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Chapter No.5
Second Part
1
The Time Value of Money
Would you prefer to
have Rs. 1 million now or
$1 million 10 years
from now?
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Uses of Time Value of Money
Time Value of Money, or TVM, is a concept that is
used in all aspects of finance including:
Bond valuation
Stock valuation
Accept/reject decisions for project management
Financial analysis of firms
And many others!
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Formulas
Common formulas that are used in TVM calculations:*
Present value of a lump sum:
PV = CFt / (1+r)t OR PV = FVt / (1+r)t
PV = S [CFt / (1+r)t]
t=0
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Formulas (continued)
Future value of a cash flow stream:
n
FV = S [CFt * (1+r)n-t]
t=0
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Variables
where
r = rate of return
t = time period
n = number of time periods
PMT = payment
CF = Cash flow (the subscripts t and 0 mean at time t
and at time zero, respectively)
PV = present value (PVA = present value of an annuity)
FV = future value (FVA = future value of an annuity)
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Types of TVM Calculations
There are many types of TVM calculations
The basic types will be covered in this review
module and include:
Present value of a lump sum
Future value of a lump sum
Present and future value of cash flow streams
Present and future value of annuities
Keep in mind that these forms can, should, and
will be used in combination to solve more complex
TVM problems
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Basic Rules
The following are simple rules that you should always use no
matter what type of TVM problem you are trying to solve:
1. Stop and think: Make sure you understand what the problem is
asking. You will get the wrong answer if you are answering the
wrong question.
2. Draw a representative timeline and label the cash flows and
time periods appropriately.
3. Write out the complete formula using symbols first and then
substitute the actual numbers to solve.
4. Check your answers using a calculator.
While these may seem like trivial and time consuming tasks, they
will significantly increase your understanding of the material and
your accuracy rate.
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Present Value of a Lump Sum
Present value calculations determine what the value
of a cash flow received in the future would be worth
today (time 0)
The process of finding a present value is called
“discounting” (hint: it gets smaller)
The interest rate used to discount cash flows is
generally called the discount rate
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Example of PV of a Lump Sum
How much would $100 received five years from now be worth
today if the current interest rate is 10%?
1. Draw a timeline
i = 10%
? $100
0 1 2 3 4 5
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Example of PV of a Lump Sum
2. Write out the formula using symbols:
PV = CFt / (1+r)t
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Future Value of a Lump Sum
You can think of future value as the opposite of
present value
Future value determines the amount that a sum of
money invested today will grow to in a given period of
time
The process of finding a future value is called
“compounding” (hint: it gets larger)
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Example of FV of a Lump Sum
3. Substitute the numbers into the formula:
FV = $100 * (1+.1)5
4. Solve for the future value:
FV = $161.05
5. Check answer using a financial calculator:
i = 10%
n=5
PV = $100
PMT = $0
FV = ?
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Some Things to Note
In both of the examples, note that if you were to
perform the opposite operation on the answers (i.e.,
find the future value of $62.09 or the present value of
$161.05) you will end up with your original investment
of $100.
This illustrates how present value and future value
concepts are intertwined. In fact, they are the same
equation . . .
Take PV = FV / (1+r)t and solve for FV . You will get FV = PV *
t t t
(1+r)t.
As you get more comfortable with the formulas and
calculations, you may be able to do the calculations on
your calculator alone. Be sure you understand WHAT
you are entering into each register and WHY.
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FV = $100 * (1+.1)5
FV = [CF1*(1+r)n-1]+[CF2*(1+r)n-2]+[CF3*(1+r)n-3]+[CF4*(1+r)n-
4
]
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Present Value of a Cash Flow Stream
A cash flow stream is a finite set of payments that
an investor will receive or invest over time.
The PV of the cash flow stream is equal to the sum
of the present value of each of the individual cash
flows in the stream.
The PV of a cash flow stream can also be found by
taking the FV of the cash flow stream and
discounting the lump sum at the appropriate
discount rate for the appropriate number of
periods.
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Example of PV of a Cash Flow Stream
Joe made an investment that will pay $100 the first year,
$300 the second year, $500 the third year and $1000 the
fourth year. If the interest rate is ten percent, what is the
value of this cash flow stream?
1. Draw a timeline:
i = 10%
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Example of PV of a Cash Flow Stream
2. Write out the formula using symbols:
n
PV = S [CFt / (1+r)t]
t=0
OR
PV = [CF1/(1+r)1]+[CF2/(1+r)2]+[CF3/(1+r)3]+[CF4/(1+r)4]
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Example of PV of a Cash Flow Stream
4. Solve for the present value:
PV = $90.91 + $247.93 + $375.66 + $683.01
PV = $1397.51
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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.
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Example of FV of a Cash Flow Stream
Assume Joe has the same cash flow stream from his investment but
wants to know what it will be worth at the end of the fourth year
1. Draw a timeline:
0 1 2 3 4
$1000
i = 10% ?
?
?
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Example of FV of a Cash Flow Stream
2. Write out the formula using symbols
n
FV = S [CFt * (1+r)n-t]
t=0
OR
FV = [CF1*(1+r)n-1]+[CF2*(1+r)n-2]+[CF3*(1+r)n-3]+[CF4*(1+r)n-4]
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Example of FV of a Cash Flow Stream
4. Solve for the Future Value:
FV = $133.10 + $363.00 + $550.00 + $1000
FV = $2046.10
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Annuities
An annuity is a cash flow stream in which the cash
flows are all equal and occur at regular intervals.
Note that annuities can be a fixed amount, an
amount that grows at a constant rate over time, or
an amount that grows at various rates of growth
over time. We will focus on fixed amounts.
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Example
Mr. Ahad receive every year (at the end)
520 for next 15 years what value of today if
value of r=10%
FVA= C *(1+i) n
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Annuity Formula
PVA= C *1-(1+i) -n
i
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Annuity Formula
i
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Example of PV of an Annuity
Assume that Sally owns an investment that will pay her
$100 each year for 20 years. The current interest rate is
15%. What is the PV of this annuity?
1. Draw a timeline
0 1 2 3 …………………………. 19 20
?
i = 15%
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Example of PV of an Annuity
2. Write out the formula using symbols:
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Example of PV of an Annuity
5. Check answer using a calculator
Make sure that the calculator is set to one period per year
PMT = $100
n= 20
i = 15%
PV = ?
Note that you do not need to enter anything for future value (or
FV=0)
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Example of FV of an Annuity
Assume that Sally owns an investment that will pay her
$100 each year for 20 years. The current interest rate is
15%. What is the FV of this annuity?
1. Draw a timeline
0 1 2 3 …………………………. 19 20
?
i = 15%
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Example of FV of an Annuity
5. Check using calculator:
Make sure that the calculator is set to one period per year
PMT = $100
n = 20
i = 15%
FV = ?
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