CH08b MoreTimeValue-ToPost

INTRODUCTION TO BUSINESS FINANCE
CHAPTER 8B
MORE TIME VALUE OF MONEY
TIME VALUE OF MONEY PAGE 1

Projects with
Multiple Future Cash Flows
So far we’ve looked at cases with one future Cash Flow:
These cases also called:

 Two CF problems
 “Lump Sum” problems

Most real-world problems involve multiple future CFs.
Solved (easily) by treating them as sets of two CF problems.
Example – Find:
How much would an investor pay now to purchase a CD returning
 $6K in one year, and
 $8K in two years,
with an interest rate (r) of 10.4%?

Solution:
Cash Flow Diagram for investor: 8k

|
6k |
|
|
|
|
| r = 10.4%
|
|
|
|
|
|
|
|
|------------------------------|--------------------------------------------------
|
a 1 2 time

CF0 = PVTOT = amount investor pays now, comprised of:
 a tranche that will grow to $6K in one year (CF1),
 another tranche that will grow to $8K in two years (CF2),
where r for each tranche = 10.4%.
IE: CF0 = tranche a + tranche b.
From the Fundamental Time Value Eq, we know:

 tranche a = 6/(1+10.4%)^1
 tranche b = 8/(1+10.4%)^2
→ CF0 = a + b

Reminder:
 $12.00K that the investor pays for the CD = CF0 = PVTOT
= The PV of all the investor’s future cash inflows for this project.
 PVTOT is comprised of:
a $5.44K tranche for the $6K repayment, and
a $6.56K tranche for the $8K repayment.

Multiple Future Cash Flows:
General Case
Generalizing the above example →
In words:
The total PV (PVTOT or CFo) of a set of future Cash Flows (CFs)
= the sum of the individually discounted CFs.
First discount each future CF, then add them up.
With math:
For a set of future Cash Flows (CF1,...CFn),
PVTOT == CFO = PV(CF1) +,… + PV(CFn)

 Using summation notation:
PVTOT = CFO = Σ CFi / (1+r)Ti 74c)
i = 1,...number of future cash flows, n.
Ti = Time of Cash Flow i, where T = 0 at PV
This equation called “Fundamental Discounted CF Equation.”

Very Important
 Given Can Find

Future CFs, r PVTOT (or CF0)
PVTOT, r, uniform CFs The uniform CF
PVTOT , CFs r (iterate) Usually need Excel, etc

Meanings of:
PVTOT = CF0 =Σ CFi / (1+r)Ti
i = 1,...number of future cash flows
From lender’s perspective (CD investor in above example):

1. PVTOT (or CF0) is amount we invest now (principal we commit now)
to receive the future stream of cash flows.
2. With PVTOT (or CF0) constant: As r ↑, Future CFs ↑

Should lender try to maximize r?
--> No. Charge very high r --> a. Customers go to competitors with lower r
b. Few customers you get will have very high probability of going bankrupt (Must have been refused by other
lenders)

From borrower’s perspective (CD seller in above example):
1. CF0 is amount we can get now if we agree to pay the future stream of
cash flows.
2. With future CFs constant: As r ↑, CF0 ↓
--> as a borrower, you want lowest r possible, to get biggest CFo.
How can borrower reduce r?

Consumers:
Build a history of borrowing and paying back fully on time.

EXAMPLE:
Velocity Advisors offers to pay you $6K at the end of the next year
(CF1 at EOY1) and CF2 = $12K at EOY2, in return for
your payment now of CF0. Velocity’s interest rate on this deal is 10%.
Find:
a) Cash Flow Diagram for you.
b) CF0
c) If you have just $15.00K to invest now, can you participate in
Velocity’s deal?

Solution
a) CF Diagram:
Looks just like the first example.
Just make 2 yr payment = 12k and r = 10%

b) CFO = Total amount you pay now will grow at 10% annually,
and be repaid in two tranches ($6K at EOY1 and $12K at EOY2).
→ CF0 = 6/1.1 + 12/(1.1)^2 = 15.37K

a + b
CFo = blob a plus blob b

Interpretation:
CF0 = A portion corresponding to the 1st repayment (CF1),

+ a portion corresponding to the 2nd repayment (CF2).
→ $15.37K = $5.45 to get the 1st repayment {from $6K / (1+10%)}

+ $9.92 to get the 2nd repayment {from $12K / (1+10%)2}

c) Yes or no. Why?
Cannot participate. We have 15K available, need 15.31 to partcipate

EXAMPLE:
Zero Motorcycle’s Streetfighter S is available at Amazon for $9K.
Rent-A-Center (RAC) is offering the same bike for zero down, and two
uniform annual payments of $6K, starting one year from now. Your bank
gives you 10% annual interest on your savings account.
Find:
Should you buy the bike from Amazon or RAC? Why? Assume for the
RAC option that you would invest enough now in your savings account to
make the two future payments.

