Chapter 4: Time Value of Money

Objective
Explain the concept of compounding and discounting and to provide examples of real life applications
1 Copyright, 2000 Prentice Hall Author Nick Bagley, bdellaSoft, Inc.

Value of Investing $1
Continuing in this manner you will find that the following amounts will be earnt:

1 Year 2 Years 3 Years 4 Years

$1.1 $1.21 $1.331 $1.4641

2

Value of $5 Invested
More generally, with an investment of $5 at 10% we obtain
1 Year 2 years 3 years $5*(1+0.10) $5.5*(1+0.10) $6.05*(1+0.10) $5.5 $6.05 $6.655 $7.3205
3

4 Years $6.655*(1+0.10)

Future Value of a Lump Sum

FV = PV * (1 + i )
3,500

FV with growths from -6%to +6% Future Value of $1000

3,000

6%

2,500

2,000

4%

1,500

2% 0% -2% -4% -6%

0 2 4 6 8 10 12 14 16 18 20

1,000

500

Years

Example: Future Value of a Lump Sum

Your bank offers a CD with an interest rate of 3% for a 5 year investments. You wish to invest $1,500 for 5 years, how much will your investment be worth?

FV = PV * (1 + i )

= $1500 * (1 + 0.03) 5 = $1738 .1111145

n i PV FV Result
5

5 3% 1,500 ? 1738.911111

Present Value of a Lump Sum

FV = PV * (1 + i )
n n

Divide both sides by (1 + i ) to obtain : FV n PV = = FV * (1 + i ) n (1 + i )

Example: Present Value of a Lump Sum

You have been offered $40,000 for your printing business, payable in 2 years. Given the risk, you require a return of 8%. What is the present value of the offer?

FV PV = (1 + i ) n 40,000 = (1 + 0.08) 2 = 34293 .55281 $34,293.55 today

7

Solving Lump Sum Cash Flow for Interest Rate

FV = PV * (1 + i ) n FV = (1 + i ) n PV FV n (1 + i ) = PV FV n i= 1 PV

Example: Interest Rate on a Lump Sum Investment

If you invest $15,000 for ten years, you FV i=n 1 receive $30,000. PV What is your annual 30000 10 = 1 = 10 2 1 = 2 1 return? 15000
1 10

= 0.071773463 = 7.18% (to the nearest basis point)

Review of Logarithms
The basic properties of logarithms that are used by finance are:

ln( x ) x

= x, x > 0

ln(e ) = x ln( x * y ) = ln( x) + ln( y ) ln( x ) = y ln( x)

y
10

Review of Logarithms
The following properties are easy to prove from the last ones, and are useful in finance

ln( x / y ) = ln( x) ln( y ) ln( x * y * z ) = ln( x) + ln( y ) + ln( z ) ln( x + y ) ln( x) * ln( y )
11

Solving Lump Sum Cash Flow for Number of Periods

FV = PV * (1 + i ) n FV = (1 + i ) n PV FV ln = ln ((1 + i ) n ) = n * ln (1 + i ) PV FV ln PV = ln ( FV ) ln ( PV n= ln (1 + i ) ln (1 + i )
12

Effective Annual Rates of an APR of 18%

Ana n ul Pr e t g ec na e rt ae 1 8 1 8 1 8 1 8 1 8 1 8 Fe u n yo r qec f C mo n in o pud g 1 2 4 1 2 5 2 35 6 An a nul Ef civ R t f e t e ae 1. 0 80 1. 1 88 1. 5 92 1. 6 95 1. 8 96 1. 2 97

13

The Frequency of Compounding

Note that as the frequency of compounding increases, so does the annual effective rate What occurs as the frequency of compounding rises to infinity?
km m EFF = Lim 1 + 1 = e k 1 m m
14

The Frequency of Compounding

k 1 + EFF = 1 + m m 1 km m 1+ = (1 + EFF ) m
m

k m = m * (1 + EFF ) 1
1 m

15

The Frequency of Compounding

Ana nul E etv Rt f ci e a f e 1 2 1 2 1 2 1 2 1 2 1 2 1 2 Cm ud g o p ni o n Feuny r qec 1 2 4 1 2 5 2 35 6 I fny n i i t Ana nul Pr et g ec n e a Rt a e 1. 0 2 0 1. 6 1 6 1. 9 1 4 1. 9 1 3 1. 5 1 3 1. 3 1 3 1. 3 1 3

16

Derivation of PV of Annuity Formula: Algebra. 1 of 5

pmt pmt PV = + + 1 2 (1 + i ) (1 + i ) pmt pmt pmt ++ + 3 n 1 n (1 + i ) (1 + i ) (1 + i )
17

Derivation of PV of Annuity Formula: Algebra. 2 of 5

1 1 PV = pmt *{ + + 1 2 (1 + i ) (1 + i ) 1 1 1 ++ + } 3 n 1 n (1 + i ) (1 + i ) (1 + i )

18

Derivation of PV of Annuity Formula: Algebra. 3 of 5

1 1 PV * (1 + i ) = pmt * (1 + i ) *{ + + 1 2 (1 + i ) (1 + i ) 1 1 1 ++ + } 3 n 1 n (1 + i ) (1 + i ) (1 + i )

