FINANCE

FIN2004
Lecture 3: Time Value of Money
1
Time Value Analysis
As we discussed, cash is crucial in financial valuation. One of the
main problems in finance is determining what value we should place
on prospective cash profits that will accrue to a project/ investment.
This has two components: time and uncertainty. For now we will
assume away uncertainty and concentrate on how to devise
techniques for evaluating the worth of certain cash flows that will
come in at various dates in the future.
This is crucial, because it will allow us to compare the value of
profits that may be coming in at very different times.
The main insight that we will start with is that a dollar paid today is
worth more than a dollar paid tomorrow.
2
Learning Objectives
Be able to compute the future value of an investment made
today
Be able to compute the present value of cash to be received
at some future date
Be able to draw and explain the use of a time line
Be able to solve time value of money problems
Be able to explain what is an amortized loan and calculate
the periodic payments of such a loan
3
Lecture Outline
1. Basic Definitions and Concepts
2. Future Value and Compounding
3. Present Value and Discounting
4. Multiple Cash Flows
5. Annuities
6. Effective Annual Rate vs. Nominal Rate
4
$1 received today is preferred to $1 received
some time in the future. Why?
lost earnings: can invest the money to earn
interest
loss of purchasing power: because of the presence
of inflation
trade-off depends on the rate of return
What is the Time Value of Money?
5
Year 0 Year 1 Year 2
Today
End of
year 1
End of
year 2
Beginning
of year 1
Beginning
of year 2
Beginning
of year 3
0 1 2 3
Timelines
Drawing timelines can be helpful in understanding time value of
money problems
6
Basic Definitions: PV and FV
Present Value (PV) the value of something today. On
a timeline t = 0. Present Value is also referred to as the
market value of a cash flow to be received in the future.
Translating a value that comes at some point in the
future to its value in the present is referred to as
discounting.
Future Value (FV) the value of a cash flow sometime
in the future. On a timeline t > 0.
Translating a value to the future is referred to as
compounding.
7
Meaning Of Future And Present Values
Keep in mind that all that present values and
future values do is to put cash flows which
come in at different times on a
COMPARABLE BASIS!
Once they are then in the same units we will
be able to compare and make decisions on
which pattern of cash flows are preferable.
8
Annuities & Perpetuities
An annuity is the word used to describe a series of cash flows in
which the same cash flow CF (or payment) takes place each
period for a set number of periods.
An ordinary annuity is one in which the first cash flow occurs
one period from now (end of the period 1).
An annuity due is an annuity in which the first cash flow occurs
immediately (at the beginning of period 1).
A perpetuity is simply a set of equal payments that are paid
forever.
A growing perpetuity, is a set of payments which grow at a
constant rate each period and continue forever.
9
The principal in a loan context is theoriginal amount
borrowed.
Interest is thecompensation for the opportunity cost
of funds and the uncertainty of repayment of the
amount borrowed. Sometimes, referred to as:
Discount rate
Cost of capital
Opportunity cost of capital
Required return
More Definitions
10
More Timelines
CF
0
CF
1
CF
3
CF
2
0 1 2 3
i%
Time line for a $100 lump sum due at the end of Year 2
100
0 1 2 Year
i%
General Timeline
11
Time line for an ordinary annuity of $100 for 3 years
100 100 100
0 1 2 3
i%
Time line for uneven CFs: -$50 at t = 0 and $100, $75, and
$50 at the end of Years 1 through 3.
100 50 75
0 1 2 3
i%
- 50
A negative sign means it is a cash outflow
More Timelines
12
Back to Future Values
We can think of Future Value as an amount to
which an investment will grow after earning
interest.
Simple Interest: Interest earned only on the original
investment.
Compound Interest: In addition to interest earned on
the original investment, interest is also earned on
interest previously received (on the original
investment).
13
Savings Example: Simple Interest
Today you deposit $100 into a fixed deposit
account paying 5% simple interest. How much
should you have in 5 years?
Solution: $100 + 5 years * 100(5%) = $125
Interest earned per year: $5
Principal
14
Example: Simple Interest
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125
Interest earned per year: $5
15
