9/26/2016

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
Financial Management

Financial Management
Understand and being able to compute the nominal,
periodic and annual equivalent interest rates

Compute the present and future values for annuities and

perpetuities and its applications on mortgage
amortization schedule

Prepared by Phan Ngoc Anh, MBA Know how to determine the payout figures for existing
loans

TIME VALUE OF MONEY CONCEPT TIME VALUE OF MONEY CONCEPT

EXAMPLE:
EXAMPLE:
GRANDMOMS ANH : Its
The Washington Post: WILL IN THE
On 12/02/1982, General dangerous keeping
INHERITANCE
EM: Yes. But one lots of money. As
Motors Acceptance
Should we trade $500 NOW ANH $30,000 year from now long as youve
Corporation (GMAC), - a
Financial Management

EM $30,000 when I graduate decided to go, I

branch of General Motors, for $10,000 IN 30 YEARS? from IU, I will need would transfer
sold securities to the public $ to go study $11,500 to your
at $500 each. Holders will be abroad. Will you bank account each
entitled to a single lump sum ANH : Ill keep it for give me back year in 3
you. Ill give you $34,000 ? consecutive years
payment of $10,000 in 2012 back your $30,000 until youre done
(30 years). when youre done with your degree
with school
abroad.

1
 9/26/2016

TIME VALUE OF MONEY CONCEPT TIME VALUE OF MONEY CONCEPT

EXAMPLE:

1
WHY ?
NOW YEAR
FUTURE
FV > $ 30,000 ?
PV = $ 30,000
= $ 30,000 + ?
Financial Management

Financial Management
Opportunity cost
= $ 30,000 + $ 30,000 *r 1

2
Uncertainty

Inflation
3

DRAWING A TIME LINE SIMPLE INTEREST

Why needs a time line ? Interest is earned on principal only. There is no re-investing of
A time line depicts the cash flows (cash in and cash out both interest for the next period
positive and negative) on a horizontal line, with time zero at
the left and future periods shown moving from left to right
FORMULA: SI = PV*r*n
Because money has a time value, the cash flow associated in which:
Financial Management

Management
with an investment must be measured at the same point in
time FV (Future value) FinancialManagement
SI : Simple interest earned

0 1 2 N-1 PV: Principal, or original amount borrowed (lent) at time 0

N
r : Interest rate per time period (%)
3
Financial

n: Number of time periods (months, quarters, years,etc.)

PV (Present value) The interval from 0 to 1, 1 to 2, (n-1) to
n, etc. are called periods. Periods can be
months, quarters, years, etc.

2
 9/26/2016

SIMPLE INTEREST SIMPLE INTEREST

Beginning Simple
Period Ending Balance (FVn) What is the simple interest earned on $100 bank deposit at
Balance Interest
1 PV PV*r FV1 = PV + PV*r = PV(1+r) 6% p.a for 5 years ?
2 PV*(1+r) PV*r FV2 = PV*(1+r) + PV*r = PV*(1+2r)
3 PV*(1+2r) PV*r FV3 = PV*(1+3r)

n PV*(1+(n-1)r) PV*r FVn = PV*(1+nr)

Financial Management
SI = FVn - PV = PV * (1+ n * r) - PV = PV * r * n

COMPOUND INTEREST COMPOUND INTEREST

Interest is earned on principal and interest reinvested from Beginning Compound
Period Ending Balance (FVn)
prior periods. It is interest-on-interest, or compounding effect, Balance Interest
that accounts for the dramatic difference between simple and 1 PV PV*r FV1 = PV + PV*r = PV(1+r)
compound interest. 2 PV*(1+r) PV*(1+r)*r FV2 = PV*(1+r)2
3 PV*(1+r)2 PV*(1+r)2*r FV3 = PV*(1+r)3

Management

FORMULA: CI = PV*(1+r)n - PV
FinancialManagement

n PV*(1+r)n-1 PV*(1+r)n-1*r FVn = PV*(1+r)n

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
Financial

r : Interest rate per time period (%)

n: Number of time periods (months, quarters, years,etc.)

3
 9/26/2016

COMPOUND INTEREST TIME VALUE TERMINOLOGY

0 1 2 3 4
What is the compound interest earned on $100 bank
deposit at 6% p.a for 5 years ?
PV FV
Future value (FV) is the amount an investment is worth after
one or more periods at some given interest rate.

Financial Management
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
Financial Management

Financial Management interest rate of 5% per annum ?

