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## CHAPTER 2 Time Value of Money

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**CHAPTER 2Time Value of Money**Future value Present value Annuities Rates of return Amortization**Last week**• Objective of the firm • Business forms • Agency conflicts • Capital budgeting decision and capital structure decision**The plan of the lecture**• Time value of money concepts • present value (PV) • discount rate/interest rate (r) • Formulae for calculating PV of • perpetuity • annuity • Interest compounding • How to use a financial calculator**Financial choices with time**• Which would you rather receive? • $1000 today • $1040 in one year • Both payments have no risk, that is, • there is 100% probability that you will be paid**Financial choices with time**• Why is it hard to compare ? • $1000 today • $1040 in one year • This is not an “apples to apples” comparison. They have different units • $1000 today is different from $1000 in one year • Why? • A cash flow is time-dated money**Present value**• To have an “apple to apple” comparison, we • convert future payments to the present values • or convert present payments to the future values • This is like converting money in Canadian $ to money in US $.**Some terms**• Finding the present value of some future cash flows is called discounting. • Finding the future value of some current cash flows is called compounding.**0**1 2 3 10% 100 FV = ? What is the future value (FV) of an initial $100 after 3 years, if i = 10%? • Finding the FV of a cash flow or series of cash flows is called compounding. • FV can be solved by using the arithmetic, financial calculator, and spreadsheet methods.**Solving for FV:The arithmetic method**• After 1 year: • FV1 = c ( 1 + i ) = $100 (1.10) = $110.00 • After 2 years: • FV2 = c (1+i)(1+i)= $100 (1.10)2 =$121.00 • After 3 years: • FV3 = c ( 1 + i )3 = $100 (1.10)3 =$133.10 • After n years (general case): • FVn = C ( 1 + i )n**Set up the Texas instrument**• 2nd, “FORMAT”, set “DEC=9”, ENTER • 2nd, “FORMAT”, move “↓” several times, make sure you see “AOS”, not “Chn”. • 2nd, “P/Y”, set to “P/Y=1” • 2nd, “BGN”, set to “END” • P/Y=periods per year, • END=cashflow happens end of periods**Solving for FV:The calculator method**• Solves the general FV equation. • Requires 4 inputs into calculator, and it will solve for the fifth. 3 10 -100 0 INPUTS N I/YR PV PMT FV OUTPUT 133.10**What is the present value (PV) of $100 received in 3 years,**if i = 10%? • Finding the PV of a cash flow or series of cash flows is called discounting (the reverse of compounding). • The PV shows the value of cash flows in terms of today’s worth. 0 1 2 3 10% PV = ? 100**Solving for PV:The arithmetic method**• i: interest rate, or discount rate • PV = C / ( 1 + i )n • PV = C / ( 1 + i )3 = $100 / ( 1.10 )3 = $75.13**Solving for PV:The calculator method**• Exactly like solving for FV, except we have different input information and are solving for a different variable. 3 10 0 100 INPUTS N I/YR PV PMT FV OUTPUT -75.13**Solving for N:If your investment earns interest of 20% per**year, how long before your investments double? 20 -1 0 2 INPUTS N I/YR PV PMT FV OUTPUT 3.8**Solving for i:What interest rate would cause $100 to grow to**$125.97 in 3 years? 3 -100 0 125.97 INPUTS N I/YR PV PMT FV OUTPUT 8**Now let’s study some interesting patterns of cash flows…**• Annuity • Perpetuity**Ordinary Annuity**0 1 2 3 i% PMT PMT PMT Annuity Due 0 1 2 3 i% PMT PMT PMT ordinary annuity and annuity due**Value an ordinary annuity**• Here C is each cash payment • n is number of payments • If you’d like to know how to get the formula below (not required), see me after class.**Solving for FV:3-year ordinary annuity of $100 at 10%**• $100 payments occur at the end of each period. Note that PV is set to 0 when you try to get FV. 3 10 0 -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. FV is now set to 0. 3 10 100 0 INPUTS N I/YR PV PMT FV OUTPUT -248.69**Example**• you win the $1million dollar lottery! but wait, you will actually get paid $50,000 per year for the next 20 years if the discount rate is a constant 7% and the first payment will be in one year, how much have you actually won?