The Time Value of Money
Chapter 5 - The Time Value of Money
Compounding and Discounting Single Sums
2005, Pearson Prentice Hall
We know that receiving P 1.00 today is worth more than P 1.00 in the future. This is due to opportunity costs. The opportunity cost of receiving P 1.00 in the future is the interest we could have earned if we had received the P 1.00 sooner.
Today Future
If we can measure this opportunity cost, we can:
Translate P 1.00 today into its equivalent in the future (compounding).
Today Future
?
Translate P 1.00 in the future into its equivalent today (discounting).
Today Future
Future Value - single sums
Compound Interest
If you deposit P 100.00 in an account earning 6.0%, how much would you have in the account after 1 year?
and Future Value
PV = -100
FV = 106
0 1 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 1 ) (use FVIF table, or) FV = PV (1 + i)n FV = 100 (1.06)1 = P 106.00
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Future Value - single sums
If you deposit P 100.00 in an account earning 6.0%, how much would you have in the account after 5 years?
If you deposit P 100.00 in an account earning 6.0% with quarterly compounding, how much would you have in the account after 5 years?
Future Value - single sums
PV = -100
FV = 133.82
PV = -100
FV = 134.68
0 5 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .06, 5 ) (use FVIF table, or) FV = PV (1 + i)n FV = 100 (1.06)5 = P 133.82
0 20 Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .015, 20 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.015)20 = P 134.68
If you deposit P 100.00 in an account earning 6.0% with monthly compounding, how much would you have in the account after 5 years?
Future Value - single sums
What is the FV of P 1,000.00 earning 8.0% with continuous compounding, after 100 years?
Future Value - continuous compounding
PV = -100
0
FV = 134.89
60
PV = -1000
0
FV = 2.98M
100
Mathematical Solution: FV = PV (FVIF i, n ) FV = 100 (FVIF .005, 60 ) (cant use FVIF table) FV = PV (1 + i/m) m x n FV = 100 (1.005)60 = P 134.89
Mathematical Solution: FV = PV (e in) FV = 1000 (e .08x100) = 1000 (e 8) FV = P 2,980,957.99
Present Value
If you receive P 100.00 one year from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%?
Present Value - single sums
PV = -94.34
FV = 100
0 1 Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 1 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.06)1 = P 94.34
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If you receive P 100.00 five years from now, what is the PV of that P 100.00 if your opportunity cost is 6.0%?
Present Value - single sums
What is the PV of P 1,000.00 to be received 15 years from now if your opportunity cost is 7.0%?
Present Value - single sums
PV = -74.73
0
FV = 100
5
PV = -362.45
0
FV = 1000
15
Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .06, 5 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.06)5 = P 74.73
Calculator Solution: P/Y = 1 I=7 N = 15 FV = 1,000 PV = - P 362.45
What is the PV of P 1,000.00 to be received 15 years from now if your opportunity cost is 7.0%?
Present Value - single sums
If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return?
Present Value - single sums
PV = -362.45
FV = 1000
PV = -5,000
0
FV = 11,933
5
0 15 Mathematical Solution: PV = FV (PVIF i, n ) PV = 100 (PVIF .07, 15 ) (use PVIF table, or) PV = FV / (1 + i)n PV = 100 / (1.07)15 = P 362.45
Calculator Solution: P/Y = 1 N=5 PV = -5,000 FV = 11,933 I = 19%
If you sold land for P 11,933.00 that you bought 5 years ago for P 5,000.00, what is your annual rate of return?
Present Value - single sums
Mathematical Solution: PV = FV (PVIF i, n ) 5,000 = 11,933 (PVIF ?, 5 ) PV = FV / (1 + i)n 5,000 = 11,933 / (1+ i)5 .419 = ((1/ (1+i)5) 2.3866 = (1+i)5 (2.3866)1/5 = (1+i) i = .19
Suppose you placed P 100.00 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to P 500.00?
Present Value - single sums
PV = -100
0
FV = 500
?
Calculator Solution: P/Y = 12 FV = 500 I = 9.6 PV = -100 N = 202 months
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Suppose you placed P 100.00 in an account that pays 9.6% interest, compounded monthly. How long will it take for your account to grow to P 500.00?
Present Value - single sums
Hint for single sum problems:
In every single sum present value and future value problem, there are four variables:
Mathematical Solution:
PV = FV / (1 + i)n 100 = 500 / (1+ .008)N 5 = (1.008)N ln 5 = ln (1.008)N ln 5 = N ln (1.008) 1.60944 = .007968 N
FV, PV, i and n.
When doing problems, you will be given three variables and you will solve for the fourth variable. Keeping this in mind makes solving time value problems much easier!
N = 202 months
The Time Value of Money
Compounding and Discounting Cash Flow Streams
Annuities
Annuity: a sequence of equal cash flows, occurring at the end of each period.
