Compensation For Lending

Time Value Of Money Operations

Mutual
ies
Funds of pan
Return Com ty ”
• The value of a given sum of money depends on when the Corporate icul
r
Othe ate Diff
% & “ In
money is received Gov’t Gov’t Bonds o r por
per annum idua
l C ds
• Interest - rental amount charged for the use of money Bonds
Indiv Bon
h i p”
eC
Fn = P + In “Blu porate
Co r
ds
where Bon
5%
P = present value of a single sum of money Risk-Free
Rate
Fn = future value of P after n time periods Risk
0
In = accumulated interest Assume
marginal
1
• i - annual interest rate i= (i PC + i R + i I ) Tax Rate
(1 - t) t=50%
- change in value for $1 over a one-year period
Risk-Free Gov’t Bond Yield
1
i= (i PC + i R +i I )
(1 - t) 1
5% = (0.5%+0 + 2%)
1 − 0 .5
• Why do lenders charge interest? Low-Risk Interest Rate
– Compensation for postponing consumption 1
6% = ( 0.5% + 0.5%+ 2%)
– Compensation for risk 1 − 0.5
– Compensation for inflation Risky Corporate Bond Yield
– Only after-tax compensation of value to investor 1
• t is the tax rate on interest income 15% = ( 0.5%+5%+ 2%)
1 − 0.5

Week 3 - 1 Week 3 - 2

Single Sums of Money

Interest Rate Calculation Approaches F
n
F = P (1 + i)
Fn = P + In 0 1 2 3 (n-3) (n-2) (n-1)
... n

Two approaches used to determine the value of In:

F
P=
• Simple interest approach (1 + i) n
P

In = P i n Fn = P(1 + i n)
P - present value
• Compound interest approach
- equivalent value of an amount of money at time 0
In = i Fn-1 Fn = Fn-1 (1 + i)
F - future value
$1,000 loan over 2 years - interest rate 7% per annum - equivalent value of an amount of money at time n
Simple Interest Compound Interest
Example 1: $1,000 loan at 6% compounded annually. If the
F2 = $1,000 [1+ 0.07(2)] F1 = 1,000 (1+0.07) loan is to be repaid after 5 years, how much will be
= $1,140.00 = 1,070 owed?
F2= 1,070 (1+0.07) F = P (1+i)n
=$1,144.90 = $1,000 (1 + 0.06)5
OR F2 = 1,000 (1.07)(1.07) = $1,000 (1.3382)
= 1,000 (1.07)2 = $1,338.20
= $1,144.90 Example 2: How much must be deposited today in order to
For Compound Interest at Year n accumulate $2,000 in two years in a savings account?
Fn = P(1 + i)n
P = F (1 + i) -n
• assume compound interest unless otherwise stated $2,000
=
(1 + 0.06) 2
= $1,780
Week 3 - 3 Week 3 - 4
 Future Value Factor Present Value Factor

(F|P i,n) = (1 + i)n (P|F i,n) = (1 + i)-n

Find the present value given the future value.

Find the future value given the present value.
F = P (F|P i,n) P = F (P|F i,n)
= P (F|P 6,5) = F (P|F 6,2)
= $1,000 (1.3382) = $2,000 (0.8900)
= $1,338.20 = $1,780
Future Value Factor Table
Present Value Factor Table
(F|P i,n)
(P|F i,n)

Week 3 - 5
N.B. Discrete versus continuous compounding factors. Week 3 - 6

Series of Cash Flows Series of Cash Flows

Present Value of a series of cash flows Present Value

A1 A2 A n -1 An
P = A0 + + + ... + +
(1 + i) (1 + i) 2 (1 + i) n -1 (1 + i) n
P = A0 +A1(1+i)-1 +A2 (1+i)-2 +...+Ak (1+i)-k +...
$3,000 $3,000 + An-1(1+i)-(n-1) +An (1+i)-n
n
$2,000 = A0 + ∑Ak (1+i)-k
k=1
$1,000 n

0 = A0 + ∑Ak (P| F i,k)

k=1
1 2 3 4

i = 10%

where

$5,000
(P|F i,k) = Present Value Factor
A1 A2 A3 A4
P = A0 + + + +
(1 + i) (1 + i) 2 (1 + i) 3 (1 + i) 4
1000 3000 2000 3000
= -5000 + + + +
1.1 (11. ) 2 (11
. ) 3 (11
. )4
= $1,939.90

Week 3 - 7 Week 3 - 8
 Series of Cash Flows Series of Cash Flows

Future value of a series of cash flows Future Value

F = A0(1+i)n + A1(1+i)n-1 + ... + An-1(1+i) + An

$3,000 $3,000 F = A 0 (1 + i) n +A 1 (1 + i) n -1 +A 2 (1 + i) n -2 +...

+ A k (1 + i) n -k + ... +A n-1 (1 + i) +A n
$2,000 n

$1,000 = ∑A
k =0
k (1 + i) n-k
n

∑A
0
= k (F|Pi,n - k)
1 2 3 4 k =0

i = 10%

$5,000 where

(F|P i,n-k) = Future Value Factor

F = A0(1+i)4 + A1(1+i)3 + A2(1+i)2 + A3(1+i) + A4
= -5000(1.1)4 + 1000(1.1)3 + 3000(1.1)2 + 2000(1.1) + 3000
= $2,840.50

Opportunity Cost?

Week 3 - 9 Week 3 - 10

Future Value - Bank Account Example

Present Value Versus Future Value
Future value of a series of cash flows
$3,000 $3,000 F = A0(1+i)n + A1(1+n)n-1 + ... + An-1(1+i) + An
$2,000 $3,000 $3,000

$1,000 $2,000
0 $1,000
0
1 2 3 4
1 2 3 4
i = 10%
i = 10%
F = $2,840.50
P = $1,939.90
$5,000 $5,000

As calculated from the individual cash flows:

• 10% interest compounded annually (positive or negative
account balance)
P (EOY 0) = $1,939.90
• bank account (with overdraft privileges)
F (EOY 4) = $2,840.50
2,840.50 Amount Amount
“Rented” Interest Deposited/ Account
F (EOY 4) = P (EOY 0) (F|P 10,4) EOY During Year 10% Withdrawn Balance
= 1939.90 (1.4641) 0 -- -- -5000 -5000
= $2840.50 0 1 2 3 4 1 -5000 -500 1000 -4500
2 -4500 -450 3000 -1950
1,939.90
P (EOY 0) = F (EOY 4) (P|F 10,4) 3 -1950 -195 2000 -145
4 -145 -14.50 3000 $2,840.50
= 2840.50 (0.6830)
= $1939.90
0 1 2 3 4

Week 3 - 11 Week 3 - 12
 Tuition Payment Strategy
Optimal Tuition Payment Strategy
July 1 Aug 1 Sept 1 Oct 1 Nov 1 Dec 1 Jan 1

1. Fees invoice sent in July.

2. U of T recommends early payment.
3,034 3,034+S/C
– at least first installment by August 15 = 3,173
3. Payment by installments allowed.
– Total Fee $8,668 8,668 5,634 5,634

– Minimum First Installment $5,634

– Balance $3,034
4. First installment due before the first day of class. 1 Interest on bank savings account: 0.25% per month
⇒ 3.04% per annum
5. Remainder of tuition fees due January 15.
6. Service charge (i.e. interest) charged on the balance 2 U of T “service charge”: 1.5% per month
outstanding from October 15. ⇒ 19.56% per annum

– Rate charged - 1.5% per month compounded 1 PV|July 1 = $8,668 Payment (January)

=> 19.56% per annum! 2 PV|July 1 = 5,634(P|F 0.25%,2) + (3,034 + S/C)(P|F 0.25%,6)
Payment(January) = 3,034(F|P 1.5%,3) = $3,173
What is the optimal payment strategy is consistent with PV|July 1 = 5,634(P|F 0.25%,2)+ 3,034(F|P 1.5%,3)(P|F 0.25%,6)
money having a “time value?” = 5,634(0.9950) + 3,034(1.0457)(0.9851) = $8,731
3 PV|July 1 = 5,634(P|F 0.25%,2) + 3,034(P|F 0.25%,3)
= 5,634(0.9950) + 3,034(0.9925)
2009-2010
= $8,617
Fee schedule

