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We know that receiving P 1.00 today is worth more than P 1.00 in the future. This is due to opportunity costs. The opportunity cost of receiving P 1.00 in the future is the interest we could have earned if we had received the P 1.00 sooner.
Today Future
?
Translate P 1.00 in the future into its equivalent today (discounting).
Today Future
Compound Interest
If you deposit P 100.00 in an account earning 6.0%, how much would you have in the account after 1 year?
PV = -100
FV = 106
0 1 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 1 ) (use FVIF table, or) FV = PV (1 + i)n FV = 100 (1.06)1 = P 106.00
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If you deposit P 100.00 in an account earning 6.0% with quarterly compounding, how much would you have in the account after 5 years?
PV = -100
FV = 133.82
PV = -100
FV = 134.68
0 5 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 5 ) (use FVIF table, or) FV = PV (1 + i)n FV = 100 (1.06)5 = P 133.82
0 20 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .015, 20 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.015)20 = P 134.68
If you deposit P 100.00 in an account earning 6.0% with monthly compounding, how much would you have in the account after 5 years?
What is the FV of P 1,000.00 earning 8.0% with continuous compounding, after 100 years?
PV = -100
0
FV = 134.89
60
PV = -1000
0
FV = 2.98M
100
Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .005, 60 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.005)60 = P 134.89
Present Value
If you receive P 100.00 one year from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%?
PV = -94.34
FV = 100
0 1 Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 1 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.06)1 = P 94.34
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If you receive P 100.00 five years from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%?
What is the PV of P 1,000.00 to be received 15 years from now if your opportunity cost is 7.0%?
PV = -74.73
0
FV = 100
5
PV = -362.45
0
FV = 1000
15
Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 5 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.06)5 = P 74.73
What is the PV of P 1,000.00 to be received 15 years from now if your opportunity cost is 7.0%?
If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return?
PV = -362.45
FV = 1000
PV = -5,000
0
FV = 11,933
5
0 15 Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .07, 15 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.07)15 = P 362.45
If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return?
Mathematical Solution: PV = FV (PVIF i, n ) 5,000 = 11,933 (PVIF ?, 5 ) PV = FV / (1 + i)n 5,000 = 11,933 / (1+ i)5 .419 = ((1/ (1+i)5) 2.3866 = (1+i)5 (2.3866)1/5 = (1+i) i = .19
Suppose you placed P 100.00 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to P 500.00?
PV = -100
0
FV = 500
?
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Suppose you placed P 100.00 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to P 500.00?
Mathematical Solution:
PV = FV / (1 + i)n 100 = 500 / (1+ .008)N 5 = (1.008)N ln 5 = ln (1.008)N ln 5 = N ln (1.008) 1.60944 = .007968 N
N = 202 months
Annuities
Annuity: a sequence of equal cash flows, occurring at the end of each period.
Examples of Annuities:
If you buy a bond, you will receive equal semi-annual coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will pay a stream of equal payments.
If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years?
1000
0 1
1000
2
1000
3
N=3
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If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 1,000 (FVIFA .08, 3 ) FV = PMT (1 + i)n - 1 i FV = 1,000 (1.08)3 - 1 0.08
What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%?
1000
(use FVIFA table, or)
1000
2
1000
3
= P 3,246.40
What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%?
Mathematical Solution: PV = PMT (PVIFA i, n ) PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or) PV = PMT 11 (1 + i)n i 1 (1.08 )3 0.08 = P 2,577.10
PV = 1000
1-
Perpetuities
Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. You can think of a perpetuity as an annuity that goes on forever.
PV = PMT (PVIFA i, n )
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Mathematically, (PVIFA i, n ) =
1-
1 n (1 + i)
1-
1 (1 + i) n
We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large?
1
So were left with PVIFA =
What should you be willing to pay in order to receive P 10,000.00 annually forever, if you require 8.0% per year on the investment?
PV =
PMT i
PV =
PMT i
= P 10,000.00 0.08
= P 125,000.00
year 5
year 6
year 7
in END Mode
PV
in END Mode
FV
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1,000
2
1,000
3
year 6
year 7
year 8
in BEGIN Mode
PV
in BEGIN Mode
FV
Using an interest rate of 8.0%, we find that: The Future Value (at 3) is P 3,246.40. The Present Value (at 0) is P 2,577.10.
1000
1
1000
2 3
If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3?
-1000
0
-1000
1
-1000
2 3
Same 3-year time line, Same 3 P 1,000.00 cash flows, but The cash flows occur at the beginning of each year, rather than at the end of each year. This is an annuity due.
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = -1,000 FV = P 3,506.11
If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3? Mathematical Solution:
Simply compound the FV of the ordinary annuity one more period:
What is the PV of P 1,000.00 at the beginning of each of the next 3 years, if your opportunity cost is 8.0%?
1,000
0
1,000
1
1,000
2 3
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = 1,000 PV = P 2,783.26
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4,000
2
6,000
3
7,000
4
PV = 1000
1-
(1.08)
= P 2,783.26
Is this an annuity? How do we find the PV of a cash flow stream when all of the cash flows are different? (Use a 10% discount rate.)
4,000
2
6,000
3
7,000
4
4,000
2
6,000
3
Sorry! Theres no quickie for this one. We have to discount each cash flow back separately.
period CF PV (CF) 0 -P 10,000.00 -P 10,000.00 1 2,000.00 1,818.18 2 4,000.00 3,305.79 3 6,000.00 4,507.89 4 7,000.00 4,781.09 PV of Cash Flow Stream: P 4,412.95
(1+ (1+
quoted rate m
)m-
APY =
.0785 4
)4- 1
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Instructions
Get the best interest rate for the following initial deposits: P 1,000.00, P 5,000.00, and P 10,000.00 for one (1) year. The best rate shall come from a survey/canvass of two commercial banks and one savings bank. List down the following information: name of bank, branch, the name of the authorized representative of the bank, and the contact number.
Instructions
On the next meeting, each group will reveal the rates for the three initial deposits. The group with the best rates will get the highest score (10 points). Each group will submit a one page report for the interest rates obtained to be submitted on the next meeting. Another one page report for the net (of taxes) computation of the best rate The next meeting will be next Thursday.
Practice Problems
Example
Cash flows from an investment are expected to be P 40,000.00 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20.0% rate of return, what is the PV of these cash flows?
P0 0 0 1 0 2 0 3 40 4 40 5 40 6 40 7 40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
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P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
Then discount this single sum back to time 0. PV: End mode; P/YR = 1; I = 20; N = 3; FV = 119,624; Solve: PV = P 69,226.00
P 119,624.00
P 69,226.00 P 119,624.00
Retirement Example
After graduation, you plan to invest P 400.00 per month in the stock market. If you earn 12.0% per year on your stocks, how much will you have accumulated when you retire in 30 years?
400 0 1 400 2 400 3 400 . . . 360 0
400 1
400 2
400 3
400 . . . 360
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Retirement Example If you invest P 400.00 at the end of each month for the next 30 years at 12.0%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 400 (FVIFA .01, 360 ) FV = PMT (1 + i)n - 1 i FV = 400 (1.01)360 - 1 .01 = P 1,397,985.65
? 0 1
? 2
? 3
? . . . 360
100,000 = PMT 1 -
Team Assignment
Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require P 250,000.00 per year at the beginning of each year. If you plan to retire in 30 years, what are the equal monthly payments necessary to achieve this goal? The funds in your retirement account will compound at 10.0% annually.
27 28 29
250 30
How much do we need to have by the end of year 30 to finance the trip? PV30 = PMT (PVIFA .10, 5) (1.10) = = 250,000 (3.7908) (1.10) = = P 1,042,470.00
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250
250 30
P 1,042,466
Now, assuming 10.0% annual compounding, what monthly payments will be required for you to have P 1,042,466.00 at the end of year 30?
250 27 28 29 30
P 1,042,466.00
PMT = -P 461.17
So, you would have to place P 461.17 in your retirement account, which earns 10.0% annually, at the end of each of the next 360 months to finance the 5-year world tour.
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