Chapter 9: Mathematics of Finance

1. Chapter 9: Mathematics of Finance

2. 9-1: Time Value of Money Problems • Whenever we take out loans, make investments, or deal with money over time, common questions arise. • How much will this be worth in 10 years? • How will inflation eat into my retirement savings over the next 30 years? • How much do I need to save each month to have $1,000,000 at age 60? • How much do I need to pay each month on a 30 year mortgage of $400,000 if the interest rate is 5.25% • These are called Time Value of Money (TVM) problems.

3. Common Notations • P = Present Value: the current value of an investment or loan or sum of money. • F = Future Value: The value of an investment, loan or sum of money in the future. • r = Annual Percentage Rate • m = Number of periods per year. Example: If you make monthly loan payments, them m = 12

4. Common Notations…cont’d • i = Interest Rate per Period: Example: The annual interest rate is 6% and there are 12 payments per year. Then i = .06/12 = .005, or 0.5% per month. i = r/m • t = Time, measured in years • n = Total number of periods. Example: You have a 10 year loan that is paid monthly. Then you have n = 10*12=120 total periods. n = m*t • R = The amount of a Rent. This is the regular payment made on a loan or into an investment.

5. Example • Suppose you deposit $1000 into an account that compounds interest quarterly. The annual rate of interest is 2.3% and you are going to keep it in the account for 4.5 years. At the end of this time, the account will be worth $1108.72 • P = $1000 F = $1108.72 r = .023 • m = 4 i = .023/4 = .00575 t = 4.5 • n = 18

6. 9-2: Percent Increase/Decrease • If a quantity increases by some percent, we can create a multiplier that helps us convert a beginning value to an ending value. • To create the appropriate multiplier: • Percent Increase: 1 + i • Percent Decrease: 1 - i

7. Example • This year, the SCCC student population is 11,350. • The administration estimates that will increase by 2% next year. How many students can we expect next year? • The multiplier = 1+0.02 = 1.02 • New student population = 11,350(1.02) = 11577

8. Example • The current balance of my retirement account is $244,350. • If the value of the account drops by 5.2% over the next year, what will be the new value? • Multiplier = 1 - .052 = .948 • New Value = $244,350(.948) = $231,643

9. 9-3: Compound Interest • When we invest money, interest may be applied to the account on a regular basis. For example, if we invest in an account that pays interest monthly, we say the interest compounds monthly. Anything in the account at the time of compounding gets interest added to it. In the monthly case, we have 12 compoundings per year, with each compounding representing 1/12 of the total annual interest rate.

10. Example • We invest $1000 in an account that compounds monthly. The annual interest rate is 3.6%. If we keep it in the account for 5 years, adding or removing nothing, how much will be in the account at the end of 5 years? • First, we need to note that the interest per period is i = .036/12 = .003. • Let’s begin by building a table…

11. Example

12. Example

13. Example

14. Compound Interest Formula • If P dollars earn an annual interest rate of i per period for n periods, with no additional principal added or removed, then the future value (F) is given by: • F = P(1+i)n

15. Example • A bank account is opened with $4,000 in the account. It earns 6% annual interest. If it earns interest quarterly (four times per year), then what is in the account after 10 years?

16. Example • Suppose you invest $500 today at an annual rate of 1.5%, compounded daily. How long before the balance doubles?

17. 9-4: Rule of 72 • Given some investment that grows at an annual interest rate, r, (not expressed as a decimal), then the amount of time in years it takes for the investment to double is approximately:

18. Example • How long will it take for an investment to double if it earns 5% annual interest? • Note that estimating the doubling time does not require that we know how much is originally invested!

19. Example • If you want your investment to double in 30 months, what annual interest rate do you need to secure?

20. 9-5: Yield • Because each compounding acts on the original balance and any interest that has been previously earned, the net interest earned will not be the same as the annual interest rate at the end of the investment. The “true” interest rate earned is called the Yield.

21. Example • Invest $100 for 1 years, compounded monthly at an annual rate of 12%. • F = 100(1+.01)12 = $112.68 • This represents a yield of 12.68%, which is higher than the original 12% stated above. The yield is often called the Annual Percentage Yield (APY). Always ask what this is when you take out a loan…time, compounding and bank fees can substantially increase your rate of interest and therefore your total payments due! • APR = 12% • APY = 12.68%

22. Yield Formula • The formula for yield in the t = 1 year case is:

23. Where did the formula come from?

24. Why is it important to know the APY? • The APY, or yield, is helpful since it simplifies calculations. If we know the APY, then it does not matter how many times we compound per year because the APR will give us actual percentage increase at the end of a year. • APR = Annual Percentage Rate or nominal rate or rate • APY = Annual Percentage Yield or effective rate or yield

25. 9-6: Annuities • When additional payments or deposits (rents) are made at regular intervals into an investment, then we call these annuities: • Ordinary Annuity: Payment is due at the END of each period. • Annuity Due: Payment is due at the START of each period. • This will complicate our Future Value calculations.

26. Example • We invest in an account that compounds annually. The annual interest rate is 3%. If we add $800 at the end of each year (an ordinary annuity), how much will be in the account at the end of 5 years total? • Let’s look at a picture of what is going on here.

27. Example Start Year 1 Year 2 Year 3 Year 4 Year 5 Investment Period $800 $800 $800 $800 $800 Each of these $800 investments earns interest for a different period of time. Hence, the value of each of these deposits is different at the end of the 5-year period.

28. Example The End Start End Year 1 End Year 2 End Year 3 End Year 4 End Year 5 Investment Period $800 $800 $800 $800 $800 This one is worth $800(1+.03)4 at the End $900.41 This one is worth $800(1+.03)3 at the End $874.18 This one is worth $800(1+.03)2 at the End $848.72 This one is worth $800(1+.03)1 at the End $824 This one is worth $800 at the End $800

29. Example • We can add all of these up: • $800(1.03)4 + $800(1.03)3 + $800(1.03)2 + $800(1.03)1 + $800 • =$900.41 + $874.18 + $848.72 + $824 + $800 • =$4247.31

30. A General Formula • Now imagine if the monthly payments were deposited and monthly interest credited. We would then have 5*12 = 60 different deposits to find the values for so we can add them up. • To avoid this inefficiency, we instead use the following formula, which is equivalent to going through that process.

31. A General Formula • If R dollars are paid at the end of each period, with an interest rate of I per period, then the Future Value of the Annuity is:

32. Where did the formula come from? We can generalize the example before and think about adding R + R(1+i) + R(1+i)2 + R(1+i)3 + … + R(1+i)n-1. Let us call this sum S. Hence, (1+i)S - S = R(1+i)n - R S (1+i - 1) = R(1+i)n - R Hence, the sum S is (R(1+i)n - R)/i

33. Check • We invest in an account that compounds annually. The annual interest rate is 3%. If we add $800 at the end of each year (an ordinary annuity), how much will be in the account at the end of 5 years total?

34. Example • What is the future value if you invest $95 per month for 7 years at an annual rate of 3.75%? • R = 95 • i = .0375/12 • n = 12*7 = 84 Note that I try to keep as many decimal places as possible until the end

35. FV for Annuities Due • When payments or deposits are made at the beginning of a period (rather than at the end as in the previous examples), an adjustment is needed. • We can view each payment as if it were made at the end of the preceding period. This would require one more payment (n+1 total) than usual and would require that we subtract the last payment so we don’t overpay.

36. FV for Annuities Due

37. Example • If $300 payments are made at the beginning of the month for 18 years (a college savings fund), what is the Future Value if the annual interest rate is 5.5%

38. 9-7: Future Value (FV) on Excel • The FV command will do these computations for us automatically. • Command Format: • =FV(rate, nper, pmt, [pv], [type]) This is i, the rate per period This is n, the total # of periods This is R, the amount of rent This is P, the Present Value Blank for ordinary annuity, 1 for annuity due

39. Excel Examples • If $300 payments are made at the beginning of the month for 18 years (a college savings fund), what is the Future Value if the annual interest rate is 5.5% • What is the future value if you invest $95 per month (paid at the end of the month) for 7 years at an annual rate of 3.75%?

40. 9-8: PV of Annuities • Suppose you have an ordinary 20-year annuity that you pay $500 into at the end of each quarter. The annual interest rate is 7%. • What is the lump-sum of money which should be deposited at the start of the annuity that would produce the exact same amount of money at the end of the period, without any additional payments? • This is know as the Present Value of the Annuity

41. Present Value of an Ordinary Annuity

42. Example • Suppose you set up an ordinary annuity account which is to last 10 years and earn 4% annual interest rate. If your rent payment is $150 per month, how much do you need to deposit as a lump sum up front to achieve the same end result without any regular payments?

43. 9-9: Present Value (PV) on Excel • The PV command will do these computations for us automatically. • Command Format: • =PV(rate, nper, pmt, [fv], [type]) This is i, the rate per period This is n, the total # of periods This is R, the amount of rent This is the FV you want after the last pmt… Optional Blank for ordinary annuity, 1 for annuity due

44. Can you figure out how this comes from the formula for the Future Value of an Ordinary Annuity?

45. Loan Payment Formula Start here with the original formula Divide both sides by [ ] to get R alone Here is the formula for the loan payment.

46. Loan Payment Formula • Using basic algebra, we can rewrite this as:

47. Example • Suppose you want to buy a home and take out a 30-year mortgage for $240,000. The annual interest rate is 5.75%. • What is the monthly payment? • What total amount of money do you pay over the life of the loan (assuming all regular payments are made)? • How much of your total payments is interest?

48. Example (a) • We use the formula to get $1400.57 per month .

49. Example (b) and (c) • The total amount of money we pay is: • 360x$1400.57 = $504,205.20 • Hence, the amount of interest paid is: • $504,205.20 - $240,000 = $264,205.20

50. #69 You borrowed $150,000, which you agree to pay back with monthly payments at the end of each month for the next 10 years. At 6.25% interest, how much is each payment?