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- chapter 3
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You are on page 1of 49

www.irfanullah.co

1

Graphs, charts, tables, examples, and figures are copyright 2012, CFA

Institute. Reproduced and republished with permission from CFA Institute.

All rights reserved.

Contents

1. Introduction

2. Interest Rates: Interpretation

3. The Future Value of a Single Cash Flow

4. The Future Value of a Series of Cash Flows

5. The Present Value of a Single Cash Flows

6. The Present Value of a Series of Cash Flows

7. Solving for Rates, Number of Periods, or Size

of Annuity Payments

www.irfanullah.co 2

Video Lecture 1

39 minutes

Video Lecture 2

40 minutes

1. Introduction

Time value of money

Interest rates

Present value

Future value

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2. Interest Rates: Interpretation

Interest rates can be interpreted as:

1. Required rate of return

2. Discount rate

3. Opportunity cost

Say you lend $900 today and receive $990 after one year

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Required Rate of Return Discount Rate Opportunity Cost

Interest Rates: Investor Perspective

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As investors, we can view an interest rate as:

Real risk-free interest rate +

Inflation premium +

Default risk premium +

Liquidity premium +

Maturity premium

Nominal

Risk-free

Rate

Practice Question 1

Jill Smith wishes to compute the required rate of return. Which of the

following premiums is she least likely to include?

A. Inflation premium

B. Maturity premium

C. Nominal premium

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Answer: C

Required rate of return includes inflation premium, maturity premium, default

risk premium, and liquidity premium. There is no such component as a

nominal premium.

Practice Question 2

Which of the following is least likely true?

A. Discount rate is the rate needed to calculate present value

B. Opportunity cost represents the value an investor forgoes

C. Required rate of return is the maximum rate of return an investor

must receive to accept an investment

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Answer: C

Required rate of return is the minimum rate of return an investor must

receive to accept an investment. Therefore, option C is least likely to be the

interpretation of interest rates.

Investments Maturity

(in years)

Liquidity Default risk Interest Rates (%)

A 1 High Low 2.0

B 1 Low Low 2.5

C 2 Low Low r

D 3 High Low 3.0

E 3 Low High 4.0

Practice Question 3

1. Explain the difference between the interest rates on

Investment A and Investment B.

2. Estimate the default risk premium.

3. Calculate upper and lower limits for the interest rate on

Investment C, r.

8

3. Future Value of a Single Cash Flow

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FV

N

= PV (1 + r)

N

0 1 2

PV = 100 and r = 10%

What is the FV after one year?

What is the FV after two years?

Practice Question 4

Cyndia Rojers deposits $5 million in her savings account. The account holders are

entitled to a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash

would she most likely be able to withdraw?

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FV Calculation Using a Financial Calculator

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Keystrokes Explanation Display

[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9

[2nd] [QUIT] Return to standard calc mode 0

You invest $100 today at 10% compounded annually. How

much will you have in 5 years?

Keystrokes Explanation Display

[2nd] [QUIT] Return to standard calc mode 0

[2

nd

] [CLR TVM] Clears TVM Worksheet 0

5 [N] Five years/periods N = 5

10 [I/Y] Set interest rate I/Y = 10

100 [PV] Set present value PV = 100

0 [PMT] Set payment PMT = 0

[CPT] [FV] Compute future value FV = -161.05

Set to floating decimal

3.1 Frequency of Compounding

You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated

annual interest rate of 10% compounded quarterly. How much will you

have at the end of three years?

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Multiple Compounding Periods - Calculator

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You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual

interest rate of 10% compounded quarterly. How much will you have at the end of

three years?

Practice Question 5

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Donald invested $3 million in an American bank that promises to pay 4% compounded daily. Which

of the following is closest to the amount Donald receives at the end of the first year? Assume 365

days in a year.

A. $3.003 million

B. $3.122 million

C. $3.562 million

3.2 Continuous Compounding

Infinite compounding periods per year continuous compounding

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FV

N

= PV e

r N

An investment worth $50,000 earns interest that is compounded

continuously. The stated annual interest is 3.6%. What is the

future value of the investment after 3 years?

Concept Building Exercise

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Frequency Future value of $100 Return

Annual 112 12.00%

Semiannual 112.36 12.36%

Quarterly

Monthly

Daily

Continuous

Assume the stated annual interest rate is 12%. What is the future value of $100 at

different compounding frequencies?

3.3 Stated and Effective Rates

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With a discrete number of compounding periods:

EAR = (1 + Periodic interest rate)

m

1

With continuous compounding:

EAR = e

r

1

4. The Future Value of a Series of Cash Flows

Annuity: finite set of level sequential cash flows

Ordinary annuity: an annuity where the first cash flow occurs one period from today

Annuity due: an annuity where the first cash flow occurs immediately

Perpetuity: set of level never-ending sequential cash flows with the first cash flow

occurring one period from today

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0 1 2

0 1 2

4.1 Future Cash Flows Ordinary Annuity

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0 1 2 3 4 5

Ordinary annuity with A = 1,000 r = 5% and N = 5

Ordinary Annuity - Formula

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0 1 2 3 4 5

Ordinary annuity with A = 1,000 r = 5% and N = 5

FV

N

= A {[(1+r)

N

1]/r}

FV

N

= A {Future Value Annuity Factor}

Ordinary Annuity - Calculator

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Ordinary annuity with A = 1,000 r = 5% and N = 5

N = 5

I/Y = 5

PV = 0

PMT = 1,000

CPT FV

Practice Question 6

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Haley deposits $24,000 in her bank account at the end of every year. The account

earns 12% per annum. If she continues this practice, how much money will she have

at the end of 15 years?

Practice Question 7

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Iago wishes to compute the future value of an annuity worth $120,000. He is aware

that the FV annuity factor is 21.664 and the interest rate is 4.5%. Which of the

following is least likely to be useful for the future value computation?

A. Annuity worth

B. Future value annuity factor

C. Interest rate

Answer: C

4.2 Unequal Cash Flows

Time Cash Flow ($)

1 1,000

2 2,000

3 3,000

4 4,000

5 5,000

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What is the future value at year 5?

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End of Lecture 1

5. Finding the Present Value of a Single Cash Flow

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PV = FV

N

(1+r)

-N

For a given discount rate, the farther in the future the amount to be received,

the small the amounts present value.

Holding time constant, the larger the discount rate, the smaller the present

value of a future amount.

Practice Question 8

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Liam purchases a contract from an insurance company. The contract promises to pay

$600,000 after 8 years with a 5% return. What amount of money should Liam most

likely invest? Solve using the formula and TVM functions on the calculator.

Answer: 406,104

Practice Question 9

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Mathews wishes to fund his son, Nathans, college tuition fee. He purchases a security

that will pay $1,000,000 in 12 years. Nathans college begins 3 years from now. Given

that the discount rate is 7.5%, what is the securitys value at the time of Nathans

admission?

Answer: 521,583

Practice Question 10

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Orlando is a manager at an Australian pension fund. 5 years from today he wants a

lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year,

compounded monthly, how much should Orlando invest today?

Answer: 32,760

6. Present Value of a Series of Cash Flows

Present value of a series of equal cash flows (annuity)

Present value of a perpetuity

Present value indexed at times other than zero

Present value of a series of unequal cash flows

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6.1 Present Value of a Series of Equal Cash Flows

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0 1 2 3 4 5

Ordinary annuity with A = 10 r = 5% and N = 5

PV of an Ordinary Annuity: Using the Formula

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0 1 2 3 4 5

Ordinary annuity with A = 10 r = 5% and N = 5

PV = A {[1 1/(1+r)

N

]/r}

PV of an Ordinary Annuity: Using the Calculator

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0 1 2 3 4 5

Ordinary annuity with A = 10 r = 5% and N = 5

Annuity Due The Concept

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0 1 2 3 4 5

Annuity due with A = 10 r = 5% and N = 5

PV of an Annuity Due: Using the Formula

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0 1 2 3 4 5

Annuity due with A = 10 r = 5% and N = 5

PV (annuity due) = A {[1 1/(1+r)

N

]/r} (1+r)

PV of an Annuity Due: Using the Calculator

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0 1 2 3 4 5

Annuity due with A = 10 r = 5% and N = 5

Key Strokes Display

[2nd] [BGN] [2nd] [SET] BGN

[2nd] [QUIT]

BGN

0

[2nd] [CLR TVM]

BGN

0

5 [N]

BGN

N = 5

5 [I/Y]

BGN

I/Y = 5

10 [PMT]

BGN

PMT = 10

0 [FV]

BGN

FV = 0

[CPT] [PV]

BGN

[2nd] [BGN] [2nd] [SET] END

[2nd] [QUIT] 0

6.2 Present Value of a Perpetuity

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PV = A/r

Present value is one period before the first

cash flow

Simple example to understand the formula:

You invest $100 and get 5% for ever. What is

the cash flow?

6.3 Present Values Indexed at Times Other Than t=0

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An annuity or perpetuity beginning sometime in the future can be expressed in present

value terms one period prior to the first payment

Discount back to todays present value

Practice Question 11

www.irfanullah.co 39

Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth

$100 per year indefinitely. The first payment will be received at t = 4. Given that the

required rate of return is 10%, how much should Mr. Graham pay today?

Answer: 751.31

6.4 The Present Value of a Series of Unequal Cash Flows

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Find the present value of each individual cash

Sum the respective present values

0 1 2 3

Practice Question 12

www.irfanullah.co 41

Andy makes an investment with the expected cash flow shown in the table below.

Assuming a discount rate of 9% what is the present value of this investment?

Answer: 550

Time Period Cash Flow($)

1 50

2 100

3 150

4 200

5 250

7. Solving for Rates, Number of Periods, or Size of

Annuity Payments

Solving for Interest Rates and Growth

Solving for Number of Periods

Solving for the Size of Annuity Payments

Review of Present Value and Future Value Equivalence

The Cash Flow Additivity Principle

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7.1 Solving for Interest Rates and Growth Rates

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A $100 deposit today grows to $121 in 2 years.

What is the interest rate? Use both the formula and the

calculator method.

The population of a small town is 100,000 on 1 Jan

2000. On 31 December 2001 the population is

121,000. What is the growth rate?

You invest $900 today and receive a $100 coupon

payment at the end of every year for 5 years. In

addition, you receive $1,000 and the end of year 5.

What is the interest rate?

7.2 Solving for the Number of Periods

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You invest $2,500. How many years will it take to triple the amount given that

the interest rate is 6% per annum compounded annually? Use both the formula

and the calculator method.

Answer: 18.85 years

7.3 Solving for the Size of Annuity Payments

www.irfanullah.co 45

Freddie bought a car worth $42,000 today. He was required to make a 15% down payment. The

remainder was to be paid as a monthly payment over the next 12 months with the first payment

due at t=1. Given that the interest rate is 8% per annum compounded monthly, what is the

approximate monthly payment?

Answer: 3,106

7.4 Review of Present and Future Value Equivalence

A lump sum can be considered equivalent

to an annuity

An annuity can be considered equivalent

to a future value

A lump sum can be considered equivalent

to a future value

www.irfanullah.co 46

Ordinary annuity with A = 10 r = 5% and N = 5 PV = 43.29

0 1 2 3 4 5

FV = 55.26

Lump sum = PV = 43.29

7.5 The Cash Flow Additivity Principle

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Amounts of money indexed at the same point in time are additive

0 1 2 3

Summary

1. Interest Rates

2. Future Value

3. Present Value

4. Solving for Rates, Number of

Periods, or Size of Annuity

Payments

www.irfanullah.co 48

Conclusion

Review learning objectives

Examples and practice problems from the

curriculum

Practice questions from other sources

www.irfanullah.co 49

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