Professional Documents
Culture Documents
Session One
They had to choose between a single lump sum $104 million, or $198 million paid out over 25 years (or $7.92 million per year). The winning couple opted for the lump sum. Did they make the right choice? What basis do we make such an economic comparison? To make such comparisons (the lottery decision problem), we must be able to compare the value of money at different point in time.
The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
Future Values
You have $100 invested in a bank account. Suppose banks are currently paying an interest rate of 6 percent per year on deposits. So after a year, your account will earn interest of $6: FV = PV (1 + r) FV = 100 (1+06) Value of investment after 1 year = $106
Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today
Interest Earned
Value 100
6 106
Future Years 2 3
6 112
6 118
6 124
6 130
Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance. Interest Earned Per Year =Prior Year Balance x .06
Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100
6 106
Future Years 2 3
6.36 112.36
6.74 119.10
7.15 126.25
7.57 133.82
Market Value
Assume that the companys stock will continue to appreciate at an annual rate of 24.58% for the next 27 years.
27
FYI - The value of Manhattan Island land is well below this figure.
Present Values
Present Value = PV PV =
Future Value after t periods (1+r) t
Present Values
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?
PV
3000 (1.08)2
$2,572
8,000.00
PV1 PV2
3,703.70 3,429.36
Total PV
$15,133.06
Present Values
$8,000 $4,000 Present Value Year 0
0 1 2
$ 4,000
Year
$8,000
4000/1.08 4000/1.082 Total = $3,703.70 = $3,429.36 = $15,133.06
PV
C1 (1 r )
1
(1 r ) 2 ....
C2
Perpetuities
PV of Perpetuity Formula
PV
C = cash payment r = interest rate
C r
PV
$1,000,000
Perpetuities
Example - continued If the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today?
PV
$751,315
Annuities
PV of Annuity Formula
PV C
1 r
1 t r ( 1 r )
Annuities
PV Annuity Factor (PVAF) - The present value of $1 a year for each of t years.
PVAF
1 r
1 t r ( 1 r )
Annuities
Example - Annuity You are purchasing a car. You are scheduled to make 3 annual installments of $4,000 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)?
PV 4 ,000
1 .10
1 .10 ( 1 .10 ) 3
PV $9,947.41
Annuities
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
FV C PVAF (1 r )
Annuities
Example - Future Value of annual payments You plan to save $4,000 every year for 20 years and then retire. Given a 10% rate of interest, what will be the FV of your retirement account?
FV 4 ,000
1 .10
1 .10 ( 1 .10 ) 20
(1.10)
20
FV $229,100
EAR = (1 + .01)12 - 1 = r EAR = (1 + .01)12 - 1 = .1268 or 12.68% APR = .01 x 12 = .12 or 12.00%
Inflation
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
1+ nominal interest rate 1 real interest rate = 1+inflation rate
approximation formula
Inflation
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+.06 1 real interest rate = 1+.02
1 real interest rate = 1.039 real interest rate = .039 or 3.9% Approximation = .06 - .02 = .04 or 4.0%
The End