Lecture 2

Time Value of Money

Compounding and Discounting

Yexiao Xu

School of Management
The University of Texas at Dallas
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How Ready Is America to Retire?

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Outline
n What determines interest rate?
̶ Consumption allocation
n Time value of money
̶ Present Value versus Future Value
n Interest Rate Convention
̶ APR versus EAR
n Multiple Cash Flow Analysis
̶ Annuity
n Applications
̶ Mortgage, auto loan
n Investing for retirement
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2.1 What determines interest rate?
Consumption Allocation
n Why do we need financial markets?
̶ Allocate consumption as desired. (one function)
n Today’s income and desire may be different
Income Desire
̶ Ms. Patience $50,000 $10,000
̶ Ms. Impatience $50,000 $90,000
n What if there is tomorrow?
Tomorrow’s Income
̶ Ms. Patience $55,000
̶ Ms. Impatience $55,000
n Solutions:
̶ IOU: if Ms. Patience and Ms. Impatience are good friends
̶ Financial intermediaries
• There are costs and award to reallocate consumption
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2.1 What determines interest rate?
Reward and Cost
n Interest rate (Assume 10%)
̶ It is a cost for borrowers
̶ It is a reward for lenders
n Reward for Ms. Patience to wait
̶ Reward: $40,000 + $40,000*(10%) = $44,000
̶ Total consumption: $55,000 + $44,000= $99,000
n Cost to Ms. Impatience to consume early
̶ Cost: $40,000 + $40,000*(10%) = $44,000
̶ Total consumption: $55,000 – $44,000 = $11,000
n Reallocated Consumption:
Today Tomorrow
̶ Ms. Patience $10,000 $99,000
̶ Ms. Impatience $90,000 $11,000
n But what determines the rate?
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2.1 What determines interest rate?
The Effect of Changing Interest Rate
$tomorrow
Slope of budget constraint
$110 = - (1+r)
99 P

$55 Y Decrease r

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I
$ today
10 $50 90 $100

n The Impact of interest rates on consumption:

̶ r decrease: Ms Patience ß Ms. Impatience Ý
̶ r increase: Ms Patience Ý Ms. Impatience ß
n Who sets the interest rate?
̶ Individual will not impact the interest rate
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2.1 What determines interest rate?
The Equilibrium Interest Rate
r Demand
for Loan
$110
Supply
for Loan

r* L

r↑
r↑

$ Amount
m* $100

n Demand and supply of loan:

̶ Demand for loan: Ms Impatience
̶ Supply for load: Ms Patience
n The Equilibrium Interest Rate
̶ The interest rate at which the total demand for loans by
borrowers equals the total supply of loans by lenders
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 2.2 Time Value of Money
Time Value of Money
n Accounting
̶ Recording economic activities
• Everything has to add up
̶ Reflecting the past truthfully
n Finance
̶ Most efficiently allocate money and create value
• Owning money posses opportunities
• Using money needs to pay costs
̶ It is about future not past!
n An important lesson in Finance
̶ A dollar earned tomorrow is not equivalent to a dollar
today, or
̶ Dollars cannot be added over time in Finance!!!
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 2.2 Time Value of Money
Time Value of Money
n The future value of money
̶ A dollar today is worth more than a dollar tomorrow
0 FV1
Time
1
-P
• When giving up $P today, you’ll get back $FV1 tomorrow
• FV1 = P ´ (1 + r)
n The future value of money
̶ A dollar tomorrow is worth less than a dollar today
0 C
Time
1
PV
• If you have $C tomorrow, you can only consume $PV today
• PV =
C
(1+ r)
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 2.2 Time Value of Money
Future versus Present Value
n Future Value (FV) in T periods
̶ The future dollar amount (FV) in T periods that an initial
principal (P) will grow to given an interest rate (r)
̶ FVT = P ´ (1 + r)T
̶ A period can be a year, a month, … depending on interest rate
̶ This is also referred to as compounding
n Present Value (PV)—dollar value at time 0
̶ An equivalent dollar amount (PV) you can spend today if you
will receive a cash flow (C) in T periods given interest rate r
PV = C T = C´ 1 T
̶ (1+ r) (1+ r)
̶ This is also referred to as discounting
̶ r is also called discount rate
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 2.2 Time Value of Money
The Amazing Effect of Compounding

n Example:
If you are 20 and you get $10,000 from your rich
grandfather. You can either buy a used BMW today,
or invest in an IRA account that earns an annual rate
of 11%
̶ What is your total asset at age 65?
̶ Answer:
FV = 10,000*(1+11%)45= $1,095,302
n Lesson A: Compounding effect is tremendous
̶ It is the seventh wonder of the world!!!

