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8 8 Chapter Time Value of Money Time Value of Money Slides Developed by: Terry Fegarty Seneca College

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© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 8 – Outline (1) The Time Value of Money Time Value Problems Amount ProblemsFuture Value Other Issues Financial Calculators Spreadsheet Solutions The Present Value of an Amount Finding the Interest Rate Finding the Number of Periods

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© 2006 by Nelson, a division of Thomson Canada Limited 3 Chapter 8 – Outline (2) Annuities The Future Value of an Annuity The Future Value of an AnnuityDeveloping a Formula The Future Value of an AnnuitySolving Problems The Sinking Fund Problem Compound Interest and Non-Annual Compounding The Effective Annual Rate The Present Value of an AnnuityDeveloping a Formula The Present Value of an AnnuitySolving Problems

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© 2006 by Nelson, a division of Thomson Canada Limited 4 Chapter 8 – Outline (3) Amortized Loans Loan Amortization Schedules Mortgage Loans The Annuity Due Perpetuities Continuous Compounding Multipart Problems Uneven Streams Imbedded Annuities

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© 2006 by Nelson, a division of Thomson Canada Limited 5 The Time Value of Money $100 in your hand today is worth more than $100 in one year Money earns interest The higher the interest, the faster your money grows Q:How much would $1,000 promised in one year be worth today if the bank paid 5% interest? A:$ If we deposited $ after one year we would have earned $47.62 ($ ×.05) in interest. Thus, our future value would be $ $47.62 = $1,000. Example

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© 2006 by Nelson, a division of Thomson Canada Limited 6 The Time Value of Money Present Value The amount that must be deposited today to have a future sum at a certain interest rate The discounted value of a sum is its present value In our example, what is the present value? $ Example

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© 2006 by Nelson, a division of Thomson Canada Limited 7 The Time Value of Money Future Value The amount a present sum will grow into at a certain interest rate over a specified period of time In our example, The present sum (value) is $ The interest rate is 5% The time is 1 year The future value is $1,000 Example

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© 2006 by Nelson, a division of Thomson Canada Limited 8 Time Value Problems Time value deals with four different types of problems Amount a single amount that grows at interest over time Future value Present value Annuity a stream of equal payments that grow at interest over time Future value Present value

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© 2006 by Nelson, a division of Thomson Canada Limited 9 Time Value Problems 4 methods to solve time value problems Use formulas Use financial tables Use financial calculator Use financial functions in spreadsheet

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© 2006 by Nelson, a division of Thomson Canada Limited 10 Amount ProblemsFuture Value The future value (FV) of an amount How much a sum of money placed at interest (k) will grow into in some period of time If the time period is one year FV 1 = PV + kPV or FV 1 = PV(1+k) If the time period is two years FV 2 = FV 1 + kFV 1 or FV 2 = PV(1+k) 2 If the time period is generalized to n years FV n = PV(1+k) n

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© 2006 by Nelson, a division of Thomson Canada Limited 11 Amount ProblemsFuture Value The (1 + k) n depends on Size of k and n Can develop a table depicting different values of n and k and the proper value of (1 + k) n Can then use a more convenient formula FV n = PV [FVF k,n ] These values can be looked up in an interest factor table. Q:If we deposited $438 at 6% interest for five years, how much would we have? A:FV 5 = $438(1.06) 5 = $438(1.3382) = $ Example

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© 2006 by Nelson, a division of Thomson Canada Limited 12 Table 8-1: The Future Value Factor for k and n FVF k,n = (1+k) n % Example

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© 2006 by Nelson, a division of Thomson Canada Limited 13 Other Issues Problem-Solving Techniques Three of four variables are given We solve for the fourth The Opportunity Cost Rate The opportunity cost of a resource is the benefit that would have been available from its next best use Lost investment income is an opportunity cost

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© 2006 by Nelson, a division of Thomson Canada Limited 14 Financial Calculators How to use a typical financial calculator in time value Five time value keys Use either four or five keys Some calculators distinguish between inflows and outflows If a PV is entered as positive the computed FV is negative

