Time value of money

Week 6
Solve problem
• 4-16
• 4-17
• 4-18
Perpetuities
• Annuities whose payments continue for a specific number of periods
—for example, $100 per year for 10 years.
• Some securities promise to make payments forever like British govt
bonds named “consols”.
• Any bond that promises to pay interest perpetually is called a consol,
or a perpetuity.
• E.g. The interest rate on the consols was 3.5%, so a consol with a face
value of $1,000 would pay $35 per year in perpetuity.
UNEVEN, OR IRREGULAR, CASH
FLOWS
• E.g. the dividends on common stocks are typically expected to
increase over time, and investments in capital equipment almost
always generate cash flows that vary from year to year
• There are two important classes of uneven cash flows:
(1) those in which the cashflow stream consists of a series of annuity
payments plus an additional final lump sum in Year N, and
(2) All other uneven streams.
Annuity Plus Additional Final Payment
• Stream 1 that it is a 5-year, 12%, ordinary annuity plus a final payment
of $1,000. We can find the PV of the annuity,
 Stream 1:

Step 1: Calculate PV of annuity $100 by using above formula;

Step 2: Calculate PV of final payment of $1000 by using PV= FV / (1+i)N
Step 3: Sum up the results of step 1 & step 2
Spread sheet
• Similarly, we could use Excel’s PV function,
•
=PV(I,N,PMT,FV) = PV(0.12,5,100,1000)
= −$927.90
Practice questions: annuity plus one
additional payment
1. What is the present value of a 5-year ordinary annuity of $100 plus
an additional $500 at the end of Year 5 if the interest rate is 6%?
2. How would the PV change if the $100 payments occurred in Years 1
through 10 and the $500 came at the end of Year 10 if the interest
rate is 6%?
 Irregular or uneven cashflow Stream

• PV= CF / (1+i)n
• Pv1 = 100 / (1+0.12)1 = 89.29
• PV2 = 300/ (1+0.12)2 =239.1629
• Pv3= 300/(1+0.12)3 =213.53
• PV4 = 300/ (1+0.12)4 = 190.66
• PV5= 500 /(1+0.12)5 =283.71
Now , sum-up each of the PVs of CF stream (1016.35)
Practice question uneven stream
• What is the present value of the following uneven cash flow stream:
$0 at Time 0, $100 at the end of Year 1 (or at Time 1), $200 at the end
of Year 2, $0 at the end of Year 3, and $400 at the end of Year 4—
assuming the interest rate is 8%?
 Irregular Cash Flow Stream: Financial
calculator

• Draw the timeline first:

• Using financial calculator, we will calculate PV of uneven cashflow:
• Press CF, CF0=0 press 0 and ENTER press , CF1 enter number(100)
press ENTER,
• Press twice to reach CF2 repeat the steps till u reach last check point
• After entering CF5=500 press NPV screen will show “I” (interest) write
interest (%) and press screen will show NPV press CPT to get answer
i.e. $1016.35
Using Financial Calculator

• Use F01 option for year 2 3 & 4 (frequency)

• Enter data press NPV, set I press arrow down button
(Showing NPV on screen) then press CPT button
To clear memory of CF
• Press CF button then 2nd CE/C
Spreadsheet stream 2
• Use function of NPV
• =NPV(rate, value1, value 2….)
Calculating FV of annuity plus additional
payment stream 1
• Step by step approach
FVAN = PMT( 1+i) N-t
Calculating FV of annuity plus additional
payment stream 1
• Use FVA formula for PMT constant payments

• Add the additional payment as it is because it is paid at the end of the

period when term is completed.
FV of Annuity plus additional payment:
financial calculator
• Step one calculate PV
• Step 2: n=5 i/y= 12, PV= -927.90, pmt=0 CPT FV= 1635.28
Calculating FV of annuity plus additional
payment stream 1: Spreadsheet approach

