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Lecture 3-Time Value of Money-Principles of Financial Economics

This lecture covers topics related to the time value of money including future values, present values, multiple cash flows, perpetuities, and annuities. Specific topics include calculating future and present values using simple and compound interest, applying time value of money concepts to multiple cash flows, and determining the present value of perpetuities and annuities. Examples are provided to demonstrate calculating future and present values in various time value of money applications.

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44 views42 pages

Lecture 3-Time Value of Money-Principles of Financial Economics

This lecture covers topics related to the time value of money including future values, present values, multiple cash flows, perpetuities, and annuities. Specific topics include calculating future and present values using simple and compound interest, applying time value of money concepts to multiple cash flows, and determining the present value of perpetuities and annuities. Examples are provided to demonstrate calculating future and present values in various time value of money applications.

Uploaded by

80tek
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 3

Time Value of Money


Topics Covered

 Future Values
 Present Values
 Multiple Cash Flows
 Perpetuities and Annuities
Future Values

Future Value - Amount to which an investment


will grow after earning interest.

Compound Interest - Interest earned on


interest.

Simple Interest - Interest earned only on the


original investment.
Future Values

Example - Simple Interest


Interest earned at a rate of 6% for five years on a
principal balance of $100.
Future Values

Example - Simple Interest


Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years


1 2 3 4 5
Interest Earned
Value 100
Future Values

Example - Simple Interest


Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years


1 2 3 4 5
Interest Earned 6
Value 100 106
Future Values

Example - Simple Interest


Interest earned at a rate of 6% for five years on a principal
balance of $100.

Today Future Years


1 2 3 4 5
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130

Value at the end of Year 5 = $130


Future Values

Example - Compound Interest


Interest earned at a rate of 6% for five years on the
previous year’s balance.
Future Values

Example - Compound Interest


Interest earned at a rate of 6% for five years on the
previous year’s balance.

Interest Earned Per Year =Prior Year Balance x .06


Future Values

Example - Compound Interest


Interest earned at a rate of 6% for five
years on the previous year’s balance.
Future Values

Future Value of $100 = FV

FV  $100  (1  r ) t
Future Values

FV  $100  (1  r ) t

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?
Future Values

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

FV  $100  (1  .06 )  $133 .82


5
Future Values with Compounding

70 Interest Rates
60 0%
5%
50 10%
FV of $1

40 15%

30

20

10

0
10

12

14

16

18

20

22

24

26

28

30
0

Number of Years
Present Values

Present Value Discount Factor


Value today of a Present value of
future cash a $1 future
flow. payment.
Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Present Values

Present Value = PV

Future Value after t periods


PV = (1+ r) t
Present Values

Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on your
money, how much money should you set aside today in order
to make the payment when due in two years?
Present Values

Discount Factor = DF = PV of $1

DF  1
(1 r ) t

 Discount Factors can be used to compute the


present value of any cash flow.
Time Value of Money
(applications)

 The PV formula has many applications.


Given any variables in the equation, you can
solve for the remaining variable.

PV  FV  1
(1 r ) t
PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash now,
or make three payments: $8,000 now and $4,000 at the end of
each of the following two years. If your cost of money is 8%,
which do you prefer?
PV of Multiple Cash Flows

 PVs can be added together to evaluate


multiple cash flows.

PV  C1
(1 r ) 1  (1 r ) 2 ....
C2
Perpetuities & Annuities

Perpetuity
A stream of level cash payments that never
ends.

Annuity
Equally spaced level stream of cash flows for
a limited period of time.
Perpetuities & Annuities

PV of Perpetuity Formula

PV  C
r

C = cash payment
r = interest rate
Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?
Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?
Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?
Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?

PV  1, 000 , 000
( 1 .10 ) 3
 $751,315
Perpetuities & Annuities

PV of Annuity Formula

PV  C  1
r  1
r ( 1 r ) t 
C = cash payment
r = interest rate
t = Number of years cash payment is received
Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present value


of $1 a year for each of t years.

PVAF   1
r  1
r ( 1 r ) t 
Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to
make 3 annual installments of $4,000 per year.
Given a rate of interest of 10%, what is the price you
are paying for the car (i.e. what is the PV)?
Perpetuities & Annuities

Applications
 Calculation of periodic payments
– Mortgage payment
– Annual income from an investment payout
– Future Value of annual payments
Perpetuities & Annuities

Example - Future Value of annual payments


You plan to save $4,000 every year for 20 years and
then retire. Given a 10% rate of interest, what will be
the FV of your retirement account?
Perpetuity

A benefactor wishes to donate a sum for


research at the University. If the interest rate is
10 per cent and the aim of the donation is to
provide $100,000 every year, then the amount
that should be set aside today is:
Perpetuity

A benefactor wishes to donate a sum for


research at the University. If the interest rate is
10 per cent and the aim of the donation is to
provide $100,000 every year, then the amount
that should be set aside today is:
Present value of the perpetuity:
C 100,000
  $1,000,000
r 0.10
Growing Perpetuity

 The benefactor realises that there is a need to


account for growth in salaries, which he estimates at
4 per cent, starting in Year 1. Therefore instead of
providing $100,000 in year 1, he must provide 1.04 x
$100,000 in Year 1 and so on…
PV of a stream of Cash Flows

 Recall that the present value of a stream of


cash flows is:
Compound Interest and Present
Values

 When money is invested at compound interest, each interest


payment is reinvested to earn more interest in subsequent
periods.
 Continuous compounding means that payment is spread evenly
and continuously throughout a year.
 In general, an investment of $1 at a rate of r per annum
compounded m times a year amounts to at the end of the year
to:
m
  r 
1   
  m 
Continuous Compounding

 A General Equation for Compounding More


Frequently than Annually
Example of Continuous
Compounding

 Fred has found an institution that will pay him 8%


annual interest, compounded semi-annually. If he
leaves the money in the account for 24 months (2
years), he will be paid 4% interest compounded over
four periods.
Continuous Compounding

• A General Equation for Compounding More


Frequently than Annually
– Recalculate the example for the Fred Moreno example
assuming (1) semiannual compounding and (2)
quarterly compounding.
Continuous Compounding

 With continuous compounding the number of


compounding periods per year approaches
infinity.
 Through the use of calculus, the equation
thus becomes: rt
e
 Continuing with the previous example, find
the Future value of the $100 deposit after 5
years if interest is compounded continuously.
Examples

 Suppose you invest $1 at a continuously


compounded rate of 11 per cent (r=0.11) for
one year. What is the value at the end of the
period?
 Suppose the investment is over a period of
two years. What is the value of the final
investment?

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