LECTURE 05

THETIMEVALUEOFMONEY
INSTRUCTOR SLIDES
QUANTITATIVEMETHODS
Interest Rates
Interest rates can be thought of in three ways:
The minimum rate of return that we require to accept a payment at a later date.
The discount rate that must be applied to a future cash flow in order to determine its
present value.
The opportunity cost of spending the money today as opposed to saving it for a certain
period and earning a return on it.
Interest rates are determined by the demand and supply of funds.
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Components of Interest Rates
Real risk-free rate - single-period return on a risk-free security assuming zero inflation.
Inflation Premium - added to the real risk-free rate to reflect the expected loss in
purchasing power over the term of a loan.
o The real risk-free rate plus the inflation premium equals the nominal risk-free rate.
Default Risk Premium - compensates investors for the risk that the borrower might fail
to make promised payments in full in a timely manner.
Liquidity Premium - compensates investors for any difficulty that they might face in
converting their holdings readily into cash at their fair value.
Maturity Premium - compensates investors for the higher sensitivity of the market values
of longer term debt instruments to changes in interest rates.
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4
EffectiveAnnual Rates Example
Assume the stated annual rate is 12%
2
4
12
12
i = =6 m =2
2
EAR =1.06 1 =12.36%
12
i = =3 m =4
4
EAR =1.0
Semiannual Compounding
Quarterly Compounding
M



3 1 =12.55%
12
i = =1 onthly Compound m =12
12
EAR =1
ing
.01

1 =12.68%
Future Valueof a Single Cash Flow
Drawing up time lines will help candidates avoid careless mistakes when handling TVM
questions. A general time line for the future value concept looks like this:
If we wanted to determine the future value after 15 periods, the PV and FV would be
separated by a future value factor of (1 +r)
15
, where r would be the interest rate
corresponding to the length of each period.
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Future Valueof a Single Cash Flow
Example:
Calculate the FV of $750 at the end of 12 years if the annual interest rate is 7%.
Solution
PV =-750; I/Y = 7; N = 12; CPT FV FV = $1,689.14
Example:
Calculate the value after 20 years of an investment of $500, which will be made after 7
years. The expected annual rate of return is 8%.
Solution
PV =-500; I/Y = 8; N = 13; CPT FV FV = $1,359.81
Note: The investment will earn interest for 13 periods
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Present Valueof a Single Cash Flow
Calculating the present value involves determining the value in todays terms of a cash flow
or cash flow stream that will be received in the future.
Remember:
For a given discount rate, the longer the time period till the future amount is received,
the lower the present value.
For a given time period, the higher the discount rate, the lower the present value of the
amount.
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Present Valueof a Single Cash Flow
Example:
Given a discount rate of 10%, what is the PV of a $1,500 cash flow that will be received in 6
years?
Solution
FV =-1,500; I/Y = 10; N = 6; CPT PV PV = -$846.71 (ignore the negative sign)
Example:
What is the present value of a cash flow of $1,200 that will be received in 15 years if the
discount rate is 8%?
Solution
FV =-1,200; I/Y =8; N =15; CPT PV PV = -$378.29 (ignore the negative sign)
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FV and PV of Series of Cash Flow
An annuityis a finite set of level sequential cash flows.
Ordinary Annuities
An ordinary annuity is an annuity where the cash flows occur at the endof each
compounding period.
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Future Valueof an Ordinary Annuity
Example:
What is the future value after ten years of seven $1,000 payments to be received at the end of
each of the first 7 years assuming that the interest rate is 4%?
Solution
Step 1: Find the value of this 7 year annuity at the end of Year 7:
N =7; I/Y=4; PMT=-$1,000; CPT FV FV
7
=$7,898.29
Step 2: Find the future value at t =10 of FV
7
:
N =3; I/Y=4; PMT=0; PV
7
=-$7,898.29; CPT FV = FV
10
=$8,884.51
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Present Valueof an Ordinary Annuity
Example:
What is the present value of seven annual payments of $1,000 if the first payment will be
received after 4 years and the interest rate is 4%?
