CHAPTER 2 Time Value of Money

Future value Present value Annuities Rates of return Amortization

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Which would you rather have?

In One Year $100 $1m $1,000 $500 $200 $150 $110? $105? Int. Rate 0% 999,900% 900% 400% 100% 50% 10% 5%
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Today $100 $100 $100 $100 $100 $100 $100? $100?

Time lines
0
I%

CF0

CF1

CF2

CF3

Show the timing of cash flows. Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the end of the first period (year, month, etc.) or the beginning of the second period.
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General Assumption:
Cash Flows (CFs) occur at the END of the period, unless stated otherwise.

Payments (PMTs) occur at the END of the period (ordinary annuity), unless stated otherwise (annuity due).
Calculator: Orange Key, BEG/END
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CFs can either be: a) Lump Sum ($1000 to received in 1 year or 5 years, or $1000 invested today), or b) recurring CFs (non-constant CFs), e.g. $100 in YR1, $200 in YR 2, $300 in YR) 3) or PMTs (constant CFs, e.g. $100 per year for 3 years). Calculator: CFj key vs. PMT key
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Drawing time lines

$100 lump sum due in 2 years
0
I%

100

3 year $100 ordinary annuity

0
I%

1 100

2 100

3 100
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Drawing time lines

Uneven cash flow stream
0
I%

-50

100

75

50

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What is the future value (FV) of an initial $100 after 3 years, if I/YR = 10%?

Finding the FV of a cash flow or series of cash flows is called compounding. FV can be solved by using the step-by-step, financial calculator, and spreadsheet methods.

0
10%

100

FV = ?
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Solving for FV: The step-by-step and formula methods

After 1 year: FV1 = PV (1 + I) = $100 (1.10) = $110.00 After 2 years: 2 2 FV2 = PV (1 + I) = $100 (1.10) =$121.00 After 3 years: 3 3 FV3 = PV (1 + I) = $100 (1.10) =$133.10 After N years (general case): N FVN = PV (1 + I)

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See graph on p. 31. Note that FV grows geometrically, or exponentially, because of the compounding process. Why isnt it a straight line?

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Solving for FV: The calculator method

Solves the general FV equation. Requires 4 inputs into calculator, and will solve for the fifth. (Set to P/YR = 1 and END mode.)
3 N 10 I/YR -100 PV 0 PMT FV
133.10
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INPUTS OUTPUT

What is the present value (PV) of $100 due in 3 years, if I/YR = 10%?

Finding the PV of a cash flow or series of cash flows is called discounting (the reverse of compounding). The PV shows the value of cash flows in terms of todays purchasing power.
1
10%

PV = ?

100
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Solving for PV: The arithmetic method

Rearranging the equation: FVn = PV ( 1 + i )n, we can solve for PV to get: PV = FVn / ( 1 + i )n

Now solve the general FV equation for PV:

PV = FVn / ( 1 + i )n
PV = FV3 / ( 1 + i )3 = $100 / ( 1.10 )3 = $75.13
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Solving for PV: The calculator method

Solves the general FV equation for PV. Exactly like solving for FV, except we have different input information and are solving for a different variable.
3 N 10 I/YR PV
-75.13
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INPUTS OUTPUT

0 PMT

100 FV

Solving for I: What interest rate would cause $100 to grow to $125.97 in 3 years?

Solves the general FV equation for I/YR. PV should be entered as negative, using +/- key FV should be entered as positive Cash Out (-CF), Cash In (+CF)
INPUTS OUTPUT 3 N I/YR 8
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-100 PV

0 PMT

125.97

FV

Solving for N: If sales grow at 20% per year, how long before sales double?

Solves the general FV equation for N. Hard to solve without a financial calculator or spreadsheet.

INPUTS N OUTPUT 3.8

20 I/YR

-1 PV

0 PMT

2 FV

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What is the difference between an ordinary annuity and an annuity due?

Ordinary Annuity
0
i%

1 PMT

2 PMT 2

3 PMT 3

Annuity Due
0
i%

PMT

PMT

PMT
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Solving for FV: 3-year ordinary annuity of $100 at 10%

$100 payments occur at the end of each period, but there is no PV.

INPUTS OUTPUT

3 N

10 I/YR

0 PV

-100 PMT FV 331

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Solving for PV: 3-year ordinary annuity of $100 at 10%

$100 payments still occur at the end of each period, but now there is no FV.

