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Chapter Objectives
2
Case Study – Warren Buffet’s Berkshire
Hathaway
F $100.36(1 0.2458)27
$37.902 trillions
Time Value of Money
So, the total amount repaid at the end of five years would be the
original amount ($5,000) plus the interest ($1,750), or $6,750.
Compound Interest
Compound interest reflects both the remaining principal and any
accumulated interest. For $1,000 at 10%…
(1) (2)=(1)x10% (3)=(1)+(2)
Amount owed at Interest amount Amount owed at
Period beginning of period for period end of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331
n 0: P
Compound interest is commonly n 1: F1 P(1 i )
used in personal and professional
financial transactions. n 2 : F2 F1 (1 i ) P(1 i ) 2
n N : F P(1 i ) N
Compounding Process
End of Beginning Interest Ending
Year Balance earned Balance
0 $1,000
1 $1,000 $80 $1,080
2 $1,080 $86.40 $1,166.40
3 $1,166.40 $93.31 $1,259.71
$1,080
$1,166.40
0 $1,259.71
1
2
$1,000
3
$1,080
$1,166.40
Compounding Process
o n = 0: $20,000
o n = 0: $200
o n = 1 ~ 5: $5,141.85
Cash Flow Tables
Plan 1 Plan 2
Year 0 $20,000.00 $200.00 $200.00
Year 1 5,141.85 0
Year 2 5,141.85 0
Year 3 5,141.85 0
Year 4 5,141.85 0
Year 5 5,141.85 30,772.48
The amount of loan = $20,000, origination fee = $200,
interest rate = 9% APR (annual percentage rate)
Future-Present Value
$3,000 at the end of year seven is equivalent to how much today (time zero) if the
interest rate is 6% per year?
Excel 1 – Future Value
Given: P = $2,000,
i = 10%, N = 8 years
Find: F
F $2,000(1 0.10)8
$2,000(F / P ,10%,8)
$4,287.18
Excel 2 – Future Value
Exercise 1 – Present Value
Betty will need $12,000 in five years to pay for a major overhaul
on her tractor engine. She has found an investment that will
provide a 5% return on her invested funds. How much does Betty
need to invest today so she will have her overhaul funds in five
years?
Given:
F = $1,000, i = 12%, N = 5
years
Find: P
P $1,000(1 0.12)5
$1,000(P / F ,12%,5)
$567.43
Exercise 2 – Multiple Payments
Finding an Equivalent Value for Multiple Payments
Compounding Process: $511.90
Compute the equivalent value V3 100(1 0.10)3 $80(1 0.10)2 $120(1 0.10) $150
of the cash flow series at n = 3, $200(1 0.10)1 $100(1 0.10)2
using i = 10%. Discounting Process: $264.46
$511.90 $264.46
$776.36
V3
Solution
$200 V
$150
$200
$100
$120
$100
= $120
$150
$80
$100 $100
$80
0 1 2 3 4 5 0 1 2 3 4 5
0 1 2 3 4 5
Types of Cash Flows
How much will you have in 40 years if you save $3,000 each year and
your account earns 8% interest each year?
Present Values of Annuity
F
A A A
0 1 2 N 1 2 N
How much would you need to set aside each year for 25 years, at 10%
interest, to have accumulated $1,000,000 at the end of the 25 years?
Annual Payout
0 1 2 N
A A A
P
0 1 2 N
Equivalent Present Worth
0 N
If you had $500,000 today in an account earning 10% each year, how
much could you withdraw each year for 25 years?
Exercise 3 – Instalments
Finding N
Acme borrowed $100,000 from a local bank, which charges them an interest
rate of 7% per year. If Acme pays the bank $8,000 per year, now many years
will it take to pay off the loan?
So,
This can be solved by using the interest tables and interpolation, but we
generally resort to a computer solution.
Payback Period
Principle
N Cash Flow Cum. Flow
How fast can I recover my initial
investment? 0 −$105,000+$20,000 −$85,000
Method 1 $15,000 −$70,000
Based on the cumulative cash 2 $25,000 −$45,000
3 $35,000 −$10,000
flow (or accounting profit) $45,000 $35,000
4
Screening Guideline 5 $45,000 $80,000
If the payback period is less than 6 $35,000 $115,000
or equal to some specified bench-
mark period, the project would be Payback period should occurs
considered for further analysis. somewhere between
Weakness N = 3 and N = 4.
Does not consider the time value
of money
Example 5 – Rate of Return
Finding i
Jill invested $1,000 each year for five years in a local company and sold her
interest after five years for $8,000. What annual rate of return did Jill earn?
So,
Again, this can be solved using the interest tables and interpolation, but
we generally resort to a computer solution.
Exercise 4 – Interest Rate
$1,000
$500 Option A: F3 $500(1 i)3 $1,000
Option B: F3 $502(1 i)2 $502(1 i) $502 $1,000
A
$500
0 1 2 3 i = 8% A
Option A : F3 $500(1.08)3 $1,000 0 1 2 3
$1,630
$502 $502 $502
Option B : F3 $502(1.08)2 $502(1.08) $502
$502 $502 $502
B $1,630
B
0 1 2 3 0 1 2 3
Excel Spreadsheet
Irene just purchased a new sports car and wants to also set aside cash for
future maintenance expenses. The car has a bumper-to-bumper warranty
for the first five years. Irene estimates that she will need approximately
$2,000 per year in maintenance expenses for years 6-10, at which time she
will sell the vehicle. How much money should Irene deposit into an account
today, at 8% per year, so that she will have sufficient funds in that account
to cover her projected maintenance expenses?
present value
Uniform Gradient
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000
Geometric Gradient
Acme Miracle projects good things for their new weight loss pill, LoseIt.
Revenues this year are expected to be $1.1 million, and Acme believes they
will increase 15% per year for the next 5 years. What are the present value
and equivalent annual amount for the anticipated revenues? Acme uses an
interest rate of 20%.
Use the geometric gradient formula to find the present value, then
convert the present amount to an annual amount.
Variable Interest
For an 18% nominal rate, compounded quarterly, the effective interest is.
Ali plans to buy a Honda 500Z with MSRP $20,870 with instant rebate $2,443.
He is required to pay down payment of $3,427 on a loan with 6.25% APR for a
total of 72 months. What would be his monthly payment?
Continuous Compounding
C
r
i lim 1 1 C
C
CK
er /K 1
Effective Interest Rates
0
1 2 3
$1,000
ia e0.06 1
6.18%
F $1, 000( F / P, 6.18%,3)
$1,197.09
Effective Interest Rates