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Drake DRAKE UNIVERSITY UNIVERSITE D’AUVERGNE Time Value of Money Discounted Cash Flow Analysis MBA 220.

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Presentation on theme: "Drake DRAKE UNIVERSITY UNIVERSITE D’AUVERGNE Time Value of Money Discounted Cash Flow Analysis MBA 220."— Presentation transcript:

1 Drake DRAKE UNIVERSITY UNIVERSITE D’AUVERGNE Time Value of Money Discounted Cash Flow Analysis MBA 220

2 UNIVERSITE D’AUVERGNE Drake Drake University Which would you Choose? On December 31, 2003 Norman and DeAnna Shue of Columbia, South Carolina had reason to celebrate the coming new year after winning the Powerball Lottery. They had 2 options. $110 Million Paid in 30 yearly payments of $3,666,666 $60 Million

3 UNIVERSITE D’AUVERGNE Drake Drake University Time Value of Money A dollar received (or paid) today is not worth the same amount as a dollar to be received (or paid) in the future WHY? You can receive interest on the current dollar

4 UNIVERSITE D’AUVERGNE Drake Drake University A Simple Example You deposit $100 today in an account that earns 5% interest annually for one year. How much will you have in one year? Value in one year = Current value + interest earned = $ (.05) = $100(1+.05) = $105 The $105 next year has a present value of $100 or The $100 today has a future value of $105

5 UNIVERSITE D’AUVERGNE Drake Drake University Using a Time Line An easy way to represent this is on a time line Time 01 year 5% $100$105 Beginning of First Year End of First year

6 UNIVERSITE D’AUVERGNE Drake Drake University What would the $100 be worth in 2 years? You would receive interest on the interest you received in the first year (the interest compounds) Value in 2 years = Value in 1 year + interest = $ (.05)= $105(1+.05) = $ Or substituting $100(1+.05) for $105 = [$100(1+.05)](1+.05) = $100(1+.05) 2 =$110.25

7 UNIVERSITE D’AUVERGNE Drake Drake University On the time line Time Cash -$100 $ Flow Beginning of year 1 End of Year 1 Beginning of Year 2 End of Year 2

8 UNIVERSITE D’AUVERGNE Drake Drake University Generalizing the Formula = (100)(1+.05) 2 This can be written more generally: Let t = The number of periods = 2 r = The interest rate per period =.05 PV = The Present Value = $100 FV = The Future Value = $ FV = PV(1+r) t ($110.25) = ($100)( ) 2 This works for any combination of t, r, and PV

9 UNIVERSITE D’AUVERGNE Drake Drake University Future Value Interest Factor FV = PV(1+r) t (1+r) t is called the Future Value Interest Factor (FVIF r,t ) FVIF’s can be found in tables or calculated Interest Rate Periods OR (1+.05) 2 = Either way original equation can be rewritten: FV = PV(1+r) t = PV(FVIF r,t )

10 UNIVERSITE D’AUVERGNE Drake Drake University Calculation Methods FV = PV(1+r) t  Tables using the Future Value Interest Factor (FVIF)  Regular Calculator  Financial Calculator  Spreadsheet

11 UNIVERSITE D’AUVERGNE Drake Drake University Using the tables FVIF 5%,2 = Plugging it into our equation FV = PV(FVIF r,t ) FV = $100(1.1025) = $110.25

12 UNIVERSITE D’AUVERGNE Drake Drake University Using a Regular Calculator  Calculate the FVIF using the y x key (1+.05) 2 =  Proceed as Before Plugging it into our equation FV = PV(FVIFr r,t ) FV = $100(1.1025) = $110.25

13 UNIVERSITE D’AUVERGNE Drake Drake University Financial Calculator Financial Calculators have 5 TVM keys N = Number of Periods = 2 I = interest rate per period =5 PV = Present Value = $100 PMT = Payment per period = 0 FV = Future Value =? After entering the portions of the problem that you know, the calculator will provide the answer

14 UNIVERSITE D’AUVERGNE Drake Drake University Financial Calculator Example On an HP-10B calculator you would enter: 2 N5 I -100 PV0 PMT FV and the screen shows

15 UNIVERSITE D’AUVERGNE Drake Drake University Spreadsheet Example Excel has a FV command =FV(rate,nper,pmt,pv,type) =FV(0.05,2,0,100,0) = note: Type refers to whether the payment is at the beginning (type =1) or end (type=0) of the year

16 UNIVERSITE D’AUVERGNE Drake Drake University Practice Problem If you deposit $3,000 today into a CD that pays 4% annually for a period of five years, what will it be worth at the end of the five years? FV = PV(1+r) t = PV(FVIF r,t ) FV = $3,000(1+.04) 5 =$3,000( ) FV = $3, FVIF 0.4,5 = (1+0.04) 5 =

17 UNIVERSITE D’AUVERGNE Drake Drake University Calculating Present Value We just showed that FV=PV(1+r) t This can be rearranged to find PV given FV, i and n. Divide both sides by (1+r) t which leaves PV = FV/(1+r) t

18 UNIVERSITE D’AUVERGNE Drake Drake University Example If you wanted to have $ at the end of two years and could earn 5% interest on any deposits, how much would you need to deposit today? PV = FV/(1+r) t PV = $110.25/(1+0.05) 2 = $100.00

19 UNIVERSITE D’AUVERGNE Drake Drake University Present Value Interest Factor PV = FV/(1+r) t 1/(1+r) t is called the Present Value Interest Factor (PVIF r,t ) PVIF’s can be found in tables or calculated Interest Rate Periods OR 1/(1+.05) 2 = Either way original equation can be rewritten: PV = FV/(1+r) t = FV(PVIF r,t )

20 UNIVERSITE D’AUVERGNE Drake Drake University Calculating PV of a Single Sum  Tables - Look up the PVIF PVIF 5%,2 = PV = (0.9070) =  Regular calculator -Calculate PVIF PVIF =1/ (1+r) t PV = (0.9070) =  Financial Calculator 2 N 5 I FV0 PMT PV =  Spreadsheet Excel command =PV(rate,nper,pmt,fv,type) Excel command =PV(.05,2,0,110.25,0)=100.00

21 UNIVERSITE D’AUVERGNE Drake Drake University Example Assume you want to have $1,000,000 saved for retirement when you are 65 and you believe that you can earn 10% each year. How much would you need in the bank today if you were 25? PV = 1,000,000/(1+.10) 40 =$22,094.93

22 UNIVERSITE D’AUVERGNE Drake Drake University What if you are currently 35? Or 45? If you are 35 you would need PV = $1,000,000/(1+.10) 30 = $57, If you are 45 you would need PV = $1,000,000/(1+.10) 20 = $148, This process is called discounting (it is the opposite of compounding)

23 UNIVERSITE D’AUVERGNE Drake Drake University Annuities Annuity: A series of equal payments made over a fixed amount of time. An ordinary annuity makes a payment at the end of each period. Example A 4 year annuity that makes $100 payments at the end of each year. Time01234 CF’s

24 UNIVERSITE D’AUVERGNE Drake Drake University Future Value of an Annuity The FV of the annuity is the sum of the FV of each of its payments. Assume 6% a year Time FV of CF 100(1+.06) 0 = (1+.06) 1 = (1+.06) 2 = (1+.06) 3 = FV =

25 UNIVERSITE D’AUVERGNE Drake Drake University FV of An Annuity This could also be written FV=100(1+.06) (1+.06) (1+.06) (1+.06) 3 FV=100[(1+.06) 0 +(1+.06) 1 +(1+.06) 2 +(1+.06) 3 ] or for any n, r, payment, and t

