Mod 2 - TVM - Compounding - Slides

7/7/15
Time Value of Money:

Compounding
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania
Copyright Michael R. Roberts
Last Time
Time Value of Money
Intuition time units like different
currencies
Tools time line and discount factor
Discounting Moving CFs back in time
Lesson: Dont add CFs with different time
unitsever!
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This Time
Time Value of Money
Compounding
USING THE TOOLS:

COMPOUNDING
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Compounding
Compounding CFs moves them forward in time
0
CF0
CF1
CF2
CF3
CF4
CF3 (1+ R )
CF2 (1+ R )
CF1 (1+ R )
CF0 (1+ R )
Compounding
0
CF0
CF1
CF2
CF3
CF4
CF3 (1+ R )
t > 0 because we are moving cash

flows forward in time
CF2 (1+ R )
CF1 (1+ R )
CF0 (1+ R )
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Compounding
0
CF0
CF1
CF2
CF3
CF4
CF3 (1+ R )
CF2 (1+ R )
We can add/subtract these CFs because they

are in the same time units (date 4)
CF1 (1+ R )
CF0 (1+ R )
Future Value
Future value, FVt() of CFs is compounded
value of CFs as of t
0
CF0
CF1
CF2
CF3
CF4
CF3 (1+ R ) = FV4 (CF3 )

1
CF2 (1+ R ) = FV4 (CF2 )

2
These are future values of CFs

as of year 4
CF1 (1+ R ) = FV4 (CF1 )

3
CF0 (1+ R ) = FV4 (CF0 )

4
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Example 1 Savings
How much money will I have after
three years if I invest $1,000 in a
savings account paying 3.5% interest
per annum?
Example 1 Savings
per annum?
Step 1: Put cash flows on a time line
0
1,000
3
?
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Example 1 Savings
per annum?
Step 2: Move cash flow forward
0
3
1,000 (1+ 0.035 )
1,000
Example 1 Savings
per annum?
0
1,000
3
1,108.7179
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Example 1 Savings
per annum?
0
3
1,108.7179
1,000
This is the future value of the 1,000

Example 2 Savings
How much money will we have four
years from today if we save $100 a
year, beginning today, for the next
three years, assuming we earn 5%
per annum?
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Example 2 Savings
How much money will we have four
years from today if we save $100 a
year, beginning today, for the next
three years, assuming we earn 5%
per annum?
Step 1: Put cash flows on a time line
0
100
100
100
100
Example 2 Savings
Step 2: Move CFs forward in time
0
100
100
100
100
?
100 (1+ 0.05 )
100 (1+ 0.05 )
100 (1+ 0.05 )

100 (1+ 0.05 )
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Example 2 Savings
Step 2: Move CFs forward in time
0
100
100
100
100
?
105.00
110.25
115.763
121.551
Example 2 Savings
Step 3: Add up cash flows
0
100
100
100
100
4
452.564 =
105.00
110.25
115.763
121.551
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Example 2 Savings
0
100
100
100
100
452.564
Interpretation 1: We will have $452.56

at the end of four years if we save $100
starting today for the next three years
and our money earns 5% per annum.
Example 2 Savings
0
100
100
100
100
452.564
Interpretation 2: The future value four

years from today of saving $100
starting today for the next three years
at 5% per annum is $452.56.
10
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Example 2 Savings (Account)

Year
0
Interest
Pre-Deposit
Balance
Deposit
$100.00
Post-Deposit
Balance
$100.00

Year
0
1
Interest
$5.00
Pre-Deposit
Balance
Deposit
$100.00
Post-Deposit
Balance
$100.00
100 0.05
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Year
0
1
Interest
$5.00
Pre-Deposit
Balance
Deposit
$100.00
Post-Deposit
Balance
$100.00
$105.00
=
100 + 5.00

