Mod 1 - TVM - Intuition Discounting - Slides

7/7/15
Time Value of Money:

Intuition and Discounting
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania
Copyright Michael R. Roberts
This Time
Time Value of Money
Intuition, tools, and discounting
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Intuition
Currency
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Currency
Currency
$/
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Currency
X
/$
Currency
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Currency
/$
Currency
$/
$/
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Currency
X
/$
Messages (Look up)

1. Cant add/subtract different
currencies
2. Must convert currencies to
common (base) currency using
exchange rate
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Time Value of Money
Time Value of Money

Money received/paid at different
times is like different currencies
Money has a time unit
Must convert to common/base

unit to aggregate
Need exchange rate for time
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THE TOOLS: TIME LINE &

DISCOUNT FACTOR
Time Line
Time Periods
0
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Time Line
0
CF0
CF1
CF2
CF3
CF4
Cash Flows
Time Line
0
CF0
CF1
CF2
CF3
CF4
Lesson: Get in the habit of placing

cash flows on a time line
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Aggregating Cash Flows

0
CF0
CF1
CF2
CF3
CF4
Can we add/subtract cash flows in

different time periods

0
CF0
CF1
CF2
CF3
CF4
X
No!
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0
CF0
CF1
CF2
CF3
CF4
X
Lesson: Never* add/subtract cash
flows received at different times

0
CF0
CF1
CF2
CF3
CF4
X
Need exchange rate for time to
convert to common time unit
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Discount Factor
The discount factor is our exchange
rate for time
(1+ R )t
t = time periods into future (t > 0) or
past (t < 0) to move CFs
R=
Definition: R is the rate of return offered

by investment alternatives in the capital
markets of equivalent risk.
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Definition: R is the rate of return offered

by investment alternatives in the capital
markets of equivalent risk.
A.k.a., discount rate, hurdle rate,
opportunity cost of capital
To determine R, consider the risk of the

cash flows that you are discounting.
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Investment
Average Annual Return, R
Treasury-Bills (30-Day)
3.49%
Treasury-Notes (10-Year)
5.81%
Corporate Bonds (Investment Grade)
6.60%
Large-Cap Stocks
11.23%
Mid-Cap Stocks
15.15%
Small-Cap Stocks
25.32%

Investment
Average Annual Return, R
Treasury-Bills (30-Day)
3.49%
Treasury-Notes (10-Year)
5.81%
Corporate Bonds (Investment Grade)
6.60%
Large-Cap Stocks
11.23%
Mid-Cap Stocks
15.15%
Small-Cap Stocks
25.32%
Riskier investment, higher return

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USING THE TOOLS:

DISCOUNTING
Discounting
Discounting CFs moves them back in time
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
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Discounting
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
t < 0 because we are moving cash

flows back in time
Discounting
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
We can add/subtract these CFs because they

are in the same time units (date 0)
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Present Value
Present value, PVt() of CFs is discounted value
of CFs as of t
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R ) = PV0 (CF1 )

1
CF2 (1+ R ) = PV0 (CF2 )

2
CF3 (1+ R ) = PV0 (CF3 )

3
These are present values of future CFs

as of today (period 0)
CF4 (1+ R ) = PV0 (CF4 )

4
Example Savings
How much do you have to save today
to withdraw $100 at the end of each
of the next four years if you can earn
5% per annum?
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Example Savings
Step 1: Put cash flows on a time line
0
100
100
100
100
Example Savings
Step 2: Move CFs back in time to today
0
100
100
100
100
100
(1+ 0.05 )
100
1+
( 0.05 )2
100
(1+ 0.05 )3
100
(1+ 0.05 )4
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Example Savings
Step 2: Move CFs back in time to today
0
100
100
100
100
95.238
90.703
86.384
82.270
Example Savings
Step 3: Add up CFs (all in time 0 units)
0
= 354.60
100
100
100
100
+ 95.238
+ 90.703
+ 86.384
+ 82.270
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Example Savings
0
354.60
100
100
100
100
Interpretation 1: We need $354.60

today in an account earning 5% each
year so that we can withdraw $100 at
the end of each of the next four years
Example Savings
0
354.60
100
100
100
100
Interpretation 2: The present value of

