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University of Technology, Jamaica Fin Man Unit 5: The Time Value of Money

Importance of time with respect to money The time value of money is considered the most important concept in finance. The time value of money is the process of calculating the value of an asset in the past, present or future. It is based on the premise that the original principal will increase in value over time by interest. This means that a dollar invested today is going to be worth more tomorrow. We know that receiving $10,000 today is worth more than receiving $10,000 in the future. This is due to opportunity costs. The opportunity cost of receiving $10,000 in the future is the interest we could have earned if we had received the $10,000 sooner. Time line concepts Cash flow time lines are a very important tool that helps you to visualize the timing of cash flows associated with a particular situation. A cash outflow is designated with a negative sign, while a cash inflow is designated with a positive sign (in most cases the positive sign is implied). The interest rate that is applied to the situation is given on the time line. A cash flow time line can be illustrated as follows:

Time lines show timing o


According to this cash flow time line, $10,000 is invested today at 10% for a period of 3 years. Future Value If we know the value of an investment today, the time period of the investment and the interest rate that we will earn, then we can calculate the future value of the investment. Translating the $10,000 invested today into its equivalent in the future is known as compounding where both the original investment and any interest previously earned by the investment earn additional interest

10%

Problem 1: If you deposit $10,000 in an account earning 10%, how much would you have in the account after 3 years? In general, FVn = PV(1 + i)n where PV = Present Value, FV = Future Value, i = interest rate n = number of compounding periods Using interest factor tables, the future value of an amount invested today equals the amount originally invested multiplied by a multiple that is based on the interest rate earned, i, and the amount of times interest is earned, n. This multiple, which equals (1 + i)n, is called the future value interest factor for i and n, and is designated FVIFi,n; using this concept, FVn = PV (1 + i)n = PV(FVIFi,n) In our example, Present Value

CF0

CF1

CF

=-10,000

FVn = PV(FVIFi,n) = 10,000 (FVIF10%,3) = 10,000 x 1.3310 = 13,310

Present value is the value of an amount to be received (or paid) in the future stated in todays (present) dollars i.e., the current value of a future amount. If we know the value of an investment some time in the future, the time period of the investment and the interest rate that we will earn, then we can calculate the present value of the investment. When we find the present value, PV, of an amount we are said to be discounting the future value to the present at the 1

Tick marks at ends of perio is today; Time 1 is the end or the beginning of Period

opportunity cost rate, which is the rate that can be earned on an investment with equal risk. The present value is therefore the opposite of the future value and if we have the opportunity to earn a positive rate of return, then the present value must always be less than the future value. Problem 2: Assume that you need $10,000 in 3 years. How much do you need to deposit today at a discount rate of 12% compounded annually? Calculation Solve FVn = PV (1 + i)n for PV: PV = FVn/(1 + i)n = FVn [1/(1+i)]n Alternatively, using interest factor tables: PVn = FV (1 + i)n = FV(PVIFi,n) In our example, PVn = FV(PVIFi,n) = 10,000 (PVIF12%,3) = 10,000 x 0.7118 = 7,118 Hints for solving single sum problems In every single sum future value and present value problem, there are 4 variables: FV, PV, i and n When doing problems, you will be given 3 of these variables and asked to solve for the 4th variable. Keeping this in mind makes time value problems much easier!

Problem 3: In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later, in 1988, the average cost was $13,700. What was the growth rate in tuition over the 30-year period? Problem 4: Jill currently has $300,000 in a brokerage account. The account pays a 10 percent annual interest rate. Assuming that Jill makes no additional contributions to the account, how many years will it take for her to have $1,000,000 in the account? Annuities An annuity is referred to as a series of equal payments that are made at equally spaced intervals e.g. - $100 received each year for the next 5 years. An ordinary annuity is an annuity with cash flows that occur at the end of the period, whereas an annuity due is an annuity with cash flows that occur at the beginning of the period. Ordinary Annuity Ordinary annuity problems can be calculated using interest factor tables as follows: FVA = PMT (FVIFA(i,n)) PVA = PMT (PVIFA(i,n)) Problem 5: Today is your 23rd birthday. Your aunt just gave you $1,000. You have used the money to open up a brokerage account. Your plan is to contribute an additional $2,000 to the account each year on your birthday, up through and including your 65th birthday, starting next year. The account has an annual expected return of 14 percent. How much do you expect to have in the account right after you make the final $2,000 contribution on your 65th birthday? Problem 6: What is the present value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate? Annuity Due An annuity due has cash flows at the beginning of the period. Each payment will therefore earn interest for one more period than if it were an ordinary annuity and the future value of an annuity due will be greater, all else equal. Calculations are therefore always multiplied by a factor (1 + i) Problem 7: If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have at the end of year 3? 2

