TIME VALUE OF MONEY

What did we miss?

□ The Concept of Time Value of Money.
□ Deferred Annuity.
□ Amortization Schedule.
□ Effective Annual Rate.
□ Perpetuity.
□ Growing Annuity.
 Deferred Annuity

◆ Cash flow might include a combination of Single

Amount and Annuity, if the annuity will be paid at
some time in the future, it is referred to as Deferred
Annuity.

Yr. 0 1 2 3 4 5 6 7 8
CF 1000 2000 3000 1000 1000 1000 1000 1000

If the Discount rate is 8 % what is the present value of Cash Flows?

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Mixed Stream with Annuity (Deferred Annuity)

Mixed Stream CF Annuity CF

Year 0 1 2 3 4 5 6 7 8
Cash 1000 2000 3000 1000 1000 1000 1000 1000
Flow
925.9 n=1, i=8%

1,714.7 PV of Annuity = PVIFA(5yrs, 8%)*A

n=2, i=8% = (3.993*1000) = 3993
2,381.5 n=3, i=8%

PV1-3 5,022.1 3,993

PV A 3,169.8 PV of 3993 for 3 Yrs @ 8%
Total 8,191.9

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Deferred Annuity
($1,000 per year to be paid 4 - 8 years in the future)
(first step)
Beginning of fourth period

A1 A2 A3 A4 A5
Present $1,000 $1,000 $1,000 $1,000 $1,000
value
$3,993

0 1* 2 3 4 5 6 7 8

*Each number represents the end of the period; that is, 4 represents the end of the fourth period

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The present value of a deferred annuity
($1,000 per year to be paid 4 - 8 years in the future)
(second step)
End of third period—Beginning of fourth period

i=8%, n=3

$3,170 $3,993 A1 A2 A3 A4 A5
Present (single amount) $1,000 $1,000 $1,000 $1,000 $1,000
value

0 1 2 3 4 5 6 7 8

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 Deferred Annuity- Complex Example

Carol plans on retiring on her 60th birthday. She wants to put the equal amount of
funds aside each year for the next twenty years -- starting next year - so that she will
be able to withdraw $50,000 per year for twenty years once she retires, with the
first withdrawal on her 61st birthday. Carol is 20 years old today. How much must
she set aside each year for her retirement if she can earn 10% on her funds?
N=20 yrs, r=10%, A=50,000
N=20 yrs, r=10%, A=? N=20 yrs, r=10%, PV=?

20 yrs age Phase-3 40 yrs age Phase-2 60 yrs age Phase-1 80 yrs age

Phase-1
PVA(n=60)= $425,678.19

n=60 Another Way to solve PVA n=60

PVA60 = $50,000 (PV annuity
factor (PVIFA) for N=20, i=10%)

PV60 = $50,000 (8.5136)

n=60 PV60 = $425,678.19
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© 2003 McGraw-Hill Ryerson Limited
 Deferred Annuity-Example

Carol plans on retiring on her 60th birthday. She wants to put the same amount of
funds aside each year for the next twenty years -- starting next year -- so that she will
be able to withdraw $50,000 per year for twenty years once she retires, with the first
withdrawal on her 61st birthday. Carol is 20 years old today. How much must she set
aside each year for her retirement if she can earn 10% on her funds?
N=20 yrs, r=10%, A=50,000
N=20 yrs, r=10%, A=? N=20 yrs, r=10%, PV=?

20 Phase-3 40 Phase-2 60 Phase-1 80

Phase-2
Because she will stop making payments on her 40th birthday (first is on her 21st
birthday, last is on her 40th birthday), we must calculate the balance in the account on
her 40th birthday:
PV40 = $425,678.19 / (1 + 0.10)20 = $63,274.35

PV40 = PV60 / (1 + 0.10)20

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 Deferred Annuity-Example

Carol plans on retiring on her 60th birthday. She wants to put the same amount of
funds aside each year for the next twenty years -- starting next year -- so that she will
be able to withdraw $50,000 per year for twenty years once she retires, with the first
withdrawal on her 61st birthday. Carol is 20 years old today. How much must she set
aside each year for her retirement if she can earn 10% on her funds?
Annuity N=20 yrs, r=10%, A=50,000
N=20 yrs, r=10%, A=? N=20 yrs, r=10%, PV=? Annuity

