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UV5137 Jun. 1, 2011 DEVELOPING FINANCIAL INSIGHTS: USING A FUTURE VALUE (FV) AND A PRESENT

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Jun. 1, 2011

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Base Case Starting Point

Most everyone is familiar with the concept that money placed in a savings account will grow to a larger amount as the years pass if the money in that account earns interest at a specified annual compounded rate. For example, $500 invested in a savings account that earns 10% interest compounded annually will grow to become $550 (i.e., $500 × 1.10) after one year, $605 (i.e., $550 × 1.10) after two years, and $665.50 (i.e., $605 × 1.10) after three years. 1

Think about the numerical example just depicted. It took three sequential calculations to arrive at the $665.50 answer—one calculation for each year involved. If the question had been posed as involving 12 years or even 25 years, a multitude of tedious, repetitive calculations would have been required. Is there a shortcut? Yes. If we take the 1.10 multiplier amount from each of the three parenthetical notations above and simply multiply them together—1.10 × 1.10 × 1.10—we get a numerical factor of 1.331. So, if some reference book could provide us with the 1.331 multiplier as being applicable to a 10% situation over three years, all we would have to do is take the initial $500 amount put into the savings account and multiply it by 1.331 to get the very same answer as above—$665.50.

Are there reference materials that provide such multipliers for a variety of interest and years combinations? Yes, there are, and they are referred to as future value (FV) factors. Such reference materials are useful because no matter the initial amount invested, a specified combination of time and interest will always have the same multiplier effect. Thus, future value factor tables are readily available, depicting a number of possible different interest rates along one axis and a number of different years along the other. 2 In fact, Exhibit 1 presents just such a

1 The 1.10 multiplier comes from the fact that in one year there will be 100% of that year’s starting monetary amount plus an additional 10% due to a year’s worth of interest having been accumulated at a 10% rate. Thus, 100% + 10% = 110%, which converts to an arithmetic multiplier of 1.10. 2 This case explores cash flows on an annual basis. Appendix 1 explains what to do when cash flows occur on a monthly or quarterly basis.

This case was prepared by Professor Mark Haskins. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright © 2011 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

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table. In it we can find the 10% column and the three-years row and find the multiplier amount at the intersection of those two table coordinates, and it is 1.331—the same as we determined it should be. Moreover, if we were using a financial calculator or Excel, the embedded programs in those tools would derive the exact same multiplier once we entered the data pertaining to years and interest rate.

Can We Reverse the Flow of Time?

In business, the basic question posed above often requires us to reverse the focus. For example, the question might be some form of “My customer is willing to pay me $665.50 in three years; what is the equivalent monetary amount, as of today, of that future receipt?” Pause for just a moment—the same basic interplay of time and interest described in the first example must be in play in this scenario also…right? Of course, but instead of a current invested monetary amount growing into a larger future amount due to the compounding of interest, we must now work with a stipulated future monetary amount and in essence, unwind, roll back in time, reverse the compounding of interest phenomenon. In this instance, we are being asked to ascertain the present value (PV)—the value today—of a future monetary amount, using the relevant interest and year information.

To do that, the process is simply the reverse of what we did earlier. So, if the relevant interest environment is 10% and the number of years is three, we execute the following three calculations:

1. $665.50 ÷ 1.10 = $605

2. $605 ÷ 1.10 = $550

3. $550 ÷ 1.10 = $500

Thus, receiving $665.50 in three years, when the interest rate environment is 10%, is equivalent to receiving $500 today. In short, this has to be true because as we saw earlier, if we invest $500 today in a savings account that pays 10% interest, that savings account balance will grow to become $665.50 in three years. Another way to state this is this: If, over the next three years, relevant interest rates are 10%, the economic value of $665.50 in three years is exactly equal to $500 today.

As before, this can become a laborious series of calculations if the number of years involved is substantial. And, just as before, there is a shortcut. Mathematically, whereas the compounding of interest phenomenon was a multiplicative mathematical task, the unwinding of a compounded interest phenomenon must be a divisive mathematical task. Specifically, we find

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that: 1 ÷ 1.10 = 0.90909, and then 0.90909 ÷ 1.10 = 0.82644, and finally, 0.82644 ÷ 1.10 = 0.7513. 3 And, if we take 0.7513 × $665.50, we get $500 (with a bit of rounding).

