MathReview

DoingProblems

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BasicEquation
ThebasicequationthatlinksPresentValuetoFuture Valueis:
FutureValue=Presentvaluex(1+InterestRate)Number ofPeriods Unfortunately,thissimpleequationforgetsanumberof importantconsiderations: Whataboutpayments? Whatiftheperiod,payments,orinterestratevaryover time?

Theequationcanbecomeverycomplicated!

TheFullEquation
Thefullequationlookslikethis:
FV=Presentvaluex(1+InterestRate0 )Number ofPeriods +Payment1 x(1+InterestRate1 )Number ofPeriods1 +Payment2 x(1+InterestRate2 )Number ofPeriods2 . +Payment x(1+InterestRate )Number ofPeriodsn n n

Fortunatelyforus,somesmartmathematician figuredoutawaytodotheequationifthepayment andtheinterestratewereconstantovertime.

TheInflationProblem
Theinflationproblemandthesimplegrowth problemarethemostbasicproblemsandare handledmosteasilybythebasicequation.
FutureValue=Presentvaluex(1+InterestRate)Number ofPeriods

Thisproblemcanbehandledbymosthandheld calculatorsthatwillallowyoutoraiseanumbertoa power,byalmostanybusinesscalculator,orbyany spreadsheetprogram.

SampleInflationandSimpleGrowthProblems
Ifacouplehasalifestylethatrequires$40,000ayeartoday, howmuchwilltheyneedintwentyyearsifinflationis4%? FV=$40,000x(1+.04)20 =$40,000x2.19=$87,645 OntheHP12CemulatorandExcel: PV=$40,000n=20I=4%PMT=0 FV=$87,645 Theapproachwouldbeidenticalifthequestionwashow muchwould$40,000growtointwentyyearsifI couldearn 4%compoundedannually?

AveragingGrowthandInflationRates
Growthratesdonotaveragelikeordinarynumbers. Thetechnicaltermisthattheyaveragegeometrically. Ifsomethinggrowsat3%oneyearand3%thenext year,theaveragegrowthrateisnot0.Theeffectis compoundedthus:
FV2 =PV1x(1+InterestRate2)= =(PV0 x (1+InterestRate1))x(1+InterestRate2)

AveragingGrowthandInflationRates(continued)
Thetotalrateofreturnforthetwoyearsis: (FV2 /PV1)1 FactoringthisintotheBasicEquationwehave: FV2 =PV1 x(1+InterestRateaverage)2 Goingbacktoalgebrawefindthat: InterestRateaverage=((FV2 /PV1)1/2)1 Letsimaginetherewas$1,000intheaccount:
Aftertwoyears,theaccountwouldbe:FV=$1,000x1.03x.97=$999 Theaveragerateofreturnwouldbe:(999/1000) 1=0.05%

AveragingGrowthandInflationRates: SampleProblem
IftheendofthisyearCPIaverages3.4%forthelastthreeyearsandthe reportedratewas5%twoyearsagoand1%lastyear,whatwastherate forthisyear? Totalinflationforthethreeyearswas: =((1+.034)x(1+.034)x(1+.034))1=1.10551=10.55% Totalinflationforthefirsttwoyearswas: =((1+.05)x(1+.01))1=1.0605=6.05% Howeverwecannotsimplysubtractthemtogettheanswer.Weneedto gobacktotheformulathatcombinesthem.Considergoodscosting$1000 startingthreeyearsago.Theywouldnowcost$1105.50.Ayearagothey cost$1060.50. Thustheywentupby(1105.5/1060.5)1=1.04241 =4.24%

MortgageProblems
Thereareawidevarietyofpotentialmortgageproblemsthat maybeencountered. Itshouldberememberedthatwhiletheyarebeingreferred toasmortgageproblems,heretheyapplytoallloans.Ifyou thinkoftheminthereverse,theyallapplytosituationswhere youaccumulatemoneythroughaseriesofequalpayments. Thisisareminderthateverycashflowtransactionhastwo partiesinvolved:onewhoisgivingcashnowandanotheris givingapromisenowtogivecashbackinthefuture.

