Using TI BAII plus

N number of periods
I/Y interest rate per period
PV present value
FV future value
PMT annuity or constant periodic cash flow
CPT - compute key

Set P/Y key to 1

Level Cash Flows: Perpetuities & Annuities.

Annuities: Cash flows of equal amount every period for a

limited number of periods.
Example: Loan payments for automobile, periodic
earnings from lottery wins, etc..

Perpetuities: Cash flows of equal amount every period

for an unlimited number of periods.
Example: Property tax payments, preferred stocks, etc..
Perpetuities
Present Value:
The PV of a perpetuity is calculated by dividing
the level cash flow by the interest rate.

0 1 2 3 .

PV C C C C C

C Note: This formula gives you the

PV of a perpetuity = present value of a perpetuity
r starting one period from now
Perpetuities
Example:
In order to create an endowment, which pays $100,000
per year, forever, how much money must be set aside
today if the rate of interest is 10%?

0 1 2 .

PV $100,000 $100,000 $100,000

$100,000 = $1,000,000
PV of perpetuity =
0.10
Perpetuities
Example contd.:
If the first perpetuity payment will not be received until
four years from today, how much money needs to be set
aside today?
0 1 2 3 4 5 .
10% 10%
10%

PV $100,000 $100,000 $100,000

$100,000 = $1,000,000
PV at end of Year 3 =
0.10

$1,000,000
PV today = = $751,315
(1.10)3
Annuities
Present Value: The PV of a t period annuity with
cash flow of C and discount rate r is given by:

0 1 2 3 . t

PV C C C C C

1 1
C
PV of t-period annuity = t
r r (1 r )

Note: This formula gives you the present value of an annuity

starting one period from now. This is called a regular annuity.
Annuities
Present Value Interest Factor of Annuity:

In the present value formula for an annuity

1 1
C
r
r (1 r ) t

the term in the parentheses is called the Present Value Interest Factor
of an annuity (PVIFA).
There is a table that can be used to find present values of $1
annuities for different rates and time periods, as shown in the next
slide.
Annuities
Annuities
Example: You are purchasing a car. You are scheduled to make
3 annual installments of $4,000 per year, with the first
payment one year from now. Given a rate of interest of 10%,
what is the price you are paying for the car?
0 1 2 3
10% 10% 10%

$4,000 $4,000 $4,000

1 1
PV of 3-period annuity = $4,000
3
$9,947.41
0.10 0.10(1 0.10)

Or, from the PVIFA table = $4,000 x 2.487 = $9,947.41

Annuities
Future Value: The FV of a t period annuity with cash
flow of C and discount rate r is given by:

0 1 2 3 . t

C C C C FV

FV of t-period annuity = C x [(1 + r)t 1]

r
Note: This formula gives you the future value of an annuity
starting one period from now. This is called a regular annuity.
Annuities
Future Value Interest Factor of Annuity:

In the future value formula for an annuity, the term

[(1 + r)t 1]
r
is called the Future Value Interest Factor of an annuity (FVIFA).
There is a table that can be used to find future values of $1
annuities for different rates and time periods, as shown in the
next slide.
Annuities
Annuities

Annuities Due:

A level stream of payments starting immediately, is known

as an annuity due. The difference between an annuity
due and a regular annuity is shown in the following
example.
Annuities
A Few Problems

Find the investment period that will convert $1000 into

$2000 if the interest rate is 8% (annual compounded)

At what interest rate (annual compounded) will $500

grow to $2000 in 15 years

PV of four end-of-period payments of $100, with the first

payment to be received three years from today (assume
8% annual compounded)
Growth in Annuities & Perpetuities
A growing perpetuity with a growth rate of g has a PV
that can be shown as:

0 1 2 3 .

PV C C(1+g) C(1+g)2 C(1+g)3

PV of a growing C
perpetuity = r-g
Growth in Annuities & Perpetuities
A growing annuity with a
growth rate of g has a PV that
can be shown as:

0 1 2 3 . t

PV C C(1+g) C(1+g)2 C(1+g)3

C1 1 g
T
PV of growing annuity 1
r g 1 r


 Inflation and the Time Value of Money
Inflation: Rate at which prices as a whole are increasing.
Nominal interest rate: Rate at which money invested grows.
Real interest rate: Rate at which the purchasing power of
an investment increases.

Technically speaking: 1 + Real rate = 1 + Nominal Rate

1 + Inflation Rate

Which can be approximated to saying:

Real rate of interest = Nominal rate of interest Inflation rate

Inflation and the Time Value of Money
Example:
If the interest rate on one year government bonds is 5.0% and
the inflation rate is 2.2%, what is the real interest rate?

Real interest rate = [(1+ 0.05)/(1+0.022)]-1 = 1.027-1 =

2.7%

Real interest rate 5% - 2.2% = 2.8%

Aside: real/real = nominal/nominal

Inflation and the Time Value of Money
Effective Annual Interest Rate [EAR]: Interest rate that is
annualized using compound interest

Annual Percentage Rate [APR]: Interest rate that is annualized

using simple interest.

If m is the number of compounding per year, then we can say:

m
APR
EAR 1 1
m
Inflation and the Time Value of Money
Example:
Given a monthly rate of 1%, what is the Effective Annual Rate
[EAR]? What is the Annual Percentage Rate [APR]?

APR = 1% x 12 = 12%

12
0.12
EAR 1 1 12.68%
12
Summary
Future value (FV) is the amount to which an
investment will grow after earning interest.

The present value (PV) of a future cash payment

is the amount you would need to invest today to
create that future cash payment.

A level stream of payments which continues

forever is called a perpetuity.

One which continues for a limited number of

years is called an annuity.
Summary
You can use the FV and PV formulas to calculate
their value or you can use the shortcut formulae.

Annual percentage rates (APR) do not recognize

the effect of compound interest, that is, they
annualize assuming simple interest.

Effective Annual Rates (EAR) annualize using

compound interest.