Chapter two
HOW TO CALCULATE PRESENT
VALUES
Lecturer
: Yusuf Hussein Mohamed
Presentation Agenda
Key
Concepts and Skills
Overview and goal
Why do we care about this topic?
Calculate future values and present value .
Calculate future values and present value
for Annuities.
Loan payment
Key Concepts and Skills
Be
able to compute the future value of an
investment made today
Be able to compute the present value of cash to
be received at some future date
Be able to compute the return on an investment
Interest
If we borrow an amount of money today, we will repay
a larger amount later. The increase in value is known
as interest. The money gains value over time.
The amount of a loan or a deposit is called the
principal. The interest is usually computed as a
percent of the principal. This percent is called the rate
of interest (or the interest rate, or simply the rate).
The rate of interest is assumed to be an annual rate
unless otherwise stated.
14-14
Present and Future Values
A present
value is the discounted value of one
or more future cash flows
A future value is the compounded value of a
present value
The discount factor is the present value of a
dollar invested in the future
The compounding factor is the future value of
a dollar invested today
5
Present and Future Values
Why
is a dollar today worth more than a dollar
tomorrow?
The
discount factor:
Decreases as time increases
The farther away a cash flow is, the more we
discount it
Decreases as interest rates increase
When interest rates are high, a dollar today is
worth much more than that same dollar will be in
the future
6
Calculate
Goals
the value today of cash flows
expected in the future.
Calculate the amount of money needed to
today to generate some future value of money.
Why do we care about this topic?
Time value of money = price of borrowing and
lending
1. Present value calculations are important
A. evaluation of investment projects
B. capital budgeting
C. pricing of bonds and stocks
D. firm valuation
The Time Value of Money
Which
would you rather have ?
$100
today - or
$100 one year from today
Sooner
is better !
Basic Definitions
Present
Value earlier money on a time line
Future Value later money on a time line
Interest rate exchange rate between earlier
money and later money
Discount
rate
Cost of capital
Opportunity cost of capital
**** Required return ****
General Formula
FV
= PV(1 + r)N
FV
= future value
PV = present value
r = period interest rate, expressed as a decimal
T = number of periods
PV= FV/1+in
Simple Interest
Example:
Invest $1,000 today for a five-year term and
receive 8 percent annual simple interest.
Value (tim e n) P (n P k)
Value 5
$1,000 (5 $1,000 .08)
$1,000 (5 $80)
$1,000 $400
$1,400
Compound Interest
Example :
Invest $1,000 today for a five-year term and
receive 8 percent annual compound interest.
How much will the accumulated value be at
time 5?
Future Value P ( 1 k)n
FV1 P (1 .08)1 $1,080
FV2 P (1 .08)(1 .08) P (1 .08) 2 $1,166.40
FV3 P (1 .08)(1 .08)(1 .08) P (1.08) 3 $1,259.71
FV4 P (1.08)(1.08)(1.08)(1.08) P (1.08) 4 $1,360.49
FV5 P (1 .08) 5 $1,469.33
Present value
Present
Value - find the amount of money
to invest today to have $1000 in 5 years if the
investment earns 10%.
Present Value of an Amount Example
The
Lexington Property Development
Company has a $10,000 note receivable from a
customer due in three years. How much is the
note worth today if the interest rate is
A. 9%? = = $7,722
B. 12% compounded monthly? = $6,989
C. 8% compounded quarterly?= = $7,885
D.10% compounded semiannually? = $7,463
Future Value of an Amount Example
What will a deposit of $4,500 left in the bank be
worth under the following conditions:
A.
B.
C.
D.
Left for nine years at 7% interest?
Left for six years at 10% compounded semiannually?
Left for five years at 8% compounded quarterly?
Left for 10 years at 12% compounded monthly?
Calculating the Rate of Return
If we know the present value, the future value and the number of time
periods, we can calculate the rate of return we have earned
For example, suppose we invested $5,000 six years ago Today, it is
worth $10,000. What is the annually compounded rate of returned?
