Beruflich Dokumente
Kultur Dokumente
Topics Covered
Future Values
Present Values
Multiple Cash Flows
Perpetuities and Annuities
Effective Annual Interest Rate
Inflation & Time Value
Future Values
Future Value - Amount to which an
investment will grow after earning interest.
Compound Interest - Interest earned on
interest.
Simple Interest - Interest earned only on the
original investment.
Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a principal balance of $100.
Future Values
Example - Simple Interest
Interest earned at a rate of 6% for three years
on a principal balance of $100.
Today Future Years
1
2
3
Interest Earned
6
Value 100
106
112
6
118
Future Values
Example - Compound Interest
Interest earned at a rate of 6% for three years on
the previous years balance.
Interest Earned Per Year =Prior Year Balance x .
06
Future Values
Example - Compound Interest
Interest earned at a rate of 6% for three years on
the previous years balance.
Today
Future Years
1
2
3
Interest Earned
6.00
6.36
Value 100
106.00 112.36 119.10
6.74
FV PV (1 r )
Future Values
FV $100 (1 r )
Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for three years?
Present Values
Present Value
Discount Factor
Value today of a
future cash
flow.
Present value of
a $1 future
payment.
Discount Rate
Present Values
Present Value = PV
PV =
Perpetuities
Suppose you will receive a fixed payment
every period (month, year, etc.) forever.
This is an example of a perpetuity.
Perpetuities
PV of Perpetuity Formula
PV
C = cash payment
r = interest rate
C
r
PV
15 ,PV
000
.05
15, 000
.05
$300,000
$300,000
PV
300 , 000
(1.05 ) 3
$259,151
Annuities
Annuity: a sequence of equal cash flows,
occurring at the end of each period. This
is known as an ordinary annuity.
0
PV
4
FV
Annuity-due
A sequence of periodic cash flows
occurring at the beginning of each period.
0
PV
4
FV
Examples of Annuities-due
Monthly Rent payments: due at the
beginning of each month.
Car lease payments.
Cable TV and most internet service bills.
PV C
1
r
1
t
r (1 r )
C = cash payment
r = interest rate
t = Number of years cash payment is received
PVAF
1
r
1
r (1 r ) t
Mortgage payment
Annual income from an investment payout
Future Value of annual payments
FV C PVAF (1 r )
PV C
1
r
1
t
r (1 r )
(1 r )
C = cash payment
r = interest rate
t = Number of years cash payment is received
Why an IRA?
Imagine in the last example, you didnt take
advantage of the tax-sheltered environment of
an IRA.
Your annual investment return would be taxed!
With a 28% tax rate, our annual after-tax return
would fall from 9% to 6.48% (=9%(1-.28)).
At age 65: I would have $135,519 vs. $191,975.
You would have $535,392 vs. $1,102,114: 52%
less!! The IRS killed Kenny,!
Non-Annual Interest
Compounding
When interest is compounded more frequently than once
a year.
Important non-annual compounding terms and things to
know:
EAR = (1 + .01) - 1 = r
EAR = (1 + .01)12 - 1 = .1268 or 12.68%
APR = .01 x 12 = .12 or 12.00%
Non-annual annuities
Ordinary:
PV = C(PVAFAPR/m,nm)
FVnm = C(PVAFAPR/m,nm)(1+APR/m)nm
Annuity-Due:
PV = C(PVAFAPR/m,nm)(1+APR/m)
FVnm = C(PVAFAPR/m,nm)(1+APR/m)nm+1
Inflation
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.
Inflation
1+nominal interest rate
1 real interest rate =
1+inflation rate
approximation formula
Inflation
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?
1+.050
1 real interest rate = 1+.022
Saving
s
Bond