Use your calculator

Refer to the table

4
 9/26/2016

FUTURE VALUE (cont) THE RELATIONSHIP BETWEEN INTEREST RATE AND

SINGLE CASH FLOW CASE
In 1626, Peter bought Manhattan Island
FUTURE VALUE
for $24. What is the value of the island
in 2011, given an interest rate of 8% per Future value of $1
annum ?
After 385 years (1626-2011), the value
of $24 would be:
$24 * (1+0.08)385 =
Financial Management

Financial Management
$177,156,500,000,000

Given todays real estates value in New

York, Manhattan Island costs alot less!

Assuming the interest rate is only 4%

per year, the value of $24 would be:
$24 * (1+0.04) 385 = $86,755.544 Periods

PRESENT VALUE PRESENT VALUE

SINGLE CASH FLOW CASE FINDING THE PRESENT VALUE THE SINGLE CASH FLOW CASE

EXAMPLE 1:
Can be derived from the Future value formula

In 1995, Coca Cola needed $ 1 billion to launch its new

Present value project and issued IOU (I Owe You) certificates onto the
interest factor market. Holder of this certificate will be entitled to a lump
sum of $1,000 in 25 years. How much would you buy this
IOU certificate by Coca Cola, assuming the market interest
rate is 8.53% per year ?
The price of this IOU is the current value of $1,000 in 25 years:

19 20

5
 9/26/2016

PRESENT VALUE PRESENT VALUE

FINDING THE DISCOUNT RATE THE SINGLE CASH FLOW CASE
FINDING THE PRESENT VALUE THE SINGLE CASH FLOW CASE
EXAMPLE 2: EXAMPLE 3:

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?

21 22

PRESENT VALUE PRESENT VALUE

FINDING THE NUMBER OF PERIODS THE SINGLE CASH FLOW CASE FINDING THE NUMBER OF PERIODS THE SINGLE CASH FLOW CASE
EXAMPLE 5: EXAMPLE 5 SOLUTION:

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

Per a financial calculator:

23 24

6
 9/26/2016

PRESENT VALUE AND INTEREST RATE

PRESENT VALUE AND INTEREST RATE
PV of
$1
No. of Present value of $100 at different interest rates
periods
(year) 5% 10% 15% 20%

1 $95.24 $90.91 $86.96 $83.33

2 $90.70 $82.64 $75.61 $69.44

3 $86.38 $75.13 $65.75 $57.87

4 $82.27 $68.30 $57.18 $48.23

5 $78.35 $62.09 $49.72 $40.19

Periods
(year)
25 26

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
Financial Management

CF1 CF2 CF3 CFn-1 CFn

CFn *(1+r)n-n
CFn-1 * (1+r)n-(n-1)
CF3 * (1+r)n-3
CF2 *(1+r)n-2
CF1*(1+r)n-1

28

7
 9/26/2016

FUTURE VALUE PRESENT VALUE

MULTIPLE CASH FLOWS CASE MULTIPLE CASH FLOWS CASE
EXAMPLE Discount all cash flows back to present and add them
together
Suppose you plan to deposit into a bank account $100 now;
$200 in a year; and $300 in 2 years. How much will you have
by the end of year 3, given the banks interest rate of 10% ?

29 30

PRESENT VALUE PRESENT VALUE

MUTIPLE CASH FLOWS CASE MUTIPLE CASH FLOWS CASE
EXAMPLE 1:
A car dealer offers you the following terms:
OPTION 1 OPTION 2

INSTALLMENTS

DOWN PAYMENT Down payment $9,000

$4,000 in 1 year
$15,500 $ 4,000 in 2 years
(Assuming the prevailing
market interest rate of
31
8%) 32

8
 9/26/2016

PRESENT VALUE PRESENT VALUE

MUTIPLE CASH FLOWS CASE MUTIPLE CASH FLOWS CASE
GRANDMOMS ANH : Its
WILL IN THE dangerous keeping
INHERITANCE lots of money. As
EM: Yes. But one long as youve
ANH $30,000 year from now decided to go, I
EM $30,000 when I graduate would transfer
from IU, I will need $11,500 to your
$ to go study bank account each
abroad. Will you year in 3 consecutive
ANH : Ill keep it for give me back years until youre
you. Ill give you $34,000 ? done with your
back your $30,000 degree abroad.
when youre done (Assuming an
with school interest rate of 9.5%)
34

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

Ordinary annuity: Payments occur at the end of each period (i.e.

Financial Management

first cash flow starts one period from today)

Annuity due: Payments occur at the beginning of each period (i.e.
first cash flow starts now) FV
C (Annuity)

1 2 3 N-1 N

36
PV C (Annuity)

9
 9/26/2016

FUTURE VALUE OF AN ANNUITY FUTURE VALUE OF AN ANNUITY

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

Note: This formula gives a value at the time

37 38 of the last Cash Flow

FUTURE VALUE OF AN ANNUITY FUTURE VALUE OF AN ANNUITY

ILLUSTRATION 1 ILLUSTRATION 2

Eg. 2: Suppose you save $4,000 per year for 20

Eg. 1 : You plan to retire exactly 35 years from today with
savings of $2 million. If the interest rate is 9% p.a. how years and then retire. Given the interest rate of
much will you need to put aside each year to reach your 10% per year, how much will you have at
goal ? retirement ?
Assume that your first payment will occur one year from
now and that your final payment will occur in exactly 35
years

39 40

10
 9/26/2016

PRESENT VALUE OF AN ANNUITY PRESENT VALUE OF AN ANNUITY

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
41 42

PRESENT VALUE OF AN ANNUITY PRESENT VALUE OF AN ANNUITY

ILLUSTRATION 1
You will receive $500 at the end of each of the next five
years. The current interest rate is 9 per cent per annum.
What is the present value of this series of cash flows?
ILLUSTRATION 2
You borrow $7,500 to buy a car and agree to repay the
loan by way of equal monthly repayments over five years.
The current interest rate is 12 per cent per annum,
compounded monthly. What is the amount of each
monthly repayment?

43 44

11
 9/26/2016

VALUE OF A GROWING ANNUITY PRESENT VALUE OF A GROWING ANNUITY

ILLUSTRATION 1
PRESENT VALUE OF GROWING ANNUITY (g is the Eg 1: Mr. Booth decides to fund a scholarship for Chicago
growth rate) students for the next 10 years of $300,000 in the first year,
and this amount will increase by 5% each year. How much
should he donate today, if the school can earn 10% p.a ?

FUTURE VALUE OF GROWING ANNUITY (g is the

growth rate)

45 46

PRESENT VALUE OF A PERPETUITY

MEASURING VALUE FOR A An annuity with an infinite number of payments

PERPETUITY C C C

0
Financial Management

PV 1 2 3

48

12
 9/26/2016

PRESENT VALUE OF A PERPETUITY CONSTANT GROWTH PERPETUITY

ILLUSTRATION 1
A landlord expects to lease his building forever. The estimated revenue
and operating cost of the building (cleaning, other services..) is given: 0 1 2 3 4 .
- Annual revenue : $10,000
- Annual cost : $2,000
- Tax cost: 35% C C(1+g) C(1+g)2 C(1+g)3
Assume that the income from the building is expected to last forever.
Calculate the present value of the estate, given the interest rate of 5% p.a.
SOLUTION

49 50

CONSTANT GROWTH PERPETUITY

ILLUSTRATION

Ex: Mr. Booth was originally planning to donate $10,000

for his former MBAs program, starting one year from
NOMINAL INTEREST RATE Vs. EFFECTIVE
today. But after careful consideration, he decides that the ANNUAL INTEREST RATE (EAR)
scholarship he endows at school should keep pace with
inflation, which is expected to be 4% per year. How does
this change his donated amount? (r = 10%) Financial Management

51

13

INFLATION AND THE TIME VALUE OF MONEY
Consider $100 which can be invested at 10% when
inflation is 6%. How many $1 hamburgers can be
bought in 1 year if their price rises in line with
inflation ?
53
INFLATION AND THE TIME VALUE OF MONEY
NOMINAL vs. REAL INTEREST RATE
(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate)
Rearranging:
Real rate = (1+ nominal rate)/(1+inflation rate) -1
Applied to previous example:
Real rate = (1+0.1)/(1+0.06) -1 = 3.8%
55
9/26/2016
INFLATION AND THE TIME VALUE OF MONEY
NOMINAL vs. REAL INTEREST RATE
As inflation increases so does the minimum expected return. The
interest rates used so far includes an element due to inflation.
Removing inflation from the nominal rate creates the real rate of
return. They are linked by the following FISHER EFFECT equation:
(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate)
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?
54
ANNUAL PERCENTAGE RATE vs.
EFFECTIVE ANNUAL RATE
Annual Percentage Rate (APR) Interest rate that
is annualized using simple interest
m: The number of times the interest is
compounded during the year
Effective (equivalent) Annual Rate (EAR): interest
rate is actually earned per year
56
14
 9/26/2016

ANNUAL PERCENTAGE RATE vs. COMPOUNDING FREQUENCY

EFFECTIVE ANNUAL RATE
Effective (equivalent) Annual Rate (EAR) is the
annually compounded interest rate that is equivalent
to the stated rate on the loan
ILLUSTRATION 1
What happens to the future value as the number of
compounding periods increases?
PV = 1,000; r_nominal = 10%; time = 2 years

rnom = quoted rate/stated rate/ or APR 58

COMPOUNDING FREQUENCY COMPOUNDING FREQUENCY

ILLUSTRATION 2 ILLUSTRATION 2
Below is the listed rate by the three banks:
ACB: 15%, compounded daily
Eximbank: 15.5%, compounded quarterly
Techcombank: 16%, compounded annually

If you have some money and want to deposit in

the bank, which bank youre gonna choose?

59 60

15
 9/26/2016

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
Financial Management

per year for the next 10 years ?

62

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

5,000 5,000 5,000 5,000

63 64

16
 9/26/2016

PRINCIPLE 3 : PRACTICAL EXAMPLE 1

FUTURE VALUE OF ANNUITY DUE
What if you plan to make the first contribution today? Eg.1 : You will receive (and deposit) $75 per year for four
years, then $200 at the end of the 6th year. If your account
0 1 2 3 4 . 29
earns 8% compounded annually, what will the future value be
at end of year 6 ?
5,000 5,000 5,000 5,000

65 66

PRACTICAL EXAMPLE 2 PRACTICAL EXAMPLE 3

Ex 2: Due Annuity Ex 3: Unequal payments

RadioShack is selling TVs on the following terms: Consider a project that returns $2,000 in each of the 3rd
No payments until end of month 13 (beg of month 14) and 4th year, and $5,000 in the 5th and 6th year. At an
after purchase opportunity cost of 6% p.a., what is this project worth ?
At end of month 13 (beg of month 14) make 12
monthly payments of $75 each
Your interest rate is 6% p.a.
While BestBuy is selling the same TV for $750 cash

67 68

17
 9/26/2016

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
Financial Management

of all payments equals the loan amount

Eg. Mortgage loans, auto loans, consumer loans, business
loans,

70

COMPUTING LOAN PAYMENTS COMPUTING LOAN PAYMENTS

Payment amount is set such that the present value
of all payments equals the loan amount
ILLUSTRATION
Ex: Suppose you enter a fixed-rate mortgage loan of $22,000
at 12% p.a. compounded annually
The loan is repaid every year over 6 years

Loan
amount

71 72

18
 9/26/2016

COMPUTING PAYOUT FIGURE COMPUTING PAYOUT FIGURE

ILLUSTRATION ILLUSTRATION (cont)
The payout figure is the present value of all remaining repayments If you make an extra payment, this reduces the outstanding
Ex: 30 year $100,000 fixed rate mortgage at 12% p.a. with monthly principal balance
repayments Consider a payment of $50,000 after 10 years, then the
repayments will be reduced:
The present value of the repayment scheme is the amount you
borrow

After 10 years (120 repayments), the payout figure is

73 74

BANK LOANS

Suppose you buy a new car on the following terms:

MORTGAGE PRACTICAL EXAMPLES $20,000 cash price less $2,000 down payment : $18,000
borrowed
Loan term 3 years, monthly payment of $C
Nominal interest rate 12% p.a. compounded monthly
Financial Management

BANK LOANS

REFINANCING What is the monthly payment amount?

How much of the first payment is interest and how much is
principal?
CHOOSING A MORTGAGE LOAN After 1 year, how much do you still owe?
76

19
 9/26/2016

BANK LOANS (cont) BANK LOANS (cont)

After one year, how much do you still owe?
What is the monthly payment amount?

How much of the first payment is interest and

principal?
Interest =

Principal =

77 78

REFINANCING REFINANCING

Your current mortgage calls for monthly payments Step 1. Whats the remaining balance on your current loan ?

of $1477.98 at a quoted rate of 7.5% p.a with 15

years remaining
ANZ bank offers a 7% mortgage Step 2. What will your new monthly payment be ? Assume the
transaction costs are added to your loan balance
If transaction costs are $3,000 (fees, stamp duty,
etc), should you refinance your mortgage?

79 80

20
 9/26/2016

REFINANCING (cont) CHOOSING A MORTGAGE

Step 3. Compare repayments City Bank:

Rate: 6.57% p.a. compounded monthly
Monthly fee: $8
Upfront cost: $550

ACB loan:
Rate 6.45% p.a. compounded monthly
No monthly fee
Upfront cost: $820

81 82
Assume you need $100,000 over a 25 year term

CHOOSING A MORTGAGE (cont) CHOOSING A MORTGAGE (cont)

How do you compare loans ? CITY BANK

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

83 84 Total monthly cost =

21
 9/26/2016

CHOOSING A MORTGAGE (cont) EXTENSION PROBLEM

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 =

85 86
Total monthly cost =

22