Corporate Finance: Fifth Edition
Corporate Finance: Fifth Edition
Corporate Finance: Fifth Edition
Fifth Edition
Chapter 4
The Time Value of Money
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Chapter Outline (1 of 2)
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Chapter Outline (2 of 2)
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Learning Objectives (1 of 4)
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Learning Objectives (2 of 4)
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Learning Objectives (4 of 4)
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4.1 The Timeline (1 of 4)
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4.1 The Timeline (2 of 4)
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4.1 The Timeline (3 of 4)
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4.1 The Timeline (4 of 4)
• Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.
Constructing a Timeline
• Problem
– Suppose you must pay tuition of $10,000 per year for
the next two years. Your tuition payments must be
made in equal installments at the start of each
semester. What is the timeline of your tuition
payments?
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Textbook Example 4.1 (2 of 2)
Solution
• Assuming today is the start of the first semester, your first
payment occurs at date 0 (today). The remaining
payments occur at semester intervals. Using one semester
as the period length, we can construct a timeline as
follows:
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Alternative Example 4.1 (1 of 2)
Problem
Suppose you can purchase a three-year bond with a $1,000
face value and a coupon rate of 4.5%, paid semi-annually.
Draw a timeline for the cash inflows of the bond.
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Alternative Example 4.1 (2 of 2)
Solution
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4.2 The Three Rules of Time Travel
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Rule 1: Comparing and Combining
Values
• A dollar today and a dollar in one year are not equivalent.
• It is only possible to compare or combine values at the
same point in time.
– Which would you prefer: A gift of $1,000 today or
$1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more. One factor
to consider: How long is “later?”
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Rule 2: Moving Cash Flows Forward in
Time (1 of 2)
• To move a cash flow forward in time, you must compound
it.
– Suppose you have a choice between receiving $1,000
today or $1,210 in two years. You believe you can earn
10% on the $1,000 today but want to know what the
$1,000 will be worth in two years.
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Rule 2: Moving Cash Flows Forward in
Time (2 of 2)
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Using a Financial Calculator: The
Basics (1 of 2)
• H P 10 BI I
– Future Value FV
‒ Present Value PV
‒ I/Y I/Y
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Using a Financial Calculator: The
Basics (2 of 2)
• HP 10BII
– Number of Periods
– Gold → C All
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Using a Financial Calculator: Setting
the Keys
• HP 10BII
– Gold → C All (Hold down [C] button)
Check P/YR
– # → Gold → P/YR
Sets Periods per Year to #
– Gold → DI S P → #
Gold and [=] button
Sets display to # decimal places
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Using a Financial Calculator
• HP 10B II
– Cash flows moving in opposite directions must have
opposite signs.
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Financial Calculator Solution
• Inputs:
– N=2
– I = 10
– PV = 1,000
• Output:
– FV = −1,210
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Figure 4.1 The Composition of Interest
over Time
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Textbook Example 4.2 (1 of 2)
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Textbook Example 4.2 (2 of 2)
Solution
• You can apply Eq. 4.1 to calculate the future value in each case
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Textbook Example 4.2: Financial
Calculator Solution for N = 7 years
• Inputs:
– N=7
– I = 10
– P V = 1,000
• Output:
– F V = −1,948.72
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Alternative Example 4.2 (1 of 2)
• Problem
– Suppose you have a choice between receiving $5,000
today or $10,000 in five years. You believe you can
earn 10% on the $5,000 today, but want to know what
the $5,000 will be worth in five years.
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Alternative Example 4.2 (2 of 2)
• Solution
– The time line looks like this:
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Rule 3: Moving Cash Flows Back in
Time
• To move a cash flow backward in time, we must discount
it.
• Present Value of a Cash Flow
C
PV = C ÷ (1 + r )n =
(1 + r )n
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Textbook Example 4.3 (1 of 2)
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Textbook Example 4.3 (2 of 2)
Solution
• The cash flows for this bond are represented by the following
timeline:
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Alternative Example 4.3 (1 of 2)
• Problem
– Suppose you are offered an investment that pays
$10,000 in five years. If you expect to earn a 10%
return, what is the value of this investment today?
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Alternative Example 4.3 (2 of 2)
• Solution
– The $10,000 is worth:
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Alternative Example 4.3: Financial
Calculator Solution
• Inputs:
– N=5
– I = 10
– F V = 10,000
• Output:
– P V = −6,209.21
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Applying the Rules of Time Travel
(1 of 5)
• Recall the first rule: It is only possible to compare or
combine values at the same point in time. So far we’ve
only looked at comparing.
– Suppose we plan to save $1,000 today, and $1,000 at
the end of each of the next two years. If we can earn a
fixed 10% interest rate on our savings, how much will
we have three years from today?
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Applying the Rules of Time Travel
(2 of 5)
• The time line would look like this:
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Applying the Rules of Time Travel
(3 of 5)
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Applying the Rules of Time Travel
(4 of 5)
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Applying the Rules of Time Travel
(5 of 5)
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Table 4.1 The Three Rules of Time
Travel
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Textbook Example 4.4 (1 of 3)
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Textbook Example 4.4 (2 of 3)
Solution
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Textbook Example 4.4 (3 of 3)
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Textbook Example 4.4: Financial
Calculator Solution
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Alternative Example 4.4 (1 of 4)
• Problem
– Assume that an investment will pay you $5,000 now
and $10,000 in five years.
– The timeline would like this:
0 1 2 3 4 5
$5,000 $10,000
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Alternative Example 4.4 (2 of 4)
• Solution
– You can calculate the present value of the combined
cash flows by adding their values today.
– The present value of both cash flows is $11,209.
0 1 2 3 4 5
$5,000
$6,209 $10,000
÷ 1.105
$11,209
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Alternative Example 4.4 (3 of 4)
• Solution
– You can calculate the future value of the combined
cash flows by adding their values
in Year 5.
0 1 2 3 4 5
$10,000
$5,000 x 1.105 $8,053
$18,053
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Alternative Example 4.4 (4 of 4)
• Solution
Present
Value
0 1 2 3 4 5
$11,209 $18,053
÷ 1.105
Future
Value
0 1 2 3 4 5
$11,209 $18,053
x 1.105
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4.3 Valuing a Stream of Cash Flows
(1 of 2)
• Based on the first rule of time travel we can derive a
general formula for valuing a stream of cash flows: if we
want to find the present value of a stream of cash flows,
we simply add up the present values of each.
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4.3 Valuing a Stream of Cash Flows
(2 of 2)
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Textbook Example 4.5 (1 of 4)
Solution
• The cash flows you can promise Uncle Henry are as follows:
• How much money should Uncle Henry be willing to give you today in
return for your promise of these payments? He should be willing to
give you an amount that is equivalent to these payments in present
value terms. This is the amount of money that it would take him to
produce these same cash flows, which we calculate as follows:
5000 8000 8000 8000
PV = + + +
1.06 1.062 1.063 1.064
= 4716.98+7119.97+6716.95+6336.75
= 24,890.65
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Textbook Example 4.5 (3 of 4)
• Now suppose that Uncle Henry gives you the money, and then
deposits your payments to him in the bank each year. How
much will he have four years from now? We need to compute
the future value of the annual deposits. One way to do so is to
compute the bank balance each year:
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Textbook Example 4.5 (4 of 4)
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Textbook Example 4.5: Financial
Calculator Solution
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Alternative Example 4.5 (1 of 2)
• Problem
– What is the future value in three years of the following
cash flows if the compounding rate is 5%?
