www.irfanullah.co 1 Graphs, charts, tables, examples, and figures are copyright 2012, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.
Contents 1. Introduction 2. Interest Rates: Interpretation 3. The Future Value of a Single Cash Flow 4. The Future Value of a Series of Cash Flows 5. The Present Value of a Single Cash Flows 6. The Present Value of a Series of Cash Flows 7. Solving for Rates, Number of Periods, or Size of Annuity Payments
www.irfanullah.co 2 Video Lecture 1 39 minutes Video Lecture 2 40 minutes 1. Introduction Time value of money
Interest rates
Present value
Future value www.irfanullah.co 3 2. Interest Rates: Interpretation Interest rates can be interpreted as: 1. Required rate of return 2. Discount rate 3. Opportunity cost
Say you lend $900 today and receive $990 after one year
www.irfanullah.co 4 Required Rate of Return Discount Rate Opportunity Cost Interest Rates: Investor Perspective www.irfanullah.co 5 As investors, we can view an interest rate as:
Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium Nominal Risk-free Rate Practice Question 1 Jill Smith wishes to compute the required rate of return. Which of the following premiums is she least likely to include? A. Inflation premium B. Maturity premium C. Nominal premium
www.irfanullah.co 6 Answer: C
Required rate of return includes inflation premium, maturity premium, default risk premium, and liquidity premium. There is no such component as a nominal premium. Practice Question 2 Which of the following is least likely true? A. Discount rate is the rate needed to calculate present value B. Opportunity cost represents the value an investor forgoes C. Required rate of return is the maximum rate of return an investor must receive to accept an investment
www.irfanullah.co 7 Answer: C
Required rate of return is the minimum rate of return an investor must receive to accept an investment. Therefore, option C is least likely to be the interpretation of interest rates.
Investments Maturity (in years) Liquidity Default risk Interest Rates (%) A 1 High Low 2.0 B 1 Low Low 2.5 C 2 Low Low r D 3 High Low 3.0 E 3 Low High 4.0 Practice Question 3 1. Explain the difference between the interest rates on Investment A and Investment B. 2. Estimate the default risk premium. 3. Calculate upper and lower limits for the interest rate on Investment C, r. 8 3. Future Value of a Single Cash Flow www.irfanullah.co 9 FV N = PV (1 + r) N
0 1 2 PV = 100 and r = 10% What is the FV after one year? What is the FV after two years? Practice Question 4 Cyndia Rojers deposits $5 million in her savings account. The account holders are entitled to a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash would she most likely be able to withdraw?
www.irfanullah.co 10 FV Calculation Using a Financial Calculator www.irfanullah.co 11 Keystrokes Explanation Display [2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9 [2nd] [QUIT] Return to standard calc mode 0 You invest $100 today at 10% compounded annually. How much will you have in 5 years? Keystrokes Explanation Display [2nd] [QUIT] Return to standard calc mode 0 [2 nd ] [CLR TVM] Clears TVM Worksheet 0 5 [N] Five years/periods N = 5 10 [I/Y] Set interest rate I/Y = 10 100 [PV] Set present value PV = 100 0 [PMT] Set payment PMT = 0 [CPT] [FV] Compute future value FV = -161.05 Set to floating decimal 3.1 Frequency of Compounding You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual interest rate of 10% compounded quarterly. How much will you have at the end of three years?
www.irfanullah.co 12 Multiple Compounding Periods - Calculator www.irfanullah.co 13 You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual interest rate of 10% compounded quarterly. How much will you have at the end of three years?
