Time Value of Money - ST

Slide 2.
1
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5
th
Edition, Pearson Education Limited 2010
Chapter 1
The finance function
Slide 2.2
th
Key concepts
Relationship between risk and return.
Time value of money.
Slide 2.3
th
Risk and return
Risk refers to the possibility that actual
outcome may differ from expected outcome.
Risk can be measured by standard deviation.
Investors require increasing compensation
(return) for taking on increasing risk.
Slide 2.4
th
Risk and return (Cont.)
Return refers to the financial rewards
gained as a result of making an
investment.
Return of an investment in forms of
dividend payments and capital gains
(share price increases), or interest
payment.
Return on an investment can be measured
over a standard period such as 1 year.

Slide 2.5
th
Risk and return (Cont.)
Shareholder return is annual dividend (D
1
)
plus share price increase (P
1
P
0
).
Relative return in percentage terms is
100 [(P
1
P
0
) + D
1
]/P
0
.
This is called total shareholder return.
Slide 2.6
th
Time value of money
Refers to the fact that the value of money
changes over time, and relevant to anyone
expecting to pay or receive money over a
period of time, due to 3 main factors:
Time
Inflation
Risk

Slide 2.7
th
Time value of money
1. The One-Period Case
2. The Multi-period Case
3. Compounding Periods
4. Simplifications
5. What Is a Firm Worth?
6. Summary and Conclusions
Slide 2.8
th
1. The One-Period Case: Future Value
If you were to invest $10,000 at 5-percent interest
for one year, your investment would grow to
$10,500

$500 would be interest ($10,000 .05)
$10,000 is the principal repayment ($10,000 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000(1.05).

The total amount due at the end of the investment
is called the Future Value (FV).
Slide 2.9
th
In the one-period case, the formula for FV can
be written as:
FV = C
0
(1 + r)

Where C
0
is cash flow at date 0 and r is the
appropriate interest rate.
FV = $10,500
Year 0 1
C
0
= $10,000
$10,000 x 1.05
C
0
(1 + r)
Slide 2.10
th
If you were to be promised $10,000 due in one
year when interest rates are at 5-percent, your
investment would be worth $9,523.81 in todays
dollars.
05 . 1
000 , 10 $
81 . 523 , 9 $ =
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is call the Present Value (PV) of
$10,000.
Note that $10,000 = $9,523.81(1.05).
Slide 2.11
th
In the one-period case, the formula for PV can
be written as:

r
C
PV
+
=
1
1
Where C
1
is cash flow at date 1 and r is
the appropriate interest rate.
C
1
= $10,000
Year 0 1
PV = $9,523.81
$10,000/1.05
C
1
/(1 + r)
Slide 2.12
th
1. The One-Period Case: Net Present Value
The Net Present Value (NPV) of an investment
is the present value of the expected cash
flows, less the cost of the investment.
Suppose an investment that promises to pay
$10,000 in one year is offered for sale for
$9,500. Your interest rate is 5%. Should you
buy?
81 . 23 $
81 . 523 , 9 $ 500 , 9 $
05 . 1
000 , 10 $
500 , 9 $
=
+ =
+ =
NPV
NPV
NPV
Yes!
Slide 2.13
th
In the one-period case, the formula for NPV can be
written as:
P V C o s t N P V + =
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested
our $9,500 elsewhere at 5-percent, our FV would
be less than the $10,000 the investment promised
and we would be unambiguously worse off in FV
terms as well:
$9,500(1.05) = $9,975 < $10,000.

1. The One-Period Case: Net Present Value (Cont.)
Slide 2.14
th
2. The Multiperiod Case: Future Value
The general formula for the future value of an
investment over many periods can be written
as:
FV = C
0
(1 + r)
T
Where
C
0
is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
Slide 2.15
th
Suppose that Jay Ritter invested in the initial
public offering of the Modigliani company.
Modigliani pays a current dividend of $1.10,
which is expected to grow at 40-percent per
year for the next five years.
What will the dividend be in five years?

