Personal finance: Time Value

(a) (b) (c)

In conclusion, the longer the
the larger the total amount
1. N 3 1. Interest earned FV3 - PV The incremental interest pe
Interest 7% 1,837.56 for the first 3 years equal to
PV 1,500 (1,500) The greater the previous int
Interest earned $ 337.56
FV after 3 years:
$1,500 x (1+7%)^3 $1,837.56 2. Interest earned FV6 - FV3
2,251.10
2. N 6 (1,838)
Interest 7% Interest earned $ 413.54
PV 1,500
3. Interest earned FV9 - FV6
FV after 6 years: 2,757.69
$1,500 x (1+7%)^6 $2,251.10 (2,251)
Interest Earned $ 506.59
3. N 9
Interest 7%
PV 1500

FV after 6 years:
$1,500 x (1+7%)^9 $2,757.69
In conclusion, the longer the investment period
the larger the total amount of interest will be.
The incremental interest per 3 -year period increases also;
for the first 3 years equal to 337.56 while from year 3-6, additional interest earned is 413.54.
The greater the previous interest earned, the greated the impact of compunding
Future value of an annuity

I. Future value of an ordinary annuity vs annuity due

1. Ordinary annuity 2. Annuity Due

a N 10 a 36,216.41 x 1.08 $ 39,113.72

Interest 8%
PMT 2,500 b 4,057.59 x 1.12 $ 4,544.50
FV $ 36,216.41
c 223,248 x 1.20 $ 267,897.60
b. N 6
Interest 12% d 126,827.44 x 1.09 $ 138,241.91
PMT 500
FV $ 4,057.59 e 2,140,721.08 x 1.14 $ 2,440,422.03

c. N 5 II. The annuity due results in a greater future value in each case.
Interest 20% By depositing the payment at the beginning rather than at the en
PMT 30,000 of the year, it has one additional year of compounding.
FV $ 223,248.00

d. N 8
Interest 9%
PMT 11,500
FV $ 126,827.44

e. N 30
Interest 14%
PMT 6,000
FV $ 2,140,721.08
ture value in each case.
nning rather than at the end
of compounding.
Present value of an annuity

I.Present value of an ordinary annuity vs annuity due

1. Ordinary annuity 2. Annuity Due

a N 3 a 31,491.79 x 1.07 $ 53,536.04

Interest 7% b 374,597.55 x 1.12 $ 419,549.26
PMT 12,000 c 2,281.68 x 1.20 $ 3,386.02
12,000 x (1-(1+7%)^-3/7%) d 810,092.28 x 1.5 $ 1,215,138.42
PV $ 31,491.79 e 85,292.70 x 1.10 $ 93,821.97

b. N 15 II.
Interest 12% The annuity due results in a greater present value in each case.
PMT 55,000 BY depositing the payment at the beginning rather than at the end of th
55,000 x (1-(1+12%)^-15/12%) it has one less year to discount back.
PV $ 374,597.55

c. N 9
Interest 20%
PMT 700
700,000 x (1-(1+20%)^9/20%)
PV $ 2,821.68

d. N 7
Interest 5%
PMT 140,000
140,000 x (1-(1+5%)^7/5%)
PV $ 810,092.28

e. N 5
Interest 10%
PMT 22,500
22,500 x (1-(1+10%)^5/10%)
PV $ 85,292.70
esent value in each case.
nning rather than at the end of the year,
Relationship between future value and present value-Mixed Stream

Year Cashflow Formula Present value

a. CF 1 800 800 x (1+5%)^-1 761.9
CF 2 900 900 x (1+5%)^-2 816.33
CF 3 1,000 1,000 x (1+5%)^-3 863.84
CF 4 1,500 1,500 x (1+5%)^-4 1,234.05
CF 5 2,000 2,000 x (1+5%)^-5 1,567.05
NPV $ 5,243.17

b. The maximum amount to pay for an

opportunity to buy this stream is $ 5,243.17

c. Since the discount rate is higher than 5%, most probably, the present
value of the cash flow stream is lower than $5,243.17
Changing compounding frequency

a. Compounding frequency
1. Frequency of conversion N Interest Formula FV
Annual 5 12 5,000 x (1+12%)^5 $ 8,811.71
Semi Annual 5 12 5,000 x (1+6%)^10 $ 8,954.24
Quarterly 5 12 5,000 x (1+3%)^20 $ 9,030.56

