LN04Brooks671956 02 LN04

Chapter 4
The Time Value

of Money
(Part 2)
2013 Pearson Education, Inc. All rights reserved. 4-2

1. Compute the future value of multiple cash flows.
2. Determine the future value of an annuity.
3. Determine the present value of an annuity.
4. Adjust the annuity equation for present value and future value
for an annuity due and understand the concept of a perpetuity.
5. Distinguish between the different types of loan repayments:
discount loans, interest-only loans and amortized loans.
6. Build and analyze amortization schedules.
7. Calculate waiting time and interest rates for an annuity.
8. Apply the time value of money concepts to evaluate the lottery
cash flow choice.
9. Summarize the ten essential points about the time value of
money.

Learning Objectives
4.1 Future Value of Multiple Payment
Streams
With unequal periodic cash flows, treat each
of the cash flows as a lump sum and
calculate its future value over the relevant
number of periods.
Sum up the individual future values to get
the future value of the multiple payment
streams.
Figure 4.1 The time line of a
nest egg
4.1 Future Value of Multiple
Payment Streams (continued)
Example 1: Future Value of an Uneven Cash
Flow Stream:
Jim deposits $3,000 today into an account that
pays 10% per year, and follows it up with 3 more
deposits at the end of each of the next three years.
Each subsequent deposit is $2,000 higher than the
previous one. How much money will Jim have
accumulated in his account by the end of three
years?


Streams (Example 1 Answer)

FV = PV x (1+r)
n

FV of Cash Flow at T
0
= $3,000 x (1.10)
3
= $3,000 x 1.331= $3,993.00
1
= $5,000 x (1.10)
2
= $5,000 x 1.210 = $6,050.00
2
= $7,000 x (1.10)
1
= $7,000 x 1.100 = $7,700.00
3
= $9,000 x (1.10)
0
= $9,000 x 1.000 = $9,000.00
Total = $26,743.00

Streams (Example 1 Answer)
ALTERNATIVE METHOD:
Using the Cash Flow (CF) key of the calculator, enter the
respective cash flows.

CF
0
=-$3000;CF
1
=-$5000;CF
2
=-$7000;CF
3
=-$9000;

Next calculate the NPV using I=10%; NPV=$20,092.41;

Finally, using PV=-$20,092.41; n=3; i=10%;PMT=0;
CPT FV=$26,743.00


4.2 Future Value of an Annuity
Stream

Annuities are equal, periodic outflows/inflows., e.g. rent,
lease, mortgage, car loan, and retirement annuity payments.
An annuity stream can begin at the start of each period
(annuity due) as is true of rent and insurance payments or
at the end of each period, (ordinary annuity) as in the case
of mortgage and loan payments.
The formula for calculating the future value of an annuity
stream is as follows:
FV = PMT * (1+r)
n
-1

r
where PMT is the term used for the equal periodic cash flow, r
is the rate of interest, and n is the number of periods
involved.

Stream (continued)
Example 2: Future Value of an Ordinary
Annuity Stream
Jill has been faithfully depositing $2,000 at the end
of each year since the past 10 years into an
account that pays 8% per year. How much money
will she have accumulated in the account?

Example 2 Answer

Future Value of Payment One = $2,000 x 1.08
9
= $3,998.01
Future Value of Payment Two = $2,000 x 1.08
8
= $3,701.86
Future Value of Payment Three = $2,000 x 1.08
7
= $3,427.65
Future Value of Payment Four = $2,000 x 1.08
6
= $3,173.75
Future Value of Payment Five = $2,000 x 1.08
5
= $2,938.66
Future Value of Payment Six = $2,000 x 1.08
4
= $2,720.98
Future Value of Payment Seven = $2,000 x 1.08
3
= $2,519.42
Future Value of Payment Eight = $2,000 x 1.08
2
= $2,332.80
Future Value of Payment Nine = $2,000 x 1.08
1
= $2,160.00
Future Value of Payment Ten = $2,000 x 1.08
0
= $2,000.00
Total Value of Account at the end of 10 years $28,973.13

Stream (continued)

Stream (continued)

Example 2 (Answer)
FORMULA METHOD
FV = PMT * (1+r)
n
-1

r
where, PMT = $2,000; r = 8%; and n=10.
FVIFA [((1.08)
10
- 1)/.08] = 14.486562,
FV = $2000*14.486562 $28,973.13

USING A FINANCIAL CALCULATOR
N= 10; PMT = -2,000; I = 8; PV=0; CPT FV = 28,973.13

Stream (continued)

USING AN EXCEL SPREADSHEET

Enter =FV(8%, 10, -2000, 0, 0); Output = $28,973.13

Rate, Nper, Pmt, PV,Type
Type is 0 for ordinary annuities and 1 for annuities
due
USING FVIFA TABLE (A-3)

Find the FVIFA in the 8% column and the 10 period
row; FVIFA = 14.486
FV = 2000*14.4865 = $28.973.13

FIGURE 4.3 Interest and principal
growth with different interest rates
for $100-annual payments.
4.3 Present Value of an Annuity

( )
r
r
PMT PV
n
(
|
|
.
|
\
|
+
=
1
1
1
To calculate the value of a series of equal
periodic cash flows at the current point in time,
we can use the following simplified formula:
The last portion of the equation, is the
Present Value Interest Factor of an Annuity (PVIFA).

Practical applications include figuring out the nest egg needed
prior to retirement or lump sum needed for college expenses.
FIGURE 4.4 Time line of present
value of annuity stream.
(continued)
Example 3: Present Value of an
Annuity.
John wants to make sure that he has saved up
enough money prior to the year in which his
daughter begins college. Based on current
estimates, he figures that college expenses will
amount to $40,000 per year for 4 years
(ignoring any inflation or tuition increases
during the 4 years of college). How much
money will John need to have accumulated in
an account that earns 7% per year, just prior to
the year that his daughter starts college?

(continued)
( )
r
r 1
1
1
PMT PV
n
(
|
|
.
|
\
|
+
=
Example 3 Answer
Using the following equation:

1. Calculate the PVIFA value for n=4 and r=7%3.387211.
2. Then, multiply the annuity payment by this factor to get
the PV,
PV = $40,000 x 3.387211 = $135,488.45

(continued)
Example 3 Answercontinued

FINANCIAL CALCULATOR METHOD:
Set the calculator for an ordinary annuity (END mode) and
then enter:
N= 4; PMT = 40,000; I = 7; FV=0; CPT PV = 135,488.45
SPREADSHEET METHOD:
Enter =PV(7%, 4, 40,000, 0, 0); Output = $135,488.45

Rate, Nper, Pmt, FV, Type
(continued)
Example 3 Answercontinued

PVIFA TABLE (APPENDIX A-4) METHOD
For r =7% and n = 4; PVIFA =3.3872
PV
A
= PMT*PVIFA = 40,000*3.3872
= $135,488 (Notice the slight rounding error!)

4.4 Annuity Due and Perpetuity

A cash flow stream such as rent, lease, and
insurance payments, which involves equal periodic
cash flows that begin right away or at the beginning
of each time interval is known as an annuity due.
Figure 4.5 An ordinary annuity versus an annuity
due.

PV annuity due = PV ordinary annuity x (1+r)
FV annuity due = FV ordinary annuity x (1+r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why?

Financial calculator
Mode BGN for annuity due
Mode END for an ordinary annuity
Spreadsheet
Type =0 or omitted for an ordinary annuity
Type = 1 for an annuity due.

(continued)
Example 4: Annuity Due versus Ordinary
Annuity
Lets say that you are saving up for retirement
and decide to deposit $3,000 each year for the
next 20 years into an account which pays a rate
of interest of 8% per year. By how much will
your accumulated nest egg vary if you make
each of the 20 deposits at the beginning of the
year, starting right away, rather than at the
end of each of the next twenty years?
(continued)
Example 4 Answer
Given information: PMT = -$3,000; n=20; i= 8%; PV=0;

( ) | |
r
1 r 1
PMT FV
n
+
=

FV ordinary annuity = $3,000 * [((1.08)
20
- 1)/.08]
= $3,000 * 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity * (1+r)
FV of annuity due = $137,285.89*(1.08) = $148,268.76


(continued)

Perpetuity
A Perpetuity is an equal periodic cash flow
stream that will never cease.
The PV of a perpetuity is calculated by using
the following equation:

r
PMT
PV =

(continued)

Example 5: PV of a perpetuity
If you are considering the purchase of a consol that
pays $60 per year forever, and the rate of interest
you want to earn is 10% per year, how much
money should you pay for the consol?
Answer:
r=10%, PMT = $60; and PV = ($60/.1) = $600
$600 is the most you should pay for the consol.
4.5 Three Loan Payment
Methods
Loan payments can be structured in one of 3
ways:
1)Discount loan
Principal and interest is paid in lump sum at end

2)Interest-only loan
Periodic interest-only payments, principal due at end.

