7/9/2015

Outline

Time Value of Money

Future Value
Present Value
Perpetuity
Annuity

Future Value
In the one-period case, the formula for FV
can be written as:
FV = C0 (1 + r)
Where C0 is cash flow today (time zero), and
r is the appropriate interest rate.

The Multi-period Case

The general formula for the future value of
an investment over many periods can be
written as:
FV = C0 (1 + r) T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash
is invested.

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The Multi-period Case

Suppose a stock currently pays a
dividend of $1.10, which is expected to
grow at 40% per year for the next five
years.
What will the dividend be in five years?

How Long is the Wait?

If we deposit $5,000 today in an account paying
10%, how long does it take to grow to $10,000?

FV = C0 (1 + r) T

(1.10)T =

What Rate Is Enough?

Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years. You
have $5,000 to invest today. What rate of interest must
you earn on your investment to cover the cost of your
childs education?

$10,000
=2
$5,000

T * ln(1.10) = ln( 2)

FV = C0 (1 + r) T
$5.92 = $1.10 (1.40)5

$ 10,000 = $5,000 (1.10 )T

T=

ln( 2)
0 .6931
=
= 7.27 years
ln(1.10) 0.0953

Compounding Periods
q For example, if you invest $50 for 3
years at 12% compounded semiannually, your investment will grow to

About 21.15%.

FV = C0 (1 + r )

(1 + r)12 =

$50,000
= 10
$5,000

$ 50,000 = $5,000 (1 + r )12

(1 + r) = 101 12

.12
FV = $50 1 +

23

= $ 50 (1.06 )6 = $ 70.93

r = 101 12 1 = 1.2115 1 = . 2115

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Compounding Periods
Compounding an investment m times a
year for T years provides for future value of
wealth:
r

FV = C 0 1 +
m

mT

Effective Annual Rates of Interest

A reasonable question to ask in the above
example is what is the effective annual
rate of interest on that investment?
.12 2 3
FV = $50 (1 +
) = $50 (1.06) 6 = $70. 93
2
The Effective Annual Rate (EAR) of interest is the
annual rate that would give us the same end-ofinvestment wealth after 3 years:

$ 50 (1 + EAR )3 = $70 .93

Effective Annual Rates of Interest

FV = $50 (1 + EAR ) = $70.93
3

(1 + EAR )3 =
$70 .93
EAR =

$50

$70.93
$ 50

13

1 = .1236

So, investing at 12.36% compounded

annually is the same as investing at 12%
compounded semi-annually.

Effective Annual Rates of Interest

Find the Effective Annual Rate (EAR) of
an 18% APR loan that is compounded
monthly.
What we have is a loan with a monthly
interest rate rate of 1%.
This is equivalent to a loan with an annual
interest rate of 19.56%.
nm

1+
m

12

. 18
= 1 +
= (1. 015) 12 = 1. 1956
12

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Continuous Compounding
The general formula for the future value of an
investment compounded continuously over
many periods can be written as:
FV = C0 erT
Where
C0 is cash flow at date 0,

Present Value
In the one-period case, the formula for PV
can be written as:
PV =

r is the stated annual interest rate,

C1
1+ r

T is the number of years, and

Where C1 is cash flow at date 1, and

e is a transcendental number approximately

equal to 2.718. ex is a key on your calculator.

r is the appropriate interest rate.

Present Value
If you were to be promised $10,000 due in one
year when interest rates are 5-percent, your
investment would be worth

$ 9,523.81 =

$10,000
1.05

The amount that a borrower would need to set

aside today to be able to meet the promised
payment of $10,000 in one year is called the
Present Value (PV).

Present Value
In the one-period case, the formula for PV
can be written as:
PV =

C1
1+ r

Where C1 is cash flow at date 1, and

r is the appropriate interest rate.

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Present Value and Discounting

How much would an investor have to set
aside today in order to have $20,000 five
years from now if the current rate is 15%?
PV

$20,000

$ 9,943.53 =

Multiple Cash Flows

Consider an investment that pays $200
one year from now, with cash flows
increasing by $200 per year through year
4. If the interest rate is 12%, what is the
present value of this stream of cash flows?
If the issuer offers this investment for
$1,500, should you purchase it?

$20,000
(1.15)5

Multiple Cash Flows

0

Simplifications
Perpetuity
A constant stream of cash flows that lasts forever

Growing perpetuity
200

400

600

800

178.57

A stream of cash flows that grows at a constant rate

forever

Annuity

318.88

A stream of constant cash flows that lasts for a fixed

number of periods

427.07

Growing annuity

508.41
1,432.93

Present Value < Cost ? Do Not Purchase

A stream of cash flows that grows at a constant rate

for a fixed number of periods

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Perpetuity

Perpetuity: Example

A constant stream of cash flows that lasts forever

C

What is the value of a British consol that

promises to pay 15 every year for
ever?
The interest rate is 10-percent.

