The Time Value of Money

Economics 71a Spring 2007 Mayo, Chapter 7 Lecture notes 3.1

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More applications

Compounding
PV = present or starting value FV = future value R = interest rate n = number of periods

First example
PV = 1000 R = 10% n=1 FV = ? FV = 1000*(1.10) = 1,100

Example 2
Compound Interest

PV = 1000 R = 10% n=3 FV = ?

FV = 1000*(1.1)*(1.1)*(1.1) = 1,331
FV = PV*(1+R)^n

Example 3:
The magic of compounding

PV = 1 R = 6% n = 50 FV = ?
> FV = PV*(1+R)^n = 18 > n = 100, FV = 339 > n = 200, FV = 115,000

Example 4:
Doubling times

Doubling time = time for funds to double

FV 2 (1 R)n PV log(2) n log(1 R) log(2) n log(1 R)

Example 5
Retirement Saving

PV = 1000, age = 20, n =45 R = 0.05

> FV = PV*(1+0.05)^45 = 8985 > Doubling 14

R = 0.07
> FV=PV*(1+0.07)^45 = 21,002 > Doubling = 10

Small change in R, big impact

Retirement Savings at 5% interest

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More applications

Present Value
Go in the other direction Know FV FV Get PV PV

(1 R)n

Answer basic questions like what is $100 tomorrow worth today

Example
Given a zero coupon bond paying $1000 in 5 years

How much is it worth today? R = 0.05 PV = 1000/(1.05)^5 = $784 This is the amount that could be stashed away to give 1000 in 5 years time

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More applications

Annuity
Equal payments over several years
> Usually annual

Types: Ordinary/Annuity due

> Beginning versus end of period

Present Value of an Annuity

Annuity pays $100 a year for the next 10 years (starting in 1 year) What is the present value of this? R = 0.05 10 100
PV
i1

(1 R)

772

Future Value of An Annuity

Annuity pays $100 a year for the next 10 years (starting in 1 year) What is the future value of this at year 10? R = 0.05
FV 100(1.05)i
i0 9

Why the Funny Summation?

Period 10 value for each
> Period 10: > Period 9: > Period 8: > > Period 1: 100 100(1.05) 100(1.05)(1.05) 100(1.05)^9

Be careful!

Application: Lotteries
Choices
> $16 million today > $33 million over 33 years (1 per year)

R = 7%
PV 1 (1 0.07)i i1
33

PV=$12.75 million, take the $16 million today

Another Way to View An Annuity

Annuity of $100
> Paid 1 year, 2 year, 3 years from now

Interest = 5% PV = 100/(1.05) + 100/(1.05)^2 + 100/(1.05)^3 = 272.32

Cost to Generate From Today

Think about putting money in the bank in 3 bundles One way to generate each of the three $100 payments How much should each amount be?
> 100 = FV = PV*(1.05)^n (n = 1, 2, 3) > PV = 100/(1.05)^n (n = 1, 2, 3)

The sum of these values is how much money you would have to put into bank accounts today to generate the annuity Since this is the same thing as the annuity it should have the same price (value)

Perpetuity
This is an annuity with an infinite life

Discounting to infinity
Math review:
s ai
i1

as a i1 a i
i1 i2

s as a a s 1 a

Present Value of a Constant Stream

a 1 1 R

PV

i1

y (1 R)i ai

1 1 R

PV y

i1

1 1 a y (1 R) (1 R) PV y (y) 1 1 R 1 1 a R 1 (1 R) 1 R (1 R)

Perpetuity Examples and Interest Rate Sensitivity

Interest rate sensitivity
> y=100 > R = 0.05, PV = 2000 > R = 0.03, PV = 3333

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More applications

Mixed Stream
Apartment Building

Pays $500 rent in 1 year Pays $1000 rent 2 years from now Then sell for 100,000 3 years from now R = 0.05
500 1000 100000 PV 87, 767 2 3 1.05 (1.05) (1.05)

Mixed Stream
Investment Project

Pays -1000 today Then 100 per year for 15 years R = 0.05
100 PV 1000 38 i (1.05) i1
15

Implement project since PV>0 Technique = Net present value (NPV)

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More applications

Term Structure
We have assumed that R is constant over time In real life it may be different over different horizons (maturities) Remember: Term structure Use correct R to discount different horizons

Term Structure
y1 y2 y3 PV 2 (1 R1 ) (1 R2 ) (1 R3 )3

Discounting payments 1, 2, 3 years from now

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More examples

Frequency and compounding

APR=Annual percentage rate Usual quote:
> 6% APR with monthly compounding

What does this mean?

> R = (1/12)6% every month

That comes out to be

> (1+.06/12)^12-1 > 6.17%

Effective annual rate

General Formulas
Effective annual rate (EFF) formula
APR m EFF (1 ) 1 m

Limit as m goes to infinity

APR EFF e APR 1 EFF e

For APR = 0.06 limit EFF = 0.0618

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More examples

More Examples
Home mortgage Car loans College Calculating present values

Home Mortgage
Amortization

Specifications:
> $100,000 mortgage > 9% interest > 3 years (equal payments) pmt

Find pmt
> PV(pmt) = $100,000

Mortgage PV
Find PMT so that
PMT PV 100000 i (1.09) i1 PMT 1 100000 i (1.09) i1
3 3

Solve for PMT

> PMT = 39,504

Car Loan
Amount = $1,000 1 Year
> Payments in months 1-12

12% APR (monthly compounding) 12%/12=1% per month PMT?

Car Loan
Again solve, for PMT
PMT PV 1000 i (1.01) i1 PMT 1 1000 i (1.01) i1
12 12

PMT 88.85 =

Total Payment
12*88.85 = 1,066.20 Looks like 6.6% interest Why?
> Paying loan off over time

Payments and Principal

How much principal remains after 1 month?
> You owe (1+0.01)1000 = 1010 > Payment = 88.85 > Remaining = 1010 88.85 = 921.15

How much principal remains after 2 months?

> (1+0.01)*921.15 = 930.36 > Remaining = 930.36 88.85 = 841.51

College
1. Compare
Should you go?
PV(wage with college)-PV(tuition) PV(wage without college)

2. What about student loans? 3. Replace PV(tuition) with PV(student loan payments) Note: Some of these things are hard to estimate Second note: Most studies show that the answer to this question is yes

Calculating Present Values

Sometimes difficult Methods
> Tables (see textbook) > Financial calculator (see book again) > Excel spreadsheets (see book web page) > Java tools (well use these sometimes) > Other software (matlab)

Discounting and Time: Summary

Powerful tool Useful for day to day problems
> Loans/mortgages > Retirement

We will use it for

> Stock pricing > Bond pricing

Goals
Compounding and Future Values Present Value Valuing an income stream
> Annuities > Perpetuities

Mixed streams Term structure again Compounding More examples