Value of Money 2005, Pearson Prentice Hall The Time Value of Money Compounding and Discounting Single Sums We know that receiving P 1.00 today is worth more than P 1.00 in the future. This is due to opportunity costs. The opportunity cost of receiving P 1.00 in the future is the interest we could have earned if we had received the P 1.00 sooner. Today Future If we can measure this opportunity cost, we can: Translate P 1.00 today into its equivalent in the future (compounding). Translate P 1.00 in the future into its equivalent today (discounting). ? Today Future Today ? Future Compound Interest and Future Value Future Value - single sums If you deposit P 100.00 in an account earning 6.0%, how much would you have in the account after 1 year? Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 1 ) (use FVIF table, or) FV = PV (1 + i) n FV = 100 (1.06) 1 = P 106.00 0 1 PV = -100 FV = 106 Page Future Value - single sums If you deposit P 100.00 in an account earning 6.0%, how much would you have in the account after 5 years? 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 = P 133.82 0 5 PV = -100 FV = 133. 82 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 = P 134.68 0 20 PV = -100 FV = 134. 68 Future Value - single sums If you deposit P 100.00 in an account earning 6.0% with quarterly compounding, how much would you have in the account after 5 years? 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 = P 134.89 0 60 PV = -100 FV = 134. 89 Future Value - single sums If you deposit P 100.00 in an account earning 6.0% with monthly compounding, how much would you have in the account after 5 years? 0 100 PV = -1000 FV = 2.98M Future Value - continuous compounding What is the FV of P 1,000.00 earning 8.0% with continuous compounding, after 100 years? Mathematical Solution: FV = PV (e in ) FV = 1000 (e .08x100 ) = 1000 (e 8 ) FV = P 2,980,957.99 Present Value Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 1 ) (use PVIF table, or) PV = FV / (1 + i) n PV = 100 / (1.06) 1 = P 94.34 PV = -94. 34 FV = 100 0 1 Present Value - single sums If you receive P 100.00 one year from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%? Page 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 = P 74.73 Present Value - single sums If you receive P 100.00 five years from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%? 0 5 PV = -74. 73 FV = 100 Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .07, 15 ) (use PVIF table, or) PV = FV / (1 + i) n PV = 100 / (1.07) 15 = P 362.45 Present Value - single sums What is the PV of P 1,000.00 to be received 15 years from now if your opportunity cost is 7.0%? 0 15 PV = -362. 45 FV = 1000 Calculator Solution: P/Y = 1 N = 5 PV = -5,000 FV = 11,933 I = 19% 0 5 PV = -5,000 FV = 11,933 Present Value - single sums If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return? Mathematical Solution: PV = FV (PVIF i, n ) 5,000 = 11,933 (PVIF ?, 5 ) PV = FV / (1 + i) n 5,000 = 11,933 / (1+ i) 5 .419 = ((1/ (1+i) 5 ) 2.3866 = (1+i) 5 (2.3866) 1/5 = (1+i) i = .19 Present Value - single sums If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return? Present Value - single sums Suppose you placed P 100.00 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to P 500.00? Mathematical Solution: PV = FV / (1 + i) n 100 = 500 / (1+ .008) N 5 = (1.008) N ln 5 = ln (1.008) N ln 5 = N ln (1.008) 1.60944 = .007968 N N = 202 months Hint for single sum problems: In every single sum present value and future value problem, there are four variables: FV, PV, i and n. When doing problems, you will be given three variables and you will solve for the fourth variable. Keeping this in mind makes solving time value problems much easier! Page The Time Value of Money Compounding and Discounting Cash Flow Streams 0 1 2 3 4 Annuity: a sequence of equal cash flows, occurring at the end of each period. 