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LEARNING OBJECTIVES
Differentiate between simple interest compound
interest ; Being able to compute the amount of interest
TIME VALUE OF MONEY that will be earned on an investment
Understand the concept the time value of money;
VALUATION OF FUTURE CASH FLOWS Being able to compute the present and future values of
lump sum payment (single period case) as well as for
multiperiod case
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Understand and being able to compute the nominal,
periodic and annual equivalent interest rates
Prepared by Phan Ngoc Anh, MBA Know how to determine the payout figures for existing
loans
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WHY ?
NOW YEAR
FUTURE
FV > $ 30,000 ?
PV = $ 30,000
= $ 30,000 + ?
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Opportunity cost
= $ 30,000 + $ 30,000 *r 1
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Uncertainty
Inflation
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with an investment must be measured at the same point in
time FV (Future value) FinancialManagement
SI : Simple interest earned
N
r : Interest rate per time period (%)
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SI = FVn - PV = PV * (1+ n * r) - PV = PV * r * n
FORMULA: CI = PV*(1+r)n - PV
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in which:
CI: Compound interest earned CI = FVn - PV = PV * (1+ r)n PV = PV * [(1+ r)n -1]
PV: Principal, or original amount borrowed (lent) at time
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Present value (PV) is the current value of one or more future
cash flows from an investment.
The number of time periods between the present value and the
future value is represented by N.
The rate of interest for discounting or compounding is called r.
All time value questions involve four values: PV, FV, r and N.
Given three of them, it is always possible to calculate the fourth.
FUTURE VALUE
SINGLE CASH FLOW CASE
Future value
interest factor
FVn = PV * (1 + r)n
FUTURE VALUE AND PRESENT VALUE (FVIF)
THE SINGLE CASH FLOW CASE A father set aside $5,000 for his
newborn childs education. How much
will he have after 18 years, given the
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$177,156,500,000,000
EXAMPLE 1:
Can be derived from the Future value formula
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You want to begin saving for your daughters college Suppose you are offered an investment that will allow you to
education and you estimate that she will need $150,000 in double your money in 6 years. You have $10,000 to invest.
17 years. If you feel confident that you can earn 8% per What is the implied rate of interest?
year, how much do you need to invest today?
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Suppose you want to buy a new house. You How much do you need to have in the future?
currently have $15,000, and you figure you need to Down payment =
have a 10% down payment plus an additional 5% of Closing costs =
Total needed =
the loan amount for closing costs. Assume the type
of house you want will cost about $150,000 and Start with the basic equation and solve for n (remember your
you can earn 7.5% per year, how long will it be logs)
before you have enough money for the down
payment and closing costs? Using the formula
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Periods
(year)
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FUTURE VALUE
MULTIPLE CASH FLOWS CASE
Compound all cash flows to last period and add them
FUTURE VALUE AND PRESENT VALUE together
THE MULTIPLE CASH FLOWS CASE
0 1 2 3(n-1) n
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INSTALLMENTS
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ANNUITY CONCEPT
An annuity is a finite series of equal payments that occurs at regular
FUTURE VALUE AND PRESENT VALUE intervals
Eg. Rent payment $1,000 each month for 12 months
ANNUITY Eg. Insurance premium of $100 each month for 36 months
1 2 3 N-1 N
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PV C (Annuity)
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FV
Eg. Starting one year from today, deposit $500 into bank
account every year for 6 years. If r =6% pa., how much is in the C (Annuity)
bank account after 6 years ?
0
500 500 500 500 500 500
PV 1 2 3 N-1 N
0 1 2 3 4 5 6 C (Annuity)
Not compounded
Contract date Compounded 1 year The future value of an annuity is
Compounded 2 years
(1 r ) n 1
Compounded 3 years
Compounded 4 years FV C 1 (1 r ) (1 r ) 2 .... (1 r ) n 1 C
r
Compounded 5 years
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E.g: Starting one year from today, to withdraw 500 each year in
6 years from a saving account earning 6% p.a. How much is your C (Annuity)
initial investment ?
