How to calculate present values?

Abhinav Anand (IIM Bangalore)

Time value of money

Today versus tomorrow

I Which is better? $100 today or tomorrow? Why?
Time value of money

Today versus tomorrow

I Which is better? $100 today or tomorrow? Why?
I Rule: A dollar today is worth more than a dollar tomorrow
Time value of money

Today versus tomorrow

I Which is better? $100 today or tomorrow? Why?
I Rule: A dollar today is worth more than a dollar tomorrow

Example
I X has $100 in a bank account that pays 7% yearly interest
I What is the value of the investment next year?

100(1 + r ) = 107

I What is the interest earned?

100r = 7
Compound interest

Example
I What is the amount after two years?

[100(1 + r )](1 + r ) = 100(1 + r )2 = 100(1.07)2 ≈ 114.5

Compound interest

Example
I What is the amount after two years?

[100(1 + r )](1 + r ) = 100(1 + r )2 = 100(1.07)2 ≈ 114.5

I X earned interest (in second year) on interest (from first year)

Compound interest

Example
I What is the amount after two years?

[100(1 + r )](1 + r ) = 100(1 + r )2 = 100(1.07)2 ≈ 114.5

I X earned interest (in second year) on interest (from first year)

I In general, future value of $C0 in t years at interest rate r % is

FV (t) = C0 (1 + r )t
Compound growth

5%

6%
6

7%
5

8%
(1+r)^t

9%
4

10%
3
2
1

5 10 15 20

Figure: Compound growth causes exponential increase in amount. Hence even very
small changes in growth rates can matter a lot.
Present values

From future value

I In general, since

FV
FV (t) = C0 (1 + r )t ⇒ C0 ≡ PV =
(1 + r )t

I r is discount rate and 1

(1+r )t is discount factor
Present values

From future value

I In general, since

FV
FV (t) = C0 (1 + r )t ⇒ C0 ≡ PV =
(1 + r )t

I r is discount rate and 1

(1+r )t is discount factor
I What is $114.5 in two years time worth today if interest rate
is 7%?
I
114.5
PV = ≈ 100
(1 + 0.07)2
Valuing investment opportunities

Example
I Suppose there is an investment opportunity for buying land at
$700000. With certainty, this can be sold next year for
$800000. Assume that the risk-free rate of return in the
market is 7% and risky rate of return in the market is 12%.
Should the investment opportunity be taken? Why?
Valuing investment opportunities

Example
I Suppose there is an investment opportunity for buying land at
$700000. With certainty, this can be sold next year for
$800000. Assume that the risk-free rate of return in the
market is 7% and risky rate of return in the market is 12%.
Should the investment opportunity be taken? Why?

Answer
Yes. The hurdle rate (cost of capital) is 7% since that’s what the
shareholders can get risk-free in the market. Hence the present
value of the investment opportunity is
8
PV = ≈ 7.47
1 + 0.07
Net present value
PV - investment = NPV
I
C1
NPV = C0 +
1+r
where C0 < 0 is the investment—negative cash flow at time 0

Risky investment
We assumed that the investment was risk-free in the example.
What if now we assume it is risky?
Net present value
PV - investment = NPV
I
C1
NPV = C0 +
1+r
where C0 < 0 is the investment—negative cash flow at time 0

Risky investment
We assumed that the investment was risk-free in the example.
What if now we assume it is risky?
Answer
Now the hurdle rate is 12%
8
PV = ≈ 7.14
1 + 0.12
Yes, the investment should still be made
Multiple cash-flows

Example
I What if there are multiple cash-flows C1 , C2 , . . . , Cm in
periods 1, 2, . . . , m?
Multiple cash-flows

Example
I What if there are multiple cash-flows C1 , C2 , . . . , Cm in
periods 1, 2, . . . , m?
C1 C2 Cm
PV = + 2
+ ... +
1+r (1 + r ) (1 + r )m

where r is the hurdle rate.

I This is the discounted cash flow formula (DCF)
Multiple cash-flows

Example
I What if there are multiple cash-flows C1 , C2 , . . . , Cm in
periods 1, 2, . . . , m?
C1 C2 Cm
PV = + 2
+ ... +
1+r (1 + r ) (1 + r )m

where r is the hurdle rate.

I This is the discounted cash flow formula (DCF)
I Hence NPV is
C1 C2 Cm
NPV = C0 + + + ... +
1+r (1 + r )2 (1 + r )m
Which projects to finance?

