Cash Flow, Interest

& Equivalence

Prof. Chandana Perera

Cash Flow
Amount of cash being received and paid by a business
during a defined period of time.
It has three main streams:
1. Operational cash flow: is a result of the company's core
business activities.
2. Investment cash flow: is due to capital expenditure,
investments or acquisitions.
3. Financing cash flow: is a result of financial activities, such
as interests and dividends.
 Cash Flow Diagrams

Beginning of Year 1 End of Year 1

7%
0 1 2 3 4

Initial Investment

• The arrows signify cash flows and are placed at end of period
• Downward arrows - Expenses (negative cash flow)
• Upward arrows – Receipts (positive cash flow)
 Time Value of Money
Which would you prefer –

Rs.10,000 today or Rs.10,000 in 5 years?

Obviously, Rs.10,000 today.

You already recognize that there is TIME VALUE TO

MONEY!!
Why TIME?
Why is TIME such an important
element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
Types of Interest
 Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).

• Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
Simple Interest Formula

Formula SI = P x i x N

SI: Simple Interest

P: Deposit today (t=0)
i: Interest Rate per Period
N: Number of Time Periods
 Simple Interest Example
• Assumethat you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?
SI = P(i)(N)

= $1,000(.07)(2)

= $140
Simple Interest (FV)
• Whatis the Future Value (F) of the
deposit?
F = P + SI
= $1,000 + $140
= $1,140
• FutureValue is the value at some future time
of a present amount of money, or a series of
payments, evaluated at a given interest rate.
Simple Interest (PV)

• Whatis the Present Value (P) of the

previous problem?

The Present Value is simply the $1,000 you

originally deposited.
That is the value today!
• PresentValue is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate.
Compound Interest
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2
years.

0 1
7%
2

$1,000
FV2
Compound Interest (Future Value)
F1 = P (1+i)1 = $1,000 (1.07)
= $1,070
F2 = F1 (1+i)1 = P (1+i)(1+i) =
$1,000(1.07)(1.07) = P (1+i)2
= $1,000(1.07)2 = $1,144.90
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
General
General Future
Future Value
Value Formula
Formula
(Compound
(Compound Interest)
Interest)

F1 = P(1+i)1
F2 = P(1+i)2

General Future Value Formula:

F = P (1+i)N
Example
Julie wants to know how large her deposit of
$10,000 today will become at a compound
annual interest rate of 10% for 5 years.

$10,000
10%
0 1 2 3
4 5

$10,000

F5
Solution
Calculation based on general formula:
F = P (1+i)N

F5 = $10,000 (1+ 0.10)5

= $16,105.10
 Comparing Cash Flows
500 500

7%
0 1 2 3 4

100 What is the better

400
cash flow?
1,000
200 200
100

7%
0 1 2 3 4

1,000
Economic Equivalence
• Economic equivalence allows us to compare
alternatives on a common basis.
• Each alternative can be reduced to an equivalent
basis dependent on
 interest rate,
 amount of money involved, and
 timing of monetary receipts or expenses.
• Usingthese elements we can “move” cash flows so
that we can compare them at particular points in
time.
Notations

Notation used in formulas for compound interest

calculations.
i = effective interest rate per interest period
N = number of compounding (interest) periods
P = present sum of money; equivalent value of one
or more cash flows at a reference point in time; the present
F = future sum of money; equivalent value of one or
more cash flows at a reference point in time; the future
A = end-of-period cash flows in a uniform series
continuing for a certain number of periods, starting at the
end of the first period and continuing through the last
Compound Interest Formulas

Compound interest formulas are applied to “move” cash

flows along the cash flow diagram.
Using the standard notation, we find that a present
amount, P, can grow into a future amount, F, in N time
periods at interest rate i according to the formula below.

In a similar way we can find P given F by

 Standard Notation for Interest Factors

This is also known as the single payment compound

amount factor. The term on the right is read “F given P
at i% interest per period for N interest periods.”

is called the single payment present worth factor.

 Examples
$2,500 at time zero is equivalent to how much after six years if the
interest rate is 8% per year?

F = 2,500 (1+0.08)6

$3,000 at the end of year seven is equivalent to how much today (time
zero) if the interest rate is 6% per year?
P = 3,000/ (1+0.06)7 = $3,000 / (1.06)7 = $1,995
 Annuity
 An Annuity represents a series of equal payments
(or receipts) occurring over a specified number of
equidistant periods.

Examples
 Student Loan Payments
 Car Loan Payments
 Mortgage Payments
 Retirement Savings
Parts of an Annuity

End of End of End of

Period 1 Period 2 Period 3
$100 $100 $100

0 1 2 3
Today
Annuity Formulae
 Example
Example of
of an
an Annuity
Annuity --
-- FVA
FVA

0 7% 1 2 3 4

$1,000 $1,000 $1,000

$1,070
$1,145

F3 = $3,215

F3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0

= $1,145 + $1,070 + $1,000
= $3,215 =$3,215
Example of an Annuity -- PVA

0 7% 1 2 3 4

$1,000 $1,000 $1,000

$934.58
$873.44
$816.30
$2,624.32 = P
P = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
=$2,624.32 = $934.58 + $873.44 +
$816.30 = $2,624.32
Finding F given A

How much will you have in 40 years if you

save $3,000 each year and your account
earns 8% interest each year?
Finding P given A

How much would is needed today to provide

an annual amount of $50,000 each year for
20 years, at 9% interest each year?
Finding A when given F

How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?
Finding A when given P

If you had $500,000 today in an account

earning 10% each year, how much could you
withdraw each year for 25 years?
It can be challenging to solve for N or i.

• We may know P, A, and i and want to find N.

• We may know P, A, and N and want to find i.
• Theseproblems present special challenges that are
best handled on a spreadsheet.
 Finding N
Acme borrowed $100,000 from a local bank, which
charges them an interest rate of 7% per year. If Acme
pays the bank $8,000 per year, how many years will it
take to pay off the loan?

So,

This can be solved by using the interest tables and

interpolation, but we generally resort to a computer
solution.
 Finding i
Jill invested $1,000 each year for five years in a local
company and sold her interest after five years for
$8,000. What annual rate of return did Jill earn?

So,

Again, this can be solved using the interest tables

and interpolation, but we generally resort to a
computer solution.
There are specific spreadsheet functions
to find N and i.
The Excel function used to solve for N is
NPER(rate, pmt, pv), which will compute the number of payments
of magnitude pmt required to pay off a present amount (pv) at a
fixed interest rate (rate).

One Excel function used to solve for i is

RATE(nper, pmt, pv, fv), which returns a fixed interest rate
for an annuity of pmt that lasts for nper periods to either its
present value (pv) or future value (fv).
We need to be able to handle cash
flows that do not occur until some
time in the future.
• Deferred annuities are uniform series that do not begin
until some time in the future.
• If the annuity is deferred J periods then the first payment
(cash flow) begins at the end of period J+1.

1 J J+1
Finding the value at time 0 of a deferred
annuity is a two-step process.

1. Use (P/A, i%, N-J) find the value of the deferred

annuity at the end of period J (where there are N-J
cash flows in the annuity).
2. Use (P/F, i%, J) to find the value of the deferred
annuity at time zero.
Uniform Gradient Cash Flow
Sometimes cash flows change by a constant amount each
period.
We can model these situations as a uniform gradient of cash
flows. The table below shows such a gradient.
End of Period Cash Flows
1 0
2 G
3 2G
: :
N (N-1)G
Uniform Gradient Series.
Similar to the other types of cash flows, there is a
formula we can use to find the present value, and a
set of factors developed for interest tables.
Uniform Gradient Series.

We can also find A or F equivalent to a uniform

gradient series.
The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an 2 3,000
annuity portion of the cash
3 4,000
flows and a gradient
portion. 4 5,000

End of Year Annuity ($) Gradient ($)

1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000
 Varying Interest Rates

• Interest rates often change with time (e.g., a variable rate

mortgage).
• We often must resort to moving cash flows one period at a time,
reflecting the interest rate for that single period.
 Varying Interest Rates
The present equivalent of a cash flow occurring at the end of period N can be
computed with the equation below, where ik is the interest rate for the kth period.

If F4 = $2,500 and i1=8%, i2=10%, and i3=11%, then

 Perpetuity
Perpetuity: a stream of cash flow continues forever e.g., scholarships
from endowment funds.

Example: What is the one time amount to be donated to award a scholarship of

Rs.10,000 annually?
Interest rate = 9%

P = Rs.10,000/0.09 = Rs.111,111
Nominal and Effective Interest Rates

• More often than not, the time between successive

compounding, or the interest period, is less than one year
(e.g., daily, monthly, quarterly).
• The annual rate is known as a nominal rate.
• A nominal rate of 12%, compounded monthly, means an
interest of 1% (12%/12) would accrue each month, and the
annual rate would be effectively somewhat greater than 12%.
• The more frequent the compounding the greater the effective
interest.
 Frequency of Compounding
• If the interest is compounded more than once a year,
effective interest rate is more than annual interest rate
E.g. monthly compounding, quarterly compounding

( )
𝑚
𝑖
1 +𝑖𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 = 1 +
𝑚

( )
𝑚
𝑖
𝑖𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 = 1 + −1
𝑚
Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the
effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.
Frequency
Frequency of
of Compounding
Compounding
General Formula:
F= P(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
F: FV at the end of Year n
P: PV of the Cash Flow today
Effective interest for n number of years

( )
𝑚𝑛
𝑖
𝑖𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 = 1+ −1
𝑚
Impact
Impact of
of Compounding
Compounding Frequency
Frequency

$1,000 is invested for 2 Years at an annual interest rate of 12%.

Annual F2 = 1,000(1+ [.12/1])(1)(2) = 1,254.40
Semi F2 = 1,000(1+ [.12/2])(2)(2) = 1,262.48
Qrtly F2 = 1,000(1+ [.12/4])(4)(2) = 1,266.77
Monthly F2 = 1,000(1+ [.12/12])(12)(2) = 1,269.73
Daily F2 = 1,000(1+[.12/365])(365)(2) = 1,271.20
Example
• You make quarterly deposits into a savings account
earning 8% interest compounded monthly.
• What is the effective interest rate per quarter?

( )
• Solution 𝑖
𝑚𝑛
𝑖𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 = 1+ −1
𝑚
• i = 0.08, m =12, n = ¼

= 2.013 per quarter

 Continuous Compounding
• Interest compounded in small intervals of time;
• Here, the effective interest rate is:

• ic = Continuous Compounding Interest Rate per period

• i = Nominal Interest Rate pa
• K = Number of payment periods per year
Example
• What is the effective interest rate per quarter at a
nominal rate of 8% compounded continuously?
Actual Dollars and Constant Dollars
• Actual Dollars or Nominal Dollars or Current Dollars:
the estimate of future cash flow that includes any anticipated inflation.

• Constant or Real dollars:

the inflation effect has been removed and the cash flow is expressed in $
terms for a base year.

• The base year can be any year, e.g. this year or 10 years back
or 15 years into the future.
Preal Pnominal

0 1 2 3
Base Year
4 5
 The Fisher Equation
• The Fisher equation estimates the relationship between the
nominal or market interest rates and the real interest rates
under inflation. The market Interest Rate (i) is a function of:
• 1. Earning Power related to Inflation Free Interest Rate (ir)
• 2. Purchasing Power related to the Inflation Rate (iinf)
• Fisher Equation describes the mathematical relationship as:

i × i is relatively small
r inf
END