1

2011 Financial Management

Fundamentals of Financial Management,
Prepared by: Amyn Wahid
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Obviously, $10,000 today $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY TIME VALUE TO MONEY!!
Time Value of Money Time Value of Money Time Value of Money Time Value of Money
Which would you prefer -- $10,000 $10,000
today today or $10,000 in 5 years $10,000 in 5 years?
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We know that receiving $10,000 today is worth
more than $10,000 after 5 years. 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.
Today
Future
Time Value of Money Time Value of Money Time Value of Money Time Value of Money
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Time Value of Money Time Value of Money
How about a choice between $1,000
today or $1,060 one year from today?
If the money is not needed
immediately and saving accounts
interest rate is 6%, then one would be
indifferent about the two alternatives
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Time Value of Money Time Value of Money
The preceding example focus on
two concepts
1. Money is preferred now then later
2. There may be a mechanism to
adjust for time differences
In a nutshell, time value of money
simply refers to the fact that $1
today has more value then $1 at
some future time
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TIME TIME allows you the opportunity to
postpone consumption and earn
INTEREST INTEREST.
Why TIME? Why TIME? Why TIME? Why TIME?
Why is TIME TIME such an important
element in your decision?
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Time Value Terminology Time Value Terminology
Future value (FV) is the amount an
investment is worth after one or more
periods. (for future value you always
compound)
Present value (PV) is the current value
of future cash flows of an investment.
(for present value you always discount)
0 1 2 3 4
PV
FV
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Future & Present Value Future & Present Value
Translate $1 today into its equivalent in the
future (COMPOUNDING).
Translate $1 in the future into its equivalent
today (DISCOUNTING).
?
?
Today
Future
Today
Future
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Time Value Terminology Time Value Terminology
The number of time periods between
the present value and the future
value is represented by t or n.
The rate of interest for discounting or
compounding is called r or i.
All time value questions involve four
values: PV, FV, n and i. Given three
of them, it is always possible to
calculate the fourth.
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5
Timelines Timelines
0 1 2 3 4 5
PV FV
Today
XA timeline is a graphical device used to clarify the
timing of the cash flows for an investment
XEach tick represents one time period
Timelines Timelines
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Types of Interest Types of Interest Types of Interest Types of Interest
Compound Interest Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
Simple Interest Simple Interest
Interest paid (earned) on only the
original amount, or principal borrowed
(lent).
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Simple Interest Formula Simple Interest Formula Simple Interest Formula Simple Interest Formula
Formula Formula SI = P
0
(i)(n)
SI: Simple Interest
P
0
: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
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SI = P
0
(i)(n)
= $1,000(.07)(2)
= $140 $140
Simple Interest Example Simple Interest Example Simple Interest Example Simple Interest Example
Assume that you deposit $1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?
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FV FV = P
0
+ SI
= $1,000 + $140
= $1,140 $1,140
Future Value Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Simple Interest (FV) Simple Interest (FV) Simple Interest (FV) Simple Interest (FV)
What is the Future Value Future Value (FV FV) of the
deposit?
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FV FV = P
0
+ SI
= P
0
+ P
0
(i)(n)
= P
0
[1 + (i)(n)]
= 1000 [1 + (0.07)(2)]
= 1,000[1.14]
= $1,140
Simple Interest (FV) Simple Interest (FV) Simple Interest (FV) Simple Interest (FV)
To find the Future Value Future Value (FV FV) of the deposit
directly we can use the following formula?
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The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
Simple Interest (PV) Simple Interest (PV) Simple Interest (PV) Simple Interest (PV)
What is the Present Value Present Value (PV PV)?
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PV PV
0
= P
0
= FV FV
n
/ [1 + (i)(n)]
= 1140 / [1 + (0.07)(2)]
= $1000
Simple Interest (PV) Simple Interest (PV) Simple Interest (PV) Simple Interest (PV)
What is the Present Value Present Value (PV PV) of the
previous problem?
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0
5000
10000
15000
20000
1st Year 10th
Year
20th
Year
30th
Year
Future Value of a Single $1,000 Deposit
10% Simple
Interest
7% Compound
Interest
10% Compound
Interest
Why Compound Interest? Why Compound Interest? Why Compound Interest? Why Compound Interest?
F
u
t
u
r
e

V
a
l
u
e

(
U
.
S
.

D
o
l
l
a
r
s
)
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Another Example Another Example
You invest $100 in a savings account that earns
10% interest per annum (compounded) for three
years.
After one year: $100 - (1+0.10) = $110
After two years: $110 - (1+0.10) = $121
After three years: $110 - (1+0.10) = $133.10
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The accumulated value of this investment at the
end of three years can be split into two
components:
original principal $100
interest earned $33.10
Using simple interest, the total interest earned
would only have been $30. The other $3.10 is
fromcompounding.
Another Example Another Example
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Assume that you deposit $1,000 $1,000 at
a compound interest rate of 7% for
2 years 2 years.
Future Value Future Value
Single Deposit (Graphic) Single Deposit (Graphic)
Future Value Future Value
Single Deposit (Graphic) Single Deposit (Graphic)
0 1 2 2
$1,000 $1,000
FV FV
2 2
7%
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FV FV
1 1
= PP
0 0
(1+i)
1
= $ $1 1,,000 000 (1.07)
= $ $1 1,,070 070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
Future Value Future Value
Single Deposit (Formula) Single Deposit (Formula)
Future Value Future Value
Single Deposit (Formula) Single Deposit (Formula)
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FV FV
1 1
= PP
0 0
(1+i)
1
= $1,000 $1,000 (1.07)
= $1,070 $1,070
FV FV
2 2
= FV
1
(1+i)
1
= PP
0 0
(1+i)(1+i) = $1,000 $1,000(1.07)(1.07)
= PP
0 0
(1+i)
2
= $1,000 $1,000(1.07)
2
= $1,144.90 $1,144.90
You earned an EXTRA $4.90 $4.90 in Year 2 with
compound over simple interest.
Future Value Future Value
Single Deposit (Formula) Single Deposit (Formula)
Future Value Future Value
Single Deposit (Formula) Single Deposit (Formula)
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FV FV
1 1
= P
0
(1+i)
1
FV FV
2 2
= P
0
(1+i)
2
General Future Value Future Value Formula:
FV FV
nn
= P
0
(1+i)
n
or FV FV
nn
= P
0
(FVIF FVIF
i,n
) -- See Table I See Table I
General Future General Future
Value Formula Value Formula
General Future General Future
Value Formula Value Formula
etc.
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FVIF FVIF
i,n
is found on Table I at the end
of the book
Valuation Using Table I Valuation Using Table I Valuation Using Table I Valuation Using Table I
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469

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FV FV
2 2
= $1,000 (FVIF FVIF
7%,2
)
= $1,000 (1.145)
= $1,145 $1,145 [Due to Rounding]
Using Future Value Tables Using Future Value Tables Using Future Value Tables Using Future Value Tables
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
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Example Example
What will $1 000 amount to in 5 years time if
interest is 12% per annum, compounded annually?
From the example, now assume interest is 12% per
annum, compounded monthly.
Always remember that n is the number of
compounding periods, not the number of years.
)
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FV $1000 1 0.12
$1000 1.76234
$1 762.34
= +
= -
=
)
$1816.70
1.8167 $1000
0.01 1 $1000 FV
60
=
- =
+ =
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Interpretation Interpretation
The difference in values is due to the
larger number of periods in which interest
can compound. Hence, the larger the
compounding periods, the greater the
future value.
Future values also depend critically on the
assumed interest rate - the higher the
interest rate, the greater the future value.
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Julie Miller wants to know how large her deposit
of $10,000 $10,000 today will become at a compound
annual interest rate of 10% for 5 years 5 years.
Story Problem Example Story Problem Example Story Problem Example Story Problem Example
0 1 2 3 4 5 5
$10,000 $10,000
FV FV
5 5
10%
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Calculation based on Table I:
FV FV
5 5
= $10,000 (FVIF FVIF
10%, 5
)
= $10,000 (1.611)
= $16,110 $16,110 [Due to Rounding]
Story Problem Solution Story Problem Solution Story Problem Solution Story Problem Solution
Calculation based on general formula:
FV FV
nn
= P
0
(1+i)
n
FV FV
5 5
= $10,000 (1+ 0.10)
5
= $16,105.10 $16,105.10
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Assume that you need $1,000 $1,000 in 2 years. 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2 2
$1,000 $1,000
7%
PV
1
PV PV
0 0
Present Value Present Value
Single Deposit (Graphic) Single Deposit (Graphic)
Present Value Present Value
Single Deposit (Graphic) Single Deposit (Graphic)
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PV PV
0 0
= FV FV
2 2
/ (1+i)
2
= $1,000 $1,000 / (1.07)
2
= FV FV
2 2
/ (1+i)
2
= $873.44 $873.44
Present Value Present Value
Single Deposit (Formula) Single Deposit (Formula)
Present Value Present Value
Single Deposit (Formula) Single Deposit (Formula)
0 1 2 2
$1,000 $1,000
7%
PV PV
0 0
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PV PV
0 0
= FV FV
1 1
/ (1+i)
1
PV PV
0 0
= FV FV
2 2
/ (1+i)
2
General Present Value Present Value Formula:
PV PV
0 0
= FV FV
nn
/ (1+i)
n
or PV PV
0 0
= FV FV
nn
(PVIF PVIF
i,n
) -- See Table II See Table II
General Present General Present
Value Formula Value Formula
General Present General Present
Value Formula Value Formula
etc.
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PVIF PVIF
i,n
is found on Table II at the end
of the book.
Valuation Using Table II Valuation Using Table II Valuation Using Table II Valuation Using Table II
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681

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PV PV
2 2
= $1,000 $1,000 (PVIF
7%,2
)
= $1,000 $1,000 (.873)
= $873 $873 [Due to Rounding]
Using Present Value Tables Using Present Value Tables Using Present Value Tables Using Present Value Tables
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
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Example Example
Your rich grandmother promises to give
you $10000 in 10 years time. If interest
rates are 12% per annum, how much is
that gift worth today?
)
219.73 $3
0.321973 000 $10
0.12 1 000 $10 PV
10
=
- =
+ - =

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Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 $10,000 in 5 years 5 years at a discount
rate of 10%.
Story Problem Example Story Problem Example Story Problem Example Story Problem Example
0 1 2 3 4 5 5
$10,000 $10,000
PV PV
0 0
10%
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Calculation based on general formula:
PV PV
0 0
= FV FV
nn
/ (1+i)
n
PV PV
0 0
= $10,000 $10,000 / (1+ 0.10)
5
= $6,209.21 $6,209.21
Calculation based on Table I:
PV PV
0 0
= $10,000 $10,000 (PVIF PVIF
10%, 5
)
= $10,000 $10,000 (.621)
= $6,210.00 $6,210.00 [Due to Rounding]
Story Problem Solution Story Problem Solution Story Problem Solution Story Problem Solution
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Solving for the Discount Rate Solving for the Discount Rate (i) (i)
You currently have $100 available for investment for a
21 year period. At what interest rate must you invest
this amount in order for it to be worth $500 at
maturity?
Given any three factors in the present value or future
value equation, the fourth factor can be solved.
i can be solved by one of the 2 ways:
take the n
th
root of both sides of the equation; or
use the future value tables to find a corresponding
value. In this example, the FVIF after 21 years is 5.
r = 7.97%
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Solving for the Time Periods Solving for the Time Periods (n) (n)
How long does it take to double $5,000 at a
compound rate of 12% per year (approx.)?
n can be solved by one of the 2 ways:
take logs on both sides of the equation; or
use the future value tables to find a
corresponding value.
n= ln2 / ln1.12 n= ln2 / ln1.12
== 6.116 yrs 6.116 yrs
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The Rule of 72 The Rule of 72
The Rule of 72 is a handy rule of thumb
that states:
If you earn r % per year, your
money will double in about 72 / r %
years.
For example, if you invest at 6%, your
money will double in about 12 years.
This rule is only an approximate rule.
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I love this
stuff!
Can we do
some more?
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Practice Questions Practice Questions
1. What would $100 be worth after 5 years at a rate of 15%?
2. You have located an investment that pays 12%. The rate sounds
good to you, so you invest $400. How much will you have in 3
years?
3. Suppose you need $400 to buy text books next year. You can
earn 7% on your money. How much do you have to put up
today?
4. Suppose you need to have $1000 in 4 years. If you can earn 8%,
how much do you need to invest to make sure you have $1000
when you need it?
5. You would like to buy a new automobile. You have about
$50,000, but the car cost around $68500. If you can earn 15% ,
can you buy the to buy the car in 2 years time if the cost of the
car is expected to remain same . Do you have enough?
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Practice Questions Practice Questions
6. Your company proposes to buy an asset for $335. This
investment is very safe. You will sell off the asset in 3 years for
$400. You know that you could invest the $335 elsewhere at 10%
with very little risk. Should you go for the investment?
7. You are considering a one year investment. If you put up $1,250,
you will get back $1350. What rate is the investment paying?
8. You estimate that you will need about $80,000 to send your child
to college in 8 years. You have about $35,000 now. If you earn
12% per year, will you make it?At what rate, will you just reach
your goal?
9. Suppose we are interested in purchasing an asset that cost
$50,000. We currently have $25,000. If we can earn 12% on this
$25,000, how long until we have the $50,000
10. You have been saving funds to buy the Giant Company. The total cost
will be $10 million. You currently have about $2.3 million. IF you can earn
5%on your money, how long will you have to wait?
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Answers Answers
1. $201.1357
2. $561.9712
3. $373.83
4. $735.03
5. You are still about
$2,375 short
6. No. You can make $445.89
in the other alternative
7. 8%
8. $86658.71( YES), 10.89%
9. 6.1163 years
10. 30.13 years
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Annuities Annuities
An An Annuity Annuity represents a series of equal payments (or
receipts) occurring over a specified number of
equidistant periods. Payments or receipts normally
occur at the end of each period.
Examples include consumer loans, car loan
payments, student loan payments, insurance
premiums and home mortgages.
A perpetuity perpetuity is an annuity in which the cash flows
continue forever.
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Parts of an Annuity Parts of an Annuity Parts of an Annuity Parts of an Annuity
0 1 2 3
$100 $100 $100
End End of
Period 1
End End of
Period 2
Today
Equal Equal Cash Flows
Each 1 Period Apart
End End of
Period 3
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FVA FVA
nn
= R(1+i)
n-1
+ R(1+i)
n-2
+
... + R(1+i)
1
+ R(1+i)
0
Overview of an Overview of an
Ordinary Annuity Ordinary Annuity -- -- FVA FVA
Overview of an Overview of an
Ordinary Annuity Ordinary Annuity -- -- FVA FVA
R R R
0 1 2 n n n+1
FVA FVA
nn
R = Periodic
Cash Flow
Cash flows occur at the end of the period
i%
. . .
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FVA FVA
3 3
= $1,000(1.07)
2
+
$1,000(1.07)
1
+ $1,000(1.07)
0
= $1,145 + $1,070 + $1,000
= $3,215 $3,215
Example of an Example of an
Ordinary Annuity Ordinary Annuity -- -- FVA FVA
Example of an Example of an
Ordinary Annuity Ordinary Annuity -- -- FVA FVA
$1,000 $1,000 $1,000
0 1 2 3 3 4
$3,215 = FVA $3,215 = FVA
3 3
7%
$1,070
$1,145
Cash flows occur at the end of the period
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FVA FVA
nn
= R (FVIFA
i%,n
)
FVA FVA
3 3
= $1,000 (FVIFA
7%,3
)
= $1,000 (3.215) = $3,215 $3,215
Valuation Using Table III Valuation Using Table III Valuation Using Table III Valuation Using Table III
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
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Future Value of an Annuity Future Value of an Annuity
FVA = FVA = R[(1+i)
n
1]
i
1000[(1+0.07)
3
1] =
0.07
$3214.9
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Example Example
What is the future value $200 deposited at the
end of every year for 10 years if the interest rate
is 6% per annum?
)
10
1.06 - 1
FV $200
0.06
$200 13.1808
$2 636.16


= -
= -
=
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PVA PVA
nn
= R/(1+i)
1
+ R/(1+i)
2
+ ... + R/(1+i)
n
Overview of an Overview of an
Ordinary Annuity Ordinary Annuity -- -- PVA PVA
Overview of an Overview of an
Ordinary Annuity Ordinary Annuity -- -- PVA PVA
R R R
0 1 2 n n n+1
PVA PVA
nn
R = Periodic
Cash Flow
i%
. . .
Cash flows occur at the end of the period
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PVA PVA
3 3
= $1,000/(1.07)
1
+
$1,000/(1.07)
2
+
$1,000/(1.07)
3
= $934.58 + $873.44 + $816.30
= $2,624.32 $2,624.32
Example of an Example of an
Ordinary Annuity Ordinary Annuity -- -- PVA PVA
Example of an Example of an
Ordinary Annuity Ordinary Annuity -- -- PVA PVA
$1,000 $1,000 $1,000
0 1 2 3 3 4
$2,624.32 = PVA $2,624.32 = PVA
3 3
7%
$ 934.58
$ 873.44
$ 816.30
Cash flows occur at the end of the period
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PVA PVA
nn
= R (PVIFA
i%,n
)
PVA PVA
3 3
= $1,000 (PVIFA
7%,3
)
= $1,000 (2.624) = $2,624 (D to R) $2,624 (D to R)
Valuation Using Table IV Valuation Using Table IV Valuation Using Table IV Valuation Using Table IV
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
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Present Value of an Present Value of an
Annuity Annuity
PVA = PVA = R 1 1
(1+i)
n
i
10001 1 (1 + 0.07)
3
=
0.07
$2624.3
57
Example 1
You will receive $500 at the end of each of the next 5 years. The
current interest rate is 9%per annum. What is the present value of
this series of cash flows?
Example 2
You borrow $7 500 to buy a car and agree to repay the loan by way
of equal monthly repayments over 5 years. The current interest rate
is 12%per annum, compounded monthly. What is the amount of
each monthly repayment?
)
,
5
1 - 1/ 1.09
PV $500
0.09
$500 3.8897
$1 944.83


= -



= -
=
)
,
60
1 - 1/ 1.01
$7 500 R
0.01
R $7 500 44.955
$166.83


= -



=
=
Examples Examples
58
MORE EXAMPLES MORE EXAMPLES
59
Solving for the Solving for the
Annuity Payment Annuity Payment (R) (R)
Suppose we want to know the
amount that we have to deposit in
order to accumulate a given sum
after a number of years
e.g $10,000 down payment required
after 5 years How much you need to
save every year at 4 % interest rate?
60
Computations Computations Using Using
Table III Table III
FVA FVA
nn
= R (FVIFA
i%,n
) see slide 34
$10,000 = R (FVIFA
4%,5
)
$10,000 = R (5.416)
R = $1846.38
61
Computations Computations
Using Formula Using Formula
)
)
n
5
1 + i - 1
FV R
i
1.04 - 1
10000 R
0.04
R 5.416
10000
R
5.416
$1846.27


= -


= -
= -
=
=
62
Solving for the number of Solving for the number of
periods in an annuity periods in an annuity (n) (n)
Suppose we want to know the
number of years it would take a
certain amount to accumulate a
given sum
E.g the same question as before but
now we are given the annual
payment of $1846.27 and we have to
find the number of years
63
Computations Computations Using Using
Table III Table III
FVA FVA
nn
= R (FVIFA
i%,n
)
$10,000 = 1846.27 (FVIFA
4%,n
)
(FVIFA
4%,n
) = (5.416)
n = 5 periods
i,e 5 years
64
Computations Computations
Using Formula Using Formula
)
)
)
n
n
n
1 + i - 1
FV R
i
1.04 - 1
10000 1846.27
0.04
0.2167 1.04
Apply logs or ln on both sides
ln 1.2167
n =
ln 1.04
n = 5 years


= -


= -
=
65
Solving for the interest rate Solving for the interest rate
in an annuity in an annuity (i) (i)
Suppose we want to know
interest rate now and the other
things are known to us.
E.g using the same example we
would find the interest rate and
hence verify that it is 4%.
66
Computations Computations Using Using
Table III Table III
FVA FVA
nn
= R (FVIFA
i%,n
)
$10,000 = 1846.27 (FVIFA
i%,5
)
(FVIFA
i%,5
) = (5.416)
i = 4%
67
Computations Computations
Using Formula Using Formula
The equation becomes really complex and can The equation becomes really complex and can
only be solved by trial and error approach, only be solved by trial and error approach,
Newton Newton Raphson or bisection methods Raphson or bisection methods
)
)
)
n
5
5
1 + i - 1
FV R
i
1 + i - 1
10000 1846.27
i
5.416i = 1 + i - 1


