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668 vues12 pagesDeveloping Financial Insights

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Developing Financial Insights

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Developing Financial Insights

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Jun. 1, 2011

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Most everyone is familiar with the concept that money placed in a savings account will

grow to a larger amount as the years pass if the money in that account earns interest at a

specified annual compounded rate. For example, $500 invested in a savings account that earns

10% interest compounded annually will grow to become $550 (i.e., $500 1.10) after one year,

$605 (i.e., $550 1.10) after two years, and $665.50 (i.e., $605 1.10) after three years.1

Think about the numerical example just depicted. It took three sequential calculations to

arrive at the $665.50 answerone calculation for each year involved. If the question had been

posed as involving 12 years or even 25 years, a multitude of tedious, repetitive calculations

would have been required. Is there a shortcut? Yes. If we take the 1.10 multiplier amount from

each of the three parenthetical notations above and simply multiply them together1.10 1.10

1.10we get a numerical factor of 1.331. So, if some reference book could provide us with the

1.331 multiplier as being applicable to a 10% situation over three years, all we would have to do

is take the initial $500 amount put into the savings account and multiply it by 1.331 to get the

very same answer as above$665.50.

Are there reference materials that provide such multipliers for a variety of interest and

years combinations? Yes, there are, and they are referred to as future value (FV) factors. Such

reference materials are useful because no matter the initial amount invested, a specified

combination of time and interest will always have the same multiplier effect. Thus, future value

factor tables are readily available, depicting a number of possible different interest rates along

one axis and a number of different years along the other.2 In fact, Exhibit 1 presents just such a

1

The 1.10 multiplier comes from the fact that in one year there will be 100% of that years starting monetary

amount plus an additional 10% due to a years worth of interest having been accumulated at a 10% rate. Thus, 100%

+ 10% = 110%, which converts to an arithmetic multiplier of 1.10.

2

This case explores cash flows on an annual basis. Appendix 1 explains what to do when cash flows occur on a

monthly or quarterly basis.

This case was prepared by Professor Mark Haskins. It was written as a basis for class discussion rather than to

illustrate effective or ineffective handling of an administrative situation. Copyright 2011 by the University of

Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to

sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,

used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,

recording, or otherwisewithout the permission of the Darden School Foundation.

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February

2013 to August 2013.

-2-

UV5137

table. In it we can find the 10% column and the three-years row and find the multiplier amount at

the intersection of those two table coordinates, and it is 1.331the same as we determined it

should be. Moreover, if we were using a financial calculator or Excel, the embedded programs in

those tools would derive the exact same multiplier once we entered the data pertaining to years

and interest rate.

In business, the basic question posed above often requires us to reverse the focus. For

example, the question might be some form of My customer is willing to pay me $665.50 in

three years; what is the equivalent monetary amount, as of today, of that future receipt? Pause

for just a momentthe same basic interplay of time and interest described in the first example

must be in play in this scenario alsoright? Of course, but instead of a current invested

monetary amount growing into a larger future amount due to the compounding of interest, we

must now work with a stipulated future monetary amount and in essence, unwind, roll back in

time, reverse the compounding of interest phenomenon. In this instance, we are being asked to

ascertain the present value (PV)the value todayof a future monetary amount, using the

relevant interest and year information.

To do that, the process is simply the reverse of what we did earlier. So, if the relevant

interest environment is 10% and the number of years is three, we execute the following three

calculations:

1. $665.50 1.10 = $605

2. $605 1.10 = $550

3. $550 1.10 = $500

Thus, receiving $665.50 in three years, when the interest rate environment is 10%, is

equivalent to receiving $500 today. In short, this has to be true because as we saw earlier, if we

invest $500 today in a savings account that pays 10% interest, that savings account balance will

grow to become $665.50 in three years. Another way to state this is this: If, over the next three

years, relevant interest rates are 10%, the economic value of $665.50 in three years is exactly

equal to $500 today.

As before, this can become a laborious series of calculations if the number of years

involved is substantial. And, just as before, there is a shortcut. Mathematically, whereas the

compounding of interest phenomenon was a multiplicative mathematical task, the unwinding of

a compounded interest phenomenon must be a divisive mathematical task. Specifically, we find

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February

2013 to August 2013.

