IFT Notes for Level I CFA^{®} Program

Let’s say that one year from today you will receive a cash flow of $110. What is the value of that $110 today? (Assume that the interest rate is 10%)

- The $110 one year from today has a present value of $100. In other words, you will be indifferent between $100 today and $110 one year from today.

- What if you were going to receive $121 at the end of two years, what is its present value?

- Using these two examples we can write a general formula for computing PV. Given a cash flow that is to be received in N periods and an interest rate of r per period, the PV can be computed as:

where:

N = number of periods

r = rate of interest

FV = future value of investment

**Instructor’s Note**

Notice that this formula can also be obtained by simply rearranging the formula for FV that we studied earlier.

Based on this formula we can make two observations

- For a given discount rate, the farther in the future the amount to be received, the smaller the amount’s present value.

__Mathematical explanation__: In the first case the PV is $110/1.1, whereas in the second case PV is $110/1.1^{2}. Since we are dividing by a larger number the PV will be lower in the second case.

__Intuitive explanation__: Clearly receiving a certain amount of money sooner is better than receiving the same amount of money latter.

- Holding time constant, the larger the discount rate, the smaller the present value of a future amount.

- In the first case PV is $110/1.1, whereas in the second case PV is $110/1.2. Clearly the PV is going to be lower in the second case, because we are dividing by a larger number.

**Example**

Liam purchases a contract from an insurance company. The contract promises to pay $600,000 after 8 years with a 5% return. What amount of money should Liam most likely invest? Solve using the formula and TVM functions on the calculator.

**Solution:
**

__Calculator Method__

N = 8, I/Y = 5%, PMT = 0, FV = $600,000; CPT PV PV = – $406,104

**Example**

Mathews wishes to fund his son, Nathan’s, college tuition fee. He purchases a security that will pay $1,000,000 in 12 years. Nathan’s college begins 3 years from now. Given that the discount rate is 7.5%, what is the security’s value at the time of Nathan’s admission?

**Solution:**

**Example**

Orlando is a manager at an Australian pension fund. 5 years from today he wants a lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year, compounded monthly, how much should Orlando invest today?

**Solution:**

We have monthly compounding, therefore the inputs to our calculator will be

N = 5 x 12 = 60

I = 4 /12%

PMT = 0

FV = $40,000

CPT PV = – $32,760.12

**Ordinary Annuity**

An ordinary annuity is a series of equal payments at equal intervals for a finite period of time. Examples of ordinary annuity: mortgage payments, pension income etc.

Consider an ordinary annuity with A = $10, r = 5% and N = 5.

We can compute the PV of this annuity using three methods

__Brute-Force Method__:

Simply take each cash flow and compute the PV. Add all values to get the PV for the annuity.

PV = $43.29.

__Formula Method__:

The present value can also be computed using the following formula:

where:

A = annuity amount

r = interest rate per period corresponding to the frequency of annuity payments

N = number of annuity payments

The term in square brackets is called the present value annuity factor (PVAF). Hence the equation above can also be written as: PV = A x PVAF**.**

Therefore, using the formula we get,

__Calculator Method__:

The keystrokes to solve this using a financial calculator are given below:

Keystrokes |
Explanation |
Display |

[2nd] [QUIT] | Return to standard calc mode | 0 |

[2^{nd}] [CLR TVM] |
Clears TVM Worksheet | 0 |

5 [N] | Five years/periods | N = 5 |

5 [I/Y] | Set interest rate | I/Y = 5 |

0 [FV] | Set to 0 because there is no final payment other than the periodic annuity amounts | FV = 0 |

10 [PMT] | Set annuity payment | PMT = 10 |

[CPT] [PV] | Compute present value | PV = -43.29 |

**Annuity Due**

With an annuity due the first payment is received at the start of the first period. So if we have an annuity due with A = $10, r = 5% and N = 5. The cash flows will be

Again, there are three methods to calculate the PV of this annuity due.

__Brute-Force method__

Take each cash flow and compute the PV. Add all values to get the PV for the annuity.

PV = $45.46.

Notice that with an annuity due you are receiving money faster, which means that the

PV _{annuity due} ($45.46) > PV _{ordinary annuity} ($43.29).

