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Ch.

2 - Time Value of
Money

Topics Covered
Future Values
Present Values
Multiple Cash Flows
Perpetuities and Annuities
Non-annual interest compounding

Effective Annual Interest Rate

The Time Value of Money


Compounding and
Discounting Single Sums

The greatest mathematical discovery of all

time is compound interest.


Albert Einstein

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.

Example: Simple vs. Compound


Interest
Compare $100 invested at 10% interest

compound annually vs. 10% simple annual


interest for 3 years.

Future Value of Single Cash Flow

FV PV (1 i)

Future Values of $100 with Compounding


Interest Rates

Example: Futurama Value?


Fry is frozen in the year 2000 with $0.93 in

his checking account that pays 2.25%


compounded annually. How much does Fry
have in his account when he awakes a
thousand years later in the year 3000?

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Present Value
Today's value of a lump sum received at a future point in
time:

FVn PV 1 i

PV

FVn
(1 i )

n
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Example: Paying for Babys MBA


Just had a baby. You think the baby will take

after you and earn academic scholarships to


attend college to earn a Bachelors degree.
However, you want send your baby to a topnotch 2-year MBA program when baby is 25.
You have estimated the future cost of the
MBA at $102,000 for year 1 and $107,000 for
year 2.

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Example: Paying for Babys MBA


Today, you want to finance both years of

babys MBA program with one payment


(deposit) into an account paying 6.5% interest
compounded annually.
How large must this deposit be?

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Present Value of One Dollar ($)

The Power of High Discount Rates

1.00

0%

0.75
0.5
5%
0.25

10%
15%
20%
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods

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Time Value of Money


(applications)

Implied Interest Rates


Internal Rate of Return
Time necessary to accumulate funds

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Example : Finding Rate of Return


or Interest Rate
A broker offers you an investment (a zero

coupon bond) that pays you $1,000 five years


from now for the cost of $740 today.
What is your annual rate of return?

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The Time Value of Money


Compounding and Discounting
Cash Flow Streams

4
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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
FV20

Examples of Ordinary Annuities:


If you buy a bond, you will receive equal

semi-annual coupon interest payments over


the life of the bond.
If you borrow money to buy a house or a car,
you will re-pay the loan with a stream of equal
payments.

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Annuity-due
A sequence of periodic cash flows occurring

at the beginning of each period.

0
PV

4
FV22

Examples of Annuities-due
Monthly Rent payments: due at the beginning

of each month.
Car lease payments.
Cable & Satellite TV and most internet
service bills.

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What is the difference between an ordinary


annuity and an annuity due?
Ordinary Annuity
0

i%

Annuity Due
0

PMT

i%

PMT

PMT

PMT

PMT

PMT
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Solving for FV:


3-year ordinary annuity of $100 at 10%
$100 payments occur at the end of each

period, but there is no PV.

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
331
25

Solving for PV:


3-year ordinary annuity of $100 at 10%
$100 payments still occur at the end of each

period, but now there is no FV.

INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-248.69

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Solving for FV:


3-year annuity due of $100 at 10%
Now, $100 payments occur at the beginning of each

period.
FVAdue= FVAord(1+I) = $331(1.10) = $364.10.
Alternatively, set calculator to BEGIN mode and
solve for the FV of the annuity:
BEGI
N
INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV
364.10

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Solving for PV:


3-year annuity due of $100 at 10%
Again, $100 payments occur at the beginning of each

period.
PVAdue= PVAord(1+I) = $248.69(1.10) = $273.55.
Alternatively, set calculator to BEGIN mode and solve for
the PV of the annuity:
BEGI
N
INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-273.55

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Annuities
Applications
Value of payments
Implied interest rate for an annuity
Calculation of periodic payments
Mortgage payment
Annual income from an investment payout
Future Value of annual payments

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Example: Invest Early in an IRA


How much would you have at age 65 if you

deposit $2,400 at the end of each year in an


investment account with a 9% expected
annual return starting at:
(A) age 44?
(B) age 22?

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A) Start at age 44

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B) Start at age 22

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Solving for PMT:


How much must the 44-year old deposit annually
to catch the 22-year old?
To find the required annual contribution, enter the

number of years until retirement and the final goal


of $1,058,030 and solve for PMT.

INPUTS
OUTPUT

21

I/YR

PV

1,058,030

PMT

FV

-18,639

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Now about this?


Lets assume that the 44-year old has already

accumulated $120,000 in the IRA account.


How much would he have to deposit on an
annual basis at the 9% expected annual
return to catch up with the 22-year old and be
a millionaire at age 65?

