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Background
PV analysis: PV = C1 /(1 + r)
observations:
PV analysis and FV analysis both yield the same
conclusion; the difference is only the time at which the cash
flows are compared
NPV also gives the same conclusion (A and B cost the
same, so we are really just comparing their PVs)
AFM 271 - Time Value of Money Slide 5
Cont’d
PV analysis:
FV analysis:
NPV analysis:
Cont’d
compound interest: interest earned on original
principal and on previously earned interest
FV after 1 yr = C0 × (1 + r)
FV after 2 yrs = C0 × (1 + r) × (1 + r)
..
.
n terms
z }| {
FV after n yrs = C0 × (1 + r) × (1 + r) × · · · × (1 + r)
= C0 × (1 + r)n
other examples:
text p. 85: Julius Caesar lent one penny to someone;
assuming 6% annual interest, what would be owed
on this loan 2,000 years later?
the island of Manhattan was purchased in 1626 for
the equivalent of $24; what would this amount be
worth in 2005, assuming 5% annual interest?
AFM 271 - Time Value of Money Slide 9
Cont’d
m×T
in the limit: limm→∞ 1 + m
SAR
= eSAR×T
this is called continuous compounding:
FV1 = $1 × e0.10 = $1.1052 EAR = 10.52%
why does EAR increase as compounding period decreases
(i.e. as compounding frequency increases)?
Cont’d
converting between compounding frequencies: e.g. 10%
compounded semi-annually is equivalent to what rate
compounded weekly?
time line:
... ...
C0 C1 C2 C3 Ck Cn
Cont’d
Summarizing to here:
simple interest: FV = C0 × (1 + n × r)
discrete compounding/discounting:
SAR mT CT
FVT = C0 × 1 + PV0 = mT
m 1 + SAR
m
CT
= C0 × (1 + r)n =
(1 + r)n
C0 = 0 C1 = C C2 = C C3 = C C4 = C C5 = C
PV of a perpetuity is
C C C
PV = + + +···
(1 + r) (1 + r)2 (1 + r)3
C
=
r
e.g. if r = 3%, find PV of a perpetuity paying $200/year:
Cont’d
0 1 2 3 4
PV of a growing perpetuity is
C C(1 + g) C(1 + g)2 C(1 + g)3
PV = + + + +···
(1 + r) (1 + r)2 (1 + r)3 (1 + r)4
C
=
(r − g)
AFM 271 - Time Value of Money Slide 18
Cont’d
Annuities
Cont’d
1 − (1 + r)−n
PV of annuity = C ×
r
AFM 271 - Time Value of Money Slide 22
Cont’d
(1 + r)n − 1
FV of annuity after n periods = C ×
r
exercise: use the formulas on slides 22 and 23 to verify
the calculations on slides 20 and 21
AFM 271 - Time Value of Money Slide 23
Cont’d
Cont’d
Cont’d
e.g. XYZ Fund will pay out distributions over next 10 years.
The first distribution, $80 per unit, will be paid out a year
from today. Subsequent distributions will grow at a rate of
8%. No further cash flow is expected once the ten
distributions have been paid out. Find the PV of one fund
unit (assume r = 11%).
AFM 271 - Time Value of Money Slide 29
Mortgages
find the monthly payment after the initial 5 year term, if the
interest rate changes to 8%