Simple Interest
16
Example: Compound Interest
Suppose now you deposit your $100 into a Savings Deposit where interest is
earned at 5% on the previous years balance:
Interest Earned Per Year =Prior Year Balance x 5%
After 1 year:
FV
1
=PV +INT
1
=PV +PV (i)
=PV(1 +i) =$100(1.05)
=$105.00
After 2 years (Displaying the Meaning of Compounding):
In General, FV
n
= PV(1 + i)
n
Original invested amount
FV
2
=PV(1 +i)
2
=PV(1 +2i +i * i)
=PV(Principal +2 years of Simple Interest + Interest on Interest)
=$100(1.05)
2
=$110.25
17
Compound Interest
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
Interest earned per year increases from $5
18
Compound Interest
19
Effects of Compounding
Simple interest vs. Compound interest
Consider the previous example of a 2 year investment:
FV with simple interest = 100 + 5 + 5 = 110
FV with compound interest = 110.25
The extra 0.25 comes from the interest of .05(5) = 0.25
earned on the first interest payment
The effect of compounding is small for a small number of
periods, but increases as the number of periods increases.
20
Another Compounding Example
Suppose one of your ancestors deposited $10 at
5.5% interest 200 years ago. How much would the
investment be worth today?
FV = 10(1.055)
200
= 447,189.84
What is the effect of compounding?
Simple interest = 10 + 200(10)(.055) = 120.00
Compounding added $447,069.84 to the value of the
investment!
21
Future Values: General Formula
FV = PV(1 + r)
t
= PV (1+i)
n
FV = future value
PV = present value
r = i = period interest rate, expressed as a decimal (e.g. 5% =.05)
t = n = number of periods
Future value interest factor = (1 + r)
t
(FVIF)
FV = ?
0 1 2 3
5%
CF
Finding FVs (moving to the right on a time line) is called compounding.
22
Example: Future Value as a General Growth
Suppose your company expects to increase unit
sales by 15% per year for the next 5 years. If you
currently sell 3 million cars in one year, how
many cars do you expect to sell in 5 years?
FV = 3,000,000(1.15)
5
= 6,034,072
23
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
A B C D E
Initial depos it 100
Interes t rate 0% 6% 12%
Y e a r F V a t 0 % F V a t 6 % F V a t 1 2 %
0 100.00 100.00 100.00 <-- =$B $2*(1+D$3)^$A 6
1 100.00 106.00 112.00 <-- =$B $2*(1+D$3)^$A 7
2 100.00 112.36 125.44
3 100.00 119.10 140.49
4 100.00 126.25 157.35
5 100.00 133.82 176.23
6 100.00 141.85 197.38
7 100.00 150.36 221.07
8 100.00 159.38 247.60
9 100.00 168.95 277.31
10 100.00 179.08 310.58
11 100.00 189.83 347.85
12 100.00 201.22 389.60
13 100.00 213.29 436.35
14 100.00 226.09 488.71
15 100.00 239.66 547.36
16 100.00 254.04 613.04
17 100.00 269.28 686.60
18 100.00 285.43 769.00
19 100.00 302.56 861.28
20 100.00 320.71 964.63
F U T U R E V A L U E O F A S I N G L E P A Y M E N T A T D I F F E R E N T I N T E R E S T R A T E S
H o w $ 1 0 0 a t t i m e 0 g r o w s a t 0 % , 6 % , 1 2 %
0
100
200
300
400
500
600
700
800
900
1000
0 5 10 15 20
F V at 0%
F V at 6%
F V at 12%
24
Four Ways to Find FVs
1. Solve the equation with a regular calculator.
2. Use Future Value tables.
3. Use a financial/programmable calculator.
4. Use EXCEL spreadsheet.
25
Future Value: Using a FV Table
A loaf of bread today costs $1.28. If grocery
prices are going up at the rate of 6% per year, how
much will a loaf of bread cost in 5 years?
Solution: $1.28 x 1.3382 = $1.71
This future value factor was found from the FV
Table: look under the column for interest of 6%
and the row for period of 5 years
26
Future Value Table
27
Financial Calculator Solution
Financial calculators solve this equation:
There are 4 variables. If 3 are known, the calculator will
solve for the 4th.
( )
n
i 1 PV FV + =
Excel: For an Excel Solution Example, please see slide 23.
28
Quick Review Part 1
What is the difference between simple interest
and compound interest?
Suppose you have $500 to invest and you believe
that you can earn 8% per year over the next 15
years.
How much would you have using simple interest?
$1100
How much would you have at the end of 15 years
using compound interest? $1,586.08
29
Present Values
How much do I have to invest today to have some amount in
the future?
We re-arrange FV = PV(1 + r)
n
to solve for PV = FV / (1 + r)
n
When we talk about discounting, we mean finding the
present value of some future amount. It is the reverse of
compounding.
When we simply talk about the value of something, we are
talking about the present value. If we want future value, we
specifically indicate that we want the future value.
30
( )
n
n
i + 1
1
FV =
i + 1
FV
= PV
|
.
|

