S 4,5 - Time Value of Money

S 4,5 - Time value of money -
Discounted cash flow valuation
B.B.Chakrabarti
Professor of Finance
Time Value of Money
• Time value of money refers to the fact that
Rs.100 in hand today is worth more than
Rs.100 at a future point of time.
• This is because we can earn interest by
investing the money in hand and so, its value
at a future point of time becomes more than
Rs.100 due to addition of interest amount.
Compounding and Discounting
The future and present values of a sum of money are
linked as follows:
FV = PV * (1 + r/m)^mT
where
FV = future value
PV = present value
r = rate of interest per annum
T = number of years
m = compounding frequency
Compounding and Discounting
The present value of a future sum of
money can be determined as follows:
PV = FV * [1/(1+r/m)^mT]
1/(1+r/m)^mT is the PV factor.

How Long is the Wait?
If we deposit Rs.5,000 today in an account paying 10%,
how long does it take to grow to Rs.10,000?
FV  C0  (1  r )T (1.10)T
 Rs.5,000
Rs.10,000
T Rs.10,000
(1.10)  2
Rs.5,000
ln( 1.10)  ln( 2)

T
ln( 2) 0.6931
T   7.27 years
ln( 1.10) 0.0953
What Rate Is Enough?
Assume the total cost of a college education will be
Rs.50,000 when your child enters college in 12 years. You
have Rs.5,000 to invest today. What rate of interest must
you earn on your investment to cover the cost of your
child’s education?
12
FV  C0  (1  r ) T  Rs.5,000
Rs.50,000 (1r)
12 Rs.50,000 (1  r )  10
1 12
(1r)  10
Rs.5,000
112
r 10 11.2115
1.2115
21.15%
Multiple Cash Flows
• Consider an investment that pays Rs.200 one
year from now, with cash flows increasing by
Rs.200 per year through year 4. If the interest
rate is 12%, what is the present value of this
stream of cash flows?
• If the issuer offers this investment for
Rs.1,500, should you purchase it?
Multiple Cash Flows
0 1 2 3 4
200 400 600 800

178.57
318.88
427.07
508.41
1,432.93
Present Value < Cost → Do Not Purchase
Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:
mT
 r
FV  C0  1  
 m
Compounding Periods
 For example, if you invest Rs.50 for 3 years

at 12% compounded semi-annually, your
investment will grow to
2 3
 .12 
FV  Rs.50  1    Rs.50  (1.06) 6  Rs.70.93
 2 
Effective Annual Rates of Interest
A reasonable question to ask in the above
example is “what is the effective annual rate of
interest on that investment?”
.12 23
FV  Rs.50 (1  )  Rs.50 (1.06)6  Rs.70.93
2
The Effective Annual Rate (EAR) of interest is the
annual rate that would give us the same end-of-
investment wealth after 3 years:
Rs.50(1 EAR)3  Rs.70.93,
or,EAR12.36%
So, investing at 12.36% compounded annually is the
same as investing at 12% compounded semi-
annually.
Some Cash Flow Streams
• Perpetuity
– A constant stream of cash flows that lasts forever
• Growing perpetuity
– A stream of cash flows that grows at a constant rate
forever
• Annuity
– A stream of constant cash flows that lasts for a fixed
number of periods
• Growing annuity
– A stream of cash flows that grows at a constant rate for a
fixed number of periods
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3
C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
C
PV 
r
Perpetuity: Example
What is the value of a British consol that
promises to pay £15 every year for ever?
The interest rate is 10-percent.
£15 £15 £15

…
0 1 2 3
£15
PV   £150
.10
Growing Perpetuity
A growing stream of cash flows that lasts forever
C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3
C
PV 
rg
Growing Perpetuity: Example
The expected dividend next year is Rs.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?
Rs.1.30 Rs.1.30×(1.05) Rs.1.30 ×(1.05)2

…
0 1 2 3
Rs.1.30
PV   Rs.26.00
.10  .05
Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T
C C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
(1  r ) T
C 1 
PV  1  T 
r  (1  r ) 
Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on 36-
month loans?
$400 $400 $400 $400


0 1 2 3 36
$400  1 
PV  1 36 
 $12,954.59
.07 / 12  (1  .07 12) 
What is the present value of a four-year annuity of $100
per year that makes its first payment two years from today if the
discount rate is 9%?
4
$100 $100 $100 $100 $100
PV1   t
 1
 2
 3
 4
 $323.97
t 1 (1.09) (1.09) (1.09) (1.09) (1.09)
$297.22 $323.97 $100 $100 $100 $100
0 1 2 3 4 5
$327 .97
PV   $297 .22
0 1.09
Growing Annuity
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1


0 1 2 3 T
T 1
C C  (1  g ) C  (1  g )
PV   
(1  r ) (1  r ) 2
(1  r ) T
C   1 g  
T
PV  1    
r  g   (1  r )  
 
Growing Annuity: Example
A defined-benefit retirement plan offers to pay Rs.20,000 per
year for 40 years and increase the annual payment by 3% each
year. What is the present value at retirement if the discount
rate is 10%?
Rs.20,000 Rs.20,000×(1.03) Rs.20,000×(1.03)39


0 1 2 40
Rs.20,000   1.03 
40 
PV  1      Rs.265,121.57
.10  .03   1.10  
 
Growing Annuity: Example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?
$8,500  (1.07) 2  $8,500  (1.07) 4 
$8,500  (1.07)  $8,500  (1.07) 3 
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77
0 1 2 3 4 5
$34,706.26
Additional Problems
Microsoft Office
Excel 97-2003 Worksheet

S 4,5 - Time Value of Money

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S 4,5 - Time value of money -

Discounted cash flow valuation

1/(1+r/m)^mT is the PV factor.

ln( 1.10)  ln( 2)

200 400 600 800

 For example, if you invest Rs.50 for 3 years

£15 £15 £15

Rs.1.30 Rs.1.30×(1.05) Rs.1.30 ×(1.05)2

$400 $400 $400 $400

$297.22 $323.97 $100 $100 $100 $100

A growing stream of cash flows with a fixed maturity

C C×(1+g) C ×(1+g)2 C×(1+g)T-1

Rs.20,000 Rs.20,000×(1.03) Rs.20,000×(1.03)39

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