Are there reference materials that provide such factor multipliers for a variety of interest and year combinations when we are seeking to derive the present value of a future monetary amount? Yes, and they contain a host of PV factors. Such reference materials are useful because no matter the future amount to be received, a specified combination of time and interest will always have the same multiplier effect. Exhibit 2 provides an example of such a reference table. In it, we can find the 10% column and the three-years row and extract the multiplier factor at the intersection of those two coordinates and it is, just as we thought it should be, 0.7513. (Please note that the example depicted at the bottom of the table in Exhibit 2 is an additional one, different from the one discussed here.) Moreover, if we are using a financial calculator or Excel, the embedded algorithms in those tools use the same factor once we have entered into those tools the relevant number of years (three) and interest rate (10%).

Moving Beyond Single Ending or Starting Monetary Amounts

The two scenarios described above are emblematic of the simplest of situations—they both started with single monetary amounts to be compounded (the Exhibit 1-related example) or discounted (the Exhibit 2-related example). In many personal and business financial situations the reality is that there are multiple cash amounts coming in or going out over the course of a stipulated time period that are pertinent to the sought-after FV or PV. Let’s lay the foundation for those sorts of scenarios.

Assume you invest $80 today and at the beginning of each of the next two years for a total of three such deposits, in a 6% savings account. At the end of three years, what will that account have in it? Clearly, we could answer that question by applying the technique and Exhibit 1 factors we described and used in the very first example. That is, we could find the future value of three lump sums—one of which is invested for three years, one of which is in the account for two years, and one of which is invested for only one year. In fact, at the bottom of Exhibit 3, this approach is depicted. But there is an easier, quicker way. Since this scenario involves three applications of the Exhibit 1 factors, we can develop reference materials that accumulate the effects of a variety of multiple applications of Exhibit 1’s factors. Indeed, the Exhibit 3 factors portray such accumulations. Please note that the Exhibit 3 factors are various summations of sequential Exhibit 1 factor amounts for a given interest rate. For this scenario’s three deposits in a 6% savings account, the Exhibit 3 factor is 3.375, which is the sum of the Exhibit 1 6% factors associated with one year, two years, and three years (1.06 + 1.1236 + 1.191, subject to minimal rounding). So 3.375 × $80 = $270, the amount to which three (starting today) annual invested amounts of $80 each grow to in a 6% account at the end of three years.

3 Some readers may have anticipated, or be interested to note, that the 0.7513 present value multiplier figure can also be derived by the following: 1 ÷ (1.10)³, which is the same as 1 ÷ 1.331, which indeed equals 0.7513.

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As before, let’s reverse the direction of the time frame. Assume, for example, you are to receive $70 at the end of each of the next three years. The natural question to arise is, what is the single present value monetary amount, as of today, that is equivalent to that series of three receipts? Assuming a 12% interest rate environment, this question can be answered by applying the technique and Exhibit 2 factors that we used in an earlier example. If we were to pursue that approach, we would have to execute three separate calculations for each of the three $70 receipts—that approach is depicted at the bottom of Exhibit 4. 4 But as we were able to do in using Exhibit 1 to develop Exhibit 3, we can use Exhibit 2 to develop Exhibit 4, which in turn can then be used as a shortcut for PV situations with multiple cash flows in the future. Indeed, Exhibit 4 is simply the summation of Exhibit 2 factors for a variety of time periods within an interest rate column. So, in this example, we can easily go to Exhibit 4’s 12% column, three- years row, and find the factor of 2.402, which is the sum (with a bit of rounding) of the pertinent Exhibit 2 factors (0.8929 + 0.7972 + 0.7118). And 2.402 × $70 = $168.14. The interpretation of this present value is as follows: In a 12% interest rate environment, receiving $168.14 today is equivalent to receiving three payments of $70 at the end of each of the next three years.

