Time Value of Money Sept 2011

1lML vALuL Cl MCnL?
12/3/2011 1
2
1he 8ole of 1lme value ln llnance
Most Iinancial decisions involve costs & beneIits that
are spread out over time.
Time value oI money allows comparison oI cash
Ilows Irom diIIerent periods.
Question: Your Iather has oIIered to give you some
money and asks that you choose one oI the Iollowing
two alternatives:
$1,000 today, or
$1,100 one year Irom now.
What do you do?
12/3/2011
3
1he 8ole of 1lme value ln llnance
(conL)
The answer depends on what rate oI interest you
could earn on any money you receive today.
For example, iI you could deposit the $1,000 today at
12 per year, you would preIer to be paid today.
Alternatively, iI you could only earn 5 on deposited
Iunds, you would be better oII iI you chose the
$1,100 in one year.
12/3/2011
luLure value versus resenL value

Suppose a Iirm has an opportunity to spend $15,000 today on
some investment that will produce $17,000 spread out over the
next Iive years as Iollows:
Is this a wise investment?
To make the right investment decision, managers need to
compare the cash Ilows at a single point in time.
?ear Cash flow
1 $3000
2 $000
3 $000
$3000
$2000
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llgure 1
1lme Llne
12/3/2011
llgure 2
Compoundlng and ulscounLlng
12/3/2011
llgure 3
CalculaLor keys
12/3/2011
CompuLaLlonal 1ools (conL)

W lectronic spreadsheets:
Like Iinancial calculators, electronic spreadsheets have
built-in routines that simpliIy time value calculations.
The value Ior each variable is entered in a cell in the
spreadsheet, and the calculation is programmed using an
equation that links the individual cells.
Changing any oI the input variables automatically changes
the solution as a result oI the equation linking the cells.
12/3/2011
aslc aLLerns of Cash llow

The cash inIlows and outIlows oI a Iirm can be described by
its general pattern.
The three basic patterns include a single amount, an annuity, or
a mixed stream:
12/3/2011
10
luLure value of a Slngle AmounL
Future value is the value at a given Iuture date oI an
amount placed on deposit today and earning interest
at a speciIied rate. Found by applying compound
interest over a speciIied period oI time.
4254und interest is interest that is earned on a
given deposit and has become part oI the principal at
the end oI a speciIied period.
!rinci5al is the amount oI money on which interest
is paid.
12/3/2011
11
ersonal llnance Lxample
WII Fred Moreno places $100 in a savings account
paying 8 interest compounded annually, how much
will he have at the end oI 1 year?
Future value at end oI year 1 $100 L (1 0.08) $108
WII Fred were to leave this money in the account Ior
another year, how much would he have at the end oI the
second year?
Future value at end oI year 2 $100 L (1 0.08) L (1 0.08)
$116.64
12/3/2011
12
luLure value of a Slngle AmounL 1he
LquaLlon for luLure value
We use the Iollowing notation Ior the various inputs:
'
n
Iuture value at the end oI period n
!' initial principal, or present value
r annual rate oI interest paid. (Note. On Iinancial calculators, is
typically used to represent this rate.)
n number oI periods (typically years) that the money is leIt on deposit
The general equation Ior the Iuture value at the end oI period n
is
W '
n
!' L (1 r)
n
12/3/2011
13
luLure value of a Slngle AmounL 1he
Wane Farber places $800 in a savings account paying 6 interest
compounded annually. She wants to know how much money will
be in the account at the end oI Iive years.
WThis analysis can be depicted on a time line as Iollows:
'
5
$800 L (1 0.06)
5
$800 L (1.33823) $1,070.58
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1
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1
llgure
luLure value 8elaLlonshlp
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1
resenL value of a Slngle AmounL
!resent value is the current dollar value oI a Iuture amount
the amount oI money that would have to be invested today at a
given interest rate over a speciIied period to equal the Iuture
amount.
It is based on the idea that a dollar today is worth more than a
dollar tomorrow.
isc4unting cash fl4s is the process oI Iinding present
values; the inverse oI compounding interest.
The discount rate is oIten also reIerred to as the opportunity
cost, the discount rate, the required return, or the cost oI
capital.
12/3/2011
1
W!aul Shorter has an opportunity to receive $300 one year
Irom now. II he can earn 6 on his investments, what is the
most he should pay now Ior this opportunity?
!' L (1 0.06) $300
!' $300/(1 0.06) $283.02
12/3/2011
1
resenL value of a Slngle AmounL 1he
LquaLlon for resenL value
WThe present value, !' oI some Iuture amount,
'
n
to be received n periods Irom now,
assuming an interest rate (or opportunity cost) oI
r is calculated as Iollows:
12/3/2011
1
resenL value of a Slngle AmounL 1he
W!am Valenti wishes to Iind the present value oI $1,700 that will
be received 8 years Irom now. !ams opportunity cost is 8.
9I $100/(1 + 00)
$100/103 $1
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20
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21
llgure
resenL value 8elaLlonshlp
12/3/2011
22
AnnulLles
WAn annuity is a stream oI equal periodic cash Ilows,
over a speciIied time period. These cash Ilows can be
inflows oI returns earned on investments or outflows oI
Iunds invested to earn Iuture returns.
An 4rdinary (deferred) annuity is an annuity Ior which
the cash Ilow occurs at the end oI each period
An annuity due is an annuity Ior which the cash Ilow
occurs at the -eginning oI each period.
An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound
Ior an additional period.
12/3/2011
23
WFran Abrams is choosing which oI two annuities to receive.
Both are 5-year $1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due. Fran has listed the
cash Ilows Ior both annuities as shown in Table 5.1 on the
Iollowing slide.
noLe LhaL Lhe amounL of boLh annulLles LoLal $000
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2
1able 1 Comparlson of Crdlnary AnnulLy and AnnulLy
uue Cash llows ($1000 ?ears)
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2
llndlng Lhe luLure value of an
Crdlnary AnnulLy
You can calculate the Iuture value oI an ordinary
annuity that pays an annual cash Ilow equal to by
using the Iollowing equation:
As beIore, in this equation r represents the interest
rate and n represents the number oI payments in the
annuity (or equivalently, the number oI years over
which the annuity is spread).
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2
WFran Abrams wishes to determine how much money she will have at
the end oI 5 years iI he chooses annuity A, the ordinary annuity and it
earns 7 annually. Annuity A is depicted graphically below:
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2
ersonal llnance Lxample (conL)
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2
llndlng Lhe resenL value of an
Crdlnary AnnulLy
You can calculate the present value oI an ordinary
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2
Crdlnary AnnulLy (conL)
WBraden Company, a small producer oI plastic toys, wants to determine
the most it should pay to purchase a particular annuity. The annuity
consists oI cash Ilows oI $700 at the end oI each year Ior 5 years. The
required return is 8.
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30
1able 2 Long MeLhod for llndlng Lhe resenL
value of an Crdlnary AnnulLy
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31
Crdlnary AnnulLy (conL)
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32
llndlng Lhe luLure value of an
AnnulLy uue
You can calculate the present value oI an annuity due
that pays an annual cash Ilow equal to by using
the Iollowing equation:
12/3/2011
33
WFran Abrams now wishes to
calculate the Iuture value oI an
annuity due Ior annuity B in
Table 5.1. Recall that annuity B
was a 5 period annuity with the
Iirst annuity beginning
immediately.
WNote: BeIore using your calculator
to Iind the Iuture value oI an
annuity due, depending on the
speciIic calculator, you must either
switch it to BIN mode or use the
DU key.
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3
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3
AnnulLy uue
You can calculate the present value oI an ordinary
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3
AnnulLy uue (conL)
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3
MaLLer of lacL
Wansas truck driver, Donald Damon, got the surprise oI his liIe
when he learned he held the winning ticket Ior the !owerball
lottery drawing held November 11, 2009. The advertised lottery
jackpot was $96.6 million. Damon could have chosen to collect
his prize in 30 annual payments oI $3,220,000 (30 L $3.22
million $96.6 million), but instead he elected to accept a lump
sum payment oI $48,367,329.08, roughly halI the stated jackpot
total.
12/3/2011
3
llndlng Lhe resenL value of a
erpeLulLy
A 5er5etuity is an annuity with an inIinite liIe,
providing continual annual cash Ilow.
II a perpetuity pays an annual cash Ilow oI CF,
starting one year Irom now, the present value oI the
cash Ilow stream is
!' r
12/3/2011
3
WRoss Clark wishes to endow a chair in Iinance at his
alma mater. The university indicated that it requires
$200,000 per year to support the chair, and the
endowment would earn 10 per year. To determine the
amount Ross must give the university to Iund the chair,
we must determine the present value oI a $200,000
perpetuity discounted at 10.
!' $200,000 0.10 $2,000,000
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0
luLure value of a Mlxed SLream
WShrell Industries, a cabinet manuIacturer, expects to
receive the Iollowing mixed stream oI cash Ilows over
the next 5 years Irom one oI its small customers.
12/3/2011
1
WII the Iirm expects to earn at least 8 on its investments, how
much will it accumulate by the end oI year 5 iI it immediately
invests these cash Ilows when they are received?
WThis situation is depicted on the Iollowing time line.
12/3/2011
2
(conL)
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3
resenL value of a Mlxed SLream
WFrey Company, a shoe manuIacturer, has been oIIered an
opportunity to receive the Iollowing mixed stream oI cash Ilows
over the next 5 years.
12/3/2011

WII the Iirm must earn at least 9 on its investments,
what is the most it should pay Ior this opportunity?
WThis situation is depicted on the Iollowing time line.
12/3/2011

(conL)
12/3/2011
Compoundlng lnLeresL More

lrequenLly 1han Annually
Compounding more Irequently than once a year
results in a higher eIIective interest rate because you
are earning on interest on interest more Irequently.
As a result, the eIIective interest rate is greater than
the nominal (annual) interest rate.
Furthermore, the eIIective rate oI interest will
increase the more Irequently interest is compounded.
12/3/2011
1able 3 luLure value from lnvesLlng $100 aL

lnLeresL Compounded Semlannually over 2 MonLhs (2
?ears)
12/3/2011
1able luLure value from lnvesLlng $100 aL

lnLeresL Compounded CuarLerly over 2 MonLhs (2
?ears)
12/3/2011
1able luLure value from lnvesLlng $100 aL

lnLeresL Compounded CuarLerly over 2 MonLhs (2
?ears)
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0
Compoundlng lnLeresL More lrequenLly
1han Annually (conL)
WA general equation Ior compounding more Irequently than
annually
WRecalculate the example Ior the Fred Moreno example assuming
(1) semiannual compounding and (2) quarterly compounding.
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1
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2
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3
ConLlnuous Compoundlng
4ntinu4us c4254unding involves the
compounding oI interest an inIinite number oI times
per year at intervals oI microseconds.
A general equation Ior continuous compounding
where e is the exponential Iunction.
12/3/2011

WFind the value at the end oI 2 years (n 2) oI Fred
Morenos $100 deposit (!' $100) in an account
paying 8 annual interest (r 0.08) compounded
continuously.
W'
(continuous compounding) $100 L e

0.08 L 2
W $100 L 2.7183
0.16
W $100 L 1.1735
$117.35
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12/3/2011
nomlnal and LffecLlve Annual

8aLes of lnLeresL
The n42inal (stated) annual rate is the contractual annual
rate oI interest charged by a lender or promised by a borrower.
The effective (true) annual rate (EAR) is the annual rate oI
interest actually paid or earned.
In general, the eIIective rate ~ nominal rate whenever
compounding occurs more than once per year
12/3/2011

WFred Moreno wishes to Iind the eIIective annual rate
associated with an 8 nominal annual rate (r 0.08)
when interest is compounded (1) annually (m 1); (2)
semiannually (m 2); and (3) quarterly (m 4).
12/3/2011
locus on LLhlcs
W ow Fair Is Check Into Cash?
There are more than 1,100 Check Into Cash centers among an
estimated 22,000 payday-advance lenders in the United States.
A payday loan is a small, unsecured, short-term loan ranging Irom $100
to $1,000 (depending upon the state) oIIered by a payday lender.
A borrower who rolled over an initial $100 loan Ior the maximum oI
Iour times would accumulate a total oI $75 in Iees all within a 10-week
period.
On an annualized basis, the Iees would amount to a whopping 391.
The 391 mentioned above is an annual nominal rate |15 L
(365/14)|. Should the 2-week rate (15) be compounded to calculate
the eIIective annual interest rate?
12/3/2011
Speclal AppllcaLlons of 1lme value ueposlLs needed Lo

AccumulaLe a luLure Sum
WThe Iollowing equation calculates the annual cash payment ()
that wed have to save to achieve a Iuture value ('
n
):
WSuppose you want to buy a house 5 years Irom now, and you
estimate that an initial down payment oI $30,000 will be required
at that time. To accumulate the $30,000, you will wish to make
equal annual end-oI-year deposits into an account paying annual
interest oI 6 percent.
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0
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1
Speclal AppllcaLlons of 1lme
value Loan AmorLlzaLlon
4an a24rtizati4n is the determination oI the equal
periodic loan payments necessary to provide a lender
with a speciIied interest return and to repay the loan
principal over a speciIied period.
The loan amortization process involves Iinding the
Iuture payments, over the term oI the loan, whose
present value at the loan interest rate equals the
amount oI initial principal borrowed.
A l4an a24rtizati4n schedule is a schedule oI equal
payments to repay a loan. It shows the allocation oI
each loan payment to interest and principal.
12/3/2011
2
Speclal AppllcaLlons of 1lme value Loan
AmorLlzaLlon (conL)
The Iollowing equation calculates the equal periodic loan
payments necessary to provide a lender with a speciIied
interest return and to repay the loan principal !' over a
speciIied period:
Say you borrow $6,000 at 10 percent and agree to make equal
annual end-oI-year payments over 4 years. To Iind the size oI
the payments, the lender determines the amount oI a 4-year
annuity discounted at 10 percent that has a present value oI
$6,000.
12/3/2011
3
12/3/2011
1able Loan AmorLlzaLlon Schedule

($000 rlnclpal 10 lnLeresL ?ear 8epaymenL
erlod)
12/3/2011

12/3/2011
locus on racLlce
W New Century Brings Trouble Ior Subprime Mortgages
In 2006, some $300 billion worth oI adjustable ARMs were
reset to higher rates.
In a market with rising home values, a borrower has the option
to reIinance their mortgage, using some oI the equity created
by the homes increasing value to reduce the mortgage
payment.
But aIter 2006, home prices started a three-year slide, so
reIinancing was not an option Ior many subprime borrowers.
s a reaction to pro-lems in the su-prime area lenders
tightened lending standards. What effect do you think this had
on the housing market?
12/3/2011
Speclal AppllcaLlons of 1lme value

llndlng lnLeresL or CrowLh 8aLes
It is oIten necessary to calculate the compound annual
interest or growth rate (that is, the annual rate oI
change in values) oI a series oI cash Ilows.
The Iollowing equation is used to Iind the interest
rate (or growth rate) representing the increase in
value oI some investment between two time periods.
12/3/2011

WRay Noble purchased an investment Iour years ago Ior
$1,250. Now it is worth $1,520. What compound annual
rate oI return has Ray earned on this investment?
!lugging the appropriate values into quation 5.20, we
have:
Wr ($1,520 $1,250)
(1/4)
1 0.0501 5.01 per
year
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0
Wan acobs can borrow $2,000
to be repaid in equal annual
end-oI-year amounts oI $514.14
Ior the next 5 years. She wants
to Iind the interest rate on this
loan.
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1
12/3/2011
2
Speclal AppllcaLlons of 1lme value llndlng an
unknown number of erlods
Sometimes it is necessary to calculate the number oI
time periods needed to generate a given amount oI
cash Ilow Irom an initial amount.
This simplest case is when a person wishes to
determine the number oI periods, n it will take Ior an
initial deposit, !' to grow to a speciIied Iuture
amount, '
n
given a stated interest rate, r.
12/3/2011
3
WAnn Bates wishes to
determine the number oI years
it will take Ior her initial
$1,000 deposit, earning 8
annual interest, to grow to
equal $2,500. Simply stated, at
an 8 annual rate oI interest,
how many years, n will it take
Ior Anns $1,000, !' to grow
to $2,500, '
n
?
12/3/2011

12/3/2011

WBill Smart can borrow $25,000 at
an 11 annual interest rate; equal,
annual, end-oI-year payments oI
$4,800 are required. e wishes to
determine how long it will take to
Iully repay the loan. In other
words, he wishes to determine
how many years, n it will take to
repay the $25,000, 11 loan, !'
n
iI the payments oI $4,800 are

made at the end oI each year.
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12/3/2011
8evlew of Learnlng Coals

W L1 Discuss the role oI time value in Iinance,
the use oI computational tools, and the basic
patterns oI cash Ilow.
Financial managers and investors use time-value-oI-
money techniques when assessing the value oI
expected cash Ilow streams. Alternatives can be
assessed by either compounding to Iind Iuture value or
discounting to Iind present value. Financial managers
rely primarily on present value techniques. The cash
Ilow oI a Iirm can be described by its patternsingle
amount, annuity, or mixed stream.
12/3/2011

(conL)
W L2 Understand the concepts oI Iuture value
and present value, their calculation Ior single
amounts, and the relationship between them.
Future value (FV) relies on compound interest to
measure Iuture amounts: The initial principal or
deposit in one period, along with the interest earned on
it, becomes the beginning principal oI the Iollowing
period.
The present value (!V) oI a Iuture amount is the
amount oI money today that is equivalent to the given
Iuture amount, considering the return that can be
earned. !resent value is the inverse oI Iuture value.
12/3/2011

(conL)
W L3 Find the Iuture value and the present value
oI both an ordinary annuity and an annuity due,
and Iind the present value oI a perpetuity.
The Iuture or present value oI an ordinary annuity can
be Iound by using algebraic equations, a Iinancial
calculator, or a spreadsheet program. The value oI an
annuity due is always r greater than the value oI an
identical annuity. The present value oI a perpetuity
an inIinite-lived annuityis Iound using 1 divided by
the discount rate to represent the present value interest
Iactor.
12/3/2011
0
8evlew of Learnlng Coals (conL)
W L4 Calculate both the Iuture value and the
present value oI a mixed stream oI cash Ilows.
A mixed stream oI cash Ilows is a stream oI unequal
periodic cash Ilows that reIlect no particular pattern.
The Iuture value oI a mixed stream oI cash Ilows is the
sum oI the Iuture values oI each individual cash Ilow.
Similarly, the present value oI a mixed stream oI cash
Ilows is the sum oI the present values oI the individual
cash Ilows.
12/3/2011
1
W L5 Understand the eIIect that compounding
interest more Irequently than annually has on
Iuture value and the eIIective annual rate oI
interest.
Interest can be compounded at intervals ranging Irom
annually to daily, and even continuously. The more
oIten interest is compounded, the larger the Iuture
amount that will be accumulated, and the higher the
eIIective, or true, annual rate (AR).
12/3/2011
2
W L6 Describe the procedures involved in (1)
determining deposits needed to accumulate a Iuture sum,
(2) loan amortization, (3) Iinding interest or growth rates,
and (4) Iinding an unknown number oI periods.
(1) The periodic deposit to accumulate a given Iuture sum can
be Iound by solving the equation Ior the Iuture value oI an
annuity Ior the annual payment. (2) A loan can be amortized
into equal periodic payments by solving the equation Ior the
present value oI an annuity Ior the periodic payment. (3)
Interest or growth rates can be estimated by Iinding the
unknown interest rate in the equation Ior the present value oI a
single amount or an annuity. (4) An unknown number oI
periods can be estimated by Iinding the unknown number oI
periods in the equation Ior the present value oI a single amount
or an annuity.
12/3/2011
3
ChapLer 8esources on
MyllnanceLab
Chapter Cases
roup xercises
Critical Thinking !roblems
12/3/2011
lnLegraLlve Case 1rack SofLware

lnc
W%able 1: Track SoItware, Inc. !roIit, Dividends,
and Retained arnings, 20062012
12/3/2011

lnc
W%able 2: Track
SoItware, Inc.
Income Statement
($000)Ior the Year
nded December
31, 2012
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lnc
W%able 3a: Track SoItware, Inc. Balance Sheet ($000)
12/3/2011

lnc
W%able 3b: Track SoItware, Inc. Balance Sheet ($000)
12/3/2011

lnc
W%able 4: Track SoItware, Inc. Statement oI Retained
arnings ($000) Ior the Year nded December 31, 2012
12/3/2011

lnc
W%able 5: Track
SoItware, Inc.
!roIit, Dividends,
and Retained
arnings, 2006
2012
12/3/2011
0
lnc
a. Upon what Iinancial goal does Stanley seem to be Iocusing?
Is it the correct goal? Why or why not?
Could a potential agency pro-lem exist in this Iirm? xplain.
b. Calculate the Iirms earnings per share (!S) Ior each year,
recognizing that the number oI shares oI common stock
outstanding has remained unchanged since the Iirms
inception. Comment on the !S perIormance in view oI your
response in part a.
c. Use the Iinancial data presented to determine Tracks
operating cash flow and free cash flow in
2012. valuate your Iindings in light oI Tracks current cash
Ilow diIIiculties.
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1
lnc
d. Analyze the Iirms Iinancial condition in 2012 as it relates to
(1) liquidity, (2) activity, (3) debt, (4) proIitability, and (5)
market, using the Iinancial statements provided in Tables 2
and 3 and the ratio data included in Table 5. Be sure to
evaluate the Iirm on both a cross-sectional and a time-series
basis.
e. What recommendation would you make to Stanley regarding
hiring a new soItware developer? Relate your
recommendation here to your responses in part a.
12/3/2011
2
lnc
I. Track SoItware paid $5,000 in dividends in 2012. Suppose an
investor approached Stanley about buying 100 oI his Iirm.
II this investor believed that by owning the company he
could extract $5,000 per year in cash Irom the company in
perpetuity, what do you think the investor would be willing
to pay Ior the Iirm iI the required return on this investment is
10?
g. Suppose that you believed that the FCF generated by Track
SoItware in 2012 could continue Iorever. You are willing to
buy the company in order to receive this perpetual stream oI
Iree cash Ilow. What are you willing to pay iI you require a
10 return on your investment?
12/3/2011

Time Value of Money Sept 2011

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Time Value of Money Sept 2011

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1lML vALuL Cl MCnL?

luLure value versus resenL value

CompuLaLlonal 1ools (conL)

aslc aLLerns of Cash llow

resenL value of a Mlxed SLream

resenL value of a Mlxed SLream

Compoundlng lnLeresL More

1able 3 luLure value from lnvesLlng $100 aL

1able luLure value from lnvesLlng $100 aL

1able luLure value from lnvesLlng $100 aL

ersonal llnance Lxample

(continuous compounding) $100 L e

ersonal llnance Lxample (conL)

nomlnal and LffecLlve Annual

ersonal llnance Lxample

Speclal AppllcaLlons of 1lme value ueposlLs needed Lo

1able Loan AmorLlzaLlon Schedule

ersonal llnance Lxample (conL)

Speclal AppllcaLlons of 1lme value

ersonal llnance Lxample

ersonal llnance Lxample (conL)

ersonal llnance Lxample (conL)

ersonal llnance Lxample

iI the payments oI $4,800 are

ersonal llnance Lxample (conL)

8evlew of Learnlng Coals

8evlew of Learnlng Coals

8evlew of Learnlng Coals

lnLegraLlve Case 1rack SofLware

lnLegraLlve Case 1rack SofLware

lnLegraLlve Case 1rack SofLware

lnLegraLlve Case 1rack SofLware

lnLegraLlve Case 1rack SofLware

lnLegraLlve Case 1rack SofLware

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