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Structure

I. Annuity
1. What is an Anuity?
2. Perpetuities
II. Project Appraisal Rules
Chapter 4: Time Value of 1. Payback Period
2. Net Present Value
Money Applications
3. Internal Rate of Return
4. Net Present Value versus Internal Rate of Return

I. ANNUITY 1. What is an Annuity?

1. What is an Annuity? An annuity is any collection of equal payments made

at regular time intervals such as monthly, quarterly, or
- Present Value of an Annuity
annually over a finite period of time
- Future Value of an Annuity
If payments are made at the end of each period, the
2. Perpetuities annuity is referred to as ordinary annuity or regular
- Present Value of Level Perpetuity annuity
- Present Value of Growing Perpetuity
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Examples of Annuity Assumptions of Regular Annuity

You just bought a car and will make monthly payments for - the first cash flow will occur exactly one period from now
the next five years. Is this an annuity? - all subsequent cash flows are separated by exactly one
period
You sponsor an orphan by paying $32 every month to a
fund. Is this an annuity? - all periods are of equal length
- the term structure of interest is flat
- all cash flows have the same (nominal) value

Present Value of Annuity Annuity Formula Notation

A sum of money paid at the beginning of an annuity, PV = the present value of the annuity
to which the annuity’s payments are accepted as
i = interest rate to be earned over the life of the annuity
equivalent, is called the annuity’s present value.
n = the number of payments
Example: Hoa borrowed $160,000 to buy a house. To pay off
this mortgage loan, she agreed to make payments of $1,735.52 A = the periodic payment (annuity)
per month for 30 years.
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PV Annuity Formula Examples

1. What is the value today of receiving $3,000 every year

for the next 30 years if the interest rate is 5%?
A  1  2. Your grandmother has offered to give you $1,000 per
PV  *  1  
i  1  i n 
year for the next 10 years. What is the present value of
this 10-year, $1,000 annuity discounted back to the
present at 5%?

Example 2 PV Annuity Formula: Payment

A  1 
PV  *  1  
i  1  i n 

A
i

* 1  1  i 
 n

PV * i
A 

1  1  i 
 n

Verify the answer:7721.73;
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PV Annuity Formula: Number of

Amortized loans Payments

Suppose you plan to get a $9000 loan from a furniture

dealer at 18% annual interest with annual payments that PV 
A
i

* 1  1  i  ;
n

PV * i
A
 1  1  i 
n

you will pay off in over 5 years. What will your annual
payments be on this loan?
1  i n  1  PV * i ;  n * ln1  i   ln1  PV * i 
A  A 
 PV * i 
ln1  
PV * i  A 
1  i n  1 ; n
A ln1  i 

Example
Future Value of an Annuity
The time line: i=5%
A sum of money to which an annuity’s payments and 0 1 2… 10
Time
interest accumulate in the end is called the annuity’s
future value Cashflow: 3000 3000 … 3000

Example: How much money will you accumulate by the FV [?]

end of year 10 if you deposit $3,000 each for the next ten
We want to know the future value of the 10 cash flows.
years in a savings account that earns 5% per year?
We can compute the future value of each cash flow and sum
them together:

3000(1.05)9 + 3000(1.05)8 + … + 3000 = 37,733.68

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Example FV Annuity Formula

The picture can't be display ed.

A  1 
PV  *  1  
i  1  i n 
* 1  i 
n
FV  PV
A  1 
FV  *  1   * 1  i n
The earlier cash flows have higher future values because they
have more years to earn interest.
i  1  i n 
Year 1 cash flow can earn 9 years of interest.
Year 10 cash flow does not earn any interest.

A
i

* 1  i   1
n

17

Back to the example Examples

1. Find the future value of quarterly payments of $750 for

5 years, assuming an 8% interest rate

2. Each month, Carrie deposits $250 into a savings

FV 
3000
0.05
 10
* (1  0.05)  1  account that pays 4.5% (compounded monthly).
Assuming that she keeps this up, and that the interest
rate does not change, how much will her deposits have
grown to after 5 years?
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FV Annuity Formula:
FV Annuity Formula: Payment Number of Payments

FV
A

i

* 1  i   1
n

FV 
A
i

* 1  i   1
n
 1
FV * i
A
 1  i 
n

A 
FV * i ln 1  i   
n 
n * ln 1  i   ln  1 
FV * i 


1  i n  1  
ln  1 
FV * i 

 A 

 A 
n 
ln 1  i 

Sinking funds 2. Perpetuities

Problem A perpetuity is an annuity that continues forever or has no

Suppose Calvin has set a goal of having $10,000 in a maturity. For example, a dividend stream on a share of
savings account in 5 years. He plans to make equal preferred stock. There are two basic types of perpetuities:
deposits to the account at the end of each month, and Growing perpetuity in which cash flows grow at a constant
expects the account to earn 3.6% interest. How much rate, g, from period to period.
should each of his deposits be?
Level perpetuity in which the payments are constant rate
from period to period.
A = $152.37
Even if the cash flows are infinite, present values can be
finite if the discount rate is higher than the growth rate.
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Present Value of a Level Perpetuity Examples

Recall the annuity formula: 1. What is the present value of $600 perpetuity at 7%
A = level (constant) payment per period. discount rate?
i = rate per period.
2. If you decide to rent an apartment with a fixed rent
The picture can't be display ed.

of $2,000 per month and live there forever (subletting

it to your children after you die), how much is this
• Let n -> infinity with i > 0: apartment worth if the mortgage rate is 6% per year
(Ignore tax, liquidity and other concerns).
A
PV 
i
26

Present Value of a Growing Perpetuity Example

In growing perpetuities, the periodic cash flows grow at a The Present Value of a Growing Perpetuity
constant rate each period.
What is the present value of a perpetuity stream of cash
The present value of a growing perpetuity can be calculated flows that pays $500 at the end of year one but grows at a
using a simple mathematical equation: rate of 4% per year indefinitely? The rate of interest used
to discount the cash flows is 8%.

What if the growth rate is 6%?

i: rate per period, g: growth per period,
PMTperiod 1 : payment at the end of the first period.

27 28
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II. PROJECT APPRAISAL RULES 1. Payback Period

1. Payback Period Payback Period = number of years to recover

2. Net Present Value initial costs

3. Internal Rate of Return Computation

Estimate the cash flows
4. Net Present Value versus Internal Rate of Return
Subtract the future cash flows from the initial cost until
the initial investment has been recovered

Decision Rule – Accept if the payback period is

less than some preset limit

Computing Payback for the Project Computing Payback for the Project
Project A: Consider Capital budgeting project B which yields the following
cash flows:
Initial cost: 165000
Year 0 1 2 3 4 5
Cash flow return: Year 1: 63120; Year 2: 70800; Year 3: 91080
CF -1000 500 400 200 200 100
Assume we will accept the project if it pays back within two
years.
Year 1: 165,000 – 63,120 = 101,880 still to recover Calculate the pay back period?
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3

Do we accept or reject the project?

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Advantages and Disadvantages

Advantages
Easy to understand
Adjusts for uncertainty of later cash flows

Disadvantages
Ignores the time value of money
Ignores cash flows beyond the cutoff date

2. Net Present Value Example

Net Present Value - Present value of cash Q: Suppose we can invest $50 today & receive $60 after 1 year.
flows minus initial investments. What is our increase in value?

A: Profit = - $50 + $60

Opportunity Cost of Capital - Expected rate $10
Added Value
of return given up by investing in a project
$50 Initial Investment
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Net Present Value (NPV) Net Present Value

NPV = PV (Ct) - required investment Terminology

Ct = Cash Flow at time t

Ct
NPV   C 0 
(1  r ) t t = time period of the investment

r = “opportunity cost of capital”

C1 C C
NPV C0   2 2 ... t t
(1 r) (1 r)
1
(1 r)
The Cash Flow could be positive or negative at any time period.

Example Example: Valuing an Office Building

Suppose we can invest $50 today and receive $60 in one year. Step 1: Forecast cash flows
What is our increase in value given a 10% expected return?
Cost of building = C0 = 350,000

Sale price in Year 1 = C1 = 400,000

60
Profit = -50 +  $4.55
1.10 Step 2: Estimate opportunity cost of capital
$4.55 Added Value
If equally risky investments in the capital market
$50 Initial Investment
This is the definition of NPV
offer a return of 7%, then

Cost of capital = r = 7%
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Valuing an Office Building Risk and Present Value

Step 3: Discount future cash flows Higher risk projects require a higher rate of return

PV  (1Cr1 )  400
(1.07)  373,832
, 000 Higher required rates of return cause lower PVs

NPV  350,000  373,832 PV of C1  $400,000 at 7%

 ahead
Step 4: Go 23,832
if PV of payoff exceeds i 400,000
PV   373,832
1  .07

Risk and Present Value Net Present Value – Decision Rule

PV of C 1  $400,000 at 12% If the NPV is positive, accept the project

400,000 If the NPV is negative, reject the project
PV   357 ,143
1  .12

Ranking Criteria: Choose the highest NPV

PV of C1  $400,000 at 7%
400,000
PV   373 ,832
1  .07
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Example Net Present Value $466,000

$450,000
You have the opportunity to purchase an office building. Example - continued
You have a tenant lined up that will generate $16,000 per year in
cash flows for three years. At the end of three years you $16,000 $16,000 $16,000
anticipate selling the building for $450,000. How much would
you be willing to pay for the building?
Present Value 0 1 2 3

14,953
Assume a 7% opportunity cost of capital
13,975
380,395
$409,323

Example - continued Example - continued

If the building is being offered for sale at a price of If the building is being offered for sale at a price of
$350,000, would you buy the building and what is the added $350,000, would you buy the building and what is the added
value generated by your purchase and management of the value generated by your purchase and management of the
building? building?

