McGraw-Hill/Irwin Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

• Be able to compute the future value of

multiple cash flows
• Be able to compute the present value
of multiple cash flows
• Understand how interest rates are
quoted

5-2
 Chapter Outline

5.1 Future and Present Values of

Multiple Cash Flows
5.2 Valuing Level Cash Flows:
Annuities and Perpetuities
5.3 Comparing Rates: The Effect of
Compounding Periods

5-3
Future Value: Multiple Cash Flows
Example 1
• You think you will be able to deposit
$4,000 at the end of each of the next three
years in a bank account paying 8 percent
interest.
• You currently have $7,000 in the account.
• How much will you have in 3 years?
• How much in 4 years?

5-4
Future Value: Multiple Cash Flows
Example 1 - Formulas
• Find the value at year 3 of each cash
flow and add them together.
– Year 0: FV = $7,000(1.08)3 = $ 8,817.98
– Year 1: FV = $4,000(1.08)2 = $ 4,665.60
– Year 2: FV = $4,000(1.08)1 = $ 4,320.00
– Year 3: value = $ 4,000.00
– Total value in 3 years = $21,803.58

• Value at year 4 = $21,803.58(1.08)= $23,547.87

5-5
Future Value: Multiple Cash Flows
Example 2
• Suppose you invest $500 in a mutual
fund today and $600 in one year.
• If the fund pays 9% annually, how much
will you have in two years?

FV = $ 500 x (1.09)2 = $ 594.05

+ $ 600 x (1.09) = $ 654.00
= $1,248.05

5-6
 Example 2 Continued
• How much will you have in 5 years if you
make no further deposits?
• First way:
 FV = $500(1.09)5 + $600(1.09)4 = $1,616.26
• Second way – use value at year 2:
 FV = $1,248.05(1.09)3 = $1,616.26

5-7
Future Value: Multiple Cash Flows
Example 3 - Formula
• Suppose you plan to deposit $100 into
an account in one year and $300 into
the account in three years.
• How much will be in the account in five
years if the interest rate is 8%?

FV = $100(1.08)4 + $300(1.08)2 = $136.05 +

$349.92 = $485.97

5-8
 Example 3 Time Line
0 1 2 3 4 5

$100 $300
X (1.08)2 =
$349.92

X (1.08)4 = $136.05
$485.97

5-9
Present Value: Multiple Cash Flows
Example 4

– You are offered an investment that will

pay
• $200 in year 1,
• $400 the next year,
• $600 the following year, and
• $800 at the end of the 4th year.
• You can earn 12% on similar investments.
• What is the most you should pay for this
one?
5-10
Present Value: Multiple Cash Flows
Example 4 - Formula

Find the PV of each cash flow and add

them:
– Year 1 CF: $200 / (1.12)1 = $ 178.57
– Year 2 CF: $400 / (1.12)2 = $ 318.88
– Year 3 CF: $600 / (1.12)3 = $ 427.07
– Year 4 CF: $800 / (1.12)4 = $ 508.41
– Total PV = $1,432.93
5-11
 Example 4 Time Line
0 1 2 3 4
Time
(years)

200 400 600 800

178.57
= 1/(1.12)2 x
318.88
= 1/(1.12)3 x
427.07
= 1/(1.12)4 x
508.41
1,432.93

5-12
 Quick Quiz 1
• Suppose you are looking at the following
possible cash flows:
– Year 1 CF = $100;
– Years 2 and 3 CFs = $200;
– Years 4 and 5 CFs = $300.
– The required discount rate is 7%
• What is the value of the CFs at year 5?
• What is the value of the CFs today?

5-13
 Quick Quiz 1
$ 874.12 PV
$ 213.90
$ 228.87
$ 163.26
$ 174.69
$ 93.46

7%
Period 0 1 2 3 4 5

CFs 0 100 200 200 300 300

$ 300.00
$ 321.00
$ 228.98
$ 245.01
$ 131.08
FV = $ 1,226.07
5-14
 Annuities and Perpetuities
• Annuity – finite series of equal payments
that occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of
the period, it is called an annuity due
• Perpetuity – infinite series of equal
payments.

5-15
 Annuities and Perpetuities
Basic Formulas
• Perpetuity: PV = C / r
• Annuities:
 1 
 1  (1  r ) t 
PV C  
 r 
 

 (1  r ) t  1
FV C  
 r 

5-16
Important Points to Remember
• Interest rate and time period must
match!
– Annual periods  annual rate
– Monthly periods  monthly rate
• The Sign Convention
– Cash inflows are positive
– Cash outflows are negative

5-17
 Annuity – Sweepstakes
Example
• Suppose you win the Publishers
Clearinghouse $10 million sweepstakes.
• The money is paid in equal annual
installments of $333,333.33 over 30 years.
• If the appropriate discount rate is 5%, how
much is the sweepstakes actually worth
today?
 PV = $333,333.33[1 – 1/1.0530] / .05 =
$5,124,150.29
5-18
 Buying a House
• You are ready to buy a house and you have $20,000 for
a down payment and closing costs.
• Closing costs are estimated to be 4% of the loan value.
• You have an annual salary of $36,000.
• The bank is willing to allow your monthly mortgage
payment to be equal to 28% of your monthly income.
• The interest rate on the loan is 6% per year with monthly
compounding (.5% per month) for a 30-year fixed rate
loan.
• How much money will the bank loan you?
• How much can you offer for the house?
5-19
 Buying a House - Continued
• Bank loan
– Monthly income = 36,000 / 12 = 3,000
– Maximum payment = .28(3,000) = 840
– PV = 840[1-1/1.005360] / 0.005 = 140,105
• Total Price
– Closing costs = .04(140,105) = 5,604
– Down payment = 20,000 – 5,604 = 14,396
– Total Price = 140,105 + 14,396 = 154,501

5-20
 Finding the Payment
• Suppose you want to borrow $20,000 for a
new car.
• You can borrow at 8% per year, compounded
monthly (8/12 = .66667% per month).
• If you take a 4 year loan, what is your monthly
payment?
– 20,000 = C [ 1 – 1/1.006666748] / 0.066667
– C = 488.26

5-21
Finding the Number of Payments
Another Example
• Suppose you borrow $2,000 at 5% and you are
going to make annual payments of $734.42.
How long before you pay off the loan?
– 2,000 = 734.42(1 – 1/1.05t) / .05
– .136161869 = 1 – 1/1.05t
– 1/1.05t = .863838131
– 1.157624287 = 1.05t
– t = ln(1.157624287) / ln(1.05) = 3 years

5-22
 Finding the Rate
• Suppose you borrow $10,000 from your
parents to buy a car. You agree to pay
$207.58 per month for 60 months. What is
the monthly interest rate?

No formula for r => Trial and Error!!!

5-23
 Annuity – Finding the Rate
• Trial and Error Process
– Choose an interest rate and compute the PV of
the payments based on this rate
– Compare the computed PV with the actual loan
amount
– If the computed PV > loan amount, then the
interest rate is too low
– If the computed PV < loan amount, then the
interest rate is too high
– Adjust the rate and repeat the process until the
computed PV and the loan amount are equal
5-24
 Future Values for Annuities
• Suppose you begin saving for your retirement by
depositing $2,000 per year in an IRA. If the
interest rate is 7.5%, how much will you have in
40 years?

 (1  r ) t  1
FV C  
 r 
 (1.075) 40  1
FV  2000   454,513.04
 .075 

5-25
 Annuity Due
• You are saving for a new house and you put $10,000 per
year in an account paying 8%. The first payment is made
today. How much will you have at the end of 3 years?

 (1  r ) t  1
FVAD C   (1  r )
 r 
 (1.08) 3  1
FVAD  10000  (1.08) 35,061.12
 .08 

5-26
Annuity Due Timeline
0 1 2 3

10000 10000 10000

32,464

35,016.12

5-27
 Perpetuity
Example 5.7
• Perpetuity formula: PV = C / r
• Current required return:
– 40 = 1 / r
– r = .025 or 2.5% per quarter
• Dividend for new preferred:
– 100 = C / .025
– C = 2.50 per quarter

5-28
Table 5.2

5-29
 Interest Rates
• Effective Annual Rate (EAR)
– The interest rate expressed as if it were compounded
once per year.
– Used to compare two alternative investments with
different compounding periods

• Annual Percentage Rate (APR) “Nominal”

– The annual rate quoted by law
– APR = periodic rate X number of periods per year
– Periodic rate = APR / periods per year
5-30
 Things to Remember
• You ALWAYS need to make sure that the
interest rate and the time period match.
– Annual periods  annual rate.
– Monthly periods  monthly rate.

• If you have an APR based on monthly

compounding, you have to use monthly periods
for lump sums or adjust the interest rate
accordingly.

5-31
 EAR Formula
m
 APR 
EAR  1   1
 m 

APR = the quoted rate

m = number of compounds per year

5-32
 Decisions, Decisions
• Which savings accounts should you choose:
– 5.25% with daily compounding.
– 5.30% with semiannual compounding.
• First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
• Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%

5-33
 Computing APRs
• What is the APR if the monthly rate is .5%?
 .5%(12) = 6%
• What is the APR if the semiannual rate
is .5%?
 .5%(2) = 1%
• What is the monthly rate if the APR is 12%
with monthly compounding?
 12% / 12 = 1%
 Can you divide the above APR by 2 to get the
semiannual rate?
 NO. You need an APR based on semiannual
compounding to find the semiannual rate. 5-34
 Computing EAR and APR
• Suppose you can earn 1% per month on $1
invested today.
– What is the APR? 1(12) = 12%
– How much are you effectively earning?
• FV = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%

5-35
 Computing EAR and APR
• Suppose if you put it in another account, you
earn 3% per quarter.

– What is the APR? 3(4) = 12%

– How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%

5-36
Computing APRs from EARs


APR m (1  EAR)
1
m
-1
 
M = number of compounding periods per year

5-37
 APR - Example
• Suppose you want to earn an effective rate of
12% and you are looking at an account that
compounds on a monthly basis. What APR
must they pay?
 
APR 12 (1  .12)1/ 12  1 .113 8655 or 11.39%

5-38
 Computing Payments with APRs
• Suppose you want to buy a new computer.
• The store is willing to allow you to make monthly payments.
• The entire computer system costs $3,500.
• The loan period is for 2 years.
• The interest rate is 16.9% with monthly compounding.
• What is your monthly payment?
– Monthly rate = .169 / 12 = .01408333333
– Number of months = 2(12) = 24
– 3500 = C[1 – 1 / 1.01408333333) 24] / .01408333333
– C = 172.88

5-39
 Future Values
with Monthly Compounding
• Suppose you deposit $50 a month into an
account that has an APR of 9%, based on
monthly compounding. How much will you have
in the account in 35 years?
– Monthly rate = .09 / 12 = .0075
– Number of months = 35(12) = 420
– FV = 50[1.0075420 – 1] / .0075 = 147,089.22

5-40
 Present Value with Daily
Compounding
• You need $15,000 in 3 years for a new car. If
you can deposit money into an account that
pays an APR of 5.5% based on daily
compounding, how much would you need to
deposit?
– Daily rate = .055 / 365 = .00015068493
– Number of days = 3(365) = 1095
– PV = 15,000 / (1.00015068493)1095 =
12,718.56

5-41
Chapter 5
END