Future value Present value Rates of return Amortization CHAPTER 2 Time Value of Money

Future value

Present value

Rates of return

Amortization

CHAPTER 2Time Value of Money

Introduction

In fact, of all the concepts used in finance, none is more important than the time value of money, which is also called discounted cash flow (DCF) analysis.

PV : present value, or beginning amount, in your account

i : interest rate

INT : dollars of interest you earn

FV : future value

n : number of periods involved in the analysis

Time lines show timing of cash flows.

CF0 CF1 CF3CF2

0 1 2 3i%

Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.

Time line for a $100 lump sum due at the end of Year 2.

100

0 1 2 Yeari%

Time line for an ordinary annuity of $100 for 3 years.

100 100100

0 1 2 3i%

Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at the end of

Years 1 through 3.

100 50 75

0 1 2 3i%

-50

What’s the FV of an initial $100 after 3 years if i = 10%?

FV = ?

0 1 2 310%

Finding FVs (moving to the righton a time line) is called compounding.

100

After 1 year:

FV1 = PV + INT1 = PV + PV (i)= PV(1 + i)= $100(1.10)= $110.00.

After 2 years:

FV2 = PV(1 + i)2

= $100(1.10)2

= $121.00.

After 3 years:

FV3 = PV(1 + i)3

= $100(1.10)3

= $133.10.

In general,

FVn = PV(1 + i)n.

Three Ways to Find FVs

Solve the equation with a regular calculator.

Use a spreadsheet.

10%

What’s the PV of $100 due in 3 years if i = 10%?

Finding PVs is discounting, and it’s the reverse of compounding.

100

0 1 2 3

PV = ?

Solve FVn = PV(1 + i )n for PV:

PV =

FV

1+ i = FV

11+ i

nn n

n

PV = $100

11.10

= $100 0.7513 = $75.13.

3

Finding the Time to Double

20%

2

0 1 2 ?

-1 FV = PV(1 + i)n

$2 = $1(1 + 0.20)n

(1.2)n = $2/$1 = 2nLN(1.2) = LN(2) n = LN(2)/LN(1.2) n = 0.693/0.182 = 3.8.

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Copyright © 2002 by Harcourt, Inc. All rights reserved.

Ordinary Annuity

PMT PMTPMT

0 1 2 3i%

PMT PMT

0 1 2 3i%

PMT

Annuity Due

What’s the difference between an ordinary annuity and an annuity due?

PV FV

What’s the FV of a 3-year ordinary annuity of $100 at 10%?

100 100100

0 1 2 310%

110 121FV = 331

ordinary annuity

i

1)i1( PMT = ANFV

n

i

ni)+(1

11

PMT = ANPV

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FV Annuity Formula

The future value of an annuity with n periods and an interest rate of i can be found with the following formula:

.33110.

100

0.10

1)0(1

i

1i)(1PMT

3

n

What’s the PV of this ordinary annuity?

100 100100

0 1 2 310%

90.91

82.64

75.13248.69 = PV

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PV Annuity Formula

The present value of an annuity with n periods and an interest rate of i can be found with the following formula:

69.24810.

100

0.10)0(1

11-

ii)(1

11-

PMT

3

n

Special Function for Annuities

For ordinary annuities, this formula in cell A3 gives 248.96:

=PV(10%,3,-100)

A similar function gives the future value of 331.00:

=FV(10%,3,-100)

Find the FV and PV if theannuity were an annuity due.

100 100

0 1 2 3

10%

100

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PV and FV of Annuity Due vs. Ordinary Annuity

PV of annuity due:

= (PV of ordinary annuity) (1+i)

= (248.69) (1+ 0.10) = 273.56

FV of annuity due:

= (FV of ordinary annuity) (1+i)

= (331.00) (1+ 0.10) = 364.1

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annuity due

)i1(i

1)i1( PMT = due ANFV

n

)i1(i

i)+(11

1

PMT = due ANPVn

Excel Function for Annuities Due

Change the formula to:

=PV(10%,3,-100,0,1)

The fourth term, 0, tells the function there are no other cash flows. The fifth term tells the function that it is an annuity due. A similar function gives the future value of an annuity due:

=FV(10%,3,-100,0,1)

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Uneven Cash Flow Streams

We will use Payment (PMT) for annuity situations where the cash flows are equal amounts, and we will use the term Cash flow (CF) to denote uneven cash flows.

What is the PV of this uneven cashflow stream?

0

100

1

300

2

300

310%

-50

4

90.91247.93225.39-34.15

530.08 = PV

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How to find PV of this uneven cash

1- We could find the PV of each individual cash flow using the numerical.

2- using NPV in excel .

8 - 28


Spreadsheet Solution

Excel Formula in cell A3:

=NPV(10%,B2:E2)

A B C D E

1 0 1 2 3 4

2 100 300 300 -50

3 530.09

HOME WORK

Find the future value of the following annuities. The first payment in these annuities is made at the end of Year 1;

a. $400 per year for 10 years at 10 percent. b. $200 per year for 5 years at 5 percent. c. $400 per year for 5 years at 0 percent. d. Now rework parts a, b, and c assuming that payments are

made at the beginning of each year; that is, they are annuities due.

HOME WORK

Find the present value of the following ordinary annuities: a. $400 per year for 10 years at 10 percent. b. $200 per year for 5 years at 5 percent. c. $400 per year for 5 years at 0 percent. d. Now rework parts a, b, and c assuming that payments are

made at the beginning of each year; that is, they are annuities due.

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Future value Present value Rates of return Amortization CHAPTER 2 Time Value of Money