1

Lecture 2
TIME VALUE OF MONEY

Topic cover

2

Time lines/Present values/Future values
Simple Interest vs. Compound Interest Rate
Multiple cash flows
Perpetual cash flows
Ordinary Annuity/ Annuity Due cash flows
Inflation & Time value of Money
Effective interest rate
Mortgage loans



TIME VALUE OF MONEY





3
US$ 1 in hand
today is worth
more than US$ 1
received in the
future:
Uncer-
tainty Inflation
Interest earning,
compensation for
sacrificing
consuming today.
TIME LINES
Why should set up a time line?
- Visible
- Control and know the problems






The interval from 0 to 1, 1 to 2, etc. called periods, can be
years, quarters, months. 4
Periods
0 1 2 3
4
PV
FV
5
SIMPLE VS. COMPOUND INTEREST

Simple interest rate:
Interests just earn on initial investment, not on interests
received. The interest and principal after n periods is:




Where:
S: the amount of money received after n periods
P: the amount of money at the beginning
n: number of periods
r: interest rate of each period
6
S = P(1 + n*r)
SIMPLE VS. COMPOUND INTEREST (CONT.)

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years
1 2 3 4 5
Value 100
Interest Earned


7
6
106
6
112
6
118
6
124
6
130
Value at the end of Year 5 = $130
SIMPLE VS. COMPOUND INTEREST (CONT.)

Compound interest rate:
Interests earn on both principal and interests received. The
interest and principal after n periods is:





Where:
C: the amount of money received after n periods
P: the amount of money at the beginning
n: number of periods
r: interest rate of each period


8
C = P(1 + r)
n
SIMPLE VS. COMPOUND INTEREST (CONT.)

Example - Compound Interest
Interest earned at a rate of 6% for five years on the
previous years balance.

Today Future Years
1 2 3 4 5
Value 100

Interest Earned

9
6
106
6.36
112.36
6.74
119.10
7.15
126.25
7.57
133.82

Value at the end of Year 5 = $133.82
1
-
1
0

Assuming that the worth of $100 needs to be calculated
after 5 years at a 6% interest per year, we have:
1
st
year$100 X 1.06 = $106
2
nd
year...$106 X 1.06 = $112.36
3
rd
year$112.36 X 1.06 = $119.10
4
th
year$119.10 X 1.06 = $126.25
5
th
year.$1126.25 X 1.06 = $133.82
SIMPLE VS. COMPOUND INTEREST (CONT.)
11
PRESENT & FUTURE VALUE
12
If you invest $1,000 today and are promised
$1,200 in one year time

$1,000 is the present value (PV)

$1,200 is the future value (FV)

FUTURE VALUES
Future value: the amount to which a cash flow or series
of cash flows growing over time when compounded at a
given interest rate.




Where:
FV: the amount of money received after n periods
PV: the amount of money at the beginning
n: number of periods
r: interest rate of each period


13
n
n
r PV FV ) 1 ( + =
FUTURE VALUE (CONT.)
14
070 , 1 ) 07 . 0 1 (
1
= + = PV FV
0 1
$1,000, 7%
FV
1

0
$1,000, 7%
FV
2

1 2
145 , 1 ) 07 . 0 1 (
2
2
= + = PV FV
Future value after one year:
Future value after two year:
FUTURE VALUES (CONT.)
Peter Minuit bought Manhattan Island for $24 in
1626. Was this a good deal if we keep it until
2006 (means 380 years)? Assume compounded
interest rate is 8%

To answer, determine $24 is worth in the year
2006, compounded at 8%.






15
trillion
FV
57 . 120 $
) 08 . 1 ( 24 $
380
=
+ =
FYI - The value of Manhattan Island land is
well below this figure.
FUTURE VALUES (CONT.)

