0% found this document useful (0 votes)
205 views121 pages

Time Value of Money

The document discusses key concepts related to the time value of money, including future value, present value, compounding, and discounting. It provides examples of calculating future and present values using the basic time value of money formulas and a financial calculator. It also examines how to calculate the interest rate, discount rate, or number of periods given certain inputs like the future or present value. The key relationships discussed are that higher interest rates decrease present value, while longer time periods also decrease present value.

Uploaded by

Amit Mishra
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
0% found this document useful (0 votes)
205 views121 pages

Time Value of Money

The document discusses key concepts related to the time value of money, including future value, present value, compounding, and discounting. It provides examples of calculating future and present values using the basic time value of money formulas and a financial calculator. It also examines how to calculate the interest rate, discount rate, or number of periods given certain inputs like the future or present value. The key relationships discussed are that higher interest rates decrease present value, while longer time periods also decrease present value.

Uploaded by

Amit Mishra
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 121

The Time Value of Money

Time Value Topics


 Future value
 Present value
 Rates of return
 Amortization

2
The Time Value of Money

Compounding and
Discounting Single Sums
We know that receiving $1 today is
worth more than $1 in the future.
This is due to opportunity costs.
The opportunity cost of receiving
$1 in the future is the interest we
could have earned if we had
received the $1 sooner.
Today Future
If we can measure this
opportunity cost, we can:
 Translate $1 today into its equivalent in
the future (compounding).
Today Future

?
Translate $1 in the future into its equivalent
today (discounting
Today Future

?
Time Lines of
The Cash Flows
Time lines show timing of
cash flows.

0 1 2 3
R%

CF0 CF1 CF2 CF3


Tick marks at ends of periods, so Time
0 is today; Time 1 is the end of Period
1; or the beginning of Period 2.
7
Ordinary Annuity vs. Annuity Due

Ordinary Annuity
0 1 2 3
R%

PMT PMT PMT


Annuity Due
0 1 2 3
R%

PMT PMT PMT


8
Future Value
Time line for a $100 lump sum
due at the end of Year 2.

0 1 2 Year
R%

100

10
Time line for an ordinary
annuity of $100 for 3 years

0 1 2 3
R%

100 100 100

11
Time line for uneven CFs

0 1 2 3
R%

-50 100 75 50

12
Compound Interest
 Interest is earned on previously earned interest
 $100 invested at 10% with annual compounding
 1st year interest is $10.00Principal is $110
 2nd year interest is $21.0 Principal is $121.0
 3rd year interest is $33.10Principal is $133.10
 Total interest earned: $33.10

13
FV of an initial $100 after
3 years (R = 10%)

0 1 2 3
10%

100 FV = ?

Finding FVs (moving to the right


on a time line) is called compounding.

14
After 1 year

FV1 = PV + RNT1 = PV + PV (R)


= PV(1 + R)
= $100(1.10)
= $110.00.

15
After 2 years

FV2 = FV1(1+R) = PV(1 + R)(1+R)


= PV(1+R)2
= $100(1.10)2
= $121.00.

16
After 3 years
FV3 = FV2(1+R)=PV(1 + R)2(1+R)
= PV(1+R)3
= $100(1.10)3
= $133.10

In general,
FVN = PV(1 + R)N.

17
Financial Calculator Solution
Financial calculators solve this
equation:

FVN + PV (1+R)N = 0.

There are 4 variables. If 3 are


known, the calculator will solve
for the 4th.

18
Calculator Keys

 Texas Instruments BA-II Plus


 FV = future value
 PV = present value
 I/Y = period interest rate
 P/Y must equal 1 for the I/Y to be the period rate
 Interest is entered as a percent, not a decimal
 N = number of periods
 Remember to clear the registers (CLR TVM) after
each problem
 Other calculators are similar in format

19
The setup to find FV

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

20
If the $100 is entered as a positive
Number, then

INPUTS 3 10 100 0
NN I/YR
I/YR PV
PV PMT
PMT FV
FV

OUTPUT -133.10

21
Quick Quiz – Part I
 What is the difference between simple
interest and compound interest?
 Suppose you have $500 to invest and you
believe that you can earn 8% per year over
the next 15 years.
 How much would you have at the end of 15 years
using compound interest?
 How much would you have using simple interest?

22
Present Value
What’s the PV of $100 due in
3 years if R = 10%?
Finding PVs is discounting, and it’s
the reverse of compounding.

0 1 2 3
10%

PV = ? 100
24
Solve FVN = PV(1 + R )N for
PV

FVN N
PV =
(1+R) N
= FVn ( 1
1 +R
)
3
 1 
PV = $100 
 1.10 
= $100 0.7513  = $75.13.

25
Financial Calculator Solution

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Either PV or FV must be negative. Here


PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
26
Present Values – Example 2
 You want to begin saving for your
daughter’s college education and you
estimate that she will need $150,000 in
17 years. If you feel confident that you
can earn 8% per year, how much do
you need to invest today?
 PV = 150,000 / (1.08)17 = 40,540.34

27
Present Values – Example 3
 Your parents set up a trust fund for you
10 years ago that is now worth
$19,671.51. If the fund earned 7% per
year, how much did your parents
invest?
 PV = 19,671.51 / (1.07)10 = 10,000

28
Present Value – Important Relationship I

 For a given interest rate – the longer the


time period, the lower the present value
 What is the present value of $500 to be
received in 5 years? 10 years? The discount
rate is 10%
 5 years: PV = 500 / (1.1)5 = 310.46
 10 years: PV = 500 / (1.1)10 = 192.77

29
Present Value – Important Relationship II

 For a given time period – the higher the


interest rate, the smaller the present
value
 What is the present value of $500 received
in 5 years if the interest rate is 10%? 15%?
 Rate = 10%: PV = 500 / (1.1)5 = 310.46
 Rate = 15%; PV = 500 / (1.15)5 = 248.59

30
Quick Quiz – Part II
 What is the relationship between present
value and future value?
 Suppose you need $15,000 in 3 years. If you
can earn 6% annually, how much do you
need to invest today?
 If you could invest the money at 8%, would
you have to invest more or less than at 6%?
How much?

31
Finding the Time to Double

0 1 2 ?
20%

-1 2
FV = PV(1 + R)N

Continued on next slide

32
Time to Double (Continued)

$2= $1(1 + 0.20)N


(1.2)N = $2/$1 = 2
N LN(1.2) = LN(2)
N = LN(2)/LN(1.2)
N = 0.693/0.182 = 3.8.

33
Time to Double– Example 2

 Suppose you are offered an investment


that will allow you to double your
money in 6 years. You have $10,000 to
invest. What is the implied rate of
interest?
 r = (20,000 / 10,000)1/6 – 1 = .122462 =
12.25%

34
Discount Rate – Example 3
 Suppose you have a 1-year old son and
you want to provide $75,000 in 17 years
towards his college education. You
currently have $5,000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?
 r = (75,000 / 5,000)1/17 – 1 = .172688 =
17.27%

35
Financial Calculator Solution

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

36
Finding the Interest Rate
or
Discount Rate

 Often we will want to know what the


implied interest rate is in an investment
 Rearrange the basic PV equation and
solve for r
 FV = PV(1 + R)N
 r = (FV / PV)1/N – 1

37
Finding the Interest Rate

0 1 2 3
?%

-1 FV = PV(1 + R)N 2
$2 = $1(1 + R)3
(2)(1/3) = (1 + R)
1.2599 = (1 + R)
I = 0.2599 = 25.99%.
38
Financial Calculator

INPUTS 3 -1 0 2
N I/YR PV PMT FV
OUTPUT 25.99

39
Finding the Interest Rate- Example 2
 Suppose you have a 1-year old son and
you want to provide $75,000 in 17 years
towards his college education. You
currently have $5,000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?
 r = (75,000 / 5,000)1/17 – 1 = .172688 =
17.27%

40
Finding the Number of Periods
 Start with basic equation and solve for
N (remember your logs)
 FV = PV(1 + R)N
 N = ln(FV / PV) / ln(1 + R)
 You can use the financial keys on the
calculator as well; just remember the
sign convention.

