Time Value Terminology

0 1 2 3 4

PV
x

FV

Future value (FV) is the amount an investment is worth after one or more periods. (for future value you always compound) Present value (PV) is the current value of future cash flows of an investment. (for present value you always discount)

Recap Recap

Time Value Terminology

x

The number of time periods between the present value and the future value is represented by t or n. The rate of interest for discounting or compounding is called r or i. All time value questions involve four values: PV, FV, n and i. Given three of them, it is always possible to calculate the fourth.

Types of Interest Types of Interest

x

Simple Interest
Interest paid (earned) on only the original amount, or principal borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).

General Future General Future Value Formula Value Formula

FV1 = P0(1+i)1 FV2 = P0(1+i)2
etc.

General Future Value Formula: FVn = P0 (1+i)n or FVn = P0 (FVIFi,n) -- See Table I

An Example An Example
Julie Miller wants to know how large her deposit of $10,000 today will become at a compound annual interest rate of 10% for 5 years. years

10%

$10,000

FV5

Story Problem Solution Story Problem Solution

Calculation based on general formula: FVn = P0 (1+i)n FV5 = $10,000 (1+ 0.10)5 = $16,105.10 x Calculation based on Table I: FV5 = $10,000 (FVIF10%, 5) = $10,000 (1.611) = $16,110 [Due to Rounding]
x

Present Value Present Value Single Deposit (Graphic) Single Deposit (Graphic)
Assume that you need $1,000 in 2 years. Lets examine the process to determine how much you need to deposit today at a discount rate of 7% compounded annually.

7%

$1,000
PV0 PV1

Present Value Present Value Single Deposit (Formula) Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 = FV2 / (1+i)2 = $873.44 0 7% 1 2

$1,000
PV0

General Present General Present Value Formula Value Formula

PV0 = FV1 / (1+i)1 PV0 = FV2 / (1+i)2
etc.

General Present Value Formula: PV0 = FVn / (1+i)n or PV0 = FVn (PVIFi,n) -- See Table II

Valuation Using Table II Valuation Using Table II

PVIFi,n is found on Table II at the end of
the book.
Period 6 6 6 6 6 6 % .666 .666 .666 .666 .666 6 % .999 .999 .666 .666 .666 6 % .999 .999 .666 .666 .666

Using Present Value Tables Using Present Value Tables

PV2 = $1,000 (PVIF7%,2) = $1,000 (.873) = $873 [Due to Rounding] Period 6 % 6 % 6 .666 .999 6 .666 .9 9 9 6 .999 .999 6 .999 .666 6 .666 .666

6 % .999 .666 .999 .666 .666

Example
Your rich grandmother promises to give you $10000 in 10 years time. If interest rates are 12% per annum, how much is that gift worth today?
PV = $10 000 ( + 0.12 ) 1 = $10 000 0.321973 = $3 219.73
10

Story Problem Example Story Problem Example

Julie Miller wants to know how large of a deposit to make so that the money will grow to $10,000 in 5 years at a discount rate of 10%.

10%

5
$10,000

PV0

Story Problem Solution Story Problem Solution

x

Calculation based on general formula: PV0 = FVn / (1+i)n PV0 = $10,000 / (1+ 0.10)5 = $6,209.21 Calculation based on Table I: PV0 = $10,000 (PVIF10%, 5) = $10,000 (.621) = $6,210.00 [Due to Rounding]

Solving for the Discount Rate (i)

x

You currently have $100 available for investment for a 21 year period. At what interest rate must you invest this amount in order for it to be worth $500 at maturity? Given any three factors in the present value or future value equation, the fourth factor can be solved. take the nth root of both sides of the equation; or use the future value tables to find a corresponding value. In this example, the FVIF after 21 years is 5. r = 7.97%

i can be solved by one of the 2 ways:

x x

Solving for the Time Periods (n)

x

How long does it take to double $5,000 at a compound rate of 12% per year (approx.)? take logs on both sides of the equation; or use the future value corresponding value. tables to find a

n can be solved by one of the 2 ways:

x x

n= ln2 / ln1.12 = 6.116 yrs

The Rule of 72
x

The Rule of 72 is a handy rule of thumb that states:

If you earn r % per year, your money will double in about 72 / r % years.
x

For example, if you invest at 6%, your money will double in about 12 years. This rule is only an approximate rule.