C
C
C
PV =
+
+
+L
2
(1 + r ) (1 + r ) (1 + r ) 3
C
PV =
r

15

15

15

PV =

15
= 150
.10

Growing Perpetuity

Growing Perpetuity: Example

A growing stream of cash flows that lasts forever

The expected dividend next year is $1.30, and

dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of
this promised dividend stream?

C (1+g)

C (1+g) 2

PV =

C
C (1+ g ) C (1 + g ) 2
+
+
+L
(1 + r )
(1 + r ) 2
(1 + r ) 3

C
PV =
rg

$1.30

$1.30 (1.05)

$1.30 (1.05) 2

PV =

$1. 30
= $26. 00
.10 . 05

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Annuity: Example

Annuity
A constant stream of cash flows with a fixed
maturity
C
C
C
C

If you can afford a $400 monthly car payment,

how much car can you afford if interest rates are
7% on 36-month loans?

L
0

PV =

C
C
C
C
+
+
+L
(1 + r ) (1 + r ) 2 (1 + r ) 3
(1 + r ) T

PV =

C
1
1

r (1+ r )T

$ 100
$100
$100
$ 100
$100
PV1 =
=
+
+
+
= $323 .97
t
(1 .09)1 (1.09 )2 (1 .09)3 (1.09 )4
t =1 (1.09 )

PV

$323.97

$100

1
2
$327 . 97
= $297 . 22
1. 09

$100

$100

$100

$400

$400

$400

L
0

PV =

What is the present value of a four-year annuity of $100 per

year that makes its first payment two years from today if the
discount rate is 9%?

$297.22

$400

36

$400
1

= $12, 954.59
1
36
.07 / 12 (1 + .07 12)

Annuity: Example
Mark Young has just won the state lottery,
paying $50,000 a year for 20 years. He is to
receive his first payment a year from now. The
state advertises this as the Million Dollar Lottery
because $,1000,000 = $50,000*20. If the
interest rate is 8%, what is the true value of the
lottery?
Suppose you put Rs.3,000 per year into an LIC
Insurance scheme. The account pays 6%
interest per year. How much will you have when
you retire is 30 years?

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Annuity Variations
Delayed Annuity
Daniel will receive a four-year annuity $500
per year, beginning at year 6, If the interest
rate is 10%, what is the present value of her
annuity?

Annuity Variations
Infrequent Annuity
Nirmala receives an annuity of Rs.450
payable once every two years. The annuity
stretches out over 20 years. The first payment
occurs at year 2 i.e. two years from today.
The annual interest rate is 6%

Annuity Variations
Annuity Due
Mark Young has just won the state lottery, paying
$50,000 a year for 20 years. He is to receive his first
payment immediately. The state advertises this as the
Million Dollar Lottery because $,1000,000 =
$50,000*20. If the interest rate is 8%, what is the true
value of the lottery?

Annuity Variations
Equating PV of two annuities
Munish and Urvashi Thakur are saving for the
4-year college education of their newborn
daughter, Durga. The Thakurs estimate that
college expenses will run Rs.30,000 per year
when their daughter reaches college in 18
years. The annual interest will be 14%. How
much money must they deposit in the bank
each year so that their daughter will be
completely supported through four years of
college?

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Growing Annuity

Growing Annuity: Example

A growing stream of cash flows with a fixed

maturity
C
C (1+g) C (1+g) 2
C (1+g) T-1

A defined-benefit retirement plan offers to pay $20,000

per year for 40 years and increase the annual payment by
3% each year. What is the present value at retirement if
the discount rate is 10%?

L
0

PV =

$20,000

C
C (1+ g )
C (1 + g) T 1
+
+
L
+
(1 + r )
(1 + r ) 2
(1 + r ) T

Growing Annuity: Example

0
1
$34,706.26

$9, 095 $9, 731.65 $10,412.87 $11,141.77

40

$20,000 1.03
1
= $265,121. 57
.10 .03 1.10
40

FV of an Annuity

You are evaluating an income generating property. Net rent is

received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?
$8, 500 (1. 07) 2 =
$8, 500 (1. 07) 4 =
$8, 500 (1. 07) =
$8, 500 (1. 07) 3 =

$ 8,500

L
0

PV =

T
C 1+ g
PV =

1
r g (1 + r )

$20,000 (1.03) $20,000 (1.03) 39

(1 + r )T 1
FV = C

John decides to save by depositing $10,000 into

an account per year for 5 years. The first deposit
would occur at the end of the first year. The
effective annual rate on the account is 9%. What
is the balance after 15 years?

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FV of a Growing Annuity
(1 + r )T (1 + g )T
FV = C

rg

Suppose you are presented with two options for a growing

annuity. Each annuity begins on the same day and lasts for
10 payments, with an annual interest rate of 10%.

What Is a Firm Worth?

Conceptually, a firm should be worth the
present value of the firms cash flows.
The tricky part is determining the size,
timing, and risk of those cash flows.

In Option 1, the initial payment is $7,500 and the growth

rate is 6%. In Option 2, the initial payment is $10,000 and
the growth rate is 3%. Which option has the larger future
value on the day of the last payment?

Thank you!!!

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