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Presented by: Raman Sachdeva
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r ˜e say that money has a time value because that money
can be invested with the expectation of earning a
positive rate of return
r In other words, ´a dollar received today is worth more
than a dollar to be received tomorrowµ
r That is because today·s dollar can be invested so that
we have more than one dollar tomorrow
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r   n amount of money today, or the
 
current value of a future cash flow
r 0 n amount of money at some future
0
time period
r    length of time (often a year, but can be a
month, week, day, hour, etc.)
r   The compensation paid to a lender (or
 
saver) for the use of funds expressed as a percentage
for a period (normally expressed as an annual rate)
  
r PV  Present value
r FV  Future value
r Pmt  Per period payment amount
r N  ither the total number of cash flows or
the number of a specific period
r i  The interest rate per period
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timeline is a graphical device used to clarify the
timing of the cash flows for an investment

ach tick represents one time period

 

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]  0
r Suppose that you have an extra $100 today that you
wish to invest for one year. If you can earn 10% per
year on your investment, how much will you have in
one year?

èè 

è    

0   w    


]  0
 
r Suppose that at the end of year 1 you decide to extend
the investment for a second year. How much will you
have accumulated at the end of year 2?

è 

è    

0   w   w    



 w  

0   
   0
r Recognizing the pattern that is developing, we
can generalize the future value calculations as
follows:

0  Ú w 


  

 
  

   
 

Ú w  Ú 



0  
]    

r Note from the example that the future value is increasing at


an increasing rate
r In other words, the amount of   earned each year is
increasing
r Ñear 1: $10
r Ñear 2: $11
r Ñear 3: $12.10
r The reason for the increase is that each year you are earning
interest on the interest that was earned in previous years in
addition to the interest on the original principle amount
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r ün Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly
purchased Manhattan from the Indians for $24 worth of beads
and other trinkets. ˜as this a good deal for the Indians?
r This happened about 371 years ago, so if they could earn 5% per
year they would now (in 1997) have:

     


   
  
 è    
  

      


     
  
|  
]    
 
r The ˜all Street Journal (17 Jan. 92) says that all of New Ñork city real
estate is worth about $324 billion. üf this amount, Manhattan is about
30%, which is $97.2 billion
r t 10%, this is $54,562 trillion! üur U.S. GNP is only around $6 trillion
per year. So this amount represents about 9,094 years worth of the total
economic output of the US !
r t 5% it seems the Indians got a bad deal, but if they earned 10% per
year, it was the Dutch that got the raw deal
r Not only that, but it turns out that the Indians really had no claim on
Manhattan (then called Manahatta).
Manahatta). They lived on Long Island!
r s a final insult, the British arrived in the 1660·s and unceremoniously
tossed out the Dutch settlers.
]   
r So far, we have seen how to calculate the future
value of an investment
r But we can turn this around to find the amount
that needs to be invested to achieve some
desired future value:

0
 Ú 

w 

  
r Suppose that your


year old daughter has just
announced her desire to attend college. fter some
research, you determine that you will need about
!""#""" on her !$
!$th
th birthday to pay for four years of
college. If you can earn $% per year on your
investments, how much do you need to invest today to
achieve your goal?

 
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w

 
r n annuity is a series of nominally equal payments
equally spaced in time
r nnuities are very common:
r Rent
r Mortgage payments
r Car payment
r Pension income
r The timeline shows an example of a 5
5year, $100
annuity
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è    
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r How do we find the value (PV or FV) of an
annuity?
r First, you must understand the principle of value
additivity:
r The value of any stream of cash flows is equal to the
sum of the values of the components
r In other words, if we can move the cash flows
to the same time period we can simply add them
all together to get the total value
 
  
r ˜e can use the principle of value additivity to find the
present value of an annuity, by simply summing the
present values of each of the components:


 w  
2  2  2  2 
2      
w   w   w  
    
 
 
   
 
r Using the example, and assuming a discount rate of
10% per year, we find that the present value is:
    
 Ú Ú 
w w w w w
   
    

è
è
 

è
è èè èè èè èè èè

è    
 
   
 
r ctually, there is no need to take the present
value of each cash flow separately
r ˜e can use a closed
closedform of the PV equation
instead:
  

 w 


 w  
2 
2   
 2 
   


 
   
 
r ˜e can use this equation to find the present
value of our example annuity as follows:

  

 2 
w

2   
 


          


 
  
 

| 0
  
r ˜e can also use the principle of value additivity to find
the future value of an annuity, by simply summing the
future values of each of the components:

2   w    2   w    2   w  
    
0      2 
 
| 0
   
 
r Using the example, and assuming a discount rate of
10% per year, we find that the future value is:

Ú w w w w


   
0      Ú  



èè èè èè èè
 è
 èè
èèè
èè
  è
  

è    
| 0
   
 
r Just as we did for the PV equation, we could
instead use a closed
closedform of the FV equation:


 w     
2   w  

0    2 
   

          


 
  
 

| 0
   
 
r ˜e can use this equation to find the future value
of the example annuity:

 w
  
0 Ú   Ú  
 

 &
r Thus far, the annuities that we have looked at begin
their payments at the end of period 1; these are referred
to as ` `
r annuity due is the same as a regular annuity, except
that its cash flows occur at the beginning of the period
rather than at the end

 
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è    
 
   &
r ˜e can find the present value of an annuity due in the
same way as we did for a regular annuity, with one
exception
r Note from the timeline that, if we ignore the first cash
flow, the annuity due looks just like a four
fourperiod
regular annuity
r Therefore, we can value an annuity due with:
   w 


Ú  
w 
   
 


 
   &
 
r Therefore, the present value of our example
annuity due is:

   w 


  
w 

2     
 


£      


     
0
   &
r To calculate the FV of an annuity due, we can
treat it as regular annuity, and then take it one
more period forward:

 w     
0   2  w  
 


 
 
 
 


è    
0
   &
 
r The future value of our example annuity is:

 w
  
0  Ú   w
 Ú  
 

£       


      
&
 
r deferred annuity is the same as any other
annuity, except that its payments do not begin
until some later period
r The timeline shows a five
fiveperiod deferred
annuity
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è      

&
 
r ˜e can find the present value of a deferred annuity in
the same way as any other annuity, with an extra step
required
r Before we can do this however, there is an important
rule to understand:
˜   
 ` 
  
  ` `  `  `

&
   
r To find the PV of a deferred annuity, we first
find use the PV equation, and then discount
that result back to period 0
r Here we are using a 10% discount rate

 è
è  
è è èè èè èè èè èè

è      
2 




  

Ú 
w

!   Ú 
 



!  Ú Ú 
w
 

0
&
 
r The future value of a deferred annuity is
calculated in exactly the same way as any other
annuity
r There are no extra steps at all
X  ] 0 '
r Very often an investment offers a stream of cash
flows which are not either a lump sum or an
annuity
r ˜e can find the present or future value of such
a stream by using the principle of value
additivity
X  ] 0 ' 
!
r ssume that an investment offers the following cash
flows. If your required return is 7%, what is the
maximum price that you would pay for this investment?

èè èè èè

è    

  


2     
w 
w 
w 
X  ] 0 ' 
(
r Suppose that you were to deposit the following
amounts in an account paying 5% per year. ˜hat
would the balance of the account be at the end of the
third year?
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è    

0  w  w
 
    
£ )) ]    
£
r So far we have assumed that the time period is equal to
a year
r However, there is no reason that a time period can·t be
any other length of time
r ˜e could assume that interest is earned semi
semiannually,
quarterly, monthly, daily, or any other length of time
r The only change that must be made is to make sure that
the rate of interest is adjusted to the period length
£ )) ]    
£
 
r Suppose that you have $1,000 available for investment.
fter investigating the local banks, you have compiled
the following table for comparison. In which bank
should you deposit your funds?

†     
 

 £    è  
! 
£    è  

£    è  
£ )) ]    
£
 
r To solve this problem, you need to determine which
bank will pay you the most interest
r In other words, at which bank will you have the highest
future value?
r To find out, let·s change our basic FV equation slightly:


 
0 Ú   
 
      
 
 

 

  
£ )) ]    
£
 
r ˜e can find the FV for each bank as follows:

 w

 £   †  0   

  
! 
£   †  0      
  

  

£   †  0       
  
      
  
£   † 
]   ]    
r There is no reason why we need to stop increasing the
compounding frequency at daily
r ˜e could compound every hour, minute, or second
r ˜e can also compound every instant (i.e.,
continuously):

0  2 

O       


        
 
   
          
]   ]     
r Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. ˜hat is
the future value of your $1,000 investment?

  w
0 Ú   Ú  
   
 
 

   
 
 |  


  
      
]   ]     
r Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. If you
plan to leave the money in the account for 5 years, what
is the future value of your $1,000 investment?

  w
0 Ú  Ú 

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