Time Value of Money

1. Time Value of Money Review of Basic Concepts

2. PV FV Types of problems • Single Sum. One sum ($1) will be received or paid either in the • Present (Present Value of a Single Sum or PV) • Future (Future Value of a Single Sum or FV)

3. PV-OA PMT PMT PMT PMT PMT Types of Annuity Problems Ordinary annuity(OA) A series of equal payments (or rents) received or paid at the end of a period, assuming a constant rate of interest. PV-OA(Present value of an ordinary annuity)

4. FV-OA PMT PMT PMT PMT PMT Types of Annuity Problems Ordinary annuity(OA) A series of equal payments (or rents) received or paid at the end of a period, assuming a constant rate of interest. FV-OA (Future value of an ordinary annuity)

5. FV-AD PMT PMT PMT PMT PMT 0 Types of Problems Annuity Due(AD) A series of equal payments (or rents) received or paid at the beginning of a period, assuming a constant rate of interest. FV-AD (future value of an annuity due) Note: Each rent or payment is discounted (interest removed) one less period under a FV-AD.

6. PV-AD PMT PMT PMT PMT PMT 0 Types of Problems Annuity Due(AD) A series of equal payments (or rents) received or paid at the beginning of a period, assuming a constant rate of interest. PV-AD (present value of an annuity due) Note: Each rent or payment compounds (interest added) one more period in a PV-AD

7. 0 1 2 3 4 5 PMT PMT PMT n = 3 d = 2 Deferred Annuities This is an ordinary annuity of 3 periods deferred for 2 periods. We could find either the PV or the FV of the annuity.

8. Calculation Variables • There will always be at least four variables in any present or future value problem. Three of the four will be known and you will solve for the fourth. • Single sum problems: • n = number of compounding periods • i = interest rate • PV = Value today of a single sum ($1) • FV = Value in the future of a single sum ($1) • PMT = 0 (important it using PV calculator!) 15 15

9. Annuity Problems • n = number of payments or rents • i = interest rate • PMT = Periodic payment (rent) received or paid • And either: • FV of an annuity (OA or AD) = Value in the future of a series of future payments • OR • PV of an annuity (OA or AD) = Value today of a series of payments in the future When we know any three of the four amounts, we can solve for the fourth!

10. i and n must match! • The “n” refers to periods not necessarily defined as years! The period may be annual, semi-annual, quarterly or another time frame. • The “n” and the “i” must match. That is, if the time period is semi-annual then so must the interest rate. • Interest rates are assumed to be annual unless otherwise stated so you may have to adjust the rate to match the time period.

11. Single Sum Formulas • FV = (1+i)n • PV = FV (1+i)n

12. Single Sum Formulas • FV = (1+i)n • PV = FV (1+i)n • Present value calculators are generally no more expensive than those that do nth powers and nth roots!

13. (1 + i)- 1 PMT i 1 1 - (1 + i)n PMT i Annuity Formulas • FV-OA = • PV-OA =

14. Formulas vs. Tables • Before fancy calculators, people had no easy way to compute nth roots and raise numbers to the nth power. • So they created tables for of sums of $1 or annuities of $1. • The values on the table, I call the “interest factor” or IF. • So we have PVIF (for n and i)and the PVIF-OA (for n and i) and so forth

15. vertically for the “n” and horizontally for the “i” Using the tables The tables are the result of the required multiplications and division at various “n” and “i” and are to be read

16. Study the tables . . • They are very logical. • All sums in the future are worth LESS in the present. • All factors on the present value of a single sum table are less than one. All present sums are worth more than themselves in the future. • All factors on the future value of a single sum table are greater than one. • Notice how the factors change dramatically as the “i” increases and the “n” lengthens! 24

17. “Formulas” for the IF Tables • PV = FV * IF {IF from PV of $ table} • FV = PV * IF {IF from FV of $ table} • PV-OA = PMT * IF {IF from PV-OA table} • FV-OA = PMT * IF {IF from FV-OA table} • PMT = (PV-OA) / IF {IF from PV-OA table} • or • PMT = (FV-OA) / IF {from FV-OA table} “IF” stands for “interest factor” from the appropriate n row and i column of the table

18. Adjustments to ordinary annuity tables Rules for annuity dues and deferred annuities

19. Conversion to Annuity Due • To find IF for FV-AD: Add one to the number of periods and look up IF on table. Then subtract one from the interest factor listed. • To find IF for PV-AD: Subtract one from the number of periods and look up IF on table. Add one to the interest factor. • Or look up the IF on the appropriate table and multiply by (1 + i).

