R5 Time Value of Money Slides

Level I - Quantitative Methods
Time Value of Money

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents
1.
2.
3.
4.
5.
6.
7.
Introduction
Interest Rates: Interpretation
The Future Value of a Single Cash Flow
The Future Value of a Series of Cash Flows
The Present Value of a Single Cash Flows
The Present Value of a Series of Cash Flows
Solving for Rates, Number of Periods, or Size
of Annuity Payments
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Video Lecture 1
39 minutes
Video Lecture 2
40 minutes
1. Introduction
Time value of money
Interest rates
Present value
Future value
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2. Interest Rates: Interpretation

Interest rates can be interpreted as:
1. Required rate of return
2. Discount rate
3. Opportunity cost
Say you lend $900 today and receive $990 after one year
Required Rate of Return
Discount Rate
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Opportunity Cost
Interest Rates: Investor Perspective

As investors, we can view an interest rate as:
Nominal
Risk-free
Rate
Real risk-free interest rate +

Inflation premium +
Default risk premium +
Liquidity premium +
Maturity premium
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Practice Question 1
Jill Smith wishes to compute the required rate of return. Which of the
following premiums is she least likely to include?
A. Inflation premium
B. Maturity premium
C. Nominal premium
Answer: C
Required rate of return includes inflation premium, maturity premium, default
risk premium, and liquidity premium. There is no such component as a
nominal premium.
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Practice Question 2
Which of the following is least likely true?
A. Discount rate is the rate needed to calculate present value
B. Opportunity cost represents the value an investor forgoes
C. Required rate of return is the maximum rate of return an investor
must receive to accept an investment
Answer: C
Required rate of return is the minimum rate of return an investor must
receive to accept an investment. Therefore, option C is least likely to be the
interpretation of interest rates.
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Practice Question 3
Investments
Maturity
(in years)
Liquidity
Default risk
Interest Rates (%)
High
Low
2.0
Low
Low
2.5
Low
Low
High
Low
3.0
Low
High
4.0
1.
Explain the difference between the interest rates on

Investment A and Investment B.
2.
Estimate the default risk premium.
3.
Calculate upper and lower limits for the interest rate on

Investment C, r.
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3. Future Value of a Single Cash Flow

PV = 100 and r = 10%
What is the FV after one year?
What is the FV after two years?
FVN = PV (1 + r)N
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Practice Question 4
Cyndia Rojers deposits $5 million in her savings account. The account holders are
entitled to a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash
would she most likely be able to withdraw?
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FV Calculation Using a Financial Calculator

Set to floating decimal
Keystrokes
Explanation
Display
[2nd] [FORMAT] [ ENTER ]
Get into format mode
DEC = 9
[2nd] [QUIT]
Return to standard calc mode
You invest $100 today at 10% compounded annually. How

much will you have in 5 years?
Keystrokes
Explanation
Display
[2nd] [QUIT]
Return to standard calc mode
[2nd] [CLR TVM]
Clears TVM Worksheet
5 [N]
Five years/periods
N=5
10 [I/Y]
Set interest rate
I/Y = 10
100 [PV]
Set present value
PV = 100
0 [PMT]
Set payment
PMT = 0
[CPT] [FV]
Compute future value
FV = -161.05
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3.1 Frequency of Compounding

You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated
annual interest rate of 10% compounded quarterly. How much will you
have at the end of three years?
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Multiple Compounding Periods - Calculator

You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual
interest rate of 10% compounded quarterly. How much will you have at the end of
three years?
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Practice Question 5
Donald invested $3 million in an American bank that promises to pay 4% compounded daily. Which
of the following is closest to the amount Donald receives at the end of the first year? Assume 365
days in a year.
A. $3.003 million
B. $3.122 million
C. $3.562 million
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3.2 Continuous Compounding

Infinite compounding periods per year continuous compounding
FVN = PV e r N
An investment worth $50,000 earns interest that is compounded
continuously. The stated annual interest is 3.6%. What is the
future value of the investment after 3 years?
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Concept Building Exercise

Assume the stated annual interest rate is 12%. What is the future value of $100 at
different compounding frequencies?
Frequency
Future value of $100
Return
Annual
112
12.00%
Semiannual
112.36
12.36%
Quarterly
Monthly
Daily
Continuous
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3.3 Stated and Effective Rates

With a discrete number of compounding periods:
EAR = (1 + Periodic interest rate)m 1
With continuous compounding:

EAR = er 1
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4. The Future Value of a Series of Cash Flows

Annuity: finite set of level sequential cash flows
Ordinary annuity: an annuity where the first cash flow occurs one period from today
Annuity due: an annuity where the first cash flow occurs immediately
Perpetuity: set of level never-ending sequential cash flows with the first cash flow
occurring one period from today
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4.1 Future Cash Flows Ordinary Annuity

Ordinary annuity with A = 1,000 r = 5% and N = 5
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Ordinary Annuity - Formula

FVN = A {[(1+r)N 1]/r}

FVN = A {Future Value Annuity Factor}
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Ordinary Annuity - Calculator

N=5
I/Y = 5
PV = 0
PMT = 1,000
CPT
FV
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Practice Question 6
Haley deposits $24,000 in her bank account at the end of every year. The account
earns 12% per annum. If she continues this practice, how much money will she have
at the end of 15 years?
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Practice Question 7
Iago wishes to compute the future value of an annuity worth $120,000. He is aware
that the FV annuity factor is 21.664 and the interest rate is 4.5%. Which of the
following is least likely to be useful for the future value computation?
A. Annuity worth
B. Future value annuity factor
C. Interest rate
Answer: C
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4.2 Unequal Cash Flows

Time
Cash Flow ($)
1,000
2,000
3,000
4,000
5,000
What is the future value at year 5?
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End of Lecture 1
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5. Finding the Present Value of a Single Cash Flow

PV = FVN (1+r)-N
For a given discount rate, the farther in the future the amount to be received,
the small the amounts present value.
Holding time constant, the larger the discount rate, the smaller the present
value of a future amount.
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Practice Question 8
Liam purchases a contract from an insurance company. The contract promises to pay
$600,000 after 8 years with a 5% return. What amount of money should Liam most
likely invest? Solve using the formula and TVM functions on the calculator.
Answer: 406,104
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Practice Question 9
Mathews wishes to fund his son, Nathans, college tuition fee. He purchases a security
that will pay $1,000,000 in 12 years. Nathans college begins 3 years from now. Given
that the discount rate is 7.5%, what is the securitys value at the time of Nathans
admission?
Answer: 521,583
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Practice Question 10
Orlando is a manager at an Australian pension fund. 5 years from today he wants a
lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year,
compounded monthly, how much should Orlando invest today?
Answer: 32,760
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6. Present Value of a Series of Cash Flows

Present value of a series of equal cash flows (annuity)
Present value of a perpetuity
Present value indexed at times other than zero
Present value of a series of unequal cash flows
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6.1 Present Value of a Series of Equal Cash Flows

Ordinary annuity with A = 10 r = 5% and N = 5
0
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PV of an Ordinary Annuity: Using the Formula

0
PV = A {[1 1/(1+r)N]/r}
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PV of an Ordinary Annuity: Using the Calculator

0
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Annuity Due The Concept

Annuity due with A = 10 r = 5% and N = 5
0
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PV of an Annuity Due: Using the Formula

0
PV (annuity due) = A {[1 1/(1+r)N]/r} (1+r)
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PV of an Annuity Due: Using the Calculator

0
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Key Strokes
Display
[2nd] [BGN] [2nd] [SET]
BGN
[2nd] [QUIT]
BGN
[2nd] [CLR TVM]
BGN
5 [N]
BGN
N=5
5 [I/Y]
BGN
I/Y = 5
10 [PMT]
BGN
PMT = 10
0 [FV]
BGN
FV = 0
[CPT] [PV]
BGN
[2nd] [BGN] [2nd] [SET]
END
[2nd] [QUIT]
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6.2 Present Value of a Perpetuity

PV = A/r
Present value is one period before the first
cash flow
Simple example to understand the formula:
You invest $100 and get 5% for ever. What is
the cash flow?
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6.3 Present Values Indexed at Times Other Than t=0

An annuity or perpetuity beginning sometime in the future can be expressed in present
value terms one period prior to the first payment
Discount back to todays present value
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Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth
$100 per year indefinitely. The first payment will be received at t = 4. Given that the
required rate of return is 10%, how much should Mr. Graham pay today?
Answer: 751.31
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6.4 The Present Value of a Series of Unequal Cash Flows

