10/10/2019 The Time Value of Money Learning Outcomes: Calcutate future values and understand ‘compounding Calculate present values and understand discounting. Calculate implied interest rates and waiting time from the time value of money equation. ‘Apply the time value of money equation using formula, calculator, and spreadsheet. Explain the Rule of 72, a simple estimation of doubling values. Future Value and Compounding Interest * The value of money at the end of the stated Period is called the future or compound value of that cum of money. “Determine the attractiveness of alternative investments Figure out the effect of Inflation on the future cost of assets, such as a car or a house. | Business Mathematics Business Mathematics10/10/2019 The Multiple-Period Scenario n FV = PVx (1+r) Example 2: If YOU close out your account after 3 years, how much money will you have accumulated? How” much of that is the Interest-on-interest component? What about after 10 years? Fu = #2001106)" #200"2.191016 = 6238.20, n interest = #238, 20 -P2O0 - 836 = #2.20, Methods of Solving Future Value Problems * Method 1: Formula Method ~Time-consuming, tedious * Method 2: Financial Calculator Method = Quick and easy ‘+ Method 3: Spreadsheet Method = Most versatile ‘= Method 4:Time Value Table Method = Easy and convenient but most limiting in scope {| Methods of Solving Future Value Problems Example 3: Compounding of Interest Let’s say you want to know how much money you will have accumulated in your bank account after 4 years, if you deposit all 5,000 of your high-school graduation gifts into an account that pays a fixed interest rate of 5% per year. You leave the money untouched for all four of your college years. Methods of Solving Future Value Problems example 3: Answer FTP 05,000(3.05)= 6,077.59 prev = 6077.59 Fv=6077.59 Time value table method! FV'= PPMP, 33, 4) = 8000"(1.215508) 6077.59, where (FIF St.) = Foture value interest factor sted under thes akin and nthe yea ow of te Future Vaue 66 PV=5,000; Type=o; Methods of Solving Future Value Problems. Example 4: Future Cost due to Inflation Let’s say that you have seen your dream house, which is currently listed at 300,000, but unfortunately, you are not in a position to buy it right away and will have to wait at least another 5 years before you will be able to afford it. If house values are appreciating at the average annual rate of inflation of 5%, how much will a similar house cost after 5 years? ‘Methods of Solving Future Value Problems: Example 4 (Answer) Py = current cost of the house = 83000 n= 5 years; F = average annual inflation rate = 5%, Solving for FV, using the Formula Method, we have Fv = #3000061 054 0514.05)0.05)1.08) = P300,000°(1.276: = 8382,884.5 So the house will cost B382,884.50 after 5 years10/10/2019 Methods of Solving Future Value Problems Calculator method: Pv=-300, Fv=0382,884'5 1/Y=5; PMT=0; CPT ‘Spreadsheet method: Rate=.05; Nper=5; Pmt=0; PV=-P300,000; Type =0; FV=8382,884.5 Time value table meth FV=PV(FVIF,S%,5)=300,000*(1.27628)=6362,884.5; where (FVIF, 56,5) = Future value interest factor listed under the 5% column and in the 5-year row of the future value of Fi table=1.276 Present Value and Discounting ‘Involves discounting the interest that would have been earned over a given period at a given rate of interest, + It ls therefore the exact opposite or inverse of calculating the future value of a sum of money. + Such calculations are useful for determining today’s Price or the value today of an asset or cash flow ‘hat will be received in the future. + The formula used for determining PV is as follows: PV=FVx 1/(1+r)? |g Single-Period Scenario When calculating the present value or discounted value of a future lump sum to be received one period from today, we are basically deducting the interest that would have been earned on a sum of money from its future value at the given rate of interest. PV = F/(1+r) since n = 1 00; r = 10%; and n =1; The Multiple-Period Scenario When multiple periods are involved... ‘The formula used for determining PV Is as follow: PV = FVx1/(1+r)? where the term in brackets is the present value interest factor for the relevant rate of interest and number of periods involved, and is the reciprocal of the future value interest factor (FVIF) a Present Value and Discoun Example 5: Discounting Interest Let’s say you just won a jackpot of 50,000 at the casino and would like to save a portion of it so as to have 40,000 to put down on a house after 5 years. Your bank pays a 6%. rate of interest. How much money will you have to set aside from the jackpot winnings? Present Value and Discounting Example 5 (Answer) FV = amount needed = ®40,000 N = 5 years; Interest rate = 6%; Using the °PV=FVx 1/(1+r)° + PV = 40,000 x 1/(1.06)5 + PV = 40,000 x 0.747258 + PV = 829,890.33 Amount needed to set aside todaybiel dietiel adn Present Value and Discounting PMT=0; cpr pv= 3nt=0; Fu=P40,000; Type=0; Time valye table PV = FV(PVIF, 6%, 5) = 40,000°(0.7473)=P29,802 where (PVIE, 66,5) = Present value interest factor listed under the 6% column and in the 5-year row of the Present Value of Pi tabie=0.7473, Using Time Lines + When solving time value of money Problems, especially the ones involving multiple periods and complex combinations it is always @ good idea to draw a time line and label the cash flows, interest rates and number of periods involved. Using Time Lines ‘Time tines of growth