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Quant Time Val ue of

Money (r eading #6)


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Presented by: Aditya Ahluwalia
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Overview
Time value of money
Interest rates
Future Value and Present Value of a single sum
Annuities
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Other applications of TVM functions
Funding obligations
Amortizing a loan
Compounding frequencies
Time Value of Money
100 dollars today is worth more than 100 dollars to be received
one year from now
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How much more?
By the amount of interest that can be earned
Interest rates
Interest rate can be interpreted as
> Required rate of return to make an investor lend funds
> Discount rate should adequately account for the risk of the investment
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> Opportunity cost of current consumption
Nominal risk-free rate = real risk-free rate + expected inflation rate
Default risk: The risk that a borrower will not make the promised payments
in a timely manner.
Liquidity risk: The risk of receiving less than fair value if the investment
Interest rates
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Liquidity risk: The risk of receiving less than fair value if the investment
must be sold for cash quickly.
Maturity risk: Longer term investments can be more volatile than shorter
term investments and require a maturity risk premium.
required interest rate on a security = nominal risk-free rate
+ default risk premium
+ liquidity premium
+ maturity risk premium
Example: FV of a single sum
Calculate the FV of a $250 investment at the end of five years if it earns an
annually compounded rate of return of 9%.
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N = Number of compounding periods
I/Y = Interest rate per period
PV = Present Value
PMT = Payment per period
FV = Future Value
N = 5;
UNDERSTANDING THE FINANCIAL CALCULATOR
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N = 5;
I/Y = 9;
PV = 250;
PMT = 0;
CPT FV = -$384.66
Example: PV of a single sum
Given a discount rate of 8.5%, calculate the PV of a $800 cash flow that will be
received in seven years.
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Example: FV of an ordinary annuity
What is the future value of an ordinary annuity that pays $250 per year at the end of each of
the next 6 years, given the investment is expected to earn a 9% rate of return?
0 1 2 3 4 5 6
250 250 250 250 250 250
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Answer:
N = 6; I/Y = 9; PMT = -250; CPT FV = $1880.83
FV of an Ordinary Annuity
0 1 2 3 4 5 6
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250 250 250 250 250 250
FV
6
= $1880.83
Example: PV of an ordinary annuity
What is the PV of an annuity that pays $100 per year at the end of each of
the next 15 years given an 8% discount rate?
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Answer:
N = 15; I/Y = 8; PMT = -100; FV = 0; CPT PV = $855.94
Example: PV of an ordinary annuity beginning later than t = 1,
What is the present value of four $200 end-of-year payments if the first payment is
to be received three years from today and the appropriate rate of return is 7%?
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Answer:
The time line for this cash flow stream is shown in the following figure.
PV of an Annuity Beginning at t = 3
PV
0
= $591.68 PV
2
= $677.44
0 1 2 3 4 5 6
$200 $200 $200 $200
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Step 1: Find the present value of the annuity as of the end of year 2 (PV
2
)
Input the relevant data and solve for PV
2
N = 4; I/Y = 7; PMT = -200; FV = 0; CPT PV = PV
2
= $677.44
Step 2: Find the present value of PV
2
Input the relevant data and solve for PV
0
N = 2; I/Y = 7; PMT = 0; FV = -677.44; CPT PV = PV
0
= $591.68
Example: PV of a bonds cash flows
A bond will make coupon interest payments of 75 euros (7.5% of its face value) at the
end of each year and will also pay its face value of 1,000 euros at maturity in five
years. If the appropriate discount rate is 9%, what is the present value of the bonds
promised cash flows?
75 75 75 75 75
0 1 2 3 4 5
+ 1000
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Answer
Cash flows for a 5-year, 9%, 1,000 euro bond
N = 5; PMT = 75; I/Y= 9; FV = 1,000; CPT PV = -941.65
75 75 75 75 75
0 1 2 3 4 5
Payment are an ordinary maturity
The maturity of the payment is a
single future value
1000
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N = 5; PMT = 75; I/Y= 9; FV = 1,000; CPT PV = -941.65
With a yield to maturity of 9%, the value of the bond is 941.65 euros.
Note that the PMT and FV must have the same sign, since both are cash flows paid to the investor
(paid by the bond issuer). The calculated PV will have the opposite sign from PMT and FV.
Example: FV of an annuity due
What is the future value of an annuity that pays $150 per year at the beginning of
each of the next three years, commencing today, if the cash flows can be invested at
an annual rate of 7.5%?
0 1 2 3
+150 +150 +150
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Answer:
To solve this problem, put your calculator in the BGN mode ([2nd] [BGN] [2nd]
[SET] [2
nd
] [QUIT] on the TI ), then input the relevant data and compute FV.
N = 3; I/Y = 7.5; PMT = -150; CPT FV = $520.93
FV of an Annuity Due
0 1 2 3
+150 +150 +150 FV = $520.93
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Alternatively, we could calculate the FV for an ordinary annuity and multiply it by
(1 + I/Y). Leaving your calculator in the END mode, enter the following inputs:
N = 3; I/Y = 7.5; PMT = -150; CPT -> FVA
O
= $484.59
FVA
D
= FVA
O
* (1 + I/Y) = 484.59 * 1.075 = $520.93
+150 +150 +150 FV
3
= $520.93
Example: PV of an Annuity Due
Given a discount rate of 7%, what is the present value of a 3-year annuity that
makes a series of $1200 payments at the beginning of each of the next three years,
starting today?
0 1 2 3
+1200 +1200 +1200
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Answer:
First, lets solve this problem using the calculators BGN mode. Set your calculator to the
BGN mode ([2nd] [BGN] [2nd] [SET] [2nd] [QUIT] on the TI or [g] [BEG] on the HP),
enter the relevant data, and compute PV.
N = 3; I/Y = 7; PMT = -1200; CPT PVA
D
= $3369.62
PV for an Annuity Due
0 1 2 3
+1200 +1200 +1200
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PV=$4127.93
Alternatively, this problem can be solved by leaving your calculator in the END mode.
First, compute the PV of an ordinary 3-year annuity. Then multiply this PV by (1 + I/Y).
To use this approach, enter the relevant inputs and compute PV.
N = 3; I/Y =- 7; PMT = -1200; CPT PVA
O
= $3149.17
PVA
D
= PVA
O
* (1 + I/Y) = $3149.17 * 1.07 = $3369.62
+1200 +1200 +1200
Example: PV of a perpetuity
Assume the preferred stock of Alstom Corporation pays $8.5 per year in
annual dividends and plans to follow this dividend policy forever. Given an
7.5%rate of return, what is the value of Alstoms preferred stock?
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8.50
$113.33
0.075
perpetuity PV = =
Answer:
Example: Rate of return for a perpetuity
Using the Alstom preferred stock described in the preceding example, determine the rate
of return that an investor would realize if she paid $85.00 per share for the stock.
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8.50
/ 0.10 10.00%
85.00 perpetuity
PMT
I Y
PV
= = = =
Answer:
Example: Computing an annuity payment needed to achieve a given FV
At an expected rate of return of 15%, how much must be deposited at the end of each
year for the next 10 years to accumulate $10,000?
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Answer:
N = 10; I/Y = 15; FV = +$10,000; CPT PMT = -$492.52(ignore sign)
Example: Computing the number of years in an ordinary annuity
Suppose you have a $3,000 sum earning a 6% return. How many annual end-of-year
$500 withdrawals can be made?
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Answer:
I/Y = 6; PMT = 500; PV = -3,000; CPT N = 7.66 years
Example: Funding a retirement plan
Assume an investor wants to retire in 10 years at the age of 60. She expects to earn 12% on her
investments prior to her retirement and 8% thereafter. How much must she deposit at the end of
each year for the next 10 years in order to be able to withdraw $15,000 per year at the beginning
of each year for 20 years after retirement?
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Example: Calculating the rate of compound growth
Sales at Acme, Inc., for the last five years (in millions) have been 3.2, 4.7, 5.8, 7.2, 8.6.
What is the compound annual growth rate of sales over the period?
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Answer:
The five years of sales represent four years of growth. Mathematically, the compound
annual growth rate of sales is (8.6/3.2)
1/4
-1 = 28.04%.
OR
FV = 8.6, PV = - 3.2, N = 4, CPTI/Y = 28.04%
Note that if sales were 3.2 and grew for four years at an annual compound rate of
28.04%, they would grow to 3.2 (1.2804)
4
= 8.6.
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Example: Constructing an amortization schedule
Construct an amortization schedule to show the interest and principal components of
the end-of-year payments for a 10%, 5-year, $35,000 loan.
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Amortization Table
Period Beginning
Balance
Payment Interest
Component
(1)
Principal
Component
(2)
Ending Balance
(3)
1 $35,000.00 $9,232.91 $3,500.00 $5,732.91 $29,267.09
2 $29,267.09 $9,232.91 $2,926.71 $6,306.20 $22,960.89
3 $22,960.89 $9,232.91 $2,296.09 $6,936.82 $16,024.07
4 $16,024.07 $9,232.91 $1,602.41 $7,630.50 $8,393.56
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5 $8,393.56 $9,232.91 $839.36 $8,393.55 $0.00
Example: Computing EARs for a range of compounding frequencies
Using a stated rate of 8%, compute EARs for semiannual, quarterly, monthly, daily and
continuous compounding.
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Example: Computing EARs for a range of compounding frequencies
Using a stated rate of 8%, compute EARs for semiannual, quarterly, monthly, daily and
continuous compounding.
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Answer:
EAR with:
semiannual compounding = (1 + 0.04)
2
- 1
quarterly compounding = (1 + 0.02)
4
- 1
monthly compounding = (1 + 0.00667)
12
- 1
daily compounding = (1 + 0.0002192)
365
- 1
1.08160 -1 = 0.08160 = 8.160%
1.08243 -1 = 0.08243 = 8.243%
1.08304 -1 = 0.08304 = 8.304%
1.08328 -1 = 0.08328 = 8.328%
Notice here that the EAR increases as the compounding frequency increases.
The limit of shorter and shorter compounding periods is called continuous
compounding. To convert an annual stated rate to the EAR with continuous
compounding, we use the formula e
r
- 1 = EAR.
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For 8%, we have e
0.08
- 1 = 8.3287%. The keystrokes are 0.08 [2nd] [e
x
] [-] 1 [=]
0.0832871.
Example: FV of a single sum using monthly compounding
Compute the FV of $7,000 today, five years from today using an interest rate of 10%,
compounded monthly.
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Answer:
N = 5 * 12 = 60; I/Y = 10 / 12 = 0.83333; PV = -$7,000; CPT FV = $11,516.93
N = Number of compounding periods
I/Y = Interest rate per period
PV = Present Value
PMT = Payment per period
FV = Future Value
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