Chapter 3

Time Value of Money

3-1

The Time Value of Money



The Interest Rate Simple Interest Compound Interest Amortizing a Loan

  

3-2

The Interest Rate

Which would you prefer -- $10,000 today or $10,000 in 5 years years?
Interest is the money paid for the use of money.

Obviously, $10,000 today today. You already recognize that there is TIME VALUE TO MONEY!! MONEY

3-3

Why TIME?
Why is TIME such an important element in your decision? TIME allows you the opportunity to postpone consumption and earn INTEREST. INTEREST

3-4

Types of Interest
 Simple

Interest

Interest paid (earned) on only the original amount, or principal borrowed (lend).
 Compound

Interest

Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).
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Simple Interest Formula

Formula SI: P0: i: n:
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SI = P0(i)(n) Simple Interest Deposit today (t=0) Interest Rate per Period Number of Time Periods

Simple Interest Example

 Assume

that you deposit $1,00 in an account earning 8% simple interest for 10 years. What is the accumulated interest at the end of the 10nd year?

SI

= P0(i)(n) = $1,00(.08)(10) = $80

3-7

Simple Interest (FV)

 What

is the Future Value (FV of the FV) deposit?

FV = P0 + SI = $1,00 + $80 = $180

 Future

Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate.

3-8

Simple Interest (PV)

 What

is the Present Value (PV of the PV) previous problem?

The Present Value is simply the $1,00 you originally deposited. That is the value today!

 Present

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Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

Compound interest
 Interest

that is earned on a given deposit and has become part of principal at the end of a specified period  Future value of a present amount at a future date, found by applying compound interest over a specified period of time.

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The equation for future value

FV=PV*(1+i)n


If Fred places $100 in a savings account paying 8% interest compounded annually, at the end of 1 year he will have $108 in the account.<100*(1.08)=$108>

If Fred were to leave this money in the account for another year, he would be paid interest at the rate of 8% on the new principal of $108.At the end of this second year there would be $116.64 in the account.<108*(1.08)=116.64> or <100*(1.08)2=116.64>

3-11

General Future Value Formula

FV1 = P0(1+i)1 FV2 = P0(1+i)2 General Future Value Formula: FVn = P0 (1+i)n or FVn = P0 (FVIFi,n) -- See Table I FVIF
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etc.

Valuation Using Table I

FVIFi,n is found on Table I at the end
of the book or on the card insert. Period 1 2 3 4 5 6% 1.060 1.124 1.191 1.262 1.338 7% 1.070 1.145 1.225 1.311 1.403 8% 1.080 1.166 1.260 1.360 1.469

3-13

Using Future Value Tables

FV2 = $1,000 (FVIF7%,2) FVIF = $1,000 (1.145) = $1,145 [Due to Rounding] Period 6% 7% 8% 1 1.060 1.070 1.080 2 1.124 1.145 1.166 3 1.191 1.225 1.260 4 1.262 1.311 1.360 5 1.338 1.403 1.469

3-14

Story Problem Example

Julie Miller wants to know how large her deposit of $10,000 today will become at a compound years. annual interest rate of 10% for 5 years

0
10% $10,000

FV5
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Story Problem Solution



Calculation based on general formula: FVn = P0 (1+i)n FV5 = $10,000 (1+ 0.10)5 = $16,105.10 based on Table I: FV5 = $10,000 (FVIF10%, 5) FVIF = $10,000 (1.611) = $16,110 [Due to Rounding]

 Calculation

3-16

Present value of a single amount

The

current dollar value of a future amount-the amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount.

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Concept of present value

The

process of finding present value is often referred to as discounting cash flows. It is

concerned with answering the following question:" if I can earn i percent on my money, what is the most I would be willing to pay now for an opportunity to receive FV n dollars n periods from today?
3-18

Equation for calculating PV

PV*(1+i)n=FV

PV=FV/(1+i)n

3-19

Present Value Single Deposit (Graphic)

Assume that you need $1,000 in 2 years. Lets examine the process to determine how much you need to deposit today at a discount rate of 7% compounded annually.

7%

$1,000
PV0
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PV1

Present Value Single Deposit (Formula)

PV0 = FV2 / (1+i)2 = FV2 / (1+i)2 0 7% 1 = $1,000 / (1.07)2 = $873.44 2

$1,000
PV0
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General Present Value Formula

PV0 = FV1 / (1+i)1 PV0 = FV2 / (1+i)2
etc.