0 1 2 3
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Alternative Example 4.5 (2 of 2)
• Solution
0 1 2 3
$2,000 $2,315
x 1.05 x 1.05 x 1.05
$2,000 $2,205
x 1.05 x 1.05
$2,000 $2,100
x 1.05
$6,620
Or
0 1 2 3
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Future Value of Cash Flow Stream
FVn = PV × (1 + r ) n
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4.4 Calculating the Net Present Value
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Textbook Example 4.6 (1 of 4)
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Textbook Example 4.6 (2 of 4)
Solution
• As always, we start with a timeline. We denote the upfront
investment as a negative cash flow (because it is money
we need to spend) and the money we receive as a positive
cash flow.
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Textbook Example 4.6 (4 of 4)
FV = $500 ×1.102 + $500 ×1.10 + $500 = $1655 in three years
• As you see, you can use your bank savings to repay the
loan. Taking the opportunity therefore allows you to spend
$243.43 today at no extra cost.
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Textbook Example 4.6: Financial
Calculator Solution
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Alternative Example 4.6 (1 of 2)
• Problem
– Would you be willing to pay $5,000 for the following
stream of cash flows if the discount rate is 7%?
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Alternative Example 4.6 (2 of 2)
• Solution
– The present value of the benefits is:
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Alternative Example 4.6: Financial
Calculator Solution
• On a present value basis, the
benefits exceed the costs by
$366.91.
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4.5 Perpetuities and Annuities (1 of 2)
• Perpetuities
– When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.
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4.5 Perpetuities and Annuities (2 of 2)
C
PV (C in perpetuity) =
r
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Textbook Example 4.7 (1 of 2)
Endowing a Perpetuity
• Problem
– You want to endow an annual M BA graduation party at
your alma mater. You want the event to be a
memorable one, so you budget $30,000 per year
forever for the party. If the university earns 8% per year
on its investments, and if the first party is in one year’s
time, how much will you need to donate to endow the
party?
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Textbook Example 4.7 (2 of 2)
Solution
• The timeline of the cash flows you want to provide is
• Problem
– You want to endow a chair for a female professor of
finance at your alma mater. You’d like to attract a
prestigious faculty member, so you’d like the
endowment to add $100,000 per year to the faculty
member’s resources (salary, travel, databases, etc.). If
you expect to earn a rate of return of 4% annually on
the endowment, how much will you need to donate to
fund the chair?
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Alternative Example 4.7 (2 of 2)
• Solution
– The timeline of the cash flows looks like this:
• Annuities
– When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is called an
annuity.
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Present Value of an Annuity (2 of 3)
• Re-arranging terms
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Present Value of an Annuity (3 of 3)
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Textbook Example 4.8 (1 of 3)
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Textbook Example 4.8 (2 of 3)
Solution
• Option (a) provides $30 million of prize money but paid annually. In
this case, the cash flows are an annuity in which the first payment
begins immediately, sometimes called an annuity due.
• Because the first payment is paid today, the last payment will occur in
29 years (for a total of 30 payments). We can compute the present
value of the final 29 payments as a standard annuity of $1 million per
year using the annuity formula:
million 1 1
PV 29 yr annuity of $1 = $1 million × 1
yr .08 1.0829
= $11.16 million today
• Adding the $1 million we receive upfront, this option has a present value of
$12.16 million:
• Therefore, the present value of option (a) is only $12.16 million, and so it is
more valuable to take option (b) and receive $15 million upfront—even though
we receive only half the total cash amount. The difference, of course, is due to
the time value of money. To see that (b) really is better, if you have the $15
million today, you can use $1 million immediately and invest the remaining $14
million at an 8% interest rate. This strategy will give you $14 million × 8% =
$1.12 million per year in perpetuity! Alternatively, you can spend $15 million −
$11.16 million = $3.84 million today, and invest the remaining $11.16 million,
which will still allow you to withdraw $1 million each year for the next 29 years
before your account is depleted.
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Textbook Example 4.8: Financial
Calculator Solution (1 of 2)
• Since the payments begin today, this is an Annuity Due.
