Here are the steps to solve this problem:
1) Make a timeline showing the expected cash flows over the 7 years:
Year 1: $5,000
Year 2: $2,000
Year 3: $2,000
Year 4: $2,000
Year 5: $2,000
Year 6: $2,000
Year 7: $10,000 (sale price)
2) Discount each cash flow back to the present using a 10% discount rate:
PV of year 1 cash flow = $5,000 / 1.1 = $4,545
PV of year 2 cash flow = $2,000 / 1.1^2 = $
Here are the steps to solve this problem:
1) Make a timeline showing the expected cash flows over the 7 years:
Year 1: $5,000
Year 2: $2,000
Year 3: $2,000
Year 4: $2,000
Year 5: $2,000
Year 6: $2,000
Year 7: $10,000 (sale price)
2) Discount each cash flow back to the present using a 10% discount rate:
PV of year 1 cash flow = $5,000 / 1.1 = $4,545
PV of year 2 cash flow = $2,000 / 1.1^2 = $
Here are the steps to solve this problem:
1) Make a timeline showing the expected cash flows over the 7 years:
Year 1: $5,000
Year 2: $2,000
Year 3: $2,000
Year 4: $2,000
Year 5: $2,000
Year 6: $2,000
Year 7: $10,000 (sale price)
2) Discount each cash flow back to the present using a 10% discount rate:
PV of year 1 cash flow = $5,000 / 1.1 = $4,545
PV of year 2 cash flow = $2,000 / 1.1^2 = $
Here are the steps to solve this problem:
1) Make a timeline showing the expected cash flows over the 7 years:
Year 1: $5,000
Year 2: $2,000
Year 3: $2,000
Year 4: $2,000
Year 5: $2,000
Year 6: $2,000
Year 7: $10,000 (sale price)
2) Discount each cash flow back to the present using a 10% discount rate:
PV of year 1 cash flow = $5,000 / 1.1 = $4,545
PV of year 2 cash flow = $2,000 / 1.1^2 = $
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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?