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The Time Value of Money

• master time value of money mechanics


• and crunch the numbers

Schweser CFA Level 1 Book 1 – Reading #5


#5 The time value of money
 LOS 5.a - Interest rate interpretation

 LOS 5.b - Real risk-free rate and premiums

 LOS 5.c - Effective annual rate (EAR)

 LOS 5.d - Different frequencies of compounding

 LOS 5.e - Present value (PV); future value (FV); annuity

 LOS 5.f - Solution by timeline demonstration

 Concept checkers
Time Lines

 Draw time lines to better show the cash flows


 Cash Inflow: positive; you receive money
 Cash Outflow: negative; you pay money
 Present value (PV): discount all future cash flows into today’s value
 Future value (FV): compound all cash flows to the value of a future date

 N = Number of compounding periods


 I/Y = Interest rate of compounding periods
 PMT = Payment, periodic cash flow
 CPT = compute
Time Lines

 Time Line demonstration.


 T = 0, today, cash outflow = 1000
 Time length : 8 years
 At the end of each year : cash inflow = 600
 Blue numeric numbers from 1 to 8: end of 1st year … end of 8th year

 End of 1st year = beginning of 2nd year


 End of year i = beginning of year i+1

+600 +600 +600 +600 +600 +600 +600 +600

0 1 2 3 4 5 6 7 8

-1000
LOS 5.a Interpret interest rates as required rates of return, discount rates, or
opportunity costs
LOS 5.a Interpret interest rates as required rates of return, discount rates,
or opportunity costs

 Compound Interest or Interest on Interest: the interest earned


on the previous period's interest earnings.

 Interest rate interpretation

 Required rate of return: the required return at which investors will invest
 Discount rates: borrow rate of investors from banks, as he will pay the interest
 Opportunity cost of current consumption: This is value of the best alternative
foregone, or in other words, this is the return of something else that you have to
give up when consume in this project.
LOS 5.b Explain an interest rate as the sum of a real risk-free rate, and
premiums that compensate investors for bearing distinct types of risk
LOS 5.b Explain an interest rate as the sum of a real risk-free rate, and premiums that
compensate investors for bearing distinct types of risk

 Risk free rate: The interest rate without any potential risks
 Nominal risk-free rate = real risk-free rate + expected inflation rate (e.g., U.S.
Treasury bill (T-bills) )
 Real risk-free rate: , if the risk-free rate of return is 3% and the inflation rate is 2%,
the real risk-free rate of return is 1%.
 Types of risks (risks of securities contain the first three types of risks):
 Default risk: ex. Firms unable to pay back its debt (bonds)
 Liquidity risk: ex. Sell securities for cash less than fair value in illiquid markets
 Maturity risk: ex. Long term bonds are more volatile
 Exchange rate risk: change in exchange rate if you buy or sell in foreign
currency.
 ….
 Required interest rate: the sum of nominal risk-free rate and risk premiums
 Nominal risk-free rate +
 Default risk premium +
 Liquidity premium +
 Maturity risk premium…
 (premium: additional part as compensation for additional risk)
LOS 5.c Calculate and interpret the effective annual rate, given the stated
annual interest rate and the frequency of compounding
LOS 5.c Calculate and interpret the effective annual rate, given the stated annual interest rate
and the frequency of compounding

 Stated annual interest rate: or quoted interest rate, is the interest rate announced
by financial institutions yearly.
 Effective annual rate (EAR): the annual rate of return actually being earned after
adjustments have been made for different compounding periods

 𝐸𝐴𝑅 = (1 + 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑟𝑎𝑡𝑒)𝑚 −1


 Periodic rate: stated annual rate divided by m
 m: the number of compounding periods per year
LOS 5.c Calculate and interpret the effective annual rate, given the stated annual interest rate
and the frequency of compounding

 Effective annual rate (EAR): the annual rate of return actually being earned after
adjustments have been made for different compounding periods

 𝐸𝐴𝑅 = (1 + 𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑟𝑎𝑡𝑒)𝑚 −1


 Periodic rate: stated annual rate divided by m
 m: the number of compounding periods per year
LOS 5.c Calculate and interpret the effective annual rate, given the stated annual interest rate
and the frequency of compounding
LOS 5.c Calculate and interpret the effective annual rate, given the stated annual interest rate
and the frequency of compounding
LOS 5.c Calculate and interpret the effective annual rate, given the stated annual interest rate
and the frequency of compounding
LOS 5.d Solve time value of money problems for different frequencies of compounding

We need to consider the case of compounding periods are other than annual, or the frequencies of
compounding are different than annual.
LOS 5.d Solve time value of money problems for different frequencies of compounding
LOS 5.d Solve time value of money problems for different frequencies of compounding
LOS 5.d Solve time value of money problems for different frequencies of compounding
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a
single sum of money, an ordinary annuity, an annuity due, a perpetuity (PV
only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Future value of a single sum: this value determines the value of an investment at the
end of project with n compounding periods.

