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CHAPTER 6 Time Value of Money

Future value Present value Annuities Rates of return Amortization


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Time lines
0
i%

CF0

CF1

CF2

CF3

Show the timing of cash flows. Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the end of the first period (year, month, etc.) or, the beginning of the second period.
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Drawing time lines: $100 lump sum due in 2 years; 3-year $100 ordinary annuity
$100 lump sum due in 2 years
0
i%

100

3 year $100 ordinary annuity


0
i%

100

100

100
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Drawing time lines: Uneven cash flow stream; CF0 = -$50, CF1 = $100, CF2 = $75, and CF3 = $50
Uneven cash flow stream
0
i%

-50

100

75

50

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What is the future value (FV) of an initial $100 after 3 years, if i/yr = 10%?

Finding the FV of a cash flow or series of cash flows when compound interest is applied is called compounding. FV can be solved by using the arithmetic, financial calculator, and spreadsheet methods.
1
10%

-100

FV = ?
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Solving for FV: The arithmetic method

After 1 year: FV1 = PV ( 1 + i ) = $100 (1.10) = $110.00 After 2 years: 2 2 FV2 = PV ( 1 + i ) = $100 (1.10) =$121.00 After 3 years: 3 3 FV3 = PV ( 1 + i ) = $100 (1.10) =$133.10 After n years (general case): n FVn = PV ( 1 + i )

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What is the present value (PV) of $100 due in 3 years, if i/yr = 10%?

Finding the PV of a cash flow or series of cash flows when compound interest is applied is called discounting (the reverse of compounding).

0
10%

PV = ?

100
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Solving for PV: The arithmetic method

Solve the general FV equation for PV:

PV = FVn / ( 1 + i )n PV = FV3 / ( 1 + i )3 = $100 / ( 1.10 )3 = $75.13 Can be also solved for i & n

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Self-Test Questions

What amount must you deposit today in a three-year CD paying 4% interest annually to provide you with $2249.73 at the end of the CDs maturity? You invest $5000 today in a CD that pays 5% interest annually. If you leave your money invested for its entire maturity period, you will have $6077.53; What is the CDs term to maturity?
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Will the FV of a lump sum be larger or smaller if compounded more often, holding the stated i% constant?

LARGER, as the more frequently compounding occurs, interest is earned on interest more often.
10%

0 100

3 133.10

Annually: FV3 = $100(1.10)3 = $133.10 0 0 1 1 2 3 2 4 5 3 6

5%

100

Semiannually: FV6 = $100(1.05)6 = $134.01

134.01
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Annuity

A series of payments of an equal amount at fixed intervals for a specified number of periods.

Two types of Annuities : Ordinary Annuity Annuity due


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What is the difference between an ordinary annuity and an annuity due?


Ordinary Annuity
0
i%

1 PMT

2 PMT 2

3 PMT 3

Annuity Due
0
i%

PMT

PMT

PMT
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Ordinary Annuity (FV)

If you deposit $100 at the end of each year for 3 years in a savings account that pays 5% interest per year, how much will you have at the end of three years?
0
5%

100

100

100
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Ordinary Annuity (PV)

you deposit $100 at the end of each year for 3 years in a savings account that pays 5% interest per year. What is the PV of all of these ordinary annuities?
0
5%

100

100

100
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Annuity Due (FV)

If you deposit $100 at the Beginning of each year for 3 years in a savings account that pays 5% interest per year, how much will you have at the end of three years?
0
5%

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Annuity Due (PV)

If you deposit $100 at the Beginning of each year for 3 years in a savings account that pays 5% interest per year, how much will you have at the end of three years?
0
5%

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Self-Test Questions
What amount today deposited in a bank account paying 3% annually would allow you to withdraw $7500 at the end of each of the next 3 years?

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What is the PV of this uneven cash flow stream?


0
10%

2 300

3 300

4 -50

100

530.08 = PV
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Perpetuities
A stream of equal payments expected to continue forever. Payment PV (perpetuity) = Interest rate If the value of a perpetuity today $6000 and current interest rate is 6%, what payment would you receive in perpetuity?

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Classifications of interest rates

Nominal rate (iNOM) also called the quoted, APR 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. 6-20

Classifications of interest rates

Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest actually being earned, taking into account compounding.

EFF% for 10% semiannual investment EFF% = ( 1 + iNOM / m )m - 1 = ( 1 + 0.10 / 2 )2 1 = 10.25%

An investor would be indifferent between an investment offering a 10.25% annual return and one offering a 10% annual return, compounded semiannually.
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Why is it important to consider effective rates of return?

An investment with monthly payments is different from one with quarterly payments. Must put each return on an EFF% basis to compare rates of return. Must use EFF% for comparisons. See following values of EFF% rates at various compounding levels.
EARANNUAL EARQUARTERLY EARMONTHLY EARDAILY (365) 10.00% 10.38% 10.47% 10.52%
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Can the effective rate ever be equal to the nominal rate?

Yes, but only if annual compounding is used, i.e., if m = 1. If m > 1, EFF% will always be greater than the nominal rate.

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What is the FV of $100 after 3 years under 10% semiannual compounding? Quarterly compounding?
i NOM mn FVn PV ( 1 ) m 0.10 23 FV3S $100( 1 ) 2

6 $134.01 FV3S $100(1.05) 12 $134.49 FV3Q $100(1.025)


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Whats the FV of a 3-year $100 annuity, if the quoted interest rate is 10%, compounded semiannually?
0
5%

1 2

2 4

3 6

100

100

100

Payments occur annually, but compounding occurs every 6 months.

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Loan amortization

Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, etc. EXAMPLE: Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal payments.

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Step 1: Find the Annual Payment

Recognize that the $1000 represents the present value of an annuity of PMT dollars per year for 3 years, discounted at 10%. PVAn = PMT (PVIFAi,n) 1000 = PMT ( PVIFA10%,3) 1000 = PMT * 2.4869 PMT = $402.11
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Step 2: Find the interest paid in Year 1

The borrower will owe interest upon the initial balance at the end of the first year. Interest to be paid in the first year can be found by multiplying the beginning balance by the interest rate. INTt = Beg balt (i) INT1 = $1,000 (0.10) = $100
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Step 3: Find the principal repaid in Year 1

If a payment of $402.11 was made at the end of the first year and $100 was paid toward interest, the remaining value must represent the amount of principal repaid. PRIN = PMT INT = $402.11 - $100 = $302.11
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Step 4: Find the ending balance after Year 1

To find the balance at the end of the period, subtract the amount paid toward principal from the beginning balance. END BAL = BEG BAL PRIN = $1,000 - $302.11 = $697.89
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Constructing an amortization table: Repeat steps 1 4 until end of loan


Year
1 2 3 TOTAL

BEG BAL PMT


$1,000 698 366 $402 402 402 1,206.34

INT
$100 70 37 206.34

PRIN

END BAL $302 $698


332 366 366 0 -

1,000

Interest paid declines with each payment as the balance declines. What are the tax implications of this?
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Illustrating an amortized payment: Where does the money go?


$
402.11

Interest
302.11

Principal Payments

Constant payments. Declining interest payments. Declining balance.

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