© 2010 Financial Management

Fundamentals of Financial Management,

m Prepared by: Amyn Wahid
 —ecap

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 Time Value Terminology
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× Future value (FV) is the amount an

investment is worth after one or more
periods. (for future value you always
compound)
× Present value (PV) is the current value
of future cash flows of an investment.
(for present value you always discount)

 Time Value Terminology
× !he number of time periods between
the present value and the future
value is represented by µt¶ or µn¶.

× !herate of interest for discounting or

compounding is called µr¶ or µi¶.
× All time value questions involve four
values: PV, FV, n and i. Given three
of them, it is always possible to
calculate the fourth.

 Types of Interest

× Simple Interest
Interest paid (earned) on only the
original amount, or principal borrowed
(lent).
× ompound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

 General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIF
FVIFi,n) -- ee Table I
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 án Example
uulie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

ë m M   5
10%
$10,000
FV5
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 tory Problem olution
× alculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
× alculation based on !able I:
FV5 = $10,000 (FVIF
FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [[ue to Rounding]
^
 Present Value
ingle [eposit (Graphic)
Assume that you need $1,000 in 2 years.
Let¶s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
ë 1 2
7%
$1,000
PV0 PV1
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 Present Value
ingle [eposit (Formula)

PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2

= FV2 / (1+i)2 = $873.44

ë 1 2
7%
$1,000
PV0
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 General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIF
PVIFi,n) -- ee Table II
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 Valuation Using Table II
PVIFi,n is found on !able II at the end
of the book.
Period 6% 7% 8%
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 Using Present Value Tables
PV2 = $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to —ounding]
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 Example
Îour rich grandmother promises to give
you $10000 in 10 years¶ time. If interest
rates are 12% per annum, how much is
that gift worth today?

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 tory Problem Example
uulie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a discount
rate of 10%.
ë m M   5
10%
$10,000
PV0
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 tory Problem olution

× alculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
× alculation based on !able I:
PV0 = $10,000 (PVIF
PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [[ue to Rounding]
mj
 olving for the [iscount Rate (i)

× Îou currently have $100 available for investment for a

21 year period. At what interest rate must you invest
this amount in order for it to be worth $500 at
maturity?
× Given any three factors in the present value or future
value equation, the fourth factor can be solved.
i can be solved by one of the 2 ways:
× take the nth root of both sides of the equation; or
× use the future value tables to find a corresponding
value. In this example, the FVIF after 21 years is 5.
× r = 7.97%
mÔ
 olving for the Time Periods (n)

× †owlong does it take to double $5,000 at a

compound rate of 12% per year (approx.)?
n can be solved by one of the 2 ways:
× take logs on both sides of the equation; or
× use the future value tables to find a
corresponding value.
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6.116 yrs
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 The Rule of 72
× !he µ—ule of 72¶ is a handy rule of thumb
that states:
If you earn r % per year, your
money will double in about 72 / r %
years.
× For
example, if you invest at 6%, your
money will double in about 12 years.

× !his rule is only an approximate rule.

mÑ
 Practice Questions
1. What would $100 be worth after 5 years at a rate of 15%?
2. Îou have located an investment that pays 12%. !he rate sounds
good to you, so you invest $400. †ow much will you have in 3
years?
3. Suppose you need $400 to buy text books next year. Îou can
earn 7% on your money. †ow much do you have to put up
today?
4. Suppose you need to have $1000 in 4 years. If you can earn 8%,
how much do you need to invest to make sure you have $1000
when you need it?
5. Îou would like to buy a new automobile. Îou have about
$50,000, but the car cost around $68500. If you can earn 15% ,
can you buy the to buy the car in 2 years time if the cost of the
car is expected to remain same . Do you have enough?
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 Practice Questions
6. Îour company proposes to buy an asset for $335. !his
investment is very safe. Îou will sell off the asset in 3 years for
$400. Îou know that you could invest the $335 elsewhere at 10%
with very little risk. Should you go for the investment?
7. Îou are considering a one year investment. If you put up $1,250,
you will get back $1350. What rate is the investment paying?
8. Îou estimate that you will need about $80,000 to send your child
to college in 8 years. Îou have about $35,000 now. If you earn
12% per year, will you make it?At what rate, will you just reach
your goal?
9. Suppose we are interested in purchasing an asset that cost
$50,000. We currently have $25,000. If we can earn 12% on this
$25,000, how long until we have the $50,000
10. Îou have been saving funds to buy the Giant ompany. !he total cost
will be $10 million. Îou currently have about $2.3 million. IF you can earn
5% on your money, how long will you have to wait?
Mm
 ánswers

1. $201.1357 6. No. Îou can make $445.89

2. $561.9712 in the other alternative

3. $373.83 7. 8%

4. $735.03 8. $86658.71( Î S), 10.89%

5. Îou are still about 9. 6.1163 years

$2,375 short 10. 30.13 years

MM
 ánnuities

× án ánnuity represents a series of equal payments (or

receipts) occurring over a specified number of
equidistant periods. Payments or receipts normally
occur at the end of each period.
ù xamples include consumer loans, car loan
payments, student loan payments, insurance
premiums and home mortgages.
× A perpetuity is an annuity in which the cash flows
continue forever.