-3-

UV5137

that: 1 1.10 = 0.90909, and then 0.90909 1.10 = 0.82644, and finally, 0.82644 1.10 =

0.7513.3 And, if we take 0.7513 $665.50, we get $500 (with a bit of rounding).

Are there reference materials that provide such factor multipliers for a variety of interest

and year combinations when we are seeking to derive the present value of a future monetary

amount? Yes, and they contain a host of PV factors. Such reference materials are useful because

no matter the future amount to be received, a specified combination of time and interest will

always have the same multiplier effect. Exhibit 2 provides an example of such a reference table.

In it, we can find the 10% column and the three-years row and extract the multiplier factor at the

intersection of those two coordinates and it is, just as we thought it should be, 0.7513. (Please

note that the example depicted at the bottom of the table in Exhibit 2 is an additional one,

different from the one discussed here.) Moreover, if we are using a financial calculator or Excel,

the embedded algorithms in those tools use the same factor once we have entered into those tools

the relevant number of years (three) and interest rate (10%).

The two scenarios described above are emblematic of the simplest of situationsthey

both started with single monetary amounts to be compounded (the Exhibit 1-related example) or

discounted (the Exhibit 2-related example). In many personal and business financial situations

the reality is that there are multiple cash amounts coming in or going out over the course of a

stipulated time period that are pertinent to the sought-after FV or PV. Lets lay the foundation for

those sorts of scenarios.

Assume you invest $80 today and at the beginning of each of the next two years for a

total of three such deposits, in a 6% savings account. At the end of three years, what will that

account have in it? Clearly, we could answer that question by applying the technique and

Exhibit 1 factors we described and used in the very first example. That is, we could find the

future value of three lump sumsone of which is invested for three years, one of which is in the

account for two years, and one of which is invested for only one year. In fact, at the bottom of

Exhibit 3, this approach is depicted. But there is an easier, quicker way. Since this scenario

involves three applications of the Exhibit 1 factors, we can develop reference materials that

accumulate the effects of a variety of multiple applications of Exhibit 1s factors. Indeed, the

Exhibit 3 factors portray such accumulations. Please note that the Exhibit 3 factors are various

summations of sequential Exhibit 1 factor amounts for a given interest rate. For this scenarios

three deposits in a 6% savings account, the Exhibit 3 factor is 3.375, which is the sum of the

Exhibit 1 6% factors associated with one year, two years, and three years (1.06 + 1.1236 +

1.191, subject to minimal rounding). So 3.375 $80 = $270, the amount to which three (starting

today) annual invested amounts of $80 each grow to in a 6% account at the end of three years.

3

Some readers may have anticipated, or be interested to note, that the 0.7513 present value multiplier figure can

also be derived by the following: 1 (1.10), which is the same as 1 1.331, which indeed equals 0.7513.

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February

2013 to August 2013.

-4-

UV5137

As before, lets reverse the direction of the time frame. Assume, for example, you are to

receive $70 at the end of each of the next three years. The natural question to arise is, what is the

single present value monetary amount, as of today, that is equivalent to that series of three

receipts? Assuming a 12% interest rate environment, this question can be answered by applying

the technique and Exhibit 2 factors that we used in an earlier example. If we were to pursue that

approach, we would have to execute three separate calculations for each of the three $70

receiptsthat approach is depicted at the bottom of Exhibit 4.4 But as we were able to do in

using Exhibit 1 to develop Exhibit 3, we can use Exhibit 2 to develop Exhibit 4, which in turn

can then be used as a shortcut for PV situations with multiple cash flows in the future. Indeed,

Exhibit 4 is simply the summation of Exhibit 2 factors for a variety of time periods within an

interest rate column. So, in this example, we can easily go to Exhibit 4s 12% column, threeyears row, and find the factor of 2.402, which is the sum (with a bit of rounding) of the pertinent

Exhibit 2 factors (0.8929 + 0.7972 + 0.7118). And 2.402 $70 = $168.14. The interpretation of

this present value is as follows: In a 12% interest rate environment, receiving $168.14 today is

equivalent to receiving three payments of $70 at the end of each of the next three years.

