6-1 Chapter 6 The Time Value of Money Future Value Present Value Rates of Return Amortization.
Future value Present value Rates of return Amortization
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Future value
Present value
Rates of return
Amortization
CHAPTER 7Time Value of Money
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Time lines show timing of cash flows.
CF0 CF1 CF3CF2
0 1 2 3i%
Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.
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Time line for a $100 lump sum due at the end of Year 2.
100
0 1 2 Yeari%
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Time line for an ordinary annuity of $100 for 3 years.
100 100100
0 1 2 3i%
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Time line for uneven CFs -$50 at t = 0 and $100, $75, and $50 at the end of
Years 1 through 3.
100 50 75
0 1 2 3i%
-50
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What’s the FV of an initial $100 after 3 years if i = 10%?
FV = ?
0 1 2 310%
100
Finding FVs is compounding.
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After 1 year:
FV1 = PV + INT1 = PV + PV(i)= PV(1 + i)= $100(1.10)= $110.00.
After 2 years:
FV2 = PV(1 + i)2
= $100(1.10)2
= $121.00.
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After 3 years:
FV3 = PV(1 + i)3
= 100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.
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Four Ways to Find FVs
Solve the equation with a regular calculator.
Use tables.
Use a financial calculator.
Use a spreadsheet.
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Financial calculators solve this equation:
FVn = PV(1 + i)n.
There are 4 variables. If 3 are known, the calculator will solve for the 4th.
Financial Calculator Solution
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Here’s the setup to find FV:
Clearing automatically sets everything to 0, but for safety enter PMT = 0.
Set: P/YR = 1, END
INPUTS
OUTPUT
3 10 -100 0N I/YR PV PMT FV
133.10
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10%
What’s the PV of $100 due in 3 years if i = 10%?
Finding PVs is discounting, and it’s the reverse of compounding.
100
0 1 2 3
PV = ?
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Solve FVn = PV(1 + i )n for PV:
n
nnn
i+11
FV = i+1
FV =PV
PV = $1001
1.10 = $100 PVIF
= $100 0.7513 = $75.13.
i,n
3
.
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Financial Calculator Solution
3 10 0 100N I/YR PV PMT FV
-75.13
Either PV or FV must be negative. HerePV = -75.13. Put in $75.13 today, take out $100 after 3 years.
INPUTS
OUTPUT
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If sales grow at 20% per year, how long before sales double?
Solve for n:
FVn = 1(1 + i)n; 2 = 1(1.20)n
Use calculator to solve, see next slide.
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20 -1 0 2N I/YR PV PMT FV
3.8
Graphical Illustration:
01 2 3 4
1
2
FV
3.8
Year
INPUTS
OUTPUT
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Ordinary Annuity
PMT PMTPMT
0 1 2 3i%
PMT PMT
0 1 2 3i%
PMT
Annuity Due
What’s the difference between an ordinary annuity and an annuity due?
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What’s the FV of a 3-year ordinary annuity of $100 at 10%?
100 100100
0 1 2 310%
110 121FV = 331
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3 10 0 -100
331.00
Financial Calculator Solution
Have payments but no lump sum PV, so enter 0 for present value.
INPUTS
OUTPUTI/YRN PMT FVPV
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What’s the PV of this ordinary annuity?
100 100100
0 1 2 310%
90.91
82.64
75.13248.68 = PV
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Have payments but no lump sum FV, so enter 0 for future value.
3 10 100 0
-248.69
INPUTS
OUTPUTN I/YR PV PMT FV
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Find the FV and PV if theannuity were an annuity due.
100 100
0 1 2 3
10%
100
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3 10 100 0
-273.55
Switch from “End” to “Begin.”Then enter variables to find PVA3 = $273.55.
Then enter PV = 0 and press FV to findFV = $364.10.
INPUTS
OUTPUTN I/YR PV PMT FV
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What is the PV of this uneven cashflow stream?
0
100
1
300
2
300
310%
-50
4
90.91247.93225.39 -34.15530.08 = PV
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Input in “CFLO” register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
Enter I = 10, then press NPV button to get NPV = 530.09. (Here NPV = PV.)