MortgageProblems
(continued)
Mortgageproblemsalwaysinvolveaseriesofequalpayments.(Inthecaseof adjustablemortgagestheymayhavetobebrokendownintoaseriesofcases wherethepaymentsareequal.) Sincepaymentsareinvolved,youwillneedamoderatelycapablebusiness calculatororaspreadsheettodothecalculations.TheHP12Ccalculatorisone choice.The12CprocessandtheExcelmethodologyareverymuchthesame.You identifythevaluethatyouaretryingtocalculate(numberofperiods,interestrate, Presentvalue(generallytheamountofthemortgagebutnotalways),the Payment,andtheFutureValue(oftenzerobutnotalways)andentervaluesforthe otherfour. IfyouneedtoworkwiththeHP12Ccalculator,gobacktothelessononmathand review. IfyouaresomewhatfamiliarwithExcel,youcanlookundertheother functionstab(usuallyadropdownnexttotheAutoSum).Thereareformsfor eachvariable.DonotconfusePresentValue(PV)withNetPresentValue(NPV) theyareverydifferentfunctions.Eachfunctionhasadescriptionofhowtofillout theoperationwizardassociatedwithit.

MortgageProblems: TheDirectCalculations
Givenanyofthefourvalues(PresentValue,FutureValue,Payment, interestrate,andnumberofpayments)youcancalculatethefifth. Thecriticalaspectofthisisthattheinterestrate,numberof payments,andpaymentmustbeforthesameamountoftime. Thiscanbeconfusingbecauseinterestratesareusuallyprovidedin annualterms,periodsareprovidedinyears,butthepaymentscited aremonthly.Interestrateandnumberofpaymentsmustbe alignedwiththeperiodicityofthepayment. Thusifyouaretalkingaboutmonthlypayments,yearsneedtobe convertedtomonths,andannualinterestratesmustbeconverted tomonthlyinterestrates.Differentbusinesscalculatorsdothisin differentways.Itisimportanttoknowhowyourdevicehandles this. ThefollowingexampleswillusethetechniquesoftheHP12Cand Excel.

MortgageProblems: TheDirectCalculationExamples
Youwanttotakeouta15yearmortgagefor$200,000.You canaffordtopay$3,000permonth.Whatinterestratecan youafford? PV FV PMT No.ofPMTINTRate $200,000 $0 $1800 180 0.5851% RememberthattherateshownbytheHP12CandExcel wouldbeamonthlyrate(multiplyby12togettheannualrate of7.02%)
Notethatthepaymenthasbeengivenanegativesign.Thisisbecausethe cashflowhasbeenportrayedfromtheborrowerspointofview.They received$200,000fromthelender(that$200,000wasgiventothe seller).Thecashflowofpaymentsisgoingfromtheborrowertothebank, thusitisanegativeoranoutflowfromtheborrower.

MortgageProblems: TheDirectCalculationsExamples
Ifyouaretryingtobuyahousefor$300,000,thelendermayrequirea 20%downpayment.Thirtyyearloansarecurrentlyavailableinthe UnitedStatesforabout3.75%. 1. Firstcalculatetheamountoftheloan. LoanAmountAllowed=$300,000x(120%) =$300,000x.8=$240,000 2. Thencalculatethepayment. PV FVNo.ofPMT INTRate PMT $240,000 $0 360 .0375/12 $1,111.48 Notethatthepaymenthasanegativesignbecauseitisacashoutflow.

MortgageProblems TheDirectCalculationsExamples
Letssayyouwanttopayoffthepreviousmortgageas quicklyaspossibleandyouareabletomakepaymentsof $1,500.Howsoonwouldyoupayoffthemortgage? PV FVPayment INTRate No.ofPMT $240,000 $0 $1,500.0375/12 223 Themortgagewouldbepaidoffin223months,or18 yearsand7months
Note:Somecalculatorsprovideevenmonths;some(likeExcel)providefractionsofmonths.Always rounduptodeterminehowmanymonthsbeforethetotalwillbepaid.

