1 Chapter 4 Time Value of Money

2 Time Value Topics Future value Present value Rates of return Amortization

3 Time Value Basic Concepts Time lines Future value / Present value of lump sum FV / PV of annuity Perpetuities Uneven CF stream Compounding periods Nominal / Effective / Periodic rates Amortization Rates of return Amortization

Value = FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Net operating profit after taxes Required investments in operating capital − = Determinants of Intrinsic Value: The Present Value Equation...

5 Time lines show timing of cash flows. CF 0 CF 1 CF 3 CF I% Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.

6 Time line for a $100 lump sum due at the end of Year Year I%

7 Time line for an ordinary annuity of $100 for 3 years I%

8 Time line for uneven CFs I% -50

Simple vs Compound Interest Simple Interest: I = P x R x T Interest $ amount = Principal x Interest Rate x Time NO accumulation of interest earning interest

Compounding $$ Growing Money to accumulate value in future Solve for Future Value (FV) Mathematical process (multiply)

11 FV of an initial $100 after 3 years (I = 10%) FV = ? % Finding FVs (moving to the right on a time line) is called compounding. 100

12 After 1 year FV 1 = PV + INT 1 = PV + PV (I) = PV(1 + I) = $100(1.10) = $110.00

13 After 2 years FV 2 = FV 1 (1+I) = PV(1 + I)(1+I) = PV(1+I) 2 = $100(1.10) 2 = $121.00

14 After 3 years FV 3 = FV 2 (1+I)=PV(1 + I) 2 (1+I) = PV(1+I) 3 = $100(1.10) 3 = $ In general, FV N = PV(1 + I) N

15 Four Ways to Find FVs Step-by-step approach using time line (as shown in Slides 11-14). Solve the equation with a regular calculator (formula approach). Use a financial calculator. Use a spreadsheet.

16 Financial calculator: HP10BII 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 =.

17 HP10BII (Continued) To permanently show all digits, hit ORANGE shift, then DISP, then. (period key). Set decimal mode: Hit ORANGE shift, then./, key. Note: many non-US countries reverse the US use of decimals and commas when writing a number.

18 HP10BII: Set Time Value Parameters 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.

19 Financial calculators solve this equation: PV (1+I) N = FV N There are 4 variables (PV, I, N, FV). If 3 are known, calculator solves for 4th. Financial Calculator Solution

NI/YR PV PMTFV INPUTS OUTPUT 20 Clearing automatically (shift Clear-All) sets everything to 0, but for safety enter PMT = 0. Here’s the setup to find FV

After 4 years PV = N = i = FV = ? = 21

After 4 years, but different compounding per year Semi-annual PV = $100 N = 4 yrs i = 10% FV = ? = Quarterly PV = $100 N = periods i = per period FV = ? = 22

23 Spreadsheet Solution Use FV function: see spreadsheet in Ch04 Mini Case.xls = FV(I, N, PMT, PV) = FV(0.10, 3, 0, -100) =

Discounting $$ Money needed today to accumulate x$ value in future Solve for Present Value (PV) Mathematical process (divide)

25 What’s the PV of $110 due in 1 year if I/YR = 10%? 10% Finding PVs is discounting, it’s reverse of compounding PV = ?

Solve FV N = PV(1 + I ) N for PV PV = FV N (1+I) N = FV N I N PV= 110 PV= $110 1

What’s the PV of $110 due in 1 year if I/YR = 10%? Annual Compounding FV = $ N = i = PV = ? = Semi-annually FV = $ N = periods i = per period PV = ? = 27

28 What’s the PV of $100 due in 3 years if I/YR = 10%? 10% Finding PVs is discounting, and it’s the reverse of compounding PV = ?

Solve FV N = PV(1 + I ) N for PV PV = FV N (1+I) N = FV N I N PV= $100 1 = $100(0.7513) = $

30 Either PV or FV must be negative. Here PV = Put in $75.13 today, take out $100 after 3 years. N I/YR PV PMTFV INPUTS OUTPUT Financial Calculator Solution

31 Spreadsheet Solution Use PV function: see spreadsheet in Ch04 Mini Case.xls = PV(I, N, PMT, FV) = PV(0.10, 3, 0, 100) =

Cash Flow signs Investing $ today Outlay (invest) $ today in present to earn greater return in the future. Earn interest (revenue), plus principal PV = FV = + Borrowing $ today Take in (borrow) $ today in present to use now, then repay with interest in the future. Pay interest (expense), plus principal PV = + FV =

Periods or Interest Rate unknown Solve for N Invest $100 today earning 10% & need $ How long will it take Solve for i Deposit $100 today. You need $ in 4 years. What’s the annual interest rate if the money is compounded quarterly?

Periods or Interest Rate unknown Solve for N Invest $100 today earning 10% & need $ How long will it take Solve for i Deposit $100 today. You need $ in 4 years. What’s the annual interest rate if the money is compounded quarterly?

Periods or Interest Rate unknown Solve for N Invest $100 today earning 10% & need $ How long will it take? NPER(rate,pmt,pv,fv,type) =NPER(0.1,0,-100,146.41)=4 Solve for i Deposit $100 today. You need $ in 4 years. What’s the annual interest rate if the money is compounded quarterly? RATE(Nper,Pmt,pv,fv,type) =RATE(4*4,0,-100,148.45)*4 =(2.5%)*4 = 10%

36 20% 2 012? FV= PV(1 + I) N Continued on next slide Finding the Time to Double

37 Time to Double (Continued) $2= $1( ) N (1.2) N = $2/$1 = 2 N LN(1.2)= LN(2) N= LN(2)/LN(1.2) N= 0.693/0.182 = 3.8

38 NI/YR PV PMTFV INPUTS OUTPUT Financial Calculator Solution

39 Spreadsheet Solution Use NPER function: see spreadsheet in Ch04 Mini Case.xls = NPER(I, PMT, PV, FV) = NPER(0.10, 0, -1, 2) = 3.8

40 ?% FV= PV(1 + I) N $2= $1(1 + I) 3 (2) (1/3) = (1 + I) = (1 + I) I= = 25.99% Solve for Interest Rate

41 NI/YR PV PMTFV INPUTS OUTPUT Financial Calculator

42 Spreadsheet Solution Use RATE function: = RATE(N, PMT, PV, FV) = RATE(3, 0, -1, 2) =

Ordinary Annuity vs. Annuity Due Series of equal payments made at fixed intervals or specified number of periods. Ordinary end Annuity beg

44 Ordinary Annuity $100=PMT$ I% $ I% $100=PMT Annuity Due Ordinary Annuity vs. Annuity Due

45 What’s the FV of a 3-year ordinary annuity of $100 at 10%? % ??? FV = ???

46 FV Annuity Formula 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 = $100 (1+0.10) = $331

47 Financial Calculator Formula for Annuities Financial calculators solve this equation: FV N + PV(1+I) N + PMT (1+I) N -1 I = 0 There are 5 variables (PV, PMT, N, I, FV. If 4 are known, calculator solves for 5th. Pay attention to inflows & outflows (signs).

48 Have payments but no lump sum PV, so enter 0 for present value. N I/YR PMT FVPV INPUTS OUTPUT Financial Calculator Solution

49 Spreadsheet Solution Use FV function: see spreadsheet. = FV(I, N, PMT, PV) = FV(0.10, 3, -100, 0) =

50 What’s the PV of this ordinary annuity? % ??? ????? = PV

51 PV Annuity Formula 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 = $ − 0.1(1+0.1) 3 = $248.69

52 Have payments but no lump sum FV, so enter 0 for future value. NI/YR PV PMTFV - INPUTS OUTPUT Financial Calculator Solution

53 Spreadsheet Solution Use PV function: see spreadsheet. = PV(I, N, PMT, FV) = PV(0.10, 3, 100, 0) =

54 Find the FV and PV if the annuity were an annuity due % 100

55 PV and FV of Annuity Due vs. Ordinary Annuity PV of annuity due: = (PV of ordinary annuity) (1+I) = ($248.69) ( ) = $ FV of annuity due: = (FV of ordinary annuity) (1+I) = ($331.00) ( ) = $364.10

56 PV of Annuity Due: Switch from “End” to “Begin” N I/YR PV PMT FV INPUTS OUTPUT BEGIN Mode

57 FV of Annuity Due: Switch from “End” to “Begin” ? N I/YRPV PMT FV INPUTS OUTPUT BEGIN Mode

58 Excel Function for Annuities Due Change the formula to: =PV(0.10,3,-100,0,1) The fourth term, 0, tells the function there are no other cash flows. The fifth term tells the function that it is an annuity due. A similar function gives the future value of an annuity due: =FV(0.10,3,-100,0,1)

Retirement problem for you Scenario Want to retire in 35 years Deposit (invest) $2500 year into an S&P 500 Index fund (which returns 12.1% annually) How much will you have to retire on in 35 years? How much cash did you have to outlay in total to accumulate that much? Solution Pmt = $2500 N= 35 i = 12.1% FV = ? = $1,104,853 $2500/yr x 35 yrs = $87,500 total cash outlay

Retirement problem for your friend the slacker Scenario Want to retire with you in 35 years, but is ski bum & fails to save his 1 st 15 years Deposit (invest) $2500 year into an S&P 500 Index fund (which returns 12.1% annually) How much will you have to retire on in 35 years? How much cash did you have to outlay in total to accumulate that much? Solution Pmt = $ N= i = % FV = ? = $ $2500/yr x ? yrs = $50,000 total cash outlay $1,104,853 vs. $182,231

61 What is the PV of this uneven cash flow stream? % = PV

62 Financial calculator: HP10BII 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).

63 Financial calculator: HP10BII (more) 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).

64 CF & HP Input in “CFLO” register: CF0 = CF1 = CF2 = CF3 = CF4 = Enter I/YR =, then press NPV button to get NPV = ? (Here NPV = PV.)

65 Excel Formula in cell A3: =NPV(10%,B2:E2)

66 Nominal rate (I NOM ) Stated in contracts, and quoted by banks and brokers. Not used in calculations or shown on time lines Periods per year (M) must be given. Examples: 8%; Quarterly 8%, Daily interest (365 days)

67 Periodic rate (I PER ) I PER = I NOM /M, where M is number of compounding periods per year. M = 4 for quarterly, 12 for monthly, and 360 or 365 for daily compounding. Used in calculations, shown on time lines. Examples: 8% quarterly: I PER = 8%/4 = 2%. 8% daily (365): I PER = 8%/365 = %.

68 The Impact of Compounding Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated I% constant? Why?

69 The Impact of Compounding (Answer) LARGER! If compounding is more frequent than once a year--for example, semiannually, quarterly, or daily--interest is earned on interest more often.

70 FV Formula with Different Compounding Periods I NOM FV N = PV 1 + M M N

71 $100 at a 12% nominal rate with semiannual compounding for 5 years = $100(1.06) 10 = $ I NOM FV N = PV 1 + M M N 0.12 FV 5S = $ x5

72 FV of $100 at a 12% nominal rate for 5 years with different compounding FV(Ann.)= FV=100; i=12%; n=5 $100(1.12) 5 = $ FV(Semi.)= FV= ? ; i=, n=5%= $ FV(Quar.)= $100(1.03) 20 = $ FV(Mon.)= $100(1.01) 60 = $ FV(Daily)= $100(1+(0.12/365)) (5x365) = $

Nominal vs. Effective Rates (APR vs. EAR or Eff) $100 today, 10% nominal rate compounded annually vs. semi-annually.

74 Effective Annual Rate (EAR = EFF%) The EAR is the annual rate that causes PV to grow to the same FV as under multi-period compounding.

75 Effective Annual Rate Example Example: Invest $1 for one year at 12%, semiannual: FV = PV(1 + I NOM /M) M FV = $1 (1.06) 2 = $ 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. Nom=12%; p/yr=2; Eff%= 12.36% In Excel: EFFECT(NomRate, Npery) =EFFECT(0.12,2) = 12.36%

76 Comparing Rates 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.

77 EFF% = 1 + − 1 I NOM M M EFF% for a nominal rate of 12%, compounded semiannually = 1 + − = (1.06) = = 12.36%.

78 Finding EFF with HP10BII 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).

79 EAR (or EFF%) for a Nominal Rate of 12% (APR) EAR Annual = 12%. EAR Q =2 p/yr= 12.55%. EAR M =12 p/yr= 12.68%. EAR D(365) =365 p/yr= 12.75%.