\
|
( )
PV = $100
1
1.10
= $100 0.7513 =
$75.13.
|
\

|
.
3
PV Factor
PV Factor for n = 3 and i = 10%
Present Value Generally:
31
Present Value One Period Example
Suppose you need $10,000 in one year for the down
payment on a new car. If you can earn 7% annually,
how much do you need to invest today?
PV = 10,000 / (1.07)
1
= 9345.79
32
Present Value Example 2
You want to begin saving for your daughters
university education and you estimate that she will
need $150,000 in 17 years. If you feel confident
that you can earn 8% per year, how much do you
need to invest today?
FV = $150,000, r = 8%, n = 17
PV = 150,000 / (1.08)
17
= 40,540.34
33
Present Values Example 3
Your parents set up a trust fund for you 10 years ago
that is now worth $19,671.51. If the fund earned 7%
per year, how much did your parents invest?
We know the value today is $19,671.51 and we want
to know what it was worth 10 years ago if the annual
compound interest it has been receiving is 7%, so
PV = 19,671.51 / (1.07)
10
= 10,000
34
Present Value Important Relationship 1
For a given amount to be received in the future and
for a given interest rate available the longer into the
future that amount is to be received, the lower the
present value of that amount
E.g., What is the present value of $500 to be
received in 5 years? 10 years? The discount rate is
10%
5 years: PV = 500 / (1.1)
5
= 310.46
10 years: PV = 500 / (1.1)
10
= 192.77
35
Present Value Important Relationship 2
For a given amount to be received at a given
time period in the future the higher the
interest rate, the smaller the present value of
that amount
E.g., What is the present value of $500
received in 5 years if the interest rate is 10%?
15%?
Rate = 10%: PV = 500 / (1.1)
5
= 310.46
Rate = 15%; PV = 500 / (1.15)
5
= 248.58
36
Quick Review Part 2
What is the relationship between present value
and future value?
Suppose you need $15,000 in 3 years. If you can
earn 6% annually, how much do you need to
invest today? $12,594.29
If you could invest the money at 8%, would you
have to invest more or less than if you invested it
at 6%? How much? Less $686.81
37
Multiple Cash Flows Example
Suppose you plan to deposit $100 into an account
in one years time and $300 into the account in
three years from now. How much will be in the
account in five years if the interest rate is 8%?
FV = 100(1.08)
4
+ 300(1.08)
2
= 136.05 + 349.92
= 485.97
38
Example: Multiple Cash Flows
0 1 2 3 4
200 400 600 800
i =12%
Find the PV of each cash flow and then sum the cash flows
Year 1 CF: 200 / (1.12)
1
= 178.57
Year 2 CF: 400 / (1.12)
2
= 318.88
Year 3 CF: 600 / (1.12)
3
= 427.07
Year 4 CF: 800 / (1.12)
4
= 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = 1432.93
39
Example: Multiple Cash Flows Timeline
0 1 2 3 4
200 400 600 800
178.57
318.88
427.07
508.41
1432.93 = PV
i = 12%
40
Ordinary Annuity
PMT PMT PMT
0 1 2 3
i%
PMT PMT
0 1 2 3
i%
PMT
Annuity Due
Difference Between Annuity &Annuity Due:
PV
FV
The difference between the two is (1+i) .
41
Example: PV of an Ordinary Annuity
100 100 100
0 1 2 3
10%
90.91
82.64
75.13
248.69 = PV
Whats the PV of a 3-year ordinary annuity of
$100 at 10%?
42
Have payments but no lump sum FV, so enter
nothing or 0 for future value
3 10 100 0
N I/YR PV PMT FV
-248.69
INPUTS
OUTPUT
Example: PV of an Ordinary Annuity
Using a Financial Calculator:
43
PV of an Ordinary Annuity
PV Annuity Due = PV Annuity * (1+r)
Annuity PV =
(

r
Factor PV - 1
* PMT
Regular Lump Sum
PV Factor=
( )
(

+
t
r 1
1
(

|
|
.
|

\
|
+
=
+
+ +
+
+
+
=
(

n n
r r
PMT
r r r r ) 1 (
1
1 *
1
*
) 1 (
1
...
) 1 (
1
1
1
* PMT
Factor PV - 1
* PMT
2
44
DEPOSITS AT END OF YEAR
Begi nni ng
of year 1
Begi nni ng
of year 2
Begi nni ng
of year 3
Begi nni ng
of year 4
Begi nni ng
of year 5
Begi nni ng
of year 6
Begi nni ng
of year 7
Begi nni ng
of year 8
Begi nni ng
of year 9
Begi nni ng
of year 10
End of
year 10
0 1 2 3 4 5 6 7 8 9 10
$100 $100 $100 $100 $100 $100 $100 $100 $100 $100
168.95 <-- =100*(1.06)^9
159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1
100.00 <-- =100*(1.06)^0
Total 1318.08 <-- Sum of the above
Example: FV of an Ordinary Annuity
( ) | |
(

+ = 1 ) 1 *
1
FV
n
r
r
PMT
( )
10 1
FV 100 1.06 1
.06
(
=

FV 100 13.1808 1,318.18 = =
45
DEPOSITS AT BEGINNING OF YEAR
Begi nni ng
of year 1
Begi nni ng
of year 2
Begi nni ng
of year 3
Begi nni ng
of year 4
Begi nni ng
of year 5
Begi nni ng
of year 6
Begi nni ng
of year 7
Begi nni ng
of year 8
Begi nni ng
of year 9
Begi nni ng
of year 10
End of
year 10
0 1 2 3 4 5 6 7 8 9 10
$100 $100 $100 $100 $100 $100 $100 $100 $100 $100
179.08 <-- =100*(1.06)^10
168.95 <-- =100*(1.06)^9
159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1
Total 1397.16 <-- Sum of the above
Example: FV of an Annuity Due
( )
10 1
FV 100 1.06 1 (1.06)
.06
(
=

FV 100 13.1808 (1.06) 100 13.9716 1397.16 = = =
) 1 ( * Annuity of FV Due Annuity of FV r + =
46
Annuity Lottery Example
Suppose you win a $10 million lottery prize. The money
is paid in equal annual end-of-year installments of
$333,333.33 over 30 years. If the appropriate discount
rate is 5%, how much is the sweepstakes actually worth
today?
= 5,124,150.29
47
Recall that a perpetuity is a set of equal payments that are paid forever.
If the periodic payment is $C, then the present value of the perpetuity
is:
A growing perpetuity, is a set of payments which grow at a constant
rate forever. For example:
If the first payment is $C
1
, then the present value of the perpetuity is:
r
C
PV =
g r
C
PV
1

=
Perpetuities Revisited
C C g
2 1
1 = + ( )
C C g C g
3 2 1
2
1 1 = + = + ( ) ( )
and
48
Implied Discount Rate
Sometimes we will want to know what the implied
interest rate is for an investment
We can re-arrange the basic PV and FV equations and
then solve for the implied interest rate i
FV = PV(1 + i)
n
i = (FV / PV)
1/n
1
More on discount rates later!
49
Effective Annual Rate (EAR)
The effective annual rate of interest refers to the actual rate
paid (or received) after taking into consideration any
compounding that may occur during the year. If interest is
compounded more than once a year, then the stated rate will
be different than the effective rate. If interest is compounded
(or applied) exactly once a year, then the effective annual rate
will be equal to the stated rate
If you want to compare two alternative investments with
different compounding periods you need to compute the EAR
and use that for comparison.
50
Annual Percentage Rate (APR)
(Nominal Annual Rate or Quoted Rate or Stated Rate)
This is the annual rate that is quoted by law
By definition APR = period rate * the number of periods
per year
Consequently, to get the period rate we rearrange the APR
equation:
Period rate = APR / number of periods per year
Note that you should NEVER divide the effective rate by
the number of periods per year it will NOT give you the
period rate
51
Computing APRs
What is the APR if the monthly rate is 0.5%?
0.5% * (12) = 6%
What is the APR if the semiannual rate is 4%?
4% * (2) = 8%
What is the monthly rate if the APR (based on the monthly
rate) is 12%?
12% / 12 = 1%
Can you divide the above APR by 2 to get the semiannual
rate? NO!!! You need an APR based on semiannual
compounding to find the semiannual rate.
52
Things to Remember
You ALWAYS need to make sure that the interest rate
and the time period match.
If you are looking at annual periods, you need an annual
rate.
If you are looking at monthly periods, you need a monthly
rate.
E.g., If you have an APR based on monthly
compounding, you have to use monthly periods for lump
sums, or adjust the interest rate appropriately if you have
payments other than monthly
53
Example: Computing EARs
Suppose you can earn 1% per month on $1 invested today.
What is the APR? 1%*(12) = 12%
How much are you effectively earning?
FV = 1(1.01)
12
= 1.1268
Rate = (1.1268 1) / 1 = .1268 = 12.68%
Suppose if you put it in another account, you earn 3% per quarter.
What is the APR? 3%*(4) = 12%
How much are you effectively earning?
FV = 1(1.03)
4
= 1.1255
Rate = (1.1255 1) / 1 = .1255 = 12.55%
54
EAR General Formula
1
m
APR
1 EAR
m

+ =
m =compounding frequency per year
APR is the quoted or stated rate
EAR = - 1
(1 + )
APR
m
m
= ( 1 + )
2
- 1
0.10
2
= (1.05)
2
- 1.0
= 0.1025 = 10.25%.
Example: How do we find EAR for a nominal rate of 10%, compounded
semiannually?
55
Example: Computing Effective Annual Rates
Provided below is the amount earned on a dollar invested
at APR = 8% at different compounding intervals:
Compounding
Intervals
Final Sum EAR
1 $1.0800 8.00%
2 $1.0816 8.16%
12 $1.0830 8.30%
365 $1.0833 8.33%

$1.0833 8.33%


56
Comparing Savings Accounts
You are looking at two savings accounts. One pays 5.25%,
with daily compounding. The other pays 5.3% with
semiannual compounding. Which account should you use?
First account:
EAR = (1 + .0525/365)
365
1 = 5.39%
Second account:
EAR = (1 + .053/2)
2
1 = 5.37%
Which account should you choose and why?
57
Implied Discount Rate Example
You are looking at an investment that will pay
$1200 in 5 years if you invest $1000 today. What is
the implied rate of interest?
r = (1200 / 1000)
1/5
1 = .03714 = 3.714%
With a Calculator the sign convention matters!
N = 5
PV = -1000 (you pay 1000 today)
FV = 1200 (you receive 1200 in 5 years)
Compute I/Y = 3.714%
58
Finding the Number of Periods
Start with basic equation and solve for t
(remember your logs)
FV = PV(1 + r)
t
lnFV = ln PV(1+r)
t
= lnPV + ln(1+r)
t
lnFV lnPV = t * ln(1+r)
t = ln(FV / PV) / ln(1 + r)
You can use the financial keys on the calculator as
well.
59
Number of Periods Example
Suppose you want to buy a new house. You currently have
$15,000. To buy the house you need to have a 10% down
payment plus an additional 5% in closing costs.* If the
type of house you want costs about $150,000 and you can
earn 7.5% per year, how long will it be before you have
enough money for the down payment and closing costs?
*Note: closing costs are only paid on the loan amount, not on
the total amount paid for the house.
60
Number of Periods Example Continued
How much do you need to have in the future?
Down payment =.1(150,000) =15,000
Closing costs =.05(150,000 15,000) =6,750
Total needed =15,000 +6,750 =21,750
Compute the number of periods
PV =-15,000
FV =21,750
I/Y =7.5
Compute N =5.14 years
Using the formula
t =ln(21,750 / 15,000) / ln(1.075) =5.14 years
61
Summary
62
Appendix: Additional Slides
Please review these slides on your own
63
Different Types of Loans
a. Pure Discount Loans
No interest; principal paid at maturity; issued at discount
b. Interest Only Loans
Interest paid throughout the loan period; principal paid at
maturity
c. Loans with Fixed Principal Payments
Interest and fixed amount of principal paid throughout the
loan period.
d. Amortized Loans
Interest and a portion of the principal paid throughout the
loan period
64
a. Pure Discount Loans
Principal
Payment
Yr 1 Yr 2 Yr 3
$
Interest
Loan Inception
65
Pure Discount Loans - Example
Treasury bills are excellent examples of pure
discount loans. The principal amount is repaid at
some future date, without any periodic interest
payments.
If a T-bill promises to repay $10,000 in 12
months and the market interest rate is 7 percent,
how much will the bill sell for in the market?
PV = 10,000 / 1.07 = 9345.79
66
b. Interest Only Loan
Yr 1
$
Interest
Principal
Payment
Yr 2 Yr 3
Interest Interest Interest
67
b. Interest Only Loan - Example
Consider a 3-year, interest only loan with a 7%
