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CHAPTER 6

Time Value of Money

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

3 year $100 ordinary annuity


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,
financial calculator, and spreadsheet
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

Given a zero coupon bond paying $1000 in 5 years

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
terms of todays purchasing power.

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

Go in the other direction


Know FV
FV
Get PV
PV
n
(1 R)

Answer basic questions like what is $100


tomorrow worth today
6-20

Annuity

Equal payments over several years

Usually annual

Types: Ordinary/Annuity due

Beginning versus end of period

6-21

Present Value of an Annuity

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

Future Value of An Annuity

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

Why the Funny Summation?

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

PV=$12.75 million, take the $16 million


today

6-25

Another Way to View An


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

Cost to Generate From Today

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

Input cash flows in the calculators CFLO


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?

Solves the general FV equation for I.

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%.

How much money will she have when she is 65


years old?
6-44

Solving for FV:


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

Semiannually: FV6 = $100(1.05)6 = $134.01

3
6

134.01
6-48

Classifications of interest rates

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

Classifications of interest rates

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

When is each rate used?

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

FV3Q $100 (1.025) $134.49


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


home mortgages, auto loans, business
loans, retirement plans, etc.
Financial calculators and spreadsheets are
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

BEG BAL PMT

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

Calculating annual loan payments

Based upon the loan information, the


home buyer must make annual
payments of $2,207.07 on the loan.

INPUTS
OUTPUT

20

7.5

-22500

I/YR

PV

PMT

FV

2207.07
6-67

Determining the balloon payment

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

Discounting payments 1, 2, 3 years from now

6-70

Frequency and compounding

APR=Annual percentage rate


Usual quote:

What does this mean?

R = (1/12)6% every month

That comes out to be

6% APR with monthly compounding

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

Effective annual rate


6-71

General Formulas

Effective annual rate (EFF) formula


APR m
EFF (1
) 1
m

Limit as m goes to infinity

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

Find PMT so that


3

PMT
PV
100000
i
(1.09)
i1
3

1
100000
i
(1.09)
i1

PMT

Solve for PMT

PMT = 39,504

6-76

Car Loan

Amount = $1,000
1 Year

Payments in months 1-12

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?

Paying loan off over time

6-79

Payments and Principal

How much principal remains after 1


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

Should you go?

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

We will use it for

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

Next Lecture

Topics

Finish deriving useful formulae


Bonds

Reading

Chapter 5

6-9090