Professional Documents
Culture Documents
Chapter 4
Time Value of Money: Valuing
Cash Flow Streams
FVn = C (1+r )
n
(1+r )
n
• Now suppose that Uncle Henry gives you the money, and
then deposits your payments to him in the bank each year.
How much will he have four years from now? We need to
compute the future value of the annual deposits. One way
to do this is to compute the bank balance each year:
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.1 Present Value of a
Stream of Cash Flows (5 of 6)
Example:
• Suppose you plan to invest $20,000 in an account paying
8% interest.
• You will invest an additional $1000 at the end of each year
for 15 years.
• How much will you have in the account in 15 years?
• To compute the solution, we enter the four variables we
know and solve for the one we want to determine, FV.
Example 1:
• For the HP-10BII or the TI-BAII Plus calculators:
– Enter 15 and press the N key.
– Enter 8 and press the I/Y key (I/YR for the HP )
– Enter −20,000 and press the PV key.
– Enter −10,000 and press the PMT key.
– Press the FV key (for the TI, press “CPT” and then
“FV”).
• Notice that PV and PMT (the amount we’re putting into the
bank) are entered as a negative number and FV (the amount we
take out of the bank) is shown as a positive number.
• It is important to enter the signs correctly to indicate the
direction the cash flows are moving. It is also important to note
that an interest rate of 8% is entered as “8” in a financial
calculator, but as “0.08” in Excel.
Evaluate
• This answer of $3641 is precisely the same result we
found earlier. As long as we apply the three rules of valuing
cash flows, we will always get the correct answer.
• Then we’ll compute its value three years later (its future
value).
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.2a Computing the Future
Value (3 of 4)
Execute:
C C C
PV = + 2
+ 3
+......
(1+r) (1+r) (1+r)
C
PV (C in Perpetuity ) =
r
Problem
• You want to endow an annual graduation party at your
alma mater. You want the event to be memorable, so you
budget $30,000 per year forever for the party. If the
university earns 8% per year on its investments, and if the
first party is in one year’s time, how much will you need to
donate to endow the party?
Execute
• Use the formula for a perpetuity:
C
PV = ,
r
$30,000
= = $375,000 today
0.08
Evaluate
• If you donate $375,000 today, and if the university invests
it at 8% per year forever, then the graduates will have
$30,000 every year to fund their graduation party.
Problem:
• You just won the lottery, and you want to endow a
professorship at your alma mater.
• You are willing to donate $4 million of your winnings for
this purpose.
• If the university earns 5% per year on its investments, and
the professor will be receiving her first payment in one
year, how much will the endowment pay her each year?
Execute:
• From the formula for a perpetuity,
C
PV = , so C = PV r
r
C = $4,000,000 .05 = $200,000
Evaluate:
• If you donate $4,000,000 today, and if the university
invests it at 5% per year forever, then the chosen professor
will receive $200,000 every year.
C C C C
PV = + + + ......
(1 + r) (1 + r)2 (1 + r)3 (1 + r)N
1 1
PV ( Annuity of C for N periods with Interest Rate r ) = C 1-
r (1 + r )N
• Both the financial calculator and Excel will give you the PV
of the 29 payments ($11,158,406, or 11.16 million), to
which you must add the first payment of $1 million just as
shown.
0 1 2 3 4 5 6
1 1
PV (6 - year annuity) = $10,000
0.07 1.076
1-
0 1 2 3 4 5 6
+$47,665
$57,665
FV ( Annuity ) = PV (1 + r )
N
C 1
(1 + r )
N
= 1-
r (1 + r )
N
1
(
= C (1 + r ) - 1
r
N
)
FV = $10,000
1
0.10
(1.1030 - 1) lim
x →
A
= $10,000 164.49
= $1.645 million at age 65
C
PV ( Growing perpetuity ) =
r -g
• The cost of the party next year is $30,000, and the cost
then increases 4% per year forever. From the timeline, we
recognize the form of a growing perpetuity and can value it
that way.
$30,000
PV = = $750,000 today
( 0.08 - 0.04 )
Evaluate
• You need to double the size of your gift!
