Finance Lecture 3

Shah Ahmed
March 25, 2014
Abstract
This will be an easy document to read, hopefully. Im going to break everything
down and make sure nothing is ambiguous, mostly for Adnan. But, if you nd yourself
stuck or something doesnt quite work, do let me know. Exercises can be found at the
end. Enjoy.
What follows is an introduction to the time-value of money.
1 Recap
Recall from the last homework, to nd how much money will be worth in the future, you
found,
= P(1 + r)
t
2 Notation
From now on we will use the notation of PV , which is the present value, or how much you
invest in the beginning, FV , which is the future value, or how much your money will be
worth later, r for the interest rate in decimal form and t for the number of periods, which
we use as years. Thus, our new equation is:
FV = PV (1 + r)
t
(1)
It is identical to what you originally found, just with dierent labels.
3 Manipulation
3.1 Solving for PV
We can move variables around using basic math. For example, if I wanted PV on one side,
I would divide both sides by (1 + r)
t
, then:
1
FV
(1 + r)
t
= PV (2)
Why is this useful? Lets say Adnan wanted to be a millionaire by the time he retired
and he could invest at an interest rate of 12%, how much would he have to put in the bank
today? That amount would be the PV . Lets break it down, the number of years, t, would
be 47. The FV would be 1,000,000 and r would be .12, now we can calculate the PV :
1, 000, 000
1.12
47
= 4, 961.31
This means, if I give Adnan $4,961.31 and he invests it at 12% until he retires, he would
have a million dollars. This is eectively why we save for retirement. You can see now that
you can solve for any of the 4 variables.
3.2 Solving for r
We will now solve for r:
Using our original equation (1), we divide by PV :
FV
PV
= (1 + r)
t
Now raise to the power of
1
t
:
(
FV
PV
)
1
t
= ((1 + r)
t
)
1
t
Recall that if you raise a power to a power, you multiply the powers, and t
1
t
= 1, and
anything to the 1 power is itself. This simplies to:
(
FV
PV
)
1
t
= 1 + r
Now subtract 1 and we nd r,
(
FV
PV
)
1
t
1 = r (3)
We now have an equation for r, given that we have the other three values.
3.3 Solving for t
Finally, we solve for t, which tends to cause people the most trouble. Note, that youve done
this with logarithms in the last problem set. It will become clear why we need logarithms.
2
We begin with our original equation in (1), now we divide by PV ,
FV
PV
= (1 + r)
t
We take ln or log on both sides, either will do the trick. We use ln(or log) because it drops
exponents to coecients(multiplication items), thus we can use simple division to move
any other items.
ln(
FV
PV
) = t ln(1 + r)
We are now able to divide ln(1 + r),
ln(
FV
PV
)
ln(1 + r)
= t (4)
At this point, we have an equation for every variable of the original equation. We can
now solve for complex, but applicable situations in our lives.
4 Exercises
1. Nabil invests $1000 today at 12% to withdraw when he graduates(two years), how
much will he withdraw?
2. Nadir will need $80,000 when he buys a nice car in four years. If the interest rate is
13%, how much should he put in the bank today if he wants to buy the car in four
years?
3. Galeeb has $15,000 to invest today, and he wants to have $100,000 in 17 years. What
interest rate should he invest in? (Round to 2 decimal places for percent and 4
decimal places if you use the decimal representation, example 12.34% or .1234)
4. Adnan nds $20 on the oor and decides to invest at 11% at his local bank. How
many years will it take for it to become $23? (Round to 2 decimal places)
5. Abba has $15,000 and can invest it at 10% starting in 1990 (instead of doing other
things with it *cough**cough*), how much will it be worth in 2014?
6. (Challenge) Amma puts $4,000 in the bank today, $5,000 in the bank in one year and
$6,000 in two years (she makes three deposits in total), how much will her account
have in 10 years?
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