Академический Документы
Профессиональный Документы
Культура Документы
$6,078
$6,000
$5,788
$5,750
Simple Compound $7,000
$5,513
$5,500
$5,250
$5,250
$5,000
$5,000
Year
23
Problem 1.2
If you invest $100 today in an account that
pays 7% each year for four years and 3%
each year for five years, how much will you
have in the account at the end of the nine
years?
24
Discounting
Discounting
Discounting is translating a future value
into a present value.
The discount factor is the inverse of the
1
compound factor:
1+
To translate a future value into a present
FV
value, PV=
1+
Example
Suppose you have a goal of saving $100,000
three years from today. If your funds earn
4% per year, what lump-sum would you have
to deposit today to meet your goal?
Example, continued
Known values:
FV = $100,000
n=3
i = 4%
Unknown: PV
Example, continued
$100,000 1
PV = 3 =$100,000
1+0.04 1+0.04 3
PV = $100,000 0.8889964
PV = $88,899.64
Check:
FV3 = $88,899.64 (1 + 0.04)3 = $100,000
Short-cut: Calculator
HP10B BAIIPlus HP12C TI83/84
PV = $10,00010 = $7,089.19
1+0.035
Frequency of compounding
If interestis compounded more than once
per year, we need to make an adjustment
in our calculation.
The stated rate or nominal rate of interest
is the annual percentage rate (APR).
The rate per period depends on the
frequency of compounding.
Discrete compounding:
Adjustments
Adjust the number of periods and the rate
per period.
Suppose the nominal rate is 10% and
compounding is quarterly:
The rate per period is 10% 4 = 2.5%
The number of periods is
number of years 4
Continuous compounding:
Adjustments
The compound factor is eAPR x n.
1
The discount factor is .
eAPR x n
Suppose the nominal rate is 10%.
For five years, the continuous compounding
factor is e0.10 x 5 = 1.6487
The continuous compounding discount factor
for five years is 1 e0.10 x 5 = 0.60653
Try it: Frequency of
compounding
If you invest $1,000 in an investment that
pays a nominal 5% per year, with interest
compounded semi-annually, how much will
you have at the end of 5 years?
Try it: Answer
Given:
PV = $1,000
n = 5 2 = 10
i = 0.05 2 = 0.25
Solve for FV
40
Problem 2.2
Suppose you set aside an amount today in an
account that pays 5% interest per year,
compounded quarterly, for five years. If your
goal is to have $1,000 at the end of five
years, what would you need to set aside
today?
41
Problem 2.3
Suppose you set aside an amount today in an
account that pays 5% interest per year,
compounded continuously, for five years. If
your goal is to have $1,000 at the end of five
years, what would you need to set aside
today?
42
0 1 2 3 4 5
| | | | | |
CF CF CF CF CF
PV? FV?
CF CF CF CF
Ordinary
PV FV
CF CF CF CF
Annuity due
PV FV
CF CF CF CF
Deferred annuity
PV FV
Key to valuing annuities
The key to valuing annuities is to get the
timing of the cash flows correct.
When in doubt, draw a time line.
Example: PV of an annuity
What is the present value of a series of three
cash flows of $4,000 each if the discount rate
is 6%, with the first cash flow one year from
today?
0 1 2 3 4
| | | |
1 1
3
1+0.06
PV = $4,000 0.06
PV = $4,000 2.67301
PV = $10,692.05
Example: PV of an annuity
Calculator short cuts
Given:
PMT = $4,000
i = 6%
N=3
Solve for PV
Example: PV of an annuity
Spreadsheet short-cuts
=PV(RATE,NPER,PMT,FV,TYPE)
=PV(.06,3,4000,0)
Future value
=PV(RATE,NPER,PMT,FV,TYPE)
=PV(0.06,3,4000,0,1)
Any other way?
There is one period difference between an
ordinary annuity and an annuity due.
Therefore:
PVannuity due = PVordinary annuity (1 + i)
and
FVannuity due = FVordinary annuity (1 + i)
Valuing a deferred annuity
A deferred annuity is an annuity that
begins beyond one year from today.
That means that it could begin 2, 3, 4, years
from today, so each problem is unique.
Valuing a deferred annuity
0 1 2 3 4 5
| | | |
CF CF CF CF
4-payment PV0 PV1
ordinary annuity,
then discount
value one period
0 1 2 3 4 5 6 7 8 9 10
| | | | |
PV? CF CF CF CF CF
Example, cont.
Using an ordinary annuity:
PV3 = $23,956.26 Discount 3 periods at 8%
PV0 = $19,017.25
Using an annuity due:
PV4 = $25,872.76
Discount 4 periods at 8%
PV0 = $19,017.25
Example: Deferred annuity
Calculator solutions
HP10B BAIIPlus TI83/84
0 CF 0 CF 1 [2nd] {
0 CF 0 CF 1 F1 0 0 0 6000 6000
0 CF 0 CF 1 F2 6000 6000 6000}
0 CF 0 CF 1 F3 STO [2nd] L1
6000 CF 6000 CF 1 F4 [APPS] [Finance]
6000 CF 6000 CF 1 F5 [ENTER] 7
6000 CF 6000 CF 1 F6 NPV(.08,0,L1)
6000 CF 6000 CF 1 F7 [ENTER]
6000 CF 6000 CF 1 F8
8i 8i
NPV NPV
Example: Deferred annuity
Spreadsheet solutions
A B
1. =PV(0.08,3,0,PV(0.08,5,6000,0))
Year Cash flow 2. =PV(0.08,4,0,PV(0.08,5,6000,0,1))
1 1 $0 3. =NPV(0.08,A1:A9)
2 2 $0
3 3 $0
4 4 $6000
5 5 $6000
6 6 $6000
7 7 $6000
8 8 $6000
Perpetuities
A perpetuity is an even cash flows that
occurs at regular intervals of time, forever.
The valuation of a perpetuity is simple:
PV = 1 + 2 + 3 +
1+ 1+ 1+ 1+
PV =
Problem Set 3
Problem 3.1
Which do you prefer if the appropriate
discount rate is 6% per year:
1. An annuity of $4,000 for four annual
payments starting today.
2. An annuity of $4,100 for four annual
payments, starting one year from today.
3. An annuity of $4,200 for four annual
payments, starting two years from today.
73
5.3 Nominal and effective
rates
APR & EAR
The annualpercentage rate (APR) is the
nominal or stated annual rate.
The APR ignores compounding within a year.
The APR understates the true, effective rate.
77
Frequency of compounding
If interest
is compounded more frequently
than annually, then this is considered in
compounding and discounting.
There are two approaches
1. Adjust the i and n; or
2. Calculate the EAR and use this
Example: EAR &
compounding
Suppose you invest $2,000 in an investment
that pays 5% per year, compounded
quarterly. How much will you have at the
end of 4 years?
Example: EAR &
compounding
Method 1:
FV = $2,000 (1 + 0.0125)16 = $2,439.78
Method 2:
EAR = (1 + 0.054)4 1 = 5.0945%
FV = $2,000 (1 + 0.050945)4 = $2,439.78
Try it: APR & EAR
Suppose a loan has a stated rate of 9%, with
interest compounded monthly. What is the
effective annual rate of interest on this loan?
Try it: Answer
0.09 12
EAR = 1+ 1
12
EAR = 1.007512 1
EAR = 9.3807%
Problem Set 4
Problem 4.1
What is the effective interest rate that
corresponds to a 6% APR when interest is
compounded monthly?
84
Problem 4.2
What is the effective interest rate that
corresponds to a 6% APR when interest is
compounded continuously?
85
5.4 Applications
Saving for retirement
Suppose you estimate that you will need $60,000
per year in retirement. You plan to make your first
retirement withdrawal in 40 years, and figure that
you will need 30 years of cash flow in retirement.
You plan to deposit funds for your retirement
starting next year, depositing until the year before
retirement. You estimate that you will earn 3% on
your funds.
How much do you need to deposit each year to
satisfy your plans?
Deferred annuity time line
0 1 2 3 4 5 6 7 8 39 40 41 42 43 79
| | | | | | | | | | | | | |
D D D D D D D D W W W W W W
W W W W W
PV Ordinary annuity
Ordinary annuity FV
D D D D D D D D D
Two steps
Step 1: Present value of ordinary annuity
N = 30; i = 3%; PMT = $60,000
PV39 = $1,176,026.48
Step 2: Solve for payment in an ordinary
annuity
N = 39; i = 3%; FV = $1,176,026.48
PMT = $16,280.74
What does this mean?
If there are 39 annual deposits of $16,280.74
each and the account earns 3%, there will be
enough to allow for 30 withdrawals of
$60,000 each, starting 40 years from today.
Balance in retirement account
$1,400,000
$1,200,000
$1,000,000
Balance in
the $800,000
retirement $600,000
account
$400,000
$200,000
$0
1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69
Year into the future
Practice problems
Problem 1
What is the future value of $2,000 invested
for five years at 7% per year, with interest
compounded annually?
Problem 2
What is the value today of 10,000 promised
in four years if the discount rate is 4%?
Problem 3
What is the present value of a series of five
end-of-year cash flows of $1,000 each if the
discount rate is 4%?
Problem 4
Suppose you plan to save $3,000 each year
for ten years. If you earn 5% annual interest
on your savings, how much more will you
have at the end of ten years if you make your
payments at the beginning of the year
instead of the end of the year?
Problem 5
Sue plans to deposit $5,000 in a savings
account each year for thirty years, starting
ten years from today. Yan plans to deposit
$3,500 in a savings account each year for
forty years, starting at the end of this year. If
both Sue and Yan earn 3% on their savings,
who will have the most saved at the end of
forty years?
Problem 6
Suppose you have two investment
opportunities:
Opportunity 1: APR of 12%, compounded
monthly
Opportunity 2: APR of 11.9%, compounded
continuously
Which opportunity provides the better
return?
Problem 7
If you can earn 5% per year, what would you
have to deposit in an account today so that
you have enough saved to allow withdrawals
of $40,000 each year for twenty years,
beginning thirty years from today?
Problem 8
Suppose you deposit 50000 in an account
that pays 4% interest, compounded
continuously. How much will you have in the
account at the end of ten years if you make
no withdrawals?
The end