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Chapter 3 Time Value of Money
Chapter 3 Time Value of Money
Money
Learning Objectives
Understand the concept of the time value of
money.
Be able to determine the time value of money:
Future Value.
Present Value.
A p1 r
t
0 1 2 3 4 5
i = 10%
$100 ?
0 1 2 3 4 5
2. Write out the formula using symbols:
FVt = CF0 * (1+r)t
Example of FV of a Lump Sum
3. Substitute the numbers into the formula:
FV = $100 * (1+.1)5
FV = $161.05
Future Value of a Cash Flow
Stream
The future value of a cash flow stream is equal to the
sum of the future values of the individual cash flows.
The FV of a cash flow stream can also be found by
taking the PV of that same stream and finding the FV
of that lump sum using the appropriate rate of return
for the appropriate number of periods.
The following equation can be used to find the
Future Value of a Cash Flow Stream at the end
of year t.
where
FVt = the Future Value of the Cash Flow Stream at the end of
year t,
CFt = the cash flow which occurs at the end of year t,
r = the discount rate,
t = the year, which ranges from zero to n, and
n = the last year in which a cash flow occurs
For example, consider an investment which
promises to pay $100 one year from now,
$300 two years from now, 500 three years
from now and $1000 four years from now.
How much will be the future value of the cash
flow streams at the end of year 4, given that
the interest rate is 10%,?
The Future Value at the end of year 4 of the
investment can be found as follows in the next
slide:
1. Draw a timeline:
0 1 2 3 4
?
i = 10% ?
?
?
2. Write out the formula using symbols
n
FV = [CFt * (1+r)n-t]
t=0
OR
FV = [CF1*(1+r)n-1]+[CF2*(1+r)n-2]+ [CF3*(1+r)n3] +
[CF4*(1+r)n-4]
Solution:
Annuities
An annuity is a cash flow stream in which the cash
flows are all equal and occur at regular intervals.
To considered as annuity the following conditions
must be present
The periodic payment must be equal in amount
The time period between payments should be constant
The interest rate per year remains constant
The interest is compounded at the end of each time period
Types of Annuities
There are different types of annuities, among
these are
1. An ordinary annuity is one where the payments
are made at the end of each period
2. An annuity due is one where the payments are
made at the beginning of each period
3. A deferred annuity is one where the payments do
not commence until period of times have elapsed
4. A perpetuity is an annuity in which the payments
continue indefinitely
Ordinary Annuity
Ordinary Annuity
The amount of an ordinary annuity (annuity in
arrears) consists of the sum of the equal periodic
payments and compounded interest on the
payments immediately after the final payments.
The future value (or accumulated value) of an
annuity is the amount due at the end of the term
FV of ordinary annuity, it is the sum of all the
periodic payments made and interest accrued up
to and including the final payment period
1 r 1
n
FVordianryAnnuity CF
r
Where
CF = Cash flow per period
r = interest rate
n = number of payments
Year 1 2 3 4 5
Begin 0 5,000.00 10,300.00 15,918.00 21,873.08
Interest 0 300 618 955.08 1,312.38
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46
1 r n 1
FVordianryAnnuity CF
r
1 0.06 5 1
FVoa 5000
0 .06
1.06 5 1
FVoa 5000
0. 06
1.3382255776 1
FVoa 5000
0.06
0.3382255776
FVoa 5000
0.06
FVoa 50005.63709296
FVoa 28185.4648
Annuity Due
A form of annuity where periodic receipts or
payments are made at the beginning of the period
and one period of the annuity term remains after
the last payment.
FVad FVoa 1 i
FVad FVoa 1 i
Where:
FVad = Future Value of an Annuity Due
FVoa = Future Value of an Ordinary Annuity
i = Interest Rate Per Period
Example: What amount will accumulate if we deposit $5,000
at the beginning of each year for the next 5 years? Assume an
interest of 6% compounded annually.
PV = 5,000, i = .06, n = 5
Year 1 2 3 4 5
Begin 0 5,300.00 10,918.00 16,873.08 23,185.46
Interest 0 300 618 955.08 1,312.38
Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00
End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46
0.3382255776 1.06
FVad 5000
0.06
FVad 28185.46481.06
FVad 29,876.59
Example: What amount will accumulate if we
deposit $1,000 at the beginning of each year for the
next 5 years? Assume an interest of 5%
compounded annually.
PV = 1,000
i = .05
n=5
Or
= $1000*5.53*1.05
= $5801.91
Future value of Deferred Annuity
When the amount of an annuity remains on
deposit for a number of periods beyond the
final payment, the arrangement is known as a
deferred annuity.
When the amount of an ordinary annuity continues
to earn interest for an additional one year period
we have an annuity due situation
When the amount of an ordinary annuity continues
to earn interest for more than one additional
periods, we have a deferred annuity situation.
Formula to calculate future value of deferred annuity
1 i n m 1 i m
FV P 1 p 1
i i
CFt
PV
t
1 r
Example: Present Value of a
single cash flow:
PV = 50,000(PVIF)5,8%
=50,000 x 0.681
= 34050
II. Valuing a Stream of Cash
Flows
• Valuing a lump sum (single) amount is easy to
evaluate because there is one cash flow.