$100 received at the end of each of the
next four years is $354.60 when the
discount rate is 5%.
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Example Savings
0
354.60
100
100
100
100
Interpretation 3: Todays price for a

contract that pays $100 at the end of
each of the next four years is $354.60
when the discount rate is 5%.
Comment: We are assuming that the

discount rate, R, is constant over time.
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0
100
100
100
100
100
(1+ 0.05 )
100
(1+ 0.05 )2
100
(1+ 0.05 )3
100
(1+ 0.05 )4

0
100
100
100
100
100
(1+ 0.05 )
100
(1+ 0.05 )2
100
1+
( 0.05 )3
100
(1+ 0.05 )4
Common assumption but still an assumption

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Example 2 Savings (Account)

Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Year Interest
Withdrawal
0
$354.60

Year Interest
0
1 $17.73
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
354.60 0.05
*Activity happens at end of the period

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Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Year Interest
Withdrawal
0
$354.60
1 $17.73
$372.32
354.60 + 17.73

Year Interest
0
1 $17.73
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
$372.32
PV0 ( $372.32 ) = $372.32 (1+ 0.05 ) = $354.60

1
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Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Year Interest
Withdrawal
0
$354.60
1 $17.73
$372.32
$100.00

Year Interest
0
1 $17.73
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
$372.32
$100.00
$272.32
372.32 100
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Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Year Interest
Withdrawal
0
$354.60
1 $17.73
$372.32
$100.00
$272.32
2 $13.62
$285.94
$100.00
$185.94
3
$9.30
$195.24
$100.00
$95.24
4
$4.76
$100.00
$100.00
$0.00
Summary
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Lessons
Never add/subtract cash flows from different
time periods
Use (i.e., multiply by) discount factor to
change cash flows time units
(1+ R )t
t < 0 moves CF back in time (discounting)
t > 0 moves CF forward in time (compounding)
Lessons
Use a time line to help formulate
problems
0
CF0
CF1
CF2
CF3
CF4
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Lessons
Present value as of time s of a cash
flow at time t > s is denoted, PVs (CFt)
Tells us the value future cash flows
Tells us the price of a claim to those
cash flows
Coming up next
Compounding
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Problems
Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
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Problem Notation 1
Which of the following present value notations
denotes the value as of period 4 of a cash flow
received in period 12?
a) PV0(CF)
b) PV0(CF12)
c) PV4(CF)
d) PV4(CF12)
e) PV12(CF4)
10
11
12
CF12
PV4(CF12)
Problem Notation 2
Which of the following present value notations
denotes the value as of today of a cash flow
received in period 6?
a) PV0(CF6)
b) PV6(CF0)
c) PV4(CF)
d) PV4(CF12)
e) PV4(CF4)
6
CF6
PV0(CF6)
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Problem Inheritance 1
You will receive an inheritance of $500,000 in 20
years on your 40th birthday. What is the value of
the inheritance today if the discount rate is 10%?
0
19
20
$500,000
500,000
Present Value = PV0 (CF20 ) = PV0 ( 500,000 ) =
= 74,321.814
(1+ 0.10 )20
Problem Inheritance 2
Your brother offers you $150,000 today for a claim
to your future inheritance. Should you accept his
offer?
Yes. The present value of your inheritance,
$74,321, is substantially less than your brothers
offer, $150,000. Your brother should take finance.
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Problem Bond Price 1

What is the present value (i.e., price) today of a
bond that will pay its owner $1,000,000 five years
from today if the discount rate is 4% per annum?
(This is called a zero-coupon or discount bond)
0
5
$1 mil
Price = PV0 (CF5 ) = PV0 (1,000,000 ) =
1,000,000
= 821,927.1067
(1+ 0.04 )5

The price today of a bond that will pay its owner
$1,000,000 in five years is $747,258.17. What is
the annual rate of return on this bond? (This rate is
also called a bond yield or yield-to-maturity.)
0
5
$1 mil
$747,258.17
1,000,000
Price = PV0 (CF5 ) 747,258.1729 =
(1+ R )5
1,000,000
R =
747,258.1729
1/ 5
1= 6.00%
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What is the price two years from today of a bond
that will pay its owner $1,000,000 five years from
today if the discount rate is fixed at 4% per
annum?
0
5
$1 mil
Price = PV2 (CF5 ) = PV2 (1,000,000 ) =
1,000,000
= 888,996.3587
(1+ 0.04 )3
Problem Education 1
Some studies estimate that private college will cost
$130,428 per year in 2030 (http://www.cnbc.com/id/
47565202). Assuming your child will attend college for four
years at a constant cost of $130,428 per year, how much
money do you need at the start of their first year when the
first bill is due to finance all of their college years if you
can earn a risk-free return of 5%?
College
1
Year
Period
130,428
?
130,428
130,428
130,428
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Problem Education 1 (Cont.)