 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼|𝑌)𝑁
 PV = present value
 I|Y = rate of return per compounding period
 N = total number of compounding periods
 (this expression only considers one cash outflow of PV at t=0; FV is the value of this
investment at the end of period N)
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Future value of a single sum


 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼|𝑌)𝑁
 PV = present value
 I|Y = rate of return per compounding period
 N = total number of compounding periods
 (this expression only considers one cash outflow of PV at t=0; FV is the value of this
investment at the end of period N)

or use 𝐹𝑉 = 300 × (1 + 0.08)10 = $647.68


LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Present value of a single sum


𝐹𝑉
 𝑃𝑉 =
(1+𝐼|𝑌)𝑁

 (1 + 𝐼|𝑌)𝑁 is referred as future value factor or future value interest factor


LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Present value of a single sum


𝐹𝑉
 𝑃𝑉 =
(1+𝐼|𝑌)𝑁
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Present value of a single sum


𝐹𝑉
 𝑃𝑉 =
(1+𝐼|𝑌)𝑁

 Ex. PV of a zero-coupon bond


LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Annuities: An annuity is a series of equal dollar payments that are made at the end of
equidistant points in time such as monthly, quarterly, or annually over a finite period of
time.
 Ex. Receiving $1000 per year at the end of next 8 years

 Ordinary annuities: If payments are made at the end of each period, the annuity is
referred to as ordinary annuity.
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 You can use the following formula to calculate FV of an ordinary Annuity


LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 You can use the formula in previous slide or use calculator to crunch the
result as follows:
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Mathematic formula to calculate the Present value of


LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate
and interpret the
future value (FV)
and present value
(PV) of a single
sum of money, an
ordinary annuity,
an annuity due, a
perpetuity (PV
only), and a series
of unequal cash
flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

Annuity Due: is an annuity in which all the cash flows occur at the beginning of
the period.

For example, rent payments on apartments are typically annuity due as rent is paid
at the beginning of the month.

Computation of future/present value of an annuity due requires compounding the


cash flows for one additional period, beyond an ordinary annuity.
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Future value of annuity due (first payment at t=0)


 Method 1: Set to BGN mode (button press [2ND] [PMT], [2ND] [ENTER]; screen upper
right corner will appear BGN)
 Method 2: By default END mode, compute as normal annuity, then convert to annuity
due by the formula below:
 𝐹𝑉𝐴𝐷 = 𝐹𝑉𝐴𝑂 × (1 + 𝐼|𝑌)

0 1 2 3

+100 +100 +100 FVA(D)

0 1 2 3

+100 +100 +100


FVA(O)
LOS 5.e Calculate
and interpret the
future value (FV)
and present value
(PV) of a single sum
of money, an
ordinary annuity,
an annuity due, a
perpetuity (PV
only), and a series
of unequal cash
flows
LOS 5.e Calculate
and interpret the
future value (FV)
and present value
(PV) of a single sum
of money, an
ordinary annuity,
an annuity due, a
perpetuity (PV
only), and a series
of unequal cash
flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Present value of annuity due (first payment at t=0)


 Method 1: Set to BGN mode (button press [2ND] [PMT], [2ND] [ENTER]; screen upper
right corner will appear BGN)
 Method 2: By default END mode, compute as normal annuity, then convert to annuity
due by the formula below:
 𝑃𝑉𝐴𝐷 = 𝑃𝑉𝐴𝑂 × (1 + 𝐼|𝑌)

0 1 2 3

+100 +100 +100


PVA(D)

0 1 2 3

+100 +100 +100


PVA(O)
LOS 5.e Calculate
and interpret the
future value (FV)
and present value
(PV) of a single sum
of money, an
ordinary annuity,
an annuity due, a
perpetuity (PV
only), and a series
of unequal cash
flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Perpetuity: When a constant cash flow (C) will occur at regular intervals
forever it is called a perpetuity. Perpetuity is continuous and has no end,
therefore, there is no future value of perpetuity.