– First,
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Textbook Example 4.8: Financial
Calculator Solution (2 of 2)
– Then
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Future Value of an Annuity
FV (annuity) = PV × (1 + r ) N
C 1
= 1 N
× (1 + r ) N
r (1 + r )
1
= C × (1 + r ) N 1
r
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Textbook Example 4.9 (1 of 3)
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Textbook Example 4.9 (2 of 3)
Solution
• As always, we begin with a timeline. In this case, it is helpful to
keep track of both the dates and Ellen’s age:
• Ellen’s savings plan looks like an annuity of $10,000 per year for
30 years. (Hint: It is easy to become confused when you just
look at age, rather than at both dates and age. A common error
is to think there are only 65 − 36 = 29 payments. Writing down
both dates and age avoids this problem.)
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Textbook Example 4.9 (3 of 3)
Solution
• To determine the amount Ellen will have in the bank at age
65, we compute the future value of this annuity:
1
FV = $10, 000 ×
0.10
1.1030 1
= $10, 000 ×164.49
= $1.645 million at age 65
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Textbook Example 4.9: Financial
Calculator Solution (1 of 2)
• Since the payments begin in one year, this is an Ordinary
Annuity.
– Be sure to put the calculator back on “End” mode:
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Textbook Example 4.9: Financial
Calculator Solution (2 of 2)
– Then
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Growing Cash Flows (1 of 2)
• Growing Perpetuity
– Assume you expect the amount of your perpetual
payment to increase at a constant rate, g.
C
PV (growing perpetuity) =
rg
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Textbook Example 4.10 (1 of 2)
Solution
The cost of the party next year is $30,000, and the cost then
increases 4% per year forever. From the timeline, we
recognize the form of a growing perpetuity. To finance the
growing cost, you need to provide the present value today of
$30, 000
PV $750, 000 today
0.08 0.04
You need to double the size of your gift!
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Alternative Example 4.10 (1 of 2)
• Problem
– In Alternative Example 4.7, you planned to donate
money to endow a chair at your alma mater to
supplement the salary of a qualified individual by
$100,000 per year. Given an interest rate of 4% per
year, the required donation was $2.5 million. The
university has asked you to increase the donation to
account for the effect of inflation, which is expected to
be 2% per year. How much will you need to donate to
satisfy that request?
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Alternative Example 4.10 (2 of 2)
Solution
The timeline of the cash flows looks like this:
• Growing Annuity
– The present value of a growing annuity with the initial
cash flow c, growth rate g, and interest rate r is defined
as:
– Present Value of a Growing Annuity
1 1+ g
N
PV = C × 1
(r g ) (1 + r )
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Textbook Example 4.11 (1 of 3)
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Textbook Example 4.11 (2 of 3)
Solution
• Her new savings plan is represented by the following timeline:
FV = $150, 463×1.1030
= $2.625 million in 30 years
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Alternative Example 4.11 (1 of 2)
• Problem
– You want to begin saving for your retirement. You plan
to contribute $12,000 to the account at the end of this
year. You anticipate you will be able to increase your
annual contributions by 3% each year for the next 45
years. If your expected annual return is 8%, how much
do you expect to have in your retirement account when
you retire in 45 years?
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Alternative Example 4.11 (2 of 2)
• Solution
– The present value of the series of deposits is:
1 1 + .03
45
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4.6 Using an Annuity Spreadsheet or
Calculator
• Spreadsheets simplify the calculations of T V M problems
– N PE R
– RAT E
– PV
– PM T
– FV
• These functions all solve the problem:
1 1 FV
NPV = PV + PMT × 1 NPER
+ NPER
=0
RATE (1 + RATE ) (1 + RATE )
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Textbook Example 4.12 (1 of 4)
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Textbook Example 4.12 (2 of 4)
Solution
• We represent this problem with the following timeline:
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Textbook Example 4.12 (3 of 4)
Solution
• To compute the solution, we enter the four variables we
know (N P E R = 15, R A T E = 8%, P V = −20,000, P M T = 0)
and solve for the one we want to determine (F V ) using the
Excel function F V(R A T E, N P E R, P M T, P V ). The
spreadsheet here calculates a future value of $63,443.