Some studies estimate that private college will cost
$130,428 per year in 2030 (http://www.cnbc.com/id/
47565202). Assuming your child will attend college for four
years at a constant cost of $130,428 per year, how much
money do you need at the start of their first year when the
first bill is due to finance all of their college years if you
can earn a risk-free return of 5%?
Savings = PV0 (CF0 ) + PV0 (CF1 ) + PV0 (CF2 ) + PV0 (CF3 )
= 130,428 +
130,428
130,428
130,428
+
2 +
(1+ 0.05 ) (1+ 0.05 ) (1+ 0.05 )3
= 485,615.7940
Problem Education 2
Continuing the previous problem, assume that you put the
money into a savings account earning an annual risk-free
return of 5% per annum. How much money will be in the
account at the end of the first year after you make the
second payment of $130,428?
Savings = PV1 (CF2 ) + PV1 (CF3 )
=
130,428
130,428
+
(1+ 0.05 ) (1+ 0.05 )2
= 242,519.18
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Problem Stock Return

If you invested $100 in a portfolio of small stocks in
1925 and reinvested all dividends, your portfolio
would be worth $2,655,590 in 2011. (This is true.)
What is the typical annual rate of return on your
investment?
0
85
100
86
$2,655,590
PV0 (CF86 ) =
CF86
2,655,590
2,655,590
100 =
R =
100
(1+ R )86
(1+ R )86
1/ 86
1= 12.5755%
Problem Company Value

Your candy store generates enough after-tax profit to pay
dividends of $50,000 per year. You plan on closing the
store and liquidating all of the assets for $200,000 three
years from today immediately after receiving the last
dividend payment. What is the value of your store today if
the discount rate is 12%, you do not owe any money (i.e.,
no debt), and the next dividend will be received one year
from today?
0
1
2
3
?
50,000
Value =
50,000
250,000
50,000
50,000
250,000
+
= 262,447.6130
2 +
(1+ 0.12 ) (1+ 0.12 ) (1+ 0.12 )3
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Extra Slides
Example 1 Savings
to have $150 in two years assuming
that you can earn 2% per annum?
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Example 1 Savings
Step 1: Put cash flows on a time line
0
2
150
Example 1 Savings
Step 2: Move cash flow back to today
0
CF2 (1+ R )
1
2
2
150
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Example 1 Savings
0
150 (1+ 0.02 )
1
2
2
150
Example 1 Savings
0
144.175
2
150
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Example 1 Savings
0
2
150
144.175
144.175 is the present value of the $150, PV0(150)

Example 1 Savings
0
144.175
2
150
144.175 is the price you should pay today for a

claim that pays $150 two years from today
39

Mod 1 - TVM - Intuition Discounting - Slides

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7/7/15

Time Value of Money:

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Messages (Look up)

Copyright Michael R. Roberts

Time Value of Money

Copyright Michael R. Roberts

Time Value of Money

Must convert to common/base

THE TOOLS: TIME LINE &

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Lesson: Get in the habit of placing

Aggregating Cash Flows

Can we add/subtract cash flows in

Aggregating Cash Flows

Aggregating Cash Flows

Aggregating Cash Flows

Definition: R is the rate of return offered

Copyright Michael R. Roberts

Definition: R is the rate of return offered

Copyright Michael R. Roberts

To determine R, consider the risk of the

Copyright Michael R. Roberts

To determine R, consider the risk of the

Average Annual Return, R

Corporate Bonds (Investment Grade)

Copyright Michael R. Roberts

To determine R, consider the risk of the

Average Annual Return, R

Corporate Bonds (Investment Grade)

Riskier investment, higher return

USING THE TOOLS:

Copyright Michael R. Roberts

Copyright Michael R. Roberts

t < 0 because we are moving cash

Copyright Michael R. Roberts

We can add/subtract these CFs because they

Copyright Michael R. Roberts

CF1 (1+ R ) = PV0 (CF1 )

CF2 (1+ R ) = PV0 (CF2 )

CF3 (1+ R ) = PV0 (CF3 )

These are present values of future CFs

CF4 (1+ R ) = PV0 (CF4 )

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Interpretation 1: We need $354.60

Interpretation 2: The present value of

Interpretation 3: Todays price for a

Comment: We are assuming that the

Copyright Michael R. Roberts