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Chapter Two: How To Calculate Present Values
Chapter Two: How To Calculate Present Values
Chapter Two: How To Calculate Present Values
Presentation Agenda
Key
Interest
discount factor:
Decreases as time increases
The farther away a cash flow is, the more we
discount it
Decreases as interest rates increase
When interest rates are high, a dollar today is
worth much more than that same dollar will be in
the future
6
Calculate
Goals
$100
today - or
$100 one year from today
Sooner
is better !
Basic Definitions
Present
rate
Cost of capital
Opportunity cost of capital
**** Required return ****
General Formula
FV
= PV(1 + r)N
FV
= future value
PV = present value
r = period interest rate, expressed as a decimal
T = number of periods
PV= FV/1+in
Simple Interest
Example:
Invest $1,000 today for a five-year term and
receive 8 percent annual simple interest.
Value (tim e n) P (n P k)
Value 5
$1,000 (5 $1,000 .08)
$1,000 (5 $80)
$1,000 $400
$1,400
Compound Interest
Example :
Invest $1,000 today for a five-year term and
receive 8 percent annual compound interest.
How much will the accumulated value be at
time 5?
Future Value P ( 1 k)n
FV1 P (1 .08)1 $1,080
FV2 P (1 .08)(1 .08) P (1 .08) 2 $1,166.40
FV3 P (1 .08)(1 .08)(1 .08) P (1.08) 3 $1,259.71
FV4 P (1.08)(1.08)(1.08)(1.08) P (1.08) 4 $1,360.49
FV5 P (1 .08) 5 $1,469.33
Present value
Present
If we know the present value, the future value and the number of time
periods, we can calculate the rate of return we have earned
For example, suppose we invested $5,000 six years ago Today, it is
worth $10,000. What is the annually compounded rate of returned?
FVn = PV0
k =
1 k
FVn
PV0
1
n
10, 000
5, 000
12.25%
1
6
FVn = PV0
FVn
PV
0
ln 1 k
ln
n=
40, 000
25, 000
ln 1.08
ln
6.11 years
$100
$100
$100
Annuity Due
0
$100
$100
$100
$100
Assume that we want to save $2,000 at the end of each year for the
next 10 years. If we can earn 10% on our investments, how much
will we have saved?
FVOrdinary
Annuity
1 k
1
= PMT
10
1.10 1
2, 000
0.10
$31, 874.85
n
FVAnnuity
Due
1 k
1
= PMT
1 k
1.10 10 1
2, 000
1.10
0.10
$35, 062.33
n
You have just won a lottery. The Lottery Corporation gives you two
options. You can take $1,000,000 at the end of each year for 25
years or a lump sum of $10,000,000 today. If the appropriate
discount rate is 10%, what should you do?
PVOrdinary
Annuity
1 1 k
= PMT
1 1.10 25
1, 000, 000
0.10
Lets continue with the example from the previous page, but
now the Lottery Corporation gives you the option of taking
$1,000,000 at the beginning of each year for 25 years or a
lump sum of $10,000,000 today. If the appropriate discount
rate is 10%, what should you do?
PVAnnuity
Due
1 1 k n
= PMT
1 k
1 1.10 25
1, 000, 000
1.10
0.10
C
C
(
1
g
)
C
(
1
g
)
P
V
(1P
rV
)
rgr
2
23
Growing Perpetuity
C(1+g)
C (1+g)2
.P
$
1
3
0
V
5$26.0
$1.30(1.05)
$1.30 (1.05)2
QR
1 1
m
Where:
kEffective = Effective annual interest rate
QR = the quoted interest rate
M = the number of compounding periods per year
k Effective
QR
1 1
m
.06
1
12
6.17%
12
$2,500
PMT
($2,500 .06)
$833.33 $150.00
$983.33
The END