TIME VALUE OF MONEY Compound interest results when the interest paid on the investment during the first

period is added to the principal and during the second period the interest is earned on the original principal plus the interest earned during the first period. I. The future value of an investment if compounded annually at a rate of i for n years will be FVn = PV (l + i)n where n = the number of years during which the compounding occurs i = the annual interest (or discount) rate PV = the present value or original amount invested at the beginning of the first period FVn = the future value of the investment at the end of n years a. The future value of an investment can be increased by either increasing the number of years we let it compound or by compounding it at a higher rate. If the compounded period is less than one year, the future value of an investment can be determined as follows: FVn where m= II. = PV mn

b.

the number of times compounding occurs during the year

Determining the present value, that is, the value in today's dollars of a sum of money to be received in the future, involves nothing other than inverse compounding. The differences in these techniques come about merely from the investor's point of view. The present value of a sum of money to be received in the future can be determined with the following equation: PV where: n = FVn = the number of years until payment will be received, i = the interest rate or discount rate PV = the present value of the future sum of money FVn = the future value of the investment at the end of n years

The present value of a future sum of money is inversely related to

both the number of years until the payment will be received and the interest rate. III. An annuity is a series of equal dollar payments for a specified number of years. Because annuities occur frequently in finance, for example, bond interest payments, we treat them specially. A. A compound annuity involves depositing or investing an equal sum of money at the end of each year for a certain number of years and allowing it to grow. This can be done by using our compounding equation, and compounding each one of the individual deposits to the future or by using the following compound annuity equation: FVn = n 1 PMT (1 + i) t t =0 = the annuity value deposited at the end of each year = the annual interest (or discount) rate = the number of years for which the annuity will last = the future value of the annuity at the end of the nth year

where: PMT i n FVn B.

Pension funds, insurance obligations, and interest received from bonds all involve annuities. To compare these financial instruments we would like to know the present value of each of these annuities. This can be done by using our present value equation and discounting each one of the individual cash flows back to the present or by using the following present value of an annuity equation: PV where: PMT i PV n = n PMT t =1 1 (1 + i) t

= the annuity deposited or withdrawn at the end of each year = the annual interest or discount rate = the present value of the future annuity = the number of years for which the annuity will last

C.

This procedure of solving for PMT, the annuity value when i, n, and PV are known, is also the procedure used to determine what payments are associated with paying off a loan in equal installments. Loans paid off in this way, in periodic payments, are called amortized loans. Here again we know three of the four values in the annuity equation and are solving for a

value of PMT, the annual annuity. IV. Annuities due are really just ordinary annuities where all the annuity payments have been shifted forward by one year. Compounding them and determining their present value is actually quite simple. Because an annuity, due merely shifts the payments from the end of the year to the beginning of the year, we now compound the cash flows for one additional year. Therefore, the compound sum of an annuity due is FVn(annuity due) = PMT (FVIFAi,n) (1 + i)

Likewise, with the present value of an annuity due, we simply receive each cash flow one year earlier that is, we receive it at the beginning of each year rather than at the end of each year. Thus the present value of an annuity due is PV(annuity due) V. = PMT (PVIFAi,n) (1 + i)

A perpetuity is an annuity that continues forever, that is every year from now on this investment pays the same dollar amount. A. B. An example of a perpetuity is preferred stock which yields a constant dollar dividend infinitely. The following equation can be used to determine the present value of a perpetuity: PV = where: PV = the present value of the perpetuity pp = the constant dollar amount provided by the perpetuity i = the annual interest or discount rate

CAPITAL BUDGETING DECISION CRITERIA Capital budgeting involves the decision making process with respect to the investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the various decision criteria.

I.

Methods for evaluating projects A. The payback period method 1. The payback period of an investment tells the number of years required to recover the initial investment. The payback period is calculated by adding the cash inflows up until they are equal to the initial fixed investment. Although this measure does, in fact, deal with cash flows and is easy to calculate and understand, it ignores any cash flows that occur after the payback period and does not consider the time value of money within the payback period. To deal with the criticism that the payback period ignores the time value of money, some firms use the discounted payback period method. The discounted payback period method is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period. The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.

2.

3.

4.

B.

Present-value methods 1. The net present value of an investment project is the present value of its free cash flows less the investments initial outlay NPV where: FCFt = the annual free cash flow in time period t (this can take on either positive or negative values) the required rate of return or appropriate discount rate or cost of capital the initial cash outlay the project's expected life =

t =1

FCFt (1 + k) t

- IO

k IO n a.

= = =

The acceptance criteria are accept if NPV 0 reject if NPV < 0

b.

The advantage of this approach is that it takes the time value of money into consideration in addition to dealing with cash flows.

2.

The profitability index is the ratio of the present value of the expected future free cash flows to the initial cash outlay, or profitability index = a.

t =1

FCFt (1 + k) t IO

The acceptance criteria are accept if PI 1.0 reject if PI < 1.0

b. c.

The advantages of this method are the same as those for the net present value. Either of these present-value methods will give the same accept-reject decisions to a project.

C.

The internal rate of return is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. Thus the internal rate of return is represented by IRR in the equation below: IO = 1.

t =1

FCFt (1 + IRR) t

The acceptance-rejection criteria are: accept if IRR required rate of return reject if IRR < required rate of return The required rate of return is often taken to be the firm's cost of capital.

2.

The advantages of this method are that it deals with cash flows and recognizes the time value of money; however, the procedure is rather complicated and time-consuming. The primary drawback of the internal rate of return deals with the reinvestment rate assumption it makes. The IRR implicitly assumes that the cash flows received over the life of the project can be reinvested at the IRR while the NPV assumes that the cash flows over the life of the project are reinvested at the required rate of return.

3.