FV = C
0
(1 + r)
T

$5.92 = $1.10(1.40)
5
2. The Multiperiod Case: Future Value
Slide 2.16
th
Future Value and Compounding
Notice that the dividend in year five, $5.92,
is considerably higher than the sum of the
original dividend plus five increases of 40-
percent on the original $1.10 dividend:

$5.92 > $1.10 + 5[$1.10.40] = $3.30

This is due to compounding.
Slide 2.17
th
0 1 2 3 4 5
1 0 . 1 $
3
) 4 0 . 1 ( 1 0 . 1 $
0 2 . 3 $
) 4 0 . 1 ( 1 0 . 1 $
5 4 . 1 $
2
) 4 0 . 1 ( 1 0 . 1 $
1 6 . 2 $
5
) 4 0 . 1 ( 1 0 . 1 $
9 2 . 5 $
4
) 4 0 . 1 ( 1 0 . 1 $
2 3 . 4 $
Future Value and Compounding
Slide 2.18
th
Present Value and Compounding
How much would an investor have to set
aside today in order to have $20,000 five
years from now if the current rate is 15%?
0 1 2 3 4 5
$20,000 PV
5
) 15 . 1 (
000 , 20 $
53 . 943 , 9 $ =
Slide 2.19
th
How Long is the Wait?
If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?
T
r C F V ) 1 (
0
+ =
T
) 1 0 . 1 ( 0 0 0 , 5 $ 0 0 0 , 1 0 $ =
2
000 , 5 $
000 , 10 $
) 10 . 1 ( = =
T
2 ln ) 1 0 . 1 ln ( =
T
years 27 . 7
0953 . 0
6931 . 0
) 10 . 1 ln(
2 ln
= = = T
Slide 2.20
th
Assume the total cost of a university education will be
$50,000 when your child enters university in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your childs education? About 21.15%.
What Rate Is Enough?
T
r C F V ) 1 (
0
+ =
1 2
) 1 ( 0 0 0 , 5 $ 0 0 0 , 5 0 $ r + =
10
000 , 5 $
000 , 50 $
) 1 (
1 2
= = + r
1 2 1
1 0 ) 1 ( = + r
2 1 1 5 . 1 2 1 1 5 . 1 1 1 0
1 2 1
= = = r
Slide 2.21
th
3. Compounding Periods
Compounding an investment m times a year
for T years provides for future value of
wealth:
T m
m
r
C FV

|
.
|
\
|
+ = 1
0
For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to
93 . 70 $ ) 06 . 1 ( 50 $
2
12 .
1 50 $
6
3 2
= =
|
.
|
\
|
+ =

FV
Slide 2.22
th
Effective Annual Interest Rates
A reasonable question to ask in the above
example is what is the effective annual rate of
interest on that investment?
The Effective Annual Interest Rate (EAR) is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
9 3 . 7 0 $ ) 0 6 . 1 ( 5 0 $ )
2
1 2 .
1 ( 5 0 $
6 3 2
= = + =

F V
9 3 . 7 0 $ ) 1 ( 5 0 $
3
= + E A R
Slide 2.23
th
Effective Annual Interest Rates (Cont.)
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semiannually.
9 3 . 7 0 $ ) 1 ( 5 0 $
3
= + = E A R F V
50 $
93 . 70 $
) 1 (
3
= + EAR
1236 . 1
50 $
93 . 70 $
3 1
=
|
.
|
\
|
= EAR
Slide 2.24
th
Continuous Compounding (Advanced)
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C
0
e
rT
Where
C
0
is cash flow at date 0,
r is the stated annual interest rate,
T is the number of periods over which the cash is
invested, and
e is a transcendental number approximately equal
to 2.718. e
x
is a key on your calculator.
Slide 2.25
th
4. Simplifications
Perpetuity
A constant stream of cash flows that lasts forever.
Growing perpetuity
A stream of cash flows that grows at a constant rate
forever.
Annuity
A stream of constant cash flows that lasts for a fixed
number of periods.
Growing annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods.
Slide 2.26
th
Perpetuity
A constant stream of cash flows that lasts forever.
0

1
C
2
C
3
C
The formula for the present value of a perpetuity is:
+
+
+
+
+
+
=
3 2
) 1 ( ) 1 ( ) 1 ( r
C
r
C
r
C
PV
r
C
PV =
Slide 2.27
th
Perpetuity: Example
What is the value of a British CONSOL that promises
to pay 15 each year, every year until the sun turns
into a red giant and burns the planet to a crisp?
The interest rate is 10-percent.
0

1
15
2
15
3
15
150
10 .
15
= = PV
Slide 2.28
th
Growing Perpetuity
A growing stream of cash flows that lasts forever.
0

1
C
2
C(1+g)
3
C (1+g)
2
The formula for the present value of a growing
perpetuity is:
+
+
+
+
+
+
+
+
=
3
2
2
) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( r
g C
r
g C
r
C
PV
g r
C
PV
=
Slide 2.29
th
Growing Perpetuity: Example
The expected dividend next year is $1.30 and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
0

