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Lecture 9

This lecture is part of Chapter 4:

Investing in the Company

Today’s Lecture

stream of cash flows

Time Value

have done for bonds.

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.

deciding on an investment.

Time Value

time value of money:

investments we have right now

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

16

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:

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

Substitute Line 1

Or:

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

Time Value

Or:

Hence we have:

= PV * ( 1 + 2r + r 2)

2

= PV * ( 1 + r)

2

FV2 = PV * ( 1 + r)

Time Value

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

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)

Note the minus!

The number of years

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

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

years. Note how the curve bend Upwards!

Inflation

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

less goods, or one needs more dollars to pay

for the same item.

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

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

Not

Eg.

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:

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

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

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

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:

Discount

value of money is that of discount.

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).

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.

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

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

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

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

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

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.

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

Interest can compound

Discount is an important concept

Compound or be poor!

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