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LN5 Financial Markets I

BNAD 301 Mario Samano

Compounding
Reinvesting the principal plus the interest
Suppose you invest $1,000 in a savings account @ 10% per year
What is the amount of money at the end of the …rst year?

1; 000 + 1; 000 10% = 1000 + 1000 0:1


= 1000 (1 + 0:1)
= 1000 1:1
= 1100:

Compounding means that you reinvest the money for another year:

1100 + 1100 10% = 1100 (1 + 0:1)


= 1100 1:1
= 1210:

Note that at the end of the …rst year you have

1000 1:1

and you reinvest that amount for another year. We get

(1000 1:1) 1:1 = 1000 1:12 = 1210:

If we reinvest for …ve years we will get the following

year starting amount interest earned ending amount


1 $1000 $100.00 $1100
2 $1100 $110.00 $1210
3 $1210 $121.00 $1331
4 $1331 $133.10 $1464
5 $1464 $146.41 $1610

Some de…nitions:
P V =present value or beginning amount in your account. Here, it is $1000.
i =interest rate, usually expressed in percent per year. Here, it is 10% or 0.1
n =number of years the account will earn interest. Here, n = 5:
F V =future value at the end of n years. Here, F V = $1610:
Let’s do the same process (compounding) but in general.
Suppose at the beginning you have P V and you invest it at an interest rate of i: How much money do
you have at the end of n years?
At the end of the …rst year you have
P V (1 + i)
this is in our example 1000 1:1
We reinvest this amount of money again at the same interest rate we will get at the end of the second
year:
(P V (1 + i)) (1 + i) = P V (1 + i)2
In our example this number was 1000 1:12

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We can reinvest this new amount of money for a third year to get

P V (1 + i)2 (1 + i) = P V (1 + i)3 :

This indicates that after n years we will get a future value of

F V = P V (1 + i)n :

In our example n = 5; so F V = 1000 (1:1)5 = 1610:51:

Some terminology
In some contexts, the term (1 + i)n is called total cumulative factor

FV = P V (1 + i)n
| {z }
total cumulative factor (TCF)

Also, if you calculate the rate of return this way:


…nal initial
rate of return = 100
initial

FV PV
= 100
PV
P V (1 + i)n PV
= 100
PV

= ((1 + i)n 1) 100


| {z }
total cumulative return (TCR)

we get the expression for the total cumulative return.

Reinvesting at a Di¤erent Rate


Suppose we believe that in the second year the interest rate will go up to 8%, then at the end of the second
year we will have
10; 600 (1 + 0:08) = 11; 448:
So if we have two di¤erent interest rates, say i1 and i2 , the future value equation looks like

F V = P V (1 + i1 )(1 + i2 )
which in our example this is i1 = 0:06 and i2 = 0:08

FV = 10; 000 (1 + 0:06) (1 + 0:08)


= 11; 448

Exercise
You have $10,000 to invest for two years. The bank o¤ers you two options
two-year CDs (certi…cates of deposit) at 7% per year, or
one-year CDs at 6% per year (the …rst year), the rate for second year is unknown.
What is the future value of option 1?
What has to be the value of the interest rate in the second year of option 2 so that its future value is the
same as in option 1?

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Doubling Time
Several questions can be answered using the equation F V = P V (1 + i)n :
Suppose that you begin with P V = 1 and you want to …nd the number of years you need so that at
i = 1% = 0:01 of interest per year, your 1 dollar becomes 2 dollars.
Namely, we want F V = 2 but we do not know the value of n:
Our formula looks now like
2 = 1 (1 + 0:01)n
= 1 1:01n
= 1:01n
and we want to solve for n:
This is easy, we can write in Excel a table to calculate di¤erent values for 1:01n by changing n and we
…nd the n such that 1:01n equals 2. This turns out to be n = 69:
What if we want to …nd the number of years so that 1 dollar becomes 2 dollars at an interest rate of 2%.
We can do it too in Excel by creating a column that computes the values 1:02n until we see the value of 2.
The formal way to solve for this equation is using logarithms.
Remember that the natural logarithm (base e) is de…ned as
log x := the number y such that ey = x
where e = 2:7182::: is a constant. So for example,
log e = 1
log e5 = 5
log 1 = 0:
The property of the function log that we need is
log ab = b log a:
Let us use this property to solve our previous equation
2 = 1:01n
using logarithm on both sides of the equation we get
log 2 = n log(1:01)
log 2
n =
log 1:01
= 69:66

Exercise
Suppose the CFO of the University puts $100,000 in an instrument that pays 0.5% at the end of each 6
months. Also, at the end of every six months, the principal and the interest are reinvested.
How much money will there be at the end of the 4th year?
How much time does it take to get $110,000?

F V = 100; 000 (1 + 0:005)8 = 104; 070:70


Here, F V = 110; 000 so
110; 000 = 100; 000 (1 + 0:005)n
dividing by 100,000 both sides and applying log to both sides of the equation
log(1:1) = n log(1 + 0:005)
log(1:1)
= n
log(1 + 0:005)
19:1 = n
so it would take at least 19 years and a half.

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Present Value and Discounting
How much money will we have in 10 years if we invest $1,000 today at an interest rate of 8%?
But now we will be interested in questions like: how much money to invest today SO THAT I have $1,000
in 1 year at an interest rate of 10%.
Present Value
Suppose we want to have $1,000 one year from now by putting some amount of money in a savings
account at 10% per year.
So we know that F V = 1000; i = 10% = 0:1 and n = 1:
Our present value equation becomes

F V = P V (1 + i)n
1000 = P V (1 + 0:1)1
1000 = P V 1:1

then we can solve for P V;


1000
PV = = 909:09
1:1
this means that if we deposit in a CD $909.09 at 10% per year, we will get $1000 at the end of one year

Present Value
Now, suppose that the $1000 are not needed until two years from now.
Would we need more or less than $909:09 ?
Now our equation looks like

F V = P V (1 + i)n
1000 = P V (1 + 0:1)2
1000 = P V 1:12

so we can solve for P V again


1000
PV = = 826:45
1:12
Calculating present values is called discounting. In general we can write
FV
PV = :
(1 + i)n

Exercise
Find the amount of money that you need to deposit in a CD (certi…cate of deposit) @ 20% such that you
get $10,000 in 5 years.
Same question for n = 1; 3; 7; and 9
Plot your results in a graph where the vertical axis is the amount of money you need to deposit today
and the horizontal axis is time.

Internal Rate of Return


Now suppose that we invest $75 and we get $100 …ve years from now.
Then what we know is that P V = 75; F V = 100 and n = 5:
We want to know the value of the interest rate that made this to happen.
In our equation for present value this looks like

F V = P V (1 + i)n
100 = 75 (1 + i)5

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so we can solve for i;
1
100 5
1+i= = 1:0592
75
so i = 1:0592 1 = 0:0592 = 5:92%:

In general we have
1
FV n
i= 1
PV
this is called the internal rate of return (IRR).

Annuities
Remember that we can solve for the present value as
FV
PV = ;
(1 + i)n

so for a given F V and an interest rate i we can know the present value for di¤erent values of n:
This can also be called cash ‡ow.
It should be clear that the cash ‡ow is di¤erent for each di¤erent value of n: Speci…cally, the larger n is,
the smaller the present value.
Often the future cash ‡ows in a savings plan, an investment project, or a loan repayment schedule are
the same each year. We call such a level stream of cash ‡ows or payments an annuity.

Future Value of Annuities


For example, suppose that you intend to save $100 each year for the next three years. How much will you
have accumulated at the end of that time if the interest rate is 10% per year?

FV = 100 1:13 + 100 1:12 + 100 1:1


= 364:10:

The key is to keep track of each of the di¤erent payments: not all of them earn the same interest because
they are deposited at di¤erent times.

Present Value of Annuities


Often we want to compute the present value rather than the future value of an annuity stream.
For example, how much would you have to put into a fund earning an interest rate of 10% per year to
be able to take out $100 per year for the next three years?
The answer is the present value of the three cash ‡ows:
100 100 100
PV = + +
1:1 1:12 1:13
= 248:69:

Annuities: Exercise
You win the lottery and you receive the prize in four payments of $20,000 each over the next four years.
Wells Fargo o¤ers you a CD in which you will save your four payments running @ 1.5% per year.
What is the actual value of your prize at the end of the four years? i.e. what is the future value of these
annuities?
Then you go to Chase and they o¤er you the same scheme but @2% per year. Would you expect the F V
to be greater or less than the one from the …rst o¤er? What is that value?

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Example: Mortgage Loan and Payments
Suppose you just decided to buy a house and need to borrow $100,000.
A bank o¤ers you a mortgage loan to be repaid over 30 years in 360 monthly payments (30 12 = 360).
If the interest rate is 12% per year, what is the amount of the monthly payment? (the monthly interest
rate is 12%/12=1%)
By payment we mean annuity, but in many applications we will …nd the word payment.
We want to …nd the amount of the monthly payment (the same at each of the 360 months) so that the
present value of the discounted sum of those payments equals $100,000.
If the payment per month is PMT, then
PMT PMT PMT PMT
$100; 000 = + + + ::: +
1:01 1:012 1:013 1:01360
1 1 1 1
= PMT + 2
+ 3
+ ::: +
1:01 1:01 1:01 1:01360
It turns out that
1 1 1 1
+ 2
+ 3
+ ::: + = 97:21
1:01 1:01 1:01 1:01360
then
$100; 000
PMT = = $1028:61:
97:21
So every month, for 30 years, you will have to pay $1028.61
Now you go to a second bank and they o¤er you the following deal: 15-year mortgage loan with a monthly
payment of $1,100. Is this a better deal?
Now we know PMT=$1,100 instead of interest rate.
So this payment is greater than $1028.61 but the mortgage is ended in half the time.
We can …nd the monthly internal rate of return implied by this second o¤er,
!
1 1 1 1
100; 000 = 1; 100 + + 3 + ::: +
(1 + i) (1 + i)2 (1 + i) (1 + i)
180

or simply
1 1 1 1
90:90 = + 2 + 3 + ::: + 180
(1 + i) (1 + i) (1 + i) (1 + i)
and we should try to solve for i:
We …nd i = 0:00867 = 0:867%:

Loan Amortization
Mortgage loans is an example of …xed payments every month
Part of each payment is interest on the outstanding balance of the loan and the other part is repayment
of principal.
after each payment, the outstanding balance is reduced by the amount of principal repaid.
Therefore, portion of payment that goes to the payment of interest decreases and the portion that goes
to the repayment of principal increases.

Loan Amortization: Example


You take a $100,000 home mortgage loan @ 9% per year to be repaid with interest in three annual install-
ments.
we want to know the payment to be made in each of the three years
this is equivalent fo …nd the payment over three years at 9% so that the P V is $100,000
PMT PMT PMT
100; 000 = + +
1:09 1:092 1:093
1 1 1
= PMT + 2
+
1:09 1:09 1:093

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it turns out that
1 1 1
+ + = 2:53
1:09 1:092 1:093
so
100; 000
PMT = = 39; 505:39
2:53

yr ini. balance payment interest paid principal paid balance


1 100,000 39; 505:39 9; 000:00 30; 505:39 69; 494:61
2 69; 494:61 39; 505:39 6; 254:51 33; 250:88 36; 243:73
3 36; 243:73 39; 505:39 3; 261:94 36; 243:73 0

Analysis of Investment Projects (Cost-Bene…t Analysis)


We are now begin to use the methods we have seen to calculate present values to give advice to …rms.
We are interested in a quantity called net present value (NPV) of a project.
This number is the amount by which it is expected to increase the wealth of the …rm’s current shareholders.
Stated as an investment criterion for the …rm’s managers, the NPV rule is: invest if the proposed project’s
NPV is positive.

Analysis of Investment Projects: Example


Generic Jeans Company, a manufacturer of casual clothing, is considering whether to produce a new line of
jeans called Ewa.
It requires an initial outlay of $100,000 for new specialized equipment.
The …rm’s marketing department forecasts that given the nature of consumer preferences for jeans, the
product will have an economic life of three years.

year (t) cash ‡ows (CFt ) in thousands of dollars


0 $100
1 $50
2 $40
3 $30

A negative sign in front of a cash ‡ow forecast for a particular year means a cash out‡ow.
To calculate the project’s NPV we need to specify the capitalization rate (k) (it is just an interest rate
with a special name)
So the project’s cost of capital or Net Present Value is the sum of all the cash ‡ows properly
discounted,
CF1 CF2 CF3
NPV(k) = CF0 + + 2
+
(1 + k) (1 + k) (1 + k)3
Let’s say that the interest rate is k = 8% = 0:08

yr (t) cash ‡ows (CFt ) in thousands present value of CFt


0 $100 $100
50
1 $50 1+0:08 = 46:29630
40
2 $40 (1+0:08)2
= 34:29355
30
3 $30 (1+0:08)3
= 23:81497
total = 4:40482

Since $4,404.82 is positive, project should be accepted.


Some remarks: The NPV depends on the forecasts and on the value of the interest rate.
The forecasting part is very di¢ cult and it is beyond the scope of this course.
However, we can analyze the change on the NPV by a change in the interest rate and the change in cash
‡ows.

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It is reasonable to think that for some value of k the NPV will be negative (the discount factor can be
very large so that the present value of the cash ‡ows cannot cover the initial investment).
Our goal is to …nd the interest rate k such that the NPV of the jeans project is 0:

year (t) cash ‡ows (CFt ) in thousands of dollars


0 $100
1 $50
2 $40
3 $30

Find the NPV for k = 6%; 8%; 10%; 11%, and 12%: Construct a table to exhibit your results.
Plot your results (k in the horizontal axis). What does the graph suggest to answer our main question
(where the NPV is 0)?
Use Excel’s Goal Seek tool to …nd the exact number.
Decision Making: Two Projects
We have two projects. Both have an initial outlay of $2,000.
The cash ‡ow structure of the two projects is

year Project 1 Project 2


1 $0 $2,000
2 $2,500 $200

Which project is better? i.e. which one has a higher NPV?


The answer will depend of the interest rate. The NPV for each of the two projects is

0 2500
N P V1 = 2000 + +
1 + k (1 + k)2
2000 200
N P V2 = 2000 + + :
1 + k (1 + k)2

Decision Making: Two Projects


Project 2 is most of the times better (has higher NPV) except when k = 0:05 = 5%: