Annuities and Present Value

Continuing our analysis of the time value of money.

Revised by DBH 1/2006

Scenario

You are age 35 today and you start to think for the first time about retirement. You calculate a careful budget and find you have only $100 per month you can set aside for retirement savings. Is it even worth it? Suppose we can invest in an investment fund that historically pays an average rate of 8% Lets do the math

Do the Math (#1)

Monthly payment into fund (enter as negative) -$100.00 Interest Rate 8% per annum 0.006666667 monthly PV (Initial start-up money) 0 Time: 30 years 360 months Accumulation (FV function) $149,035.94

With disciplined investing, you could accumulate a fund of $149,000+ depositing only $100 per month at 8%. (Many securities funds have historically done better than 8%)

How much do I need now for later?

Suppose youve done that for 30 years and have accumulated your fund. You determine you need $1,200 per month over your Social Security to survive in retirement. If you expect to live 20 more years (to age 85) can you do it on your little fund?

Do the Math #2
Monthly payment from fund Interest rate 8% per annum Future value of fund at end (pay out) Time 20 years Present value (size of fund required) PV $1,200.00 0.006666667 0 240 ($143,465.15)

You should have little trouble living for 20 years with your retirement fund provided you are a disciplined investor and spender.

Net Present Value

Businesses must make the same kinds of decisions we look at as individuals. They decide whether or not to invest in a project that will pay off gradually, over a period of years. But often, in these analyses, the cash flows from these investments are not always equalthey may increase or decrease as time passes This can be measured using a tool called Net Present Value (NPV function in Excel)this is explored in ch. 9.

A Simple Illustration of NPV

Lets assume a new project costs $1 million in initial capital investment on a given date (well call this Year 0). Over the next five years (Years 1 through 5), the project is projected to produce $280 K in annual new cash flow to the firm ($1.4 mil. over its life) Our hurdle rate (cost of capital) is 12%--we must earn at least 12% on any new investment to satisfy our stockholders Should we do the project?

Excel NPV calculation

Year 1 Year 2 Year 3 $280,000 $280,000 $280,000

Year 4
Year 5

$280,000
$280,000

NPV at 12% Less Initial Inv. (Year 0)

Net Present Value

$1,009,337 -$1,000,000
$9,337

The NPV function in Excel calculates the present value today of the cash flows for the next five years (discounted at 12%) Result= the project has a small positive NPV and can be approved. (It will earn at least 12%)

Suppose cash flows are uneven?

Suppose the cash flows were uneven but did better later in the project? Total cash flows are identical ( $1.4 million) Still a good idea? Not necessarilyin the case at right the NPV is negativeit wont earn 12% over its life. The earlier we can recover our cost, the more likely well meet our hurdle rate.

Year 1 Year 2 Year 3 Year 4 Year 5

$200,000 $250,000 $300,000 $300,000 $350,000

NPV Less Initial Inv. (Year 0) Net Present Value

$980,659 -$1,000,000 -$19,341

More to come

Well explore this concept a bit more in Chapter Nine and also illustrate a method of estimating the projected rate of return for a given project (Internal Rate of Return or IRR) The present value calculations would be a challenge to do by hand, but are easy using computerized financial functions.