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# CHAPTER 6

Future value
Present value
Annuities
Rates of return
Amortization
6-1

Time lines
0

CF1

CF2

CF3

i%

CF0

## Show the timing of cash flows.

Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the
first period (year, month, etc.) or the
beginning of the second period.
6-2

## Drawing time lines:

\$100 lump sum due in 2 years;
3-year \$100 ordinary annuity
\$100 lump sum due in 2 years
0

i%

100

0

100

100

100

i%

6-3

## Drawing time lines:

Uneven cash flow stream; CF0 = -\$50,
CF1 = \$100, CF2 = \$75, and CF3 = \$50
Uneven cash flow stream
0

100

75

50

i%

-50

6-4

## What is the future value (FV) of an initial

\$100 after 3 years, if I/YR = 10%?

## Finding the FV of a cash flow or series of

cash flows when compound interest is
applied is called compounding.
FV can be solved by using the arithmetic,
methods.

10%

100

FV = ?
6-5

## Solving for FV:

The arithmetic method

After 1 year:
FV1 = PV ( 1 + i ) = \$100 (1.10)
= \$110.00
After 2 years:
2
2
FV2 = PV ( 1 + i ) = \$100 (1.10)
=\$121.00
After 3 years:
3
3
FV3 = PV ( 1 + i ) = \$100 (1.10)
=\$133.10
After n years (general case):
n
FVn = PV ( 1 + i )

6-6

## Solving for FV:

The calculator method

## Solves the general FV equation.

Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and
END mode.)

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
133.10
6-7

Extra example

PV = 1000
R = 10%
n=1
FV = ? FV = 1000*(1.10) = 1,100

6-8

Example 2

Compound Interest

PV = 1000
R = 10%
n=3
FV = ?
FV = 1000*(1.1)*(1.1)*(1.1) = 1,331
FV = PV*(1+R)^n
6-9

Example 3:

## The magic of compounding

PV = 1
R = 6%
n = 50
FV = ?

FV = PV*(1+R)^n = 18
n = 100, FV = 339
n = 200, FV = 115,000
6-10

Example 4:
Doubling times

## Doubling time = time for funds to

double
FV
2 (1 R)n
PV
log(2) n log(1 R)
log(2)
n
log(1 R)

6-11

Example 5
Retirement Saving

## PV = 1000, age = 20, n =45

R = 0.05

R = 0.07

FV = PV*(1+0.05)^45 = 8985
Doubling 14
FV=PV*(1+0.07)^45 = 21,002
Doubling = 10

## Small change in R, big impact

6-12

Retirement Savings at 5%
interest

6-13

Goals

## Compounding and Future Values

Present Value
Valuing an income stream

Annuities
Perpetuities

Mixed streams
Term structure again
Compounding
More applications
6-14

Example

## How much is it worth today?

R = 0.05
PV = 1000/(1.05)^5 = \$784
This is the amount that could be
stashed away to give 1000 in 5 years
time

6-15

Goals

## Compounding and Future Values

Present Value
Valuing an income stream

Annuities
Perpetuities

Mixed streams
Term structure again
Compounding
More applications
6-16

## What is the present value (PV) of \$100

due in 3 years, if I/YR = 10%?

## Finding the PV of a cash flow or series of

cash flows when compound interest is
applied is called discounting (the reverse of
compounding).
The PV shows the value of cash flows in

10%

PV = ?

100
6-17

## Solving for PV:

The arithmetic method

## Solve the general FV equation for PV:

PV = FVn / ( 1 + i )n
PV = FV3 / ( 1 + i )3
= \$100 / ( 1.10 )3
= \$75.13

6-18

## Solving for PV:

The calculator method

## Solves the general FV equation for PV.

Exactly like solving for FV, except we
have different input information and are
solving for a different variable.

INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-75.13
6-19

Present Value

Know FV
FV
Get PV
PV
n
(1 R)

## Answer basic questions like what is \$100

tomorrow worth today
6-20

Annuity

Usually annual

6-21

## Annuity pays \$100 a year for the next

10 years (starting in 1 year)
What is the present value of this?
10
R = 0.05
100
PV
i1

(1 R)

772

6-22

## Annuity pays \$100 a year for the next

10 years (starting in 1 year)
What is the future value of this at year
10?
9
R = 0.05 FV
100(1.05)i
i0

6-23

## Period 10 value for each

Period
Period
Period

Period

10: 100
9: 100(1.05)
8: 100(1.05)(1.05)
1:

100(1.05)^9

Be careful!
6-24

Application: Lotteries

Choices

## \$16 million today

\$33 million over 33 years (1 per year)

R = 7%
33

1
i
(1
0.07)
i1

PV

today

6-25

Annuity

Annuity of \$100

## Paid 1 year, 2 year, 3 years from now

Interest = 5%
PV = 100/(1.05) + 100/(1.05)^2 +
100/(1.05)^3
= 272.32

6-26

## Think about putting money in the bank in 3

bundles
One way to generate each of the three \$100
payments
How much should each amount be?