Future value of $100 at various interest rates
Number of
periods
5% 10% 15% 20%
1 $105.00 $110.00 $115.00 $120.00
2 $110.25 $121.00 $132.25 $144.00
3 $115.76 $133.10 $152.09 $172.80
4 $121.55 $146.41 $174.90 $207.36
5 $127.63 $161.05 $201.14 $248.83


16
FUTURE VALUES (CONT.)
17
r=0%
r= 5%
r=10%
r=20%
0 1 2 3 4 5 6
Periods
Future value of $100
100
200
300
400
500
PRESENT VALUE
Present value: the value today of a future cash
flow or series of cash flows




Where:
PV: the amount of money received after n periods
FV: the amount of money at the beginning
n: number of periods
r: interest rate of each period


18
n
n
r
FV
PV
) 1 ( +
=
PRESENT VALUE ILLUSTRATION
19
You wish to provide $100,000 for your newborn childs
college education in 18 years. How much do you need
to invest today if the interest rate is 6% p.a.?

035 , 35
) 06 . 1 (
000 , 100
) 1 (
18
= =
+
=
n
r
FV
PV
0 18
PV
100,000
PRESENT VALUE (CONT.)
Example
You just bought a new computer for $3,000. The
payment terms are 2 years same as cash. If you can
earn 8% on your money, how much money should you
set aside today in order to make the payment when due
in two years?






20
572 , 2 $
2
) 08 . 1 (
3000
= = PV
PRESENT VALUES (CONT.)
Present value of $100 at various interest rates
Number of
periods
5% 10% 15% 20%
1 $95.24 $90.91 $86.96 $83.33
2 $90.70 $82.64 $75.61 $69.44
3 $86.38 $75.13 $65.75 $57.87
4 $82.27 $68.30 $57.18 $48.23
5 $78.35 $62.09 $49.72 $40.19

21
PRESENT VALUES (CONT.)
22
r=0%
r= 5%
r=10%
r=20%
0 10 20 30
Periods
Present value of $100
20
40
600
80
100
INTEREST RATE

We have formula to calculate future value:



=> Determine interest rate as following:

23
r =
n
FV /PV - 1

n
n
r PV FV ) 1 ( + =
NUMBER OF YEARS




Determine number of years as following:


24
n = ln(FV/PV)/ln (1 + r)
We have formula to calculate future value:
n
n
r PV FV ) 1 ( + =
25
PRESENT VALUE OF MULTIPLE CASH FLOWS
Uneven cash flows occur at the end of each period: a
stream of cash flows where the amount varies from one
period to the next.
26
( )
n
r
Cn
r
C
r
C
PV
+
+ +
+ + + =
1
) 1 ( ) 1 (
....
2
2
1
1





Present Value (PV) of unenven cash flows: total
present value of each payment.
1 2 3
n
0
C
1
C
2
C
3
C
n
PVs can be added together to evaluate multiple cash flows.
PRESENT VALUE OF MULTIPLE CASH FLOWS (CONT.)
Example












27





A car dealer offers to sell you a car with the following deals:
Option 1: Pay cash $12,000
Option 2: $5,000 down and $4,000 at the end of each
year for the next two years
Which option is better, assuming that the current interest
rate on the market is at 5% p.a.?
0 2 1
5,000 4,000 4,000
438 , 12
05 . 1
000 , 4
05 . 1
000 , 4
000 , 5
2
= + + = PV
You prefer to choose option 1 because PV of this option is
smaller => you have to pay less
MULTIPLE CASH FLOWS (CONT.)
28
0 2 1
5,000 4,000 4,000
503 , 11
15 . 1
000 , 4
15 . 1
000 , 4
000 , 5
2
= + + = PV
Example
Similarly but now interest rate on
the market is at 15% p.a..
Option 1: Pay cash $12,000
Option 2: $5,000 down and
$4,000 at the end of each
year for the next two years

Which option is better?
You prefer to choose option 2 because PV of this option is
smaller => you have to pay less
FUTURE VALUE OF MULTIPLE CASH FLOWS
29
( )
0
2
2
1
1
1 ... ) 1 ( ) 1 ( r C r C r C FV
n
n n
+ + + + + + =


Future Value (FV) of unenven cash flows: total future
value of each payment.









FVs can be added together to evaluate future value of
multiple cash flows.

C1
3 2 1
C3 C2
...
n
Cn
30
PERPETUAL CASH FLOWS
31
...
) 1 ( ) 1 ( ) 1 (
3 2 1
+
+
+
+
+
+
=
r
C
r
C
r
C
PV
r
C
PV =
0
C
3 2 1
C C
...

-Perpetual cash flows: a stream of equal
payments expected to occur at the end of each
period forever.
PV OF PERPETUAL CASH FLOWS (CONT.)
Example - Perpetuity

Ex: You decide to endow a scholarship of $100,000
per year in perpetuity for your school. How much do
you need to donate if the university can earn a
return of 10% p.a. on the endowment?







32
PV = =
100 000
10
000 000
,
.
$1, ,
PV OF CONSTANT GROWTH PERPETUITY
33
...
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
3
2
2
1
1
+
+
+
+
+
+
+
+
=
r
g C
r
g C
r
C
PV
0
C
3 2 1
C(1+g)
2
C(1+g)
1

g r
C
PV

=
-Growing perpetual cash flows: series of equal
growing payments occur at the end of each period.

CONSTANT GROWTH PERPETUITY (CONT.)
34
667 , 666 , 1
04 . 0 10 . 0
000 , 100
=

=
g r
C
PV
0
100,000
3 2 1
108,160 104,000
After careful consideration, you decide that the scholarship you
endow at your school should keep pace with inflation, which is
expected to be 4% per year. How does this change the your
donated amount?
PV OF CONSTANT GROWTH PERPETUITY (CONT.)
Example Growing Perpetuity

The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever.

If the discount rate is 10%, what is the value of this
promised dividend stream?

35
00 . 26 $
05 . 10 .
30 . 1 $
=

= PV
36
WHAT IS AN ANNUITY?
37
An annuity is a series of regular equal cash flows, for
example:
$1,000 per month for 360 months,
$5,000 per year for 20 years.

Ordinary annuity: payments/receipts occur at the end
of each period (i.e. cash flows start 1 period from
today)

Annuity Due (Deferred annuity): payments/receipts
occur at the beginning of each period

ORDINARY ANNUITY
- Ordinary annuity: series of equal payments occur
at the end of each period.





Example Annuity
Example: starting one year from today, withdraw $500 each
year in 6 year from a saving account earning 6% p.a.
How much is your initial investment?









38
1 2 3
n
0
C C C C
PRESENT VALUE OF AN ORDINARY ANNUITY
39
Discounted 6 years
0 1 2 3 4 5 6
$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

Discounted 5 years
Discounted 2 years
Discounted 3 years
Discounted 4 years
Discounted 1 year
Contract date
( ) ( ) ( ) ( ) ( ) ( )
6 5 4 3 2 1
06 . 1 500 06 . 1 500 06 . 1 500 06 . 1 500 06 . 1 500 06 . 1 500

+ + + + + = PV
Starting one year from today, to withdraw $500 each year in 6
year from a saving account earning 6% p.a. How much is your
initial investment?
PRESENT VALUE OF AN ORDINARY ANNUITY
40
C
0
n 1 2
C C
...
...
note: this formula gives a value one period
before the first cashflow in the stream
(

+
=
n
r r
C
PV
) 1 (
1
1
PRESENT VALUE OF AN ORDINARY ANNUITY (CONT.)
41
A popular state lottery pays the winner $50,000 per
year for 25 years. If the first payment is made one
year from now, what is the cash value of the prize,
assuming an interest rate of 10% p.a.?

852 , 453
) 10 . 1 (
1
1
10 . 0
000 , 50
25
=
(

= PV
ORDINARY ANNUITY
Example Annuity
You are purchasing a car. You are scheduled to make 3
annual installments of $4,000 per year. Given a rate of
interest of 10%, what is the price you are paying for the
car (i.e. what is the PV)?









42
1 2
3
0
4,000
41 . 947 , 9 $
) 10 . 1 (
1
1
10 .
000 , 4
3
=
(

=
PV
PV
4,000 4,000
PRESENT VALUE OF AN ORDINARY ANNUITY
43
??? decides to fund a scholarship for IU students for the next
10 years of $300,000 per year. How much should he/she
donates today, if the school can earn 10% p.a.?