19

Derivation of PV of Annuity Formula: Algebra. 4 of 5

PV * (1 + i ) = pmt *{ 1 1 + + 0 1 (1 + i ) ( 1 + i ) 1 1 1 1 1 ++ + +[ ]} 2 n2 n 1 n n (1 + i ) (1 + i ) (1 + i ) (1 + i ) (1 + i ) 1 1 = pmt * + pmt *{ + 0 1 (1 + i ) (1 + i ) 1 1 1 1 1 ++ + + } pmt (1 + i ) 2 (1 + i ) n2 (1 + i ) n1 (1 + i ) n (1 + i ) n
20

Derivation of PV of Annuity Formula: Algebra. 5 of 5

1 1 PV * (1 + i ) = pmt * + PV pmt 0 n (1 + i ) (1 + i ) 1 PV * (1 + i ) + PV = pmt pmt n (1 + i ) 1 pmt *{1 } n (1 + i ) = pmt * 1 1 PV = n i i (1 + i )
21

PV of Annuity Formula

pmt *{1 PV = i

1 } n (1 + i )

pmt 1 = * 1 (1 + i ) n i

22

PV Annuity Formula: Payment

PV =

pmt 1 * 1 (1 + i ) n i

pmt n = * 1 (1 + i ) i PV * i pmt = n 1 (1 + i )

23

PV Annuity Formula: Number of Payments

pmt n PV = * 1 (1 + i ) ; i

PV * i n = 1 (1 + i ) pmt

(1 + i )

PV * i PV * i = 1 ; n * ln (1 + i ) = ln1 pmt pmt PV * i ln1 pmt PV * i = 1 ; n= pmt ln (1 + i )

(1 + i ) n

24

Annuity Formula: PV Annuity Due

PVdue = PVreg * (1 + i ) pmt n *{1 (1 + i ) } * (1 + i ) i pmt 1 n = *{(1 + i ) (1 + i ) } i =

25

Derivation of FV of Annuity Formula: Algebra

pmt 1 PV = * 1 (1 + i ) n (reg. annuity) i FV = PV * (1 + i ) (lump sum)
n

FV =

pmt 1 n * (1 + i ) * 1 i (1 + i ) n

pmt n = * (1 + i ) 1 i

26

FV Annuity Formula: Payment

pmt n FV = * (1 + i ) 1 i FV * i pmt = n (1 + i ) 1

27

FV Annuity Formula: Number of Payments

pmt n FV = * (1 + i ) 1 i FV * i n 1+ = (1 + i ) pmt

FV * i ln (1 + i ) = n * ln (1 + i ) = ln1 + pmt FV * i ln1 + pmt n= ln (1 + i )

n 28

Perpetual Annuities / Perpetuities

Recall the annuity formula:
PV = pmt 1 * 1 (1 + i ) n i

Let n -> infinity with i > 0:

pmt PV = i
29

Mortgage: The payment

We will examine this problem using a financial calculator The first quantity to determine is the amount of the loan and the points
L oan =$500000 * (1 0.1) =$450 ,000 P oints =$500000 =$13 ,500
30

* (1 0.1) * 0.03

Calculator Solution
n i PV FV PMT ? Result -2,697.98

360 0.5% 450,000 0

This is the monthly repayment

31

Calculator Solution
n i PV FV PMT ? Result -2,697.98 418,745

360 .5% 450,000 0 300 .5% ?

0 -2,697.98

Outstanding @ 60 Months
32

Summary of Payments
The family has made 60 payments = $2687.98*12*5 = $161,878.64 Their mortgage repayment = 450,000 - 418,744.61 = $31,255.39 Interest = payments - principle reduction = 161,878.64 - 31,255.39 = $130,623.25
33

Amortization of Principal
450000.00 400000.00 350000.00

Outstanding Balance

300000.00 250000.00 200000.00 150000.00 100000.00 50000.00 0.00 0 24 48 72 96 120 144 168 192 216 240 264 288 312 336 360

Months

34

After Tax Cash Flow

$2,900 $2,700 $2,500 Month $2,300 $2,100 $1,900 $1,700 $1,500 0 24 48 72 96 120 144 168 192 216 240 264 288 312 336 360 Monthly Cash Flow

35

Percent of Interest and Principal

100% 90% 80% 70%

% Interest

Percent

60% 50% 40% 30% 20% 10% 0% 0 24 48 72 96 120 144 168 192 216 240 264 288 312 336 360

% Principal

Months

36

10% Aditional Payments

500000 450000 400000

Principal Outstanding

350000 300000 250000 200000 150000 100000 50000 0 0 24 48 72 96 120 144 168 192

Months

37

216

240

264

288

312

336

360

Time

U.S.A.
$10,000

Japan
0.01 $/
1,000,000

10% $/$ (direct)

3% /

$11,000

? $/

1,030,000

38

Time

U.S.A.
$10,000

Japan
0.01 $/
1,000,000

10% $/$ (direct)

3% /

$11,124 $11,000

0.0108 $/

1,030,000

39

Time

U.S.A.
$10,000

Japan
0.01 $/
1,000,000

10% $/$ (direct)

3% /

$10,918 $11,000

0.0106 $/

1,030,000

40

Time

U.S.A.
$10,000

Japan
0.01 $/
1,000,000

10% $/$ (direct)

3% /

$11,000 $11,000

0.01068 $/

1,030,000

41