Chapter 4

The Time Value

of Money
Chapter 3 Homework
Chapter 3 (P81-84):
Problems 1 4 , 7, 9, 11, 14,
16, 17, 19
Last modified: Saturday, August
24, 2013, 4:36 PM
Chapter 4 Homework
Chapter 4 (P133-137):
Problems 10, 13, 15, 18, 20, 21,
23 29, 34, 36, 37, 40, 43, 47
49
Last modified: Saturday, August
24, 2013, 4:35 PM
4-3
Chapter Outline
4.1 The Timeline
4.2 The Three Rules of Time Travel
4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5 Perpetuities and Annuities
4.6 Solving Problems with a Spreadsheet Program
4.7 Non-Annual Cash Flows
4.8 Solving for the cash payments
4.9 The Internal Rate of Return

4-4
4.1 The Timeline
A timeline is a linear representation of the
timing of potential cash flows.
Drawing a timeline of the cash flows will
help you visualize the financial problem.
4-5
4.1 The Timeline (contd)
Assume that you made a loan to a friend.
You will be repaid in two payments, one at
the end of each year over the next two
years.
4-6
4.1 The Timeline (contd)
Differentiate between two types of cash
flows
Inflows are positive cash flows.
Outflows are negative cash flows, which are
indicated with a (minus) sign.
4-7
4.1 The Timeline (contd)
Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.
The first cash flow at date 0 (today) is represented as a
negative sum because it is an outflow.
Timelines can represent cash flows that take place at the
end of any time period a month, a week, a day, etc.
4-8
Textbook Example 4.1
4-9
4.2 Three Rules of Time Travel
Financial decisions often require combining
cash flows or comparing values. Three
rules govern these processes.

Table 4.1 The Three Rules of Time Travel

4-10
The 1st Rule of Time Travel
It is only possible to compare or combine
values at the same point in time.
A dollar today and a dollar in one year are
not equivalent.
Having money now is more valuable than
having money in the future; if you have the
money today you can earn interest on it.
4-11
The 2nd Rule of Time Travel
To move a cash flow forward in time, you
must compound it.
Suppose you have a choice between receiving
$1,000 today or $1,210 in two years. You
believe you can earn 10% on the $1,000
today, but want to know what the $1,000 will
be worth in two years. The time line looks like
this:
4-12
(1 ) (1 ) (1 ) (1 )
times
= + + + = +
n
n
FV C r r r C r
n
The 2nd Rule of Time Travel (contd)
Future Value of a Cash Flow
4-13
Figure 4.1 The Composition of Interest
Over Time
4-14
Textbook Example 4.2
4-15
Alternative Example 4.2
Problem
Suppose you have a choice between receiving
$5,000 today or $10,000 in five years. You
believe you can earn 10% on the $5,000
today, but want to know what the $5,000 will
be worth in five years.
4-16
0
3 4 5 2 1
$5,000 $5, 500 $6,050 $6,655 $7,321 $8,053 x 1.10 x 1.10 x 1.10 x 1.10 x 1.10
Alternative Example 4.2 (contd)
Solution
The time line looks like this:




In five years, the $5,000 will grow to:
$5,000 (1.10)
5
= $8,053
The future value of $5,000 at 10% for five years
is $8,053.
You would be better off forgoing the gift of $5,000 today
and taking the $10,000 in five years.
4-17
The 3rd Rule of Time Travel
To move a cash flow backward in time, we
must discount it.
Present Value of a Cash Flow
(1 )
(1 )
= + =
+
n
n
C
PV C r
r
4-18
Textbook Example 4.3
4-19
Alternative Example 4.3
Problem
Suppose you are offered an investment that
pays $10,000 in five years. If you expect to
earn a 10% return, what is the value of this
investment today?
Solution
The $10,000 is worth:
$10,000 (1.10)
5
= $6,209

