Professional Documents
Culture Documents
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Chapter 2
Time Value of Money
Interest: The Cost of
Money
Economic Equivalence
Interest Formulas –
Single Cash Flows
Equal-Payment Series
Dealing with Gradient Power-Ball Lottery
Series
Composite Cash Flows.
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Decision Dilemma—Take a Lump Sum or Annual
Installments
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Option A Option B
(Lump Sum) (Installment
Plan)
0 $104 M
1 $7.92 M
2 $7.92 M
3 $7.92 M
25 $7.92 M
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What Do We Need to Know?
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Time Value of Money
Money has a time value
because it can earn more
money over time (earning
power).
Money has a time value
because its purchasing
power changes over time
(inflation).
Time value of money is
measured in terms of
interest rate.
Interest is the cost of
money—a cost to the
borrower and an earning to
the lender
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Delaying Consumption
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Account Value Cost of Refrigerator
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Which Repayment Plan?
End of Year Receipts Payments
Plan 1 Plan 2
Year 0 $20,000.00 $200.00 $200.00
Year 1 5,141.85 0
Year 2 5,141.85 0
Year 3 5,141.85 0
Year 4 5,141.85 0
Year 5 5,141.85 30,772.48
The amount of loan = $20,000, origination fee = $200, interest rate = 9% APR
(annual percentage rate)
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Cash Flow Diagram
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End-of-Period Convention
0
1
0 1
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Methods of Calculating Interest
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Simple Interest
P = Principal amount
i = Interest rate End of Beginnin Interest Ending
Year g earned Balance
N = Number of Balance
interest periods 0 $1,000
Example:
1 $1,000 $80 $1,080
P = $1,000
i = 8% 2 $1,080 $80 $1,160
N = 3 years
3 $1,160 $80 $1,240
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Simple Interest Formula
F P (iP) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N
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Compound Interest
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Compound Interest
P = Principal amount
i = Interest rate End Beginning Interest Ending
of Balance earned Balance
N = Number of Year
interest periods 0 $1,000
Example:
1 $1,000 $80 $1,080
P = $1,000
i = 8% 2 $1,080 $86.40 $1,166.40
N = 3 years
3 $1,166.40 $93.31 $1,259.71
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Compounding Process
$1,080
$1,166.40
0 $1,259.71
1
$1,000
2
3
$1,080
$1,166.40
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$1,259.71
0 1 2
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Compound Interest Formula
n 0: P
n 1: F1 P(1 i)
n 2 : F2 F1 (1 i ) P(1 i ) 2
n N : F P(1 i ) N
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Some Fundamental Laws
F m a
V i R
E m c 2
F P(1 i ) N
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Compound Interest
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Practice Problem: Warren Buffett’s
Berkshire Hathaway
Went public in 1965: $18
per share
Worth today (August 22,
2003): $76,200
Annual compound growth:
24.58%
Current market value:
$100.36 Billion
If he lives till 100 (current
age: 73 years as of 2003),
his company’s total market
value will be ?
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Market Value
F $100.36(1 0.2458) 27
$37.902 trillions
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EXCEL Template
In 1626 the Indians sold Manhattan Island to Peter Minuit
Of the Dutch West Company for $24.
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Excel Solution
P $1
i 8%
N 377 years
FV(8%,377,0,1)
= $3,988,006,142,690
$3,988,006,142,690
A
275,000,000
$14,502
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Excel Worksheet
A B C
1 P 1
2 i 8%
3 N 377
4 FV
5 FV(8%,377,0,1)
= $3,988,006,142,690
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Practice Problem
Problem Statement
If you deposit $100 now (n = 0) and $200 two
years from now (n = 2) in a savings account
that pays 10% interest, how much would you
have at the end of year 10?
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Solution
0 1 2 3 4 5 6 7 8 9 10
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Practice problem
Problem Statement
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn 10% interest, what would be the
balance at the end of 4 years?
0 1
$1,210
4
?
2 3
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$1,210 ?
0 1 3
2 4
$1,000 $1,000
$1,500
$1,100
$1,000
$1,210 $2,981
$2,100 $2,310
-$1,210 + $1,500
$1,100 $2,710
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Solution
End of Beginning Deposit Withdraw Ending
Period balance made balance
n=0 0 $1,000 0 $1,000
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