Rules
I Net present value rule: Invest only in those projects that have
NPV > 0. Only these increase shareholder value
I Rate of return rule: Invest only when return on investment is
more than the hurdle rate (cost of capital)
Example: Multiple cash flows

Problem
I Now suppose that X is advised that at the end of two years
the land can be sold for $840000. Each year, however, the
land can be rented out at $30000. Investment is not risk-free.
Now should the investment opportunity be taken?
Example: Multiple cash flows

Problem
I Now suppose that X is advised that at the end of two years
the land can be sold for $840000. Each year, however, the
land can be rented out at $30000. Investment is not risk-free.
Now should the investment opportunity be taken?

Answer
Since the investment is risky, the hurdle rate is 12%. At the end of
year 1 there is a cash flow of $30000, and at the end of the second
year, there is another cash-flow of $30000+$840000 = $870000.
Hence PV is
.30 8.70
PV = + ≈ 7.2
1 + 0.12 (1 + 0.12)2

Hence the investment opportunity should be taken

Perpetuity

Definition
I A perpetuity is an offer of a yearly fixed-income C forever. Its
present value is
C
PV =
r
(Why?)
Perpetuity

Definition
I A perpetuity is an offer of a yearly fixed-income C forever. Its
present value is
C
PV =
r
(Why?)

Proof
Same cash-flow forever means
C C C
PV = + 2
+ + ...+
1+r (1 + r ) (1 + r )3

1 C C C
PV = 2
+ 3
+ + ...
1+r (1 + r ) (1 + r ) (1 + r )4
Perpetuity

Proof
I Subtracting,  
1 C
PV −1 =−
1+r 1+r
C
PV =
r

Problem
Bill Gates wishes to endow his foundation with a yearly budget of
$1 billion in perpetuity. Suppose he can manage to earn a return
of 10% yearly in the financial markets. How much money does Bill
Gates need to set aside to fund his organization?
Perpetuity

Proof
I Subtracting,  
1 C
PV −1 =−
1+r 1+r
C
PV =
r

Problem
Bill Gates wishes to endow his foundation with a yearly budget of
$1 billion in perpetuity. Suppose he can manage to earn a return
of 10% yearly in the financial markets. How much money does Bill
Gates need to set aside to fund his organization?

Answer
1
PV = 0.1 = 10 billion
Delayed perpetuity
Problem
I Suppose the Gates endowment needs to kick in at the start of
year 4. How much money does Bill Gates need to set aside
now? (Assume same rate of return.)

Answer
Now the cash flows from year 1 onwards are: 0, 0, 0, $1b, $1b, . . .
The present value of this sequence is
C 1 1 1
PV = 3
= = 7.5
r (1 + r ) 0.1 (1 + 0.1)3

If the perpetuity pays 0 till end of year T and rate of return is r

C 1
PV =
r (1 + r )T
Annuities

Definition
I An annuity pays a fixed sum for a fixed number of years
I Cash flow of an annuity starting this year is

C , C , C , . . . , C , 0, 0, . . . ,

I This looks like a difference between a perpetuity starting now

and a delayed perpetuity
I Hence the present value of an annuity that pays C in years 1,
2, . . . , T is
C C 1
PV = −
r r (1 + r )T
Annuities

Problem
I An “easy payment” scheme offers a car at no downpayment
and yearly fixed payments of $5000. What is its true price if
rate of return is 7%?
Annuities

Problem
I An “easy payment” scheme offers a car at no downpayment
and yearly fixed payments of $5000. What is its true price if
rate of return is 7%?

Answer
Payment consists of cash-flow C = 5000 from years 1–5 and 0
from year 6 onwards. Hence
5000 5000 1
PV = − = 20, 500
0.07 0.07 (1 + 0.07)5
Annuities

Problem
I Suppose a lottery prize of $590.5 million is to paid out over 30
years in equal installments of $19.683 million each. Suppose
the prevailing interest rate is 3.6%. Suppose also that the
winner demands that instead of 30 yearly payments, she be
paid an lumpsum amount now. How much will she get?
Annuities

Problem
I Suppose a lottery prize of $590.5 million is to paid out over 30
years in equal installments of $19.683 million each. Suppose
the prevailing interest rate is 3.6%. Suppose also that the
winner demands that instead of 30 yearly payments, she be
paid an lumpsum amount now. How much will she get?

