Fabricio Chala, CFA, FRM

Time Value of
Money S3
Review: Interest Rates
❖  Interest can have different dimensions:

❖  Daily ❖  Simple

❖  Monthly
r ❖  Compound

❖  Annual ❖  ACT / 360

❖  ACT / 365 (aka ACT / ACT)

❖  …? ❖  30 / 360
❖  …?
Review: PV and FV
❖  Hot to calculate Future Value:

❖  How to calculate Present Value:

Review: Additivity Principle
❖  IMPORTANT: Amounts of money indexed at the same
point in time are additive
Annuity
❖  An Annuity is a finite set of level sequential cash flows.
❖  Ordinary Annuity:
CF CF CF

Today Year 1 … Year “n”

A⎡ ⎛ 1 ⎞ ⎤
N
A
FV = ⎡⎣(1+ r) − 1⎤⎦
N
PV = ⎢1− ⎜ ⎟ ⎥
r r ⎣ ⎝ 1+ r ⎠ ⎦

Where A is the regular Cash Flow in any period.

❖  What about an Annuity that starts today?

Annuity: Examples
❖  You decided to buy a car on credit. The bank offered you a loan in which you will
have to pay $ 4,800 annually at a 7% interest rate for 3 years. How much did you
pay for the car?
Annuity: Examples
❖  You decided to buy a car on credit. The bank offered you a loan in which you will
have to pay $ 4,800 annually at a 7% interest rate for 3 years. How much did you
pay for the car?

PV = cost of car
A= 4,800
r= 7%
A⎡ ⎛ 1 ⎞ ⎤
N
N= 3
PV = ⎢1− ⎜ ⎟ ⎥
r ⎣ ⎝ 1+ r ⎠ ⎦
Numerator 0.183702123
PV = 12,596.72
Annuity: Examples
❖  Yesterday you bought a flat and have agreed to pay $ 400 per month at a 7.2%
interest rate compounded monthly for 3 years. How much was the downpayment
if the flat cost you $ 15,000?
Annuity: Examples
❖  Yesterday you bought a flat and have agreed to pay $ 400 per month at a 7.2%
interest rate compounded monthly for 3 years. How much was the downpayment
if the flat cost you $ 15,000?

PV = loan for apt

A= 400
r/m = 0.60%
mxN = 36
A ⎡ ⎛ ⎤
m.N
1 ⎞
PV = ⎢1− ⎜⎝ ⎟⎠ ⎥ Numerator 0.193744493
r/m⎣ 1+ r / m ⎦ PV = 12,916.30
Value of apt = 2,083.70
Annuity: Application to loans
❖  Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with yearly payments.
Please, write down the loan’s payment schedule.
Annuity: Application to loans
❖  Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with yearly payments.
Please, write down the loan’s payment schedule.

Debt
Period Outstanding Payment Interest Capital New Debt
1 200,000 83,270 24,000 59,270 140,730

2 140,730 83,270 16,888 66,382 74,348

3 74,348 83,270 8,922 74,348 0

Annuity: Application to loans
❖  Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with semi-annual
payments. Please, write down the loan’s payment schedule.
Annuity: Application to loans
❖  Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with semi-annual
payments. Please, write down the loan’s payment schedule.

Semester Debt Outstanding Payment Interest Capital Remaining Debt

1 200,000 40,673 12,000.00 28,673 171,327
2 171,327 40,673 10,279.65 30,393 140,935
3 140,935 40,673 8,456.08 32,216 108,718
4 108,718 40,673 6,523.09 34,149 74,569
5 74,569 40,673 4,474.12 36,198 38,370
6 38,370 40,673 2,302.22 38,370 0
Growing Annuity

CF CF*(1+g) CF*(1+g)n-1

Today Year 1 … Year “n”