Practice Questions
1. 2.

What would $100 be worth after 5 years at a rate of 15%? You have located an investment that pays 12%. The rate sounds good to you, so you invest $400. How much will you have in 3 years? Suppose you need $400 to buy text books next year. You can earn 7% on your money. How much do you have to put up today? Suppose you need to have $1000 in 4 years. If you can earn 8%, how much do you need to invest to make sure you have $1000 when you need it? You would like to buy a new automobile. You have about $50,000, but the car cost around $68500. If you can earn 15% , can you buy the to buy the car in 2 years time if the cost of the car is expected to remain same . Do you have enough?

3.

4.

5.

Practice Questions
6.

Your company proposes to buy an asset for $335. This investment is very safe. You will sell off the asset in 3 years for $400. You know that you could invest the $335 elsewhere at 10% with very little risk. Should you go for the investment? You are considering a one year investment. If you put up $1,250, you will get back $1350. What rate is the investment paying? You estimate that you will need about $80,000 to send your child to college in 8 years. You have about $35,000 now. If you earn 12% per year, will you make it?At what rate, will you just reach your goal? Suppose we are interested in purchasing an asset that cost $50,000. We currently have $25,000. If we can earn 12% on this $25,000, how long until we have the $50,000
You have been saving funds to buy the Giant Company. The total cost will be $10 million. You currently have about $2.3 million. IF you can earn 5% on your money, how long will you have to wait?

7. 8.

9.

10.

Answers
1. 2. 3. 4. 5.

$201.1357 $561.9712 $373.83 $735.03 You are still about $2,375 short

6.

No. You can make $445.89 in the other alternative 8% $86658.71( YES), 10.89% 6.1163 years 30.13 years

7. 8. 9. 10.

Annuities
x

An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods. Payments or receipts normally occur at the end of each period. Examples include consumer loans, car loan payments, student loan payments, insurance premiums and home mortgages. A perpetuity is an annuity in which the cash flows continue forever.

Types of Annuities Types of Annuities

x Ordinary

Annuity: Payments or Annuity receipts occur at the end of each period. Due: Payments or Due receipts occur at the beginning of each period.

x Annuity

Parts of an Annuity Parts of an Annuity

End of Period 1 End of Period 2 End of Period 3

1 $100

2 $100

3 $100

Today

Equal Cash Flows Each 1 Period Apart

Parts of an Annuity Parts of an Annuity

(Annuity Due) Beginning of Period 1 Beginning of Period 2 Beginning of Period 3

0 $100

1 $100

2 $100 Equal Cash Flows Each 1 Period Apart

Today

Overview of an Overview of an Ordinary Annuity -- FVA Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 i%

1 R

n+1

. . .
R R

R = Periodic Cash Flow

FVAn = R(1+i) + R(1+i) + ... + R(1+i)1 + R(1+i)0

n-1 n-2

FVAn

Example of an Example of an Ordinary Annuity -- FVA Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 7%

1 $1,000

2 $1,000

3 $1,000 $1,070 $1,145

FVA3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0 = $1,145 + $1,070 + $1,000 = $3,215

$3,215 = FVA3

Valuation Using Table III Valuation Using Table III

FVAn FVA3 = R (FVIFAi%,n) = $1,000 (FVIFA7%,3) = $1,000 (3.215) = $3,215 (D to R) Period 6 % 6 % 6 % 6 99 9 66 6 66 6 . 9 . 6 . 6 6 99 9 99 9 99 9 . 9 . 9 . 9 6 99 9 66 6 66 6 . 9 . 6 . 6 6 99 9 66 6 66 6 . 9 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6

Future Value of an Annuity

x

FVA = R

[(1+i)
i

1]

1000 (1+0.07)3 1

$3214.9

0.07

Overview View of an Overview View of an Annuity Due -- FVAD Annuity Due -- FVAD
Cash flows occur at the beginning of the period

0 i% R

1 R

2 R

3 R

. . .

n-1 R

FVADn = R(1+i)n + R(1+i)n-1 + ... + R(1+i)2 + R(1+i)1 = FVAn (1+i)

FVADn

Example of an Example of an Annuity Due -- FVAD Annuity Due -- FVAD

Cash flows occur at the beginning of the period

0 7% $1,000

1 $1,000

2 $1,000

3 $1,070 $1,145 $1,225

FVAD3 = $1,000(1.07)3 + $1,000(1.07)2 + $1,000(1.07)1 = $1,225 + $1,145 + $1,070 = $3,440

$3,440 = FVAD3

Valuation Using Table III Valuation Using Table III

FVADn = R (FVIFAi%,n)(1+i) FVAD3 = $1,000 (FVIFA7%,3)(1.07) = $1,000 (3.215)(1.07) = $3,440 (D to R) Period 6 % 6 % 6 % 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6

Overview of an Overview of an Ordinary Annuity -- PVA Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 i%

1 R

n+1

. . .
R R R = Periodic Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2 + ... + R/(1+i)n

Example of an Example of an Ordinary Annuity -- PVA Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 7% $ 934.58 $ 873.44 $ 816.30

1 $1,000

2 $1,000

3 $1,000

$2,624.32 = PVA3

PVA3 =

$1,000/(1.07)1 + $1,000/(1.07)2 + $1,000/(1.07)3

= $934.58 + $873.44 + $816.30 = $2,624.32

Valuation Using Table IV Valuation Using Table IV

PVAn PVA3 = R (PVIFAi%,n) = $1,000 (PVIFA7%,3) = $1,000 (2.624) = $2,624 (D to R) Period 6 % 6 % 6 % 6 99 9 66 6 66 6 . 9 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 99 9 66 6 . 6 . 9 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6

Present Value of an Annuity

x

PVA = R

1 1 (1+i)n i

10001 1 (1 + 0.07)3

=
$2624.3

0.07

Overview of an Overview of an Annuity Due -- PVAD Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 i% R

1 R

n-1

. . .
R R

PVADn

R: Periodic Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1 = PVAn (1+i)

Example of an Example of an Annuity Due -- PVAD Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 7% $1,000.00 $ 934.58 $ 873.44

1 $1,000

2 $1,000

$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 + $1,000/(1.07)2 = $2,808.02

Valuation Using Table IV Valuation Using Table IV

PVADn = R (PVIFAi%,n)(1+i) PVAD3 = $1,000 (PVIFA7%,3)(1.07) = $1,000 (2.624)(1.07) = $2,808 (D to R) Period 6 % 6 % 6 % 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6 6 66 6 66 6 66 6 . 6 . 6 . 6

Perpetuity
xA

perpetuity is an ordered annuity whose payments or receipts continue forever

PVA= R / i = $100 / 0.08 = $1,250

EXAMPLES

Solving for the Annuity Payment (R)

x

Suppose we want to know the amount that we have to deposit in order to accumulate a given sum after a number of years

e.g $10,000 down payment required after 5 years How much you need to save every year at 4 % interest rate?

