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Intermediate Finance: Session 2

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Intermediate Finance

Session 2
Time Value of Money

Refers to the observation that it is


better to receive money sooner than
later
Time Value of Money
• Refers to the observation that it is better to
receive money sooner than later
• There are two important implicit
assumptions in the above statement
Time Value of Money
• Refers to the observation that it is better to
receive money sooner than later
• Assumption 1: Money that you have in hand
today can be invested to earn a positive rate
of return, producing more money tomorrow
Time Value of Money
• Refers to the observation that it is better to
receive money sooner than later
• Assumption 1: Money that you have in hand
today can be invested to earn a positive rate
of return, producing more money tomorrow
• Assumption 2: Money is considered capital
or a direct factor of production
Perpetuity
• What is a perpetuity?
Perpetuity
• Why would someone offer you such a deal?
Perpetuity
• What can you deduce from this equation?
Perpetuity
Perpetuity
• How do you arrive at the last line?
Perpetuity
• What can you deduce from this equation?
Perpetuity
• What can you deduce from this equation?
Perpetuity
• What can you deduce from this equation?
What's the safest retail estate
investment opportunity in
Lahore?
What's the safest retail estate
investment opportunity in
Lahore?
Imagine an apartment building where
cash flows to the landlord after expenses
will be $100,000 next year. These cash
flows are expected to rise at 5 percent
per year. We assume that this rise will
continue indefinitely … Market
interest rate is 11 % . Is this a
perpetuity?
Growing Perpetuity
Growing Perpetuity
• What are the assumptions in this equation?
Growing Perpetuity
1. The numerator in formula is the cash flow
one period hence, not at date 0.
2. The discount rate r must be greater than the
growth rate g for the growing perpetuity
formula to work
3. We can apply the growing perpetuity formula
only by assuming a regular and discrete
pattern of cash flow.
Growing Perpetuity
Annuities
Annuities
Annuities
Common Pitfalls
Delayed Annuity
• Biden Khanum will receive a four-year
annuity of $500 per year, beginning at date 6.
If the interest rate is 10 percent, what is the
present value of her annuity?
• How do you solve this now?
Delayed Annuity
• Biden Khanum will receive a four-year
annuity of $500 per year, beginning at date 6.
If the interest rate is 10 percent, what is the
present value of her annuity?
• Step 1: Always make a timeline
Delayed Annuity
• Biden Khanum will receive a four-year
annuity of $500 per year, beginning at date 6.
If the interest rate is 10 percent, what is the
present value of her annuity?
• Step 1: Always make a timeline
Delayed Annuity
• Step 1: Always make a timeline

• Step 2: Find the PV at Date 5


Delayed Annuity
• Step 1: Always make a timeline

• Step 2: Find the PV at Date 5


Delayed Annuity
• Step 2: Find the PV at Date 5

• Students frequently think that $1,584.95 is the


present value at Date 6 because the annuity
begins at Date 6.
Delayed Annuity
• Step 1: Always make a timeline

• Step 2: Find the PV at Date 5


Delayed Annuity
• Step 2: Find the PV at Date 5

• Step 3: Discount the PV to Date 0


Delayed Annuity
• Summary
Annuity Due
Annuity Due
Annuity Due
Infrequent Annuity
• Amanat Chan receives an annuity of $450,
payable once every two years. The annuity
stretches out over 20 years. The first payment
occurs at Date 2—that is, two years from
today. The annual interest rate is 6 percent.
Find the PV.
Infrequent Annuity
• Amanat Chan receives an annuity of $450,
payable once every two years. The annuity
stretches out over 20 years. The first payment
occurs at Date 2—that is, two years from
today. The annual interest rate is 6 percent.
Find the PV.
• Step 1: Determine the interest rate over a
two year period
Infrequent Annuity
• Amanat Chan receives an annuity of $450,
payable once every two years. The annuity
stretches out over 20 years. The first payment
occurs at Date 2—that is, two years from
today. The annual interest rate is 6 percent.
Find the PV.
• Step 1: Determine the interest rate over a
two year period
Infrequent Annuity
• Step 1: Determine the interest rate over a
two year period

• Step 2: Determine the number of periods


Infrequent Annuity
• Step 1: Determine the interest rate over a
two year period

• Step 2: Determine the number of periods


• The annuity stretches out over 20 years, so
N=20
Infrequent Annuity
• Step 1: Determine the interest rate over a
two year period

• Step 2: Determine the number of periods


• The annuity stretches out over 20 years, so
N=20
Infrequent Annuity
• Step 1: Determine the interest rate over a
two year period

• Step 2: Determine the number of periods


What we want is the present value of a $450
annuity over 10 periods, with an interest rate
of 12.36 percent per period
Infrequent Annuity
• Summary
Equating PV of 2 Annuities
• Ertugrul and Halima want to send their new
born daughter to LUMS
Equating PV of 2 Annuities
• They estimate that LUMS expenses will run
$30,000 per year when their daughter reaches
college in 18 years. The annual interest rate
over the next few decades will be 14 percent.
• How much money must they deposit in the
bank each year so that their daughter will be
completely supported through four years of
college?
Equating PV of 2 Annuities
Equating PV of 2 Annuities
• They will be making deposits to the bank over the
next 17 years. They will be withdrawing $30,000 per
year over the following four years. We can be sure
they will be able to withdraw fully $30,000 per year
if:
PV of the deposits = PV of the four $30,000
withdrawals
Equating PV of 2 Annuities
Equating PV of 2 Annuities
Equating PV of 2 Annuities
• Assuming that Ertugrul and Halima make
deposits to the bank at the end of each of the
17 years, we calculate the annual deposit that
will yield a present value of all deposits of
$9,422.91
Growing Annuities
• Cash flows in business are likely to grow over
time, due either to real growth or to inflation.
• How is it different from growing perpetuity?
Growing Annuities
• Cash flows in business are likely to grow over
time, due either to real growth or to inflation.
Growing Annuities
• You have just graduate from LUMS and you
have been offered a job at $80,000 a year. You
anticipate your salary increasing by 9 percent
a year until your retirement in 40 years. Given
an interest rate of 20 percent, what is the
present value of your lifetime salary?
Growing Annuities
• You have just graduate from LUMS and you
have been offered a job at $80,000 a year. You
anticipate your salary increasing by 9 percent
a year until your retirement in 40 years. Given
an interest rate of 20 percent, what is the
present value of your lifetime salary?
Application
WHAT IS A FIRM’S WORTH?
Firm’s Worth
• How do you value firms which are not listed
on stock exchange?
Firm’s Worth
• How do you value firms which are not listed
on stock exchange?
• One way to think about the question of how
much a firm is worth is to calculate the
present value of its future cash flows.
Firm’s Worth
Firm’s Worth
• Layers is expected to generate net cash flows (cash
inflows minus cash outflows) of $5,000 in the first
year and $2,000 for each of the next five years.
• The firm can be sold for $10,000 seven years from
now.
• After considering other investments available in the
market with similar risks, the owners of the firm
would like to be able to make 10 percent on their
investment in the firm.
• Suppose you have the opportunity to acquire Layers
for $12,000.
Should You Acquire …
Should You Acquire Layers?

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