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Time value of money

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Multiple Cash Flows

Valuing Level Cash Flows: Annuities

and Perpetuities

Comparing Rates: The Effect of

Compounding

Loan Types and Loan Amortization

6 (Calculators)-0

Example 6.1

end of each of the next three years in a

bank account paying 8%/y. You currently

have $7,000 in the account. How much

will you have in three years? In four

years? FV3? FV4?

8%

t=0 1 2 3

-7000 -4000 -4000 -4000

6 (Calculators)-1

Multiple Cash Flows –Future Value

Example 6.1

ValueBetter:

at year 4:

FV3=8,817.98+4,665.60+4,320+4,000

1 N; 83N,

I/Y;8I/Y,-7000PV,-4000PMT,

-21,803.58 PV; CPT FV CPT FV

= 23,547.87

= 21,803.58

FV3?

8%

t=0 1 2 3

-7000 -4000 -4000 -4000

-4,320.00

-4,665.60

-8,817.98

6 (Calculators)-2

Multiple Cash Flows – FV

Example 2

Suppose you

Basic invest $500 in a mutual

Solution

2 N, 9 I/Y, -500 PV, CPT FV=594.05

fund today and $600 in one year. If the

1N,9 I/Y,-600 PV, CPT FV=654

fund pays

Total:9%

594.05annually,

+654=1,248.05how much will

you have in two years?

FV?

9%

t=0 1 2 3

-500 -600

6 (Calculators)-3

Multiple Cash Flows – FV

Example 2

Suppose

Smart Solutionyou invest $500 in a mutual

Add PMT2=-600 and Subtract it from the FV

fund today

2N,9 I/Y,-500 and

PV,-600 $600

PMT, in one year. If the

CPT FV=1,848.05

fund pays

Subtract: 9%

1,848.05 annually, how much will

– 600=1,248.05

FV?

9%

t=0 1 2 3

-500 -600 -600

6 (Calculators)-4

Multiple Cash Flows – Example 2

Continued

How much will you have in 5 years if you make no further

deposits?

FV?

9%

0 1 … 5

-500 -600

First way:

Year 0 CF: 5 N; -500 PV; 9 I/Y; CPT FV = 769.31

Year 1 CF: 4 N; -600 PV; 9 I/Y; CPT FV = 846.95

Total FV = 769.31 + 846.95 = 1,616.26

Second way – use value at year 2:

3 N; -1,248.05 PV; 9 I/Y; CPT FV = 1,616.26

6 (Calculators)-5

Multiple Cash Flows – FV

Example 3

Suppose you plan to deposit $100 into an account in

one year and $300 into the account in three years.

How much will be in the account in five years if the

interest rate is 8%? FV?

8%

0 1 3 5

-100 -300

Year 1 CF: 4 N; -100 PV; 8 I/Y; CPT FV [136.05]; STO 1

Year 3 CF: 2 N; -300 PV; 8 I/Y; CPT FV [349.92]; STO 2

Total FV: +RCL 1= 485.97

6 (Calculators)-6

Example 6.3

You are offered an investment that will pay you $200 in

one year, $400 the nextYear year, $600 the next year, and

1 CF:

$800 at the1 N;

end of the Year 2year.

fourth CF: You can earn 12%/y

12 I/Y; 200 FV; CPT 3

Year PV [-178.57]; STO 1

CF:

2 N; 12 I/Y; 400 FV; Year

CPT 4 PV [-318.88]; STO 2

CF:

on very similar

3 N;investment.

12 I/Y; 600 FV;What

CPT PV is[-427.07];

Total CF: the most STOyou

3

4 N; 12

should pay for this+one?I/Y; 800 FV; CPT PV [-508.41]; STO 4

RCL 1 + RCL 2 + RCL 3= 1,432.93

PV? 12%

0 1 2 3 4

200 400 600 800

6 (Calculators)-7

Example 6.3- Using CF

STEP1: Clear ALL CF memory:

STEP 2: Enter Cash Flows

CF ; 2 nd CLR WORK

You are offered an investment

CFo 0 ENTER that

↓ will pay you $200 in

one year, $400 the C01next year, $600

200 ENTER ↓ F01[1]the

↓ next year, and

$800 at the end ofC02 the fourth

400 ENTERyear. You

↓ F01[1] ↓ can earn 12%/y

on very similar investment.

C03 STEP 3: What

600 ENTER isNPV=

↓ F01[1]

Calculate the

↓ most

CF0 + you

PV

should pay for this C02 NPV; I 12 ENTER;

800 ENTER

one? ↓; CPT

↓ F01[1] ↓ [1,432.93]

PV? 12%

0 1 2 3 4

200 400 600 800

6 (Calculators)-8

Example 6.3 Timeline

0 1 2 3 4

178.57

318.88

427.07

508.41

1,432.93

6 (Calculators)-10

Multiple Uneven Cash Flows –

Using the Calculator

Another way to use the financial calculator for uneven

cash flows is to use the cash flow keys

Press CF and enter the cash flows beginning with year 0.

