Corporate Finance

Time Value of Money

Session One

 A suburban Chicago couple won the Lottery.

Decision DilemmaTake a Lump Sum or Annual Installments

They had to choose between a single lump sum $104 million, or $198 million paid out over 25 years (or $7.92 million per year). The winning couple opted for the lump sum. Did they make the right choice? What basis do we make such an economic comparison? To make such comparisons (the lottery decision problem), we must be able to compare the value of money at different point in time.

Time Value of Money

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.

Future Values and Compound Interest

Future Value Amount to which an investment will grow after earning interest.

Compound Interest Interest earned on interest.

Simple Interest Interest earned only on original investment; no interest is earned on interest.

Future Values
You have $100 invested in a bank account. Suppose banks are currently paying an interest rate of 6 percent per year on deposits. So after a year, your account will earn interest of $6: FV = PV (1 + r) FV = 100 (1+06) Value of investment after 1 year = $106

Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today
Interest Earned

Value 100

6 106

Future Years 2 3

6 112

6 118

6 124

6 130

Value at the end of Year 5 = $130

Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance. Interest Earned Per Year =Prior Year Balance x .06

Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100
6 106

Future Years 2 3
6.36 112.36

6.74 119.10

7.15 126.25

7.57 133.82

Value at the end of Year 5 = $133.82

Practice Problem: Warren Buffetts Berkshire Hathaway

Went public in 1965: $18 per share
Worth today (August 22, 2003): $76,200 Annual compound growth: 24.58% Current market value: $100.36 Billion If he lives till 100 (current age: 73 years as of 2003), his companys total market value will be ?

Market Value
Assume that the companys stock will continue to appreciate at an annual rate of 24.58% for the next 27 years.

F $100.36(1 0.2458) $37.902 trillions

27

Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal? Suppose the interest rate is 8%.

Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1629. Was this a good deal?
To answer, determine $24 is worth in the year 2003, compounded at 8%.

FV $24 (1 .08 ) $75 .979 trillion

374

FYI - The value of Manhattan Island land is well below this figure.

Present Values

Present Value = PV PV =
Future Value after t periods (1+r) t

Present Values
Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

PV

3000 (1.08)2

$2,572

PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now and $4,000 at the end of the following two years. If your cost of money is 8%, which do you prefer?
Immediate payment

8,000.00

PV1 PV2

4 , 000 (1.08 )1 4 , 000 (1.08 ) 2

3,703.70 3,429.36

Total PV

$15,133.06

Present Values
$8,000 $4,000 Present Value Year 0
0 1 2

$ 4,000

Year

$8,000
4000/1.08 4000/1.082 Total = $3,703.70 = $3,429.36 = $15,133.06

PV of Multiple Cash Flows

PVs can be added together to evaluate multiple cash flows.

PV

C1 (1 r )
1

(1 r ) 2 ....
C2

Perpetuities & Annuities

Perpetuity A stream of level cash payments that never ends.
Annuity Equally spaced level stream of cash flows for a limited period of time.

Perpetuities
PV of Perpetuity Formula

PV
C = cash payment r = interest rate

C r

Perpetuities Example - Perpetuity

In order to create an endowment, which pays $100,000 per year, forever, how much money must be set aside today if the rate of interest is 10%?

PV

100 , 000 .10

$1,000,000

Perpetuities
Example - continued If the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today?

PV

1, 000 , 000 (1 .10 ) 3

$751,315

Annuities
PV of Annuity Formula

PV C

1 r

1 t r ( 1 r )

C = cash payment r = interest rate t = Number of years cash payment is received

Annuities
PV Annuity Factor (PVAF) - The present value of $1 a year for each of t years.

PVAF

1 r

1 t r ( 1 r )

Annuities
Example - Annuity You are purchasing a car. You are scheduled to make 3 annual installments of $4,000 per year. Given a rate of interest of 10%, what is the price you are paying for the car (i.e. what is the PV)?

PV 4 ,000

1 .10

1 .10 ( 1 .10 ) 3

PV $9,947.41

Annuities
Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments
Mortgage payment Annual income from an investment payout Future Value of annual payments

FV C PVAF (1 r )

Annuities
Example - Future Value of annual payments You plan to save $4,000 every year for 20 years and then retire. Given a 10% rate of interest, what will be the FV of your retirement account?

FV 4 ,000

1 .10

1 .10 ( 1 .10 ) 20

(1.10)

20

FV $229,100

Effective Interest Rates

Effective Annual Interest Rate - Interest rate that is annualized using compound interest.
Annual Percentage Rate - Interest rate that is annualized using simple interest.

Effective Interest Rates

example Given a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What is the Annual Percentage Rate (APR)?

EAR = (1 + .01)12 - 1 = r EAR = (1 + .01)12 - 1 = .1268 or 12.68% APR = .01 x 12 = .12 or 12.00%

Inflation
Inflation - Rate at which prices as a whole are increasing.
Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases.

Inflation
1+ nominal interest rate 1 real interest rate = 1+inflation rate

approximation formula

Real int. rate nominal int. rate - inflation rate

Inflation
Example If the interest rate on one year govt. bonds is 6.0% and the inflation rate is 2.0%, what is the real interest rate?
1+.06 1 real interest rate = 1+.02

1 real interest rate = 1.039 real interest rate = .039 or 3.9% Approximation = .06 - .02 = .04 or 4.0%

The End