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Time Value of Money

(Text reference: Chapter 4) Topics Background One period case - single cash ow Multi-period case - single cash ow Multi-period case - compounding periods Multi-period case - multiple cash ows Perpetuities Annuities Mortgages Amortization schedules
AFM 271 - Time Value of Money Slide 1

Background
the economic value of a cash ow depends on when it occurs (i.e. the timing of the cash ow) $1 today > $1 tomorrow > $1 a year from now > . . . present value calculations allow us to determine the value today of a stream of cash ows to be recd/paid in the future, by taking into account the time value of money this is an important concept which is widely used both in corporate and in personal nancial decision-making

AFM 271 - Time Value of Money

Slide 2

Contd
notation: PV = present value = value today of a stream of cash ows FV = future value = value at some future time of a stream of cash ows C = cash ow r = interest rate (a.k.a. discount rate) T = number of years m = number of periods in a year n = total number of periods (n = m T ) we will often apply subscripts to indicate time, e.g. Ct is a cash ow occurring at time t
AFM 271 - Time Value of Money Slide 3

One Period Case - Single Cash Flow


cash ow assumptions: timing and size are given in all our examples, and for now there is no risk as long as we measure investment alternatives at the same point in time, we can rank them consistently example: you have $100,000. An investment costs C0 = $100,000 today, and returns C1 = $104,000 in a year. A bank offers a 5% annual interest rate on deposits. Should you make the investment (option A) or put your money in the bank (option B)? FV analysis: PV analysis: PV = C1 /(1 + r)
AFM 271 - Time Value of Money Slide 4

Contd
net present value: NPV = (PV of future cash ows) - (cost of investment today) NPV < 0 dont invest (since the cost of the investment today exceeds the value today of all its future cash ows) calculate NPV for options A and B:

observations: PV analysis and FV analysis both yield the same conclusion; the difference is only the time at which the cash ows are compared NPV also gives the same conclusion (A and B cost the same, so we are really just comparing their PVs)
AFM 271 - Time Value of Money Slide 5

Contd
another example: a piece of land costs $20,000 and will be worth $21,500 a year from now. The bank pays a 4% annual interest rate. Should you invest? PV analysis:

FV analysis:

NPV analysis:

AFM 271 - Time Value of Money

Slide 6

Multi-Period Case - Single Cash Flow


two types of interest: simple interest: interest earned only on original principal FV after 1 yr = C0 + C0 r FV after 2 yrs = C0 + C0 r + C0 r . . .
n terms

FV after n yrs = C0 + C0 r + C0 r + + C0 r = C0 (1 + n r)

AFM 271 - Time Value of Money

Slide 7

Contd
compound interest: interest earned on original principal and on previously earned interest FV after 1 yr = C0 (1 + r) FV after 2 yrs = C0 (1 + r) (1 + r) . . .
n terms

FV after n yrs = C0 (1 + r) (1 + r) (1 + r) = C0 (1 + r)n

AFM 271 - Time Value of Money

Slide 8

Contd
the power of compounding ($100 deposited at 6% and 10%)
Time (years) 6% simple 6% compound 10% simple 10% compound 1 106 106 110 110 2 112 112.36 120 121 4 124 126.25 140 146.41 10 160 179.08 200 259.37 50 400 1842.02 600 11739.09 100 700 33930.21 1100 1378061.23

other examples: text p. 85: Julius Caesar lent one penny to someone; assuming 6% annual interest, what would be owed on this loan 2,000 years later? the island of Manhattan was purchased in 1626 for the equivalent of $24; what would this amount be worth in 2005, assuming 5% annual interest?
AFM 271 - Time Value of Money Slide 9

Contd
discounting moves a cash ow that is expected to occur in the future back to today (i.e. nding PV) compounding moves a cash ow from present to future value amounts (i.e. nding FV) cash ows at different points in time cannot be compared or aggregated, unless rst brought to the same point in time (via discounting and/or compounding) example: C0 = 120, C5 = 130. Adding these up to 250 is meaningless (like adding 120 + $130), but we can nd the value of the combined CFs at any point in time by discounting and/or compounding (like using exchange rates for currency conversion).
AFM 271 - Time Value of Money Slide 10

Contd
some examples: how much must be invested today in order to receive $1,000 in 5 years if interest is compounded at 7% per annum?

what is the annual compound interest rate equivalent to a simple interest rate of 6% for a ve year investment?

suppose a banks annual compound interest rate is 4%. What is the PV of $100 invested for 5 years at 4% simple interest?

