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Lec 4
Lec 4
Lecture 4 1
Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?
2
Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?
0 1 2 3 4 5
$400
$600
3
Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?
P = F/(1+i)n = F(1+i)-n
0 1 2 3 4 5
$400
$600
Interest is compounded yearly
P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16
4
Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?
0 1 2 3 4 5
$400
$600
Interest is compounded yearly Interest is compounded monthly
P = 400(P/F, 12%/12, 3*12) +
P = 400(P/F,12%,3) + 600(P/F,12%,5) 600(P/F, 12%/12, 5*12)
= 400 (0.7118) + 600 (0.5674)
= 400(P/F, 1%, 36) + 600(P/F, 1%, 60)
= 284.72 + 340.44 = $625.16
= 400 (0.6989) + 600 (0.5504)
= 279.56 + 330.24 = $609.80
5
Annuity
The fixed/specified income payable
at stated intervals
for a fixed or a contingent period
6
Example
You borrowed $5,000 from a bank at 8% interest rate and you
have to pay it back in 5 years.
Plan C: Pay in five end-of-year payments.
a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
8
Annuity- Uniform Payment Series
F
0 1 2 N
A A A
0 1 2 N
0 N
9
Annuity- Interest Formulas (Uniform Payment)
A A A A
| | | |
F = 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4
| | | |A
| | | A(1+i)1
| | A(1+i)2
| A(1+i)3
10
Uniform series (contin.)
i F = A(1+i)4 - A
In general,
1 i n 1
F A
i \ uniform series
compound-amount
factor
11
12
13
Uniform series (contin.)
\ uniform series
sinking-fund factor
14
Uniform series (contin.)
i
A F
1 i 1
n
\ uniform series
sinking-fund factor
Examples:
To buy a new car in 3 years time.
16
Sinking Funds
• A = F(A/F, i, n)
i
A F
1 i 1
n
17
Finding A when Given F
18
Finding an Annuity Value (Sinking Fund)
F
i
A F
0 1 2 3 (1 i ) 1
N
N
A=? F ( A / F ,i, N )
Example:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
19
Finding an Annuity Value (Sinking Fund)
F
i
A F
0 1 2 3 (1 i ) 1
N
N
A=? F ( A / F ,i, N )
Example:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
Solution: A = $5,000(A/F,7%,5) = $869.50
A = $5,000 (0.1739) = $869.50
20
Finding an Annuity Value (Sinking Fund)
21
Finding an Annuity Value (Sinking Fund)
OR
A = F (A/F, 6%, 20) = $80,000(.0272) = $2176
22
Present Worth
1 i n 1
In general, F A
i
23
Present Worth
1 i n 1
In general, F A
i
1 i n 1
1 i n 1
P 1 i n P A n
i 1 i
A
i
i (1 i ) n
A P
(1 i ) 1
n
25
Example: Present Worth
Our consulting firm would like to purchase a used testing machine
from an independent testing/inspection lab, and we make two
offers:
1) a lump-sum of $40,000 or
2) monthly payments of $1200 over 3 years at a 6% annual interest
rate. Which option do you think the testing lab would prefer,
assuming it has to replace the sold machine?
26
Example: Present Worth
Our consulting firm would like to purchase a used testing machine
from an independent testing/inspection lab, and we make two
offers:
1) a lump-sum of $40,000 or
2) monthly payments of $1200 over 3 years at a 6% annual interest
rate. Which option do you think the testing lab would prefer,
assuming it has to replace the sold machine?
The lab would prefer the $40k payment now, because it is greater
than the present worth of the proposed loan terms.
27
• This is how mortgages and car loans work:
– The bank gives you an amount P today
– You pay equal amounts A until you have paid the loan
plus interest
• In the first year:
– You pay mainly interest, and little of the principal
• In the last year:
– You pay mainly the principal, and little interest
– Since little of your original loan P is still owed
28
Capital-Recovery Factor
Finding A when Given P
29
Finding A when Given P
30
Sinking Fund Factor
Find A, given F, I, N
i
A F
N
(1 i) 1
a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
33
Convert Annual to Present
(1 i ) n 1
P A n
for i 0
i (1 i )
34
A more complicated example
35
Numerical example
36
Find F When A is Given (Future Value of an
annuity)
F
(1 i ) 1
N
FA
0 1 2 3
N i
A A( F / A, i , N )
Example :
• Given: A = $5,000, N = 5 years, and i = 6%
• Find: F
• Solution: F = $5,000(F/A,6%,5) = $28,185.46
37
Validation
$28.185.46
38
Finding an Annuity Value (Find A When F is Given)
F
i
A F
0 1 2 3 (1 i ) 1
N
N
A=? F ( A / F ,i, N )
Example:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
Solution: A = $5,000(A/F,7%,5) = $869.50
39
Multiple Payments
• How much do you need
to deposit today (P) to
$25,000
withdraw $25,000 at n
=1, $3,000 at n = 2, and
$3,000 $5,000
$5,000 at n =4, if your
0
1 2 3 4
account earns 10%
annual interest?
40
Uneven Payment Series $25,000
$3,000 $5,000
0
1 2 3 4
$25,000
P
$3,000 $5,000
0 0 0
1 2 3 4
+ 1 2 3 4
+ 1 2 3 4
P2
P4
P1
P1 $25, 000( P / F ,10%,1) P2 $3, 000( P / F ,10%, 2) P4 $5, 000( P / F ,10%, 4)
$22, 727 $2, 479 $3, 415
P P1 P2 P3 $28, 622
41
Review of Interpolation
42
Typical format for look-up table
43
Interpolation gives an estimate!
• The unknown interest rate that you want will typically not be
included in those tables:
• But you can interpolate between two tabulated values to
estimate it
• Linear interpolation is not exact:
• The exact conversion factors are non-linear!
• Therefore, interpolation can cause errors:
• Typically from 2-5%
• Errors will be smaller when interpolating between values that
are closer to each other
44
Interpolation example
• You are considering a project that costs $1000 in year 0,
and pays $144 annually for 10 years i=?
45
Interpolation example
46
Interpolation example
47
Interpolation example
• Using the look-up tables, we found that:
48
Interpolation example
• Reading across at A/P = .144 lets us “eyeball” how close
the IRR is to 7%
• Interpolation just lets us do that more exactly!
8.5
Interest rate, i
8
7.5
7
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)
49
Interpolation example
8.5
Interest rate, i
8
7.5
7
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)
Interest rate, i
8
7.5
7 0.14238
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)
• Using trial and error, the exact value of the IRR is 7.2459%
52
Interpolation Review
• Interpolation is approximate, not exact!
• It requires:
– One interest rate that gives a smaller ratio
– One interest rate that gives a larger ratio
• The answer must lie between the two.
53
Types of Annuities
54
Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3
0 1 2 3
0 1 2 3 4 5 6 7
57
Deferred Annuities
58
PV of a Deferred Annuity (cont.)
• To find the PV of a deferred annuity, we first
find use the PVA equation, and then discount
that result back to period 0
• Here we are using a 10% discount rate
PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100
0 1 2 3 4 5 6 7
59
FV of a Deferred Annuity
60