Week 3 - 13 Week 3 - 14

Optimal Tuition Payment Strategy

Uniform Series of Cash Flows
Alternative 3 is the optimal payment strategy and has a
• A uniform series of cash flows exists when all cash flows
Present Value (July 1) savings of: are equal
A A A A A
PV1|July 1 - PV3|July 1 = 8,688 - 8,617 = $51

...
These savings are created by the time value of money at
1 2 n-2 n-1 n
0.25% per month.

Only $8,617 need be deposited into a bank account on July 1

to meet the September & October payments.
End of P
Beginning Interest Payment Month
of Month Balance (0.25%) to U of T Balance • Also called an annuity

July 1 8,617 22 -- 8,639 P = A(1 + i) -1 +A(1 + i) -2 + ... +A(1 + i) -(n -1) + A(1 + i) -n
n
Aug 1 8,639 22 -- 8,660 = ∑ A(1 + i) -k

Sept 1 3,026 7 5,634 3,034 k =1

⎡ (1 + i) n − 1⎤
Oct 1 0 0 3,034 0 P = A⎢ n ⎥
______ ⎣ i(1 + i) ⎦
Total Interest $ 51 Uniform series, Present Value Factor
P = A(P|A i,n)

Week 3 - 15 Week 3 - 16
 Deferred Annuity Funding
Uniform Series of Cash Flows
Suppose that the first withdrawal will not occur until three
- Annuity Funding years after the deposit. How much must be deposited to
receive the five annual $2,000 payments.
• Annuity funding
$2000 $2000 $2000 $2000 $2000
$2,000
0

1 2 3 4 5 6 7

1 2 3 4 5
P?
⎡ (1 + i) n − 1⎤
P = A⎢ n ⎥
But we know that at Year 2 $8200.40 will be sufficient to
⎣ i(1 + i) ⎦ generate 5 payments of $2,000.
P = A (P | A i, n) $8200.40
Example: An individual wishes to deposit a single sum of
money into a savings account so that five annual with-
drawals of $2,000 can be made. The first withdrawal is
to occur a year after the deposit and the rate of interest is 0
7%.
1 2 3 4 5 6 7
⎡ (1 + i) n - 1⎤
P = A⎢ n ⎥
= A(P | A i, n) P?
⎣ i(1 + i) ⎦
⎡ (1.07) − 1 ⎤
5 Therefore, we must discount the single sum of $8200.40
= 2000 ⎢ 5⎥
= 2000 (P | A 7,5)
⎣ 0.07(1.07) ⎦ back to Year 0.
= 2000 [4.1002] = $8200.40 $8200.40
P = = $8,200.40 (P|F 7%,2)
(1.07) 2
Therefore, if $8,200.40 is deposited into the fund, then five = $7,162.55
annual withdrawals can be made. Only $7,162.55 must be deposited. Deferring the withdrawal
for two years reduces the deposit required by $1,037.85.
Week 3 - 17 Week 3 - 18

Applications of the
Uniform Series of Cash Flows Sinking Fund - College Education Planning
A A A A A $30,000

...
1 2 n-2 n-1 n

P F Sept. A Sept.
1990 2009

Present Value Factor, Annuity P = A (P|A i,n) • Funding a college education over 20 years
Capital Recovery Factor A = P (A|P i,n) • Need to estimate in September 1990
Future Value Factor, Annuity F = A (F|A i,n) – cost of education ($30,000)
Sinking Fund Factor A = F (A|F i,n) – average interest rate over 20 years (7%)

A = F (A|F i,n)
= 30000 (A|F 7,20)
= 30000 (0.0244)
= $732 per year

Week 3 - 19 Week 3 - 20
 College Education Planning
Multiple Compounding Periods in a Year
- Four Annual Installments
• Not all interest rates are stipulated as annual compounding
rates
$7,500
$1,000 Loan - 8% Interest Compounded Quarterly
=> 2% per 3-month period for 4 interest periods