 Present value of a perpetuity

𝑃𝑀𝑇
𝑃𝑉𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝐼|𝑌
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Similarly, we can set N as large as possible to get this $56.25


 N= 9999; I|Y = 8; PMT = 4.5; FV = 0; [CPT][PV] = -56.25
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 Present value of a perpetuity


𝑃𝑀𝑇
 𝑃𝑉𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝐼|𝑌

 Similarly, we can set N as large as possible to get this 6%


 N= 9999; PV = -75; PMT = 4.5; FV = 0; [CPT][I|Y] = 6
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows

 PV and FV of Uneven Cash Flow series


+4000
+3500
+2000

0 1 2 3 4 5 6
-500
-1000

 Year 1 and 2: negative cash flows


 Year 3: 0 cash flow
 Year 4, 5 and 6: positive cash flows

 Compute the FV for each cash flow: compound each flow to year 6
 Sum up them
 σ𝑛𝑖=1 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝐶𝐹𝑖
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
LOS 5.e Calculate and interpret the future value (FV) and present value (PV) of a single sum of money,
an ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows
Applications

What is the balance in an account at the end of 10 years if


$2,500 is deposited today and the account earns 4%,
compounded annually? Quarterly?
Applications

If you deposit $10 in an account that pays 5% interest,


compounded annually, how much will you have at the end of
10 years ? 50 years? 100 years?
Applications

How much interest on interest is earned in an account by the


end of 5 years if $100,000 is deposited and interest is 4% per
year, compounded continuously?
Applications

How much will be in an account at the end of five years the


amount deposited today is $10,000 and interest is 8% per
year, compounded semi-annually ?
Applications

Suppose you want to have 0.5$ million saved by the time you
reach age 30 and suppose that you are 20 years old today. If
you can earn 5% on your funds, how much would you have to
invest today to reach your goal?
Applications

How much would I have to deposit in an account today that


pays 12% interest, compounded quarterly, so that I have a
balance of $20,000 in the account at the end of 10 years?
Applications

Suppose I want to be able to withdraw $5000 at the end of


five years and withdraw $6,000 at the end of six years, leaving
a zero balance in the account after the last withdrawal. If I can
earn 5% on my balances, how much must I deposit today to
satisfy my withdrawals needs?
Applications

Suppose you deposit $100,000 in an account today that pays


6% interest, compounded annually. How long does it take
before the balance in your account is $500,000?
Applications

The lucky Loan Company will lend you $100,000 today with
terms that require you to pay off the loan in thirty-six monthly
installments of $500 each. What is the effective annual rate of
interest that the Lucky Loan Company is charging you?
Applications

How much does it take for your money to grow to ten times
its original value if the interest rate of 5% per year?
Applications

Under what conditions does the effective annual rate of


interest(EAR) differ from the annual percentage rate (APR)?
Applications

As the frequency of compounding increases within the annual


period, what happens to the relation between the EAR and
the APR?
Applications

If interest is paid at a rate of 5% per year, compounded


quarterly, what is the : a) annual percentage rate? b) effective
annual rate?
Applications

Consider an annuity consisting of three cash flows of $2,000


each. Assume a 4% interest rate. What is the present value of
the annuity if the first cash flow occurs: a) today; b) one year
from today; c) two years from today; d) three years from
today; e) four years from today
Applications

Suppose you wish to retire forty years from today. You


determine that you need $50,000 per year once you retire,
with the first retirement funds withdrawn once year from the
day you retire. You estimate that you will earn 6% per year on
your retirement funds and that you will need funds up to and
including your 25th birthday after retirement.
a) How much must you deposit in an account today so that
you have enough funds for retirement?
b) How much must you deposit each year in an account,
starting on year from today, so that you have enough
funds for retirement?
Applications

Jim needs $800,000 to retire in 15 years. He will save $20,000


at the end of each of the next five years, and $40,000 at the
end of the years 11-15. If his investment account returns 11%
per year, what equal payments must he make into the
account at the end of years 6 thru 10?
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Loan Amortization

Amortized loan: a special type of loan that is paid off by making a series of regular &
equal payments
• Part of each payment goes towards paying off the simple interest from the unpaid
balance while the rest goes towards paying off the principal of the loan
• This differs from installment loans where the interest over the lifetime of the loan is
computed at purchase
• Interest for an amortized loan is computed on the unpaid balance
• The amount of loan and interest payment do not remain fixed over the term of
loan.