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 2.2 Time Value of Money
The Rate of Return Matters!

n Example:
For the same problem as before, but the bank charge
you 1% fee. In other words, you only earn 10% from
your IRA account a year
̶ What will you get at age 65?
̶ FV=10,000*(1+10%)45 = $728,904
n Lesson B: 1% difference in interest rate makes
big difference!
̶ The SEC rule

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2.2 Time Value of Money
Can You Earn 11%: Reality Check
n Fact:
̶ One dollar in small stocks in 1926 would have
become $6,402 in 2000
• $6402 = $1*(1+r)75 Þ r = 12.4% per year
̶ One dollar in large stocks in 1926 would have
become $2,587 in 2000
• $2587 = $1*(1+r)75 Þ r = 11.05% per year
n Other example of Compounding:
̶ Earning (or dividend)
̶ Populations
̶ Sales, and Productions
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 2.2 Time Value of Money
Discounting
n The process of finding the equivalent present value of
future cash flows (dollars) is called discounting
n Equivalent to what?
̶ After paying the cost of being impatient
• The other party will be rewarded for being patient
̶ After paying the cost to avoid being exposed to uncertainty
• The other party will be rewarded for risk bearing
• We do not consider this effect for now
n The concept of discounting is crucial in finance
̶ Project valuation
̶ Security valuation
n Sometimes we refer discounting as considering the
effect from adverse factors
̶ Failure of FDA approval of a drug
̶ Consumers dislike a new product
̶ Regulations, etc
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 2.2 Time Value of Money
A Discounting Example
n Example:
Four years ago when you just entered a college, your
parents were preparing your education abroad, which
will cost $45,000. If they can earn 10% a year from an
investment, how much do they need at that time?
̶ PV= $45,000 / (1.10)4 = $30,736
̶ What if they started when you were in high school (8 years
ago)?
• PV= $45,000 / (1.10)8 = $20,993

n Lesson C: Starting early

̶ It’s never too early to save

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2.2 Time Value of Money
Why Do We Need to Save More?
Tuition Inflation

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 2.2 Time Value of Money
The Rule of 72
n Manipulating the Formula:
̶ FVT = P ´ (1 + r)T
n Finding interest rate (or growth rate)
̶ (FVT/P) = (1 + r)T Þ r = (FVT/P)1/T-1
n How many years (T)?
̶ (FVT/P) = (1 + r)T Þ T = log(FVT/P)/log(1+r)
n Rule of 72 in finance
̶ Question: It takes how many years to double your
investment?
̶ Answer: number of years * interest rate » 72
̶ Example: At a rate of 7.2%, you can double your
principle in 10 years (72 / 7.2 = 10 )
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 2.3 Interest Rate Convention
Interest Rate Quoting Convention
n What if interests are paid over different horizon?
̶ How to compare?
n There are two different ways to quote interest rate
̶ Annual Percentage Rate (APR)
• The interest that you are going to get in each subperiod (a
month, a quarter, or every six months)
Example: a 6% CD on a monthly basis è0.5% each month
• Some times it is also called the stated rate or quoted rate
• As a convention, these rates are quoted as if they were annual
rates è0.5%*12 = 6%
̶ Effective Annual Rate (EAR), also called APY
• Interest for a whole year (compounding effect)
Example: REAR = ( 1+.5%)12-1= 6.17% > 6%
• It is also called annual yield
n They are the same thing but are quoted differently
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 2.3 Interest Rate Convention
Converting Between the Two Rates
n Converting from APR to EAR
̶ REAR = (1+ RAPR/m)m –1
̶ m is the number of periods in a year
̶ For the same APR, the larger the m, the higher the EAR
# of Periods EAR
Year 1 10.0000%
Quarter 4 10.38129
Month 12 10.47131
Week 52 10.50648
Day 365 10.51558

n Converting from EAR to APR

̶ RAPR = [(1+ REAR)1/m –1]*m
̶ m is the number of periods in a year
n FYI: By law, in consumer lending, the rate that must be
quoted on a loan agreement is Annual Percentage Rate (APR)
̶ It allows people to quickly figure out interest each period
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 2.3 Interest Rate Convention
Interest Rate on Different Bases
n The interests quoted on different securities are usually
on different bases:
̶ annual basis -- Eurobond, consol
̶ semi-annual basis -- corporate bond
̶ quarterly basis -- stock dividend
̶ monthly basis -- mortgage, CD
n Example: What is the semiannual bond equivalent
yield for a CD with 6% interest (monthly basis)?
̶ Step 1: calculate the annual equivalent rate (EAR)
REAR = ( 1+6%/12)12-1 = 6.17%
̶ Step 2: find the semiannual bond equivalent yield (APR)
which will yield the calculated annual rate
RAPR = [(1+6.17%)1/2-1]*2 = 3.039%*2 = 6.078%
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2.4 Present and Future Values for Multiple Cash Flows
Future Value of Multiple Cash Flows
C1 C2 C3 CT-1 CT

PV FV

n Convention: Period 0 is the beginning of the1st period

n Future Value of above cash flows
̶ Compute future value for each cash flow
̶ Add up all the future values
̶ FV = C1(1+r)T-1 + C2(1+r)T-2 + …+ CT
n Example: r=10%
0 1 2 3
Time
82 91 100
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2.4 Present and Future Values for Multiple Cash Flows
Present Value of Multiple Cash Flows
C1 C2 C3 CT-1 CT

PV FV

n Present Value for multiple cash flows

̶ Compute present value for each cash flow
̶ Add up all the future values
̶ PV = C1 + C2 2 ++ CT T
1+ r (1+ r) (1+ r)
n Example: r = 10%
0 1 2 3
Time

110 121 133

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 2.4 Present and Future Values for Multiple Cash Flows
Perpetuity
n Discounting is simple but tedious
̶ Simplification for special cases
n Perpetuity
C C C C

PV

̶ Constant stream of cash flows without end

̶ PV = Cr ,
p i.e. C1 = C2 = . . . = C
n Example: British consol
̶ A British consol that pays £1 coupon (cash) each year. At a
5% discount rate, how much would you willing to pay?
̶ PV = 1 / 5% = £20

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2.4 Present and Future Values for Multiple Cash Flows
Growing Perpetuity
C C(1+g) C (1+g)2 C(1+g)3

PV

n Unending stream of cash flows growing at a rate g

̶ C1=C, C2=C(1+g), C3= C(1+g)2, C4 = C(1+g)3, …
̶ PV = rC
GP
-g
• g is the grow rate of cash flow (like your pay raise), which is
different from the discount rate r
• We must have: g<r (Why?)
• The cash flow occurs starting one period from now
n Example
̶ Common Stock
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 2.4 Present and Future Values for Multiple Cash Flows
Annuity Formula
C C C C C
n Annuity: level stream of
fixed payments that lasts
T
for a fixed number of periods
PV
n Present value annuity
é ù
C
̶ PV = r ê1-
ê 1 ú
A

ëê (1+ r)T úûú

̶ Intuition: PV = C - C ´ 1
r r (1+ r)T
n Future value annuity
̶ FV = PV ´(1+ r)T = C
FA A
é
r êë(1 + r)T -1ù
úû

̶ Intuition: FV = C
r ´ (1+ r) T -C
r

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 2.4 Present and Future Values for Multiple Cash Flows
Growing Annuity Formula
n Growing Annuity: a fixed number of periods of
payments that grow at a constant rate g
n Present Vale growing annuity
̶ PV = C êê1-
é
(1+ g) Tù
ú
GA
r - g ê (1+ r) T úú
êë úû
n Future Vale growing annuity
̶ FV = PV ´(1+ r)T = r - C é(1+ r)T - (1+ g)T ù
FGA GA
g êë úû

n Special case
̶ When T → ∞, we need g < r

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2.4 Present and Future Values for Multiple Cash Flows
PV versus Annuity
n Remember
̶ Annuity is for multiple cash flows!!!
̶ PV is for a single cash flow
n Annuity occurs in the future
̶ Example: Your new employer offers you a pension of a
20-year annuity of $5000 per year, payable when you retire
at age 65. How much does it cost to the company if you are
20 now
• Step 1: find the present value of the pension at age 65
é ù
• PV65 = 5000 ê1- 1 ú = $42 ,560
10% ë (1+10%) úû
ê 20

• Step 2: discount to today

• PV20 = 42,560 / (1+10%)45 = $584

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 2.5 Applications
Is It Worth To Buy A Lottery?
n Example: Mrs. Lucky has spent $20 each month to buy
lottery ticket for the past 20 years. Suppose she has a
very good chance (1%) to win the $1 million Texas
state lottery which pays him $50,000 a year for the next
20 years. Assuming interest rate is 12%
̶ If she wins, what will she actually get in today’s value?
• We need to compute the present value as,
$50 ,000 é 1 ù
PV0 = ê1- ú = $373,472
12% êë (1+12%)20 úû
• The expected payoff = 1%*$373,472 + 99%*$0 = $3,735
̶ How much would she have gotten if invested?
• Relative to the past 20 years, today is “future” :
FV0 = $20 éê(1+1%)20 *12 -1ùú = $19,785
1% ë û

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2.5 Applications
Car Loan

n SALE! SALE!
n3%* FINANCING OR $500 REBATE
FULLY LOADED MUSTANG

nonly $16,999

*3% APR on 36 month loan.

n

nTF Banks are making 6% car loans, should you

choose the 3% financing or $500 rebate?