General Present Value Formula: PV0 = FVn / (1+i)n or PV0 = FVn (PVIFi,n) -- See Table II PVIF
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Valuation Using Table II

PVIFi,n is found on Table II at the end
of the book or on the card insert.
Period 1 2 3 4 5
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6% .943 .890 .840 .792 .747

7% .935 .873 .816 .763 .713

8% .926 .857 .794 .735 .681

Using Present Value Tables

PV2 = $1,000 (PVIF7%,2) = $1,000 (.873) = $873 [Due to Rounding] Period 6% 7% 8% 1 .943 .935 .926 2 .890 .873 .857 3 .840 .816 .794 4 .792 .763 .735 5 .747 .713 .681

3-24

Story Problem Example

Julie Miller wants to know how large of a deposit to make so that the money will grow to $10,000 in 5 years at a discount rate of 10%.

0
10%

5
$10,000

PV0
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Story Problem Solution



Calculation based on general formula: PV0 = FVn / (1+i)n PV0 = $10,000 / (1+ 0.10)5 = $6,209.21 Calculation based on Table I: PV0 = $10,000 (PVIF10%, 5) PVIF = $10,000 (.621) = $6,210.00 [Due to Rounding]

3-26

Graphical view of FV
GRAPHICAL VIEW OF FV

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Future value relationship

the interest rates, higher the future value  Longer the period of time, higher the future value  For an interest rate of 0% the FV is always equal to its PV(1.00). But for any interest rate greater than zero, future value is greater than the present value
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 Higher

A graphical view of present value

3-29

Present value relationship

The The At

higher the discount rate, the lower the present value longer the period of time, the lower the present value the discount rate 0%,the present value is always equal to its future value

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Types of Annuities
 An

Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

 Ordinary

Annuity: Annuity Payments or receipts occur at the end of each period.

 Annuity

Due: Due Payments or receipts occur at the beginning of each period.

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Examples of Annuities
    
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Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

Parts of an Annuity
(Ordinary Annuity) End of Period 1 End of Period 2 End of Period 3

1 $100

2 $100

3 $100

Today
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Equal Cash Flows Each 1 Period Apart

Parts of an Annuity
(Annuity Due) Beginning of Period 1 Beginning of Period 2 Beginning of Period 3

0 $100

1 $100

2 $100

Today
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Equal Cash Flows Each 1 Period Apart

Overview of an Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 i%

1 R

n+1

. . .
R R

R = Periodic Cash Flow

FVAn =
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R(1+i)n-1 +

R(1+i)n-2 +

FVAn

... + R(1+i)1 + R(1+i)0

Example of an Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 7%

1 $1,000

2 $1,000

3 $1,000 $1,070 $1,145

FVA3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0 = $1,145 + $1,070 + $1,000 = $3,215

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$3,215 = FVA3

Future value interest factor for an ordinary annuity

FVIFi,n=1/i*<(1+i)n-1> FVA=PMT*(FVIFAi,n)

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Hint on Annuity Valuation

The future value of an ordinary annuity can be viewed as occurring at the end of the last cash flow period, whereas the future value of an annuity due can be viewed as occurring at the beginning of the last cash flow period.
3-38

Valuation Using Table III

FVAn FVA3 = R (FVIFAi%,n) = $1,000 (FVIFA7%,3) = $1,000 (3.215) = $3,215 Period 6% 7% 8% 1 1.000 1.000 1.000 2 2.060 2.070 2.080 3 3.184 3.215 3.246 4 4.375 4.440 4.506 5 5.637 5.751 5.867

3-39

Overview View of an Annuity Due -- FVAD

Cash flows occur at the beginning of the period

0 i% R

1 R

2 R

n-1

. . .
R R

FVADn = R(1+i)n + R(1+i)n-1 + ... + R(1+i)2 + R(1+i)1 = FVAn (1+i)

3-40

FVADn

numerical


Martin has $10000 that she can deposit in any of three saving counts for a 3 year period. Bank A compounds interest on an annual basis, bank B compounds interest twice each year, Bank C compounds interest each quarter. All three banks have a stated annual interest rate of 4% What amount would Ms.Martin have at the end of third year? On the basis of your findings in banks, which bank should she prefer.

