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Lecture 4: Time Value of Money (Part 1)
Chapter 4: Time Value of Money 1: Analysing Single Cash Flows
Question 1 (Textbook - Question 2)
How are the present value and future value related?
The measure that relates present values to future values is the interest rate i. A present value can be moved forward in time with interest to arrive at the future value (Future value in N years = FVN = PV (1+i)N . A future value can be discounted back to the present by rearranging the equation so that the FV is divided by the interest factor.
Question 2 (Textbook- Question 4)
How are present values affected by changes in interest rates?
Interest rates have an inverse relationship to present values. Increases in expected interest rates result in lower present values because future values are discounted at a higher rate to become smaller present values. Decreases in expected interest rates result in higher present values because future values are discounted at a lower rate.
Question 3 (Textbook - Problem 4-4)
One Year Future Value What is the future value of $400 deposited for one year earning an interest rate of 9 percent per year?
Compounding with Different Interest Rates A deposit of $750 earns interest rates of 9 percent in the first year and 12 percent in the second year. What would be the second year future value?
Present Value Compute the present value of an $850 payment made in 10 years when the discount rate is 12 percent.
PV = FV / (1 + i)N PV = $850 / (1 + 0.12)10 = $850 / 3.10585 = $273.68 Or N=10, I=12, PMT=0, FV=−850, CPT PV == 273.68 Question 8 (Textbook - Problem 4 -17) Rule of 72 Approximately what interest rate is needed to double an investment over five years?
N = 72 / 5 = 14.40 percent
Question 9 (Textbook - Problem 4 -21)
Interest-on-Interest Consider a $2,000 deposit earning 8 percent interest per year for five years. What is the future value, and how much total interest is earned on the original deposit vs. how much is interest earned on interest?
The $2,000 investment will grow to a future value of $2,938.66 [= FV5 = $2,000 × (1 + 0.08)5], assuming compounded interest over the 5 years. The total interest earned is $938.66. The interest earned on the original investment is $160 per year for 5 years, or $800. The interest earned on the interest is the difference of $138.66 [= $938.66 − $800].
Question 10 (Textbook - Problem 4 -33)
Future Value At age 30 you invest $1,000 that earns 8 percent each year. At age 40 you invest $1,000 that earns 12 percent per year. In which case would you have more money at age 60?
FVAge 60 = $1,000 × (1.12)20 = $1,000 × 9.64629 = $9,646.29 Or N=20, I=12, PV=−1000, PMT=0, CPT FV == 9,646.29 Question 11 (Textbook - Problem 4 -37) Solving for Rates What annual rate of return is earned on a $4,000 investment made in year 2 when it grows to $6,500 by the end of year seven?
General TVM Ten years ago, Hailey invested $3,000 and locked in an 8 percent annual interest rate for 30 years (ending 20 years from now). Aidan can make a 20-year investment today and lock in a 10 percent interest rate. How much money should he invest now in order to have the same amount of money in 20 years as Hailey?
PV = FV20 / (1 + i)N PV = $30,187.97 / (1 + 0.10)20 = $30,187.97 / 6.72750 = $4,487.25 Or N=20, I=10, PMT=0, FV=30,187.97, CPT PV == −4,487.249 Question 13 (Textbook - Problem 4 -44) Moving Cash Flows You are scheduled to receive a $500 cash flow in one year, a $1,000 cash flow in two years, and pay an $800 payment in three years. If interest rates are 10 percent per year, what is the combined present value of these cash flows?