1 6 ,0 00 1 6 ,0 0 0 46 6 ,0 0 0
N P V   3 5 0 , 0 00   
(1.0 7 ) 1 (1.0 7 ) 2 (1.07 ) 3
N P V  $ 5 9 ,3 2 3
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3. Internal Rate of Return Internal Rate of Return – Decision Rule

Internal Rate of Return (IRR) - Discount rate at which NPV = 0. • Minimum Acceptance Criteria:

Accept project if the Required rate of return < IRR

C1 C2 Ct • Ranking Criteria:
0  C0    ... 
(1  IRR) (1  IRR)
1 2
(1  IRR) t
Select alternative with the highest IRR

Example Example

You can purchase a building for $350,000. The You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows (i.e. rent) during investment will generate $16,000 in cash flows (i.e. rent) during
the first three years. At the end of three years you will sell the the first three years. At the end of three years you will sell the
building for $450,000. What is the IRR on this investment? building for $450,000. What is the IRR on this investment?

16,000 16,000 466,000

0   350,000   
(1  IRR ) 1
(1  IRR ) 2
(1  IRR ) 3

IRR = 12.96%
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Internal Rate of Return Example

200 Consider the following project:
150
IRR=12.96% $50 $100 $150
100
NPV (,000s)

50

0 0 1 2 3
-50
0 5 10 15 20 25 30 35 -$200
-100 The internal rate of return for this project is 19.44%
-150
$50 $100 $150
-200 NPV  0  200   
Discount rate (%) (1  IRR ) (1  IRR ) (1  IRR )3
2

NPV Payoff Profile Internal Rate of Return

If we graph NPV versus the discount rate, we can see the IRR
Disadvantages:
as the x-axis intercept.
IRR may not exist, or there may be multiple IRRs
0% $100.00 $120.00
$100.00
Scale problem
4% $73.88
8% $51.11 $80.00
12% $31.13 $60.00
$40.00
Advantages:
16% $13.52 IRR = 19.44%
NPV

20% ($2.08) $20.00 Easy to understand and communicate

24% ($15.97) $0.00
28% ($28.38) ($20.00)
-1% 9% 19% 29% 39%
32% ($39.51) ($40.00)
36% ($49.54) ($60.00)
40% ($58.60) ($80.00)
44% ($66.82)
Discount rate
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Multiple IRRs Example

There are two IRRs for this project:
$200 $800 Suppose an investment will cost $90,000 initially and will
Which one should we use? generate the following cash flows:
0 1 2 - $800
3 Year 1: 132,000
-$200
Year 2: 100,000
NPV

$100.00
Year 3: -150,000
$50.00 The required return is 15%.
100% = IRR2
$0.00 Should we accept or reject the project?
-50% 0% 50% 100% 150% 200%
($50.00) Discount rate Let us look at the NPV profile.
0% = IRR1
($100.00)

NPV profile The Scale Problem

$4,000.00 Would you rather make 100% return or 50% return on

$2,000.00 your investments?
$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
What if the 100% return is on a $1 investment, while
($2,000.00)
the 50% return is on a $1,000 investment?
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate
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4. NPV versus IRR Mutually Exclusive vs. Independent

NPV and IRR will generally give the same decision. Mutually Exclusive Projects: only ONE of several
Exceptions:
potential projects can be chosen, e.g., acquiring
an accounting system.
Non-conventional cash flows – cash flow signs change more than
once RANK all alternatives, and select the best one.
Mutually exclusive projects
Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
Must exceed a MINIMUM acceptance criteria

Example With Mutually Exclusive Projects NPV Profiles

Period Project Project $160.00 IRR for A = 19.43%

The required return
A B for both projects is
$140.00
IRR for B = 22.17%
$120.00
0 -500 -400 10%. $100.00 Crossover Point = 11.8%
$80.00
1 325 325 A

NPV
$60.00
B
$40.00
2 325 200 Which project
$20.00
should you accept $0.00
IRR 19.43% 22.17% and why? ($20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
($40.00)
NPV 64.05 60.74 Discount Rate

9-63 9-64
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Example Example

Compute the IRR, NPV for the following two projects. Assume Project A Project B
the required return is 10%. CF0 -$200.00 -$150.00
Year Project A Project B PV0 of CF1-3 $241.92 $240.80
0 -$200 -$150

1 $200 $50 NPV = $41.92 $90.80

2 $800 $100 IRR = 0%, 100% 36.19%
3 -$800 $150

Mutually Exclusive Projects Project Interactions

Example When you need to choose between mutually exclusive

projects, the decision rule is simple. Calculate the NPV of each
Select one of the two following projects, based on project, and, from those options that have a positive NPV,
highest NPV. choose the one whose NPV is highest.

System C0 C1 C2 C3 NPV
Faster  800 350 350 350  118.5
Slower  700 300 300 300  87.3

assume 7% discount rate