Practice Your FV and PV Skills

1. You just turned 35 and have been saving for an around-the-world vacation. You want to take the trip to celebrate your 40th birthday. You have set aside, as of today, $15,000 for such a trip. You expect the trip will cost $25,000. The financial instruments you have invested the $15,000 in have been earning, on average, about 8%. (You may ignore income taxes.)

a. Will you have enough money in that vacation account on your 40th birthday to take the trip? What will be the surplus, or shortfall, in that account when you turn 40? (Hint: Exhibit 1 will be useful in answering this question.)

b. If you had to, you could further fund the trip by making, starting today, five annual $500 contributions to the account. If you adhered to such a plan, how much will be in the account on your 40th birthday? (Hint: Exhibit 3 and the answer to part (a) above will both be useful in answering this question.)

2. Your company has been offered a contract for the development and delivery of a solar- powered military troop transport vehicle. The request for proposal provides all the necessary technical specifications and it also stipulates that two working, economically feasible prototypes must be delivered in four years, at which time you will receive your only customer payment—a single and final payment of $50 million. Assume a reinvestment interest rate of 18% for all the monies received over the next four years. (You may ignore income taxes.)

4 Appendix 2 shows how to adjust the data in Exhibit 4 for cash flows at the beginning (instead of the end) of the year.

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a. What lump-sum dollar amount would you be willing to accept today instead of the $50 million in four years? (Hint: Exhibit 2 will be useful in answering this question.)

b. Alternatively, what four yearly receipts, starting a year from now, would you be willing to accept? (Hint: Exhibit 4 and the answer to part (a) above will both be useful in answering this question.)

3. The aged but centrally located golf course you manage does not have an in-ground automated water sprinkling system. Instead, to properly water the course, sprinklers and hoses must be repeatedly set, moved, and put away by some of the grounds crew—a tedious and laborious task. If over the next 12 years you project annual savings of about $40,000 from having an automated system, what is the maximum price you would be willing to pay today for an installed, automated golf course sprinkler system? (Assume an interest rate of 6%, and you may ignore income taxes.)

a. Redo your calculation using a 10-year time period and $48,000 in annual savings.

b. Redo your initial calculation one more time using $50,000 in annual savings for the first six years and $30,000 in annual savings for the next six years.

4. The cafeteria you operate has a regular clientele for all three meals, seven days a week. You want to expand your product line beyond what you are currently able to offer. To do so requires the purchase of some additional specialty equipment costing $45,000, but you project a resultant increase in sales (after deducting the cost of sales) of about $8,000 per year for each of the next eight years with this new equipment. Assuming a required rate of return (i.e., a hurdle rate) of 8%, should you pursue this opportunity? Why or why not? Do the analysis under two conditions:

a. You are part of an income-tax-exempt enterprise.

b. The enterprise you are part of is subject to a 40% corporate income tax rate, and the straight-line, depreciable life of the equipment you are contemplating purchasing is five years.

5. You are contemplating the purchase of a one-half interest in a corporate airplane to facilitate the expansion of your business into two new geographic areas. The acquisition would eliminate about $220,000 in estimated annual expenditures for commercial flights, mileage reimbursements, rental cars, and hotels for each of the next 10 years. The total purchase price for the half-share is $6 million, plus associated annual operating costs of $100,000. Assume the plane can be fully depreciated on a straight-line basis for tax purposes over 10 years. The company’s weighted average cost of capital (commonly referred to as WACC) is 8%, and its corporate tax rate is 40%. Does this endeavor present a positive or negative net present value (NPV)? If positive, how much value is being created for the company through the purchase of this asset? If negative, what additional annual cash flows would be needed for the NPV to equal zero? To what phenomena might those additional positive cash flows be ascribable?

6. The final tally is in: This year’s operating costs were down $100,000, a decrease directly attributable to the $520,000 investment in the automated materials handling system put in

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place at the beginning of the year. If this level of annual savings continues for five more years, resulting in six total years of annual savings, what compounded annual rate of return will that represent? If these annual savings continue for nine more years, what compounded annual rate of return will that represent? (You may ignore income taxes.)

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Exhibit 1

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Future Value Factors for a Single Lump Sum Invested Today for n Years:

Exhibit 1 Factors = (1 + Interest) years

Annual Interest Rates 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Years 1
Annual Interest Rates
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Years
1
1.0200
1.0400
1.0600
1.0800
1.1000
1.1200
1.1400
1.1600
1.1800
1.2000
2
1.0404
1.0816
1.1236
1.1664
1.2100
1.2544
1.2996
1.3456
1.3924
1.4400
3
1.0612
1.1249
1.1910
1.2597
1.3310
1.4049
1.4815
1.5609
1.6430
1.7280
4
1.0824
1.1699
1.2625
1.3605
1.4641
1.5735
1.6890
1.8106
1.9388
2.0736
5
1.1041
1.2167
1.3382
1.4693
1.6105
1.7623
1.9254
2.1003
2.2878
2.4883
6
1.1262
1.2653
1.4185
1.5869
1.7716
1.9738
2.1950
2.4364
2.6996
2.9860
7
1.1487
1.3159
1.5036
1.7138
1.9487
2.2107
2.5023
2.8262
3.1855
3.5832
8
1.1717
1.3686
1.5938
1.8509
2.1436
2.4760
2.8526
3.2784
3.7589
4.2998
9
1.1951
1.4233
1.6895
1.9990
2.3579
2.7731
3.2519
3.8030
4.4355
5.1598
10
1.2190
1.4802
1.7908
2.1589
2.5937
3.1058
3.7072
4.4114
5.2338
6.1917
11
1.2434
1.5395
1.8983
2.3316
2.8531
3.4785
4.2262
5.1173
6.1759
7.4301
12
1.2682
1.6010
2.0122
2.5182
3.1384
3.8960
4.8179
5.9360
7.2876
8.9161
13
1.2936
1.6651
2.1329
2.7196
3.4523
4.3635
5.4924
6.8858
8.5994
10.6993
14
1.3195
1.7317
2.2609
2.9372
3.7975
4.8871
6.2613
7.9875
10.1472
12.8392
15
1.3459
1.8009
2.3966
3.1722
4.1772
5.4736
7.1379
9.2655
11.9737
15.4070
16
1.3728
1.8730
2.5404
3.4259
4.5950
6.1304
8.1372
10.7480
14.1290
18.4884
17
1.4002
1.9479
2.6928
3.7000
5.0545
6.8660
9.2765
12.4677
16.6722
22.1861
18
1.4282
2.0258
2.8543
3.9960
5.5599
7.6900
10.5752
14.4625
19.6733
26.6233
19
1.4568
2.1068
3.0256
4.3157
6.1159
8.6128
12.0557
16.7765
23.2144
31.9480
20
1.4859
2.1911
3.2071
4.6610
6.7275
9.6463
13.7435
19.4608
27.3930
38.3376
example (assuming 10%):
Today
1
2
3
Start here
$100
× 1.10
$110
× 1.10
$121
× 1.10
$133.10
OR: $100.00 ×
1.331
=
$133.10
(so: PV amount × Exhibit 1 factor = FV amount)

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Exhibit 2

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Present Value Factors for a Single Amount n Years in the Future:

Exhibit 2 Factors = 1 ÷ Exhibit 1 Table Factor in the Same Cell

Annual Interest Rates 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Years 1
Annual Interest Rates
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Years
1 0.9804
0.9615
0.9434
0.9259
0.9091
0.8929
0.8772
0.8621
0.8475
0.8333
2 0.9612
0.9246
0.8900
0.8573
0.8264
0.7972
0.7695
0.7432
0.7182
0.6944
3 0.9423
0.8890
0.8396
0.7938
0.7513
0.7118
0.6750
0.6407
0.6086
0.5787
4 0.9238
0.8548
0.7921
0.7350
0.6830
0.6355
0.5921
0.5523
0.5158
0.4823
5 0.9057
0.8219
0.7473
0.6806
0.6209
0.5674
0.5194
0.4761
0.4371
0.4019
6 0.8880
0.7903
0.7050
0.6302
0.5645
0.5066
0.4556
0.4104
0.3704
0.3349
7 0.8706
0.7599
0.6651
0.5835
0.5132
0.4523
0.3996
0.3538
0.3139
0.2791
8 0.8535
0.7307
0.6274
0.5403
0.4665
0.4039
0.3506
0.3050
0.2660
0.2326
9 0.8368
0.7026
0.5919
0.5002
0.4241
0.3606
0.3075
0.2630
0.2255
0.1938
10 0.8203
0.6756
0.5584
0.4632
0.3855
0.3220
0.2697
0.2267
0.1911
0.1615
11 0.8043
0.6496
0.5268
0.4289
0.3505
0.2875
0.2366
0.1954
0.1619
0.1346
12 0.7885
0.6246
0.4970
0.3971
0.3186
0.2567
0.2076
0.1685
0.1372
0.1122
13 0.7730
0.6006
0.4688
0.3677
0.2897
0.2292
0.1821
0.1452
0.1163
0.0935
14 0.7579
0.5775
0.4423
0.3405
0.2633
0.2046
0.1597
0.1252
0.0985
0.0779
15 0.7430
0.5553
0.4173
0.3152
0.2394
0.1827
0.1401
0.1079
0.0835
0.0649
16 0.7284
0.5339
0.3936
0.2919
0.2176
0.1631
0.1229
0.0930
0.0708
0.0541
17 0.7142
0.5134
0.3714
0.2703
0.1978
0.1456
0.1078
0.0802
0.0600
0.0451
18 0.7002
0.4936
0.3503
0.2502
0.1799
0.1300
0.0946
0.0691
0.0508
0.0376
19 0.6864
0.4746
0.3305
0.2317
0.1635
0.1161
0.0829
0.0596
0.0431
0.0313
20 0.6730
0.4564
0.3118
0.2145
0.1486
0.1037
0.0728
0.0514
0.0365
0.0261
example (assuming 8%):
Today
1
2
3
$200.00
Start here
$158.77
1.08 ÷
$171.47
1.08 ÷
$185.19
1.08 ÷
OR: $200.00 ×
0.7938
=
158.76*
(So: PV amount = Exhibit 2 factor × FV amount)
*difference between $158.77 and $158.76 due to rounding

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Exhibit 3

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Future Value Factors for a Series of Invested Amounts at the Beginning of n Years:

Table Factors = Sum of Exhibit 1 Factors for Corresponding Cell and All Preceding Cells
Table Factors = Sum of Exhibit 1 Factors for Corresponding Cell
and All Preceding Cells for that Interest Rate
Annual Interest Rates
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Years
1
1.020
1.040
1.060
1.080
1.100
1.120
1.140
1.160
1.180
1.200
2
2.060
2.122
2.184
2.246
2.310
2.374
2.440
2.506
2.572
2.640
3
3.122
3.246
3.375
3.506
3.641
3.779
3.921
4.066
4.215
4.368
4
4.204
4.416
4.637
4.867
5.105
5.353
5.610
5.877
6.154
6.442
5
5.308
5.633
5.975
6.336
6.716
7.115
7.536
7.977
8.442
8.930
6
6.434
6.898
7.394
7.923
8.487
9.089
9.730
10.414
11.142
11.916
7
7.583
8.214
8.897
9.637
10.436
11.300
12.233
13.240
14.327
15.499
8
8.755
9.583
10.491
11.488
12.579
13.776
15.085
16.519
18.086
19.799
9
9.950
11.006
12.181
13.487
14.937
16.549
18.337
20.321
22.521
24.959
10
11.169
12.486
13.972
15.645
17.531
19.655
22.045
24.733
27.755
31.150
11
12.412
14.026
15.870
17.977
20.384
23.133
26.271
29.850
33.931
38.581
12
13.680
15.627
17.882
20.495
23.523
27.029
31.089
35.786
41.219
47.497
13
14.974
17.292
20.015
23.215
26.975
31.393
36.581
42.672
49.818
58.196
14
16.293
19.024
22.276
26.152
30.772
36.280
42.842
50.660
59.965
71.035
15
17.639
20.825
24.673
29.324
34.950
41.753
49.980
59.925
71.939
86.442
16
19.012
22.698
27.213
32.750
39.545
47.884
58.118
70.673
86.068
104.931
17
20.412
24.645
29.906
36.450
44.599
54.750
67.394
83.141
102.740
127.117
18
21.841
26.671
32.760
40.446
50.159
62.440
77.969
97.603
122.414
153.740
19
23.297
28.778
35.786
44.762
56.275
71.052
90.025
114.380
145.628
185.688
20
24.783
30.969
38.993
49.423
63.002
80.699
103.768
133.841
173.021
224.026
example (using 6%):
Today
1
2
3
Start here
from Exhibit 1
$80
$80
$80
× 1.06 =
$84.80
× 1.1236
$89.89
× 1.191
$95.28
$269.97
OR: $80.00 ×
3.375
=
270.00*
(So: PV amounts × Exhibit 3 factor = FV amount)
*di fference be tween $269.97 and $270.00 due to rounding
^Thi s exhibi t depicts fa ctors for annuities due (where the ca s h flows occur a t the s ta rt of ea ch yea r) a s opposed to an
ordinary annuity si tua tion (whe re the ca s h flows occur a t the end of the yea r). Mos t published ta bles of thi s s ort
a re for the la tter.

