1. Chapter 4: Time Value of Money
Objective
Explain the concept of compounding
and discounting and to provide
examples of real life
applications

2. Chapter 4 Contents Compounding Frequency of Compounding
Present Value and Discounting
Alternative Discounted Cash Flow Decision Rules
Multiple Cash Flows
Annuities
Perpetual Annuities
Loan Amortization
Exchange Rates and Time Value of Money
Inflation and Discounted Cash Flow Analysis
Taxes and Investment Decisions

3. Financial Decisions Costs and benefits being spread out over time
The values of sums of money at different dates
The same amounts of money at different dates have different values.

4. Time Value of Money
Interest
Purchasing power
Uncertainty

5. Compounding Present value (PV) Future value (FV)
Simple interest: the interest on the original principal
Compound interest: the interest on the interest
Future value factor

6. Value of Investing $1 at an Interest Rate of 10%
Continuing in this manner you will find that the following amounts will be earned:

7. Value of $5 Invested
More generally, with an investment of $5 at 10% we obtain

8. Value of $5 Invested
If we can earn 10% interest on the principal $5, then after 4 years

9. Future Value of a Lump Sum

10. Example: Future Value of a Lump Sum
Your bank offers a CD (Certificate of Deposit) with an interest rate of 3% for a 5 year investments.
You wish to invest $1,500 for 5 years, how much will your investment be worth?

11. Example: Reinvesting at a Different Rate
You have $10,000 to invest for two years.
Two years CDs and one year CDs are paying 7% and 6% per year respectively.
What should you do?
Reinvestment rate?
You are sure the interest rate on one-year CDs will be 8% next year.
With the two-year CD
With the sequence of two one-year CDs

12. Frequency of Compounding
Annual percentage rate (APR)
Effective annual rate (EFF)
Suppose you invest $1 in a CD, earning interest at a stated APR of 6% per year compounded monthly.
General formula

13. Effective Annual Rates of an APR of 18%

14. The Frequency of Compounding
Note that as the frequency of compounding increases, so does the annual effective rate.
What occurs as the frequency of compounding rises to infinity?

15. Present Value
In order to reach a target amount of money at a future date, how much should we invest today?
Discounting
Discounted-cash-flow (DCF)

16. Present Value of a Lump Sum

17. Example: Present Value of a Lump Sum
You have been offered $40,000 for your printing business, payable in 2 years.
Given the risk, you require a return of 8%.
What is the present value of the offer?

18. Solving Lump Sum Cash Flow for Interest Rate

19. Example: Interest Rate on a Lump Sum Investment
If you invest $15,000 for ten years, you receive $30,000.
What is your annual return?

20. Solving Lump Sum Cash Flow for Number of Periods

21. NPV (Net Present Value) Rule
NPV rule: Accept a project if its NPV is positive.
Opportunity cost of capital: The rate (of return) we could earn somewhere else if we did not invest in the project under evaluation.
Yield to maturity or Internal Rate of Return (IRR)

22. Example: Evaluate a Project
A five-year savings bond with face value $100 is selling for a price of $75.
Your next-best alternative for investing is an 8% bank account.
Is the savings bond a good project?

23. Example: Evaluate a Project

24. Example: Borrowing You need to borrow $5,000 to buy a car.
A bank can offer you a loan at an interest rate of 12%.
A friend says he will lend the $5,000 if you pay him $9,000 in four years.
Should you borrow from the bank or the friend?

25. PV of Annuity Formula

26. Example: Buying an Annuity
You are 65 years old and expect to live until age 80.
For a cost of $10,000, an insurance company will pay you $1,000 per year for the rest of your life.
You can earn 8% per year on your money in a bank account.
Does it pay to buy the insurance policy?

27. Perpetual Annuities / Perpetuities
Recall the annuity formula:
Let n -> ∞ with i > 0:

28. Loan Amortization
Home mortgage loans or car loans are repaid in equal periodic installments.
Part of each payment is interest on the outstanding balance of the loan.
Part is repayment of principal.
The portion of the payment that goes toward the payment of interest is lower than the previous period’s interest payment.
The portion that goes toward repayment of principal is greater than the previous period’s.

29. Calculator Solution
This is
the yearly
repayment

30. Amortization Schedule for 3-Year Loan at 9%

31. Example: Exchange Rates
Investing $10,000 in dollar-denominated bonds offering an interest rate of 10% per year
Investing in yen-denominated bonds offering an interest rate of 3% per year
The exchange rate for the yen is now $0.01 per yen.
Which is the better investment for the next year?

32. Time U.S.A. Japan 0.01 $/¥ 3% ¥ / ¥ ? $/¥ $10,000 $11,000 ¥ 1,000,000¥
1,030,000¥
Time
10% $/$ (direct)
0.01 $/¥
3% ¥ / ¥
? $/¥
U.S.A.
Japan

33. Time U.S.A. Japan 0.01 $/¥ 3% ¥/¥ 0.0108 $/¥ $10,000 $11,124 $11,000 ¥
1,000,000¥
1,030,000¥
Time
10% $/$ (direct)
0.01 $/¥
3% ¥/¥
$/¥
U.S.A.
Japan

34. Time U.S.A. Japan 0.01 $/¥ 3% ¥ / ¥ 0.0106 $/¥ $10,000 $10,918 ¥
$11,000 ¥
1,000,000¥
1,030,000¥
Time
10% $/$ (direct)
0.01 $/¥
3% ¥ / ¥
$/¥
U.S.A.
Japan

35. Time U.S.A. Japan 0.01 $/¥ 3% ¥ / ¥ 0.01068 $/¥ $10,000 $11,000 ¥
1,000,000¥
1,030,000¥
Time
10% $/$ (direct)
0.01 $/¥
3% ¥ / ¥
$/¥
U.S.A.
Japan

36. The Real Rate of Interest

37. Switch to a Gas Heat ?
You currently heat your house with oil and your annual heating bill is $2,000.
By converting to gas heat, you estimate that this year you could cut your heating bill by $500.
You think the cost differential between gas and oil is likely to remain the same for many years.
The cost of installing a gas heating system is $10,000.
Your alternative use of the money is to leave it in a bank account earning an interest rate of 8% per year.
Is the conversion worthwhile?

38. Switch to a Gas Heat ?
Assume that the $500 cost differential will remain forever.
The investment in switch of heating is a perpetuity, i.e. paying $10,000 now for getting $500 per year forever.
If the $500 cost differential will increase over time with the general rate of inflation, then the 5% rate of return is a real rate of return.
The conversion is not worthwhile unless the rate of inflation is greater than 2.875% per year.

39. Taxes

40. Taking Advantage of a Tax Loophole
You are in a 40% tax bracket and currently have $100,000 invested in municipal bonds earning a tax-exempt rate of interest of 6% per year.
Now you buy a house at a cost of $100,000.
A bank offers a loan for you at an interest rate of 8% per year.
Does it pays for you to borrow?