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Week 3

1) The document discusses the time value of money, including compound interest, present values, and future values. 2) Key concepts covered are compound interest, calculating present and future values using formulas, and the effects of compounding over time. 3) Examples are provided to demonstrate how to calculate future values for investments earning interest over multiple periods.

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jc c
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24 views

Week 3

1) The document discusses the time value of money, including compound interest, present values, and future values. 2) Key concepts covered are compound interest, calculating present and future values using formulas, and the effects of compounding over time. 3) Examples are provided to demonstrate how to calculate future values for investments earning interest over multiple periods.

Uploaded by

jc c
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 3:

Time Value of Money

Prof. Chiyoung Cheong


Time Value of Money:
Compound Interest, Present & Future Values
Objectives:
• Master the concept of compound interest
• Work the algebra and lots of examples

Text:
• Chapter 4
Quick Math Review: Exponents
Assuming a, b > 0; a, b  1; and x and y are any real numbers :
1. a x a y = a x+y
2. 1 / a x = a -x
3. a x / a y = a x-y
4. (a x) y = a xy
5. a x b x = (ab) x
6. a x / b x = (a / b) x
LOGARITHMIC FUNCTIONS
• The inverse of the exponential function.
•x = a y  y = loga x

Natural Log: logarithrnic to base e ( 2.71828)


x = ey  y = ln x
Time Value of Money Definitions and Rules
• Present Value – earlier money on a time line
• Future Value – later money on a time line
• Interest rate – “exchange rate” between earlier money and
later money
– We also refer to the interest rate as the Discount rate, Cost
of capital, Opportunity cost of capital, Required return

• Rules
1. Only cash flows that occur at the same point in time can be
compared
2. To move a cash flow forward you must compound
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3. To move a cash flow backward you must discount
Aziz Alimov
Notation

• Time Convention:
• – 0 Today, or Right Now.
• – 1 Next period, for example day or year
• – n Some time period (in the future).
• – N (or T) often to denote a final time period.

• Return - Rate of Return- Interest rate


• r rate of return.
Basic Definitions
• Present Value (PV)
– The current value of future cash flows
discounted at the appropriate discount rate
– Value at t=0 on a time line
• Future Value (FV)
– The amount an investment is worth after one
or more periods.
– “Later” money on a time line
Basic Definitions
• Interest rate (r)
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
– Terminology depends on usage
Time Line of Cash Flows
•Tick marks at ends of periods
• Time 0 is today;
• Time 1 is the end of Period 1
0 1 2 3
r%

CF0 CF1 CF2 CF3


+CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF
Time Value of Money
Time Value of Money (TVM) is key to valuation of
projects and securities. It is the fundamental tool
you should learn in this class! Two basic rules:
1) Dollar today is worth more than a dollar in the future
2) Safe dollar is worth more than a risky dollar

Let’s ignore risk for now and consider the following


pair of sure things:

Easy: $100 today vs. $105 today


Less Easy: $100 today vs. $105 next year
Future Values
• Suppose you invest $1,000 for one year at 5% per
year. What is the future value in one year?
– Interest = =
– Value in one year = principal + interest = +
=
– Future Value (FV) = =
• Suppose you leave the money in for another year.
How much will you have two years from now?
▪ FV = = =

▪ DRAW A TIMELINE!

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Future Values: General Formula
• FV = PV(1 + r)t
– FV = future value
– PV = present value
– r = period interest rate, expressed as a decimal
– T = number of periods
• Future value interest factor = (1 + r)t

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Effects of Compounding
• Simple interest (interest is earned only on the
original principal)
• Compound interest (interest is earned on
principal and on interest received)
• Consider the previous example
– FV with simple interest = $1,000 + 50 + 50 = $1,100
– FV with compound interest = $1,102.50
– The extra $2.50 comes from the interest of .05($50)
= $2.50 earned on the first interest payment

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Figure 4.1

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Figure 4.2

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Using A Financial Calculator
• Texas Instruments BA-II Plus (Other calculators are similar)
– FV = future value
– PV = present value
– I/Y = period interest rate
• P/Y must equal 1 for the I/Y to be the period rate
• Interest is entered as a percent, not a decimal
– N = number of periods
– Remember to clear the registers (CLR TVM) before (and after)
each problem

• In your answers, you should report 2 decimal points


Present Values
• How much do I have to invest today to have some
amount in the future?
▪ FV = PV(1 + r)t
▪ Rearrange to solve for PV = FV / (1 + r)t
▪ PV interest factor = 1 / (1 + r)t
• When we talk about discounting, we mean finding
the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

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Summary: Present and Future Value
Formulas (single cash flow)
CFn
PV0 =
(1 + r ) n
FVn = CF (1 + r ) n

where
CF or C is cash flow
n is the number of time periods and
r is the discount rate per period
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More Frequent Compounding
Semi-Annual Compounding:
FVn years from now = PV (1+ rsemiannual ) 2n
Quarterly Compounding:
FVn years from now = PV (1+ rquarterly ) 4n

 Monthly Compounding:
FVn years from now = PV (1+ rmonthly )12n
 Daily Compounding:
FVn years from now = PV (1+ rdaily ) 365n


Discount Rate
• Often, we will want to know what the
implied interest rate is in an investment
• Rearrange the basic PV equation and solve
for r
▪ FV = PV(1 + r)t
▪ r = (FV / PV)1/t – 1
• If you are using formulas, you will want to
make use of both the yx and the 1/x keys

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Finding the Number of Periods
• Start with basic equation and solve for t
(remember your logs)
▪ FV = PV(1 + r)t
▪ t = ln(FV / PV) / ln(1 + r)
• You can use the financial keys on the
calculator as well.
– ln is the natural logarithm and can be found on
the calculator.
– Just remember the sign convention.

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