0 1 2 3 4 Annuities If you buy a bond, you will receive equal semi-annual coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will pay a stream of equal payments. Examples of Annuities: Calculator Solution: P/Y = 1 I = 8 N = 3 PMT = -1,000 FV = P 3,246.40 Future Value - annuity If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years? 0 1 2 3 1000 1000 1000 Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 1,000 (FVIFA .08, 3 ) (use FVIFA table, or) FV = PMT (1 + i) n - 1 i FV = 1,000 (1.08) 3 - 1 = P 3,246.40 0.08 Future Value - annuity If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years? Calculator Solution: P/Y = 1 I = 8 N = 3 PMT = -1,000 PV = P 2,577.10 0 1 2 3 1000 1000 1000 Present Value - annuity What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%? Page Mathematical Solution: PV = PMT (PVIFA i, n ) PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or) 1 PV = PMT 1 - (1 + i) n i 1 PV = 1000 1 - (1.08 ) 3 = P 2,577.10 0.08 Present Value - annuity What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%? Other Cash Flow Patterns 0 1 2 3 The Time Value of Money Perpetuities Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. You can think of a perpetuity as an annuity that goes on forever. Present Value of a Perpetuity When we find the PV of an annuity, we think of the following relationship: PV = PMT (PVIFA i, n ) Mathematically, (PVIFA i, n ) = We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large? 1 - 1 (1 + i) n i When n gets very large, this becomes zero. So were left with PVIFA = 1 i 1 - 1 (1 + i) n i Page PMT i PV = So, the PV of a perpetuity is very simple to find: Present Value of a Perpetuity What should you be willing to pay in order to receive P 10,000.00 annually forever, if you require 8.0%per year on the investment? PMT P 10,000.00 i 0.08 PV = = = P 125,000.00 Ordinary Annuity vs. Annuity Due P 1,000.00 P 1,000.00 P 1,000.00 4 5 6 7 8 Begin Mode vs. End Mode P 1,000.00 P 1,000.00 P 1,000.00 4 5 6 7 8 year year year 5 6 7 PV in END Mode FV in END Mode Begin Mode vs. End Mode P 1,000.00 P 1,000.00 P 1,000.00 4 5 6 7 8 year year year 6 7 8 PV in BEGIN Mode FV in BEGIN Mode Earlier, we examined this ordinary annuity: Using an interest rate of 8.0%, we find that: The Future Value (at 3) is P 3,246.40. The Present Value (at 0) is P 2,577.10. 0 1 2 3 1,000 1,000 1,000 Page What about this annuity? Same 3-year time line, Same 3 P 1,000.00 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. 0 1 2 3 1000 1000 1000 Calculator Solution: Mode = BEGIN P/Y = 1 I = 8 N = 3 PMT = -1,000 FV = P 3,506.11 0 1 2 3 -1000 -1000 -1000 Future Value - annuity due If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3? 0 1 2 3 -1000 -1000 -1000 Future Value - annuity due If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3? Calculator Solution: Mode = BEGIN P/Y = 1 I = 8 N = 3 PMT = -1,000 FV = P 3,506.11 Future Value - annuity due If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3? Mathematical Solution: Simply compound the FV of the ordinary annuity one more period: FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) (use FVIFA table, or) FV = PMT (1 + i) n - 1 i FV = 1,000 (1.08) 3 - 1 = P 3,506.11 .08 (1 + i) (1.08) Calculator Solution: Mode = BEGIN P/Y = 1 I = 8 N = 3 PMT = 1,000 PV = P 2,783.26 0 1 2 3 1,000 1,000 1,000 Present Value - annuity due What is the PV of P 1,000.00 at the beginning of each of the next 3 years, if your opportunity cost is 8.0%? Present Value - annuity due Mathematical Solution: Simply compound the FV of the ordinary annuity one more period: PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08) (use PVIFA table, or) 1 PV = PMT 1 - (1 + i) n i 1 PV = 1000 1 - (1.08 ) 3 = P 2,783.26 .08 (1 + i) (1.08) Page 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 0 1 2 3 4 -10,000 2,000 4,000 6,000 7,000 Sorry! Theres no quickie for this one. We have to discount each cash flow back separately. 