• What do we need to do if there are multiple cash flow?
– Equal Cash Flows: Annuity or Perpetuity
– Unequal/Uneven Cash Flows
N FVt
PV
t 1 1 i
t
Valuing a Stream of Cash
Flows
? 1000 2000 3000
0 1 2 3
• Uneven cash flows exist when there are
different cash flow streams each year
• Treat each cash flow as a Single Sum
problem and add the PV amounts together.
• What is the present value of the preceding
cash flow stream using a 12% discount rate?
0 1 2 3 4 5
Present Value of an Annuity
• The present value of an annuity can be
calculated by taking each cash flow and
discounting it back to the present, and adding
up the present values.
• We can use the principle of value additivity to
find the present value of an annuity, by simply
summing the present values of each of the
components:
Present Value of an Annuity
(cont.)
• Alternatively, there is a short cut that can be
used in the calculation [A = Annuity; r =
Discount Rate; n = Number of years]
• Thus, there is no need to take the present
value of each cash flow separately
• The closed-form of the PVA equation is:
1 1
(1 r ) N
PV FV
r
Present Value of an Annuity
(cont.)
• Using the example, and assuming a discount rate
of 10% per year, we find that the present value is:
62.0
68.3
9
75.1
0
82.6
3
90.9
4
1
379.08 100 100 100 100 100
0 1 2 3 4 5
• We can use this equation to find the present
value of our annuity example as follows:
1
1
(1 0.1)5
PV 100
0.1
1
1 (1.1)5
PV 100
0.1
PV 100
0.3791
PV 1003.791
0.1
PV 379.1
This equation works for all regular (ordinary)
annuities, regardless of the number of payments
Annuities Due
• The annuities that we begin their payments at
the end of period 1 are referred as regular
annuities (ordinary annuities)
• An annuity due is the same as a regular
annuity, except that its cash flows occur at the
beginning of the period rather than at the end
0 1 2 3 4 5
Present Value of an Annuity Due
• The formula for the present value of an annuity due,
sometimes referred to as an immediate annuity, is used to
calculate a series of periodic payments, or cash flows, that
start immediately
• We can find the present value of an annuity due in the
same way as we did for a regular annuity, with one
exception
• Note from the timeline that, if we ignore the first cash flow,
the annuity due looks just like a four-period regular annuity
• Therefore, we can value an annuity due with:
1 1
(1 i ) n1
PV CF CF
i
Present Value of an Annuity
Due (cont.)
• Therefore, the present value of our
example annuity due is:
1
1 1 0.151
PVAD 100 100 416.98
0 .1
Note that this is higher than the PV of the
regular annuity
Deferred Annuities
• A deferred annuity is the same as any
other annuity, except that its payments
do not begin until some later period
• The timeline shows a five-period
payment deferred annuity
0 1 2 3 4 5 6 7
PV of a Deferred Annuity
PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100
0 1 2 3 4 5 6 7
PV of a Deferred Annuity (cont.)
1
1
1 0.15
1
PVDA 100
2
0 .1 1 0.1
1 0.6209 1
PVDA 100 2
0.1 1.1
0.3791 1
PVDA 100
0.1 1.21
PVDA 1003.7910.8264
PVAD 379.10.8264
PVAD 313.29
Or we can calculate with two steps
1
1
1 0.1 5
PV2 100
Step 1: 0.1
1 0.6209
PV2 100
0.1
0.3791
PV2 100
0.1
PV2 379.1
379.1 379.1
PV0 2 313.29
Step 2: 1.1 1.21
Uneven Cash Flows
• Very often an investment offers a
stream of cash flows which are not
either a lump sum or an annuity
• We can find the present or future
value of such a stream by using the
principle of value additivity
Uneven Cash Flows: An
Example (1)
• Assume that an investment offers the
following cash flows. The required return
is 7%, what is the maximum price that
you would pay for this investment?
0 1 2 3 4 5
Uneven Cash Flows: An
Example (2)
• Suppose that you need to deposit the
following amounts in an account paying 5%
per year. What should be the balance of the
account at the end of the third year?
300 500 700
0 1 2 3 4 5
Present value of a Growing
Annuity
• A cash flow that grows at a constant
rate for a specified period of time is a
growing annuity
• A time line of a growing annuity is as
follows
A1 g A1 g A1 g
2 n
.....
0 1 2 ...... n
• The present value of a growing annuity can be
calculated using the following formula
1 g n
1 1 r n
PVga A1 g
rg
1 0.08 20
1 1 0.1520
PVga Birr 500 X 100,0001 0.08
0.15 0.08
PVga Birr 551,736,683
IV. Present value of perpetuity annuity
• A perpetuity is an annuity of with an infinite duration.
• Hence the present value of perpetuity may be
expressed as follows
PV∞ = CF x PVIFA
• Where PV∞ = present value of a perpetuity
• CF = constant annual cash flows
• PVIFA = present value interest factor for
perpetuity (an annuity of
infinite duration)