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Keown Perfin5 Im 03
Keown Perfin5 Im 03
This is the third chapter in the four-chapter section of the text entitled “Part 1: Financial
Planning.” This section introduces building blocks that are fundamental to the remainder of the
text and serve as a foundation for financial planning. The first chapter focused on the importance
of the financial planning process, while the second focused on quantitative tools for measuring
financial well-being and strategies for developing a budget based on financial goals. This chapter
introduces another quantitative concept, the time value of money. Because applications of this
concept are made in subsequent chapters on taxes, consumer credit, mortgages, life insurance,
investments, and retirement planning, it is critical that the students understand the calculations as
well as the logic underlying the time value of money concepts.
CHAPTER SUMMARY
Compound interest and the time value of money are two important factors to consider when
developing a financial plan. This chapter explains the concept of the time value of money under
three assumptions: 1) a single payment, “lump sum;” 2) a terminating fixed stream of payments,
“annuity;” and 3) a never-ending fixed stream of payments, “perpetuity.” Calculations and
applications for present value and future value are illustrated using either a financial calculator
or the interest factor tables. Using compound interest to generate returns is dependent on three
factors: length of the investment period, amount invested, and the rate of return, or interest rate.
The use of these factors to determine the return on an investment is discussed and illustrated
with calculations. Finally, amortized loans and perpetuities are discussed and calculated.
After reading this chapter, students should be able to accomplish the following objectives and
define the associated key terms:
CHAPTER OUTLINE
B. Calculator Clues
1. Set calculator to one payment “annual” per year
2. Set to display at least four decimals, due to how small percentages are in
decimal format.
3. Set to “end” mode, because most annuity payments are made or received at the
end of the period.
4. Every problem has at least one positive number and one negative number
5. Be sure to enter a zero for any unused variable
6. Enter the interest rate as a percent rather than a decimal
V. Present Value
A. Discount rate, or the interest rate used to bring future dollars back to present dollars
B. Present-value interest factor (PVIFi,n)
C. PV = FVn(PVIFi,n) or FVn /(1 + i)n
D. Appendix B factor table
APPLICABLE PRINCIPLES
CLASSROOM APPLICATIONS
1. Discuss the difference between simple interest and compound interest. Combine the math of
the problem with a graphical illustration to demonstrate how much interest the interest earns
when reinvested. Ask the class how the length of time magnifies this effect.
2. Ask students to describe the difference between future value and the future value of an
annuity. Discuss why a 10-year annuity started immediately is more valuable in 30 years
than a 20-year annuity started 10 years from today, although more money is invested in the
20-year annuity.
3. Have students identify examples of perpetuities. Discuss how the total amount received
from the perpetuity increases if the recipient lives longer than anticipated, even though the
installment amount remains the same.
4. Ask students to calculate the price of several purchases (e.g., movie ticket, new car, pair of
jeans) at several future dates, assuming different rates of inflation. Assuming a 3 percent
annual rate of inflation, what would dinner and a movie cost when they return to campus for
their twenty-fifth-year college reunion?
1. Compound interest is interest paid on interest. First, interest is earned on the original
amount of principal; then, as the interest is reinvested (by leaving it alone and not spending
it), additional interest is earned on the amount reinvested plus the interest on the principal.
The more frequently interest is added, or compounded; the faster a given sum of money will
grow. Compounding can be done annually, semi-annually, quarterly, monthly, or even
daily.
Relationship to Time Value of Money: Time value of money calculations are based on the
growth of a sum of money over a period of time, also known as compounding. In order to
solve a time-value calculation, you must know (or assume) an interest rate at which money
will compound.
2. Future value is the value of a certain sum of money at a certain future point in time. This
value is of great importance because it allows us to project how much “growth” a certain
rate of return will provide. When comparing a portfolio’s estimated future value to the
estimated purchasing power of each dollar within the portfolio, the future value serves as a
gauge to estimate future standard of living.
3. The Rule of 72 provides a “ballpark estimate” of how long it takes for a sum of money to
double in value. To calculate how long doubling will take, divide the expected annual
interest rate into 72; e.g., 72 divided by 6 percent = 12 years. The answer tells the
approximate time it will take for a given sum (e.g., $5,000) to double (e.g., $10,000). The
Rule of 72 can also be used to project how prices will double through inflation. For
example, at 4 percent inflation, prices will double every 18 years (72/4 = 18).
However, when solving for a straight present- or future-value there is no periodic payment
being made; therefore, the PMT variable is zero.
Note: To solve a time value of money problem using the interest factor tables rather than the
time value of money function keys you must locate the factor using the interest rate and
number of periods. This factor replaces both the interest rate and number of period inputs.
Once the factor has been determined it is simply multiplied by the investment amount. This
alternative may be used whether the investment is a periodic payment, a present value, or a
future value by using the various factor tables.
