McGraw-Hill/I rwin

Copyright 2012 by The McGraw-Hill Companies, I nc. All rights reserved.

5-2
Money has a time value. It can be expressed in
multiple ways:

A dollar today held in savings will grow.

A dollar received in a year is not worth as much as a dollar
received today.
Time Value of Money
5-3
Future Values
Future Value: Amount to which an investment will grow
after earning interest.

Let r = annual interest rate
Let t = # of years

Simple Interest Compound Interest


FV = Initial investment (1 )
t
Compound
r +
FV = Initial investment (1 )
Simple
r t +
5-4
Simple Interest: Example
Interest earned at a rate of 7% for five years on a
principal balance of $100.

Example - Simple Interest
Today Future Years
1 2 3 4 5
Interest Earned
Value 100
Value at the end of Year 5: $135
7
107
7
114
7
121
7
128
7
135
5-5

Interest earned at a rate of 7% for five years on the
previous years balance.

Example - Compound Interest
Today Future Years
1 2 3 4 5
Interest Earned
Value 100


Compound Interest: Example
7
107
7.49
114.49
8.01
122.50
8.58
131.08
9.18
140.26
Value at the end of Year 5 =$140.26
5-6
The Power of Compounding
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
1 6 11 16 21 26 31 36
F
u
t
u
r
e

V
a
l
u
e

Year
Simple Interest
Compound Interest
Interest earned at a rate of 7% for the first forty years on
the $100 invested using simple and compound interest.
5-7
Present Value
What is it?
Why is it useful?
5-8
Present Value
Present Value:
Discount Rate:
Discount Factor:
1
(1 )
t
r
PV FV
+
=
1
(1 )
t
r
DF
+
=
Recall: t = number of years
r
5-9
Present Value: Example
Example
Always ahead of the game, Tommy, at 8 years old, believes
he will need $100,000 to pay for college. If he can invest at a
rate of 7% per year, how much money should he ask his rich
Uncle GQ to give him?
10
1
(1.07)
1
$100, 000 $50,835
(1 )
t
PV FV
r
= = ~
+
Note: Ignore inflation/taxes
$100, 000 10 7% FV t yrs r = = =
5-10
The PV formula has many applications. Given
any variables in the equation, you can solve for
the remaining variable.
1
(1 )
t
r
PV FV
+
=
Time Value of Money
(applications)
5-11
0
20
40
60
80
100
120
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
P
V

o
f

$
1
0
0
0%
5%
10%
15%
Present Values: Changing Discount Rates
Discount Rates
The present value of $100 to be received in 1 to 20 years at varying discount rates:
5-12
PV of Multiple Cash Flows
1 2
1 2
(1 ) (1 ) (1 )
....
t
t
C C C
r r r
PV
+ + +
= + + +
The present value of multiple cash flows can be calculated:
1
2
:
The cash flow in year 1
The cash flow in year 2
The cash flow in year t (with any number of cash flows in between)
t
Denote
C
C
C
=
=
=
Recall: r = the discount rate
5-13
Multiple Cash Flows: Example
Example
Your auto dealer gives you the choice to pay $15,500 cash now or
make three payments: $8,000 now and $4,000 at the end of the
following two years. If your cost of money (discount rate) is 8%, which
do you prefer?

1
2
4,000
1
(1 .08)
4,000
2
(1 .08)
Initial Payment* 8,000.00
3, 703.70
3, 429.36
Total PV $15,133.06
PV of C
PV of C
+
+
= =
= =
=
* The initial payment occurs immediately and therefore would not be discounted.
5-14
Perpetuities
Let C = Yearly Cash Payment
PV of Perpetuity:




C
r
PV =
What are they?
Recall: r = the discount rate
5-15
Perpetuities: Example
Example :
In order to create an endowment, which pays $185,000 per year
forever, how much money must be set aside today if the rate of
interest is 8%?



What if the first payment wont be received until 3 years from
today?
185,000
.08
$2, 312, 500 PV = =
2
2,312,500
(1 .08)
$1, 982, 596 PV
+
= =
5-16
Annuities
What are they?
Annuities are equally-spaced, level streams of cash flows
lasting for a limited period of time.
Why are they useful?
5-17
Present Value of an Annuity
Let:
C = yearly cash payment
r = interest rate
t = number of years cash payment is received
1 1
(1 )
t
r
r r
PV C
+
(
=

The terms within the brackets are
collectively called the annuity factor.

5-18
Annuities: Example
Example:
You are purchasing a home and are scheduled to make 30
annual installments of $10,000 per year. Given an interest
rate of 5%, what is the price you are paying for the house
(i.e. what is the present value)?
30
1 1
.05
.05(1 .05)
$10, 000
$153, 724.51
PV
PV
+
(
=

=
5-19
Future Value of Annuities
Example - Future Value of annual payments
You plan to save $4,000 every year for 20 years and then retire.
Given a 10% rate of interest, how much will you have saved
by the time you retire?
20
20
1 1
.10
.10(1 .10)
$4, 000 (1 .10)
$229,100
FV
FV
+
(
= +

=
5-20
Annuity Due
How does it differ from an ordinary annuity?




What is it?
Recall: r = the discount rate
(1 )
Annuity Due Annuity
FV FV r = +
How does the future value differ from an ordinary annuity?



(1 )
Annuity Due Annuity
PV PV r = +
5-21
Annuities Due: Example
) 1 ( r FV FV
Annuity AD
+ =
Example: Suppose you invest $429.59 annually at the
beginning of each year at 10% interest. After 50 years,
how much would your investment be worth?
000 , 550 $
) 10 . 1 ( ) 000 , 500 ($
) 1 (
=
=
+ =
AD
AD
Annuity AD
FV
FV
r FV FV
5-22
Interest Rates: EAR & APR
What is EAR?


What is APR?


How do they differ?
5-23
*where MR = monthly interest rate
EAR & APR Calculations
1 ) 1 (
12
+ = MR EAR
Effective Annual Interest Rate (EAR):
Annual Percentage Rate (APR):
12 = MR APR
5-24
EAR and APR: Example
Example:
Given a monthly rate of 1%, what is the Effective Annual
Rate(EAR)? What is the Annual Percentage Rate (APR)?


% 00 . 12 ) 12 ( ) 01 . 0 (
% 68 . 12 1 ) 01 . 1 (
12
= =
= =
APR
EAR
5-25
Inflation
What is it?
What determines inflation rates?
What is deflation?
5-26
Inflation and Real Interest
1+nominal interest rate
1+inflation rate
1 real interest rate= +
Exact calculation:
Approximation:
rate inflation - rate interest nominal rate interest Real ~
5-27
Inflation: Example
Example
If the nominal interest rate on your interest-bearing savings account is
2.0% and the inflation rate is 3.0%, what is the real interest rate?
1+.02
1+.03
1 real interest rate=
1 real interest rate= 0.9903
real interest rate = -.0097 or -.97%
Approximation = .02-.03 = .01 1%
+
+
=
5-28
Appendix A: Inflation
Annual U.S. Inflation Rates from 1900 - 2010