20. Page 480 Ordinary Annuity Example • Suppose I must make three payments of $500, each at the end of each of the next three years. The interest rate is 8%. How much should I set aside today to have the required payments? • This is an ordinary annuity: PV-OA= PMT * (PVIF-OA n,i) where n = 3 payments and i = 8% PV-OA = $500 * 2.5771 = $1,289

21. Stop and think . . . • If the first payment comes immediately instead of at the end of the first year, • Will the present value be • MORE or • LESS?

22. Annuity Due Example • If the first payment comes immediately, this would be an annuity due problem. • We can use one of the formulas to adjust the IF – the easiest to memorize is the “multiply by (1+i)” rule: PV-AD= PMT (PVIF-OA n,i)(1+i) where n = 3 payments and i = 8% PV-AD = $500 (2.5771)(1 + .08) = $1,391 36

23. Annuity Due Example • Alternative adjustment to the IF table is even easier – at least if you write the method at the top of your table! • Look up IF for (n-1) and add 1: PVIF-OA (n=2, i=8%) = 1.7833 + 1 = 2.7833 PV-AD = $500 (2.7833) = $1,392 36

24. PMT PMT PMT PMT PMT 0 • This is an ordinary annuity of 4 periods (n-1) • The first payment comes immediately and therefore is NOT discounted! Annuity Due Example • This second method is also the “logical” decision you would make from looking at the time-line. FV-AD

25. 0 1 2 3 4 5 PMT PMT PMT n = 3 d = 2 Deferred Annuities When using the tables, there are some short-cuts for doing deferred annuities

26. Using PV Tables – Deferred Annuity • Let d = number of periods deferred and n = number of periodic payments • Look up (d+n) on the appropriate table. Look up d on the same table. Subtract the smaller interest factor from the larger to get the deferred annuity IF. • Or look up interest factor for n periods on appropriate annuity table. Then look up interest factor from the corresponding “lump sum” table for d. Multiply the two interest factors together to get the deferred annuity IF.

27. 0 1 2 3 4 5 $100 $100 $100 n = 3 d = 2 Deferred Annuity Example • Let i = 12% • Find the present value of the annuity due:

28. 0 1 2 3 4 5 $100 $100 $100 n = 3 d = 2 • Alternative 1 – Work as two part problem • Find present value of ordinary annuity at end of year 2. Then discount it back to beginning of year 1 • PV-OA IF(n=3, i=12%) = 2.4018 • 2.4018 * $100 = $240.18 • PVIF (n=2, i=12%) = .7972 • $240.18 * .7972 = $191.47

29. 0 1 2 3 4 5 $100 $100 $100 n = 3 d = 2 Alternative 2 – Adjust the ordinary annuity table IF:Look up PV-OA IF for (d+n) and then subtract the PV-OA IF for d PV-OA IF(n=5,i=12%) = 3.6048PV-OA IF(n=2,i=12%) = -1.6901Adjusted IF = 1.9147 $100 * 1.9147 = $191.47

30. 0 1 2 3 4 5 $100 $100 $100 n = 3 d = 2 Alternative 3 – Adjust the ordinary annuity table IF:Look up PV-OA IF for n and then multiply by the PV IF for d PV-OA IF(n=3,i=12%) = 2.4018PV IF (n=2,i=12%) = 0.7972Adjusted IF = 1.9147 $100 * 1.9147 = $191.47

31. 0 1 2 3 4 5 PMT PMT PMT n = 3 d = 2 Deferred Annuities FV If it is a FV problem, this is pretty much the only way to analyze the facts. However . . . .

32. 0 1 2 3 4 5 PMT PMT PMT n = 3 d = 2 Deferred Annuities PV We could do it the same way if we wanted to compute the present value, but we could also analyze it as an annuity due problem.

33. PV 0 1 2 3 4 5 6 PMT PMT PMT n = 3 d = 3 Note that in the last period we have zero left which earns no interest at any interest rate Deferred Annuities Then it would be 3 annuity due payments and the period before the annuity starts would be 3 periods instead of 2.

34. PV 0 1 2 3 4 5 6 PMT PMT PMT n = 3 d = 3 Deferred Annuities Now see if you can work the problem (with the tables) if you analyzed the annuity as having the first payment happen immediately.

35. Spreadsheet demo • We’ll look at using Excel functions to solve lease problems • =NPV • =IRR • =PMT • =PV • =FV