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Chapter 5 finance notes

Chapter 5 finance notes

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Overview

This chapter introduces an important financial concept: the time value of money. The PV and FV

of a sum, as well as the present and future values of an annuity, are explained. Special

applications of the concepts include intra-year compounding, mixed cash flow streams, mixed

cash flows with an embedded annuity, perpetuities, deposits to accumulate a future sum, and

loan amortization. Numerous business and personal financial applications are used as examples.

The chapter drives home the need to understand time value of money at the professional level

because funding for new assets and programs must be justified using these techniques. Decisions

in your personal life should also be acceptable on the basis of applying time-value-of-money

techniques to anticipated cash flows.

This chapter explains the algebra of the time value of money. There are three ways to compute

time-value-of-money problems: with a financial calculator (or spreadsheet), with formulas, and

with time value factor tables. A good understanding of the formulas is necessary to value more

complex cash flow streams in later chapters; however, the understanding of financial calculators

and spreadsheets is just as important.

If you invest $C today at an interest rate of i, you will have $C + $C(i) = $C*(1 + i) in one

period.

The general form is: FV = PV(1 + i)N

where

i is the interest rate per period

PV is the value at period 0

FV is the value at period N

Compounding solves for the value at the end of the investment duration (FV), and discounting

solves for the value at the beginning of the investment duration (PV).

Similarly, PV = FV / (1 + i) N

Example 1: $10,000 at 5% interest gives $10,000 * (1.05)1 = $10,500

What will be the amount of $10,000 deposit is year 2

FV = $10,000 * (1.05)2 = $11,025.

Calculator Solution:

Please follow these steps before you start using financial calculator.

Press 2nd then press I/Y button. You will notice P/Y = 1.0000 on calculators screen. Press enter

and then press CPT.

If P/Y is not 1.0000 then you need to press 1 first and then press enter followed by CPT.

1

Once it is done then you need to clear all the previous work done on this calculator.

To do this:

1) Press 2nd the Press CE|C

2) Press 2nd then press FV

3) Press 2nd then press CPT

This should clear all the previous work based on financial calculations and therefore previous

work will not create any bias in your new calculations.

Above mentioned 1), 2), and 3 steps are repeated after each financial calculation.

Follow the steps to use financial calculator to solve Example 1.

5 press I/Y

2 press N

-10,000 press PV (Remember it is not a sign on your calculator; it is +|- sign that you need

to press after you typed 10000)

CPT press FV

The reason we use +|- sign because calculator will give you positive output if your input amount

is negative and therefore we need to press +|- sign after we key-in amount for PV.

It is advisable to put small sign by pressing +|- button in front of 10,000 because calculator will

give you a positive answer if input is negative.

Same rule is applied to find PV if FV, N, and interest rate are given

Or

IF PV, FV, and N are given and you need to find I/Y

Or

IF PV, FV, and I/Y are given and you need to find N

We will do following questions to apply what we learned above.

Example 2: John D. has deposited $300 in a guaranteed investment account with a promised rate

of 6% compounded annually. He plans to leave it there for 3 full years when he will make a

payment to buy a computer. What amount he will be able to pay at that time?

This problem is asking you to estimate FV of current amount (PV) of $300 if you invest $300 at

6% for 3 years.

FV = PV * (1 + i) n

FV = 300 * (1.06) 3 = 300 * 1.19102 = $357.30

6 press I/Y

3 press N

300 press +|- (and it will show as -300) press PV

CPT FV and you will see $357.30 on your screen.

Example 3: What is the present value of $100 to be received 10 years from today, assuming an

opportunity cost of 9 percent?

9 press I/Y

10 press N

100 press +|- (and it will show as -100) press FV

CPT PV and you will see $42.24 on your screen.

(make sure that you followed steps 1), 2), and 3) above to clear the memory of the calculator

otherwise you may end up with different answer).

You can also use mathematical equation:

PV = FV / (1 + i) n

PV = 100 / (1.09) 10 = 100 / 2.367 = $42.24

Example 4: Congratulations! You have just won the lottery! However, the lottery bureau has

just informed you that you can take your winnings in one of two ways. Choice X pays

$1,000,000. Choice Y pays $1,750,000 at the end of five years from now. If the discount rate in

the economy is 4 percent per year, which would you choose?

Option X gives you money right away whereas option Y will give you cash in 5 years. You need

to compare both these options on the same scale, i.e. in todays term and therefore you need to

3

estimate the PV of option Y and compare the PV of option Y with the amount offered to you in

option X.

4 press I/Y

5 press N

1750000 press +|- press FV

CPT PV and you will see $1,438,372.43 on your screen.

Since the PV of options Y is greater than the amount you will get in option X therefore you

should pick option Y, i.e. wait for 5 years and collect $1,750,000 in 5 years.

Example 5: You just deposited $4,000 in a bank that promises to pay you back $5,900 in 5

years. What is the annual rate of interest you will earn on this investment?

5 press N

4000 press +|- press PV

5900 press FV

Press CPT then press I/Y and you will see 8.083 on your screen which means I/Y should be

8.08% per year.

Remember, when both PV and FV are given then we use +|- sign only for PV.

By using regular financial equation:

FV = PV(1 + i)N

5900 = 4000 * (1+i) 5

(5900/4000) = (1+i) 5

(1.4750) 1/5 = 1+i

1.0808 = 1+i

i = 1.0808 1= 0.0808 or 8.08%.

Example 6: In how many years you will double your money if interest rate is 5% per year?

