Present Value Essentials

Present Value Essentials

Present Value Essentials Basic Assumptions: All cash payments (receipts) Certainty regarding: Amount of cash flows Timing of cash flows All cash flows are immediately

reinvested at designated interest rate Basic Concepts: For Accounting almost always Present value. I.e.: Answer the question: Some amount of money is to be paid or received in the future (or a series of payments), how much is it worth now, given a certain required rate of return

Basic Concepts I: Time Value of Money: Invested money earns interest (if in bank) or some rate of return (if invested in something else) Compound interest: Money earned on investment is reinvested immediately at required rate

of return (interest earned on interest received) Basic Concepts II: Interest; rate of return; discount rate: For PV analysis they mean the same. From now, only interest will be used Future Value:

Value of an investment after a designated period of time, given a specified interest rate Present Value vs. Future Value Present value is based on future value, specifically the compound interest formula. Therefore Future value discussion to help you understand present value

Basic Future Value Concepts: Invested money earns more money $1,000 today is worth more than $1,000 one year from today because: $1,000 invested at 10% grows to $1,100 in one year $1,100 is the future value of $1,000 @ 10% after one year

Future Value Example: year 1 year 2 year 3 Value of investment after three years: Investment interest interest rate earned $100.00 10% $10.00 $110.00 10%

$11.00 $121.00 10% $12.10 $133.10 FV Example $ 1,000 @ 10% grows to (alternate view):

$1,100 in one year $1,210 in two years $1,331 in three years OR $1,000 * 1.1*1.1*1.1 = $1,331 Future Value Example: Another way to determine the future value of $100 invested to earn 10%, interest compounded annually:Use the Compound interest formula: (1 +r)n Where r = interest rate/compounding period and n = number of compounding periods (1 + .1)3 = 1.331 * 100 = $133.10 Compounding:

Number of times per year interest is calculated May be annually, semi-annually, quarterly, etc. However: Interest rate is expressed on annual basis, unless stated to be for another period. Therefore: if annual interest rate is 10% ---- Compounding:

Semi-annual: 5% twice a year Quarterly: 2.5% four times a year Monthly: 10/12% 12 times a year In other words: If more than one compounding period/year, interest rate is divided by # of periods. # of years multiplied by # of periods Compounding:

Why does it matter? Because interest adds up faster. E.g.: 10%, 3 years, semi-annual compounding: (1 + .1/2)3*2 = 1.34 > (1 +.1)3 = 1.31 Future Value Calculation: FV of r= 10%, annual

compounding and n= 3 years: FV (r, n) = FV (10%,3) = 1.331 $100 invested for 3 years at 10% = $100 * FV (10%, 3) = X $100 * 1.331 = X = $133.10 Present Value (PV): Accounting almost always wants to know what something is worth now PV asks: If $133.10 will be received

in 3 years, how much is it worth today if 10% is the appropriate discount rate? Use FV formula to answer the question: PV of $133.10 (to be paid or received in 3 years) X * FV(10%,3)

= $ 133.10 X * 1.331 = $ 133.10 (X* 1.331)/1.331 = $133.10/1.331 = $100 PV = Reciprocal of FV OR 1/FV therefore: PV(10%,3) = 1/FV(10%,3) = 1/(1+.1)3 = .75132 PV of $133.10 (to be paid or received in 3 years (again))

$ 133.10 * PV(10%,3) = X $ 133.10 * .75132 = X = $100 This is the equation you must use Do not use the formula, use table instead (p. C10) Part II Annuities Basic PV used for single sum payments E.g. a note payable due in 5 years

PV of Annuity used for questions relating to a series of equal payments at regular intervals E.g. car payments, payments on a student loan PV of 3 payments of $ 100 each? Payments made at end of each of the next three years, 10% interest rate: PVA $100 (10%,3)

PV annuity (PVA) $100, 10%, 3 years: Option 1: we could express the above as follows: receive PV Factor answer: end of year 1 $100.00 (10%,1) 0.9091 $90.91 end of year 2 $100.00 (10%,2) 0.8264 $82.64 end of year 3 $100.00 (10%,3) 0.7513 $75.13 $248.68

PV annuity (PVA) $100, 10%, 3 years: Option 2: Use simple algebra, factor out constant: Restated equation: $100 * (.9091 + .8264 + .7531) $100 * 2.4868 =X = X = $248.68 PV annuity (PVA) Present value of an annuity (PVA) 3 periods, 10% = (.9091 + .8264 + .7531) = 2.4868 Libby ordinary annuity table, page 748:

PVA (10%,3) = 2.4869 Kimmel ordinary annuity table, Appendix C: PVA (10%,3) = 2.48685 Present Value (PV) of $ 1 period 1 2 3 1% 0.99 0.98 0.971

2% 0.98 0.961 0.942 10% 0.909 0.826 0.751 PV of an ordinary annuity of $1 period 1 2 3

1% 0.99 1.97 2.941 2% 0.98 1.942 2.884 10% 0.909 1.736 2.487 PV annuity due (PVA due)

Difference: 1st payment is at beginning of period compared to at the end for an ordinary annuity Example: Rent or lease payments Libby does not have table for it However: not a big problem PVA due: 3 payments, 10% Option 1:

we could express the above as follows: receive PV Factor answer: beginning of year$100.00 1 (10%,0) 1 $100.00 beginning of year$100.00 2 (10%,1) 0.9091 $90.91 beginning of year$100.00 3 (10%,2)

0.8264 $82.64 $273.55 PVA due: 3 payments, 10% Option 2: Calculate the factor: PVA due (10%,3) = 1 +PVA(10%,2) = 1 + 1.73554 = 2.73554 * $ 100 = $2.73.55 Compared to ordinary annuity: 2.4868

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