8.time Value of Money 2

Chapter 5 - The Time Value of Money
2005, Pearson Prentice Hall
Future Value
Future Value - single sums

If you deposit $100 in an account earning 6%, how much would you have in the account after 5 years?
PV = -100
FV = 133.82
0 5 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 5 ) (use FVIF table, or) FV = PV (1 + i)n FV = 100 (1.06)5 = $133.82

If you deposit $100 in an account earning 6% with quarterly compounding, how much would you have in the account after 5 years?
PV = -100
FV = 134.68
0 20 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .015, 20 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.015)20 = $134.68

If you deposit $100 in an account earning 6% with monthly compounding, how much would you have in the account after 5 years?
PV = -100
0
FV = 134.89
60
Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .005, 60 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.005)60 = $134.89
Present Value
Present Value - single sums

If you receive $100 five years from now, what is the PV of that $100 if your opportunity cost is 6%?
PV = -74.73
0
FV = 100
5
Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 5 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.06)5 = $74.73
The Time Value of Money

Compounding and Discounting Cash Flow Streams
Future Value - annuity

If you invest $1,000 each year at 8%, how much would you have after 3 years? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 1,000 (FVIFA .08, 3 )
FV = PMT (1 + i)n - 1 i FV = 1,000 (1.08)3 - 1 .08
(use FVIFA table, or)
= $3246.40
Present Value - annuity

What is the PV of $1,000 at the end of each of the next 3 years, if the opportunity cost is 8%?
Mathematical Solution: PV = PMT (PVIFA i, n ) PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or) PV = PMT 1 1 - (1 + i)n i
PV = 1000
1 1 - (1.08 )3 .08
= $2,577.10
Ordinary Annuity vs. Annuity Due

$1000 $1000 $1000
Begin Mode vs. End Mode

1000 1000 1000

1000 1000
year 6
1000
year 7
year 5

1000 1000
year 6
1000
year 7
year 5
PV
in END Mode

1000 1000
year 6
1000
year 7
year 5
PV
in END Mode
FV
in END Mode

1000 1000
year 6
1000
year 7
year 8

1000 1000
year 6
1000
year 7
year 8
PV
in BEGIN Mode

1000 1000
year 6
1000
year 7
year 8
PV
in BEGIN Mode
FV
in BEGIN Mode
Earlier, we examined this ordinary annuity:

1000
0 1
1000
2
1000
3

1000
0 1
1000
2
1000
3
Using an interest rate of 8%, we find that:

1000
0 1
1000
2
1000
3
Using an interest rate of 8%, we find that: The Future Value (at 3) is $3,246.40.

1000
0 1
1000
2
1000
3
Using an interest rate of 8%, we find that: The Future Value (at 3) is $3,246.40. The Present Value (at 0) is $2,577.10.
What about this annuity? 1000

0
1000
1
1000
2 3
Same 3-year time line, Same 3 $1000 cash flows, but The cash flows occur at the
beginning of each year, rather than at the end of each year. This is an annuity due.
Future Value - annuity due

If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have at the end of year 3?

-1000
0
-1000
1
-1000
2 3
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = -1,000 FV = $3,506.11

-1000
0
-1000
1
-1000
2 3
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = -1,000 FV = $3,506.11

Mathematical Solution:
Simply compound the FV of the ordinary annuity one more period:

FV = PMT (FVIFA i, n ) (1 + i)

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08)

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) FV = PMT (1 + i)n - 1 i
(1 + i)

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) FV = PMT (1 + i)n - 1 i
(1 + i)
FV = 1,000 (1.08)3 - 1 = $3,506.11 (1.08) .08
Present Value - annuity due

What is the PV of $1,000 at the beginning of each of the next 3 years, if your opportunity cost is 8%?

1000
0
1000
1
1000
2 3
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = 1,000 PV = $2,783.26

1000
0
1000
1
1000
2 3
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = 1,000 PV = $2,783.26



PV = PMT (PVIFA i, n ) (1 + i)

PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08)
(use PVIFA table, or)


PV = PMT 1 1 - (1 + i)n i (1 + i)


PV = PMT 1 1 - (1 + i)n i (1 + i)
PV = 1000
1-
1 (1.08 )3
.08
(1.08)
= $2,783.26
Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4
Is this an annuity? How do we find the PV of a cash flow

stream when all of the cash flows are different? (Use a 10% discount rate.)
Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4
Sorry! Theres no quickie for this one.