F = P (F|P 2,4)
Sept Sept
2 2 = $1000 (1.0824)
0 0 = $1,082.40
0 1
9 2
Equivalent to

F = P (F|P 8.24,1)
= $1000 (1.0824)
= $1,082.40

Nominal Interest Rate = 8%

Effective Annual Rate = 8.24%

27,182
A = [7500 + 7500 (P|A 7,3)] (A|F 7,20) Q1 1,000.00 20.00 1,020.00

= [7500(1 + 2.6243)](0.0244) Q2 1,020.00 20.40 1,040.40

= $663 per year Q3 1,040.40 20.81 1,061.21

Q4 1,061.21 21.22 1,082.43

Week 3 - 21 Week 3 - 22

Bank Account Compounding

Effective Interest Rates
Bank Rate: 8% compounded quarterly
r = nominal annual interest rate
Consider two different types of bank accounts:
m = number of compounding periods per year
ieff = effective interest rate per year 1. Savings Account: Interest paid on minimum quarterly
balance
m
⎛ r⎞ 2. Daily Interest Account: Interest earned from time of
i eff = ⎜1 + ⎟ − 1
⎝ m⎠ deposit
⎛ r ⎞
= ⎜ F|P , m⎟ − 1 What happens to monthly deposits to the bank account?
⎝ m ⎠
Let i be the monthly rate; then,
e.g. 8% Interest Compounded Quarterly

UofT Tuition
ieff = (1 + i )12 − 1
r = .08 r/m = .02 4
“Service Charge”
⎛ 0.08 ⎞
m=4 1.5% per month = ⎜1 + ⎟ −1
ieff = (1+0.015)12 - 1 ⎝ 4 ⎠
ieff = (F|P 2,4) - 1 = (F|P 1.5,12) - 1
= 1.0824 - 1 = 8.24% → ieff = 19.56%
vs. 18% nominal rate
⇒ (1 + i )12 = (1.02) 4
• Discrete compounding
(1 + i )3 = 1.02
• In the limit (m → ∞) continuous compounding ∴ i = (1.02)1/ 3 − 1 = 0.0066227
– optional topic (Section 3.6)
– always use the discrete compounding i = 0.66227%
tables in Appendix A.

Week 3 - 23 Week 3 - 24
Interest Earned: Three Monthly Deposits of $10,000 Interest Earned: Three Monthly Deposits of $10,000

1. Minimum Quarterly Balance F=? Savings Account

Quarterly Interest Rate: 2.0000%

Jan Feb Mar
Deposit End-of-Quarter End-of-Day
Apr Interest Balance
January 1 10,000.00 10,000.00
January 31 10,000.00
Minimum balance = 10,000 I = 200 February 1 10,000.00 20,000.00
∴ F = 30,200 February 28 20,000.00
March 1 10,000.00 30,000.00
2. Interest Earned From Time F=? March 31 200.00 30,200.00
of Deposit
Jan Feb Mar Note minimum balance for the quarter is $10 000.

Apr Daily Account

Monthly Interest Rate: 0.66227%

• Use monthly rate of 0.66227%
January deposit 10000 (1+.0066)3 = 10,200 Deposit End-of-Month End-of-Day
Interest Balance
February deposit 10000 (1+.0066)2 = 10,133
January 1 10,000.00 10,000.00
March deposit 10000 (1+.0066) = 10,066 January 31 66.23 10,066.23
∴ F = 30,399 February 1 10,000.00 20,066.23
OR February 28 132.89 20,199.12
March 1 10,000.00 30,199.12
3.0199 1.0066
March 31 200.00 30,399.12
F = 10,000 (F|A 0.66%,3) (F|P 0.66%,1)
= 30,399

Week 3 - 25 Week 3 - 26

Relationship Between the Present Value

Series of Cash Flows - Special Cases
Factor, Inflation Rates and Time
Present Value Interest
of $1 Rate
Three Special Cases
$1.00 0%

• each has a closed-form solution

2% (0.82)
$0.75 1. Uniform series of cash flows (annuity)
5% (0.61) Ak = A k = 1,...,n

$0.50 2. Gradient series of cash flows

10% (0.39)
⎧ 0 k =1
Ak = ⎨
⎩Ak −1 + G k = 2,..., n
$0.25 15% (0.25)
3. Geometric series of cash flows

25% (0.11) ⎧ A k =1
Ak = ⎨
2 4 6 8 10 Years ⎩ k −1(1 + j)
A k = 2,..., n

Present Value (P|F i,n)

“Discount Factor” < 1.00
• present value factors listed are for 10 years at stated
interest rate

Week 3 - 27 Week 3 - 28
 Gradient Series of Cash Flows
Gradient Series of Cash Flows
(n-1)G
(n-2)G
Computer Maintenance Service Agreement (five years)
2G $5,000 per year service fee
G $600 annual escalation factor
0 ...
1 2 3 n-1 n
What is the Present Value Cost at a 6% Interest Rate?
End of period

Contract Fees Annuity Gradient

0 1 2 3 4 5
= 0 1 2 3 4 5
+ 0 1 2 3 4 5
P
600
• Each successive cash flow increases by a fixed amount 1,200
1,800
equal to G 5,000
2,400
$5,000/year
5,600
• Note that there is no cash flow at end of period 1
6,200

6,800
A k = ( k − 1)G k = 1,..., n
n 7,400
P = ∑A
k =1
k (1 + i) − k
n i = 6%
= G ∑ ( k - 1)(1 + i) - k n=5
k =1
⎡1 − (1 + ni)(1 + i) − n ⎤
PV (EOY 0) = A (P|A 6,5) + G (P|G 6,5)
P = G⎢ ⎥
⎣ i2 ⎦
= 5,000(4.2124) + 600(7.9345)
= $25,822.70
Gradient Series, Present Value Factor
P = G (P|G i,n)

Week 3 - 29 Week 3 - 30

Geometric Series of Cash Flows Geometric Series, Present Value Factor

An

An-1

A3 P = A1 (P|A1 i,j,n)
A2
A1
0 ...
A stockholder owns 1,000 shares of XYZ Company and
1 2 3 n-1 n intends to own these shares for 10 years.
End of period
j = % change in cash flow
The shareholder expects next year’s dividend on a share to be
P $2.50. The expected annual growth in dividends is 4%.
• Each successive cash flow increases by a fixed
percentage equal to j What is the present value of the future dividend stream if
A k = A k −1 (1 + j) k = 2,..., n money has a time value of 5%?
A k = A 1 (1 + j) k −1 k = 1,..., n
P = A1 (P|A1 5,4,10)
n = 1,000 (2.50) (9.1258)
P= ∑ A (1 + j)
k =1
1
k −1
(1 + i) − k = $22,814.50

⎧ ⎡1 − (1 + j)n (1 + i)− n ⎤
⎪⎪A1 ⎢ ⎥ i≠ j
P=⎨ ⎣ i− j ⎦
⎪ nA1 i= j
⎪⎩1 + i

Week 3 - 31 Week 3 - 32
Geometric Series - Stock Purchase Evaluation
3.56
3.42
3.29
3.16
2.92
3.04 A1 = 2.50
2.81
2.60
2.70 j = 4%
2.50

0 1 2 3 4 5 6 7 8 9 10
“Dividend Stream” An = A1(1+j)n-1

Present Value of Dividends per Share

P = A1 (P|A1 i,j,n)
= 2.50 (P|A1 5,4,10)
= 2.50 (9.1258) = $22.81

i = 5%: Investor requires at least this rate of return.

Total Return: 1. from dividends

2. from value of share
Investor forecasts price of share to be $50.00 at the end of
Year 10.
$22.81 $30.70
PVFuture Returns = PVDIV + 50 (P|F 5,10) = 53.51 per share

Overvalued? => Sell (or “short”)

Under Valued? => Buy

Week 3 - 33