Time value of money &

Discounted cashflow applications

 TVM : Overview

Key Take-aways:
 Time value of money is one of the most fundamental concepts of finance
 What is opportunity cost?
 Calculations involving compound interest
 Annuity calculations
 PV, FV and NPV
 Effective rate of return, IRR, etc.
 Time value of money is an important tool that is leveraged in almost all of the valuation
models that we will study including for equities and bonds
 Tips on efficient and accurate use of the calculator for solving time value of money
problems
TVM : There are 3 ways of looking at Interest rates

 Required rate of return:

 Returns required by investors to induce them to postpone consumption
 Rate of interest that can convert consumers into investors or lenders

 Discount rate:
 Generic term that measures the rate of return reflecting the time value of money

 Opportunity cost:
 Value of next best option that investors forgo by choosing what they do
 Postponing consumption
TVM : Background: First, Let us take a quick look at the
basic economic concept of Opportunity cost
 Opportunity Cost
 Difference between a particular action and the value of the best alternative
 Explicit recognition of the reality that taking an action eliminates other avenues/
options
 Indication of the relative importance of a decision

 If opportunity cost is small => cost of incorrect choice is small

 If opportunity cost is large => cost is large

 Examples
 buying your groceries (likely small)
 buying a car (potentially large)

 Not always obvious or easy to calculate

Time value of money

 How much it costs to rent money A dollar today

 Keeping the money at home creates an opportunity cost
is worth more
 Interest rate is a measure of this opportunity cost
than a dollar
 Price of impatience and the value of waiting
tomorrow
 Example: Assume you have $100 and interest rate is 10%
 PV = $100

 At the end of year 1, FV = PV + r(PV) = PV(1+r) = $110; Where:

 FV = Future Value
 PV = Present Value
 r = interest rate (or discount rate)
 At the end of year 2, FV = $110 x 1.1 = $121
 Interest on interest = $1 = Compound Interest (Interest on interest)

 In general, FV = PV(1+r)^n; where n = number of time periods

 Reversing the logic: PV = FV/ (1+r)^n
 TVM : In PV calculation, choice of discount rate is very
critical
$120
PV Factor

$100

$80

$60

$40
PV of $100 FV

Discount rate 0%
Discount rate 5%
$20 Discount rate 10%
Discount rate 15%
Discount rate 20%
Discount rate 25%
Discount rate 30%
$-
1 2 3 4 5 6 7 8 9 10 11

Time Period
TVM : Inflation and risk impact interest rates
 Real risk-free rate is a theoretical rate on a single period loan that has no expectation
of inflation.

 In a certain world interest rate is a risk free rate

 Closest is government short term debt like U.S. T-bills
 An interest rate on government debt might not necessarily be “risk-free”.

 In real world however few factors come into play:

 1) Inflation Risk: Lenders charge an inflation premium to account for expected increase in
prices.
 2) Default Risk: Compared to governments there is risk inherent in lending to private
companies, driven primarily by business dynamics such as industry climate, competition,
economy, etc.
 3) Liquidity risk: Risk of receiving less than fair value.
 4) Maturity risk: Longer maturity => Higher risk (will be covered in debt securities)
TVM : Inflation and risk impact interest rates
 Interest rates are affected by the forces of demand and supply.

 Nominal rates normally include an inflation premium

 nominal risk-free rate = real risk-free rate + inflation premium

 Required interest rate on a security =

 nominal risk-free rate +
 default premium +
 liquidity risk +
 maturity risk
TVM : Frequency of compounding

 Certain investment products pay interest more than once a year.

 In these cases, by convention the stated or quoted annual interest rate is:
 Periodic rate X No. of compounding periods in a year

 FVN = PV (1 + rs/m )(m x n)

 where: rs is the stated annual interest rate; m is the no. of compounding periods
in a year and n is the no. of years

 Continuous compounding: when number of compounding periods in a year

approaches infinity

 FVN = PV x e(rs x n); where e ~ 2.7183

 Effective interest rate = (1 + rs/m)(m ) - 1

 And in the case of continuous compounding, effective interest rate = er s - 1

TVM : Annuity calculations

 PV of annuities
 Loan payments
 Calculating EMI’s
 Annuity due calculations
 Compounding periods

 Tips for using the calculator effectively and accurately

TVM : Series of CF’s

 Annuities consist of periodic payments of the same value.

 Two types of annuities:

 Ordinary annuity
 1st CF occurs 1 period from now
 Annuity due:
 1st CF paid now (or immediately)

 Perpetuity: is a perpetual ordinary annuity, i.e. a series of never ending CF’s

 Interesting notes:
1. We can view an annuity as the difference between 2 perpetuities with different starting
dates
2. PV of a series of unequal CF’s = Sum of the PV’s of the individual CF’s
3. Use the appropriate formula (PV/ FV) to solve for other unknowns including: rates, # of
periods or size of annuity payments. You need 4 to find the 5 th variable.
4. Focus on level 1 is direct application of concepts or formula……integration across subject
areas increases by level
TVM : Annuity calculations
 Ordinary Annuity - Equal CF’s
 FV = A [ (1+r)^N -1]/ r

 Ordinary Annuity – Unequal CF’s

 Best approach is to find the FV of individual CF’s, i.e. by compounding the CF’s one at a
time.

 However, our friend TI BAII plus has an inbuilt TVM and cash-flow worksheets that will
prove to be extremely useful through-out the examination.
TVM : Annuity calculations
 Reverse the equation to find the present value
 PV = FV / (1+r)N
 PV = A [(1 – 1/(1+r)N] / r
 This can be obtained by using the prior equation for each of the annuity CF’s

 Annuity Due: Treat the 1st CF as one component of PV and for the remaining CF’s use
the above formula and sum the two components.
 In short,
 FVAD = FVAO (1+r)
 PVAD = PVAO (1+r)

 Perpetuity
 PV = A/r
TVM : Applications

 Loan Payment calculations

 Principal and interest components on a specified loan
 Computing annuity payment needed to achieve a given FV (e.g. retirement plan)
 Computing periods, required rate, etc.
 Rate of compound growth (CAGR) calculations

 ALWAYS REMEMBER: Cash-flows follow the additivity principle

“Present value of any stream of cash-flows is always equal to the sum of the present
values of the cash-flows.”
Discounted Cash Flows : Concept of Net Present Value
(NPV)
 One way to determine the value of an asset is to determine the PV of its future Cash
Flows
 For valuing a company this could be the future (projected) stream of earnings
 Another is to find out what it would cost to acquire such an asset
 In the case of an acquisition this would be the purchase price or total cost of acquiring the
target company

 Difference between the two is NPV

 NPV = PV of projected future CF – Cost of acquisition
 Decision Making Rule For NPV : Accept the project for which NPV > 0 and reject the
project for which NPV < 0. For mutually exclusive projects, select the project with
maximum NPV
 NPV = ∑ CFi / ( 1+r) N

---> NPV encapsulates the value created or lost by a decision

---> To be successful, firms must find +ve NPV opportunities

and avoid -ve NPV choices
DCF : Internal rate of return (IRR)
 Represents the rate of return generated by an investment

 The IRR is the discount rate which makes the NPV = 0

 0 = CF1 / ( 1+ IRR) + CF2 / ( 1+ IRR)2 + …. CFN / ( 1+ IRR )N

 It is called IRR because it only depends on the CF’s of the investment……no other
external data is needed

 We will use this concept for finding the yield to maturity for bonds, and dollar weighted
rate of return for portfolios

 IRR Decision Making Rule: Accept investment decisions for which the IRR is greater
than the opportunity cost of capital also known as the hurdle rate.

 IRR and NPV should give similar answers for independent projects
 However when the project’s initial cost is different or when cash flow timing is different,
they can give conflicting answers
 Always go with NPV, since that maximizes the value of the firm
DCF : Other applications of TVM
 NPV – already discussed

 IRR – also discussed

 Money market yields – we will defer the discussion to Fixed Income section
 Bank discount yield, r(bd ) = (D/F) x (360/t)
 r(bd) is the annualized yield on bank discount basis, D is difference between face value and purchase
price, F is face value and t is number of days to maturity
 Holding Period Yield, HPY = (P1-P0+D1)/P0
 Effective Annual Yield, EAY = [(1+HPY)365/t] – 1
 Money Market Yield, rMM = {[(360 x rbd)]/[360 – (t x rbd)]} or simply, HPY*(360/t)
 This is also referred to as the CD equivalent yield
 Computed on purchase price (as compared to bank discount yield)

 Bond equivalent yield, BEY = 2 x semiannual discount rate

 This is due to the fact that on the U.S. bonds interest is paid twice in a year.
DCF : Other applications of TVM
 Basic Bond Valuation
 Zero Coupon
 Coupon bonds and Yield to Maturity valuation approach

 Basic Equity valuation

 Dividend discount model; P0=(P1+D1)/(1+r)
 Constant growth model; P0 = D1/(r-g)
 Free CF model

 Portfolio returns: Money weighted (IRR) and Time weighted returns (preferred)
DCF : Money weighted and time weighted rate of
return
 Money weighted rate of return :
 It applies IRR concept and takes into account all cash inflows and outflows
 The beginning value of the account and the deposits in the account are taken as cash Inflow
 All withdrawals from the account are taken as outflows
 Net the cash flows and set the PV of cash inflows = cash outflows
 Solve for money weighted rate of return (r)

 Time weighted rate of return :

 It is compound growth rate at which Rs. 1 compounds over a specified time horizon.
 Value the portfolio immediately before/after significant withdrawals and form sub periods
corresponding to the dates of deposits and withdrawals
 Calculate HPR for each sub period
 Calculate the product of (1+ HPR) for each sub period for the entire time horizon , calculate
the Geometric mean of the above product to arrive at annual time weighted rate of return.

 Time weighted rate of return is preferred over Money weighted rate of return because
it is not affected by the timing of cash deposits and withdrawals from the account
DCF : Holding Period Yield & Bank Discount Yield
 Holding Period Yield ( HPY) = (P1-P0+D1)/P0
 Where, D1 is interest payment, F is face value and t is number of days to
maturity
 P0 is initial price of instrument
 P1 is price received for instrument at maturity
 Characteristics :
 They are based on the original amount invested and not on the Face value like BDY

 Bank discount yield,

 It can be calculated as rbd = (D/F) x (360/t).
 rbd is the annualized yield on bank discount basis, D is difference between face
value and purchase price, F is face value and t is number of days to maturity
 Characteristics :
 They are annualized without compounding
 They are based on a 360 day year
 They are based on % of face value and not on the original amount invested
 Because of all these characteristics they are not considered true yields
DCF : Effective Annual Yield & Money Market
Yield
 Effective Annual Yield :
 It is calculated as : EAY = ( 1+ HPY) 365 / t - 1
 Characteristics :
 It is a compound annual rate
 It is based on 365 day year
 It is based on HPY

 Money Market Yield

 It is calculated as rMM = HPY * ( 360/t)
 It can also be calculated as ( 360 * rbd ) / ( 360 – t* rbd) where t is number of days
in maturity
 Characteristics :
 It does not involve compounding ( based on simple interest)
 It is based on 360 day year
 It is based on percentage of the initial invetsment
DCF : Calculator tips
TI BA II plus
 Compound sum of $1, FV = $1(1 + r)^n
 $1 +/- PV, # of periods N, Interest rate per period I/Y, 0 PMT, CPT FV
 Present value of $1, PV = $1/ (1+r)^n
 $1 +/- FV, # of periods N, Interest rate per period I/Y, 0 PMT, CPT PV
 Sum of an annuity of $1, FV = $1[(1+r)^n -1]/r
 $1 +/- PMT, # of periods N, Interest rate per period I/Y, 0 PV, CPT FV
 Present Value of an annuity of $1, PV = $1[(1+r)^n -1]/[r(1+r)^n]
 $1 +/- PMT, # of periods N, Interest rate per period I/Y, 0 FV, CPT PV

HP 12 C
 Compound sum of $1, FV = $1(1 + r)^n
 $1 CHS PV, # of periods N, Interest rate per period i, 0 PMT, FV
 Present value of $1, PV = $1/ (1+r)^n
 $1 CHS FV, # of periods N, Interest rate per period i, 0 PMT, PV
 Sum of an annuity of $1, FV = $1[(1+r)^n -1]/r
 $1 CHS PMT, # of periods N, Interest rate per period i, 0 PV, FV
 Present Value of an annuity of $1, PV = $1[(1+r)^n -1]/[r(1+r)^n]
 $1 CHS PMT, # of periods N, Interest rate per period i, 0 FV, PV
DCF : Calculator tips - NPV

TI BA II plus
 CF, 2nd, CLR WRK; clear memory for CF calculations, CF0 = 0.0
 $amount, +/-, Enter; initial cash flow; CF0 = ($amount)
 $amount, Enter; period 1 CF; C01 = $amount
 $amount, Enter; period 2 CF; C02 = $amount
 Other period CF’s in a similar manner (as applicable)
 NPV, r, Enter; r% discount rate; I = r%
 CPT; calculate NPV; NPV = $$$
DCF : Calculator tips - IRR

TI BA II plus
 CF, 2nd, CLR WRK; clear memory for CF calculations, CF0 = 0.0
 $amount, +/-, Enter; initial cash flow; CF0 = ($amount)
 $amount, Enter; period 1 CF; C01 = $amount
 $amount, Enter; period 2 CF; C02 = $amount
 Other period CF’s in a similar manner (as applicable)
 IRR CPT; calculate IRR; IRR = i%
Thank You

Any more questions?