Chapter 3 The Time Value of Money © 2005 Thomson/South-Western

2 Time Value of Money  The most important concept in finance  Used in nearly every financial decision  Business decisions  Personal finance decisions

3 Cash Flow Time Lines CF 0 CF 1 CF 3 CF k% Time 0 is today Time 1 is the end of Period 1 or the beginning of Period 2. Graphical representations used to show timing of cash flows

Year k% Time line for a $100 lump sum due at the end of Year 2

5 Time line for an ordinary annuity of $100 for 3 years k%

6 Time line for uneven CFs - $50 at t = 0 and $100, $75, and $50 at the end of Years 1 through k% -50

7 The amount to which a cash flow or series of cash flows will grow over a period of time when compounded at a given interest rate. Future Value

8 Calculating FV is compounding! Question: How much would you have at the end of one year if you deposited $100 in a bank account that pays 5 percent interest each year? Translation: What is the FV of an initial $100 after 3 years if k = 10%? Key Formula: FV n = PV (1 + k) n

9 Three Ways to Solve Time Value of Money Problems  Use Equations  Use Financial Calculator  Use Electronic Spreadsheet

10 Solve this equation by plugging in the appropriate values: Numerical (Equation) Solution PV = $100, k = 10%, and n =3

11 Financial calculators solve this equation: There are 4 variables (FV, PV, k, n). If 3 are known, the calculator will solve for the 4th. Financial Calculator Solution

12 First: set calculator to show 4 digits to the right of the decimal place To enter “Format” register: Type: 2 nd, period See: DEC (decimal) = (varies) Type: 4, enter See: DEC = 4 Exit Format register: hit CE/C See Financial Calculator Solution

13 INPUTS OUTPUT ? NI/YR PV PMTFV Here’s the setup to find FV: Clearing automatically sets everything to 0, but for safety enter PMT = 0. Set:P/YR= 1, END Financial Calculator Solution

14 Spreadsheet Solution Set up ProblemClick on Function Wizard and choose Financial/FV

15 Spreadsheet Solution Reference cells: Rate = interest rate, k Nper = number of periods interest is earned Pmt = periodic payment PV = present value of the amount

16 Present Value  Present value is the value today of a future cash flow or series of cash flows.  Discounting is the process of finding the present value of a future cash flow or series of future cash flows; it is the reverse of compounding.

% PV = ? What is the PV of $100 due in 3 years if k = 10%?

18 INPUTS OUTPUT 3 10 ? 0100 NI/YR PV PMTFV Financial Calculator Solution VITAL: Either PV or FV must be negative. Here PV = Put in $75.13 today, take out $100 after 3 years.

19 If sales grow at 20% per year, how long before sales double?

20 INPUTS OUTPUT ? N I/YR PV PMTFV 3.8 Graphical Illustration: FV 3.8 Year Financial Calculator Solution

21 Future Value of an Annuity  Annuity: A series of payments of equal amounts at fixed intervals for a specified number of periods.  Ordinary (deferred) Annuity: An annuity whose payments occur at the end of each period.  Annuity Due: An annuity whose payments occur at the beginning of each period.

22 PMT 0123 k% PMT 0123 k% PMT Ordinary Annuity Versus Annuity Due Ordinary Annuity Annuity Due

% FV= 331 What’s the FV of a 3-year Ordinary Annuity of $100 at 10%?

24 Financial Calculator Solution INPUTS OUTPUT ? NI/YRPV PMT FV

25 Present Value of an Annuity  PVA n = the present value of an annuity with n payments.  Each payment is discounted, and the sum of the discounted payments is the present value of the annuity.

= PV % What is the PV of this Ordinary Annuity?

27 We know the payments but no lump sum FV, so enter 0 for future value. Financial Calculator Solution INPUTS OUTPUT 310 ? NI/YRPV PMT FV

% 100 Find the FV and PV if the Annuity were an Annuity Due.

29 ANNUITY Due: Switch from “End” to “Begin” Method: (2 nd BGN, 2 nd Enter) Then enter variables to find PVA 3 = $ Then enter PV = 0 and press FV to find FV = $ Financial Calculator Solution INPUTS OUTPUT 310 ? NI/YRPV PMT FV

30 What is the PV of a $100 perpetuity if k = 10%?  You MUST know the formula for a perpetuity: PV = PMT k  So, here: PV = 100/.1 = $1000

k = ? You pay $ for an investment that promises to pay you $250 per year for the next four years, with payments made at the end of each year. What interest rate will you earn on this investment? Solving for Interest Rates with Annuities

32 Financial Calculator Solution INPUTS OUTPUT 4 ? N I/YR PV PMT FV

33 What interest rate would cause $100 to grow to $ in 3 years?

34 What interest rate would cause $100 to grow to $ in 3 years? INPUTS OUTPUT 3 ? % NI/YRPV PMT FV

35 Uneven Cash Flow Streams  A series of cash flows in which the amount varies from one period to the next:  Payment (PMT) designates constant cash flows—that is, an annuity stream.  Cash flow (CF) designates cash flows in general, both constant cash flows and uneven cash flows.

% = PV What is the PV of this Uneven Cash Flow Stream?

37 Financial Calculator Solution  In “CF” register, input the following:  CF0 =0  C01 =100F01 =1  C02 =300F01 =1  C03 =300F01 =1  C04 =-50F01 =1  In “NPV” Register:  Enter I = 10%  Hit down arrow to see “NPV = 0”  Hit CPT for compute  See “NPV = ” (Here NPV = PV.)