26 UNIVERSITE D’AUVERGNE Drake Drake University FVIF of an Annuity (FVIFA r,t ) Just like for the FV of a single sum there is a future value interest factor of an annuity This is the FVIFA r,t FV annuity =PMT(FVIFA r,t )

27 UNIVERSITE D’AUVERGNE Drake Drake University Calculation Methods  Tables - Look up the FVIFA FVIFA 6%,4 = FV = 100( ) =  Regular calculator -Approximate FVIFA FVIFA = [(1+r) t -1]/r FV = 100( ) =  Financial Calculator 4 N 6 I 0 PV -100 PMT FV =  Spreadsheet Excel command =FV(rate,nper,pmt,pv,type) Excel command =FV(.06,4,100,0,0)=

28 UNIVERSITE D’AUVERGNE Drake Drake University Practice Problem Your employer has agreed to make yearly contributions of $2,000 to your Roth IRA. Assuming that you have 30 years until you retire, and that your IRA will earn 8% each year, how much will you have in the account when you retire?

29 UNIVERSITE D’AUVERGNE Drake Drake University Present Value of an Annuity The PV of the annuity is the sum of the PV of each of its payments Time /(1+.06) 1 = /(1+.06) 2 = /(1+.06) 3 = /(1+.06) 4 = PV =

30 UNIVERSITE D’AUVERGNE Drake Drake University PV of An Annuity This could also be written PV=100/(1+.06) /(1+.06) /(1+.06) /(1+.06) 4 PV=100[1/(1+.06) 1 +1/(1+.06) 2 +1/(1+.06) 3 +1/(1+.06) 4 ] or for any r, payment, and t

31 UNIVERSITE D’AUVERGNE Drake Drake University PVIF of an Annuity PVIFA r,t Just like for the PV of a single sum there is a future value interest factor of an annuity This is the PVIFA r,t PV annuity =PMT(PVIFA r,t )

32 UNIVERSITE D’AUVERGNE Drake Drake University Calculation Methods  Tables - Look up the PVIFA PVIFA 6%,4 = FV = 100( ) =  Regular calculator -Approximate FVIFA PVIFA = [(1/r)-1/r(1+r) t ] FV = 100( ) =  Financial Calculator 4 N 6 I 0 FV-100 PMT PV =  Spreadsheet Excel command =PV(rate,nper,pmt,fv,type) Excel command =PV(.06,4,100,0,0)=

33 UNIVERSITE D’AUVERGNE Drake Drake University Annuity Due The payment comes at the beginning of the period instead of the end of the period. Time CF’s Annuity CF’s Annuity Due How does this change the calculation methods?

34 UNIVERSITE D’AUVERGNE Drake Drake University So what about the Shue Family? The PV of the 30 equal payments of $3,666,666 is simply the summation of the PV of each payment. This is called an annuity due since the first payment comes today. Lets assume their local banker tells them they can earn 3% interest each year on a savings account. Using that as the interest rate what is the PV of the 30 payments?

35 UNIVERSITE D’AUVERGNE Drake Drake University Present Value of an Annuity Due The PV of the annuity due is the sum of the PV of each of its payments Time M 3.6M 3.6M 3.6M 3.6M 3.6M/(1+.03) 1 =3.559M 3.6M/(1+.03) 2 =3.456M 3.6M/(1+.03) 3 =3.355M 3.6M/(1+.03) 29 =1.555M PV =$ 74,024, M/(1+.03) 0 =3.6M

36 UNIVERSITE D’AUVERGNE Drake Drake University Wrong Choice? It would cost $74,024,333 to generate the same annuity payments each year, the Shue’s took the $60 Million instead of the 30 payments, did they made a mistake? Not necessarily, it depends upon the interest rate used to find the PV. The rate should be based upon the risk associated with the investment. What if we used 6% instead?