2. Frequency of conversion N Interest Formula FV

Annual 6 16 5,000 x (1+16%)^6 $ 12,181.98
Semi Annual 6 16 5,000 x (1+8%)^12 $ 12,590.85
Quarterly 6 16 5,000 x (1+4%)^24 $ 12,816.52

3. Frequency of conversion N Interest Formula FV

Annual 10 20 5,000 x (1+20%)^10 $ 30,958.68
Semi Annual 10 20 5,000 x (1+10%)^20 $ 33,637.50
Quarterly 10 20 5,000 x (1+5%)^40 $ 35,199.94

b. Effective interest rate

1. Frequency of conversion Formula EIR
Annual (1+0.12/1)^1-1 12%
Semi Annual (1+0.12/2)^2-1 12.4%
Quarterly (1+0.12/4)^4-1 12.6%

2. Frequency of conversion Formula EIR

Annual (1+0.16/1)^1-1 16%
Semi Annual (1+0.16/2)^2-1 16.6%
Quarterly (1+0.16/4)^4-1 17%

3. Frequency of conversion Formula EIR

Annual (1+0.20/1)^1-1 20%
Semi Annual (1+0.20/2)^2-1 21.0%
Quarterly (1+0.20/4)^4-1 21.6%
Risk Premiums

a. Risk-free rate of interest

Security A 2% + 9% 11%
Security B 2% + 7% 9%

b. Risk premium
Risk premium = Default risk + Maturity risk + Liquidity risk + Other risk
Security A 1% + 0.5% + 1% + 0.5% 3%
Security B 2% + 0.5% + 1% + 1.5% 6%

c. Nominal rate of interest

Risk free rate + Risk premium
Security A 11% + 3% 14%
Security B 9% + 6^ 15%

Security A is less risky than Security B because of its characteristics.

However, Security B hasa lower risk-free rate of return that Security A.
Valuation of Assets

Asset End of Year Amount N Interest PMT/FV

A 1 $5,000
2 $5,000 3 18% $5,000
3 $5,000

B. 1-∞ $300

C. 1 0 5 16% 35,000
2 0
3 0
4 0
5 35,000

D. 1-5 1,500 6 12% PMT = $ 1,500

6 8,500 FV = $7,000

E. 1 2,000 2,000
2 3,000 3,000
3 5,000 5,000
14%
4 7,000 7,000
5 4,000 4,000
6 1,000 1,000
 PV of Cash Flow
Formula
5,000 x ((1-(1.18)^-3/.18 $ 10,871.36

(1/0.15)*300 $ 2,000.00

35,000 x (1+16%)^-5 $ 16,663.96

1,500 x ((1-(1+12%)^-6/12%
$ 9,713.53
7,000 x (1+12%)^-6

2,000 x (1+14%)^-1
3,000 x (1+14%)^-2
5,000 x (1+14%)^-3 $14,115.27
7,000 x (1+14%)^-4
4,000 x (1+14%)^-5
1,000 x (1+14%)^-6
Yield to Maturity

Bond A is selling at a discount to par.

Bond B is selling at par value.
Bond C is selling a a premium to par.
Bond D is selling at a discount to par.
Bond E is selling at a premium to par.
Bond Valuation -quarterly interest.

N I PMT FV
4 x 10 12%/4 3 5,000
0.10 x 5,000/ 4

40 3% 125

Solve for PV:

Formula
PMT 5,000 x (1.3%)^-40 $ 1,532.78
FV 125 x (1+1-3%)^-40/3% $ 2,889.35
PV $ 4,422.13