= _ The Time Value of Money Key Concepts > Interest Calculation > The future value of an investment made today > The present value of cash to be received at some future date > The return on an investment > The number of periods that equates a present value and a future value given an interest rate > Effect of compounding more than once a year > Quoted rate vs. effective rate 21. Interest Rate > Three components of interest: * Principal * Interest rate + Investment horizon (Time) > Two ways to calculate interests: * Simple Interest Calculation + Compound Interest Calculation ex) $100 to invest (principal) at 10% annual interest. What will be the value of investment in three years? Simple Interest Year one, interest = $100 x .10 = $10 value of investment = $100 + $10 x 1=$110 Year two, interest = $100 x .10 = $10 value of investment = $100 + $10 + $10 = $120 Year three, interest = $100 x .10 = $10 value of investment = $100 + $10 + $10 + $10 = $130ex) $100 to invest (principal) at 10% annual interest. What will be the value of investment in three years? Compound Interest Year one, interest = $100 x .10=$10 value of investment = $100 + $10 = $110 Year two, interest = $100 x .10 + $10 x .10= S11 value of investment = $100 + $10 + $11 = $121 Year three, interest = $100 x .10 + $21 x 10 += $12.1 value of investment = $100 + $10 + $11 + $12.1= $133.1 Example: $100 invested at 10% for five years Beginning Simple Total Enaing Yeor Amount’ Interest Interest Earned Amount 1 ‘$100.00 ‘10 ‘$10.00 ‘s110.00 2 +1000 10 11.00 121.00 3 121.00 10 1210 133.10 4 138.10 10 1331 146.41 5 146.41 10 1484 161.05 otal $50 Total $11.05 Total $61.06 simple compound interest interest interestvalue of j investment dra Compounding » The total value of an investment of some principal amount at an (compound) interest rate, “r’, after ‘t’ years equals to: Value of investment = principal x (1+interest rate)* > ‘interest on interest’2. Present Value and Future Value > Future Value — the amount to which an investment grows after earning interest. > Present Value — the current value of future cash flows discounted at the appropriate interest rate. > Interest rate — “exchange rate” between the present value and the future value Future Value Formula > FV=PV(1+ Fr) + FV = future value + PV =present value + r=period interest rate, expressed as a decimal + t= number of periods > Future value interest factor (FVIF) = (1 + rtFuture Value Example > Suppose you invest $1,000 for one year at 5% per year. What is the future value in two years? + FV, = 1000(1.05)(1.05) = 1000(1.05)?= 1,102.50 Future Value Interest Factors (F VIF) Interest Rate ‘Number of Periods 5% 10% 15% 1 1.0500 1.1000——*1.1500 2 14025 1.2100 1.8225 2 1.4676 1.9310 1.6200 4 1.2185 1.4641 1.7490 5 1.2763 1.6105 = 2.0114Future ofS) 20% 10% Discounting Discounting: the process to find the present value of a future cash flow (discounted at the appropriate interest rate). Example) Suppose you need $133.10 in three years, and you know the fair market interest is 10% on your money. How much do you have to invest today to reach your goal? ‘How much now? $133.10 in 3 yrs.Present Value Formula >pv=— (1+r)é + FV = future value + PV =present value + r= discount rate, expressed as a decimal + t= number of periods 1 a+ry > Present value interest factor (PVIF) = Geers) Figure: Present Value, Discount Rate, and Time: As the length of time until payment grows, present values decline. As shown in the above figure, present values {end to become smaller as the time horizon grows. Also, for given length of time, the higher the discount rate is, the lower is the present value.Present Value Example Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today? Example: Present Value Example Mr. Smart, who works for a securities firm, has just been selected by his employer to start his MBA education in one year with financial support from the company. The tuition and fees of MBA education is expected to be $50,000 in the first year and $52,000 in the second year. Assuming that all expenses occur at the beginning of each year, calculate the present value of the support he will get from his employer. The current market interest rate is 2%.$B Worst (or Smart?) MLB Contract Ever Deferred money makes Chris Davis deal look better for the Orioles The Orioles have a seven year, $161 million contract with Chris Davis, but $42 million of that money is deferred. That changes the picture a lot and makes for a better deal for the Orioles In January 2016, Orioles signed with Chris Davis a seven year contract worth $161 million dollars. That probably conjured an idea in your mind. that the Orioles would be paying Davis $23 million per year for the seven ‘years of the contract. It tured out that the contract had deferred a significant amount of its value beyond Davis's playing career. The Orioles deferred a total of $42 million dollars of the contract: the O's ch will pay Davis $17 million per year for the seven contracted years. year, $6 million is deferred. ‘The money will come due eventually, with Davis structured to receive a $3.5 million payment each year from 2023-32, with an additional $1.4 terest-free deferral, million coming each year from 2033-37. That is a which is actually a pretty big victory for the Orioles. 