FINA 2303 Chapter 4 Spring 2023

FINA 2303 Spring 2023
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Chapter 4
Time Value of Money: Valuing Cash Flow Streams

Rule Formula

1. Only values at the same point in time None
Can be compared or combined

2. To calculate a cash flow’s future value, 𝐹𝑉 𝐶 1 𝑟
we must compound it

3. To calculate the present value of a 𝑃𝑉
future cash flow, we must discount it

Ekkachai Saenyasiri Page 1 1/24/2023

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Example: Find PV of the following cash flow stream (interest rate = 10%)

2,000 4,000 6,000 7,000

t =0 t =1 t =2 t=3 t =4

2,000 4,000 6,000 7000

PV0 of the cash flow stream =   
1 .1 1 .1 2 1.13 1 .1 4

= 1818.18 + 3305.79 + 4507.89 + 4781.09 = 14,412.950

Suppose that you have to pay $10,000 to receive the cash flow stream. How much profit
(in term of PV0) did you receive from this investment?

Net Present Value (NPV) = present value of cash inflows – present value of cash outflows

NPV = 14,412.95 – 10,000 = 4,412

If you decide to invest today, you will be $4,412 richer now.
(Note: We always invest only when NPV > 0)


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Example: If you deposit $10 at the end of year 1 to 7, and $50 at the end of year 9, how
much you will have at the end of year 11?

FV11
$10 10 10 10 10 10 10 50
| | | | | | | | | | | |
t =0 1 2 3 4 5 6 7 8 9 10 11

FV11 =10 * (1.1)10+ 10 * (1.1)9 + 10 * (1.1)8 + 10 * (1.1)7 +10 * (1.1)6 + 10 * (1.1)5 +

10 * (1.1)4+ 50 * (1.1)2

FV11 =25.94 +23.58 +21.44 + 19.49 + 17.72 + 16.11 + 14.64 + 60.5

FV11 = 199.4


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From the example above, you can also find the answer using the calculation below

Total PV0 = 69.89
FV11
$10 10 10 10 10 10 10 50
| | | | | | | | | | | |
t =0 1 2 3 4 5 6 7 8 9 10 11

10 10 10 10 10 10 10 50
PV0 of the cash flow stream =  2  3 4  5  6  7  9
1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1 1 .1

PV0 = 9.09 +8.26 +7.51+ 6.83 +6.21 + 5.64 + 5.13 +21.20 = 69.89

FV11 = 69.89 (1.1)11 = 199.4

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Perpetuity

Perpetuity is a constant cash flow that occurs at regular intervals and continues forever

PV $ $ $ $ $ $ $ $ $ ∞
C C C C C C C C C
| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10

Ct
Value of perpetuity at time t-1 =
r

Value of Perpetuity at time t‐1 = the value of the perpetuity at one period before first cash flow C

Ct = the constant dollar amount provided by the perpetuity (start from t)

r = annual interest rate

Value of Perpetuity at time 0 = C1/r
Value of Perpetuity at time 3 = C4/r

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Proof ‐ Perpetuity Formula

PV $ $ $ $ $ $ $ $ $ ∞
C C C C C C C C C
| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10
A 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 ⋯ ∞ ∞

(1+r) A 1 𝑟 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 1 𝑟 ⋯ ∞ ∞

B 1 𝑟 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 𝐶 ⋯ ∞ ∞

B‐ A 1 𝑟 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 𝐶 ∞

𝑟 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 𝐶

𝑇𝑜𝑡𝑎𝑙𝑃𝑉 𝐶/𝑟

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(PICTURE 1)

PV

40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 ∞
| | | | | | | | | | | | | | | | | | | |

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

What should you be willing to pay now in order to receive $40 annually forever (start
from next year), if you require 20% per year on the investment?

Value of perpetuity at time 0= = 40/ 0.2 = $200

You are indifferent between

1. receiving $40 every year

2. receiving $200 right away

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(PICTURE 2)

Find PV0 of the following cash flows stream (interest rate = 20%)

Value at t= 6
PV0
40 40 40 40 40 40 40 40 40 ∞
| | | | | | | | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Value of perpetuity at time 6 = = = 200
.

𝑃𝑉 = 66.9796
.

/ .
Note that
. . . .