You have to press the “Enter” key for each cash flow

Use the down arrow key to move to the next cash flow

The “F” is the number of times a given cash flow occurs

in consecutive periods

Use the NPV key to compute the present value by

entering the interest rate for I, pressing the down arrow,

and then computing the answer

Clear the cash flow worksheet by pressing CF and then

2nd CLR Work

6 (Calculators)-12

Decisions, Decisions

Your broker calls you and tells you that he has this great

investment opportunity. If you invest $100 today, you will

receive $40 in one year and $75 in two years. If you

require a 15% return on investments of this risk, should

you take the investment?

Use the CF keys to compute the value of the

investment

CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1

NPV; I = 15; CPT NPV = 91.49

No – the broker is charging more than you would be willing to

pay.

If you enter CF0 = -100, NPV= -8.51 <0 negative investment

6 (Calculators)-13

Saving For Retirement

put some money away for

retirement. You will receive five

annual payments of $25,000 each

beginning in 40 years. How much

would you be willing to invest today if

you desire an interest rate of 12%?

6 (Calculators)-14

Saving For Retirement Timeline

0 1 2 … 39 40 41 42 43 44

CF; CF0 = 0;

C01 = 0; F01 = 39;

The cash flows years 1 – 39 are 0 (C01 = 0; F01 = 39)

C02 = 25,000; F02 = 5;

NPV; I = 12; CPT NPV = 1,084.71

The cash flows years 40 – 44 are 25,000 (C02 = 25,000;

F02 = 5)

6 (Calculators)-15

Annuity

Ordinary

Annuityannuity

Due

first

What payment occurs at

is the relationship

Annuity – finite series of equalADpayments

the BEGINNING

the

b/tPV endtypes

two

OA

of

= the

PVof

ofperiod

the period

*(1+r)

annuity?

r Ordinary Annuity

0 1 2 … N

100 100 100 100

r Annuity Due

0 1 2 … N

100 100 100 100

6 (Calculators)-16

Perpetuity

r Perpetuity

0 1 2 … Infinite

100 100 100 100

6 (Calculators)-17

Annuities and Perpetuities – Basic

Formulas

Perpetuity: PV = C / r

Annuities:

1

1

(1 r ) t

PV C

r

(1 r ) t 1

FV C

r

6 (Calculators)-18

Annuities and the Calculator

Most problems are ordinary annuities

You can switch your calculator between

the two types

2nd BGN 2nd Set

If you see “BGN” or “Begin” in the

display of your calculator, you have it

set for an annuity due

6 (Calculators)-19

Annuity Due

You are saving for a new house and you put $10,000 per year in

an account paying 8%. The first payment is made today. How

much will you have at the end of 3 years (before the 4th payment)?

8% Annuity Due

0 1 2 3

10K 10K 10K ?

2nd BGN 2nd Set (you should see BGN in the display)

3 N ; -10,000 PMT; 8 I/Y; CPT FV = 35,061.12

2nd BGN 2nd Set (be sure to change it back to an ordinary

annuity)

Alternatively: 3 N ; -10,000 PMT; 8 I/Y; CPT FV [32,464]; *1.08

6 (Calculators)-24

Compounding again!

• Deposit $1,000 at 8% nominal annual interest rate, how

much will you have at the end of 2 years?

• If compounded annually:

• FV= 1000*(1+.08)^2= 1,166.40

• Earn 8%/year

If compounded quarterly:

N=4*2=8 quarters, I/Y=8%/4=2%/quarter

FV= 1000*(1+.02)^8=1,171.66

How much do you effectively earn if compounded

quarterly?

1000*(1+EAR)^2=1,171.66 (Effective Annual Rate)

Solve for EAR: 8.24%

Alternatively, EAR=(1+.08/4)^4-1=8.24%

6 (Calculators)-28

EAR - Formula

m

APR

EAR 1 1

m

Remember that the APR is the quoted rate

m is the number of compounding periods per year

6 (Calculators)-29

Effective Annual Rate (EAR)

after accounting for compounding that

occurs during the year

If you want to compare two alternative

investments with different compounding

periods you need to compute the EAR

and use that for comparison.

6 (Calculators)-30

Annual Percentage Rate

This is the annual rate that is quoted by law

By definition APR = period rate times the

number of periods per year

Consequently, to get the period rate we

rearrange the APR equation:

Period rate = APR / number of periods per year

You should NEVER divide the effective rate by

the number of periods per year – it will NOT

give you the period rate

6 (Calculators)-31

Computing APRs

.5%?

.5(12) = 6%

What is the APR if the semiannual rate is

.5%?

.5(2) = 1%

What is the monthly rate if the APR is

12% with monthly compounding?

12 / 12 = 1%

6 (Calculators)-32

Computing EARs - Example

Suppose you can earn 1% per month on $1

invested today.

What is the APR? 1(12) = 12%

How much are you effectively earning?

FV = 1(1.01)12 = 1.1268

Rate = (1.1268 – 1) / 1 = .1268 = 12.68%

Suppose you put it in another account and earn

3% per quarter.

What is the APR? 3(4) = 12%

How much are you effectively earning?

FV = 1(1.03)4 = 1.1255

Rate = (1.1255 – 1) / 1 = .1255 = 12.55%

6 (Calculators)-33

Decisions, Decisions II

pays 5.25%, with daily compounding. The other

pays 5.3% with semiannual compounding.

Which account should you use?

First account:

EAR = (1 + .0525/365)365 – 1 = 5.39%

Second account:

EAR = (1 + .053/2)2 – 1 = 5.37%

Which account should you choose and why?

6 (Calculators)-34

Decisions, Decisions II Continued

Let’s verify the choice. Suppose you

invest $100 in each account. How much

will you have in each account in one

year?

First Account:

365 N; 5.25 / 365 = .014383562 I/Y; 100 PV; CPT FV =

105.39

Second Account:

2 N; 5.3 / 2 = 2.65 I/Y; 100 PV; CPT FV = 105.37

You have more money in the first

account.

6 (Calculators)-35

Computing APRs from EARs

compute the APR? Rearrange the EAR

equation and you get:

APR m (1 EAR)

1

m

-1

6 (Calculators)-36

APR - Example

rate of 12% and you are looking at an

account that compounds on a monthly

basis. What APR must they pay?

APR 12 (1 .12)1 / 12

1 .1138655152

or 11.39%

6 (Calculators)-37

Future Values with Monthly

Compounding

Suppose you deposit $50 a month into an

account that has an APR of 9%, based

on monthly compounding. How much will

you have in the account in 35 years?

35(12) = 420 N

9 / 12 = .75 I/Y

50 PMT

CPT FV = 147,089.22

6 (Calculators)-39

Present Value with Daily

Compounding

You need $15,000 in 3 years for a new

car. If you can deposit money into an

account that pays an APR of 5.5% based

on daily compounding, how much would

you need to deposit?

3(365) = 1,095 N

5.5 / 365 = .015068493 I/Y

15,000 FV

CPT PV = -12,718.56

6 (Calculators)-40

Continuous Compounding

Sometimes investments or loans are

figured based on continuous

compounding

EAR = eq – 1

The e is a special function on the calculator

normally denoted by ex

Example: What is the effective annual

rate of 7% compounded continuously?

EAR = e.07 – 1 = .0725 or 7.25%

6 (Calculators)-41

Remember

“quoted” or APR

What you use to compare various investment

opportunities is “effective rate” (EAR)

Implied, usually need to calculate

What type of rate is the I/Y?

The period rate, the unit rate for calculating APR

and EAR.

If APR is given, I/Y=APR/m

If EAR is given, I/Y=(1+EAR)^1/m - 1

6 (Calculators)-42

How to lie, cheat, and steal with

interest rates:

RIPOV RETAILING

Going out for business sale!

$1,000 instant credit!

12% simple interest!

Three years to pay!

Low, low monthly payments!

Assume you buy $1,000 worth of furniture from this store and

agree to the above credit terms. What is the APR of this loan?

The EAR?

6 (Calculators)-43

How to lie, cheat, and steal with

interest rates:

1. Borrow $1,000 today at 12% per year for

three years, you will owe

$1,000 + $1000(.12)(3) = $1,360.

payments of $1,360/36 = $37.78.

-1000 PV; 37.78 PMT; 36 N; CPT I/Y = 1.767%/month

APR = 12(1.767%) = 21.204%

EAR = 1.0176712 - 1 = 23.39% (!)

6 (Calculators)-44

Types of loan

borrower repay a single lump sum at the end

of the term.

Interest-only loans

borrower pay interest each period and repay

the entire principal at the end of the term.

Amortized loans

borrower repay parts of the principal over

time

6 (Calculators)-45

Amortized Loan with Fixed

Payment - Example

Each payment covers the interest expense plus

reduces principal

Consider a 4 year loan with annual payments.

The interest rate is 8% and the principal

amount is $5000.

What is the annual payment?

4N

8 I/Y

5000 PV

CPT PMT = -1509.60

Click on the Excel icon to see the amortization

table

6 (Calculators)-46

6

Calculators

End of Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Comprehensive Problem

An investment will provide you with $100 at the

end of each year for the next 10 years. What is

the present value of that annuity if the discount

rate is 8% annually?

What is the present value of the above if the

payments are received at the beginning of

each year?

If you deposit those payments into an account

earning 8%, what will the future value be in 10

years?

What will the future value be if you open the

account with $1,000 today, and then make the

$100 deposits at the end of each year?

6 (Calculators)-48

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