August 29, 2012 (Cont.

)
Chapter Six: Discounted Cash Flow Valuation
Important Lesson Number 3: You cannot add two cash flows together at different points in time. They must be at the same
point in time. Opportunity costs matter.

Additional Notes:
- In this chapter, we use many timelines to answer problems. Chapter 6 in the textbook has examples of these timelines
(plus theyre hard to type, so I excluded them from the notes.)
- Do NOT round on intermediate steps! You can round to the penny on the final answer. On the test you will just round to
whatever Dr. Laplante has rounded to in his given answers, and as long as you have done the work right, you will get
the right answer!
- Interest rates go down, PVs go up and vice versa
- Never leave value on the table.

Chapter Outline
- Future and Present Values of Multiple Cash Flows
- Valuing Level Cash Flows: Annuities and Perpetuities
- Comparing Rates: The Effect of Compounding Periods
- Loan Types and Loan Amortization

Future and Present Values of Multiple Cash Flows
- Multiple CFs FV Example 1
- Find the value at year 3 of each cash flow and add them together. 8% per year is the cost of capital.
- Today (year 0): 7000
Year 1: 4,000
Year 2: 5,000
Year 3: 2,000
- Step 1: Create a timeline. Begin at Year 0 and go through at least year 3, since that is where you want to find the
value.
- Find the value at year 3 of each cash flow and add them together.
- Due to the effect of compounding, you cant just add these values together; you have to find the future
values of each of these years and then add them together.
Year 0 FV = 7000
- FV = 7000(1.08)
3
= 8817.984
Year 1 FV = 4,000
- FV = 4000(1.08)
2
= 4665.60
Year 2 FV = 5,000
- FV = 5000(1.08)
1
= 5400.00
Year 3 FV = 2,000
- Total value in 3 years
FV =? 8817.984 + 4665.60 + 5400 + 2000
FV =? 20,883.584
o What if, now, you want the value at time 40?
Instead of taking each cash flow forward individually, take the FV of all cash flows at the end of year 3
forward 37 years.
FV = 20,883.584(1.08)
37 =
$360,150.4705

- Multiple CFs FV Example 2
- Suppose you invest $500 in a mutual fund today and $600 in one year, and $700 in three years. If the fund pays 9%
annually, how much will you have in four years?
- A mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors
for the purpose of investing in securities such as stocks, bonds, money market instruments and similar
assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to
produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and
maintained to match the investment objectives stated in its prospectus.


Step 1: write a timeline!
I--------I-------I-----I---------I
0 1 2 3 4 (target)
$500 $600 0 $700

FV =? Year 0 = 500(1.09)
4
= 705.7908050
FV =? Year 1 = 600(1.09)
3
= 777.0174
FV =? Year 3 = 700(1.09) = 763
705.7908050 + 777.0174 + 763.00 = 2245.808205

- How much will you have in 40 years if you make no further deposits?
I--------I-------I-----I---------I-----------------------I
0 1 2 3 4 40
$500 $600 0 $700

Cash flows are worth $2,245.80 at Year 4
FV =? 2245.808205(1.09)
36
= 49,971.98375
Once you have a lump sum, you can calculate the PV or FV anywhere on the timeline.

- Multiple CFs PV Example 1 - Discounting
- Find the PV of each cash flow and add them up. Your required return is 12% annually.
Step 1: Draw a timeline
I----------------I--------------I----------------I------------I-----
0 1 2 3 4
$200 $400 $600 $800
Year 1: 200
Year 2: 400
Year 3: 600
Year 4: 800
- Find the PV of each cash flow and add them together
PV = 200/ (1.12)
1
= 178.5714286
PV = 400/ (1.12)
2
= 318.8775510
PV = 600/ (1.12)
3
= 427.0681487
PV = 800/ (1.12)
4
= 508.4144627
Total PV =? 178.5714286 + 318.8775510 + 427.0681487 + 508.4144627
Total PV =? 1432.931591