MortgageProblems OtherExamples
Oneoftheclassicquestionsishowmuchinterestdoyoupay onyourmortgage? Thisquestiondoesnotrequireanythingbutasimple calculatorifyouaretalkingaboutthewholeperiodofthe mortgage. Ifyoumakeallyourpaymentsforthetermofthemortgage, youhavepaidthepaymenttimesthenumberofmonthsthat themortgagewasscheduled. Apaymentismadeupoftwoparts:interestandprincipal. Andyouknowwhatthetotalpaymentswereandwhatthe totalprincipalwas.Theremainderisinterest. Interestpaid=(PaymentxNo.Payments) PrincipalPaid

MortgageProblems OtherExamples
However,nowpretendyouarethelenderofamortgageandeachyearyouhave tosendanoticeofinterestpaidtotheborrowerssotheycanpotentiallydeductit fromtheirtaxes. Youknowthetotalthattheypaid(paymentsx12months),butthatwasnotall interest. Tofindouttheinterest,youneedtofigureouthowprincipalwaspaid.Consider thefirstyearinthelastexamplewhereyoudecidedtopay$1,500perperiod. Theamountpaidis$1,500x12=$18,000 Thebalanceafterthefirstyearwouldbe: PV Payment INTRate NoofPMTFV $240,000$1,500 .0375/12 12 $230,844 Thesignisnegativebecauseyoustillowethatamount.Thus,principalpaidis $240,000 $230,844=$9,156.Interestpaidis$18,000 $9,156=$8,844.

AccumulationProblems
Accumulationproblemsareverymuchlikemortgage problemsexceptthattheFutureValueisveryseldomzero andthePresentValuemayormaynotbezero. Increatingasignconvention,youmustrememberthatinan accumulationproblemyouaregivingyourmoneyinexchange forapromiseofafuturevalue.YoudeposityourPVandmake yourpaymentstosomeinstitutionthatwillreturnyousome futurevalue.Thus,fromyourperspective,yourPVandyour paymentsareanoutflowofcashifyouwantyourfuturevalue tohaveapositivesign.

AccumulationProblems Continued
Interestratesforaccumulationaregiveninannualtermsbut itisnotjustlikeamortgage. Mortgageinterestratesaresetbythebankandare specifically12timesthemonthlyrate. Annualratesofreturnoninvestmentsareusuallyderived fromannualperformance.Thusifamonthlyrateofreturnis neededthecompoundedmonthlyrateofreturnshouldbe used. Thus: MonthlyRateofReturn=(1+Annualrateofreturn)1/12
Thedifferencemayseemsmallbutover20yearsitissignificant

AccumulationProblems Continued
Inaccumulationproblemsyoutypicallyknowthepresent valueoftheaccount.Thusyoutypicallywanttoknowhow muchyouhavetosaveorhowmuchyouwillhave.Insome casesyoumightwanttoknowhowlongitwilltakeyouor whatrateofreturnyouneed. Ineverycaseyouneedtoestablishvaluesforthefour knowns,andthencalculatetheoneunknown. Mostbusinesscalculatorsallowyoutosetthetimingofa paymentasthestartorendoftheperiod.Thisisbecausethe choicecreatesaverydifferentanswer.Thestandardfor Accumulationsproblemsisendofperiodbecauseitis generallyacashoutflowandpeopletendtowaittomake suchcontributions.

AccumulationProblems Sample
Youwanttoknowhowmuchyouhavetosavetobuythatboat youhavebeenlookingat.Itcosts$40,000witha25%down payment.Youareabletosave$150dollarspermonth.Andyou canputitinanaccountthatpays4%.Howlongbeforeyouwill havethedownpayment? PV PaymentINTRateFV NoofPMT $0 $150.04/12 $10000 61months

YouTryIt
Now,youdoit.Willthe$150per monthbeenoughtocoverthe paymentsontheboatiftheloan is6%for12years? Writeyouranswerdownbefore lookingatthenextpage.

Answer
Thepaymentwouldbe$292.Thereforeyour$150will notbeenoughtocoverthepaymentsontheboatifthe loanis6%for12years.

AccumulationProblems: Sample
Yourretirementanalysissaysthatyouneedto accumulate$600,000byage67ifyouwanttoretire. Youcurrentlyare32andhave$40,000accumulated. Howmuchdoyouneedtosaveeachyearifyoucan expecttoearn7%annually? PV INTRateNoofPMTFV Pmt $40,000 7%35yrs $600,000 $1,251 Thepaymenthasanegativesignbecauseyouare givingittotheinstitutionasacashflow.

DistributionProblems
Distributionproblemsareverymuchlike accumulationproblemsexceptthattheFutureValue isveryoftenzeroandthePresentValueisgenerally notzero. Increatingasignconventionyoumustremember thatinadistributionproblemyouarereceivingyour moneyfromyourinstitution.YoudepositedyourPV, anegative,becauseitiswhatyougaveawayforthe promiseofthepayments(positivecashflow)that youarenowreceiving.

DistributionProblems Continued
Aswithaccumulationproblems,annualratesofreturnoninvestmentsare usuallyderivedfromannualperformance.Thusifamonthlyrateofreturn isneeded,thecompoundedmonthlyrateofreturnshouldbeused. ThemosttypicalquestionsareHowmuchdoIneedtolastXnumberof years?orHowmuchcanIwithdrawandhaveitlastforXnumberofyears? OccasionallythequestionmaybeHowlongwillthisamount(PV)lastifI withdraw$XXXX?orWhatratedoIneedforthemoneytolastforX years? Ineverycaseyouneedtoestablishvaluesforthefourknowns,then calculatetheoneunknown. Mostbusinesscalculatorsallowyoutosetthetimingofapaymentatthe startorendoftheperiod.Thisisbecausethechoicecreatesavery differentanswer.ThestandardforDistributionProblemsisstartofperiod becauseitisgenerallyacashflowreceivedandpeopletendtowantthe paymenttolive.

DistributionProblems: Samples
Yourcollegesavingsplanindicatesthatyouneedtoplanfor fouryearsofcollegeat$20,000.Youcanonlyearn2%onthe moneybecauseoftheshorttermnatureoftheexpense.How muchdoyouneedtoaccumulate? INTRateNo.ofPMTFV Pmt 2%4yrs $0 $20,000 PV $77,677.67

Remembertosetyourcalculatorforstartoftheperiod payments.

YouTryIt!
Howmuchwouldyouhavetosaveeveryyearifyour childis4yearsold,willbeattendingcollegeatage 18,andyouwillbeabletoearn7.5%interest annually? Writeyouranswerdownonapieceofpaperbefore lookingatthenextpage.

Answer $3,324.40
Donotforgetthattheseareendoftheperiod payments.

DistributionProblems: Samples
Youhaveaccumulatedaretirementaccountof$600,000.You are67yearsoldandwanttoknowhowmuchyoucanwithdraw peryearforthenext30yearsifyoucanearn5%ininterest. INTRateNoofPMTPV 5%30yrs $600,000 FV $0 Pmt $37,112

Again,remembertousethebeginningoftheperiodpayment

Accumulation Distribution Problems

Muchoffinancialplanningisreallyanapplicationofthe Accumulation Distributionproblems.Peoplewanttosave upforsomethingandthenspendit.Collegesavingsand retirementsavingsaretheclassicexamples. Therearesomesixtyfourwaysthatsuchaproblemcanbe stated.Wearenotgoingtotouchonthem.Theexamplein thedistributionproblemsistheclassicone.Thethingforyou torememberisthattypicallyyouneedtodothedistribution partoftheproblemfirst,thentheaccumulationpart.

InflationAdjustedRateofReturn
TheInflationAdjustedRateofReturn,sometimesreferredtoas theRealRateofReturn,isnotsimplythedifferencebetweenthe inflationrateofthenominalrateofreturn.Thecalculationis: InflationAdjustedRateofReturn= ((1+rateofreturn)/(1+rateofreturn))1 WhensucharateofreturnisusedinanAccumulationand/or DistributionProblem,thepaymentdeterminedistheinitial paymentofaseriesofpaymentsthatincreasesattheinflationrate. Sucharateisoftenusedbyfinancialplannersbecauseitcreatesan initialpaymentthatislowerandthereforemorepalatablefora client.Howevereachsubsequentpaymentishigher.Ifapersons incomeisincreasingthatisokaybutifnotitwillcreatean unexpectedburden.