Ch. 2 - Time Value of Money

Topics Covered Future Values Present Values Multiple Cash Flows Perpetuities and Annuities Non-annual interest compounding Effective Annual Interest Rate 2

Compounding and Discounting Single Sums The Time Value of Money Compounding and Discounting Single Sums

“The greatest mathematical discovery of all time is compound interest Albert Einstein

Future Values Future Value - Amount to which an investment will grow after earning interest. Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original investment. 3

Example: Simple vs. Compound Interest Compare $100 invested at 10% interest compound annually vs. 10% simple annual interest for 3 years.

Future Value of Single Cash Flow 21

Future Values of $100 with Compounding Interest Rates 24

Example: Futurama Value? Fry is frozen in the year 2000 with $0.93 in his checking account that pays 2.25% compounded annually. How much does Fry have in his account when he “awakes” a thousand years later in the year 3000?

Today's value of a lump sum received at a future point in time: Present Value Today's value of a lump sum received at a future point in time: Formula can be rearranged to compute required return, if price and dividend known: Equity Valuation As will be discussed in chapter 5, the required return on common stock is based on its beta, derived from the CAPM Valuing CS is the most difficult, both practically & theoretically Preferred stock valuation is much easier (the easiest of all) Whenever investors feel the expected return, rˆ, is not equal to the required return, r, prices will react: If exp return declines or reqd return rises, stock price will fall If exp return rises or reqd return declines, stock price will rise Asset prices can change for reasons besides their own risk Changes in asset’s liquidity, tax status can change price Changes in market risk premium can change all asset values Most dramatic change in market risk: Russian default Fall 98 Caused required return on all risky assets to rise, price to fall

Example: Paying for Baby’s MBA Just had a baby. You think the baby will take after you and earn academic scholarships to attend college to earn a Bachelor’s degree. However, you want send your baby to a top-notch 2-year MBA program when baby is 25. You have estimated the future cost of the MBA at $102,000 for year 1 and $107,000 for year 2.

Example: Paying for Baby’s MBA Today, you want to finance both years of baby’s MBA program with one payment (deposit) into an account paying 6.5% interest compounded annually. How large must this deposit be?

The Power of High Discount Rates 1.00 0% 0.75 Present Value of One Dollar ($) 0.5 5% 10% 0.25 15% 20% 0 2 4 6 8 10 12 14 16 18 20 22 24 Periods

Time Value of Money (applications) Implied Interest Rates Internal Rate of Return Time necessary to accumulate funds 39

Example : Finding Rate of Return or Interest Rate A broker offers you an investment (a zero coupon bond) that pays you $1,000 five years from now for the cost of $740 today. What is your annual rate of return?

Compounding and Discounting The Time Value of Money Compounding and Discounting Cash Flow Streams 1 2 3 4

Annuities Annuity: a sequence of equal cash flows, occurring at the end of each period. This is known as an ordinary annuity. 1 2 3 4 PV FV

Examples of Ordinary Annuities: If you buy a bond, you will receive equal semi-annual coupon interest payments over the life of the bond. If you borrow money to buy a house or a car, you will re-pay the loan with a stream of equal payments.

Annuity-due A sequence of periodic cash flows occurring at the beginning of each period. 1 2 3 4 PV FV

Examples of Annuities-due Monthly Rent payments: due at the beginning of each month. Car lease payments. Cable & Satellite TV and most internet service bills.

What is the difference between an ordinary annuity and an annuity due? PMT 1 2 3 i% PMT 1 2 3 i% Annuity Due

Solving for FV: 3-year ordinary annuity of $100 at 10% $100 payments occur at the end of each period, but there is no PV. 3 10 -100 INPUTS N I/YR PV PMT FV OUTPUT 331

Solving for PV: 3-year ordinary annuity of $100 at 10% $100 payments still occur at the end of each period, but now there is no FV. 3 10 100 INPUTS N I/YR PV PMT FV OUTPUT -248.69

Solving for FV: 3-year annuity due of $100 at 10% Now, $100 payments occur at the beginning of each period. FVAdue= FVAord(1+I) = $331(1.10) = $364.10. Alternatively, set calculator to “BEGIN” mode and solve for the FV of the annuity: BEGIN 3 10 -100 INPUTS N I/YR PV PMT FV OUTPUT 364.10

Solving for PV: 3-year annuity due of $100 at 10% Again, $100 payments occur at the beginning of each period. PVAdue= PVAord(1+I) = $248.69(1.10) = $273.55. Alternatively, set calculator to “BEGIN” mode and solve for the PV of the annuity: BEGIN 3 10 100 INPUTS N I/YR PV PMT FV OUTPUT -273.55

Annuities Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments Mortgage payment Annual income from an investment payout Future Value of annual payments 54

Example: Invest Early in an IRA How much would you have at age 65 if you deposit $2,400 at the end of each year in an investment account with a 9% expected annual return starting at: (A) age 44? (B) age 22?