= -


= -
68
Julie Miller will receive the set of cash
flows below. What is the Present Value Present Value
at a discount rate of 10% 10%?
Mixed Flows Example Mixed Flows Example Mixed Flows Example Mixed Flows Example
0 1 2 3 4 5 5
$600 $600 $400 $400 $100 $600 $600 $400 $400 $100
PV PV
0 0
10% 10%
69
1. Solve a piece piece- -at at- -a a- -time time by
discounting each piece piece back to t=0.
2. Solve a group group- -at at- -a a- -time time by first
breaking problem into groups of
annuity streams and any single
cash flow group. Then discount
each group group back to t=0.
How to Solve? How to Solve? How to Solve? How to Solve?
70
Piece Piece- -At At- -A A- -Time Time Piece Piece- -At At- -A A- -Time Time
0 1 2 3 4 5 5
$600 $600 $400 $400 $100 $600 $600 $400 $400 $100
10%
$545.45 $545.45
$495.87 $495.87
$300.53 $300.53
$273.21 $273.21
$ 62.09 $ 62.09
$1677.15 $1677.15 = = PV PV
0 0
of the Mixed Flow of the Mixed Flow
71
Group Group- -At At- -A A- -Time (#1) Time (#1) Group Group- -At At- -A A- -Time (#1) Time (#1)
0 1 2 3 4 5 5
$600 $600 $400 $400 $100 $600 $600 $400 $400 $100
10%
$1,041.60 $1,041.60
$ 573.57 $ 573.57
$ 62.10 $ 62.10
$1,677.30 $1,677.30 = = PV PV
0 0
of Mixed Flow of Mixed Flow [Using Tables] [Using Tables]
$600(PVIFA
10%,2
) = $600(1.736) = $1,041.60
$400(PVIFA
10%,4
) $400(PVIFA
10%,2
)
=$400(3.170) $400(1.736) = $573.60
$100 (PVIF
10%,5
) = $100 (0.621) = $62.10
72
Group Group- -At At- -A A- -Time (#2) Time (#2) Group Group- -At At- -A A- -Time (#2) Time (#2)
0 1 2 3 4
$400 $400 $400 $400 $400 $400 $400 $400
PV PV
0 0
equals
$1677.30. $1677.30.
0 1 2
$200 $200 $200 $200
0 1 2 3 4 5
$100 $100
$1,268.00 $1,268.00
$347.20 $347.20
$62.10 $62.10
Plus Plus
Plus Plus
73
Present Value of Present Value of
Multiple Cash Flows Example Multiple Cash Flows Example
You deposit $1,500 in one year, $2000 in two
years and $2,500 in three years in an account
paying 10% interest per annum. What is the
present value of these cash flows?
$2 500 - (1.10)
-3
= $1 878
$2 000 - (1.10)
-2
= $1 653
$1 500 - (1.10)
-1
= $1 364
Total = $4 895
74
You deposit $1,000 now, $1,500 in one year,
$2,000 in two years and $2,500 in three years in
an account paying 10% interest per annum. How
much do you have in the account at the end of
the third year?
$1 000 - (1.10)
3
= $1 331
$1 500 - (1.10)
2
= $1 815
$2 000 - (1.10)
1
= $2 200
$2 500 - 1.00 = $2 500
Total = $7 846
Future Value of Future Value of
Multiple Cash Flows Example Multiple Cash Flows Example
75
Uneven Series of Payment Date Uneven Series of Payment Date
( An Example) ( An Example)
Year 1 2 3 4 5 6
Payment $500 $500 $700 $700 $700 $1,000
Karee Brow will receive the set of cash flows below. What
is the Present Value Present Value at a discount rate of 10% 10%? If Karee
Brow was depositing the cash flows instead determine the
Future Value Future Value at the same discount rate
Karee Brow will receive the set of cash flows below. What
is the Present Value Present Value at a discount rate of 10% 10%? If Karee
Brow was depositing the cash flows instead determine the
Future Value Future Value at the same discount rate
PV = $2870.92
FV = $5086.01
PV = $2870.92
FV = $5086.01
76
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.
(1 + [ i / m ] )
m
- 1
Effective Annual Effective Annual
Interest Rate Interest Rate
Effective Annual Effective Annual
Interest Rate Interest Rate
77