1 1+ g
N
PV = C × 1-
r - g 1+ r
FV= $150,463×1.1030
=$2.625 million in 30 years
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.7 Retirement Savings with
a Growing Annuity (5 of 5)
Evaluate
• Ellen will have $2.625 million at age 65 using the new
savings plan. This sum is almost $1 million more than she
had without the additional annual increases in savings.
Because she is increasing her savings amount each year
and the interest on the cumulative increases continues to
compound, her final savings is much greater.
1 1.04 20
PV = $10,000 1-
0.10 - 0.04 1.10
= $10,000 11.2384
= $112,384 today
FV = $112,384×1.10 40
=$5,086,416 in 40 years
P
C=
1 1
1 -
r (1 + r )N
Using Eq. 4.9, we can solve for the loan payment, C, given
N= 30,r= 0.08, andP= $80,000.
P 80,000
C= = = $7106.19
1 1 1 1
1- 1-
r (1 + r )N
0.08 (1.08)30
Evaluate
• Your firm will need to pay $7106.19 each year to repay the
loan. The bank is willing to accept these payments
because the PV of 30 annual payments of $7106.19 at 8%
interest rate per year is exactly equal to the $80,000 it is
giving you today.
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.8a Computing a Loan
Payment (1 of 5)
Problem:
• Suppose you accept your parents’ offer of a 2007 BMW M6
convertible, but that’s not the kind of car you want.
• Instead, you sell the car for $61,000, spend $11,000 on a used
Corolla, and use the remaining $50,000 as a down payment for
a house.
• The bank offers you a 30-year loan with equal monthly
payments and an interest rate of 6% per year, and requires a
20% down payment.
• How much can you borrow, and what will be the payment on the
loan?
Note, we need to use the monthly interest rate. Since the quoted
rate is an APR, we can just divide the annual rate by 12:
0.06
r= = 0.005
12
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.8a Computing a Loan
Payment (4 of 5)
Execute:
• Eq. 4.8 gives the payment (cash flow) as follows:
P 200,000
C= = = $1,199.10
1 1 1 1
1- 1-
r (1 + r )N
0.005 (1.005)365
2000
1000=
(1+r)6
1000×(1+r)6 =2000
1
2000 6
1+r=
1000
=1.1225,or
r=12.25%
Problem
• Let’s return to the lottery prize in Example 4.4. How high of
a rate of return do you need to earn by investing on your
own in order to prefer the $15 million payout?
• We need to solve for the rate of return that makes the two
offers equivalent. Anything above that rate of return would
make the present value of the annuity lower than the $15
million lump sum payment, and anything below that rate of
return would make it greater than the $15 million payment.
Execute
• We set the present value of option (a) equal to option (b), which
is already in present value since it is an immediate payment of
$15 million:
1 1
$15 million=$1 million+$1 million × 1-
r (1+r )29
1 1
$14 million=$1 million× 1-
r (1+r )29
Using a financial calculator to solve for r :
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.
Example 4.9 Computing the Rate of
Return with a Financial Calculator
(5 of 6)
Excel Formula:
RATE (NPER,PMT,PV,FV ) RATE(29,1000000,-14000000,0)
Evaluate
• 5.72% is the rate of return that makes giving up the $15
million payment and taking the 30 installments of $1 million
an even trade in terms of present value. If you could earn
more than 5.72% investing on your own, then you could
take the $15 million, invest it and generate 30 installments
that are each more than $1 million. If you could not earn at
least 5.72% on your investments, you would be unable to
replicate the $1 million installments on your own and would
be better off choosing the installment plan.
Excel Formula:
= RATE (NPER, PMT, PV,FV ) = RATE(6,10000,-51000,0)
Excel Formula:
=NPER (RATE,PMT, PV, FV ) = NPER(0.10,-10000,-1645000,3850000)
1 1
PV ( 48 - period annuity of $500 ) = $500 1-
0.005 1.00548
= $21,290
Evaluate
• Thus, taking the loan is equivalent to paying $21,290
today, which is costlier than paying cash. You should pay
cash for the car.
Week 0 1 2 3 4 5 3,900
1 1
0.00096 1.000963,900
PV (3,900-period annuity of $5,000)=$5,000× 1- =$5,084,886