Multiple Uneven Cash Flows: Texas Instruments BA-II Plus
(Quick and reliable SHORTCUT to drag CFs back to PVexcept you have to practice a lot to get good at using it
without making mistakes)
The cash flow key can be used for uneven cash flows.
1. CF and enter the cash flows beginning with year 0
2. Enter after entering each cash flow
3. Use the down arrow key to move to the next cash flow
4. F is the number of times a given cash flow occurs in consecutive years F stands for frequency; should be 1 if only occurs
once, 2 if the same value occurs two periods in a row, etc.
5. Use the NPV key to compute the present value by entering the interest rate for I pressing the down arrow and then
compute
6. Clear the cash flow keys by pressing CF and then 2
nd
[CLR Work] (Not the same as 2
nd
CLR TVM)

- Multiple CFs PV Example 2
o You are offered an investment that costs $5000. It will pay you $1000 in one year, $2000 in two years and $3000
in three years. If you want to earn 10% on your money should you do it?
y0 y1 y2 y3
|-------------|----------|----------|----------|----------|
-5000 1000 2000 3000 in FV

If PV of the 3 cash flows are > than $5,000 then invest. If not, then dont!
PV = 1000/ (1.1)
1
= 909.090909
PV = 2000/ (1.1)
2
= 1652.892562
PV = 3000/ (1.1)
3
= 2253.944403
PV =? 909.090909 + 1652.892562 + 2253.944403 = 4815.927874
o Using the CF keys,
CF, 2
nd
[CLR WORK]
CF0 = 0
C01 = 1000 ENTER F01 = 1
C02 = 2000 ENTER F02 = 1
C03 = 3000 ENTER F03 = 1
NPV, I = 10 ENTER CPT
NPV = 4815.927874
- We would reject his offer b/c it is only worth $4815.93, yet you must pay $5,000

- Multiple CFs PV & FV Example 1
o Suppose you are looking at the following possible cash flows: Year 1 CF = $100; Years 2 and 3 CFs = $200;
nothing in Year 4, Year 5 CF = $100. The required discount rate is 7%.
o Step 1: Make a timeline.
y 0 y1 y2 y3 4 5 6
|-------------|----------|----------|----------|----------|------I--
100 200 200 0 100
o 1. What is the value of the cash flows today? $502.7038829
- Algebraically:
PV = 100/ (1.07) + 200/ (1.07)
2
+ 200/ (1.07)
3
+ 100/ (1.07)
5

- Using the CF function:
- CF, 2
nd
(Clr Work)
CF0 = 0, down arrow
C01 = 100 Enter, down, F01 = 1, Down
C02 = 200 Enter, down, F02 = 2 Enter down
C03 = 0, Enter, down F03 = 1 Down
C04 = 100, Enter, down, F04 = 1
NPV; I = 7, Enter, down, CPT
NPV= $502.7038829

- Would you rather have $502.70 right now, or $100 in a year, $200 for the following two years, and $100
in five years? They are the same amount of moneyif your opportunity cost is 7%
o If you need the money now you can borrow against the future cash flows; financial markets allow
for separation of using and getting cash
September 3, 2012
o 2. What is the value of the cash flows at year 6?
Algebraically: FV = 502.7038829(1.07)
6
Using the calculator:
2
nd
[CLR TVM]
PV = 502.7038829 (your value today, at time 0)
I/Y = 7
N = 6
CPT FV => -754.4229751
Annuities Defined
- Annuity a finite series of equal payments that occur at regular intervals
o To be finite means that it is an actual number (not infinity) of payments, ending at some point in the future.
Series of equal payments means that it is always the same amount. Regular intervals means that the same
amount of time will pass between all payments.
- If the first payment occurs at the end of the period, it is called an ordinary annuity.
o Example: Car payments, where payment is due at the same frequency for an amount of time (72 months); pay at
end of month
o Fixed-rate mortgage payments are the same payment over and over again for a finite number of months, make
payments at end of the month
o bonds
- If the first payment occurs at the beginning of the period, it is called an annuity due
o Example: Leases/rent, where payment is due at the beginning of the month, every month for an amount of time
(e.g. the length of the lease)- if not then people would leave after that month when the payment is due (nomads)
o Oil rigs- lease 1 million/day, Leases can be very expensive. Also for airlines they pay big leases.
Annuities
- 0 1 2 3 4 5
|----------|----------|----------|----------|----------|
100 100 100 100 100 Ordinary annuity
200 200 200 200 200 Annuity due

Very time consuming to find PV of these annuities. There is a shortcut.

Ordinary Annuity
- Basic Formulas
- Annuities:


o PV equation converts t payments of amount C into a lump sum one period prior to the first payment in the stream
occurring
4 variables: PV, C, r, t
PV is a function of 3 variables- C is the payment amount (new variable)
The payment DRIVES everything
4 variables in chapter 5
Use decimal form for r in equations; rate and payment frequency must be consistent
Always check to make sure that the payments and the interest rates are consistent with the same
intervals of time.
0 1
1
1
(1 )
(1 ) 1
t
t
t t
r
PV C
r
r
FV C
r
(

(
+
= (
(
(

( +
=
(

The book characterized T as the numbers of periods- dont think of it that way. Easier to think of T as
the NUMBER of payments.
C= payment amount
R= periodic rate consistent with payment frequency
This equation (diff from the book): Converting t payments into a lump sum value one period prior
to the first cash flow in the stream occurring. 1 period prior to one= zero
o FV equation
Converting t payments into a lump sum value when the last payment occurs

o Mathematical proofs for these formulas are on eLC if you want to see where they come from. Laplante derived
these formulas for us- differing from the book.

- Examples:
Ordinary Annuity
0 1 2 3 4 5
|----------|----------|----------|----------|----------|
100 100 100 100 100
PV FV
o Payment amount (C) = $100
o Payments (t) = 5
o R = .10
Annuity Due
-1 0 1 2 3 4 5
|--------|--------|--------|--------|--------|--------|
200 200 200 200 200
PV FV
o Payment amount (C) = $200
o Payments (t) = 5
o R = .10 (or 10%)
o PV occurs at -1 because the first cash flow occurs at time 0
o FV occurs at time 4 because that is when the last payment occurs in this case; use FV = PV(1+r) to find FV
o To find the PV at time 0 bring the PV at time -1 up one period

o FV = 200[(1+.1)
5
-1/.10]

Annuity Due
- Basic Formulas:





- Annuities Due:

FV of Annuities
0 1 2 3 4 5
|----------|----------|----------|----------|----------|
200 200 200 200 200 A
200 200 200 200 200 B
FV FV
FV for A/B= 200[(1+.10)
5
-1/ .1] = $1221.02
Same FV amounts but differ from classification of annuities.
Occurring at two different points of time
Prefer B if you were getting these payments
IF paying these payments, then prefer A.
- Preference over ordinary annuity or annuity due depends on if you are receiving or paying the money
o If were paying the money we would prefer an ordinary annuity b/c we can keep our cash longer, and vice-versa
- For PV you move lump sum value forward one period, regardless of ordinary annuity or annuity due.

Annuities and the Calculator
( )
0 0
Annuity due Ordinary Annuity 1
(1 ) 1
t
t t
PV PV r
r
FV C
r
= +
( +
=
(

- You can use the PMT key on the calculator for the equal payment
o R = I/Y key
o T = N key
o C = PMT key
- The sign convention still holds
o PV/FV- one has to be outflow, the other an inflow
- PV Annuity Example 1
o Suppose you win $10 million in the Texas Lotto. The money is paid in equal annual installments over 25 years.
Assume the first payment occurs in one year. If the appropriate discount rate is 4%, how much are your
winnings actually worth today?
o PMT = 10M total/25 yearly payments = $400,000; I/Y = 4; N = 25
So, PV = -6,248,831.977 (This tells you that the 10M is actually only worth 6.25M today.)
Rather have 10 million today- because you can earn interest
I--------I----------------------------I
0 1 25
400K 400K
PV= 400K [1-(1/1.04
25
) / .04] = 6,248,831.977

Or
Calculator
2
nd
(CLR TVM)
400K = PMT
4= I/Y
25= N
CPT PV
PV= -6,248,831.977
Saying: 25 PMTs of 400K are really worth ~6.25 million today

- PV Annuity Example 2
o Is the Lotto an ordinary annuity? No, it is an annuity due. What is the value of the stream of payments today?
o Because we have found the PV of the annuity 1 period prior to today we must bring it up 1 period; (4% interest)
Annuity Due PV = 6,248,831.977(1.04)
Annuity Due PV = 6,498,785.256 (value today)
Take cash option: $10mill/2= $5,000,000 (value today)
But payments over 25 years are worth 6.5 mill today
So better to choose the payments over 25 years (no chance of default)
PV of lottery depending on what the rates are: when the discount rate is lower, the PV is higher.
I-------------I------I------I-------I
-1 0 1 2.. 24
6.25 mill 400K 400K
- PV Annuity Example 3
o You have $20,000 for a down payment and closing costs for a house. Closing costs are estimated to be 4% of the
loan value. Your annual salary is $36,000 and the bank allows the maximum 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
for a 30-year fixed rate loan. How much money will the bank loan you? How much can you offer for the house?

o Bank loan
Monthly income = 36000/12 = $3000
Maximum payment = .28(3000) = $840 (C)
Monthly rate is unknown, 6% year with compounding monthly (APR), to get periodic rate divide by 12
Monthly rate= 6%/12= 0.5% per month
PV = $840[1- (1/1.005
360
)]/.005 = $140,104.9561 (amount you can borrow)

WHERE DOES THE .005 COME FROM? 6%/12 (because of monthly compounding)
o Total Price
Closing costs = .04(140,104.9561) = $5604.198244
Down payment = 20000 5604.198244 = $14,395.80176
Total Price = 140104.9561 + 14395.80176 = $154,501
(you have $20,000 in cash)
- You can buy a house worth $154,501. The bank would tell you this number. They will compute it for you. Based on your
pre-tax income- problem! Your after-tax income can be half of what you make pre-tax. Property taxes not included
either in the equation. Home owners insurance is not in there also. Utilities are not included. Repairs are not included.
Lawn mowers are not free. Maintenance is not included. Food is not included in this. There is no car payment in that
equation. So basically dont trust the bank with how much of a house you can afford.
- Read the fine print to see where the equation is coming from. Dont trust some number they spit out! They will
overestimate how much you can afford!
September 5, 2012
Ordinary Annuity Payment
Basic Formulas, Solve for C








Formula 1: PV of annuity
Formula 2: FV of annuity

Payment
- Finding the Payment
o C = 20,000[(1-(1/(1.0075)
48
))/.0075]
-1
= $497.7008475
o Suppose you want to borrow $20,000 for a new car. You can borrow at 9% per year, compounded monthly. If
you take a 4 year loan, what is your monthly payment?
2nd [CLR TVM]
PV = 20000, I/Y = (9%/12 =) 0.75 (75 basis points), N = (4*12) 48, CPT PMT=>
-497.7008475



1
1 0
1
1
1
(1 )
(1 ) 1
t
t
t t
r
C PV
r
r
C FV
r

(
+
= (
(
(

( +
=
(



Amortized Loan with Fixed Payment - Example

Rate Periods (#pmts) Principal (PV) PMT

0.08 5 20,000 5009.13

Year Start Bal. Interest Payment Principal End Bal.
1 20,000 1600.00 5009.13 3409.13 16,590.87
2 16,590.87 1327.27 5009.13 3681.86 12,909.01
3 12,909.01 1032.72 5009.13 3976.41 8,932.60
4 8,932.60 714.61 5009.13 4294.52 4,638.08
5 4,638.08 371.05 5009.13 4638.08 0.00
Rate Periods Principal PMT

0.08 5 20,000 =(1/((1-1/(1+A2)^B2)/A2))*C2
Year Start Bal. Interest Payment Principal End Bal.
1 =C2 =B4*$A$2 =$D$2 =D4-C4 =B4-E4
2 =F4 =B5*$A$2 =$D$2 =D5-C5 =B5-E5
3 =F5 =B6*$A$2 =$D$2 =D6-C6 =B6-E6
4 =F6 =B7*$A$2 =$D$2 =D7-C7 =B7-E7
5 =F7 =B8*$A$2 =$D$2 =D8-C8 =B8-E8

Note that the amount of interest paid off decreases per period. The bulk of the interest is paid at the beginning. The amount of
principal you are paying over time is going up. Most interest is in early payments, most of principal in the later payments.
This is important b/c interest payments on mortgages are tax deductible (number 1 deduction is usually interest
payments on mortgages for most people)

Ordinary Annuity
Basic Formulas, Solve for t











You can use the natural log to get t by itself.