rates (top) and discount rotes {Gottom ilstrave presen va and fare valve Today Future date pv Present vale (1+ growth rte" = FY = fire value ae PV 11 dicount ate)® Applications of the Time Value of Money Equation * Calculating the amount of savings required One Equation and Four Variables Any time value problem involving lump sums-ie., 2 single outflow and a single inflow--requires the use of single equation consisting of 4 variables: Fv, PV, ©, If 3 cout of 4 variables are given, we can solve the ‘unknown one. FVPV x (14e)" eat pvaris TyasTOES Saving for retirement ‘Newo0 1 Using the equation 1 mnt x = ag = $2000 X O72 = SIBKAM ero0 2 Using the TYM keys Ipt ot 02a Oe ee) a =H Saving for retirement ik [inna ———— What's the cost of that loan? Problem joa, acage den elo boow $5,000 soi fib He apes py ick haan kp spent ie yas rom ‘ower ecto colge The bank ste hat ep sl adobe '$7,91276 abn bros he $540 fo te ack, what ces ie iagonbiloa? ‘Solution Aine ie bein hisinsane Sys & prasion MemreminestO) pyar What's the cost of that loan?10/10/2019 eo 2 Using te TH ays ee “J 9 9 9 9 or 30 When will I be rich? When will I be rich? Problem Yous gl eal Ty ot ics pss smi Using the equation th S704 Hig ed cpa ce reso elec hat you can cara 15% eer year on your pri, ou dont plano ‘n($1,90000/$3738.24) (267.8638) net ital ney hip Wo wba fn oe , eee ‘iho gown on Giver 1 mo orgs be ‘prove: maine Fineness pr ecalh Solution seetketnetine, ating pode pawn ERPBI yam When will I be rich?P ‘roblems and Luercises Joanna's Dad is looking to deposit a sum of money immediately into an account that pays an annual interest rate of 9% so that her 1° year college tuition costs are provided for. Currently, the average college tuition cost is P15,000 and is expected to increase by 4% (the average annual inflation rate). Joanna just turned 5 years old, and is expected to start college when she turns 18. How much money will Joanna’s Dad have to deposit into the account? KZA Problem 1 (Solution) ‘Step 1. Calculate the average annual college tuition cost when Joanna tums 18, i.e, the future compounded value of the current tuition cost at an annual increase of 4%. PV = -15,000; n= 13; 12496; PMI cpr Fv=P24, 976.10 v= P15,000 x (1.08)! 15,000 x 1.66507 24,976.10 Problem 1 (Solution) Step 2. Calculate the present value of the annual tuition cost using an interest rate of 9% per year. [FV = 24,976.10; n=13; 129%; PMT = 0; CPT PV = P8,146.67 on Pv = P24,976.10% (1/(1+0.09) = 24,97610% 0.92618 = 75,146.67 ‘50, Joanna's Dad will hve to deposit P8,146.67 into an account today so that she will have her first-year {ution coats provided for when she starts college a the ge off Problem 2 BPI offers to pay you a lump sum of P20,000 after 5 years if you deposit P9,500 with them today. BDO, on the other hand, says that they will pay you a lump sum of P22,000 after 5 years if you deposit P10,700 with them today. Which offer should you accept, and why? Problem 2 (Solution) ‘To answer this question, you have to calculate the rate of return that wil be earned on each investment and accept the ‘one that has the higher rate of retum. BPrs Offer PV = -P9,500; n=5; FV =P20,000; PMT = 0; CPT |= 16,054% oR Rate = (FVIPV)""- 1 = (P20,000/P9,500)"* 1 = 1.16054-1 = 16.058%Problem 2 (Solution) 00's offer PV=-P10,700 5: FV=P22,000; PMT =o: CPT i215 sa7% oR Rate = (FVIPyytin= 4 = 4.18507 —4 15.507% (P22,000/P10,700)15 + Decision YOU MUST Make: ‘You ‘should accept BPI's offer, since provides @ higher ‘annual rate of retum ie 18.05% Problem 3 You have decided that you will sell off your house, which is currently valued at P300,000, at a point when it appreciates in value to P450,000. If houses are appreciating at an average annual rate of 4.5% in your: neighborhood, for approximately how long will you be staying in the house? Leg Problem 3 (Solution) 230,000; FV = 450,000; I = 4.5%; PMT = 0; CPT n = 9.21 years or 9 years and 3 months oR In(EV/PV)I/fIn(4+i)] In(450,000/(300,000])/{In(1.045)] 40547 / .04402 = 9.21 years [EE Problem 4 Your arch-nemesis, who happens to be an marketing major, makes the following remark: “You finance types think you know it all..well, let's see if you can tell me, without using a financial calculator, what rate of return would an investor have to earn in order to double P100 in 6 years?” How would you respond? ig Problem 4 (Solution) Use the rule of 72 to silence him once and for all, and then prove the answer by compounding 2 sum of money at that rate for 6 years to show him how close your response was to the actual rate of return....hen ask him politely if he would like you to be his “lifeline” on "Who Wants to be 2 Millionaire?” Rate of return required to double a sum of money = 72/N = 72/6 = 12% Verification: P100(1.12)* = P197.38...which is pretty close to double Problem 4 (Solution) The accurate answer would be calculated as follows: PV = -100; FV = 200; n = 6; PMT = 0; I= 12.246% oR = (FV/PV)#/" - 1 = (200/100)/ 6 - 4 1.12246 -1 12246 or 12.246%Problem 5 Problem 5 (Solution) You want to save P25,000 for a down PeYMeP a CDeBoUse. BPI orrers ve | | aes Pay 9.35% per year if you deposit 7 PMT = 0; PY = -11,000; P11,000 with them, while BDO cfien Bee opmmagt Per year if you invest P10,000 with them. 200 How long will you have to wait to have the down payment accumulated Corns 11.558 years under each option? for Given Variable Match for Calculator and pana Time in Years Spreadsheet Int Rates