ALLOCATION RESOURCES OVER TIME CHAPTER 4

IN THIS CHAPTER
1. Concepts of compounding and discounting?
2. Alternative discounted cash flows: NPV rule and internal rate of return
3. Applications of alternative cash flows
4. Multiple cash flow and annuity
5. Applications of annuities
6. Perpetuity and application of perpetuity
7. Exchange rates and time value of money
8. Impacts of inflation and tax on investment decision
COMPOUNDING AND THE FUTURE VALUE FOR ONE CASH FLOW

• Compounding- the process of going from today’s value, or present value (PV) to
future value (FV)
• FV is the amount of money an investment will grow to at some date in the future by
earning interest at some compound rate
• PV is the initial amount of money you put for investment
• Simple interest: The interest on the original principal
• Compound interest: The interest earned on interest
COMPOUNDING AND THE FUTURE VALUE FOR ONE CASH FLOW
Suppose you initially deposit $100 into a banking account that earns interest rate of
10% per year? How much will you have after five years?

Year Beginning amount Simple interest Ending amount Compound

interest
1 $100 $10 $110 $10

2 $110 $11 $121 $21

3 $121 $12.1 $133.1 $33.1

4 $133.1 $13.31 $146.41 $46.41

5 $146.41 $14.641 $161.051 $61.051

COMPOUNDING AND THE FUTURE VALUE FOR ONE CASH FLOW

Your future value at the end of each year

At the end of year 1: FV = $100 (1+10%) = $110
At the end of year 2: FV = $110 (1+10%) = $121
At the end of year 3: FV = $121 (1+10%) = $133.1
At the end of year 4: FV = $133.1 (1+10%) = $146.41
At the end of year 5: FV = $146.41 (1+10%) = $161.051

Generally, at the end of year n: FV = $100 (1+i)^n = $100 (1+10%)^5

Where: i and n are interest rate and the number of periods respectively
For any present value invested, we have the future value factor is (1+i)^n
COMPOUNDING AND THE FUTURE VALUE FOR ONE CASH FLOW
THE RULE OF 72
• A rule of thumb that can help you estimate future values when you do not have your
calculator
• This rule states that the number of years it takes for a sum of money to double in
value (the “doubling time”) is approximately equal to the number 72 divided by the
interest rate expressed in percent per year
!"
Doubling time =
#$%&'&(% ')%&
• For example: If the interest rate is 10%, we say it should take approximately
72/10=7.2 years to double your money
COMPOUNDING, FUTURE VALUE AND ITS APPLICATION
SAVING FOR OLD AGE
• We normally estimate for the future and make the financial support for any uncertain events
• Depositing in a banking account, insurance purchase, and any other types of savings can
ensure people to alleviate and even eliminate any unwanted consequences
• Consider a situation: you are now 35 and intend to deposit your savings of $200 into banking
account paying 8% per year for 45 years
Calculation 1: FVPV ($200, 8%, 30) = $200 × 1.08^45 = $6384.09

Calculation 2: Apply the rule of 72, with 8% interest rate, we need to 72/8=9 years to double your
initial value

Hence, with 45 years this means we need 45/9= 5 times that been doubled.
$200 × 2 × 2 × 2 × 2 × 2 = $6400
COMPOUNDING, FUTURE VALUE AND ITS APPLICATION
REINVESTING AT A DIFFERENT RATE
• You are planning to buying a bond and keep this investment for two years with the price of
$100. You are given the fixed interest rate for two year bond (A) is 8%, while the interest
rate for a bond (B) are paying 7%. Which one will you choose?
• To answer the question, you need to know what is the interest rate paid for bond (B) in the
next year (The reinvestment rate)
• Suppose the interest rate in year 2 for bond (B) is 9%
• At the end of year 2
• For bond (A): FVPV ($100, 8%, 2) = $100 × 1.08^2 = $116.64
• For bond (B): FVPV = $100 × 1.07 × 1.09 = $116.63

FV of bond (A) is higher than FV of bond (B), hence, choosing bond A

THE FREQUENCY OF COMPOUNDING
EFFECTIVE ANNUAL RATE
• Effective annual rate (EFF) is an equivalent interest rate, if compounding were only once per
year
• Annual percentage rate (APR) is stated interest rate on loans and saving accounts with a
certain frequency of compounding
• Generally, the formula for the effective rate is
!"#
EFF (APR, m) = (1+ ) ^m -1
$
Where m: the number of compounding periods per year
• There are different effective annual rates corresponding to an annual percentage rate for
different compounding frequencies
• If compounding is done once per year, then the effective annual rate is the same as the
annual percentage rate
THE FREQUENCY OF COMPOUNDING
EFFECTIVE ANNUAL RATE
• As the compounding frequency increases, the effective annual rate gets larger and
larger
• The future value with annual percentage rate with a certain frequency of
compounding
*+,
FVm (PV, APR, m, n) = PV (1+ )^ mn
-
*+,
Where is the interest rate per compounding period
-
m is the number of compounding per year
mn the total number of compounding periods over the n years
 PRESENT VALUE AND DISCOUNTING
• Calculating present values is the reverse of calculating future values
• PV tells us the amount you have to invest today to have a certain amount in the future
• The PV for one cash flow is simply given by
%&
PVFV (FV, i, n) = (1)
(()*)^-
(1) is the present value of FV at an interest rate of i for n periods
• The PV for one cash flow with the compounding periods per year
%&
PVm (FV, APR, n, m) = !"#
() $ ^$-

• The PV for continuous discounting

PV con = FV × e^(-APR×m) (m: number of compounding)
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
NPV RULE
FV = PV (1+i)^n (1)
• Based on (1), we have the most common decision rule is the net present value
(NPV) rule
• NPV rule is widely used because if it used correctly, you will make the right
decision
• NPV rule states that: Accept any project with a present value of future cash
flows that exceed the initial investment. We must use PV in order to make them
comparable
• NPV is a measure of how much your current wealth changes as a result of
your choice
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
NPV RULE
• For NPV calculation of any investment, we use the opportunity cost of capital
(also called the market capitalization rate) as the interest rate
• The opportunity cost of capital is simply the rate that we can earn somewhere
else if we did not invest it in the project under valuation
• For example: You have a decision to invest in a one year bond or deposit
money into banking account in one year
The money you pay immediately for a bond is the PV of the cash inflows that
the bond generates. This amount of money may instead invest in a banking
account that can earn at 8% per year. Here, 8% is the opportunity cost of
capital for the investment on a bond
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
NPV RULE
• From the cash inflow of a bond (amount of money you receive in one year), you
discount it for the opportunity cost of capital (Here the interest rate that you can earn
from a bank) (1)
• If the value of (1) exceeds PV of cash inflow for a bond, your decision is investment in a
bond is more worthwhile (You can earn the same return even you pay less now)
• If the value of (1) does not exceed PV of cash inflow for a bond, you should not invest in a
bond

• The NPV rule can be also stated that we should invest in the project if its future value
is greater than the future value that will obtain in the next best alternatives. Here, if
the FV of depositing PV of cash inflow of a bond in a bank that earns 8% is higher
than the cash inflow a bond generates in one year, your decision is to deposit in a
bank and vice versa.
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
INTERNAL RATE OF RETURN
• The internal rate of return (IRR) is the discount rate that makes the PV of future cash
inflows equal to the PV of cash outflows.
• In other words, the IRR is exactly that the interest rate at which the NPV is equal to
zero
• Because the PV of future cash flows is greater when the discount rate is small, hence,
if IRR is higher than opportunity cost of capital, then the NPV at the opportunity cost
of capital itself must be positive.
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
SOME RULES
• Choose an investment project with the highest NPV if you face several
alternative investments
• Choose the investment alternative with the shortest payback period or in
another way, choose the investment in which you can “get your money back”,
or meet your growth goal in the shortest period of time.
• The “payback rule” is not a reliable for general investment choice purposes
in the case of using IRR
• Remind that NPV is safe and widely used
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
SOME APPLICATIONS- INVESTING IN LAND
• Suppose you are facing between two investment: investing money in the bank, or
investing in land
• Example: You have an opportunity to buy a piece of land for $15,000 and you are sure
that 3 years from now it will be worth $25,000. You can either earn 8% per year by
investing money in the bank. Is the investment in land worthwhile?
Here, 8% is considered as an opportunity cost of capital and we discount the FV with 8%.
n=3 I = 8% FV = $25,000 PV = $19845.8 NPV = $4845.8
NPV > 0, hence, investing in land is worthwhile
• You can think this situation in another way, if you invest $15,000 in a bank that pays 8% per
year. After 3 years, you have
n=3 i = 8% PV = $15,000 FV = $18895.68
FV if investing in a bank ($18895.68) is lower than FV of land in 3 years, hence,
purchasing a land is worthwhile
ALTERNATIVE DISCOUNTED CASH FLOW DECISION RULES
SOME APPLICATIONS- USE OF OTHER PEOPLE’S MONEY
• Some financial decisions involve receiving cash in the present and pay back at some future
date
• Consider a situation when a student borrow money $3000 from a bank to cover the tuition
fees at the interest rate of 10% per year and you have to pay bank in 4 years
• However, your friend brings you another deal: Your friend will lend you $3000 if you pay him
$5000 in 4 years.
In this example, the PV of cash outflow $5000 at 10% per year is $3415.06 while you only
receive $3000. NPV = -$415.06. Hence, your friend’s deal is not worthwhile
In other words, you can think that the interest rate that your friend charges you is higher than
10% per year. How can you calculate this rate?
MULTIPLE CASH FLOWS
• Time line is a useful tool in analyzing the timing of cash flows
• A negative sign in front of a cash flow means that you put in that amount of money (a cash
outflow from you) whereas no sign means that you take out that amount (cash inflow to you).
• Future value of a stream of cash flows: Suppose each year in some years from now you
deposit some amount of money. The question is that how much will you have at the end of
period?
• Present value of a stream of cash flows: In some cases, we need to compute the PV rather
than the FV of a series of cash flows