Ordinary Annuity: Number of Payments
0 1
1
1
(1 )
(1 ) 1
t
t
t t
r
PV C
r
r
FV C
r
(

(
+
= (
(
(

( +
=
(


Finding the Number of Payments
Suppose you borrow $2000 at 5% compounded annually and you are going to make annual payments of $734.42. How long
before you pay off the loan?
2nd [CLR TVM]
PV = 2000, PMT = -734.42, I/Y = 5, CPT N=> 2.99998737
The answer, then, is 3 years. (This is because of the to-the-penny rounding in the payment.)

Example 2
You have a balance of $2,063.50 on your Bank of America credit card. BOA charges 14.32% per year with monthly
compounding. If you choose you can make the minimum monthly payment of $20. If you only make this minimum payment
each month how long will it take to pay off your current balance? Finding the Number of Payments
What is the monthly rate?
-b/c interest is calculated daily we must know the # of days in a month. Since this varies we use the average days per
mo. (if 365 days in a year this is 30.416 days/mo.)
- Periodic interest:
( (

))

= 1.01193503
This gives the FV of PV 1 after a month, the $0.01193503 means there was a 1.193503% interest rate

2nd [CLR TVM]
( )
( )
ln
*
ln 1
*
ln
ln 1
C
C r PV
t
r
C r FV
C
t
r
| |
|

\ .
=
+
+ | |
|
\ .
=
+
PV = 2063.50, PMT = -20, I/Y = 1.193333 (14.32/12), CPT N => ERROR 5(because you will never be able to pay it off, see
below for why)
What is interest/month on the balance of 2063.50 * .0119333= $24.62/month
Therefore you are not even paying for any interest when you pay the minimum balance of 20/month, and your loan will take
FOREVER to pay off! It compounds monthly. Interest on interest grows exponentially.

Ordinary Annuity
Basic Formulas, Solve for r


You cannot solve algebraically to get r on the left and everything else on the right because its in two places, and it is an
exponent in one of those places.

Finding the Rate
Suppose you borrow $10,000 from your parents to buy a car. You agree to pay $207.58 per month for 60 months. What is the
monthly interest rate?
Because you cant solve algebraically you must guess. (Trial and Error)
- Guess 1: (PV) 10000 > 207.58[(1-(1/(1+.01)
60
))/.01] = 9331.766872
o Equation for PV of an annuity ^^
You should guess a smaller rate because as interest rates go up, PVs go down; and vice versa.
- How do you know when you get the right rate? When you get 10,0000 on both sides of the equation.
- Try again, and again, and again
- Sign convention matters!!!
0 1
1
1
(1 )
(1 ) 1
t
t
t t
r
PV C
r
r
FV C
r
(

(
+
= (
(
(

( +
=
(

2nd [CLR TVM]
PV = 10,000, PMT = -207.58, N = 60, CPT I/Y => (The calculator uses guess and check, that is why the screen pauses)
0.74993901% 75 basis points per month

Future Values for Annuities
- Suppose you plan on saving for your retirement by depositing $2000 per year in an IRA, starting 8 years from today.
You are 21 years old and will make your last deposit when you turn 65 and retire. If the interest rate is 13% per year,
how much will you have when you retire?
o IRA- individual retirement account; created by govt to encourage saving; money isnt taxed until it is withdrawn
(tax-deferred account)
FV =?
Use a timeline! Today (age 21) is time 0. Age 29 is year 8. Age 65 is year 44.
I/Y = 13, N = 37, PMT = 2000, CPT FV = 1,400,373.475
*N= 37 because there are 36 end-of-the-year payments between ages 29 and 65, but there is also a payment to start it,
at age 29.
- Instead of starting in eight years you decide to start saving today (At your 21
st
Birthday). If you make your last annual
deposit when you turn 29 how much money will you have for retirement when you turn 65?
You can use the same timeline.
I/Y = 13, N = 9 (years between 21 and 29), PMT = 2000, cpt fv = 30,831.41443 (when you turn 21).
-Now, use the 30831 as your pv.
FV = 2000[(1.13
9
-1)/.13] = 30,831.41443 (how much in your account at 29)
FV = 30831,41443(1.13)
36
= 2,510,830.609 (36 years until your 65
th
birthday, how much you have at 65)
Future Values for Annuities
WHY YOUR IPHONE WILL MAKE YOU POOR
Whats that iPhone costing you? Youre 21 and plan on retiring at age 67.
Voice: $60 Data $25 Unlimited Text $20
15% tax and fees
I rate is 9% per year compounded monthly.
-120.75 pmt ; 552 n ; .75 i/y ; cpt fv = $979,525.7789 from monthly payments