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35

More Annuity Fun!


Springfield mogul Montgomery Burns, age 85, wants

to retire at age 100 so he can steal candy from


babies full time. Once Mr. Burns retires, he wants to
withdraw $100 million at the beginning of each year
for 10 years from a special off-shore account that will
pay 20% annually. In order to fund his retirement, Mr.
Burns will make 15 equal end-of-the-year deposits in
this same special account that will pay 20% annually.
How large of an annual deposit must be made to fund
Mr. Burns retirement plans?

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Perpetuities
Suppose you will receive a fixed payment

every period (month, year, etc.) forever. This


is an example of a perpetuity.
PV of Perpetuity Formula

PV

PMT
i

PMT = periodic cash payment


i = interest rate
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Perpetuities & Annuities


Example - Perpetuity
You want to create an endowment to fund a football
scholarship, which pays $15,000 per year, forever,
how much money must be set aside today if the rate
of interest is 5%?

PV

15 ,PV
000

.05

15, 000
.05

$300,000
$300,000

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What is the PV of this uneven cash


flow stream?
0

100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV
40

Solving for PV:


Uneven cash flow stream
Input cash flows in the calculators CF register:

CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50

Under NPV, enter I = 10, down arrow, and press

CPT button to get NPV = $530.087. (Here NPV


= PV.)

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The Time Value of Money


Non-annual Interest
Compounding and
Discounting

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Classifications of interest rates


Nominal rate (INOM) also called the quoted or state

rate. An annual rate that ignores compounding effects.

INOM is stated in contracts. Periods must also be given,


e.g. 8% Quarterly or 8% Daily interest.

Periodic rate (IPER) amount of interest charged each

period, e.g. monthly or quarterly.

IPER = INOM / M, where M is the number of compounding


periods per year. M = 4 for quarterly and M = 12 for
monthly compounding.

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Classifications of interest rates


Effective (or equivalent) annual rate (EAR = EFF%)

the annual rate of interest actually being earned,


accounting for compounding.

EFF% for 10% semiannual investment


EFF% = ( 1 + INOM / M )M - 1
= ( 1 + 0.10 / 2 )2 1 = 10.25%

Should be indifferent between receiving


10.25% annual interest and receiving 10%
interest, compounded semiannually.
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Why is it important to consider effective


rates of return?
Investments with different compounding intervals provide

different effective returns.


To compare investments with different compounding
intervals, you must look at their effective returns (EFF% or
EAR).
See how the effective return varies between investments
with the same nominal rate, but different compounding
intervals.
EARANNUAL
EARQUARTERLY
EARMONTHLY
EARDAILY (365)

10.00%
10.38%
10.47%
10.52%

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When is each rate used?


INOM

written into contracts, quoted by banks and


brokers. Not used in calculations or shown on time
lines.
IPER
Used in calculations and shown on time lines.
If M = 1, INOM = IPER = EAR.
EAR Used to compare returns on investments with
different payments per year. Used in calculations
when annuity payments dont match compounding
periods.

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FV and PV with non-annual


interest compounding
n = number of years
m = number of times interest is paid per year
inom = stated annual rate (APR)
inom /m = periodic rate

Single CF
FVnm = PV(1 + inom/m)nm
PV = FVnm/(1 + inom/m)nm
Annuities:
Use periodic rate and number of annuity payment and
compounding periods if interest compounding period and
annuity payment period are the same.
Otherwise, need to find effective interest rate for each annuity
payment period.

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What is the FV of $100 after 3 years under 10%


semiannual compounding? Quarterly compounding?

I NOM M N
FVn PV ( 1
)
M
0.10 2 3
FV3S $100( 1
)
2
6
FV3S $100(1.05) $134.01
FV3Q $100(1.025)12 $134.49
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Futurama Value Revisited


How much money would Fry have in his bank

account in the year 3000 from the $0.93


deposited in the year 2000 if the 2.25%
annual rate was compounded quarterly?

49

Lets buy a car!


Prof. Outback decides to purchase a brand-new 2007

Jeep Liberty Limited 4WD with heated premium leather


seats, sunroof, and satellite radio for $28,800. After
paying tax and license, Prof. Outback has $4,000 as a
down payment. Jeep offers Prof the choice of 3.9%
APR financing for 60 months or a $3,000 rebate. Prof.
Outback can receive 6.25% APR financing for 60
months through E-Loan if the rebate option is selected.

Which option would result in the lower monthly payment?


At what APR along without the rebate would the Prof. be
indifferent between the two options?

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Monthly Payments

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Indifference APR

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