Lecture 12

Lecture Organization
 Present Value and Discounting
 Ordinary annuity
 Perpetuity
Time Value Terminology

 “Time value of money" and "the money

value of time"
 A dollar today is worth more than a dollar
later“
WHY?
Every dollar generates interest every year
and every time period
Future and Present Value Terminology

 PV is the Present Value, that is, the value

today.
 FV is the Future Value, that is, the value
at a future date.
 Time Value Terminology
 Denotation:
 The number of years between the Present Value
and the Future Value is represented by “t ”.
 The rate of interest is represented by “r ”.

 In general, the Future Value, FVt, of $X invested

today at r% for t periods is

FVt = $X  (1 + r)t

 The expression (1 + r)t is the Future Value Interest

Factor or compounding factor

Quick Quiz -

 Q. Deposit $5,000 today in an account

paying 12%. How much will you have in 6
years if the interest is compound?

 A. Multiply the $5000 by the (FVIF) Future

Value Interest Factor:
$5000  (1 + r )t = $5000  (1+0.12)6
= $9869.11
Present Value Formula

 The PV of $X to be received in t periods when the

discount rate is r is

PV = $X/(1 + r )t
 The relationship between PV and FV

PV = FV/(1 + r )t
Where
Discount Factor or Present Value Interest Factor
= 1/(1 + r )t
Chapter 6: Future and Present Value of Multiple Cash Flow

 Multiple Cash Flows: two or more

payments through the time
 Calculate the future value of each
cash flow and add them up
Future Value Calculated

Example: Calculation of Future Value of $2,000

invested at the end of each of the next five
years, assuming Interest Rate is 10%.
 Future value calculated by compounding each cash flow
separately and adding them up
Future and Present Value of Multiple Cash Flow

 How to calculate Present Values of

multiple cash flows:

 Discount each amount to time 0

separately and then add them all up.
Future Value Calculated

Example: Calculation of Present Value of

investment project that pays $1,000 at the
end of every year for the next five years
assuming Interest Rate is 6%
Annuities and Perpetuities -- Basic Formulas

0 $C $C $C t
...
time line, # of periods

 Ordinary Annuity— identical cash flows

occurring at the end of each period for a
fixed number of periods.

PVA = C × (1 - [1/(1 + r )t ] )/r

1
(1  t
)
(1  r )
PVA C 
r
Example: Annuity Calculations

 Suppose we expect to receive $1000 at the

end of each of the next 5 years. Our
discount rate is 6%. What is the value
today of this set of cash flows?
PV = $1000  {1 - 1/(1.06)5}/.06
= $4212.36
Annuities Future Value

 Annuity Future Value

FVt = C  ( [(1 + r )t - 1]/r )

Example:
Q. Parents of newly born boy set up an account for
him. To this account they decided to allocate $1,000
every year (annually) starting next year. What the
amount the boy will get when he is of 21 years old if
the interest rate of the account is 5%?
A. Set up the problem as FV of annuity:
FV21 =$1000  ([(1 + 0.05 )21 – 1]/0.05)= $35,719
Example
 Q: How much will you have on your account
in 13 years if you deposit $1000 payments at
the end of each year for the next 10 years (10
payments)? Note, between the end of year 10
and year 13 you are not depositing but you
are keeping money on the account. Assume
an interest rate of 7.4%.
 A: Draw a time line and set this up as a future
value equation
FV of 10 payments after 10 years =
1000*((1+7.4%)^10-1)/7.4% = $14080.26
FV after 13 years =$14080.26*(1+7.4%)3
= $17443.09
Example
 Q: You are going to withdraw $1,000 at the end of
each year for the next 6 years from an account
that pays constant interest compounded
annually. The account balance will reduce to zero
when the last withdrawal is made. How much
money will be in the account immediately after
the fifth withdrawal is made? The interest rate on
the account is 15%.
 Q: Do you need to use formula for FVA?
 A: Draw a time line
Example
 Q: You are going to make mortgage payments of
$20,000 per year at the end of each year for the
next 20 years. The bank charges you a constant
mortgage rate of 10% compounded annually. You
will pay off your mortgage completely when the
last payment is made on year 20. What will your
mortgage balance be immediately after the fifth
payment is made?
 Do you need to know your initial balance?
 After the 5th withdrawal is made there will be 15
remaining payments left. The present value of 15
remaining payments equals the present value of
ordinary annuity.
 Use the Ordinary Annuity Formula: t=15, r=10%,
C=$20,000
 Example:

Example: Finding the payment, C, given PVA, r, t.

 Q. You want to buy a Mazda Miata. It costs $25,000.
With a 10% down payment, the bank will loan you the
rest at 12% per year (1% per month) for 60 months.
What will your monthly payment be?
 A. You will borrow .90  $25,000 = $22,500 . This is
the amount today, so it’s the present value. The rate is
1%, and there are 60 periods:
PV = C × (1 - [1/(1 + r )t ] )/r 
C = PV /[(1 - [1/(1 + r )t ] )/r]
C = $22,500/ ({1 - (1/(1.01)60}/.01 )
C = $22,500/44.955 = $500.50 per month
Example: Perpetuity Calculations

0 $1,000 $1,000 $1,000 $1,000

…..
Year, t
Perpetuity

 What is the present value of cash flow of $1000

per year forever. This is called a perpetuity

 PV of perpetuity is easy to calculate:

PV = C/r
 PV= $1000/.06 = $16,666.66…
Growing Perpetuity Calculations

0 $1,000 $1,000(1+g) $1,000*(1+g)2 $1,000(1+g)3

…..
Year, t

 What is the present value of cash flow of the

growing perpetuity

 PV of perpetuity is easy to calculate:

PV of Growing Perpetuity = C/(r-g)

 PV= $1000/(.06 – 0.02)= $25,000.00