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Quantitative Methods

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Time Value of Money

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Graphs, charts, tables, examples, and figures are copyright 2012, CFA
Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.
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Contents
1. Introduction
2. Interest Rates: Interpretation Video Lecture 1
3. The Future Value of a Single Cash Flow 39 minutes

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4. The Future Value of a Series of Cash Flows

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5. The Present Value of a Single Cash Flows
6. The Present Value of a Series of Cash Flows
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Solving for Rates, Number of Periods, or Size
of Annuity Payments
Video Lecture 2
40 minutes

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1. Introduction
• Time value of money

• Interest rates

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• Present value

• Future value nm
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2. Interest Rates: Interpretation
Interest rates can be interpreted as:
1. Required rate of return
2. Discount rate

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3. Opportunity cost

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

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Required Rate of Return Discount Rate Opportunity Cost

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Interest Rates: Investor Perspective

As investors, we can view an interest rate as:

Real risk-free interest rate +

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Nominal
Risk-free
Rate Inflation premium +

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Default risk premium +

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Liquidity premium +
Maturity premium

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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

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C. Nominal premium

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Answer: C

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Required rate of return includes inflation premium, maturity premium, default
risk premium, and liquidity premium. There is no such component as a
nominal premium.

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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

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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

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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.

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Practice Question 3
Investments Maturity Liquidity Default risk Interest Rates (%)
(in years)
A 1 High Low 2.0
B 1 Low Low 2.5

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C 2 Low Low r
D 3 High Low 3.0

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E 3 Low High 4.0

1. Explain the difference between the interest rates on

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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.

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3. Future Value of a Single Cash Flow
PV = 100 and r = 10%
FVN = PV (1 + r)N What is the FV after one year?
What is the FV after two years?

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0 1 2

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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
Keystrokes Explanation Display
Set to floating decimal
[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9
[2nd] [QUIT] Return to standard calc mode 0

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You invest $100 today at 10% compounded annually. How
much will you have in 5 years?

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Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0
Clears TVM Worksheet

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[2nd] [CLR TVM] 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

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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
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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Practice Question 5
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

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C. $3.562 million

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3.2 Continuous Compounding
Infinite compounding periods per year  continuous compounding

FVN = PV e r N

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

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continuously. The stated annual interest is 3.6%. What is the
future value of the investment after 3 years?

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Concept Building Exercise
Assume the stated annual interest rate is 12%. What is the future value of $100 at
different compounding frequencies?

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Frequency Future value of $100 Return

Annual 112 12.00%

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Semiannual 112.36 12.36%

Quarterly

Monthly

Daily nm
Continuous

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3.3 Stated and Effective Rates
With a discrete number of compounding periods:
EAR = (1 + Periodic interest rate)m – 1

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With continuous compounding:
EAR = er – 1

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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

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0 1 2

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

0 1 2
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• Perpetuity: set of level never-ending sequential cash flows with the first cash flow
occurring one period from today

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4.1 Future Cash Flows – Ordinary Annuity

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

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0 1 2 3 4 5

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Ordinary Annuity - Formula

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

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0 1 2 3 4 5

FVN = A {[(1+r)N – 1]/r}

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FVN = A {Future Value Annuity Factor}

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

N=5

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I/Y = 5

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PV = 0

PMT = 1,000

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Practice Question 6
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?

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Practice Question 7
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

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B. Future value annuity factor
C. Interest rate

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Answer: C
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4.2 Unequal Cash Flows

Time Cash Flow ($)


1 1,000
2 2,000

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3 3,000
4 4,000

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5 5,000

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What is the future value at year 5?

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End of Lecture 1

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5. Finding the Present Value of a Single Cash Flow

PV = FVN (1+r)-N

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

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the small the amount’s present value.

Holding time constant, the larger the discount rate, the smaller the present
value of a future amount.

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Practice Question 8
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.

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Answer: 406,104

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Practice Question 9
Mathews wishes to fund his son, Nathan’s, college tuition fee. He purchases a security
that will pay $1,000,000 in 12 years. Nathan’s college begins 3 years from now. Given
that the discount rate is 7.5%, what is the security’s value at the time of Nathan’s
admission?

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Answer: 521,583

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Practice Question 10
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?

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Answer: 32,760

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6. Present Value of a Series of Cash Flows
• Present value of a series of equal cash flows (annuity)

• Present value of a perpetuity

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• Present value indexed at times other than zero

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• Present value of a series of unequal cash flows

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6.1 Present Value of a Series of Equal Cash Flows
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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PV of an Ordinary Annuity: Using the Formula
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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PV = A {[1 – 1/(1+r)N]/r}

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PV of an Ordinary Annuity: Using the Calculator
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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Annuity Due – The Concept
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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PV of an Annuity Due: Using the Formula
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

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PV (annuity due) = A {[1 – 1/(1+r)N]/r} (1+r)

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PV of an Annuity Due: Using the Calculator
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5
Key Strokes Display
[2nd] [BGN] [2nd] [SET] BGN

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[2nd] [QUIT] BGN 0
[2nd] [CLR TVM] BGN 0

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5 [N] BGN N=5
5 [I/Y] BGN I/Y = 5

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10 [PMT] BGN PMT = 10
0 [FV] BGN FV = 0
[CPT] [PV] BGN

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


[2nd] [QUIT] 0

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6.2 Present Value of a Perpetuity

PV = A/r

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Present value is one period before the first

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cash flow

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Simple example to understand the formula:
You invest $100 and get 5% for ever. What is
the cash flow?

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6.3 Present Values Indexed at Times Other Than t=0

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


value terms one period prior to the first payment

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Discount back to today’s present value

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Practice Question 11
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?

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Answer: 751.31

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6.4 The Present Value of a Series of Unequal Cash Flows

Find the present value of each individual cash

Sum the respective present values

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0 1 2 3

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Practice Question 12
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?
Time Period Cash Flow($)
1 50

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2 100
3 150
4 200

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5 250

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Answer: 550

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

• Solving for Interest Rates and Growth

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• Solving for Number of Periods
• Solving for the Size of Annuity Payments

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• Review of Present Value and Future Value Equivalence

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The Cash Flow Additivity Principle

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7.1 Solving for Interest Rates and Growth Rates
A $100 deposit today grows to $121 in 2 years.
What is the interest rate? Use both the formula and the
calculator method.

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The population of a small town is 100,000 on 1 Jan
2000. On 31 December 2001 the population is

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121,000. What is the growth rate?

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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?

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7.2 Solving for the Number of Periods
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.

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Answer: 18.85 years

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7.3 Solving for the Size of Annuity Payments
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?

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Answer: 3,106

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7.4 Review of Present and Future Value Equivalence

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

A lump sum can be considered equivalent 0 1 2 3 4 5


to an annuity

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Lump sum = PV = 43.29

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An annuity can be considered equivalent
to a future value

FV = 55.26
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A lump sum can be considered equivalent
to a future value

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7.5 The Cash Flow Additivity Principle

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

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0 1 2 3

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Summary
1. Interest Rates

2. Future Value

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3. Present Value

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4. Solving for Rates, Number of
Periods, or Size of Annuity
Payments
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Conclusion

• Review learning objectives

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• Examples and practice problems from the
curriculum

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• Practice questions from other sources

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