We have to discount each cash flow back separately.
Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4

Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4

Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4

Uneven Cash Flows

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4

-10,000
0
2,000
1
4,000
2
6,000
3
7,000
4
period CF 0 -10,000 1 2,000 2 4,000 3 6,000 4 7,000 PV of Cash Flow Stream:
PV (CF) -10,000.00 1,818.18 3,305.79 4,507.89 4,781.09 $ 4,412.95
Annual Percentage Yield (APY)

Which is the better loan: 8% compounded annually, or 7.85% compounded quarterly? We cant compare these nominal (quoted) interest rates, because they dont include the same number of compounding periods per year! We need to calculate the APY.

APY =
(1+
quoted rate m
- 1

APY =
(1+
quoted rate m
- 1
Find the APY for the quarterly loan:

APY =
(1+
quoted rate m
- 1

APY =
.0785 1+ 4
)4- 1

APY =
(1+
quoted rate m
- 1

APY =
.0785 1+ 4
)4- 1
APY = .0808, or 8.08%

APY =
(1+
quoted rate m
- 1

APY =
.0785 1+ 4
)4- 1
APY = .0808, or 8.08%
The quarterly loan is more expensive than

the 8% loan with annual compounding!
Practice Problems
Example
Cash flows from an investment are
expected to be $40,000 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20% rate of return, what is the PV of these cash flows?
Example
Cash flows from an investment are
expected to be $40,000 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20% rate of return, what is the PV of these cash flows?
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
This type of cash flow sequence is

often called a deferred annuity.
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
How to solve: 1) Discount each cash flow back to time 0 separately.
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
How to solve: 1) Discount each cash flow back to time 0 separately. Or,
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
2) Find the PV of the annuity: PV: End mode; P/YR = 1; I = 20; PMT = 40,000; N = 5 PV = $119,624
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
2) Find the PV of the annuity: PV3: End mode; P/YR = 1; I = 20; PMT = 40,000; N = 5 PV3= $119,624
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
119,624
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
119,624
Then discount this single sum back to time 0. PV: End mode; P/YR = 1; I = 20;
N = 3; FV = 119,624; Solve: PV = $69,226
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
69,226
119,624
$0
0
0
1
0
2
0
3
40
4
40
5
40
6
40
7
40
8
69,226
119,624
The PV of the cash flow

stream is $69,226.
Retirement Example
After graduation, you plan to invest

$400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated when you retire in 30 years?
Retirement Example
After graduation, you plan to invest

$400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated when you retire in 30 years?
400 400 2 400 3 400 . . . 360
400 0 1
400 2
400 3
400
. . . 360
400 0 1
400 2
400 3
400
. . . 360
Using your calculator,

P/YR = 12 N = 360 PMT = -400 I%YR = 12 FV = $1,397,985.65
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30?
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30? Mathematical Solution:
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n )
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 400 (FVIFA .01, 360 )
(cant use FVIFA table)
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 400 (FVIFA .01, 360 ) FV = PMT (1 + i)n - 1 i
Retirement Example If you invest $400 at the end of each month for the next 30 years at 12%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 400 (FVIFA .01, 360 ) FV = PMT (1 + i)n - 1 i FV = 400 (1.01)360 - 1 .01 = $1,397,985.65
House Payment Example

If you borrow $100,000 at 7% fixed interest for 30 years in order to buy a house, what will be your monthly house payment?

If you borrow $100,000 at 7% fixed interest for 30 years in order to buy a house, what will be your monthly house payment?
? 0 1
? 2
? 3
?
. . . 360
? 0 1
? 2
? 3
?
. . . 360

P/YR = 12 N = 360 I%YR = 7 PV = $100,000 PMT = -$665.30


PV = PMT (PVIFA i, n )

PV = PMT (PVIFA i, n ) 100,000 = PMT (PVIFA .07, 360 )
(cant use PVIFA table)


PV = PMT 1 1 - (1 + i)n i


PV = PMT 1 1 - (1 + i)n i 1 (1.005833 )360 .005833
100,000 = PMT 1 -
PMT=$665.30
Team Assignment
Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require $250,000 per year at the beginning of each year. If you plan to retire in 30 years, what are the equal monthly payments necessary to achieve this goal? The funds in your retirement account will compound at 10% annually.
250 250 250 250 250 27 28 29 30 31 32 33 34 35
How much do we need to have by

the end of year 30 to finance the trip?
PV30 = PMT (PVIFA .10, 5) (1.10) =

= 250,000 (3.7908) (1.10) = = $1,042,470
250 250 250 250 250 27 28 29 30 31 Using your calculator, 32 33 34 35
Mode = BEGIN PMT = -$250,000 N=5 I%YR = 10 P/YR = 1 PV = $1,042,466
250 250 250 250 250 27 28 29 30 31 32 33 34 35
1,042,466
Now, assuming 10% annual

compounding, what monthly payments will be required for you to have $1,042,466 at the end of year 30?
250 250 250 250 250 27 28 29 30 31 32 33 34 35
1,042,466

Mode = END N = 360 I%YR = 10 P/YR = 12 FV = $1,042,466 PMT = -$461.17
So, you would have to place $461.17 in

your retirement account, which earns 10% annually, at the end of each of the next 360 months to finance the 5-year world tour.
Practice
A Client has $202.971,39 in an account that
earns 8% per year, compounded monthly. The clients 35th birthday was yesterday and she will retire when the account value is $1 million. A. At what age can she retire if she puts no more money in the account? B. At what age can she retire if she puts $250 per month into the account every month, beginning one month from now?
Answer
A. PV = $ 202.971,39
I/Y = 8%/12 = 0.6667%. A = 0. FV = $1.000.000,N = 240 months = 20 years. She will be 55 years old. FV = PV (1+i)n $ 1.000.000,- = $202.971,39 (1+0.6667%)n (1.000.000,- / 202.971,39) = (1.006667) n ln 4.9268 = n x ln (1.006667) 1.5947 = n x 0.006645 n = 240 bulan
B. A = $250/month N = 18.335 years She will be 53 years old.

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Chapter 5 - The Time Value of Money

2005, Pearson Prentice Hall

Future Value - single sums

Future Value - single sums

Future Value - single sums

Present Value - single sums

The Time Value of Money

Future Value - annuity

(use FVIFA table, or)

Present Value - annuity

Ordinary Annuity vs. Annuity Due

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Begin Mode vs. End Mode

Earlier, we examined this ordinary annuity:

Earlier, we examined this ordinary annuity:

Earlier, we examined this ordinary annuity:

Using an interest rate of 8%, we find that:

Earlier, we examined this ordinary annuity:

Earlier, we examined this ordinary annuity:

What about this annuity? 1000

Future Value - annuity due

Future Value - annuity due

Future Value - annuity due

Future Value - annuity due

Future Value - annuity due

Future Value - annuity due

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08)

(use FVIFA table, or)

Future Value - annuity due

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) FV = PMT (1 + i)n - 1 i

(use FVIFA table, or)

Future Value - annuity due

FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) FV = PMT (1 + i)n - 1 i

(use FVIFA table, or)

FV = 1,000 (1.08)3 - 1 = $3,506.11 (1.08) .08

Present Value - annuity due

Present Value - annuity due

Present Value - annuity due

Present Value - annuity due

Present Value - annuity due

Present Value - annuity due

Present Value - annuity due

PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08)

(use PVIFA table, or)

Present Value - annuity due

PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08)

(use PVIFA table, or)

Present Value - annuity due

PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08)

(use PVIFA table, or)

Uneven Cash Flows

Is this an annuity? How do we find the PV of a cash flow

Uneven Cash Flows

Sorry! Theres no quickie for this one.

Uneven Cash Flows

Sorry! Theres no quickie for this one.

Uneven Cash Flows

Sorry! Theres no quickie for this one.