TOPIC 4

VALUATION OF FUTURE CASH FLOWS -

Time Value of Money -
Answers to Concepts Review and Critical Thinking Questions

Q4.3 Compounding and Interest Rates. What happens to a future value if you
increase the rate r? What happens to a present value?

The future value rises (assuming a positive rate of return); the present
value falls.

Q4.8 Time Value of Money. Would you be willing to pay $1,000 today in exchange for
$2,000 in 8 years? What would be the key considerations in answering yes or no?
Would your answer depend on who is making the promise to repay?

The key considerations would be: (1) Is the rate of return implicit in the offer
attractive relative to other, similar risk investments? and (2) Thus, our answer does
depend on who is making the promise to repay.

Solutions to Questions and Problems

Formulae

t
1. FV = PV(1 + r)

t
2. PV = FV / (1 + r)

1/t
3. r = (FV / PV) –1

4. t = ln(FV / PV) / ln(1 + r)

Q4.2 Calculating Future Values. For each of the following, compute the future value:

Present Value Years Interest Rates Future Value

 $3,150 7 18%

$8,453 19 6

$89,305 13 12

$227,382 29 5

To find the FV of a lump sum, we use:

t
FV = PV(1 + r)
t
0 = PV(1 + r) – FV

PV=3,150 FV=?
|_______________|___ ___________|_________---
_________| I/Y=18%
0 1 2 7
7
FV = $3,150(1.18) - $10,034.24 =0
ND
Calculator: 2 CLR TVM (shown once only)
3150 +/- PV 18 I/Y 7 N CPT FV = 10,034.24

PV=8,453 FV=?
|_______________|___ ___________|_________---
_________| I/Y=6%
0 1 2 19
19
FV = $8,453(1.06) = $ 25,575.39
Calculator: 8453 PV 6 I/Y 19 N CPT FV = 25,575.39

PV=89,305 FV=?
|_______________|___ ___________|_________---
_________| I/Y=12%
0 1 2 13
13
FV = $89,305(1.12) = $389,681.75
Calculator: 89305 PV 12 I/Y 13 N CPT FV = 389,681.75
PV=227,382 FV=?
|_______________|___ ___________|_________---
_________| I/Y=5%
0 1 2 29
29
FV = $227,382(1.05) = $935,935.14
Calculator: 227382 PV 5 I/Y 29 N CPT FV = 935,935.14

Q4.6 Calculating Interest Rates. Assume the total cost of a college education will be
$320,000 when your child enters college in 18 years. You presently have $75,000 to
invest. What annual rate of interest must you earn on your investment to cover the
cost of your child's college education?

PV=75000 FV=320000
|_______________|___ ___________|_________---
_________| I/Y=?
0 1 2 18

To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula,
that is:

t t
FV = PV(1 + r) { or PV = FV / (1 + r) }

Solving for r, we get:

1/t
r = (FV / PV) –1
1/18
r = ($320,000 / $75,000) –1
r = 0.0839 or 8.39%
Calculator: 75000 +/- PV 320000 FV 18 N CPT I/Y = 8.39

Q4.10 Calculating Present Values. Imprudential, Inc., has an unfunded pension

liability of $750 million that must be paid in 25 years. To assess the value of the
firm's stock, financial analysts want to discount this liability back to the present. If
 the relevant discount rate is 7 percent, what is the present value of this liability?

PV= ? FV=750,000,000
|_______________|___ ___________|_________---
_________| I/Y=7%
0 1 2 25

To find the PV of a lump sum, we use:

t
PV = FV / (1 + r)
25
PV = $750,000,000 / (1.07)
PV = $138,186,883

Calculator: 750,000,000 FV 7 I/Y 25 N CPT PV = 138,186,883

Q4.13 Calculating Interest Rates and Future Values. In 1895, the first U.S. Open
Golf Championship was held. The winner's prize money was $150. In 2009, the
winner's check was $1,350,000. What was the annual percentage increase in the
winner's check over this period? If the winner's prize increases at the same rate, what
will it be in 2045?

PV=150 FV=1,350,000
|_______________|___ ___________|_________---
_________| I/Y=?
0(1895) 1 2
114(2009)

To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula,
that is:

t
FV = PV(1 + r)

Solving for r, we get:

 1/t
r = (FV / PV) –1
1/114
r = ($1,350,000 / $150) –1
r = 0.0831 or 8.31%
Calculator: 150 +/- PV 1350000 FV 2009–1895 =114 N CPT I/Y = 8.31

To find what the winner’s check will be in 2045, we use the FV of a lump sum, so:

PV=1,350,000 FV=?
|_______________|___ ___________|_________---
_________| I/Y=8.31%
0(2009) 1 2 36(2045)
t
FV = PV(1 + r)
36
FV = $1,350,000(1.0831)
FV = $23,900,213.39
Calculator: 1350000 PV 8.31 I/Y 2045 – 2009 = 36 N CPT FV =
23,900,213.39

Q4.15 Calculating Rates of Return. Although appealing to more refined tastes, art as a
collectible has not always performed so profitably. During 2003, Sotheby's sold the
Edgar Degas bronze sculpture Petite danseuse de quartorze ans at auction for a price
of $10,311,500. Unfortunately for the previous owner, he had purchased it in 1999 at
a price of $12,377,500. What was his annual rate of return on this sculpture?

