Professional Documents
Culture Documents
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
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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?
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r ün Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly
purchased Manhattan from the Indians for $24 worth of beads
and other trinkets. as this a good deal for the Indians?
r This happened about 371 years ago, so if they could earn 5% per
year they would now (in 1997) have:
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r Suppose that your
year old daughter has just
announced her desire to attend college. fter some
research, you determine that you will need about
!""#""" on her !$
!$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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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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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:
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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:
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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:
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w
2
2
2
r e can use this equation to find the present
value of our example annuity as follows:
2
w
2
2 w 2 w 2 w
0 2
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r Using the example, and assuming a discount rate of
10% per year, we find that the future value is:
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r Just as we did for the PV equation, we could
instead use a closed
closedform of the FV equation:
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2 w
0 2
w
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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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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:
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w
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r Therefore, the present value of our example
annuity due is:
w
w
2
w
0 2 w
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0
&
r The future value of our example annuity is:
w
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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:
`
` ` ` `
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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
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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
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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
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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?
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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
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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?
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£
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:
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£
r e can find the FV for each bank as follows:
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£ 0
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£ 0
£ 0
£
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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):
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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?
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