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Chapter 1 - 5
Chapter 6 - 10
Chapter 11 - 15
Chapter 16 - 17
Here we will discuss the effective annual rate, time value of money problems, PV of a perpetuity,
an ordinary annuity, annuity due, a single cash flow and a series of uneven cash flows. For each,
you should know how to both interpret the problem and solve the problems on your approved
calculator. These concepts will cover LOS' 5.b and 5.c.
The stated annual rate, or quoted rate, is the interest rate on an investment if an institution were
to pay interest only once a year. In practice, institutions compound interest more frequently,
either quarterly, monthly, daily and even continuously. However, stating a rate for those small
periods would involve quoting in small fractions and wouldn't be meaningful or allow easy
comparisons to other investment vehicles; as a result, there is a need for a standard convention
for quoting rates on an annual basis.
The effective annual yield represents the actual rate of return, reflecting all of the compounding
periods during the year. The effective annual yield (or EAR) can be computed given the stated
rate and the frequency of compounding. We'll discuss how to make this computation next.
Formula 2.1
Effective annual rate (EAR) = (1 + Periodic interest
rate)m - 1
Where: m = number of compounding periods in one
year, and
periodic interest rate = (stated interest rate) / m
Keep in mind that the effective annual rate will always be higher than the stated rate if there is
more than one compounding period (m > 1 in our formula), and the more frequent the
compounding, the higher the EAR.
Assume that the future value of $10,000 five years from now is at 8%, but assuming quarterly
compounding, we have quarterly r = 8%/4 = 0.02, and periods N = 4*5 = 20 quarters.
Compare these results to the figure we calculated earlier with annual compounding ($14,693.28)
to see the benefits of additional compounding periods.
Exam Tips and Tricks
On PV and FV problems, switching the time units - either by calling for
quarterly or monthly compounding or by expressing time in months and
the interest rate in years - is an often-used tactic to trip up test takers who
are trying to go too fast. Remember to make sure the units agree for r and
N, and are consistent with the frequency of compounding, prior to solving.
The formula for the PV of a perpetuity is derived from the PV of an ordinary annuity, which at N
= infinity, and assuming interest rates are positive, simplifies to:
Formula 2.2
PV of a perpetuity = annuity payment A
interest rate r
Formula 2.3
(1) FV = PV * (1 + r)N
(2) PV = FV * { 1 }
(1 + r)N
FV = $14,693.28
At an interest rate of 8%, we calculate today's value that will grow to $10,000 in five years:
PV = ($10,000)*(0.680583) = $6805.83
A. $100,000
B. $117,459
C. $148,644
D. $161,506
Answer:
The problem asks for a value today (PV). It provides the future sum of money (FV) =
$1,000,000; an interest rate (r) = 10% or 0.1; yearly time periods (N) = 20, and it indicates
annual compounding. Using the PV formula listed above, we get the following:
Using a calculator with financial functions can save time when solving PV and FV problems. At
the same time, the CFA exam is written so that financial calculators aren't required. Typical PV
and FV problems will test the ability to recognize and apply concepts and avoid tricks, not the
ability to use a financial calculator. The experience gained by working through more examples
and problems increase your efficiency much more than a calculator.
Formula 2.4
Future Value Annuity Factor = ((1 + r)n - 1)/r
Formula 2.5
Present Value Annuity Factor = (1 - (1 + r)-n /r
FV Annuity Factor
The FV annuity factor formula gives the future total dollar amount of a series of $1 payments,
but in problems there will likely be a periodic cash flow amount given (sometimes called the
annuity amount and denoted by A). Simply multiply A by the FV annuity factor to find the future
value of the annuity. Likewise for PV of an annuity: the formula listed above shows today's value
of a series of $1 payments to be received in the future. To calculate the PV of an annuity,
multiply the annuity amount A by the present value annuity factor.
The FV and PV annuity factor formulas work with an ordinary annuity, one that assumes the first
cash flow is one period from now, or t = 1 if drawing a timeline. The annuity due is distinguished
by a first cash flow starting immediately, or t = 0 on a timeline. Since the annuity due is basically
an ordinary annuity plus a lump sum (today's cash flow), and since it can be fit to the definition
of an ordinary annuity starting one year ago, we can use the ordinary annuity formulas as long as
we keep track of the timing of cash flows. The guiding principle: make sure, before using the
formula, that the annuity fits the definition of an ordinary annuity with the first cash flow one
period away.
A. $109,000
B. $143.200
C. $151,900
D. $165,600
Answer:
The problem gives the annuity amount A = $10,000, the interest rate r = 0.09, and time periods N
= 10. Time units are all annual (compounded annually) so there is no need to convert the units on
either r or N. However, the starting today introduces a wrinkle. The annuity being described is an
annuity due, not an ordinary annuity, so to use the FV annuity factor, we will need to change our
perspective to fit the definition of an ordinary annuity.
Drawing a timeline should help visualize what needs to be done:
Figure 2.1: Cashflow Timeline
The definition of an ordinary annuity is a cash flow stream beginning in one period, so the
annuity being described in the problem is an ordinary annuity starting last year, with 10 cash
flows from t0 to t9. Using the FV annuity factor formula, we have the following:
Multiplying this amount by the annuity amount of $10,000, we have the future value at time
period 9. FV = ($10,000)*(15.19293) = $151,929. To finish the problem, we need the value at t10.
To calculate, we use the future value of a lump sum, FV = PV*(1 + r)N, with N = 1, PV = the
annuity value after 9 periods, r = 9.
Notice that choice "C" in the problem ($151,900) agrees with the preliminary result of the value
of the annuity at t = 9. It's also the result if we were to forget the distinction between ordinary
annuity and annuity due, and go forth and solve the problem with the ordinary annuity formula
and the given parameters. On the CFA exam, problems like this one will get plenty of takers for
choice "C" - mostly the people trying to go too fast!!
It helps to set up this problem as if it were on a spreadsheet, to keep track of the cash flows and
to make sure that the proper inputs are used to either discount or compound each cash flow. For
example, assume that we are to receive a sequence of uneven cash flows from an annuity and
we're asked for the present value of the annuity at a discount rate of 8%. Scratch out a table
similar to the one below, with periods in the first column, cash flows in the second, formulas in
the third column and computations in the fourth.
Time Cash Present Value Result of
Period Flow Formula Computation
1 $1,000 ($1,000)/(1.08)1 $925.93
2 $1,500 ($1,500)/(1.08)2 $1,286.01
3 $2,000 ($2,000)/(1.08)3 $1,587.66
4 $500 ($500)/(1.08)4 $367.51
5 $3,000 ($3,000)/(1.08)5 $2,041.75
Suppose we are required to find the future value of this same sequence of cash flows after period
5. Here's the same approach using a table with future value formulas rather than present value, as
in the table above:
Check the present value of $9,122.86, discounted at the 8% rate for five years: