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Future value Present value Rates of return Amortization

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

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Future value Present value Rates of return Amortization

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

  2. 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

  3. Time lines show timing of cash flows. 0 1 2 3 i% CF0 CF1 CF2 CF3 Tick marksat ends of periods, so Time 0 is today; Time 1 is the end of Period 1; or the beginning of Period 2.

  4. Time line for a $100 lump sum due at the end of Year 2. 0 1 2 Year i% 100

  5. Time line for an ordinary annuity of $100 for 3 years. 0 1 2 3 i% 100 100 100

  6. Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at the end of Years 1 through 3. 0 1 2 3 i% -50 100 75 50

  7. What’s the FV of an initial $100 after 3 years if i = 10%? 0 1 2 3 10% 100 FV = ? Finding FVs (moving to the right on a time line) is called compounding.

  8. 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.

  9. After 3 years: FV3 = PV(1 + i)3 = $100(1.10)3 = $133.10. In general, FVn = PV(1 + i)n.

  10. Three Ways to Find FVs • Solve the equation with a regular calculator. • Use a spreadsheet.

  11. What’s the PV of $100 due in 3 years if i = 10%? Finding PVs is discounting, and it’s the reverse of compounding. 0 1 2 3 10% 100 PV = ?

  12. Solve FVn = PV(1 + i )n for PV: 3 1    PV = $100    1.10   = $100 0.7513 = $75.13.

  13. Finding the Time to Double 0 1 2 ? 20% 2 -1 FV = PV(1 + i)n $2 = $1(1 + 0.20)n (1.2)n = $2/$1 = 2 nLN(1.2) = LN(2) n = LN(2)/LN(1.2) n = 0.693/0.182 = 3.8.

  14. What’s the difference between an ordinaryannuity and an annuitydue? Ordinary Annuity 0 1 2 3 i% PMT PMT PMT Annuity Due 0 1 2 3 i% PMT PMT PMT PV FV

  15. What’s the FV of a 3-year ordinary annuity of $100 at 10%? 0 1 2 3 10% 100 100 100 110 121 FV = 331

  16. ordinaryannuity

  17. 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:

  18. What’s the PV of this ordinary annuity? 0 1 2 3 10% 100 100 100 90.91 82.64 75.13 248.69 = PV

  19. 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:

  20. 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)

  21. Find the FV and PV if theannuity were an annuity due. 0 1 2 3 10% 100 100 100

  22. 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

  23. annuitydue

  24. 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)

  25. 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.

  26. What is the PV of this uneven cashflow stream? 4 0 1 2 3 10% 100 300 300 -50 90.91 247.93 225.39 -34.15 530.08 = PV

  27. 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 .

  28. Spreadsheet Solution A B C D E 1 0 1 2 3 4 2 100 300 300 -50 3 530.09 Excel Formula in cell A3: =NPV(10%,B2:E2)

  29. 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.

  30. 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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