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Future Value (FV): amount to which an investment will grow after earning interest.
() $100 = $100 (1 + )
Compound growth means that value increases each period by the factor (1 + growth rate). The
value after t periods will equal de initial value times (1+growth rate)^t. When money is invested
at compound interest, the growth rate is the interest rate.
Money in hand today has a time value: a dollar today is worth more than a dollar tomorrow.
() =
(1 + )
To calculate present value, we discounted the future value at the interest rate r. The calculation is
therefore termed a discounted cash-flow (DCF) calculation (another term for the PV of a future
cash flow), and the interest rate r is known as the discount rate (the interest rate used to compute
present values of future cash flows).
To work out how much you will have in the future if you invest for t years at an interest rate r,
multiply the initial investment by (1+r)^t. To find the present value of a future payment, run the
process in reverse and divide by (1+r)^t.
Thus, present values decline when future cash payments are delayed. The longer you have to wait
for money, the less its worth today.
The expression 1/(1+r)^t is called the discount factor: the present value of a $1 future payment.
As you move to higher interest rates, present values decline. As you move to longer discounting
periods, present values also decline.
It is very important to use present values when comparing alternative patterns of cash payment.
You should never compare cash flows occurring at different times without first discounting them
to a common date. By calculating PV, we see how much cash must be set aside today to pay
future bills.
Until now, we only used a single cash flow. But most real-world investments will involve many
cash flows over time. Then there are many payments, its a stream of cash flows.
Problems involving multiple cash flows are simple extensions of single cash-flow analysis. To find
the value at some future date of a stream of cash flows, calculate what each cash flow will be
worth at that future date and then add up these future values.
A similar adding-up principle works for present value calculations
When we calculate de PV of a future cash flow, we are asking how much that cash flow would be
worth today. If there is more than one future cash flow, we simply need to work out what each
cash flow would be worth today and then add these PV.
The PV of a stream of future cash flows is the amount you need to invest today to generate that
stream.
Any sequence of equally spaced, level cash flows is called an annuity (equally spaced level stream
of cash flows, with a finite maturity).
If the payment stream lasts forever, it is called a perpetuity: stream of level cash payments that
never ends.
We can rearrange this relationship to derive the present value of a perpetuity, given r and C.
PV of perpetuity = C / r
1- This formula IS NOT the formula of the PV of a single cash payment. A payment of $1 at the end
of 1 year has a PV of 1/(1+r), while the perpetuity has a value of 1/r.
2- The perpetuity formula tells us the value of a regular stream of payments starting one period
from now.
Sometimes you may need to calculate the value of a perpetuity that doesnt start to make
payments for several years.
VER LIBRO PARA ESTA PARTE!!
You can always value an annuity by calculating the PV of each cash flow and finding the total.
However, it is usually quicker to use a simple formula which states that if the interest rate is r,
then the PV of an annuity that pays C dollars a year for each of t periods is:
1 1
= [ ]
(1 + )
We can know where the formula comes from, if we remember that an annuity is equivalent to the
difference between an immediate and a delayed perpetuity. VER LIBRO.
An amortizing loan (example 5.10). Amortizing means that part of the monthly payment is used
to pay interest on the loan, and part is used to reduce the amount of the loan.
Because the loan is progressively paid off, the fraction of each payment devoted to interest
steadily falls over time, while the fraction used to reduce the loan increases.
Annuities Due
The perpetuity and annuity formulas assume that the first payment occurs at the end of the
period.
However, streams of cash payments often start immediately. A level stream of payments starting
immediately is known as an annuity due.
Each of the cash flows in the annuity due comes one period earlier than the corresponding cash
flow of the ordinary annuity.
Therefore: PV of an annuity due =(1+r) * PV of an annuity
$1 = $1 (1 + )
1 1
(1 + ) 1
=[ ] (1 + ) =
(1 + )
Remember that our ordinary annuity formulas assume that the first cash flow doesnt occur until
the end of the first period. If the first cash flow comes immediately, the FV of the cash flow stream
is greater, since each flow has an extra year to earn interest.
Until now, we have mainly used annual interest rates to value a series of annual cash flows. But
interest rates may be quoted for days, months, years or any convenient interval.
Effective annual interest rate (EAR): interest rate that is annualized using compound interest
(annually compounded rate).
When comparing interest rates, it is best to use EAR. But unfortunately, short-term rates are
sometimes annualized by multiplying the rate per period by the number of periods in a year. Such
rates are called annual percentage rates (APR): interest rate that is annualized using simple
interest.
= (1 + )# 1
#
Resumen: The EAR is the rate at which invested funds will grow over the course of a year. It
equals the rate of interest per period compounded for the number of periods in a year.
Whenever anyone quotes an interest rate, they are talking about a nominal rate, not a real one.
The nominal interest rate is the rate at which money invested grows.
The real interest rate is the rate at which the purchasing power of an investment increases.
1 +
1 + =
1 +
Useful approximation:
This approximation works best when both the inflation rate and the real rate are small. If they are
not, dont use the approximation, but the accurate formula.
REMEMBER: Current dollar cash flows must be discounted by the nominal interest rate; real
cash flows must be discounted by the real interest rate.
Mixing up nominal cash flows and real discount rates (or real rates and nominal flows) is totally
wrong.
Real or Nominal?
Any present value calculation done in nominal terms can also be done in real terms, and vice
versa. Most financial analysts forecast in nominal terms and discount at nominal rates. However,
in some cases real cash flows are easier to deal with.