A) Start at age 44

B) Start at age 22

Solving for PMT: How much must the 44-year old deposit annually to catch the 22-year old? To find the required annual contribution, enter the number of years until retirement and the final goal of $1,058,030 and solve for PMT. 21 9 1,058,030 INPUTS N I/YR PV PMT FV OUTPUT -18,639

Now about this? Let’s assume that the 44-year old has already accumulated $120,000 in the IRA account. How much would he have to deposit on an annual basis at the 9% expected annual return to catch up with the 22-year old and be a millionaire at age 65?

More Annuity Fun! Springfield mogul Montgomery Burns, age 85, wants to retire at age 100 so he can steal candy from babies full time. Once Mr. Burns retires, he wants to withdraw $100 million at the beginning of each year for 10 years from a special off-shore account that will pay 20% annually. In order to fund his retirement, Mr. Burns will make 15 equal end-of-the-year deposits in this same special account that will pay 20% annually. How large of an annual deposit must be made to fund Mr. Burns’ retirement plans?

Perpetuities Suppose you will receive a fixed payment every period (month, year, etc.) forever. This is an example of a perpetuity. PV of Perpetuity Formula PMT = periodic cash payment i = interest rate

Perpetuities & Annuities Example - Perpetuity You want to create an endowment to fund a football scholarship, which pays $15,000 per year, forever, how much money must be set aside today if the rate of interest is 5%? 47

What is the PV of this uneven cash flow stream? 100 1 300 2 3 10% -50 4 90.91 247.93 225.39 -34.15 530.08 = PV

Solving for PV: Uneven cash flow stream Input cash flows in the calculator’s “CF” register: CF0 = 0 CF1 = 100 CF2 = 300 CF3 = 300 CF4 = -50 Under NPV, enter I = 10, down arrow, and press CPT button to get NPV = $530.087. (Here NPV = PV.)

Non-annual Interest Compounding and Discounting The Time Value of Money Non-annual Interest Compounding and Discounting

Classifications of interest rates Nominal rate (INOM) – also called the quoted or state rate. An annual rate that ignores compounding effects. INOM is stated in contracts. Periods must also be given, e.g. 8% Quarterly or 8% Daily interest. Periodic rate (IPER) – amount of interest charged each period, e.g. monthly or quarterly. IPER = INOM / M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding.

Classifications of interest rates Effective (or equivalent) annual rate (EAR = EFF%) – the annual rate of interest actually being earned, accounting for compounding. EFF% for 10% semiannual investment EFF% = ( 1 + INOM / M )M - 1 = ( 1 + 0.10 / 2 )2 – 1 = 10.25% Should be indifferent between receiving 10.25% annual interest and receiving 10% interest, compounded semiannually.

Why is it important to consider effective rates of return? Investments with different compounding intervals provide different effective returns. To compare investments with different compounding intervals, you must look at their effective returns (EFF% or EAR). See how the effective return varies between investments with the same nominal rate, but different compounding intervals. EARANNUAL 10.00% EARQUARTERLY 10.38% EARMONTHLY 10.47% EARDAILY (365) 10.52%

When is each rate used? INOM written into contracts, quoted by banks and brokers. Not used in calculations or shown on time lines. IPER Used in calculations and shown on time lines. If M = 1, INOM = IPER = EAR. EAR Used to compare returns on investments with different payments per year. Used in calculations when annuity payments don’t match compounding periods.

FV and PV with non-annual interest compounding n = number of years m = number of times interest is paid per year inom = stated annual rate (APR) inom /m = periodic rate Single CF FVnm = PV(1 + inom/m)nm PV = FVnm/(1 + inom/m)nm Annuities: Use periodic rate and number of annuity payment and compounding periods if interest compounding period and annuity payment period are the same. Otherwise, need to find effective interest rate for each annuity payment period.

What is the FV of $100 after 3 years under 10% semiannual compounding What is the FV of $100 after 3 years under 10% semiannual compounding? Quarterly compounding?

Futurama Value Revisited How much money would Fry have in his bank account in the year 3000 from the $0.93 deposited in the year 2000 if the 2.25% annual rate was compounded quarterly?

Let’s buy a car! Prof. Outback decides to purchase a brand-new 2007 Jeep Liberty Limited 4WD with heated premium leather seats, sunroof, and satellite radio for $28,800. After paying tax and license, Prof. Outback has $4,000 as a down payment. Jeep offers Prof the choice of 3.9% APR financing for 60 months or a $3,000 rebate. Prof. Outback can receive 6.25% APR financing for 60 months through E-Loan if the rebate option is selected. Which option would result in the lower monthly payment? At what APR along without the rebate would the Prof. be indifferent between the two options?

Monthly Payments

Indifference APR