10Yer Detered | Att Payment | POSH 26 Sseoomes] —_sr7eeneee| sts sear a Sseonee8| _srzsene00] sisarosey s23.00.008] —soovnovo| _sv7.00.ee| 5145.25] 523,000.000] sooveoeo] s17.200.000] s15.905902 zie | s2ne008e8| seaenoe0] _sv7a00nee| #1831936 arat_ | szasenees| seasneo] _sv7asnsee| _ s1z5.0 ‘arz_|sz3soneee| seasaeo| _st7sennee| S120] 2 5350.00) s236a909 2 $3,500900] _s2a561 25 53500000] $2,148.65 26 ‘saseesee| s2eteare aR 0.0 535004 51.56.23] 33500900] #17677] 20. 3500900] $1680 28 sasesee] s1era.aze 2a ‘saseenee] _ sisrraz 2a sia00.0 0,723 2m 5109.00 54.02 2885 51.09.90 $2755 26 51.09.09 502515] 287 5100.09 ses] “eur Freteoo Tistevesee| —_ size210.74] 3. Return on an Investment » 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 +9)! r=(FV/PV)!-1 > Ifyou are using the above formula, you will want to make use of both the y* and the I/x keys in your calculator.Discount Rate Example You are looking at an investment that will pay $1,200 in 5 years if you invest $1000 today. What is the implied rate of interest? B In 1934, the first edition of a book described by many as the “bible” of financial statement analysis was published. Security Analysis has proven so popular among financial analysts that it has never been out of print, According to an item in The Wall Street Journal, a copy of the first edition was sold by a rare book dealer in 1996 for $7,500. The original price of the first edition was $3.37. What is the annually compounded rate of inerease in the value of the book? Pn4. Finding the Number of Years Start with the TVM equation and solve for t (remember you use natural log) FV=PV(1+r)' t=In(FV / PV) /In(1 +n) Example: Finding the number of years You want to purchase a new car and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car?Practice Question > An analyst projects that the stock price of Best Electronics Co. will increase by 8% per year for the foreseeable future, The stock currently sells at 46,900. If the analyst’s projection holds true, how many years will you have to wait from today until the stock price reaches W4Million? ‘WSMillion? » 5. The Effect of Compounding More Than Once a Year Until now we have assumed that we pay interest once a year (i.e., compounding once a year). What if the compounding interval is less than a year, or we compound more than once in a year? Is paying 10% a year equal to paying 5% every six months? 28 14Suppose the annual quote rate of an investment is 10%. Let’s see how much our investment of $1 grows as we change the compounding interval. (1) 10% annual compounding for 1 year is: $1 x (1.10)=$1.10 (2) 10% semiannual compounding: $1 x (1.05) x (1.05) =$1 x (1.05)?=$1.1025 (3) 10% Quarterly compounding: $1 x (1.025)! = $1.1038 (4) 10% Monthly compounding: $1 x (1.0083)!2= $1.1043 2» Quoted Rate vs. Effective Rate > Quoted or Stated (Annual) Interest Rate: The annual rate expressed in terms of the interest payment made each period. » Effective Annual Rate: The interest rate expressed as if it were compounded once per year.In general, an investment of $1 at a stated interest rate ‘r’ per annum compounded ‘m’ times a year amounts to : r m EAR -(14+7) =i m 3 EAR Questions Q. Depending on the issuer, a typical credit card agreement quotes an interest rate of 25 to 29% APR on the revolving balance. Monthly payments are required. What is the actual interest rate you pay on such a credit card?Compounding Times ‘Actual annual Interval Compounding rate you earn Annual 1 10.000000% Quarterly 4 10.381289% Monthly 12 10.471307% Weekly 52 10.506479% Daily 365 10.515578% By Hour 8,760 10.517029% By Minute 525,600 10.517091% By Second 31,536,000 10.517092% By Mili-second 3,153,600,000 10.517076% 1/ « (continuous) © 10.517092% 33 Extreme Case of Compounding: Continuous Compounding What about compounding infinitely (20) during the year or compounding continuously? Continuous compounding FAR =lim| 1+] -1 = e'-1 a where e = 2.71828. 34 17Continuous Compounding Example > What is the effective annual rate of 10% interest rate compounded continuously? The future value of an investment at annual (stated) rate r compounded m times a year over t years equals: PV, = PV x (1+ sr The present value of a future value discounted at annual (stated) rate r compounded m times a year over t years equals: py =—“ (og)Practice Questions Q. Ifyou deposit $1,000 in a 4% savings account that pays interests quarterly over the next 5 years, how much will you get in 5 years? Q. How much will you have to deposit now in a saving account that pays 4% a year to have $10,000 from the account ten years from now? The account pays interests monthly. 37 19