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Lecture 2

The document discusses various topics related to time value of money calculations including: - Future value and compound interest calculations where interest is earned on both the principal and previous interest amounts. - Present value calculations which determine the current amount needed to be invested to achieve a future value, given a discount rate. - Calculations involving multiple cash flows which use compound interest formulas to determine the future or present value of multiple deposits/payments occurring at different points in time. - The relationship between future and present value calculations and how the formulas can be rearranged based on knowing either the future or present value amount.

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Samantha Yu
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Download as PPT, PDF, TXT or read online on Scribd
45 views

Lecture 2

The document discusses various topics related to time value of money calculations including: - Future value and compound interest calculations where interest is earned on both the principal and previous interest amounts. - Present value calculations which determine the current amount needed to be invested to achieve a future value, given a discount rate. - Calculations involving multiple cash flows which use compound interest formulas to determine the future or present value of multiple deposits/payments occurring at different points in time. - The relationship between future and present value calculations and how the formulas can be rearranged based on knowing either the future or present value amount.

Uploaded by

Samantha Yu
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 4

Chapter 5 in the 5th edition

Future Values and Compound Interest

Present Values

Multiple Cash Flows

Perpetuities and Annuities

Inflation and Time Value of Money

Effective Annual Interest Rates

* Use of a Financial Calculator


Future Values and Compound Interest
Financial managers often have to compare cash
payments or receipts which occur at different points of
time.
Since a dollar today does not have the same value as
a dollar tomorrow, a pattern of relationship has to be
established to compare and contrast cash flows at
different times.
- A present amount of money grows to Future Value when it
is able to earn interest.
- There are two kinds of interest that money can earn :
- Simple interest
- Compound interest
Future Value
Simple Interest
Interest is earned only on the original investment.
Example:
You invest $100 in an account paying simple interest at the rate of
6% per year. How much will the account be worth in 5 years?

You earn interest only on the original investment, every year.


Interest earned per year = $100 x 6% = $6.00
Total interest earned over 5-year period = $6.00 x 5 = $30.00
Balance in account at end of Year 1 = $100 + $6 = $106
Balance in account at end of Year 3 = $100 + $18 = $118
Balance in account at end of Year 5 = $100 + $30 = $130
Future Value
Compound Interest
Interest is earned on the value of money that is in the account at the
beginning of the period. Thus, previous periods earned interest can
also earn interest on the next period.
- Example:
You invest $100 in an account paying compound interest at the rate
of 6% per year. How much will the account be worth in 5 years?
You earn interest on interest
Interest earned per year = Previous years balance x interest
rate
Interest earned in Year 1 = $100.00 x 6% = $6.00
Interest earned in Year 2 = $106.00 x 6% = $6.36
Interest earned in Year 3 = $112.36 x 6% = $6.74
Interest earned in Year 4 = $119.10 x 6% = $7.15
Interest earned in Year 5 = $126.25 x 6% = $7.57
Future Value
Compound Interest
Value at the end of Year 1 = $100.00 +[$100 x 6%] =
$100 x (1+r)
Value at the end of Year 2 = $106.00 + [$106 x 6%] =
$100 x (1+r)2
.
Value at the end of Year 5 = $100 x (1+r)5
In general, value at the end of year t

FV = Value today x (1+r)t


Future Value
- Example:
You invest $1000 in an account paying
compound interest at the rate of 5% per year.
How much will the account be worth in 8 years?

FV = $1000 x (1+r)t
= $1000 x (1+0.05)8
= $1477.45
Future Value
Time Value Tables
Present Value
Lets turn things around
How much do you need to invest today into an account
paying compound interest at the rate of 5% per year, in
order to receive $1477.45 at the end of eight years?

Today Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8

$1477.45

Present Future
Value Value
Present Value

Simply invert the FV formula to get the PV formula.

Today Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 Yr7 Yr8

$1477.45

Present value = $1477.45


= $1,000
(1+ 0.05) 8
Future
Value
Present Value
In general, we can write the PV formula as

PV = FV after t periods
(1 + r)t
Present Value
Example:
You have been offered $1 million five years from now.
If the interest rate is expected to be 10% per year, how
much is this prize worth to you in todays dollars?

Today Year 5

$1 million
Present value = $1,000,000
(1+ 0.10)5

= $620,921
Present Value
The PV and the FV are very much related to each
other.

FV = PV x (1 + r)t PV = FV x 1/(1 + r)t


= $620,921 x (1 + 0.10)5 = $1 million x 1/ (1 + 0.10)5
= $1 million = $620,921
Present Value
Multiple Cash Flows
Future Value
Example:
You deposit $1,200 in your bank account today; $1,400 one year
later; and $1,000 two years from today. If your bank offers you an
8% annually compounded interest rate on your account, how
much money will you have in the account three years from today?
Multiple Cash Flows
Future value example

0 1 2 3
8% 8% 8%

$1,200 $1,400 $1,000

?
??

???
Multiple Cash Flows

0 1 2 3
8% 8% 8%

$1,200 $1,400 $1,000

$1,000x(1+0.08)1=$1,080.00

$1,400x(1+0.08)2=$1,632.96

$1,200x(1+0.08)3=$1,511.65

FV = $4,224.61
Multiple Cash Flows
Present Value
Example:
Your auto dealer gives you the choice to pay $15,500 cash now,
or make three payments: $8,000 now and $4,000 at the end
of the following two years.
If your cost of money is 8%, which do you prefer?

Option 1: $15,500 today


Option 2: $8,000 today; $4,000 at the end of one year; and $4,000
at the end of two years.

We can only compare these two options if both of them are


converted for the same time period. Today will be an ideal one
to do that.
Multiple Cash Flows
Present value of option # 2:

0 1 2
8% 8%

$8,000 $4,000 $4,000

$4,000/
(1+0.08)1=$3,703.70
$4,000/
(1+0.08)2=$3,429.36

PV = $15,133.06
Multiple Cash Flows
Compare the present value of the two options at
present:

- Option 1: $15,500
- Option 2: $15,133

Thus option 2 is a better choice for the buyer. That


means, option 1 is a better payment for the seller.
Finding Interest Rates and
Investment Periods
Make use of a Financial Calculator for
accurate results
Could also use a PV Table
Built-in spread sheet functions

Credit card debt


Doubling your investment

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