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Time Value of Money 1: Analyzing Single Cash Flows

McGraw-Hill/Irwin

ACT3211 FINANCIAL MANAGEMENT

© 2009 The McGraw-Hill Companies, Inc.

**Chapter 4 Learning Goals
**

LG1: Create a cash flow time line LG2: Compute the future value of money LG3: Use the power of compounding to increase wealth LG4: Calculate the present value of a payment made in the future LG5: Move cash flows from one year to another LG6: Apply the Rule of 72 LG7: Compute the rate of return LG8: Calculate the number of years needed to grow an investment to a specific amount of money

ACT3211 FINANCIAL MANAGEMENT

Introduction

The ability to work problems using the principles of the Time Value of Money will be one of them most important skills you will learn

± Financial managers ± Any kind of manager in businesses of all sizes ± Personal life

ACT3211 FINANCIAL MANAGEMENT

The basic idea behind the time value of money is that RM1 today is worth more than RM1 promised next year Factors to consider:

± Size of the cash flows ± Time between the cash flows ± Rate of return

Opportunity cost Interest rate Required rate of return Discount rate

ACT3211 FINANCIAL MANAGEMENT

**Organizing Cash Flows
**

A helpful tool for analysis of cash flows is the time line, which shows the magnitude of cash flows at different points in time

± Cash we receive is called an inflow and is represented by a positive number ± Cash that leaves us is called an outflow and is represented by a negative number

Cash flow Period 100 5% 0

ACT3211 FINANCIAL 1 MANAGEMENT

105

2

**Single-period Future Value
**

You invest RM100 today in an account earning 5% per year. Compute the future value in one year.

Value in one year = Today¶s cash flow + Interest earned

**= RM100 + (RM100 x 0.05) = RM100 x (1 + 0.05) = RM105 In general: FV = PV x (1 + i)N
**

ACT3211 FINANCIAL MANAGEMENT

**Compounding and Future Value
**

In the example above, suppose you leave the money invested for two years. What is the future value? Value in 2 years = RM100 x (1 + 0.05)2 = RM110.25 The total interest of $10.25 represents $10 earned on the original $100 investment plus $0.25 earned on the $5 first year¶s interest

± This represents compounding, i.e. earning interest on interest

ACT3211 FINANCIAL MANAGEMENT

Financial Calculator Solution

INPUT OUTPUT

2 N

5 I/YR

-100 PV

0 PMT

FV 110.25

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** Suppose we leave the deposit for five years? FV = RM100 x (1.05)5 = RM127.63 Financial calculator solution:
**

INPUT OUTPUT

ACT3211 FINANCIAL MANAGEMENT

5 N

5 I/YR

-100 PV

0 PMT

FV 127.63

**The Power of Compounding
**

Compound interest is an extremely powerful tool for building wealth. Albert Einstein is supposed to have said: ³the most powerful force in the universe is compound interest´ Let¶s illustrate the power of compounding over long periods of time. Using the above example, what is the future value of the RM100 if it is invested for 20 years at 5% interest.

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** Financial calculator solution:
**

INPUT OUTPUT 20 N 5 I/YR -100 PV 0 PMT FV 265.33

Now let¶s double the amount of time invested to 40 years. Will the future value be double as well?

ACT3211 FINANCIAL MANAGEMENT

INPUT OUTPUT

40 N

5 I/YR

-100 PV

0 PMT

FV 704

Notice that time value of money relationships are not linear. Rather they are exponential What if our interest rate was 10 percent per year rather than FINANCIAL ACT3211 5 percent?

MANAGEMENT

** Does doubling the interest rate double the future value?
**

INPUT OUTPUT 40 N 10 I/YR -100 PV 0 PMT FV 4,525.93

Far from it! Because interest grows exponentially, even a small change in the interest rate causes the future value to change dramatically

ACT3211 FINANCIAL MANAGEMENT

Present Value

Watching money grow into the future (compounding) makes intuitive sense. Why would anyone care about finding the present value of a future cash flow, which uses the opposite process, called discounting? It may surprise you to learn that much of finance involves the application of present value. Finance is about valuing things, and that often means finding the present value of future cash flows.

