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=
ExampleFuture Value of an
Annuity
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 32
.
Present Value of an Annuity
C = equal cash flow
The discounting term is called the present
value interest factor for annuities (PVIFA).
You can also refer to Present Value Annuity
table for calculating the present value of
annuity
( ) { }
(
+
=
r
r
C PVA
t
1 1/ 1
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 33
.
Example 1
You will receive $1 000 at the end of each of
the next ten years. The current interest rate is
6 per cent per annum. What is the present
value of this series of cash flows?
( ) { }
360.10 $7
7.3601 000 $1
0.06
1.06 1/ 1
000 $1 PVA
10
=
=
(
=
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 34
.
Example 2
You borrow $10 000 to buy a car and agree
to repay the loan by way of equal monthly
repayments over four years. The current
interest rate is 12 per cent per annum,
compounded monthly. What is the amount
of each monthly repayment?
( ) { }
$263.33
37.97 000 $10
0.01
1.01 1/ 1
000 $10
48
=
=
(
=
C
C
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 35
.
Perpetuities
The future value of a perpetuity cannot be
calculated, as the cash flows are infinite.
The present value of a perpetuity is calculated
as follows:
where C is cash flow
and r is rate.
r
C
= PV
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 36
.
Comparing Rates
The quoted or stated interest rate is the
interest rate expressed in terms of the
interest payment made each year.
The effective annual interest rate (EAR) is
the interest rate expressed as if it was
compounded once per year.
When interest is compounded more
frequently than annually, the EAR will be
greater than the quoted interest rate.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 37
.
Calculation of EAR
1
m
Rate Quoted
1 EAR
m
+ =
m = number of times the interest is compounded
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 38
.
Comparing EARS
Consider the following interest rates quoted
by three banks:
Bank A: 8.3%, compounded daily
Bank B: 8.4%, compounded quarterly
Bank C: 8.5%, compounded annually
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 39
.
Comparing EARS
8.50% 1
1
0.085
1 EAR
8.67% 1
4
0.084
1 EAR
8.65% 1
365
0.083
1 EAR
1
C Bank
4
B Bank
365
A Bank
=
(
+ =
=
(
+ =
=
(
+ =
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 40
.
Comparing EARS
Which is the best rate? For a saver, Bank B
offers the best (highest) interest rate. For a
borrower, Banks A and C offer the best (lowest)
interest rates.
The highest quoted interest rate is not
necessarily the best.
Compounding during the year can lead to a
significant difference between the quoted
interest rate and the EAR, especially for higher
rates.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 41
.
Annual Percentage Rate (APR)
The interest rate charged per period
multiplied by the number of periods
per year.
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
1
m
APR
1 EAR
m
+ =
m = number of times the interest is compounded
.
Types of Loans
An interest-only loan requires the borrower to
only pay interest each period, and to repay
the entire principal at some point in the
future.
An amortised loan requires the borrower to
repay parts of both the principal and interest
over time.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 43
.
Amortisation of a Loan
Year Beginning
Balance
Total
Payment
Interest
Paid
Principal
Paid
Ending
Balance
1 $5000.00 $1285.46 $450.00 $835.46 $4164.54
2 $4164.54 $1285.46 $374.81 $910.65 $3253.89
3 $3253.89 $1285.46 $292.85 $992.61 $2261.28
4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33
5 $1179.33 $1285.46 $106.13 $1179.33 $0.00
Totals $6427.30 $1427.30 $5000.00
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 44
.
Quick Quiz Part I
What is the difference between simple interest
and compound interest?
Suppose you have $500 to invest and you
believe that you can earn 8% per year over the
next 15 years.
How much would you have at the end of
15 years using compound interest?
How much would you have using simple
interest?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 45
.
Quick Quiz Part II
What is the relationship between present
value and future value?
Suppose you need $15 000 in 3 years. If you
can earn 6% annually, how much do you
need to invest today?
If you could invest the money at 8%, would
you have to invest more or less than at 6%?
How much?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 46
.
Quick Quiz Part III
What are some situations in which you might
want to know the implied interest rate?
You are offered the following investments:
You can invest $500 today and receive
$600 in 5 years. The investment is low
risk.
You can invest the $500 in a bank
account paying 4%.
What is the implied interest rate for the
first choice, and which investment should
you choose?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 47
.
Quick Quiz Part IV
When might you want to compute the
number of periods?
Suppose you want to buy some new
furniture for your family room. You currently
have $500, and the furniture you want costs
$600. If you can earn 6%, how long will you
have to wait if you dont add any additional
money?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 48
.
Comprehensive Problem
You have $10 000 to invest for five years.
How much additional interest will you earn if
the investment provides a 5% annual return,
when compared to a 4.5% annual return?
How long will it take your $10 000 to double
in value if it earns 5% annually?
What annual rate has been earned if $1 000
grows into $ 4 000 in 20 years?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 49
.
Summary and Conclusions
For a given rate of return, the value at some point in the
future of an investment made today can be determined by
calculating the future value of that investment.
The current worth of a future cash flow or series of cash
flows can be determined for a given rate of return by
calculating the present value of the cash flow(s) involved.
It is possible to find any one of the four components
(PV, FV, r, t) given the other three.
A series of constant cash flows that arrive or are paid at the
end of each period is called an ordinary annuity.
For financial decisions, it is important that any rates are
converted to effective rates before being compared.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 50