Scribd
Upload
53 views

2 - The Time Value of Money - FS

The document discusses key concepts related to time value of money including compound growth, effective annual rate, present values, discount factors, discounted cash flows, annuities, perpetuities, growing cash flows, bonds, net present value, internal rate of return, hurdle rate, and the impact of inflation on interest rates, future values, and present values. Compounding allows money to grow exponentially over time, while discounting acknowledges that money in the future is worth less today due to its time value and earning potential.

Uploaded by

Brandy Newman
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
53 views

2 - The Time Value of Money - FS

The document discusses key concepts related to time value of money including compound growth, effective annual rate, present values, discount factors, discounted cash flows, annuities, perpetuities, growing cash flows, bonds, net present value, internal rate of return, hurdle rate, and the impact of inflation on interest rates, future values, and present values. Compounding allows money to grow exponentially over time, while discounting acknowledges that money in the future is worth less today due to its time value and earning potential.

Uploaded by

Brandy Newman
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 24

The time value of money

Introduction to Finance

Compound growth
Invest $1 today at interest rate of 10% per annum,
compounded annually
Time (T)

Value after T
years

$1 (1+0.10)
= $1.10

$1
(1+0.10)2 =
$1.21

$1
(1+0.10)3 =
$1.33

In general, $1 invest today for a period of T years at interest


rate R, compounded annually, will grow to:
$1 (1 + R)T

Effective annual rate (EAR)


Interest rates are usually stated in the form of an annual
percentage rate (APR)

An effective annual rate (EAR) is defined as the equivalent


interest rate, if compounding were only once per year

To find EAR, computing the FV at the end of the year per


dollar invested at the beginning of the year

EAR = (1+APR/m)m - 1

Discount Factors and Present


Values (PV)
Conversely, in order to end up with $1 at the end of T years, today we
need to invest only:
$1 1/(1 + R)T

This is the present value (PV) of the $1 that we expect to receive T years
from now

The discount factor that multiplies $1 in the above formula reflects the
time value of money
$1 expected T years from now is not as valuable as $1 for sure today
If we had $1 today, we could invest it for T years and earn interest at
R% per annum
PV (lost interest) is the opportunity cost of having to wait T years to
receive $1

Present value of $1
1.2
1
0.8
2%
4%
6%

0.6
0.4
0.2
0

Discounting Factors
Calculating PVs is called discounting

The interest rate is often referred as the discount rate


Distinguish to discounting in retailing?

The calculation of PVs is called discounted cash flow (DCF)


analysis

Discounted Cash Flows


Company invests $1000 today in a project that is expected to generate incremental
cash flows of $300 at the end of Years 1-5:

300

300

300

300

300

1000

Present value of expected future cash flows:


PV = 300/(1+0.10) + 300/(1+0.10)2 + 300/(1+0.10)3 + 300/(1+0.10)4
+ 300/(1+0.10)5 = 1,137.23

assuming opportunity cost of capital = 10% per annum

Net present value, NPV = 1,137.23 1000 = 137.23

Annuities
An annuity is a stream of N equal future cash flows C:

The annuity factor AN,R is the sum of the corresponding N present value
factors, calculated using R as the discount rate:

The present value of an annuity is the product of annual cash flow C and
the annuity factor AN,R:
PV = C AN,R

In previous example, C = 300 and A5,10% = 3.7908:


PV = 300 3.7908 = 1,137.23

Perpetuities
A perpetuity is an infinite stream of equal future cash flow C:

The present value of a perpetuity is obtained by letting N in the


annuity formula:
PV = C/R

Convince yourself that the formula for the annuity factor AN,R on the

previous slide can be obtained as difference in the present values of two


perpetuities, one of which starts N periods after the other:
AN,R = 1/R 1/(1+R)N 1/R

Growing Perpetuities
Suppose expected future cash flows grow indefinitely at constant
rate G:

C(1+G)N+1

C
0

C(1+G)

C(1+G)2

Present value of stream of expected future cash flows is given by


Gordon growth model:

PV = C/(R-G), R > G
where C is cash flow exactly one period from now

Growing Annuities
Now the expected future cash flows grow at constant rate G for N periods
only:

C(1+G)N+1

C
0

C(1+G)

C(1+G)2

Can deduce the present value of this growing annuity by forming the
difference between two growing perpetuities, staggered in time by N periods:
PV = C/(R-G) 1/(1+R)N C(1+G)N/(R-G)
= C/(R-G) {1-[(1+G)/(1+R)N}
Note: we recover the annuity formula when G = 0

Bonds
A bond is a loan instrument that typically pays a fixed percentage C of the
face value of the loan at regular intervals until the loan expires, at which
point it also repays the face value

C+ face value

Cash flows expressed as percentages of face value


Present value of loan is
PV = C/(1+y) + C/(1+y)2 + + C/(1+y)T = C AT,y + 100 PVT,y

Discount rate y used to calculate present value is known as the yield-tomaturity of the bond
Discount rate that makes net present value of the bond equal to zero i.e
that prices the bond fairly

Net present value


In return for some initial investment I, a typical capital project is expected
to generate a stream of future cash flows Ct, t = 1, 2, T

C1

C2

C3

CT

Net present value of project equals:


NPV = - I + C1/(1+R) + C2/(1+R)2 + + Ct/(1+R)T
If NPV >0, then the project adds value for the companys shareholders
Provided capital is not rationed, company should undertake the project

Net present value


Interest rate = 5%
Year

Net income per year (USD)

NPV (USD)

Project A

Project B

Project A

Project B

-1000

-1000

-1000

-1000

700

666.667

500

453.515

600

2000

518.302

1.727,6752

800

1000

638,484

727,6752

Internal Rate of Return


Internal rate of return IRR, is the value of the discount rate R that makes
NPV = 0

If a project is expected to generate a stream of positive future cash flows in


return for some initial investment I, then graph of NPV vs R looks like:
NPV
NPV>0: accept

IRR

NPV<0: reject

hurdle rate

hurdle rate

The NPV > 0 rule for accepting capital projects is then equivalent to the
rule:
IRR > hurdle rate

Hurdle rate
The hurdle rate for a project is the minimum rate of return that the providers of
the firms capital require from the investment

Also known as opportunity cost of capital


How much providers of firms capital could earn from investing the money
instead in a well-diversified portfolio of financial securities of same risk as
project

Hurdle rate is obtained from financial markets


Hurdle rate
Market rate
Risk-free
return

Market risk premium


Risk

Calculating IRR
Choose any pair of discount rates r1, r2 to satisfy:
NPV1 > 0
NPV2 < 0

Calculating IRR
IRR = OE = OA + AE = r1 + AE
M AE/EB = AC/BD
AE = ABAC/(AC+BD)

NPV

C
NPV1
A

0
r1

NPV2

r2

Interest rate and Inflation


iR real interest rate
iN nominal interest rate
inflation rate

Inflation and Future Value


Using real interest rate:

Using nominal interest rate:

Inflation and Present Value


Using real interest rate:

Using nominal interest rate:

Budget planning under


inflation condition
Using real interest rate to estimate real income

Using nominal interest rate to estimate nominal income

Estimate real income under


inflation
Using real interest rate:

Using nominal interest rate:

Estimate capital budget under


inflation
Using real interest rate:

Using nominal interest rate:

You might also like