Analyzing Financial Statements and Evaluating a Firm’s Performance 3

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SEU_FIN500_PPT_Mod04_Ch05.pptx

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Chapter 5

The Time Value of Money

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Learning Objectives

Explain the mechanics of compounding, and bringing the value of money back to the present.

Understand annuities.

Determine the future or present value of a sum when there are nonannual compounding periods.

Determine the present value of an uneven stream of payments and understand perpetuities.

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COMPOUND INTEREST, FUTURE, AND PRESENT VALUE

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Using Timelines to Visualize Cash Flows

Timeline of cash flows

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Simple Interest

Interest is earned only on principal.

Example: Compute simple interest on $100 invested at 6% per year for three years.

1st year interest is $6.00

2nd year interest is $6.00

3rd year interest is $6.00

Total interest earned: $18.00

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Compound Interest

Compounding is when interest paid on an investment during the first period is added to the principal; then, during the second period, interest is earned on the new sum (that includes the principal and interest earned so far).

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Compound Interest

Example: Compute compound interest on $100 invested at 6% for three years with annual compounding.

1st year interest is $6.00 Principal now is $106.00

2nd year interest is $6.36 Principal now is $112.36

3rd year interest is $6.74 Principal now is $119.10

Total interest earned: $19.10

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Future Value

Future Value is the amount a sum will grow to in a certain number of years when compounded at a specific rate.

FVN = PV (1 + r)n

FVN = the future of the investment at the end of “n” years

r = the annual interest (or discount) rate

n = number of years

PV = the present value, or original amount invested at the beginning of the first year

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Future Value Example

Example: What will be the FV of $100 in 2 years at interest rate of 6%?

FV2 = PV(1 + r)2 = $100 (1 + 0.06)2

= $100 (1.06)2

= $112.36

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How to Increase the Future Value?

Future Value can be increased by:

Increasing number of years of compounding (N)

Increasing the interest or discount rate (r)

Increasing the original investment (PV)

See example on next slide

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Changing R, N, and PV

a. You deposit $500 in bank for 2 years. What is the FV at 2%? What is the FV if you change interest rate to 6%?

FV at 2% = 500*(1.02)2 = $520.20

FV at 6% = 500*(1.06)2 = $561.80

b. Continue the same example but change time to 10 years. What is the FV now?

FV = 500*(1.06)10= $895.42

c. Continue the same example but change contribution to $1,500. What is the FV now?

FV = 1,500*(1.06)10 = $2,686.27

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Figure 5-2

Figure 5-2 illustrates that we can increase the FV by:

Increasing the number of years for which money is invested; and/or

Investing at a higher interest rate.

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Computing Future Values using Calculator or Excel

Review discussion in the text book

Excel Function for FV:

= FV(rate,nper,pmt,pv)

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Present Value

Present value reflects the current value of a future payment or receipt.

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Present Value

PV = FVn {1/(1 + r)n}

FVn = the future value of the investment at the end of n years

n = number of years until payment is received

r = the interest rate

PV = the present value of the future sum of money

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PV example

What will be the present value of $500 to be received 10 years from today if the discount rate is 6%?

PV = $500 {1/(1+0.06)10}

= $500 (1/1.791)

= $500 (0.558)

= $279.00

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Figure 5-3

Figure 5-3 illustrates that PV is lower if:

Time period is longer; and/or

Interest rate is higher.

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Using Excel

Excel Function for PV:

= PV(rate,nper,pmt,fv)

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ANNUITIES

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Annuity

An annuity is a series of equal dollar payments for a specified number of years.

Ordinary annuity payments occur at the end of each period.

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FV of Annuity

Compound Annuity

Depositing or investing an equal sum of money at the end of each year for a certain number of years and allowing it to grow.

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FV Annuity - Example

What will be the FV of a 5-year, $500 annuity compounded at 6%?

FV5 = $500 (1 + 0.06)4 + $500 (1 + 0.06)3 + $500(1 + 0.06)2 + $500 (1 + 0.06) + $500

= $500 (1.262) + $500 (1.191) + $500 (1.124) + $500 (1.090) + $500

= $631.00 + $595.50 + $562.00 + $530.00 + $500

= $2,818.50

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FV of an Annuity – Using the Mathematical Formulas

FVn = PMT {(1 + r)n – 1/r}

FV n = the future of an annuity at the end of the nth year

PMT = the annuity payment deposited or received at the end of each year

r = the annual interest (or discount) rate

n = the number of years

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FV of an Annuity – Using the Mathematical Formulas

What will $500 deposited in the bank every year for 5 years at 6% be worth?

FV = PMT ([(1 + r)n – 1]/r) = $500 (5.637) = $2,818.50

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FV of Annuity: Changing PMT, N, and r

What will $5,000 deposited annually for 50 years be worth at 7%?