80 Can effective rate ever be equal to nominal? Yes, but only if annual compounding is used, i.e., if p/yr = 1. If p/yr > 1, EFF% will always be greater than nominal.

81 When is each rate used? I NOM :Written into contracts, quoted by banks and brokers. Not used in calculations or shown on time lines, unless annual compounding.

82 I PER :Used in calculations, shown on time lines. If I NOM has semi-annual compounding, then periodic rate is I PER = I NOM /2 When is each rate used? (Continued)

83 When is each rate used? (Continued) 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 don’t match interest compounding periods.

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

85 I PER = %/365 = % per day FV=? % -100 Convert interest to daily rate

86 FV 273 = $100 ( ) 273 = $100 ( ) = $ Find FV

87 INPUTS OUTPUT NI/YRPVFVPMT I PER =I NOM /M = /365 = per day. Calculator Solution

88 Non-matching rates and periods What’s value at end of Year 3 of following CF stream if quoted interest rate is 10%, compounded annually, semiannually?

89 Time line for non-matching rates and periods % mos. periods 100

90 What’s PV of this 3-yr, $100 per yr CF Stream, 10%=I, semi-annual compounding? % = PV

91 Non-matching rates and periods Payments occur annually, but compounding occurs each 6 months. So can’t use normal annuity valuation techniques.

92 1st Method: Compound Each CF % FVA 3 = $100(1.05) 4 + $100(1.05) 2 + $100 = $331.80

93 2nd Method: Treat as an annuity, use financial calculator Find the EFF% (EAR) for the quoted rate: 10 shift Nom; 2 sift p/yr; EFF% = ?

94 INPUTS OUTPUT NI/YRPVFVPMT Use EAR = 10.25% as the annual rate in calculator.

95 What’s the PV of this stream? %

96 Comparing Investments You are offered a note that pays $1,000 in 15 months (or 456 days) for $850. You have $850 in a bank that pays a % nominal rate, with 365 daily compounding. You plan to leave the money in the bank if you don’t buy the note. The note is riskless. Should you buy it?

97 I PER = % per day. 1, days -850 Daily time line ……

98 Three solution methods 1. Greatest future wealth: FV 2. Greatest wealth today: PV 3. Highest rate of return: EFF%

99 1. Greatest Future Wealth Find FV of $850 left in bank for 15 months and compare with note’s FV = $1,000. FV Bank =$850( ) 456 =$ in bank. Buy the note: $1,000 > $

100 Calculator Solution to FV INPUTS OUTPUT NI/YRPV FV I PER =I NOM /M = /365 = per day. PMT

101 Find PV of note, and compare with its $850 cost: PV=$1,000/( ) 456 =$ Buy the note: $ > $ Greatest Present Wealth

INPUTS OUTPUT NI/YRPVFV PMT /365 = PV of note is greater than its $850 cost, so buy the note. Raises your wealth. Financial Calculator Solution

103 Find the EFF% on note and compare with 7.0% bank pays, which is your opportunity cost of capital: FV N = PV(1 + I) N $1,000= $850(1 + I) 456 Now we must solve for I. 3. Rate of Return

% per day INPUTS OUTPUT NI/YRPVFVPMT Convert % to decimal: Decimal = /100 = EAR = EFF%= ( ) = 13.89%. Calculator Solution

105 P/YR=365 NOM%= (365)= EFF%=13.89 Since 13.89% > 7.0% opportunity cost, buy the note. Using interest conversion

106 Amortization Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal payments.

PMT % -1, INPUTS OUTPUT N I/Y R PV FV PMT Step 1: Find the required payments.

108 Step 2: Find interest charge for Year 1. INT t = Beg bal t (I) INT 1 = $1,000(0.10) = $100

109 Repmt = PMT - INT = $ $100 = $ Step 3: Find repayment of principal in Year 1.

110 Step 4: Find ending balance after Year 1. End bal= Beg bal - Repmt = $1,000 - $ = $ Repeat these steps for Years 2 and 3 to complete the amortization table.

111 Amortization Table YEAR BEG BALPMTINT PRIN PMT END BAL 1$1,000$402$100$302$ TOT1, ,000

112 Interest declines because outstanding balance declines.

113 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.