Module 2
How to Calculate
Present Values
Business Finance
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Topic Outline
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Future Value and Compounding
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Present Value and Discounting
More on Present and Future Values
Multiple Cash Flows
Perpetuities
Annuities
EAR and APR
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6 Future Value and
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0 Compounding
The future value (FV) is the amount to
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which an investment will grow after
earning interest.
If you invest $ today at an interest rate of r,
you will have $ + $(r) = $(1 + r) in one
year.
Example: $100 at 10% interest per year
gives $100(1.1) = $110.
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0 Compounding
Reinvesting the interest, we earn interest
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on interest, i.e., compounding FV =
$(1 + r)(1 + r) = $(1 + r)2
Example: $100 at 10% interest per year
for 2 years gives $100(1.1)(1.1) =
$100(1.1)2 = $121.
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0 Compounding
In general, for t periods, FV = $(1 + r)t
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where (1 + r)t is the compound interest
or interest earned on interest at the rate, r,
for t periods. It is also called future value
interest factor, FVIF(r,t).
Example: $100 at 10% interest per year
for 10 years gives $100(1.1)10 = $259.37.
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0 Compounding
Interest can be compounded more than
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once a year. In such cases, the formula for
FV becomes: FV = $ (1 + (r / m))t x m,
where m is the number of total
compounding periods in a year.
Example: $100 at 10% interest per year
compounded semi-annually for 3 years
gives $100(1+(0.10 / 2))3 x 2 = $100(1 +
0.5)6 = $134.
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Exercises
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1. Simple Interest versus Compound
Interest. First City Bank pays 8 percent
simple interest on its savings account
balances, whereas Second City Bank
pays 8 percent interest compounded
annually. If you made a $5,000 deposit in
each bank, how much more money would
you earn from your Second City Bank
account at the end of 10 years?
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Exercises
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2. Calculating Future Values. Compute
the future value of $1,000 compounded
annually for:
a. 10 years at 5 percent.
b. 10 years at 10 percent.
c. 20 years at 5 percent.
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6 Present Value and
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0 Discounting
The value today of a future cash flow is
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called the present value (PV). Remember
that FV = $(1 + r). Rearrange and solve for
$, which is the present value. Therefore,
PV = FV / (1 + r).
Example: $110 in 1 period with an interest
rate of 10% has a PV = $110 / (1.1) =
$100.
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PV of future amount in t periods at r is: PV
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= FV [1 / (1 + r)t] where [1 / (1 + r)t] is the
discount factor, or the present value
interest factor, PVIF(r,t).
Example: If you have $259.37 in 10
periods and the interest rate was 10%,
how much did you deposit initially?
PV = $259.37 [1/(1.1)10] = $259.37(.3855)
= $100
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0 Discounting
Present values are directly related to the
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future cash flows and inversely related to
the discount rate, r, and time, t.
The higher the future cash flows, the
higher the PV; the higher the discount
rate and longer the term, the lower the
PV.
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6 More on Present and
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0 Future Values
Present Value versus Future Value.
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Present value interest factors are
reciprocals of future value interest factors:
PVIF(r,t) = 1 / (1 + r)t and FVIF(r,t) =
(1 + r)t
Example: FVIF(10%,4) = 1.14 = 1.464;
PVIF(10%,4) = 1 / 1.14 = 0.683
Basic present value equation: PV = FV [1 /
(1 + r)t] = FV / (1 + r)t
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Exercises
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6 Present Years Interest Future Value
Value Rate
6 7% $13,827
9 15% $43,852
18 11% $725,380
23 18% $590,710
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6 More on Present and
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0 Future Values
Determining the Discount Rate.
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Rearrange the PV equation to solve for r: r
= (FV / PV)1/t – 1
Example: What interest rate makes a PV
of $100 become a FV of $150 in 6
periods?
r = (150 / 100)1/6 – 1 = 7%
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6 More on Present and
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0 Future Values
Finding the Number of Periods.
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Rearrange the PV formula and solve for t.
t = ln(FV / PV) / ln(1 + r)
Example: How many periods before $100
today grows to $150 at 7%?
t = ln(150 / 100) / ln(1.07) = 6 periods
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Multiple Cash Flows
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Many finance situations involve more than
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one cash flow.
Whether they are equal, consecutive
payments or irregular, unequal cash flows
over time, they are referred to as a stream
of cash flows.
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Multiple Cash Flows
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Many finance situations involve more than
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one cash flow.
Whether they are equal, consecutive
payments or irregular, unequal cash flows
over time, they are referred to as a stream
of cash flows.
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Multiple Cash Flows
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Example: An investor has determined that
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the expected future cash flows of an asset
will follow the following schedule: $5,000
at the beginning of year 1, $2,000 at the
beginning of year 2, $500 at the beginning
of year 3, and $10,000 at the beginning of
year 4. Suppose that the discount rate
from the cash flows above is 8%. What is
the present value of the cash flows at 8%?
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Perpetuities
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A perpetuity is a perpetual annuity; that
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means, cash flows go on forever.
The PV of a perpetuity is equal to the
periodic cash flow divided by the
appropriate discount rate, or PV = C / r.
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Perpetuities
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Example: If a person receives $500 per
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year forever, beginning next year, and the
interest rate is a constant 5% forever, what
is the present value of the cash flows?
PV = C / r = $500 / 0.05 = $10,000
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Perpetuities
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Cash flows growing at a constant rate.
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The present value of a stream of cash
flows growing at a constant rate, g, is
given by the following formula: PV =
C / (r - g).
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Perpetuities
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For example: Assume that the cash flows
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are annually adjusted for expected growth
of 6%. How much should the present
value be if the first year’s cash flow is
$100 and the discount rate is 8%?
PV = C / (r - g) = $100 / (0.08 - 0.06) =
$5,000
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Annuities
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An annuity is a series of equal cash flows
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that occur at regular intervals for a fixed
number of time periods.
Present Value for Annuity Cash Flows.
The present value of an annuity of cash
flow C per period for t periods at r percent
interest: PV = C[1 – 1/(1 + r)t] / r
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Annuities
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Example: If a person is willing to make 36
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monthly payments of $100 at 1.5% per
month, what size loan can you obtain?
PV = 100[1 – 1/(1.015)36] / .015 =
100(27.6607) = $2,766.07
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Annuities
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To find the payment, C, given PV, r, and t,
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use C = PV {r / [1 – 1/(1 + r)t]}
Example: If you borrow $400, promising to
repay in 4 monthly installments at 1% per
month, how much are your payments?
C = $400 {.01 / [1 – 1/(1.01)4]} =
$400(0.2563) = $102.51
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Annuities
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Future Value for Annuities.
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FV =
C[(1 + r)t – 1] / r
Example: If you make 20 payments of
$1,000 at the end of each period at 10%
per period, how much will your account
grow to be?
FV = $1,000[(1.1)20 – 1] / .1 =
$1,000(57.275) = $57,275
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EAR and APR
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Consider a bank which pays 6% interest
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per year, compounded quarterly; this is
equivalent to 1.5% interest each quarter.
The 6% rate in this example is sometimes
referred to as the annual percentage
rate, stated interest rate, the quoted
rate or the nominal rate.
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EAR and APR
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However, when interest is compounded
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more than once a year, the actual rate the
depositor receives is greater than the
quoted rate.
The true rate is often called the effective
annual rate or the effective annual yield.
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EAR and APR
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EAR = [1 + APR / m]m – 1 where m is the
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number of periods per year
Example: 6% compounded monthly is
[1 + (0.06/12)]12 – 1 = 16.67%.
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EAR and APR
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Growth
Compound- Periods Factor of Effective
Per-Period Interest
ing per Year Invested Annual
Rate (APR / m)
Period (m) Funds ((1 + Rate
APR)m)
Annually 1 0.06 1.06 6.000%
Semiannually 2 0.12 / 2 = 0.03 1.032 6.090%
Quarterly 4 0.12 / 4 = 0.015 1.0154 6.136%
Monthly 12 0.12 / 12 = 0.005 1.00512 6.168%
Weekly 52 0.12 / 52 = 0.0011538 0.001153852 6.180%
Daily 365 0.12 / 365 = 0.0001644 1.0001644365 6.183%
Continuously ∞ -- e0.06 6.184%
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EAR and APR
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To compute the APR given the EAR, APR
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= m[(1 + EAR)1/m – 1].
For example: 13.54% EAR is 4[(1 +
01354)1/4 – 1] = 12.9% APR compounded
quarterly.
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