Answer
She will get the present value of the 30-year annuity:
19.68 19.68 1
PV = − = 357.5
0.036 0.036 (1 + 0.036)30
Annuities

Problem
I A couple buys a house with a mortgage value $250000 with
interest rate 12% and promises to pay in 30 yearly equal
installments. What is the annual fixed payment due to the
bank?

Answer
Here the fixed cash-flows to the bank need to be determined
C C 1 PV
PV = − ⇒C = 1 1 1
r r (1 + r )T r − r (1+r )T

250
C= 1 1 1
≈ 31
0.12 − 0.12 (1+0.12)30
Annuities

Problem
I Suppose Y saves $20000 per year an earns a return of 8% on
savings. What is the amount he has saved after the end of
five years?
Annuities

Problem
I Suppose Y saves $20000 per year an earns a return of 8% on
savings. What is the amount he has saved after the end of
five years?

Answer
This is the sum of future values of the cash-flows:
(C = 20, r = 0.08)

FV = C (1 + r )4 + C (1 + r )3 + C (1 + r )2 + C (1 + r ) + C
Annuities

Problem
I Suppose Y saves $20000 per year an earns a return of 8% on
savings. What is the amount he has saved after the end of
five years?

Answer
This is the sum of future values of the cash-flows:
(C = 20, r = 0.08)

FV = C (1 + r )4 + C (1 + r )3 + C (1 + r )2 + C (1 + r ) + C

Equivalently, the present value of an annuity paid for by Y

C C 1
PV = − ⇒ FV = PV (1 + r )5 = 79854 ∗ (1 + 0.08)5
r r (1 + r )5
Future and present values

I Quite generally, future values can always be found by

multiplying present values by (1 + r )t .

FV = PV (1 + r )t

I Hence in the problem in the last slide, the future value is the
difference in perpetuities postmultiplied by its growth rate.
 
C C 1
FV (T ) = − (1 + r )T
r r (1 + r )T

C C
FV (T ) = (1 + r )T −
r r
C C
C (1+r )4 +C (1+r )3 +C (1+r )2 +C (1+r )+C = (1+r )T −
r r
Growing perpetuties

The Gates Foundation problem

I When Bill Gates endowed his foundation with $1billion he
forgot to make allowances for growth in miscellaneous
expenditures—salaries, costs, currency inflation etc. Suppose
that growth rate of cash flows is g = 4%. How much money
does Bill Gates needs to set aside now?

Answer
The sequence of cash flows is:
C , C (1 + g ), C (1 + g )2 , . . . , C (1 + g )T + . . ., hence

C C (1 + g ) C (1 + g )2 C 1
PV = + 2
+ 3
+. . . = =
1+r (1 + r ) (1 + r ) r −g 0.10 − 0.04
Growing annuities

I Suppose there is a annuity with growth rate g which pays C

in periods 1, 2, . . . , T .
I The cash flows are:
C , C (1 + g ), C (1 + g )2 , . . . , C (1 + g )T − 2, C (1 + g )T −1

C C (1 + g ) C (1 + g )T − 2 C (1 + g )T −1
PV = + +. . .+ +
1 + r (1 + r )2 (1 + r )T −1 (1 + r )T
 T
C C 1+g
PV = −
r −g r −g 1+r
I (Why?)
I (What is the range of g ?)
Growing annuities
Problem
I Y can join a club for one year for $5000 or can pay $12,500
and be a member for three years. Which option is better?
Assume that the discount rate is 10% and annual
(end-of-the-year) fee increases by 6%.

Answer
In the second option, there is only one cash-flow from Y to the
club: $12,500. In the first option, the cash flow sequence is:
5000, 5000(1 + 0.06), 5000(1 + 0.06)2 . Hence the present value of
this stream is:
5000 5000(1 + 0.06) 5000(1 + 0.06)2
PV = + +
1 + 0.10 (1 + 0.10)2 (1 + 0.10)3
 T
C C 1+g
Alertnatively, we can use: PV = r −g − r −g 1+r
Interest rates

Quoted rates and effective rates

I In France and Germany, the government pays interest on its
bonds at the end of the year, say 6%
I In the US and UK, the government pays 3% each six months
(semi-annually)
I However, these two interest rates are not equivalent
I For 100$ face-value bond, France pays $106 at the end of the
year while UK pays

[100 · (1 + 0.03)](1 + 0.03) = 106.09

I Here the quoted annual rate is 6% but the effective annual

rate is ≈ 6.1%
Quoted rates and effective rates

Problem
I Bank offers loan at an annual percentage rate (APR) 12%
with interest to be paid monthly. What is the effective annual
rate?

