Topic 05 Time Value of Money Students

Chapter 5
The Time Value

Book Cover
10e
of Money
Copyright
Copyright
© 2018
© 2020
by The
by The
McGraw-Hill
McGraw-Hill
Companies,
Companies,
Inc.
Inc.AllAllrights 5- 1
rightsreserved
reserved
Topics Covered
5.1 Future Values and Compound Interest

5.2 Present Values
5.3 Multiple Cash Flows
5.4 Reducing the Chore of the Calculations: Part 1
5.5 Level Cash Flows: Perpetuities and Annuities
5.6 Reducing the Chore of the Calculations: Part 2
5.7 Effective Annual Interest Rates
5.8 Inflation & The Time Value of Money
Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 2

Future Values and Compound Interest (1 of 8)
 Future Value
– Amount to which an investment will grow after
earning interest
 Compound Interest
– Interest earned on interest
 Simple Interest
– Interest earned only on the original investment
Example — Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100
Interest earned per year = 100 .06 = $6
$ $ $
Example — Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100
Today Future Years

1 2 3 4 5 6
Interest Earned 6 6 6 6 6
Value 100
Value at the end of Year 5 = $130
Example — Compound Interest

Interest earned at a rate of 6% for five years on
the previous year’s balance
Interest earned per year = prior year balance .06

Example — Compound Interest

Interest earned at a rate of 6% for five years on
the previous year’s balance
Today Future Years

1 2 3 4 5
Interest Earned 6 6.36 6.74 7.15 7.57
Value 100
Value at the end of Year 5 = $133.82
 Future Value = FV
FV = PV 1+r t
FV = $100 1+r t

Example — FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five
years?
FV = PV 1+r t
FV5 = $100 1 + .06 5
5- 10
Manhattan Island Sale
Peter Minuit bought Manhattan Island for

$24 in 1626. Was this a good deal?
To answer, determine what $24 is worth in the
year 2016, compounded at 8%
FV = PV 1+r n
Note: The value of Manhattan Island land is well

below this figure
Present Values (1 of 6)
Present Value Discount Factor

Value today of a Present value of a
future cash flow $1 future payment
Discount Rate
Interest rate used
to compute
present values of
future cash flows
5- 12
 Present value = PV
FV
PV = t
1+r
 Discounted Cash Flow (DCF)

– Method of calculating present value by
discounting future cash flows
Future cash flow
Present value

Example
You just bought a new computer for $3,000. The
payment terms are 2 years same as cash. If you can
earn 8% on your money, how much money should
you set aside today in order to make the payment
when due in two years?
FV
PV = t
1+r
3,000
PV0 = =
1.08 2
5- 16
 Drawing a time line can help us to calculate the

present value of the payments to Kangaroo Autos
– Example 5.4 page 126
Time Value of Money (Applications)

(1 of 3)
 The PV formula has many applications.

Given any variables in the equation, you
can solve for the remaining variable.
FV
PV = t
1+r

(2 of 3)
Example
The US Govt borrowed money for 10 years,
but it did not announce an interest rate. It
simply offered to sell each IOU for $777.40.
What is the interest rate?
FV 1,000
PV = t 777.40 =
1+r 1 + r 10

(3 of 3)
 Value of Free Credit

 Implied Interest Rates
 Internal Rate of Return
– Example 5.5 page 128
 Time necessary to accumulate funds

Future Value of Multiple Cash Flows
Example: pg 128: draw your time line
You are able to put $1,200 in the bank now, and another
$1,400 in 1 year. If you earn an 8% rate of interest, how
much will you be able to spend on a computer in 2 years?
0 1 2
FV = PV 1+r t
$1,200 $1,400
FV at year 2
FV8%,1
FV2 = 1,400 1 + .08 1
FV8%,2
FV2= 1,200 1 + .08 2
= 2,911.68
Present Value of Multiple Cash Flows (1 of 2)
 PVs can be added together to evaluate

multiple cash flows
C1 C2
PV = + +…
1+r 1 1+r 2

Present Value of Multiple Cash Flows (2 of 2)
Example 5.7 pg 129‐130: draw your time line

Your auto dealer gives you the choice to pay $15,500 cash now, or
make three payments: $8,000 now and $4,000 at the end of the
following two years. If your cost of money is 8%, which do you prefer?
FV
PV = t
1+r
PV8%,1
PV8%,2
Calculations: Part 1 – Financial Calculators

(1 of 3)
n i PV PMT FV
 n is the number of periods

 i is the interest rate, expressed as a
percentage (not a decimal)
 PV is the present value
 PMT is the amount of any recurring payment
 FV is the future value

(2 of 3)
Example: What is the future value of Peter Minuit’s $24

investment if invested at 8% for 393 years?
n i PV PMT FV
393 8 24 0 FV
• Key‐in “0” for the variable that are not available: PMT
• Press “CPT” to calculate the variable that we are looking for: FV
FV = $327.90

(3 of 3)
Example: You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on your money, how
much money should you set aside today in order to make the payment
when due in two years?
n i PV PMT FV
2 8 PV 0 3000
• Key‐in “0” for the variable that are not available: PMT
• Press “CPT” to calculate the variable that we are looking for: PV
FV = $1,455.77
Perpetuities and Annuities (1 of 11)
 Perpetuity
– A stream of level cash payments that never
ends
 Annuity
– Level stream of cash flows at regular intervals
with a finite maturity
 PV of Perpetuity Formula
C
PVA∞ =
r
C = cash payment
r = interest rate

Example
In order to create an endowment, which pays
$100,000 per year forever, how much money
must be set aside today in the rate of interest is
10%?
C 100,000
PVA∞= PV0 =
r .10
= $1,000,000

Example (continued): draw your time line
If the first perpetuity payment will not be
received until three years from today, how much
money needs to be set aside today?
0 1 2 3 4 …. ∞
100 100 …. ∞
2 steps are involve
– Step 1: Determine the PVA a period before the
annuity started
– Step 2: Determine the PV of step 1 at year 0
Example (continued): draw your time line
If the first perpetuity payment will not be
received until three years from today, how much
money needs to be set aside today?
0 1 2 3 4 …. ∞
FV
PV0 = 100 100 …. ∞
1+r t
1,000,000
= 100,000
1 + .10 2 PVA∞2 =
.10
 PV of Annuity Formula
– Level stream of cash flows at regular
intervals with a finite maturity
1 1
PVA = C − t
r r 1+r
C = cash payment
r = interest rate
t = Number of years cash payment is received

Example
You are purchasing a car. You are scheduled to make 3 annual
installments of $8,000 per year. Given a rate of interest of
10%, what is the price you are paying for the car (i.e. what is
the PV)?
FV
PV = t
1+r
PV10%,1
PV10%,2
PV10%,3

Example (continued)
You are purchasing a car. You are scheduled to make 3 annual
installments of $8,000 per year. Given a rate of interest of
10%, what is the price you are paying for the car (i.e. what is
the PV)?
1 1
PVA = C − t
r r 1+r

 Applications
– Value of payments
– Implied interest rate for an annuity
– Calculation of periodic payments
• Mortgage payment
• Annual income from an investment payout
• Future Value of annual payments
 Future Value of Annuity
1 + r)n−1
FVA = C
r

Example — Future value of annual payments
You plan to save $3,000 every year for 4 years. Given an
8% rate of interest, what will be the FV of your account?
1 + r)n−1
FVA = C
r

Example: You are purchasing a home and are scheduled
to make 30 annual installments of $10,000 per year.
Given an interest rate of 5%, what is the price you are
paying for the house (i.e. what is the present value)?
1 1
PVA = C − t
r r 1+r

Example — Future value of annual payments
You plan to save for 50 years and then retire. Given a 10% rate
of interest, if you desire to have $500,000 at retirement, how
much must you save each year?
1 + r)n−1
FVA =C
r
Annual Savings = C =
Annuities Due (1 of 2)
 Annuity Due
– Level stream of cash flows starting immediately
 How does it differ from an ordinary annuity?
PVADue = PVA 1+r

 How does the future value differ from an ordinary
annuity?
FVADue = FVA 1+r

Annuities Due (2 of 2)
Example: Suppose you invest $429.59 annually at the beginning
of each year at 10% interest. After 50 years, how much would
your investment be worth?
FVADue = FVA 1+r

1 + r)n−1
FVADue = C 1+r
r
1 + 10%)50−1
FVADue = 429.59 1 + .10
10%
FVADue == 550,000

(1 of 2)
Example: You are purchasing a car. You are scheduled to make 3

annual installments of $8,000 per year. Given a rate of interest of
10%, what is the price you are paying for the car?
n i PV PMT FV
3 10 PV ‐8000 0
• Key‐in “0” for the variable that are not available: FV

• Press “CPT” to calculate the variable that we are looking for: PV
FV = $19,894.82
(2 of 2)
Example : You are taking out a mortgage for $100,000. You will
pay it back over 30 years paying 1% per month. What is your
monthly payment?
n i PV PMT FV
360 1 100,000 PMT 0
• Key‐in “0” for the variable that are not available: FV

• Press “CPT” to calculate the variable that we are looking for: PMT
PMT = $321.64
Effective Interest Rates (1 of 3)
 Effective Annual Interest Rate

– Interest rate that is annualized using
compound interest
 Annual Percentage Rate
– Interest rate that is annualized using simple
interest

 Annual Percentage Rate (APR)
APR = r m
 Effective Annual Interest Rate (EAR)

𝑟
EAR = 1 −1
𝑚
*where m = compounding frequency a year

Example: Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual Percentage Rate
(APR)?: Compounding monthly
APR = r m = .01 12 = .12 or 12.00%

𝑟
EAR = 1 −1
𝑚

Inflation (1 of 5)
 Inflation
– Rate at which prices as a whole are increasing
 Nominal Interest Rate
– Rate at which money invested grows
 Real Interest Rate
– Rate at which the purchasing power of an
investment increases
Inflation (2 of 5)
Annual U.S. Inflation Rates from 1900 ‐ 2015
5- 48
Inflation (3 of 5)
1 + nominal interest rate

1 + real interest rate =
1 + inflation rate
 Approximation formula
Real int. rate ≈ nominal int. rate − inflation rate
5- 49
Inflation (4 of 5)
Example: If the interest rate on one year govt. bonds
is 6.0% and the inflation rate is 2.0%, what is the real
interest rate?
1 + nominal interest rate
1 + inflation rate
1+.06
1+.02
1 + real interest rate = 1.039
1 + real interest rate = .039 or 3.9%
Approximation = .06 − .02 = .04 or 4.0%
Inflation (5 of 5)
 Remember:
– Current dollar cash flows must be discounted
by the nominal interest rate
– Real cash flows must be discounted by the real
interest rate

Topic 05 Time Value of Money Students

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Topic 05 Time Value of Money Students

Uploaded by

Copyright:

Available Formats

Chapter 5

The Time Value

5.1 Future Values and Compound Interest

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 2

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 3

Future Values and Compound Interest (2 of 8)

Example — Simple Interest

Interest earned per year = 100 .06 = $6

Example — Simple Interest

Today Future Years

Value at the end of Year 5 = $130

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 5

Future Values and Compound Interest (4 of 8)

Example — Compound Interest

Interest earned per year = prior year balance .06

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 6

Example — Compound Interest

Today Future Years

Value at the end of Year 5 = $133.82

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 7

Future Values and Compound Interest (6 of 8)

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 8

FV5 = $100 1 + .06 5

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 9

Future Values and Compound Interest (8 of 8)

Peter Minuit bought Manhattan Island for

Note: The value of Manhattan Island land is well

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 11

Present Value Discount Factor

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 13

 Discounted Cash Flow (DCF)

Future cash flow

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 14

 Drawing a time line can help us to calculate the

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 17

Time Value of Money (Applications)

 The PV formula has many applications.

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 18

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 19

Time Value of Money (Applications)

 Value of Free Credit

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 20

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 21

Present Value of Multiple Cash Flows (1 of 2)

 PVs can be added together to evaluate

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 22

Example 5.7 pg 129‐130: draw your time line

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 23

Calculations: Part 1 – Financial Calculators

 n is the number of periods

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 24

Example: What is the future value of Peter Minuit’s $24

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 25

Calculations: Part 1 – Financial Calculators

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 27

Perpetuities and Annuities (2 of 11)

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 28

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 29

Perpetuities and Annuities (4 of 11)

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 31

Perpetuities and Annuities (6 of 11)

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 32

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 5- 33

Perpetuities and Annuities (8 of 11)