41
Number of Periods – Example 1

 You want to purchase a new car and


you are willing to pay $20,000. If you
can invest at 10% per year and you
currently have $15,000, how long will it
be before you have enough money to
pay cash for the car?
 N= ln(20,000 / 15,000) / ln(1.1) = 3.02
years

42
Number of Periods – Example 2

 Suppose you want to buy a new house. You


currently have $15,000 and you figure you need
to have a 10% down payment plus an additional
5% of the loan amount for closing costs. Assume
the type of house you want will cost about
$150,000 and you can earn 7.5% per year, how
long will it be before you have enough money
for the down payment and closing costs?

43
Number of Periods – Example 2 Continued

 How much do you need to have in the future?


 Down payment = .1(150,000) = 15,000

 Closing costs = .05(150,000 – 15,000) = 6,750

 Total needed = 15,000 + 6,750 = 21,750

 Compute the number of periods


 Using the formula
 N= ln(21,750 / 15,000) / ln(1.075) = 5.14 years

 Per a financial calculator:


 PV = -15,000, FV = 21,750, I/Y = 7.5, CPT N = 5.14 years

44
Quick Quiz – Part III
 What are some situations in which you might want to
know the implied interest rate?
 You are offered the following investments:
 You can invest $500 today and receive $600 in 5 years. The
investment is considered low risk.
 You can invest the $500 in a bank account paying 4%.
 What is the implied interest rate for the first choice and
which investment should you choose?

45
Spreadsheet Example
 Use the following formulas for TVM calculations
 FV(rate,nper,pmt,pv)
 PV(rate,nper,pmt,fv)
 RATE(nper,pmt,pv,fv)
 NPER(rate,pmt,pv,fv)
 The formula icon is very useful when you can’t
remember the exact formula
 Click on the Excel icon to open a spreadsheet
containing four different examples.

46
The Time Value of
Money
Compounding and
Discounting
Cash Flow Streams

0 1 2 3 4
Annuities
 Annuity: a sequence of equal
cash flows, occurring at the
end of each period.

0 1 2 3 4
Ordinary Annuity vs. Annuity Due
Ordinary Annuity

0 1 2 3
R%

PMT PMT PMT


Annuity Due
0 1 2 3
R%

PMT PMT PMT


49
What’s the FV of a 3-year
ordinary annuity of $100 at 10%?

0 1 2 3
10%

100 100 100


110
121
FV = 331
50
FV Annuity Formula
 The future value of an annuity
with n periods and an interest
rate of R can be found with the
following formula:
N 3
(1+ R) 1 (1+ .10 ) 1
FV A = C[ - ]  100[ - ]  $331
R R .10 .10

51
Financial Calculator Solution

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00

Have payments but no lump sum PV,


so enter 0 for present value.
52
What’s the PV of this ordinary annuity?

0 1 2 3
10%

100 100 100


90.91
82.64
75.13
248.69 = PV 53
PV Annuity Formula
The present value of an annuity with n periods and an interest rate of i can
be found with the following formula:

1 1 C 1
PV = C[ - ]  [1  ]
R R(1 + R ) N R (1 + R ) N

100 1
PV = [1  ]  $248.69
.10 (1+ .10 )3

54
Financial Calculator Solution

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Have payments but no lump sum FV,


so enter 0 for future value.
55
Annuity – Sweepstakes Example

 Suppose you win the Publishers


Clearinghouse $10 million sweepstakes. The
money is paid in equal annual end-of-year
installments of $333,333.33 over 30 years. If
the appropriate discount rate is 5%, how
much is the sweepstakes actually worth
today?
 30 N; 5 I/Y; 333,333.33 PMT; CPT PV =
5,124,150.29

56
Buying a House

 You are ready to buy a house and you have $20,000


for a down payment and closing costs. Closing costs
are estimated to be 4% of the loan value. You have an
annual salary of $36,000 and the bank is willing to
allow your monthly mortgage payment to be equal to
28% of your monthly income. The interest rate on the
loan is 6% per year with monthly compounding (.5%
per month) for a 30-year fixed rate loan. How much
money will the bank loan you? How much can you
offer for the house?

57
Buying a House - Continued
 Bank loan
 Monthly income = 36,000 / 12 = 3,000
 Maximum payment = .28(3,000) = 840
 30*12 = 360 N
 .5 I/Y
 -840 PMT
 CPT PV = 140,105
 Total Price
 Closing costs = .04(140,105) = 5,604
 Down payment = 20,000 – 5,604 = 14,396
 Total Price = 140,105 + 14,396 = 154,501

58
Annuities on the Spreadsheet - Example
 The present value and future value
formulas in a spreadsheet include a place
for annuity payments
 Click on the Excel icon to see an example

59
Find the FV and PV if the
annuity were an annuity due.
(1 + R) N 1
FV A = C[ - ](1 + R)
R R

(1 + 10% )3 1
FV A = 100 [ - ](1 + 10% )  $364
10% 10%

0 1 2 3
10%

100 100 100


60
PV and FV of Annuity Due
vs. Ordinary Annuity

 PV of annuity due:
 = (PV of ordinary annuity) (1+R)
 = (248.69) (1+ 0.10) = 273.56

 FV of annuity due:
 = (FV of ordinary annuity) (1+R)
 = (331.00) (1+ 0.10) = 364.1
61
PV of Annuity Due: Switch
from “End” to “Begin

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

62
FV of Annuity Due: Switch
from “End” to “Begin

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -364.1

63
The Time Value of Money

0 1 2 3

Other Cash Flow Patterns


What is the PV of this
uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50


90.91
247.93
225.39
-34.15
530.08 = PV 65
Valuing “uneven” Cash Flows

First, set your calculator to 1 payment per year. Then, use


the cash flow menu:

CF0
0 CF3
600 I 12

CF1
200 F3
1 NPV 1,432.93

F1
1 CF4 800

CF2 400 F4
1
F2
1
Perpetuities

 Suppose you will receive a fixed


payment every period (month,
year, etc.) forever. This is an
example of a perpetuity.
 You can think of a perpetuity as
an annuity that goes on forever.
Perpetuity
A constant stream of cash flows that lasts forever
C C C

0 1 2 3

C C C
PV    
(1  r ) (1  r ) (1  r )
2 3

C
PV 
r
Present Value of a Perpetuity

 So, the PV of a perpetuity is


very simple to find:

PMT
PV =
R
What should you be willing to
pay in order to receive
$10,000 annually forever, if
you require 8% per year on
the investment?
PV = C $10,000
R .08

= $125,000
Nominal rate (RNOM)

 Stated in contracts, and quoted by banks


and brokers.
 Not used in calculations or shown on time
lines
 Periods per year (M) must be given.
 Examples:
 8%; Quarterly
 8%, Daily interest (365 days)

71
Periodic rate (IPER )
 RPER = RNOM/M, where M is number of compounding
periods per year. M = 4 for quarterly, 12 for monthly,
and 360 or 365 for daily compounding.
 Used in calculations, shown on time lines.
 Examples:
 8% quarterly: RPER = 8%/4 = 2%.

 8% daily (365): RPER = 8%/365 = 0.021918%.

72
The Impact of Compounding
 Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated R% constant?
 Why?

73
The Impact of Compounding (Answer)

 LARGER!
 If compounding is more frequent than
once a year--for example, semiannually,
quarterly, or daily--interest is earned on
interest more often.

74
FV Formula with Different
Compounding Periods

MN
 RNOM 
FVN = PV 1 +
 M 

75
$100 at a 12% nominal rate with
semiannual compounding for 5 years

MN
 RNOM 
FVN = PV 1 +
 M 
2x5
 0.12 
FV5S = $100 1 + 
 2 
= $100(1.06)10 = $179.08
76
FV of $100 at a 12% nominal rate for
5 years with different compounding

FV(Annual)= $100(1.12)5 = $176.23.


FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.

77
Effective Annual Rate (EAR =
EAR%)
 The EAR is the annual rate which
causes PV to grow to the same FV as
under multi-period compounding.

78
Effective Annual Rate Example
 Example: Invest $1 for one year at 12%,
semiannual:
FV = PV(1 + RNOM/M)M
FV = $1 (1.06)2 = 1.1236.
 EAR% = 12.36%, because $1 invested for
one year at 12% semiannual compounding
would grow to the same value as $1 invested
for one year at 12.36% annual compounding.

79
Comparing Rates
 An investment with monthly payments
is different from one with quarterly
payments. Must put on EAR% basis to
compare rates of return. Use EAR%
only for comparisons.
 Banks say “interest paid daily.” Same
as compounded daily.

80
Decisions, Decisions
 You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays
5.3% with semiannual compounding. Which account
should you use?
 First account:

 EAR = (1 + .0525/365)365 – 1 = 5.39%


 Second account:
 EAR = (1 + .053/2)2 – 1 = 5.37%
 Which account should you choose and why?

81
EAR (or EAR%) for a Nominal
Rate of of 12%

EARAnnual = 12%.

EARQ = (1 + 0.12/4)4 - 1 = 12.55%.

EARM = (1 + 0.12/12)12 - 1 = 12.68%.

EARD(365) = (1 + 0.12/365)365 - 1 = 12.75%.

82
Can the effective rate ever be
equal to the nominal rate?
 Yes, but only if annual compounding is
used, i.e., if M = 1.
 If M > 1, EAR% will always be greater
than the nominal rate.

83
When is each rate used?

RNOM: Written into contracts, quoted


by banks and brokers. Not
used in calculations or shown
on time lines.

84
When is each rate used? (Continued)

RPER: Used in calculations, shown on


time lines.
If RNOM has annual compounding,
then RPER = RNOM/1 = RNOM.

85
When is each rate used? (Continued)

 EAR (or EAR%): Used to compare


returns on investments with different
payments per year.
 Used for calculations if and only if
dealing with annuities where payments
don’t match interest compounding
periods.

86
Amortization Loans

 Amortized Loan: a loan that is


repaid in equal payments over
its life.
 Each periodic payment includes
not only interest but also a
portion of principal.

87
Amortization
 Construct an amortization schedule for
a $1,000, 10% annual rate loan with 3
equal payments.

88
Step 1: Find the required
payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
89
Step 2: Find interest charge
for Year 1.

INTt = Beg balt (R)

INT1 = $1,000(0.10) = $100.

90
Step 3: Find repayment of
principal in Year 1.

Repmt = PMT - INT


= $402.11 - $100
= $302.11.

91
Step 4: Find ending balance
after Year 1.

End bal = Beg bal - Repmt


= $1,000 - $302.11 = $697.89.

Repeat these steps for Years 2 and 3


to complete the amortization table.

92
Amortization Table
BEG PRIN END
YEAR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366

3 366 402 37 366 0

TOT 1,206.34 206.34 1,000

93
Interest declines because
outstanding balance declines.
$450
$400
$350
$300
$250 Interest
$200 Principal
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3

94
Amortization

 Amortization tables are widely


used--for home mortgages, auto
loans, business loans, retirement
plans, and more. They are very
important!
 Financial calculators (and
spreadsheets) are great for setting
up amortization tables.
95
Amortized Loan with Fixed Principal Payment
- Example

 Consider a $50,000, 10 year loan at 8%


interest. The loan agreement requires the firm
to pay $5,000 in principal each year plus
interest for that year.
 Click on the Excel icon to see the amortization
table

96
Amortized Loan with Fixed Payment -
Example

 Each payment covers the interest expense plus reduces


principal
 Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is $5,000.
 What is the annual payment?
 4N
 8 I/Y
 5,000 PV
 CPT PMT = -1,509.60
 Click on the Excel icon to see the amortization table

97
Fractional Time Periods
 On January 1 you deposit $100 in an
account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
 How much will you have on October 1,
or after 9 months (273 days)? (Days
given.)

98
Convert interest to daily rate

RPER = 11.33463%/365
= 0.031054% per day.
0 1 2 273
0.031054%

-100 FV=?