A ⎡ ⎛ 1+ g ⎞ ⎤
N

PV = ⎢1− ⎜⎝ ⎟⎠ ⎥
r−g⎣ 1+ r ⎦

❖  Where: g= growth rate

Growing Annuities: Examples
❖  A retirement plan offers an annual payment of $ 40,000 for 20 years. This
payment will increase at a 2% rate every year. Please, calculate the
Present Value of the retirement plan if the discount rate is 10.0%
Growing Annuities: Examples
❖  A retirement plan offers an annual payment of $ 40,000 for 20 years. This
payment will increase at a 2% rate every year. Please, calculate the
Present Value of the retirement plan if the discount rate is 10.0%

PV = value today of flows

A ⎡ ⎛ 1+ g ⎞ ⎤
N A= 40,000
PV = ⎢1− ⎜⎝ ⎟⎠ ⎥
r= 10%

r−g⎣ 1+ r ⎦ N=
g=
20
2%

PV = 389,561.69
Annuities: Examples
❖  You decided to buy a car on credit. The bank offered you a loan in which
you will have to pay $ 4,800 annually at a 7% interest rate for 3 years.
How much did you pay for the car?
❖  Yesterday you bought a flat and have agreed to pay $ 400 per month at a
7.2% interest rate compounded monthly for 3 years. How much was the
downpayment if the flat cost you $ 15,000?
❖  A retirement plan offers an annual payment of $ 40,000 for 20 years. This
payment will increase at a 2% rate every year. Please, calculate the
Present Value of the retirement plan if the discount rate is 10.0%
❖  Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and
the loan (including interest) has to be canceled in 3 years with yearly
payments. Please, write down the loan’s payment schedule.
Perpetuity
❖  An ordinary annuity that extends indefinitely

∞
A⎡ ⎛ 1 ⎞ ⎤ A
N
A
PV = ∑ n = lim ⎢1− ⎜⎝ ⎟⎠ ⎥ =
n=0 (1+ r ) n→∞ r ⎣ 1+ r ⎦ r
Example: UK Consol Bonds, some types of preferred stocks

❖  PV of a ordinary annuity = Difference between PVs of Perpetuities

❖  A growing perpetuity at a rate of “g”:

PV = A / (r – g)
Perpetuities: Examples

❖  What is the PV of a perpetual Disney bond that pays $ 10 yearly

and its discount rate is 5.0%?

❖  Many analysts expect Coca Cola’s next year dividend to be $1.30

and they believe that dividends will grow at a constant rate of 5.0%
in perpetuity. If the discount rate is 10%, calculate the present
value of the future dividends

❖  Given a 5% discount rate, find the present value of a three-year

ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities
Perpetuities: Examples
❖  What is the PV of a perpetual Disney bond that pays $ 10 yearly
and its discount rate is 5.0%?

A= 10
r= 5%
A
PV = PV = 200
r
Perpetuities: Examples
❖  Many analysts expect Coca Cola’s next year dividend to be $1.30
and they believe that dividends will grow at a constant rate of 5.0%
in perpetuity. If the discount rate is 10%, calculate the present
value of the future dividends

❖  Given a 5% discount rate, find the present value of a three-year

ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities
Perpetuities: Examples
❖  Many analysts expect Coca Cola’s next year dividend to be $1.30
and they believe that dividends will grow at a constant rate of 5.0%
in perpetuity. If the discount rate is 10%, calculate the present
value of the future dividends.

A= 1.3
r= 10%
A g= 5%
PV =
r−g PV = 26.0
Perpetuities: Examples
❖  Given a 5% discount rate, find the present value of a three-year
ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities
Perpetuities: Examples
❖  Given a 5% discount rate, find the present value of a three-year
ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities

Year 1 2 3 4 5 …
Perpetuity 1 1,000 1,000 1,000 1,000 1,000 1,000
Perpetuity 2 1,000 1,000 1,000

Value of Perpetuity 1 20,000

Value of Perpetuity 2 17,277
Perpetuity 1 - Perpetuity 2 2,723.25
Solving for…
❖  Rates

❖  Number of Periods

❖  Size of Annuity Payments