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Chapter 4

The time value


of money

PowerPoint to accompany:

Learning Objectives

Explain the mechanics of compounding: how money


grows over time when it is invested

Determine the future or present value of a sum of


money

Discuss the relationship between compounding (future


value) and bringing money back to the present (present
value)

Calculate the effective annual rate of interest and then


explain how it differs from the nominal or stated interest
rate

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Learning Objectives

(contd)

Define an ordinary annuity and calculate its future value


and present value

Apply the annuity present value model to the process of


loan amortisation

Understand the notion of a general annuity and the


concept of equivalent interest rates

Determine the present value of an annuity due

Understand how perpetuities work

Deal with complex cash flows and deferred annuities

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Learning Objectives

(contd)

Determine how bond values change in response to


changing interest rates

Interpolate values within financial tables

Formulate multi-part and non-standard problems

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Compound interest concepts

Compound interest is where interest paid on an


investment during the first period is added to the
principal, and during the second period interest is
earned on the original principal plus the interest earned
during the first period

Money invested at compound interest accumulates at an


increasing rate each period: exponential behaviour

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Compound interest rates

The periodic rate of compound interest, i, is defined by


the following equation:
i/jm

(4.1)

where m is the number of times that interest is


compounded each year, and j is the annual rate of
compound interest or the nominal annual rate

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Compound interest rates

(contd)

The total number of compounding periods, n, is given


by the following equation:
(4.2)

where interest is compounded m times per year for t


periods

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Future value
Investing a sum of money (present value) at compound
interest results in a future value
Future Value (FV)
$1418.52
i = 6% per half year

Present Value (PV)


$1000.00

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Computing the future value

The future value at the end of the nth period, FVn, can
be determined using the following equation:
FVn = PV(1 + i)n

(4.3)

FV can also be computed using financial tables, a


financial calculator, or a spreadsheet

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Computing the future value

The future value interest factor (FVIFi,n) is the


future value of $1 for n periods at i%

If $PV is invested or borrowed today, its future value


can be found by multiplying PV by the FVIF as follows:
FVn = PV(FVIFi,n)

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(contd)

(4.4)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Computing future value

(contd)

FVIFi,n values can be obtained from financial


tables, however:

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table values will only give approximate answers

tables are limited to a specific set of values

(e.g. there is no value for i=6.2%; nor for n=240)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Moving money through time with


the aid of a financial calculator (p.86)

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Financial calculators can simplify time-value-of-money calculations

Using a Sharp EL-735 calculator (or most other financial calculators):

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Moving money through time with


the aid of a financial calculator (contd)

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Additional tips for the use of calculators:

For time-value-of-money calculations, use finance


mode

To select two decimal places (for displaying dollars


and cents), press 2ndF, then TAB, followed by 2

To clear the calculator between successive problems,


press 2ndF, then C/CE

The answers obtained using a financial calculator will


be more accurate than those obtained using tables

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Using spreadsheets for time-valueOf-money problems (p.87)

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The table below shows some of the functions used with Microsoft
Excel when moving money through time:

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Present value

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The present value is the current value of a sum of


money representing a future payment that is discounted
at an appropriate interest rate to reflect the time value
of money and other factors

The discount rate is the interest rate that converts a


future value to the present value

The discount factor is the quantity that converts a


particular future sum of money to its present value

Discounting is the process of converting a future value


to its present value

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.4: Computing the


present value (pp.88-89)

To determine an unknown PV, the following equation is


used:
PV = FVn / (1 + i)n

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(4-5)

To reach a savings target of $3,000 after two years at


8% p.a. compounded quarterly, how much would we
have to invest today?

Answer (using a financial calculator):


Substitute FV=$3000, i =2% per quarter and n = 8
quarters (two years) into Equation 4-5:
PV = $3,000 / (1.02)8 = $3,000 / 1.17166
= $2,560.47

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.4: Computing the


present
value (pp.88-89) (contd)
To determine an unknown PV, the following equation can
also used:
PV = FVn(PVIFi,n) (4-6)

To reach a savings target of $3,000 after two years at 8%


p.a. compounded quarterly, how much would we have to
invest today?

Answer (using a financial table):


Substitute FV=$3000, i =2% per quarter and n = 8
quarters (two years) into Equation 4-6:
PV = FVn (PVIFi,n) =
$3,000 (PVIF2%,8)
=

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$2559.00

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.5: Solving for the


number
of
periods,
n
(p.90)

To determine an unknown n, the following equation is


used:
n = log(FV/PV) / log(1 + i)

(4-7)

How many months did it take to repay a loan of $300 if


the sum repaid was $358.84 at an interest rate of 12%
p.a. compounded monthly?

Answer: Substituting in Equation 4-7:


n = log(358.84 / 300) / log1.01
= log1.19613 / log1.01
= 18 months

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.6: Solving for the


interest
rate,
i
(p.90-1)
To determine an unknown i, the following equation is used:
i = (FV/PV)1/n - 1

(4-8)

Assume that two years ago, an investment of $10,000 was


made

The investment has grown to a sum of $12,668. The interest


was compounded quarterly. Has the investment earned at
least 12% p.a.?

Answer: Substituting in Equation 4-8:


i = ($12 668/$10 000)1/8 - 1
= (1.2688).125 1
= 3% per quarter = nominal rate of 12% p.a

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.7: Making interest rates


comparable (p.91)

To determine the effective annual interest rate (EAR),


the following equation is used:
EAR = (1 + j/m)m 1

(4-9a)

What is the effective annual rate if 12% p.a. is


compounded twice per year?

Answer: Substituting in Equation 4-9a:


EAR = (1 + 12/2)2 1
= (1.06)2 1
= 12.36% (greater than the nominal
interest rate!)

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

The Rate of simple interest


Simple interest:

is often used in short-term investing and borrowing

is not compounded: interest is only paid on the original


principal borrowed or invested

is directly proportional to the time of the investment


SI = P x r x t

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where P = principal, r = interest rate and t = time

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Annuities

An annuity is a series of equal dollar payments


for a specified number of periods

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e.g. payments on a housing loan, pension receipts


from a superannuation pension fund or interest
payments on bonds

An ordinary annuity is an annuity whose


payments are made at the end of each period

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Future value of an ordinary


annuity

The future value of an ordinary annuity can be


calculated using the following equation:
[(1+ i) n -1]
FVn = PMT
i

(4.11)

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Future value of an ordinary


annuity: Table 4.3 (p.95) (contd)

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.9: Future value of an


ordinary annuity (p.96) (contd)

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What is the FV of an annuity of $100 per quarter for one


and a half years if the interest rate is 8% per annum
compounded quarterly? As remarked in relation to Table
4.3, this means the annuity has the following features:
PMT = $100 per quarter, n = 6 quarters, and i = 2% per
quarter (.02 as a decimal)

Answer:

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Future value of an ordinary


annuity (contd)

To determine the payment amount of an annuity the


following equation is used:

i(FV )
PMT =
(1+ i) -1
n

To determine the number of annuity periods the


following
equation is used:
n = log[{FV.i/PMT} + 1]
log(1 + i)

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(4.13)

(4.14)

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Solving for the annuity interest


rate

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To solve for the annuity interest rate:

use trial and error if using a financial calculator

rearrange Equation 4-12 and use FVIFA tables:

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Present value of an ordinary


annuity

The present value of an ordinary annuity can


be calculated using the following equation:
(4-15)

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.12: Present value of an


ordinary annuity (p.98) (contd)

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What is the PV of an annuity of $100 per quarter for one


and a half years if the interest rate is 8% per annum
compounded quarterly?

The annuity has the following features: PMT = $100 per


quarter, n = 6 quarters, and i = 2% per quarter (.02 as a
decimal)

Answer on next slide

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.12: Present Value of an


Ordinary Annuity (p.98) (contd)

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Answer:

Substituting in Equation 4-15 we have:

This PV amount is correct as is shown in Table 4.4


(p.100)

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Amortising a loan: Table 4.4

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(p.100)

Loan amortisation is the process of paying off a loan

Term loans are amortised in equal instalments over a


specified number of periods (terms)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Present value of an ordinary


annuity (contd)

To determine the payment amount of an annuity:


(4.17)

To determine the number of annuity periods:


n = -log[1 - (PV.i/PMT)]
log(1 + i)

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(4.18)

The annuity interest rate is found by trial and error

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Annuity due

Annuity due is an annuity where payments are made at


the beginning of each period

To determine the present value of an annuity due:


(4.20)

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Or:

PVdue = PMT(1 + PVIFAi,n 1)

(4.21)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Ordinary annuity versus annuity


due: Figure 4.4 (p.105)

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As Figure 4.4 shows, the timing of the payments in these


two types of annuity differ:

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Perpetuity

Perpetuity is an annuity with an infinite life

e.g. the dividend stream on preference shares

To determine the present value of a perpetuity, the


following equation is used:
PV = PMT/i

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(4.22)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Complex cash flows

Complex cash flows are cash flows that are


irregular

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e.g. revenue tapering off as a product is outdated

To determine the PV of an irregular cash flow,


the PV of each individual cash flow are added

To determine the overall FV of unequal cash


flows, the FV of the sum of the PV of each
individual cash flow is calculated

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Bond valuation

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A bond:

is a long-term debt security

pays the owner of the security a predetermined


amount of interest each year (coupons) and a
principal amount at maturity

usually has a fixed interest rate

Bond prices change in response to interest rate


changes in financial markets

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Bond pricing at the time of


acquisition

There are two present value components of a


bond:

present value of the coupon interest payments

present value of the maturity value

Thus, the bond price can be given by:


[1- (1 + i) -n ]
FVn
PV PMT

i
(1 + i) n

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(4.23)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Bond pricing if the yield changes

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If the investors yield increased from 10% to


12%, the PV would be lower

If the investors yield decreased to 8% from


10%, the price (PV) would be higher

Bond prices decrease as bond yields increase

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Solving multi-part and nonstandard problems


1. Draw a timeline
Identify what is known and needs to be known

2. Determine what unknown(s) the problem involves


3. Identify the class of problem

Compounding or discounting? Annuity? Perpetuity?

4. Identify any traps in the problem


5. Formulate the problem

Which equation to use? How to set up spreadsheet?

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How financial managers use this


material

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Almost all business decisions involve cash flows that


occur in different time periods

A dollar today is not worth the same as in a years time,


so cash flows need to be valued in such a way that they
are comparable

Financial managers require an understanding of the


time value of money to ensure profitable investments
are made

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End of Chapter 4

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Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition