I H C HOA SEN Khoa Kinh t Thng m i

KHOA KINH T THNG M I

CORPORATE FINANCE
ThS. Nguy n T ng Minh Email: minh.nguyentuong@yahoo.com.vn

CORPORATE FINANCE
CHAPTER 2 THE TIME VALUE OF MONEY

References
Fundamentals of Corporate Finance, Brealey et al., McGraw Hill, 5th edition, USA, 2007. Foundation of Financial Management, Block & Hirt, McGraw Hill, 12th edition,USA, 2008. Other relevant materials.

Chapter 2: THE TIME VALUE OF MONEY

Main Contents:
1. 2. 3. 4. Future values and Compound interest Present values Multiple cash flow Level cash flow: Perpetuities and Annuities 5. Inflation and the time value of money 6. Effective annual interest rate

I. Future values and Compound interest

Interest = interest rate x initial investment

Capital after the 1st year Capital after the 2nd year

= = = =

initial investment x (1 + interest rate) capital after the 1st year x (1 + interest rate) initial investment x (1 + interest rate)2 initial investment x (1 + interest rate)t

Capital after the t year

Present value Future value

I. Future values and Compound interest (contd)

Future value after the t year = Present value x (1 + interest rate)t

+ $6 r = 6% 0 Saving $106 1

+ $6.36 $112.36 2

+ $6.74 $119.10 3

Present value

Why do the interest after each year higher than the privous ones ?

Future value

because interests are calculated based on original investment and its interest of previous years

I. Future values and Compound interest (contd)

I. Future values and Compound interest (contd)

I. Future values and Compound interest (contd)

Compound interest earning interest on interest
Accumulated interest over periods

Interest

Original investment

Simple interest

interest only from the original investment

Interest

Original investment

Accumulated interest over periods

I. Future values and Compound interest (contd)

Do you know ??? MANHATTAN Island
1626, bou

ght with 2 $ 4

Peter Minuit ??? How much equivalent in 2006 value ? The average standard of interest rate is 3.5% 24(1+3.5%)380 = 11,427,000 USD
outstanding successful deal!!!

I. Future values and Compound interest (contd)

II. Present Values

Now!!!! offered $100,000 A dollar today is worth more than 1 dollar tomorrow At the year-end!! offered $100,000

Time value of money

Time 0 1 2 3 4 5 t

II. Present Values (contd)

Original investment (Present Value) Receiving value (Future Value)

Int 1

Int 2

Int 3

+
0 1

+
2

+
Time 3
t

FV = PV (1 + r ) FV PV = (1 + r )t

II. Present Values (contd)

How much do we need to invest now in order to produce $106 at the end of the year with interest rate of 6% ?

FV 106 PV = = = $100 t 1 (1 + r ) (1 + 6%)

II. Present Values (contd)

$3,000

$2,600

Strategy 1: Save money in 1 year, interest rate 8%

Strategy 2: Save money in 2 year, interest rate 8% suggestion

Which strategy should he select ?

Calculate PV of each strategy, and compare with his available fund If PV < available fund: select the strategy

II. Present Values (contd)

The longer the time before you must make a payment, the less you need to invest today

II. Present Values (contd)

Discount factor

1 PV = FV (1 + r )t

Discount factor

To measure the PV of $1 received in year n

II. Present Values (contd)

Finding the value of free credit
$20,000

Down payment: $8,000

The 2nd pay out: $12,000

Free credit provider

No free credit privided Discount $1,000

Which company should you select ? PV = 20,000 1,000 = $19,000 Choose Toyota for cheaper purchasing

II. Present Values (contd)

Finding the interest rate

issue

How much is the interest rate ?

t

Repay $1,000 paid at the end of 25 years Price of IOU: $129.20

1 PV = FV (1 + r ) r = ...

III. Multiple Cash Flow

Single CF2 Single CF1 Multiple CF Single CF3 Single CF4

FV = PV (1 + r )t FV PV = t (1 + r )

A single cash flow

Now, we calculate the FV, PV of a Multiple Cash Flow

III. Multiple Cash Flow (contd)

Future Value of multiple cash flow

2 years later

Year 1: deposit $1,200 Year 2: deposit $1,400 r = 8%

How much will he spend on a laptop after 2 years ?

III. Multiple Cash Flow (contd)

III. Multiple Cash Flow (contd)

Present Value of multiple cash flow 2
drawing 2 strategies Installment plan

Down payment: $8,000

$16,000

Year 1: $4,000 Year 2: $4,000 r = 8%

Pay $15,500 at once (deducted $500)

Which strategy should be chosen ?

III. Multiple Cash Flow (contd)

Present Value of multiple cash flow (contd)

< $15,500

The strategy 2 of installment plan should be chosen

III. Multiple Cash Flow (contd)

Present Value of multiple cash flow (contd) Characteristics of PV of a stream of future cash flows
is the amount that needs to be invested today to generate the stream of future cash flows.

Total future cash flow: - $16,000 Available cash: $15,133.06

Dont worry

Total of PV of future cash flow = available cash = $15,133.06

III. Multiple Cash Flow (contd)

Present Value of multiple cash flow (contd)
to prove this:

IV. Level Cash flows: Perpetuity and Annuity

Iphone5 0

$x 1

$x 2

$x 3

$x 4

Annuity

$x 0 1

$x 2

$x 3

$x 4

. .

Perpetuity

IV. Level Cash flows: Perpetuity and Annuity (contd)

What is an annuity and a perpetuity ?

Annuity
sequence of equal cash flow with a determined last period

Perpetuity
sequence of equal cash flows that never end

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value perpetuity

issue

Bank of England

Consols

Cash flow of 1 Consol $10 0 1 $10 2 $10 3 $10 . 4 .

Market interest rate: 10% Value of the consol = PV of the endless cash flow

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value perpetuity (contd) Cash flow of 1 Consol $10 0 1 $10 2 $10 3 $10 . 4 .

Market interest rate: 10%

Cash payment from perpetuity = interest rate x C = r x PV

PV

PV =

C r

PV of 1 consol = 10/10% = $100

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value perpetuity (contd)

Endow in finance $100,000 per year, forever Generous man r= 10%

How much is the amount that the man must set aside today ?

C 100,000 PV = = = $1,000,000 r 10%

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value perpetuity (contd)

Market interest rate: 10%

Generous man

$10 1 2 3 4

$10 5

. .

PV

C 1 100,000 1 PV = x = x = $751,314.80 t 3 r (1 + r ) 10% (1 + 10%)

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value perpetuity (contd)

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities

1 1 PV = C t r r (1 + r ) 1 (1 + r )t PV = C r

Annuity factor

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd) Kangaroo Autos offer a payment scheme of $4,000 a year at the end of each of the next 3 years, r = 10% $4,000 0 1 $4,000 2 $4,000 3

1 (1 + r )t PV = C r

1 (1 + 10%)3 = $9,947.41 = 4000 10%

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd) Receive equally installments each year: $11.828 mio. Total year: 25. Interest rate: 5.9%
Lottery winner of $295.7 mio

$11.828 0 1

$11.828 2

$11.828 25

1 (1 + r )t PV = C r
It is a fair trade ? - No!!!

1 (1 + 5.9%)25 = $152.6mio = 11.828 5.9%

What is a solution ? -Lottery winner receives the down payment of $143.1 mio

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd) If he could live more 30 years, how much could Bill Gates spend yearly as taking his $46bio ? His money is invested to earn 9%.
Bill Gates the richest man of $46 bio

PV = $46 bio 0

$? 1

$? 2
t

$? 30

1 (1 + r ) PV = C r 46 C = = $4.48bio 1 (1 + 9%) 9%
52

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd)

Price: $125,000
Pay down 20% Lending 80% of the cottage price r= 1% per month t= 30 years What is the monthly mortgage payment ?

PV = $100,000 0

$? 1

$? 2

$? 360

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd)
1 (1 + r ) PV = C r 100 ,000 C = 1 (1 + 1 %) 1%
t

= $ 1,028 . 61

DETAIL OF THE MONTHLY DEBT PAYMENT

Months of repayment

Beginning of month balance $100,000 $99,971.39

1 2 360

063

Interest

Amortization of loan

Monthend payment

End of month balance

$1,000 $999.71

$28.61 $28.9

$1,028.61 $99,971.39 $1,028.61 $99,942.49

IV. Level Cash flows: Perpetuity and Annuity (contd)

How to value annuities (contd)

IV. Level Cash flows: Perpetuity and Annuity (contd)

Annuities Due
value of a stream of cash payments starts immediately (at the beginning of a period).

Future value of an annuity

FV of an annuity =

(1 + r ) 1 C r
t

1 (1 + r ) PV of an annuities due = C r

(1 + r )

IV. Level Cash flows: Perpetuity and Annuity (contd)

Future value of an annuity (contd) r= 8%
$13,000

$3,000 0 1

$3,000 2

$3,000 3

$3,000 4

Can you buy this red car at the end of year 4 ?

You can buy the red car

FV of an annuity = C

(1 + r ) 1 (1 + 8%) 1 = 3000 = $13,518.34 r 8%

IV. Level Cash flows: Perpetuity and Annuity (contd)

Future value of an annuity (contd)
in 50 more years

$500,000 r= 10% will be retired

How much could she save each year from this year ?

05

FV of an annuity = C

(1 + r ) 1 r 500,000 C = = $429.59 (1 + 10%) 1 10%

IV. Level Cash flows: Perpetuity and Annuity (contd)

Annuities due
t

FV of an annuities due = C

(1 + r ) 1 (1 + r ) r

in 50 more years

$500,000 r= 10% will be retired If she save the money at the beginning of each year, how much should she deposit ? C = ??? Compare outcome with the previous FV annuity, any conclude about this?

V. INFLATION AND THE TIME VALUE OF MONEY

Investment return 6%

Inflation 10%

value of money is eroded

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Real versus Nominal Cash flow
What can be used for measuring the inflation rate ? CPI used for measuring the inflation rate.

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Real versus Nominal Cash flow (contd)

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Real versus Nominal Cash flow (contd)
What is the nominal dollar ? refer to the actual number of dollars

What is the real dollar ? refer to the amount of purchasing power

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Real versus Nominal Cash flow (contd)
buy In 1990
pr ov i

Pay monthly $800 for 30 years

de

lo an

Year 1990 2011

CPI 133.8 190.3

??? What is the real monthly payment of 2011 compared with real 1990 dollar ?

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Real versus Nominal Cash flow (contd)
??? What is the real monthly payment of 2011 compared with real 1990 dollar ?

CPI increased (1990/2011): Real payment of 2004 compared with 1990:

What do you think the real amount paid in 2011 with that in 1990 ?

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate

investment(1 + normal interest rate) Real FV of investment = 1 + inflation rate 1 + Real interest rate = 1 + normal interest rate 1 + inflation rate

What is the nominal interest rate ? rate at which money invested growths interest rate board of commercial banks

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

invest to earn interest rate: 6%

simultaneously, reduce the income with inflation rate of 2% how much is the real interest rate ?

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

Attention!!!

In reality, if nominal interest rate and inflation rate are small, the real interest rate will be

Real interest rate = nominal interest rate inflation rate

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)
compare the nominal and real values of investment under the inflation rate of 7% and nominal interest rate of 10%

Nominal Interest rate FV (after 1 year) PV 10% $100 $90.91

Real 2.8% $93.46 $90.91

Nominal PV and Real PV are equal to each other

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

His total assets: $46 bio. Spend $4.5 bio per year, in 30 years Interest rate = 9% Inflation rate = 5% He would like to ensure the same power of purchasing of 2042 as in 2012

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

He would like to ensure the same power of purchasing of 2042 as in 2012 Solution Spend less in 2012 and then increase expenditure in line with inflation Real interest rate: . Annual spending in 2012:.

V. INFLATION AND THE TIME VALUE OF MONEY (contd)

Inflation and interest rate (contd)

VI. EFFECTIVE ANNUAL INTEREST RATE

Borrow $100 Interest 1% per month

Putting off the payment up to 1 year

Total payment after 1 year: 100(1+1%)12= $112.68

VI. EFFECTIVE ANNUAL INTEREST RATE (contd)

0 $100 1 $112.68

How much is the equivalent interest rate? 12.68%

Effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

VI. EFFECTIVE ANNUAL INTEREST RATE (contd)

Method to convert to effective annual interest rate from an annual percentage rates (APRs) APRs: annualized by multiplying the rate per period by the number of period in a year.

Steps to convert to effective annual interest rate 1 Take the quoted APR divided by the number of compounded period in a year Monthly interest: APR / 12 Quarterly interest: APR / 4 Semi-annually interest: APR / 2

VI. EFFECTIVE ANNUAL INTEREST RATE (contd)

Steps to convert to effective annual interest rate (contd)

Convert to effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

1 + effective annual interest rate = (1 + quarterly rate)4

1 + effective annual interest rate = (1 + semi-annually rate)2

VI. EFFECTIVE ANNUAL INTEREST RATE (contd)

Why do we use the effective annual interest rate ?

To measure the actual income of the depositors or expense of the borrowers

LAST SELF TEST A car loan requiring quarterly payments carries an ARP of 8 percent. What is the effective annual rate of interest ?

Thank you for your attention !