Year
0
1
Interest
Pre-Deposit
Balance
Deposit
$100.00
Post-Deposit
Balance
$100.00
$5.00
$105.00
=
1
FV1 (100 ) = 100 (1+ 0.05 )
12
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Year
0
1
Interest
Pre-Deposit
Balance
$5.00
$105.00
Deposit
$100.00
$100.00
Post-Deposit
Balance
$100.00

Year
0
1
Interest
Pre-Deposit
Balance
$5.00
$105.00
Deposit
$100.00
$100.00
Post-Deposit
Balance
$100.00
$205.00
=
105 + 100
13
7/7/15

Year
0
1
2
3
4
Interest
Pre-Deposit
Balance
$5.00
$10.25
$15.76
$21.55
$105.00
$215.25
$331.01
$452.56
Deposit
$100.00
$100.00
$100.00
$100.00
$0.00
Post-Deposit
Balance
$100.00
$205.00
$315.25
$431.01
$452.56
More Generally
Can add CFs at any point in time if same units
0
CF0
CF1
CF2
CF3
CF4
CF3 (1+ R ) = PV2 (CF3 )

1
CF4 (1+ R ) = PV2 (CF4 )

2
CF1 (1+ R ) = FV2 (CF1 )

1
CF0 (1+ R ) = FV2 (CF0 )

2
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7/7/15
Summary
Lessons
We use compounding to move cash
flows forward in time
Denote the value of cash flows in the
future as future value FVs (CFt)
FVs (CFt ) = CFt (1+ R )
st
for t < s
15
7/7/15
Coming up next
Problem Set
Useful shortcuts for PV and FV of
common streams of cash flows
Problems
16
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Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
Problem Notation 1
Which of the following future value notations
denotes the value as of period six of a cash flow
received today?
a) FV0(CF6)
b) FV6(CF0)
c) FV4(CF)
d) FV0(CF0)
e) FV6(CF6)
CF0
FV6(CF0)
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7/7/15
Problem Notation 2
Which of the following future value notations
denotes the value as of period 11 of a cash flow
received in period 2?
a) FV11(CF11) 0 1 2
b) FV2(CF2)
CF2
c) FV2(CF)
d) FV11(CF2)
e) FV2(CF11)
10
11
FV11(CF2)
Problem House Value

What will the value of your house be in 10 years
if the current value is $500,000 and local home
prices are expected to appreciate by 5% per
year in the future?
0
500,000
10
?
Future Value = FV10 (CF0 ) = 500,000 (1+ 0.05 ) = 814,447.3134

10
18
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Problem 1 Savings
Your expect to earn $60,000 in after-tax income
this year and expect that income to grow by 3%
per year thereafter. If you save 10% of your
income each year, how much will you have at
the end of four years if you can invest that
money at 6% per annum? Assume that you are
paid at the end of each year and that you will
receive your first paycheck one year from today?
Problem 1 Savings (Cont.)

Period
Income
60,000
60,000
x 1.03
60,000
x 1.032
60,000
x 1.033
Savings
6,000.00
6,180.00
6,365.40
6,556.36
FV
6,000 x
6,180 x
6,365.40 6,556.36
3
2
1.06
1.06
x 1.06
=
=
=
=
7,146.10 + 6,943.85 + 6,747.32 + 6,556.36
FV
= 27,393.63
19
7/7/15
Problem 2 Savings
Imagine that your goal is to retire 34 year from today
with $1,000,000 in savings. Assuming you currently have
$5,000 in savings, what rate of return must you earn on
that savings to hit your goal?
0
32 33
5,000
34
1,000,000
1,000,000
34
FV34 ( 5,000 ) = 5,000 (1+ R ) = 1,000,000 R =
5,000
1/ 34
1= 16.86%
, or
PV0 (1,000,000 ) =
1,000,000
1,000,000
34 = 5,000 R =
5,000
(1+ R )
1/ 34
1= 16.86%
Problem 3 Savings
How much money do you need to save each
year for the next three years, starting next year,
in order to have $12,000 at the end of the fourth
year? Assume that you save the same amount
each year and that you earn 3% per annum.
Period
CF
CF
CF
12,000
CF (1+ 0.05 ) + CF (1+ 0.05 ) + CF (1+ 0.05 ) = 12,000