INPUTS OUTPUT

3 N

10 I/YR PV
-248.69

100 PMT

0 FV

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Solving for FV: 3-year annuity due of $100 at 10%

Now, $100 payments occur at the beginning of each period. FVAdue= FVAord(1+I) = $331(1.10) = $364.10. Alternatively, set calculator to BEGIN mode and solve for the FV of the annuity (Orange Key, MAR key):
BEGIN INPUTS OUTPUT 3 N 10 I/YR 0 PV -100 PMT FV
364.10
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Solving for PV: 3-year annuity due of $100 at 10%

Again, $100 payments occur at the beginning of each period. PVAdue= PVAord(1+I) = $248.69(1.10) = $273.55. Alternatively, set calculator to BEGIN mode and solve for the PV of the annuity:
BEGIN INPUTS OUTPUT 3 N 10 I/YR PV
-273.55
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100 PMT

0 FV

What is the present value of a 5-year $100 ordinary annuity at 10%?

Be sure your financial calculator is set back to END mode and solve for PV:

N = 5, I/YR = 10, PMT = 100, FV = 0. PV = $379.08

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What if it were a 10-year annuity? A 25-year annuity? A perpetuity?

10-year annuity

N = 10, I/YR = 10, PMT = 100, FV = 0; solve for PV = $614.46. N = 25, I/YR = 10, PMT = 100, FV = 0; solve for PV = $907.70.

25-year annuity

Perpetuity

PV = PMT / I = $100/0.1 = $1,000.

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The Power of Compound Interest

A 20-year-old student wants to save $3 a day for her retirement. Every day she places $3 in a drawer. At the end of the year, she invests the accumulated savings ($1,095) in a brokerage account with an expected annual return of 12%.

How much money will she have when she is 65 years old?
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Solving for FV: If she begins saving today, how much will she have when she is 65?

If she sticks to her plan, she will have $1,487,261.89 when she is 65.

INPUTS OUTPUT

45 N

12 I/YR

0 PV

-1095 PMT FV
1,487,262
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Solving for FV: If you dont start saving until you are 40 years old, how much will you have at 65?

If a 40-year-old investor begins saving today, and sticks to the plan, he or she will have $146,000.59 at age 65. This is $1.3 million less than if starting at age 20. Lesson: It pays to start saving early.
25 N 12 I/YR 0 PV -1095 PMT FV
146,001
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INPUTS OUTPUT

Solving for PMT: How much must the 40-year old deposit annually to catch the 20-year old?

To find the required annual contribution, enter the number of years until retirement and the final goal of $1,487,261.89, and solve for PMT.
25 N 12 I/YR 0 PV PMT
-11,154.42
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INPUTS OUTPUT

1,487,262

FV

What is the PV of this uneven cash flow stream?

0
10%

2 $300

3 $300

4 -$50

$100 90.91 247.93 225.39 -34.15 $530.08 = PV

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We can always treat each CF as a separate lump sum, discount each CF to PV separately, and sum up the PVs, like in the previous slide.
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Solving for PV: Uneven cash flow stream

Input cash flows in the calculators CFLO register:

CF0 CF1 CF2 CF3 CF4

= = = = =

0 100 300 300 -50

Enter I/YR = 10, press NPV (Orange, PRC) to get NPV = $530.087. (Here NPV = PV.)
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Will the FV of a lump sum be larger or smaller if compounded more often, holding the stated I% constant?

LARGER, as the more frequently compounding occurs, interest is earned on interest more often.
10%

0 100

3 133.10

Annually: FV3 = $100(1.10)3 = $133.10 0 0 1 1 2 3 2 4 5 3 6

5%

100

Semiannually: FV6 = $100(1.05)6 = $134.01

134.01
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Calculator Solution

N 3 6

I/YR 10 5

PV 100 100

PMT 0 0

FV $133.10 $134.01

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Classifications of interest rates

Nominal rate (INOM) also called the quoted or state rate. An annual rate that ignores compounding effects.

INOM is stated in contracts. Periods must also be given, e.g. 8% Quarterly or 8% Daily interest.

Periodic rate (IPER) amount of interest charged each period, e.g. monthly or quarterly.

IPER = INOM / M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding.
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Classifications of interest rates

Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest actually being earned, accounting for compounding.

EFF% for 10% semiannual investment EFF% = ( 1 + INOM / M )M - 1 = ( 1 + 0.10 / 2 )2 1 = 10.25%

Should be indifferent between receiving 10.25% annual interest and receiving 10% interest, compounded semiannually.
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Why is it important to consider effective rates of return?

Investments with different compounding intervals provide different effective returns. To compare investments with different compounding intervals, you must look at their effective returns (EFF% or EAR). See how the effective return varies between investments with the same nominal rate, but different compounding intervals.
EARANNUAL EARQUARTERLY EARMONTHLY EARDAILY (365) 10.00% 10.38% 10.47% 10.52%
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HP-10B Calculation Solution for finding EFF% (EAR%) when nominal rate is 10%:

10, Orange Key, NOM% (I/YR Key) 10% interest, compounded semi-annually: 2, Orange Key, P/YR (PMT Key) Orange Key, EFF% (Solution: 10.2500%) 10% interest, compounded quarterly: 4, Orange Key, P/YR Orange Key, EFF% (Solution: 10.3813%)

10% interest, compounded monthly: 12, Orange Key, P/YR Orange Key, EFF% (Solution: 10.4713%)
10% interest, compounded daily: 365, Orange Key, P/YR Orange Key, EFF% (Solution: 10.5156%)

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When is each rate used?

INOM written into contracts, quoted by banks and brokers. Not used in calculations or shown on time lines. IPER Used in calculations and shown on time lines. If M = 1, INOM = IPER = EAR. EAR Used to compare returns on investments with different payments per year. Used in calculations when annuity payments dont match compounding periods.

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What is the FV of $100 after 3 years under 10% semiannual compounding? Quarterly compounding?

INOM M N FVn PV ( 1 ) M 0.10 2 3 FV3S $100 ( 1 ) 2 6 FV3S $100 (1.05) $134.01 FV3Q $100 (1.025)12 $134.49
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Can the effective rate ever be equal to the nominal rate?

Yes, but only if annual compounding is used, i.e., if M = 1. If M > 1, EFF% will always be greater than the nominal rate.

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Compounding daily became common at banks in the 1970s when maximum interest rates at banks were set by the Federal Reserve according to Reg Q. What is the problem if banks cant pay the market interest rate? Daily compounding was one way to increase int. rates on savings accounts.
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Whats the FV of a 3-year $100 annuity, if the quoted interest rate is 10%, compounded semiannually?
0
5%

100

100

100

Payments occur annually, but compounding occurs every 6 months. Cannot use normal annuity valuation techniques.
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Method 1: Compound each cash flow

0
5%

100

100

100 110.25 121.55 331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100 FV3 = $331.80

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Method 2: Financial calculator

Find the EAR and treat as an annuity. EAR = ( 1 + 0.10 / 2 )2 1 = 10.25%.

INPUTS OUTPUT

3 N

10.25 I/YR

0 PV

-100 PMT FV
331.80
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Find the PV of this 3-year ordinary annuity.

Could solve by discounting each cash flow, or Use the EAR and treat as an annuity to solve for PV.
3 N 10.25 I/YR PV
-247.59
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INPUTS OUTPUT

100 PMT

0 FV

Loan amortization

Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, etc. Financial calculators and spreadsheets are great for setting up amortization tables. EXAMPLE: Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal payments.
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Step 1: Find the required annual payment

All input information is already given, just remember that the FV = 0 because the reason for amortizing the loan and making payments is to retire the loan.
3 N 10 I/YR
-1000 0

INPUTS OUTPUT

PV

PMT
402.11

FV

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Step 2: Find the interest paid in Year 1

The borrower will owe interest upon the initial balance at the end of the first year. Interest to be paid in the first year can be found by multiplying the beginning balance by the interest rate. INTt = Beg balt (I) INT1 = $1,000 (0.10) = $100
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Step 3: Find the principal repaid in Year 1

If a payment of $402.11 was made at the end of the first year and $100 was paid toward interest, the remaining value must represent the amount of principal repaid. PRIN = PMT INT = $402.11 - $100 = $302.11
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Step 4: Find the ending balance after Year 1

To find the balance at the end of the period, subtract the amount paid toward principal from the beginning balance. END BAL = BEG BAL PRIN = $1,000 - $302.11 = $697.89
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Constructing an amortization table: Repeat steps 1 4 until end of loan

Year 1 2 BEG BAL $1,000 698 PMT $402 402 INT $100 70 PRIN $302 332

END BAL $698

366

3
TOTAL

366

402
1,206.34

37
206.34

366
1,000

0
-

Interest paid declines with each payment as the balance declines. What are the tax implications of this?
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Illustrating an amortized payment: Where does the money go?

$
402.11

Interest
302.11

Principal Payments

Constant payments. Declining interest payments. Declining balance.

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HP-10B Calculator Solution for Amortization Step 1: Solve for PMT: N 3 I 10 PV 1000 PMT 402.11 FV 0

Step 2: To amortize the loan, payment by payment:

PMT 1: Orange Key, AMORT (FV key), =, =, = Solution: $302.11 (Principal), $100 (Interest) $697.89 (Balance) PMT 2 Orange Key, AMORT, =, =, = ($332.32, $69.79, $365.57) PMT 3 Orange Key, AMORT, =, =, = (365.55, 36.56, .02)

To amortize a series of payments, in this case PMT 1 through PMT 3: 1 INPUT 3, Orange Key, AMORT =, =, = (998.98, 206.35, .02)
Note: The last payment would have to be increased by $.02 to ensure that the loan balance is $0.00 at the end of the loan.
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