Lecture 15

 Time Value of Money

◦ Future Value Concept
◦ Present Value Concept
◦ Multiple Cash Flow
 Future Value
 Present Value
 Annuities cash Flows
◦ Present Value
◦ Future Value
 Annuities Due
 Perpetuities
 We will frequently encounter situations where
we have multiple cash flows that are all the
same amount.
◦ Series of equal installments for a loan-repayment
 A series of constant, or level, cash flows that
occur at the end of each period for some fixed
number of periods is called an ordinary
Annuity.
 For annuity calculation, we use a variation of
present value equation.
 The present value of an annuity of C dollars per

period for t periods when interest rate is r is:

PV=C  (1 - Present value factor)/r = C  [1 - 1/(1 + r)t ]/r
Where
C = Periodic payment or annuity
r = rate of interest
t = number of periods
The term in the parenthesis is called present value
interest factor of an annuity (PVIFAr,t).
 Interest Rates
Number 5% 10% 15% 20%
of Periods
1 0.9524 0.9091 0.8696 0.8333
2 1.8594 1.7255 1.6257 1.5278
3 2.7232 2.4869 2.2832 2.1065
4 3.5460 3.1699 2.8550 2.5887
5 4.3259 3.7908 3.3522 2.9906
By looking at your budget you know you can pay
$632 for a new car, bank is offering you a loan for
48 months at 1% per month. How much should you
borrow?
PVIFA = (1 – Present value factor)/r
= [1 - (1/1.0148 )]/0.01
= (1 – 0.6203)/0.01 = 37.9740
So, Present value = $632 x 37.9740 = $ 24,000
Therefore, you can afford to borrow $24,000
 If you want to buy a new car costing $23,000.
With a 10% down payment, the bank will loan
you the rest at 9% per year (.75% per month) for
60 months. How much will each monthly
payment be?
 You will borrow 0.90 x $23,000 = $20,700. This

is the amount today, so it’s the PV. The rate

is .09/12 = .0075, and there are 60 periods:
$20,700 = C x [( 1 - 1/(1.0075)60]/.0075
=C x 48.1734
C = $20,700/48.1734
C = $429.70 per month
 To repay a loan of $1,000, Mr. X can only afford to
pay $20 per month. Interest rate is 1.5% per
month. How long will it take to repay the loan?
 Here, PV = $1,000, C = $20 , r = 1.5% per month

$1000 = $20 x (1 – PVF)/0.015

($1,000/20) x 0.015 = 1 – PVF
PVF = 0.25 = 1/ (1 + r)t
1.015t = 1/0.25 = 4
 So how long will it take to quadruple the money?
1.015x = 4  93 month or 7.75 years
 An insurance company offers to pay you $1,000
per year if you pay $6,710 up front. What rate is
applicable in this 10-year annuity?
 Here

C = $1,000, PV = $6,710 and t = 10, r = ?

$6,710 = $1,000 x (1 – PVF) / r
6.71 = {1- [1 /(1 + r)10]} / r
Looking at the PVIFA table for 10 periods, 6.7101
is the value for 8%. So insurance company is
offering 8%
 Annuity Future Value
FVt = C  (Future value factor - 1)/r
= C  [(1 + r)t - 1]/r
 Previously we determined that a 21-year old
could accumulate $1 million by age 65 by
investing $15,091 today and letting it earn
interest (at 10% compounded annually) for 44
years.
 Now, rather than plunking down $15,091 in one

chunk, suppose she would rather invest smaller

amounts annually to accumulate the million.
 If the first deposit is made in one year, and

deposits will continue through age 65, how large

must they be?
 Set this up as a FV problem:
$1,000,000 = C x [(1.10)44 - 1] / 0.10
C = $1,000,000/652.6408 = $1,532.24
Becoming a millionaire just got easier!
 Unfortunately, most people don’t start saving for
retirement that early in life. (Many don’t start at
all!)
 Suppose a 40-year old person has decided it’s time

to get serious about saving. Assuming that he

wishes to accumulate $1 million by age 65, he can
earn 10% compounded annually, and will begin
making equal annual deposits in one year, how
much must each deposit be?
 Set this up as a FV problem:
r = 10%
t = 65 - 40 = 25
FV = $1,000,000
Then:
$1,000,000 = C x [(1.10)25 - 1] / 0.10
C = $1,000,000/98.3471 = $10,168.07
 Moral of the story: Putting off saving for retirement

makes it a lot more difficult!

 So far, we have discussed only ordinary annuities,
where cash flows occur at the end of each period,
e.g. loan repayments
 However, when you lease an asset, the first lease

payment is usually due immediately, second at the

beginning of second period and so on.
 An Annuity due is an annuity for which cash flows

occur at the beginning of each period.

 The time line for Annuity due, having 5 payments
of $400 each, would be like:
0 1 2 3 4 5
Time
(years)

$400 $400 $400 $400 $400

 Present value of a four year $400 ordinary
annuity at 10% is $1,267.95
 Adding on the extra $400, we get $1,667.95, the
present value of this annuity due.
 The relationship between an annuity due and an
ordinary annuity is just:
Annuity due value = Ordinary annuity value
x (1 + r)
 Annuities cash Flows
◦ Present Value
◦ Future Value
 Annuities Due
 Perpetuities
 The Effect of Compounding Periods
◦ EAR
◦ APR
 Loan Amortization