99
Find FV

FV273 = $1001.00031054 
273

= $1001.08846 = $108.85.

100
Calculator Solution

RPER = RNOM/M
= 11.33463/365
= 0.031054% per day.

INPUTS 273 -100 0


N I/YR PV PMT FV
OUTPUT 108.85
101
Non-matching rates and periods
 What’s the value at the end of Year 3 of
the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?

102
Time line for non-matching rates and
periods

0 1 2 3 4 5 6 6-mos.
5% periods

100 100 100

103
Non-matching rates and periods
 Payments occur annually, but
compounding occurs each 6 months.
 So we can’t use normal annuity
valuation techniques.

104
1st Method: Compound Each CF

0 1 2 3 4 5 6
5%

100 100 100.00


110.25
121.55
331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100


= $331.80. 105
2nd Method: Treat as an
annuity, use financial calculator

Find the EAR for the quoted rate:

EAR = ( 0.10
1+ 2 ) - 1 = 10.25%.
2

106
Use EAR = 10.25% as the
annual rate in calculator.

INPUTS 3 10.25 0 -100


N I/YR PV PMT FV
OUTPUT
331.80

107
What’s the PV of this stream?

0 1 2 3
5%

100 100 100

90.70
82.27
74.62
247.59 108
Comparing Investments
 You are offered a note which pays
$1,000 in 15 months (or 456 days) for
$850. You have $850 in a bank which
pays a 6.76649% nominal rate, with
365 daily compounding, which is a daily
rate of 0.018538% and an EAR of
7.0%. You plan to leave the money in
the bank if you don’t buy the note. The
note is riskless.
 Should you buy it?
109
Daily time line

RPER = 0.018538% per day.

0 365 456 days

-850 1,000

110
Three solution methods
 1. Greatest future wealth: FV
 2. Greatest wealth today: PV
 3. Highest rate of return: Highest
EAR%

111
1. Greatest Future Wealth

Find FV of $850 left in bank for


15 months and compare with
note’s FV = $1,000.

FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.
112
Calculator Solution to FV

RPER = RNOM/M
= 6.76649%/365
= 0.018538% per day.

INPUTS 456 -850 0


N I/YR PV PMT FV
OUTPUT 924.97
113
2. Greatest Present Wealth

Find PV of note, and compare


with its $850 cost:
PV = $1,000/(1.00018538)456
= $918.95.

114
Financial Calculator Solution

6.76649/365 =
INPUTS 456 .018538 0 1000
N I/YR PV PMT FV

OUTPUT -918.95

PV of note is greater than its $850


cost, so buy the note. Raises your
wealth.
115
3. Rate of Return
Find the EAR% on note and compare
with 7.0% bank pays, which is your
opportunity cost of capital:
FVN = PV(1 + R)N
$1,000 = $850(1 + R)456
Now we must solve for R.

116
Calculator Solution

INPUTS 456 -850 0 1000


N I/YR PV PMT FV
OUTPUT 0.035646%
per day
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EAR% = (1.00035646)365 - 1
= 13.89%.
117
Using interest conversion

P/YR = 365
NOM% = 0.035646(365) = 13.01
EAR% = 13.89
Since 13.89% > 7.0% opportunity cost,
buy the note.

118
Growing Perpetuities

 The cash flows of a growing


perpetuity grow at a constant rate
forever.
 The present value of a growing
perpetuity is:
PMT
PV =
R-g
119
Present Value of Growing Annuity
 Cash flows in business are very likely to grow
over time, due either to real growth or
inflation.
 The present value of a growing annuity is for
a finite number of growing cash flows:

N
C (1 + g )
PV = [1  ]
Rg (1 + R ) N

120
Present Value of Growing Annuity-
Example
 Ruben Ramirez, a first year MBA student at CSUF, is
going to be offered a job at $100,000 a year after his
graduation. He anticipates his salary increasing by
6% a year until his retirement in 30 years. Given an
interest rate of 10 percent, what is the present value
of his lifetime salary?

100,000 (1+ 6% )30


PV = [1  ]  $1,677,122
10%  6% (1+10 )30

121

You might also like