Chapter 4 The Time Value Of Money

Introduction

This chapter introduces the concepts and skills necessary to understand the time value of money and its applications.

Finance 311

TIME VALUE OF MONEY OR DISCOUNTED CASH FLOW ANALYSIS

Very Important concept -- Almost everything from this point on in finance based upon understanding this concept. You must get this material down cold. You can do problems using formulas, calculators, and spreadsheets. We will primarily use financial calculators. No tables will be used. Please have your HP 10 b II financial calculators with you in class.
Finance 311
3

Key Terms

Future Value (FV) Future Value of an Annuity (FVAN) Future Value of an Annuity Due (FVAND) Present Value (PV) Present Value of an Annuity (PVAN) Present Value of an Annuity Due (PVAND)
4

Finance 311

Examples of Problems Solved

Sinking Fund Problems Capital Recovery Problems Loan Amortization Problems Retirement Planning Deferred Annuities Capital Budgeting
5

Finance 311

Notation

i (I/YR) to denote the interest rate per period n (N) to denote the number of periods PMT to denote cash payments (Annuity) PV to denote the present value dollar amount T to denote the tax rate t to denote time PV0 = principal amount at time 0 FVn = future value n time periods from time 0
Finance 311
6

Simple Interest
Interest

= Principal X Rate X Time I = PV0 x i x t

Finance 311

Future Value of a Cash Flow

At the end of year n for a sum compounded at interest rate i is FVn = PV0 ( 1 + i )n Formula

Please consider drawing Time Lines to help you in your calculations.

Finance 311
8

FINANCIAL CALCULATOR

There are usually at least five input keys N I/yr PV PMT FV There are other keys that we will discuss later (for instance, P/YR or payments per year). Also, I strongly prefer that you use the HP 10b II calculator.
Finance 311
9

Assume that you invest $1,000 at an annual interest rate of 6 percent, How much would you have at the end of 12 years?
P/YR = 1 PV = (1,000)

I = 6%
PMT = 0

n = 12
FV = ? 2,012.20
Finance 311
10

Present Value of a Cash Flow

PV0 = FVn 1 ( 1 + i )n
1___ FVIFi,n

Formula

PVIF i , n =

Reciprocal of FVi,n

Finance 311

11

Example Using Formula

What is the PV of $100 one year from now if the i = 12%, compounded annually ? PV 0 = $100 x 1/ ( 1 + .12 ) 1 = $100 x 1/ ( 1.12) = $100 x ( .89286 ) = $ 89.286
Finance 311
12

Example Using Financial Calculator

P/YR =1 FV = 100 PMT = 0 n=1 I = 12% PV = ?

(89.29)
Finance 311
13

Example Using EXCEL

Finance 311

14

Another Example Using the Formula

What is the PV of $100 one year from now with 12 percent interest compounded monthly?
PV0 = $100 1/(1 + .12/12)(12 1) = $100 1/(1.126825)

= $100 (.88744923)
= $ 88.74
Finance 311
15

Example using Financial Calculator

Set P/YR to 12 by pressing 12 then pressing yellow then press P/YR N = 1 yellow XP/YR = 12 (or you can put 12 in the N function directly) FV = 100 PMT = 0 I/YR = 12 Then press PV to get (88.74) Then set the P/YR back to 1.
Finance 311
16

Annuity
A series of equal $ CFs for a specified number of periods Ordinary annuity is where the CFs occur at the end of each period Annuity due is where the CFs occur at the beginning of each period - The easiest way to solve an annuity due problem is to use your begin (BEG) button on your calculator. But do not forget to set the calculator back to end of period after your calculation. 17
Finance 311

Future Value of an Ordinary Annuity

FVIFA i , n = ( 1 + i ) n - 1 Formula i Calculator - use your PMT key

Solves Sinking Fund Problems

Finance 311
18

Present Value of an Ordinary Annuity

1PVIFA i , n =
Use your PMT key.

1 ( 1+ i ) n i

Formula

Solves Capital Recovery Problems

Finance 311
19

Annuity Due

Future Value of an Annuity Due

FVAND n = PMT ( FVIFA i , n ) ( 1 + i ) Useful for Retirement Planning

Present Value of an Annuity Due

PVAND 0 = PMT ( PVIFA i , n ) ( 1 + i ) Useful in leasing analysis.

Please use your calculator and your BEG button. But do not forget to go back to the END mode after you complete the problem.
Finance 311
20

Present Value of a Perpetuity

PVPER 0 = PMT/ i Expect to receive $100 a year forever. Interest rate is 5%. PV =? 100/.05 = 2,000
Finance 311
21

FINDING INTEREST RATES OR GROWTH RATES

You invest $300 and receive $483.15 five years later. What rate of return have you earned? 10.00% You invest $300 and receive $79.14 a year for each of five years. What rate of return have you earned? 10.00% The EPS of Tiger Incorporated grew from $.75 in 1997 to $1.85 in 2004. What was the annual rate of growth? 13.77%
Finance 311
22

Simple and Compound Interest

Simple Interest
interest paid on the principal sum only

Compound Interest
interest paid on the principal and on prior

interest which has not been paid or withdrawn

Finance 311

23

Other than annual compounding

You have $100 to invest:

Bank A pays 6% compounded annually $106.00 Bank B pays 6% compounded semi-annually$106.09 Bank C pays 6% compounded quarterly$106.14 Bank D pays 6% compounded monthly$106.17 Bank E pays 6% compounded daily$106.18

How much would you have at the end of one year in each bank?
Finance 311
24

Present value
PV 0 = FV n (1+

1
i nom ) mn
M

Compounding interest
Finance 311
25

A Realistic Problem

You want to purchase a car that costs $23,000. You have two financing alternatives.
A. Receive a $2,000 rebate on the vehicle. But

make (beginning of the month) monthly payments at a 5.4% annual rate for a period of three years. B. Obtain 0% (interest) financing for the three years. Make monthly payments at the beginning of the month. Your cost will be $23,000.

What are the monthly payments under each alternative? Which alternative is cheaper?
Finance 311

26

Effective rate of interest

i eff = ( 1 + i nom/ m )m - 1

Bank X pays 5.60% compounded quarterly Bank Y pays 5.57% compounded daily Where do you invest for one year? 5.7187% for the quarterly compounding 5.7276% for the daily compounding27 Finance 311

Interest Compounded More Frequently Than Once Per Year

m = # of times interest is compounded n = # of years

Future Value
FVn = PV0

inom 1+ m

nm

Present Value
FVn PV0 = inom nm (1 + ) m
Finance 311

28

Compounding and Effective Rates

Effective annual rate of interest

ieff = (1 + inom/m)m 1

Rate of interest per compounding period

im = (1 + ieff)1/m 1

Please use the Nominal and Effective buttons on your calculator. I prefer that you use annual interest rates.
Finance 311

29

LOAN AMORTIZATION TABLE

Assume that you borrow $10,000 for five years at an annual interest rate of 12 percent. You make equal annual payments that include interest and principal. Prepare a loan amortization schedule or table.

Finance 311

30

LOAN AMORTIZATION
Year 1 2 3 4 5 Payment $2,774.10 2,774.10 2,774.10 2,774.10 2,774.10 Interest $1,200.00 1,011.11 799.55 562.60 297.22 Principal $1,574.10 1,762.99 1,974.55 2,211.50 2,476.86 Loan Balance $8,425.90 6,662.91 4,688.36 2,476.86 0

Hint: Learn how to use your AMORT key in your calculator to construct the table.
Finance 311

31

ASSUME THAT YOU BORROW $125,000 FOR THIRTY YEARS TO BUY A HOUSE AND THE INTEREST RATE IS 6.5%.

What are the monthly payments? How much of the first payment goes to pay off the loan? How much do you pay back over the life of the loan? If the loan were 15 years at 6.25%, what would the monthly payments be? How much do you pay back over the life of the loan?

Use your AMORT button to do these calculations.

Finance 311

32

DEALING WITH AN UNEVEN CASH FLOW STREAM

Year 1 2 3 4 5 Cash Flow $200 300 400 500 600

Finance 311

33

FINDING THE NET PRESENT VALUE OF AN INVESTMENT (NPV)

NPV = PV of cash flows - cash flow in year 0 On calculator use CFj key and NPV key Use your Nj button for the same cash flows. IRR = interest rate that makes the NPV=0

Finance 311

34

Example Using EXCEL

Finance 311

35

Conclusion

Future Value Future Value of an Annuity Future Value of an Annuity Due Present Value Present Value of an Annuity Present Value of an Annuity Due
Finance 311

36