Attention!

In Even weeks lecture starts earlier!!!

At 16.00 – 18.00 in room EF. 13-15
In odd weeks at 18.10 -19.40

Midterm exam: 26. October 2010.

Topic: present value calculations

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 Investment decisions and time value of money

„Res tantum valet quantum vendi protest”

A thing is worth only what someone else will pay for it.
(unknown)

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 Learning goals

1. Discuss the role of time value in finance

2. Understand the concepts of future and present
value
3. Find the future and present value of ordinary
annuity
4. Find the present value of a perpetuity

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 Materials to learn from
Lawrence J. Gitman: Principles of Managerial Finance,
Addison - Wesley 10th Edition – see sharepoint: CH4 +
web
– http://wps.aw.com/aw_gitman_pmf_11

Brealey and Myers: Principles of corporate Finance, West

Publishing Company
www.mhhe.com/business/finance

Lecture material

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 Basic principles of finance

Time value of money - a

dollar today worth more
than a dollar tomorrow
A safe dollar is worth
more than a risky one

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 Basic idea and theories

1. Theory of Present
Value
2. Castle-in-the –air
Theory

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 Castle-in-the-air Theory
Baloon theory by Lord Keynes
(1936)
Investor psychology
Follow others
Succesful investor: identify
timepoint of building castle in the
air, and buy before that point
„Tronics prosperity”

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 Theory of Present Value

Theory by John B.
Williams
Based on : dividends and
assumes long-term
decisions
Compares actual value
and real value

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 Basics

Yield
– Rate of return
– Rate of interest
– Income
Maturity
Nominal/ par/face value-the principal
Future and present value
Simple interest
Compound interest

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 Concept of time value of money postulate

All operations with money must be compared

between alternatives to find the best result.

Interest rate is a simple but prominent equivalent of

any change of time value of money.

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 Rate of return rule

We accept investments that offer rates of return

in excess of their opportunity cost of capital

Cost of capital invested: the return forgone by

NOT INVESTING in other securities

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 Future value and present value

Changing in time value of money gets future and

present nomination
Getting from present value to future value is called
compounding.
Getting from future value to present value is called
discounting.

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 PV and FV

PV – cash in hand today

FV – cash received at given future date

Time line – can be used to depict the cash flows

in time

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 Simple interest

Present value = discount future value by an appropriate

interest rate
Interest rate – opportunity cost of capital
PRINCIPAL – AMOUNT OF MONEY ON WHICH INTEREST IS
PAID
Up to 1 year
PV= FV / (1+ r)
FV = PV ( 1+ r)
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 Where to use simple interest

Money market instruments

– Treasury bills (T-bill)
– Local authority/ public utility bills
– Certificate of deposit (CD)
– Commercial paper (CP)
– Bill of exchange
– Bankers` acceptance (BA)

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 Money market

Short term instruments

Pure discount securities
Contracts up to 1 year
Huge volume and vigorous competition
No physical place
Essentially for professionals ( banks,institutional investors,
brokerage firms, companies)
Liquidity ( fine spreads based on interest rate of lending and
borrowing)
Creditworthiness
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 Money market securities

T-bills
– Domestic instruments issued by governments to raise short term finance
balancing cashflow
– Non-interest bearing and interest-bearing, sold at discount in auction
– Negotiable
– Generally 13,26,52 weeks
Certificate of deposit - CD
– Usually issued by banks, is simple the evidence of time deposit
– Negotiable not as time deposit
– Sold at discount or pay coupon
– Interest payed at maturity
– 30 days to 3 month or could be longer

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 Money market securities 2

Commercial paper- CP
– Issued by large, safe and well-known companies
bypassing banks to achieve lower borrowing rates
(sometimes below the bank’s prime rate)
– Very short term (max 270 days, most 60days or less)
– Issued at discount
– Unsecured security

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 Money market securities 3

Trade bill, bills of exchange, bankers’acceptance

– Used by companies for trade purposes
– The seller draws up a bill to the buyer to pay and
asks to sign it
– Could be sold at a discount to the bank
– Bank’s signature is a guaranty ( eligible bills in UK
the Bank of England is the guarantor)

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 HELP!!!

Computational tools for

finding PV and FV:
– Financial tables
– Financial Calculators
– Computers and
spreadsheets

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 FV
FV = PV ( 1+ r)t PV = $100
r = interest rate r = 10%
PV = recent cashflow FV = ?
t = 1 year
FV = future cashflow
t = 3 years
t = time period FV = 100 (1 + 0.10) = 110
FVIF= (1 + r)t FV = 100 (1.10)3 = 133.
FV = PV ( FVIF)

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 Future value and present value
(1 + r)ⁿ is a future value factor (FVF)
To simplify calculations of FV use table of FVF.
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 1,01 1,02 1,03 1,04 1,05 1,06 1,07 1,08 1,09 1,1

2 1,02 1,04 1,06 1,08 1,10 1,12 1,14 1,17 1,19 1,21

3 1,03 1,06 1,09 1,12 1,16 1,19 1,23 1,26 1,295 1,33

4 1,04 1,08 1,13 1,17 1,22 1,26 1,31 1,36 1,41 1,46

5 1,05 1,1 1,16 1,22 1,28 1,34 1,40 1,47 1,54 1,61

6 1,06 1,13 1,19 1,27 1,34 1,42 1,50 1,59 1,68 1,77

7 1,07 1,15 1,23 1,32 1,41 1,50 1,61 1,71 1,83 1,94

8 1,08 1,17 1,27 1,37 1,48 1,59 1,72 1,85 1,99 2,14

9 1,09 1,20 1,30 1,42 1,55 1,69 1,84 1,999 2,17 2,36

10 1,1 1,22 1,34 1,48 1,63 1,79 1,97 2,16 2,37 2,59
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 Nominal and Effective Annual Rate
of Interest (EAR)
EAR = (1+ r/t )t - 1