3)Amortized loan
Equal periodic payments of principal and interest

Methods (continued)
Example 6: Discount versus Interest-only versus
Amortized loans

Roseanne wants to borrow $40,000 for a period of 5 years.
The lenders offers her a choice of three payment structures:
1) Pay all of the interest (10% per year) and principal in one lump sum
at the end of 5 years;
2) Pay interest at the rate of 10% per year for 4 years and then a final
payment of interest and principal at the end of the 5
th
year;
3) Pay 5 equal payments at the end of each year inclusive of interest
and part of the principal.
Under which of the three options will Roseanne pay the least interest
and why? Calculate the total amount of the payments and the amount
of interest paid under each alternative.
Methods (continued)
Method 1: Discount Loan.
Since all the interest and the principal is paid at the
end of 5 years we can use the FV of a lump sum
equation to calculate the payment required, i.e.
FV = PV x (1 + r)
n

FV
5
= $40,000 x (1+0.10)
5

= $40,000 x 1.61051
= $64, 420.40
Interest paid = Total payment - Loan amount
Interest paid = $64,420.40 - $40,000 = $24,420.40

Methods (continued)
Method 2: Interest-Only Loan.
Annual Interest Payment (Years 1-4)
= $40,000 x 0.10 = $4,000
Year 5 payment
= Annual interest payment + Principal payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $20,000

Methods (continued)
Method 3: Amortized Loan.
n = 5; I = 10%; PV=$40,000; FV = 0; CPT PMT=$10,551.86
Total payments = 5*$10,551.8 = $52,759.31
Interest paid = Total Payments - Loan Amount
= $52,759.31-$40,000
Interest paid = $12,759.31

Loan Type Total Payment Interest Paid
Discount Loan $64,420.40 $24,420.40
Interest-only Loan $60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.31

4.6 Amortization Schedules
Tabular listing of the allocation of each loan
payment towards interest and principal reduction
Helps borrowers and lenders figure out the payoff
balance on an outstanding loan.

Procedure:
1) Compute the amount of each equal periodic
payment (PMT).
2) Calculate interest on unpaid balance at the end of
each period, minus it from the PMT, reduce the
loan balance by the remaining amount,
3) Continue the process for each payment period,
until we get a zero loan balance.

(continued)
Example 7: Loan amortization schedule.
Prepare a loan amortization schedule for the
amortized loan option given in Example 6
above. What is the loan payoff amount at
the end of 2 years?

PV = $40,000; n=5; i=10%; FV=0;
CPT PMT = $10,551.89

(continued)

The loan payoff amount at the end of 2
years is $26,241.03
Year Beg. Bal Payment Interest Prin. Red End. Bal
1 40,000.00 10,551.89 4,000.00 6,551.89 33,448.11
2 33,448.11 10,551.89 3,344.81 7,207.08 26,241.03
3 26,241.03 10,551.89 2,264.10 7,927.79 18,313.24
4 18,313.24 10,551.89 1,831.32 8,720.57 9,592.67
5 9,592.67 10,551.89 959.27 9,592.67 0
4.7 Waiting Time and Interest
Rates for Annuities
Problems involving annuities typically have 4
variables, i.e. PV or FV, PMT, r, n
If any 3 of the 4 variables are given, we can easily
solve for the fourth one.
This section deals with the procedure of solving
problems where either n or r is not given.
For example:
Finding out how many deposits (n) it would take to reach a
retirement or investment goal;
Figuring out the rate of return (r) required to reach a
retirement goal given fixed monthly deposits,

Rates for Annuities (continued)
Example 8: Solving for the number of
annuities involved
Martha wants to save up $100,000 as soon
as possible so that she can use it as a down
payment on her dream house. She figures
that she can easily set aside $8,000 per
year and earn 8% annually on her deposits.
How many years will Martha have to wait
before she can buy that dream house?
Rates for Annuities (continued)
Example 8 Answer
Method 1: Using a financial calculator
INPUT ? 8.0 0 -8000 100000
TVM KEYS N I/Y PV PMT FV
Compute N 9.00647
Method 2: Using an Excel spreadsheet
Using the =NPER function we enter the following:
Rate = 8%; Pmt = -8000; PV = 0;
FV = 100000; Type = 0 or omitted;
i.e. =NPER(8%,-8000,0,100000,0)
The cell displays 9.006467.


