CHAPTER 4: TIME VALUE OF MONEY

A. OVERVIEW Motivation: Which one would you choose: $100 now or $100 ten years later? Why? Definition: Time value of money refers to the belief that a dollar now is worth more than a dollar that will be received at a later time Terms: Present value: Bring the future dollar amount to the present by discounting Future value: Bring the present dollar amount to a reference point in the future by compounding B. FUTURE VALUE: ONE LUMP SUM Definition: Compound interests are interests earned on a principal and become part of the principal at the end of each period Definition: Future value is the value of the present amount by applying and adding compound interests over a specified period of time I. Warm-up question: Simple interest Example 1: Suppose Diana lends $100 to Michael. Interest is calculated as simple interest at an annual rate of 8%. What is the future value (FV1) of $100 after 1 year? Example 2: Suppose Michael borrows for 2 years. Find FV2. II. Compound interest Example 3: Suppose Michael borrows for 2 years, at an annual interest rate of 8%, compounded annually. Find FV2. Example 4: What about n years? General formula: Future value, one lump sum, with compound interest FVn = PV * (1+k)n Example 5: Find the future value of $100 after 30 years, compounded at an annual rate of 8 percent. Example 6: What if $100 compounded semi-annually at an annual interest of 8% for 2 years? General formula: Future value, one lump sum, with compound interest compounded frequency m FVn = PV * (1+k/m)n*m Example 7: Find the future value of $100 compounded quarterly at an annual rate of 8% for 10 years. Formula for continuous time: FVn = PV * exp{k*n} Example 8: Find the future value of $100 compounded continuously at an annual rate of 8% for 10 years. Formula for effective annual rate: EAR = (1+k/m)m - 1

Interpretation: EAR can be viewed as the annual interest rate that would result in the same FV as using the nominal rate. Example 9: Find EAR associated with an 8% annual interest rate, compounded annually, semiannually, quarterly. Formula: Annual % rate Annual % rate = periodic rate * number of periods in a year Example 10: A monthly interest rate of 1 percent gives an annual percentage rate of 12%. Formula: Real interest rate 1+real rate = (1+nominal rate)/(1+inflation rate) Real rate ~ nominal rate inflation rate Example 10b: Interest rate on 1-year government borrowing was 2.6%. Inflation was 1.5%. What is the real rate of interest? C. FUTURE VALUE: ANNUITY Definition: An annuity is a stream of equal annual cash flow a. Ordinary annuity: cash flow occurs at the end of each period b. Annuity due: cash flow occurs at the beginning of each period Definition: A mixed stream is a stream of cash flow of unequal amounts over a period of time I. Ordinary Annuity Manual approach: Example 11: Find the future value of an ordinary annuity of $100 for 5 years. Use an annual interest rate of 8%. Formula: future value of an ordinary annuity FVAn = PMT * FVIFAk,n (ordinary)

FVIFAk ,n = (1 + k )
t =1

t 1

(1 + k )n 1 = k

Example 13: Find FVAn of an ordinary annuity of $100 at an interest rate of 8% for 10 years. II. Annuity due Formula: future value of an annuity due FVAn = PMT * FVIFAk,n (annuity due)

FVIFA k , n = (1 + k )
t =1

(1 + k )n 1 = * (1 + k ) k

Example 14: Suppose the future value of an ordinary annuity of $100 is $615.4, compounded at an annual interest rate of 7% for 5 years. What is the future value if it is an annuity due?

D. PRESENT VALUE: ONE LUMP SUM Definition: Present value is the current dollar value of a future amount Definition: Discounting as a method to bring the future value back to the present Example 15 Suppose Michael has an opportunity to receive $100 next year. Michael currently earns an annual interest of 7% on his investments. What is the maximum amount that Michael is willing to pay for receiving the $100 next year? Example 16 What if the $100 is to be received after 2 years instead of 1 year? Formula: Present value, one lump sum

PVn = FV PVIFk ,n
PVIFk ,n = 1 (1 + k )n

Example 17 Find the present value of $4000, to be received 5 years from now, assuming an opportunity cost of 8%. E. PRESENT VALUE: ANNUITY AND MIXED STREAM Graphic approach: Example 18 Find the present value of a stream of annual cash-flow of $3000 for 4 years, at an interest rate of 6%. Formula: Present value, ordinary annuity

PVAn = PMT PVIFAk ,n

PVIFAk ,n =
t =1 n

(1 + k )t

1 1 (1 + k )n = k

Example 19 Find PVIFA7%,10 Formula: Present value, perpetuity

PVA =

PMT k

Example 20 Find the present value of a perpetuity of $800 at an interest rate of 8%. Question: What if the stream of cash flows consists of mixed values? Example 21 Find the present value of the following stream of cash flows, at an interest rate of 7%: Year end Cash flow 1 100 2 3 4 5 200 300 300 100

Example 22 Suppose interest rate is 10%. Is the PV10%,5 higher or lower than PV7%,5? Why? Note: In the case of an embeded annuity, you may want to separate the cash flows into two categories: the embeded annuity and the mixed flow. You can calculate the PV for the two categories separately and then add them up to get the total PV. F. SPECIAL APPLICATION (OPTIONAL) Example 23 Savings A $350,000 house requires a 30% down-payment. You have 3 years to save at an annual interest rate of 3%. How much do you need to save per month? Example 24 Loan amortization Suppose you borrow $10,000 and the loan is amortized over 3 years at an interest rate of 7%. What is the annual payment? Construct a payment schedule (amortization schedule). Example 25 Annual interest rate (compounded) Suppose Diana borrows $15000 to be repaid in 5 years with an annual payment of $5000. What is the interest rate? Example 26 Growth rate of cash flows Fine the annual growth rate. Year Cash flow 1 2 3 4 5 1250 1300 1371 1440 1520

Summary

NOTE THAT OUR NOTATIONS FOR FVA, FVIFA, PVA, PVIFA ARE DIFFERENT FROM THOSE USED BY THE TEXT BOOK!