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NUMERICALS


Ramish wishes to choose the better of two equally costly cash flow streams: annuity X and annuity Y.X is an annuity due with a cash inflow of $9000 for each of 6 years is an ordinary annuity with cash inflow of 410000 or each of 6 years. Assume that he can earn 15% on his investment. On a subject basis, which annuity do you think is more attractive and why? Find the future value at the end of year 6,for both annuity x and Y.

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NUMERICALS


what is the present value of $ 6000 to be received at the end of 6 years if the discount rate is 12%? $100 at the end of three years is worth how much today, assuming a discount rate of 100% 10% 0%

  

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Example of an Annuity Due -- FVAD

Cash flows occur at the beginning of the period

0 7% $1,000

1 $1,000

2 $1,000

3 $1,070 $1,145 $1,225

FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3 2 + $1,000(1.07)1 $1,000(1.07) = $1,225 + $1,145 + $1,070 = $3,440
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Valuation Using Table III

FVADn FVAD3 = R (FVIFAi%,n)(1+i) = $1,000 (FVIFA7%,3)(1.07) = $1,000 (3.215)(1.07) = $3,440 Period 6% 7% 8% 1 1.000 1.000 1.000 2 2.060 2.070 2.080 3 3.184 3.215 3.246 4 4.375 4.440 4.506 5 5.637 5.751 5.867

3-45

Present value of ordinary annuity

PVA=PMT(PVIFAi,n) PVIF=

1 - 1 (1+i)n i

3-46

PRESENT VALUE OF ANNUITY DUE

PVIF=PVIFA*(1+i)

3-47

PV of an ordinary annuity

Braden company a small producer of toys wants to determine the most it should pay to purchase a particular ordinary annuity. the annuity consist of cash flows of 700v at the end of each year for 5 years. The firm requires the annuity to provide a minimum return of 8%.

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Long method for finding the present value of an ordinary annuity



Year

      

CF PVIF8%,n (1) (2) 1 700 0.926 2 700 0.857 3 700 0.794 4 700 0.735 5 700 0.681 present value of annuity=2795.10 PVIF=1/i*(1-1/(1+i)n)

PV (1*2) 648.20 599.90 555.80 514.50 476.70

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Finding present value of an Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 i%

1 R

n+1

. . .
R R R = Periodic Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2 + ... + R/(1+i)n

3-50

Example of an Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 7%

1 $1,000

2 $1,000

3 $1,000

$ 934.58 $ 873.44 $ 816.30 $2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 + $1,000/(1.07)3

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= $934.58 + $873.44 + $816.30 = $2,624.32

Hint on Annuity Valuation

The present value of an ordinary annuity can be viewed as occurring at the beginning of the first cash flow period, whereas the present value of an annuity due can be viewed as occurring at the end of the first cash flow period.
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Valuation Using Table IV

PVAn PVA3 = R (PVIFAi%,n) = $1,000 (PVIFA7%,3) = $1,000 (2.624) = $2,624 Period 6% 7% 8% 1 0.943 0.935 0.926 2 1.833 1.808 1.783 3 2.673 2.624 2.577 4 3.465 3.387 3.312 5 4.212 4.100 3.993

3-53

Overview of an Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 i% R

1 R

n-1

. . .
R R

PVADn

R: Periodic Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1 = PVAn (1+i)

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Example of an Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 7% $1,000.00 $ 934.58 $ 873.44

1 $1,000

2 $1,000

$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 + $1,000/(1.07)2 = $2,808.02

3-55

Valuation Using Table IV

PVADn = R (PVIFAi%,n)(1+i) PVAD3 = $1,000 (PVIFA7%,3)(1.07) = $1,000 (2.624)(1.07) = $2,808 Period 6% 7% 8% 1 0.943 0.935 0.926 2 1.833 1.808 1.783 3 2.673 2.624 2.577 4 3.465 3.387 3.312 5 4.212 4.100 3.993
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Steps to Solve Time Value of Money Problems

1. Read problem thoroughly 2. Determine if it is a PV or FV problem 3. Create a time line 4. Put cash flows and arrows on time line 5. Determine if solution involves a single CF, annuity stream(s), or mixed flow 6. Solve the problem 7. Check with financial calculator (optional)
3-57

Mixed Flows Example

Julie Miller will receive the set of cash flows below. What is the Present Value at a discount rate of 10% 10%?