1
$1.30
2
$1.30(1.05)
3
$1.30 (1.05)
2
00 . 26 $
05 . 10 .
30 . 1 $
=
= PV
Slide 2.30
th
Annuity
A constant stream of cash flows with a fixed maturity.
0 1
C
2
C
3
C
The formula for the present value of an annuity is:
T
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+
+
+
+
+
+
=
(
+
=
T
r r
C
PV
) 1 (
1
1
T
C
Slide 2.31
th
Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on
36-month loans?
0
1
$400
2
$400
3
$400
59 . 954 , 12 $
) 12 07 . 1 (
1
1
12 / 07 .
400 $
36
=
(
+
= PV
36
$400
Slide 2.32
th
Growing Annuity
A growing stream of cash flows with a fixed maturity.
0 1
C
The formula for the present value of a growing annuity:
T
T
r
g C
r
g C
r
C
PV
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
2
+
+
+ +
+
+
+
+
=

(
(
|
|
.
|
\
|
+
+
=
T
r
g
g r
C
PV
) 1 (
1
1
2
C(1+g)
3
C (1+g)
2
T
C(1+g)
T-1
Slide 2.33
th
Growing Annuity
A retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3-
percent each year. What is the present value at
retirement if the discount rate is 10-percent?
0 1
$20,000
57 . 121 , 265 $
10 . 1
03 . 1
1
03 . 10 .
000 , 20 $
40
=
(
(
|
.
|
\
|
= PV
2
$20,000(1.03)
40
$20,000(1.03)
39
Slide 2.34
th
5. What Is a Firm Worth?
Conceptually, a firm should be worth the
present value of the firms cash flows.
The tricky part is determining the size, timing,
and risk of those cash flows.
Slide 2.35
th
6. Summary and Conclusions
Two basic concepts, future value and present
value.
Interest rates are commonly expressed on an
annual basis, but semi-annual, quarterly, monthly
and even continuously compounded interest rate
arrangements exist.
The formula for the net present value of an
investment that pays $C for N periods is:
=
+
+ =
+
+ +
+
+
+
+ =
N
t
t N
r
C
C
r
C
r
C
r
C
C N PV
1
0
2
0
) 1 ( ) 1 ( ) 1 ( ) 1 (

Slide 2.36
th
6. Summary and Conclusions (Cont.)
We presented four simplifying formulae:

r
C
PV = : Perpetuity
g r
C
PV
= : Perpetuity Growing
(
+
=
T
r r
C
PV
) 1 (
1
1 : Annuity
(
(
|
|
.
|
\
|
+
+
=
T
r
g
g r
C
PV
) 1 (
1
1 : Annuity Growing
Slide 2.37
th
1. You are planning to move next year. You recently told
your best friend that you have decided to sell all of
your current furniture just prior to moving as you do
not want to pay to transport it across the country. Your
friend offered to pay you $2,000 next year for this
furniture. What is your friend's offer worth today if you
can earn 6 percent on your money?
A) $1,779.99
B) $1,818.22
C) $1,886.79
D) $2,000.00
E) $2,120.00
Multiple choices
Slide 2.38
th
1. C

Multiple choices
Slide 2.39
th
2. All else constant, the present value _____ when
the discount rate increases.
A) increases
B) decreases
C) remains constant
D) can either increase or decrease
E) can either remain constant or decrease
Multiple choices
Slide 2.40
th
2. B
Multiple choices
Slide 2.41
th
3.
Terry is considering purchasing a used tractor and restoring
it. He estimates that his total restoration cost including his
labor, in today's dollars, will be $21,400. He also estimates
that he can resell the tractor 1 year from now at a price of
$24,000. Should Terry undertake this project if he requires
a 9.5 percent rate of return? Why or why not?
A) Yes; because the price of $24,000 provides a return in
excess of 9.5 percent
B) Yes; because the selling price is greater than the cost
C) No; because the present value of the sales price is less
than $21,400
D) No; because the net present value is -$102.16
E) No; because the net present value is $517.81
Multiple choices
Slide 2.42
th
3. A.

Multiple choices
Slide 2.43
th
4. Paul is considering a business investment which
is guaranteed to pay $4,000 one year from today.
What is the maximum amount Paul should pay
today for this investment if he wants to earn a 9.75
percent rate of return?
A) $3,411.68
B) $3,644.65
C) $3,661.67
D) $3,689.02
E) $3,701.08
Multiple choices
Slide 2.44
th
4. B
Multiple choices
Slide 2.45
th
5. Ann is considering buying an office building at a
cost of $199,900. She estimates that she can
resell the building after one year at a price of
$229,500. What discount rate approximately
equates those two prices?
A) 83 percent
B) 60 percent
C) 14.81 percent
D) 10 percent
E) 33 percent
Multiple choices
Slide 2.46
th
5. C
Multiple choices
Slide 2.47
th
6. The Corner Art Store owns a painting which they
display in their showroom. The painting is currently
valued at $1,350 but is currently not for sale. The
value of the painting is increasing by 7.4 percent
annually. Which one of the following prices best
represents the value of the painting next year
should the store decide to sell it at that time?
A) $1,350
B) $1,400
C) $1,450
D) $1,500
E) $1,550
Multiple choices
Slide 2.48
th
6. C
Multiple choices
Slide 2.49
th
7. On your 5th birthday, your grandparents opened
an investment account in your name and made an
initial deposit of $2,500. The account pays 4.5
percent interest. How much will you have in the
account on your 21st birthday if you don't add or
withdraw any money before then?
A) $4,711.68
B) $5,002.10
C) $5,055.93
D) $5,207.19
E) $5,211.14
Multiple choices
Slide 2.50
th
7. C
Multiple choices
Slide 2.51
th
8.
Today, you are investing $27,500 in a new project. The
project will return $8,000, $9,500, and $11,000 at the end
of each of the next three years, respectively. What is the
net present value of this project at a 9 percent discount
rate?
A) -$3,670.57
B) -$3,209.11
C) $3,711.09
D) $3,787.88
E) $3,901.11
Multiple choices
Slide 2.52
th
8. A
Multiple choices
Slide 2.53
th
9.
Your goal is to have $15,000 in your savings account 3 years from now
so that you can purchase a home. Which one of the following
statements is correct given this situation? Assume that you only make
one initial deposit into the savings account.
A) The higher the interest rate on your savings, the larger the amount
that you need to deposit today to fund this account.
B) If you deposit $7,500 today and earn 7 percent interest, you will reach
your goal in 3 years.
C) If you have $10,000 to deposit today, you will need to earn at least 15
percent interest to reach your goal.
D) The less money you have to deposit today into the account, the
greater the interest rate must be if you are to reach your goal of
$15,000.
E) You will have to deposit $12,460 today if the interest you can earn is
4.7 percent.
Multiple choices
Slide 2.54
th
9. D
Multiple choices
Slide 2.55
th
10. What is the future value of $12,000 received
today if it is invested at 10.5 percent compounded
annually for 25 years?
A) $131,484.77
B) $145,625.76
C) $147,475.83
D) $152,521.75
E) $153,374.89
Multiple choices
Slide 2.56
th
10. B
Multiple choices
Slide 2.57
th
11. Consider an eight-year investment costing
$55,000. It is expected to pay $3,000 per year in
each of the next five years and $15,000 per year
in the last three years. If the required discount rate
is 12 percent, what is the net present value of this
investment?
A. $86,257.28
B. ($23,742.72)
C. $5,000
D. $60,000.00
Multiple choices
Slide 2.58
th
11. B
Multiple choices
Slide 2.59
th
Jim makes a deposit of $12,000 in a bank
account. The deposit is to earn interest annually at
the rate of 9 percent for seven years.
a) How much will Jim have on deposit at the end of
seven years?
b) Assuming the deposit earned a 9 percent rate of
interest compounded quarterly, how much would
he have at the end of seven years?
c) In comparing parts (a) and (b), what are the
respective effective annual yields? Which
alternative is better?
Exercises 1
Slide 2.60
th
John is considering the purchase of a lot. He can
buy the lot today and expects the price to rise to
$15,000 at the end of 10 years. He believes that
he should earn an investment yield of 10 percent
annually on this investment. The asking price for
the lot is $7,000. Should he buy it?
Exercises 2
Slide 2.61
th
An investor can make an investment in a real
estate development and receive an expected cash
return of $45,000 after six years. Based on a
careful study of other investment alternatives, she
believes that an 18 percent annual return
compounded quarterly is a reasonable return to
earn on this investment. How much should she
pay for it today?
Exercises 3
Slide 2.62
th
Your uncle has given you a bond that will pay
$500 at the end of each year forever into the
future. If the market yield on this bond is 8.25
percent, how much is it worth today?
Exercises 4
Slide 2.63
th
Suppose you have an investment that is expected to
generate a $20,000 cash flow next year and that this is
expected to increase by 5 percent per year forever into the
future.
a) If your required rate of return on this investment is 18
percent, how much is it worth to you today?
b) Suppose now that you do not know how fast the cash
flows will grow in the future, but that you expect them to
grow at a constant rate. Suppose also that this
investment is currently priced at $200,000. If the required
rate of return is still 18 percent, how fast does the market
expect the annual cash flows to grow?
Exercises 5

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