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2
1he 8ole of 1lme value ln llnance
Most Iinancial decisions involve costs & beneIits that
are spread out over time.
Time value oI money allows comparison oI cash
Ilows Irom diIIerent periods.
Question: Your Iather has oIIered to give you some
money and asks that you choose one oI the Iollowing
two alternatives:
$1,000 today, or
$1,100 one year Irom now.
What do you do?
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3
1he 8ole of 1lme value ln llnance
(conL)
The answer depends on what rate oI interest you
could earn on any money you receive today.
For example, iI you could deposit the $1,000 today at
12 per year, you would preIer to be paid today.
Alternatively, iI you could only earn 5 on deposited
Iunds, you would be better oII iI you chose the
$1,100 in one year.
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llgure 1
1lme Llne
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llgure 2
Compoundlng and ulscounLlng
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llgure 3
CalculaLor keys
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$100/103 $1
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20
ersonal llnance Lxample
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llgure
resenL value 8elaLlonshlp
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AnnulLles
WAn annuity is a stream oI equal periodic cash Ilows,
over a speciIied time period. These cash Ilows can be
inflows oI returns earned on investments or outflows oI
Iunds invested to earn Iuture returns.
An 4rdinary (deferred) annuity is an annuity Ior which
the cash Ilow occurs at the end oI each period
An annuity due is an annuity Ior which the cash Ilow
occurs at the -eginning oI each period.
An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound
Ior an additional period.
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23
ersonal llnance Lxample
WFran Abrams is choosing which oI two annuities to receive.
Both are 5-year $1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due. Fran has listed the
cash Ilows Ior both annuities as shown in Table 5.1 on the
Iollowing slide.
noLe LhaL Lhe amounL of boLh annulLles LoLal $000
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2
1able 1 Comparlson of Crdlnary AnnulLy and AnnulLy
uue Cash llows ($1000 ?ears)
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2
llndlng Lhe luLure value of an
Crdlnary AnnulLy
You can calculate the Iuture value oI an ordinary
annuity that pays an annual cash Ilow equal to by
using the Iollowing equation:
As beIore, in this equation r represents the interest
rate and n represents the number oI payments in the
annuity (or equivalently, the number oI years over
which the annuity is spread).
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2
ersonal llnance Lxample
WFran Abrams wishes to determine how much money she will have at
the end oI 5 years iI he chooses annuity A, the ordinary annuity and it
earns 7 annually. Annuity A is depicted graphically below:
WThis analysis can be depicted on a time line as Iollows:
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2
ersonal llnance Lxample (conL)
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2
llndlng Lhe resenL value of an
Crdlnary AnnulLy
You can calculate the present value oI an ordinary
annuity that pays an annual cash Ilow equal to by
using the Iollowing equation:
As beIore, in this equation r represents the interest
rate and n represents the number oI payments in the
annuity (or equivalently, the number oI years over
which the annuity is spread).
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2
llndlng Lhe resenL value of an
Crdlnary AnnulLy (conL)
WBraden Company, a small producer oI plastic toys, wants to determine
the most it should pay to purchase a particular annuity. The annuity
consists oI cash Ilows oI $700 at the end oI each year Ior 5 years. The
required return is 8.
WThis analysis can be depicted on a time line as Iollows:
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1able 2 Long MeLhod for llndlng Lhe resenL
value of an Crdlnary AnnulLy
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llndlng Lhe resenL value of an
Crdlnary AnnulLy (conL)
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llndlng Lhe luLure value of an
AnnulLy uue
You can calculate the present value oI an annuity due
that pays an annual cash Ilow equal to by using
the Iollowing equation:
As beIore, in this equation r represents the interest
rate and n represents the number oI payments in the
annuity (or equivalently, the number oI years over
which the annuity is spread).
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33
ersonal llnance Lxample
WFran Abrams now wishes to
calculate the Iuture value oI an
annuity due Ior annuity B in
Table 5.1. Recall that annuity B
was a 5 period annuity with the
Iirst annuity beginning
immediately.
WNote: BeIore using your calculator
to Iind the Iuture value oI an
annuity due, depending on the
speciIic calculator, you must either
switch it to BIN mode or use the
DU key.
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3
ersonal llnance Lxample (conL)
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3
llndlng Lhe resenL value of an
AnnulLy uue
You can calculate the present value oI an ordinary
annuity that pays an annual cash Ilow equal to by
using the Iollowing equation:
As beIore, in this equation r represents the interest
rate and n represents the number oI payments in the
annuity (or equivalently, the number oI years over
which the annuity is spread).
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3
llndlng Lhe resenL value of an
AnnulLy uue (conL)
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3
MaLLer of lacL
Wansas truck driver, Donald Damon, got the surprise oI his liIe
when he learned he held the winning ticket Ior the !owerball
lottery drawing held November 11, 2009. The advertised lottery
jackpot was $96.6 million. Damon could have chosen to collect
his prize in 30 annual payments oI $3,220,000 (30 L $3.22
million $96.6 million), but instead he elected to accept a lump
sum payment oI $48,367,329.08, roughly halI the stated jackpot
total.
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llndlng Lhe resenL value of a
erpeLulLy
A 5er5etuity is an annuity with an inIinite liIe,
providing continual annual cash Ilow.
II a perpetuity pays an annual cash Ilow oI CF,
starting one year Irom now, the present value oI the
cash Ilow stream is
!' r
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3
ersonal llnance Lxample
WRoss Clark wishes to endow a chair in Iinance at his
alma mater. The university indicated that it requires
$200,000 per year to support the chair, and the
endowment would earn 10 per year. To determine the
amount Ross must give the university to Iund the chair,
we must determine the present value oI a $200,000
perpetuity discounted at 10.
!' $200,000 0.10 $2,000,000
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0
luLure value of a Mlxed SLream
WShrell Industries, a cabinet manuIacturer, expects to
receive the Iollowing mixed stream oI cash Ilows over
the next 5 years Irom one oI its small customers.
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luLure value of a Mlxed SLream
WII the Iirm expects to earn at least 8 on its investments, how
much will it accumulate by the end oI year 5 iI it immediately
invests these cash Ilows when they are received?
WThis situation is depicted on the Iollowing time line.
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2
luLure value of a Mlxed SLream
(conL)
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3
resenL value of a Mlxed SLream
WFrey Company, a shoe manuIacturer, has been oIIered an
opportunity to receive the Iollowing mixed stream oI cash Ilows
over the next 5 years.
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locus on LLhlcs
W ow Fair Is Check Into Cash?
There are more than 1,100 Check Into Cash centers among an
estimated 22,000 payday-advance lenders in the United States.
A payday loan is a small, unsecured, short-term loan ranging Irom $100
to $1,000 (depending upon the state) oIIered by a payday lender.
A borrower who rolled over an initial $100 loan Ior the maximum oI
Iour times would accumulate a total oI $75 in Iees all within a 10-week
period.
On an annualized basis, the Iees would amount to a whopping 391.
The 391 mentioned above is an annual nominal rate |15 L
(365/14)|. Should the 2-week rate (15) be compounded to calculate
the eIIective annual interest rate?
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locus on racLlce
W New Century Brings Trouble Ior Subprime Mortgages
In 2006, some $300 billion worth oI adjustable ARMs were
reset to higher rates.
In a market with rising home values, a borrower has the option
to reIinance their mortgage, using some oI the equity created
by the homes increasing value to reduce the mortgage
payment.
But aIter 2006, home prices started a three-year slide, so
reIinancing was not an option Ior many subprime borrowers.
s a reaction to pro-lems in the su-prime area lenders
tightened lending standards. What effect do you think this had
on the housing market?
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