Financial Institution

Zaheer Swati 1

Unit 4

PRESENT VALUE FOR CASH FLOWS

Different Financial instruments have very different streams of cash payments to the holder (known as cash
flows), with very different timing
All else being equal, instruments are evaluated against one another based on the amount of each cash flow and
the timingof each cash flow
The concept of present value(or present discounted value) is based on the commonsense notion that a dollar of
cash flow paid to you one year from now is less valuable to you than a dollar paid to you today. This notion is
true because you could invest the dollar in a savings account that earns interest and have more than a dollar in
one year.






There are two type of PV problem
Single-sumproblems
Multi-period cash flow problems

4.1 Present Value Applications
There are four basic types of credit instruments which include present value concepts:
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discount Bond

4.1.1 Simple Loan
Simple Loans require payment of one amount which equals the loan principal plus the interest (simple or
compound)





Example 4.1: How much would you pay today for loan, which will be worth Rs. 16,000 in three years? Assume interest
is 5%?
Solution: 16,000 / (1 +0.05)
3



Answer: Rs. 13,821.40
$100 at 10%
Year: 0 1 2 3 n
$100 $110 $121 $133

PV
n
=FV

n
i 1
1

PV of Simple Loan
Financial Institution


Zaheer Swati 2

Unit 4

Example 4.2: You are trying to save up Rs. 2,500 to go on a trip 2 years fromnow. You are going to invest your money
in a high-interest savings account where it will earn 7.1% interest, compounded quarterly. How much money do you
have to invest now to make sure you have enough for your trip?
Solution:
2,500 / (1 +0.071/4)
2*4



Answer: Rs. 2,171.76

Example 4.3: There are four opportunities of investment of Rs. 950. All cash inflows are presented in below mentioned
table. Assume that discount rate is 14 percent. Which investment is best?

Cash flows 1 2 3 4 5 Total
A 100 200 300 400 500 1,500
B 600 ----- 400 200 300 1,500
C ----- ----- 1,200 ---- 300 1,500
D
500
----- 400 600 ----
1,500


Solution:

Cash flows 1 2 3 4 5 Total
A 87.72 153.89 202.49 236.83 259.68 940.61
B 526.32 ----- 269.99 118.42 155.81 1,070.54
C ----- ----- 809.97 ---- 155.81 965.78
D 438.60 ----- 269.99 355.25 ---- 1,063.84


4.1.2 Fixed Payment Loan
Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often
monthly, in equal dollar amounts over the loan term.
Installment Loans, such as auto loans and home mortgages are frequently of the fixed-payment type
Present value of annuity has been used for these types of problems

Financial Institution


Zaheer Swati 3

Unit 4







Example 4.4: You are making car payments of Rs. 315/month for the next 3 years. You know that your car loan has an
interest rate of 12.4% per annum, discounted monthly, what was the initial price of the car?
Solution:
315 [
12 / 124 . 0
) 12 / 124 . 0 1 (
1
1
12 * 3

]


Answer: Rs. 9,429.53

Example 4.5: Mr. Mohammad Ali has received a job offer froma large investment bank as an accountant. His base
salary will be Rs. 35,000 constant to date of retirement. He will receive his first annual salary payment one year fromthe
day he begins to work. In addition, he will get an immediate Rs. 10,000 bonus for joining the company. Mr. Ali is
expected to work for 25 years. What is the present value of the offer if the discount rate is 12 percent?
Solution:
35,000 [
12 . 0
) 12 . 0 . 0 1 (
1
1
25

]

PVA
25
= 274,509.87
Bonus =10,000


Answer: Rs. 284,509.87

Example 4.6: You have just joined the investment banking firm. They have offered you two different salary arrangements.
You can have Rs. 50,000 per year for the next 3 years or Rs. 35,000 per year for the next 3 years, along with a Rs. 50,000
bonus today. If the market interest rate is 16%, which salary arrangement do you prefer?
Solution:
50,000 [
16 . 0
) 16 . 0 1 (
1
1
3

] =Rs. 112,294.48
35,000 [
16 . 0
3 ) 16 . 0 1 (
1
1

] =78,606.13 +50,000 =128,606.14

Answer: Option B
PVA
n
=

CCF [
i
i
n
) 1 (
1
1

]
General Formula
Constant Rate
Financial Institution


Zaheer Swati 4

Unit 4

Example 4.7: You need to decide how much money to invest each month in order to have Rs. 5,000 in 6 years time. You
will be investing at an interest rate of 7.2%, compounded monthly. What should your monthly payments be?

Solution: CCF = 5,000
[
12 / 072 . 0
) 12 / 072 . 0 1 (
1
1
12 * 6

]


Answer: Rs. 85.73

Example 4.8: Suppose you borrow Rs. 22,000 at 12 percent compound annual interest to be repaid over the next 6 years.
Equal installment payments are required at the end of each year. What will be installment amount and prepare loan
amortization table (rounding to Rupee)?
Solution:
CCF = PVA
[
i
i
n
) 1 (
1
1

]
CCF = 22,000
[
12 . 0
) 12 . 0 1 (
1
1
6

]
CCF = 22,000
4.111


CCF = 5,351
Loan Amortization Schedule
1 2 3 4 5
Year End Installment Payments Interest Principal Repayment Outstanding
12 % on 5 2-3 5-4
0 --- --- --- 22,000
1 5,351 22,000 * 0.12 =2,640 2,711 19,289
2 5,351 19,289 * 0.12 =2,315 3,036 16,253
3 5,351 16,253 * 0.12 =1,950 3,401 12,852
4 5,351 12,852 * 0.12 =1,542 3,809 9,043
5 5,351 9,043 * 0.12 =1,085 4,266 4,777
6 5,351 4,777 * 0.12 =573 4,777 0

Financial Institution


Zaheer Swati 5

Unit 4

4.2 Effective Annual Rates
Effective Annual Rates (EAR) are use to compare securities and investments with different compounding cycle
or life






Example 4.9 : National Bank offers a stated annual interest rate of 4.1 percent, compounded quarterly, while Allied Bank
offers a stated annual interest rate of 4.05 percent, compounded monthly. In which bank should you deposit your
money?
Solution:
National Bank EAR =(1 +
4
041 . 0
)
4
1 = 4.16%


Allied Bank EAR =(1 +
12
0405 . 0
)
12
1 = 4.13%


Answer: National Bank
Example 4.10: What is the PV of $100 received in:
a. Year 10 at a discount rate of 1 percent?

PV =$100/1.01
10

Answer: $90.53

b. Year 10 at a discount rate of 13 percent?

PV =$100/1.13
10


Answer: $29.46

c. Year 15 at a discount rate of 25 percent?


PV =$100/1.25
15

Answer: $ 3.52
Example 4.11: For each of the following, compute the future value:
Present Value Years Interest Rate Future Value
$1,000 4 10% $ 1,464.1
$2,500 6 12.25% $ 5,001.01

EAR =(1 +
m
APR
)
m
- 1
Financial Institution


Zaheer Swati 6

Unit 4

Example 4.12: A factory costs $800,000. You believe that it will produce a cash flow of $170,000 a year for 10 years.
If the opportunity cost of capital is 14 percent, what is the PV of the factory?

PVA
10
=

170,000 [
14 . 0
) 14 . 0 1 (
1
1
10

]


Answer: $ 886,739.66

Example 4.13: A machine costs $380,000 and it is expected to produce the following cash flows.
Year 1 2 3 4 5 6 7 8 9 10
CF ($000S) 50 57 75 80 85 92 92 80 68 50

If the cost of capital is 12 percent, should we buy or not?

10 9 8 7 6
5 4 3 2
1.12
$50,000
1.12
$68,000
1.12
$80,000
1.12
$92,000
1.12
$92,000

1.12
$85,000

1.12
$80,000
1.12
$75,000
1.12
$57,000
1.12
$50,000
PV




PV=44,642.8571 +45,440.0510 +53,383.5186 +50,841.4463 +48,231.2827 +46,610.0632 +41,616.1278 +
32,310.6582 +24,521.4817 +16,098.6618


Answer: $ 403,687.15


Example 4.14: How much must you deposit today in a bank account?
(a) If you wish to have Rs. 10,000 at the end of 3 months, if the bank pays 5.0% APR?
Solution:
10,000 / (1 +0.05/12)
3


Answer: Rs. 9,876.03

(b) If you wish to have Rs. 50,000 at the end of 24months, if the bank pays 8.0% APR?
Solution:
50,000 / (1 +0.08/12)
24



Answer: Rs. 42,629.82

Financial Institution


Zaheer Swati 7

Unit 4

(c) If you wish to have Rs. 6,000 at the end of 12 months, if the bank pays 9.0% APR?
Solution:
6,000 / (1 +0.09/12)
12


Answer: Rs. 5,485.43

(d) If you wish to have: Rs. 10,000 at the end of 1 months, if the bank pays 5.0% APR?
Solution:
10,000 / (1 +0.05/12)

Answer: Rs. 9,958.51

(e) If you wish to have Rs. 6,000 at the end of 6 months, if the bank pays 9.0% APR?
Solution:
6,000 / (1 +0.09/12)
6


Answer: Rs. 5,736.95

(f) If you wish to have Rs. 12,000 at the end of 12 months, if the bank pays 6.0% APR?
Solution:
12,000 / (1 +0.06/12)
12


Answer: Rs. 11,302.86

Example 4.15: Which project, A or B, could be sold for the most money today? Project A will generate cash flows of Rs.
400, Rs. 500, and Rs. 600 in the third, fourth, and sixth years, respectively, of the project's life. Project B will generate
cash flows of Rs. 700 in year two and Rs. 800 in year nine, Investments similar to "A" return 10% on average, while
investments similar to "B" return 11%?

Solution Project A:

3
10 . 0 1
400

+
4 10 . 0 1
500

+

6
10 . 0 1
600

300.5259 +341.5067 +338.6844

Answer: Rs. 980.72

Solution Project B:

2
11 . 0 1
700

+
9 11 . 0 1
800

568.1357 +312.7398

Answer: Rs. 880.88
Project A is worth more since it has a higher total PV

Financial Institution


Zaheer Swati 8

Unit 4

Example 4.16: As winner of a breakfast cereal competition, you can choose one of the following prizes:
a. $100,000 now
b. $180,000 at the end of 5 years
c. $11,400 a year forever
d. $19,000 for each of 10 years
If the interest rate is 12 percent, which is the most valuable prize?

Solution:
a. PV = = $100,000

b. PV =$180,000/1.12
5
= $102,136.83

c. PV =$11,400/0.12 = $95,000

d. PVA
10
=

19,000 [
12 . 0
) 12 . 0 1 (
1
1
10

] = $ 107,354.24

Prize (d) is the most valuable because it has the highest present value

Example 4.17: The Rs. 100 on the time points of 0, 1, 2, 3 are equivalent to Rs. 453 in the time point 4 under a 5%
interest rate?









PVA
n
=

100 [
05 . 0
) 05 . 0 1 (
1
1
3

](1+0.05) = Rs. 454.60

PV
n
=453

4
05 , 0 1
1

=Rs. 372.68


-
0
1 2
4
A =100, -
+
FV=453, -
5 % =r
3
A =100, -
A =100, - A =100, -