Chapter 04 TI

Chapter 4
The Time Value

of Money
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
Copyright 2014 Pearson Education, Inc. All rights reserved.
4-2
Chapter Outline (contd)

4.6 Solving Problems with a Spreadsheet or
Calculator
4.7 Non-Annual Cash Flows
4.8 Solving for the Cash Payments
4.9 _The Internal Rate of Return
4-3
Learning Objectives
1. Draw a timeline illustrating a given set of
cash flows.
2. List and describe the three rules of time
travel.
3. Calculate the future value of:
4. A single sum.
5. An uneven stream of cash flows, starting
either now or sometime in the future.
6. An annuity, starting either now or
sometime in the future.
4-4
Learning Objectives
7. Several cash flows occurring at regular
intervals that grow at a constant rate
each period.
8. Calculate the present value of:
9. A single sum.
10. An uneven stream of cash flows, starting
either now or sometime in the future.
11. An infinite stream of identical cash flows.
12. An annuity, starting either now or
sometime in the future.
4-5
Learning Objectives
13. Given four out of the following five inputs
for an annuity, compute the fifth: (a)
present value, (b) future value, (c)
number of periods, (d) periodic interest
rate, (e) periodic payment.
14. Given three out of the following four
inputs for a single sum, compute the
fourth: (a) present value, (b) future
value, (c) number of periods, (d) periodic
interest rate.
4-6
Learning Objectives
15. Given cash flows and present or future
value, compute the internal rate of
return for a series of cash flows.
4-7
Learning Objectives
1. Draw a timeline illustrating a given set of
cash flows.
2. List and define three rules of time travel.
3. Calculate the future value of:
a. A single sum.
b. An uneven stream of cash flows, starting either
now or sometime in the future.
c. An annuity, starting either now or sometime in
the future.
d. A growing annuity.
4-8
Learning Objectives
4. Calculate the present value of:
a. A single sum.
b. An uneven stream of cash flows, starting either
now or sometime in the future.
c. An infinite stream of identical cash flows.
d. An annuity, starting either now or sometime in
the future.
e. A growing perpetuity
f. A growing annuity.
4-9
Learning Objectives
5.
6.
Given four out of the following five inputs

for an annuity, compute the fifth: (a)
present value, (b) future value, (c)
number of periods, (d) periodic interest
rate, (e) periodic payment.
Given three out of the following four
inputs for a single sum, compute the
fourth: (a) present value, (b) future
value, (c) number of periods, (d) periodic
interest rate.
4-10
Learning Objectives
7.
Given cash flows and an interest rate,

compute the Net Present Value for a
series of cash flows.
8. Solve problems with a spreadsheet or
calculator.
9. Evaluate time value of money problems
when cash flows are not annual.
10. Given cash flows and present or future
value, compute the Internal Rate of
Return for a series of cash flows.
4-11
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.
4-12
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.
4-13

Differentiate between two types of cash
flows
Inflows are positive cash flows.
Outflows are negative cash flows, which are
indicated with a (minus) sign.
4-14

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.
4-15
Textbook Example 4.1
4-16
Textbook Example 4.1 (contd)
4-17
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
4-18
The 1st Rule of Time Travel

A dollar today and a dollar in one year are
not equivalent.
It is only possible to compare or combine
values at the same point in time.
Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
To answer this, you will have to compare the
alternatives to decide which is worth more. One
factor to consider: How long is later?
4-19
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:
4-20
The 2nd Rule of Time Travel

(contd)
Future Value of a Cash Flow
4-21
Using a Financial Calculator: The

Basics
TI BA II Plus
Future Value
FV
Present Value
PV
I/Y
I/Y
Interest Rate per Year

Interest is entered as a percent, not a decimal
For 10%, enter 10, NOT .10
4-22
Using a Financial Calculator:

The Basics (cont'd)
TI BA II Plus
Number of Periods
2nd CLR TVM
2ND
FV
Clears out all TVM registers

Should do between all problems
4-23
Using a Financial Calculator:

Setting the keys
TI BA II Plus
2ND P/Y
2ND
I/Y
Check P/Y
2ND P/Y # ENTER

Sets Periods per Year to #
2ND
I/Y
ENTER
ENTER
2ND FORMAT # ENTER

Sets display to # decimal places
2ND
4-24
Using a Financial Calculator

TI BA II Plus
Cash flows moving in opposite directions must
have opposite signs.
4-25
Financial Calculator Solution

Inputs:
N=2
I = 10
PV = 1,000
Output:
10
I/Y
1,000
PV
CPT
FV
FV = 1,210
-1,210
4-26
Figure 4.1 The Composition of

Interest Over Time
4-27
4-28
4-29
Textbook Example 4.2 Financial

Calculator Solution for n=7 years
Inputs:
N=7
I = 10
PV = 1,000
Output:
FV = 1,948.72
10
I/Y
1,000
PV
CPT
FV
-1,948.72
4-30
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.
4-31
Alternative Example 4.2 (contd)

Solution
The time line looks like this:
1
$5,000
x 1.10
$5, 500
x 1.10
$6,050
x 1.10
$6,655
x 1.10
$7,321
x 1.10
$8,053
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.
4-32

Inputs:
N=5
I = 10
PV = 5,000
Output:
FV = 8,052.55
10
I/Y
5,000
PV
CPT
FV
-8,052.55
4-33
The 3rd Rule of Time Travel

To move a cash flow backward in time, we
must discount it.
Present Value of a Cash Flow
C
P
V
(
1
r
)
n
(
1
r
)
n
4-34
4-35
4-36

Inputs:
N = 10
I=6
FV = 15,000
10
I/Y
15,000 FV
Output:
PV = 8,375.92
CPT
PV
-8,375.92
4-37

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?
4-38

Solution
The $10,000 is worth:
$10,000 (1.10)5 = $6,209
4-39
Alternative Example 4.3:

Inputs:
N=5
I = 10
10
I/Y
FV = 10,000
Output:
PV = 6,209.21
10,000 FV
CPT
PV
-6,209.21
4-40
Applying the Rules of Time Travel

Recall the 1st rule: It is only possible to
compare or combine values at the same
point in time. So far weve only looked at
comparing.
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?
4-41

(cont'd)
The time line would look like this:
4-42

(cont'd)
4-43

(cont'd)
4-44

(cont'd)
4-45
Table 4.1 The Three Rules of

Time Travel
4-46
4-47
4-48

CF
1,000
ENTER
1,000
ENTER
ENTER
NPV
10
ENTER
CPT
2,735.54
4-49

Problem
Assume that an investment will pay you
$5,000 now and $10,000 in five years.
The time line would like this:
0
$5,000
$10,000
4-50
Alternative Example 4.4 (cont'd)

Solution
You can calculate the present value of the combined
cash flows by adding their values today.
0
$5,000
$6,209
$11,209
1.105
$10,000
The present value of both cash flows is $11,209.
4-51

Solution
You can calculate the future value of the
combined cash flows by adding their values
in Year 5.
1
$5,000
x 1.105
$10,000
$8,053
$18,053
The future value of both cash flows is $18,053.

4-52

Present
Value
0
$11,209
$18,053
1.105
$11,209
x 1.105
Future
Value
5
$18,053
4-53
4.3 Valuing a Stream of Cash

Flows
Based on the first rule of time travel we can
derive a general formula for valuing a
stream of cash flows: if we want to find the
present value of a stream of cash flows, we
simply add up the present values of each.
4-54
4.3 Valuing a Stream of Cash

Flows (contd)
Present Value of a Cash Flow Stream

N
C
n
P
V
P
V
(
C
)
n
n
(
1
r
)
n
0
n
0
4-55
4-56
Textbook
Example 4.5
(contd)
4-57

CF
ENTER
5,000
ENTER
8,000
ENTER
ENTER
NPV
ENTER
CPT
24,890.66
4-58

Problem
What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0
$2,000
$2,000
$2,000
4-59

Solution
$2,000
$2,315
x 1.05
x 1.05
x 1.05
x 1.05
x 1.05
$2,000
$2,205
$2,000
Or
x 1.05
$2,000
$2,000
$2,100
$4,100
$2,000
x 1.05
x 1.05
$4,305
$6,305
x 1.05
$2,100
$6,620
$6,620
4-60
Future Value of Cash Flow

Stream
Future Value of a Cash Flow Stream with a
Present Value of PV
n
F
V
P
V
(
1
r
)
n
4-61
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).
4-62
4-63
Textbook Example 4.6 (cont'd)
4-64

CF
-1,000
ENTER
500
ENTER
ENTER
NPV
10
ENTER
CPT
243.43
4-65

Problem
Would you be willing to pay $5,000 for the
following stream of cash flows if the discount
rate is 7%?
1
$3,000
$2,000
$1,000
4-66

Solution
The present value of the benefits is:
3000 / (1.05) + 2000 / (1.05)2 + 1000 / (1.05)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
4-67

CF
-5,000
ENTER
3,000
ENTER
2,000
ENTER
1,000
ENTER
NPV
ENTER
CPT
366.91
On a present value
basis, the benefits
exceed the costs by
$366.91.
4-68

Perpetuities
When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.
4-69

(contd)
The value of a perpetuity is simply the cash
flow divided by the interest rate.
Present Value of a Perpetuity
C
P
V
(
C
i
n
p
e
r
p
e
t
u
i
t
y
)
4-70
4-71
4-72

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?
4-73

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:
C
$
1
0
0
,
0
0
0
P
V
$
2
,
5
0
0
,
0
0
0
r .
0
4
You would need to donate $2.5 million to endow

the chair.
4-74

(contd)
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
C
C
CC
C
PV
...
2
3
N
n
n
1
(
1
r
)
(
1
r
)
(
1
r
)
(
1
r
)
(
1
r
)
4-75

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.
4-76

(contd)
You have created a 20-year annuity of $5
per year, plus you will receive your $100
back in 20 years. So:
$
100
PV
(
20
yea
ann
of
$
5
pe
ye
)
PV
($
1
in
2
y
)
Re-arranging terms:
PV
(
20
year
annuity
of
$
5
per
year
)
$
100
PV
($
100
in
20
yea
)
100
100
20
$
62
.
31
(
1
.
05
)
4-77

For the general formula, substitute P for the
principal value and:
P
V
(a
n
n
u
ityo
fC
fo
rN
p
e
rio
d
s)
PP
V
(P
inp
e
rio
dN
)
P
1
P
P1
N
(1r)
(
1
r
)
4-78
4-79
Textbook
Example
4.8
4-80

Since the payments begin today, this is an
Annuity Due.
First, put the calculator on Begin mode:
2ND
PMT
2ND
ENTER
2ND
CPT
4-81

Calculator Solution (cont'd)
Then:
30
I/Y
1,000,000
CPT
PMT
PV
-12,158,406
$15 million > $12.16 million, so take the lump sum.
4-82
Future Value of an Annuity

Future Value of an Annuity
N
F
V
(
a
n
n
u
i
t
y
)P
V
(
1
r
)
C
1
N

1
(
1
r
)
N
r
(
1
r
)
1
N
C

(
1
r
)
4-83
4-84
4-85

Since the payments begin in one year, this
is an Ordinary Annuity.
Be sure to put the calculator back on End
mode:
2ND
PMT
2ND
ENTER
2ND
CPT
4-86

Calculator Solution (cont'd)
Then
30
10
I/Y
10,000
CPT
PMT
FV
-1,644,940
4-87
Growing Cash Flows

Growing Perpetuity
Assume you expect the amount of your
perpetual payment to increase at a constant
rate, g.
Present Value of a Growing Perpetuity

C
P
V
(
g
r
o
w
i
n
g
p
e
r
p
e
t
u
i
t
y
)
rg
4-88
4-89
4-90

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?
4-91

(contd)
Solution
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
$
1
0
0
,
0
0
0
P
V
$
5
,
0
0
0
,
0
0
0
r.
0
4
.
0
2
You would need to donate $5.0 million to endow the chair.