Practice Question 5 www.irfanullah.co 14 Donald invested $3 million in an American bank that promises to pay 4% compounded daily. Which of the following is closest to the amount Donald receives at the end of the first year? Assume 365 days in a year. A. $3.003 million B. $3.122 million C. $3.562 million 3.2 Continuous Compounding Infinite compounding periods per year continuous compounding www.irfanullah.co 15 FV N = PV e r N
An investment worth $50,000 earns interest that is compounded continuously. The stated annual interest is 3.6%. What is the future value of the investment after 3 years? Concept Building Exercise www.irfanullah.co 16 Frequency Future value of $100 Return Annual 112 12.00% Semiannual 112.36 12.36% Quarterly Monthly Daily Continuous Assume the stated annual interest rate is 12%. What is the future value of $100 at different compounding frequencies? 3.3 Stated and Effective Rates www.irfanullah.co 17 With a discrete number of compounding periods: EAR = (1 + Periodic interest rate) m 1
With continuous compounding: EAR = e r
1
4. The Future Value of a Series of Cash Flows Annuity: finite set of level sequential cash flows
Ordinary annuity: an annuity where the first cash flow occurs one period from today
Annuity due: an annuity where the first cash flow occurs immediately
Perpetuity: set of level never-ending sequential cash flows with the first cash flow occurring one period from today www.irfanullah.co 18 0 1 2 0 1 2 4.1 Future Cash Flows Ordinary Annuity www.irfanullah.co 19 0 1 2 3 4 5 Ordinary annuity with A = 1,000 r = 5% and N = 5 Ordinary Annuity - Formula www.irfanullah.co 20 0 1 2 3 4 5 Ordinary annuity with A = 1,000 r = 5% and N = 5 FV N = A {[(1+r) N 1]/r} FV N = A {Future Value Annuity Factor} Ordinary Annuity - Calculator www.irfanullah.co 21 Ordinary annuity with A = 1,000 r = 5% and N = 5 N = 5
I/Y = 5
PV = 0
PMT = 1,000
CPT FV Practice Question 6 www.irfanullah.co 22 Haley deposits $24,000 in her bank account at the end of every year. The account earns 12% per annum. If she continues this practice, how much money will she have at the end of 15 years?
Practice Question 7 www.irfanullah.co 23 Iago wishes to compute the future value of an annuity worth $120,000. He is aware that the FV annuity factor is 21.664 and the interest rate is 4.5%. Which of the following is least likely to be useful for the future value computation? A. Annuity worth B. Future value annuity factor C. Interest rate
Answer: C
4.2 Unequal Cash Flows Time Cash Flow ($) 1 1,000 2 2,000 3 3,000 4 4,000 5 5,000 www.irfanullah.co 24 What is the future value at year 5? www.irfanullah.co 25 End of Lecture 1 5. Finding the Present Value of a Single Cash Flow www.irfanullah.co 26 PV = FV N (1+r) -N
For a given discount rate, the farther in the future the amount to be received, the small the amounts present value.
Holding time constant, the larger the discount rate, the smaller the present value of a future amount. Practice Question 8 www.irfanullah.co 27 Liam purchases a contract from an insurance company. The contract promises to pay $600,000 after 8 years with a 5% return. What amount of money should Liam most likely invest? Solve using the formula and TVM functions on the calculator.
Answer: 406,104 Practice Question 9 www.irfanullah.co 28 Mathews wishes to fund his son, Nathans, college tuition fee. He purchases a security that will pay $1,000,000 in 12 years. Nathans college begins 3 years from now. Given that the discount rate is 7.5%, what is the securitys value at the time of Nathans admission?
