a

by using the following equation: particular annuity. The annuity consists of cash flows of

$700 at the end of each year for 5 years. The firm requires

the annuity to provide a minimum return of 8%.

This situation can be depicted on a time line as follows:

rate and n represents the number of payments in

the annuity (or equivalently, the number of years

over which the annuity is spread).

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Table 5.2 Long Method for Finding the Finding the Future Value of an Annuity

Present Value of an Ordinary Annuity Due

You can calculate the present value of an annuity

due that pays an annual cash flow equal to CF by

using the following equation:

rate and n represents the number of payments in

the annuity (or equivalently, the number of years

over which the annuity is spread).

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and an annuity due, both offering similar terms except the

timing of cash flows. We have already calculated the value of the Future value of ordinary Future value of annuity

ordinary annuity, but need to calculate the value of an annuity annuity due

due. $5,705.74 $6,153.29

than the future value of an ordinary annuity.

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Matter of Fact

Due

You can calculate the present value of an ordinary Kansas truck driver, Donald Damon, got the surprise

annuity that pays an annual cash flow equal to CF of his life when he learned he held the winning ticket

by using the following equation: for the Powerball lottery drawing held November 11,

2009. The advertised lottery jackpot was $96.6

million. Damon could have chosen to collect his prize

in 30 annual payments of $3,220,000 (30 $3.22

million = $96.6 million), but instead he elected to

As before, in this equation r represents the interest accept a lump sum payment of $48,367,329.08,

rate and n represents the number of payments in roughly half the stated jackpot total.

the annuity (or equivalently, the number of years

over which the annuity is spread).

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A perpetuity is an annuity with an infinite Ross Clark wishes to endow a chair in finance at his

life, providing continual annual cash flow. alma mater. The university indicated that it requires

$200,000 per year to support the chair, and the

If a perpetuity pays an annual cash flow of endowment would earn 10% per year. To determine

CF, starting one year from now, the present the amount Ross must give the university to fund the

value of the cash flow stream is chair, we must determine the present value of a

$200,000 perpetuity discounted at 10%.

PV = CF r

PV = $200,000 0.10 = $2,000,000

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Shrell Industries, a cabinet manufacturer, expects to If the firm expects to earn at least 8% on its

receive the following mixed stream of cash flows over investments, how much will it accumulate by the end

the next 5 years from one of its small customers. of year 5 if it immediately invests these cash flows

when they are received?

This situation is depicted on the following time line.

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Frey Company, a shoe manufacturer, has been If the firm must earn at least 9% on its investments,

offered an opportunity to receive the following mixed what is the most it should pay for this opportunity?

stream of cash flows over the next 5 years. This situation is depicted on the following time line.

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Compounding Interest More Frequently

8% Interest Compounded Semiannually over 24

Than Annually Months (2 Years)

Compounding more frequently than once a year

results in a higher effective interest rate because

you are earning on interest on interest more

frequently.

As a result, the effective interest rate is greater

than the nominal (annual) interest rate.

Furthermore, the effective rate of interest will

increase the more frequently interest is

compounded.

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Table 5.4 Future Value from Investing $100 at Table 5.5 Future Value at the End of Years 1 and

8% Interest Compounded Quarterly over 24 2 from Investing $100 at 8% Interest, Given

Months (2 Years) Various Compounding Periods

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Continuous Compounding

Than Annually (cont.)

A general equation for compounding more frequently Continuous compounding involves the

than annually compounding of interest an infinite number of times

per year at intervals of microseconds.

A general equation for continuous compounding

assuming (1) semiannual compounding and (2)

quarterly compounding. where e is the exponential function.

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Personal Finance Example

Interest

Find the value at the end of 2 years (n = 2) of Fred The nominal (stated) annual rate is the

Morenos $100 deposit (PV = $100) in an account contractual annual rate of interest charged by a

paying 8% annual interest (r = 0.08) compounded lender or promised by a borrower.

continuously. The effective (true) annual rate (EAR) is the

annual rate of interest actually paid or earned.

FV2 (continuous compounding) = $100 e0.08 2 In general, the effective rate > nominal rate

= $100 2.71830.16 whenever compounding occurs more than once per

= $100 1.1735 = $117.35 year

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Personal Finance Example Needed to Accumulate a Future Sum

Fred Moreno wishes to find the effective annual rate The following equation calculates the annual cash payment (CF)

associated with an 8% nominal annual rate (r = 0.08) that wed have to save to achieve a future value (FVn):

when interest is compounded (1) annually (m = 1);

(2) semiannually (m = 2); and (3) quarterly (m = 4).

Suppose you want to buy a house 5 years from now, and you

estimate that an initial down payment of $30,000 will be

required at that time. To accumulate the $30,000, you will wish

to make equal annual end-of-year deposits into an account

paying annual interest of 6 percent.

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Special Applications of Time Value: Loan Special Applications of Time Value: Loan

Amortization Amortization (cont.)

Loan amortization is the determination of the The following equation calculates the equal periodic loan

equal periodic loan payments necessary to provide payments (CF) necessary to provide a lender with a specified

a lender with a specified interest return and to interest return and to repay the loan principal (PV) over a

repay the loan principal over a specified period. specified period:

The loan amortization process involves finding the

future payments, over the term of the loan, whose

present value at the loan interest rate equals the

amount of initial principal borrowed. Say you borrow $6,000 at 10 percent and agree to make

A loan amortization schedule is a schedule of equal annual end-of-year payments over 4 years. To find the

size of the payments, the lender determines the amount of a

equal payments to repay a loan. It shows the

4-year annuity discounted at 10 percent that has a present

allocation of each loan payment to interest and value of $6,000.

principal.

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Special Applications of Time Value:

($6,000 Principal, 10% Interest, 4-Year

Repayment Period) Finding Interest or Growth Rates

It is often necessary to calculate the compound

annual interest or growth rate (that is, the annual

rate of change in values) of a series of cash flows.

The following equation is used to find the interest

rate (or growth rate) representing the increase in

value of some investment between two time

periods.

Pearson Education Limited, 2015. 5-45 Pearson Education Limited, 2015. 5-46

Personal Finance Example

Finding an Unknown Number of Periods

Ray Noble purchased an investment four years ago Sometimes it is necessary to calculate the number

for $1,250. Now it is worth $1,520. What compound of time periods needed to generate a given amount

annual rate of return has Ray earned on this of cash flow from an initial amount.

investment? Plugging the appropriate values into This simplest case is when a person wishes to

Equation 5.20, we have: determine the number of periods, n, it will take for

an initial deposit, PV, to grow to a specified future

r = ($1,520 $1,250)(1/4) 1 = 0.0501 = 5.01% per amount, FVn, given a stated interest rate, r.

year

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