• Step 1: Calculate PV of annuity plus FV by using following

function
=PV( rate,nper,PMT,FV)
• Step 2: use PV answer to compute FV by using FV function
i.e.
=FV(rate,nper,PMT,PV)
Calculating FV of Uneven Stream
Future value of uneven stream
FV1 = CF1 * (1+0.12)5-1 = 157.35
FV2 = CF2 * (1+0.12)5-2 = 421.47 • FVAN = PMT( 1+i) N-t
FV3 = CF3 * (1+0.12)5-3 = 376.32
FV4 = CF4 * (1+0.12)5-4 = 336.00
FV5 = CF5 * (1+0.12)5-5 = 500
Finding FV of uneven stream: Using
Financial calculator
• To calculate FV of uneven stream firstly you need to calculate NPV by
using CF option in Financial calculator.
• And after that in 2nd step you will use TVM options to enter data i.e.
n=5, I/Y= 12, PV= -1016.35, PMT= 0, CPT FV
Spreadsheet: Excel
• Find NPV by using NPV function, i.e.
=NPV(rate, value 1, value 2,…..) press enter
• Compound NPV to find NFV by using FV function i.e
• = FV(rate,nper,pmt,-NPV)
• =FV(0.12,5,0,-1016.35)
Problem 4-7: solve by formula
• An investment will pay $100 at the end of each of the next 3 years,
$200 at the end of Year 4, $300 at the end of Year 5, and $500 at the
end of Year 6. If other investments of equal risk earn 8% annually,
what is this investment’s present value? Its future value?
• PV=CF/(1+i)N
• FV=CF*(1+i)n-t
Amortization
• A loan that is to be repaid in equal amounts on a monthly, quarterly, or
annual basis is called an amortized loan.
• For example, suppose a company borrows $100,000, with the loan to be
repaid in 5 equal payments at the end of each of the next 5 years. The
lender charges 6% on the balance at the beginning of each year. find the
amount of the payment, PMT, such that the sum of their PVs equals the
amount of the loan,i.e. $100,000:
PMT can be calculated by using following
formula

100,000 = PMT [1/0.06 -1 / 0.06(1 +0.06) 5

100,000 = PMT [4.21185]
100,000 / 4.21185 =PMT
PMT= 23742
To solve we need to calculate PMT firstly:
Use financial calculator or spread sheet to calculate PMT

• With Excel, you would use the PMT function: =PMT(I,N,PV,FV)

= PMT(0.06,5,100000,0) = −$23,739.64
• Each payment of PMT will consist of two parts—part interest and part
repayment of principal. This breakdown is shown in the amortization
schedule
Practice question
• A company borrows $100,000, with the loan to be repaid. The lender
charges 6% on the balance at the beginning of each year. If the loan
were amortized over 5 years with 60 equal monthly payments, how
much would each payment be, and how would the first payment be
divided between interest and principal?
Problem 4-20: part a & b
a. Set up an amortization schedule for a $25,000 loan to be repaid in
equal installments at the end of each of the next 5 years. The interest
rate is 10%.

b. How large must each annual payment be if the loan is for $50,000?
Assume that the interest rate remains at 10% and that the loan is still
paid off over 5 years.
Problem 4-20: part a
• With a financial calculator, enter N = 5, I/YR = 10, PV = -25000, and FV
= 0, and then press the PMT key to get PMT = $6,594.94
4-20: Part b
• Here the loan size is doubled, so the payments also double in size to
$13,189.87:
• enter N = 5, I/YR = 10, PV = -50000, and FV = 0, and then press the
PMT key to get PMT = $13,189.87.
4-30: part 1
• Your company is planning to borrow $1 million on a 5-year, 15%,
annual payment, fully amortized term loan. What fraction of the
payment made at the end of the second year will represent
repayment of principal?
• First, find PMT by using a financial calculator: N = 5, I/YR = 15, PV = -
1000000, and FV = 0. Solve for PMT = $298,315.55.
Home practice
• 4-14: uneven cash flows (PV)
• 4-15 : calculate Interest rate using financial calculator
• 4-25 calculate N using financial calculator