• NPV rule is useful to deal with investing decision related with multiple cash flows
ANNUITIES

• Annuities involve the stream of payments on an installment (savings plan, loan

repayment,…)
• If the cash flows start immediately, it is called an immediate annuity
• If the cash flows start at the end of the current period rather than immediately, it is
called an ordinary annuity
 PRESENT VALUE OF ANNUITY
How much would you have to put into a fund earning at interest rate of i
% per year to be able to take out $1 per year for the next 3 years?
What is the difference if you want take out $1 at the end and at the
beginning of each year?
("#("$%)^(#()
•For ordinary annuity: PV = %

("#("$%)^(#()
•For immediate annuity: PV = (1+i) %
FUTURE VALUE OF ANNUITY
How much will you have at the end of year 3 if you save $1 for each
year?
What is the difference if you save money at the end and at the
beginning of each year?
"$% .#"
•For ordinary annuity: FV = %
"$% .#"
•For immediate annuity: FV = (1+i) %
APPLICATION OF ANNUITY
BUYING AN INSURANCE PACKAGE
• You are 65 years old and are considering whether to buy an insurance package with
a premium of $10,000 and promises to pay you $1000 per year for the rest of the
year
• Suppose we make an assumption that you are expected to live until 80 years and
the annual payment you receive from insurance company which can be deposited in a
bank account with 8% per year
• Suppose we have an ordinary annuity with the first payment occurring at the end of
year 65 and ending at the end of 80, so we have 15 payments
• The question is whether this insurance is worthwhile?
APPLICATION OF ANNUITY
BUYING AN INSURANCE PACKAGE
• In order to answer this question you are required to calculate the NPV with 15
annual payments of $1000 each and initial cash flow of $10,000.

n = 15 i=8 PMT = $1000 PV = ?

/0(/23)^(0$) /0(/26.68)^(0/9)
PV = PMT × = $1000 × = $8559.48
3 6.68
NPV = $8559.48 - $10,000 = -$1440.52
NPV < 0, buying an insurance is not worthwhile
APPLICATION OF ANNUITY
BUYING AN INSURANCE PACKAGE
• We can also compute the implied interest rate on annuity, or the discount rate that
makes NPV = 0
/0(/23)^(0/9)
PV = $1000 × = $10,000 → i = 5.56%
3
• We can also compute number of years that makes this insurance worthwhile
/0(/26.68)^(0$)
PV = $1000 × = $10,000 → n = 20.91
6.68
APPLICATION OF ANNUITY
TAKING A MORTGAGE LOAN
• Taking a mortgage loan usually requires you to pay back in monthly payments
• Suppose you desire to buy a house and need to borrow $50,000 from bank. In
exchange for this financing, you are required to repay over 20 years with 240
monthly payments, if the interest rate is quoted as an annual percentage rate at 12%
• The question is that what is the amount of the monthly payment?

n = 240 PV = $50,000 i = 1% PMT = ?

