Class 3: The Time Value of Money Contd

COMM 298 Section Introduction to Finance

Complete Notes
Winter 2012/2013
Dr. Cornelia Kullmann

Objectives
M To be able to compare, add, or subtract sums of money received at
different points in time we use the concepts of compounding and
discounting.
Three rules of time travel.

Compound Interest
M Interest is not only earned on the amount initially invested but also
on any accrued interest.
You earn interest on interest. This can seriously add up!

M With compound interest, money grows exponentially instead of

linearly.
M Small differences in the rate of return can have large impact on
profits over long periods of time.

How Compound Interest Works

M An Example:
M

Assume you invest P = $100 at an effective annual rate of interest r = 5% for 4

years. You take no money out of your account before the end of year 4.
Draw a timeline first! Then:
After one year, at t=1, the future value of P, denoted by FV1 is given by

FV1 = P + rP = P * (1+ r) = $100 * (1.05) = $105

From the end of year 1 to the end of year two, the $105 will grow at 5%, i.e.

FV2 = FV1 * (1+ r) = P * (1+ r)* (1+ r) = P * (1+ r)2

= $105* (1.05) = $100 *1.05*1.05 = $100 *1.052 = $110.25

After 3 years, you will have:

FV3 = FV2 ! (1.05) = $100 ! (1.05)2 ! (1.05) = $100 ! (1.05)3 = $115.76

By repeated multiplication, you will find the value after 4 years to be:

FV4 = FV3 ! (1.05) = $100 ! (1.05)3 ! (1.05) = $100 ! (1.05)4 = 121.55

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General Compound Interest Formula

M First rule of time travel (Compounding)
M Moving to the right on the timeline

M An investment of PV that is invested at a periodic rate of return of r

grows to FVn after n periods, i.e.

FVn = PV0 * (1+ r)

M Where: n = number of time periods for which interest is earned

(n does not have to be in years)
r = effective periodic interest rate
M

Note:

Total interest earned is I = FVn - PV

simple interest is n*r*PV
compound interest is total interest minus simple interest, i.e. FVn PV - n*r*PV = FVn-PV(1+n*r)
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Example
M

Suppose at age 20 you decide to save for your retirement. You plan to put
$100 into an account paying 8% interest pear year for 45 years.
Assume you earn simple interest only. How much money will you have
after 45 years?
M FV45(simple interest case) = $100*(1+0.08*45) = $460

Assume now that you earn compound interest. How much money will
you have after 45 years?
M FV45(compound interest case) = $100*(1+0.08)45 = $3,192

In the compound interest case, how much interest do you earn on interest
earned previously (interest on interest)?
The total interest earned is $3,192 - $100 = $3,092.
The simple interest earned is $100*45*0.08 = $360.
Therefore the compound interest (interest on interest on interest) is $3,092 $360 = $2,732
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Example: The Manhattan Purchase

M Native Americans allegedly sold Manhattan to the British for $24 in
1626.
Had they invested this money at an effective annual rate of return of
7.2%, what would the money have grown to in 1999?
M What is n? 1999 -1626 = 373
M Then: FV1999 = $24*(1+0.072)373 = $4.4 trillion (12 0s)
According to Case (2000), the aggregate value of all residential real estate in
the US was about $11.6 trillion at the end of 1999 .

What would it have been worth at the end of 2009?

M n = 2009 1626 = 383
M Then: FV2009 = $24*(1+0.072)383 = 8.88 trillion

Note that the value doubled over 10 years.

Compound interest -> investments grow exponentially

Aside: The Rule of 72

M For effective interest rates between, say, 5%-20%, money doubles in
approximately

72
years.
r !100

72 72
=
= 10 years.
In our last example, this would have been
r 7.2
=> For r = 7.2%, Rule of 72 works well.

iClicker Example: Compound Interest

M

Suppose you invest $1000 today. The effective annual interest rate
is 6%. At the beginning of year 5, you take all the money out of the
account to buy a new TV.
How much money can you spend?
a)
b)
c)
d)
e)

$1,360.49
$1,262.48
$1,338.23
$1,300.00
None of the above

Answer: b) $1,262.48
Timeline:
0
1
2
3
4
5
Period
-----|------|------|------|------|------|-------$1000
FV4 = ?
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General Present Value Formula

M Second Rule of Time Travel (Discounting)
M Moving to the left on the timeline

M In Finance, we often have to find todays value of (more or less

certain) future cash flows. Said differently, we have to look for a
present value.
M From
FV = PV * (1+ r)n
n

M We can easily get:

! 1 $
FVn
1
'n
PV0 =
=
FV
*
=
FV
*
=
FV
*
(1+
r)
#
&
n
n
n
" 1+ r %
(1+ r)n
(1+ r)n

FVn
!n
PV0 =
= FVn * (1+ r)
n
(1+ r)

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Example: Discounting
M You think you will need a new computer in three years.
You expect the computer to cost $1,000 in three years.
If the annual interest rate you earn on your savings is 4%, how much
money do you have to set aside today to be able to buy the computer in
three years?

