Ch04 PPT Brighamfm1ce

PowerPoint Presentation
prepared by
Traven Reed Canadore College
chapter 4
Time Value of Money
Corporate Valuation and the Time Value of Money

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Copyright 2011 by Nelson Education Ltd. All rights reserved.
4-3
Time Value Topics

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Time lines Future value Present value Effective rates of return Amortization
4-4
Time lines show timing of cash flows

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0
I%
1 CF1
2 CF2
3 CF3
CF0
Tick marks at the ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.
4-5
Time line for a $100 lump sum due at the end of Year 2
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I%
2 Year 100
4-6
Time line for an ordinary annuity of $100 for 3 years

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0
I%
1 100
2 100
3 100
4-7
Time line for uneven CFs

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0
I%
1 100
2 75
3 50
-50
4-8
FV of an initial $100 after 3 years (i = 5%)

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0
5%
3 FV = ?
100
Finding FVs (moving to the right on a time line) is called compounding.

4-9
After 1 year (Formula Approach)

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FV1 = = = =
PV + INT1 = PV + PV (I) PV(1 + I) $100(1.05) $105.00
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After 2 years (Formula Approach)

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FV2 = = = =
FV1(1+I) = PV(1+I)(1+I) PV(1+I)2 $100(1.05)2 $110.25
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After 3 years (Formula Approach)

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FV3 = = = =
FV2(1+I)=PV(1 + I)2(1+I) PV(1+I)3 $100(1.05)3 $115.76
In general, FVN = PV(1 + I)N

4-12
Growth of $1
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Three Ways to Find FVs

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Solve the equation with a regular calculator. Use a financial calculator. Use a spreadsheet.
4-14
(Reference Only) Financial calculator: HP10BII

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Adjust display brightness: hold down ON and push + or -. Set number of decimal places to display: Orange Shift key, then DISP key (in orange), then desired decimal places (e.g., 3). To temporarily show all digits, hit Orange Shift key, then DISP, then =
4-15
(Reference Only) HP10BII (contd)

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To permanently show all digits, hit ORANGE shift, then DISP, then . (period key) Set decimal mode: Hit ORANGE shift, then ./, key.
4-16
(Reference Only) HP10BII: Set Time Value Parameters

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To set END (for cash flows occurring at the end of the year), hit ORANGE shift key, then BEG/END. To set 1 payment per period, hit 1, then ORANGE shift key, then P/YR
4-17
Financial Calculator Solution

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Financial calculators solve this equation: FVN + PV (1+I)N = 0 There are 4 variables. If 3 are known, the calculator will solve for the 4th.
4-18
Heres the setup to find FV

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INPUTS 3 N OUTPUT
5 -100 I/YR PV
0 PMT
FV 115.76
Clearing automatically sets everything to 0, but for safety enter PMT = 0 Set: P/YR = 1, END
4-19
Spreadsheet Solution
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Use the FV function: = FV(I, N, PMT, PV) = FV(0.05, 3, 0, -100) = 115.76
4-20
Whats the PV of $100 due in 3 years if i = 10%?

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Finding PVs is discounting, and it s the reverse of compounding. 0

10%
3 100
PV = ?
4-21
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Solve FVN = PV(1 + I

PV = FVN (1+I)N = FVN
N )
for PV
N
1 1+I
1 PV = $100 1.10
= $100(0.7513) = $75.13
4-22

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INPUTS OUTPUT
3 N
10 I/YR
PV -75.13
0 PMT
100 FV
Either PV or FV must be negative. Here PV = -75.13. Put in $75.13 today, take out $100 after 3 years.
4-23
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Use the PV function: = PV(I, N, PMT, FV) = PV(0.10, 3, 0, 100) = -75.13
4-24
Finding the Interest Rate

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0
?%
10 150
-100
FV = PV(1 + $150 = $100(1 + I)10 (1.5)(1/10) = (1 + I) 1.0414 = (1 + I) I = 0.0414 = 4.14%