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(PICTURE 3)

Find PV0 of the following cash flows stream (interest rate = 20%)

PV 40 40 40 40 40 40

| | | | | | | | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Shortcut  Picture 3 = Picture 1 – Picture 2 = 200 ‐ 66.98 = 133.02

PV0 of Picture 3 = = 200 – 66.9796 =133.02
. . .

PV0 of picture 3 =

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40 40 40 40 40 40 40 40 40 40 40 40 40 40 40 ∞
1 | | | | | | | | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
40 40 40 40 40 40 40 40 40 ∞
2 | | | | | | | | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
40 40 40 40 40 40
3 | | | | | | | | | | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Picture 3 = Picture 1 – Picture 2 =

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Annuity
An annuity is a series of equal dollar payments for a specified number of years.
We can write the formula for annuity in picture 3 as
Value of annuity at time t-1=
Value of annuity at time t-1 = 1
Value of annuity at time t-1 = value of the annuity at one period before first cash flow at t
Ct = the constant dollar amount provided by the annuity (start from t)
r = interest rate per period
n = the number of period we receive C  NOT the same as t

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Example: Use Perpetuity Formula

PV $ $ $ $ $ $ $ $ $ ∞
10 10 10 10 10 30 10 10 10
| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10

If r = 10%, compute total PV

PV $ $ $ $ $ $ $ $ $ ∞
10 10 10 10 10 10 +20 10 10 10
| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10

10 20
𝑇𝑜𝑡𝑎𝑙 𝑃𝑉
10% 1 10%

Total PV = 111.290
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Example

What is the present value of receiving $15 every year beginning two years from now?
Assume interest rate = 10%.

Note that this formula will give you an amount one year before first payment.
FV1
15 15 15 15 15 15 15 15 ∞
| | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12
C2 15
Value of Perpetuity at time 1    150
0.1 0.1
FV1 150
PV0    136.3636
(1  r )1 1.1

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Example

What is the present value of receiving $15 every year beginning now?

There are many ways to find the answer. One easy way is the following
PV0 = C/r
= 15/0.1
= 150
15 15 15 15 15 15 15 15 15 15 ∞
| | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12
Total Present value = $15 now + Perpetuity start from the end of period 1

Total Present value = 15
.

= 15 = 15 + 150 = 165 0
.

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Example

What is the present value of receiving $20 for 6 years beginning 3 years from now?
FV2
20 20 20 20 20 20
| | | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10 11 12

 1 
1  6
(1  0.1) 
Value of Annuity at time 2  20  = 87.1052
0.1
FV2 87.1052
PV0    71.9878
(1  r ) 2
1.12

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Example: House Payment

If you borrow $100,000 at 7% fixed interest rate for 30 years in order to buy a house,
what will be your monthly house payment? Assume first payment begins in one month.

PV0 = $100,000

? ? ? ? ? … ? ?

| | | | | | |
0 1 2 3 4 5 359 360

n = 360 per month, r = 7%/12 = 0.5833% per month, PV0 = $100,000

 1 
1  
 (1  r ) n 
Value of Annuity at time 0  C1  
r
 1 
1  
 (1  0.005833) 360 
100,000  C 
0.005833

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100,000 = C * (150.3136)
100,000
 665.28 = C
150.3136


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Example: Travelling around the world after retirement
Upon retirement, your goal is to spend 5 years traveling around the world. To travel in
style will require $250,000 per year at the beginning of each year.
If you plan to retire in 30 years, what are the equal monthly payments necessary to
achieve this goal? The funds in your retirement account will compound at 12% APR
compounded monthly.
? ? ? ? ? 250,000 250,000 250,000 250,000 250,000
| | | | | | | | | |
0 1 2 3 4 5 360 372 384 396 408
PV of the traveling plan = PV of the 360 monthly payments
 1 
1  
250,000 250,000 250,000 250,000 250,000 (1  0.01) 360
360
 372
 384
 396
 408
 PMT  
(1.01) (1.01) (1.01) (1.01) (1.01) 0.01

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6,954.17 + 6,171.47 + 5,476.87 + 4,860.44 + 4,313.39 = PMT (97.2183)
27776.35 = PMT (97.2183)
27776.35 /(97.2183) = PMT
285.71 = PMT = Monthly payment
So, you would have to place $285.71 in your retirement account, which earns 12%
compounded monthly, at the end of each of the next 360 months to finance the 5-year world
tour.

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Future Value of an Annuity

 1  r n  1
FV =  
C
 r 

Example: After graduation, you plan to invest $400 per month in the stock market. If
you can earn 12% per year (compounded monthly, i.e., 1% per month) on your stocks,
how much will you have accumulated when you retire in 30 years?

FV360 = ?

400 400 400 400 400 … 400 400

| | | | | | |
0 1 2 3 4 5 359 360

 1  0.01360  1
400    = 1,397,985.65
FV360= 0.01
 
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There are many ways to find the solution. One of them is the following.

 1   1 
1   1  
 (1  r ) n   (1  0.01) 360 
Value of Annuity at time 0  C1    400    38,887.3324
r 0.01

FV360 = PV0 (1+r)360 = 38,887.3324 (1.01)360 = 1,397,985.65
Note:
You cannot say you have 400 * 360 = 144,000  WRONG because this calculation does
not take into account that 400s at different time are not the same

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Growing Perpetuity
𝑃𝑉 only if r > g
Note that: Cash flow (C) in the equation above is the cash flow in one period after PV

Example: The next dividend payment by MSFT will be $2.85 per share. The dividends are
anticipated to maintain a 5% growth rate forever. If investors require a 12 % return on
the stock, what is the current price?
2.85 2.85(1+5%) 2.85(1+5%)2 
t =0 t =1 t =2 t=3 t =
2.85
Current Stock Price  PV   40.7143 0
(0.12 - 0.05)
What if g = ‐5%  PV = 2.85/(0.12 – (‐0.05)) = 2.85/0.17 = 16.76

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Growing Annuity
  1  g n 
1    
 1 r  
Ct   
Value of growing annuity at time t‐1=  rg

 
 
Example: A publishing company is trying to decide whether to revise its popular
textbook. The revision will cost $65,000. Cash flows from increased sales will be $18,000
the first year. These cash flows will increase by 4% per year. The book will go out of print
five years from now. Assume that initial cost is paid now, and revenues are received at
the end of each year. If the publisher requires an 11 percent return for such an
investment, should it undertake the revision?

  1  0.04 5 
1    
1  0.11  
PV of increased sales  18000   71479.470
0.11  0.04 
 
 

Answer: NPV = 71,479.47 ‐ 65,000 = +6,479.47 ‐‐> NPV > 0

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With an ordinary annuity, we assume that the payments occur at the end of each period.

Example: We wish to know what $500 received at the end of each year for next 5 years
is worth to us today given r= 6%.
PV

500 500 500 500 500
| | | | | |
0 1 2 3 4 5

 1   1 
1    1  
 (1  ) n
 (1.06 ) 5
= 500   = 500 *4.2124 = 2106.18
r
Value of annuity at time 0 = C t 1
r 0.06

500 500 500 500 500
Or PV0 =    
1.06 1.062 1.063 1.064 1.065

PV0 = 471.698 + 444.998 + 419.810 + 396.047 + 373.629 = 2106.180

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With an annuity due, the payments occur at the beginning of each period. It is just
ordinary annuity in which all the annuity payments have been shifted forward by one year.

Example: We wish to know what $500 received at the beginning of each year for next 5
years is worth to us today given r = 6%.

PV

500 500 500 500 500

| | | | | |
0 1 2 3 4 5

 1 
1  4

(1.06)
PV0 = = 500 + 500   = 500 + (500 *3.4651) = 2232.553
0.06

Compared to ordinary annuity, with annuity due we receive cash 1 year faster.
Therefore, PV of annuity due is higher than PV of ordinary annuity.

In this example, Annuity due = 1.06 * Ordinary annuity = 1.06 * 2,106.18 = 2232.5530


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Amortized Loan

Amortized loan is a loan in which the borrower makes periodic payments that
include interest on the loan plus some part of the loan balance

Example: Amortized Loans with Fixed Payment.
 Each payment covers the interest expense and reduces principal
 Consider a 4 year loan with annual payments. The interest rate is 8%
compounded annually and the principal amount is $5,000. How much is
the annual payment?
 4 N
 8 I/Y
 5,000 PV
 CPT PMT = ‐1,509.60

 1 
1  
(1  0.08) 
4
5,000  PMT 

0.08

PMT = 1509.60
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The amortization table (fixed payment)

Interest paid in year 1 = 8% * 5,000 = 400
Principal paid in year 1 = 1509.60 – 400 = 1109.60

Year Beginning Total Interest Paid Principal Ending

Balance Payment Paid Balance

1 5,000.00 1,509.60 400.00 1,109.60 3,890.40

2 3,890.40 1,509.60 311.23 1,198.37 2,692.03
3 2,692.03 1,509.60 215.36 1,294.24 1,397.79

4 1,397.79 1,509.60 111.82 1,397.78 0.00

Totals 6,038.40 1,038.41 5,000.00

Ending Balance = Principle Outstanding


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Example: Outstanding Loan Balance
Suppose we have a $100,000 20‐year mortgage with monthly payment at 12% APR
compounded monthly. Compute outstanding loan balance at the end of year 5.

20 years = 240 months
Interest rate = 12%/12 = 1% per month

Compute monthly payment

 1 
1  
 (1  0.01) 240 
100,000  PMT  
0.01

PMT = 1,101.09

After 60 months, you still have to pay 180 more payments (1,101.09 each)

Outstanding balance = the value of the remaining future loan payments
 1 
1  
180 
(1  0.01)
Outstanding balance at the end of year 5  1101.09    91,744.7
0.01

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100,000
1101 1101 1101 … 1101 1101

| | | | | | | | | | | | |
0 1 2 3 239 240
91,744.7
1101 1101 1101 … 1101 1101

| | | | | | | | | | | | |
0 1 2 3 60 61 62 63 239 240
The outstanding amount you owe at any point in time
= the value of your future obligations on the loan

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Common Mistakes

1. Forget that when using present value of annuity (or perpetuity) formula or financial
calculator annuity function, we will get the value of annuity in one year before the first
periodic cash flow
value of annuity=1243.43
 1 
500 500 500 
 1  
3 
(1  10 %) 
1243 .43 2  500 3 

| | | | | 10 %
0 1 2 3 4 5
Financial calculator input: N = 3, PMT = 500, I/Y = 10, FV = 0  CPT PV = ‐1243.43 at time 2

2. Forget that when use the future value of annuity formula, the number we get will be in
exactly the same year as of last periodic cash flow
future value of annuity = 1655

500 500 500  1  10%3  1
16555  500   
| | | | |  10% 
0 1 2 3 4 5

Financial calculator input: N = 3, PMT = 500, I/Y = 10, PV = 0  CPT FV = ‐16555

3. Add or subtract money across year without taking into account time value of money

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Example: Suppose we plan to save $1,000 today, and $1,000 at the beginning of each of
the next two years. If we earn a fixed 10% interest rate on our savings, how much will
we have three years from today?

1,000 1,000 1,000

t =0 t =1 t =2 t=3

There are many ways to compute for FV3; for example

Method #1: Total FV3 = 1,000 * 1.13 + 1,000 * 1.12 + 1,000 * 1.11

= 1,331 + 1,210 + 1,100 = 36413

 1  10%3  1
Method #2: Use future value of annuity formula 33102  1000   
 10% 

Then use the compounding formula FV3 = 33102 * (1+10%)1 = 36413

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Method #3: Use value of annuity formula

2485.85

1,000 1,000 1,000

t = -1 t =0 t =1 t =2 t=3

 1 
 1  
3 
(1  10 %)
2486 .85 1  1000 0  
10 %

Or use financial calculator N = 3, I/Y = 10, PMT = 1000, FV = 0  CPT PV = ‐2486.85
Note that 2486.85 is at year ‐1

FV3 = 2486.85‐1 * (1+10%)4 = 36413

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Example: You have just won MegaMillion for $125 Million dollar (5 equal annual
payments start from now). But if you choose lump sum payment, you can get $100
million right now. Will you choose to get lump sum payment? (Assume interest rate =
10%)

25 25 25 25 25

t =0 t =1 t =2 t=3 t =4

25 25 25 25
PV of the cash flow stream = 25 +  2  3  4
1.1 1.1 1.1 1.1

= 25 + 22.727+ 20.661 + 18.783 + 17.075 = 104.250

It is better to choose 5 payments than $100 million lump sum.