M Timeline:
0
1
2
3
|-------|-------|-------|-------|---?
$1,000

Period
Cash Flows

1, 000
!3
PV0 =
=
$1,
000
*
(1.04)
= $889.00
3
(1+ 0.04)
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iClicker Example: Discounting

M You have $1000 in the bank right now. You want to have $1000 three
years from now to buy a new computer.
How much money can you spend today if the annual interest rate is 5%?
a) $863.84
b) $163.70
c) $136.16
d) $ 92.97
e) None of the above
Timeline:
0
1
2
3
Periods
---|---------------|---------------|---------------|----------$1,000
PV0 = ?
$864
$907
$952
$1,000
CFs
c) is correct answer
First: How much do you have to invest today to have $1,000 in 3 years?
PV of $1000 in 3 years is $1000*(1.05)-3 = $863.84
You can spend $1,000 $863.84 = $136.16 today

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Compounding vs. Discounting

M By compounding, you can go from todays value (the present value
or PV) to a future value (FVn) n periods from now.
Future value is the amount of money that an initial investment will grow
to at some future point
n

FVn = PV0 * (1+ r)

M By discounting you can figure out what a future sum of money (FVn)
is worth today (PV0) or, e.g., two periods from now (PV2).
M Notation:

FVn
!n
PV0 =
=
FV
*
(1+
r)
n
(1+ r)n

P, PV, P0, or PV0: Principal or Present Value (amount of money today).

M Pm , PVm or Vm for m<n: Value of FVn m periods from now.

FVn: Future Value n periods from now

I = total amount of interest earned
r = effective per period interest rate
n = number of time periods over which interest accrues.
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The Third Rule of Time Travel

M

To combine or compare values of cash flows that occur at different points in

time, you have to bring them to the same point in time by compounding or
discounting them.
T
S
R
Q
K
P Periods
-|---------|----------|----------|----------|---------|-$Y
$X
CFs

Suppose the effective per period interest rate is r. What is the value of the two
cash flows of $Y at t = S and $X at t = K at t = R?

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Example: The Third Rule of Time Travel (1)

M Suppose we plan to save $1,000 today, and $1,000
at the end of each of the next two years. If we can
earn a fixed 10% interest rate on our savings, how
much will we have three years from today?

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Example: The Third Rule of Time Travel (2)

What is PV of these three cash flows at t=0?

PV0 = $3, 641* (1+ 0.1)!3 = $2, 735.54

Of course we could also discount the $1,000 at t=1 by one period and $1,000 at t=2
by two Periods, add that to $1,000 at t=0.

PV0 = $1, 000 + $1, 000 * (1.1)!1 + $1, 000 * (1.1)!2 = $2, 735.54
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Example: The Third Rule of Time Travel (3)

Alternatively, you can get the same result as follows:

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Summary: The Three Rules of Time Travel

M

The Three Rules of Time Travel:

1. You can move (the value of) a cash flow forward in time by
compounding it.

FVn = PV0 * (1+ r)n

2. You can move the value of a cash flow backward in time by

discounting it.

FVn
!n
PV0 =
=
FV
*
(1+
r)
n
n
(1+ r)

3. To combine or compare values of cash flows that occur at different

points in time, you have to bring them to the same point in time by
compounding or discounting them.
Where:

PV0
FVn
n
r

= present value (sometimes denoted by P for Principal) at t = 0

= future value n periods from now
= the number of time periods over which interest accrues
= the effective periodic interest rate

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iClicker Question: Combining all Three Laws

M
M

What is the value of the cash flows below at the beginning of period Q?
The effective interest rate is 10% per period.
T
S
R
Q
K
P
N
Periods
-|---------|----------|----------|----------|---------|---------|--$300
$500 CFs
a)$671.51
b)$800.00
c) $738.66
d)$812.52
e)None of the above

Correct solution is a), because the beginning of a period is always at the end of the
previous period, which in this example is R

300 *1.1+ 500 *1.1!4 = 671.51

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Moving along the Timeline One Step at a Time

M Suppose the effective monthly interest rate is 0.5%.
M Consider the following cash flows:
-1
0
1
2
3
4
5
Months
-|---------|----------|----------|----------|---------|---------|--$300
$500 CFs
M
M

What is the value of these cash flows at t = 3?

There are many ways of solving this.
1. Solving for V3 directly: 300*(1 + 0.005)3 + 500*(1 + 0.005)-2 = $799.56
2. Solving for PV0 first, then solving for (F)V3:
M PV0 = 300 + 500*(1 + 0.005)-5 = 787.69 => V3 = 787.69*(1+0.005)3 = $799.56

3. Solving for PV(-1) = 300*(1 + 0.005)-1 +500*(1 + 0.005)-6 = 783.77

V3 = 783.77*(1+0.005)4 = $799.56
To get PV(-1) we could have used PV0 and discounted it back by one period to get
PV(-1) = 787.69*(1 + 0.005)-1 = 783.77

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