 # Chapter 3 The Time Value of Money © 2005 Thomson/South-Western.

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Chapter 3 The Time Value of Money © 2005 Thomson/South-Western

2 Time Value of Money  The most important concept in finance  Used in nearly every financial decision  Business decisions  Personal finance decisions

3 © 2005 Thomson/South-Western Cash Flow Time Lines CF 0 CF 1 CF 3 CF 2 0123 k% Time 0 is today Time 1 is the end of Period 1 or the beginning of Period 2. Graphical representations used to show timing of cash flows

4 © 2005 Thomson/South-Western 100 012 Year k% Time line for a \$100 lump sum due at the end of Year 2

5 © 2005 Thomson/South-Western Time line for an ordinary annuity of \$100 for 3 years 100 0123 k%

6 © 2005 Thomson/South-Western Time line for uneven CFs - \$50 at t = 0 and \$100, \$75, and \$50 at the end of Years 1 through 3 100 50 75 0123 k% -50

7 © 2005 Thomson/South-Western The amount to which a cash flow or series of cash flows will grow over a period of time when compounded at a given interest rate. Future Value

8 © 2005 Thomson/South-Western FV n = FV 1 = PV + INT = PV + (PV x k) = PV (1 + k) = \$100(1 + 0.05) = \$100(1.05) = \$105 How much would you have at the end of one year if you deposited \$100 in a bank account that pays 5% interest each year? Future Value

9 © 2005 Thomson/South-Western FV = ? 0123 10% 100 Finding FV is Compounding. What’s the FV of an initial \$100 after 3 years if k = 10%?

10 © 2005 Thomson/South-Western After 1 year: FV 1 =PV + Interest 1 = PV + PV (k) =PV(1 + k) =\$100 (1.10) =\$110.00. After 2 years: FV 2 =PV(1 + k) 2 =\$100 (1.10) 2 =\$121.00. After 3 years: FV 3 =PV(1 + k) 3 =100 (1.10) 3 =\$133.10. In general, FV n = PV (1 + k) n Future Value

11 © 2005 Thomson/South-Western Three Ways to Solve Time Value of Money Problems  Use Equations  Use Financial Calculator  Use Electronic Spreadsheet

12 © 2005 Thomson/South-Western Solve this equation by plugging in the appropriate values: Numerical (Equation) Solution PV = \$100, k = 10%, and n =3

13 © 2005 Thomson/South-Western Present Value  Present value is the value today of a future cash flow or series of cash flows.  Discounting is the process of finding the present value of a future cash flow or series of future cash flows; it is the reverse of compounding.

14 © 2005 Thomson/South-Western 100 0123 10% PV = ? What is the PV of \$100 due in 3 years if k = 10%?

15 © 2005 Thomson/South-Western Solve FV n = PV (1 + k ) n for PV:

16 © 2005 Thomson/South-Western Future Value of an Annuity  Annuity: A series of payments of equal amounts at fixed intervals for a specified number of periods.  Ordinary (deferred) Annuity: An annuity whose payments occur at the end of each period.  Annuity Due: An annuity whose payments occur at the beginning of each period.

17 © 2005 Thomson/South-Western PMT 0123 k% PMT 0123 k% PMT Ordinary Annuity Versus Annuity Due Ordinary Annuity Annuity Due

18 © 2005 Thomson/South-Western 100 0123 10% 110 121 FV= 331 What’s the FV of a 3-year Ordinary Annuity of \$100 at 10%?

19 © 2005 Thomson/South-Western Numerical Solution (using table):

20 © 2005 Thomson/South-Western Present Value of an Annuity  PVA n = the present value of an annuity with n payments.  Each payment is discounted, and the sum of the discounted payments is the present value of the annuity.

21 © 2005 Thomson/South-Western 248.69 = PV 100 0123 10% 90.91 82.64 75.13 What is the PV of this Ordinary Annuity?

23 © 2005 Thomson/South-Western 100 0123 10% 100 Find the FV and PV if the Annuity were an Annuity Due.

24 © 2005 Thomson/South-Western Numerical Solution

25 © 2005 Thomson/South-Western 250 0123 k = ? - 864.80 4 250 You pay \$864.80 for an investment that promises to pay you \$250 per year for the next 4 years, with payments made at the end of each year. What interest rate will you earn on this investment? Solving for Interest Rates with annuities

26 © 2005 Thomson/South-Western Uneven Cash Flow Streams  A series of cash flows in which the amount varies from one period to the next:  Payment (PMT) designates constant cash flows—that is, an annuity stream.  Cash flow (CF) designates cash flows in general, both constant cash flows and uneven cash flows.

27 0 100 1 300 2 3 10% -50 4 90.91 247.93 225.39 -34.15 530.08 = PV What is the PV of this Uneven Cash Flow Stream?

28 © 2005 Thomson/South-Western Numerical Solution

29 © 2005 Thomson/South-Western Semiannual and Other Compounding Periods  Annual compounding is the process of determining the future value of a cash flow or series of cash flows when interest is added once a year.  Semiannual compounding is the process of determining the future value of a cash flow or series of cash flows when interest is added twice a year.

30 0123 10% 100 133.10 0123 5% 456 134.01 123 0 100 Annually: FV 3 = 100(1.10) 3 = 133.10. Semi-annually: FV 6/2 = 100(1.05) 6 = 134.01. Compounding Annually vs. Semi-Annually

31 © 2005 Thomson/South-Western Simple (Quoted) Rate k SIMPLE = Simple (Quoted) Rate used to compute the interest paid per period Effective Annual Rate EAR= Effective Annual Rate the annual rate of interest actually being earned Annual Percentage Rate APR = Annual Percentage Rate = k SIMPLE periodic rate X the number of periods per year Distinguishing Between Different Interest Rates

32 © 2005 Thomson/South-Western How do we find EAR for a simple rate of 10%, compounded semi-annually?

33 © 2005 Thomson/South-Western FV of \$100 after 3 years if interest is 10% compounded semi-annual? Quarterly?

34 © 2005 Thomson/South-Western Amortized Loans  Amortized Loan: A loan that is repaid in equal payments over its life.  Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, and so forth to determine how much of each payment represents principal repayment and how much represents interest.  They are very important, especially to homeowners

35 © 2005 Thomson/South-Western Step 1: Construct an amortization schedule for a \$1,000, 10% loan that requires 3 equal annual payments. PMT 0123 10% -1,000

36 Step 2: Find interest charge for Year 1 INT t = Beginning balance t x (k) INT 1 = 1,000 x 0.10 = \$100.00 Repayment= PMT - INT = \$402.11 - \$100.00 = \$302.11. Step 3: Find repayment of principal in Year 1

37 © 2005 Thomson/South-Western End bal=Beginning bal. - Repayment =\$1,000 - \$302.11 = \$697.89. Repeat these steps for the remainder of the payments (Years 2 and 3 in this case) to complete the amortization table. Step 4: Find ending balance after Year 1

38 Interest declines, which has tax implications. Loan Amortization Table 10% Interest Rate * Rounding difference