Financial Management

For
MBA Program

Banbul Shewakena
(Assistant Professor of Financial Management)

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 Chapter 3
Present Value and Opportunity Cost of
Capital

• Present and future value calculations rely on the

principle of time value of money.
Time value of money: One dollar today is worth more than
one dollar tomorrow.
 why time has time value?
The following four factors are responsible for money to
have time value:
• Consumption Preference: Individuals prefer current
consumption to future consumptions. So people would
have to be offered more in the future to give up current
consumption. 2
 Cont’d
• Inflation: general increase in prices (inflation) erodes the
purchasing power of money. Hence, the value of money
decreases with time when there is inflation.

• Uncertainty (Risk): As compared to today’s money, future

cash flows have risks (default risk). Hence, delaying cash
collection means assuming greater risks. Individuals want
to be rewarded for this additional risk assumed.

• Investment Opportunities: cash received today could be

invested and fetch additional income.
Time value of money demonstrates that, all things being
equal, it is better to have money now than later.
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 3.1. Compounded versus Simple Interest
• Basically, simple interest is interest paid on the original
principal only.
• However, compound interest is the interest earned not only
on the original principal, but also on all interests earned
previously.
• In other words, at the end of each year, the interest earned
is added to the original amount and the money is
reinvested.
Example
1. Compute interest on 100 ETB deposit for two years at a rate
of 5% using simple and compound interest.

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 Simple and Compound Interest…
Solution
1. Simple interest rate
I=prt
= 100*5%*2=10ETB
I =10ETB

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 2. Compound Interest
I=prt
100*5%*1=5ETB
105*5%*1=5.25ETB
I= 5ETB+5.25ETB = 10.25ETB
Or
Compound Interest (Ic) = P × (1 + i) n – P
= 100*(1+0.05)^2
=100*(1.05)^2
=110.25-10
10.25
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 3.2 The Present Value

•Present value (PV) is the value today of a future

cash flow. To find the present value of a future
cash flow, Ct, the cash flow is multiplied by a
discount factor:
(1)PV = discount factor * Ct;

The discount factor (DF) is the present value of

€1 future payment and is determined by the rate
of return on equivalent investment alternatives
in the capital market.
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 PV….
Example
2. Assume you want to receive 100ETB after
1year. What amount has to be deposited
today at a rate of 5%?
PV=

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 PV…..
Example
• What is $570 next year worth now, at an
interest rate of 10% ?
• PV = $570 / (1+0.10)1 = $570 / 1.10
= $518.18 (to nearest cent)

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 2.3 The Future Value

• The future value (FV) is the amount to which an

investment will grow after earning interest. The
future value of a cash flow, C0 , is

Example
3. Assume you have deposited 100ETB today at a
rate of 5%. What will be the amount after two
years?
FV=100*(1.05)^2
= 100*1.1025
= 110.25 10
 FV…
Example
1. $1000 lump sum investment earning 10
percent interest per year. Determine the value
of your investment at the end of two years

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 2.4 Principle of Value Additivity

The principle of value additivity states that

present values (or future values) can be added
together to evaluate multiple cash flows. Thus, the
present value of a string of future cash flows can
be calculated as the sum of the present value of
each future cash flow:

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 2.4 Principle of Value Additivity…
• The principle of value additivity can be applied to
calculate the present value of the income stream
Example:
• Compute the present value of the following income
stream of €1,000, €2000 and €3,000 in year 1, 2
and 3 from now, respectively. 10% interest rate
• PV= 1,000/(1.1)^1 + 2,000(1.1)^2 + 3,000(1.1)^3

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2.5 Net Present Value
•Most projects require an initial
investment.
•Net present value is the difference
between the present value of future cash
flows and the initial investment, C0,
required to undertake the project:

•Note that if C0 is an initial investment,

then C0 < 0. 14
 NPV…
Example
4. Your friend needs 10,000 ETB, and will pay you back
10,700 ETB in a year. Is it good investment when you get
10% elsewhere?
NPV=

If NPV is positive the project is value adding- so invest on it.

If NPV= 0 – not investing unless you have other purpose
If NPV= -ve – not investing

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• Project X requires an initial investment of $35,000 but is
expected to generate revenues of $10,000, $27,000 and
$19,000 for the first, second and third years,
respectively. The target rate of return is 12%. Since the
cash inflows are uneven, the second formula listed
above is used.
• NPV = {$10,000 / (1 + 0.12)1} + {$27,000 / (1 + 0.12)2} + {$19,000 / (1 + 0.12)3} - $35,000
NPV = $8,929 + $21,524 + $13,524 - $35,000
NPV = $8,977

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• Project Y also requires a $35,000 initial
investment and will generate $27,000 per year
for two years. The target rate remains 12%.
Because each period produces equal revenues,
the first formula above can be used.
• NPV = $27,000/(1 + 0.12)2 - $35,000
NPV = $45,631 - $35,000
NPV = $10,631

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 2.6 Perpetuities and Annuities

A Perpetuity is a constant cash flow that is

paid (received) at a regular time interval forever.
PV = C/i
Where: C is the periodic cash flow, and
i is the discount rate
Cases to be used – bond, real estate
example
5. What is the present value of perpetuity paying
1000 ETB at the end of each year. r=8%
PV=
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 2.6 Perpetuities and Annuities

Growing perpetuity
In case the cash flow of the perpetuity is
growing at a constant rate rather than being
constant, the present value formula is slightly
changed.
PV of Growing Perpetuity = C1/(r-g)
Example
6. Consider example three if there is a growth of
5% what is the PV of perpetuity?

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 2.6 Perpetuities and Annuities

Annuities, however, are regular cash

flows that occur at equal intervals of time for a
fixed period of time and fixed interest (discount)
rate.

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 Types of Annuities

Ordinary Annuity: a series of equal payments made at the end of each

period.

PV = PMT [1- (1/(1+i)n]

i
FV = PMT [(1+i)n - 1)]
i
Where: PMT is the periodic cash flows,
i is the discount rate, and
n is the number of periods

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 Ordinary Annuity……
Example
7. Assume part of your portfolio is bond. One
particular bond will pay you 1000ETB for five
years at the end of each year. What is the
present value of the cash flows if the interest
rate is 10%?
PV of Annuity = 1000((1-1/(1+0.1)^5)
0.1

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Example
8. If at the end of each month a saver deposited
100ETB into a saving account that paid 6%
compounded monthly, how would she/he has
at the end of 10years?
FV annuity = 100(1+0.06)^5-1
0.06

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 Types of Annuities….
Annuity Due: a series of equal cash
payments made at the beginning of each
period.
PV = PMT (1-1/(1+i) n
i
FV = PMT [(1+i) n - 1] * (1+ i)
i
Growing Annuities: a cash flow that grows
at a constant rate and paid at a regular
interval of time.

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Example
9. The tressurer of ABC imports expects to invest
50,000 ETB of the firms funds in a long term
investment vehicle at the beginning of each year
for the next 5years. He expects that the company
will earn 6% interest that will compounded
annually. What is the value of payments at the
end of 5years?
FV annuity = ?

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Example
10.

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 2.7 Nominal and Real Rates of Interest
Inflation is the rate at which prices as a whole are
increasing, whereas nominal interest rate is the
rate at which money invested grows.
The formula for converting nominal interest rate
to a real interest rate is:

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2.7 Nominal and Real Rates of Interest

Cash flows can either be in current

(nominal) or constant (real) dollars.
If you deposit €100 in a bank account with an
interest rate of 5 percent, the balance is €105
by the end of the year.
Whether €105 can buy you more goods and
services than €100 today depends on the rate
of inflation over the year.

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Example
• Suppose you bought 1000 ETB renaissance
dam bond with a coupon rate of 5.5%, the
inflation rate reported by government is 4%.
What is the real interest rate?
RR= (1+RN)/(1+RI) -1

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THANK YOU

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