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4-1
McGraw-Hill/Irwin
Chapter Outline
4.1 Future Value and Compounding
4.2 Present Value and Discounting
4.3 More on Present and Future Values
Solving for:
Implied interest rate
Number of periods
4-3
Basic Definitions
Present Value
(PV)
Future Value
(FV)
Basic Definitions
Interest rate (r)
Discount rate
Cost of capital
Opportunity cost of capital
Required return
Terminology depends on usage
4-5
Time 0 is today;
Time 1 is the end of Period 1
CF1
CF2
CF3
r%
CF0
PMT = Constant CF
4-6
r%
2 Year
100
4-7
= 100(1.10)2 = 121.00
4-10
Effects of Compounding
Simple interest
Interest earned only on the original
principal
Compound interest
Interest earned on principal and on
interest received
Interest on interest interest earned
on reinvestment of previous interest
payments
Return 4-11
to Quiz
Effects of Compounding
Consider the previous example
FV w/simple interest
= 100 + 10 + 10 = 120
FV w/compound interest
=100(1.10)2 = 121.00
The extra 1.00 comes from the interest
of .10(10) = 1.00 earned on the first
interest payment
4-12
,
.
/
0
4-13
4-15
4-16
=PV(1+r)t
=100(1.10)5
=100(1.6105)
=161.05
Table 4.1
4-19
Figure 4.1
4-20
4-21
= 10(1.055)200
=10(44718.984)
=447,189.84
Calculator Solution
200
,
5.5
10
S.
0
/
%0
= 447,189.84
4-23
=PV(1+r)t
=3(1.15)5
=3(2.0114)
=6.0341 million
Calculator Solution
5 ,
15 3 .
0 /
%0
= -6.0341
4-24
Future Value:
Important Relationship I
For a given interest rate:
The longer the time period,
The higher the future value
FV = PV(1 + r)t
For a given r, as t increases, FV increases
4-25
Future Value
Important Relationship II
For a given time period:
The higher the interest rate,
The larger the future value
FV = PV(1 + r)t
For a given t, as r increases, FV increases
4-26
Figure 4.2
4-27
Present Values
The current value of future cash flows
discounted at the appropriate discount rate
Value at t=0 on a time line
Answers the questions:
How much do I have to invest today to have
some amount in the future?
What is the current value of an amount to be
received in the future?
4-29
Present Values
Present Value = the current value of
an amount to be received in the future
Why is it worth less than face value?
Opportunity cost
Risk & Uncertainty
Discount Rate = (time, risk)
4-30
Time 0 is today;
Time 1 is the end of Period 1
CF1
CF2
CF3
r%
CF0
PMT = Constant CF
4-31
Present Values
FV = PV(1 + r)t
Rearrange to solve for PV
PV = FV / (1+r)t
PV = FV(1+r)-t
Discounting = finding the present value
of one or more future amounts.
Return
to Quiz 4-32
10%
PV = ?
100
10-
0/
1000
%. = 4-33
=FV(1+r)-t
=10,000(1.07)-1
=10,000/1.07
=9,345.79
Calculator Solution
1
,
7
0
/
10000 0
%. = -9345.79
4-34
=FV(1+r)-t
=150,000(1.08)-17
=150,000/(1.08)17
=-40,540.34
Calculator Solution:
17
,
8
0
/
150000 0
%. = -40540.34
4-35
=FV(1+r)-t
=19,671.51(1.07)-10
=19.671.51/(1.07)10
=-10,000
Calculator Solution:
10
,
7
0
/
19671.51 0
%. = -10000
Present Value:
Important Relationship I
For a given interest rate:
The longer the time period,
The lower the present value
FV
PV
t
(1 r )
For a given r, as t increases, PV decreases
4-37
Present Value:
Important Relationship I
What is the present value of $500 to be
received in 5 years? 10 years? The
discount rate is 10%
0
-310.46
-192.77
PV?
r=10%
10
500
PV?
500
(1.10)5 =1.6105
(1.10)10 = 2.5937
4-38
Present Value
Important Relationship II
For a given time period:
The higher the interest rate,
The smaller the present value
FV
PV
t
(1 r )
For a given t, as r increases, PV decreases
4-39
Present Value:
Important Relationship II
What is the present value of $500 received
in 5 years if the interest rate is 10%? 15%?
Rate = 10%
Calculator Solution:
5
,
10
0
/
500
0
%. = -310.46
Rate = 15%
Calculator Solution:
5
,
15
0
/
500
0
%. = -248.59
4-40
Figure 4.3
4-41
4-43
Discount Rate
To find the implied interest rate,
rearrange the basic PV equation and
solve for r:
FV = PV(1 + r)t
r = (FV / PV)1/t 1
If using formulas with a calculator, make
use of both the yx and the 1/x keys
4-44
4-45
6
,
10000
S.
0
/
20000
0
%= 12.25%
Excel: =RATE(6,0,-10000,20000) = 0.1225
4-46
Calculator:
17 ,;5000 S.;0 /; 75000 0 %- = 17.27%
FV = PV(1 + r)t
FV
ln
PV
t
ln(1 r )
Calculator: %,
Excel:
Calculator Solution:
10 -; 15000 S .;20000 0;
%, = 3.02 years
Excel: =NPER(0.10,0,-15000,20000)= 3.02
4-50
PV
t
ln(1 r )
Formula Solution:
FV/PV = 20,000/15,000 = 1.333
ln(1.333) = 0.2877
ln(1.10) = 0.0953
t = 0.2877/0.0953 = 3.0189
4-51
Table 4.4
4-54
0/
%0
0/
=PV(.06, 3, 0, 15000)
Return
to Quiz
4-56
15000 0
0/
Return
to Quiz 4-57
500 S.
0/
600 0
%-
r = (600/500)1/5 - 1 = 3.714%
=RATE(5, 0, -500, 600)
The bank account pays a higher rate.
Return
to Quiz 4-58
0/
600 0
%,
Chapter 4
END
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