1 The Role of Time Value in Finance Time Value of money is one of the most important concepts in finance.

Money that the firm has in its possession today is more valuable than money in the future because the money it now has can be invested and earn positive returns. Future Value versus Present Value Future Value techniquestypically measure cash flows at the end of a projects life while present value techniques measure cash flows at the start of a projects life (time zero). Future Value is cash you will receive at a given future date, and present value is just like cash in hand today. Time line can be used to depict cash flows associated with a given investment. It is a horizontal line on which zero appears at the leftmost end and future periods are marked from left to right. -10000 3000 5000 4000 3000 2000

Compounding and Discounting COMPOUNDING Future Value

-10000 3000

5000 4000 3000 2000

Present Value

DISCOUNTING

2 The future value technique uses compounding to find the future value of each cash flow at the end of the investments life and then sums these values to find the investments future value. The present value technique uses discounting to find the present value of each cash flow at time zero and then sums these values to find the investments value today. Computational tools Financial Calculators can be used to simplify time value computations. It includes numerous preprogrammed financial routines. The keystrokes on some of the more calculators are menu-driven: After you select the appropriate routine, the calculator prompts you to input each value; on these calculators, a compute key is not needed to obtain a solution. number of periods interest rate per period present value

N I PV PMT FV CPT

N I PV

PMT amount of payment (used only for annuities) FV CPT future value compute key used to initiate financial calculation once all values are input

Electronic Spreadsheetshave built-in routines that simplify time value calculations. The value for each variable is entered in a cell in the spreadsheet, and the calculation is programmed using an equation that links the individual cells. If values of the variables are changed, the solution automatically changes as a result of the equation linking cells. Financial Tablesinclude various future and present value interest factors that simplify the time value calculations. The values shown in these tables are easily developed from formulas, with various degrees of rounding. The financial tables are typically indexed by the interest rate (in columns) and the number of periods (in rows). Basic Pattern of Cash Flow Single Amount: a lump-sum amount either currently held or expected at some future date. Annuity: a level periodic stream of cash flow. Mixed Stream: a stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that reflect no particular pattern.

3 Future Value of a Single Amount Future Value is the value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. It is found by applying compound interest over a specified period of time. Compound interest is the interest earned on a given deposit and has become part of the principal at the end of a specified period. Principal is the amount of money on which interest is paid. General equation for the future value at the period n: FVn= PV x (1+i)n where: FVn PV i n = future value at the end of period n = initial principal, or present value = annual rate of interest paid (On financial calculators, I is typically used to represent this rate) = number of periods (typically years) that money is left on deposit

Future value interest factor is the value in each cell of the table. It is the multiplier used to calculate, at a specified rate, the future value of a present amount as of a given time. General equation for future value using FVIFi,n: FVn = PV x (FVIFi,n) The higher the interest rate, the higher the future value, and the longer the period of time, the higher the future value.

FUTURE VALUE OF AN ANNUITY

Annuity (ordinary annuity) The cash flows occur at the end of each period.

FORMULA: FVAn = PMT * FVPIFAi,n Where: FVAn = future value of an annuity PMT = amount to be deposited annually at the end of each year FVPIFAi,n = future value interest factor for an annuity HOW TO GET FVPIFAi,n: FVIFAi,n = 1/i * [(1+i)^n -1] Found in TABLE A-3

FUTURE VALUE OF AN ANNUITY DUE

Annuity due The cash flow occurs at the beginning of each period.
FORMULA: FVAn = PMT * FVPIFAi,n

Where: FVAn = future value of an annuity due PMT = amount to be deposited annually at the end of each year FVPIFAi,n = future value interest factor for an annuity HOW TO GET FVPIFAi,n FVIFAi,n(annuity due) = FVIFAi,n * (1+i) Each cash flow on an annuity due earns interest for one year more than an ordinary annuity (from the start to the end of the year).

PRESENT VALUE OF A SINGLE AMOUNT

Present Value -is the current value of a future amount -a sum of money invested at a given interest rate (r) for a given period of time (t) in order to accumulate a future amount. Discounting Cash Flows -process of finding present values Annual Rate of Return -referred to as the discount rate, required return, cost of capital and opportunity cost Equation of Present Value

Where: PV = Present Value FV =Future Value I = opportunity cost n = periods from now

Example: Maurhea has an opportunity to receive $300 one year from now. If she can earn 6% on her investments in the normal course of events, what is the most she should pay now for this opportunity?

PRESENT VALUE OF ANNUITY DUE

Annuity-is a stream of equal periodic cash flows, over a specified time Annuity Due -cash flows occurs at the beginning of each period. Present Value of an Annuity Due-sum of present values of payments at the beginning of the term

Equation of Present Value of an Annuity Due PVIFAi%,n(annuity due)= PVIFAi%,nx(1+0.08) Or

Example: Sandra wants to find the present value of a 5 year annuity due of $700, assuming an 8% opportunity cost. PVIFA8%,5yrs(annuity due)= PVIFA8%,5yrsx(1+0.08) =3.993x1.08=4.312 PVA5 =PMTx PVIFA8%,5yrs(annuity due) =$700x4.312 PVA5 =$3,018.40

8 RISK A measure of the uncertainty surrounding the return that an investment will earn. Used interchangeably with uncertainty to refer to the variability of returns associated with a given asset. Example: A $1,000 government bond that guarantees its holder $5 interest after 30 days has no risk, because there is no variability associated with the return. A $1,000 investment in a firms common stock, the value of which over the same 30 days may move up or down a great deal, is very risky because of high variability of return. The total rate of return is the total gain or loss experienced on an investment over a given period.

Where; rt = actual, expected, or required rate of return during period t Ct = cash (flow) received from the asset investment in the time period t-1 tp t Pt = price (value) of asset at time t Pt-1 = price (value) of asset at time t - 1 Standard Deviation () The most common statistical indicator of an assets risk. It measures the dispersion around the expected return. The expected return is the average return that an investment is expected to produce over time. For an investment that has j different possible returns, the expected return is calculated as follows:

where;

The expression for the standard deviation of returns, r ,

The higher the standard deviation, the greater the risk.

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BETA THE CAPITAL ASSET PRICING MODEL Unsystematic Risk - unique to a given security business, liquidity, and default risks. Also called securitys risk. Systematic Risk or non-diversifiable risk. Not unique to the given security. Purchasing power, interest rate and market risk fall under this category. BETA (b) Measures a securitys volatility relative to an average security. It does help you to figure out risk and expected return. It is a measure of securitys return over time to that of the overall market. Under the CAPITAL ASSET PRICING MODEL (CAPM), the following formula is very helpful in determining a shares expected return: r = r + b(r - r ) Expected Return = risk-free rate + beta x (market risk of return r = the expected return on security j; r = the risk-free rate on a security r = the expected return on the market portfolio b = beta EXAMPLE Assume that r = 6% and r = 10%. If a share has a beta of 2.0, its risk premium should be: 6% + 2.0 (10% - 6%) = 6% + 8% = 14% BETA-MEANING 0 = the securitys return is independent of the market. 0.5 = the security is half volatile as the market. 1.0 = the security is volatile or risky as the market. 2.0 = the security is twice as volatile or risky as the market.