Time value of money Chapter 4
Introduction
Time value of money
An amount of money today is worth more than it will be at some point in time in the future (Why?)
• Risk
• Opportunity cost of capital
Should not be confused with a decrease in purchasing power (due to inflation)
An interest calculation involves:
• Calculating the end value – Future value (FV) of an amount invested in the present
A discounting calculation involves:
• Calculating the present value (PV) of an amount received at some point in the future
Nominal and effective interest rates
Nominal interest rate vs effective interest rate
• Interest is compounded when the amount earned on the initial principal becomes part of the
principal at the end of the first compounding period
• The effective interest rate should be used when evaluating returns – best possible returns
available
• The more regular the nominal interest rate is compounded during a year the higher the
effective interest rate
leftiron
I I
M
Where :
leff effective annual rate of interest
inom nominal annual interest rate
Calculations are based on nominal interest rates
Set up calculator
Future value
• The calculation of interest on a present amount to result in some future amount
Example
R10 000 is being placed in a savings account
calculator
Paying 10% interest compounded annually
What is earned (end value + interest) at the end
of the first year?
Equation for calculating future value (FV):
Where:
• FVn is the future value of the amount at the end of n periods
• PV is the initial principal
• i is the annual rate of interest paid
• n is the number of periods of the investment
Future value of an annuity
An annuity: a series of equal cash flows for each of a specified number of periods.
There are two types of annuities:
• Ordinary annuity : End
• Annuity due : Begin
Ordinary annuity
Equation for calculating an ordinary annuity:
Where:
• FVAn is the FV of an annuity at the end of n periods
• PMT is the amount invested periodically
• FVIFA is the future value interest factor for an annuity
• i is the annual interest rate
• n is the number of periods of the investment
Using the financial calculator; for
Calculate the FV of R 12 000 invested annually (at the end of each year) for 5 years
(Investors required rate of return - 15% - NACA)
Annuity due
• Invest at the beginning of each year!
• Use the previous example!
• Using the financial calculator; for example:
Equation for calculating an annuity due:
Where:
• FVn is the FV of an annuity at the end of n periods
• PMT is the amount invested periodically at the beginning of each period
• FVIF is the future value interest factor
• i is the annual interest rate
• n is the number of periods of the investment
Comparing future and present value
• Future value and present value are the inverse of each other:
Present value
The present value of a single amount
• Discounting determines the present value of a future amount.
• The opportunity to earn a certain rate – discount rate, required rate, cost of capital, opportunity
cost
For example:
I
• You have the opportunity to receive R1000,
1 year from now. If you can earn 16% if you
invest the amount, the present value of the
R1000 is:
Present value of a mied stream
Cash flow from various future periods
There are 2 types of cash flows:
• Mixed stream – no particular pattern
• Annuity – pattern of equal annual cash flows
For example, 12% return can be earned
Present value of an
annuity to infinity
• An annuity with an infinite life. Co
For example, receive a perpetuity of R1000
per year (end of each year) at 5%
Not in text book Two options for retirement:
• Life annuity • 1/3 cash lump sum and 2/3 reinvested in a life or living annuity
• Living annuity • Or Full amount invested in life or living annuity
Variations of future and present value techniques
3 Types:
• The calculation of the deposits needed to accumulate a future sum
• The amortisation of loans
• The determination of interest or growth rates
Deposits to accumulate a future sum
Investor may wish to determine the annual deposit necessary to accumulate a certain amount of money
Example: R 100 000 will be required 5 years from
now, what must the end-of-year deposits be at 12%:
an amortisation
The equal amount loan payments necessary.
Example: R 6 000 000 at 14% is borrowed.
Calculate equal annual end-of-year payments
over 10 periods needed:
Use of loan amortisation schedule: see page 62 (6th ed.)
Determining growth rates
Find out the growth rate of a cash flow stream
Determining the net present value and internal rate of return
• Investor can evaluate an investment decision based on the net present value (NPV) and the
internal rate of return (IRR).
• Net present value (NPV)
Measures in monetary terms how much value an investment will generate
NPV
NPV greater than zero – good investment, did contribute
NPV less than zero – bad investment, did not generate additional funds
NPV? = Discount (RRR) all cash inflows (future value) to present value and subtracting the initial
investment (cash outflow)
For example:
Investor’s required rate of return is 10%. He invests R 100 000 and can earn the following annual cash
inflows for the next 5 years:
Net present value NPU
You can invest R100 000 in a company which
will realise the following annual cash flows
(Required rate of return = 10%) :
Internal rate of return IRR
Measures in percentage terms whether
an investment will be acceptable.
Ranking conflics between NPV and IRR
Example: Projects – Not mutually exclusive
Assume Required rate = 10% for both projects
• Invest in Project A or Project B?
• Both – profitable (choose either A (higher IRR) or B (higher NPV)
Example: Projects – Mutually exclusive
Assume Required rate = 10% for both projects
• Invest in Project A or Project B?
• NPV-
• reinvestment assumption
• Show the amount of gain/wealth increase as currency amount
Self evaluation
• Illustrate the relationship between nominal and effective interest rates
• Understand the concepts of future value with specific reference to annual compounding! intra-year
compounding and the future value of an annuity
• Explain the relationship between future value and present value
• Understand the concepts of present value with specific reference to a single amount a mixed
stream perpetuity, and an annuity
• Determine the net present value and internal rate of return
COMPARE
R10 000 is being placed in a savings account
Paying 10% interest compounded annually
Calculate the FV of R 12 000 invested annually (at
the end of each year) for 5 years
(Investors required rate of return - 15% - NACA)
You have the opportunity to receive R1000, 1
year from now. If you can earn 16% if you invest
the amount, the present value of the R1000 is:
Loans
R 6 000 000 at 14% is borrowed. Calculate
equal annual end-of-year payments over 10
periods needed:
R 100 000 will be required 5 years from
now, what must the end-of-year deposits be
at 12%:
