TIME VALUE OF MONEY

MARIOS MAVRIDES

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Time value of money

•A dollar today is worth more than a dollar tomorrow. Why?

•Money can be invested and earn a return
•Money can be used in consumption
•Deposits in the bank earning 2% return
•Government bonds are considered to be risk free
•Any investment yielding more than government securities contain what
we call a “risk premium”
•Investments in real estate earning more than 6% or maybe less
•Investments are not always profitable
•Risk is always present, even with bank deposits and government
securities

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Future Value (FV)

The future value of a cash flow using compound interest is

FVN = PV(1+r)N

Compound interest means that after each period interest is added to the
principle and the resulting amount is earning more interest in the second
period.

For example, 100 at 10% becomes $110 at the end of the year. In the
second year the amount of $110 earns $11 interest and the amount
becomes $121. In the third year, interest is $12.1 and the total amount at
the end of the 3rd year is $133.1

FV3 = $100(1+0.1)3 = $133.1

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Present Value (PV)

The present value of a cash flow given at a future date

Basically, PV is the reverse of the FV calculation in the previous example

Because the FV includes interest, we use the formula below to deduct the
interest that has been added to arrive at the present value

We know that FV=PV(1+r)N

Solving for PV = FV/(1+r)N

What is the PV of $133.1 given in three years?

PV = $133.1/(1+0.1)3 = $13.1/1.331 = $100

Calculate the PV of $100 given in two years!

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Annual and semiannual compounding

What is the future value of $200 in two years from today if the
interest rate is 10% compounded annually?

FV = PV(1+r)N = 200(1 + 0.1)2 = 242

What is the future value of $200 in two years from today if the
interest rate is 10% compounded semiannually?

FV = PV(1+r)N = 200(1 + 0.05)4 = 243.1

What is the future value of $200 in two years from today if the
interest rate is 10% compounded monthly?

FV = PV(1+r)N = 200(1 + 0.0083)24 = 244.1

More frequent compounding leads to higher FV

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Interest rates are always expressed annually

Interest rates in books , research and newspapers are expressed

annually, unless stated otherwise

For example, if you are given a 6% interest, it means that it is for one
year.

A deposit of $100 at 6% will give $6 for one year

If the deposit is only for six months at 6%, then the interest earned is $3

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Exercise

Your parents will buy you a car as a gift, once you get your MBA in two
years time. The car will be worth $30,000 at that time. How much
money your parents need to deposit today at an interest rate of 8% in
order to accumulate $30,000 in two years?

PV = 30,000/(1+0.08)2 = 25,720

What if two equal deposits (P) were made, at the beginning of each year,
in order to accumulate the same amount of money in two years?

30,000 = P*1.08 + P*1.082

30,000 = 2.24P
P = 13,393

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Future Value of a cash flows stream

Calculate the future value of three payments of $100 each, made at the
beginning of each of the next three years, at the end of year 3, if the interest
rate is 10%, compounded annually.

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Present value of a cash flow stream

Calculate the present value of three payments of $100 each, made at the
beginning of each of the next three years, if the interest rate use for
discounting is 10%.

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Self check
Using the result for the PV in the previous slide, we can verify that the
FV calculation is correct.

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Perpetuity

A series of periodic equal payments for ever.

The value of the perpetuity is the present value of the cash payments
received or paid in the future.

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Suppose you invest $100 at 5% a year in a certificate of deposit. Each
year you withdraw $5 and reinvest the remainder of $100.

P is the initial investment

C is the coupon payment (annuity)
R is the interest rate

The interest C is calculated as C=P*r, Therefore P=C/r

The value of the Certificate of Deposit is equal to the interest divided by

the interest rate

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Present value of an annuity

An annuity is a series of periodic equal payments for a specific number of

periods (years, months etc). It is like a perpetuity but it doesn’t last
forever. The value of the annuity today is the PV of the cash flows
received discounted to the present.

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Example

Suppose you invest in a $100 perpetuity in a bank account paying 5%

interest. Τhe cost of the perpetuity is P = $5/0.05 = $100. It will pay $5 for
ever and the cost will always be $100.

Suppose now that after 20 years you decided to withdraw the money and
receive $100. The perpetuity has been converted into a 20 year annuity.

So, the value of the annuity is the value of the perpetuity less the PV of P
received after 20 years.

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Future Value of an Annuity

Given the formula for the present value of an annuity, we can easily derive a
formula for the future value of an annuity simply by moving the amount of
the present value into the future, N periods forward on the timeline.

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Exercise

Ellen is 35 years old and she has decided it is time to plan seriously for her
retirement. At the end of each year until she is 65, she will save $10,000 in a
retirement account. If the account earns 10% per year, how much will Ellen
have in the account at age 65?

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Growing Perpetuity

A growing perpetuity is a stream of cash flows that occur at regular intervals

and grow at a constant rate forever. For example, a growing perpetuity with
a first payment of $100 that grows at a rate of 3% has the following timeline:

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Exercise 1

Suppose your company would like to organize a Christmas party every year
for ever, at a cost of $30,000 each year. For that purpose, the company
deposits a lump sum amount in the bank, to ensure that then party will take
place every year. How much money the company needs to deposit in the
bank today, if the interest rate is 8%?

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Exercise 2

Same as exercise 1, however, the cost of then party increases by 4%

each year due to inflation. Determine the amount needed for the
deposit today.

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Growing Annuity

A growing annuity is a stream of N growing cash flows, paid at regular

intervals. It is a growing perpetuity that eventually comes to an end. The
following timeline shows a growing annuity with initial cash flow C, growing at
rate g every period until period N:

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Exercise 3
Ellen is now 35 and she is considering saving for her retirement. Savings are
$10,000 in year one and that amount will be growing by 5% each year, until
she becomes 65. With this plan, if she earns 10% per year on her savings, how
much will Ellen have in the account at age 65? Please note that growth begins
in year 2, so the number of growing years is 29

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Exercise 4
Suppose you are opening a business that requires an initial investment of
$100,000. Your bank manager has agreed to lend you this money. The terms of
the loan state that you will make equal annual payments for the next ten years
and will pay an interest rate of 8% with the first payment due one year from
today. What is your annual payment?

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Exercise 5
What is the balance of the loan after the first payment of $14,903 has
been paid?

Answer
Interest for the first year is 8% of the loan. The rest reduces the balance
of the loan

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Calculating the amount of the loan payment directly

We can calculate the loan payment directly, by rearranging the following

equation .
Very useful to know if you are planning to get a loan

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Calculating cash flow when FV of an annuity is given
Exercise 6
Suppose you have just graduated from college and you decide to be prudent
and start saving for a down payment on a house. You would like to have
$60,000 saved 10 years from now. If you can earn 7% per year on your
savings, how much do you need to save each year to meet your goal?

FV (annuity)

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Exercise 7
Suppose you have an investment opportunity that requires a $1000
investment today and will have a $2000 payoff in six years. Calculate the
annual rate of return over the six year period.

r = 0.1225 or 12.25%

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Exercise 8
Suppose your firm needs to purchase a new forklift. The dealer gives you two
options: (1) a price for the forklift if you pay cash and (2) the annual payments if
you take out a loan from the dealer. To evaluate the loan that the dealer is
offering you, you will want to compare the rate on the loan with the rate that
your bank is willing to offer you. Given the loan payment that the dealer quotes,
how do you compute the interest rate charged by the dealer? Suppose the cash
price of the forklift is $40,000, and the dealer offers financing with no down
payment and four annual payments of $15,000.

Solve for r using the “trial and error” method r = 0.1845 or 18.45%
You may also use a financial calculator or excel 27
Calculating number of periods
Suppose we invest $10,000 in an account paying 10% interest, and we want to
know how long it will take for the amount to grow to $20,000. We want to
determine the number of periods N.

Solve for N using the trial and error method or excel

N = 7 years

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Projecting financial needs
Suppose your company needs to make a deposit in the bank at the end of
each year for the next three years, in order to purchase a plot of land in
three years for business use. Today, the land is worth $2 million and it is
expected to appreciate in value each year by 10%. The bank offers an
interest rate of 6%.

Calculate the value of the land in three years

FV = 2m*(1+0.1)3 = 2.66m

Calculate the payment required to be made by the company each year.

P*1.062 + P*1.06 + P = 2.66m

P = 2,66m / 3.18 = 0,836m

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Exercise 9

Calculate the annual return (annual yield) of a $200 investment

expected to pay back $230 in a year? (30/200 = 0.15 or 15%)
Is the investment acceptable if the required rate of return is 20%?
(no, it is not worth taking the risk, it is expected to yield 15%)
What is the value of the above investment for the investor who
requires 20%

(X + 0.2X = 230)
Solving for X = 191.67

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Exercise 10

Calculate the annual return (annual yield) of a $200 investment

expected to pay back $260 in two years?
FV = PV(1+r)N
260 = 200(1+r)2,
1+r=SQRT(1.3)
1+r = 1.1
r = 0.14 or 14%

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Exercise 11

Suppose you get an $800 loan from the bank and you are required to pay it off
with two equal annual payments (P). Calculate the payment P if the interest
rate used is 10%?

Solution
$800 is the present value of the two equal payments (P). The sum of the two
payments discounted to the present should be equal to $800. The first
payment is discounted for one period and the second for two periods. That is

P/1.1 + P/1.21 = 800

P(0.909) + P(0.826) = 800
P(1.735) = 800
P is $461

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Exercise 12

Suppose you get an $800 loan from the bank with an interest rate of 10%. If
you can only pay $300 per year, calculate the number of years needed to
pay off the loan!

Solution
At the end of the year the balance of the loan will be 800 + 10%(800) = 880,
less the 300 payment, the balance will be 580
At the end of the second year the balance of the loan will be 580+10%(580)
less the 300 payment, that is 338
At the end of the third year, the balance will be less and last payment will be
in the fourth year

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Expected return, required return and risk

•Percentage return is always expressed on an annual basis.

•Expected return refers to the percentage return expected by the investor
based on the information provided today.
•Required return refers to the percentage return required by the investor
in order for him/her to proceed with a specific investment.
•If the expected return exceeds the required, the investment is acceptable,
it means the investment is worth it because it provides the required return
plus.

•The required return is the cost of capital for debt or equity of the
company. Investors buy shares expecting a return of let say 8%. If the
shares do not increase by 8% during the year, then investors sell the shares
and prices fall.

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Risk Analysis

•Risk reflects the uncertainty regarding future cash flows, which may be
more or less than expected.
•The higher the risk involved with a specific investment, the higher the
required return by the investor.
•The investor will proceed with a risky investment, only if the expected
return is high enough to compensate him for the risk undertaken

Future cash flows must be discounted at the required return which is risk
weighted

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