CORPFIN 7005 - Principles of Finance (M)

Topic 2: The time value of money

1. Why is a dollar today worth more than a dollar 1 year from now?

Textbook Page 123-124

2. What is the difference between the interest rate (i) and the growth rate (g) in the future
value equation?

The interest rate and the growth rate in the future value equation essentially
represent the same concept. The growth rate is used when we deal with numerical
values such as sales or change over time. When referring to money being invested,
we use the term interest rate.

3. Your birthday is coming up, and instead of any presents, your parents promised to give
you $3000 in cash. Since you have a part time job and, thus, don’t need the cash
immediately, you decide to invest the money in a bank term deposit that pays 8 per cent
compounding quarterly for the next 2 years. How much money can you expect to gain in
this period of time?

0 2 years
├────────────────────┤
PV = $3,000 FV = ?

Amount invested today = PV = $3,000

Return expected from investment = i = 8%
Duration of investment = n = 2 years
Frequency of compounding = m = 4
Value of investment after 2 years = FV2

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mn 42
 i   0.08 
FV 2 = PV  1 +  = $3,000  1 + 
 m  4 
= $3,000  (1.02 ) 8
= $3,514.98

PV=-3000; N=8; I/Y=2%; PMT=0

Solve FV
FV=+3514.98

4. You want to buy some zero coupon bonds that have a value of $1000 at the end of 3 years.
The bonds are said to pay 4 per cent interest per annum. How much should you pay for
them today?

0 3 years
├────────────────────┤
PV =? FV = $1,000

Face value of bond at maturity = FV3 = $1,000

Appropriate discount rate = i = 4%
Number of years to maturity = n = 3 years.
Present value of bond = PV

FV n $1,000
PV = =
(1 + i )n
(1.04 ) 3
= $889

FV=1000; N=3; I/Y=4%; PMT=0

Solve PV
PV=-889

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5. You invest $150 in an investment fund today that pays 9 per cent interest per annum. How
long will it take to double your money?

0 n years
├────────────────────┤
PV = $150 FV = $300

Value of investment today = PV = $150

Interest on investment = n = 9%
Future value of investment = FV = $300
Number of years to double investment = n

FVn = PV × (1 + i ) n
300 = 150 × (1.09 ) n
(1.09 ) n = 300 150 = 2.00
n × ln(1.09 ) = ln( 2.00 )
ln( 2.00 )
n= = 8.043 years
ln( 1.09 )

FV=300; PV=-150; I/Y=9%; PMT=0

Solve N
N=8.043

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6. Infosys Technologies Ltd, an Indian technology company, reported a profit of $419

million this year. Analysts expect the company’s earnings to be $1.468 billion in 5 years.
What is the expected growth rate in the company’s earnings?

Earnings in current year = PV = $419 million

Expected earnings five years from now = $1,468 million
To calculate the expected earnings growth rate, we set up the future value equation.

FV5 = PV  (1 + g ) 5
1468 = 419(1 + g ) 5
1468
(1 + g ) 5 = = 3.5036
419
1
g = (3.5036) 5
−1
= 28.5%

FV=1468; PV=-419; N=5; PMT=0

Solve I/Y
I/Y=28.5%

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7. You have $2500 you want to invest in your classmate’s start-up business. You believe
the business idea to be great and hope to get $3700 back at the end of 3 years. If all goes
according to the plan, what will be your return on investment?

0 3 years
├────────────────────┤
PV = $2500 FV = $3700

Amount invested in project = PV = $2500

Expected return three years from now = FV =$3700
To calculate the expected rate of return, we set up the future value equation.

FV3 = PV  (1 + i ) 3
3700 = 2500(1 + i ) 3
3700
(1 + i ) 3 = = 1.4800
2500
1
i = (1.4800) 3
− 1 = 0.1396
= 13.96%

FV=3700; PV=-2500; N=3; PMT=0

Solve I/Y
I/Y=13.96%

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8. When you were born your parents set up a bank account in your name with an initial
investment of $5000. You are turning 21 in a few days and will have access to all your
funds. The account was earning 7.3 per cent for the first 7 years, and then the rates went
down to 5.5 per cent for 6 years. The economy then did well and your account was earning
8.2 per cent for 3 years in a row. Unfortunately, the next 2 years you only earned 4.6 per
cent. Finally, as the economy recovered, your return jumped to 7.6 per cent for the last 3
years.
a. How much money was in your account before the rates went down drastically (end
of year 16)?
b. How much money is in your account now, end of year 21?
c. What would be the balance now if your parents made another deposit of $1200 at
the end of year 7?

0 1 7 13 14 15 16 21 years
├───┼∙∙∙∙∙∙∙∙∙∙┼∙∙∙∙∙∙∙∙∙∙∙∙────┼────┼───┼───∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙──┤
PV = $5,000 FV = ?
i1 = 7.3% i2 = 5.5% i3 = 8.2% i4 = 4.6% i5 = 7.6%

a. Initial investment = PV = $5000

Interest rate for first 7 years = i1 = 7.3%
Interest rate for next 6 years = i2 = 5.5%
Interest rate for next 3 years = i3 = 8.2%
Investment value at age 16 years = FV16

FV16 = PV  (1 + i1 ) 7  (1 + i2 ) 6  (1 + i3 ) 3
= 5000  (1 + 0.073 )  (1.055 ) 6  (1.082 ) 3
7

= 5000  (1.6376 )  (1.3788 )  (1.2667 )

= $14300.94

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b. Interest rate for from age 17 to 18 = i4 = 4.6%

Interest rate for next 3 years = i5 = 7.6%
Investment at start of 16th year = PV = $14 300.94
Investment value at age 21 years = FV21

FV 21 = FV16  (1 + i4 ) 2  (1 + i5 ) 3
= 14300 .55  (1 + 0.046 )  (1.076 ) 3
2

= 14300 .55  (1.0941 )  (1.2458 ))

= $19492.38

c. Additional investment at start of 8th year = $1,200

Total investment for next 6 years = $8187.82 + $1200 = $9387.82
[$5000 x (1+0.073)7 = $8187.82]
Interest rate for next 6 years = i2 = 5.5%
Interest rate for years 13 to 16 = i3 = 8.2%
Interest rate for from age 17 to 18 = i4 = 4.6%
Interest rate for next 3 years = i5 = 7.6%
Investment value at age 21 = FV21

FV 21 = FV7  (1 + i2 ) 6  (1 + i3 ) 3  (1 + i4 ) 2  (1 + i5 ) 3
= 9387 .82  (1.055 ) 6  (1.082 ) 3  (1.046 )  (1.076 ) 3
2

= 9387 .82  (1.3788 )  (1.2667 )  (1.0941 )  (1.2458 )

= $22349.16

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9. Luke Wilkshire and his agent are evaluating three contract options to return to play in the
A-League after a successful career with Dutch Ereduvusue team, Feyenoord. Each option
offers a signing bonus and a series of payments over the life of the contract. Wilkshire
uses a 10 per cent rate of return to evaluate the contracts. Given the cash flows for each
option, which one should he choose?

Year Cash Flow Type Option A Option B Option C

0 Signing Bonus $1,000,000 $1,200,000 $500,000
1 Annual Salary $700,000 $700,000 $700,000
2 Annual Salary $750,000 $700,000 $700,000
3 Annual Salary $800,000 $700,000 $700,000
4 Annual Salary $850,000 $700,000 $1,600,000

Year Option A PV (Option A) Option B PV (Option B) Option C PV (Option C)

0 $1,000,000 $1,000,000 $1,200,000 $1,200,000 $500,000 $500,000
1 $700,000 $636,364 $700,000 $636,364 $700,000 $636,364
2 $750,000 $619,835 $700,000 $578,512 $700,000 $578,512
3 $800,000 $601,052 $700,000 $525,920 $700,000 $525,920
4 $850,000 $580,561 $700,000 $478,109 $1,600,000 $1,092,822
Total $4,100,000 $3,437,812 $4,000,000 $3,418,906 $4,200,000 $3,333,618

Option A is the best choice (PV=$3,437,812) for Luke Wilkshire as it provides the
highest PV.

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10. Jimmal Bolts Ltd reported earnings of $2.1 million last year. The company’s primary
business line is manufacturing nuts and bolts. Since this is a mature industry, the analysts
are certain that the sales will grow at a steady rate of 7 per cent a year for as far as they
can tell. The company reports profit that represents 23 percent of sales. The management
would like to buy a new fleet of trucks but can only do so once the profit reaches $620,000
a year. At the end of what year will Jimmal Bolts Ltd be able to buy the new fleet of
trucks? What will the sales and profit be that year?

Current level of sales for Jimmal = PV = $2 100 000

Profit margin = 23%
Profit for the year = 0.23 x 2100000 = $483 000
Target profit level in the future = FV = $620 000
Projected growth rate of sales = g = 7%
To calculate the time needed to reach the target FV, we set up the future value
equation.

FVn = PV × (1+g)n
620000 = 483000 × (1.07)n
620000
1.07n = = 1.2836
483000
n × ln(1.07) = ln(1.2836)
ln(1.2836)
n= = 3.7 years
ln(1.07)

FV=620000; PV=-483000; I/Y=7; PMT=0

Solve N; N=3.7 years

The company achieves its profit target during the fourth year.
Sales level at end of year 4 = FV4
FVn = PV  (1 + g ) n
= 2100000  (1.07 ) 4 = $2752671.62
Profit for the year = $2,752,671.62 x 0.23 = $633,114.47

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