Examples: House Mortgaged Loans, Auto Loans


In an amortized loan, the present value can be thought of as the amount borrowed, n
is the number of periods the loan lasts for, i is the interest rate per period, and
payment is the loan payment that is made.
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Loan Amortization

• Interest Component = Beginning Balance * Periodic Interest Rate

• Principal Component = Payment - Interest

• Sum of Principal Repayments = Original Amount of Loan

• Sum of Interest Payments =


Sum of Total Payments – Sum of Principal Repayments
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Loan Amortization

For Example: Beginning balance of a loan is $100000, interest rate is 10% and loan
term is 10 years. What is the installment payment? Construct amortization schedule.

Amortization Schedule:
Beginning Interest Principal Ending
Period Payment
Balance Component Component Balance
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Loan Amortization

For Example: Beginning balance of a loan is $100000, interest rate is 10% and loan
term is 10 years.

Amortization Schedule:
Beginning Interest Principal Ending
Period Payment
Balance Component Component Balance
1 100000 16275 10000 6275 93725
2 93725 16275 9373 6902 86823
3 86823 16275 8682 7592 79231
4 79231 16275 7923 8351 70880
5 70880 16275 7088 9187 61693
6 61693 16275 6169 10105 51588
7 51588 16275 5159 11116 40472
8 40472 16275 4047 12227 28245
9 28245 16275 2825 13450 14795
10 14795 16275 1480 14795 0
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Note: Once you have


solved for the
payment, $2637.97,
the remaining
principal on any
payment date can be
calculated by entering
N = number of
remaining payments
and solving for the PV

For example:
N=4, PMT = 2637.97,
I|Y = 10, FV = 0, [CPT]
-> PV = 8362.03
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Faster method

PMT = 802.43
N = 18
I|Y = 5
FV = 0
[CPT] -> PV = 9380.02
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Solving for payment:


LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Solving for number of periods:


LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Solving for rate of return/discount rate:


LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Geometric Mean:
The formula for
computation of
geometric mean
in constant time
is:
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

The connection Between PV, FV and Series of Cash Flows

• Alternative interpretation of present value:


• How much money you put in the bank today
• In order to make future withdraws
• The final withdraw will exhaust the account
• PV of 100, 200, 300 for the following 3 years will be 481.5928, the assumed interest rate is 10%.
PV CF CF CF
0 1 2 3
100 200 300
Comp ratio 1.1 1.21 1.331
PV 90.90909 165.2893 225.3944
Sum(PV) 481.5928

• This is similar to invest 481.5928 now, and withdraw 100, 200, 300 for each year of the following
3 years, the money in account will generate interest but finally just be offset by the final with
draw of 300

CF1 CF2 CF3


Invest 481.5928 529.7521 472.7273 300
Withdraw 100 200 300
Balance 429.7521 272.7273 0

• Another way is to look at future values of this 3 cash flows for 641
LOS 5.f Demonstrate the use of a time line in modeling and solving time value of money problems

Cash Flow additivity principle: It refers to the present value of any stream of cash flows equal the
sum of the present values of the cash flows.

• The sum of the two series of cash flows is same as the present values of the two series taken
together.
Example: If we have 3 projects 1 2 and 3, each project’s cash flows are indicated in the table below

rate = 10% 1 2 3 4 PV

Project 1 100 100 100 100 316.9865

Project 2 0 0 300 0 225.3944

Project 3 100 100 400 100 542.381

We compute the PV, and what do we observe?

Indeed, the P3 CF = P1 CF + P2 CF if we add each period Project 1 and Project 2 cash flows, we get
Project 3

The PV show the same result that PV3 = PV1 + PV2 = 316.9865 + 225.3944 = 542.381

This is a demonstration of the additivity principle


End of Chapter

Reading #5: the time value of money

(1) Nominal risk-free rate = real risk-free rate + expected inflation rate
(2) Required return on a security = real risk-free rate + expected inflation + default risk premium +
liquidity premium + maturity risk premium

(3) Effective annual rate (EAR)


𝑠𝑡𝑎𝑡𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 𝑚
𝐸𝐴𝑅 = (1 + ) −1
𝑚

(4) 𝐹𝑉 = 𝑃𝑉(1 + 𝐼/𝑌) 𝑁


𝑁
(5) PV = 𝐹𝑉 Τ(1 + 𝐼/𝑌)

(6) Annuity due: cash flows occur at the beginning of each time period
(7) Ordinary annuity: cash flows occur at the end of each time period

𝑃𝑀𝑇
(8) Perpetual annuities: 𝑃𝑉 =
𝐼/𝑌

Concept Checkers: Page 131, to be done by yourself including challenge problems. Check the
answers to find out the mistake you make and try to comprehend the answers of each question.