__Formula method__:

We can also use the following formula:

where:

A = annuity amount

r = interest rate per period corresponding to the frequency of annuity payments

N = number of annuity payments

Therefore using the formula,

**Instructor’s Note**:

Notice that is basically the formula for computing the PV of an ordinary annuity. If you use the ordinary annuity formula the PV that you get will be at time period -1. So this needs to be taken forward one period by multiplying it by (1 + r)

__Calculator Method__:

Set the calculator to BGN mode. This tells the calculator that payments happen at the start of every period. (The default calculator setting is END mode which means that payments happen at the end of every period). The keystrokes are shown below:

Keystrokes |
Explanation |
Display |

[2nd] [BGN] [2nd] [SET] | Set payments to be received at beginning rather than end | BGN |

[2nd] [QUIT] | Return to standard calc mode | BGN 0 |

[2nd] [CLR TVM] | Clears TVM Worksheet | BGN 0 |

5 [N] | Four years/periods | BGN N = 5 |

5 [I/Y] | Set interest rate | BGN I/Y = 5 |

10 [PMT] | Set payment | BGN PMT = 10 |

0 [FV] | Set future value | BGN FV = 0 |

[CPT] [PV] | Compute present value | BGN PV = -45.46 |

[2nd] [BGN] [2nd] [SET] | Set payments to be received at the end | END |

[2nd] [QUIT] | Return to standard calc mode | 0 |

Always remember to put your calculator back in the END mode after you are done with the calculations.

A perpetuity is a series of never ending equal cash flows. The present value of perpetuity can be calculated by using the following formula:

where:

A = annuity amount

r = discount rate

Let’s say that we have a really simple perpetuity where we receive $10 at the end of every year forever, and let’s say that the interest rate is 5%.

The PV of this perpetuity can be computed as:

**Instructor’s Note**:

Keep in mind that the present value of $200 is one period before the first cash flow. Many students show the present value of $200 at the same time as the first cash flow, which is incorrect.

An annuity or perpetuity beginning sometime in the future can be expressed in present value terms one period prior to the first payment. That value can then be discounted back to today’s present value.

Let’s say you are offered a cash flow of $10 at the end of year 5, end of year 6, and so on forever. What is the PV of these cash flows, assuming a discount rate of 10%?

The PV of the perpetuity at the end of year 4 can be computed as:

This value has to be discounted back four periods to get the PV at time period 0.

PV_{0} = $100/1.1^{4} = $68.30

**Example**

Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth $100 per year indefinitely. The first payment will be received at t = 4. Given that the required rate of return is 10%, how much should Mr. Graham pay today?

**Solution:**

The time line for this scenario is

The PV of the perpetuity at the end of year 3 can be computed as

This value has to be discounted back 3 periods to get the PV at time period 0.

PV_{0} = $1,000/1.1^{3} = $751.31

When we have unequal cash flows, we can first find the present value of each individual cash flow and then sum the respective present values.

Let’s say that we have the following cash flows:

Time period |
Cash Flow |

1 | $100 |

2 | $200 |

3 | $300 |

Assuming a discount rate of 10%, the PV of these cash flows can be computed as:

PV = 100/1.1 + 200/1.1^{2} + 300/ 1.1^{3} = $481.59

**Example**

Andy makes an investment with the expected cash flow shown in the table below. Assuming a discount rate of 9% what is the present value of this investment?

Time Period |
Cash Flow($) |

1 | 50 |

2 | 100 |

3 | 150 |

4 | 200 |

5 | 250 |

**Solution:**

PV = 50/1.09 + 100/1.09^{2} + 150/1.09^{3} + 200/1.09^{4} + 250/1.09^{5} = $550.03

We can also use the cash flow register on our financial calculator to solve this problem quickly. The key strokes are as follows:

Keystrokes |
Explanation |
Display |

[2nd] [QUIT] | Return to standard mode | 0 |

[CF] [2nd] [CLR WRK] | Clear CF Register | CF = 0 |

0 [ENTER] | No cash flow at t = 0 | CF0 = 0 |

[↓] 50 [ENTER] | Enter CF at t = 1 | C01 = 50 |

[↓] [↓] 100 [ENTER] | Enter CF at t = 2 | C02 = 100 |

[↓] [↓] 150 [ENTER] | Enter CF at t = 3 | C03 = 150 |

[↓] [↓] 200 [ENTER] | Enter CF at t = 4 | C04 = 200 |

[↓] [↓] 250 [ENTER] | Enter CF at t = 5 | C05 = 250 |

[↓] [NPV] [9] [ENTER] | Enter discount rate | I = 9 |

[↓] [CPT] | Compute NPV | 550.03 |