Chapter 4: Time Value of Money Objective Explain the concept of compounding and discounting and to provide examples of real life applications Copyright, 2000 Prentice Hall ©Author Nick Bagley, bdella. Soft, Inc. 1
Compounding: Future Value of a Lump Sum 5
The Frequency of Compounding Annual Percentage Rate (APR) ¡ Effective Annual Rate (EFF): The equivalent interest rate, if compounding were only once a year. ¡ 10
Effective Annual Rates of an APR of 18% 11
The Frequency of Compounding Note that as the frequency of compounding increases, so does the annual effective rate ¡ What occurs as the frequency of compounding rises to infinity? ¡ 12
The Frequency of Compounding 13
The Frequency of Compounding 14
Annuities A level stream of Cash Flows or Payments ¡ Immediate Annuity: The Cash Flows start immediately. ¡ Ordinary Annuity: The Cash Flows start at the end of the current period. ¡ 15
Derivation of PV of Ordinary Annuity Formula 16
Derivation of PV of Ordinary Annuity Formula 17
PV of Ordinary Annuity Formula 18
Annuity Formula: PV of Immediate Annuity 19
Derivation of FV of Annuity Formula 20
Perpetual Annuities / Perpetuities ¡ Recall the annuity formula: • Let n -> infinity with i > 0: 21
Alternative Discounted Cash Flow Decision Rules 1. NPV rule: the NPV is the difference between the present value of all future cash inflows minus the present value of all current and future cash outflows. Accept a project if its NPV is positive. 22
DCF rules Example: You have the opportunity to buy a piece of land for $10, 000. You are sure that 5 years from now it will be worth $20, 000. If you can earn 8% per year by investing your money in bank, is this investment in the land worthwhile? 23
NPV rule solution 24
Alternative Discounted Cash Flow Decision Rules 2. FV rule: Invest if the future value of the investment is larger than the future value that can be obtained from the next best alternative. 25
FV rule solution 26
Alternative Discounted Cash Flow Decision Rules 3. IRR rule: The IRR is the discount rate at which the NPV is zero. Invest if the IRR is greater than the opportunity cost of capital. 27
IRR rule solution 28
Alternative Discounted Cash Flow Decision Rules 4. Choose the investment alternative with fastest payback. 29
Payback rule solution 30
Loan Amortization The process of paying a loan principal gradually over its term ¡ Example: $100, 000 mortgage loan, APR: 9%, repaid in 3 annual installments pmt=? pmt=$39504. 48 31
Loan Amortization ¡ First Year: Interest: (0. 09)(100000)=9000 pmt: 39504. 48 principal: 30504. 48 Outstanding Balance: 69494. 52 32
Loan Amortization ¡ Second Year: Interest: (0. 09)(69494. 52)=6254. 51 pmt: 39504. 48 principal: 33250. 97 Outstanding Balance: 36243. 54 33
Loan Amortization ¡ Third Year: Interest: (0. 09)(36243. 54)=3262 pmt: 39504. 48 principal: 36244 Outstanding Balance: 0 34
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Computing NPV in Different Currencies In any TVM calculation, the cash flows and the interest rate must be denominated in the same currency. 41
Inflation and Future Values Example: At age 20 you save $100 and invest it at a dollar interest rate of 8% per year, and you do not take it until age 65. If the inflation is estimated 5% per year, how much will you have accumulated in the account at that time in terms of real purchasing power? 42
Solution 1: 43
Solution 2: 44
Inflation and Present Values Example: Your daughter is 10 years old, and you are planning to open an account to provide for her college education. Tuition for a year of college is now $15, 000. How much must you invest now in order to have enough to pay for her first year’s tuition 8 years from now, if you think you can earn a rate of interest that is 3% more than the inflation rate of 5%? 45
Solution: Wrong: 46
Inflation and Present Values Never use a nominal interest rate when discounting real cash flows or a real interest rate when discounting nominal cash flows. 47
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