I)N
4-25
Financial Calculator
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INPUTS OUTPUT
10 N
I/YR 4.14
-100 PV
0 PMT
150 FV
4-26
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Use the RATE function: = RATE(N, PMT, PV, FV) = RATE(10, 0, -100, 150) = 0.0414
4-27
Find the Number of Years, N

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Suppose we now have $100 and the interest rate is 20%. How long will it take to grow to $200?
0 20% -100 FV = PV (1 + I)N
200
4-28
Finding the Time

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Follow the formula approach: $200 = $100 ( 1 + 0.20)N $200/$100 = 2 = (1.2)N Ln (2) = N Ln (1.2) N = Ln(2) / Ln(1.2) N = 0.693 / 0.182 = 3.8 years
4-29

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INPUTS OUTPUTS
N 3.8
20 I/YR
-100 PV
0 PMT
200 FV
4-30
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Use the NPER function: = NPER(I, PMT, PV, FV) = NPER (0.2, 0, -100, 200) = 3.8
4-31
Ordinary Annuity vs. Annuity Due

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Ordinary Annuity
0 I% 1 PMT 2 PMT 2 3 PMT 3
Annuity Due
0 I% PMT PMT PMT
4-32
Whats the FV of a 3-year ordinary annuity of $100 at 5%?

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0
5%
1 100
2 100
3 100.00 105.00 110.25 FV = 315.25

4-33
FV Annuity Formula
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The future value of an annuity with N periods and an interest rate of I can be found with the following formula:
= PMT (1+I)N-1 I (1+0.05)3-1 = 100 0.05
4-34
= 315.25
Financial Calculator Formula for Annuities

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Financial calculators solve this equation: FVN + PV(1+I)N + PMT

(1+I)N-1 I
=0
There are 5 variables. If 4 are known, the calculator will solve for the 5th.
4-35

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INPUTS OUTPUT
3
N
5
I/YR
0
PV
-100
PMT FV
315.25
Have payments but no lump sum PV, so enter 0 for present value.
4-36
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Use the FV function: see spreadsheet. = FV(I, N, PMT, PV) = FV(0.05, 3, -100, 0) = 315.25
4-37
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Future Value of an Annuity Due

When payments occur at the beginning of the period rather than at the end, those cash flows have more time to earn extra interest.
FVAdue = FVAordinary (1 + I) FVAdue = ($315.25)(1.05) = $331.01 Set the calculator to Begin Model In Excel, FV(I, N, PMT, PV, Type) = FV(0.05, 3, -100, 0, 1)
4-38
Whats the PV of this ordinary annuity?

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0
5%
1 100
2 100
3 100
95.24 90.70 86.38 272.32 = PV

4-39
PV Annuity Formula
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The present value of an annuity with N periods and an interest rate of I can be found with the following formula:
= PMT 1 I 1 I (1+I)N 1 0.05(1+0.05)3 = $272.32
4-40
1 = 100 0.05

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INPUTS OUTPUT
3
N
5
I/YR PV
100
PMT
0
FV
-272.32
Have payments but no lump sum FV, so enter 0 for future value.
4-41
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Use the PV function: see spreadsheet. = PV(I, N, PMT, FV) = PV(0.05, 3, 100, 0) = -272.32
4-42
Find the PV if the annuity were an annuity due

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0
10%
100
100
100
4-43
PV of Annuity Due
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Since each payment for an annuity due occurs one period earlier, the payments will all be discounted for one less period. Therefore, PVAdue > PVA PV of annuity due (PVAdue) : = (PV of ordinary annuity) (1+I) = (272.32) (1+ 0.05) = $285.94
4-44
PV of Annuity Due: Switch from End to Begin

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INPUTS OUTPUT
3
N
5
I/YR PV
100
PMT
0
FV
-285.94
4-45
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Excel Function for Annuities Due