1. You just turned 35 and have been saving for an around-the-world vacation. You want to

take the trip to celebrate your 40th birthday. You have set aside, as of today, $15,000 for

such a trip. You expect the trip will cost $25,000. The financial instruments you have

invested the $15,000 in have been earning, on average, about 8%. (You may ignore

income taxes.)

a. Will you have enough money in that vacation account on your 40th birthday to take

the trip? What will be the surplus, or shortfall, in that account when you turn 40?

(Hint: Exhibit 1 will be useful in answering this question.)

b. If you had to, you could further fund the trip by making, starting today, five annual

$500 contributions to the account. If you adhered to such a plan, how much will be in

the account on your 40th birthday? (Hint: Exhibit 3 and the answer to part (a) above

will both be useful in answering this question.)

2. Your company has been offered a contract for the development and delivery of a solarpowered military troop transport vehicle. The request for proposal provides all the

necessary technical specifications and it also stipulates that two working, economically

feasible prototypes must be delivered in four years, at which time you will receive your

only customer paymenta single and final payment of $50 million. Assume a

reinvestment interest rate of 18% for all the monies received over the next four years.

(You may ignore income taxes.)

Appendix 2 shows how to adjust the data in Exhibit 4 for cash flows at the beginning (instead of the end) of

the year.

2013 to August 2013.

-5-

UV5137

a. What lump-sum dollar amount would you be willing to accept today instead of the

$50 million in four years? (Hint: Exhibit 2 will be useful in answering this question.)

b. Alternatively, what four yearly receipts, starting a year from now, would you be

willing to accept? (Hint: Exhibit 4 and the answer to part (a) above will both be

useful in answering this question.)

3. The aged but centrally located golf course you manage does not have an in-ground

automated water sprinkling system. Instead, to properly water the course, sprinklers and

hoses must be repeatedly set, moved, and put away by some of the grounds crewa

tedious and laborious task. If over the next 12 years you project annual savings of about

$40,000 from having an automated system, what is the maximum price you would be

willing to pay today for an installed, automated golf course sprinkler system? (Assume an

interest rate of 6%, and you may ignore income taxes.)

a. Redo your calculation using a 10-year time period and $48,000 in annual savings.

b. Redo your initial calculation one more time using $50,000 in annual savings for the

first six years and $30,000 in annual savings for the next six years.

4. The cafeteria you operate has a regular clientele for all three meals, seven days a week.

You want to expand your product line beyond what you are currently able to offer. To do

so requires the purchase of some additional specialty equipment costing $45,000, but you

project a resultant increase in sales (after deducting the cost of sales) of about $8,000 per

year for each of the next eight years with this new equipment. Assuming a required rate

of return (i.e., a hurdle rate) of 8%, should you pursue this opportunity? Why or why not?

Do the analysis under two conditions:

a. You are part of an income-tax-exempt enterprise.

b. The enterprise you are part of is subject to a 40% corporate income tax rate, and the

straight-line, depreciable life of the equipment you are contemplating purchasing is

five years.

5. You are contemplating the purchase of a one-half interest in a corporate airplane to

facilitate the expansion of your business into two new geographic areas. The acquisition

would eliminate about $220,000 in estimated annual expenditures for commercial flights,

mileage reimbursements, rental cars, and hotels for each of the next 10 years. The total

purchase price for the half-share is $6 million, plus associated annual operating costs of

$100,000. Assume the plane can be fully depreciated on a straight-line basis for tax

purposes over 10 years. The companys weighted average cost of capital (commonly

referred to as WACC) is 8%, and its corporate tax rate is 40%. Does this endeavor

present a positive or negative net present value (NPV)? If positive, how much value is

being created for the company through the purchase of this asset? If negative, what

additional annual cash flows would be needed for the NPV to equal zero? To what

phenomena might those additional positive cash flows be ascribable?