interest rate. The principal amount is $10,000.
Interest is paid annually.
What would the stream of cash flows be?
Years 1 2: Interest payments of .07(10,000)
= 700
Year 3: Interest + principal = 10,700
This cash flow stream is similar to the cash flows
on corporate bonds.
68
Each payment covers the interest expense plus a
fixed principal portion
$
Interest
Principal Payments
Yr 1 Yr 2 Yr 3
Interest
Interest
c. Loan with Fixed Principal Payment
69
Loan with Fixed Principal Payment -
Example
Consider a $50,000, 10 year loan at 8% interest. The
loan agreement requires the firm to pay $5,000 in
principal each year plus interest for that year.
70
Year
Beginning
Balance
Interest
Payment
Principal
Payment
Total
Payment
Ending
Balance
1 50,000 4,000 5,000 9,000 45,000
2 45,000 3,600 5,000 8,600 40,000
3 40,000 3,200 5,000 8,200 35,000
4 35,000 2,800 5,000 7,800 30,000
5 30,000 2,400 5,000 7,400 25,000
6 25,000 2,000 5,000 7,000 20,000
7 20,000 1,600 5,000 6,600 15,000
8 15,000 1,200 5,000 6,200 10,000
Fixed Principal Payment Amortization Schedule
71
d. Amortized Loan
Each equal payment covers the interest expense
plus reduces principal
$
Interest
Principal Payments
Yr 1 Yr 2 Yr 3
Interest
Interest
72
Amortized Loan - Example
Each payment covers the interest expense plus
reduces principal
Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is $5000.
What is the annual payment (via financial calculator)?
4 <N>
8 <I/YR>
5000 <PV>
<PMT> -1509.60
73
Year
Beginning
Balance
Total
Payment
Interest
Paid
Principal
Paid
Ending
Balance
1 5,000.00 1,509.60 400.00 1,109.60 3,890.40
2 3,890.40 1,509.60 311.23 1,198.37 2,692.03
3 2,692.03 1,509.60 215.36 1,294.24 1,397.79
4 1,397.79 1,509.60 111.82 1,397.78 0.01
Totals 6,038.40 1,038.41 4,999.99
Fixed Payment Amortization Schedule
74
Quick Review Part 3
What is a pure discount loan? What is a good
example of a pure discount loan?
What is an interest only loan? What is a good
example of an interest only loan?
What is an amortized loan? What is a good
example of an amortized loan?
75
Implied Discount Rate Example 2
Suppose you are offered an investment that will
allow you to double your money in 6 years. What
is the implied rate of interest?
FV = PV (1+r)
t
FV = 2, PV = 1, t = 6
r = (2/1)
1/6
1 = .122462 = 12.25%
76
Implied Discount Rate Example 3
Suppose you have a 1-year old daughter and you
want to provide $75,000 in 17 years towards her
college education. You currently have $5000 to
invest. What interest rate must you earn to have
the $75,000 when you need it?
FV = PV (1+r)
t
FV = 75, PV = 5, t = 17
r = (75,000 / 5,000)
1/17
1 = .172688 = 17.27%
77
Whats the value at the end of Year 3 of the following CF stream
if the quoted interest rate is 10%, compounded semiannually?
0 1
100
2 3
5%
4 5 6 6 month
periods
100 100
APR
Payments occur annually, but compounding occurs each 6
months.
So we cant use normal annuity valuation techniques.
Final Example
78
1st Method: Can Compound Each Cash Flow
0 1
100
2 3
5%
4 5 6
100 100.00
110.25
121.55
331.80
FV
3
= $100(1.05)
4
+ $100(1.05)
2
+ $100
= $331.80
Well get back to this again in the next slide.
79
Find the EAR for the quoted rate:
2nd Method: Can Treat as an Annuity
EAR = (1 + )- 1 = 10.25%.
0.10
2
2
Whats the PV of this stream of cash flows?
0
100
1
5%
2 3
100 100
90.70
82.27
74.62
247.59
and PV = $331.80 * PVIF 3,10.25% = $247.59
PV =