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What interest rate would cause $100 to grow to $125.97 in 3 years?
3 -100 0 125.97
8%
$100 (1 + i )3 = $125.97.
INPUTS
OUTPUT
N I/YR PV PMT FV
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Will the FV of a lump sum be larger or smaller if we compound more often,
holding the stated I% constant? Why?
LARGER! If compounding is morefrequent than once a year--for example, semiannually, quarterly,or daily--interest is earned on interestmore often.
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0 1 2 310%
0 1 2 3
5%
4 5 6
134.01
100 133.10
1 2 30
100
Annually: FV3 = 100(1.10)3 = 133.10.
Semiannually: FV6 = 100(1.05)6 = 134.01.
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We will deal with 3 different rates:
iNom = nominal, or stated, or quoted, rate per year.
iPer = periodic rate.
EAR= EFF% = .effective annual
rate
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iNom is stated in contracts. Periods per year (m) must also be given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)
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Periodic rate = iPer = iNom/m, where m is number of compounding periods per year. m = 4 for quarterly, 12 for monthly, and 360 or 365 for daily compounding.
Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.
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Effective Annual Rate (EAR = EFF%):The annual rate that causes PV to grow to the same FV as under multi-period compounding.Example: EFF% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EFF% = 10.25% because (1.1025)1 = 1.1025.
Any PV would grow to same FV at 10.25% annually or 10% semiannually.
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An investment with monthly payments is different from one with quarterly payments. Must put on EFF% basis to compare rates of return. Use EFF% only for comparisons.
Banks say “interest paid daily.” Same as compounded daily.
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How do we find EFF% for a nominal rate of 10%, compounded
semiannually?
Or use a financial calculator.
%.25.101025.0
0.105.1
0.12
10.01
1m
i1%EFF
2
2
m
Nom
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EAR = EFF% of 10%
EARAnnual = 10%.
EARQ = (1 + 0.10/4)4 – 1 = 10.38%.
EARM = (1 + 0.10/12)12 – 1 = 10.47%.
EARD(360) = (1 + 0.10/360)360 – 1 = 10.52%.
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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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When is each rate used?
iNom: Written into contracts, quoted by banks and brokers. Not used in calculations or shownon time lines.
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iPer: Used in calculations, shown on time lines.
If iNom has annual compounding,then iPer = iNom/1 = iNom.
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(Used for calculations if and only ifdealing with annuities where payments don’t match interest compounding periods.)
EAR = EFF%: Used to compare returns on investments with different payments per year.
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FV of $100 after 3 years under 10% semiannual compounding? Quarterly?
= $100(1.05)6 = $134.01.FV3Q = $100(1.025)12 = $134.49.
FV = PV 1 .+ imnNom
mn
FV = $100 1 + 0.10
23S
2x3
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What’s the value at the end of Year 3of the following CF stream if the
quoted interest rate is 10%, compounded semiannually?
0 1
100
2 35%
4 5 6 6-mos. periods
100 100
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Payments occur annually, but compounding occurs each 6 months.
So we can’t use normal annuity valuation techniques.
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1st Method: Compound Each CF
0 1
100
2 35%
4 5 6
100 100.00110.25121.55331.80
FVA3 = 100(1.05)4 + 100(1.05)2 + 100= 331.80.
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Could you find FV with afinancial calculator?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
2nd Method: Treat as an Annuity
EAR = (1 + ) – 1 = 10.25%. 0.10
22
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Or, to find EAR with a calculator:
NOM% = 10.
P/YR = 2.
EFF% = 10.25.
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EFF% = 10.25P/YR = 1NOM% = 10.25
3 10.25 0 -100 INPUTS
OUTPUT
N I/YR PV FVPMT
331.80
b. The cash flow stream is an annual annuity. Find kNom (annual) whose EFF% = 10.25%. In calculator,
c.
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What’s the PV of this stream?
0
100
15%
2 3
100 100
90.7082.27
74.62247.59
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Amortization
Construct an amortization schedulefor a $1,000, 10% annual rate loanwith 3 equal payments.
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Step 1: Find the required payments.
PMT PMTPMT
0 1 2 310%
-1,000
3 10 -1000 0 INPUTS
OUTPUT
N I/YR PV FVPMT
402.11
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Step 2: Find interest charge for Year 1.
INTt = Beg balt (i)INT1 = $1,000(0.10) = $100.
Step 3: Find repayment of principal in Year 1.
Repmt = PMT – INT = $402.11 – $100 = $302.11.
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Step 4: Find ending balance after Year 1.
End bal = Beg bal – Repmt = $1,000 – $302.11 = $697.89.
Repeat these steps for Years 2 and 3to complete the amortization table.
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Interest declines. Tax implications.
BEG PRIN ENDYR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
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$
0 1 2 3
402.11Interest
302.11
Level payments. Interest declines because outstanding balance declines. Lender earns10% on loan outstanding, which is falling.
Principal Payments
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Amortization tables are widely used--for home mortgages, auto loans, business loans, retirement plans, etc. They are very important!
Financial calculators (and spreadsheets) are great for setting up amortization tables.
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On January 1 you deposit $100 in an account that pays a nominal interest rate of 10%, with daily compounding (365 days).
How much will you have on October 1, or after 9 months (273 days)? (Days given.)
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iPer = 10.0% / 365= 0.027397% per day.
FV = ?
0 1 2 273
0.027397%
-100
Note: % in calculator, decimal in equation.
FV = $100 1.00027397 = $100 1.07765 = $107.77.
273273
...
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273 -100 0
107.77
INPUTS
OUTPUT
N I/YR PV FVPMT
iPer = iNom/m= 10.0/365= 0.027397% per day.
Enter i in one step.Leave data in calculator.
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Now suppose you leave your money in the bank for 21 months, which is 1.75 years or 273 + 365 = 638 days.
How much will be in your account at maturity?
Answer: Override N = 273 with N = 638.FV = $119.10.
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iPer = 0.027397% per day.
FV = 119.10
0 365 638 days
-100
FV = $100(1 + .10/365)638
= $100(1.00027397)638
= $100(1.1910)= $119.10.
......
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You are offered a note that pays $1,000 in 15 months (or 456 days) for $850. You have $850 in a bank that pays a 7.0% nominal rate, with 365 daily compounding, which is a daily rate of 0.019178% and an EAR of 7.25%. You plan to leave the money in the bank if you don’t buy the note. The note is riskless.
Should you buy it?
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3 Ways to Solve:
1. Greatest future wealth: FV2. Greatest wealth today: PV3. Highest rate of return: Highest EFF%
iPer = 0.019178% per day.
1,000
0 365 456 days
-850
......
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1. Greatest Future Wealth
Find FV of $850 left in bank for15 months and compare withnote’s FV = $1,000.
FVBank = $850(1.00019178)456
= $927.67 in bank.
Buy the note: $1,000 > $927.67.
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456 -850 0
927.67
INPUTS
OUTPUT
N I/YR PV FVPMT
Calculator Solution to FV:
iPer = iNom/m= 7.0/365= 0.019178% per day.
Enter iPer in one step.
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2. Greatest Present Wealth
Find PV of note, and comparewith its $850 cost:
PV = $1,000/(1.00019178)456
= $916.27.
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456 .019178 0 1000
-916.27
INPUTS
OUTPUT
N I/YR PV FV
7/365 =
PV of note is greater than its $850 cost, so buy the note. Raises your wealth.
PMT
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Find the EFF% on note and compare with 7.25% bank pays, which is your opportunity cost of capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456
Now we must solve for i.
3. Rate of Return
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456 -850 0 1000
0.035646% per day
INPUTS
OUTPUT
N I/YR PV FVPMT
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)365 – 1 = 13.89%.
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Using interest conversion:
P/YR = 365.
NOM% = 0.035646(365) = 13.01.
EFF% = 13.89.
Since 13.89% > 7.25% opportunity cost,buy the note.