Change the formula to: =PV(10%,3,-100,0,1) The fourth term, 0, tells the function there are no other cash flows. The fifth term (i.e. type) tells the function that it is an annuity due. A similar function gives the future value of an annuity due. Refer to the previous slide 4-38.
4-46
Find Annuity Payment for Ordinary Annuity (End Mode) & Annuity Due (Begin Mode)
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INPUTS OUTPUT INPUTS
10,000 -1,773.96
I/YR
PV
PMT
FV
OUTPUT INPUTS OUTPUT 5 6 0 10,000 -1,673.55

4-47
Find Period Number and Interest for Ordinary Annuity (End Mode)
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INPUTS OUTPUT 6.96 INPUTS

N
-1,200 10,000
I/YR
PV
PMT
FV
OUTPUT INPUTS OUTPUT 5 25.78

-1,200 10,000
4-48
Perpetuities
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A perpetuity is simply an annuity with an extended life. Since the payments go on forever, you cannot apply the step-by-step approach. PV of a perpetuity = PMT/I Example: A British consol with a face value of $1,000 that pays $50 per year forever. What is its value today? The going interest rate is 2.5%. PV(P) = $50/0.025 = $2,000
4-49
What is the PV of this uneven cash flow stream?

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10%
2 300
3 300
4 -50
100 90.91 247.93 225.39 -34.15 530.08 = PV
4-50
(Reference Only) Financial calculator: HP10BII

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Clear all: Orange Shift key, then C All key (in orange). Enter number, then hit the CFj key. Repeat for all cash flows, in order. To find NPV: Enter interest rate (I/YR). Then Orange Shift key, then NPV key (in orange).
51 4-51
(Reference Only) Financial calculator: HP10BII (contd)

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To see current cash flow in list, hit RCL CFj CFj To see previous CF, hit RCL CFj To see subsequent CF, hit RCL CFj + To see CF 0-9, hit RCL CFj 1 (to see CF 1). To see CF 10-14, hit RCL CFj . (period) 1 (to see CF 11).
4-52
(Reference Only) Financial calculator: HP10BII (contd)

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Input in CFLO register:

CF0 CF1 CF2 CF3 CF4 = 0 = 100 = 300 = 300 = -50
Enter I = 10%, then press NPV button to get NPV = 530.09. (Here NPV = PV.)
4-53
Excel Formula in cell A3: =NPV(10%,B2:E2)

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4-54
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Nominal or Quoted Rate (INOM)

Stated in contracts, and quoted by banks and brokers. Not used in calculations or shown on time lines Compounding periods per year (M) must be given. Examples:
8%; Quarterly 8%, Daily interest (365 days)
4-55
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Periodic rate (IPER )

IPER = INOM/M, where M is number of compounding periods per year. M = 4 for quarterly, 12 for monthly, and 365 for daily compounding. Used in calculations, shown on time lines. Examples:
8% quarterly: IPER = 8%/4 = 2%. 8% daily (365): IPER = 8%/365 = 0.021918%.
4-56
The Impact of Compounding

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Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated I% constant? Why?
4-57
The Impact of Compounding (Answer)

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LARGER! If compounding is more frequent than once a year--for example, semiannually, quarterly, or daily-interest is earned on interest more often.
4-58
FV Formula with Different Compounding Periods

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FVN = PV 1 +
INOM M
(M)(N)
4-59
$100 at a 12% nominal rate with quarterly compounding for 2 years

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FVN = PV 1 + FV5S
INOM M
MN
0.12 = $100 1 + 4 = $100(1.03)8
4x2
= $126.68
4-60
FV of $100 at a 12% nominal rate for 5 years with different compounding

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FV(Ann.) FV(Semi.) FV(Quar.) FV(Mon.) FV(Daily)
= $100(1.12)5 = $100(1.06)10 = $100(1.03)20 = $100(1.01)60 = $100(1+(0.12/365))(5x365)
= $176.23 = $179.08 = $180.61 = $181.67 = $182.19
4-61
Effective Annual Rate (EAR = EFF%)

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The EAR is the annual rate that produces the same result as if we had compounded at a given periodic rate M times per year. The effective percentage (EFF%) is the interest rate expressed as if it were compounded once per year.
4-62
Effective Annual Rate Example

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Example: Invest $1 for one year at 12%, semiannual: FV = PV(1 + INOM/M)M FV = $1 (1.06)2 = 1.1236 EFF% = 12.36%, because $1 invested for one year at 12% semiannual compounding would grow to the same value as $1 invested for one year at 12.36% annual compounding.
4-63
Comparing Rates
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An investment with monthly payments is different from one with quarterly payments. Must put on EFF% basis to compare rates of return. Use EFF% only for comparisons. Banks say interest paid daily. Same as compounded daily.
4-64
EFF% for a nominal rate of 12%, compounded monthly

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EFF% = =
1 +
INOM M
1
12
0.12 1 + 12
= (1.01)12 - 1.0 = 0.126825 = 12.6825%

4-65
(Reference) Finding EFF with HP10BII

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Type in nominal rate, then Orange Shift key, then NOM% key (in orange). Type in number of periods, then Orange Shift key, then P/YR key (in orange). To find effective rate, hit Orange Shift key, then EFF% key (in orange).
4-66
EAR (or EFF%) for a Nominal Rate of 12%

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EARAnnual EARQuarterly = (1 + 0.12/4)4 - 1
= 12.00% = 12.55%
EARMonthly = (1 + 0.12/12)12 - 1 = 12.68% EARDaily(365) = (1 + 0.12/365)365 - 1= 12.75%
4-67
Can the effective rate ever be equal to the nominal rate?

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Yes, but only if annual compounding is used, i.e., if M = 1 If M > 1, EFF% will always be greater than the nominal rate.
4-68
When is each rate used?

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INOM:
Written into contracts, quoted by banks and brokers. Not used in actual calculations or shown on time lines.
4-69
When is each rate used? (contd)

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IPER: Used in actual calculations, shown on time lines. If INOM has annual compounding, then IPER = INOM/1 = INOM. Otherwise, adjust with the number of periods involved.
4-70
When is each rate used? (contd)

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EAR (or EFF%): Used to compare returns on investments with different payments per year. Used for calculations if and only if dealing with annuities where payments dont match interest compounding periods.
4-71
Fractional Time Periods

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On January 1 you deposit $100 in an account that pays a nominal interest rate of 11.33463%, with daily compounding (365 days). How much will you have on October 1, or after 9 months (273 days)? (Days given.)
4-72
Convert interest to daily rate

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IPER = 11.33463%/365 = 0.031054% per day. FV 273 = $100 (1.00031054)273 = $100 (1.08846) = $108.85
0 0.031054% -100
273
FV=?
4-73
Calculator Solution
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IPER = INOM/M = 11.33463%/365 =0.031054% per day With inputs: N = 273, I/Y = 0.031054, PV = -100, PMT = 0 Find FV = 108.85
4-74
Amortized Loans
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Construct an amortization schedule for a $1,000, 10% annual rate loan with three equal payments.
4-75
Step 1: Find the required payments

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0
10%
1 PMT
3
N
2 PMT
-1000
PV PMT 402.11
3 PMT
0
FV
-1,000
INPUTS OUTPUT
10
I/YR
4-76
Step 2: Find interest charge for Year 1

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INTt = Beginning balancet (I) INT1 = $1,000(0.10) = $100
4-77
Step 3: Find repayment of principal in Year 1

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Repmt = PMT - INT = $402.11 - $100 = $302.11
4-78
Step 4: Find ending balance after Year 1

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Ending balance = Beginning bal - Repmt = $1,000 - $302.11 = $697.89
Repeat these steps for Years 2 and 3 to complete the amortization table.
4-79
Amortization Table
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YEAR 1 2 3 TOT
BEG BAL $1,000 698 366
PMT $402 402 402
INT
PRIN PMT
END BAL $698 366 0
$100 $302 70 37 332 366
1,206.34 206.34 1,000
4-80
Interest declines because outstanding balance declines

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$450 $400 $350 $300 $250 $200 $150 $100 $50 $0 PMT 1 PMT 2 PMT 3
Interest Principal
4-81
Interest declines because outstanding balance declines (contd)

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Amortization tables are widely used--for home mortgages, auto loans, business loans, retirement plans, and more. They are very important! Financial calculators (and spreadsheets) are great for setting up amortization tables.
4-82
Growing Annuities and Growing Perpetuities

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Cash flows are likely to grow over time, due to either to real growth or to inflation. Growing annuity is a series of finite cash flows that grow at a fixed rate. Growing perpetuity is a constant stream of cash flows without end that is expected to rise indefinitely
4-83
Real Rate
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Rr = [(1 + INOM)/(1 + inflation)] 1 Example: If the nominal annual interest rate is 10% and the expected inflation rate is 5% per annum, what is the expected real rate of return? Rr = [1.10/1.05] 1 = 0.0476 = 4.76%
4-84

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PowerPoint Presentation

Traven Reed Canadore College

Corporate Valuation and the Time Value of Money

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Time Value Topics

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Time lines show timing of cash flows

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Time line for an ordinary annuity of $100 for 3 years

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Time line for uneven CFs

Copyright 2011 by Nelson Education Ltd. All rights reserved.

FV of an initial $100 after 3 years (i = 5%)

Finding FVs (moving to the right on a time line) is called compounding.

After 1 year (Formula Approach)

PV + INT1 = PV + PV (I) PV(1 + I) $100(1.05) $105.00

Copyright 2011 by Nelson Education Ltd. All rights reserved.

After 2 years (Formula Approach)

FV1(1+I) = PV(1+I)(1+I) PV(1+I)2 $100(1.05)2 $110.25

Copyright 2011 by Nelson Education Ltd. All rights reserved.

After 3 years (Formula Approach)

FV2(1+I)=PV(1 + I)2(1+I) PV(1+I)3 $100(1.05)3 $115.76

In general, FVN = PV(1 + I)N

Three Ways to Find FVs

Copyright 2011 by Nelson Education Ltd. All rights reserved.

(Reference Only) Financial calculator: HP10BII

(Reference Only) HP10BII (contd)

Copyright 2011 by Nelson Education Ltd. All rights reserved.

(Reference Only) HP10BII: Set Time Value Parameters

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Financial Calculator Solution

Heres the setup to find FV

Use the FV function: = FV(I, N, PMT, PV) = FV(0.05, 3, 0, -100) = 115.76

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Whats the PV of $100 due in 3 years if i = 10%?

Finding PVs is discounting, and it s the reverse of compounding. 0

Solve FVN = PV(1 + I

Financial Calculator Solution

Use the PV function: = PV(I, N, PMT, FV) = PV(0.10, 3, 0, 100) = -75.13

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Finding the Interest Rate

FV = PV(1 + $150 = $100(1 + I)10 (1.5)(1/10) = (1 + I) 1.0414 = (1 + I) I = 0.0414 = 4.14%

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Find the Number of Years, N

Finding the Time

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Financial Calculator Solution

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Ordinary Annuity vs. Annuity Due

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Whats the FV of a 3-year ordinary annuity of $100 at 5%?

3 100.00 105.00 110.25 FV = 315.25

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Financial Calculator Formula for Annuities

Financial calculators solve this equation: FVN + PV(1+I)N + PMT

Financial Calculator Solution

Copyright 2011 by Nelson Education Ltd. All rights reserved.

Future Value of an Annuity Due

Whats the PV of this ordinary annuity?