AFM 271 - Time Value of Money

Slide 11

Multi-Period Case - Compounding Periods


stated annual rate: (SAR) not the whole story unless the compound frequency is given effective annual rate: (EAR) if compounding occurs m times per year, then EAR = (1 + SAR/m)m 1 example: SAR = 10%, C0 = $1 annual compounding FV1 = $1 (1 + 0.10) = $1.10 EAR = 10% EAR = 10.25% EAR = 10.38%
Slide 12

semi-annual compounding FV1 = $1 (1 + 0.10/2)2 = $1.1025 quarterly compounding FV1 = $1 (1 + 0.10/4)4 = $1.1038
AFM 271 - Time Value of Money

Contd
we can also have monthly, weekly, daily compounding, etc. example: Mastercard statement says that the annual interest rate is 18.4%, the daily interest rate is .05041%, and interest is compounded daily. What is EAR? in the limit: limm 1 + SAR m FV1 = $1 e0.10 = $1.1052
mT

= eSART

this is called continuous compounding : EAR = 10.52%

why does EAR increase as compounding period decreases (i.e. as compounding frequency increases)?

AFM 271 - Time Value of Money

Slide 13

Contd
converting between compounding frequencies: e.g. 10% compounded semi-annually is equivalent to what rate compounded weekly? compounding over several years at non-annual compounding frequencies: FVT = C0 (1 + SAR/m)mT FV of $100 invested for 6 years at 5% compounded monthly: continuous compounding over many years: FVT = C0 eSART C7 = $1,000, what is PV today if interest rate is 5.5% compounded continuously?
AFM 271 - Time Value of Money Slide 14

Multi-Period Case - Multiple Cash Flows


time line:
t =0 t=1 t=2 t=3

... ...

t=k

... ...

t=n

C0

C1

C2

C3

Ck

Cn

t = k implies end of year k, beginning of year k + 1


C3 Cn C2 1 PV = C0 + 1C +r + (1+r)2 + (1+r)3 + + (1+r)n

e.g. if r = 6%, calculate PV of the following cash ows:


t =0 t=1 t=2 t=3

-$100 $150
AFM 271 - Time Value of Money

-$80

$300
Slide 15

Contd
Summarizing to here: simple interest: FV = C0 (1 + n r) discrete compounding/discounting: SAR FVT = C0 1 + m = C0 (1 + r)n
mT

PV0 =

CT
mT

1 + SAR m CT = (1 + r)n

continuous compounding/discounting: FVT = C0 erT , PV0 = CT erT with multiple CFs, treat each one separately and add (as in the example on slide 15). There are no convenient formulas if cash ows vary in general, but there are for nice cash ows.
AFM 271 - Time Value of Money Slide 16

Perpetuities
a perpetuity is a stream of equal cash ows that occur every period forever, 1st payment one period from now:
t=0 C0 = 0 t=1 C1 = C t=2 C2 = C t=3 C3 = C t=4 C4 = C t =5 C5 = C

PV of a perpetuity is PV = C C C + + + (1 + r) (1 + r)2 (1 + r)3 C = r

e.g. if r = 3%, nd PV of a perpetuity paying $200/year:


AFM 271 - Time Value of Money Slide 17

Contd
a growing perpetuity is a stream of cash ows that occurs every period forever, has 1st payment one period from now, and grows at a rate of g per period:
0 0 1 C 2 C(1 + g) 3 C(1 + g)2 4 C(1 + g)3

PV of a growing perpetuity is C(1 + g) C(1 + g)2 C(1 + g)3 C + + + + PV = (1 + r) (1 + r)2 (1 + r)3 (1 + r)4 C = (r g)
AFM 271 - Time Value of Money Slide 18

Contd
the formula above is valid only if g < r e.g. you wish to purchase a preferred share of ABC Co. The share is expected to pay a dividend of $2.50 next year, thereafter growing at a rate of 3%. Assume an interest rate of 8%. How much should you be prepared to pay for the share? (Assume that you will never receive your initial capital back.)

note that we could have g < 0 (a decreasing perpetuity) - reconsider the example above but assume dividends will decline at a rate of 2% per year forever:

AFM 271 - Time Value of Money

Slide 19

Annuities
ordinary annuity (a.k.a. annuity in arrears): a stream of equal cash ows that occur every period, for a specied number of periods, at the end of each period. Examples include car leases, mortgages, pensions, etc. Our PV formula below (slide 22) assumes that the 1st cash ow is one period from now. e.g. nd PV of an annuity paying $1,000 per year for 4 years, r = 7%:
0 0 1 1,000 2 1,000 3 1,000 4 1,000 5 0