Computations Using Table III

x FVAn

= R (FVIFAi%,n)

$10,000 = R (FVIFA4%,5) $10,000 = R (5.416) R = $1846.38

Computations Using Formula

( 6 i ) n - 6 + FV = R i ( 9 96 - 9 .9 ) 66 6 = R 66 66 .6 = R 6 .666 666 66 R= 66 .6 6 = $9999 .99

Solving for the number of periods in an annuity (n)

x

Suppose we want to know the number of years it would take a certain amount to accumulate a given sum E.g the same question as before but now we are given the annual payment of $1846.27 and we have to find the number of years

Computations Using Table III

x

FVAn

= R (FVIFAi%,n) = 1846.27 (FVIFA4%,n)

x $10,000

(FVIFA4%,n) = (5.416) n = 5 periods i,e 5 years

Computations Using Formula

( 6 i ) n - 6 + FV = R i ( 9 9n - 9 .9 ) 999 = 99 .9 99 99 9 66 .6 6 66 (6 6 .66 = .6 )
n

Apply logs or ln on both sides ln 6 .6666 n= ln 6 .66 n=6 years

Solving for the interest rate in an annuity (i)

x Suppose

we want to know interest rate now and the other things are known to us. using the same example we would find the interest rate and hence verify that it is 4%.

x E.g

Computations Using Table III

x

FVAn

= R (FVIFAi%,n)

$10,000 = 1846.27 (FVIFAi%,5) (FVIFAi%,5) = (5.416) i = 4%

Computations Using Formula

( 6 i ) n - 6 + FV = R i ( 6 i ) 6 - 6 + 666 = 66 .6 66 66 6 i 6 6i = (6 i ) - 6 .66 +
6

The equation becomes really complex and can only be solved by trial and error approach, Newton Raphson or bisection methods

Mixed Flows Example Mixed Flows Example

Julie Miller will receive the set of cash flows below. What is the Present Value at a discount rate of 10%? 10%

10% $600

$600 $400 $400 $100

PV0

How to Solve? How to Solve?

1. Solve a piece-at-a-time by piece-at-a-time discounting each piece back to t=0. 2. Solve a group-at-a-time by first group-at-a-time breaking problem into groups of annuity streams and any single cash flow group. Then discount each group back to t=0.

Piece-At-A-Time Piece-At-A-Time
0
10% $600

$600 $400 $400 $100

$545.45 $495.87 $300.53 $273.21 $ 62.09

$1677.15 = PV0 of the Mixed Flow

Group-At-A-Time (#1) Group-At-A-Time (#1)

0
10%

$600
$1,041.60 $ 573.57 $ 62.10

$600 $400 $400 $100

$1,677.30 = PV0 of Mixed Flow [Using Tables] ) = $600(1.736) = $1,041.60 $400(PVIFA10%,4) $400(PVIFA10%,2)
$600(PVIFA
10%,2

=$400(3.170) $400(1.736) = $573.60 $100 (PVIF ) = $100 (0.621) = $62.10

Group-At-A-Time (#2) Group-At-A-Time (#2)

0
$1,268.00

1
$400

2
$400

3
$400

4
$400

Plus
$347.20

1
$200

2
$200

PV0 equals $1677.30.

3 4 5
$100

Plus
$62.10

Present Value of Multiple Cash Flows Example

x

You deposit $1,500 in one year, $2000 in two years and $2,500 in three years in an account paying 10% interest per annum. What is the present value of these cash flows? $2 500 (1.10)-3 $2 000 (1.10)-2 $1 500 (1.10)-1 Total = = = = $1 878 $1 653 $1 364 $4 895

Future Value of Multiple Cash Flows Example

x

You deposit $1,000 now, $1,500 in one year, $2,000 in two years and $2,500 in three years in an account paying 10% interest per annum. How much do you have in the account at the end of the third year? $1 000 (1.10)3 $1 500 (1.10)2 $2 000 (1.10)1 $2 500 1.00 Total = = = = = $1 331 $1 815 $2 200 $2 500 $7 846

Uneven Series of Payment Date ( An Example)

Karee Brow will receive the set of cash flows below. What is the Karee Brow will receive the set of cash flows below. What is the Present Value at aadiscount rate of 10%? IfIfKaree Brow was Present Value at discount rate of10% 10%? Karee Brow was 10% depositing the cash flows instead determine the Future Value at depositing the cash flows instead determine the Future Value at the same discount rate the same discount rate

Year

P a y m e n t $9 9 9$6 6 6$6 6 6$6 6 6$6 6 6$6 ,6 6 6

PV = $2870.92 PV = $2870.92 FV = $5086.01 FV = $5086.01

Effective Annual Effective Annual Interest Rate Interest Rate

Effective Annual Interest Rate
The actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number of compounding periods per year.