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 Types of ánnuities

× ârdinary Annuity
Annuity: Payments or
receipts occur at the end of each
period.
× Annuity Due:
Due Payments or
receipts occur at the beginning of
each period.

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 Parts of an ánnuity

nd of nd of nd of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

!oday qual ash Flows

ach 1 Period Apart
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 Parts of an ánnuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

!oday qual ash Flows

ach 1 Period Apart
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 âverview of an
ârdinary ánnuity -- FVá
ash flows occur at the end of the period
0 1 2 n n+1
i% . . .
— — —
— = Periodic
ash Flow

FVAn
FVAn = —(1+i)n-1 + —(1+i)n-2 +
... + —(1+i)1 + —(1+i)0
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 Example of an
ârdinary ánnuity -- FVá
ash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
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 Valuation Using Table III
FVAn = — (FVIFAi%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215 (D to —)
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 §uture Value of an ánnuity

× FVA =—[ n
(1+i) ±1 ]
i

[
1000 (1+0.07)3 ±1] = $3214.9

0.07
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 âverview View of an
ánnuity [ue -- FVá[
ash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
— — — — —

FVADn = —(1+i)n + —(1+i)n-1 + FVADn

... + —(1+i)2 + —(1+i)1
= FVAn (1+i)
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 Example of an
ánnuity [ue -- FVá[
ash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070

$1,145
$1,225
FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3
2
$1,000(1.07) + $1,000(1.07) 1

= $1,225 + $1,145 + $1,070

= $3,440
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 Valuation Using Table III

FVADn = — (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440 (D to —)
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 âverview of an
ârdinary ánnuity -- PVá
ash flows occur at the end of the period
0 1 2 n n+1
i% . . .
— — —

— = Periodic
ash Flow
PVAn
PVAn = —/(1+i)1 + —/(1+i)2
+ ... + —/(1+i)n

 Example of an
ârdinary ánnuity -- PVá
ash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$ 934.58
$ 873.44
$ 816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30


= $2,624.32
 Valuation Using Table IV
PVAn = — (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624 (D to —)
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 Present Value of an
ánnuity
× PVA = — 1± 1
(1+i)n
i

10001 ± 1 (1 + 0.07)3 =
$2624.3
0.07
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 âverview of an
ánnuity [ue -- PVá[
ash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
— — — —

—@  
PVADn  

PVADn = —/(1+i)0 + —/(1+i)1 + ... + —/(1+i)n-1

= PVAn (1+i)
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 Example of an
ánnuity [ue -- PVá[
ash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
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 Valuation Using Table IV

PVADn = — (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808 (D to —)
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 Perpetuity

×A perpetuity is an ordered annuity

whose payments or receipts
continue forever
PVA’= — / i
= $100 / 0.08
= $1,250

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 è á
PLè

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 olving for the
ánnuity Payment 

× Suppose we want to know the
amount that we have to deposit in
order to accumulate a given sum
after a number of years
e.g $10,000 down payment required
after 5 years †ow much you need to
save every year at 4 % interest rate?


 omputations Using
Table III
×FVAn = — (FVIFAi%,n)
$10,000 = — (FVIFA4%,5)
$10,000 = — (5.416)
— = $1846.38

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 omputations
Using Formula
ƒ  Ú 
 X  


ƒ ë 
ëëëë X  

ëë
X    
ëëëë
X
 
X


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 olving for the number of

periods in an annuity (n)
× Suppose we want to know the
number of years it would take a
certain amount to accumulate a
given sum
× .g the same question as before but
now we are given the annual
payment of $1846.27 and we have to
find the number of years

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 omputations Using
Table III
× FVAn = — (FVIFAi%,n)
× $10,000 = 1846.27 (FVIFA4%,n)
(FVIFA4%,n) = (5.416)
n = 5 periods
i,e 5 years

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 omputations
Using Formula
ƒ  Ú 
 X  


ƒ ë Ú 
ëëëë X  
 

ëë
Ú
ë
 X   ë
ÚÚ 
Ú 

Ú 
Ú ë
Ú  
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 olving for the interest rate
in an annuity (i)
×Suppose we want to know
interest rate now and the other
things are known to us.
× .g using the same example we
would find the interest rate and
hence verify that it is 4%.

Ñ
 omputations Using
Table III
× FVAn = — (FVIFAi%,n)
$10,000 = 1846.27 (FVIFAi%,5)
(FVIFAi%,5) = (5.416)
i = 4%

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 omputations
Using Formula
ƒ   Ú 
   


ƒ   
ëëëë   
  


       

!  Ú     Ú Ú

Ú      Ú   
Ú !Ú     Ú 

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 pixed Flows Example
uulie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%
10%?

ë m M   5
10%
$600 $600 $400 $400 $100
PV0

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 How to olve?