5. The time value of money is the concept that a dollar received today is worth more than a
dollar received tomorrow. Therefore, you can’t compare dollar amounts in two separate
time periods without adjusting the value of today’s payment forward in time or the later
payment backward in time using an interest rate.
Importance of concept answers may vary by student; however, the following are
representative.
To determine how money invested today will grow to fund future financial goals:
• Calculating the growth of a single investment – future value.
• Calculating the growth of a series of investments – future value of an annuity.
7. Einstein knew that, given sufficient time, compound interest could truly work wonders.
Over time, even small dollar amounts can grow into incredible sums. The sooner money is
saved, the more time it has to grow. Compound interest (interest earned on interest) will
greatly increase the initial sum invested, especially if money is left to grow for several
decades or in Peter Minuit’s case centuries.
8. Investors require a greater return because of the increased uncertainty of the future
purchasing power of their investment as the time horizon lengthens. It is almost human
nature to err on the side of having too much; therefore, the farther we try to project our
needs, the greater the “average need” becomes.
9. The most common discount rate is the inflation rate. Using the inflation rate as the discount
rate allows for “apples to apples” comparison of the future purchasing power or value of
today’s dollars. People are typically more concerned with the relative “purchasing power”
of money rather than the absolute “value” of the money.
10. The process of using present value of money calculations to convert future sums of money
into present dollars by “backing out the interest” is called discounting. Therefore, the
interest rate used in present value of money calculations is referred to as the discount rate.
11. The future-value interest factor gives a numeric representation of the power of
compounding. This shows that as the investment horizon lengthens the total return becomes
more a factor of compound interest and less a factor of subsequent investments.
12. An annuity is typically defined as a series of equal dollar payments received, whereas a
compound annuity is a series of equal dollar payments paid.
13. Interest factors for annuities are calculated by summing up a number of consecutive present-
or future-value interest factors. For example, the future-value interest factor for an annuity
of “n” years is simply the sum of individual future-value interest factors for the years 1
through n. Using an annuity factor (rather than individual factors for each year) greatly
simplifies what would otherwise be a very tedious math calculation.
14. An amortized loan is one that is paid off in equal periodic payments over time. Two
common examples are car loans and home mortgages.
15. The sign, either + or –, used when entering a time value of money equation dictates the
direction of the cash flow. Conventionally, all cash outflows or “payments” carry a negative
sign, and all cash inflows or receipts carry an implied positive sign. In other words, if the
money is flowing away from the investor then a negative sign is used, but when money is
flowing towards the investor the sign is positive. When using a calculator to solve for N—
number of payments, or I/Y—annual interest rate; the calculator requires at least one cash
flow in each direction. If the sign is incorrectly entered in the HP BA-II Plus then the
calculator will return an “Error 5” message.
16. A perpetuity is a series of equal dollar payments made at the end of a specified time period
for an infinite number of time periods. The best example of a perpetuity is a scholarship.
Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall
Understanding and Appreciating the Time Value of Money 47
1. After 18 years, her prize money will have grown to $999,000. The 8% future-value interest
factor is closest to 4 (FVIF = 3.996) at the end of year 18. The Rule of 72 can also be used.
By dividing the known variable (8%) into 72, the answer is 9, but since you are quadrupling
your money, rather than doubling it, you will need to multiply the answer of 9 by 2.
Using a financial calculator with PV = -$250,000, FV = $1 million, PMT = $0, and I/Y =
8% results in N being 18.01 years.
2. It will take approximately 9 years for Linda’s investment to increase in value to $7,755.
3. Paul must earn approximately $30,910 in year ten to maintain equivalent purchasing power.
4. Assuming annual compounding, Anthony and Michelle will have $255,000 in 25 years.
Assuming semi-annual compounding (therefore resetting the payments per year [P/Y] = 2
for the calculator solution), they will have approximately $276,300 in 25 years.
Using the factor tables the difference attributable to the increased compounding frequency is
$21,285 = $276,285 – $255,000. Using the calculator the difference attributable to the
increased compounding frequency is $21,302 = $276,302 – $255,000. Therefore, the
shorter the compounding period the larger the resultant value if all other variables are held
constant.
6. Based on a 5% return Ahmed will fall short of his goal with only $8,862 saved.
Note: Using a calculator to determine the required rate is easiest; however, in this instance
the time value of money factor can be determined by using the equation ($10,283 / $6,000).
This results in a factor of 1.714, and is approximately equal to the (FVIF7%,8) 1.718.
7. Again, solving for I/Y is easiest using a calculator; however, with two single sums (one PV
and one FV) using Appendix A and the formula FV = PV(FVIFi %, n years) is also an option.
$1,000,000 (FVIFi %, n years) = $7,039,988.71
(FVIFi %, n years) = $7,039,988.71 / $1,000,000 = 7.039
Looking at the 40-year period row in Appendix A, 7.040 is the factor for 5%. Therefore,
Dr. Evil is requiring a 5% inflation rate on his 40-year old, $1,000,000 ransom demand.