**Solving for FV:3-year annuity due of $100 at 10%**• $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 0 -100 INPUTS N I/YR PV PMT FV OUTPUT 364.10**Solving for PV:3-year annuity due of $100 at 10%**• $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 0 INPUTS N I/YR PV PMT FV OUTPUT -273.55**What is the present value of a 5-year $100 ordinary annuity**at 10%? • Be sure your financial calculator is set back to END mode and solve for PV: • N = 5, I/YR = 10, PMT = 100, FV = 0. • PV = $379.08**What if it were a 10-year annuity? A 25-year annuity? A**perpetuity? • 10-year annuity • N = 10, I/YR = 10, PMT = 100, FV = 0; solve for PV = $614.46. • 25-year annuity • N = 25, I/YR = 10, PMT = 100, FV = 0; solve for PV = $907.70. • Perpetuity (N=infinite) • PV = PMT / i = $100/0.1 = $1,000.**What is the present value of a four-year annuity of $100 per**year that makes its first payment two years from today if the discount rate is 9%? $297.22 $323.97 $100 $100 $100 $100 0 1 2 3 4 5**4**0 1 2 3 10% 100 300 300 -50 90.91 247.93 225.39 -34.15 530.08 = PV What is the PV of this uneven cash flow stream?**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 • Enter I/YR = 10, press NPV button to get NPV = $530.09. (Here NPV = PV.)**Detailed steps (Texas Instrument calculator)**• To clear historical data: • CF, 2nd ,CE/C • To get PV: • CF ,↓,100 , Enter , ↓,↓ ,300 , Enter, ↓,2, Enter, ↓, 50, +/-,Enter, ↓,NPV,10,Enter, ↓,CPT • “NPV=530.0867427”**The Power of Compound Interest**A 20-year-old student wants to start saving for retirement. She plans to save $3 a day. Every day, she puts $3 in her drawer. At the end of the year, she invests the accumulated savings ($1,095=$3*365) in an online stock account. The stock account has an expected annual return of 12%. How much money will she have when she is 65 years old?**Solving for FV:Savings problem**• If she begins saving today, and sticks to her plan, she will have $1,487,261.89 when she is 65. 45 12 0 -1095 INPUTS N I/YR PV PMT FV OUTPUT 1,487,262**Solving for FV:Savings problem, if you wait until you are 40**years old to start • If a 40-year-old investor begins saving today, and sticks to the plan, he or she will have $146,000.59 at age 65. This is $1.3 million less than if starting at age 20. • Lesson: It pays to start saving early. 25 12 0 -1095 INPUTS N I/YR PV PMT FV OUTPUT 146,001**0**1 2 3 10% 100 133.10 0 1 2 3 4 5 6 0 1 2 3 5% 100 134.01 Will the FV of a lump sum be larger or smaller if compounded more often, holding the stated i% constant? • LARGER, as the more frequently compounding occurs, interest is earned on interest more often. Annually: FV3 = $100(1.10)3 = $133.10 Semiannually: FV6 = $100(1.05)6 = $134.01**What is the FV of $100 after 3 years under 10% semiannual**compounding? Quarterly compounding?**Classifications of interest rates**• 1. Nominal rate (iNOM) – also called the APR,quoted rate, or stated rate. An annual rate that ignores compounding effects. Periods must also be given, e.g. 8% Quarterly. • 2. 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. e.g., m = 12 for monthly compounding.**Classifications of interest rates**• 3. Effective (or equivalent) annual rate (EAR, also called EFF, APY) : the annual rate of interest actually being earned, taking into account compounding. • If the interest rate is compounded m times in a year, the effective annual interest rate is**Example, EAR for 10% semiannual investment**• EAR= ( 1 + 0.10 / 2 )2 – 1 = 10.25% • An investor would be indifferent between an investment offering a 10.25% annual return, and one offering a 10% return compounded semiannually.**keys:**description: Sets 2 payments per year [↑] [C/Y=] 2 [ENTER] [2nd] [ICONV] Opens interest rate conversion menu [↓][NOM=] 10 [ENTER] Sets 10 APR. [↓] [EFF=] [CPT] 10.25 EAR on a Financial Calculator Texas Instruments BAII Plus**Why is it important to consider effective rates of return?**• An investment with monthly payments is different from one with quarterly payments. • Must use EAR for comparisons. • If iNOM=10%, then EAR for different compounding frequency: Annual 10.00% Quarterly 10.38% Monthly 10.47% Daily 10.52%**If interest is compounded more than once a year**• EAR (EFF, APY) will be greater than the nominal rate (APR).**1**2 3 0 1 2 3 4 5 6 5% 100 100 100 What’s the FV of a 3-year $100 annuity, if the quoted interest rate is 10%, compounded semiannually? • Payments occur annually, but compounding occurs every 6 months. • Cannot use normal annuity valuation techniques.**1**2 3 0 1 2 3 4 5 6 5% 100 100 100 110.25 121.55 331.80 Method 1:Compound each cash flow FV3 = $100(1.05)4 + $100(1.05)2 + $100 FV3 = $331.80**Method 2:Financial calculator**• Find the EAR and treat as an annuity. • EAR = ( 1 + 0.10 / 2 )2 – 1 = 10.25%. 3 10.25 0 -100 INPUTS N I/YR PV PMT FV OUTPUT 331.80**When is periodic rate used?**• iPER is often useful if cash flows occur several times in a year.