EAR …?…. with increasing compounding

frequency

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 Compound Interest 1

Invetments for more than 1 year

Contracts in the capital markets

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 Capital market

Instruments
– Bonds
– Government bonds
– Local authority papers
– Mortgage or other assets backed bonds
– Corporate
– Foreign
– Junk
– Shares
– Preferred
– Normal
Innovations
– Convertibles
– Variables
Investment notes 25
 Present Value

PV = $125 DF = PV / FV
FV = $132 DF = 125: 132 = 0.899
r=?
PV = FV / DF
DF = discount factor
DF = 1 / 1 + r

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 2. Future value and present value
Table of present value factor
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0,99 0,98 0,97 0,96 0,95 0,94 0,935 0,93 0,92 0,91

2 0,98 0,96 0,94 0,92 0,91 0,89 0,87 0,86 0,84 0,83

3 0,97 0,94 0,92 0,89 0,86 0,84 0,82 0,79 0,77 0,75

4 0,96 0,92 0,89 0,85 0,82 0,79 0,76 0,74 0,71 0,68

5 0,95 0,91 0,87 0,82 0,78 0,75 0,71 0,68 0,65 0,62

6 0,94 0,89 0,84 0,79 0,75 0,70 0,67 0,63 0,596 0,56

7 0,93 0,87 0,81 0,76 0,71 0,67 0,62 0,58 0,55 0,51

8 0,92 0,85 0,79 0,73 0,68 0,63 0,58 0,54 0,50 0,47

9 0,914 0,84 0,77 0,70 0,64 0,59 0,54 0,50 0,46 0,42

10 0,905 0,82 0,74 0,68 0,61 0,56 0,51 0,46 0,42 0,39

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Compound Interest 2

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 Compound Interest 3

DF8 = 0.285
FV8 =CF8 = $ 596
PV = ?
PV = FV (DF) = 596 X 0.285 = $170

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 Valuing more assets

We have plenty of investments:

PV = PV1 + PV2 + PV3 + ….+ PVn

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 Basic patterns of cash flow

Single amount : a lump sum amount

Annuity : A level periodic stream –fixed amount
for fixed period of time
Mixed stream: stream of CF that reflects no
particular pattern
Perpetuity: fixed amount of payments forever

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 Annuities

Asset that pays a fixed sum each year over a

specified period of time
Outflows or inflows
Expl: house mortgage, Installment credit, bond
Types:
– annuity due ( CF at the begining)
– Ordinary annuity ( CF at the end of each period)

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 Annuities 2

End of year CF
1 100
2 100
3 100
4 100
5 100

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 Annuities 3
The model of annuities present value calculation is:
PVa = cf / (1 + r)¹ + cf / (1 + r)² + cf / (1+ r)³ + … + cf / (1+ r)ⁿ-1;
Matematical expression:
PVIFAr, t = 1 / r X ( 1 - 1/ (1 + r)t

Pva = CF X PVIFA

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 Calculating The Future Value of an Annuity

Fred wishes to determine

how much money he will
have at the end of 5
years, if he puts $1000 at
the end of each year.
The saving account pays
7% interest per annum

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 Future and present value of stream of
cash flow
Table of future value factor of annuity
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00 1,00
2 2,01 2,02 2,03 2,04 2,05 2,06 2,07 2,08 2,09 2,1
3 3,03 3,06 3,09 3,12 3,15 3,18 3,22 3,25 3,28 3,31
4 4,06 4,12 4,2 4,25 4,31 4,38 4,44 4,51 4,57 4,64
5 5,1 5,2 5,3 5,42 5,53 5,64 5,75 5,87 5,99 6,11
6 6,2 6,3 6,5 6,63 6,8 6,98 7,15 7,34 7,52 7,72
7 7,2 7,4 7,7 7,898 8,14 8,39 8,65 8,92 9,2 9,49
8 8,3 8,6 8,9 9,21 9,55 9,897 10,26 10,64 11,03 11,45
9 9,4 9,8 10,16 10,58 11,03 11,49 11,98 12,49 13,02 13,58
10 10,5 10,95 11,46 12,01 12,58 13,18 13,82 14,49 15,19 15,94

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 Calculating The Future Value of an Annuity

Years amount PV
CF = $1000
t = 5 years 1. 1000 1311
r = 7% 2. 1000 1225
FVa = CF X FVIFA 3 1000 1145
FVa = CF X ∑ (1 + r )t-1 4. 1000 1070
5. 1000 1000
? 5000 5751

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 Table of present value annuity factor
Years 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0,99 0,98 0,97 0,96 0,95 0,94 0,93 0,925 0,917 0,91

2 1,97 1,94 1,91 1,89 1,86 1,83 1,81 1,78 1,76 1,74

3 2,94 2,88 2,83 2,76 2,72 2,67 2,62 2,58 2,53 2,49

4 3,90 3,81 3,72 3,63 3,55 3,47 3,39 3,31 3,24 3,17

5 4,85 4,71 4,58 4,45 4,33 4,21 4,10 3,99 3,89 3,79

6 5,796 5,60 5,42 5,24 5,08 4,91 4,77 4,62 4,49 4,36

7 6,73 6,47 6,23 6,00 5,79 5,58 5,39 5,21 5,03 4,87

8 7,65 7,33 7,02 6,73 6,46 6,21 5,97 5,75 5,53 5,33

9 8,57 8,16 7,79 7,44 7,11 6,8 6,52 6,25 5,99 5,76

10 9,47 8,98 8,73 8,11 7,72 7,36 7,02 6,71 6,42 6,14

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Thank you 

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