(.(()*)^(.-) (.(()/./()^(.12/)
• PV = PMT × *
= PMT ×
/./(
= $50,000 → PMT = -$1028.61
LOAN AMORTIZATION

• Many loans are repaid in equal periodic installments

• Part of each payment is interest on the outstanding balance of the loan and part is
repayment of principal
• After each payment, the outstanding balance is reduced by the amount of principal
repaid → current payment of interest is lower than the previous period’s interest and
the portion going toward repayment of principal is greater than the previous period’s
principal payment
• Example: Suppose you take $100,000 home mortgage loan at an interest rate of
8% per year to be repaid with interest in four annual installments. Show a table for
principal and interest rate paid in each installments
n=4 i = 8% PV = -$100,000 PMT = ?
LOAN AMORTIZATION
(.(()*)^(.-)
PV = PMT ×
*
Where PV = $100,000, i = 8%, n = 4 → PMT = -$30192.08
The process of paying off a loan’s principal gradually over its term is called amortization
Year Beginning Total Interest Paid Principal Remaining
balance Payment Paid balance
1 100,000 30192.08 8000 22192.08 77807.92
2 77807.92 30192.08 6224.63 23967.45 53840.47
3 53840.47 30192.08 4307.24 25884.84 27955.63
4 27955.63 30192.08 2236.45 27955.63 0
Total 120768.32 20768.32 100000
PERPETUAL ANNUITIES

• Perpetuity is a special type of annuity, refers to a stream of cash flows that lasts forever
• A disturbing feature of any perpetual annuity is that you cannot compute the FV of its cash
flow because it is finite
• However, it has a perfectly well-defined and determinable PV
• Formula for the PV of a level perpetuity is
3
PV of a level perpetuity =
*
Where: C: periodic payment
i: interest rate
• Example for perpetuity: How much money you would have to put into a bank account offering
interest rate of 5% per year in order to take out $100 every year forever
APPLICATION OF PERPETUITY
INVESTING IN PREFERRED STOCK
• Preference shares (preference stocks) are shares of a company’s stock with dividends that are
paid out to shareholders before common stock dividends are issued
• If the company enters bankruptcy, preferred stockholders are entitled to be paid from company
assets before common stockholders
• Most preference stocks have a fixed dividend, while common stocks generally do not
• A cash dividend of preferred stock is an example of perpetuity
Example: The preferred stock of a company X offers a cash dividend of $9 per year and is
selling at a price of $100 per share.
Should you invest some of your money in this company preferred stock if you are
currently deposit money in a banking account at 8% per year
•To answer this question, you compute the yield on the preferred stock
!""#$% &'(')*") .
Yield on preferred stock = = = 9%
+,'-* /00
APPLICATION OF PERPETUITY
INVESTING IN GROWING CASH FLOW
• Growing cash flow is a cash flow that grows at a constant rate
• Suppose you are considering an investment in a property with the first year’s cash flow to be
$1000, and this cash flow is expected to grow by 4% each year in perpetuity, the discount
rate is 9%. How much money are you willing to pay for this property?
3(
PV of growth perpetuity PV =
*.4
Where: C1 is the first year’s cash flow, g is the growth rate, i the discount rate
$"###
PV = = $20,000
$%&'%
You are willing to purchase this property if NPV of this investment to be positive, this means
the purchase price (initial cash outflow) is less than the PV of all cash outflow
EXCHANGE RATES AND TIME VALUE OF MONEY

• This situation arises when you consider to invest the amount of domestic currency in different currencies
• The return you receive at the end of period (in terms of domestic currency) will depend on how much the
exchange rate between domestic currency and foreign currencies will change during the investment period
• Example: You invest $50,000 either in dollar-denominated bonds offering an interest rate of 10% per
year or in yen-denominated bonds offering an interest rate of 5%.
The exchange rate JPY/USD at the beginning = 100, so $50,000 = ¥ 5,000,000
At the end of period:
You will have ¥ 5,000,000 (1+0.05) = ¥ 5,250,000 if invest in yen-denominated bonds
You will have $50,000 (1+0.1) = $55,000 if invest in dollar-denominated bonds
If the exchange rate JPY/USD at the end of period = 95, so you will have $55,263.15 if you invest in yen-
dominated bonds ($55,263.15 > $55,000 )
COMPUTING NPV IN DIFFERENT CURRENCIES
• There is a simple rule is that: In any time value of money calculation, the cash flows and the
interest rate must be denominated in the same currency
• Example: You are deciding whether to invest in a UK project or American project for five
years. The information for these two projects are as follows, given the current dollar price of
one pound is 1.2. The question is which project has the higher NPV?

