Hello I'm Professor Brian Bueche,

welcome back.
This is the final video in our
trilogy on time value of money.
Now maybe this trilogy hasn't been
as entertaining as the Lord of
the Rings trilogy.
But it certainly been shorter, and
we'll have much more beneficial
impact on your career.
So in this last video, we're going to
talk about the concept of annuities,
which is a concept we run into a lot
in doing financial calculations.
So let's get to it.
Annuity is a constant stream
of future cash flows, so
it's the same payment every period.
Now there's two different
types of Annuities.
There's an ordinary annuity, or
a annuity in, a rears, where you get
the payments at the end of each period.
Or an annuity due or
an annuity in advance where the payments
come at the start of each period.
So you almost never see in any of
the applications we do annuity due.
Everything we're going to do is
going to be an ordinary annuity so
the payments are going to come
at the end of the period.
So an example of how this would work.
How do you figure out the present
value of an ordinary annuity of $500
with three periods at an interest of 8%?
Well, you're getting the present value
of $500 one year from now at 8%.
Which would be 500 times the present
value table rate of .92593.
Plus the present value of the $500 that
you'll receive two years from now,
discounted back 8%.
Plus the present value of the $500
that you receive three years from now,
discounted back at 8%.
That's the same as saying
it's $500 times 2.57710,
which is the combination of
those three discount factors.
Gives you the present
valued annuity of 1288.55.
So the nice thing about annuities is,
if it is the constant payment.
We don't have to do three separate
present value calculations for
each of the three payments.
Instead, we're going to have a table
that'll give us one factor that will
allow us to do one calculation.

To figure out what's the present value

of getting that annuity of $500 at
the end of each of the three,
next three periods.
>> Does it have to be the same payment
each period to use the annuity formula?
>> Yes unfortunately the annuity
formula will only work if
the payment is the same each period.
If not then you have to take
the individual present value of
all the individual payments.
But fortunately, many of
the applications that we'll look at
will have constant streams of the same
payment over some number of periods.
So if we go back to our time
value of money calculation
abbreviations or elements.
In the prior videos we had present
value future value interest rate or
discount rate and number of periods.
With annuities,
we're adding one more element, and
this will be the last element,
which is PMT for payment.
This is the periodic payment for
an annuity, and
unless specified, assume it's going to
be received at the end of each period.
So it will be one of
these ordinary annuities.
So let's try doing some calculations
of present values of annuities.
First thing you could
do is use the formulas,
which is present value equals
payment divided by r times [SOUND].
You know, I think we're going to
stop using formulas at this point.
I'm not going to go through
how this is derived.
This would be very tedious to try
to figure out on your calculator.
So we're going to stop with the formulas,
and
instead rely on either the tables,
so present value equals payment.
And then we're going to pull a factor
from table four for annuities.
Now, I realize I skipped table three,
we'll come back to table three later.
Or, we're going to use that same
Excel function PV instead of
having payment zero.
This time we're going to put in a number
and we'll set future value to zero.
And we'll find out that Excel can kick out
the Present Value of the annuities, so
I'll show you both ways to do it.

So, here's the first question we're

going to look at if this course gets you
an extra 5,000 per year in
salary until retirement.
So basically everything that you
learn in this course, you will go and
apply that on your job.
And you'll get paid an extra $5,000
than you would've other wise.
How much would you've been
willing to pay for that?
>> Dude I like do not
understand the question.
How much would you pay for it?
Aren't we like receiving the extra salary?
>> I agree the terminology's a little
strange, but it's the way we tend to
think of these problems so
let me explain it a little bit.
So the idea is we figure out
the present value of that extra $5,000.
You'd be willing to pay for
this course any amount up to.
That present value.
If you did then it would
be a positive MPB project.
The initial cash outflow for
paying for the course would be
less than the present value of the future
cash inflows, the $5,000 over time.
If you paid more for the course than
the present value of those cash flows,
the future, salary increases,
then it's a negative MPB project.
You wouldn't want to do it.
So the assumption is here that
the fair price would be that we
would charge you for this course, exactly
what you would get in future benefits.
And the future benefits are the present
value of that $5,000 of
extra salary every year until you retire.
So getting back to the question.
We're going to assume again
20 years to retirement, and
inflation's expected to be 15%.
So here the relevant rate that we use,
need to use to compute the annuity
is the rate of inflation.
Because that's what's going to
make a dollar 20 years from
now worth less than a dollar today.
Prices would be going up over
the next 20 years by 15% per year.
Here is table four, which is
the present value of an annuity table.
To do this calculation, we want to go to
the row for 20, 20 periods, 20 years.
Go across to the column for 15%.
And the number that we'd

want to pull is 6.2593.