What if you want to use $100 million right now?


______________________________________________________

Answer: You still choose 5 payments from MegaMillion. Then, borrow $104.25 million
from a bank, which will charge 10% on the loan. Whenever you receive $25 million from
Megamillion, you will use this amount to repay the loan.

Using this method, your wealth (at t=0) is $4.25 million higher than when choosing the lump
sum option.
At t = 0, borrow $104.25 million
At t = 0, receive $25 million from Megamillion and use this to repay the loan
At t = 0, loan become $104.25 – 25 = $79.2466 million

At t =1, loan grow 10% to (79.2466 * 1.1) = $87.1713 million
At t =1, receive $25 million from Megamillion and use this to repay the loan
At t =1, loan become $87.1713– 25 = $62.1713 million

At t =2, loan grow 10% to (62.1713* 1.1) = $68.38843 million

At t =3, loan grow 10% to (43.38843* 1.1) = $47.72727 million
______________________________________________________

At t =4, loan grow 10% to (22.72727* 1.1) = $25 million
At t =4, loan become $25– 25 = 0

______________________________________________________

Financial Calculator
FV
PV

PMT PMT PMT PMT

t =0 t =1 t =2 t =3 t =4

Calculator Keys: Texas Instruments BA‐II Plus

– FV = future value
– PV = present value
– I/Y = periodic interest rate
• P/Y must equal 1 for the I/Y to be the periodic rate
• Interest is entered as a percent, not a decimal (10%  input is 10, not 0.1)
– PMT = equal amount of cash flow in each period (annuity)
– N = how many PMT
– Remember to clear the registers (CLR TVM) after each problem
– Always set cash flow to occur at the end of the period
– Other calculators are similar in format

______________________________________________________

Example: You are saving to make a down payment on a house. You have $10,050 saved
already, and you plan to save an additional $5,000 per year at the end of each year. If
you earn 7.25% per year on your savings, how long will it take you to save $60,000?

Total PV of your saving = PV of 60,000

,
10050 + 1 =
. % . % . %

Use financial calculator: I/Y = 7.25, PV = ‐10050, PMT = ‐5000, FV = 60000  CPT N = 7

It takes 7 years to save $60,000


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Ekkachai Saenyasiri Page 1 1/24/2023

2,000 4,000 6,000 7000

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Ekkachai Saenyasiri Page 3 1/24/2023

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Ekkachai Saenyasiri Page 5 1/24/2023

(1+r) A 1 𝑟 𝑇𝑜𝑡𝑎𝑙𝑃𝑉 1 𝑟 ⋯ ∞ ∞

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Ekkachai Saenyasiri Page 7 1/24/2023

Ekkachai Saenyasiri Page 8 1/24/2023

Ekkachai Saenyasiri Page 9 1/24/2023

Picture 3 = Picture 1 – Picture 2 =

Ekkachai Saenyasiri Page 10 1/24/2023

We can write the formula for annuity in picture 3 as

Value of annuity at time t-1=

Value of annuity at time t-1 = 1

Ct = the constant dollar amount provided by the annuity (start from t)

r = interest rate per period

n = the number of period we receive C  NOT the same as t

Ekkachai Saenyasiri Page 11 1/24/2023

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Ekkachai Saenyasiri Page 16 1/24/2023

Ekkachai Saenyasiri Page 17 1/24/2023

? ? ? ? ? 250,000 250,000 250,000 250,000 250,000

PV of the traveling plan = PV of the 360 monthly payments

Ekkachai Saenyasiri Page 18 1/24/2023

27776.35 = PMT (97.2183)

27776.35 /(97.2183) = PMT

285.71 = PMT = Monthly payment

Ekkachai Saenyasiri Page 19 1/24/2023

Ekkachai Saenyasiri Page 21 1/24/2023

2.85 2.85(1+5%) 2.85(1+5%)2 

Ekkachai Saenyasiri Page 22 1/24/2023

Ekkachai Saenyasiri Page 23 1/24/2023

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Ekkachai Saenyasiri Page 28 1/24/2023

1101 1101 1101 … 1101 1101

1101 1101 1101 … 1101 1101

Ekkachai Saenyasiri Page 29 1/24/2023

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Ekkachai Saenyasiri Page 37 1/24/2023

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