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© 2006 by Nelson, a division of Thomson Canada Limited 15 Financial Calculators N I/Y PMT FV PV Number of time periods Interest rate (%) Future Value Present Value Payment Basic Calculator Keys

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© 2006 by Nelson, a division of Thomson Canada Limited 16 Financial Calculators N I/Y PMT PV FV , Answer Example Q: What is the present value of $5,000 received in one year if interest rates are 6%? A: Input the following values on the calculator and compute the PV:

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© 2006 by Nelson, a division of Thomson Canada Limited 17 Spreadsheet Solutions Time value problems can be solved on a spreadsheet such as Microsoft ® Excel ® Click on the fx (function) button Select for the category Financial Select the function for the unknown variable For example, to solve for present value: Use PV(k, n, PMT, FV) Interest rate (k) is entered as a decimal, not a percentage

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© 2006 by Nelson, a division of Thomson Canada Limited 18 Spreadsheet Solutions To solve for: FV use =FV(k, n, PMT, PV) PV use =PV(k, n, PMT, FV) k use =RATE(n, PMT, PV, FV) N use =NPER(k, PMT, PV, FV) PMT use =PMT(k, n, PV, FV) Of the three cash variables (FV, PMT or PV) One is always zero The other two must be of the opposite sign Reflects inflows (+) versus outflows (-) Select the function for the unknown variable, place the known variables in the proper order within the parentheses and input 0, for the unknown variable.

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© 2006 by Nelson, a division of Thomson Canada Limited 19 The Present Value of an Amount Either equation can be used to solve any amount problems Solving for k or n involves searching a table.

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© 2006 by Nelson, a division of Thomson Canada Limited 20 Spreadsheet SolutionPV of Amount Click on the fx (function) button Select for the category Financial In the insert function box, select PV You will see PV(rate,nper,pmt,fv,type) Press OK Fill in rate = B4, nper = C1, pmt = 0, fv = C2 Enter OK Select the function for the unknown variable, place the known variables in the proper order within the parentheses and input 0, for the unknown variable. Example

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© 2006 by Nelson, a division of Thomson Canada Limited 21 Spreadsheet SolutionPV of Amount Example

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© 2006 by Nelson, a division of Thomson Canada Limited 22 Example 8.3: Finding the Interest Rate N PV I/Y PMT FV Answer Calculator Q: What interest rate will grow $850 into $ in three years? A: Example Interest factor is / = Look up in Table A-2 with n = 3 Interest = 5% Financial Table

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© 2006 by Nelson, a division of Thomson Canada Limited 23 Example 8.3 : Spreadsheet Solution Example

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© 2006 by Nelson, a division of Thomson Canada Limited 24 Example 8.3 : Spreadsheet Solution Click on the fx (function) button Select for the category Financial In the insert function box, select RATE You will see RATE(n, PMT, PV, FV) Press OK Fill in n = E1, PMT = 0, PV = -B2, FV = E2 Enter OK Example

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© 2006 by Nelson, a division of Thomson Canada Limited 25 Example 8.4: Finding the Number of Periods PV FV N I/Y PMT Answer Calculator Interest factor is 2 / 1 = 2 Look up in Table A-2 with k = 14% n = 5 – 6 years Financial Table Q: How long does it take money invested at 14% to double? A: The future value is twice the present value. If the present value is $1, the future value is $2 Example

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© 2006 by Nelson, a division of Thomson Canada Limited 26 Example 8.4: Finding the Number of Periods Click on the fx (function) button Select for the category Financial In the insert function box, select NPER You will see NPER(k, PMT, PV, FV) Enter OK Fill in the cell references for k (=.14) PMT = 0 PV (= -1) FV = 2 Enter OK NPER = 5.29 Example

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© 2006 by Nelson, a division of Thomson Canada Limited 27 Example 8.4: Spreadsheet Solution Example

