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Defined

that occur at regular intervals

If the first payment occurs at the end of the

period, it is called an ordinary annuity

If the first payment occurs at the beginning of

the period, it is called an annuity due

payments

If the payment stream lasts forever, it is

called a perpetuity.

The PV of perpetuity is calculated by

dividing the cash payment by the interest

rate:

PV=C/r

from now. What happens if it starts today?

2

Example (perpetuity)

income of $1,000 per year to be received

forever, if interest rates are 4%?

Example (annuity)

Assume interest rates are 10%.

You wish to buy a car making three

installments: $4,000 a year from now,

$4,000 two years from now, $4,000 three

years from now.

How much money would you have to place in

an account today to generate this stream of

cash flows?

You would need to place $9,947.41 in an

account today to generate the desired cash

flows:

-$4,000

PV today:

-$4,000

$4,000 / (1.10)2 = $3,305.79

$4,000 / (1.10)3 = $3,005.26

$9,947.41

5

-4,000

3

and perpetuity

problem using the perpetuity formula?

Formulas

Perpetuity: PV = C / r

Annuities:

(1 r ) t

PV C

(1 r ) t 1

FV C

You have just won a lottery and must

choose between the following two options:

Receive a cheque for $150,000 today.

Receive $10,000 a year for the next 25

years.

Which option gives you the biggest winnings

How should you tackle this kind of problem?

8

Clearinghouse $10 million sweepstakes.

The money is paid in equal annual

installments of $333,333.33 over 30 years.

If the appropriate discount rate is 5%,

how much is the sweepstakes actually

worth today?

Questions:

You know the payment amount for a loan

and you want to know how much was

borrowed. Do you compute a present

value or a future value?

You want to receive 5,000 per month in

retirement. If you can earn .75% per

month and you expect to need the

income for 25 years, how much do you

need to have in your account at

retirement?

10

Annuity and a Perpetuity

What is the difference in value between a

50-year bond and the perpetual bond

offering $100 cash flows when interest rates

are 10%?

11

new car. You can borrow at 8% per year,

compounded monthly (8/12 = .66667%

per month). If you take a 4 year loan, what

is your monthly payment?

12

vacation, so you put $1,000 on your

credit card. You can only afford to make

the minimum payment of $20 per month.

The interest rate on the credit card is 1.5

percent per month. How long will you

need to pay off the $1,000?

13

Example

you are going to make annual payments

of $734.42. How long before you pay off

the loan?

14

parents to buy a car. You agree to pay

$207.58 per month for 60 months. What

is the monthly interest rate?

Microsoft Office

Excel Worksheet

15

Financial Calculator

Choose an interest rate and compute the PV of the

payments based on this rate

Compare the computed PV with the actual loan

amount

If the computed PV > loan amount, then the

interest rate is too low

If the computed PV < loan amount, then the

interest rate is too high

Adjust the rate and repeat the process until the

computed PV and the loan amount are equal

16

Calculator

You can use the PMT or CF key on a

financial calculator for the equal payment

The sign convention still holds

In Excel:

Microsoft Office

Excel Worksheet

17

next 5 years. How much would you need to

deposit today if you can earn .75% per month?

Suppose you have $200,000 to deposit and can

earn .75% per month.

How many months could you receive the $5,000

payment?

How much could you receive every month for 5

years?

18

retirement by depositing $2,000 per year in

an IRA. If the interest rate is 7.5%, how

much will you have in 40 years?

19

Buying a House

$20,000 for a down payment and closing costs.

Closing costs are estimated to be 4% of the loan

value. You have an annual salary of $36,000 and

the bank is willing to allow your monthly

mortgage payment to be equal to 28% of your

monthly income. The interest rate on the loan is

6% per year with monthly compounding (.5%

per month) for a 30-year fixed rate loan. How

much money will the bank loan you? How much

can you offer for the house?

20

Annuity Due

a rent agreement for a house of $1000

monthly. What is the PV of renting the

house for a year.

21

$10,000 per year in an account paying 8%.

The first payment is made today. How

much will you have at the end of 3 years?

22

0

10000

10000

10000

32,464

35,016.12

23

Questions

You want to have $1 million to use for

retirement in 35 years. If you can earn

1% per month, how much do you need to

deposit on a monthly basis if the first

payment is made in one month?

What if the first payment is made today?

You are considering preferred stock that

pays a quarterly dividend of $1.50. If

your desired return is 3% per quarter,

how much would you be willing to pay?

24

some money away for retirement. You

will receive five annual payments of

$25,000 each beginning in 40 years. How

much would you be willing to invest

today if you desire an interest rate of

12%?

25

Growing Perpetuity

An unequal cash flow that we are able to

value easily is the growing annuity where

the cash flow grows at a constant rate g.

C

PV ( growing perpetuity )

rg

Assume you own a Condo that currently

generates 12,000 a year. You expect this to

grow at a rate of 3%, while the discount

rate is 8%. What is the value of the Condo?

26

Growing Annuity

The PV of a finite stream of cash flow that

grows at a constant rate g.

t

C

1 g

PV ( growing annuity)

1

r g

1 r

only yours for next 20 years. What is it

value today?

27

A real estate appraiser is assessing the value of a piece of land in Vancouver.

Currently the land is unoccupied but is zoned for commercial use. Plans

have been approved to build a five-story office building. Construction is

expected to start in 1 year and will take 2 years to complete, at a total cost

of $3 million. For simplicity, assume that the costs are paid in equal amounts

at the start of each construction year.

Suppose a constant annual cash flow of $400,000, net of all taxes and

operating cost, is expected at the end of each year of operation, and the

building lasts for 50 years. What is the maximum you would be willing to pay

for the land if the discount rate is 8 percent. Explain your answer.

If the cash flow from the tenants grows at 1.5% per annum, after the first year

of occupancy, recalculate the price you would be willing to pay for the land.

28

When Marilyn Monroe died, ex husband Joe

DiMaggio vowed to place fresh flows on her

grave every Sunday as long as he lived. A

bunch of fresh flowers that the former

baseball player thought appropriate for the

star cost about $5 when she died in 1962.

Based on actuarial tables, Joe could expect

to live for 30 years after the actress died.

Assuming the inflation per week is 0.0736%,

that the stated interest per week is

0.1905%, and assuming 52 weeks in a year,

what was the PV of this commitment?

29

(EAR)

This is the actual rate paid (or received)

after accounting for compounding that

occurs during the year.

If you want to compare two alternative

investments with different compounding

periods you need to compute the EAR and

use that for comparison.

30

By definition APR = period rate times the

number of periods per year

Consequently, to get the period rate we

rearrange the APR equation:

Period rate = APR / number of periods per year

the number of periods per year it will NOT give

you the period rate

31

Computing APRs

.5(12) = 6%

.5(2) = 1%

monthly compounding?

12 / 12 = 1%

32

Things to Remember

rate and the time period match.

If you are looking at annual periods, you need an

annual rate.

If you are looking at monthly periods, you need a

monthly rate.

compounding, you have to use monthly periods

for lump sums, or adjust the interest rate

appropriately if you have payments other than

monthly

33

invested today.

What is the APR? 1(12) = 12%

How much are you effectively earning?

FV = 1(1.01)12 = 1.1268

Rate = (1.1268 1) / 1 = .1268 = 12.68%

3% per quarter.

What is the APR? 3(4) = 12%

How much are you effectively earning?

FV = 1(1.03)4 = 1.1255

Rate = (1.1255 1) / 1 = .1255 = 12.55%

34

APR

Compounding Number of times Effective

period

compounded

annual rate

Year

1 10.00000%

Quarter

4

10.38129

Month

12

10.47131

Week

52

10.50648

Day

36510.51558

Hour

8,76010.51703

Minute

525,600

10.51709

35

EAR - Formula

APR

EAR 1

m is the number of compounding periods per year

36

Decisions, Decisions II

pays 5.25%, with daily compounding. The other

pays 5.3% with semiannual compounding. Which

account should you use and why?

37

EARs

compute the APR? Rearrange the EAR

equation and you get:

APR m (1 EAR)

-1

38

APR - Example

rate of 12% and you are looking at an

account that compounds on a monthly

basis. What APR must they pay?

APR 12 (1 .12)

or 11.39%

1 / 12

1 .113 8655152

39

APRs

system and the store is willing to sell it to allow

you to make monthly payments. The entire

computer system costs $3,500. The loan period

is for 2 years and the interest rate is 16.9% with

monthly compounding. What is your monthly

payment?

40

account that has an APR of 9%, based on

monthly compounding. How much will

you have in the account in 35 years?

41

Compounding

car. If you can deposit money into an

account that pays an APR of 5.5% based

on daily compounding, how much would

you need to deposit?

42

Continuous Compounding

Sometimes investments or loans are

figured based on continuous

compounding

EAR = eq 1

normally denoted by ex

rate of 7% compounded continuously?

EAR = e.07 1 = .0725 or 7.25%

43

Quick Quiz

What is the definition of an APR?

What is the effective annual rate?

Which rate should you use to compare

alternative investments or loans?

Which rate do you need to use in the time

value of money calculations?

44

Treasury bills are excellent examples of

pure discount loans. The principal

amount is repaid at some future date,

without any periodic interest payments.

If a T-bill promises to repay $10,000 in

12 months and the market interest rate is

7 percent, how much will the bill sell for

in the market?

45

a 7% interest rate. The principal amount

is $10,000. Interest is paid annually.

What would the stream of cash flows be?

Years 1 4: Interest payments of .07(10,000) = 700

Year 5: Interest + principal = 10,700

cash flows on corporate bonds and we

will talk about them in greater detail

later.

46

Payment - Example

interest. The loan agreement requires the

firm to pay $5,000 in principal each year

plus interest for that year.

Click on the Excel icon to see the

amortization table

47

reduces principal

Consider a 4 year loan with annual payments.

The interest rate is 8% and the principal amount

is $5,000.

What is the annual payment?

table

48

Question: Loans

You take on a loan of $5,000 that matures in

5 years. What is your payment schedule if

the loan bears a 9% interest and it is a

(a) Pure discount loan.

(b) Interest only loan.

(c) Fixed principal loan.

(d) Fixed payment loan.

Principal

Beginning

Ending

Year

Balance

Balance

1

2

3

4

5

Totals

$5,000

4,000

3,000

2,000

1,000

$6,350

$1,450

1,360

1,270

1,180

1,090

$1,350

Total

Payment

Interest

Paid

Principal

Paid

$450

$1,000 $4,000

360 1,000 3,000

270 1,000 2,000

180 1,000 1,000

90 1,000 0

$5,000

50

Payments

Beginning

Ending

Year

Balance

Paid

Balance

Total

Payment

Interest

Principal

Paid

1

$5,000.00 $1,285.46 $ 450.00 $ 835.46 $4,164.54

2

4,164.54

1,285.46

374.81 910.65 3,253.88

3

3,253.88

1,285.46

292.85 992.61 2,261.27

4

2,261.27

1,285.46

203.51 1,081.95

1,179.32

5

1,179.32

1,285.46

106.14 1,179.32

0.00

Totals

$6,427.30 $1,427.31 $5,000.00

51

prepare amortization tables

Click on the web surfer to check out the

Bankrate.com site and work the following

example

You have a loan of $25,000 and will repay the

loan over 5 years at 8% interest.

What is your loan payment?

What does the amortization schedule look like?

52

What is a pure discount loan? What is a

good example of a pure discount loan?

What is an interest-only loan? What is a

good example of an interest-only loan?

What is an amortized loan? What is a

good example of an amortized loan?

53

Problem

Your company will generate $55,000 in

annual revenue each year for the next

eight years from a new information

database. The computer system

needed to set up the database costs

$250,000. If you can borrow the money

to buy the computer system at 7.5%

percent annual interest, can you afford

the new system?

54

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