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College
Master of Business Administration
1
 Financial
management
Tadele Tesfay (Asst. Prof.)
2
 Chapter Three:
The Present Value of
Money
3
 Chapter
objective
•

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4
The Present Value
of Money
 What does mean present
value of money?
• The current worth of a future sum of
money or stream of cash flows given
a specified rate of return.
• It is a process of discounting the
future value of money to obtain its
value at zero time period (at
present)
• A dollar today is worth more than a
dollar in the future
• Thus, to calculate present value, we need to
know:
The amount of money to be received in
the future
The interest rate to be earned on the
deposit
The number of years the money that will
be invested
❖ The process of finding the equivalent value today of a
future cash flow is known as discounting.
❖ Compounding converts present cash flows into future
cash flows.
 Calculating the Present Value

• Using the Present Value Table

– Present value interest factor (PVIF):
a factor multiplied by a future value to
determine the present value of that amount
(PV = FV(PVIFA)
• Notice that PVIF is lower as the number of years
increases and as the interest rate increases
• It can also be calculated using a financial
calculator
FV
PV =
(1 + i )t
 Cash Flow Types and Discounting
Mechanics

• There are five types of cash flows -

Single cash flows (Lump sum cash
flows),
Cash flows stream
Annuities,
Growing annuities and
Perpetuities
 Present Value of a Single Sum of Money
I. Single Cash Flows

• Present value of a future single sum of

money is the value that is obtained when
the future value is discounted at a
specific given rate of interest.
• Cash Flow: CFt
_______________________|
Time Period: t

• The present value of this cash flow is-

PV of Single Cash Flow =  CFt 
PV =  
t 
 (1 + r ) 
Example:1
– What is the current value (PV) of a
deposit that will pay $100 at the end of
year 3, if the existing interest rate is
5% compounded annually?
– In other words, how much do we need
to deposit to have $100 in 3 years?
The mechanics of the calculation are illustrated below.

• So the present value of $100 in 3 years at 5% is

$86.38?
 Or
We can use table

PV = 100(PVIF)3,5%
=100 x 0.864
= 86.40
II. Valuing a Stream of Cash Flows
• Valuing a lump sum (single) amount is easy to
evaluate because there is one cash flow.
• What do we need to do if there are multiple cash
flow?
– Equal Cash Flows: Annuity or Perpetuity
– Unequal/Uneven Cash Flows

FV1 FV2 FV N
PV = + +  +
(1 + i ) (1 + i )
1 2
(1 + i ) N

N FVt
PV = 
t =1 (1 + i )
t
 Valuing a Stream of Cash Flows
Even cash flows

? 12% 2000 2000 2000

0 1 2 3

Uneven cash flows

? 12% 1000 2000 3000

0 1 2 3

• Uneven cash flows exist when there are different

cash flow streams each year
• Treat each cash flow as a Single Sum problem and
add the PV amounts together.
 Uneven Cash Flows
• Very often an investment offers a
stream of cash flows which are not
either a lump sum or an annuity
• We can find the present or future
value of such a stream by using the
principle of value additivity
What is the present value of the preceding uneven
cash flow stream using a 12% discount rate?

12%
1 2 3

0 1000 2000 3000

893

1,594
2,135
$4,622
Yr 1 $1,000 ÷ (1.12)1 = $ 893
Yr 2 $2,000 ÷ (1.12)2 = 1,594
Yr 3 $3,000 ÷ (1.12)3 = 2,135
$4,622

FVt n
PV = 
t = 0 (1 + r )
n

n =3 
100 200 300
PV =  + + 3
t =0  (1 + 0.12) 1
(1 + 0.12)2 (1 + 0.12) 
PV =  893 + 1594 + 2135

PV = 4622
 III. Annuities
• The present value of an annuity is the
value now of a series of equal
amounts to be received (or paid out)
for some specified number of periods
in the future.
• It is computed by discounting each of
the equal periodic amounts.
• The timeline example below shows a
5-year, $100 annuity
100 100 100 100 100

0 1 2 3 4 5
Present Value of an Annuity

• We can use the principle of value

additivity to find the present value
of an annuity

 (1 + i)
Pmt t Pmt 1 Pmt 2 Pmt N
PVA = = + +   +
t =1
t
(1 + i) 1
(1 + i) 2
(1 + i) N
• Alternatively, there is a short cut
that can be used in the calculation
– Thus, there is no need to take the present
value of each cash flow separately
– The closed-form of the PVA equation is:

 1  where,
1 − n
(1 + r ) A = Annuity;
PVA = FV  
 r  r = Discount Rate;
 
  n = Number of years]
• What is the present value of an offer of Birr
100 per year one year from now for coming
5 years with a discount rate of 10% per year.

• The present value should be:-

100 100 100 100 100
PVA = + + + + = 379.08
(110
. )
1
(110
. )
2
(110
. )
3
(110
. )
4
(110
. )
5

62.09
68.30
75.13
82.64
90.91
379.08 100 100 100 100 100

0 1 2 3 4 5
• We can use this equation to find the present
value of our annuity example as follows:
1 − 1 
 (1 + 0.1)5 
PV = 100  
 0.1 
 1  
1 − (1.1) 5 
PV = 100  
 0 .1 
 

PV = 100
0.3791
PV = 1003.791
 0.1 
PV = 379.1

This equation works for all regular (ordinary)

annuities, regardless of the number of payments
 Annuities Due
• The annuities that we begin their
payments at the end of period 1 are
referred as regular annuities (ordinary
annuities)
• An annuity due is the same as a regular
annuity, except that its cash flows occur at
the beginning of the period rather than at
the end

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
 Present Value of an Annuity Due
• The formula for the present value of an annuity due,
sometimes referred to as an immediate annuity, is used to
calculate a series of periodic payments, or cash flows, that
start immediately
• We can find the present value of an annuity due in the same
way as we did for a regular annuity, with one exception
• Note from the timeline that, if we ignore the first cash flow,
the annuity due looks just like a four-period regular annuity
• Therefore, we can value an annuity due with:

1 − 1 
 (1 + i ) n−1 
PV = CF   + CF
 i 
 
• Therefore, the present value of our
example annuity due is:

1 − 1 
 (1 + 0.1)5−1 
PV AD = 100  + 100 = 416.98
 0.1 
 

Note that this is higher than the PV of the

regular annuity
 Deferred Annuities
• A deferred annuity is the same as any
other annuity, except that its payments
do not begin until some later period
• The timeline shows a five-period
payment deferred annuity

100 100 100 100 100

0 1 2 3 4 5 6 7
 PV of a Deferred Annuity

• We can find the present value of a

deferred annuity in the same way as any
other annuity, with an extra step required
PV deferred annuity formula
 1    1 
1 −  1 −  
 (1 + i ) 
n + m  ( + )m 
 − CF   
1 i
PVDA = CF 
 i   i 
   
 
OR
  1 
1 −  (1 + i )n  
PVDA = CF    1 
 i  m
  (1 + i ) 
 
 
• To find the PV of a deferred annuity, we
can first calculate the ordinary PVA
equation, and then discount that result
back to period 0
• Here we are using the previous example a
10% discount rate with a two period
deferred

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7
PV of a Deferred Annuity (cont.)
  1 
1 − 
 (1 + 0.1)5 

  1 
PVDA = 100

2 
 0.1  (1 + 0.1) 
 
 
1 − 0.6209   1 
PVDA = 100   2
 0.1   (1.1) 
 0.3791  1 
PVDA = 100 
 0.1   (1.21)
PVDA = 1003.7910.8264

PVDA = (379.1)(0.8264 )

PVDA = 313.29
Or we can calculate with two steps
  1 
1 −   
(1 + 0.1) 5

PV2 = 100  
Step 1:  0.1 
 
 
1 − 0.6209 
PV2 = 100 
 0.1

PV2 = 100
0.3791
 0.1 
PV2 = 379.1
379.1 379.1
PV0 =  2 = = 313.29
Step 2:
 (1.1)  1.21
 Present value of a Growing
Annuity
• A cash flow that grows at a constant
rate for a specified period of time is a
growing annuity
• A time line of a growing annuity is as
follows
A(1 + g ) A(1 + g ) A(1 + g )
2 n
.....
0 1 2 ...... n
 • The present value of a growing annuity can be
calculated using the following formula
 (1 + g )n   (1 + g )n 
1 − (1 + r )n  1 − n 
PVga = A(1 + g ) 
OR PV = Initial payment  (1 + r ) 
 r−g  ga
 r−g 
   
 
• The above formula can be used when
– The growing rate is less than the discount
rate (g<r) or
– The growing rate is more than the discount
rate (g>r)
– However, it doesn’t work when the growing
rate is equal to the discount rate (g=r)
 Example:
• Suppose you have the right to get
dividend per year for the next 10 years.
The current dividend is Birr 500, but it
is expected to increase at a rate of 8%
per year. The discount rate is 15% per
year.

• Then, how much is the present value of

the dividend that you can get?
Solution:
 (1 + 0.08)10 
1 − 10 
PV ga = (Birr 500 )(1 + 0.08)
(1 + 0.15) 
 0.15 − 0.08 
 
 

 2.1589 
1 −
PV ga = 540  4.0456 

 0.07 
 
 1 − 0.5336 
PV ga = 540 
 0 . 07 
 0.4664 
PV ga = 540 
 0. 07 

PV ga = 540 * 6.6629

PV ga = Birr 3597.97
In case r = g, the formula is
PMT (n)
PV =
(1 + r )
• Example
• Assume you will receive an annual payments for the next
ten years stating a year from now. The first payment will be
$1000, and each passing year it will increase by 3.4%. If
you could invest the money in a saving account it bears
3.4% annual interest, what is the present value of this
growing annuity?
– Here we have PMT = 1000, n = 10, r = 0.034, and g =
0.034. Since r = g in this example, we must use the
above formula.
• Therefore the present value of this growing annuity is
1000(10)
PV =
(1 + 0.034 )
10,000
PV = = 9,671.18
1.034
IV. Present value of perpetuity annuity
• A perpetuity is a constant cash flow at regular
intervals forever.
• A perpetuity is an annuity of with an infinite
duration.
• The present value of a perpetuity can be written
as
PMT
PVPerpetuity =
r
• PV- the present value (or initial principal)
• PMT- the payment made at the end of each of an infinite number
of periods
• I -the discount rate for each period (assumed equal throughout)
• Hence the present value of perpetuity may be
expressed as follows
PV∞ = CF x PVIFA
• Where PV∞ = present value of a
perpetuity
• CF = constant annual cash flows
• PVIFA = present value interest
factor for perpetuity (an
annuity of infinite duration)
 1 1
PVIFA =  t =
t =1 (1 + r ) r
– The value of PVIFA is
• Example:
• Z company bond is a bond that has no
maturity and pays a fixed coupon. Assume
that you have a $1000 face value at 6%
coupon rate Z company bond. The present
value of this bond, if the interest rate is 9%,
is as follows:
PMT
PVPerpetuity =
r
60
PV perpetuity =
0.09
PV perpetuity = 666.67
 SOLVING FOR INTEREST RATE AND TIME

• At this point, you should realize that

compounding and discounting are related,
and that we have been dealing with one
equation that can be solved for either the
FV or the PV.
• FV Form: FVn = PV(1 + i)n.
• PV Form: FVn  1 
PV = = FVn
 
n
(1 + i )n
 (1 + i ) 
• There are four variables in these equations
PV, FV, i, and n
• If we know the values of any three, we can
find the value of the fourth.
SOLVING FOR i
• Suppose you can buy a security at a price of $78.35,
and it will pay you $100 after five years. Here you
know PV, FV, and n, and you want to find i, the
interest rate you would earn if you bought the
security. Problems such as this are solved as follows:
• Time Line:
0 5
? 1 2

78.35 100
Equation:
FV = PV (1 + i )n
FV
FV
i= n −1
(1 + i ) n
= PV
PV
100
1
 FV
1
n
i=5 −1
(1 + i ) n X
n =  78.35
 PV 
i = 5 1.2763 − 1
FV
1+ i = n
PV i = 1.05000 − 1
FV
i= n −1 i = .05 = 5%
PV
SOLVING FOR n
• Suppose you know that a security will provide a
return of 5 percent per year that it will cost $78.35
and that you will receive $100 at maturity, but you do
not know when the security matures. Thus, you know
PV, FV, and i, but you do not know n, the number of
periods. Here is the situation:
• Time Line:

0 5% 1 2 n-1 n=?

-78.35 100
Equation:
 100 
ln 
 FV  n=  78.35 
ln  ln(1 + .05)
n=  PV 
ln(1 + i ) ln(1.2763)
n=
ln(1.05)
Where:
0.2440
FV=Future value n=
PV=Present value 0.0488
i=rate per period
n = 5 years
End of chapter Three

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