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© 2006 by Nelson, a division of Thomson Canada Limited 28 Annuities Annuity A finite series of equal payments separated by equal time intervals Ordinary annuity Payments occur at the end of the time periods Monthly lease, pension, and car payments are annuities Annuity due Payments occur at the beginning of the time periods

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© 2006 by Nelson, a division of Thomson Canada Limited 29 Figures 8.1 and 8.2: Ordinary Annuity and Annuity Due Ordinary Annuity Annuity Due

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© 2006 by Nelson, a division of Thomson Canada Limited 30 Figure 8.3: Timeline Portrayal of an Ordinary Annuity

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© 2006 by Nelson, a division of Thomson Canada Limited 31 Future Value of an Annuity Future value of an annuity The sum, at its end, of all payments and all interest if each payment is deposited when received

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© 2006 by Nelson, a division of Thomson Canada Limited 32 Figure 8.4: FV of a Three-Year Ordinary Annuity

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© 2006 by Nelson, a division of Thomson Canada Limited 33 The Future Value of an Annuity Developing a Formula Thus, for a 3-year annuity, the formula is FVFA k,n

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© 2006 by Nelson, a division of Thomson Canada Limited 34 The Future Value of an Annuity Solving Problems There are four variables in the future value of an annuity equation The future value of the annuity itself The payment The interest rate The number of periods

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© 2006 by Nelson, a division of Thomson Canada Limited 35 Example 8.5: The Future Value of an Annuity Q: The Brock Corporation owns the patent to an industrial process and receives license fees of $100,000 a year on a 10-year contract for its use. Management plans to invest each payment until the end of the contract to provide funds for development of a new process at that time. If the invested money is expected to earn 7%, how much will Brock have after the last payment is received? Example

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© 2006 by Nelson, a division of Thomson Canada Limited 36 Example 8.5: The Future Value of an Annuity A: Use the future value of an annuity equation: FVA n = PMT[FVFA k,n ] In Table A-3, look up the interest factor at an n of 10 and a k of 7 Interest factor = Future value = $100,000[ ] = $1,381,640 FV N PMT I/Y 1,381,645 Answer PV Example

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© 2006 by Nelson, a division of Thomson Canada Limited 37 Example 8.5: Spreadsheet Solution Click on the fx (function) button Select for the category Financial In the insert function box, select FV You will see FV(k, n, PMT, PV) Enter OK Fill in the cell references for k (=.07) n (= 10) PMT (=100000) PV (=0) Enter OK FV = 1,381, Example

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© 2006 by Nelson, a division of Thomson Canada Limited 38 Example 8.5: Spreadsheet Solution Example

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© 2006 by Nelson, a division of Thomson Canada Limited 39 The Sinking Fund Problem Companies borrow money by issuing bonds for lengthy time periods No repayment of principal is made during the bonds lives Principal is repaid at maturity in a lump sum A sinking fund provides cash to pay off a bonds principal at maturity Problem is to determine the periodic deposit to have the needed amount at the bonds maturitya future value of an annuity problem

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© 2006 by Nelson, a division of Thomson Canada Limited 40 Example 8.6: The Sinking Fund Problem Q: The Greenville Company issued bonds totaling $15 million for 30 years. A sinking fund must be maintained after 10 years, which will retire the bonds at maturity. The estimated yield on deposited funds will be 6%. How much should Greenville deposit each year to be able to retire the bonds? Example

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© 2006 by Nelson, a division of Thomson Canada Limited 41 Example 8.6: The Sinking Fund Problem A:The time period of the annuity is the last 20 years of the bond issues life. On your calculator: PMT N FV I/Y 407, Answer PV Example

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© 2006 by Nelson, a division of Thomson Canada Limited 42 Compound Interest and Non- Annual Compounding Compounding Earning interest on interest Compounding periods Interest is usually compounded annually, semiannually, quarterly or monthly Interest rates are quoted by stating the nominal rate followed by the compounding period

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© 2006 by Nelson, a division of Thomson Canada Limited 43 The Effective Annual Rate Effective annual rate (EAR) The annually compounded rate that pays the same interest as a lower rate compounded more frequently

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© 2006 by Nelson, a division of Thomson Canada Limited 44 The Effective Annual Rate Example Example Q:If 12% is compounded monthly, what annually compounded interest rate will get a depositor the same interest? A:If your initial deposit were $100, you would have $ after one year of 12% interest compounded monthly. Thus, an annually compounded rate of 12.68% [($ $100) – 1] would have to be earned.