3
CF = 12,000 1.05 3 + 1.052 + 1.05 = 3,625.24

20
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Problem 4 Savings
Assume that you will be saving each year for
three years, starting next year. If your first year
savings is $2,500, at what constant rate must
your savings grow each year to hit your target
of $12,000 at the end of four years if your
savings earn 5% per annum?
Period
2,500
2,500(1+g)
CF(1+g)2
4
12,000
2,500 (1+ 0.05 ) + 2,500 (1+ g ) (1+ 0.05 ) + 2,500 (1+ g ) (1+ 0.05 ) = 12,000
3
(1+ g ) + 1.05 (1+ g ) 3.4689 = 0

2
g = 41.01%
Problem Education
Just prior to making the first payment, you find out your
child has received a scholarship that pays for tuition and
all expenses. So, instead of spending $130,428 per year
for four years beginning immediately, you decide to save
that money in an account earning 5% per annum and gift
it to her when she graduates in four years. How much
money will she receive?
Period
130,428
130,428
130,428
130,428
21
7/7/15
Problem Education (Cont.)

Solution 1:
FV4
= FV4 (CF0 ) + FV4 (CF1 ) + FV4 (CF2 ) + FV4 (CF3 )

= 130,428 (1+ 0.05 ) + 130,428 (1+ 0.05 )
4
+ 130,428 (1+ 0.05 ) + 130,428 (1+ 0.05 )

2
= 590,269.0327
Problem Education (Cont.)

Solution 2: The present value of the cash flows is:
PV0
= CF0 + PV0 (CF1 ) + PV0 (CF2 ) + PV0 (CF3 )

= 130,428 +
130,428
130,428
130,428
+
2 +
(1+ 0.05 ) (1+ 0.05 ) (1+ 0.05 )3
= 485,615.79
FV ( 485,615.79) = 485,615.79 (1+ 0.05 ) = 590,269.03
4
4
22

Mod 2 - TVM - Compounding - Slides

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7/7/15

Time Value of Money:

Copyright Michael R. Roberts

Copyright Michael R. Roberts

USING THE TOOLS:

Copyright Michael R. Roberts

Copyright Michael R. Roberts

t > 0 because we are moving cash

Copyright Michael R. Roberts

We can add/subtract these CFs because they

Copyright Michael R. Roberts

CF3 (1+ R ) = FV4 (CF3 )

CF2 (1+ R ) = FV4 (CF2 )

These are future values of CFs

CF1 (1+ R ) = FV4 (CF1 )

CF0 (1+ R ) = FV4 (CF0 )

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

This is the future value of the 1,000

Copyright Michael R. Roberts

Copyright Michael R. Roberts

100 (1+ 0.05 )

100 (1+ 0.05 )

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Interpretation 1: We will have $452.56

Interpretation 2: The future value four

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

Example 2 Savings (Account)

Copyright Michael R. Roberts

CF3 (1+ R ) = PV2 (CF3 )

CF4 (1+ R ) = PV2 (CF4 )

CF1 (1+ R ) = FV2 (CF1 )

CF0 (1+ R ) = FV2 (CF0 )

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Problem House Value

Future Value = FV10 (CF0 ) = 500,000 (1+ 0.05 ) = 814,447.3134

Copyright Michael R. Roberts

Copyright Michael R. Roberts

Problem 1 Savings (Cont.)

Copyright Michael R. Roberts

Copyright Michael R. Roberts

CF (1+ 0.05 ) + CF (1+ 0.05 ) + CF (1+ 0.05 ) = 12,000

CF = 12,000 1.05 3 + 1.052 + 1.05 = 3,625.24