FUTURE VALUE OF AN ORDINARY ANNUITY
44
66 . 487 , 3 $
500 ) 06 . 1 ( 500 ) 06 . 1 ( 500 ) 06 . 1 ( 500 ) 06 . 1 ( 500 ) 06 . 1 ( 500
1 2 3 4 5
=
+ + + + + = FV
0 1 2 3 4 5 6
Contract
date
Not compounded
Compounded 1 year
Compounded 2 year
Compounded 3 year
Compounded 4 year
Compounded 5 year
$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

$
5
0
0

Starting one year from today, deposit $500 into bank
account every year for 6 years. If r = 6% pa, how much
is in the bank account after 6 years
FUTURE VALUE OF AN ORDINARY ANNUITY
(CONT.)
45
The future value of an annuity is:
C
0
n 1 2
C C
...
...
note: this formula gives a value at
the time of the last cashflow
(

+
=
r
r
C FV
n
n
1 ) 1 (
FUTURE VALUE OF AN ORDINARY ANNUITY
46
You plan to retire exactly 35 years from today with savings of
$2 million.

If the interest rate is 9% p.a., how much will you need to put
aside each year to reach your goal? Assume that your first
payment will occur next year and that you final payment will
occur in exactly 35 years?
C
0
35 1 2
C C
...
2m.
...
. 2
1 ) 09 . 0 1 (
35
35
m
r
C FV =
(

+
=
FUTURE VALUE OF AN ORDINARY ANNUITY (CONT.)
47
Suppose you save $4,000 per year for 20 years and then
retire.

Given the interest rate is 10% pa, how much will you have at
retirement

100 , 229
1 . 0
1 ) 1 . 0 1 (
000 , 4
20
=
(

+
= FV
ORDINARY ANNUITY (CONT.)
Example - Future Value of annual payments

You plan to save $4,000 every year for 20 years
and then retire. Given a 10% rate of interest, what
will be the FV of your retirement account?






48
100 , 229 $
10 . 0
1 ) 10 . 0 1 (
000 , 4
20
=
(

+
=
FV
FV
SUMMARY SO FAR
49
We have covered the four basic concepts we need:
n
n
r
FV
PV
) 1 ( +
=
Future Value Present Value
Single
Cashflow
Ordinary
Annuity
(

+
=
n
r r
C
PV
) 1 (
1
1
(

+
=
r
r
C FV
n
n
1 ) 1 (
n
n
r PV FV ) 1 ( + =
ANNUITY DUE
- Annuity due: series of equal payments occur at the
beginning of each period.




- Example Annuity Due
You are considering to buy a car. The seller agrees with
you to pay $10,000 in five equal annual payments at an
interest rate of 12%, how much is the car worth today if
you have to make the first payment immediately?




50
1 2 3
n
0
C C C C
C
ANNUITY DUE (CONT.)
Present Value of an annuity due:




Future Value of an annuity due:


or
51
PV due = PV
annuity
(1+r)

FV due = FV
annuity
(1+r)
or ) 1 (
) 1 (
1
1 r
r r
C
PV
n
+
(

+
=
) 1 (
1 ) 1 (
r
r
r
C FV
n
n
+
(

+
=
SUMMARY SO FAR
52
n
n
r
FV
PV
) 1 ( +
=
Future Value Present Value
Single
Cashflow
Ordinary
Annuity
Annuity
Due
(

+
=
n
r r
C
PV
) 1 (
1
1
(

+
=
r
r
C FV
n
n
1 ) 1 (
n
n
r PV FV ) 1 ( + =
) 1 (
) 1 (
1
1 r
r r
C
PV
n
+
(

+
=
) 1 (
1 ) 1 (
r
r
r
C FV
n
n
+
(

+
=
GROWING ORDINARY ANNUITY

- Growing ordinary annuity: series of equally growing payments
occur at the end of each period.




Where:

C
t
= C
t-1
x (1+g)
g: growth rate

Example:
- A defined-benefit retirement plan offers to pay $20,000 per
year for 40 years and increase the annual payment by 3%
each year. What is the present value at retirement if the
discount rate is 10%?