PV $1,000,000 PV -$1,000,000
PMT n/a PMT $0
I/Y ?
(FVIF5%,40) 7.040
N 40
FV $7,039,988.71 FV $7,039,988.71
CPT I/Y 5.0%
Alternatively, this question can be used to introduce Appendix B and requires the formula
PV = FV (PVIFi %, n years) to solve:
$7,039,988.71(PVIFi %, n years) = $1,000,000
(PVIFi %, n years) = $1,000,000 / $7,039,988.71 = 0.14205
Looking at the 40-year period row in Appendix B, This time 0.142 is the factor for 5%.
8. Derek’s trust is worth approximately $8,880 today if he is to receive $20,000 at age 35.
10. Richard would be able to withdrawal approximately $54,897 ($500,000 / 9.108) at the end
of each year.
11. Step 1: You would have approximately $374,220 ($2,275 * 164.491) at the time you retire.
Note: Since the match is 50% on only the first 3% the matching contribution is only
1.5%, rather than 2.5% if there was no limit on matching contributions.
Total annual contribution = (0.05 * $35,000) + (0.015 * $35,000) = $2,275
12. Using Appendix C and the formula FV = PMT(FVIFAi %, n years) solves for the following:
Annual investment answers (Table C factors)
• 20 years—$3,000 x 72.052 (FVIFA12%, 20 years) = $216,156
• 30 years—$3,000 x 241.330 (FVIFA12%, 30 years) = $723,990
• 40 years—$3,000 x 767.080 (FVIFA12%, 40 years) = $2,301,240
Monthly investment answers (using calculator - resetting the compounding periods to 12)
• N = 20 (x12), PMT = -$250, PV = 0, I/Y =12% Therefore, FV = $247,313
• N = 30 (x12), PMT = -$250, PV = 0, I/Y =12% Therefore, FV = $873,741
• N = 40 (x12), PMT = -$250, PV = 0, I/Y =12% Therefore, FV = $2,941,193
The difference in dollar amount saved between an annual investment and a monthly
investment is $31,158 in 20 years, $149,751 in 30 years, and a whopping $639,953 in 40
years. Reducing the compounding period and increasing the number of investments made
during the year can greatly magnify the power compound interest has to drive total returns.
1. If Jinhee contributes just 5 percent of her salary ($1,850) and earns another $1,850 (100
percent) from her employer’s match, she will save a total of $3,700 a year.
• At 8 percent she’d have $958,510.90 = ($3,700 x 259.057 (FVIFA8%, 40 years))
• At 10 percent she’d have $1,637,594.10 = ($3,700 x 442.593 (FVIFA10%, 40 years)).
The employer match is “free money” that shouldn’t be passed up. It is in Jinhee’s best
interest to start saving immediately.
By making monthly payments Jinhee will earn $189.27 ($593.80 – $404.53) more interest.
Paying the loan on a monthly basis would result in an interest savings of $2,225.40
[($12,950.46 x 10) – ($1,060.66 x 120)] over the life of the loan.
1. The approximate monthly payment is using the online factor table D is $2,147.28. Using
the calculator and assuming monthly compounding (therefore resetting the payments per
year [P/Y] = 12), results in a PMT of $2,147.29.
2. His retirement income will last for 195 months (16.3 years) or until approximately age 73.
His portfolio needs to generate $3,000 in income per month ($5,800 – $2,800 retirement
annuity). Using the formula $400,000 = [$3,000 * (PVIFA 5%, X months)] from the
Appendix to Chapter 3 the PVIFA can be calculated as 133.333.
Now his retirement income will last for 945 months (78.8 years) or until approximately age
135. His portfolio only needs to cover $1,700 per month ($4,500 – $2,800). Again using
the formula $400,000 = [$1,700 * (PVIFA 5%, X months)] the PVIFA can be calculated as
235.294.
3. Note: This problem poses a more difficult variation for using the factor tables; therefore the
table and calculator solutions will be handled separately.
Factoring in the Social Security benefit, and using his current projected expense level of
$5,800 he will deplete his portfolio at age 80.
Calculator solution
PV -$400,000
PMT $3,000
I/Y 5%
N 11
FV ?
CPT FV $165,992.44
Step 2: Using the future value from above as the new present value calculates that Doug’s
portfolio will last an additional 156 months or 13 years.
Calculator solution
PV -$165,992.44
PMT $1,450
I/Y 5%
N ?
FV 0
CPT N ≈ 156 months
Because there is a PV and PMT the calculation to determine the remaining value at age 67
utilizing the factor tables must be handled in two pieces.
The difference between the two future values is the value of the remaining portfolio
$165,882. Using that as the new present value, the factor can be determined as 114.401.