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L.chapter 2. The Time Value of Money-Sv
L.chapter 2. The Time Value of Money-Sv
Chapter 2
THE TIME VALUE OF MONEY
1
Learning objectives
• Calculate the future value (FV) and the present value (PV) of a single
decisions in practice.
Contents
5.3
2.1. The timeline and the time value of money
2.1.1. The timeline
Cash flows
A timeline shows when cash flows occur and they are cash inflows
or cash outflows.
????? How to draw a timeline
Step 1: Draw a linear that we use the index t to represent a point in time
a stated number of periods from today.
Step 2: Represent multiple cash flows on the linear at the time they occur,
assign (+) to cash inflows and (-) to cash outflows
2.1.1. The timeline
Example 2.1. Mr. Nam has VND 1,000 million today. He lend
this money to his friend - Ms. Hoa. He will receive VND 600
million from Ms. Hoa one year later and VND 700 million in the
second year.
5.5
2.1.1. The timeline
Today
0 1 2 Timeline
Example 2.2. Mr. Nam has VND 1million today. He deposits this amount of
money to the bank. During a course of one year, an investment of VND 1
million would grow to VND 1.2 million.
Hence, VND 1 million today is equivalent to VND 1.2 million one year later.
Example 2.3. Mr. Nam puts VND 1,000 million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?
10%
0 1 2 3 timeline
Deposit
The future value
- VND 1,000 million ???? The total value of
money the
holder/investor can
receive after particular
periods.
2.2.1. The future value of a single cash flow
The compound
The simple
interest
interest
calculation or
calculation
compounding
Investing for more than one period
• Interest on interest
– The interest earned on the reinvestment of the previous interest
payment.
• Compound interest
– The interest calculated on the initial principle and the interest reinvested
from prior period.
– Compounding means reinvesting the interest to earn interest on interest
– Compounding periods can be any designated length of time: a year, six
months, a quarter, weekly or daily.
• Simple interest
– The interest only earned on the original principle.
– The interest is not reinvested
2.2.1. The future value of a single cash flow
10%
0 1 2 3 timeline
investment.
• Future value
– The amount an investment is worth after one or more periods.
• Compounding
– The process of accumulating interest on an investment over time
to earn more money.
• Equation
– FV = PV(1+r )n
Example– Investing for more than one period
Example 2.4. Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year
2. If the interest rate is 10% per year, how much money will he have in his investment
account after two years?
2.2. The future value
2.2.2. The future value of a cash flow stream
Example 2.4. Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year
2. If the interest rate is 10% per year, how much money will he have in his investment
account after two years?
0 1 2 time line
- VND 1,000 m. - VND 2,000 m.
2.2.2. The future value of a cash flow stream
The future value of a cash flow stream over particular periods is the
sum of the future value of each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will
receive after some periods when investing into assets.
If we use CFt to denote the CF at the end of the period t, the CF stream as:
… timeline
0 1 2 n-1 n
FVn
Future value (FV)
FVn-1
…
FV2
FV1
2.2.2. The future value of a cash flow stream
The future value of a cash flow stream over particular periods is the
sum of the future value of each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will
receive after some periods when investing into assets.
If we use CFt to denote the CF at the beginning of the period t, the CF stream as:
CF1 CF2 CFn
… timeline
0 1 2 n-1 n
FV2
FV1
Future value with multiple cash flows
Workshop Q2
• You think that you will be able to deposit $4000 at the end
of each of the next three years in a bank account paying
8% interest.
Example 2.3. Mr. Nam puts VND 1,000million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?
Back to the slide 14, after 3 years, VND1,000 m becomes VND 1,321 m
If you want to get VND 1,321 m after 3 years, you have to invest VND 1,000 m
“How much money we should invest today to obtain a certain amount in the future”
PV = FV / (1+r)n FV
… timeline
0 1 2 n-1 n
Today Future
From the equation of the future value: the present value is:
Example 2.5. Mr. Nam wants to have VND 1,000 million in one year, VND
2,000 million in two years. If the interest rate is 10% per year. How much
money does he have to invest today to receive these cash flows?
2.3.2. The present value of a cash flow stream
Example 2.5. Mr. Nam wants to have VND 1,000million in one year, VND
2,000million in two years. If the interest rate is 10% per year. How much
money does he have to invest today to receive these cash flows?
2.3.2. The present value of a cash flow stream
The present value of a cash flow stream is the sum of the present value
of each amount of money.
Other speaking, it is the cost the investor/holder has to pay to receive the
same cash flows in the future .
If we use CFt to denote the CF at the end of the period t, the CF stream as:
CF1 CF2 CFn-1 CFn
1 … timeline
0 2 n-1 n
If we use CFt to denote the CF at the beginning of the period t, the CF stream as:
0 1 … timeline
2 n-1 n
Present value
PV1
PV2
PVn
Present value and discounting
• Present value
– The amount that corresponds to today’s value of a promised
future sum.
• Discounting
– The process by which, through the operation of interest, a future
sum is converted to its equivalent present value.
– Discount rate: the interest rate that reduces a given future value
to an equivalent present value.
• Equation
– PV = FV/(1+r )n Or PV = FV(1+r )-n
– 1/(1+r )n or (1+r )-n is PVIF(r,n)
Workshop Q3
• Jane would like to travel to Europe in five years time and expects
that the trip will cost approximately $15,000. How much would she
have to save now if the bank is offering 5% pa?
• Solution:
Workshop Q4
• Mr Ford would like to buy a new car, he now has $50,000 but the car
costs $88,500. If he can earn 7%, how much does he has to invest
today to buy the car in two year? Does he have enough? Assume
the price will stay the same
• Solution:
Workshop Q5
• Mrs White need about $500,000 to buy a new house in 6 years.
Now she has about $350,000. If she can earn 5% interest per year,
could she will have that amount of money in 6 years? At what rate,
she just reach her goal?
Solution Workshop Q5
An important note
on the frequency of compounding
Growing Growing
Perpetuity Annuity
Perpetuity Annuity
2.4. Perpetuity and Annuity
2.4.1. Perpetuity
… …
0 1 2 n-1 n n + T … Forever
PV1
PV2
…
PV PVn-1
PVn
…
PVn+T
…
2.4. Perpetuity and Annuity
2.4.1. Perpetuity
… … Forever
0 1 2 n-1 n n+T
PV =???
…
…
0 1 … n-1 n+T …
2 n
timeline
PV1
PV2 …
PV PVn-1
PVn
…
PVn+T
…
(with r > g)
2.4. Perpetuity and Annuity
2.4.2. Growing perpetuity
Example 2.7. Mr. Nam receives an offer from your bank about the collection of
the future cash flow. He will get VND 2 million in one year, the endless
payment will continuously increase by 7%. The interest rate is 12%. How much
money is Mr. Nam willing to pay the bank today to get this offer?
Workshop Q8
51
2.4. Perpetuity and Annuity
2.4.3. Annuity
An annuity is a series of equal cash flows occurring at equal time intervals, for a
specified period of time
An ordinary annuity: a series of equal cash flows that occurs at the end of each period
for some fixed number of periods.
The ordinary annuity A A A
A
… timeline
0 1 2 n-1 n
The annuity due
A A A
… timeline
0 1 2 n-1 n
FV= FV=
PV= PV=
2.4. Perpetuity and Annuity
2.4.3. Annuity
Example 2.8. Ms. Lan won a local lottery with two offers. The first option is to
get VND 150 million immediately. The other option is the lottery company will
pay her VND 20 million at the end of each year in 20 years. Which offer should
she choose today if the interest of the Treasury Bond is at 10%?
2.4. Perpetuity and Annuity
2.4.4. Growing annuity
• Growing annuity is the ordinary annuity which the payment increases by
instant rate g in each period
When:
All the payments are equal to A
The interest rate r is kept at constant
The discount rate (r) is higher than the growing rate (g)
• June has put aside $500 each quarter for the last five years
• The funds have been invested at an interest rate of 8%pa
compounded quarterly.
• What amount would June be able to spend if she withdrew her
money today?
• The first deposit was made at the end of the first quarter exactly five
years ago
Workshop Q9 Solution
57
Workshop Q10
• You need to put funds aside to cover an expense of $12,500
that will occur four years from today. You can invest this in
an interest bearing deposit earning 6% compounded half
yearly. How much should you put aside each half year to
meet the expense of $12,500 if the first deposit is six
months from today?