Solution
Step 1: Find the value of this 7 year annuity at the end of Year 3:
N =7; I/Y=4; PMT=-$1,000; CPT PV PV
3
=$6,002.05
Step 2: Find the value of PV
3
as of today:
N =3; I/Y=4; PMT=0; FV
3
=-$6,002.05; CPT PV = PV
0
=$5,335.80
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FV and PV of Series of Cash Flow
Annuities Due
An annuity due is an annuity where the periodic cash flows occur at the beginning of every
period.
Two ways to calculate the PV and FV of annuities due.
1. By setting the calculator in (BGN) mode and then inserting all the variables normally, or
2. Treating the cash flow stream as an ordinary annuity over N compounding periods, and
simply multiply the resulting PV or FV by (1 +periodic interest rate).
PV
Annuity Due
=PV
Ordinary Annuity
(1 +r)
FV
Annuity Due
=FV
Ordinary Annuity
(1 +r)
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Future Valueof an Annuity Due
Example:
What is the value at the end of Year 4 of an annuity that pays $500 at the beginning of each
of the next four years, starting today. Assume that the cash flows can be invested at an
annual rate of 8%?
Solution
N =4; I/Y=8; PMT=-$500; CPT FV
Annuity Due
=$2,433.30
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Present Valueof an Annuity Due
Example:
An investor expects to receive an annuity of $1,000 at the beginning of each year for 7 years.
The first payment will be received 3 years from today. At a 6% discount rate, what is this
annuity worth today?
Solution
Note: The calculations for this example have been performed in (END) mode.
Timeline:
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Present Valueof an Annuity Due
Solution (Contd.)
Step 1: Find the value of this 7-year annuity due at the end of Year 3:
N =7; I/Y =6; PMT =-$1,000; CPT PV PV
3-Ordinary Annuity
=$5,582.38
PV
3-Annuity Due
=PV
3-Ordinary Annuity
(1 +r) =$5,582.38(1.06) =$5,917.32
Step 2: Find the value PV
3
as of today PV
0
:
N =3; I/Y =6; FV =-$5,917.32; CPT PV = PV
0
=$4,968.30
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Present Value of a Perpetuity
A perpetuity is a never ending series of level payments, where the first cash flow occurs in
the next period (at t =1).
Example: ABC Corporation pays a $10 per share annual dividend on its preferred stock.
Given a 5% rate of return and assuming that this dividend policy will continue forever, what
is the value of ABC stock? Also determine the rate of return an investor would realize if the
price of the stock were $250.
Solution
Value of ABCs preferred stock =PV
perpetuity
=$10/0.05 =$200
r =PMT / PV
perpetuity
=$10 / $250 =0.04 or 4%.
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PV and FV of Unequal Cash Flows
Recall that in an annuity, all cash flows were identical. When faced with a series of
unequal cash flows, you will have to
o Calculate the future value of each individual cash flow separately and then,
o Add up the future values.
Example:
Compute the future value, as of the end of Year 6, of the uneven cash flow stream illustrated
in the time line below. Assume that the periodic discount rate is 5%.
Time line:
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PV and FV of Unequal Cash Flows
Solution
The FV of the cash flow stream is calculated by first calculating the FV of each of the
individual cash flows, and then adding them up.
FV
1
: PV =-$1,500; I/Y = 5; N = 5; CPT FV FV
1
=-$1,914.42
FV
2
: PV =-$500; I/Y =5; N =4; CPT FV FV
2
=-$607.75
FV
3
: PV =$2,000; I/Y =5; N =3; CPT FV FV
3
=$2,315.25
FV
4
: PV =$0; I/Y =5; N =2; CPT FV FV
4
=$0
FV
5
: PV =$3,000; I/Y =5; N =1; CPT FV FV
5
=-$3,150
FV
6
: PV =$2,500; I/Y =5; N =0; CPT FV FV
6
=$2,500
FV of cash flow stream =Sum of individual future values =$5,443.08
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Compounding and Future Values
If interest payments are made monthly, the interest rate is not quoted on a monthly basis,
but is the stated annual interest rate.
