This Time
Time Value of Money
Intuition, tools, and discounting
7/7/15
Intuition
Currency
7/7/15
Currency
Currency
$/
7/7/15
Currency
X
/$
Currency
7/7/15
Currency
/$
Currency
$/
$/
7/7/15
Currency
X
/$
7/7/15
7/7/15
Time Line
Time Periods
0
7/7/15
Time Line
0
CF0
CF1
CF2
CF3
CF4
Cash Flows
Time Line
0
CF0
CF1
CF2
CF3
CF4
7/7/15
CF0
CF1
CF2
CF3
CF4
CF0
CF1
CF2
CF3
CF4
X
No!
Copyright
Michael
R.
Roberts
10
7/7/15
CF0
CF1
CF2
CF3
CF4
X
Lesson: Never* add/subtract cash
flows received at different times
Copyright
Michael
R.
Roberts
CF0
CF1
CF2
CF3
CF4
X
Need exchange rate for time to
convert to common time unit
Copyright
Michael
R.
Roberts
11
7/7/15
Discount Factor
The discount factor is our exchange
rate for time
(1+ R )t
t = time periods into future (t > 0) or
past (t < 0) to move CFs
R=
Copyright
Michael
R.
Roberts
12
7/7/15
13
7/7/15
Treasury-Bills (30-Day)
3.49%
Treasury-Notes (10-Year)
5.81%
6.60%
Large-Cap Stocks
11.23%
Mid-Cap Stocks
15.15%
Small-Cap Stocks
25.32%
Treasury-Bills (30-Day)
3.49%
Treasury-Notes (10-Year)
5.81%
6.60%
Large-Cap Stocks
11.23%
Mid-Cap Stocks
15.15%
Small-Cap Stocks
25.32%
14
7/7/15
Discounting
Discounting CFs moves them back in time
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
15
7/7/15
Discounting
Discounting CFs moves them back in time
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
Discounting
Discounting CFs moves them back in time
0
CF0
CF1
CF2
CF3
CF4
CF1 (1+ R )
CF2 (1+ R )
CF3 (1+ R )
CF4 (1+ R )
16
7/7/15
Present Value
Present value, PVt() of CFs is discounted value
of CFs as of t
0
CF0
CF1
CF2
CF3
CF4
Example Savings
How much do you have to save today
to withdraw $100 at the end of each
of the next four years if you can earn
5% per annum?
17
7/7/15
Example Savings
Step 1: Put cash flows on a time line
0
100
100
100
100
Example Savings
Step 2: Move CFs back in time to today
0
100
100
100
100
100
(1+ 0.05 )
100
1+
( 0.05 )2
100
(1+ 0.05 )3
100
(1+ 0.05 )4
18
7/7/15
Example Savings
Step 2: Move CFs back in time to today
0
100
100
100
100
95.238
90.703
86.384
82.270
Copyright
Michael
R.
Roberts
Example Savings
Step 3: Add up CFs (all in time 0 units)
0
= 354.60
100
100
100
100
+
95.238
+
90.703
+
86.384
+
82.270
Copyright
Michael
R.
Roberts
19
7/7/15
Example Savings
0
354.60
100
100
100
100
Example Savings
0
354.60
100
100
100
100
20
7/7/15
Example Savings
0
354.60
100
100
100
100
21
7/7/15
100
100
100
100
100
(1+ 0.05 )
100
(1+ 0.05 )2
100
(1+ 0.05 )3
100
(1+ 0.05 )4
100
100
100
100
100
(1+ 0.05 )
100
(1+ 0.05 )2
100
1+
( 0.05 )3
100
(1+ 0.05 )4
22
7/7/15
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
354.60 0.05
23
7/7/15
354.60 + 17.73
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
$372.32
24
7/7/15
Pre-Withdrawl
Post-Withdrawl
Balance
Balance
Withdrawal
$354.60
$372.32
$100.00
$272.32
372.32 100
25
7/7/15
Summary
26
7/7/15
Lessons
Never add/subtract cash flows from different
time periods
Use (i.e., multiply by) discount factor to
change cash flows time units
(1+ R )t
t < 0 moves CF back in time (discounting)
t > 0 moves CF forward in time (compounding)
Copyright
Michael
R.