Examples of Annuities:
If you buy a bond, you will receive equal semi-annual coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will pay a stream of equal payments.
If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years?
Future Value - annuity
1000
0 1
1000
2
1000
3
Calculator Solution: P/Y = 1 I=8 PMT = -1,000 FV = P 3,246.40
N=3
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If you invest P 1,000.00 each year at 8.0%, how much would you have after 3 years? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 1,000 (FVIFA .08, 3 ) FV = PMT (1 + i)n - 1 i FV = 1,000 (1.08)3 - 1 0.08
Future Value - annuity
What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%?
Present Value - annuity
1000
(use FVIFA table, or)
1000
2
1000
3
= P 3,246.40
Calculator Solution: P/Y = 1 I=8 N=3 PMT = -1,000 PV = P 2,577.10
What is the PV of P 1,000.00 at the end of each of the next 3 years, if the opportunity cost is 8.0%?
Mathematical Solution: PV = PMT (PVIFA i, n ) PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or) PV = PMT 11 (1 + i)n i 1 (1.08 )3 0.08 = P 2,577.10
Present Value - annuity
The Time Value of Money
PV = 1000
1-
Other Cash Flow Patterns
Perpetuities
Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. You can think of a perpetuity as an annuity that goes on forever.
Present Value of a Perpetuity
When we find the PV of an annuity, we think of the following relationship:
PV = PMT (PVIFA i, n )
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Mathematically, (PVIFA i, n ) =
1-
1 n (1 + i)
When n gets very large,
1-
1 (1 + i) n
this becomes zero.
We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large?
1
So were left with PVIFA =
Present Value of a Perpetuity
So, the PV of a perpetuity is very simple to find:
What should you be willing to pay in order to receive P 10,000.00 annually forever, if you require 8.0% per year on the investment?
PV =
PMT i
PV =
PMT i
= P 10,000.00 0.08
= P 125,000.00
Begin Mode vs. End Mode
Ordinary Annuity vs. Annuity Due
P 1,000.00 P 1,000.00 P 1,000.00
P 1,000.00 P 1,000.00 P 1,000.00
year 5
year 6
year 7
in END Mode
PV
in END Mode
FV
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Begin Mode vs. End Mode
P 1,000.00 P 1,000.00 P 1,000.00
Earlier, we examined this ordinary annuity: 1,000 8
0 1
1,000
2
1,000
3
year 6
year 7
year 8
in BEGIN Mode
PV
in BEGIN Mode
FV
Using an interest rate of 8.0%, we find that: The Future Value (at 3) is P 3,246.40. The Present Value (at 0) is P 2,577.10.
What about this annuity? 1000
0
1000
1
1000
2 3
If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3?
Future Value - annuity due
-1000
0
-1000
1
-1000
2 3
Same 3-year time line, Same 3 P 1,000.00 cash flows, but The cash flows occur at the beginning of each year, rather than at the end of each year. This is an annuity due.
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = -1,000 FV = P 3,506.11
If you invest P 1,000.00 at the beginning of each of the next 3 years at 8.0%, how much would you have at the end of year 3? Mathematical Solution:
Simply compound the FV of the ordinary annuity one more period:
Future Value - annuity due
What is the PV of P 1,000.00 at the beginning of each of the next 3 years, if your opportunity cost is 8.0%?
Present Value - annuity due
1,000
0
1,000
1
1,000
2 3
FV = PMT (FVIFA i, n ) (1 + i) FV = 1,000 (FVIFA .08, 3 ) (1.08) FV = PMT (1 + i)n - 1 i (1 + i)
(use FVIFA table, or)
FV = 1,000 (1.08)3 - 1 = P 3,506.11 (1.08) .08
Calculator Solution: Mode = BEGIN P/Y = 1 I=8 N=3 PMT = 1,000 PV = P 2,783.26
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Present Value - annuity due
Mathematical Solution:
Simply compound the FV of the ordinary annuity one more period:
Uneven Cash Flows
-10,000 2,000
0 1
4,000
2
6,000
3
7,000
4
PV = PMT (PVIFA i, n ) (1 + i) PV = 1,000 (PVIFA .08, 3 ) (1.08)
PV = PMT 11 (1 + i)n i 1 (1.08 )3 .08 (1 + i)
(use PVIFA table, or)
PV = 1000
1-
(1.08)
= P 2,783.26
Is this an annuity? How do we find the PV of a cash flow stream when all of the cash flows are different? (Use a 10% discount rate.)
Uneven Cash Flows
-10,000 2,000
0 1
-10,000 2,000 7,000
4 0 1
4,000
2
6,000
3
7,000
4
4,000
2
6,000
3
Sorry! Theres no quickie for this one. We have to discount each cash flow back separately.
period CF PV (CF) 0 -P 10,000.00 -P 10,000.00 1 2,000.00 1,818.18 2 4,000.00 3,305.79 3 6,000.00 4,507.89 4 7,000.00 4,781.09 PV of Cash Flow Stream: P 4,412.95
Annual Percentage Yield (APY)
Which is the better loan: 8% compounded annually, or 7.85% compounded quarterly? We cant compare these nominal (quoted) interest rates, because they dont include the same number of compounding periods per year! We need to calculate the APY.