ACT3211 FINANCIAL MANAGEMENT

Present Value

Example: If I want to end up with RM100 in an account at the end of one year at 5% per year, I would need to deposit how much? RM100 = PV x (1 + 5%) RM100 = PV (1.05) PV= $95.24

ACT3211 FINANCIAL MANAGEMENT

In general: PV = FV /(1 + i)N

This process is called discounting. Notice that this isn¶t a new equation. It is really the same as the future value equation we saw before (just rearranged to solve for PV instead of FV)

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Present Value

Suppose we discount the deposit for two years? PV = RM100 / (1.05)2 = RM90.70 Suppose we discount for five years? PV = RM100 / (1.05)5 = RM78.35

ACT3211 FINANCIAL MANAGEMENT

Financial Calculator Solution

INPUT OUTPUT

2 N

5 I/YR

PV -90.70

0 PMT

100 FV

ACT3211 FINANCIAL MANAGEMENT

Example 4-3

N = 2 years i = 7.5% FV = RM1000 (value at the end of 2 years)

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Example 4-3 (cont¶d)

PV = RM1000 = RM865.33 (1.075)2

ACT3211 FINANCIAL MANAGEMENT

Financial Calculator Solution

INPUT OUTPUT

2 N

7.5 I/YR

PV -865.33

0 PMT

1000 FV

ACT3211 FINANCIAL MANAGEMENT

**Discounting with Multiple Rates
**

Rather than using an exponent, we have to discount using the individual discount rates Example: the interest rates over the next three years are 7%, 8%, and 8.5%. What is the present value of RM2,500 to be received at the end of the third year? PV = RM2,500 / [(1.07)(1.08)(1.085)] = RM1993.90

ACT3211 FINANCIAL MANAGEMENT

**Using Present Value and Future Value
**

Businesses often need to move cash flows around in time. That is no problem ± we can use FV and PV to do that. Example: We expect to receive a cash flow of RM200 at the end of 3 years. What is the value of the cash flow if we move it to year 2 using a discount rate of 6%?

± We must discount the CF for one year. PV2 = FV3 / (1 + i)1 = RM200 / (1.06) = RM188.68

ACT3211 FINANCIAL MANAGEMENT

Now, what if we want to move the CF to year 5? FV5 = PV3 x (1+ i)2 = RM200 x (1.06)2 = RM224.72 Note: we could have also moved the RM188.68 from the previous problem 3 years ahead to year 5 for the same answer ACT3211 FINANCIAL

MANAGEMENT

**Computing Interest Rates
**

So far we have solved for future values and present values If you look at your financial calculator, you will see that there are 5 variables used to solve these types of time value problems:

± N, I, PV, PMT, and FV

It turns out that we can solve for any one of the 5 variables if we know the other 4 variables

± If we only know three variables there are an infinite number of solutions

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Here¶s an example where we need to solve for the interest rate: If we bought a gold coin for RM350 three years ago and we can sell it for RM475 today, what annual rate of return have we earned?

INPUT OUTPUT 3 N -350 I/YR PV 10.72 0 PMT 475 FV

ACT3211 FINANCIAL MANAGEMENT

** Note: what happens if you forget to make the present value a negative number?
**

± You will get an ³error´ message on your calculator ± Either PV or FV must always be negative

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**Solving for Time
**

Example 4-5: Suppose your company currently has sales of RM350 million. If the company grows at 7 percent per year, how long will it take before the firm reaches RM500 million in sales?

INPUT OUTPUT N 5.27 7 -350 I/YR PV 0 PMT 500 FV

ACT3211 FINANCIAL MANAGEMENT

Rule of 72

We just solved a problem where we needed to know the amount of time to get from one cash flow level to another cash flow in the future at a certain growth rate. What if we needed to know how long it takes for the cash flow to double in size? We can calculate this directly using the technique we just learned. Alternatively, there is an approximation for this particular problem called the Rule of 72.

ACT3211 FINANCIAL MANAGEMENT

The Rule of 72 is based on compounding and shows that the amount of time needed for an amount to double can be approximated by dividing 72 by the interest rate. For example, at 6% it should take 12 years for any amount to double. 12 years = 72/6

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Rule of 72 (cont¶d)

How long would it take a sum to double if the growth rate was 4% per year? Use the Rule of 72?

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Rule of 72 (cont¶d)

It would take 72/4 or 18 years. Using our calculator, we can solve for the amount exactly:

INPUT OUTPUT N 17.67 4 I/YR -1 PV 0 PMT 2 FV

ACT3211 FINANCIAL MANAGEMENT

Notice that we don¶t need to know the beginning or ending amount (we can just make our lives easy and use 1 and 2) The Rule of 72 is surprisingly accurate for small growth rates. As the rate gets very high the rule is pretty crummy (e.g. try 36 percent, or more dramatically 72 percent) The rule also works backwards: If we want to know how high our growth must be to double our sales in 10 years:

± 72/10 = 7.2 years

ACT3211 FINANCIAL MANAGEMENT

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