6. The final tally is in: This years operating costs were down $100,000, a decrease directly

attributable to the $520,000 investment in the automated materials handling system put in

2013 to August 2013.

-6-

UV5137

place at the beginning of the year. If this level of annual savings continues for five more

years, resulting in six total years of annual savings, what compounded annual rate of

return will that represent? If these annual savings continue for nine more years, what

compounded annual rate of return will that represent? (You may ignore income taxes.)

2013 to August 2013.

-7-

UV5137

Exhibit 1

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Future Value Factors for a Single Lump Sum Invested Today for n Years:

Exhibit 1 Factors = (1 + Interest)years

2%

Years

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

1.0200

1.0404

1.0612

1.0824

1.1041

1.1262

1.1487

1.1717

1.1951

1.2190

1.2434

1.2682

1.2936

1.3195

1.3459

1.3728

1.4002

1.4282

1.4568

1.4859

4%

1.0400

1.0816

1.1249

1.1699

1.2167

1.2653

1.3159

1.3686

1.4233

1.4802

1.5395

1.6010

1.6651

1.7317

1.8009

1.8730

1.9479

2.0258

2.1068

2.1911

6%

1.0600

1.1236

1.1910

1.2625

1.3382

1.4185

1.5036

1.5938

1.6895

1.7908

1.8983

2.0122

2.1329

2.2609

2.3966

2.5404

2.6928

2.8543

3.0256

3.2071

AnnualInterestRates

8%

10%

12%

1.0800

1.1664

1.2597

1.3605

1.4693

1.5869

1.7138

1.8509

1.9990

2.1589

2.3316

2.5182

2.7196

2.9372

3.1722

3.4259

3.7000

3.9960

4.3157

4.6610

1.1000

1.2100

1.3310

1.4641

1.6105

1.7716

1.9487

2.1436

2.3579

2.5937

2.8531

3.1384

3.4523

3.7975

4.1772

4.5950

5.0545

5.5599

6.1159

6.7275

1.1200

1.2544

1.4049

1.5735

1.7623

1.9738

2.2107

2.4760

2.7731

3.1058

3.4785

3.8960

4.3635

4.8871

5.4736

6.1304

6.8660

7.6900

8.6128

9.6463

14%

16%

18%

20%

1.1400

1.2996

1.4815

1.6890

1.9254

2.1950

2.5023

2.8526

3.2519

3.7072

4.2262

4.8179

5.4924

6.2613

7.1379

8.1372

9.2765

10.5752

12.0557

13.7435

1.1600

1.3456

1.5609

1.8106

2.1003

2.4364

2.8262

3.2784

3.8030

4.4114

5.1173

5.9360

6.8858

7.9875

9.2655

10.7480

12.4677

14.4625

16.7765

19.4608

1.1800

1.3924

1.6430

1.9388

2.2878

2.6996

3.1855

3.7589

4.4355

5.2338

6.1759

7.2876

8.5994

10.1472

11.9737

14.1290

16.6722

19.6733

23.2144

27.3930

1.2000

1.4400

1.7280

2.0736

2.4883

2.9860

3.5832

4.2998

5.1598

6.1917

7.4301

8.9161

10.6993

12.8392

15.4070

18.4884

22.1861

26.6233

31.9480

38.3376

example(assuming10%):

Toda y

Starthere

$100

1.10

$110

1.10

$121

1.10

$133.10

OR:$100.00 1.331

=

$133.10

(so:PVamountExhibit1factor=FVamount)

2013 to August 2013.

-8-

UV5137

Exhibit 2

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Present Value Factors for a Single Amount n Years in the Future:

Exhibit 2 Factors = 1 Exhibit 1 Table Factor in the Same Cell

2%

Years

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

0.9804

0.9612

0.9423

0.9238

0.9057

0.8880

0.8706

0.8535

0.8368

0.8203

0.8043

0.7885

0.7730

0.7579

0.7430

0.7284

0.7142

0.7002

0.6864

0.6730

4%

0.9615

0.9246

0.8890

0.8548

0.8219

0.7903

0.7599

0.7307

0.7026

0.6756

0.6496

0.6246

0.6006

0.5775

0.5553

0.5339

0.5134

0.4936

0.4746

0.4564

6%

0.9434

0.8900

0.8396

0.7921

0.7473

0.7050

0.6651

0.6274

0.5919

0.5584

0.5268

0.4970

0.4688

0.4423

0.4173

0.3936

0.3714

0.3503

0.3305

0.3118

AnnualInterestRates

8%

10%

12%

0.9259

0.8573

0.7938

0.7350

0.6806

0.6302

0.5835

0.5403

0.5002

0.4632

0.4289

0.3971

0.3677

0.3405

0.3152

0.2919

0.2703

0.2502

0.2317

0.2145

0.9091

0.8264

0.7513

0.6830

0.6209

0.5645

0.5132

0.4665

0.4241

0.3855

0.3505

0.3186

0.2897

0.2633

0.2394

0.2176

0.1978

0.1799

0.1635

0.1486

0.8929

0.7972

0.7118

0.6355

0.5674

0.5066

0.4523

0.4039

0.3606

0.3220

0.2875

0.2567

0.2292

0.2046

0.1827

0.1631

0.1456

0.1300

0.1161

0.1037

14%

16%

18%

20%

0.8772

0.7695

0.6750

0.5921

0.5194

0.4556

0.3996

0.3506

0.3075

0.2697

0.2366

0.2076

0.1821

0.1597

0.1401

0.1229

0.1078

0.0946

0.0829

0.0728

0.8621

0.7432

0.6407

0.5523

0.4761

0.4104

0.3538

0.3050

0.2630

0.2267

0.1954

0.1685

0.1452

0.1252

0.1079

0.0930

0.0802

0.0691

0.0596

0.0514

0.8475

0.7182

0.6086

0.5158

0.4371

0.3704

0.3139

0.2660

0.2255

0.1911

0.1619

0.1372

0.1163

0.0985

0.0835

0.0708

0.0600

0.0508

0.0431

0.0365

0.8333

0.6944

0.5787

0.4823

0.4019

0.3349

0.2791

0.2326

0.1938

0.1615

0.1346

0.1122

0.0935

0.0779

0.0649

0.0541

0.0451

0.0376

0.0313

0.0261

example(assuming8%):

Toda y

$200.00 Starthere

$158.77 1.08 $171.47 1.08 $185.19 1.08

OR:$200.00 0.7938

=

158.76*

(So:PVamount=Exhibit2factorFVamount)

*differencebetween$158.77and$158.76duetorounding

2013 to August 2013.

-9-

UV5137

Exhibit 3

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Future Value Factors for a Series of Invested Amounts at the Beginning of n Years:

Table Factors = Sum of Exhibit 1 Factors for Corresponding Cell

and All Preceding Cells for that Interest Rate

2%

Years

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

1.020

2.060

3.122

4.204

5.308

6.434

7.583

8.755

9.950

11.169

12.412

13.680

14.974

16.293

17.639

19.012

20.412

21.841

23.297

24.783

4%

1.040

2.122

3.246

4.416

5.633

6.898

8.214

9.583

11.006

12.486

14.026

15.627

17.292

19.024

20.825

22.698

24.645

26.671

28.778

30.969

6%

1.060

2.184

3.375

4.637

5.975

7.394

8.897

10.491

12.181

13.972

15.870

17.882

20.015

22.276

24.673

27.213

29.906

32.760

35.786

38.993

AnnualInterestRates

8%

10%

12%

1.080

2.246

3.506

4.867

6.336

7.923

9.637

11.488

13.487

15.645

17.977

20.495

23.215

26.152

29.324

32.750

36.450

40.446

44.762

49.423

1.100

2.310

3.641

5.105

6.716

8.487

10.436

12.579

14.937

17.531

20.384

23.523

26.975

30.772

34.950

39.545

44.599

50.159

56.275

63.002

1.120

2.374

3.779

5.353

7.115

9.089

11.300

13.776

16.549

19.655

23.133

27.029

31.393

36.280

41.753

47.884

54.750

62.440

71.052

80.699

14%

16%

18%

20%

1.140

2.440

3.921

5.610

7.536

9.730

12.233

15.085

18.337

22.045

26.271

31.089

36.581

42.842

49.980

58.118

67.394

77.969

90.025

103.768

1.160

2.506

4.066

5.877

7.977

10.414

13.240

16.519

20.321

24.733

29.850

35.786

42.672

50.660

59.925

70.673

83.141

97.603

114.380

133.841

1.180

2.572

4.215

6.154

8.442

11.142

14.327

18.086

22.521

27.755

33.931

41.219

49.818

59.965

71.939

86.068

102.740

122.414

145.628

173.021

1.200

2.640

4.368

6.442

8.930

11.916

15.499

19.799

24.959

31.150

38.581

47.497

58.196

71.035

86.442

104.931

127.117

153.740

185.688

224.026

example(using6%):

Toda y

$80

$80

$80

Starthere

fromExhibit1

1.06=

$84.80

1.1236 $89.89

1.191= $95.28

$269.97

OR:$80.00

3.375

=

270.00*

(So:PVamountsExhibit3factor=FVamount)

^Thi s exhi bi tdepi cts fa ctors forannuitiesdue (wheretheca s hfl ows occuratthes tartofea chyea r)a s oppos edtoan

ordinaryannuity s i tuati on(wheretheca s hfl ows occura ttheendoftheyea r).Mos tpubl i s hedta bl es ofthis s ort

a reforthel a tter.

2013 to August 2013.

-10-

UV5137

Exhibit 4

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Present Value Factors for a Series of Amounts n Years in the Future:

Exhibit 4 Factors = Sum of Exhibit 2 Factors for Corresponding Cell

and All Preceding Cells for that Interest Rate

2%

Years

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

0.980

1.942

2.884

3.808

4.713

5.601

6.472

7.325

8.162

8.983

9.787

10.575

11.348

12.106

12.849

13.578

14.292

14.992

15.678

16.351

4%

0.962

1.886

2.775

3.630

4.452

5.242

6.002

6.733

7.435

8.111

8.760

9.385

9.986

10.563

11.118

11.652

12.166

12.659

13.134

13.590

6%

0.943

1.833

2.673

3.465

4.212

4.917

5.582

6.210

6.802

7.360

7.887

8.384

8.853

9.295

9.712

10.106

10.477

10.828

11.158

11.470

AnnualInterestRates

8%

10%

12%

0.926

1.783

2.577

3.312

3.993

4.623

5.206

5.747

6.247

6.710

7.139

7.536

7.904

8.244

8.559

8.851

9.122

9.372

9.604

9.818

0.909

1.736

2.487

3.170

3.791

4.355

4.868

5.335

5.759

6.145

6.495

6.814

7.103

7.367

7.606

7.824

8.022

8.201

8.365

8.514

0.893

1.690

2.402

3.037

3.605

4.111

4.564

4.968

5.328

5.650

5.938

6.194

6.424

6.628

6.811

6.974

7.120

7.250

7.366

7.469

14%

0.877

1.647

2.322

2.914

3.433

3.889

4.288

4.639

4.946

5.216

5.453

5.660

5.842

6.002

6.142

6.265

6.373

6.467

6.550

6.623

16%

0.862

1.605

2.246

2.798

3.274

3.685

4.039

4.344

4.607

4.833

5.029

5.197

5.342

5.468

5.575

5.668

5.749

5.818

5.877

5.929

18%

0.847

1.566

2.174

2.690

3.127

3.498

3.812

4.078

4.303

4.494

4.656

4.793

4.910

5.008

5.092

5.162

5.222

5.273

5.316

5.353

20%

0.833

1.528

2.106

2.589

2.991

3.326

3.605

3.837

4.031

4.192

4.327

4.439

4.533

4.611

4.675

4.730

4.775

4.812

4.843

4.870

example(using12%):

Toda y

fromExhibit2

$62.50

.8929

$55.80

.7972

$49.83

.7118

$70

$70

$70

Starthere

$168.13

OR:$70.00

2.402

=

168.14*

(So:PVamount=Exhibit4factorFVamounts)

*differencebetween$168.13and$168.14duetorounding

^SeeAppendix2foradiscussionofhowtousethisExhibitwhencashflowsbeginimmediately.