Answer
This offer means that the customer pays 1% interest monthly. For
$1, this implies that the customer pays

1 · (1 + 0.01)12 = 1.1268

This means an effective rate of 12.68%

Quoted rate and effective rate
Formula
I If quoted rate is r % and it is paid m times each year
I Example: m = 1 annually, m = 2 semi-annually, m = 4
quarterly, m = 12 monthly, m = 365 daily etc.
I The formula for effective rate is:
 r m
1 + r¯ = 1 +
m
 r m
r¯ = 1 + −1
m

Continuous compounding
 r m
1 + rA = lim (1 + r¯) = lim 1+ = er
m→∞ m→∞ m
ln(1 + rA ) = rc
Continuous compounding

Problems
I What is $1 continuously compounded 11% per year for one
year?
I What is $1 continuously compounded 11% per year for two
years? For T years?
I Can you derive the “Rule of 70”?

Answers
I $1 continuously compounded for 1 year at 11% is
$e 0.11 = 1.116 (What is the effective annual rate?)
I $1 continuously compounded for 2 year at 11% is
$e 0.11∗2 = 1.246 In general, for T years, e rT
Continuous compounding

Retirement problem
I Suppose X has retired and wishes to use her savings of
$200000 for 20 years. The annually compounded interest rate
is 10%. How much must you save to support this retirement
plan?

Answer
This is a question about valuing an annuity that pays C = 2 lakhs
at the end of the year for 20 years:
2 2 1
PV = − = 17.02
0.10 0.10 (1 + 0.10)20
Continuous compounding

Retirement problem
I The problem formulation above assumes that X waits to
withdraw cash at the end of the year. Suppose now that X
wishes to be receive the retirement money continuously since
she reasons that her expenditure will be continuous as well.
Now how much does she need to save?

Answer
Since we need to compute the amount necessary to sustain
continuous expenses, we need to use the continuous rate
corresponding to the annual rate of 10%. This can be found from
the expression

ln(1 + rA ) = rc ⇒ ln(1 + 0.1) = rc = 0.95

The retirement problem

Answer
I We can use the continuously compounded rate to value the
annuity as the difference between two perpetuities:
C C 1
PV = −
r r e rt
Note how we replaced (1 + rA )t by e rc t
Hence the value need to be set aside is:
C C 2 2 −0.95∗20
PV = − e −rt = − e = 17.86
r r 0.95 0.95
Problem

BMA Chapter 2 #14

I A factory costs $800000. It will produce inflows of $170000
for 10 years. Suppose opportunity cost of capital is 14%.
I Is the project worth investing in?
I What is factory worth after the end of five years?
Problem

BMA Chapter 2 #14

I A factory costs $800000. It will produce inflows of $170000
for 10 years. Suppose opportunity cost of capital is 14%.
I Is the project worth investing in?
I What is factory worth after the end of five years?

Answer
170 170 1
PV = − ≈ 886
0.14 0.14 (1 + 0.14)10
Value of the factory after five years is the PV of the residual
cashflows
170 170 1
PV = − ≈ 583
0.14 0.14 (1 + 0.14)5
Problem

BMA Chapter 2 #25

I Suppose for the Gates Foundation perpetuity problem, the
rate of interest decreases from 10% to 8%. How to finance
the following:
1. $1 billion at the end of the year in perpetuity
2. $1 billion at the end of the year, then growing at 4% in
perpetuity
3. $1 billion at the end of the year, for 20 years
4. $1 billion per year spread evenly over 20 years
Problem

BMA Chapter 2 #25

I Suppose for the Gates Foundation perpetuity problem, the
rate of interest decreases from 10% to 8%. How to finance
the following:
1. $1 billion at the end of the year in perpetuity
2. $1 billion at the end of the year, then growing at 4% in
perpetuity
3. $1 billion at the end of the year, for 20 years
4. $1 billion per year spread evenly over 20 years

Answer
1 1 1 1 1
1. 0.08 = 12.5; 2. 0.08−0.04 = 25; 3. 0.08 − 0.08 (1+0.08)20
= 9.8
4. rc = ln(1 + rA ); Hence rc = ln(1.08) = 0.077, and
1
PV = 0.08 1
− 0.08 e −0.077∗20 = 10.2
I