Chapter 6 Time Value of Money. Introduction Why money has a time value –The opportunity cost of...
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Transcript of Chapter 6 Time Value of Money. Introduction Why money has a time value –The opportunity cost of...
![Page 1: Chapter 6 Time Value of Money. Introduction Why money has a time value –The opportunity cost of capital concept Time value of money and risk –Typically.](https://reader035.fdocuments.net/reader035/viewer/2022062308/56649ef15503460f94c02cc3/html5/thumbnails/1.jpg)
Chapter 6Chapter 6Chapter 6Chapter 6
Time Value of MoneyTime Value of Money
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Introduction• Why money has a time value
– The opportunity cost of capital concept
• Time value of money and risk– Typically risk and expected returns are related
to each other
• Investment decisions and the Time Value of Money– Allows us to compare present and future cash
flows on a comparable basis (apples to apples).
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Basic Time DiagramBasic Time Diagram
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• Principal (P): The amount borrowed or invested
• Interest rate (i): A percentage of the outstanding principle.
• Number of periods (n): (years or fractional of) that principal is outstanding.
• Present value (PV): present value of a single amount of cash, or series of cash flows.
• Future value (FV): future value of a single amount of cash, or series of cash flows.
Variables Used in Time Value of Variables Used in Time Value of Money ComputationsMoney Computations
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Time Value of Money – From Present Value to Future Value
and Back• A simple case is investing $1.00• Use of a time line is helpful
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Present and future values are calculated for us in the text:
• Future value of $1, Table 6.2• Present value of $1, Table 6.3• Future value of an annuity of $1, Table 6.5• Present value of an annuity of $1, Table 6.7
Compound Interest TablesCompound Interest Tables
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Present Value of a Single (Lump) Sum
Rate
Periods 10% 12% 14%
1 0.90909 0.89286 0.87719
2 0.82645 0.79719 0.76947
3 0.75131 0.71178 0.67497
4 0.68301 0.63552 0.59208
5 0.62092 0.56743 0.51937
Rate
Periods 10% 12% 14%
1 0.90909 0.89286 0.87719
2 0.82645 0.79719 0.76947
3 0.75131 0.71178 0.67497
4 0.68301 0.63552 0.59208
5 0.62092 0.56743 0.51937
Excerpt from Present Value of $1, Table 6.3
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2 0.82645 0.79719 0.76947 3 0.75131 0.71178 0.67497 4 0.68301 0.63552 0.59208 5 0.62092 0.56743 0.51937
2 0.82645 0.79719 0.76947 3 0.75131 0.71178 0.67497 4 0.68301 0.63552 0.59208 5 0.62092 0.56743 0.51937
Present Value of a Single (Lump) Sum
Present value factor of $1 for 2 periods at 12%.Present value factor of $1 for 2 periods at 12%.
$100 $100 ×× 0.797 = $79.70 present value 0.797 = $79.70 present value
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Future Value Exercise• $100,000 is put into a mutual fund yielding a
12% annual return. How much would the fund be worth in 23 years?
• $100,000 * 13.552 = $1,355,200
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Present Value of a Series of Cash Flows
• Annuity – a series of receipts (or payments) of the same amount spaced over regular time intervals (periods)– Example– Beauty of the PV factors for annuities
• Uneven series of receipts (or payments)– Example– No single PV factor may be used, the present
value of each cash flow must be calculated, then summed
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Annuity
11 22 33 44 55 66
$100$100 $100$100 $100$100 $100$100 $100$100 $100$100
An investment that involves a series of IDENTICAL cash flows at the end of each year is called an annuityannuity.
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PV of An Annuity Example
Lacey Company purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the
present value of this stream of cash payments when the discount rate is 12%?
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PV of An Annuity Example
We could solve the problem like this . . .
Present Value of an Annuity of $1Excerpted from Table 6.6
Periods 10% 12% 14%1 0.9091 0.8929 0.8772 2 1.7355 1.6901 1.6467 3 2.4868 2.4018 2.3216 4 3.1699 3.0373 2.9137 5 3.7908 3.6048 3.4331
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PV of An Annuity Example
We could solve the problem like this . . .
Periods 10% 12% 14%1 0.9091 0.8929 0.8772 2 1.7355 1.6901 1.6467 3 2.4868 2.4018 2.3216 4 3.1699 3.0373 2.9137 5 3.7908 3.6048 3.4331
$60,000 × 3.605 = $216,300$60,000 × 3.605 = $216,300
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Future Value of a Series of Cash Flows
The same techniques applied to calculating the PV of an annuity or uneven stream of cash flows may be used to calculate the FV of cash flows– Example
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The Rule of 72• A quick way to estimate the approximate
number of periods it takes to double the value of an investment.
72 % return
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Text ProblemsNote: some problems require the use of formulas )or
tables outside the text)• E 33(a) FV single sum• E 33(b) “ “• E 34(a) PV single sum• E 34(b) PV series of cash receipts• E 35(a) FV annuity + lump sum• E 35(b) “ ”• E 36(a) Lottery winnings – PV vs. annuity• E 36(b) Lottery winnings – PV vs. annuity
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The Net Present Value Method
To determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,Subtract the present value of the outflows from
the present value of the inflows.
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Typical Cash Outflows
InitialInitialinvestmentinvestment
Repairs andRepairs andmaintenancemaintenance
IncrementalIncrementaloperatingoperating
costscosts
WorkingWorkingcapitalcapital
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Typical Cash Inflows
ReductionReductionof costsof costs
Salvage valueSalvage value
IncrementalIncrementalrevenuesrevenues
Release ofRelease ofworkingworkingcapitalcapital
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The Net Present Value Method (NPV)
General decision rule . . .
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The Net Present Value Method
Lester Company has been offered a five year contract to provide component parts for a large manufacturer.
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The Net Present Value Method
• At the end of five years the working capital will be released and may be used elsewhere by Lester.
• Lester Company uses a discount rate of 10%.
Should the contract be accepted?Should the contract be accepted?
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The Net Present Value Method
Annual net cash inflows from operations
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The Net Present Value Method
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The Net Present Value Method
Present value of an annuity of $1 factor for 5 years at 10%.
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The Net Present Value Method
Present value of $1 factor for 3 years at 10%.
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The Net Present Value Method
Present value of $1 factor for 5 years at 10%.
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The Net Present Value Method
Accept the contract because the project has a positivepositive net present value.
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Expanding the Net Present Value Method
To compare two competing investment projects we can use the following net present value approaches:– Total-cost – Calculate NPV for each project.
Accept the project with the higher NPV– Incremental cost – Determine the cash flow
differences between alternatives, and calculate the NPV of these cash flows. Accept one alternative over the other if the differential NPV is positive.
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Least Cost Decisions
In decisions where revenues are not directly involved, managers should choose the
alternative that has the least total cost from a present value perspective.
Let’s look at the Home Furniture CompanyLet’s look at the Home Furniture Company..
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Least Cost Decisions
• Home Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.
• The company uses a discount rate of 10%.
HomeFurniture
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Least Cost Decisions
Old TruckOverhaul cost now 4,500$ Annual operating costs 10,000 Salvage value in 5 years 250 Salvage value now 9,000
Information Information about the about the trucks . . .trucks . . .
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Least Cost Decisions
Buy the New Truck YearCash Flows
10% Factor
Present Value
Purchase price Now $(21,000) 1.0000 $ (21,000)Annual operating costs 1-5 (6,000) 3.7908 (22,745)Salvage value of old truck Now 9,000 1.0000 9,000 Salvage value of new truck 5 3,000 0.62092 1,863 Net present value (32,882)
Keep the Old Truck YearCash Flows
10% Factor
Present Value
Overhaul cost Now $ (4,500) 1.0000 $ (4,500)Annual operating costs 1-5 (10,000) 3.7908 (37,908)Salvage value of old truck 5 250 0.62092 155 Net present value (42,253)
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Least Cost Decisions
Home Furniture should purchase the new truck.
Net present value of costs associated with purchase of new truck (32,883)$ Net present value of costs associated with remodeling existing truck (42,255) Net present value in favor of purchasing the new truck 9,372$
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The Internal Rate of Return Method
• The internal rate of return is the interest yield promised by an investment project over its useful life.
• The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero.
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The Internal Rate of Return Method
• Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
• The machine has a 10-year life.
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The Internal Rate of Return Method
Future cash flows are the same every year in this example, so we can calculate the
internal rate of return as follows:
Investment required Net annual cash flows
PV factor for theinternal rate of return
=
$104, 320 $20,000
= 5.216
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The Internal Rate of Return Method
Find the 10-period row, move across until you find the factor 5.216. Look at the top of the
column and you find a rate of 14%14%.
Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647
. . . . . . . . . . . .9 5.759 5.328 4.946 10 6.145 5.650 5.216
Using the present value of an annuity of $1 table . . .
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The Internal Rate of Return Method
• Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs.
• The machine has a 10-year life.
The internal rate of return internal rate of return on this project is 14%.
If the internal rate of return is equal to or If the internal rate of return is equal to or greater than the company’s required rate of greater than the company’s required rate of
return, the project is acceptable.return, the project is acceptable.
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Net Present Value vs. Internal Rate of Return
Net Present ValueNet Present Value Easier to use.Easier to use.
Assumes cash inflows will Assumes cash inflows will be reinvested at the be reinvested at the discount rate. This is a discount rate. This is a realistic assumption.realistic assumption.