500 500 500 500 500 500 0
Contract date N-1 N
PV 1 2 3
0
Discounted 1 year1 2 3 4 5 6 C C C C
Discounted 2 years PV ...
Discounted 3 years
(1 r) (1 r) (1 r)
2 3
(1 r)n
Discounted 4 years
Note: This formula gives a value one period
Discounted 5 years
before the first CF happens
Discounted 6 years
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PERPETUITY C C C
0
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PV 1 2 3
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INFLATION AND THE TIME VALUE OF MONEY INFLATION AND THE TIME VALUE OF MONEY
NOMINAL vs. REAL INTEREST RATE
As inflation increases so does the minimum expected return. The
Consider $100 which can be invested at 10% when interest rates used so far includes an element due to inflation.
Removing inflation from the nominal rate creates the real rate of
inflation is 6%. How many $1 hamburgers can be return. They are linked by the following FISHER EFFECT equation:
bought in 1 year if their price rises in line with
(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate)
inflation ?
Real rates: rates of return that have been adjusted for
inflation
Nominal rates: rates of return that have not been adjusted
for inflation
So if a company requires a 20% return on investment and
inflation is at 10% what is the real rate?
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INFLATION AND THE TIME VALUE OF MONEY ANNUAL PERCENTAGE RATE vs.
NOMINAL vs. REAL INTEREST RATE EFFECTIVE ANNUAL RATE
(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate) Annual Percentage Rate (APR) Interest rate that
is annualized using simple interest
Rearranging:
Real rate = (1+ nominal rate)/(1+inflation rate) -1
Applied to previous example: m: The number of times the interest is
compounded during the year
Real rate = (1+0.1)/(1+0.06) -1 = 3.8%
Effective (equivalent) Annual Rate (EAR): interest
rate is actually earned per year
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PRINCIPLE 1 :
PRESENT VALUE OF ORDINARY ANNUITY
When finding the PV of an annuity/perpetuity, our
MATCHING CASH FLOWS WITH THE formulas give us the PV one period before the first cash
flow in the sequence
FORMULAS Ex: How much do you have to put into the account earning
5% p.a (compound annually) right now to withdraw $100
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PRINCIPLE 2 : PRINCIPLE 3 :
PRESENT VALUE OF ANNUITY DUE FUTURE VALUE OF ORDINARY ANNUITY
How do we deal with a series of cash flows that begins When finding the FV of an annuity, our formula gives us the
immediately? End of year 9,
beginning year 10
future value at the time of the last cash flow in the
0 1 2 3 4 . 9 sequence
Eg: You decide to contribute $5,000 to your retirement
account each year for the next 30 years. The account earns
100 100 100 100 10% p.a. (compounding annually). What is the balance in
your account when you retire in 30 years from today ?
0 1 2 3 4 . 30
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AMORTIZING A LOAN
Determine payments required for an installment loan
MEASURING VALUE type (annuities)
MORTGAGE AND LOAN REPAYMENTS Loan is repaid in equal periodic payments including both
interest and principal
Thus, payment amount is set such that the present value
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Loan
amount
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BANK LOANS
BANK LOANS
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Principal =
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REFINANCING REFINANCING
Your current mortgage calls for monthly payments Step 1. Whats the remaining balance on your current loan ?
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ACB loan:
Rate 6.45% p.a. compounded monthly
No monthly fee
Upfront cost: $820
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Assume you need $100,000 over a 25 year term
1. Set the initial cash flow equal by assuming you Loan Amount (Total borrowed) = Cash required +
borrow the upfront fee Up-front fee
2. Compute the monthly payment for each loan
adding in any fees Monthly payment =
3. Compare the monthly cost of each loan
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ACB Loans
Suppose City Bank offers you a deal: no up-front
Loan Amount (Total borrowed) = Cash required + Up-front costs, and only $4 per month in fees
fee Is the ACB loan still a better deal ?
(everything else remains the same)
Monthly payment =
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Total monthly cost =
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