Replace phone every 2 years at $200
Add $74,319
Earn 12% instead of 9%
Total $2,692,819 Mine:$1,112,665
Pretax savings? Double it.
Productivity? Are you kidding me?
If saving for retirement- not taxed as much, so for every dollar spent on iPhone would be doubled if saving for retirement.
Growing Annuity
- consists of a finite number of payments, but the payments grow at a constant rate through time
Basic Formulas







-
- The addition of the g variable makes a total of five. They still work the same as when there were four variables,
though. (R - g will give a smaller discount rate, which in turn will cause a higher PV.) The TVM keys will not work for g.
There is no pre-programmed g variable.
- You have to do the algebra to solve these! (NO CALCULATORS)
- Also, now the C is the first cash flow and the FV is the last one. All the cash flows in the stream are based off the first
cash flow.

Future Values for Growing Annuities
You are 21 today and expect to retire when you turn 65. You will make your first deposit of $2,000 toward retirement today
and expect to earn 13% per year. You plan on increasing your deposits by 5% per year to keep up with inflation and will make
your last deposit on your 65
th
birthday. With this plan, how much money will you have for retirement when you turn 65?
This is like other annuity problems, except your payments are growing every year.
0 1
1
1
1
1
(1 ) (1 )
t
t t
t
g
r
PV C
r g
r g
FV C
r g
(
+ | |

( |
+ \ .
(
=
(
(

( + +
=
(

FV = 2000[((1.13)
45
- (1.05)
45
)/(.13 - .05)] = 5,891,409.85

Perpetuity
Definition & Timeline
Perpetuity: infinite series of equal payments occurring at regular intervals

0 1 2 * * * infinity
|--------|--------|--------|--------|--------|--------|
C C C C C C
When considering PV, you would like to bring all payments back to PV, but because there are an infinite number of payments it
can become time-consuming/hard to do.


Present Value of Perpetuity

Assumption: r is constant each period.
3 variables in this equation
PV0 is one period prior to the first cash flow.
Payments and rate need to be consistent with the number of periods.
Equation: Giving the lump sum value one period prior to the first cash flow occurring

0 1 2 * * * infinity
|--------|--------|--------|--------|--------|--------|
C C C C C C
PV
Understanding the Present Value of Perpetuity Formula
Proofs:
1) Intuitively the majority of the PV comes in the first few payments b/c the rest are heavily discounted.
2) By the annuity formula
1
0
C
PV
r
=
THE NUMBER OF PAYMENTS IS THE ONLY DIFFERENCE from the annuity formula and perpetuity. If you assume t = infinity,
then you have something bigger than 1, raised to the infinitive power (which equals infinity).
1/infinity = 0.
C((1-0)/r) = C/r

Perpetuity Example 1
Preferred Stock is an example of perpetuity. Dividends will be paid out as long as the stock is held.
However, if you go into debt and cant pay= bankruptcy, if you dont pay dividends- nothing happens

Stock Price is $35 and quarterly dividend is $.80, what is the current required return?
35 = .8/r
r = 2.29% per quarter or .02285714
Stock Price is $50 and your required return is 2.3% per quarter, what dividend do you expect?
50 = c/.023
C = $1.15 per quarter
Why use a stock as an example? Equity ownership is unlike debts. There are some debts you will never pay off but the
vast majority of loans must be paid off at some point. Oppositely, as long as you own stock, your claim will go on and
dividends (cash flows) will be owed to you. Some firms have a policy of always paying the same dividends per quarter
(preferred stock firms), and others will pay various amounts over time.

Perpetuity Example 2
You are considering a preferred stock that will start paying a quarterly dividend of $1.50 three years from today. If your
desired return is 3% per quarter, how much would you be willing to pay today?
Do a timeline!


0 1 2 3 4 Infinity
I-------- I------- I-------- I------- I-------- I
1.50 1.50 $1.50
PV 11= 1.50/.03 = $50 (At time 11 quarters)
****The PV0 is one quarter prior to year 3 (first cash flow occurring). Therefore to bring it to PV, you have to move back 11
quarters (which makes our number of periods 11 as well). Remember one period prior! Also remember payments determine
how the rate should be set up!
PV = 50/(1.03)
11
= 36.12106383

Annual Percentage Rate
***5 page discussion of rates on eLC (interest rate primer***)
- This is the annual rate that is quoted by law
- It MUST be an annual rate to be an APR; it is called the quoted or stated rate
- By definition APR = periodic rate times the number of compounding periods per year (must be on loan statements by
law)
o APR = r*m
o It is a simple interest calculation. It does not include compound interest.
o Ignores ALL interest on interest (compounding)
o APRs are always annual! Keep it straight
o with Red flag it is an APR
- To get the periodic rate we rearrange the APR equation:
-
- APR ignores interest on interest, making rates look lower

Computing APRs
What is the APR if the monthly rate is .5%? 6% (.5%*12)
If the semiannual rate is .5%? 1% (.5%*2 periods)
What is the monthly rate if the APR is 12% with monthly compounding? (When you see the word with consider it a red flag
for an APR) 1% (12%/12)

o per- Red flag for a periodic rate Ex: 2% per month

APR
m
r =

Effective Annual Rate (EAR) also known as APY (Annual Percentage Yield)
- This is the actual rate paid (or received) after accounting for compounding that occurs during the year
- ANNUAL RATE; EARs must always be per year
- If you want to compare two alternative investments with different compounding periods you need to compute the EAR
and use that for comparison.

Computing EARs Example 1
- Suppose you can earn 1% per month on $1 invested today.
What is the APR? 12% (1%*12 months)
How much are you effectively earning?
FV = $1(1.01)
12
= $1.12682503
Rate = .12682503 or 12.68%
- Suppose if you put it in another account, you earn 3% per quarter.
What is the APR? 3 %( 4) = 12%
How much are you effectively earning?
FV = $1(1.03)
4
= 1.12550881
Rate = .12550881 or 12.55%
How much are you effectively earning? EAR essentially rewrites the Ch. 5 equation, except that t, the number of
periods, must be M, the number of periods in one year. This is a progression of formulas that all mean the same
thing, and then in the last one, a -1 is added to both sides to show the EAR formula.
$1.12550881 = $1(1.03)
4
(Right out of Ch. 5)
1.12550881 = 1(1.03)
4

1.12550881 = (1.03)
4

.12550881 = (1.03)
4
-1
Effective Annual Rate = .12550881 or 12.55%
- Note that 1% per month or 12.68% per year will yield the same return. However, the interest on the interest will be
earned on 11 payments for the monthly interest, whereas if you take the quarterly compounding, you only receive
interest on the last three payments. (No interest on the first payments.)
- IF INVESTING YOU WANT MORE COMPOUNDING and IF BORROWING YOU WANT LESS COMPOUNDING.

EAR Formulas





In the future will be referred to as form I and form II.

Computing EARs Example 2
You are looking at two savings accounts. One pays 5.25%, with daily compounding. The other pays 5.35% with semiannual
compounding. Which account should you use? Obviously daily without calculating but you have to calculate EAR first;
Second is the better deal after finding EAR!
- First account:
EAR = (1 + (.0525/365))
365
1 = .05389658 or 5.39%
Number of days in a year varies by the contract! Read the fine print.
- Second account:
EAR = (1 + (.0535/2))
2
1 = .05421556 or 5.42% (The better deal!)
- On the TI:
First account:
.0525/365 = .00014384 + 1 = 1.00014384
1.00014384 y
x
365 = 1.05389858 1 = 5.39% or .05389858
Second account:
.0535/2 = .02675 + 1 = 1.02675
1.02675 y
x
2 = 1.05421556 1 = 5.42% or .05421556
Letter about Loan to Dr. Laplante (not on slides)
469.29% APR
2 week loans m= 26
EAR= (1+ 4.6929/26)
26
- 1
EAR= 73.76 = 7376%
| |
m
II. EAR 1 periodic rate 1 = +
m
APR
I. EAR 1 1
m
(
= +
(


Effective Rates Example 3
You have a balance of $2,063.50 on your BOA credit card. BOA charges 14.24% per year with daily compounding. If you choose
you can make the minimum monthly payment of $20. If you only make this minimum payment each month how long will it
take to pay off your current balance?
How many days in a year? Check contract! Laplante would guess 365 because more interest on interest. He checked- 365 days.
Finding the Number of Payments
APR= .1424
Days of month= 365
What is the monthly rate?
= 1+ .1424/365)
365/12= 30.4167
-1 = .01193501 or 1.19%

Calculator..
PV= 2063.5 PMT= -20 I/Y= 1.193501 CPT N ERROR 5

Effective Rates Example 4
Whats the iPhone costing you? Replace phone every 2 years at $200? Add $74,319
What is bi-annual rate?
APR= .09 with monthly compounding
EAR= (1+ .09/12)
24
-1= 0.19641353= 19.64%
Calculator.
200 PMT, 19.641353 I/Y, 24 N, CPT FV $74,319.06117

Compounding Frequency
APR = 7% Periodic EAR
APR/m (1 + (APR/m))
m
- 1
Annual .07 .07 This is the only point
where these are the same because there is not interest earned
Quarterly .0175 .07185903
Monthly .0058333 .07229008
Daily .00019178 .07250098
Hourly .00000799 .07250788
Minute .000000133 .07250817
Infinity .07250818
Every time you increase the frequency with which interest is earned/paid, you wind up with more, but the amount does not
keep increasing forever.
Asymptote- boundary value; Maximum EAR is .07251
If get to infinity, will reach asymptote
Hours= 8760/ year
Minute= 525,600 minutes/ year
Better off compounding to infinity!

Continuous Compounding
Sometimes investments or loans are figured based on continuous compounding

EAR = e
APR
1 where e is a constant (figured from APR=1 in the formula, APR in decimal form):
e is approximately 2.718282

- Example: What is the effective annual rate of 7% compounded continuously?
EAR = e
.07
1 = .07250818 or 7.25% (This is the most frequent rate at which interest can be earnedcompounded
continuously
Or,
2
nd
[e
x
] => 1.07250818
EAR= 1.07250818- 1= 7.25% or .0725

September 10, 2012
- Can we express the fundamental time value of money equation in terms of continuously compounded interest?
FV = PV (1+r)
t

m
APR
EAR 1 1
m

(
= +
(


FV = PV (1+EAR)
t
(where t must be in years because EAR is annual)
-- EAR = e
APR
1 plug it in!
FV = PV (1 +e
t
1)
t

FV = PVe
rt
(this is the formula for continuous compounding, when t is in years; this formula can be used to move
amounts around in time) (r= annual rate)
What is the future value of $100 in two years if your savings account pays 2% annually with continuous compounding?
PV = 100
R = 2% = .02 (annual rate)
T = 2 years
FV = 100e
(.02 * 2)
= 104.0810774

Use e on calculator by using 2
nd
Function then ln key. No time value keys- just algebra!
Solve for other variables.
PV = FVe-
rt
t = (ln[FV/PV])/r (Note: If find the time as 4.76 years round up to 5 years)
r = (ln[FV/PV])/t

-Continuous compounding is common because its easy to calculate and b/c it allows one to withdraw a precise amount at a
precise moment in time
- You dont have to wait another year/quarter/month for interest to be paid


Additional notes: Dr. Laplante will provide us formulas (in a list on eLC) that we will be given on the exam. Other
formulas need to be memorized.