Project Initial CF Annual return Interest rate (per

payment year)

UK project $25,000 £4800 4%

American project $25,000 $5500 3%
COMPUTING NPV IN DIFFERENT CURRENCIES
• NPV of the American project using the dollar interest rate of 4%
/0(/26.6:)^(09)
PV of all future cash flows = $5500 × = $25,188.39
6.6:
NPV = $25,188.39 - $25,000 = $188.39 (1)

• NPV of the UK project using the pound interest rate of 3%

/0(/26.6;)^(09)
PV of all future cash flows = £4800 × = £21,368.75 = $25,642.50
6.6;
NPV = $25,642.50 - $25,000 = $642.50 (2)
(2) > (1) → Investing in UK project is more profitable
INFLATION AND DISCOUNTED CASH FLOW ANALYSIS
Recall from Chapter 2
• The nominal interest rate: is the rate denominated in dollars or in some other
currency
• The real interest rate is denominated in units of consumer goods
• The original formula relating the real interest rate and nominal interest rate is
/2<=-3$)> 3$%&'&(% ')%&
1 + Real interest rate =
/2#$?>)%3=$ ')%&

For continuous compounding, we have a simpler expression:

Real interest rate = Nominal interest rate – Inflation rate
INFLATION AND FUTURE VALUE
• We save $200 at age 35, not to be taken out until age 65. The nominal interest rate
and the inflation rate are 8% and 5% respectively
• Here, you really care about how much you will have accumulated in the account
when you reach 65 in terms of real purchasing power (not nominal income)
• We have 2 alternative ways of calculating it
The 1st way: Calculating by using the real interest rate
/2<=-3$)>
We are given: 1+ Real interest rate = → Real interest rate = 2.857%
/2#$?>)%3=$

FV = $200 × 1.02857^30 = $465.635

INFLATION AND FUTURE VALUE
The 2nd way: we go pass through 2 steps as follow
• Compute the nominal future value by using the nominal interest rate
FV = $200 × 1.08^30 = $2012.53
• Figure out what the price will be after 30 years from now
Price level in 30 years = 1.05^30 = $4.322
• Calculate the real future value
<=-3$)> ?@%@'& A)>@& $"6/".9:
Real FV = = = $465.647
B@%@'& C'3D& A)>@& $;.:""
INFLATION AND PRESENT VALUE
Example: Suppose you plan to buy an asset five years from now and want to invest enough
money now to pay for it.
• A car you have in mind now costs $20,000 and the interest rate you can earn on your money
is 8% per year
• The amount of money you have to invest now is the PV of $20,000 to be received in five
years
$1/,///
PV = = $13,611
(./7^8
• However, it would be a mistake if you conclude that $13,611 is adequate to pay for the car
five years later.
The reason is…
• A similar will cost more for five years from now due to inflation
• Assume that the inflation rate is 5%, there are also two equivalent ways to take
account of inflation in example
INFLATION AND PRESENT VALUE
The 1st way: Calculate using the real interest rate
9:$*-;< =->?@?A> @;>? .#;>? :B =-B<;>*:-
Real interest rate = = 2.857%
()#;>? :B =-B<;>*:-
$1/,///
PV = = $17357.24
(./178C^8
• The 2nd way: Calculate using the nominal interest rate
If the price of that car will change in the same proportion with the inflation, in five
years, it will cost $20,000 × 1.05^5 = $25,525
$18,818
PV = = $17371.89
(./7^8
INFLATION AND SAVING PLANS
APPLICATION FOR MULTIPLE CASH FLOW
• Suppose you want to save in equal real annual installments over the next five years
to cover the first year’s tuition five years from now
• The tuition is now $15,000 and the real interest rate of 5%, how much must you save
each year?
/26.69 ! 0/
PV= PMT × = $15,000 → PMT = $5,525
6.69
This means the amount to save each year must be the equivalent of $5,525
• How much will you actually put into the account each year (in nominal terms) if the
inflation rate is 6% per year? (chỗ này xem lại)
TAXES AND INVESTMENT DECISIONS

• Let’s consider the impact of taxes on your investment decision

• In many countries, the interest you earn will be subject to tax
• Distinguish between before-tax interest rate and after-tax interest rate
After-tax interest rate = (1-Tax rate) × Before-tax interest rate
• The rule is maximize the net present value of after-tax cash flows. However, this is
not necessary as to minimize the taxes you pay
TAXES AND INVESTMENT DECISIONS

• You are considering between a municipal bonds paying 6% per year but tax-
exempted and 8% per year from banking account (but 20% tax on interest)
After-tax interest rate on bank account = (1-0.2) × 0.08 = 0.64 (6.4%)
• Here, the 6% paid from municipal (despite tax exempted) is not worthwhile as the
8% per year from banking account (despite 20% tax)
• Therefore, if you decide to choose one with lower tax or even no tax, it would be a
mistake