Review:

Time Value of Money

MGF 641
Financial Policies and Strategies
Outline
Mapping costs and benefits into cash flows with a
timeline
Three rules of time travel
Valuing a stream of cash flows & Net present value
Special cash flow patterns: Perpetuities and Annuities
Spreadsheet exercises
From Costs and Benefits to Cash Flows (1)
Common sense decision making process
Identify the costs and benefits of an investment
If the benefits outweigh costs, it is a good investment

Decision to get an Master in Finance while working as a
corporate financial analyst
Costs: tuition; efforts to study; sacrifice of leisure &
family time; less time for work
Benefits: better career opportunities; higher salaries;
becoming an enlightened person


From Costs and Benefits to Cash Flows (2)
In financial analysis, we monetize these costs and benefits
and call them cash flows
Costs:
Tuition: cash outflow of $3,000 each year for 3 years
(after taking into account employer reimbursement)
Efforts to study: cash outflow of $4,000 each year for 3
years
Sacrifice of leisure & family time: cash outflow of
$3,000 each year for 3 years
Less time for work: (?)
From Costs and Benefits to Cash Flows (3)
Benefits:
Better career opportunities and higher salaries: cash
inflow of $20,000 each year for 10 years after getting
the degree
Being enlightened: (?)
Time Line
+: cash inflows; -: cash outflows
Time 0: current date (decision making time)
Assuming cash flows taking place at the end of each year
Why the timeline? Because time value of money matters
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Tuition -3 -3 -3
Efforts -4 -4 -4
Time -3 -3 -3
Career & salaries +20 +20 +20 +20 +20 +20 +20 +20 +20 +20
Three Rules of Time Travel
Rule 1: Only values at the same point in time can be
compared or combined
Rule 2: To move a cash flow forward in time, compound it


Rule 3: To move a cash flows back in time, you must
discount it
r: interest rate (discount rate)

n
n
r C FV ) 1 (
0
+ =
n
n
r
C
PV
) 1 ( +
=
Future Value (FV) of Cash Flow
If the interest rate is r, then the FV of C dollars
one period from today is C(1+r),
two periods from today is C(1+r)
2
, and
n periods from today is C(1+r)
n

Date 0 1 2 n
| | | |
Value C C(1+r) C(1+r)
2
C(1+r)
n

FV
n
= C(1+r)
n
(1+r)
n
is known as the future value interest factor
(FVIF)

Example:
The employee profit sharing program of your company
allows you to deduct a certain amount from the payroll
each month. It earns 0.5% per month. How much is the
$50 I deduct from my first paycheck worth when I quit 6
years later?

Answer: $50x(1+0.005)
72
= $71.60

Future Value (FV) of a $100 Cash Flow
2.5% 0.05 0.1 0.2
Year r=2.5% r=5.0% r=10.0% r=20.0%
1 103 $ 105 $ 110 $ 120 $
2 105 $ 110 $ 121 $ 144 $
3 108 $ 116 $ 133 $ 173 $
4 110 $ 122 $ 146 $ 207 $
5 113 $ 128 $ 161 $ 249 $
10 128 $ 163 $ 259 $ 619 $
20 164 $ 265 $ 673 $ 3,834 $
50 344 $ 1,147 $ 11,739 $ 910,044 $
100 1,181 $ 13,150 $ 1,378,061 $ 8,281,797,452 $
Future Value (FV) of a $100 Cash Flow:
Power of Compounding
$-
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
0 5 10 15 20
F
u
t
u
r
e

V
a
l
u
e
Years
r=2.5%
r=5.0%
r=10.0%
r=20.0%
Present Value (PV) of a Cash Flow
If the interest rate is r%, then the PV of C dollars received
at date n
one period before date n is C/(1+r),
two periods before n is C/(1+r)
2
, and
today is C/(1+r)
n
Date 0 1 n-1 n
| | | |
Value C/(1+r)
n
C/(1+r)
n-1
C/(1+r) C
PV = C
n
/(1+r)
n
1/(1+r)
n
is known as the present value interest factor
(PVIF)
Example
A zero-coupon bond is a bond that pays no coupon and
sells at a discount (less than face value)
Suppose IBM issues a zero-coupon bond that promises to
pay $1000 after 28 years
The interest rate is 9.5%
How much is the bond worth today?
PV = 1000/(1+0.095)
28
= $78.78
Present Value (PV) of a $100 Cash Flow
2.5% 0.05 0.1 0.2
Years r=2.5% r=5.0% r=10.0% r=20.0%
1 97.56 $ 95.24 $ 90.91 $ 83.33 $
2 95.18 $ 90.70 $ 82.64 $ 69.44 $
3 92.86 $ 86.38 $ 75.13 $ 57.87 $
4 90.60 $ 82.27 $ 68.30 $ 48.23 $
5 88.39 $ 78.35 $ 62.09 $ 40.19 $
10 78.12 $ 61.39 $ 38.55 $ 16.15 $
20 61.03 $ 37.69 $ 14.86 $ 2.61 $
50 29.09 $ 8.72 $ 0.85 $ 0.01 $
Present Value (PV) of a $100 Cash Flow
Valuing a Stream of Cash Flows
When an investment involves multiple cash flows, the
present value of the cash flows {C
t
} is given by the
following:

= +
=
+
+ +
+
+
+
=
n
t
t
r
t
C
n
r
n
C
r
C
r
C
PV
1 ) 1 (
) 1 (
...
2
) 1 (
2
) 1 (
1
Example: Work Training
Suppose you work 3 nights a week in a bar
Plan to continue for the next 9 months
They offer to train you to tend bar and pay you an extra
$125 a month after you are trained
Suppose further, r=0.5% per month
What is the present value of the training to you?