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© 2006 by Nelson, a division of Thomson Canada Limited 45 The Effective Annual Rate EAR can be calculated for any compounding period using the following formula: Effect of more frequent compounding is greater at higher interest rates

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© 2006 by Nelson, a division of Thomson Canada Limited 46 Impact of Compounding Frequency $1,000 Invested at 10% Nominal Rate for One Year

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© 2006 by Nelson, a division of Thomson Canada Limited 47 The Effective Annual Rate The APR and EAR Annual percentage rate (APR) Is actually the nominal rate and is less than the EAR Compounding Periods and the Time Value Formulas Time periods must be compounding periods Interest rate must be the rate for a single compounding period For instance, with a quarterly compounding period the k nominal must be divided by 4 and the n must be multiplied by 4

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© 2006 by Nelson, a division of Thomson Canada Limited 48 Example 8.7: The Effective Annual Rate PMT N FV I/Y Answer PV Example Q: You want to buy a car costing $15,000 in 2½ years. You plan to save the money by making equal monthly deposits in your bank account, which pays 12% compounded monthly. How much must you deposit each month? A: This is a future value of an annuity problem with a 1% monthly interest rate and a 30-month time period. On your calculator :

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© 2006 by Nelson, a division of Thomson Canada Limited 49 The Present Value of an Annuity Developing a Formula Present value of an annuity Sum of all of the annuitys payments PVFA k,n

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© 2006 by Nelson, a division of Thomson Canada Limited 50 Figure 8.6: PV of a Three-Payment Ordinary Annuity

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© 2006 by Nelson, a division of Thomson Canada Limited 51 The Present Value of an Annuity Solving Problems There are four variables in the present value of an annuity equation The present value of the annuity itself The payment The interest rate The number of periods Problem usually presents 3 of the 4 variables

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© 2006 by Nelson, a division of Thomson Canada Limited 52 Example 8.9: The Present Value of an Annuity Q: The Shipson Company has just sold a large machine on an installment contract. The contract calls for payments of $5,000 every six months (semiannually) for 10 years. Shipson would like its cash now and asks its bank to it the present (discounted) value. The bank is willing to discount the contract at 14% compounded semiannually. How much should Shipson receive? Example

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© 2006 by Nelson, a division of Thomson Canada Limited 53 Example 8.9: The Present Value of an Annuity A: The contract represents an annuity with payments of $5,000. Adjust the interest rate and number of periods for semiannual compounding and solve for the present value of the annuity. PV N FV I/Y 52, Answer PMT This can also be calculated using the PVA Table A4. Look up n = 20 and k = 7%. PVA = $5,000[10.594] = $52,970 Example

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© 2006 by Nelson, a division of Thomson Canada Limited 54 Amortized Loans An amortized loans principal is paid off regularly over its life Generally structured so that a constant payment is made periodically Represents the present value of an annuity

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© 2006 by Nelson, a division of Thomson Canada Limited 55 Example 8.10: Amortized Loans PMT N PV I/Y FV Answer This can also be calculated using the PVA formula of PVA = PMT[PVFA k, n ] n = 48 and k = 1.5% $10,000 = PMT[ ] = $ Q:Suppose you borrow $10,000 over four years at 18% compounded monthly repayable in monthly installments. How much is your loan payment? A:Adjust your interest rate and number of periods for monthly compounding. On your calculator: Example