Answer: 521,583 Practice Question 10 www.irfanullah.co 29 Orlando is a manager at an Australian pension fund. 5 years from today he wants a lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year, compounded monthly, how much should Orlando invest today? Answer: 32,760 6. Present Value of a Series of Cash Flows Present value of a series of equal cash flows (annuity)
Present value of a perpetuity
Present value indexed at times other than zero
Present value of a series of unequal cash flows www.irfanullah.co 30 6.1 Present Value of a Series of Equal Cash Flows www.irfanullah.co 31 0 1 2 3 4 5 Ordinary annuity with A = 10 r = 5% and N = 5 PV of an Ordinary Annuity: Using the Formula www.irfanullah.co 32 0 1 2 3 4 5 Ordinary annuity with A = 10 r = 5% and N = 5 PV = A {[1 1/(1+r) N ]/r} PV of an Ordinary Annuity: Using the Calculator www.irfanullah.co 33 0 1 2 3 4 5 Ordinary annuity with A = 10 r = 5% and N = 5 Annuity Due The Concept www.irfanullah.co 34 0 1 2 3 4 5 Annuity due with A = 10 r = 5% and N = 5 PV of an Annuity Due: Using the Formula www.irfanullah.co 35 0 1 2 3 4 5 Annuity due with A = 10 r = 5% and N = 5 PV (annuity due) = A {[1 1/(1+r) N ]/r} (1+r) PV of an Annuity Due: Using the Calculator www.irfanullah.co 36 0 1 2 3 4 5 Annuity due with A = 10 r = 5% and N = 5 Key Strokes Display [2nd] [BGN] [2nd] [SET] BGN [2nd] [QUIT] BGN 0 [2nd] [CLR TVM] BGN 0 5 [N] BGN N = 5 5 [I/Y] BGN I/Y = 5 10 [PMT] BGN PMT = 10 0 [FV] BGN FV = 0 [CPT] [PV] BGN
[2nd] [BGN] [2nd] [SET] END [2nd] [QUIT] 0 6.2 Present Value of a Perpetuity www.irfanullah.co 37 PV = A/r Present value is one period before the first cash flow
Simple example to understand the formula: You invest $100 and get 5% for ever. What is the cash flow? 6.3 Present Values Indexed at Times Other Than t=0 www.irfanullah.co 38 An annuity or perpetuity beginning sometime in the future can be expressed in present value terms one period prior to the first payment Discount back to todays present value Practice Question 11 www.irfanullah.co 39 Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth $100 per year indefinitely. The first payment will be received at t = 4. Given that the required rate of return is 10%, how much should Mr. Graham pay today? Answer: 751.31 6.4 The Present Value of a Series of Unequal Cash Flows www.irfanullah.co 40 Find the present value of each individual cash
Sum the respective present values
0 1 2 3 Practice Question 12 www.irfanullah.co 41 Andy makes an investment with the expected cash flow shown in the table below. Assuming a discount rate of 9% what is the present value of this investment?
Answer: 550 Time Period Cash Flow($) 1 50 2 100 3 150 4 200 5 250 7. Solving for Rates, Number of Periods, or Size of Annuity Payments Solving for Interest Rates and Growth Solving for Number of Periods Solving for the Size of Annuity Payments Review of Present Value and Future Value Equivalence The Cash Flow Additivity Principle www.irfanullah.co 42 7.1 Solving for Interest Rates and Growth Rates www.irfanullah.co 43 A $100 deposit today grows to $121 in 2 years. What is the interest rate? Use both the formula and the calculator method.
The population of a small town is 100,000 on 1 Jan 2000. On 31 December 2001 the population is 121,000. What is the growth rate?
You invest $900 today and receive a $100 coupon payment at the end of every year for 5 years. In addition, you receive $1,000 and the end of year 5. What is the interest rate? 7.2 Solving for the Number of Periods www.irfanullah.co 44 You invest $2,500. How many years will it take to triple the amount given that the interest rate is 6% per annum compounded annually? Use both the formula and the calculator method. Answer: 18.85 years 7.3 Solving for the Size of Annuity Payments www.irfanullah.co 45 Freddie bought a car worth $42,000 today. He was required to make a 15% down payment. The remainder was to be paid as a monthly payment over the next 12 months with the first payment due at t=1. Given that the interest rate is 8% per annum compounded monthly, what is the approximate monthly payment? Answer: 3,106 7.4 Review of Present and Future Value Equivalence A lump sum can be considered equivalent to an annuity
An annuity can be considered equivalent to a future value
A lump sum can be considered equivalent to a future value www.irfanullah.co 46 Ordinary annuity with A = 10 r = 5% and N = 5 PV = 43.29 0 1 2 3 4 5 FV = 55.26 Lump sum = PV = 43.29 7.5 The Cash Flow Additivity Principle www.irfanullah.co 47 Amounts of money indexed at the same point in time are additive 0 1 2 3 Summary 1. Interest Rates
2. Future Value
3. Present Value
4. Solving for Rates, Number of Periods, or Size of Annuity Payments