4-20
Applying the Rules of Time Travel
Suppose we plan to save $1000 today, and
$1000 at the end of each of the next two
years. If we can earn a fixed 10% interest
rate on our savings, how much will we
have three years from today?
4-21
Applying the Rules of Time Travel
(The First Approach)
4-22
Applying the Rules of Time Travel
(The Second Approach)
4-23
0
3 4 5 2 1
$10,000
$5,000
Alternative Example 4.4
Problem
Assume that an investment will pay you $5,000
now and $10,000 in five years.
The time line would like this:
4-24
0
3 4 5 2 1
$6,209 $10,000
$5,000
$11,209
1.10
5
Alternative Example 4.4 (cont'd)
Solution
You can calculate the present value of the combined cash
flows by adding their values today.
The present value of both cash flows is $11,209.
4-25
Alternative Example 4.4 (cont'd)
Solution
You can calculate the future value of the
combined cash flows by adding their values
in Year 5.





The future value of both cash flows is $18,053.
0
3 4 5 2 1
$5,000 $8,053 x 1.10
5
$10,000
$18,053
4-26
0
3 4 5 2 1
$11,209 $18,053
1.10
5
0
3 4 5 2 1
$11,209 $18,053
x 1.10
5
Present
Value
Future
Value
Alternative Example 4.4 (cont'd)
4-27
4.3 Valuing a Stream of Cash Flows
Present Value of a Cash Flow Stream
0 0
( )
(1 )
= =
= =
+

N N
n
n
n
n n
C
PV PV C
r
4-28
(1 ) = +
n
n
FV PV r
Future Value of Cash Flow Stream
Future Value of a Cash Flow Stream with a
Present Value of PV
4-29
Textbook Example 4.5
4-30
Alternative Example 4.5
Problem
What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0
3 2 1
$2,000 $2,000 $2,000
4-31
Alternative Example 4.5 (cont'd)
Solution



Or
0
3 2 1
$2,000
$2,000
x 1.05 x 1.05
$2,315
x 1.05
$2,205
$2,000
x 1.05 x 1.05
$2,100
$6,620
x 1.05
0
3 2 1
$2,000
x 1.05
$4,100
$2,100
$4,305
$2,000 $2,000
x 1.05
$6,305
x 1.05
$6,620
4-32
4.4 Calculating the Net Present
Value
Calculating the NPV of future cash flows
allows us to evaluate an investment
decision.
Net Present Value compares the present
value of cash inflows (benefits) to the
present value of cash outflows (costs).
NPV = PV(benefits) PV(costs) = PV(benefits costs)
4-33
Textbook Example 4.6
4-34
0
3 2 1
$1,000 $3,000 $2,000
Alternative Example 4.6
Problem
Would you be willing to pay $5,000 for the
following stream of cash flows if the discount
rate is 7%?
4-35
Alternative Example 4.6 (contd)
Solution
The present value of the benefits is:
3000 / (1.07) + 2000 / (1.07)
2
+ 1000 / (1.07)
3
=
5366.91
The present value of the cost is $5,000,
because it occurs now.
The NPV = PV(benefits) PV(cost)
= 5366.91 5000 = 366.91
4-36
4.5 Perpetuities and Annuities
Perpetuities
When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.
4-37
4.5 Perpetuities and Annuities
(contd)
The value of a perpetuity is simply the
cash flow divided by the interest rate.
Present Value of a Perpetuity
( in perpetuity) =
C
PV C
r
4-38
Textbook Example 4.7
4-39
Alternative Example 4.7
Problem
You want to endow a chair for a female
professor of finance at your alma mater. Youd
like to attract a prestigious faculty member, so
youd like the endowment to add $100,000 per
year to the faculty members resources (salary,
travel, databases, etc.) If you expect to earn a
rate of return of 4% annually on the
endowment, how much will you need to donate
to fund the chair?
4-40
Alternative Example 4.7 (contd)
Solution
The timeline of the cash flows looks like this:



This is a perpetuity of $100,000 per year. The
funding you would need to give is the present value
of that perpetuity. From the formula:

You would need to donate $2.5 million to endow the
chair.




C $100, 000
PV $2,500, 000
r .04
= = =
4-41
4.5 Perpetuities and Annuities
Annuities
When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is
called an annuity.



Present Value of an Annuity

+
=
+
+ +
+
+
+
+
+
=
=
N
1 n
n N 3 2
) r 1 (
C
) r 1 (
C
...
) r 1 (
C
) r 1 (
C
) r 1 (
C
PV
4-42
Present Value of an Annuity
To find a simpler formula, suppose you invest
$100 in a bank account paying 5% interest. As
with the perpetuity, suppose you withdraw the
interest each year. Instead of leaving the $100 in
forever, you close the account and withdraw the
principal in 20 years.
4-43
Present Value of an Annuity (contd)
You have created a 20-year annuity of $5
per year, plus you will receive your $100
back in 20 years. So:


Re-arranging terms:


) years 20 in 100 ($ PV ) year per 5 $ of annuity year 20 ( PV 100 $ + =
31 . 62 $
) 05 . 1 (
100
100
) years 20 in 100 ($ PV 100 $ ) year per 5 $ of annuity year 20 ( PV
20
= =
=
4-44
Present Value of an Annuity
For the general formula, substitute P for the
principal value and:

|
|
.
|

\
|
+
=
N
r) 1 (
1
1
r
1
C r) rate interest with periods N for C of PV(annuity
N N
PV(annuityof Cfor Nperiods)
P PV(Pinperiod N)
P 1
P P 1
(1 r) (1 r)
=
| |
= =
|
+ +
\ .
C/ r P =
4-45
Textbook Example 4.8
4-46
Future Value of an Annuity
Future Value of an Annuity
( )
(annuity) V (1 )
1
1 (1 )
(1 )
1
(1 ) 1
= +
| |
= +
|
+
\ .
= +
N
N
N
N
FV P r
C
r
r r
C r
r
4-47
Textbook Example 4.9
4-48
Growing Cash Flows
Growing Perpetuities
Assume you expect the amount of your
perpetual payment to increase at a constant
rate, g.



Present Value of a Growing Perpetuity

(g<r)
(growing perpetuity)

=

C
PV
r g
4-49
Textbook Example 4.10
4-50
Alternative Example 4.10
Problem
In Alternative Example 4.7, you planned to
donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University has
asked you to increase the donation to account
for the effect of inflation, which is expected to
be 2% per year. How much will you need to
donate to satisfy that request?
4-51
Alternative Example 4.10 (contd)
The timeline of the cash flows looks like this:
The cost of the endowment will start at $100,000,
and increase by 2% each year. This is a growing
perpetuity. From the formula:
C $100, 000
PV $5, 000, 000
r .04 .02
= = =

You would need to donate $5.0 million to endow the

chair.
Solution




4-52
Growing Cash Flows
Growing Annuities
The present value of a growing annuity with
the initial cash flow c, growth rate g, and
interest rate r is defined as:
Present Value of a Growing Annuity
1 1
1
( ) (1 )
| |
| | +
| =
|
|
+
\ .
\ .
N
g
PV C
r g r
4-53
Textbook Example 4.11
4-54
4.7 Non-Annual Cash Flows
The same time value of money concepts
apply if the cash flows occur at intervals
other than annually.
The interest and number of periods must
be adjusted to reflect the new time period.
4-55
Textbook Example 4.14
4-56
4.8 Solving for the Cash Payments
Sometimes we know the present value or
future value, but do not know one of the
variables we have previously been given
as an input.
4-57
4.8 Solving for the Cash Flows
For example, when you take out a loan
you may know the amount you would like
to borrow, but may not know the loan
payments that will be required to repay it.

Loan Payment

|
|
.
|

\
|
+

=
N
r r
P
C
) 1 (
1
1
1
4-58
Textbook Example 4.15
4-59
4.9 The Internal Rate of Return
In some situations, you know the present
value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the
interest rate that sets the net present
value of the cash flows equal to zero.
4-60
Textbook Example 4.16
4-61
Textbook Example 4.17