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR EAR)?
EAR EAR = ( 1 + 6% / 4 )
4
- 1
= 1.0614 - 1 = .0614 or 6.14%! 6.14%!
BWs Effective BWs Effective
Annual Interest Rate Annual Interest Rate
BWs Effective BWs Effective
Annual Interest Rate Annual Interest Rate
78
General Formula:
FV
n
= PV PV
0 0
(1 + [i/m])
mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FV
n,m
: FV at the end of Year n
PV PV
0 0
: PV of the Cash Flow today
Frequency of Compounding Frequency of Compounding Frequency of Compounding Frequency of Compounding
79
Julie Miller has $1,000 $1,000 to invest for 2
years at an annual interest rate of
12%.
Annual FV
2
= 1,000 1,000(1+ [.12/1])
(1)(2)
= 1,254.40 1,254.40
Semi FV
2
= 1,000 1,000(1+ [.12/2])
(2)(2)
= 1,262.48 1,262.48
Impact of Frequency Impact of Frequency Impact of Frequency Impact of Frequency
80
Qrtly FV
2
= 1,000 1,000(1+ [.12/4])
(4)(2)
= 1,266.77 1,266.77
Monthly FV
2
= 1,000 1,000(1+ [.12/12])
(12)(2)
= 1,269.73 1,269.73
Daily FV
2
= 1,000 1,000(1+[.12/365])
(365)(2)
= 1,271.20 1,271.20
Impact of Frequency Impact of Frequency Impact of Frequency Impact of Frequency
81
Comparison different Comparison different
effective rates of return? effective rates of return?
An investment with monthly payments is different
from one with quarterly payments. Must put each
return on an EFF% basis to compare rates of
return. Must use EFF% for comparisons. See
following values of EFF% rates at various
compounding levels.
EAR
ANNUAL
10.00%
EAR
QUARTERLY
10.38%
EAR
MONTHLY
10.47%
EAR
DAILY (365)
10.52%
82
Can the EAR ever be Can the EAR ever be
equal to the nominal rate? equal to the nominal rate?
Yes, but only if annual
compounding is used, i.e., if m
= 1.
If m > 1, EFF% will always be
greater than the nominal rate.
83
Amortizing a loan Amortizing a loan
Installment type loan that is repaid
in equal periodic payments that
include both interest and principal.
These payments can be made
annually, semi annually, monthly
etc
84
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan balance at t-1) x (i% / m)
3. Compute principal payment principal payment in Period t.
(Payment - interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment principal payment from Step 3)
5. Start again at Step 2 and repeat.
Steps to Amortizing a Loan Steps to Amortizing a Loan
( An Overview) ( An Overview)
Steps to Amortizing a Loan Steps to Amortizing a Loan
( An Overview) ( An Overview)
85
Julie Miller is borrowing $10,000 $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV PV
0 0
= R (PVIFA
i%,n
)
$10,000 $10,000 = R (PVIFA
12%,5
)
$10,000 $10,000 = R (3.605)
R R = $10,000 $10,000 / 3.605 = $2,774 $2,774
Amortizing a Loan Example Amortizing a Loan Example Amortizing a Loan Example Amortizing a Loan Example
86
Amortizing a Loan Example Amortizing a Loan Example Amortizing a Loan Example Amortizing a Loan Example
End of
Year
Payment Interest Principal Ending
Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000


[Last Payment Slightly Higher Due to Rounding]
87
Illustration with a Illustration with a
simple example simple example
Suppose you borrow $22,000 at 12%
compound annual interest to be
repaid over the next 6 years.
The first step is to calculate R ( annual
payment)
PV PV
0 0
= R (PVIFA
i%,n
)
$22,000 $22,000 = R (PVIFA
12%,6
)
$22,000 $22,000 = R (4.111)
R R = $22,000 $22,000 / 4.111 = $5350.97 $5350.97
88
End of Chapter End of Chapter