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%: