FUTURE VALUE OF 1

SAMPLE PROBLEM

You have just deposited $15,000 in an account earning 8% APR, compounded annually.  If you leave the
money in the account for 10 years, how much will you have?

Step 1) Time Line

                        0                      1                      2                      9                      10
                        |                       |                       |           …        |                       |
                        $15,000                                                                                   ?
 
Step 2) Formula
 

You have just inherited $25,000.  You immediately place $5,000 in a mutual fund earning 12% APR,
compounded quarterly.  You plan to blow the other $20,000 on a trip to Las Vegas.  Much to your chagrin, after
2 years in Vegas, you not only did not manage to blow your inheritance, you actually now  have $50,000.  You
now take $10,000 of the $50,000 and place it in the same mutual fund.  Interest rates remain constant.  After
10 years and many sad tales, you return home penniless.  However, that day you receive your statement from
the mutual fund.  You quickly tear it open and discover that your deposits are now worth…?
 
Solution
 
Step 1) Time Line
            0                      4                      8                                              48
            |                       |                       |           …        |                       |
            $5,000                                     $10,000                                   ???
Note that the  time units of the time line are in quarters.   Thus, you place the $10,000 in the account two
years, or 8 quarters, from today.   Finally, you examine your mutual fund statement 12 years or 48 quarters
from the time you deposit the $5,000. 
 
Step 2) Formula
            Note that you will need to use the future value tool two times to answer this question.
            Also note, that APR = r * #pds/yr
                  Thus, 12% = r * 4,   r = 3%
 
Part a) FV of $5000.
 

 
Part b)FV of $10,000
 
You would like to save for the down payment for a new car.  You have just invested $1,500 in shares of
Dell.  You believe that Dell will continue to earn its historical return of 15%, compounded monthly.   The car you
wish to purchase will have a required down payment of $2,200.  Given this information, how many months
must you wait before you can purchase the car?

Step 1) Time Line

            0                                                                                              ?
            |                       |                       |           …       |                       |
            $1,500                                                                                     $2,200
 
Step 2) Formula
Note that we are moving a single value through time, so the appropriate tool is the present/future value
tool.   However, since our time periods are in months, we need to determine the monthly rate:
 
APR = r * #pds/yr
15% = r * 12
r = 1.25%/month
 
Now we need to manipulate the present value formula to the form that we need it:

 
How much must you place in an account today in order to have accumulated $100,000 is 15 years?  Assume
that interest rates are 8%, compounded semi-annually.
 
 
Step 1) Time Line
            0                      1                      2                      29                    30
            |                       |                       |           …       |                       |
            ?                                                                                              $100,000
Note that the number of periods (t) is 30 (2 per year times 15 years). 
The rate/period is
APR = r * #pds/yr
8% = r * 2
r = 4% (every 6 months)
 
Step 2) Formula
 

You uncle constantly brags about his outstanding performance in the stock market.  Indeed, at the beginning of
1992, his portfolio of assets was worth a mere $25,000.  By the end of 2000, his portfolio had appreciated in
value to $750,000 (before he lost almost all of it when the market declined!).  What was his annual rate of
return on his portfolio?
 
Solution
 
Step 1) Time Line
            1992                1993                1994                2000                2001
            |                       |                       |           …        |                       |
            $25,000                                                                                   $750,000
Note that since you started at the beginning of 1992 and ended at the end of 2000, the money was invested for
9 full years.   Also note that we want to calculate the answer in years in order to have, well, an annual rate.
 
Step 2) Formula
 

You have just deposited $1,000 in your mutual fund account and plan to keep it in the account for forty (40)
years.  The money earns 16% interest for the first 20 years and 8% for the last 20 years.   Your sibling invests
in a different account that earns 8% for the first 20 years and 16% for the next 20 years.  Which one of you
has the most money after 40 years?
 
Solution
 
Step 1) Time Line
 
            You:
            0                                  20                                40
            |           16%                 |           8%                   |
            $1,000                                                             ???
 
            Sibling
            0                                  20                                40
            |           8%                   |           16%                 |
            $1,000                                                             ???
 
Step 2) Formula
            Initially we will solve this in two steps.   First, determine the value of your investment after 20 years
(FV1)
                  FV1 = PV(1+r)t
                  FV1 = $1000(1.16)20 = $19,460.76
Next, determine the future value of $19,460.76 after 20 years (FV2) at 8%.
                  FV2 = PV (1+r)t
                  FV2 = $19,460.76(1.08)20  = $90,705.76
You could repeat this procedure for your sibling.   However, note that there is a little short-cut.   In the equation
FV = $19,460.76(1+.08)20, the $19,460.76 is really just $1000(1.16) 20.   Thus, we could get to the value at time
period 40 by conducting the following calculation:
FV = $1000(1.16)20(1.08)20  = $90,705.76.
 
So now we can calculate the amount that your sibling will have as:
FV = $1000(1.08)20(1.16)20  = $19,705.76, the same amount.   Although this may not be intuitive, recalling the
A * B is the same as B * A, you can see that the two answers must be the same.

ANNUITY

You have just won the lottery, a record $500 million, paid in equal annual installments over the next 20
years.  The first payment will be received immediately.  If lottery officials wanted to pay you at the end of the
year rather than at the beginning, how much must they offer you in order for you to be indifferent between the
two?  Assume the effective annual interest rate is 10%.
 
Solution
 
Note that since there are 20 equal payments summing to $500 million, then each payment is $25 million.
Step 1) Time Line
                        0                      1                      2                      19                    20
                        |                       |                       |           …       |                       |
Original            $25M               $25M               $25M               $25M               $0
Proposed         $0                    PMT                PMT                PMT                PMT
 
Step 2) Formula
Note that the best time to solve this question for is at t = 0.   If we can determine the value of the original
stream at t = 0, we can then treat this as the present value of the proposed stream of cash flows to determine
the fair PMT.
 
Recall the annuity tool:
it is extremely important to note that this tool when applied to the original stream of cash flows will only tell
you the value of the cash flows 1-19, NOT the value of the first $25M (recall the picture of how this tool
works). So to the PV of the annuity, you will need to add $25M.

 
Next, we treat the $234,123,002 as the present value of the proposed payment stream.  Now note that the
annuity tool will work if $234,123,002 is the present value, to determine the payment stream based on the next
20 periods.
 

What is the present value today of a constant stream of $500 payments to be received at the end of the year
for the next 10 years.  Interest rates are 8% APR, compounded annually.
 
Solution
 
Step 1) Time Line
            0                      1                      2                      9                      10
            |                       |                       |           …        |                       |
                                    $500                $500                $500                $500
 
Note that there are two ways to solve this question.   First, you could individually discount each of the 10 $500
payments back to t = 0 using the present value formula.   However, a much shorter way is to simply use the
annuity tool, which we will use.
 
Step 2) Formula
           

You are considering the purchase of a Titanic Bond, issued by the U.S. government.   This bond promises the
owner a payment of $50/year forever.  If the price of this bond is $850, what will be your rate of return on this
investment?
 
Solution
 
Step 1) Time Line
 
            |                       |                       |                       |           |           …
                                    $50                  $50                  $50
 
Step 2) Formula
 

You have just retired after a long career with a nest egg of $800,000.  Your lifelong dream has been to
purchase an RV and motor the roads of North and South America for the 20 expected years of your
retirement.  You estimate that you will require $60,000/year with which to live in retirement and you will
withdraw the $60,000 at the beginning of each year.  Thus, you will immediately withdraw $60,000 and will do
so again for the next 19 years.  Assume interest rates are 10% APR, compounded annually, how much can you
afford to spend on an RV today?
 
Solution
 
Step 1) Time Line
            0                      1                      2                      19                    20
            |                       |                       |           …        |                       |
            $60                  $60                  $60                  $60                  $0
            RV Value
 
To solve this, we will first need to subtract the present value of the 20 $60,000 payments from your retirement
fund of $800,000.   What is left over can be spent on the RV.
 
Step 2) Formula
Present value of twenty $60,000 payments, with the first to be received today.
 
BONDS

You have just purchased a bond with an annual coupon of 7%, 8 years remaining until  maturity, that is selling
at a price such that the yield to maturity is 12%.  Given this information, what is the price that you paid for the
bond?

Solution
 
Time Line
0                      1                      2                      7                      8
|                       |                       |           …        |                       |
                        $70                  $70                  $70                  $1070
 

Last year, you purchased a bond issued by IBM that offered 8% annual coupon payments, had 12 years to
maturity, and had a yield to maturity of 8%.  The first coupon of $80 has just been paid and current interest
rates have changed such that the yield to maturity on the bond is now 4%.   What was your rate of return and
the current yield on this bond?
 
Solution
 
Step 1: First note that the price of the bond when you purchased it was $1000 because the coupon rate
equaled the YTM.
 
Current yield = Coupon/Pbond = $80/$1000 = 8%
 

Rate of Return =   or coupon plus change in price divided by the initial investment.  In order
to determine this, we need to calculate the Price. After the first coupon is paid, the bond will be worth:
 

Thus, Price = $1,350.42 - $1,000 = $350.42.

 

So Rate of Return = 

Der-Bond-Hauffe is a little-known firm that just issued a bond with a maturity of 6 years, a yield to maturity of
7%, and a price of $904.67.  What must be the coupon rate of this bond?
 
Solution
 
Time Line
            0                      1                      2                      5                      6
            |                       |                       |           …        |                       |
                                    C                     C                     C                     C+1000
            $904.67
 
First, we need to determine how much of the current price is due to the payment of the face value.
 

PVface = 
 
Thus, $904.67 - $666.34 = $238.33 is the value of the coupon payments. 
 
Next, solve for what stream of 6 coupon payments has a present value of $238.33.
 

STOCKS

What is the price today of a stock that is expected to pay an annual dividend of $2.50 each year in
perpetuity?  The appropriate discount rate for a stock of this risk is 15%.
 
Solution
 
The promised payments are a simple perpetuity.  Thus, the value is:
 

What is the price today of a stock that just paid a dividend of $1 and dividends are expected to grow at a
constant rate of 4% per year, indefinitely.  The required return on equity is 18%.
 
Solution
 
The payments associated with owning this stock are simply a growing perpetuity.  We can use the Gordon
Growth model to value this stream of payments.
 

You have just purchased a stock that currently pays no dividends.  However, you expect that after 5 years, the
company will begin to pay dividends on their stock of $2.00 per share, and that this amount will grow at a
constant rate of 5% per year thereafter.  Assuming that stocks with similar risks require a rate of return of
20%, what is a fair price to have paid for this security?
 
Solution
 
Time Line
0          1          2          3          4          5          6          7
|           |           |           |           |           |           |           |           …
DIV     0          0          0          0          0          0          2          2.10     …
 
Once the dividends begin, this is a growing perpetuity.  We can value the growing stream of dividends using the
Gordon Growth model.
 

 
Note that the stock will have a value of $13.33 at t = 5 (since we are treating the $2 as the beginning of the
perpetuity).  Thus, the present value (at t = 0) of this cash flow is:
 

 
We could have achieved that same answer by treating the $2.10 payment as the first dividend, finding the value
of the growing perpetuity at t = 6, adding $2 to this value, and discounting the entire amount back to t = 0.

A firm has a return on equity of 20% and a plowback ratio of 40%.   The risk of this firm is such that
equityholders expect a 30% return.  The firm just paid a dividend of $1.  Given this information, what is the
price of the stock?
 
Solution
 
Recall that growth = return on equity * plowback.
Thus, g = .2 * .4 = .08.
 
We now have sufficient information with which to value the stock.  We know that the next dividend is expected
to be $1(1.08) = $1.08, and that dividends are expected to grow by 8% each year thereafter.
 
Thus, the price of the stock is: