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Compounding
Time
Discounting
Periodic Rate
No. Compounding
Periods
10%
monthly compounding
0.8333%
12
10.4713%
10%
quarterly compounding
2.5%
10.3813%
10%
semiannual compounding
5%
10.25%
10%
annual compounding
10%
10%
EAR
t=1
r = 12%
t=2
r = 12%
t=0
t=1
t=2
PV0 = $1,000
FV3 = $25,000
r = 9%
t=0
t=1
t=2
t=0
t=1
t=3
t=2
t=3
r = 9%
PV0 = $19,604.59
FV OF AN ANNUITY (A)
Calculate the future value of a series of regular payments at regular
intervals.
If you invest $10,000 each year for the next two years at 11% starting in one
year, how much will you have at the end of the two years?
A2 = $10,000
r = 11%
t=0
FV3 = $21,100
A3 = $10,000
r = 11%
t=1
t=2
t=0
t=1
t=2
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PV OF AN ANNUITY (A)
Calculate the present value of a series of regular payments received at
regular intervals.
If you expect to receive $10,000 each year for two years starting in one year,
and your opportunity cost is 11%, how much is it worth today?
A2 = $10,000
r = 11%
t=0
A3 = $10,000
r = 11%
t=1
t=0
t=2
t=1
r = 11%
t=2
r = 11%
PV0 = $17,125.23
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12
A1 = $1,000
t = 0 r = 2%
A2 = $1,000
t = 1 r = 2%
t=2
A0 = $1,000
t=0
r = 2% t = 1 r = 2%
A1 = $1,000
t=0
t=2
A2 = $1,000
r = 2% t = 1 r = 2%
t=2
13
A3 = $2
r = 8%
t=1
t=2
14
A3 = $2(1.02)
A2 = $2
t=0
r = 8%
g = 2%
t=1
r = 8%
g = 2%
r = 8%
g = 2%
r = 8%
g = 2%
t=2
t=3
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r = 8% r = 8%
g = 2% g = 2%
t=0
t=1
t=2
t=3
Nonconstant growth
t=4
t=5
r = 8%
g = 2%
t=6
Constant growth
PV = ?
16
t=2
t=3
Nonconstant growth
t=4
t=5
t=6
Constant growth
PV = ?
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18
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t=4
t=0
t=1
t=2
t=5
t=3
A4 = $75k
A5 = $75k
20
FV3 = ?
t=4
t=0
t=1
t=2
t=5
t=3
A4 = $75K
A5 = $75K
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Solution 2: Group the positive and negative cash flows at t = 3 and the
difference will be the deposit that is needed.
Compound out
Compound out
Discount
back
Discount
back
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Beg Balance
Cash Flow
$45,000.00
Interest
Ending Balance
$45,000.00
$45,000.00
$45,000.00
$2,250.00
$92,500.00
$92,500.00
$42,593.2823
$4,612.50
$139,455.7823
$139,705.7823
$75,000.00
$6,972.7891
$71,428.5714
$71,428.5714
$75,000.00
$3,571.4286
$0.00
23
A1 = $40
r = 12%
t=0
t=1
A2 = $40
r = 12%
A3 = $40
r = 12%
t=2
A4 = $40
r = 12%
t=3
A5 = $40
r=12%
t=4
t=5
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CF1 =
t=0
Ir =
CF2 =
r=
t=1
CF3 =
r=
t=2
CF4 =
r=
t=3
CF5 =
r=
t=4
t=5
PV0 =
25
CF1 = ?
t=0
r = 8%
CF2 = ?
r = 8%
t=1
CF3 = ?
r = 8%
t=2
CF4 = ?
r = 8%
t=3
CF5 = ?
r = 8%
t=4
t=5
26
r = 1/3%
t=1
CF2 = ?
r = 1/3%
CF3 = ?
r = 1/3%
t=2
CF4 = ?
r = 1/3%
t=3
CF360 = ?
r = 1/3%
t=4
t = 360
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SUMMARY
The quantitative processes underlying the time value of money and its
associated calculations are central to the investment process.
- Using the time value of money concepts, we can
- Determine the value of a series of future cash flows today (present value)
- Determine the value of a series of cash flows in the future (future value)
- Determine the value of a regular series of cash flows, known as an annuity,
that is equivalent to a specific value today or in the future (annuitizing)
Valuation, a key function in the investment process, is often performed using
the time value of money calculation known as present value.
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