20 Phase-3 40 Phase-2 60 Phase-1 80

Phase-3
Then, we need to calculate the deposits (A) necessary to reach the goal

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 Perpetuity

◆ A perpetuity is an annuity that has no end, or a stream of

cash payments that continues forever.
◆ Example: Edu-Reach Foundation Decided to Give 10,000 Taka Stipend
per year for 2 brilliant Students of BGMEA University for life long
period, How much the foundation has to deposit now if the bank pays
interest rate of 8% Annually
◆

◆ Solution: PV = (20,000/0.08) = 250,000

**Any bond that promises to pay interest perpetually is called a consol, or a
perpetuity. Such as IBBL Perpetual Bond in DSE
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 Growing Perpetuity

◆ There might be a situation in which the payments comprising the

perpetuity might grow at a rate (g). The present value of a growing
perpetuity can be calculated as follows.
◆ Example: Edu-Reach Foundation Decided to Give 10,000 Taka Stipend
per year for 2 brilliant Students of BGMEA University for life long
period. If the scholarship requirements grow at 4%, the initial funding
requirement increases. So, How much the foundation has to deposit now if
the bank pays interest rate of 8% Annually

Where,

PV (GP) = 500,000
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Growing Annuity

(Growing Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 10% growth 2 10% growth 3

rate (g) rate (g)

$100 $110 $121

Toda Constantly Growing Cash Flows
y Each 1 Period Apart
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Future Value of Growing Annuity

◆ A growing annuity is a cash flow that grows at a constant rate for

a specific period of time. A growing annuity may sometimes be
referred to as an increasing annuity.
g=Growth Rate
FVGA= i= Discount rate
A= Annuity Payment
Mr Rahim deposits some amount of his savings in the bank account every year,
First year he deposits 60000 taka and he expects to increase it by 5% per year as
his salary increases every year. what is the total amount Mr. Rahim will have if he
deposits for 5 years and the bank provide 12% interest rate per annum?

FVGA=
g=5%
i= 12%
A= 60,000

= 416571.43
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Present Value of Growing Annuity
◆ Mr Rahim deposits some amount of his savings in the bank account every year,
First year he deposits 60000 taka and he expects to increase it by 5% per year as
his salary increases every year. what is the present value total amount if Mr.
Rahim make deposits for 5 years and the bank provide 12% interest rate per
annum?
g=Growth Rate
◆ Formula PVGA= i= Discount rate
A= Payment/cash flow
N= no of Period
PVGA=

PVGA=

PVGA= 236571.42

If the growth rate and Interest rate is same, then Formula, FVGA= n*A
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Present Value of Growing Annuity (Monthly Compounding)

◆ Rebecca has set up a savings account with her bank and will be paying $350 a
month into the account for the next five years. The annual interest rate is 3% and
the annual growth rate is 2%. How can Rebecca work out the present value of
these payments?
◆ Formula g=Growth Rate
PVGA= i= Discount rate
A= Payment/cash flow
N= no of Period
PVGA= G= (0.02/12)= 0.0017
i= (0.03/12)= 0.0025
A= $350 x 12 = $4,200
PVGA= N= (5 x12)=60
PVGA= 20,462
**If the discount rate and the growth rate are equal, the formula below should be used instead:

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 Effective interest rate

Effective Annual Interest Rate

The effective annual interest rate is the real return on a savings
account or any interest-paying investment when the effects of
compounding over time are taken into account. It also reveals the
real percentage rate owed in interest on a loan, a credit card, or
any other debt.

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Effective interest rate
Example

Calculate effective interest rate for a loan with a nominal

interest rate of 10% for (a) semiannual, (b) quarterly, (c)
monthly and (d) daily
Solution
Effective interest rate for semiannual compounding = (1 + 10%/2)2 – 1
= 10.25%

Effective interest rate for quarterly compounding = (1 + 10%/4)4 – 1

=10.38%

Effective interest rate for monthly compounding = (1 + 10%/12)12 – 1

= 10.47%

Effective interest rate for daily compounding = (1 + 10%/365)365 – 1

= 10.5156%
Effective Annual Rate

Basket Wonders (BW) has a $1,000 CD at the

bank. The interest rate is 6% compounded
quarterly for 1 year. What is the Effective
Annual Interest Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1 = 1.0614 -
1 = .0614 or 6.14%!
Effective Annual Rate
Amortizing a Loan

What is Amortization?
Amortization is an Accounting/Finance technique used to
periodically lower the book value of a loan over a set
period of time.
Amortization is used in the process of paying
off debt through regular principal and interest payments
over time.
An amortization schedule is used to reduce the current
balance on a loan, for example a mortgage or car loan,
through installment payments.

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 Steps to Amortizing a Loan
1. Calculate the payment per period.

2. Determine the interest in Period t. (Loan

Balance at t-1) x (i% / m)

3. Compute principal payment in Period t.

(Payment - Interest from Step 2)

4. Determine ending balance in Period t. (Balance -

principal payment from Step 3)
1. Start again at Step 2 and repeat.
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Steps to Amortizing a Loan (Example)-Step 1

Julie is borrowing $10,000 at a compound annual

interest rate of 12%. Amortize the loan if annual
payments are made for 5 years.
Step 1: Payment
or
PV0 = A (PVIFA i%,n)
$10,000 = A (PVIFA 12%,5)
$10,000 = A (3.605)
A = $10,000 / 3.605 = $2,774

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 Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
(10,000 x 0.12) = 1,200

3. Compute principal payment in Period t. (Payment -

Interest from Step 2)
4. Determine ending balance in Period t. (Balance -
principal payment from Step 3)
5. Start again at Step 2 and repeat.
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 Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t. (Loan
Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
(2,774 – 1,200) = 1,574
4. Determine ending balance in Period t. (Balance -
principal payment from Step 3)
5. Start again at Step 2 and repeat.
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 Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t. (Loan
Balance at t-1) x (i% / m)
3. Compute principal payment in Period t. (Payment
- Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
(10,000 -1,574) = 8,426
5. Start again at Step 2 and repeat.
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 Amortizing a Loan (Example)
payment (Loan Balance (PMT- INT) (Balance - principal
per period at t-1) x (i%) from Step 2 PMT from Step 3)

(1) (2) (3) (4)

[Last Payment Slightly Higher Due to Rounding]

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Inflation Adjusted Interest Rate

The formula for the inflation-adjusted (real) interest rate is based on

the Fisher equation, which adjusts the nominal interest rate for
inflation. The formula is:

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Inflation Adjusted Interest Rate

Alex is considering an investment that offers a nominal interest rate

of 6%. However, the inflation rate is currently 3%. Alex wants to
know the real interest rate he will earn on his investment after
accounting for inflation.
Questions:
Calculate the Real Interest Rate: Using the exact formula, calculate
the real interest rate Alex will earn.
Compare with Approximation: Use the approximate formula to
estimate the real interest rate and compare it with the exact value.
Impact of Inflation Increase: If the inflation rate rises to 4%, what
will be the new real interest rate using the exact formula?

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Inflation Adjusted Interest Rate

Solution

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 Problems

Joan Messineo borrowed $15,000 at a 14% annual rate of interest to

be repaid over 3 years. The loan is amortized into three equal, annual,
end-of-year payments.
a. Calculate the annual, end-of-year loan payment.
b. Prepare a loan amortization schedule showing the interest and
principal breakdown of each of the three loan payments.
c. Explain why the interest portion of each payment declines with the
passage of time.

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 Problems 2
Sarah is planning for her retirement. She decides to invest in a deferred
annuity plan that will begin payments 10 years from now.
The annuity will provide her with annual payments of $15,000 for 20 years.
To fund this annuity, Sarah needs to make a single lump-sum payment today.
The insurance company offering the annuity has an expected annual return of
5%.
Questions:
Lump-Sum Investment Requirement: How much does Sarah need to invest
today to ensure she receives $15,000 per year for 20 years, starting 10 years
from now?
Total Payout Amount: What will be the total payout Sarah will receive from
the annuity over the 20 years?
Interest Earnings: How much interest will Sarah earn over the life of the
annuity?
Assumptions:
Use a discount rate of 5% compounded annually.
Payments are made at the end of each year.
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 Problems 3

James is considering an investment in a preferred stock that pays a

perpetual dividend. The stock promises to pay him $2,500 annually,
starting one year from today, with payments continuing indefinitely.
The required rate of return for investments of similar risk is 8%.
Questions:
Present Value of the Perpetuity: What is the maximum amount
James should be willing to pay today for this stock?
Impact of Required Rate Change: If the required rate of return
suddenly increases to 10%, what will be the new value of the
perpetuity?
Investment Decision: If James has $30,000 available to invest today,
would this stock be a good investment based on the initial required
rate of return (8%)?
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