So then going back to our problem
we're going to have the present value
equals 5,000.
Which is the payment times the factor
we just looked at, 6.2593.
Which means the present value is $31,297.
So in other words you'd be
willing to pay $31,297 in today's
dollars to receive $5,000 per year over
the next 20 years if inflation is 15%.
>> $5,000 for 20 years is.
Is $100,000.
Of course, we would be willing to
pay only $31,297 to get $100,000.
That is a fantastic deal.
Seems too good to be true.
>> Now it's actually a fair
deal because remember.
The present value represents the value in
today's dollars of that $100,000 that
you'll receive in future dollars.
And remember with 15% inflation.
Those future dollars are not going to
be worth the same as a dollar is today.
So think back to the gas prices.
Remember, gas was $1.53 in 1980,
$4.14 in 2011.
Well at 15% inflation, price of gas
is going to be $67 20 years from now.
So that $5,000 of extra salary is
not going to go that far when gas is
$67 dollars a a gallon.
And that's why we have to discount it
back to today's dollars to get a sense of
it's real purchasing power.
The present value represents that
purchasing power in today's dollars.
Before we move on let me quickly
show you how to do this in Excel.
So we push the function button,
and we look for PV present value.
So our rate, again, is 15%,
20 years until retirement,
we're getting 5,000 per year and
there's no future value,
there's no lump sum at the end.
Type is left blank because
it's an ordinary annuity.
We hit OK.
If you don't like to see the negative,
we'll put the little
negative sign there 31,297.
So we get the same answer using Excel.
So let's do some more practice here,
and I'll give you a chance to try to do
some of these calculations on your own.
So what if the inflation rate was only 5%.
So again we're getting
an extra $5,000 per year for

20 years, but instead of 15%

inflation is only going to be 5%.
So why don't I bring up the table and
pause sign and
have you take a crack and
answering this one.
So here again we want to look at the 20
year row because we're going out 20 years.
But now it's only going to
be five percent inflation so
we look at the row 20, column 5%.
We see that the factor is 12.4622.
So we have our formula present value
equals 5,000 times that factor,
which is 12.4622 which means
the present value would be 62,311.
So what's happened is the present value
of the $5,000 now is higher than it
was before.
What's happened is the inflation
rate is now lower.
So that $5,000 that you're getting in
the future is worth more than when
inflation was 15%.
Right, so inflation is lower,
those future dollars are going to be worth
more to you than if inflation is high.
And if those future dollars
are worth more to you,
it's going to mean that your
present value is going to go up.
What if you plan to retire in 10 years?
So now we're going to continue
with $5,000 extra per year but
you're only going to get it for 10 years.
Instead of 20 years, the inflation
rate will go back up to 15 percent,
which is what we had in the original case.
So I will bring up
the present value table, and
the pause sign, and
have you take a crack at this one.
Okay, to solve this one, we need to
go down to the row for 10 years.
And then across to the column for 15% and
we see at the intersection of
the row in column, he has 5.0188.
So in our formula, present value
equals 5,000 times that factor,
which is 5.0188, so
the present value would be $25,094.
Now this present value is lower than
the present value we had in the base case.
What's happened is we get
fewer years of the payment.
So instead of getting 20 years of $5,000,
we only get 10 years and a result,
as a result the present value of that.
Future stream of payments,
then the annuity goes down

relative to the base case.

Yeah, so that's see how this generalizes
when you look at things like 30 years, or
25%, or even a higher payment.
So instead of $5,000,
you get $10,000 new extra salary.
So here's a little sensitivity
analysis I did in Excel.
And what, yeah, want you to look at is,
let's first focus on where
the inflation rate is the same.
So we can look at the 5% at the top.
As the number periods goes
up with the same payment,
we see that the present value goes up.
So what that's in effect is, you're
getting the payment over more years, so
the value of that
annuity's going to go up.
Now if you look at the same number of
years, but changed the interest rate.
So if you look at 30 years for 5%, 15% and
25%, what you'll notice is
the present value goes down.
So holding the payment constant and
the number of years as
the interest rate goes up.
The present value goes down and
of course vice versa.
And then the last three
wells show you see what,
shows you what happened if
we increase the payment.
So if you compare 5% 30
years 5,000 to 5% 30 years
10,000 you see the present value
goes from 76,862 to 153,725.
What happens there is that
as the payment goes up,
you're getting a bigger amount each year.
Which makes the value,
the present value of that annuity go up.
So what we find is the present value is
inversely related to the discount rate or
inflation rate.
As inflation goes up,
present value goes down.
As inflation goes down,
present value goes up.
And that's because inflation affects
very directly how much that payment is
going to be worth to
you in current dollars.
The present value is positively related
to the payment and the number of periods.
And that's because with annuity, you're
getting the same payment every year.
So if you get a bigger payment or
you get more payments,
it's going to increase the present value.

Last thing to look at would be

the future value of annuities.
So I'm not even going to
show you the formula.
There's two ways to do this.
The future value is the payment
times table three factor.
So table three will have the annuity
factors for future values.
Or we can use that same formula as,
in Excel as we did a couple videos ago.
Except we replace zero with
the amount of the payment and
then we drop the present value term and
I'll, I'll show you how to do that.
So here the question would be if this
course gets you an extra 5,000 per year in
salary until re, retirement,
how much is this worth when you retire.
So instead of figuring out
the present value of that annuity,
let's figure out the future
value of the annuity.
How much dollars will you have in the
future, when this is all said and done.
So we're going to assume 20 years to
retirement, inflation is expected to be
15% per year, so here's table 3, which
is our future value of annuity table.
So we go down to the row for 20 years.
And across to the column for 15% and
we see that the intersection,
the factor is 102.4436.
So using our formula, that's future
value equals 5000, the annuity payment.
Times this factor, which is 102.4436,
which is $512,218.
So again, let me quickly jump in and
show you how to do it in Excel.
So we hit the function button.
We look for future value.
We've got 15 percent rate of inflation, 20
years to retirement, $5,000 extra salary.
There's no present value lump sum.
There's the type is left
blank because it's ordinary.
We hit okay.
Don't like to see the negative so
put the negative in front.
$512,218, so
we get the same answer in Excel as we did
with the future value into each table.
Now if you recall, a few videos ago,
we did how much would you have
if you invested $10,000 in the stock
market with 15% rate for 20 years.
And we came up with $163,635.
So getting the extra 5,000 year in salary
is worth much more to you in the future.
Then would be just investing $10,000 into

the stock market and letting it grow.

>> Dude, are you like saying
that taking this course is
like better than investing
in the stock market?
>> Actually, the best thing to do is
use your knowledge from this course to
both get a higher salary at work.
And be a better investor
in the stock market, and
then you get higher future
values on both fronts.
So far we've been working
with annual compounding.
So we have annual interest rates.
Interest is compounded annually.
But oftentimes we have to do
problems where the interest is
compounded more frequently than that.
For example, with bonds, which we're
going to see a lot, it's semi-annual
compounding, so every six months,
the interest gets applied to the bond.
So in that case what we need to
do is take the interest rate,
which is always given as an annual rate.
And divide it by 2, and
take the number of years for the bond and
multiply it by 2 to translate it from
an annual stream to semiannual stream.
Now let's do a couple examples.
So what's the present value of a $1,000
five-year, 12% savings bond with.
Annual compounding.
So this is what we saw before, where
the present value's going to be $1,000,
which is the future value.
Then we would go and look up the factor
from table 2 for 5 years, 12%.
No I'm not going to do that, but
I'll leave it for you to double check.
And we come up with 567.
Now if this was semi annual
compounding which is more typical for
the bonds we're going to see.
It's the same formula present value equals
the future value of a 1,000 times now we
want to do 6% for ten periods.
So, we have instead of five years we have
ten semi annual periods ten half years.
And we don't get 12% for
each half year, we only get 6%.
And we get a different present value, 558.
You could do this with monthly
compounding, where, now,
you would divide the interest rate by 12%.
So, instead of 12%,
it would be one percent.
You'd multiply the number
of periods by 12.

So, instead of five years.

It would be 60 months.
We would get a present value of 550.
You can even do daily compounding.
So take the 12% interest rate and
divide it by the number of days in a year,
which I think is about 365.
Take the five year period and
figure out the number of days, 1825.
And basically figure out
what's the present value,
if you had daily compounding of interest.
Which would be at the daily interest
rate for the number of days.
And you end up with 549.
>> Back in the 1970's,
I remember that my bank
started offering continuous
compounding on its savings accounts.
Instead of a free toaster,
what does continuous compounding mean?
>> So continuous compounding
literally means that interest is
always being compounded.
The way it was calculated is, I,
I don't know if you know in
mathematics the number e.
But if you take e raised
to the interest rate,
that gives you what the interest would
be if it was compounded all the time.
But as you can see on the slide, as we
did more frequent compounding periods,
it had less and
less of effect on present value.
So the reason banks can promise this,
is it wasn't requiring them to
pay that much more interest.
Than say, daily compounding or
even weekly compounding.
So you would've been better
off with the toaster.
So let's wrap up this video.
And this unit on time valued money
by looking at the example of
pricing a money a bond.
And, and don't worry you're going to get a
lot more practice with this down the road.
So how much would you pay to buy
a newly issued three year bond.
That pays coupon payments of $250 every
six months and then $10,000 at maturity.
Current market interest rate is 5%.
So notice that there's really two
different payment streams here that we
need to take the present value of.
First, we have an annuity.
We're getting $250 at
the end of every six months.
So we can use our present value

of an annuity calculation.
Then we're getting $10,000
in a lump sum of maturity,
there were going to look at
the present value of a future value.
But what complicates this
is that it's semi-annual.
So we need to double
the number of periods.
So, instead of a three year bond, we have
to view this as six semi-annual periods.
And then divide that
annual interest rate by 2.
So instead of the market
rate being 5% per year,
we're really getting 2.5%
compounding every six months.
Now we can figure out the present
value of the payment at maturity.
So the $10,000 lump.
So we're looking for the present value,
we know the future value is $10,000.
Interest rate is 2.5%.
There are six semi-annual periods, and
we set the payment equal to zero now.
And you could use the formula
with your calculator, or
the present value table or Excel.
I'm going to pop to Excel to solve this.
So for the present value of
the $10,000 value principle.
We'll bring up our function.
Present value.
We've got a rate of two and
a half percent, which we enter as 0.025.
Six semi-annual periods.
No payment at this point.
And a future value of 10,000.
That's what we're getting at maturity.
And then we'll slip in
the little minus here, so
that we don't have to look
at a negative number, 8,623.
And so as we see the present value of
the payment at maturity is $8,623.
Then we have to
figure out the present value of that
annuity of semi annual payments.
So here, we're looking for present value.
The future value set to zero.
Interest rate again,
is two and a half percent.
Six semi-annual periods, and
we're getting $250 at the end
of every semi-annual period.
So let's pop out to Excel and
solve this one.
So let's look at the present value
of that $250 semi-annual payment.
We bring up the function button.

Go over to present value.

We've got our two and
a half percent interest rate again.
We have six semi-annual periods.
We're getting a payment of 250.
We're going to leave future value out.
And leave type alone.
I'll go ahead and put the minus in.
And so we end up with 1,377.
And so carrying that over,
the present value of that annuity.
Is $1,377.
So the price of the bond,
the amount that you're willing to pay,
would be the present value of
the payment at maturity, 8,623.
Plus the present value of that annuity,
1,377, which would equal 10,000.
Which just so happens is the same
value of the payment of maturity.
When we talk about bonds,
we'll explain why that's the case.
But before we do that, let me pop out
to Excel to show you one more thing.
So here's what I want to show you, so
you're going back to these two components,
if we add them up,
we get $10,000 is the price of the bond.
Now going back to the formula,
the reason why the formula provides
both payment and future value is.
You could actually price a bond in
one step by just filing that in.
So it'll present value both streams.
So if we put in the rate as 0.025,
two and a half percent.
Six semi-annual periods.
$250 payment.
And a $10,000 future value.
We end up with, low and behold, $10,000.
So you can actually price a bond,
which is a combination of the annuity and
the lump sum, just using the one
pass through the Excel formula.
And that wraps up our look at the basic
concepts of time, value money.
Still need more practice?
No problem.
We still have plenty of more
applications to look at when we
talk about accounting for
bonds and for leases.
See you then.
>> See you next video.