100 = FV = PV*(1.05)^n (n = 1, 2, 3)
PV = 100/(1.05)^n (n = 1, 2, 3)

## The sum of these values is how much money

you would have to put into bank accounts
today to generate the annuity
Since this is the same thing as the annuity it
6-27
should have the same price (value)

Solving for N:
If sales grow at 20% per year, how long
before sales double?

## Solves the general FV equation for N.

Same as previous problems, but now
solving for N.

INPUTS
N
OUTPUT

20

-1

I/YR

PV

PMT

FV

3.8
6-28

## What is the difference between an

ordinary annuity and an annuity due?
Ordinary Annuity
0

i%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
i%

PMT

6-29

## Solving for FV:

3-year ordinary annuity of \$100 at 10%

## \$100 payments occur at the end of

each period, but there is no PV.

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
331
6-30

## Solving for PV:

3-year ordinary annuity of \$100 at 10%

## \$100 payments still occur at the end of

each period, but now there is no FV.

INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-248.69
6-31

## Solving for FV:

3-year annuity due of \$100 at 10%

## Now, \$100 payments occur at the

beginning of each period.
Set calculator to BEGIN mode.

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
364.10
6-32

## Solving for PV:

3 year annuity due of \$100 at 10%

## Again, \$100 payments occur at the

beginning of each period.
Set calculator to BEGIN mode.

INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-273.55
6-33

## What is the PV of this uneven

cash flow stream?
0

100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV
6-34

## Solving for PV:

Uneven cash flow stream

register:

CF0
CF1
CF2
CF3
CF4

=
=
=
=
=

0
100
300
300
-50

## Enter I/YR = 10, press NPV button to get

NPV = \$530.09. (Here NPV = PV.)
6-35

Perpetuity

## This is an annuity with an infinite life

6-36

Discounting to infinity

Math review:

6-37

Present Value of a
Constant Stream
a

1
1 R

PV

i1

PV y

y
(1 R)i

1
1 R

ai

i1

1
1
a
y
(1 R)
(1 R)
PV
y
(y)

1
1 R
1
1 a
R
1

(1 R)
1 R (1 R)
6-38

## Perpetuity Examples and

Interest Rate Sensitivity

## Interest rate sensitivity

y=100
R = 0.05, PV = 2000
R = 0.03, PV = 3333

6-39

Goals

## Compounding and Future Values

Present Value
Valuing an income stream

Annuities
Perpetuities

Mixed streams
Term structure again
Compounding
More applications
6-40

Mixed Stream
Apartment Building

## Pays \$500 rent in 1 year

Pays \$1000 rent 2 years from now
Then sell for 100,000 3 years from now
R = 0.05
500 1000 100000
PV

87, 767
2
3
1.05 (1.05) (1.05)

6-41

Mixed Stream
Investment Project

## Pays -1000 today

Then 100 per year for 15 years
R = 0.05
15

100
PV 1000
38
i
(1.05)
i1

## Implement project since PV>0

Technique = Net present value (NPV)

6-42

Solving for I:
What interest rate would cause \$100 to
grow to \$125.97 in 3 years?

INPUTS

3
N

OUTPUT

I/YR

-100

125.97

PV

PMT

FV

8
6-43

## The Power of Compound

Interest
A 20-year-old student wants to start saving for
retirement. She plans to save \$3 a day. Every
day, she puts \$3 in her drawer. At the end of
the year, she invests the accumulated savings
(\$1,095) in an online stock account. The stock
account has an expected annual return of 12%.

years old?
6-44

Savings problem

## If she begins saving today, and sticks to

her plan, she will have \$1,487,261.89
when she is 65.

INPUTS
OUTPUT

45

12

-1095

I/YR

PV

PMT

FV
1,487,262
6-45

## Solving for FV:

Savings problem, if you wait until you are
40 years old to start

## If a 40-year-old investor begins saving

today, and sticks to the plan, he or she will
have \$146,000.59 at age 65. This is \$1.3
million less than if starting at age 20.
Lesson: It pays to start saving early.

INPUTS
OUTPUT

25

12

-1095

I/YR

PV

PMT

FV
146,001
6-46

## Solving for PMT:

How much must the 40-year old deposit
annually to catch the 20-year old?

## To find the required annual contribution,

enter the number of years until retirement
and the final goal of \$1,487,261.89, and
solve for PMT.

INPUTS
OUTPUT

25

12

I/YR

PV

1,487,262

PMT

FV

-11,154.42
6-47

## Will the FV of a lump sum be larger or

smaller if compounded more often,
holding the stated I% constant?

## LARGER, as the more frequently compounding

occurs, interest is earned on interest more often.
10%

100

133.10
Annually: FV3 = \$100(1.10)3 = \$133.10

0
0

100

5%

1
2

2
4

3
6

134.01
6-48

## Nominal rate (iNOM) also called the quoted or

state rate. An annual rate that ignores
compounding effects.

## iNOM is stated in contracts. Periods must also be

given, e.g. 8% Quarterly or 8% Daily interest.

## Periodic rate (iPER) amount of interest

charged each period, e.g. monthly or quarterly.

## iPER = iNOM / m, where m is the number of

compounding periods per year. m = 4 for
quarterly and m = 12 for monthly
compounding.

6-49

## Effective (or equivalent) annual rate (EAR =

EFF%) the annual rate of interest actually
being earned, taking into account
compounding.

## EFF% for 10% semiannual investment

EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 1 = 10.25%

## An investor would be indifferent between

an investment offering a 10.25% annual
return and one offering a 10% annual
return, compounded semiannually.
6-50

## Why is it important to consider

effective rates of return?

## 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%
6-51

## Can the effective rate ever be

equal to the nominal rate?

## Yes, but only if annual compounding

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

6-52

## iNOM written into contracts, quoted by

banks and brokers. Not used in
calculations or shown on time lines.
iPER Used in calculations and shown on
time lines. If m = 1, iNOM = iPER =
EAR.
EAR Used to compare returns on
investments with different payments
per year. Used in calculations when
annuity payments dont match
compounding periods.

6-53

## What is the FV of \$100 after 3 years under

10% semiannual compounding? Quarterly
compounding?

iNOM mn
FVn PV ( 1
)
m
0.10 23
FV3S \$100 ( 1
)
2
6
FV3S \$100 (1.05) \$134.01
12

6-54

## Whats the FV of a 3-year \$100

annuity, if the quoted interest rate is
10%, compounded semiannually?
0

1
2

2
4

3
6

5%

100

100

100

## Payments occur annually, but compounding

occurs every 6 months.
Cannot use normal annuity valuation
techniques.
6-55

Method 1:
Compound each cash flow
0

1
2

2
4

3
6

5%

100

100

100
110.25
121.55
331.80

## FV3 = \$100(1.05)4 + \$100(1.05)2 + \$100

FV3 = \$331.80

6-56

Method 2:
Financial calculator

## Find the EAR and treat as an annuity.

EAR = ( 1 + 0.10 / 2 )2 1 = 10.25%.

INPUTS
OUTPUT

10.25

-100

I/YR

PV

PMT

FV
331.80
6-57

## Find the PV of this 3-year

ordinary annuity.

## Could solve by discounting each cash

flow, or
Use the EAR and treat as an annuity to
solve for PV.

INPUTS
OUTPUT

10.25

I/YR

PV

100

PMT

FV

-247.59
6-58

Loan amortization

## Amortization tables are widely used for

loans, retirement plans, etc.
great for setting up amortization tables.

## EXAMPLE: Construct an amortization

schedule for a \$1,000, 10% annual rate
loan with 3 equal payments.
6-59

Step 1:
Find the required annual payment

## All input information is already given,

just remember that the FV = 0 because
the reason for amortizing the loan and
making payments is to retire the loan.

INPUTS
OUTPUT

10

-1000

I/YR

PV

PMT

FV

402.11
6-60

Step 2:
Find the interest paid in Year 1

## The borrower will owe interest upon the

initial balance at the end of the first
year. Interest to be paid in the first
year can be found by multiplying the
beginning balance by the interest rate.
INTt = Beg balt (i)
INT1 = \$1,000 (0.10) = \$100
6-61

Step 3:
Find the principal repaid in Year 1

## If a payment of \$402.11 was made at

the end of the first year and \$100 was
paid toward interest, the remaining
value must represent the amount of
principal repaid.
PRIN = PMT INT
= \$402.11 - \$100 = \$302.11
6-62

Step 4:
Find the ending balance after Year 1

## To find the balance at the end of the

period, subtract the amount paid
toward principal from the beginning
balance.

