CHAPTER 5: The Time Value of Money 5.

1 Future Values and Compound Interest - Financial managers often have to compare cash payments or receipts which occur at different points of time - Since a dollar today does not have the same value as a dollar tomorrow, a pattern of relationship has to be established to compare and contrast cash flows at different times - A present amount of money grows to future value when it is able to earn interest - You have $100 invested. Banks are paying an interest rate of 6% per year on deposits o Interest = interest rate x initial investment = .06 x $100 = $6 o Value of interest after 1 yr = $100 + $6 = $106 o Value after 1 yr = initial investment x (1+r) = $100 x (1.06) = $106 o Interest in yr 2 = .06 x $106 = $6.36 o Value of account after 2 yrs = $100 x 1.06 x1.06 OR $100 x (1.06)^2 = $112.36 - Future Value (FV): amount to which an investment will grow after earning interest o Future value of $100 = $100 x (1+r)^t - You invest $1000 paying compound interest at a rate of 5% /yr. What will the account be worth in 10 years? - Compound interest: interest earned only on the original investment; no interest is earned on interest. Therefore, previous periods earned interest can also earn interest on the next period. o = Year 1 = 1000 x .05 = 50 1000 +50 = 1050 Year 2 = .05 x 1050 =52.50 1050 + 52.50 = 1102.50 Year 10 = 1000 x (1.05)^10 = $1628.89 - Simple interest: interest earned on the original investment; no interest is earned on interest o = Year 1 = 1000 x .05 = 50 1050 o Interest at year 10 = 10 x $50 = 500 = 1500 - Future Value = Value Today x (1+r)^t - Future Value interest factor or future value factor: future value of a current cash flow of $1. 5.2 Present Value - A dollar today is worth more than a dollar tomorrow - Present Value: Value today of a future cash flow. How much do you need to invest today to produce a certain amount at the end of the year? ($106)

o o $106/ (1+.06)^1 = $100 Discount rate: interest rate used to compute present values of future cash flows (r) o Present value is often called the discount value of the future payment o Present values are always calculated using compound interest o The longer you have to wait for money, the less its worth today

FINDING THE INTEREST RATE or INVESTMENT PERIOD

Use your financial calculator Use the tables look up the discount factor Rearrange the expression Rule of 72: the time it will take an investment to double... do 72/r = t For investment period: PV = $3000 x 1/(1.08)^t o = 1/(1.08)^t = .6300 o = (1.08)^-t = .63 o Log (1.08)^-t = log .63 o t log1.08 = log.63 o T = -log.63/log1.08 =6.003 5.3 Future Value of Multiple Cash Flow - Investments will involve many cash flows over time. When there are many payments youll hear business people refer to a stream of cash flows. - To find the value at some future date of a stream of cash flows, calculate what each cash flow will be worth at the future date and then add up these future values. PRESENT VALUE OF MULTIPLE CASH FLOWS - We are asking how much that cash flow would be worth today - Look at formula sheet for present value mtpl cash flows example 5.4 Level Cash flows: Perpetuities & Annuities PERPETUITIES - Perpetuities: Cash Flows of equal amount every period for an unlimited number of periods o Ex: Property tax payments, preferred stocks, etc. - Cash payment from perpetuity = interest rate x present value (C = r x PV) - PV of perpetuity = C/r = cash payment/interest rate - Perpetuity can be easily confused with the formula for present value of a single cash payment - Perpetuity formula tells us the value of a regular stream of payments starting one period from now ANNUITIES Annuities: Cash flows of equal amount every period for a limited number of periods o Ex: loan payments for automobile, periodic earnings from lottery wins, etc.

o o o

This formula gives you the present value of an annuity starting one period from now. This is called a regular annuity. Annuity factor: present value of a $1 annuity

o Annuities Due: a level stream of payments starting immediately

The present value of an annuity due of t payments of $1 per period is the same as $1 plus the present value of an ordinary annuity of t-1 payments PV annuity due = 1+[1/r 1/r(1+r)^t-1]

GROWTH IN ANNUITIES AND PERPETUITIES A growing perpetuity with a constant growth rate of g has a PV that can be shown as o o o

A growing perpetuity is an infinite stream of cash flows growing at a constant rate A growing annuity with a growth rate of g has a PV that can be shown as:

o o A growing annuity is a finite stream of cash flows growing at a constant rate 5.5 Inflation and the Time Value of Money - Inflation: rate at which prices as a whole are increasing - Nominal interest rate: rate at which money invested grows - Real interest rate: rate at which the purchasing power of an investment increases - Real value of $1: purchasing power adjusted value of a dollar - When people quote an interest rate you can be sure that it is a nominal rate, not a real rate Real rate of interest is calculated by This can be approximated as real rate of interest = nominal rate of interest inflation rate o The approximation works best when both the inflation rate and the real rate are small. When they are not small, throw it away and do it properly - Valuing real cash payments o PV = payment in current dollars / 1+ nominal interest rate 5.6 Effective Annual Interest Rates - Effective Annual interest Rate (EAR): interest rate that is annualized using compound interest - Annual Percentage Rate (APR): interest rate that is annualized using simple interest - If m is the number of compounding per year, then we can say o EAR =[(1+ (APR/m))^m] -1 - The effective annual equivalent to a monthly rate of interest is o 1+ effective annual rate = (1+monthly rate) - Per period interest rate = APR/m = [(1+effective annual rate) ^1/m] -1 Summary of chapter 5 Future value is the amount to which an investment will grow after earning interest The present value (pv) of a future cash payment is the amount you would need to invest today to create that future cash payment You can calculate the interest or discount rate and the time periods as well -

A level stream of payments which continues forever is called a perpetuity One which continues for a limited number of years is called an annuity You can use the FV and PV formulas to calculate their value, you can use the short cut formulae or you can use your financial calculator You need to distinguish between real and nominal cash flows that are affected by inflation Annual percentage rates (APR) do not recognize the effect of compound interest, that is, they annualize assuming simple interest Effective annual rates (EAR) annualize using compound interest