1
10% $600

$600 $400 $400 $100

PV0
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How to Solve?
1. Solve a piece-at-a-time by piece-at- time discounting each piece back to t=0. 2. Solve a group-at-a-time by first group-at- time breaking problem into groups of annuity streams and any single cash flow group. Then discount each group back to t=0.
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Piece-At-A-Time Piece-At0
$545.45 $495.87 $300.53 $273.21 $ 62.09

1
10% $600

$600 $400 $400 $100

$1677.15 = PV0 of the Mixed Flow

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Group-AtGroup-At-A-Time (#1)
0
10% $600
$1,041.60 $ 573.57 $ 62.10 $1,677.27 = PV0 of Mixed Flow [Using Tables] $600(PVIFA10%,2) = $600(1.736) = $1,041.60 $400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57 $100 (PVIF10%,5) = $100 (0.621) = $62.10
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$600 $400 $400 $100

Group-AtGroup-At-A-Time (#2)
0
$1,268.00

1
$400

2
$400

3
$400

4
$400

Plus
$347.20

1
$200

2
$200

PV0 equals $1677.30.

3 4 5
$100

Plus
$62.10
3-62

Frequency of Compounding
General Formula: FVn = PV0(1 + [i/m])mn
n: m: i: FVn,m: PV0:
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Number of Years Compounding Periods per Year Annual Interest Rate FV at the end of Year n PV of the Cash Flow today

Impact of Frequency
Julie Miller has $1,000 to invest for 2 years at an annual interest rate of 12%. Annual Semi
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FV2 FV2

= 1,000 1,000(1+ [.12/1])(1)(2) = 1,254.40 = 1,000 1,000(1+ [.12/2])(2)(2) = 1,262.48

Impact of Frequency
Qrtly Monthly Daily FV2 FV2 FV2 = 1,000 1,000(1+ [.12/4])(4)(2) = 1,266.77 = 1,000 1,000(1+ [.12/12])(12)(2) = 1,269.73 = 1,000 [.12/365])(365)(2) 1,000(1+ = 1,271.20

3-65

Present value of perpetuity

An

annuity with an infinite life, providing continual annual cash flow

PVIF=1/i

3-66

Effective Annual Interest Rate

The annual rate of interest actually paid or earned The actual rate of interest earned (paid) after adjusting the nominal rate for factors such as the number of compounding periods per year.

(1 + [ i / m ] )m - 1
3-67

Nominal annual rate

Contractual

annual rate of interest charged by a lender or promised by a borrower.

3-68

BWs Effective Annual Interest Rate

Basket Wonders (BW) has a $1,000 CD at the bank. The interest rate is 6% compounded quarterly for 1 year. What is the Effective Annual Interest Rate (EAR EAR)? EAR = ( 1 + 6% / 4 )4 - 1 = 1.0614 - 1 = .0614 or 6.14%!
3-69

Loan amortization
The

determination of the equal periodic loan payments necessary to provide lender with a specified interest return and to repay the loan principal over a specified period.

3-70

Steps to Amortizing a Loan

1. 2. 3. 4. 5.
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Calculate the payment per period. Determine the interest in Period t. (Loan balance at t-1) x (i% / m) Compute principal payment in Period t. (Payment - interest from Step 2) Determine ending balance in Period t. (Balance - principal payment from Step 3) Start again at Step 2 and repeat.

Amortizing a Loan Example

Julie Miller is borrowing $22,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years. Step 1: Payment PV0 = R (PVIFA i%,n) $22,000 = R (PVIFA 12%,5) $22,000 = R (3.605) R = $22,000 / 3.605 = $5351
3-72

Amortizing a Loan Example

End of Payment Year 0 --1 2 3 4 5 6
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Interest Principal Ending (Pmt-int) Balance ----$22,000 2640 2315 1951 1542 1085 573 2711 3036 3400 3809 4266 4778 19289 16253 12853 9044 4778 0

$5351 5351 5351 5351 5351 5351

Usefulness of Amortization
1. Determine Interest Expense -Interest expenses may reduce taxable income of the firm.
Calculate Debt Outstanding -- The quantity of outstanding debt may be used in financing the day-to-day activities of the firm.

2.

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