38 Semiannual and Other Compounding Periods  Annual compounding is the process of determining the future value of a cash flow or series of cash flows when interest is added once a year.  Semiannual compounding is the process of determining the future value of a cash flow or series of cash flows when interest is added twice a year.

39 Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated k constant? Why?

40 If compounding is more frequent than once a year—for example, semi-annually, quarterly, or daily—interest is earned on interest—that is, compounded—more often. Will the FV of a lump sum be larger or smaller if we compound more often, holding the stated k constant? Why? LARGER!

% % Annually: FV 3 = 100(1.10) 3 = Semi-annually: FV 6/2 = 100(1.05) 6 = Compounding Annually vs. Semi-Annually

42 Simple (Quoted) Rate k SIMPLE = Simple (Quoted) Rate Periodic Rate k PER = Periodic Rate Effective Annual Rate Annual Percentage Rate EAR= Effective Annual Rate APR = Annual Percentage Rate Distinguishing Between Different Interest Rates

43 Simple (Quoted) Rate k SIMPLE = Simple (Quoted) Rate *used to compute the interest paid per period *stated in contracts, quoted by banks & brokers *number of periods per year must also be given *Not used in calculations or shown on time lines Examples: 8%, compounded quarterly 8%, compounded daily (365 days) k SIMPLE

44 Periodic Rate = k Per  k PER : Used in calculations, shown on time lines.  If k SIMPLE has annual compounding, then k PER = k SIMPLE  k PER = k SIMPLE /m, where m is number of compounding periods per year.  Determining m:  m = 4 for quarterly  m = 12 for monthly  m = 360 or 365 for daily compounding  Examples:  8% quarterly: k PER = 8/4 = 2%  8% daily (365): k PER = 8/365 = %

45 Annual Percentage Rate APR = Annual Percentage Rate = k SIMPLE periodic rate X the number of periods per year APR = k simple

46 Effective Annual Rate EAR= Effective Annual Rate * the annual rate of interest actually being earned * The annual rate that causes PV to grow to the same FV as under multi-period compounding. * Use to compare returns on investments with different payments per year. * Use for calculations when dealing with annuities where payments don’t match interest compounding periods. EAR

47 How to find EAR for a simple rate of 10%, compounded semi-annually  Hit 2 nd then 2 to enter “ICONV” register:  NOM = simple interest rate  Type: 10, enter, down arrow twice  C/Y = compounding periods per year  Type: 2, enter, up arrow (or down arrow twice)  EFF = effective annual rate = EAR  Type: CPT (for compute)  See: POINT: Any PV would grow to same FV at 10.25% annually or 10% semiannually.

48 Continuous Compounding  The formula is FV = PV(e kt )  k = the interest rate (expressed as a decimal)  t = number of years  Calculator “workaround”  Store (as many nines as possible) in your calculator under STO + 9  Then, for N: N = # of years times “RCL 9”  Then, for I: I = simple interest divided by “RCL 9”

49 Continuous Compounding  Question: What is the value of a $1,000 deposit invested for 5 years at an interest rate of 10%, compounded continuously? INPUTS OUTPUT 5* 10/ RCL9 RCL ? N I/YR PV PMT FV

50 Fractional Time Periods % FV = ? What is the value of $100 deposited in a bank at EAR = 10% for 0.75 of the year?

51 Fractional Time Periods % FV = ? What is the value of $100 deposited in a bank at EAR = 10% for 0.75 of the year? INPUTS OUTPUT ? N I/YR PV PMT FV

52 Amortized Loans  Amortized Loan: A loan that is repaid in equal payments over its life.  Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, and so forth to determine how much of each payment represents principal repayment and how much represents interest.  They are very important, especially to homeowners!  Financial calculators (and spreadsheets) are great for setting up amortization tables.

53 Task: Construct an amortization schedule for a $1,000, 10 percent loan that requires three equal annual payments. PMT % -1,000

54 PMT % INPUTS OUTPUT ? NI/YRPV PMT FV Step 1: Determine the required payments

55 Hit 2 nd, PV to enter “Amort Register” For 1 st principal payment, 1 st interest payment, and 1 st year remaining balance, enter: P1 = 1 P2 = 1 Down arrow See: Bal = , down arrow PRN = INT = 100 Enter “Amort” Register

56 Interest declines, which has tax implications. Step 2: Create Loan Amortization Table * Rounding difference

57 Hit 2 nd, PV to enter “Amort Register” For 2nd principal payment, 2nd interest payment, and 2 nd year remaining balance, enter: P1 = 2 P2 = 2 Down arrow See: Bal = , down arrow PRN = INT = Enter “Amort” Register

58 Interest declines, which has tax implications. Step 2: Create Loan Amortization Table * Rounding difference

59 Hit 2 nd, PV to enter “Amort Register” For 3 rd principal payment, 3rd interest payment, and 3rd year remaining balance, enter: P1 = 3 P2 = 3 Down arrow See: Bal = 0, down arrow PRN = INT = Enter “Amort” Register

60 Interest declines, which has tax implications. Step 2: Create Loan Amortization Table * Rounding difference

61 1. Review Chapter 3 materials 2.Do Chapter 3 homework 3.Prepare for Chapter 3 quiz 3. Read Chapter 4 Before Next Class