58
Workshop Q10 Solution
59
Present value for annuity cash flows
• PV = PMT{(1 - (1 + r)-n) r}
– or PV = PMT x PVIFA(n,r)
0 1 2 3 … n-2 n-1 n
x1/(1+r)3
x1/(1+r)n-2
x1/(1+r)n-1
x1/(1+r)n
Workshop Q11
• What is the present value of a series of payments of $150
received each quarter for 5 years if the interest rate is 6%pa.
compounded quarterly. The first payment is to be made one
quarter from now.
62
Workshop Q11 Solution
!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!_!
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
63
2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate
Nominal interest rate (stated annual interest rate) is a rate of interest based
on the face value of the security.
Effective annual rate is the rate at which a unit of currency will grow in a year
with interest on interest included.
• The highest quoted rate is not always the best. Because the
compounding during the year can lead to a significant difference
between the nominal rate and the effective rate.
• Example: What investment is better?
A B C
If today you invest VND 1 million in 10 years at the annual rate of 15%.
The future value of the initial investment PV at the end of year n with
continuously compounding at constant yearly interest rate r is:
What will you have after ten years with continuous compounding?
period (rk) less than one year. The effective annual rate for a
year is:
The future value of the initial investment PV at the periodic interest rate rk
If you put VND 1 million in the bank with an offer that the interest
semiannually. How much of money will you get after ten years?
The relationship between the nominal interest rate, the real interest rate, and
(Fisher, 1930)
Remember:
The nominal cash flows in the future should be discounted at the nominal rate
The real cash flows should be discounted at the real interest rate
2.5. Interest Rate
2.5.2. Inflation rate and the real interest rate
rate for the next year is 6%. What is the real interest rate?
How much money should she put in the saving account today
machine. The supplier also allows ABC Company to pay VND 191.8
million after receiving the machine and 180 million VND at the end of
each year in the next 8 years. What is the discounted rate of the
Option 1:
Pay VND 1,000m at t = 0
ABC Company
is going to
invest in a new Discount
processing rate?
machine Option 2:
+ Pay VND 191.8m at t = 0
+ Pay VND 180m at the end
of the next 8 years
2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate
2.6. The application of the time value of money
2.6.2. Calculating the number of periods
Example 2.14. Ms. Lan deposits VND 100 million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year. How
long does it take for her money to grow to VND 161.05 million?
2.6. The application of the time value of money
First, we calculate the fixed payment each year for ABC company.
Then, we make the payment plan as the table in the next slide
2.6. The application of the time value of money
Where
DCF model can be used for Capital Budgeting or Valuing the securities
2.6.The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
Capital budgeting
Example 2.16. An investment project will produce the following cash flows:
t 1 2 3 4 5 6
1,000 1,200 1,300 1,300 1,250 1,150
CFt
Today cost is VND 6,000 million to conduct the project. If the discounted
interest rate is kept at 10% per period in six periods, is this investment
valuable?
2.6.The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
Capital budgeting
VND 1,000m VND 1,200m VND 1,300m VND 1,300m VND 1,250m VND 1,150m
Today 1 2 3 4 5 6
Cost = VND 6,000 m
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
Security Valuing
rt 6% 6% 6% 6% 6%
and its dividen increases 6% per year. If the required of return is 15%.
• The future value (FV) is the total value of money brought to the investor/holder
after particular periods. FV = PV * (1+r)n
FV of a single CF
FV of a stream of CF is the sum of FV of a single CF
• The present value (PV) answers the question of how much money invested today
to get a particular money in the future. PV = FV / ( 1+r)n
PV of a single CF
PV of a stream of CF is the sum of PV of a single CF
• Perpetuity is a set of identical payments occurring each period in an infinite future
The PV of perpetuity = A /r
The PV of growing perpetuity = A / (r-g)
Summary
• Annuity is a set of fixed payments occurs in a particular finite number of periods
Ordinary annuity: the first CF occurs after one period from today
Annuity due: the first CF occurs immediately
• The growing annuity is an ordinary annuity which the payment increases by instant rate g
in each period
𝑛 𝑛
1+𝑟 − 1+𝑔
PV = 𝐹𝑉 = 𝐴 ∗
𝑟−𝑔
• The stated annual interest rate or nominal interest rate (NIR) is the annual rate without
information on compounding. The effective annual interest rate (EAR) refers to the compounding
EAR =
• The relation between NIR, the real interest rate, and the inflation rate is:
(1+ NIR ) = (1+ the real interest rate)*(1+the inflation rate)
• Use the time value of money to solve the actual problems when making financial decision