2013 to August 2013.

-11-

UV5137

Appendix 1

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (F) AND A PRESENT VALUE (PV) APPROACH

What to Do When Cash Flows Occur on a Monthly or Quarterly Basis

All the examples in this case involve annual time periods. It is not unusual for payments

or receipts of cash to occur on a monthly or even a quarterly basis. There is an easy adjustment

process to accommodate such alternative time frames. All that is required is to note that, unless

stated otherwise, interest rates are always assumed to involve annual compounding. Thus, if the

scenario under consideration involves quarterly cash flows, the vertical axes of the tables in

Exhibit 1 through Exhibit 4 can be assumed to pertain to the number of quarters (instead of

years) and the stated annual interest rate must be divided by 4 (because there are four quarters

per year) before picking the appropriate interest rate column to use in the tables. So, if the desire

is to ascertain the PV of a series of quarterly payments, beginning at the end of the first quarter,

for the next three years, and the pertinent annual interest rate is 16%, these are the two required

adjustments for using the tables:

1. The number of periods to use on the tables vertical axes is 12 (3 years 4 quarters per

year).

2. The interest rate to use on the tables horizontal axes is 4% (16% annual rate 4

compounding quarters per year).

In short, for a quarterly series of cash flows, we adjust the table axes coordinates by

scaling up the number of periods by a multiple of 4 and scaling down the interest rate by a

divisor of 4. Similarly, for a monthly series of cash flows, we adjust the table axes coordinates by

scaling up the number of periods by a multiple of 12 and scaling down the interest rate by a

divisor of 12.1

Note: Technically, an interest rate of 16% compounded annually is not equivalent to a 4% rate compounded

quarterly. The reason is that the interest earned on a quarterly basis is itself subject to the next quarters

compounding, quarter after quarter. For example, $100 earning interest at a 16% annually compounded rate will

grow to $116 at the end of one year. On the other hand, $100 earning interest at the rate of 4% compounded

quarterly will grow to $117 at the end of one year. The fact that the two scenarios are not identical is assumed to be

immaterial, and thus the adjustments described above are common when using FV and PV tables.

$100

$104

$108.16

$112.49

1.04

1.04

1.04

1.04

=

=

=

=

$104

$108.16

$112.49

$117

2013 to August 2013.

-12-

UV5137

Appendix 2

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Adjusting Exhibit 4 for Cash Flows at the Beginning (Instead of the End) of the Year

example(using12%):

Toda y

$70

$70

$70

Starthere

fromExhibit2

$62.50

.8929

$55.80 .7972

_______

$188.30

fromExhibit4

OR:$70.00 (1.69+1)

$70.00 2.69

=

=

$188.30

$188.30

At times, the series of cash flows for which a present value amount needs to be calculated

begins at the start of each year as opposed to the end of each year. The discussion and example

depicted in Exhibit 4 identifies the cash flows according to this latter pattern. It is not unusual,

however, for the series of cash flows to begin immediately as depicted in the following revised

Exhibit 4 example. Please note there are still three annual cash flows, they simply now begin at

the start of their respective years.

Exhibit 4 can still be used to ascertain todays PV of this series of cash flows. The way to do

that involves two steps. First, use the appropriate interest rate column (12% in this example) and

use the two-years row, instead of the three-years row as originally done. In Exhibit 4, that factor

is 1.69, and it will be used to PV all the cash flow amounts except the very first one. Second,

because the first cash flow item occurs today, its PV is equivalent to the cash flow amount itself.

So, to value it, we simply add 1.0 to the 1.69 factor pertaining to the other cash flow amounts in

the example, arriving at an adjusted table factor of 2.69. Using that adjusted factor in the

following fashion, $70.00 2.69 = $188.30, we get the PV of a series of three annual amounts of

$70 each, where the series begins today (immediately), as equaling $188.30. In the above

depiction, this is verified by discounting each of the three amounts separately (using Exhibit 2

factors) and obtaining the same total PV amount.

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