FV = $2,032,644

Contribution = $250,000 (= 5000*50)

Change PMT = $6,000 for 50 years at 7%

FV = $2,439,173

Contribution= $300,000 (= 6000*50)

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FV of Annuity: Changing PMT, N, and r

3. Change time = 60 years, $6,000 at 7%

FV = $4,881,122

Contribution = $360,000 (= 6000*60)

4. Change r = 9%, 60 years, $6,000

FV = $11,668,753

Contribution = $360,000 (= 6000*60)

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Present Value of an Annuity

Pensions, insurance obligations, and interest owed on bonds are all annuities. To compare these three types of investments we need to know the present value (PV) of each.

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PV of Annuity – Using the Mathematical Formulas

PV of Annuity = PMT {[1 – (1 + r)–1]}/r

= 500 (4.212)

= $2,106

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Annuities Due

Annuities due are ordinary annuities in which all payments have been shifted forward by one time period. Thus, with annuity due, each annuity payment occurs at the beginning of the period rather than at the end of the period.

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Annuities Due

Continuing the same example: If we assume that $500 invested every year for 5 years at 6% to be annuity due, the future value will increase due to compounding for one additional year.

FV5 (annuity due) = PMT {[(1 + r)n – 1]/r} (1 + r)

= 500(5.637)(1.06)

= $2,987.61

(versus $2,818.80 for ordinary annuity)

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Amortized Loans

Loans paid off in equal installments over time are called amortized loans. Example: Home mortgages, auto loans.

Reducing the balance of a loan via annuity payments is called amortizing.

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Amortized Loans

The periodic payment is fixed. However, different amounts of each payment are applied toward the principal and interest. With each payment, you owe less toward principal. As a result, the amount that goes toward interest declines with every payment (as seen in Figure 5-4).

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Amortization Example

Example: If you want to finance a new machinery with a purchase price of $6,000 at an interest rate of 15% over 4 years, what will your annual payments be?

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Finding PMT – Using the Mathematical Formulas

Finding Payment: Payment amount can be found by solving for PMT using PV of annuity formula.

PV of Annuity = PMT {1 – (1 + r)–4}/r

6,000 = PMT {1 – (1 + 0.15)–4}/0.15

6,000 = PMT (2.855)

PMT = 6,000/2.855

= $2,101.59

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MAKING INTEREST RATES COMPARABLE

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Making Interest Rates Comparable

We cannot compare rates with different compounding periods. For example, 5% compounded annually is not the same as 5% percent compounded quarterly.

To make the rates comparable, we compute the annual percentage yield (APY) or effective annual rate (EAR).

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Quoted Rate versus Effective Rate

Quoted rate could be very different from the effective rate if compounding is not done annually.

Example: $1 invested at 1% per month will grow to $1.126825 (= $1.00(1.01)12) in one year. Thus even though the interest rate may be quoted as 12% compounded monthly, the effective annual rate or APY is 12.68%.

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Quoted Rate versus Effective Rate

APY = (1 + quoted rate/m)m – 1

Where m = number of compounding periods

= (1 + 0.12/12)12 – 1

= (1.01)12 – 1

= .126825 or 12.6825%

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Finding PV and FV with Nonannual Periods

If interest is not paid annually, we need to change the interest rate and time period to reflect the nonannual periods while computing PV and FV.

r = stated rate/# of compounding periods

N = # of years * # of compounding periods in a year

Example: If your investment earns 10% a year, with quarterly compounding for 10 years, what should we use for “r” and “N”?

r = 0.10/4 = 0.025 or 2.5%

N = 10*4 = 40 periods

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THE PRESENT VALUE OF AN UNEVEN STREAM AND PERPETUITIES

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The Present Value of an Uneven Stream

Some cash flow stream may not follow a conventional pattern. For example, the cash flows may be erratic (with some positive cash flows and some negative cash flows) or cash flows may be a combination of single cash flows and annuity (as illustrated in Table 5-5).

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Perpetuity

A perpetuity is an annuity that continues forever.

The present value of a perpetuity is given by PV = PP/r

PV = present value of the perpetuity

PP = constant dollar amount provided by the perpetuity

r = annual interest (or discount) rate

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Perpetuity

Example: What is the present value of $2,000 perpetuity discounted back to the present at 10% interest rate?

= 2000/0.10

= $20,000

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Key Terms

Amortized loan

Annuity

Annuity due

Annuity future value factor

Annuity present value factor

Compound annuity

Compound interest

Effective annual rate (EAR)

Future value

Future value factor

Ordinary annuity

Present value

Present value factor

Perpetuity

Simple interest

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