37 UNIVERSITE D’AUVERGNE Drake Drake University Present Value of an Annuity Due Time M 3.6M 3.6M 3.6M 3.6M 3.6M/(1+.06) 1 =3.459M 3.6M/(1+.06) 2 =3.263M 3.6M/(1+.06) 3 =3.078M 3.6M/(1+.06) 29 =676,708 PV =$ 53,499, M/(1+.06) 0 =3.6M

38 UNIVERSITE D’AUVERGNE Drake Drake University What is the right rate? The Lottery invests the cash payout (the amount of cash they actually have) in US Treasury securities to generate the annuity since they are assumed to be free of default. In this case a rate of 4.87% would make the present value of the securities equal to $60 Million (20 year Treasury bonds currently yield 5.02%)

39 UNIVERSITE D’AUVERGNE Drake Drake University Intuition Over the last 50 years the S&P 500 stock index as averaged over 9% each year, the PV of the 30 payments at 9% is $41,060,370 If you can guarantee a 9% return you could buy an annuity that made 30 equal payments of $3.6Million for $41,060,370 and used the rest of the $60 million for something else….

40 UNIVERSITE D’AUVERGNE Drake Drake University FV an PV of Annuity Due FV Annuity Due There is one more period of compounding for each payment, Therefore: FV Annuity Due = FV Annuity (1+r) PV Annuity Due There is one less period of discounting for each payment, Therefore PV Annuity Due = PV Annuity (1+r)

41 UNIVERSITE D’AUVERGNE Drake Drake University Uneven Cash Flow Streams What if you receive a stream of payments that are not constant? For example: Time FV of CF 200(1+.06) 0 = (1+.06) 1 = (1+.06) 2 = (1+.06) 3 = FV =

42 UNIVERSITE D’AUVERGNE Drake Drake University FV of An Uneven CF Stream The FV is calculated the same way as we did for an annuity, however we cannot factor out the payment since it differs for each period.

43 UNIVERSITE D’AUVERGNE Drake Drake University PV of an Uneven CF Streams Similar to the FV of a series of uneven cash flows, the PV is the sum of the PV of each cash flow. Again this is the same as the first step in calculating the PV of an annuity the final formula is therefore:

44 UNIVERSITE D’AUVERGNE Drake Drake University Quick Review FV of a Single Sum FV = PV(1+r) t PV of a Single SumPV = FV/(1+r) t FV and PV of annuities and uneven cash flows are just repeated applications of the above two equations

45 UNIVERSITE D’AUVERGNE Drake Drake University Perpetuity Cash flows continue forever instead of over a finite period of time.

46 UNIVERSITE D’AUVERGNE Drake Drake University Growing Perpetuity What if the cash flows are not constant, but instead grow at a constant rate? The PV would first apply the PV of an uneven cash flow stream:

47 UNIVERSITE D’AUVERGNE Drake Drake University Growing Perpetuity However, in this case the cash flows grow at a constant rate which implies CF 1 = CF 0 (1+g) CF 2 = CF 1 (1+g) = [CF 0 (1+g)](1+g) CF 3 =CF 2 (1+g) = CF 0 (1+g) 3 CF t = CF 0 (1+g) t

48 UNIVERSITE D’AUVERGNE Drake Drake University Growing Perpetuity The PV is then Given as:

49 UNIVERSITE D’AUVERGNE Drake Drake University Semiannual Compounding Often interest compounds at a different rate than the periodic rate. For example: 6% yearly compounded semiannual This implies that you receive 3% interest each six months This increases the FV compared to just 6% yearly

50 UNIVERSITE D’AUVERGNE Drake Drake University Semiannual Compounding An Example You deposit $100 in an account that pays a 6% annual rate (the periodic rate) and interest compounds semiannually Time01/21 3%3% FV=100(1+.03)(1+.03)=100(1.03) 2 =106.09

51 UNIVERSITE D’AUVERGNE Drake Drake University Effective Annual Rate The effective Annual Rate is the annual rate that would provide the same annual return as the more often compounding EAR = (1+i nom /m) m -1 m= # of times compounding per period Our example EAR = (1+.06/2) 2 -1= =.0609


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