You are on page 1of 32

Time Value of Money

Lecture 9
This lecture is part of Chapter 4:
Investing in the Company
Today’s Lecture

Understand the Time Value of Money

Use Excel to calculate the present and future value of a


stream of cash flows

Make time work for you!


Time Value

The core of this lecture is actually quite similar to what we


have done for bonds.

We say that money has a “Time Value” because it can be


invested and thus become more. In other words, if we have a
dollar today, we expect/hope that we will have more than a
dollar in the future.

The Time Value of money is an essential concept when


deciding on an investment.
Time Value

The are a few terms important to know as with regards to the


time value of money:

• Present Value: This is just the monetary value of the


investments we have right now

• Future Value: This is the value of our investment in the future

• Compounding: Reinvesting the interest received, in other


words, receiving interest on interest
Time Value
The present and future values can easily be calculated in Excel
A B C D E F G H I
2
3 Compounding
4
5
6 Year
7
8 present 1,000.00
9 1 1,100.00  =C8*(1+0.1)
10 2 1,210.00  =C9*(1+0.1)
11 3 1,331.00  =C10*(1+0.1)
12 4 1,464.10  =C11*(1+0.1)
13 5 1,610.51  =C12*(1+0.1)
14
15
16
17
14
15

So we see that 1000 dollars now


16

will be 1610 dollars in 5 years We assume 10% interest


Time Value
Of course this can easily be expressed mathematically, but let’s
do it step by step again by understanding what we are doing:

1st year: Value after one year = Present Value + Interest

2nd year: Value after two years = Value after one year + Interest

Substitute Line 1

Or:
Value after two years = (Present Value + Interest) + Interest

This interest needs to be on the entire “Value after one year”


Time Value
Or:

1st year: Value after one year = PV + PV* r = PV*(1 + r)

2nd year: Value after two years = PV * (1 + r) + PV * (1 + r) * r

Hence we have:

FV2 = PV * ( (1+r) + (1+r)*r) ) = PV * ( 1+r+r+r*r)


= PV * ( 1 + 2r + r 2)
2
= PV * ( 1 + r)
2
FV2 = PV * ( 1 + r)
Time Value

And thus we obtain the formula:

FV ( N ) = PV * (1 + r ) N

Let’s check this for our example

FV (5) = 1000 * (1 + 0.1) 5

And indeed this is equal to 1610 as before.


Time Value
Surprise! There’s also an Excel function for this: FV
A B C D E F G H I
2
3 Compounding
4
5
6
7
Future Value: 1,610.51
Unused parameters for this problem
8
9
10
11
12
13
=FV(10%,5,0,-1000,0)

The interest rate The present value


Note the minus!
The number of years

As expected, the same as before!


Compounding
Compounding Interest is powerful ….
3 Compounding
4
5
6 Year
7
8 0 1,000.00 2,800.00
2,600.00
9 1 1,100.00  =C8*(1+0.1) 2,400.00
10 2 1,210.00  =C9*(1+0.1) 2,200.00
2,000.00
11 3 1,331.00  =C10*(1+0.1)
1,800.00
12 4 1,464.10  =C11*(1+0.1) 1,600.00
13 5 1,610.51  =C12*(1+0.1) 1,400.00
1,200.00
14 6 1,771.56 1,000.00
15 7 1,948.72 0 2 4 6 8 10

16 8 2,143.59
17 9 2,357.95
18 10 2,593.74  =C17*(1+0.1)
19

One thousand dollars becomes nearly 2600 after 10 years!


That must be too good to be true.
Compounding
Compounding Interest is powerful …. 50-year Chart
8 0 1,000.00 2,800.00
2,600.00
9 1 1,100.00  =C8*(1+0.1) 2,400.00
10 2 1,210.00  =C9*(1+0.1) 2,200.00
2,000.00
11 3 1,331.00  =C10*(1+0.1)
1,800.00
12 4 1,464.10  =C11*(1+0.1) 1,600.00
13 5 1,610.51  =C12*(1+0.1)
120,000.00
1,400.00
1,200.00
14 6 1,771.56 1,000.00
100,000.00
15 7 1,948.72 0 2 4 6 8 10

16 8 2,143.59 80,000.00
17 9 2,357.95 60,000.00
18 10 2,593.74  =C17*(1+0.1)
40,000.00
19 11 2,853.12
20 12 3,138.43 20,000.00
13 3,452.27 0.00
14 3,797.50 0 10 20 30 40 50
15 4,177.25
16 4,594.97

One thousand dollars becomes nearly 120,000 after 50


years. Note how the curve bend Upwards!
Inflation

Inflation is the phenomenon that goods become more expensive


(and hence that thus their price ‘inflates’).

As a consequence either one dollar can buy


less goods, or one needs more dollars to pay
for the same item.