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February 2013 to August 2013.

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UV5137

Exhibit 4

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Present Value Factors for a Series of Amounts n Years in the Future:

Exhibit 4 Factors = Sum of Exhibit 2 Factors for Corresponding Cell and All Preceding Cells for that Interest Rate

Annual Interest Rates 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Years 1
Annual Interest Rates
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
Years
1
0.980
0.962
0.943
0.926
0.909
0.893
0.877
0.862
0.847
0.833
2
1.942
1.886
1.833
1.783
1.736
1.690
1.647
1.605
1.566
1.528
3
2.884
2.775
2.673
2.577
2.487
2.402
2.322
2.246
2.174
2.106
4
3.808
3.630
3.465
3.312
3.170
3.037
2.914
2.798
2.690
2.589
5
4.713
4.452
4.212
3.993
3.791
3.605
3.433
3.274
3.127
2.991
6
5.601
5.242
4.917
4.623
4.355
4.111
3.889
3.685
3.498
3.326
7
6.472
6.002
5.582
5.206
4.868
4.564
4.288
4.039
3.812
3.605
8
7.325
6.733
6.210
5.747
5.335
4.968
4.639
4.344
4.078
3.837
9
8.162
7.435
6.802
6.247
5.759
5.328
4.946
4.607
4.303
4.031
10
8.983
8.111
7.360
6.710
6.145
5.650
5.216
4.833
4.494
4.192
11
9.787
8.760
7.887
7.139
6.495
5.938
5.453
5.029
4.656
4.327
12
10.575
9.385
8.384
7.536
6.814
6.194
5.660
5.197
4.793
4.439
13
11.348
9.986
8.853
7.904
7.103
6.424
5.842
5.342
4.910
4.533
14
12.106
10.563
9.295
8.244
7.367
6.628
6.002
5.468
5.008
4.611
15
12.849
11.118
9.712
8.559
7.606
6.811
6.142
5.575
5.092
4.675
16
13.578
11.652
10.106
8.851
7.824
6.974
6.265
5.668
5.162
4.730
17
14.292
12.166
10.477
9.122
8.022
7.120
6.373
5.749
5.222
4.775
18
14.992
12.659
10.828
9.372
8.201
7.250
6.467
5.818
5.273
4.812
19
15.678
13.134
11.158
9.604
8.365
7.366
6.550
5.877
5.316
4.843
20
16.351
13.590
11.470
9.818
8.514
7.469
6.623
5.929
5.353
4.870
example (using 12%):
Today
1
2
3
from
Exhibit 2
$70
$70
$70
Start here
$62.50
.8929 ×
$55.80
.7972 ×
$49.83
.7118 ×
$168.13
OR: $70.00 ×
2.402
=
168.14*
(So: PV amount = Exhibit 4 factor × FV amounts)
*difference between $168.13 and $168.14 due to rounding
^ See Appendix 2 for a discussion of how to use this Exhibit when cash flows begin immediately.
This document is authorized for use only in PGPM - 02252013 by
Aniket Khera at Anytime Learning from February
2013 to August 2013.

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UV5137

Appendix 1

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (F) AND A PRESENT VALUE (PV) APPROACH

What to Do When Cash Flows Occur on a Monthly or Quarterly Basis

All the examples in this case involve annual time periods. It is not unusual for payments or receipts of cash to occur on a monthly or even a quarterly basis. There is an easy adjustment process to accommodate such alternative time frames. All that is required is to note that, unless stated otherwise, interest rates are always assumed to involve annual compounding. Thus, if the scenario under consideration involves quarterly cash flows, the vertical axes of the tables in Exhibit 1 through Exhibit 4 can be assumed to pertain to the number of quarters (instead of years) and the stated annual interest rate must be divided by 4 (because there are four quarters per year) before picking the appropriate interest rate column to use in the tables. So, if the desire is to ascertain the PV of a series of quarterly payments, beginning at the end of the first quarter, for the next three years, and the pertinent annual interest rate is 16%, these are the two required adjustments for using the tables:

1. The number of periods to use on the tables’ vertical axes is 12 (3 years × 4 quarters per year).

2. The interest rate to use on the tables’ horizontal axes is 4% (16% annual rate ÷ 4 compounding quarters per year).

In short, for a quarterly series of cash flows, we adjust the table axes coordinates by scaling up the number of periods by a multiple of 4 and scaling down the interest rate by a divisor of 4. Similarly, for a monthly series of cash flows, we adjust the table axes coordinates by scaling up the number of periods by a multiple of 12 and scaling down the interest rate by a divisor of 12. 1

1 Note: Technically, an interest rate of 16% compounded annually is not equivalent to a 4% rate compounded quarterly. The reason is that the interest earned on a quarterly basis is itself subject to the next quarter’s compounding, quarter after quarter. For example, $100 earning interest at a 16% annually compounded rate will grow to $116 at the end of one year. On the other hand, $100 earning interest at the rate of 4% compounded quarterly will grow to $117 at the end of one year. The fact that the two scenarios are not identical is assumed to be immaterial, and thus the adjustments described above are common when using FV and PV tables.

$100

×

1.04

=

$104

$104

×

1.04

=

$108.16

$108.16

×

1.04

=

$112.49

$112.49

×

1.04

=

$117

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February 2013 to August 2013.

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UV5137

Appendix 2

DEVELOPING FINANCIAL INSIGHTS:

USING A FUTURE VALUE (FV) AND A PRESENT VALUE (PV) APPROACH

Adjusting Exhibit 4 for Cash Flows at the Beginning (Instead of the End) of the Year

example (using 12%): Today 1 2 3 $70 $70 $70 Start here from Exhibit 2
example (using 12%):
Today
1
2
3
$70
$70
$70
Start here
from
Exhibit 2
$62.50
.8929 ×
$55.80
.7972 ×
$188.30
from Exhibit 4
OR: $70.00 × (1.69 + 1)
= $188.30
$70.00
× 2.69
= $188.30

At times, the series of cash flows for which a present value amount needs to be calculated begins at the start of each year as opposed to the end of each year. The discussion and example depicted in Exhibit 4 identifies the cash flows according to this latter pattern. It is not unusual, however, for the series of cash flows to begin immediately as depicted in the following revised Exhibit 4 example. Please note there are still three annual cash flows, they simply now begin at the start of their respective years.

Exhibit 4 can still be used to ascertain today’s PV of this series of cash flows. The way to do that involves two steps. First, use the appropriate interest rate column (12% in this example) and use the two-years row, instead of the three-years row as originally done. In Exhibit 4, that factor is 1.69, and it will be used to PV all the cash flow amounts except the very first one. Second, because the first cash flow item occurs today, its PV is equivalent to the cash flow amount itself. So, to value it, we simply add 1.0 to the 1.69 factor pertaining to the other cash flow amounts in the example, arriving at an adjusted table factor of 2.69. Using that adjusted factor in the following fashion, $70.00 × 2.69 = $188.30, we get the PV of a series of three annual amounts of $70 each, where the series begins today (immediately), as equaling $188.30. In the above depiction, this is verified by discounting each of the three amounts separately (using Exhibit 2 factors) and obtaining the same total PV amount.

This document is authorized for use only in PGPM - 02252013 by Aniket Khera at Anytime Learning from February 2013 to August 2013.