Problem 8: What is the PV of $1,000 at the beginning of each of the next 3 years, if your opportunity cost is 8%? Perpetuities A perpetuity is an annuity that continues forever i.e. a perpetual annuity. The present value of perpetuities can be computed using the following equation: PVP = PMT/i Problem 9: Suppose you were offered the opportunity to receive $250 beginning in one year and continuing forever. If you could earn 10% on your investments, how much should you pay for this perpetuity? Uneven Cash Flow Streams Unlike an annuity, an uneven cash flow stream consists of cash flows that are not all the same (equal), so we cannot use the annuity equations here. To determine the PV or FV of uneven cash flow streams, we must compute the PV or FV of each individual cash flow and sum the resulting values. Problem 10: You are given the following cash (t = 0) if the discount rate is 12 percent? 0 12% | 1 | 1,000 flows. What Periods is the present value

-10,000

2 3 4 | | | 2,000 4,000 6,000

Frequent Compounding Up to this point, we have assumed that interest is earned (computed) annually. In many instances, interest is computed more than once a year i.e., interest compounds during the year. For example, bonds generally pay interest semi-annually or quarterly. Most financial institutions compute interest more frequently perhaps monthly or even daily. The FV of a lump sum will be larger if we compound more often. If compounding is more frequent than once a year, then interest is earned on interest more often. Lenders will therefore prefer compounding to be done more often, while borrowers will prefer compounding to be done less often. Problem 11: What is the future value of $100 in 3 years time at an interest rate of 10% compounded semiannually? What is the nominal rate, periodic rate and effective annual rate? Nominal Interest rate (inom) The nominal interest rate is the quoted or stated rate. It is usually quoted per annum. This is the rate that is stated in contracts, and quoted by banks and brokers, but the compounding periods per year are usually also given. Periodic Interest rate (iper) The periodic interest rate is the rate that is actually paid each compounding period e.g. the rate that is paid quarterly or monthly if there is quarterly or monthly compounding. This rate is used in calculations and is the one shown on time lines. Periodic rate = iper = inom/m Where m= number of compounding periods per year. If inom has annual compounding, then iper = inom/1 = inom Effective Annual Rate (EAR or EFF or EAIR) The EAR is the annual rate that causes the PV to grow to the same FV as under multi-period compounding. It is useful to compare returns on investments with different payment periods/compounding periods per year.

EAIR = [1 + (k/m)]m -1
3

If m > 1, EFF% will always be greater than the nominal rate. If annual compounding is used, i.e. m=1, then the EFF would be equal to the nominal rate.

Tutorial Questions
1. If you deposit $10,000 in a bank account that pays 10% interest annually, how much money will be in your account after 5 years? [7-1] 2. What is the present value of a security that promises to pay you $5,000 in 20 years? Assume that you earn 7% if you were to invest in other securities of equal risk. [7-2] 3. If you deposit money today into an account that pays 6.5% interest, how long will it take you to double your money? [7-3] 4. Your parents are planning to retire in 18 years. They currently have $250,000 and they would like to have $1,000,000 when they retire. What annual rate of interest would they have to earn on their $250,000 in order to reach their goal, assuming they save no more money? [7-4] 5. What is the future value of a 5-year ordinary annuity that promises to pay you $300 each year? The rate of interest is 7%. [7-5] 6. What is the future value of a 5-yr annuity due that promises to pay you $300 each year? Assume that all payments are reinvested at 7% per year. [7-6] 7. An investment pays you 9% interest, compounded quarterly. What is the periodic rate of interest? What is the nominal rate of interest? What is the effective rate of interest? [7-9] 8. Which amount is worth more at 14%, compounded annually: $1,000 in hand today or $2,000 due in 6 years? [7-11] 9. Washington-Atlantic invests $4 million to clear a tract of land and to set out some young pine trees. The trees will mature in 10 years, at which time Washington-Atlantic plans to sell the forest at an expected price of $8 million. What is Washington-Atlantics expected rate of return? [7-13] 10. What is the present value of a perpetuity of $100 per year if the appropriate discount rate is 7%? If interest rates in general were to double and the appropriate discount rate rose to 14%, what would happen to the present value of the perpetuity? [7-19] 11. It is now January 1, 2001. You plan to make 5 deposits of $100 each, one every 6 months, with the first payment being made today. If the bank pays a nominal interest rate of 12%, but uses semiannual compounding, how much will be in your account after 10 years? 12. The prize in last weeks lottery was estimated to be worth $35 million. If you were lucky enough to win, the payment will be $1.75 million per year over the next 20 years. Assume that the first installment is received immediately.[7-26] a) b) c) If interest rates are 8%, what is the present value of the prize? If interest rates are 8%, what is the future value after 20 years? How would your answers change if the payments were received at the end of each year?

13. Your client is 40 years old and wants to begin saving for retirement. You advise the client to put $5,000 a year into the stock market. You estimate that the markets return will be, on average, 12% a year. Assume the investment will be made at the end of the year. [7-27] a) b) If the client follows your advice, how much money will she have by age 65? How much will she have by age 70?

14. Your friend, a professional football player, has been approached by three different clubs, seeking to recruit him. Each club is offering him a three year contract, and the terms are set out below. He is uncertain which offer to accept, and has asked for your advice. Club A's Contract Year 1 $2 million Year 2 4 million Year 3 7 million Given a discount rate is 12%: Club B's Contract Club C's Contract 3 $2 million 3 million 8 million $7 million 2 million 3 million

(i) What is the present value (PV) of each contract? (ii) Which contract offers the greatest value?

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