You are on page 1of 54

Time Value of Money

JQY
Agenda
Time Lines
Future Values
Present Values
Solving for Interest Rate and Time
Future Value of an Annuity
Present Value of an Annuity
Perpetuities
Uneven Cash Flow Streams
Semiannual and Other Compounding Periods
Comparison of Different types of interest rates
Fractional Time Periods
Amortized Loans
Amortization
What is Time Value?
We say that money has a time value because that money can
be invested with the expectation of earning a positive rate of
return
In other words, a dollar received today is worth more than a
dollar to be received tomorrow
That is because todays dollar can be invested so that we have
more than one dollar tomorrow
If you have P10,000 today, and you
deposit it in the bank, how much will
you most likely receive in 10 years?
a. P9,500
b. P14,000
c. P10,000
a. P9,500
b.P14,000
c. P10,000
Timelines
0 1 2 3 4 5
PV FV
Today
An important tool used in the time value of money analysis
A graphical representation used to show the timing of cash flows
A timeline is a graphical device used to clarify the timing of the
cash flows for an investment
Each tick represents one time period
Future Value
The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum
today
Terms:
PV present value, or beginning amount in your account
i interest rate the bank pays on the account per year
INT amount of interest you earn during the year (aka
discount rate, opportunity cost rate)
FV future value or ending amount of your account at the
end of n years
n number of periods involved in the analysis

Future Value
Simple Annual Interest
Q: Today, Peter invested P1,000 for 5 years with
simple annual interest of 10%. How much is its
future value?
A: FV = PV x [1 + (i*n)]
FV = P1,000 x [1 + (10%*5)]
FV = P1,000 x 1.5
FV = P1,500
Future Value
Interest compounded
Q: Today, Peter invested P100 for 3 years at 10%,
compounded annually. How much is its future
value?

A: FV = PV (1+i)
0 1 2 3

100 FV = ?

After 1 year : FV = PV (1+i)^1 = 100 (1+10%)^1 = 110
After 2 years: FV = PV (1+i)^2 = 100 (1+10%)^2 = 121
After 3 years: FV = PV (1+i)^3 = 100 (1+10%)^3 = 133.10




The Magic of Compounding
In 1898, USA bought the Philippines from Spain for $20 million
This happened about 114 years ago, so 5% per year could be earned,
the value of the Philippines now (in 2012) would be approximately:


If they could have earned 10% per year, the Philippines would
have been worth:
20m (1.05)
114
= 5,207,269,916
20m (1.10)
114
= 1,046,637,049,000
Agenda
Future Value
Present Value
Annuities
Rates of Return
Amortization
If you need to have P10,000 in 10
years, how much will you likely
have to invest today?
a. P7,000
b. P10,000
c. P12,000
a. P7,000
b. P10,000
c. P12,000
Present Value
The value today of a future cash flow or series
of cash flows.
Represents the amount that needs to be
invested to achieve some desired future value.
( )
PV
FV
i
N
N
=
+ 1
Present Value: An Example
Suppose that your five-year old daughter has just announced
her desire to attend college. After some research, you
determine that you will need about $100,000 on her 18th
birthday to pay for four years of college. If you can earn 8%
per year on your investments, how much do you need to
invest today to achieve your goal?
N = 13; I = 8%; PV = ?; PMT = 0; FV = 100,000
( )
PV = =
100 000
108
769 79
13
,
.
$36, .
Solving for Interest and Time
I = (FV/PV)^
1/n
1
Sample problem
You can buy a security at a price of $78.35, and it
will pay you $100 after 5 years. How much is the
interest rate youd earn if you bought the
security?
I = (100/78.35)^(1/5) 1 = 5%
Solving for Interest and Time
N = ln (FV/PV) / ln (1+i)
Sample problem
Mr. Amos invested P60,000 in stocks at a 10%
interest rate compounded semi-annually. How
many years did it take Mr. Amos for his investment
to reach P100,000?
N = ln (100,000/60,000) / ln (1 + 5%)
N = 10.47 / 2 = 5.24 years
Annuities
An annuity is a series of payments of an equal amount at
fixed intervals for a specified number of periods.
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100 annuity
Annuity = equal PMT


0 1 2 3 4 5
100 100 100 100 100
Annuities
Ordinary (Deferred) Annuity
An annuity whose payments occur at the end of
each period.
Annuity Due
An annuity whose payments occur at the
beginning of each period.
0 1 2 3 4 5
100 100 100 100 100
100 100 100 100 100 5-period Annuity Due
5-period Regular Annuity
Future Value of an Ordinary Annuity
Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much will she have at
the end of three years?


Fva = 100 {[(1+5%)^3 1] / 5%}
Fva = 315.25
Future Value of an Annuity Due
Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much will she have at the end of three
years?



Fvad = 100 {[(1+5%)^3 1] / 5%} (1+5%) = 331.01

Present Value of an Ordinary Annuity
Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much is the present
value of her payments?


Pva = 100 [1 (1/(1+5%)^3) / 5%]
Pva = 272.32
Present Value of an Annuity Due
Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much is the present value of her
payments?



Pvad = {100 [1 [1/(1+5%)^(3-1)] / 5%} + 100
Pvad = 285.94
Ordinary Annuity Solving for Payment
when FV is known
Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the end of the year?



PMT = 50,000 / [(1+5%)^5 1] / 5% = 9,048.74
Annuity Due Solving for Payment when
FV is known
Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the beginning of the year?



PMTad = 50,000 / {[(1+5%)^5 1] / 5%} (1+5%)
PMTad = 8,617.85
Ordinary Annuity Solving for Payment
when PV is known
How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the end of the year, if the present value
is 10,000?



PMT = 50,000 / [(1 (1/(1+5%)^5 )/5%] / 5% = 2,309.75
Annuity Due Solving for Payment when
PV is known
How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the beginning of the year, if the present
value is 10,000?



PMTad = 10,000 / {[(1 (1/(1+5%)^(5-1) )/5%] / 5%} + 1
PMTad = 2,199.76
Ordinary Annuity Solving for N when FV
is known
Sharon plans to save P100 per year (first payment at
end of the year). Assuming that the interest is 5%, how
many years does it take for Sharon to accumulate
1,000?



N = ln[1 (1,000/-100)5%] / ln (1+5%) = 8.31 years
-
Annuity Due Solving for N when FV is
known
Sharon plans to save P100 per year (first payment at
beginning of the year). Assuming that the interest is
5%, how many years does it take for Sharon to
accumulate 1,000?



Nad = {ln[(1,000 x 5%) / (100 x 1.05)] + 1} / ln (1+5%)
Nad = 7.98 years
Ordinary Annuity Solving for N when PV
is known
Sharon plans to save P100 per year (first payment at
end of the year), and the present value if P1,000
Assuming that the interest is 5%, solve for N:



N = - ln[1 (1000/100) 5%] / ln (1+5%) = 14.207 years
Annuity Due Solving for N when PV is
known
Sharon plans to save P100 per year (first payment at
the beginning of the year), and the present value if
P1,000 Assuming that the interest is 5%, solve for N:



Nad = {- ln[1 + 5% (1 (1000/100)] / ln (1+5%)} + 1
Nad = 13.25 years
Ordinary Annuity Solving for I when FV
and PV are known
Can only be calculated through a trial and error process
unless financial calculator is used.
However, an approximate equation can be solved,
provided that all inputs in the equation below is
known:
i = {{Annual PMT + [(FV PV)/Annual N]} / [(40% x FV) + (60% x
PV)]}}
Ordinary Annuity Solving for I when FV
and PV are known
Belle has 1,000 today. She plans to make an investment
where she pays 50 annually at the end of the year. She
expects to receive 1,500 at the end of 10 years. How
much is the interest rate that is required for this
investment so that Belle will receive 1500 after 10 years?
i = {{50 + [(1,500 1,000)/10]} / [(40% x 1,500) + (60% x 1,000)]}}
Ordinary Annuity: Solving for I
when FV is known (CALC)
Frederick will be contributing P10,000 to his
girlfriends account as a sign of his love
every month starting next month. He
calculates that in 10 years, there will be
P1,500,000 in his girlfriends account if she
does not touch any of the deposit. How much
interest is the account earning if Fredericks
calculations are correct?

Annuity Due: Solving for I when FV
is known (CALC)
Frederick contributes P10,000 to his
girlfriends account as a sign of his love
every month starting at the beginning of this
month. He calculates that in 10 years, there
will be P1,500,000 in his girlfriends account if
she does not touch any of the deposit. How
much interest is the account earning if
Fredericks calculations are correct?

Summary
Rules regarding annuity, ceteris paribus:
Ordinary Annuity Annuity Due
Future Value Lower Higher
Present Value Lower Higher
Payment Higher Lower

N Higher Lower
Interest Higher Lower
Perpetuities
A stream of equal payments expected to
continue forever
PV (Perpetuity) = Payment / Interest rate
Suppose each consol (British government
perpetual bonds) promised to pay $100 in
perpetuity, if the discount rate or opportunity
cost rate is 5% and 10%:
PV (Perpetuity) = 100/5% = $2,000
PV (Perpetuity) = 100/10% = $1,000
Uneven Cash Flow Stream
A series of cash flows in which the amount
varies from one period to the next
PMT = equal cash flows coming at regular
intervals
CF = uneven cash flows
Uneven Cash Flows: An Example (PV)
Assume 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?
0 1 2 3 4 5
100 200 300
( ) ( ) ( )
PV = + + =
100
107
200
107
300
107
51304
1 2 3
. . .
.
Uneven Cash Flows: An Example (FV)
Terminal Value = The future value of an uneven cash flow stream
Suppose that you were to deposit the following amounts in an
account paying 5% per year. What would the balance of the
account be at the end of the third year?
0 1 2 3 4 5
300 500 700
( ) ( )
FV= + + = 300 105 500 105 700 155575
2 1
. . , .
Non-annual Compounding
We could assume that interest is earned semi-annually,
quarterly, monthly, daily, or any other length of time
The only change that must be made is to make sure that the
rate of interest is adjusted to the period length
Non-annual Compounding (cont.)
Suppose that you have $1,000 available for investment.
After investigating the local banks, you have compiled the
following table for comparison. In which bank should you
deposit your funds?
Bank Interest Rate Compounding
First National 10% Annual
Second National 10% Monthly
Third National 10% Daily
Non-annual Compounding (cont.)
We can find the FV for each bank as follows:
( )
FV = = 1 000 110 1100
1
, . ,
FV = +
|
\

|
.
|
= 1 000 1
010
12
1104 71
12
,
.
, .
FV = +
|
\

|
.
|
= 1 000 1
010
365
110516
365
,
.
, .
First National Bank:
Second National Bank:
Third National Bank:
Obviously, you should choose the Third National Bank
Continuous Compounding
There is no reason why we need to stop increasing the
compounding frequency at daily
We could compound every hour, minute, or second
We can also compound every instant (i.e., continuously):
F Pe
rt
=
Here, F is the future value, P is the present value, r is the annual rate of
interest, t is the total number of years, and e is a constant equal to
about 2.718
Continuous Compounding (cont.)
Suppose that the Fourth National Bank is offering to pay
10% per year compounded continuously. What is the
future value of your $1,000 investment?
( )
F e = = 1 000 110517
0 10 1
, , .
.
This is even better than daily compounding
The basic rule of compounding is: The more frequently interest is
compounded, the higher the future value
Continuous Compounding (cont.)
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?
( )
F e = = 1 000 1 648 72
0 10 5
, , .
.
Different Rates
Nominal (Quoted, Stated, Annual Percentage) Interest Rate
The rate charged by banks and other financial institutions
For example, 6% compounded quarterly, 5% compounded monthly
Effective (Equivalent Annual) Rate
The annual rate of interest actually being earned
EAR = (1+iNOM/m)^m 1
If payment is only once a year, EAR = nominal rate
Periodic Rate
Rate charged by a lender or paid by a borrower each period
iPER = iNOM/m
If Nominal rate is quoted at 18%, payable monthly, periodic rate is 18%/12 or 1.5%
If payment is only once a year, Nominal rate = periodic rate.