FVn = PV0
k =
1 k
FVn
PV0
1
n
10, 000
5, 000
12.25%
1
6
Calculating the Number of Periods
If we know the present value, the future value and the rate of
return, we can calculate the number of time periods the money
needs to be invested for.
For example, suppose we invested $25,000 at 8%. Today, it is
worth $40,000. How long has the money been invested?
FVn = PV0
FVn
PV
0
ln 1 k
ln
n=
40, 000
25, 000
ln 1.08
ln
6.11 years
Annuities and Perpetuities Annuities
Thus
far, we have dealt only with single payments,
either today or in the future
An annuity is a stream of payments that continues for
a finite period of time
If the payment occurs at the end of the period, it is an
ordinary annuity
If the payment occurs at the start of the time period, it
is an annuity due
Difference Between Annuity Types
Ordinary Annuity
0
$100
$100
$100
Annuity Due
0
$100
$100
$100
$100
Future Value of an Ordinary
Annuity
Assume that we want to save $2,000 at the end of each year for the
next 10 years. If we can earn 10% on our investments, how much
will we have saved?
FVOrdinary
Annuity
1 k
1
= PMT
10
1.10 1
2, 000
0.10
$31, 874.85
n
Future Value of an Annuity Due
Assume that we want to save $2,000 at the beginning of each year
for the next 10 years. If we can earn 10% on our investments,
how much will we have saved?
FVAnnuity
Due
1 k
1
= PMT
1 k
1.10 10 1
2, 000
1.10
0.10
$35, 062.33
n
Present Value of an Ordinary
Annuity
You have just won a lottery. The Lottery Corporation gives you two
options. You can take $1,000,000 at the end of each year for 25
years or a lump sum of $10,000,000 today. If the appropriate
discount rate is 10%, what should you do?
PVOrdinary
Annuity
1 1 k
= PMT
1 1.10 25
1, 000, 000
0.10
$9, 077, 040.02
Present Value of an Annuity Due
Lets continue with the example from the previous page, but
now the Lottery Corporation gives you the option of taking
$1,000,000 at the beginning of each year for 25 years or a
lump sum of $10,000,000 today. If the appropriate discount
rate is 10%, what should you do?
PVAnnuity
Due
1 1 k n
= PMT
1 k
1 1.10 25
1, 000, 000
1.10
0.10
$9, 984, 744.02
C
C
(
1
g
)
C
(
1
g
)
P
V
(1P
rV
)
rgr
2
23
Growing Perpetuity
A growing stream of cash flows that lasts forever.
C
C(1+g)
C (1+g)2
The formula for the present value of a growing perpetuity is:
.P
$
1
3
0
V
5$26.0
Growing Perpetuity: Example
The expected dividend next year is $1.30 and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
$1.30
$1.30(1.05)
$1.30 (1.05)2
Nominal Versus Effective Interest
Rates
Nominal (stated) annual interest rate or
annual percentage rate (APR)
* The annual rate without considering the
effect of compounding
Effective annual interest rate (EAR) or
effective annual yield (EAY)
* The annual rate after considering the effect of
compounding
Calculating the Effective Rate
k Effective
QR
1 1
m
Where:
kEffective = Effective annual interest rate
QR = the quoted interest rate
M = the number of compounding periods per year
Example: Effective Rate
Calculation
A bank is offering loans at 6%, compounded monthly. What is the
effective annual interest rate on its loans?
k Effective
QR
1 1
m
.06
1
12
6.17%
12
Example Loan Payments
Your sister has been forced to borrow money to
pay her tuition this year. If she makes annual
payments on the loan at year end for the next
three years, and the loan is for $2,500 at a
simple interest rate of 6 percent, how much
will she pay each year?
[ 5-5]
$2,500
PMT
($2,500 .06)
$833.33 $150.00
$983.33
The END