0 1 2 3 4 -10,000 2,000 4,000 6,000 7,000 Uneven Cash Flows period CF PV (CF) 0 -P 10,000.00 -P 10,000.00 1 2,000.00 1,818.18 2 4,000.00 3,305.79 3 6,000.00 4,507.89 4 7,000.00 4,781.09 PV of Cash Flow Stream: P 4,412.95 0 1 2 3 4 -10,000 2,000 4,000 6,000 7,000 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. Annual Percentage Yield (APY) Find the APY for the quarterly loan: The quarterly loan is more expensive than the 8.0% loan with annual compounding! APY = ( 1 + ) m - 1 quoted rate m APY = ( 1 + ) 4 - 1 APY = .0808, or 8.08% .0785 4 First Group Project Page Instructions Get the best commercial bank interest rate for the following initial deposits: P 1,000.00, P 5,000.00, and P 10,000.00 for one (1) year. The best rate shall come from a survey/canvass of at least three banks. List down the following information: name of bank, branch, the name of the authorized representative of the bank, and the contact number. Instructions On the next meeting, each group will reveal the rates for the three initial deposits. The group with the best rates will get the highest score (10 points). Each group will submit a one page report for the interest rates obtained to be submitted on the next meeting. The next meeting will be next Wednesday. Practice Problems Example 0 1 2 3 4 5 6 7 8 P 0 0 0 0 40 40 40 40 40 Cash flows from an investment are expected to be P 40,000.00 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20.0%rate of return, what is the PV of these cash flows? This type of cash flow sequence is often called a deferred annuity. 0 1 2 3 4 5 6 7 8 P 0 0 0 0 40 40 40 40 40 2) Find the PV of the annuity: PV3: End mode; P/YR = 1; I = 20; PMT = 40,000; N = 5 PV3= P 119,624.00 0 1 2 3 4 5 6 7 8 P 0 0 0 0 40 40 40 40 40 Page Then discount this single sum back to time 0. PV: End mode; P/YR = 1; I = 20; N = 3; FV = 119,624; Solve: PV = P 69,226.00 P 119,624.00 0 1 2 3 4 5 6 7 8 P 0 0 0 0 40 40 40 40 40 The PV of the cash flow stream is P 69,226.00. P 69,226.00 0 1 2 3 4 5 6 7 8 P 0 0 0 0 40 40 40 40 40 P 119,624.00 Retirement Example After graduation, you plan to invest P 400.00 per month in the stock market. If you earn 12.0%per year on your stocks, how much will you have accumulated when you retire in 30 years? 0 1 2 3 . . . 360 400 400 400 400 Using your calculator, P/YR = 12 N = 360 PMT = -400 I%YR = 12 FV = P 1,397,985.65 0 1 2 3 . . . 360 400 400 400 400 Retirement Example If you invest P 400.00 at the end of each month for the next 30 years at 12.0%, 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) FV = PMT (1 + i) n - 1 i Retirement Example If you invest P 400.00 at the end of each month for the next 30 years at 12.0%, 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) FV = PMT (1 + i) n - 1 i FV = 400 (1.01) 360 - 1 = P 1,397,985.65 .01 Page House Payment Example If you borrow P 100,000.00 at 7.0% fixed interest for 30 years in order to buy a house, what will be your monthly house payment? 0 1 2 3 . . . 360 ? ? ? ? Using your calculator, P/YR = 12 N = 360 I%YR = 7 PV = P 100,000.00 PMT = -P 665.30 0 1 2 3 . . . 360 ? ? ? ? House Payment Example Mathematical Solution: PV = PMT (PVIFA i, n ) 100,000 = PMT (PVIFA .07, 360 ) (cant use PVIFA table) 1 PV = PMT 1 - (1 + i) n i 1 100,000 = PMT 1 - (1.005833 ) 360 PMT=P 665.30 .005833 Team Assignment Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require P 250,000.00 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 10.0%annually. 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) = = P 1,042,470.00 27 28 29 30 31 32 33 34 35 250 250 250 250 250 Page Using your calculator, Mode = BEGIN PMT = -P 250,000.00 N = 5 I%YR = 10 P/YR = 1 PV = P 1,042,466.00 27 28 29 30 31 32 33 34 35 250 250 250 250 250 Now, assuming 10.0% annual compounding, what monthly payments will be required for you to have P 1,042,466.00 at the end of year 30? 27 28 29 30 31 32 33 34 35 250 250 250 250 250 P 1,042,466 Using your calculator, Mode = END N = 360 I%YR = 10 P/YR = 12 FV = P 1,042,466.00 PMT = -P 461.17 27 28 29 30 31 32 33 34 35 250 250 250 250 250 P 1,042,466.00 So, you would have to place P 461.17 in your retirement account, which earns 10.0% annually, at the end of each of the next 360 months to finance the 5-year world tour.