Find the present value of each individual cash
Sum the respective present values
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Andy makes an investment with the expected cash flow shown in the table below.
Assuming a discount rate of 9% what is the present value of this investment?
Time Period
1
2
3
4
5
Cash Flow($)
50
100
150
200
250
Answer: 550
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7. Solving for Rates, Number of Periods, or Size of

Annuity Payments
Solving for Interest Rates and Growth

Solving for Number of Periods
Solving for the Size of Annuity Payments
Review of Present Value and Future Value Equivalence
The Cash Flow Additivity Principle
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7.1 Solving for Interest Rates and Growth Rates

A $100 deposit today grows to $121 in 2 years.
What is the interest rate? Use both the formula and the
calculator method.
The population of a small town is 100,000 on 1 Jan
2000. On 31 December 2001 the population is
121,000. What is the growth rate?
You invest $900 today and receive a $100 coupon

payment at the end of every year for 5 years. In
addition, you receive $1,000 and the end of year 5.
What is the interest rate?
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7.2 Solving for the Number of Periods

You invest $2,500. How many years will it take to triple the amount given that
the interest rate is 6% per annum compounded annually? Use both the formula
and the calculator method.
Answer: 18.85 years

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7.3 Solving for the Size of Annuity Payments

Freddie bought a car worth $42,000 today. He was required to make a 15% down payment. The
remainder was to be paid as a monthly payment over the next 12 months with the first payment
due at t=1. Given that the interest rate is 8% per annum compounded monthly, what is the
approximate monthly payment?
Answer: 3,106
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7.4 Review of Present and Future Value Equivalence

Ordinary annuity with A = 10 r = 5% and N = 5 PV = 43.29
A lump sum can be considered equivalent
to an annuity
Lump sum = PV = 43.29

An annuity can be considered equivalent
to a future value
FV = 55.26
A lump sum can be considered equivalent
to a future value
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7.5 The Cash Flow Additivity Principle

Amounts of money indexed at the same point in time are additive
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Summary
1. Interest Rates
2. Future Value
3. Present Value
4. Solving for Rates, Number of
Periods, or Size of Annuity
Payments
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Conclusion
Review learning objectives
Examples and practice problems from the
curriculum
Practice questions from other sources
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Level I - Quantitative Methods

Time Value of Money

2. Interest Rates: Interpretation

Interest Rates: Investor Perspective

Real risk-free interest rate +

Interest Rates (%)

Explain the difference between the interest rates on

Estimate the default risk premium.

Calculate upper and lower limits for the interest rate on

3. Future Value of a Single Cash Flow

FV Calculation Using a Financial Calculator

[2nd] [FORMAT] [ ENTER ]

Get into format mode

Return to standard calc mode

You invest $100 today at 10% compounded annually. How

Return to standard calc mode

[2nd] [CLR TVM]

Clears TVM Worksheet

Set interest rate

Set present value

Compute future value

3.1 Frequency of Compounding

Multiple Compounding Periods - Calculator

3.2 Continuous Compounding

Concept Building Exercise

Future value of $100

3.3 Stated and Effective Rates

With continuous compounding:

4. The Future Value of a Series of Cash Flows

4.1 Future Cash Flows Ordinary Annuity

Ordinary Annuity - Formula

FVN = A {[(1+r)N 1]/r}

Ordinary Annuity - Calculator

4.2 Unequal Cash Flows

Cash Flow ($)

What is the future value at year 5?

5. Finding the Present Value of a Single Cash Flow

6. Present Value of a Series of Cash Flows

6.1 Present Value of a Series of Equal Cash Flows

PV of an Ordinary Annuity: Using the Formula

PV of an Ordinary Annuity: Using the Calculator

Annuity Due The Concept

PV of an Annuity Due: Using the Formula

PV (annuity due) = A {[1 1/(1+r)N]/r} (1+r)

PV of an Annuity Due: Using the Calculator

[2nd] [BGN] [2nd] [SET]

[2nd] [CLR TVM]

[2nd] [BGN] [2nd] [SET]

6.2 Present Value of a Perpetuity

6.3 Present Values Indexed at Times Other Than t=0

Discount back to todays present value

6.4 The Present Value of a Series of Unequal Cash Flows

7. Solving for Rates, Number of Periods, or Size of

Solving for Interest Rates and Growth

7.1 Solving for Interest Rates and Growth Rates

You invest $900 today and receive a $100 coupon

7.2 Solving for the Number of Periods

Answer: 18.85 years

7.3 Solving for the Size of Annuity Payments

7.4 Review of Present and Future Value Equivalence