## END BAL = BEG BAL PRIN

= \$1,000 - \$302.11
= \$697.89
6-63

## Constructing an amortization table:

Repeat steps 1 4 until end of loan
Year

INT

PRIN

END
BAL
\$302
\$698

\$1,000

\$402

\$100

698

402

70

332

366

366

402

37

366

1,206.34

206.34

1,000

TOTAL

## Interest paid declines with each payment as

the balance declines. What are the tax
implications of this?
6-64

## Illustrating an amortized payment:

Where does the money go?
\$

402.11

Interest

302.11

Principal Payments

Constant payments.
Declining interest payments.
Declining balance.

6-65

Partial amortization

## Bank agrees to lend a home buyer \$220,000

to buy a \$250,000 home, requiring a
\$30,000 down payment.
The home buyer only has \$7,500 in cash, so
the seller agrees to take a note with the
following terms:

## Face value = \$22,500

7.5% nominal interest rate
Payments made at the end of the year, based
upon a 20-year amortization schedule.
Loan matures at the end of the 10th year.
6-66

## Based upon the loan information, the

payments of \$2,207.07 on the loan.

INPUTS
OUTPUT

20

7.5

-22500

I/YR

PV

PMT

FV

2207.07
6-67

## Using an amortization table

(spreadsheet or calculator), it can be
found that at the end of the 10th year,
the remaining balance on the loan will
be \$15,149.54.
Therefore,
Balloon payment = \$15,149.54
Final payment = \$17,356.61
6-68

Term Structure

## We have assumed that R is constant

over time
In real life it may be different over
different horizons (maturities)
Remember: Term structure
Use correct R to discount different
horizons
6-69

Term Structure
y1
y2
y3
PV

2
(1 R1 ) (1 R2 ) (1 R3 )3

6-70

Usual quote:

(1+.06/12)^12-1
6.17%

6-71

General Formulas

APR m
EFF (1
) 1
m

EFF e

APR

## For APR = 0.06

limit EFF = 0.0618
6-72

Goals

## Compounding and Future Values

Present Value
Valuing an income stream

Annuities
Perpetuities

Mixed streams
Term structure again
Compounding
More examples
6-73

More Examples

Home mortgage
Car loans
College
Calculating present values

6-74

Home Mortgage
Amortization

Specifications:

\$100,000 mortgage
9% interest
3 years (equal payments) pmt

Find pmt

PV(pmt) = \$100,000

6-75

Mortgage PV

3

PMT
PV
100000
i
(1.09)
i1
3

1
100000
i
(1.09)
i1

PMT

PMT = 39,504

6-76

Car Loan

Amount = \$1,000
1 Year

## 12% APR (monthly compounding)

12%/12=1% per month
PMT?
6-77

Car Loan

## Again solve, for PMT

12

PMT
PV
1000
i
(1.01)
i1
12

1
1000
i
(1.01)
i1

PMT

= 88.85
PMT
6-78

Total Payment

12*88.85 = 1,066.20
Looks like 6.6% interest
Why?

6-79

month?

## You owe (1+0.01)1000 = 1010

Payment = 88.85
Remaining = 1010 88.85 = 921.15

## How much principal remains after 2

months?

(1+0.01)*921.15 = 930.36
Remaining = 930.36 88.85 = 841.51
6-80

College

1. Compare

## PV(wage with college)-PV(tuition)

PV(wage without college)

## 2. What about student loans?

3. Replace PV(tuition) with PV(student loan
payments)
Note: Some of these things are hard to
estimate
Second note: Most studies show that the
answer to this question is yes
6-81

## Calculating Present Values

Sometimes difficult
Methods

## Tables (see textbook)

Financial calculator (see book again)
Excel spreadsheets (see book web page)
Java tools (well use these sometimes)
Other software (matlab)
6-82

## Discounting and Time:

Summary

Powerful tool
Useful for day to day problems

Loans/mortgages
Retirement

Stock pricing
Bond pricing
6-83

Trick

## How much money would you have to

put in the bank to get a constant
cashflow stream forever?
Formula:

6-8484

Example

## You would like to buy a house. Luckily

you rich uncle is willing to give you a
loan that you never have to pay back.
Instead, you (and all you descendants)
must agree to pay him and his
descendants \$10,000/year forever. If
the interest rate is 7%, how much is he
willing to lend you?
85
6-85

Annuity

PV
n1

1 r

n
86

6-8686

Example

## What is the present value of \$100 paid

at the end of every year for the next 10
years?

## Assume a bank offers you a 5% interest

rate forever on any deposit made today

87

6-87

Trick

C 1 C
PV
N
r 1 r r
N

C
1
1

r
1 r

88

6-8888

Example

## You decide to go for a 30 year (annual

pay)mortgage. Assume that all you can
afford is \$10,000 per year, how much can
you afford to borrow at an interest rate of
7%?

89

6-89

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Topics

Bonds