Assume PV =1 then FV will be double, i.e. 2

5 press I/Y

1 press +|- press PV

2 press FV

Press CPT then press N and you will see 14.20 on your screen which means it will take 14.20

years to double your money if interest rate is 5% per year.

You may use financial equation:

FV = PV (1 + i)N

4

2 = 1 (1 .05)N

2 = (1 .05)N

LN (2) = N * LN (1.05)

N = LN (2) / LN (1.05)

N

The future value of a mixed stream of cash flows is calculated by multiplying each years cash flow by

the appropriate future value interest factor. To find the present value of a mixed stream of cash flows

multiply each years cash flow by the appropriate present value interest factor. There will be at least as

many calculations as the number of cash flows (CFs).

Example 1: $100 is received at year 1, $200 is received at year 2, and $300 is received at year 3.

If these cash flows are deposited at 12 percent, their combined future value at the year 3 is

________.

In this example, you will need to estimate FV of each CF separately and then add them together

to get the FV of this stream of CFs.

Type 12 press I/Y

Type 100 press +|- then press PV

Type 2 press N (a word of caution: in this case you are depositing $100 at year 1 and you want to

know the FV at year 3 that means number of compounding periods N = end period start period

that is 3 -1 = 2)

CPT FV and you will see: $125.44

Similarly, estimate FV of other two CFs

Type 12 press I/Y

Type 200 press +|- then press PV

Type 1 press N

CPT FV $224

Since you deposit $300 at year 3 and want to know its value at year 3 therefore FV is $300

FV of the stream of CFs = 125.44 + 224 + 300 = $649.44

5

Example 2: The present value of $1,000 received at the end of year 1, $1,200 received at the end

of year 2, and $1,300 received at the end of year 3, assuming an opportunity cost of 7 percent,

is_________________.

In this question, you need to find PV. Follow what we have done in the previous section to

estimate PV of individual CFs and then add all those PVs to estimate PV of this stream of cash

flows.

Type 1000 press +|- then press FV

Type 1 press N (a word of caution: in this case you are depositing $1000 at year 1 and you want

to know the PV today (today means at year 0) that means number of compounding periods N =

end period start period that is 1 - 0 = 1)

CPT PV and you will see: $934.58

Similarly, estimate PV of other two CFs

Type 7 press I/Y

Type 1200 press +|- then press PV

Type 2 press N

CPT PV $1,048.13

Type 7 press I/Y

Type 1300 press +|- then press PV

Type 3 press N

CPT PV $1,061.19

FV of the stream of CFs = 934.58 + 1048.13 + 1061.19 = $3,043.89

Example 3: $1,200 is received today, $2,200 is received at the end of year 1, and $3,300 is

received at the end of year 2. If these cash flows are deposited at 12 percent, their combined

future value at the end of year 3 is ________.

Remember, in this case you need to find FV at year 3 and your first cash flow starts today

therefore N = 3-0=3 for first CF, N = 3-1 = 2 for 2nd and N= 3-2 =1 for 3rd cash flow

respectively.

Example 4: The present value of $100 received at the end of year 1, $200 received at the end of

year 2, and $300 received at the end of year 3, assuming an opportunity cost of 13 percent,

is_________________.

N= 1-0 = 1 for first CF.

N= 2- 0 = 2 for second CF

N = 3-0 =3 for third CF.

13 press I/Y

100 press +|- press FV

1 press N

CPT PV

13 press I/Y

200 press +|- press FV

2 press N

CPT PV

13 press I/Y

300 press +|- press FV

3 press N

CPT PV

$88.50

$156.63

$207.92

Annuity

An ordinary annuity is one for which payments occur at the end of each period. An annuity due

is one for which payments occur at the beginning of each period.

The ordinary annuity is the more common. For otherwise identical annuities and interest rates,

the annuity due results in a higher FV because cash flows occur earlier and have more time to

compound.

A perpetuity is an infinite-lived annuity. The factor for finding the present value of a perpetuity

can be found by dividing the discount rate into 1.0. The resulting quotient represents the factor

for finding the present value of an infinite-lived stream of equal annual cash flows.

In case of annuity, you can estimate FV and PV of stream of CFs directly unlike the case given

above where you need to estimate FV and PV of each individual CF and then add them.

Example 1: Bill plans to fund his individual retirement account (IRA) with the maximum

contribution of $2,000 at the end of each year for the next 20 years. If Bill can earn 12 percent on

his contributions, how much will he have at the end of the twentieth year?

Annuity means same CF occurring at even time interval and it is called PMT on the financial

Calculator.

7

Solution:

Type 12 press I/Y

Type 20 press N

Type 2000 then press +|- then press PMT

CPT FV and the answer is $144,104.88

Example 2: The present value of an ordinary annuity of $350 each year for five years, assuming

an opportunity cost of 4 percent, is ________________.

Solution:

Type 4 press I/Y

Type 5 press N

Type 350 then press +|- then press PMT

CPT PV and the answer is $1,558.14

Example 3: The future value of an ordinary annuity of $2,000 each year for 10 years, deposited

at 12 percent, is___________.

Example 5: The present value of an ordinary annuity of $2,350 each year for eight years,

assuming an opportunity cost of 11 percent, is__________________.

Answer is $12,093.39

Example 6: A generous benefactor to the local ballet plans to make a one-time endowment which

would provide the ballet with $150,000 per year into perpetuity. The rate of interest is expected

to be 5 percent for all future time periods. How large must the endowment be?

PV of Perpetuity = PMT / i

PV = 150,000 / .05 = $3,000,000

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