Landbank charges 10% interest rate, compounded quarterly. How much is the
nominal, EAR, and periodic rate?
Nominal = 10%, EAR = 10.38%, Periodic = 2.5%
Fractional Time Periods
If you deposit $100 in a bank that uses daily
compounding and pays a nominal rate of 10% with a
365 days, how much is the FV after 9 months?
N = 365 x 9/12 ; I = 10% / 365 ; PV = 100
FV = PV x [(1 + i)^n] = 100 x [(1 + 0.000273973)^274] =
107.79
You borrow $100 that charges 10% simple interest but
you borrow only for 274 days. How much interest do
you owe?
Interest owed = 100 x 10% x 274/365 = $7.51
Amortized Loans
A loan that is repaid in equal payments over its life.
If a firm borrows $1,000 and the loan is to be repaid in 3 equal
payments at the end of each of the next three years, and the
lender charges 6% on the loan balance, how much is the
periodic payment, and construct the loan amortization
schedule.
N = 3; I = 6%; PV = 1000; PMT = ?; FV = 0




PMT = 1,000 / [(1 (1/(1+6%)^3)/6%] / 6% = 374.11
Amortization Schedule
Payment Interest Principal Repayment Balance
Beg 1,000.00
Y1 374.11 60.00 314.11 685.89
Y2 374.11 41.15 332.96 352.93
Y3 374.11 21.18 352.93 (0.00)
Balloon Loan
A long-term loan, often a mortgage, that has
one large payment due upon maturity.
Advantage: very low interest payments,
requiring very little capital outlay during the
life of the loan.
Disadvantage: An undisciplined borrower will
be in trouble because he has to make a large
single payment upon maturity.
Partial Amortization: Balloon Loans
A house is worth $200,000, and a bank agrees to lend the
potential home buyer $175,000 secured by a mortgage on the
house. However, the buyer only has $5,000 and he is unable
to make the full $25,000 downpayment. The seller may take a
note of 20k, 8% interest rate and payments at the end of the
year based on a 20 year amortization schedule but with loan
maturing at the end of the 10
th
year.
N = 20; I = 8%; PV = 20,000; PMT = ?
Annual PMT of the note = 2,037.04
Additional Problem:
To save money for a new house, you want to begin
contributing money to a brokerage account. Your plan is to
make 40 contributions to the brokerage account. Each
contribution will be for $1,500. The first contribution will
occur today and then every quarter, you will contribute
another $1,500 to the brokerage account. Assume that the
brokerage account pays a 6 percent return with annual
compounding. How much money do you expect to have in
the brokerage account in ten years (Quarter 40)? How much
money do you expect to have in the brokerage account in
Quarter 39?

Additional Problem:
Today you opened up a local bank account. Your plan is make
five $1,000 contributions to this account. The first $1,000
contribution will occur today and then every six months you
will contribute another $1,000 to the account. (So your final
$1,000 contribution will be made two years from today). The
bank account pays a 6 percent nominal annual interest, and
interest is compounded monthly. After two years, you plan to
leave the money in the account earning interest, but you will
not make any further contributions to the account. How
much will you have in the account 8 years from today?

Problem 8-30
Erika and Kitty, who are twins, just received $30,000 each for their 25
th

birthday. They both have aspirations to become millionaires. Each plans to
make a $5,000 annual contribution to her early retirement fund on her
birthday, beginning a year from today. Erika opened an account with the
Safety First Bond Fund, a mutual fund that invests in high-quality bonds
whose investors have earned 6% per year in the past. Kitty invested in the
New Issue Bio-Tech Fund, which invests in small, newly issued bio-tech
stocks and whose investors have earned an average of 20% per year in the
funds relatively short history.
Requirement 1: If the two womens funds earn the same returns in the
future as in the past, how old will each be when she becomes a millionaire?
Requirement 2: How large would Erikas annual contributions have to be for
her to become a millionaire at the same age as Kitty, assuming their
expected returns are realized?
Requirement 3: Is it rational or irrational for Erika to invest in the bond fund
rather than in stocks?
Thank you for listening!