Financial Management I

Session 9

We have seen that

Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made.

Future Value with different interest rates (when invested) 25%

Present value with different interest rates (when not invested) 0% 5% 20% 10% 5% 0% 10% 20%

25%

Time

Time

Present Value
Present value of Multiple cash flows and annuity

PV of a constant/changing periodic sum for a specified period (annuity/Multiple CF)

Find present value of annual/periodic cash flow and then sum up all those PVs

Cash flow is positive at Rs. 1000/year at the end of each year starting 31/12/2009 till 31/12/2013. Find out the PV on 1/1/2008 if the interest rate is 10% pa.
How the time line will look? What if cash flow on 31/12/10 is Rs 1200?
Year 0 (1/1/08)
1(31/12/08) 2(31/12/09) 3(31/12/10) 4(31/12/11) 5(31/12/12) Rs.1000 Rs.1k/1.2k Rs.1000 Rs.1000

Present value equation for annuity

P= {A/(1+i)} + {A/(1+i)2} + {A/(1+i)3}+ + {A/(1+i)n}

As annuity has a constant cash flow (implies A is some non fluctuating variable Taking A out as common we have;
P= A[{1/(1+i)} + {1/(1+i)2} + {1/(1+i)3}+ + {1/(1+i)n}] It could be further solved and simplified as; P P = A [1- {1/ (1+i ) } n / i } = A [ {( 1+ i )n 1} / { i ( 1 + i )n } ] = A [ (1 / i ) { 1 / { i ( 1 + i )n}}] is the simplified general form for Annuity PV

Here, [ (1 / i ) { 1 / { i ( 1 + i )n}}] is the Present Value Factor of an Annuity (PVFA) of Rs.1 (or any other currency). Present value = Annuity x PV of an annuity factor of Rs.1 (or any other currency) P = A x PVFA n,i

Present value of growing annuity

PV P of growing annuities when the cash flow grows at a constant rate g
Escalation clause g 10%p.a. Exp. return i 15% Present rent A Rs.1000

P = {A/(1+i)} + [{A (1+g)1} / (1+i)2] + [{A (1+g)2} / (1+i)3] + + + [{A (1+g)n-1} / (1+i)n] P = A [1/(1+i)} + [{1 (1+g)1} / (1+i)2] + [{1 (1+g)2} / (1+i)3] + + + [{1 (1+g)n-1} / (1+i)n]]

P = A [ {1/(i-g)} - {1/(i-g)} {(1+g)/(1+i)}n]

P = {A /(i-g)} [1-{(1+g)/(1+i)}n] Alternative method; if i* = (i-g)/(1+g) General form

P = {A / (1 +g)} [(1/ i*) {1 / { i*(1+i*)n]

Present value equation for Multiple CF

P= {CF1 / (1+i)} + {CF2 / (1+i)2} + {CF3 / (1+i)3}+ + {CFn / (1+i)n} The general expression is P = t=1n {At/(1+i)t} Increased frequency of compounding If interest is compounded 2 times annually (every six months) when p.a. interest is 10% then interest is i/c where i is the p.a. interest rate and c is frequency of compounding and no. of periods is nxm where n is no. of years and m is frequency of compounding per year. So the equation would become; P= {CF1 / (1+ i / c)1xm} + {CF2 / (1+i/c)2xm} + {CF3 / (1+i/c)3xm}+ + {CFn / (1+i/c)nxm}

Capital recovery and loan amortization

If you invest P today for a period of n years and the interest rate is i then how much income per year you should receive to recover your investment? If P = 10000 n=4 i=10% then A=? Reverse of PV of annuity (solve annuity equation for A) P = A x PVFA n,i (PV of annuity) solving it for a we have P/PVFAn,i =A or, A=P(1/PVFAn,i)

The reciprocal of (1/PVFAn,i) is known as Capital Recovery Factor (CRF). Sinking fund (annual recovery) = Present value of investment x CRF of Rs. 1 (or any currency) Loan Amortization (what annual installment A would be able to recover a loan of P amount for n years if the rate of interest is i ? ) If P = 10000 n=5 i=10% then A=?

Perpetuity
An annuity which occurs indefinitely (irredeemable preference shares) i=8% A= Rs. 750

Here n approaches infinity Therefore, in present value of annuity equation i.e. P= A [ (1 / i ) { 1 / { i ( 1 + i )n}}] the component ( 1 + i )n tends to be zero making the entire equation simply P=A/i General form.

Present value of perpetuity = Perpetuity / Interest rate

PV of Growing perpetuity
These are annuities A which growing at a constant rate g with infinite maturity period. i the inflation rate (or appropriate discounting rate) A = Rs. 33 g = 8% i=12% P = {A / (i-g)} for i>g (General form)

Continuous compounding
Compounding is continuous not discrete Fn = P x eixn = P x ex Where, Fn is the compounded value, n=no. of years, e=2.7183, i=interest rate, x=(i x n) Compounded value of Rs.10000 with continuous compounding at the interest rate of 10% for 3 years PV = Fn/eixn = Fn x e-ixn