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JQY
Agenda
Time Lines
Future Values
Present Values
Solving for Interest Rate and Time
Future Value of an Annuity
Present Value of an Annuity
Perpetuities
Uneven Cash Flow Streams
Semiannual and Other Compounding Periods
Comparison of Different types of interest rates
Fractional Time Periods
Amortized Loans
Partial Amortization
What is Time Value?
We say that money has a time value because that money can be
invested with the expectation of earning a positive rate of return.
In other words, a peso received today is worth more than a peso
to be received tomorrow
That is because todays peso can be invested so that we have
more than one peso tomorrow
The statements above are not true in all cases. Denmark for
example, imposed a 0.2% rate on bank deposits in 2012.
Although rare, the imposition of negative interest rates are
possible especially in an attempt to encourage spending in
depressed economies.
If you have P10,000 today, and you
deposit it in the bank, how much will
you most likely receive in 10 years?
a. P9,500
a. P9,500
b. P14,000
b. P10,000
c. P14,000
c. P10,000
Timelines
An important tool used in the time value of money analysis
PV FV
0 1 2 3 4 5
Today
Future Value
The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum
today
Terms:
PV present value, or beginning amount in your account
i interest rate the bank pays on the account per year
INT amount of interest you earn during the year (aka
discount rate, opportunity cost rate)
FV future value or ending amount of your account at the
end of n years
n number of periods involved in the analysis
Future Value
Simple Annual Interest
Q: Today, Peter invested P1,000 for 5 years with
simple annual interest of 10%. How much is its
future value?
A: FV = PV x [1 + (i*n)]
FV = P1,000 x [1 + (10%*5)]
FV = P1,000 x 1.5
FV = P1,500
Future Value
Interest compounded
Q: Today, Peter invested P100 for 3 years at 10%,
compounded annually. How much is its future
value?
A: FV = PV (1+i)
0 1 2 3
100 FV = ?
a. P7,000
b. P10,000
c. P12,000
Present Value
The value today of a future cash flow or series
of cash flows.
Represents the amount that needs to be
invested to achieve some desired future value.
FVN
PV
1 i
N
Present Value: An Example
Suppose that your five-year old daughter has just announced
her desire to attend college. After some research, you
determine that you will need about $100,000 on her 18th
birthday to pay for four years of college. If you can earn 8%
per year on your investments, how much do you need to
invest today to achieve your goal?
N = 13; I = 8%; PV = ?; PMT = 0; FV = 100,000
100 ,000
PV $36,769.79
1.08
13
Solving for Interest and Time
I = (FV/PV)^1/n 1
Sample problem
You can buy a security at a price of $78.35, and it
will pay you $100 after 5 years. How much is the
interest rate youd earn if you bought the
security?
I = (100/78.35)^(1/5) 1 = 5%
Solving for Interest and Time
N = ln (FV/PV) / ln (1+i)
Sample problem
Mr. Amos invested P60,000 in stocks at a 10%
interest rate compounded semi-annually. How
many years did it take Mr. Amos for his investment
to reach P100,000?
N = ln (100,000/60,000) / ln (1 + 5%)
N = 10.47 / 2 = 5.24 years
Annuities
An annuity is a series of payments of an equal amount at
fixed intervals for a specified number of periods.
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100 annuity
Annuity = equal PMT
100 100 100 100 100
0 1 2 3 4 5
Annuities
Ordinary (Deferred) Annuity
An annuity whose payments occur at the end of
each period.
Annuity Due
An annuity whose payments occur at the
beginning of each period.
0 1 2 3 4 5
Future Value of an Ordinary Annuity
Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much will she have at
the end of three years?
N Higher Lower
0 1 2 3 4 5
0 1 2 3 4 5
FV 1,000110
. 1,100
1
First National Bank:
12
0.10
Second National Bank: FV 1,000 1 1,104 .71
12
365
0.10
Third National Bank: FV 1,000 1 1,10516
.
365
Obviously, you should choose the Third National Bank
Continuous Compounding
F Pe rt
Here, F is the future value, P is the present value, r is the annual rate of
interest, t is the total number of years, and e is a constant equal to
about 2.718
Continuous Compounding (cont.)
0 .10 1
F 1,000 e 1,10517
.
This is even better than daily compounding
The basic rule of compounding is: The more frequently interest is
compounded, the higher the future value
Continuous Compounding (cont.)
0 .10 5
F 1,000e 1,648.72
Different Rates
Nominal (Quoted, Stated, Annual Percentage) Interest Rate
The rate charged by banks and other financial institutions
For example, 6% compounded quarterly, 5% compounded monthly
Effective (Equivalent Annual) Rate
The annual rate of interest actually being earned
EAR = (1+iNOM/m)^m 1
If payment is only once a year, EAR = nominal rate
Periodic Rate
Rate charged by a lender or paid by a borrower each period
iPER = iNOM/m
If Nominal rate is quoted at 18%, payable monthly, periodic rate is 18%/12 or 1.5%
If payment is only once a year, Nominal rate = periodic rate.
Landbank charges 10% interest rate, compounded quarterly. How much is the
nominal, EAR, and periodic rate?
Nominal = 10%, EAR = 10.38%, Periodic = 2.5%
Different Rates Sample Problem 1
Marga Bank offers an investment security with
a 7.5 percent nominal annual return,
compounded quarterly. Margas competitor,
Felice Bank, is offering a similar security that
bears the same risk and same effective rate of
return. However, Felices security pays
interest monthly. What is the nominal annual
return of the security offered by Felice?
Different Rates Sample Problem 2
If it were evaluated with an interest rate of 0
percent, a 10-year regular annuity would have
a present value of $3,755.50. If the future
(compounded) value of this annuity, evaluated
at Year 10, is $5,440.22, what effective annual
interest rate must the analyst be using to find
the future value?
Fractional Time Periods
If you deposit $100 in a bank that uses daily
compounding and pays a nominal rate of 10% with a
365 days, how much is the FV after 9 months?
N = 365 x 9/12 ; I = 10% / 365 ; PV = 100
FV = PV x [(1 + i)^n] = 100 x [(1 + 0.000273973)^274] =
107.79
You borrow $100 that charges 10% simple interest but
you borrow only for 274 days. How much interest do
you owe?
Interest owed = 100 x 10% x 274/365 = $7.51
Amortized Loans
A loan that is repaid in equal payments over its life.
If a firm borrows $1,000 and the loan is to be repaid in 3 equal
payments at the end of each of the next three years, and the
lender charges 6% on the loan balance, how much is the
periodic payment? Construct the loan amortization schedule.
N = 3; I = 6%; PV = 1000; PMT = ?; FV = 0