Chapter 5 The Time Value of Money

Tangible assets and intangible assets.

Well study the relationship between value of dollars today and dollars in the future.

5.1 Future Values and Compound Interest

Future Value (FV): amount to which an investment will grow after earning interest.

() $100 = $100 (1 + )

Compound interest: interest earned on interest

In contrast, if the bank calculates the interest only on your original investment, its a simple
interest: interest earned only on the original investment.

Compound growth means that value increases each period by the factor (1 + growth rate). The
value after t periods will equal de initial value times (1+growth rate)^t. When money is invested
at compound interest, the growth rate is the interest rate.

5.2 Present Values

Money in hand today has a time value: a dollar today is worth more than a dollar tomorrow.

Present Value (PV): Value today of a future cash flow.

() =
(1 + )

To calculate present value, we discounted the future value at the interest rate r. The calculation is
therefore termed a discounted cash-flow (DCF) calculation (another term for the PV of a future
cash flow), and the interest rate r is known as the discount rate (the interest rate used to compute
present values of future cash flows).

To work out how much you will have in the future if you invest for t years at an interest rate r,
multiply the initial investment by (1+r)^t. To find the present value of a future payment, run the
process in reverse and divide by (1+r)^t.

Thus, present values decline when future cash payments are delayed. The longer you have to wait
for money, the less its worth today.

We can write the PV formula differently:

 1
= =
(1 + ) (1 + )

The expression 1/(1+r)^t is called the discount factor: the present value of a $1 future payment.

As you move to higher interest rates, present values decline. As you move to longer discounting
periods, present values also decline.

It is very important to use present values when comparing alternative patterns of cash payment.
You should never compare cash flows occurring at different times without first discounting them
to a common date. By calculating PV, we see how much cash must be set aside today to pay
future bills.

Finding the Interest Rate

The most accurate way to find the interest rate when they give us the PV and FV, is using the PV or
FV formula and despejar the r.

5.3 Multiple Cash Flows

Until now, we only used a single cash flow. But most real-world investments will involve many
cash flows over time. Then there are many payments, its a stream of cash flows.

Future Value of Multiple Cash Flows

Problems involving multiple cash flows are simple extensions of single cash-flow analysis. To find
the value at some future date of a stream of cash flows, calculate what each cash flow will be
worth at that future date and then add up these future values.
A similar adding-up principle works for present value calculations

Present Value of Multiple Cash Flows

When we calculate de PV of a future cash flow, we are asking how much that cash flow would be
worth today. If there is more than one future cash flow, we simply need to work out what each
cash flow would be worth today and then add these PV.
The PV of a stream of future cash flows is the amount you need to invest today to generate that
stream.

5.4 Level Cash Flows: Perpetuities and Annuities

Any sequence of equally spaced, level cash flows is called an annuity (equally spaced level stream
of cash flows, with a finite maturity).
If the payment stream lasts forever, it is called a perpetuity: stream of level cash payments that
never ends.

How to Value Perpetuities

Cash payment from perpetuity = interest rate * PV

C = r * PV

We can rearrange this relationship to derive the present value of a perpetuity, given r and C.

PV of perpetuity = C / r

1- This formula IS NOT the formula of the PV of a single cash payment. A payment of $1 at the end
of 1 year has a PV of 1/(1+r), while the perpetuity has a value of 1/r.
2- The perpetuity formula tells us the value of a regular stream of payments starting one period
from now.
Sometimes you may need to calculate the value of a perpetuity that doesnt start to make
payments for several years.
VER LIBRO PARA ESTA PARTE!!

How to Value Annuities

You can always value an annuity by calculating the PV of each cash flow and finding the total.
However, it is usually quicker to use a simple formula which states that if the interest rate is r,
then the PV of an annuity that pays C dollars a year for each of t periods is:

1 1
= [ ]
(1 + )

The expression in brackets is the annuity factor: the PV of a $1 annuity.

Then: PV of t-year annuity = payment * annuity factor

We can know where the formula comes from, if we remember that an annuity is equivalent to the
difference between an immediate and a delayed perpetuity. VER LIBRO.

An amortizing loan (example 5.10). Amortizing means that part of the monthly payment is used
to pay interest on the loan, and part is used to reduce the amount of the loan.
Because the loan is progressively paid off, the fraction of each payment devoted to interest
steadily falls over time, while the fraction used to reduce the loan increases.

Annuities Due
The perpetuity and annuity formulas assume that the first payment occurs at the end of the
period.
However, streams of cash payments often start immediately. A level stream of payments starting
immediately is known as an annuity due.
Each of the cash flows in the annuity due comes one period earlier than the corresponding cash
flow of the ordinary annuity.
Therefore: PV of an annuity due =(1+r) * PV of an annuity

Future Value of an Annuity

$1 = $1 (1 + )
1 1
(1 + ) 1
=[ ] (1 + ) =
(1 + )

Remember that our ordinary annuity formulas assume that the first cash flow doesnt occur until
the end of the first period. If the first cash flow comes immediately, the FV of the cash flow stream
is greater, since each flow has an extra year to earn interest.

FV of annuity due = future value of ordinary annuity * (1+r)

5.5 Effective Annual Interest Rates

Until now, we have mainly used annual interest rates to value a series of annual cash flows. But
interest rates may be quoted for days, months, years or any convenient interval.
Effective annual interest rate (EAR): interest rate that is annualized using compound interest
(annually compounded rate).
When comparing interest rates, it is best to use EAR. But unfortunately, short-term rates are
sometimes annualized by multiplying the rate per period by the number of periods in a year. Such
rates are called annual percentage rates (APR): interest rate that is annualized using simple
interest.

= (1 + )# 1
#

Resumen: The EAR is the rate at which invested funds will grow over the course of a year. It
equals the rate of interest per period compounded for the number of periods in a year.

5.6 Inflation and the Time Value of Money

Real versus Nominal Cash Flows

Prices of goods and services continually change. An overall general rise in prices is known as
inflation: rate at which prices as a whole are increasing.
Economists track the general level of prices using several different price indexes. The best known
is the consumer price index, or CPI. This measures the number of dollars that it takes to buy a
specified basket of goods and services that is supposed to represent the typical familys purchases.
Economists sometimes talk about current or nominal dollars versus constant or real dollars.
Current or nominal dollars refer to the actual number of dollars of the day; constant or real
dollars refer to the amount of purchasing power.
Sometimes expenditures are fixed in nominal terms and therefore decline in real terms.

Inflation and Interest Rates

Whenever anyone quotes an interest rate, they are talking about a nominal rate, not a real one.
The nominal interest rate is the rate at which money invested grows.
The real interest rate is the rate at which the purchasing power of an investment increases.

1 +
1 + =
1 +

Useful approximation:

This approximation works best when both the inflation rate and the real rate are small. If they are
not, dont use the approximation, but the accurate formula.

Valuing Real Cash Payments

When we calculated PV, we discounted the nominal payment, at the nominal interest rate.
You get the same result if you discount the real payment by the real interest rate. The two
methods should always give the same answer. MIRAR EJEMPLO LIBRO.

REMEMBER: Current dollar cash flows must be discounted by the nominal interest rate; real
cash flows must be discounted by the real interest rate.
Mixing up nominal cash flows and real discount rates (or real rates and nominal flows) is totally
wrong.

Real or Nominal?

Any present value calculation done in nominal terms can also be done in real terms, and vice
versa. Most financial analysts forecast in nominal terms and discount at nominal rates. However,
in some cases real cash flows are easier to deal with.