1. Solve a ³piece
piece--at- timel by
at-a-time
discounting each piece back to t=0.
2. Solve a ³group
group--at- timel by first
at-a-time
breaking problem into groups of
annuity streams and any single
cash flow group. !hen discount
each group back to t=0.


 Piece--át-
Piece át-á-Time´

ë m M   5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow


 Group--át-
Group át-á-Time´ (#1)
ë m M   5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.30 = PV0 of Mixed Flow [Using !ables]
$600(PVIFA10%,2) = $600(1.736) = $1,041.60
$400(PVIFA10%,4) ± $400(PVIFA10%,2)
=$400(3.170)± $400(1.736) = $573.60

$100 (PVIF10%,5) = $100 (0.621) = $62.10

 Group--át
Group át--á-Time´ (#2)
ë m M  

$400 $400 $400 $400

$1,268.00
ë m M PV0 equals
Plus
$200 $200 $1677.30.
$347.20
ë m M  

Plus
$100
$62.10

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 Present Value of
pultiple Cash Flows Example
× Îou deposit $1,500 in one year, $2000 in two
years and $2,500 in three years in an account
paying 10% interest per annum. What is the
present value of these cash flows?

$2 500 (1.10)-3 = $1 878

$2 000 (1.10)-2 = $1 653
$1 500 (1.10)-1 = $1 364
!otal = $4 895

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 Future Value of
pultiple Cash Flows Example
× Îou deposit $1,000 now, $1,500 in one year,
$2,000 in two years and $2,500 in three years in
an account paying 10% interest per annum. †ow
much do you have in the account at the end of
the third year?
$1 000 (1.10)3 = $1 331
$1 500 (1.10)2 = $1 815
$2 000 (1.10)1 = $2 200
$2 500 1.00 = $2 500
!otal = $7 846

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 ·neven eries of Payment Date
( án èample)

 B ow will  c iv  h s  of c
sh flows b low. Wh

is  h   s   V
lu

discou  
 of 10%?
10% If 

B ow w
s d posi i g  h c
sh flows i s
d d    i  h
Fu u V
lu
  h s
 discou  


Î
 m
  


       m

 V = $2870.92

Ñ FV = $5086.01
 Effective ánnual
Interest Rate
ffective Annual Interest —ate
!he actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1

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 ËW¶s Effective
ánnual Interest Rate
Ëasket Wonders (ËW) has a $1,000
D at the bank. !he interest rate
is 6% compounded quarterly for 1
year. What is the ffective Annual
Interest —ate ( A—
A—)?
A— = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
jm
 Frequency of Compounding

General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Îears
m: ompounding Periods per Îear
i: Annual Interest —ate
FVn,m: FV at the end of Îear n
PV0: PV of the ash Flow today
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 Impact of Frequency

uulie Miller has $1,000 to invest for 2

years at an annual interest rate of
12%.
Annual FV2 1,000(1+ [.12/1])(1)(2)
= 1,000
= 1,254.40
Semi FV2 1,000(1+ [.12/2])(2)(2)
= 1,000
= 1,262.48
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 Impact of Frequency

 rtly FV2 1,000(1+ [.12/4])(4)(2)

= 1,000
= 1,266.77
Monthly FV2 1,000(1+ [.12/12])(12)(2)
= 1,000
= 1,269.73
Daily FV2 1,000(1+[.12/365])(365)(2)
= 1,000
= 1,271.20

j
 Comparison different
effective rates of return?
× An investment with monthly payments is different
from one with quarterly payments. Must put each
return on an FF% basis to compare rates of
return. Must use FF% for comparisons. See
following values of FF% rates at various
compounding levels.
A—ANNUAL 10.00%
A— UA—! —LÎ 10.38%
A—MâN!†LÎ 10.47%
A—DAILÎ (365) 10.52%
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 Can the EáR ever be

equal to the nominal rate?

×Îes, but only if annual

compounding is used, i.e., if m
= 1.
×Ifm > 1, FF% will always be
greater than the nominal rate.

jj
 ámortizing a loan

×Installment type loan that is repaid

in equal periodic payments that
include both interest and principal.
!hese payments can be made
annually, semi annually, monthly
etc

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 teps to ámortizing a Loan
( án âverview)
1. alculate the payment per period.
2. Determine the interest in Period t.
(Loan balance at t-1) x (i% / m)
3. ompute principal payment in Period t.
(Payment - interest from tep 2)
4. Determine ending balance in Period t.
(Ëalance - principal payment from tep 3)
5. Start again at Step 2 and repeat.
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 ámortizing a Loan Example
uulie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV0 = — (PVIFA i%,n)
$10,000 = — (PVIFA 12%,5)
$10,000 = — (3.605)
— = $10,000 / 3.605 = $2,774
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 ámortizing a Loan Example

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 Àllustration with a
simple eample
× Suppose you borrow $22,000 at 12%
compound annual interest to be
repaid over the next 6 years.
first step is to calculate — ( annual
× !he
payment)
PV0 = — (PVIFA i%,n)
$22,000 = — (PVIFA 12%,6)
$22,000 = — (4.111)
— = $22,000 / 4.111 = $5350.97
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 ènd of hapter

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