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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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CHAPTER 2Time 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.

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.

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.


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

0

1

2 Year

i%

100


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

0

1

2

3

i%

100

100

100


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


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.


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.


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 = ?


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

3

1

PV

=

$100

1.10

=

$100

0.7513

=

$75.13.


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.


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


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


ordinaryannuity


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:


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


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:


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.

0

1

2

3

10%

100

100

100


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


annuitydue


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)


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?

4

0

1

2

3

10%

100

300

300

-50

90.91

247.93

225.39

-34.15

530.08 = PV


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 .


Spreadsheet Solution

ABCDE

101234

2100300300-50

3530.09

Excel Formula in cell A3:

=NPV(10%,B2:E2)


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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