53
1 2 3
n
0
C
1
C
2
C
3
C
n
VALUE OF A GROWING ANNUITY
54
Present value of growing annuity





Future value of growing annuity
( )
( )
(

+
+

=
n
n
r
g
g r
C
PV
1
1
1
) (
( ) ( )
(

+ +
=
g r
g r
C FV
n n
1 1
GROWING ANNUITY DUE
Growing annuity due: series of equally growing
payments occur at the beginning of each period.



Where:
C
t
= C
t-1
x (1+g)
g: growth rate





55
1 2 3
n
0
C
1
C
2
C
3
C
0
n-1
C
n-1
VALUE OF A GROWING ANNUITY DUE
56
Present value of growing annuity





Future value of growing annuity
( )
( )
) 1 (
1
1
1 r
r
g
g r
C
PV
n
n
+
(

+
+

=
( ) ( )
) 1 (
1 1
r
g r
g r
C FV
n n
+
(

+ +
=
Nominal Interest rate
vs.
Effective Annual Interest Rates
(EAR)
57
INFLATION & TIME VALUE OF MONEY
Inflation - Rate at which prices as a whole are
increasing.

Nominal Interest Rate - Rate at which money
invested grows.

Real Interest Rate - Rate at which the purchasing
power of an investment increases.


58
1 + real interest rate =
1+nominal interest rate
1+inflation rate
INFLATION & TIME VALUE OF MONEY
Example
If the interest rate on one year govt. bonds is 5.0% and
the inflation rate is 2.2%, what is the real interest rate?


59
2.8% or .028 = .022 - .050 = ion Approximat
2.7% or .027 = rate interest real
1.027 = rate interest real 1
= rate interest real 1
+.022 1
+.050 1
+
+
EFFECTIVE ANNUAL INTEREST RATE

Annual Percentage Rate (APR) - Interest rate that
is annualized using simple interest or stated interest
rate


Effective (equivalent) annual rate (EAR): interest
rate is actually earned per year.


60
EFFECTIVE ANNUAL INTEREST RATE (EAR)
61
The Effective Annual Rate is the annually compounded
interest rate that is equivalent to the stated rate on the loan.






Where:
EAR = effective annual rate
r per = stated rate per period
r nom = annual percentage rate or annual stated rate
m = number of periods compounded in one year

( )
= + 1 1
m
per
EAR r
| |
= +
|
\ .
1 1
m
nom
r
EAR
m
EFFECTIVE ANNUAL INTEREST RATE (EAR) (CONT.)

Example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual Percentage
Rate (APR)?



62
12.00% or .12 = 12 x .01 = APR
12.68% or .1268 = 1 - .01) + (1 = EAR
r = 1 - .01) + (1 = EAR
12
12
COMPOUNDING FREQUENCY
63
What happens to the future value as the number of
compounding periods increases?
PV=1000, r
nom
=10%, time=2 years
Annual
( )
= + =
2
1000 1 .10 1210 FV

Quarterly

| |
= + =
|
\ .
4 2
.10
1000 1 1218.40
4
FV


EFFECTIVE INTEREST RATES
64
= =
0.06
1 6.18% EAR e
Which rate is better?

6% compounded continuously
6% p.a. compounded monthly
6% p.a. compounded quarterly
6% p.a. compounded annually
= =
12
(1.005) 1 6.17% EAR
= =
4
(1.015) 1 6.14% EAR
= =
1
(1.061) 1 6.10% EAR
EFFECTIVE INTEREST RATES (CONT.)
ILLUSTRATION 1
65
Compounding
Period
Periods Per
Year
Per-period
Interest Rate
Future Value
Factor
Effective
Annual
Rate
1 year 1 8.00% 1.08 8.00%
semi-annually 2 4.00% (1.04)
2
8.16%
quarterly 4 2.00% (1.02)
4
8.24%
monthly 12 0.667% (1.00667)
12
8.30%
daily 365 0.0219% (1.000219)
365
8.328%
EFFECTIVE INTEREST RATES (CONT.)
ILLUSTRATION 2:
66
Choosing a Deposit Account
A recent ANZ Bank ad offered the following
nominal rates for a 3-year term deposit:
Interest paid monthly: 4.00%
Interest paid quarterly: 4.05%
Interest paid annually: 4.10%
Which is the best rate?
EFFECTIVE INTEREST RATES
ILLUSTRATION 2 (CONT)
67
| |
= + =
|
\ .
12
0.04
1 1
12
EAR
Monthly interest payment at 4.00% yields an effective
annual rate of:
4.0742%
Quarterly interest payment at 4.05% yields
an effective annual rate of:
| |
= + =
|
\ .
4
0.0405
1 1
4
EAR
4.1119%
Of course, annual interest payment at 4.10% yields
effective annual rate of 4.10%
CONTINUOUS COMPOUNDING
Continuous compounding: payments spread evenly and
continuously through out the year, interest is continuously
compounded.






Where:
r: interest rate per year
t: period
Period = 1 year, t = 1




68
CONTINUOUS COMPOUNDING
69
Future Value
$1,210.00
$1,212.00
$1,214.00
$1,216.00
$1,218.00
$1,220.00
$1,222.00
0 100 200 300
compounding periods

| |
+ =
|
\ .
1
lim
nom
m t
r t
nom
m
r
e
m
m = number of compounding periods per year
t = number of years
70


Matching Cash Flows
with the
Formulas
PRINCIPLE 1: CONSISTENCY
71
When finding PV or FV of a single lump sum cash
flow, the time period does not have to be a whole
number.

All that is required is a consistency between the
interest rate and the time period.

Ex: How much will you get if you invest $250,000
today at a rate of 4% p.a. for a period of 18 months.
0 18 months
$250,000
?
PRINCIPLE 2:
PRESENT VALUE OF ORDINARY ANNUITY
72
When finding the PV of an annuity / perpetuity, our
formulas give us the PV one period before the first
cash flow in the sequence.
Ex: How much do you have to put into the account
earning 5% p.a. (compound annually) right now to
withdraw $100 per year for the next 10 years
...
100
0
10 1 2
...
100 100
17 . 772
) 05 . 1 (
1
1
05 . 0
100
10
=
(

= PV
PRINCIPLE 2:
PRESENT VALUE OF ANNUITY DUE
73
How do we deal with a series of cash flows
that begins immediately
100
0
10 1 2
...
...
100 100 100
17 . 872 100
) 05 . 1 (
1
1
05 . 0
100
10
= +
(

= PV
17 . 872 ) 05 . 0 1 (
) 05 . 1 (
1
1
05 . 0
100
11
= +
(

= PV
Or
11
PRINCIPLE 3:
FUTURE VALUE OF ORDINARY ANNUITY
74
When finding the FV of an annuity, our formula gives
us the future value at the time of the last cash flow in
the sequence.

Ex: You decide to contribute $5,000 to your retirement
account each year for the next 30 years. The account
earns 10% p.a. (compounding annually). What is the
balance in your account when you retire 30 years
from today?
5,000
0
30
1 2
...
...
5,000 5,000
PRINCIPLE 3:
FUTURE VALUE OF ANNUITY DUE
75
What if you plan to make the first contribution today?
5,000
0
30
1 2
...
5,000
5,000
29
717 , 904 ) 01 . 1 (
10 . 0
1 ) 01 . 1 (
000 , 5
30
35
=
(

= FV
Or FV = FV
annuity
(1+r)
PRACTICAL EXAMPLES
76
Ex 1: You will receive $75 per year for four years, then
$200 at the end of the 6th years. If your account
earns 8% p.a. compounded annually what will the
future value be at the year of 6?
77
Ex 1: You will receive $75 per year for four years, then
$200 at the end of the 6th years. If your account
earns 8% p.a. compounded annually what will the
future value be at the year of 6?
$
7
5