PV=12,377,500 FV=10,311,500
|_______________|___ ___________|_________---
_________| I/Y=?
0(1999) 1 2 4(2003)
To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that
is:

t
FV = PV(1 + r)

Solving for r, we get:

1/t
r = (FV / PV) –1
 1/4
r = ($10,311,500 / $12,377,500) – 1
r = –.0446 or –4.46%
Calculator: 12377500 +/- PV 10311500 FV 4 N CPT I/Y = –4.46

Q5.2 Present Value and Multiple Cash Flows. Investment X offers to pay you $4,400
per year for 9 years, whereas Investment Y offers to pay you $6,100 per year for 5
years. Which of these cash flow streams has the higher present value if the discount
rate is 6 percent? If the discount rate is 22 percent?

To find the PVA, we use the equation:

t
PVA = C({1 – [1/(1 + r) ]} / r )
N
PV = PMT({1 – [1/(1 + I) ]} / I )
N
PV – PMT({1 – [1/(1 + I) ]} / I ) = 0
At a 6 percent interest rate:

PV= ? 4,400 4,400

4,400=PMT
|_______________|___ ___________|_________---
_________| I/Y=6%
0 1 2 9

9
X@6%: PVA = $4,400{[1 – (1/1.06) ] / .06 } = $29,927.45
Calculator: 4400 PMT 6 I/Y 9 N CPT PV = 29,927.45

PV= ? 6,100 6,100

6,100=PMT
|_______________|___ ___________|_________---
_________| I/Y=6%
0 1 2 5
5
Y@6%: PVA = $6,100{[1 – (1/1.06) ] / .06 } = $25,695.42
Calculator: 6100 PMT 6 I/Y 5 N CPT PV = 25,695.42
 And at a 22 percent interest rate:

PV= ? 4,400 4,400

4,400=PMT
|_______________|___ ___________|_________---
_________| I/Y=22%
0 1 2 9
9
X@22%: PVA = $4,400{[1 – (1/1.22) ] / .22 } = $16,659.65
Calculator: 4400 PMT 22 I/Y 9 N CPT PV = 16,659.65

PV= ? 6,100 6,100

6,100=PMT
|_______________|___ ___________|_________---
_________| I/Y=22%
0 1 2 5
5
Y@22%: PVA = $6,100{[1 – (1/1.22) ] / .22 } = $17,468.20
Calculator: 6100 PMT 22 I/Y 5 N CPT PV = 17,468.20

Notice that the PV of Investment X has a greater PV at a 6 percent interest rate, but a
lower PV at a 22 percent interest rate. The reason is that X has greater total cash flows.
At a lower interest rate, the total cash flow is more important since the cost of waiting
(the interest rate) is not as great. At a higher interest rate, Y is more valuable since it
has larger annual payments. At a higher interest rate, getting these payments early are
more important since the cost of waiting (the interest rate) is so much greater.
Note:
From an investment standpoint, if your cost of capital is high, then your initial payback
should be high. However, if your cost of capital is low, then you don’t mind lower
payback as long as the payback is for longer time (i.e. total payback higher)

b
Q5.3 Future Value and Multiple Cash Flows. Brick ‘n’ Sticks, has identified an
investment project with the following cash flows. If the discount rate is 8 percent,
what is the future value of these cash flows in Year 4? What is the future value at a
 discount rate of 11 percent? At 24 percent?

Year Cashflow ($)

1 910

2 1,140

3 1,360

4 1,200

FV=?
910 1140 1360 1200
|_______________|___
___________|______________|______________| I/Y
=8/11/24%
0 1 2 3 4

To solve this problem, we must find the FV of each cash flow and sum. To find the
FV of a lump sum, we use:

t
FV = PV(1 + r)

3 2
FV@8% = $910(1.08) + $1,140(1.08) + $1,360(1.08) + $1,200 = $5,144.83
Calculator: b 910 PV 8 I/Y 3 N CPT FV = 1146.34
1140 PV 8 I/Y 2 N CPT FV = 1329.96
1360 PV 8 I/Y 1 N CPT FV = 1468.80
1146.34 + 1329.96 + 1468.80 + 1200 = 5145.10

3 2
FV@11% = $910(1.11) + $1,140(1.11) + $1,360(1.11) + $1,200 = $5,358.74

3 2
FV@24% = $910(1.24) + $1,140(1.24) + $1,360(1.24) + $1,200 = $6,374.30

Notice, since we are finding the value at Year 4, the cash flow at Year 4 is simply added
to the FV of the other cash flows. In other words, we do not need to compound this
cash flow.