Chapter 3-- Measuring Wealth:

Time Value of Money

Why

must future dollars be put on a common

basis before adding?
Cash is a limited and controlled resource.
Those controlling the resource can charge
for its use.
The longer the period of use the higher the
interest (or rental fee) for the use of the cash.
Therefore, you cannot add a 1 year dollar
with a two year dollar.

Future Dollar Equivalent (Future

Value) of a Present Amount
These

can be solved using formulas, tables, a

financial calculator or a computer spreadsheet
package

Formula

solution FV = PV (1+i)n
Example -- How much will $1000 grow
to at 12% in 15 years?
Enter

1.12, yx, 15, times 1000 = $5473.56

Present Dollar Equivalent (Present

Value) of a Future Amount
These

can be solved using formulas, tables, a

financial calculator or a computer spreadsheet
package

Formula
Example

solution PV = FV/ (1+i)n

-- how much do you need today to

have $1,000,000 in 40 years if your money is
earning 12%?
Enter 1.12, yx, 40, =, 1/x, times 1000000 =
$10,747

Finding the Rate Between

Two Single Amounts

These can be solved using formulas, tables, a financial

calculator or a computer spreadsheet package

Formula

solution -- i = (FV/PV)1/n -1

Example you purchased your house for $76,900 in

1994. Your neighbors house of similar value sold for
$115,000 in 2004 ( 10 years later). What rate of return
are you earning on your house?

Enter 115000 / 76900, yx, .1, , 1, =, .0411 or 4.11%

Finding the Number of Periods

Needed Between Two Amounts

These can be solved using formulas, tables, a financial

calculator or a computer spreadsheet package

Formula

solution -- n = LN(FV/PV)/LN(1+i)

Example you inherit $120,000 from your great aunt

and invest it to earn 8% interest. How long will it take
for this to grow to $1,000,000?

Enter (1000000 / 120000) ,=, ln -- this gives you 2.1203

Enter (1.08), ln -- this gives you .0770
Divide the two results to get 27.55 years

Different Types of Annuities.

Ordinary annuities -- dollars are received or paid at the

end of the period and grow until the end of the period.
All annuity formulas to be discussed will work for
ordinary annuities with no adjustments.
Annuities due -- dollars are received or paid at the
beginning of the period and grow until the end of the
period.
All annuity formulas to be discussed will need
adjustment (for the extra years worth of interest).

Future Value of an Ordinary Annuity

and an Annuity Due

Example -- How much will you have at the end of 35

years if can earn 12% on your money and place
$10,000 per year in you 401k account at the beginning
of the year? (at the end of the year?)
Formula solution ordinary annuity

Enter (1.12,yx, 35, =, 1, = ) / .12 times 10000

FV = [((1+i)r 1) / r ] payment
The answer is $4,316,635

To solve for an annuity due just remove the 1 from the

formula above the answer is then $4,834,631

Present Value of an Ordinary Annuity

and an Annuity Due

Example -- How much is a trust fund worth today that

promises to pay you $10,000 at the end (or beginning) of
each year for 35 years if can earn 12% on your money?
Formula solution ordinary annuity

FV = [[1-(1/(1+i)r)] / r ] payment
Enter 1.12,yx, 35, =, 1/x, ,1, +/-, = ) / .12 times 10000
this will give you the answer of $81,755

To solve for an annuity due, change the 35 to 34 in the

formula above then add an additional 10000 payment to the
answer of $81,566 to get $91,566

Present Value of an Uneven Stream

of Year-end Cash Flows

Example You can invest in an athletic endorsement

that will increase net cash flows to your firm by:
$800,000 at the end of year 1
$600,000 at the end of year 2
$400,000 at the end of year 3
After that, you do not expect any additional benefit from her
endorsement. What is the present value of this endorsement if
the firm has a cost of funds of 8 percent?
Formula solution discount each future cash flow to present by
dividing by (1+i)n and then add up these results

Answer -- $1,572,679

Rate of Return on an Uneven Stream

of Year-end Cash Flows

Example you can invest in an athletic endorsement

that will increase net cash flows to your firm by:

$800,000 at the end of year 1

$600,000 at the end of year 2
$400,000 at the end of year 3
After that, you do not expect any additional benefit from her
endorsement. If this endorsement cost the firm $1,000,000
today, what is the rate of return of this endorsement?
Calculator solution 2nd , CLR WRK, CF 1000000, +/-, enter,
800000, enter, 600000, enter, 400000, enter, IRR, CPT
The answer 42.06% appears

Adjusting for Compounding More

Than Once a Year

In the formula, you divide the interest rate by the number of

compoundings and multiple the n by the number of
compoundings to account for monthly, quarterly or semi-annual
compounding
Excel Example -- What will $5,000 dollars invested today grow
to at the end of 10 years if your account promises a 10% APR
compounded monthly? You Enter -- for the monthly answer -=FV(.10/12,10*12,0,-5000,0)
You Enter -- .10/12, =, +1, =, yx ,120 times 5000 = $13,535

Adjusting for Compounding More

Than Once a Year

To adjust an APR or nominal rate to an effective rate use the

following formula:
Effective rate = [(1+ nominal rate / # of comp.)n times # of comp]-1

Adjusting for When Cash Flows Are

Received Daily
A close

approximation for level daily cash

flows is the use of mid-year cash flows.
When using a computer package with both mid
year and year-end cash flows it is easiest to use
the PV function to discount each periods cash
flow back to present individually.
When looking for the internal rate of return of
daily cash flows the problem must be worked as
a goal seek (solving for the interest rate).

Valuing Perpetuities

Value perpetual no-grow cash flows

Formula

Present value = cash flow / discount rate

Value perpetual growing cash flows

Formula

Present value =
cash flow /(discount rate - growth rate)