Annual Percentage Yield (APY)
APY =
(1+ (1+
quoted rate m
)m-
Find the APY for the quarterly loan:
APY =
.0785 4
)4- 1
APY = .0808, or 8.08%
The quarterly loan is more expensive than the 8.0% loan with annual compounding!
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First Group Project
Instructions
Get the best interest rate for the following initial deposits: P 1,000.00, P 5,000.00, and P 10,000.00 for one (1) year. The best rate shall come from a survey/canvass of two commercial banks and one savings bank. List down the following information: name of bank, branch, the name of the authorized representative of the bank, and the contact number.
Instructions
On the next meeting, each group will reveal the rates for the three initial deposits. The group with the best rates will get the highest score (10 points). Each group will submit a one page report for the interest rates obtained to be submitted on the next meeting. Another one page report for the net (of taxes) computation of the best rate The next meeting will be next Thursday.
Practice Problems
Example
Cash flows from an investment are expected to be P 40,000.00 per year at the end of years 4, 5, 6, 7, and 8. If you require a 20.0% rate of return, what is the PV of these cash flows?
P0 0 0 1 0 2 0 3 40 4 40 5 40 6 40 7 40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
This type of cash flow sequence is often called a deferred annuity.
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P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
2) Find the PV of the annuity:
How to solve: 1) Discount each cash flow back to time 0 separately. Or,
PV3: End mode; P/YR = 1; I = 20; PMT = 40,000; N = 5 PV3= P 119,624.00
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
P0 0
0 1
0 2
0 3
40 4
40 5
40 6
40 7
40 8
Then discount this single sum back to time 0. PV: End mode; P/YR = 1; I = 20; N = 3; FV = 119,624; Solve: PV = P 69,226.00
P 119,624.00
P 69,226.00 P 119,624.00
The PV of the cash flow stream is P 69,226.00.
Retirement Example
After graduation, you plan to invest P 400.00 per month in the stock market. If you earn 12.0% per year on your stocks, how much will you have accumulated when you retire in 30 years?
400 0 1 400 2 400 3 400 . . . 360 0
400 1
400 2
400 3
400 . . . 360
Using your calculator, P/YR = 12 N = 360 PMT = -400 I%YR = 12 FV = P 1,397,985.65
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Retirement Example If you invest P 400.00 at the end of each month for the next 30 years at 12.0%, how much would you have at the end of year 30? Mathematical Solution: FV = PMT (FVIFA i, n ) FV = 400 (FVIFA .01, 360 ) FV = PMT (1 + i)n - 1 i FV = 400 (1.01)360 - 1 .01 = P 1,397,985.65
House Payment Example
If you borrow P 100,000.00 at 7.0% fixed interest for 30 years in order to buy a house, what will be your monthly house payment?
(cant use FVIFA table)
? 0 1
? 2
? 3
? . . . 360
House Payment Example
Mathematical Solution: PV = PMT (PVIFA i, n ) 100,000 = PMT (PVIFA .07, 360 )
PV = PMT 11 (1 + i)n i 1 (1.005833 )360 .005833 PMT=P 665.30
Using your calculator, P/YR = 12 N = 360 I%YR = 7 PV = P 100,000.00 PMT = -P 665.30
(cant use PVIFA table)
100,000 = PMT 1 -
Team Assignment
Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require P 250,000.00 per year at the beginning of each year. If you plan to retire in 30 years, what are the equal monthly payments necessary to achieve this goal? The funds in your retirement account will compound at 10.0% annually.
27 28 29
250 30
250 250 250 250 31 32 33 34 35
How much do we need to have by the end of year 30 to finance the trip? PV30 = PMT (PVIFA .10, 5) (1.10) = = 250,000 (3.7908) (1.10) = = P 1,042,470.00
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250
250 250 250 250 32 33 34 35 27 28 29
250 30
250 250 250 250 31 32 33 34 35
27 28 29 30 31 Using your calculator,
P 1,042,466
Mode = BEGIN PMT = -P 250,000.00 N=5 I%YR = 10 P/YR = 1 PV = P 1,042,466.00
Now, assuming 10.0% annual compounding, what monthly payments will be required for you to have P 1,042,466.00 at the end of year 30?
250 27 28 29 30
250 250 250 250 31 32 33 34 35
P 1,042,466.00
Using your calculator,
Mode = END N = 360 I%YR = 10 P/YR = 12
FV = P 1,042,466.00
PMT = -P 461.17
So, you would have to place P 461.17 in your retirement account, which earns 10.0% annually, at the end of each of the next 360 months to finance the 5-year world tour.
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