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Tutorial 2 : Time Value of Money

Conducted by : Mr. Chong Lock Kuah, CFA

Key Points
The first step in time value analysis is to set up a time line, which will help you to visualize what is happening in a particular problem
0 I/YR CF1 CF2 CF3 Cash flows 1 2 3 Year

1. Time 0 is today; Time 1 is the end of period 1; or the beginning of period 2 2. Negative CF (-CF) are cash outflows

Key Points
FV is the amount to which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate PV is the value today of a future cash flow or series of cash flows Annual Percentage Rate (APR) is the contracted, quoted or stated interest rate. It is equal to periodic interest rate times the number of period per year Effective Annual Rate (EAR or EFF) is the annual interest rate actually being earned (or paid), as opposed to the quoted rate. An EAR is the interest rate expressed as if it were compounded once per year
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Key Points
Solving time value of money problems using financial calculator TI II Plus is a preferred method Before using a financial calculator, make sure that the calculator is set up as follows:
P/Y

P/Y is set equal to 1, hit

2ND

I/Y

Make sure that the calculator is in End Mode (default setting)


FORMAT

Set the calculator to display 8 decimal places, hit


CLR TVM

2ND

.
CLR WORK

Clear all memory hit

2ND

FV

and hit

2ND

CE/C

Always make sure that the interest rate and the time period match. For example, when there are more than one periods in a year, use periodic interest rate (APR/m where m is the compounding frequency per year) and input N= number of periods per year x number of yrs For example, APR =10% and the compounding frequency is twice per year and you enter in the financial calculator as I/Y =5 and then enter N= 2x number of years
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Key Points
When calculating the PV of an ordinary annuity,
0 10% 100 100 100 Ordinary Annuity 1 2 3 Year

Using a financial calculator input: N = 3, I/Y = 10, PMT =100, FV = 0, and then solve for PV = -$248.69

Key Points
When calculating the PV of an annuity due,
0 10% 100 100 100 Annuity Due 1 2 3 Year

Using a financial calculator


BGN SET

Hit

2ND

PMT

2ND

ENTER

and then enter :

N = 3, I/Y = 10, PMT =100, FV = 0, and then solve for PV = $273.55


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Key Points
When calculating the PV of series of uneven cash flows,
0 10% 0 100 300 300
CF

Year

-50

NPV = -CF0 + PV(CF) Since CF0 = 0, NPV=PV(CF)

We have to enter individual cash flows using


SET INS SET INS

key
SET INS SET

CF
INS

ENTER
SET

INS

100

ENTER
RESET

SET

ENTER

300

ENTER

ENTER

50

+/-

ENTER

And then hit


SET INS QUIT

NPV

calculator will display I=0.000000, hit

10

ENTER

CPT

NPV = 530.09
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Key Points
When calculating the FV of series of cash flows when payments occur annually, but compounding occurs each 6 months,
0 I/YR = 10% 100 100 100 1 2 3 4 5 6 period

Here we cant use normal annuity valuation techniques. You can use the EAR and treat the cash flows as an ordinary annuity or use the periodic rate and compound the cash flows individually.)
APR=10%, to compute EAR, using financial calculator, hit
ICONV

2ND

2
SET

calculator will display nom = 0.000000,


INS INS SET INS INS QUIT

10

ENTER

C/y

ENTER

CPT

EAR (or EFF) = 10.25 Finally, enter N=3, I/YR=10.25, P/Yr =1, PV=0, PMT=-100, to find FV=331.80
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RWJ Chap 5 Q1
First City Bank pays 8 percent simple interest on its savings account balances, whereas Second City Bank pays 8 percent interest compounded annually. If you made a $5,000 deposit in each bank, how much more money would you earn from your Second City Bank account at the end of 10 years? The simple interest per year is: $5,000 0.08 = $400 So after 10 years you will have: $400 10 = $4,000 in interest. The total balance will be $5,000 + $4,000 = $9,000 With compound interest we use the future value formula: FV = PV(1 +r)t FV = $5,000(1.08)10 = $10,794.62 The difference is:$10,794.62 $9,000 = $1,794.62
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RWJ Chap 5 Q15


Although appealing to more refined tastes, art as a collectible has not always performed so profitably. During 2003, Sotheby's sold the Edgar Degas bronze sculpture Petite Danseuse de Quartorze Ans at auction for a price of $10,311,500. Unfortunately for the previous owner, he had purchased it in 1999 at a price of $12,377,500. What was his annual rate of return on this sculpture?
1999 ?% -12,377,500 10,311,500 2000 2001 2002 2003

xP/Y

RESET

AMORT

BGN

CLR TVM

4
QUIT

N
P/Y

12377500

+/-

PV

PMT

10311500

FV

CPT

I/Y

I/Y =-4.46%

RWJ Chap 5 Q15


Although appealing to more refined tastes, art as a collectible has not always performed so profitably. During 2003, Sotheby's sold the Edgar Degas bronze sculpture Petite Danseuse de Quartorze Ans at auction for a price of $10,311,500. Unfortunately for the previous owner, he had purchased it in 1999 at a price of $12,377,500. What was his annual rate of return on this sculpture? To answer this question, we can use either the FV or the PV formula. Both will give the same answer since they are the inverse of each other. We will use the FV formula, that is: FV = PV(1 + r)t Solving for r, we get: r = (FV / PV)1/t 1 r = ($10,311,500 / $12,377,500)1/4 1 = 4.46% Notice that the interest rate is negative. This occurs when the FV is less than the PV.

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RWJ Chap 6 Q24 You are to make monthly deposits of $300 into a retirement account that pays 10 percent interest compounded monthly. If your first deposit will be made one month from now, how large will your retirement account be in 30 years?

xP/Y

P/Y

AMORT

RESET

BGN

QUIT

360
CLR TVM

10/12

I/Y

PV

300

+/-

PMT

CPT

FV

FV= 678,146.38

RWJ Chap 6 Q24


You are to make monthly deposits of $300 into a retirement account that pays 10 percent interest compounded monthly. If your first deposit will be made one month from now, how large will your retirement account be in 30 years?

This problem requires us to find the FVA. The equation to find the FVA is: FVA = C{[(1 + r)t 1]/r} FVA = $300[{[1 + (0.10/12)]360 1}/(0.10/12)] = $678,146.38

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RWJ Chap 6 Q36


You've just joined the investment banking firm of Dewey, Cheatum, and Howe. They've offered you two different salary arrangements. You can have $95,000 per year for the next two years, or you can have $70,000 per year for the next two years, along with a $45,000 signing bonus today. The bonus is paid immediately, and the salary is paid at the end of each year. If the interest rate is 10 percent compounded monthly, which do you prefer? Explanation: Since we have an APR compounded monthly and an annual payment, we must first convert the interest rate to an EAR so that the compounding period is the same as the cash flows.
ICONV

2ND

2
SET INS INS SET INS INS QUIT

10

ENTER

C/y

12

ENTER

CPT

EAR (or EFF) = 10.4713

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xP/Y

P/Y

BGN

CLR TVM

QUIT

2
AMORT

10.4713

I/Y

95000

PMT

FV

CPT

PV

PV= -163,839.10 The present value of the first arrangement = 163,839.10

xP/Y

P/Y

BGN

CLR TVM

QUIT

2
AMORT

10.4713

I/Y

70000

PMT

FV

CPT

PV

PV= -120,723.549 The present value of the second arrangement =$45,000 + 120,723.549 = 165,723.549

RWJ Chap 6 Q36


You've just joined the investment banking firm of Dewey, Cheatum, and Howe. They've offered you two different salary arrangements. You can have $95,000 per year for the next two years, or you can have $70,000 per year for the next two years, along with a $45,000 signing bonus today. The bonus is paid immediately, and the salary is paid at the end of each year. If the interest rate is 10 percent compounded monthly, which do you prefer? Explanation: Since we have an APR compounded monthly and an annual payment, we must first convert the interest rate to an EAR so that the compounding period is the same as the cash flows. EAR = [1 + (0.10 / 12)]12 1 = .104713 or 10.4713% PVA1 = $95,000 {[1 (1 / 1.104713)2] / 0.104713} = $163,839.09 PVA2 = $45,000 + $70,000{[1 (1/1.104713)2] / 0.104713} = $165,723.54
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RWJ Chap 6 Q40


You're prepared to make monthly payments of $340, beginning at the end of this month, into an account that pays 6 percent interest compounded monthly. How many payments will you have made when your account balance reaches $20,000? Explanation: Here we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for the number of payments.
P/Y AMORT RESET BGN CLR TVM QUIT xP/Y

6/12

I/Y

PV

340

+/-

PMT

20000

FV

CPT

N= 51.69

RWJ Chap 6 Q40


You're prepared to make monthly payments of $340, beginning at the end of this month, into an account that pays 6 percent interest compounded monthly. How many payments will you have made when your account balance reaches $20,000? Explanation: Here we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for the number of payments. Using the FVA equation: FVA = $20,000 = $340[{[1 + (.06/12)]t 1 } / (.06/12)] Solving for t, we get: 1.005t = 1 + [($20,000)/($340)](.06/12) t = ln 1.294118 / ln 1.005 = 51.69 payments
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RWJ Chap 6 Q42


You need a 30-year, fixed-rate mortgage to buy a new home for $240,000. Your mortgage bank will lend you the money at a 6.35 percent APR for this 360-month loan. However, you can afford monthly payments of only $1,150, so you offer to pay off any remaining loan balance at the end of the loan in the form of a single balloon payment. How large will this balloon payment have to be for you to keep your monthly payments at $1,150?
xP/Y P/Y AMORT RESET BGN QUIT CLR TVM

360

6.35/12

I/Y

240000

PV

1150

+/-

PMT

CPT

FV

FV= -368,936.54

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RWJ Chap 6 Q42


You need a 30-year, fixed-rate mortgage to buy a new home for $240,000. Your mortgage bank will lend you the money at a 6.35 percent APR for this 360-month loan. However, you can afford monthly payments of only $1,150, so you offer to pay off any remaining loan balance at the end of the loan in the form of a single balloon payment. How large will this balloon payment have to be for you to keep your monthly payments at $1,150? Explanation: The amount of principal paid on the loan is the PV of the monthly payments you make. So, the present value of the $1,150 monthly payments is: PVA = $1,150[(1 {1 / [1 + (.0635/12)]360}) / (.0635/12)] = $184,817.42

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Contd
The monthly payments of $1,150 will amount to a principal payment of $184,817.42. The amount of principal you will still owe is: $240,000 184,817.42 = $55,182.58 This remaining principal amount will increase at the interest rate on the loan until the end of the loan period. So the balloon payment in 30 years, which is the FV of the remaining principal will be: Balloon payment = $55,182.58 [1 + (0.0635/12)]360 = $368,936.54

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RWJ Chap 6 Q43


The present value of the following cash flow stream is $6,550 when discounted at 10 percent annually. What is the value of the missing cash flow? Year 1 2 3 4 Cash Flow $1,700 ? $2,100 $2,800

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We have to enter individual cash flows using


SET INS SET INS

CF
SET

key to find NPV


INS SET INS

CF
INS

ENTER
SET

INS

1700

ENTER
SET INS

ENTER

SET

0
INS

ENTER
SET

2100

ENTER

ENTER

2800

ENTER
SET INS

ENTER
QUIT

And then hit

NPV

calculator will display I=0.000000, hit NPV = 5,035.65

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ENTER

CPT

Given that the present value of cash stream is $6,550, the present value of year 2 cash flow = $6,550 5035.65=$1,514.35 The value of the missing CF is:$1,514.35(1.10)2 = $1,832.36