4.8 Solving a Lottery Problem

In the case of lottery winnings, 2 choices
1) Annual lottery payment for fixed number of
years, OR
2) Lump sum payout.
How do we make an informed judgment?
Need to figure out the implied rate of return
of both options using TVM functions.


(continued)

Example 9: Calculating an implied rate
of return given an annuity
Lets say that you have just won the state
lottery. The authorities have given you a
choice of either taking a lump sum of
$26,000,000 or a 30-year annuity of
$1,625,000. Both payments are assumed to
be after-tax. What will you do?

(continued)
Example 9 Answer
Using the TVM keys of a financial calculator, enter:
PV=26,000,000; FV=0; N=30; PMT = -1,625,000;
CPT I = 4.65283%
4.65283% = rate of interest used to determine the 30-
year annuity of $1,625,000 versus the $26,000,000 lump
sum pay out.
Choice: If you can earn an annual after-tax rate of
return higher than 4.65% over the next 30 years,
go with the lump sum.
Otherwise, take the annuity option.

4.9 Ten Important Points about
the TVM Equation
1. Amounts of money can be added or subtracted
only if they are at the same point in time.
2. The timing and the amount of the cash flow are
what matters.
3. It is very helpful to lay out the timing and amount
of the cash flow with a timeline.
4. Present value calculations discount all future cash
flow back to current time.
5. Future value calculations value cash flows at a
single point in time in the future
the TVM Equation (continued)
6. An annuity is a series of equal cash payments at
regular intervals across time.
7. The time value of money equation has four variables
but only one basic equation, and so you must know
three of the four variables before you can solve for
the missing or unknown variable.
8. There are three basic methods to solve for an
unknown time value of money variable:
(1) Using equations and calculating the answer;
(2) Using the TVM keys on a calculator;
(3) Using financial functions from a spreadsheet.

the TVM Equation (continued)
9. There are 3 basic ways to repay a loan:
(1) Discount loans,
(2) Interest-only loans, and
(3) Amortized loans.
10. Despite the seemingly accurate answers from
the time value of money equation, in many
situations not all the important data can be
classified into the variables of present value,
i.e., time, interest rate, payment, or future
value.
Additional Problems with Answers
Problem 1
Present Value of an Annuity Due. Julie has just
been accepted into Harvard and her father is
debating whether he should make monthly lease
payments of $5,000 at the beginning of each
month, on her flashy apartment or to prepay the
rent with a one-time payment of $56, 662.If Julies
father earns1% per month on his savings should he
pay by month or take the discount by making the
single annual payment?

Problem 1 (Answer)
P/Y = 12; C/Y = 12; MODE = BGN
INPUT 12 -56,662 5,000 0
OUTPUT 12.70%

Monthly rate = 12.7%/12 = 1.0583%

If he can get 1% interest per month...then his annual rate is 12% and
he can generate $4,984.51 per month with the $56,662 it would take
to pay off the rent. He is ahead $15.49 per month by making the one
time payment.

INPUT 12 12 -56,662 0
OUTPUT 4,984.51

Problem 2
Future Value of Uneven cash flows. If Mary
deposits $4000 a year for three years, starting a
year from today, followed by 3 annual deposits of
$5000, into an account that earns 8% per year,
how much money will she have accumulated in her
account at the end of 10 years?

Problem 2 (Answer)
Future Value in Year 10 =
$4000*(1.08)
9
(she deposits 4K a year from today)
+ $4000*(1.08)
8

+ $4000*(1.08)
7

+ $5000*(1.08)
6

+ $5000*(1.08)
5

+ $5000*(1.08)
4

= $4000*1.999 + $4000*1.8509 + $4000*1.7138 +
$5000*1.5868 + $5000*1.4693 + $5000*1.3605
=$7,996 + $7,403.6+ $6,855.2+ $7,934 + $7,346.5 +
6,802.5
=$44,337.8

Problem 2 (Answer) (continued)
ALTERNATIVE METHOD:
Using the Cash Flow (CF) key of the calculator, enter
the respective cash flows.
CF
0
=0;CF
1
=-$4000;CF
2
=-$4000;CF
3
=-$4000;
CF
4
=-$5000; CF
5
=-$5000; CF
6
=-$5000
Next calculate the NPV using I=8%;
NPV=$20,537.30;
Finally, using PV=-$20,537.30; n=10; i=8%; PMT=0;
CPT FV$44,338
Problem 3
Present Value of Uneven Cash Flows:
Jane Bryant has just purchased some
equipment for her beauty salon. She plans
to pay the following amounts at the end of
the next five years: $8,250, $8,500,
$8,750, $9,000, and $10,500. If she uses a
discount rate of 10 percent, what is the cost
of the equipment that she purchased today?

Problem 3 (Answer)

$33,765.58
$6,519.67 $6,147.12 $6,574 $7,024.79 $7,500
(1.10)
$10,500
(1.10)
$9,000
(1.10)
$8,750
(1.10)
$8,500
(1.10)
$8,250
PV
5 4 3 2
=
+ + + + =
+ + + + =
Problem 4
Computing Annuity Payment: The Corner Bar & Grill
is in the process of taking a five-year loan of $50,000
with First Community Bank. The bank offers the
restaurant owner his choice of three payment options:
1) Pay all of the interest (8% per year) and principal
in one lump sum at the end of 5 years;
2) Pay interest at the rate of 8% per year for 4 years
and then a final payment of interest and principal
at the end of the 5
th
year;
3) Pay 5 equal payments at the end of each year
inclusive of interest and part of the principal.
Under which of the three options will the owner pay the
least interest and why?
Problem 4 (Answer)
Option 1 Discount Loan:
Principal and Interest Due at end

Payment at the end of year 5 = FV
n
= PV x (1 + r)
n

FV
5
= $50,000 x (1+0.08)
5

= $50,000 x 1.46933
= $73,466.5
Interest paid = Total payment - Loan amount
Interest paid = $73,466.5 - $50,000 = $23,466.50

5 N
-50000 PV
8 I
0 PMT
CPT FV 73,466.5
Option 2: Interest-only Loan
Annual Interest Payment (Years 1-4)
= $50,000 x 0.08 = $4,000
Year 5 payment = Annual interest payment +
Principal payment
= $4,000 + $50,000 = $54,000
Total payment = $16,000 + $54,000
= $70,000
Interest paid = Total Payment Loan
Amount = 70000 50000 = $20,000

Option 3: Amortized Loan.
To calculate the annual payment of principal and
interest we can use the PV of an ordinary annuity
equation and solve for the PMT value using n = 5; I =
8%; PV = $50,000, and FV = 0.
CPT PMT $12,522.82
Total payments = 5*$12,522.82 = $62,614.11

Total Interest = Total Payments - Loan Amount
= $62,614.11-$50,000
= $12,614.11

Comparison of total payments and interest paid
under each method

Loan Type Total Payment Interest
Paid
Discount Loan $73,466.5 $23,466.50
Interest-only Loan $70,000.00 $20,000.00
Amortized Loan $62,614.11 $12,614.11

So, the amortized loan is the one with the lowest
interest expense, since it requires a higher annual
payment, part of which reduces the unpaid
balance on the loan and thus results in less
interest being charged over the 5-year term.

Problem 5
Loan amortization. Lets say that the restaurant
owner in Problem 4 above decides to go with the
amortized loan option and after having paid 2
payments decides to pay off the balance. Using an
amortization schedule calculate his payoff amount.
Amount of loan = $50,000;
Interest rate = 8%;
Term = 5 years;
Annual payment (PMT) = $12,522.82

Problem 5 (Answer)
AMORTIZATION SCHEDULE
Year
Beg. Bal. PMT Interest Prin. Red. End Bal.
1 50,000.00 12,522.82 4,000.00 8,522.82 41,477.18
2 41,477.18 12,522.82 3,318.17 9,204.65 32,272.53
3 2,272.53 12,522.82 2,581.80 9,941.02 22,331.51
4 22,331.51 12,522.82 1,786.52 10,736.30 11,595.21
5 11,595.21 12,522.82 927.62 11,595.21 0

The loan payoff amount at the end of 2
years is $32,272.53
Figure 4.2 The time line of a $1,000-
per year nest egg.

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Chapter 4

The Time Value

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