4-92
Growing Cash Flows

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:
Present Value of a Growing Annuity
N
1
1
P
V
(
rg
)
(
1
r
)
4-93
4-94
4-95

Problem
You want to begin saving for your retirement.
You plan to contribute $12,000 to the account at
the end of this year. You anticipate you will be
able to increase your annual contributions by 3%
each year for the next 45 years. If your
expected annual return is 8%, how much do you
expect to have in your retirement account when
you retire in 45 years?
4-96

(contd)
4-97
4.6 Solving Problems with a

Spreadsheet or Calculator
Spreadsheets simplify the calculations of
TVM problems
NPER
RATE
PV
PMT
FV
These functions all solve the problem:
1
F
1
V
N
P
V
P
V
P
M
T
N
P
E
R
N
P
E
R
R
A
T
E
(
1
R
A
T
E
)
(
1
R
A
T
E
)
4-98
4-99
4-100
4-101
4-102
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.
4-103
4-104
4-105
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.
4-106
4.8 Solving for the Cash

Payments
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.
4-107
4-108
4-109
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.
4-110
4-111
4-112
4-113
4-114
Chapter 4
Appendix
Appendix: Solving for the Number of

Periods
In addition to solving for cash flows or the
interest rate, we can solve for the amount
of time it will take a sum of money to grow
to a known value.
4-116
Textbook Example 4A.1
4-117
Textbook Example 4A.1 (contd)
4-118
Discussion of Data Case Key

Topic
Would your answer change if the
certification job would require her to stay
in Seattle but an MBA would allow her to
move to New York City, where Natasha has
always wanted to live?
Hint: Consider the cost of living differences
between Seattle and New York. Would her
salary be different in Seattle versus New York?
http://cgi.money.cnn.com/tools/costofliving/cos
tofliving.html
4-119
Chapter Quiz
1. Can you compare or combine cash flows at
different times?
2. How do you calculate the present value of a cash
flow stream?
3. What benefit does a firm receive when it accepts
a project with a positive NPV?
4. How do you calculate the present value of a
a.
b.
c.
d.
Perpetuity?
Annuity?
Growing perpetuity?
Growing annuity?
4-120

Chapter 04 TI

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 04 TI

Uploaded by

Copyright:

Available Formats

Chapter 4

The Time Value

4.2 The Three Rules of Time Travel

Copyright 2014 Pearson Education, Inc. All rights reserved.

Chapter Outline (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Given four out of the following five inputs

Copyright 2014 Pearson Education, Inc. All rights reserved.

Given cash flows and an interest rate,

4.1 The Timeline

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.1 The Timeline (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.1 The Timeline (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.1 The Timeline (contd)

The first cash flow at date 0 (today) is represented as a

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.1

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.1 (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

4.2 Three Rules of Time Travel

Copyright 2014 Pearson Education, Inc. All rights reserved.

The 1st Rule of Time Travel

Copyright 2014 Pearson Education, Inc. All rights reserved.

The 2nd Rule of Time Travel

Copyright 2014 Pearson Education, Inc. All rights reserved.

The 2nd Rule of Time Travel

Future Value of a Cash Flow

Copyright 2014 Pearson Education, Inc. All rights reserved.

Using a Financial Calculator: The

Interest Rate per Year

Copyright 2014 Pearson Education, Inc. All rights reserved.

Using a Financial Calculator:

2nd CLR TVM

Clears out all TVM registers

Copyright 2014 Pearson Education, Inc. All rights reserved.

Using a Financial Calculator:

2ND P/Y # ENTER

2ND FORMAT # ENTER

Using a Financial Calculator

Copyright 2014 Pearson Education, Inc. All rights reserved.

Financial Calculator Solution

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 4.1 The Composition of

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.2

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.2 (contd)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.2 Financial

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 4.2

Copyright 2014 Pearson Education, Inc. All rights reserved.

Alternative Example 4.2 (contd)

In five years, the $5,000 will grow to:

Alternative Example 4.2

Copyright 2014 Pearson Education, Inc. All rights reserved.

The 3rd Rule of Time Travel

Copyright 2014 Pearson Education, Inc. All rights reserved.

Textbook Example 4.3