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Money

Compounding and

Discounting Single Sums

We know that receiving Rs.1 today is

worth more than Rs.1 in the future.

This is due to opportunity costs.

the future is the interest we could have

earned if we had received the Rs.1

sooner.

If we can measure this opportunity cost,

we can:

If we can measure this opportunity cost,

we can:

• Translate Rs.1 today into its equivalent in the

future (compounding).

If we can measure this opportunity cost,

we can:

• Translate Rs.1 today into its equivalent in the

future (compounding).

Today Future

?

If we can measure this opportunity cost,

we can:

• Translate Rs.1 today into its equivalent in the

future (compounding).

Today Future

?

• Translate Rs.1 in the future into its equivalent

today (discounting).

If we can measure this opportunity cost,

we can:

• Translate Rs.1 today into its equivalent in the

future (compounding).

Today Future

?

• Translate Rs.1 in the future into its equivalent

today (discounting).

Today Future

?

Future Value

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 1 year?

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 1 year?

PV = FV =

0 1

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 1 year?

PV = -100 FV =

0 1

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 1 year?

PV = -100 FV = 106

0 1

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 5 years?

Future Value - single sums

If you deposit Rs.100 in an account earning 6%, how

much would you have in the account after 5 years?

PV = FV =

0 5

Future Value - single sums

If you deposit Rs.100 in an account earning 6% with

quarterly compounding, how much would you have

in the account after 5 years?

Future Value - single sums

If you deposit Rs.100 in an account earning 6% with

quarterly compounding, how much would you have

in the account after 5 years?

PV = FV =

0 ?

Future Value - single sums

If you deposit Rs.100 in an account earning 6% with

monthly compounding, how much would you have

in the account after 5 years?

Future Value - single sums

If you deposit Rs.100 in an account earning 6% with

monthly compounding, how much would you have

in the account after 5 years?

PV = FV =

0 ?

Present Value

Present Value - single sums

If you receive Rs.100 one year from now, what is the

PV of that Rs.100 if your opportunity cost is 6%?

Present Value - single sums

If you receive Rs.100 one year from now, what is the

PV of that Rs.100 if your opportunity cost is 6%?

PV = FV =

0 ?

Present Value - single sums

If you receive Rs.100 five years from now, what is

the PV of that Rs.100 if your opportunity cost is 6%?

Present Value - single sums

If you receive Rs.100 five years from now, what is

the PV of that Rs.100 if your opportunity cost is 6%?

PV = FV =

0 ?

Present Value - single sums

What is the PV of Rs.1,000 to be received 15 years

from now if your opportunity cost is 7%?

Present Value - single sums

What is the PV of Rs.1,000 to be received 15 years

from now if your opportunity cost is 7%?

PV = FV =

0 15

Present Value - single sums

If you sold land for Rs.11,933 that you bought 5

years ago for Rs.5,000, what is your annual rate of

return?

Present Value - single sums

If you sold land for Rs.11,933 that you bought 5

years ago for Rs.5,000, what is your annual rate of

return?

PV = FV =

0 5

Present Value - single sums

Suppose you placed Rs.100 in an account that pays

9.6% interest, compounded monthly. How long will

it take for your account to grow to Rs.500?

PV = FV =

0

The Time Value of Money

Cash Flow Streams

0 1 2 3 4

Annuities

• Annuity: a sequence of equal cash

flows, occurring at the end of each

period.

Annuities

• Annuity: a sequence of equal cash

flows, occurring at the end of each

period.

0 1 2 3 4

Examples of Annuities:

• If you buy a bond, you will

receive equal semi-annual coupon

interest payments over the life of

the bond.

• If you borrow money to buy a

house or a car, you will pay a

stream of equal payments.

Future Value - annuity

If you invest Rs.1,000 each year at 8%, how much

would you have after 3 years?

Future Value - annuity

If you invest Rs.1,000 each year at 8%, how much

would you have after 3 years?

0 1 2 3

Present Value - annuity

What is the PV of Rs.1,000 at the end of each of the

next 3 years, if the opportunity cost is 8%?

Present Value - annuity

What is the PV of Rs.1,000 at the end of each of the

next 3 years, if the opportunity cost is 8%?

0 1 2 3

Present Value - annuity

What is the PV of Rs.1,000 at the end of each of the

next 3 years, if the opportunity cost is 8%?

The Time Value of Money

0 1 2 3

Perpetuities

payment every period (month, year,

etc.) forever. This is an example of

a perpetuity.

• You can think of a perpetuity as an

annuity that goes on forever.

Present Value of a

Perpetuity

• When we find the PV of an annuity,

we think of the following

relationship:

Present Value of a Perpetuity

PMT

PV =

i

What should you be willing to pay in

order to receive Rs.10,000 annually

forever, if you require 8% per year

on the investment?

Ordinary Annuity

vs.

Annuity Due

4 5 6 7 8

Begin Mode vs. End Mode

4 5 6 7 8

Begin Mode vs. End Mode

year year year

4 5 5 6 6 7 7 8

Begin Mode vs. End Mode

year year year

4 5 5 6 6 7 7 8

PV

in

END

Begin Mode vs. End Mode

year year year

4 5 5 6 6 7 7 8

PV FV

in in

END END

Begin Mode vs. End Mode

4 5 6 6 7 7 8 8

Begin Mode vs. End Mode

4 5 6 6 7 7 8 8

PV

in

BEGIN

Begin Mode vs. End Mode

4 5 6 6 7 7 8 8

PV FV

in in

BEGIN BEGIN

Earlier, we examined this

“ordinary” annuity:

Earlier, we examined this

“ordinary” annuity:

1000 1000 1000

0 1 2 3

Earlier, we examined this

“ordinary” annuity:

1000 1000 1000

0 1 2 3

Using an interest rate of 8%, we

find that:

Earlier, we examined this

“ordinary” annuity:

1000 1000 1000

0 1 2 3

Using an interest rate of 8%, we

find that:

• The Future Value (at 3) is

Rs.3,246.40.

Earlier, we examined this

“ordinary” annuity:

1000 1000 1000

0 1 2 3

Using an interest rate of 8%, we

find that:

• The Future Value (at 3) is

Rs.3,246.40.

• The Present Value (at 0) is

Rs.2,577.10.

What about this annuity?

0 1 2 3

• Same 3-year time line,

• Same 3 Rs.1000 cash flows, but

• The cash flows occur at the

beginning of each year, rather

than at the end of each year.

• This is an “annuity due.”

Future Value - annuity due

If you invest Rs.1,000 at the beginning of each of

the next 3 years at 8%, how much would you have at

the end of year 3?

0 1 2 3

Future Value - annuity due

If you invest Rs.1,000 at the beginning of each of

the next 3 years at 8%, how much would you have at

the end of year 3?

Mathematical Solution: Simply compound the FV of the

ordinary annuity one more period:

FV = PMT (FVIFA i,n ) (1 + i)

FV = 1,000 (FVIFA .08,3 ) (1.08) (use FVIFA table, or)

FV = PMT (1 + i)n - 1

(1 + i)

i

FV = 1,000 (1.08)3 - 1 = Rs.3,506.11

(1.08)

.08

Present Value - annuity due

What is the PV of Rs.1,000 at the beginning of each

of the next 3 years, if your opportunity cost is 8%?

0 1 2 3

Uneven Cash Flows

-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

stream when all of the cash flows are

different? (Use a 10% discount rate).

Uneven Cash Flows

-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

Annual Percentage Yield (APY)

• 8% compounded annually, or

• 7.85% compounded quarterly?

• We can’t compare these nominal (quoted)

interest rates, because they don’t include the

same number of compounding periods per year!

We need to calculate the APY.

Annual Percentage Yield (APY)

Annual Percentage Yield (APY)

APY = (1+ quoted rate

m

) m

- 1

Credit card vs. bank loan

that charges 1% pm or from a bank that

charges 12% quoted compounded quarterly,

which one will you choose?

Example

• Cash flows from an investment are

expected to be Rs.40,000 per year at

the end of years 4, 5, 6, 7, and 8. If

you require a 20% rate of return,

what is the PV of these cash flows?

Example

• Cash flows from an investment are

expected to be Rs.40,000 per year at

the end of years 4, 5, 6, 7, and 8. If

you require a 20% rate of return,

what is the PV of these cash flows?

Rs.0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

Rs.0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8

• This type of cash flow sequence is

often called a “deferred annuity.”

Retirement Example

• After graduation, you plan to invest

Rs.400 per month in the stock market.

If you earn 12% per year on your

stocks, how much will you have

accumulated when you retire in 30

years?

Example

• After graduation, you plan to invest

Rs.400 per month in the stock market.

If you earn 12% per year on your

stocks, how much will you have

accumulated when you retire in 30

years?

400 400 400 400

0 1 2 3 . . . 360

400 400 400 400

0 1 2 3 . . . 360

Example

If you borrow Rs.100,000 at 7%

fixed interest for 30 years in order

to buy a house, what will be your

monthly house payment?

? ? ? ?

0 1 2 3 . . . 360

Example

Upon retirement, your goal is to spend 5

years traveling around the world. To

travel in style will require Rs.250,000

per year at the beginning of each year.

If you plan to retire in 30 years, what are

the equal monthly payments necessary

to achieve this goal? The funds in your

retirement account will compound at

10% annually.

250 250 250 250 250

27 28 29 30 31 32 33 34 35

the end of year 30 to finance the

trip?

Example

• You are offered a note which pays Rs.1,000 in 15

months (or 456 days) for Rs.850. You have Rs.850 in

a bank which pays a 6.76649% nominal rate, with

365 daily compounding, which is a daily rate of

0.018538% and an EAR (APY) of 7.0%. You plan to

leave the money in the bank if you don’t buy the

note. The note is riskless.

• Should you buy it?

iPer = 0.018538% per day.

-850 1,000

3 Ways to Solve:

2. Greatest wealth today: PV

3. Highest rate of return: Highest APY%

Amortization Example

for a Rs.1,000, 10% annual rate loan

with 3 equal payments.

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