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 2.5 Applications
Car Loan (cont’d)
n Answer: Assuming no down payment and a 36
month loan
̶ Bank: PV = $16,999 - 500 = $16,499,
• r = .06/12, t = 36
é ù
$16,499 = C ê1- 1 ú
0.06 /12 ë (1+ 0.06 /12) úû
ê 36

• C = 501.93
̶ 3% APR: PV = $16,999,
• r = .03/12, t = 36
é ù
$16,999 = C ê1- 1 ú
0.03 /12 ë (1+ 0.03 /12) úû
ê 36

• C = 494.35

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 2.5 Applications
Figuring out Your Mortgage
n You just bought a new house at $200,000. You put
20% down. Your bank is offering you a 30-year
mortgage at 7.2% APR. What will be your monthly
payment?
̶ Total amount of loan=$200,000*.8=$160,000
̶ Monthly interest rate=7.2%/12=0.6%
̶ Number of periods=12*30=360
n Mortgage structure
̶ The total amount of loan is paid down by the same amount
each month—interest versus principle
̶ Mortgage payment: C=$1086.06
é ù
$160,000 = C ê1 - 1 ú
0.6% êë (1+ 0.6%)360 úû
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2.5 Applications
Mortgage Payment Schedule
n How much money will bank make?
Beginning Interest Principal Total Ending
Month Balance Payment Payment Payment Balance
1 160,000.00 960.00 126.06 1,086.06 159,873.94
2 159,873.94 959.24 126.82 1,086.06 159,747.12
… … … … … …
358 3,219.47 19.32 1,066.74 1,086.06 2,152.73
359 2,152.73 12.92 1,073.14 1,086.06 1,079.58
360 1,079.58 6.48 1,079.58 1,086.06 0.00
Total 230,982.01 160,000.00 390,982.01

- You’ll mostly pay interest at the beginning

- Your payments are mainly for principal at the end
- Bank makes $230,982 >> $160,000
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2.5 Applications
What Does a 1% Difference Make?
n What would happen if your bank lower your
interest rate by 1%?
Beginning Interest Principal Total Ending
Month Balance Payment Payment Payment Balance
1 160,000.00 826.67 153.28 979.95 159,846.72
2 159,846.72 825.87 154.08 979.95 159,692.64
… … … … … …
358 2,909.73 15.03 964.92 979.95 1,944.82
359 1,944.82 10.05 969.90 979.95 974.91
360 974.91 5.04 974.91 979.95 0.00
Total 192,782.13 160,000.00 352,782.13

- A saving of $38,200 in interest payment!

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2.6 Retirement Investment
Investing for Retirement
n You get 100% Social Security benefits when turning 67
̶ You can collect social security benefit at 62 at a permanently
reduced rate, and maxed out at 70
̶ Social Security is not enough
n You need to investing a small amount each month
̶ The total amount in an investment account when retire is the
Future Value of an Annuity
̶ The IRA investment (limit $6,500 in 2023)
• Pretax dollar: Traditional IRA
• After-tax dollar: Roth IRA
̶ The 401K plan (limit $22,500 as of 2023)
• Pretax dollar
• The idea of “dollar averaging”

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2.6 Return and Risk
S&P 500 from 2000 to 2020

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2.6 Retirement Investment
How Much to Save?
n Historical return:
̶ The average stock market return from 1926 to1998 is 13%
̶ It is around 10% since then
n The 4% Rule
̶ Financial advisors believe that the amount of money one can
spend after retirement is: 4% x Total Savings
n Example: (How Much Should You Invest to Retire? )
If you want to spend $80,000 a year when retire in 35 years,
how much money do you have to put away each year?
̶ According to the 4% rule, you need $2 million to retire
̶ Assume interest rate=13%, how much do you need to invest
every year?
FV = C éê(1+ r )T -1ùú Þ $2,000,000 = C éê(1+ 0.13)35 -1ùú
rë û 0.13 ë û

̶ You need to save C = $3658.44 per year

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2.6 Retirement Investment
Things to Watch in Applying Annuity
n The first payment is due today
̶ Example: If you’ve just won a state lottery & the
payment begin today, what is the PV?
• Now a 19-year annuity + 1 payment today
n Different frequency
̶ Example: If you have $25,000 credit card debt with and
effective annual interest rate of 18%. Your new year
resolution is to get ride of the debt by paying $500 each
month. How long does it take to be debt free?
• Step 1: compute the monthly discount rate
RAPR=((1+18%)1/12 -1)*12 = 16.67% Þ rm =RAPR/12= 1.39%
• Step 2: apply the annuity formula
o $25,000=($500/0.0139)[1-1/(1+0.0139)T] è T=86 month or 7.2 years

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