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© 2006 by Nelson, a division of Thomson Canada Limited 56 Example 8.11: Amortized Loans Q: Suppose you want to buy a car and can afford to make payments of $500 a month. The bank makes three-year car loans at 12% compounded monthly. How much can you borrow toward a new car? A: Adjust your k and n for monthly compounding. On your calculator: PV N FV I/Y 15, Answer PMT This can also be calculated using the PVA Table A4. Look up n = 36 and k = 1%. PVA = $500[ ] = $15, Example

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© 2006 by Nelson, a division of Thomson Canada Limited 57 Loan Amortization Schedules Detail the interest and principal in each loan payment Show the beginning and ending balances of unpaid principal for each period Need to know Loan amount (PVA) Payment (PMT) Periodic interest rate (k)

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© 2006 by Nelson, a division of Thomson Canada Limited 58 Example 8.11: Loan Amortization Schedule Q:Develop an amortization schedule for the loan demonstrated in Example 8.11 Note that the Interest portion of the payment is decreasing while the Principal portion is increasing. Example

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© 2006 by Nelson, a division of Thomson Canada Limited 59 Mortgage Loans Mortgage loans (AKA: mortgages) Loans used to buy real estate Often the largest single financial transaction in a persons life Typically an amortized loan over 30 years During the early years of the mortgage nearly all the payment goes toward paying interest This reverses toward the end of the mortgage Halfway through a mortgages life half of the loan has not been paid off

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© 2006 by Nelson, a division of Thomson Canada Limited 60 Mortgage Loans Implications of mortgage payment pattern Long-term loans like mortgages result in large total interest amounts over the life of the loan At 6% interest, compounded monthly, over 25 years, borrower pays almost the amount of the loan just in interest! Canadian banks compound semi-annually, thus lowering interest charges Early mortgage payments and more frequent mortgage payments provide a large interest saving

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© 2006 by Nelson, a division of Thomson Canada Limited 61 Mortgage LoansExample Example PMT N FV I/Y 1, PV Answer %Interest / Principal $215,634Total Interest $150,000- Original Loan $365,634Total payments 360X # of payments $1,015.65Monthly payment Q:Calculate the monthly payment for a 30-year 7.175% mortgage of $150,000. Also calculate the total interest paid over the life of the loan. A:Adjust the n and k for monthly compounding and input the following calculator keystrokes.

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© 2006 by Nelson, a division of Thomson Canada Limited 62 The Annuity Due In an annuity due payments occur at the beginning of each period The future value of an annuity due Because each payment is received one period earlier, it spends one period longer in the bank earning interest

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© 2006 by Nelson, a division of Thomson Canada Limited 63 Figure 8.7: The Future Value of a Three-Period Annuity Due

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© 2006 by Nelson, a division of Thomson Canada Limited 64 Example 8.12: The Annuity Due FV N PMT I/Y 3,020,099 x 1.02 = 3,080,501 Answer PV NOTE: Advanced calculators allow you to switch from END (ordinary annuity) to BEGIN (annuity due) mode. Q:The Baxter Corporation started making sinking fund deposits of $50,000 per quarter today. Baxters bank pays 8% compounded quarterly, and the payments will be made for 10 years. What will the fund be worth at the end of that time? A:Adjust the k and n for quarterly compounding and input the following calculator keystrokes. Example

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© 2006 by Nelson, a division of Thomson Canada Limited 65 The Annuity Due The present value of an annuity due Formula Recognizing types of annuity problems Always represent a stream of equal payments Always involve some kind of a transaction at one end of the stream of payments End of streamfuture value of an annuity Beginning of streampresent value of an annuity

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© 2006 by Nelson, a division of Thomson Canada Limited 66 Perpetuities A perpetuity is a stream of regular payments that goes on forever An infinite annuity Future value of a perpetuity Makes no sense because there is no end point Present value of a perpetuity A diminishing series of numbers Each payments present value is smaller than the one before