Example (contd)
The present value of all 9 payments of $125 is:








PV
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$125
(1.005)
$1,097.38
2 3
4 5 6
7 8 9
= + + +
+ + +
+ +
=
Net Present Value
The present value of all costs (cash outflows) and
benefits (cash inflows) combined is the Net Present
Value (NPV)
NPV = PV(benefits) PV(costs)

Positive NPV indicates a good investment: its benefits
outweigh the costs in terms of present values


Example
At an interest rate of 10% per year, what is the NPV of
getting your MSF?
NPV = -10 + (-10)/1.1 + (-10)/1.1
2

+ 20/1.1
3
+ 20/1.1
4
+ 20/1.1
5

+ 20/1.1
6
+ 20/1.1
7
+ 20/1.1
8

+ 20/1.1
9
+ 20/1.1
10
+ 20/1.1
11

+ 20/1.1
12


= $74,207.72

Special Cash Flow Patterns
Perpetuity
Annuity
Growing Perpetuity
Growing Annuity

Perpetuity
A perpetuity is a constant payment of $C every period
forever
0 1 2 3 4 t
| | | | | |
C C C C C
The present value of a perpetuity is:



r
C
t
r
C
r
C
r
C
r
C
PV = +
+
+ +
+
+
+
+
+
= ...
) 1 (
...
3
) 1 (
2
) 1 (
) 1 (
Perpetuity Examples
University endowments
Console bonds
Preferred stocks
Common stocks with fixed dividends
Example: Lottery
Suppose the Iowa lottery offers you a choice if you win in
their new game
If you win, you may choose
A single payment of $2,500 or
A perpetuity prize of $100 per year forever!
What is the value of the perpetuity prize if the annual
interest rate is 5%?
The value is: $100/(.05) = $2,000!

Annuity
An annuity is a constant payment C every period until
date t
0 1 2 3 t-1 t t+1
| | | | | | |
C C C C C 0
The present value of an annuity running from now
until date t is:

( ) ( )
|
|
.
|

\
|
(

+
=
(

+
=
t t
r
r
PVIFA
r
r
C
PV
1
1
1
1
1
1
1
Annuity Examples
Lotteries
Bonds
Payroll saving plans
Loans and installment plans

Example
Recall the work training example
Another way to calculate the present value of all 9
payments of $125 is using the annuity formula:


. 38 . 097 , 1 $
) 005 . 0 1 (
1
1
005 . 0
125 $
9
=
(

+
= PV
Example: Lottery
Suppose the Iowa lottery offers you three choices if you
win in their new game:
A single payment of $2,500 or
A perpetuity prize of $100 per year forever or
An annuity with an annual payment of $175 for 30 years!
What is the value of the perpetuity prize if you can borrow
and lend at 5% interest?
The value is: $100/(.05) = $2,000!
What is the value of the annuity prize?
The value is:
. 18 . 690 , 2 $
) 05 . 0 1 (
1
1
05 . 0
175 $
30
=
(

+
= PV
EXCEL Functions
EXCEL has convenient functions for annuity calculations
PMT(rate, nper, pv, [fv], [type]): solve for periodic payment C:
PV(rate, nper, pmt, [fv], [type]): solve for PV of annuity
FV(rate, nper, pmt, [pv], [type]): solve for FV of annuity
RATE(nper, pmt, pv, [fv], [type]): solve for interest rate
NPER(rate, pmt, pv, [fv], [type]): solve for number of periods
Note:
[ ] : optional input
[type]: 0 or omitted for cash flows at the beginning of a
period; 1 for cash flows at the end of a period
Negative numbers for PV and PMT indicate cash outflows



Growing Perpetuity
The payment on a growing perpetuity grows at the
rate g:
0 1 2 3 4 t
| | | | | |
C C(1+g) C(1+g)
2
C(1+g)
3
C(1+g)
t-1

The present value of a growth perpetuity is:
g r
C
t
r
t
g C
r
g C
r
g C
r
C
PV

= +
+

+
+ +
+
+
+
+
+
+
+
= ...
) 1 (
1
) 1 (
...
3
) 1 (
2
) 1 (
2
) 1 (
) 1 (
) 1 (
Example
A benefactor proposes to endow a chair
at the School of Management at the
University at Buffalo
The proposal is to provide $150,000
initially plus a raise of 5% each year
Suppose the interest rate earned by
endowments is 10%. How much should
the benefactor donate?

Answer: A lot!
PV = 150,000/(10%-5%) = $3,000,000
Growing Annuity
The present value of a growing annuity with the initial
cash flow c, growth rate g, and interest rate r is
defined as:

1 1
1
( ) (1 )
| |
| | +
| =
|
|
+
\ .
\ .
N
g
PV C
r g r
Example
Recall the endowment example. If the endowment plans to
last for only 10 years. How much should the benefactor
donate?
PV = 150,000/(10%-5%)*[1- (1.05/1.1)
10
]
= $1,115,972