Reading 6: The Time Value of Money

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Reading 6: The Time Value of

Money
Learning Outcome Statements
• Covered
• 6a, 6b, 6c, 6d, 6e, 6f

• Not Covered
• None
Interest Rates
Interest rates can be thought of in three ways:
• The minimum rate of return that you require
to accept a payment at a later date.
• The discount rate that must be applied to a
future cash flow in order to determine its
present value.
• The opportunity cost of spending the money
today as opposed to saving it for a certain
period and earning a return on it.
Composition of Interest Rates
r = Real risk-free interest rate
Nominal risk-free rate
+ Inflation premium
+ Default risk premium
+ Liquidity premium
+ Maturity premium
(+ Premia for other risks)

Note: Technically, the risk-free rate and the premia should


compound:

1 + r = (1 + rf)(1 + i)(1 + rp1) · · · (1 + rpn)

Adding the risk-free rate and the premia is an approximation.


The Future Value of a Single Cash Flow
If “PV” dollars are invested today, for “N”
periods at a rate of “r”% per period, the amount
accumulated at the end will be equal to “FV”
dollars.
The Future Value of a Single Cash Flow
  you invested $100 in an account paying 6%,
If
what would be the future value of your money in
one year, and in two years?

In one year the value of $100 will be:

In two years the value of $100 will be:


Financial Calculator
Five TVM buttons on your calculator:
• n – Number of periods
• i – Interest rate per period
• PV – Present value
• PMT – Payment
• FV – Future Value

These are cash flow buttons; the sign on PV, PMT, and FV
determines whether it is a cash inflow (positive) or a cash
outflow (negative)
The Future Value of a Single Cash Flow
If you invested $100 in an account paying 6%,
what would be the future value of your money in
one year, and in two years?
The Present Value of a Single Cash Flow
Calculating the present value involves
determining the value in today’s terms of a cash
flow or cash flow stream that will be received in
the future.
The Present Value of a Single Cash Flow
An investment promises to pay you $1,200 at
the end of 15 years. What is the most you would
be willing to pay for it today if your minimum
acceptable rate of return is 8%?

  1,200
𝑃𝑉 = 15
= $ 378.29
( 1.08 )
FV and PV of a Series of Cash Flows
An annuity is a finite set of level sequential cash
flows.
An ordinary annuity is an annuity where the
cash flows occur at the end of each
compounding period.
An annuity due is an annuity where the periodic
cash flows occur at the beginning of every
period.
PV of an Annuity
What is the present value of a 10-year, $10,000 ordinary annuity
if the discount rate is 4%? What if this were an annuity due?

(Set calculator to END mode.)


N I/Y PMT FV CPT PV
10 4 10,000 0 -81,108.96
The present value of the ordinary annuity is $81,108.96

(For annuity due, change to BGN mode)


N I/Y PMT FV CPT PV
10 4 10,000 0 -84,353.32

The present value of the annuity due is $84,353.32


FV of an Annuity
How much would you have at the end of four years if you
invested in an account paying 8%. Assume you deposit $500
a) at the end of each year?
b) at the beginning of each year?
(Set calculator to END mode.)
N I/Y PV PMT CPT FV
4 8 0 -500 2,253.06
The future value of the ordinary annuity is $2,253.06
(For annuity due, change to BGN mode)
N I/Y PV PMT CPT FV
4 8 0 -500 2,433.30
The future value of the annuity due is $2,433.30
Present Value of a Perpetuity
A perpetuity is a never-ending series of level
payments, where the first cash flow occurs in the
next period (at t = 1).
Present Value of a Perpetuity
ABC Corporation pays a 10% dividend on its
perpetual preferred stock, which has a $100 par
value. Given a 5% rate of return and assuming
that this dividend policy will continue forever,
what is the value of ABC stock?

Dividend = 10% of $100 = $10

ValueABC’s preferred stock = PVPerpetuity


= $10/0.05 = $200
PV and FV of Unequal Cash Flows
The PV of a series of cash flows is the sum of
the present values of the individual cash flows.

The FV of a series of cash flows is the sum of


the future values of the individual cash flows.
PV of Unequal Cash Flows
What is the present value of cash flows of $1,000, $3,000, and
$5,000 received in 1, 2, and 3 years, respectively, if the (annual)
discount rate is 4%?

0 1 2 3

$1,000 $3,000 $5,000


$961.54 ÷ 1.04
2,773.67 ÷ 1.042
4,444.98 ÷ 1.043
$8,180.19
Practice Question
An investment is expected to produce cash flows of $10,000,
$20,000, $10,000, and $30,000 at the end of years 1, 2, 4, and 6,
respectively. If the required rate of return is 10%, the present
value of the investment is closest to:
 
A. $49,384
B. $51,078
C. $53,623
Practice Question
An investment is expected to produce cash flows of $10,000,
$20,000, $10,000, and $30,000 at the end of years 1, 2, 4, and 6,
respectively. If the required rate of return is 10%, the present
value of the investment is closest to:
 
A. $49,384
B. $51,078
C. $53,623

Correct answer: A. $49,384


0 1 2 3 4 5 6

$10,000 $20,000 $0 $10,000 $0 $30,000


I = 10%, compute PV = $49,384
FV of Unequal Cash Flows
Suppose you will deposit $500, $300, and $100 at the end of
years 1, 2, and 3 years, respectively. If you earn 10%, how much
will you accumulate by the end of year 3?

0 1 2 3

$500 $300 $100


x 1.100 100

x 1.101 330
x 1.102 605
1,035
The Frequency of Compounding
 
The stated annual interest rate rs is the rate per
year.
If N is the number of compounding periods, then
the periodic interest rate is rs /N, and

The effective annual rate (EAR) rises


as compounding frequency increases.

For continuous compounding,


Effective Annual Rate
Nominal annual rate = 8.0%
Periods Periodic
Frequency Effective Annual Rate
per Year Rate
Annual 1 8.0000%
Semiannual 2 4.0000%
Quarterly 4 2.0000%
Monthly 12 0.6667%
Daily 365 0.0219%
Continuous
Practice Question
A high-yield savings account advertises an effective annual rate
of 4.85%. If the interest is compounded daily (using a 365-day
year), then the nominal (annual) rate is closest to:
 
A. 4.504%
B. 4.736%
C. 4.969%
Practice Question
A high-yield savings account advertises an effective annual rate
of 4.85%. If the interest is compounded daily (using a 365-day
year), then the nominal (annual) rate is closest to:
 
A. 4.504%
B. 4.736%
C. 4.969%

Correct answer: B. 4.736%

Solve:
(1 + r/365)365 – 1 = 4.85%
(1 + r/365)365 = 1.0485
1 + r/365 = 1.04851/365 = 1.000130
r/365 = 0.000130
r = 0.04736 = 4.736%
Compounding and Future Values
Calculate the returns realized on an investment of $100
for one year at a stated annual interest rate of 8%
assuming different compounding frequencies.
Practice Question
What is the future value of $1,000 invested for five years at 6%
(nominal, annual) compounded quarterly?
Practice Question
What
  is the future value of $1,000 invested for five years at 6%
(nominal, annual) compounded quarterly?

n = 20 (= 5 × 4)
i = 1.5% (= 6% ÷ 4)
PV = -1,000
PMT = 0
Solve for FV = 1,346.86

Alternatively,

The future value is $1,346.86.


Using a Timeline in TVM Problems
In 18 years, Bob’s daughter will start college, with an expected
annual tuition of $30,000, due at the start of each of her four
years. How much must Bob deposit at the end of each of the next
18 years to finance the tuition, if his account earns 4.8% per
year?
0 1 2 3 4 16 17 18 19 20 21

$30k ... $30k


? ? ... ... ?
Step 1: PV of tuition: (begin mode): n = 4, i = 4.8%,
PMT = 30,000, FV = 0, solve for PV = –112,005
Step 2: Annual deposit: (end mode): n = 18, i = 4.8%,
PV = 0, FV = 112,005, solve for PMT = –4,056
Bob must deposit $4,056 into the account each year.
Solving TVM Problems
What payment must you make at the start of each year so that at
the end of 18 years you will have $100,000 if you can invest it at
5% per year?

(Set calculator to begin mode.)

n = 18
i = 5%
PV = 0
FV = 100,000
Solve for PMT = –3,385.35

The annual payment is $3,385.35.


Solving TVM Problems
If you receive $2,000 at the beginning of each year, and you can
invest it at 4.5% per year, how long will it take you to amass
$50,000?

(Set calculator to begin mode.)

i = 4.5
PV = 0
PMT = 2,000
FV = –50,000 (note the sign)
Solve for n = 17

It will take you 17 years to reach $50,000.


Solving TVM Problems
If you receive $5,000 at the end of each of the next 20 years, at
what (annual) rate must you be able to invest it to have $150,000
in 20 years?

(Set calculator to end mode.)

n = 20
PV = 0
PMT = 5,000
FV = –150,000 (note the sign)
Solve for i = 4.0715

You must invest at 4.0715% per year.

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