The calculation of how much a future dollar is worth is exactly


the same as the one for discounting bonds. Only now we need to
use the inflation rate rather than the interest rate for our
calculation.
Inflation

This is the almost same spreadsheet as we had for bonds…

A B C D E F G H I
2
3 My first inflation calculations
4
5 Current Value 1,000.00
6 Inflation 3%
7
8
9
Worth in todays
dollars
Same formula as for
10
11
In .. Years
1 970.87  =D5/(1+D6) Bonds!
12 2 942.60  =C11/(1+$D$6)
13 3 915.14  =C12/(1+$D$6)
14 4 888.49
15 5 862.61
16 6 837.48
17 7 813.09
14 8 789.41
15 9 766.42
16 10 744.09
Inflation

Note the subtle point -

Though close, there is a difference between:

1000 * (1-r) and 1000/(1+r) e


Not
Eg.

1000 * 0.97 = 970 and 1000/1.03 = 970.87

This may look like a small difference, but differences can add
up!
Inflation
From this calculation we see that in terms of today’s buying
power our original 1000 will only be worth 744 dollars in ten
years.

But we had also seen that our 1000 will grow to 2594 if invested
at 10% a year.
Oh that’s only 256 dollars less so
we still should have:

2594 – 256 = 2338 dollars

Not too bad... WRONG!


Inflation
If we know that we have 2594 in 10 year then we need to
discount this back to today with the prevailing interest rate in
order to see how much that is in today’s dollars.
A B C D E F G H I
2
3 My first inflation calculations
4
5 Current Value 2,593.74
6 Inflation 3%
7
8 Maturing in Future
9 years Value
10
11 1 2,518.19  =D5/(1+D6)
12 2 2,444.85  =C11/(1+$D$6)
13 3 2,373.64  =C12/(1+$D$6)
14 4 2,304.50
15 5 2,237.38
16 6 2,172.22
17 7 2,108.95
14 8 2,047.52
15 9 1,987.89
16 10 1,929.99

Hence we’ll only have 1930


Inflation

For this case it is more useful to combine the two calculations:

A B C D E F G H I
2
3 My first inflation calculations
4
5 Current Value 1,000.00
6 Inflation 3% Interest 10%
7
8 Value in Future
9 years Value
10
11 1 1,067.96  =D5/(1+$D$6)*(1+$H$6)
12 2 1,140.54  =C11/(1+$D$6)*(1+$H$6)
13 3 1,218.05  =C12/(1+$D$6)*(1+$H$6)
14 4 1,300.83
15 5 1,389.24
16 6 1,483.65
17 7 1,584.49
14 8 1,692.17
15 9 1,807.17
16 10 1,929.99

Indeed the same


Inflation

Couldn’t we just say Effective Interest = Interest – Inflation?


A B C D E F G H I
2
3 My first inflation calculations
4
5 Current Value 1,000.00
6 Inflation 3% Interest 10%
7 Effective Interest? 7%
8 Value in Future
9 years Value
10
11 1 1,070.00  =D5*(1+$H$7)
12 2 1,144.90  =C11*(1+$H$7)
13 3 1,225.04  =C12*(1+$H$7)
14 4 1,310.80
15 5 1,402.55
16 6 1,500.73
17 7 1,605.78
14 8 1,718.19
15 9 1,838.46
16 10 1,967.15

It’s different!
Inflation

It’s different because one should first reduce the value by the
inflation rate and then apply the interest.

Or:

1/1.03 * 1.1 = 1.06796 unequal 1.07!

It’s small but nevertheless important.


Discount

A closely related topic especially in the context of the time


value of money is that of discount.

We already used this term in the context of bonds and inflation.

When a business decides to invest a certain sum, it also needs to


discount the expected future cash flows in order to decide
whether the investment is worthwhile.
After all, if your return is too small, it
would not be wise to make the investment.
Discount

The problem is now that the cash flow is expected to grow over
the years (since the business is hopefully getting better and
better).

Conceptually, this is the same as before, only now we need to


do a separate calculation for each year.
As always, it may be complicated to imagine at first, but if we
have an idea of how to get started we can take it from there.

The obvious starting point is: The Cash Flows


Discounting uneven Cash
Flows
Let us assume that we have the following cash flows:
A B C D E F G H I
2
3 How much is a stream of cash flows worth?
4
5 Present Value ?
6 Discount 10%
7
8 In Cash
9 years Flow
10
11 1 1,000.00
12 2 1,300.00
13 3 1,200.00
14 4 1,500.00
15 5 1,400.00
16 6 1,600.00
17 7 1,700.00
14 8 1,750.00
15 9 1,900.00
16 10 2,100.00

What would they be worth?


Discounting uneven Cash
Flows
We can of course just sum them up:
A B C D E F G H I
2
3 How much is a stream of cash flows worth?
4
5 Present Value ?
6 Discount 10%
7
8 In Cash
9 years Flow
10
11 1 1,000.00
12 2 1,300.00
13 3 1,200.00
14 4 1,500.00
15 5 1,400.00
16
17
6
7
1,600.00
1,700.00 15,450.-
14 8 1,750.00
15 9 1,900.00
16 10 2,100.00
15,450.00

Is this a reasonable value for the cash flows?


Discounting uneven Cash
Flows
No! we need to have some return (namely 10% in this case):
A B C D E F G H I
2
3 How much is a stream of cash flows worth?
4
5 Present Value ?
6 Discount 10%
7
8 In Cash
9 years Flow
10
11 1 1,000.00 909.09  =C11/POWER(1+$D$6,B11)
12 2 1,300.00 1,074.38  =C12/POWER(1+$D$6,B12)
13 3 1,200.00 901.58  =C13/POWER(1+$D$6,B13)
14 4 1,500.00 1,024.52
15 5 1,400.00 869.29
16 6 1,600.00 903.16
17 7 1,700.00 872.37
14 8 1,750.00 816.39
15 9 1,900.00 805.79
16 10 2,100.00 809.64

The sum of each year’s cash flow’s present values!


Discounting uneven Cash
Flows
Thus we obtain:
A B C D E F G H I
2
3 How much is a stream of cash flows worth?
4
5 Present Value 8,986.20  =SUM(D11:D20)
6 Discount 10%
7
8 In Cash
9
10
years Flow Surprisingly little, isn’t it!
11 1 1,000.00 909.09  =C11/POWER(1+$D$6,B11)
12 2 1,300.00 1,074.38  =C12/POWER(1+$D$6,B12)
13 3 1,200.00 901.58  =C13/POWER(1+$D$6,B13)
14 4 1,500.00 1,024.52
15 5 1,400.00 869.29
16 6 1,600.00 903.16
17 7 1,700.00 872.37
14 8 1,750.00 816.39
15 9 1,900.00 805.79
16 10 2,100.00 809.64
Discounting uneven Cash
Flows
Naturally there also is an Excel function for this: NPV
Presumably standing for Net Present Value.
A B C D E F G H I
2
3 How much is a stream of cash flows worth?
4
5 Present Value 8,986.20  =NPV(D6,C11:C20)
6 Discount 10%
7
8 In Cash
9 years Flow
10
11
12
1
2
1,000.00
1,300.00 Discount Rate
13 3 1,200.00
14 4 1,500.00
15
16
5
6
1,400.00
1,600.00
Range of Cash Flows
17 7 1,700.00
14 8 1,750.00
15 9 1,900.00
16 10 2,100.00
Excel’s NPV

We just used the function NPV with NPV presumably standing


for Net Present Value.
If we look back at our previous notes though it would seem that
what we have calculated is the ‘Present Value’ and that there is
no need for the ‘Net’.
Indeed, usually one calls what we have calculated ‘Present
Value’.
‘Net Present Value’ is when we subtract from this the cost of
acquiring the cash flow in question.
Rate of Return

Of course, often things work the other way around. We bargain


to get a certain stream of cash flows and then we wonder what
the compounded yield on this asset is going to be.
Calculating the Yield
A B C D E F G H I
2
3 Purchase Price 10,000.00
4
5 Present Value 8,986.20  =SUM(D11:D20)
6 Discount 10%
7
8 In Cash
9 years Flow
10
11 1 1,000.00 909.09  =C11/POWER(1+$D$6,B11)
12 2 1,300.00 1,074.38
13 3 1,200.00 901.58
14 4 1,500.00 1,024.52
15 5 1,400.00 869.29
16 6 1,600.00 903.16
17 7 1,700.00 872.37
18 8 1,750.00 816.39
19
20
9
10
1,900.00
2,100.00
805.79
809.64 The key thing to realize is that at the
actual yield, the purchase price
equals the present value. In other
words, the net present value is zero.

Hence we can use the solver.


Calculating the Yield
A B C D E F G H I
2
3 Purchase Price 10,000.00 Net Present Value 0.00
4
5 Present Value 10,000.00 =D5-D3
6 Discount 7.84%
7
8 In Cash
9 years Flow
10
11 1 1,000.00 927.34
12 2 1,300.00 1,117.94
13 3 1,200.00 956.96
14 4 1,500.00 1,109.28
15 5 1,400.00 960.10
16 6 1,600.00 1,017.53
17 7 1,700.00 1,002.57
14 8 1,750.00 957.06
15 9 1,900.00 963.59
16 10 2,100.00 987.63
Calculating the Yield
There is also a built in Excel function: IRR
Standing for Internal Rate of Return
A B C D E F G H I
2
3 Purchase Price 10,000.00
4
5 Internal Rate of Return 7.84%
6
7
=IRR(C10:C20)
8 In Cash
9 years Flow
10 0 -10,000.00
11 1 1,000.00
12
13
2
3
1,300.00
1,200.00
This is investment in year 0.
14 4 1,500.00
15 5 1,400.00
16 6 1,600.00
17 7 1,700.00
14 8 1,750.00
15 9 1,900.00
16 10 2,100.00
Key Points of the Day

Money has Time Value


Interest can compound
Discount is an important concept

Compound or be poor!

Time is your friend! Be patient.