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Time Value of Money. Review of Basic Concepts. PV. FV. Types of problems. Single Sum. One sum ($1) will be received or paid either in the Present (Present Value of a Single Sum or PV) Future (Future Value of a Single Sum or FV). PV-OA. PMT. PMT. PMT. PMT. PMT.

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Time value of money

Time Value of Money

Review of Basic Concepts


Types of problems

PV

FV

Types of problems

  • Single Sum. One sum ($1) will be received or paid either in the

    • Present (Present Value of a Single Sum or PV)

    • Future (Future Value of a Single Sum or FV)


Types of annuity problems

PV-OA

PMT

PMT

PMT

PMT

PMT

Types of Annuity Problems

Ordinary annuity(OA)

A series of equal payments (or rents) received or paid at the end of a period, assuming a constant rate of interest.

PV-OA(Present value of an ordinary annuity)


Types of annuity problems1

FV-OA

PMT

PMT

PMT

PMT

PMT

Types of Annuity Problems

Ordinary annuity(OA)

A series of equal payments (or rents) received or paid at the end of a period, assuming a constant rate of interest.

FV-OA (Future value of an ordinary annuity)


Types of problems1

FV-AD

PMT

PMT

PMT

PMT

PMT

0

Types of Problems

Annuity Due(AD)

A series of equal payments (or rents) received or paid at the beginning of a period, assuming a constant rate of interest.

FV-AD (future value of an annuity due)

Note: Each rent or payment is discounted (interest removed) one less period under a FV-AD.


Types of problems2

PV-AD

PMT

PMT

PMT

PMT

PMT

0

Types of Problems

Annuity Due(AD)

A series of equal payments (or rents) received or paid at the beginning of a period, assuming a constant rate of interest.

PV-AD (present value of an annuity due)

Note: Each rent or payment compounds (interest added) one more period in a PV-AD


Deferred annuities

0

1

2

3

4

5

PMT

PMT

PMT

n = 3

d = 2

Deferred Annuities

This is an ordinary annuity of 3 periods deferred for 2 periods.

We could find either the PV or the FV of the annuity.


Calculation variables
Calculation Variables

  • There will always be at least four variables in any present or future value problem. Three of the four will be known and you will solve for the fourth.

    • Single sum problems:

      • n = number of compounding periods

      • i = interest rate

      • PV = Value today of a single sum ($1)

      • FV = Value in the future of a single sum ($1)

      • PMT = 0 (important it using PV calculator!)

15

15


Annuity problems
Annuity Problems

  • n = number of payments or rents

  • i = interest rate

  • PMT = Periodic payment (rent) received or paid

    • And either:

  • FV of an annuity (OA or AD) = Value in the future of a series of future payments

    • OR

  • PV of an annuity (OA or AD) = Value today of a series of payments in the future

When we know any three of the four amounts, we can solve for the fourth!


I and n must match
i and n must match!

  • The “n” refers to periods not necessarily defined as years! The period may be annual, semi-annual, quarterly or another time frame.

  • The “n” and the “i” must match. That is, if the time period is semi-annual then so must the interest rate.

  • Interest rates are assumed to be annual unless otherwise stated so you may have to adjust the rate to match the time period.


Single sum formulas
Single Sum Formulas

  • FV = (1+i)n

  • PV = FV (1+i)n


Single sum formulas1
Single Sum Formulas

  • FV = (1+i)n

  • PV = FV (1+i)n

  • Present value calculators are generally no more expensive than those that do nth powers and nth roots!


Annuity formulas

(1 + i)- 1

PMT

i

1

1 -

(1 + i)n

PMT

i

Annuity Formulas

  • FV-OA =

  • PV-OA =


Formulas vs tables
Formulas vs. Tables

  • Before fancy calculators, people had no easy way to compute nth roots and raise numbers to the nth power.

  • So they created tables for of sums of $1 or annuities of $1.

  • The values on the table, I call the “interest factor” or IF.

  • So we have PVIF (for n and i)and the PVIF-OA (for n and i) and so forth


Using the tables

vertically for the “n”

and

horizontally for the “i”

Using the tables

The tables are the result of the required multiplications and division at various “n” and “i” and are to be read


Study the tables
Study the tables . .

  • They are very logical.

    • All sums in the future are worth LESS in the present.

      • All factors on the present value of a single sum table are less than one.

        All present sums are worth more than themselves in the future.

      • All factors on the future value of a single sum table are greater than one.

    • Notice how the factors change dramatically as the “i” increases and the “n” lengthens!

24


Formulas for the if tables
“Formulas” for the IF Tables

  • PV = FV * IF {IF from PV of $ table}

  • FV = PV * IF {IF from FV of $ table}

  • PV-OA = PMT * IF {IF from PV-OA table}

  • FV-OA = PMT * IF {IF from FV-OA table}

  • PMT = (PV-OA) / IF {IF from PV-OA table}

  • or

  • PMT = (FV-OA) / IF {from FV-OA table}

“IF” stands for “interest factor” from the appropriate n row and i column of the table


Adjustments to ordinary annuity tables

Adjustments to ordinary annuity tables

Rules for annuity dues and deferred annuities


Conversion to annuity due
Conversion to Annuity Due

  • To find IF for FV-AD: Add one to the number of periods and look up IF on table. Then subtract one from the interest factor listed.

  • To find IF for PV-AD: Subtract one from the number of periods and look up IF on table. Add one to the interest factor.

  • Or look up the IF on the appropriate table and multiply by (1 + i).


Ordinary annuity example

Page 480

Ordinary Annuity Example

  • Suppose I must make three payments of $500, each at the end of each of the next three years. The interest rate is 8%. How much should I set aside today to have the required payments?

  • This is an ordinary annuity:

    PV-OA= PMT * (PVIF-OA n,i) where n = 3 payments and i = 8%

    PV-OA = $500 * 2.5771 = $1,289


Stop and think
Stop and think . . .

  • If the first payment comes immediately instead of at the end of the first year,

  • Will the present value be

  • MORE or

  • LESS?


Annuity due example
Annuity Due Example

  • If the first payment comes immediately, this would be an annuity due problem.

  • We can use one of the formulas to adjust the IF – the easiest to memorize is the “multiply by (1+i)” rule:

    PV-AD= PMT (PVIF-OA n,i)(1+i) where n = 3 payments and i = 8%

    PV-AD = $500 (2.5771)(1 + .08) = $1,391

36


Annuity due example1
Annuity Due Example

  • Alternative adjustment to the IF table is even easier – at least if you write the method at the top of your table!

  • Look up IF for (n-1) and add 1:

    PVIF-OA (n=2, i=8%) = 1.7833 + 1 = 2.7833

    PV-AD = $500 (2.7833) = $1,392

36


Annuity due example2

PMT

PMT

PMT

PMT

PMT

0

  • This is an ordinary annuity of 4 periods (n-1)

    • The first payment comes immediately and therefore is NOT discounted!

Annuity Due Example

  • This second method is also the “logical” decision you would make from looking at the time-line.

FV-AD


Deferred annuities1

0

1

2

3

4

5

PMT

PMT

PMT

n = 3

d = 2

Deferred Annuities

When using the tables, there are some short-cuts for doing deferred annuities


Using pv tables deferred annuity
Using PV Tables – Deferred Annuity

  • Let d = number of periods deferred and n = number of periodic payments

  • Look up (d+n) on the appropriate table. Look up d on the same table. Subtract the smaller interest factor from the larger to get the deferred annuity IF.

  • Or look up interest factor for n periods on appropriate annuity table. Then look up interest factor from the corresponding “lump sum” table for d. Multiply the two interest factors together to get the deferred annuity IF.


Deferred annuity example

0

1

2

3

4

5

$100

$100

$100

n = 3

d = 2

Deferred Annuity Example

  • Let i = 12%

  • Find the present value of the annuity due:


0

1

2

3

4

5

$100

$100

$100

n = 3

d = 2

  • Alternative 1 – Work as two part problem

  • Find present value of ordinary annuity at end of year 2. Then discount it back to beginning of year 1

  • PV-OA IF(n=3, i=12%) = 2.4018

    • 2.4018 * $100 = $240.18

  • PVIF (n=2, i=12%) = .7972

    • $240.18 * .7972 = $191.47


0

1

2

3

4

5

$100

$100

$100

n = 3

d = 2

Alternative 2 – Adjust the ordinary annuity table IF:Look up PV-OA IF for (d+n) and then subtract the PV-OA IF for d

PV-OA IF(n=5,i=12%) = 3.6048PV-OA IF(n=2,i=12%) = -1.6901Adjusted IF = 1.9147

$100 * 1.9147 = $191.47


0

1

2

3

4

5

$100

$100

$100

n = 3

d = 2

Alternative 3 – Adjust the ordinary annuity table IF:Look up PV-OA IF for n and then multiply by the PV IF for d

PV-OA IF(n=3,i=12%) = 2.4018PV IF (n=2,i=12%) = 0.7972Adjusted IF = 1.9147

$100 * 1.9147 = $191.47


Deferred annuities2

0

1

2

3

4

5

PMT

PMT

PMT

n = 3

d = 2

Deferred Annuities

FV

If it is a FV problem, this is pretty much the only way to analyze the facts.

However . . . .


Deferred annuities3

0

1

2

3

4

5

PMT

PMT

PMT

n = 3

d = 2

Deferred Annuities

PV

We could do it the same way if we wanted to compute the present value, but we could also analyze it as an annuity due problem.


Deferred annuities4

PV

0

1

2

3

4

5

6

PMT

PMT

PMT

n = 3

d = 3

Note that in the last period we have zero left which earns no interest at any interest rate

Deferred Annuities

Then it would be 3 annuity due payments and the period before the annuity starts would be 3 periods instead of 2.


Deferred annuities5

PV

0

1

2

3

4

5

6

PMT

PMT

PMT

n = 3

d = 3

Deferred Annuities

Now see if you can work the problem (with the tables) if you analyzed the annuity as having the first payment happen immediately.


Spreadsheet demo
Spreadsheet demo

  • We’ll look at using Excel functions to solve lease problems

  • =NPV

  • =IRR

  • =PMT

  • =PV

  • =FV


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