RWJ Chap 6 Q43


The present value of the following cash flow stream is $6,550 when discounted at 10 percent annually. What is the value of the missing cash flow? Year 1 2 3 4 Cash Flow $1,700 ? $2,100 $2,800

Explanation: We are given the total PV of all four cash flows. If we find the PV of the three cash flows we know, and subtract them from the total PV, the amount left over must be the PV of the missing cash flow. So, the PV of the cash flows we know are:
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Contd
PV of Year 3 CF: $2,100 / 1.103 = $1,577.76 PV of Year 4 CF: $2,800 / 1.104 = $1,912.44 So, the PV of the missing CF is: $6,550 1,545.45 1,577.76 1,912.44 = $1,514.35 The question asks for the value of the cash flow in Year 2, so we must find the future value of this amount. The value of the missing CF is:$1,514.35(1.10)2 = $1,832.36

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RWJ Chap 6 Q53


Suppose you are going to receive $10,000 per year for five years. The appropriate interest rate is 11 percent. a. What is the present value of the payments if they are in the form of an ordinary annuity? What is the present value if the payments are an annuity due? b. Suppose you plan to invest the payments for five years. What is the future value if the payments are an ordinary annuity? What if the payments are an annuity due? c. Which has the highest present value, the ordinary annuity or annuity due? Which has the highest future value? Will this always be true?

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a(i).
xP/Y P/Y BGN CLR TVM QUIT AMORT

11

I/Y

10000

PMT

FV

CPT

PV

PV= -36,958.97

b(ii).
2ND
xP/Y

BGN

SET

PMT

2ND

ENTER

P/Y

BGN

CLR TVM

QUIT

AMORT

11

I/Y

10000

PMT

FV

CPT

PV

PV= -41,024.46

b(i).
xP/Y P/Y RESET BGN AMORT QUIT CLR TVM

11

I/Y

10000

+/-

PMT

PV

CPT

FV

FV= 62,278.01

b(ii).
BGN SET

2ND

PMT

2ND

ENTER

xP/Y

P/Y

RESET

BGN

AMORT

QUIT

CLR TVM

11

I/Y

10000

+/-

PMT

PV

CPT

FV

FV= 69,128.60

c.
Annuity due will have the highest PV and FV.

RWJ Chap 6 Q53 Suppose you are going to receive $10,000 per year for five years. The appropriate interest rate is 11 percent. a. What is the present value of the payments if they are in the form of an ordinary annuity? What is the present value if the payments are an annuity due? b. Suppose you plan to invest the payments for five years. What is the future value if the payments are an ordinary annuity? What if the payments are an annuity due? c. Which has the highest present value, the ordinary annuity or annuity due? Which has the highest future value? Will this always be true?

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Explanation: a(i) If the payments are in the form of an ordinary annuity, the present value will be: PVA = C({ 1 [ 1/(1 + r)t ] } / r )) PVA = $10,000[ { 1 [1 / (1 + 0.11)5] }/ 0.11 ] PVA = $36,958.97 a(ii) If the payments are an annuity due, the present value will be: PVAdue = (1 + r) PVAdue = (1 + 0.11)$36,958.97 PVAdue = $41,024.46 b(i) We can find the future value of the ordinary annuity as: FVA = C{[(1 + r)t 1] / r} FVA = $10,000{[(1 + 0.11)5 1] / 0.11} FVA = $62,278.01
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Contd
b(ii) If the payments are an annuity due, the future value will be: FVAdue = (1 + r) FVAdue = (1 + 0.11)$62,278.01 FVAdue = $69,128.60

c.
Annuity due will have the highest PV and FV provided r is positive.

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