Solution: Find the CFo’s for each option and compare.
Amazon project:
CF0,Amazon = 9k goes to Amazon now, then done
RAC Project:
Put two blobs (tranches) of cash into Savings account now:
Blob 1 (PV1) grows at 10% to $6K in one year.
Blob 2 (PV2) grows at 10% to $6K in two years.
PVtot = CFo, RAC = PV1 + PV2
→ PVTOT = CF0,RAC = _______________________.
6/1.1 + 6/(1.1)^2 = 10.4K

Conclusion:
Buying from _________
Amazon is best.
Why:
For RAC Option: must set aside 10.4k now at T = 0
For Amazon Option: Just pay 9k now at T = 0

EXAMPLE: (IMPORTANT FOR EXAMPLE 2)
ShadyDeals, Inc. offers to pay you $6K in one year and $12K in 2.5
years, in return for your payment now of $14.91K. ShadyDeals’ interest
rate on this project is r.
Find:
a) Cash Flow Diagram for you. (Lender)
b) An algebraic equation to use as a start point for finding r.
c) Is r closest to 6%, 10%, or 12%?

Solution
a. Cash Flow Diagram:

Same form of diagram on the first example

b. Equation:
Use this: PVTOT = CF0 =Σ CFi / (1+r)Ti

CFo = 14.91k = 6/(1+r) + 12/(1+r)^2.5
c. Note: Can’t solve this eq for r.
→ If r = RHSide of Eq = 14.91 = LHS of Equation

RHS = 6/(1+6) + 12/(1+6)^2.5 = 16.03
6%
RHS = 6/(1+12) + 12/(1+12)^2.5 = 14.39
12%
RHS = 6/(1+ 10) + 12/(1 + 10)^2.5 = 14.91
10%
--> CORRECT ANSWER

More on Solving for
Fundamental DCF Equation's Variables
Recall Fundamental DCF Equation:
PVTOT = Σ CFi / (1+r)Ti 74c)
i = 1,...number of future cash flows n.
And what we can find with it:
Given Can Find

Future CFs, r PVTOT (CF0)
PVTOT, r, uniform CFs CF
PVTOT , CFs r (iterate)

Why r may be difficult to compute:
Consider:
PVTOT = 10 = 6 / (1+r)1 + 8 / (1+r)2 ; n = 2 and Ti integer in eq 74c.
What is r ?
 Magic of algebra →
10(1+r)2 – 6(1+r) – 8 = 0
 Quadratic eq; solutions for r are roots.
→ Two roots. Which is correct one?
If i  3 in eq. 74c, then r’s are roots of 3rd order polynomial...

If Ti's are not integers, must find roots of a real equation...
→ In general, find r via iterative numerical algorithms.
More than one r may exist. Some r's may be complex numbers.
CONSTANT CF PROJECT TYPES
(ANNUITIES)
Constant CF Project Types (Annuity Projects):
(All the future CFs are equal)
 Mortgage
 Financial Annuity
 Annuity Due (Lease)
 Perpetuity
 Etc…(not growing perpetuity)
DCF EQUATION FOR
CONSTANT CF PROJECTS (ANNUITIES)
Recall, for general multiple-CF case:
PVTOT = CFO = Σ CFi / (1+r)Ti

If CFi = CF (constant), 74c) simplifies to:
PVTOT = CF * Σ 1 / (1+r)Ti 74d)


A simpler formula for PVTOT (CFO) when future CFs are constant:
– Or --
PVTOT = CF * (1 – (1+r)^-n) / r
This is Eq 74e) in either form.
Use 74d) for any constant CF project (any Annuity project).

Use 74e) for any constant CF project EXCEPT annuities due (see below).

Consider a three year mortgage:
 Mr. SmallNetWorth (SNW) wants the biggest 3 year mortgage he

can afford, to buy the biggest shack he can find.
 Lender estimates Mr. SNW can afford to make mortgage payments

of $12.06K per year without going bankrupt.
 Lender’s policy is to charge 10% annual interest to borrower’s of

SNW’s credit quality.
Find:
How much will Lender let Mr. SNW borrow?

Solution:
Let: CFo = Amount Lender gives to Mr. SNW.

CF1 = CF2 = CF3 = CF = Annual amount paid back by SNW.
Cash Flow Diagram for __________.

Lender
r = 10%
Solver PVtot

Note:
At T = 0, Lender wants to:

 Loan a tranche that will grow to $12.06K in one year.
This is PV(CF)1
 Loan a tranche that will grow to $12.06K in two years.
This is PV(CF)2
 Loan a tranche that will grow to $12.06K in three years.
This is PV(CF)3

Solution from eq 74d:
PVTOT = CF * Σ 1 / (1+r)Ti 74d)

T1 = 1, T2 = 2, T3 = 3.
Here we have future CF at T=1, 2, and 3.

→ Algebraically: CF0 = PVTOT =
With CF = 12.06K, r = 10%:

→ CF0 = PVTOT = 12.06*(1.1/1 + 1.1/1^2 + 1.1/1^3) = 30.0K

Solution from eq 74e:
– Or --
PVTOT = CF * (1 – (1+r)^-n) / r
This is Eq 74e) in either form.
PVTOT = CFo = CF * [(1 – (1+r)^-n) / r] = 12.06 * [(1 - (1+10%)^-3)/10%] = 30.0K

TIME VALUE AND RISK REVIEW
Recall, in general, r increases with project’s risk.
 True because it is found empirically.
 US Treasury can borrow money (issue bonds) at ~ lowest interest rates.

(~ “risk free” investment).
 Subprime borrowers pay more interest to compensate for higher

probability they will default.

Financial Annuities
Financial Annuity:
A financial product where the purveyor (borrower) says:
“Give me $X now, in return for N annual (or monthly, etc)
uniform payments of $Y.”
Sum of the $Y payments is more than $X.
Used for:
• Retirees who want guaranteed income of $Y for N years.
• Consumers who think they might squander their $X.

Financial Annuity Example
Consider a 3-yr annuity
investment:
Velocity Advisors offers Diagram for you - the Lender.
3 yr, 7% annuity:
How much do customers pay You give us PV tot now, we giver 50/yr for 3 yrs.
now (CF0) to receive 3 annual
annuity pmnts of $50?
(payments made @ EOY).
Solve for 74e:= 50*(1-(1+7%)^-3)/7% = 131.22

Note:
Mortgages and Financial Annuities have same cash flow structure.
• Constant Future CFs
• Borrower’s CFs made at End of Period (EOP)
→ These are collectively called “Standard Annuities.”

We call them uniform future CF projects

Annuity Due Projects
Also called leases --> lease = annuity due for us
Annuity Due == annuity with repayments made at BOPeriod.
Cash flow structure.

• Constant Future CFs
• Borrower’s CFs made at Beginning of Period (BOP)
Annuity Due’s used when:

 Lender wants cash back quicker.
 Borrower is paying upfront each period,
for use of item during the period.
(Typically rental agreements and leases).

Example: 3-yr annuity due lease project:
1. Morning
 Lessor pays $140.4K for 2. Has a lunch
7075 Al alloy 3-D printer,

with three-year life.
3. After lunch
 Leases printer to GCC for three years via 7% annuity due.
(IE: a three year, 7% lease).
What is GCC's annual payment?

We know: PV tot or CFo, r = 7%. Find C or CF

Solution:
Cash Flow Diagram: b
a c
a = CF/(1.07)^0 = CF
b = CF/(1.07)^1
c = CF/(1.07)^2

Calculation of annual payment (CF) from 74d):
i = 1, 2, 3
T1 = 0, T2 = 1, T3 = 2
Plugging into 74d) →
140.4 = ____________________________
CF*(1/1 + 1/1.07^1 + 1/1.07^2)
CF = _____________________________
14.4 /(CF*(1/1 + 1/1.07^1 + 1/1.07^2)) = 50K
→ GCC pays $50K at BOY J for use of printer during year J.

General formulas for Annuities Due:
A. This works for any uniform CF project, including annuities due:
PVTOT = CF * Σ 1 / (1+r)Ti 74d)
B. This formula works ONLY for annuities due:
PVTOT = CF *
( 1+
) 74f)
PVTOT = CF * ( 1 + (1 – (1+r)^-(n-1)) / r )

Solve above lease project with 74f:
Find CF, where:

• r = 7%
• term (T or n) is three years.
→ PVTOT = CFO = 140.4 = CF * (1+...
CF = PVtot / ( 1 + (1 – (1+r)^-(n-1)) / r )
= ______________________________________.
140.4 / ( 1 + (1 - (1 + 7%)^-(3 - 1))/(7%) = 50.0K

Note:
Going forward, when context is clear,
we sometimes write PV instead of PVTOT or CFO
in multiple CF problems.

PERPETUITIES
Perpetuity == Uniform Cash Flow project with
repayments (at EOP) stretching on forever.
Satisfies: PV = CF * Σ 1 / (1+r)Ti 74e)

i = 1,...infinity
Convert to closed form equation. (Heuristic Method):

 Consider investing $100 in bank account that pays
10% compound annual interest forever.
 End of every year you draw $10.
 this is a perpetuity
 your principal never grows or declines
 Satisfies: CFi = CF = r * PV, or
 PV = CF/r ; The perpetuity formula 74g)

Perpetuity Example:
A local bank will pay you $100 a year for your lifetime if you deposit $3,000 in
the bank today. If you plan to live forever, what is the interest rate on this
perpetuity?
Solution:
PV = CF/r r=? r = CF/PV = 100/3000 = 3.33%

GROWING PERPETUITY
Growing Perpetuity
== Infinite stream of CFs (at EOP), growing by g each period,
and discounted at constant r.
IE: C1 is first CF. C2 = C1 * (1 + g)
→ PV = C1 / (1+r) + C2 / (1+r)2 + C3 / (1+r)3 + … to infinity
PV = p C1 / (r – g)

Example:
C1 C2
What is the PV of a growing perpetuity that pays $100 a year from now, $101
two years from now, and has an interest rate of 5%?
r
Solution:
g= 1% from $100 to $101 or (C2 - C1)/C1 = (100 - 101)/100 = 1%
PV = 100/(5% - 1%) = 2500


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INTRODUCTION TO BUSINESS FINANCE

TIME VALUE OF MONEY PAGE 1

These cases also called:

TIME VALUE OF MONEY PAGE 3

TIME VALUE OF MONEY PAGE 4

Cash Flow Diagram for investor: 8k

TIME VALUE OF MONEY PAGE 5

From the Fundamental Time Value Eq, we know:

TIME VALUE OF MONEY PAGE 7

TIME VALUE OF MONEY PAGE 9

TIME VALUE OF MONEY PAGE 10

This equation called “Fundamental Discounted CF Equation.”

 Given Can Find

TIME VALUE OF MONEY PAGE 11

From lender’s perspective (CD investor in above example):

2. With PVTOT (or CF0) constant: As r ↑, Future CFs ↑

TIME VALUE OF MONEY PAGE 12

How can borrower reduce r?

TIME VALUE OF MONEY PAGE 13

TIME VALUE OF MONEY PAGE 14

TIME VALUE OF MONEY PAGE 15

→ CF0 = 6/1.1 + 12/(1.1)^2 = 15.37K

TIME VALUE OF MONEY PAGE 17

CF0 = A portion corresponding to the 1st repayment (CF1),

→ $15.37K = $5.45 to get the 1st repayment {from $6K / (1+10%)}

TIME VALUE OF MONEY PAGE 19

TIME VALUE OF MONEY PAGE 20

TIME VALUE OF MONEY PAGE 22

TIME VALUE OF MONEY PAGE 23

For Amazon Option: Just pay 9k now at T = 0

TIME VALUE OF MONEY PAGE 25

TIME VALUE OF MONEY PAGE 27

a. Cash Flow Diagram:

TIME VALUE OF MONEY PAGE 28

Use this: PVTOT = CF0 =Σ CFi / (1+r)Ti

CFo = 14.91k = 6/(1+r) + 12/(1+r)^2.5

c. Note: Can’t solve this eq for r.

→ If r = RHSide of Eq = 14.91 = LHS of Equation

TIME VALUE OF MONEY PAGE 29

And what we can find with it:

Given Can Find

TIME VALUE OF MONEY PAGE 31

If i  3 in eq. 74c, then r’s are roots of 3rd order polynomial...

Constant CF Project Types (Annuity Projects):

(All the future CFs are equal)

Recall, for general multiple-CF case:

PVTOT = CFO = Σ CFi / (1+r)Ti

If CFi = CF (constant), 74c) simplifies to:

PVTOT = CF * Σ 1 / (1+r)Ti 74d)

TIME VALUE OF MONEY PAGE 34

This is Eq 74e) in either form.

Use 74d) for any constant CF project (any Annuity project).

TIME VALUE OF MONEY PAGE 35

 Mr. SmallNetWorth (SNW) wants the biggest 3 year mortgage he

 Lender estimates Mr. SNW can afford to make mortgage payments

 Lender’s policy is to charge 10% annual interest to borrower’s of

TIME VALUE OF MONEY PAGE 36

Let: CFo = Amount Lender gives to Mr. SNW.

Cash Flow Diagram for __________.

TIME VALUE OF MONEY PAGE 37

At T = 0, Lender wants to:

TIME VALUE OF MONEY PAGE 38

PVTOT = CF * Σ 1 / (1+r)Ti 74d)