AFM 271 - Time Value of Money

Slide 20

Contd
e.g. nd FV at the end of year 4 of an annuity paying $1,000 per year for 4 years, r = 7%:
0 0 1 1,000 2 1,000 3 1,000 4 1,000 5 0

AFM 271 - Time Value of Money

Slide 21

Contd
a simplifying formula for the PV of an annuity - nd a formula for the PV of an ordinary annuity paying C for a total of n periods, assuming an interest rate of r per period:

AFM 271 - Time Value of Money

1 (1 + r)n PV of annuity = C r

Slide 22

Contd
a simplifying formula for the FV of an annuity - nd a formula for the FV (at the end of n periods) of an ordinary annuity paying C for a total of n periods, assuming an interest rate of r per period:

(1 + r)n 1 FV of annuity after n periods = C r exercise: use the formulas on slides 22 and 23 to verify the calculations on slides 20 and 21
AFM 271 - Time Value of Money Slide 23

Contd
note that our PV formulas for annuities and perpetuities all assume that the 1st payment is one period from now and that the rate of interest per period is r ordinary annuity examples: you have an outstanding balance on your Visa account of $2,400. If you can only afford to repay at the rate of $150 per month, how long will it take you to repay the entire amount if the interest rate on the outstanding balance is 24% compounded monthly?

AFM 271 - Time Value of Money

Slide 24

Contd
redo the previous example, but assume that the interest rate is 24% compounded semi-annually:

you are 25 years old and wish to have savings of $200,000 by the time you retire on your 55th birthday. You are willing to put money aside for next 20 years. Assuming an interest rate of 6% until your retirement, how much must you set each year?

AFM 271 - Time Value of Money

Slide 25

Contd
annuity due (a.k.a. annuity in advance): payments are at the start of each period PV annuity due = (1 + r) PV ordinary annuity PV(FV) of annuity due > PV(FV) of ordinary annuity e.g. Sue has won a lottery, which pays $25,000 per year for 8 years, starting today. Calculate PV today and FV (in 8 years) of the lottery payout (assume r = 5%).

AFM 271 - Time Value of Money

Slide 26

Contd
delayed annuity: payments start after a delay by a certain number of periods this involves a two step calculation; e.g. Bill will graduate in 4 years, and will thereafter earn an annual income of $75,000 for 35 years (assume all income is received at end of a year). Calculate the PV of Bills lifetime earnings (assume r = 4%).

AFM 271 - Time Value of Money

Slide 27

Contd
infrequent annuity: payments occur less often than once per year this also involves a two step calculation; e.g. you plan to purchase a new $35,000 car every 5 years for next 30 years starting in 5 years. Calculate the PV of your car purchases (assume r = 6.5% per annum).

AFM 271 - Time Value of Money

Slide 28

Contd
growing annuity: like an ordinary annuity, but payments grow at a rate of g per period
0 1 2 3 n n+1

C(1 + g)

C(1 + g)2

C(1 + g)n1

PV = C

(1+g) (1+r)

rg

e.g. XYZ Fund will pay out distributions over next 10 years. The rst distribution, $80 per unit, will be paid out a year from today. Subsequent distributions will grow at a rate of 8%. No further cash ow is expected once the ten distributions have been paid out. Find the PV of one fund unit (assume r = 11%).
AFM 271 - Time Value of Money Slide 29

Mortgages
many varieties, but these are basically annuities with monthly payments, semi-annual compounding, a 25 year maturity (usually), and a term (typically 5 years) less than the maturity e.g. nd the monthly payment on a $225,000 mortgage, assuming the interest rate on the initial 5 year term is 6%

nd the monthly payment after the initial 5 year term, if the interest rate changes to 8%

AFM 271 - Time Value of Money

Slide 30

Amortization Schedules
applicable to loans being paid off over a number of periods, with constant monthly payments (e.g. mortgages, leases) the loan is said to be amortized over the loan period does not apply to debt where only interest is paid periodically, with principal repaid as a lump sum at maturity (e.g. corporate bonds) see spreadsheet handout (try to recreate it yourself) note that as time passes: principal balance decreases (eventually to zero when the last payment is made) interest portion of each payment becomes smaller principal portion of each payment becomes larger
AFM 271 - Time Value of Money Slide 31