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Textbook Example 4.12 (4 of 4)
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Textbook Example 4.13 (1 of 4)
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Textbook Example 4.13 (2 of 4)
Solution
• Again, we start with the timeline showing our initial deposit
and subsequent withdrawals:
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Textbook Example 4.13 (3 of 4)
Solution
• Note that P V is negative (money into the bank), while P M
T is positive (money out of the bank). We solve for the
final balance in the account, F V, using the annuity
spreadsheet:
N PE
Blank RATE PV PM T FV Excel Formula
R
Given 15 8.00% −20,000 2,000 Blank Blank
Solve for FV Blank Blank Blank Blank = FV(0.08,15,2000,
9139
−20000)
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Textbook Example 4.13 (4 of 4)
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Textbook Example 4.14 (1 of 3)
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Textbook Example 4.14 (2 of 3)
Solution
• Let’s start by writing down the timeline of the loan
payments:
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4.8 Solving for the Cash Payments
(1 of 2)
• Sometimes we know the present value or future value, but
we do not know one of the variables we have previously
been given as an input.
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4.8 Solving for the Cash Payments
(2 of 2)
• For example, when you take out a loan you may know the
amount you would like to borrow but may not know the
loan payments that will be required to repay it.
Loan or Annuity Payment
P
C=
1 1
1
r 1+ r N
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Textbook Example 4.15 (1 of 3)
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Textbook Example 4.15 (2 of 3)
Solution
• Given a down payment of 20% × $500,000 = $100,000,
your loan amount is $400,000. We start with the timeline
(from the seller’s perspective), where each period
represents one month:
P 4000, 000
C= =
1 1 1 1
1 1
r 1+ r N 0.005 1.005
48
= $9394
• Using the annuity spreadsheet:
Blank N PE R RATE PV PM T FV Excel Formula
• Your firm will need to pay $9,394 each month to repay the
loan.
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Alternative Example 4.15 (1 of 2)
• Problem
– You have just graduated and landed your dream job
with a nice salary. To reward yourself, you decide to
purchase a luxury automobile at a cost of $60,000. The
manufacturer is offering a special deal on financing: $0
down and 60 monthly payments with an annual interest
rate of 3%. What are the monthly payments?
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Alternative Example 4.15 (2 of 2)
• Solution
12 Gold P/YR
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4.9 The Internal Rate of Return
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Textbook Example 4.16 (1 of 2 )
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Textbook Example 4.16 (2 of 2)
Solution
The timeline is
The timeline shows that the future cash flows are a growing perpetuity with a
growth rate of 4%. Recall from Eq. 4.11 that the PV of a growing perpetuity is
C
. Thus, the NPV of this investment would equal zero if
(r - g )
1000, 000
1, 000, 000 =
r - 0.04
We can solve this equation for r
1000, 000
r= + 0.04 = 0.14
1, 000, 000
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Textbook Example 4.17 (2 of 3)
Solution
• Here is the timeline (from Baker, Bellingham, and Botts’s
perspective):
• The timeline shows that the future cash flows are a 30-
year annuity. Setting the NPV equal to zero requires
1 1
1, 000, 000 = 125,× 1
r 1+ r
30
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Textbook Example 4.17 (3 of 3)
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Corporate Finance (2 of 2)
Fifth Edition
Chapter 4
Appendix
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Appendix: Solving for the Number of
Periods
• In addition to solving for cash flows or the interest rate, we
can solve for the amount of time it will take a sum of
money to grow to a known value.
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Textbook Example 4A.1 (1 of 3)
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Textbook Example 4A.1 (2 of 3)
Solution
• The timeline for this problem is
• We need to find N so that the future value of our current savings plus the
future value of our planned additional savings (which is an annuity) equals our
desired amount:
1
10, 050 ×1.0725 N + 5000 ×
0.0725
1.0725 N 1 = 60, 000
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Discussion of Data Case Key Topic
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Chapter Quiz
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Copyright
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