$
7
5

$
7
5

$
7
5

$
2
0
0

0 1 2 3 4 5 6
(

+
=
08 . 0
1 ) 08 . 0 1 (
75
4
4
FV
( ) 200 08 . 1
08 . 0
1 ) 08 . 0 1 (
75
2
4
+
(

+
= FV
Practical Examples
PRACTICAL EXAMPLES
78
Ex 2: Deferred Annuity
HN Ltd is selling TVs on the following terms:
No payments until 13 months after purchase
After 13 months, make 12 monthly payments of
$75 each
Your opportunity cost is 6%p.a.
NH Ltd sells the same TV for $750 cash
PRACTICAL EXAMPLES
79
Ex 2: Deferred Annuity
HN Ltd is selling TVs on the following terms:
No payments until 13rd month after purchase
After 13 months, make 12 monthly payments of
$75 each, opportunity cost 6% p.a.
Pay cash $750
0 1 3 4 5 6 7 8 13 24 2
$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$
7
5

$820.80 =
Pay cash!
12
(

=
12
005 . 1
1
1
005 . 0
75
PV
12 12
005 . 1
1
005 . 1
1
1
005 . 0
75
x PV
(

=
PRACTICAL EXAMPLES
80
Ex 3: Unequal Payments
Consider a project that returns $2000 in each of
the 3
rd
and 4
th
years, and $5000 in the 5
th
and 6
th

years. At an opportunity cost of 6%p.a., what is this
project worth?
PRACTICAL EXAMPLES
81
Ex 3: Unequal Payments Consider a project that returns
$2000 in each of the 3
rd
and 4
th
years, and $5000 in the 5
th
and
6
th
years. At an opportunity cost of 6%p.a., what is this project
worth?
0 1 2 3 4 5 6
$2000 $2000
$5000 $5000
( ) ( ) ( ) ( )
3 4 5 6
2000 2000 5000 5000
1.06 1.06 1.06 1.06
PV = + + +
( )
( )
( )
( )
2
2
4
2
1.06 1.
1 1.06
5000
0
1 1.06
2000
0.06
6
.
0
06
PV

(
(

(
(

= +
PRACTICAL EXAMPLES
82
Ex 4: Vehicle Registration Options
HCMC Transport provides two payment options:
Register for 12 months - $500.00
Register for 6 months - $264.30
Which is the better deal?
Assume interest rate is 12% p.a. compounded
semi-annually
PRACTICAL EXAMPLES
83
Ex 4: Vehicle Registration Options
HCMC Transport provides two payment options:
Register for 12 months - $500.00
Register for 6 months - $264.30
Which is the better deal?
interest rate is 12% p.a. compounded semi-
annually
$264.30
$500.00
$264.30
500 $ = PV


MORTGAGES, LOAN AND
REPAYMENTS
84
AMORTIZED LOANS
85
Amortized loan: a loan that is repaid in equal
payments over its life

Amortization schedule: give the required payment
on each payment date and a breakdown of the
payment, showing how much is interest and how
much is repayment of principle.
AMORTIZING A LOAN
86
Determine payments required for an installment
type loan (annuities)

Loan is repaid in equal periodic payments including
both interest and principal

Thus, payment amount is set such that the present
value of all payments equals the loan amount

E.g. mortgage loans, auto loans, consumer loan,
business loans,
AMORTIZED LOANS (CONT.)
87
Periodic payment is determined based as following:







Payment amount (PMT) is set such that the present
value of all payments equals the loan amount
(

+
=
n
r r
PMT
PV
) 1 (
1
1
COMPUTING LOAN PAYMENTS
88
Ex: suppose you enter a fixed-rate mortgage loan
of $22,000 at 12% p.a., compounded annually.
The loan is repaid every year over 6 years.

( )
351 , 5
12 . 1 12 . 0
1
1 (
12 . 0
1
000 , 22
6
=

= PMT
COMPUTING LOAN PAYMENTS
89
Year
Installment
payment
Annual
interest
Principal
payment
Principal
amount owing
at year end
0 22,000
1 5,351 2,640 2,711 19,289
2 5,351 2,315 3,036 16,253
3 5,351 1,950 3,401 12,852
4 5,351 1,542 3,809 9,043
5 5,351 1,085 4,266 4,777
6 5,351 573 4,778 0
( )
351 , 5
12 . 1 12 . 0
1
1 (
12 . 0
1
000 , 22
6
=

= PMT
COMPUTING PAYOUT FIGURE
90
30-year $100,000 fixed rate mortgage at 12% p.a.
with monthly repayments
The present value of the repayment scheme is
the amount you borrow
61 . 028 , 1 $
000 , 100
01 . 1
1
1
01 . 0
360
=
=
(

=
PMT
PMT
PV
(

+
=
n
r r
PMT
PV
) 1 (
1
1
COMPUTING PAYOUT FIGURE
91
The payout figure is the present value of all remaining
repayments.

After 10 years (120 repayments), this is:

80 . 417 , 93
01 . 1
1
1
01 . 0
028 , 1
240
=
(

= PV
COMPUTING PAYOUT FIGURE
92
If you make an extra repayment, this reduces the
outstanding principal balance.
Consider a payment of $50,000 after 10 years, then
the repayments will be reduced:

07 . 478 $
80 . 417 , 43
01 . 1
1
1
01 . 1
240
=
=
(

=
PMT
PMT
PV
MORTGAGE PRACTICAL EXAMPLE

93
o Bank loans

o Refinancing

oChoosing a mortgage loan
BANK LOANS
94
Suppose you buy a new car on the following terms:

$20,000 cash price less $2,000 down payment:
$18,000 borrowed
Loan term 3 years (36 months)
Nominal interest rate 12% p.a. compounded
monthly
Monthly payments of $?
BANK LOANS (CONT)
95
1. What is the monthly payment amount?
2. How much of the first payment is interest
and principal?
= $597.86
BANK LOANS (CONT)
96
3. After 1 year, how much do you still owe?
Month Balance Interest Principal End Balance
1 18,000.00 $ 180.00 $ 417.86 $ 17,582.14 $
2 17,582.14 $ 175.82 $ 422.04 $ 17,160.11 $
3 17,160.11 $ 171.60 $ 426.26 $ 16,733.85 $
4 16,733.85 $ 167.34 $ 430.52 $ 16,303.33 $
5 16,303.33 $ 163.03 $ 434.82 $ 15,868.51 $
6 15,868.51 $ 158.69 $ 439.17 $ 15,429.33 $
7 15,429.33 $ 154.29 $ 443.56 $ 14,985.77 $
8 14,985.77 $ 149.86 $ 448.00 $ 14,537.77 $
9 14,537.77 $ 145.38 $ 452.48 $ 14,085.29 $
10 14,085.29 $ 140.85 $ 457.00 $ 13,628.29 $
11 13,628.29 $ 136.28 $ 461.57 $ 13,166.71 $
12 13,166.71 $ 131.67 $ 466.19 $ 12,700.52 $
( )
52 . 700 , 12
01 . 1
1
1
01 . 0
86 , 597
24
=
(

= PV
REFINANCING
97
Your current mortgage calls for monthly payments of
$1,477.98 at a quoted rate of 7.5% with 15 years
remaining

ANZ Bank offers a 7% mortgage

If transaction costs are $3,000 (fees, stamp duty, etc)
should you refinance your mortgage?
REFINANCING (CONT)
98
Step 1: Whats the remaining balance on your current
loan?






Step 2: What will your new monthly payment be?
Assume the transaction costs are added to your loan
balance
( )
02 . 435 , 159
12
75 .
1
1
1
12
75 .
98 . 477 , 1
) 12 15 (
=
(
(
(

+
=

PV
( )
( )
(
(
(

+
= +
12 15
12
7 .
1
1
1
12
7 .
3000 02 . 435 , 159
PMT
01 . 460 , 1 = PMT
REFINANCING (CONT.)
99
Step 3: Compare repayments
Monthly payment of Original loan: $1,477.98
Monthly payment of ANZ loan: $1,460.01
Net Savings $17.97 /mo.

Decision: Refinance!
CHOOSING A MORTGAGE
100
City Bank:
Rate: 6.57% p.a. compounded monthly
Monthly fee: $8
Up front costs: $550

ACB Loans
Rate:6.45% p.a. compounded monthly
No monthly fee
Up front costs: $820

Assume you need $100,000 over a 25 year term
CHOOSING A MORTGAGE (CONT)
101
How do you compare loans?
1. Set the initial cash flow equal by assuming you
borrow the up-front costs

2. Compute the monthly payments for each loan
adding in any fees

3. Compare the monthly cost of each loan