Roberts
Lessons
Use a time line to help formulate
problems
0
CF0
CF1
CF2
CF3
CF4
27
7/7/15
Lessons
Present value as of time s of a cash
flow at time t > s is denoted, PVs (CFt)
Tells us the value future cash flows
Tells us the price of a claim to those
cash flows
Coming up next
Compounding
28
7/7/15
Problems
Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
Copyright
Michael
R.
Roberts
29
7/7/15
Problem Notation 1
Which of the following present value notations
denotes the value as of period 4 of a cash flow
received in period 12?
a) PV0(CF)
b) PV0(CF12)
c) PV4(CF)
d) PV4(CF12)
e) PV12(CF4)
10
11
12
CF12
PV4(CF12)
Problem Notation 2
Which of the following present value notations
denotes the value as of today of a cash flow
received in period 6?
a) PV0(CF6)
b) PV6(CF0)
c) PV4(CF)
d) PV4(CF12)
e) PV4(CF4)
6
CF6
PV0(CF6)
30
7/7/15
Problem Inheritance 1
You will receive an inheritance of $500,000 in 20
years on your 40th birthday. What is the value of
the inheritance today if the discount rate is 10%?
0
19
20
$500,000
500,000
Present Value = PV0 (CF20 ) = PV0 ( 500,000 ) =
= 74,321.814
(1+ 0.10 )20
Problem Inheritance 2
Your brother offers you $150,000 today for a claim
to your future inheritance. Should you accept his
offer?
Yes. The present value of your inheritance,
$74,321, is substantially less than your brothers
offer, $150,000. Your brother should take finance.
31
7/7/15
5
$1 mil
1,000,000
= 821,927.1067
(1+ 0.04 )5
5
$1 mil
$747,258.17
1,000,000
Price = PV0 (CF5 ) 747,258.1729 =
(1+ R )5
1,000,000
R =
747,258.1729
1/ 5
1= 6.00%
32
7/7/15
5
$1 mil
1,000,000
= 888,996.3587
(1+ 0.04 )3
Problem Education 1
Some studies estimate that private college will cost
$130,428 per year in 2030 (http://www.cnbc.com/id/
47565202). Assuming your child will attend college for four
years at a constant cost of $130,428 per year, how much
money do you need at the start of their first year when the
first bill is due to finance all of their college years if you
can earn a risk-free return of 5%?
College
1
Year
Period
130,428
?
130,428
130,428
130,428
33
7/7/15
130,428
130,428
130,428
+
2 +
(1+ 0.05 ) (1+ 0.05 ) (1+ 0.05 )3
= 485,615.7940
Copyright
Michael
R.
Roberts
Problem Education 2
Continuing the previous problem, assume that you put the
money into a savings account earning an annual risk-free
return of 5% per annum. How much money will be in the
account at the end of the first year after you make the
second payment of $130,428?
Savings = PV1 (CF2 ) + PV1 (CF3 )
=
130,428
130,428
+
(1+ 0.05 ) (1+ 0.05 )2
= 242,519.18
34
7/7/15
85
100
86
$2,655,590
PV0 (CF86 ) =
CF86
2,655,590
2,655,590
100 =
R =
100
(1+ R )86
(1+ R )86
1/ 86
1= 12.5755%
50,000
Value =
50,000
250,000
50,000
50,000
250,000
+
= 262,447.6130
2 +
(1+ 0.12 ) (1+ 0.12 ) (1+ 0.12 )3
35
7/7/15
Extra Slides
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
36
7/7/15
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 1: Put cash flows on a time line
0
2
150
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 2: Move cash flow back to today
0
CF2 (1+ R )
1
2
2
150
37
7/7/15
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 2: Move cash flow back to today
0
150 (1+ 0.02 )
1
2
2
150
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 2: Move cash flow back to today
0
144.175
2
150
38
7/7/15
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 2: Move cash flow back to today
0
2
150
144.175
Example 1 Savings
How much do you have to save today
to have $150 in two years assuming
that you can earn 2% per annum?
Step 2: Move cash flow back to today
0
144.175
2
150
39