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© 2006 by Nelson, a division of Thomson Canada Limited 67 Example 8.13: Perpetuities You may also work this by inputting a large n into your calculator (to simulate infinity), as shown below. PV N PMT I/Y FV Answer Q:The Longhorn Corporation issues a security that promises to pay its holder $5 per quarter indefinitely. Investors can earn 8% compounded quarterly on their money. How much can Longhorn sell this security for? A:Convert the k to a quarterly k and plug the values into the equation. Example

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© 2006 by Nelson, a division of Thomson Canada Limited 68 Continuous Compounding Compounding periods can be shorter than a day As the time periods become infinitesimally short, interest is said to be compounded continuously To determine the future value of a continuously compounded value: Where k = nominal rate, n = number of years, e =

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© 2006 by Nelson, a division of Thomson Canada Limited 69 Example 8.15: Continuous Compounding Q: The First National Bank of Cardston is offering continuously compounded interest on savings deposits. If you deposit $5,000 at 6½% compounded continuously and leave it in the bank for 3½ years, how much will you have? What is the equivalent annual rate (EAR) of 12% compounded continuously? Example

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© 2006 by Nelson, a division of Thomson Canada Limited 70 Example 8.15: Continuous Compounding A: To determine the future value of $5,000, plug the appropriate values into the equation To determine the EAR of 12% compounded continuously, find the future value of $100 compounded continuously in one year, then calculate the annual return = $ Example = NOTE: Some advanced calculators have a function to solve for the EAR with continuous compounding

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© 2006 by Nelson, a division of Thomson Canada Limited 71 Table 8.5: Time Value Formulas

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© 2006 by Nelson, a division of Thomson Canada Limited 72 Multipart Problems Time value problems are often combined due to complex nature of real situations A time line portrayal can be critical to keeping things straight

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© 2006 by Nelson, a division of Thomson Canada Limited 73 Example 8.16: Multipart Problems Q:Exeter Inc. has $75,000 invested in securities that earn a return of 16% compounded quarterly. The company is developing a new product that it plans to launch in two years at a cost of $500,000. Management would like to bank money from now until the launch to be sure of having the $500,000 in hand at that time. The money currently invested in securities can be used to provide part of the launch fund. Exeters bank account will pay 12% compounded monthly. How much should Exeter deposit with the bank each month ? Example

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© 2006 by Nelson, a division of Thomson Canada Limited 74 Example 8.16: Multipart Problems A:Two things are happening in this problem Exeter is saving money every month (an annuity) and The money invested in securities (an amount) is growing independently at interest We have three steps First, we need to find the future value of $75,000 Then, we subtract that future value from $500,000 to determine how much extra Exeter needs to save via the annuity Then, we solve a future value of an annuity problem for the payment Example

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© 2006 by Nelson, a division of Thomson Canada Limited 75 Example 8.16: Multipart Problems Example To find the future value of the $75,000… PV N PMT I/Y 102, FV Answer To find the savings annuity value PMT N PV I/Y 14, FV Answer $500,000 - $102,645 = $397,355

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© 2006 by Nelson, a division of Thomson Canada Limited 76 Uneven Streams Many real world problems have sequences of uneven cash flows These are NOT annuities For example, if you were asked to determine the present value of the following stream of cash flows $100$200$300 Must discount each cash flow individually Not really a problem when attempting to determine either a present or future value Becomes a problem when attempting to determine an interest rate

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© 2006 by Nelson, a division of Thomson Canada Limited 77 Example 8.18: Uneven Streams $100$200$300 Example A:Start with a guess of 12% and discount each amount separately at that rate. This value is too low; select a lower interest rate. Using 11% gives us $ The answer is between 8% and 9%. Q:Calculate the interest rate at which the present value of the stream of payments shown below is $500.

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© 2006 by Nelson, a division of Thomson Canada Limited 78 Imbedded Annuities Sometimes uneven streams of cash flows will have annuities imbedded within them We can use the annuity formula to calculate the present or future value of that portion of the problem

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