(1 + [ i / m ] )m - 1

BWs Effective BWs Effective Annual Interest Rate Annual Interest Rate
Basket Wonders (BW) has a $1,000 CD at the bank. The interest rate is 6% compounded quarterly for 1 year. What is the Effective Annual Interest Rate (EAR)? EAR EAR = ( 1 + 6% / 4 )4 - 1 = 1.0614 - 1 = .0614 or 6.14%!

Frequency of Compounding Frequency of Compounding

General Formula: FVn = PV0(1 + [i/m])mn
n: m: i: FVn,m: PV0: Number of Years Compounding Periods per Year Annual Interest Rate FV at the end of Year n PV of the Cash Flow today

Impact of Frequency Impact of Frequency

Julie Miller has $1,000 to invest for 2 years at an annual interest rate of 12%. Annual Semi FV2 = 1,000(1+ [.12/1])(1)(2) 1,000 = 1,254.40 FV2 = 1,000(1+ [.12/2])(2)(2) 1,000 = 1,262.48

Impact of Frequency Impact of Frequency

Qrtly Monthly Daily FV2 = 1,000(1+ [.12/4])(4)(2) 1,000 = 1,266.77 FV2 FV2 = 1,000(1+ [.12/12])(12)(2) 1,000 = 1,269.73 = 1,000(1+[.12/365])(365)(2) 1,000 = 1,271.20

Comparison different effective rates of return?

x

An investment with monthly payments is different from one with quarterly payments. Must put each return on an EFF% basis to compare rates of return. Must use EFF% for comparisons. See following values of EFF% rates at various compounding levels.

EARANNUAL EARQUARTERLY EARMONTHLY EARDAILY (365)

10.00% 10.38% 10.47% 10.52%

Can the EAR ever be equal to the nominal rate?

x Yes,

but only if annual compounding is used, i.e., if m = 1. m > 1, EFF% will always be greater than the nominal rate.

x If

Amortizing a loan
x Installment

type loan that is repaid in equal periodic payments that include both interest and principal. These payments can be made annually, semi annually, monthly etc

Steps to Amortizing a Loan Steps to Amortizing a Loan (( An Overview) An Overview)

1. 2. 3. 4. 5. Calculate the payment per period. Determine the interest in Period t. (Loan balance at t-1) x (i% / m) Compute principal payment in Period t. (Payment - interest from Step 2) Determine ending balance in Period t. (Balance - principal payment from Step 3) Start again at Step 2 and repeat.

Amortizing a Loan Example Amortizing a Loan Example

Julie Miller is borrowing $10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years. Step 1: Payment PV0 $10,000 = R (PVIFA i%,n) = R (PVIFA 12%,5)

$10,000 = R (3.605) R = $10,000 / 3.605 = $2,774

Amortizing a Loan Example Amortizing a Loan Example

End of Payment Interest Principal Ending Year Balance 6 ------$66 ,666 6 6 6 6 6 $6666 $6666 $9999 66 6 , , , , 6 66 6 , 6 66 6 , 6 66 6 , 6 66 6 , 6 66 6 , 6 66 6 66 6 66 6 99 9 , 9 99 9 , 9 66 6 , 6 66 6 , 6 66 6 , 6 66 6 , 6 66 6 , 6 6

$66 ,666 $6666 66 , $ ,666

[Last Payment Slightly Higher Due to Rounding]

Illustration with a simple example

x

Suppose you borrow $22,000 at 12% compound annual interest to be repaid over the next 6 years. The first step is to calculate R ( annual payment)
PV0 = R (PVIFA i%,n) $22,000 = R (PVIFA 12%,6) $22,000 = R (4.111) R = $22,000 / 4.111 = $5350.97

End of Chapter