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Chapter Outline

 Future and Present Values of


Multiple Cash Flows
 Valuing Level Cash Flows: Annuities
and Perpetuities
 Comparing Rates: The Effect of
Compounding
 Loan Types and Loan Amortization

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Example 6.1

 You will be able to deposit $4,000 at the


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

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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

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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

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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

you have in two years?


FV?
9%
t=0 1 2 3
-500 -600 -600

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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

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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

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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

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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

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Example 6.3 Timeline
0 1 2 3 4

200 400 600 800


178.57

318.88

427.07

508.41
1,432.93

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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

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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

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Saving For Retirement

 You are offered the opportunity to


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%?

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Saving For Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)


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)
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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?

that occur at regular intervals


r Ordinary Annuity
0 1 2 … N
100 100 100 100
r Annuity Due
0 1 2 … N
100 100 100 100

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Perpetuity

 infinite series of equal payments

r Perpetuity
0 1 2 … Infinite
100 100 100 100

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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 

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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

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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

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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%

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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

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Effective Annual Rate (EAR)

 This is the actual rate paid (or received)


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.

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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

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Computing APRs

 What is the APR if the monthly rate is


.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%

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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%

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Decisions, Decisions II

 You are looking at two savings accounts. One


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?

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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.

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Computing APRs from EARs

 If you have an effective rate, how can you


compute the APR? Rearrange the EAR
equation and you get:


APR  m (1  EAR)
1
m
-1
 

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APR - Example

 Suppose you want to earn an effective


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%

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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

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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

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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%

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Remember

 What you often see is “nominal” or “stated” or


“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

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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?

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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.

 2. To make it easy on you, make 36 low, low


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

 3. Is this a 12% loan?


 -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% (!)

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Types of loan

 Pure discount loans


 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

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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

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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?
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