This rate must be unannualizedto bring compatibility between the periodic interest rate,
I/Y, and the number of compounding periods, N.
Example: Compute the FV after 5 years of $5,000 invested at 13% assuming quarterly
compounding.
Solution
PV =$5,000; N =5 4 = 20; I/Y = 13/4 = 3.25; CPT FV; FV -$9,479.19
The future value can also be calculated as:
FV =$5,000 (1+0.0325)
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=$9,479.19
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Continuous Compounding and Future Values
In continuous compounding, the number of compounding periods is infinite, and the
expression for the FV of an amount after N years is given as:
Example:
Calculate the FV after 3 years of an investment of $5,000 at an interest rate of 7% assuming
continuous compounding.
Solution
FV =5,000 e
(0.07 3)
=$6,168.39
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Loan Payments and Amortization
Loan amortization is the process of retiring loan obligations through predetermined
equal monthly payments.
Each of these payments includes an interest component, which is based on the principal
balance outstanding at the beginning of the period, and a principal repayment
component.
The relative proportion of the payment that is attributable to the interest and principal
components changes with each payment.
o The principal repayment component increases with the passage of time.
o The interest payment component declines over time in line with thedecreasing
amount of principal outstanding.
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Loan Payments and Amortization
Example: Loan Payment Calculations with Monthly Payments
A company borrows $75,000 at a rate of 10%. The loan will be paid off through equal
monthly installments over three years. Calculate the monthly payment required to pay off the
loan.
Solution
The number of compounding periods (N) is now 36 (12 3), the periodic interest rate (I/Y)
equals 0.833% (10/12), the amount borrowed today (PV) equals $75,000 and the amount
outstanding at the end of the loan (FV) equals zero.
N =36; I/Y =0.833; FV =-$75,000; FV = 0; CPT PMT; PMT $2,420.04
The monthly payment that must be made in order to retire the loan in 36 months equals
$2,420.04
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Loan Payments and Amortization
Example: Computing the Number of Periods in an Annuity
J ack needs to accumulate at least $1,000 with annual deposits of $80 into his bank account.
If the annual interest rate is 10%, how many end-of-year payments are required?
Solution
FV =-$1,000; PMT =$80; I/Y =10; PV =0; CPT N; N 8.51 years.
Therefore, 9 deposits are needed to accumulate more than $1,000 in the bank account with
annual deposits of $80.
Example: Computing the Discount Rate for an Annuity
What rate of return will we earn on an ordinary annuity that requires a $900 deposit today
and promises to pay $150 at the end of every year for the next 10 years?
Solution
PV =-$900; PMT = $150; N = 10; FV = 0; CPT I/Y; I/Y 10.56%
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Funding a Retirement Plan
Example: Funding a Retirement Plan
Assume that 20-year old J anet wants to retire in 40 years at the age of 60. She expects to
earn 10% on deposits prior to retirement and 8% thereafter. How much must she deposit at
the end of each of the next 40 years in order to be able to withdraw $15,000 every year at the
beginning of each year for 30 years from the age of 60 to 90?
Solution
Step 1: Calculating the amount that must be held in the retirement account at the end of Year
40 in order to fund the 30 year, $15,000 annuity due.
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Funding a Retirement Plan
Solution (Contd.)
N=30; I/Y =8; PMT =-$15,000; CPT PV; PV
Ordinary Annuity
$168,866.75
Then computing the value of the annuity due:
$168,866.75 (1.08) =PV
Annuity Due
=$182,376.09
J anet will need $182,376.09 in her account when she is 60 years old.
Step 2: Now calculating the annual payment that J anet must start depositing to accumulate
$182,379.06 over 40 years till she is 60 years old.
N =40; I/Y =10; FV =-$182,376.09; CPT PMT; PMT $412.06
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The Cash Flow AdditivityPrinciple
The present value of any stream of cash flows equals the sum of the present values of the
individual cash flows.
If we have two streams of cash flows, the sum of the present values of the two streams at
any point in time is the same as the present value of the two series combined by adding
cash flows that occur at the same point in time.
The cash flow stream can also be divided in any desired manner, and the present value of
the pieces will equal the present value of the series.
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