Time Value of Money-2
Time Value of Money-2
Time Value of Money-2
Money
FV= PV ( 1+ It)
FV= $100 ( 1+ 0.05*3)= $115
Self- Test
Explain why this statement is true: A dollar in hand today is worth more
than a dollar to be received next year.
What is compounding? What’s the difference between simple interest and
compound interest? What would the future value of $100 be after 5
years at 10% compound interest? At 10% simple interest?
Suppose you currently have $2,000 and plan to purchase a 3-year
certificate of deposit (CD) that pays 4% interest compounded annually.
How much will you have when the CD matures? How would your answer
change if the interest rate were 5% or 6% or 20%?
Present Value
Finding a present value is the reverse of finding a future value.
Finding present values is called discounting.
Discounting : The process of finding the present value of a cash flow
or a series of cash flows; discounting is the reverse of compounding.
Present Value ( Example )
A broker offers to sell you a Treasury bond that will pay $115.76 three
years from now. Banks are currently offering a guaranteed 5% interest on
3-year certificates of deposit (CDs), and if you don’t buy the bond, you will
buy a CD.
The 5% rate paid on the CDs is defined as your opportunity cost,
Opportunity cost: the rate of return you could earn on an alternative
investment of similar risk.
What’s the most you should pay for the bond?
Present Value ( Example )
FV = $115.76
Interest Rate = 5%
No of period (t/N)= 3
Time lines for a $100, 3-year, 5% ordinary annuity and for an annuity due.
Future Value of Ordinary Annuities
You deposit $100 at the end of each year for 3 years and earn 5% per year.
How much will you have at the end of the third year?
The first payment earns interest for two periods, the second payment earns
interest for one period, and the third payment earns no interest at all
because it is made at the end of the annuity’s life.
Each payment occurs one period earlier with an annuity due, all of the
payments earn interest for one additional period.
FV of an annuity due will be greater than that of a similar ordinary
annuity.
Present Value of Ordinary Annuity
PVA(N)= (The present value of an annuity of N periods.
Present Value of Ordinary Annuity
PVA(N)= (The present value of an annuity of N periods.
Self- Test 3
You just won the Florida lottery. To receive your winnings, you must
select ONE of the two following choices:
You can receive $1,000,000 a year at the end of each of the next 30
years.
You can receive a one-time payment of $15,000,000 today.
Assume that the current interest rate is 6%.
Which option is most valuable?
Option 1: 1,000,000 a year at the end of each of the next 30 years.
FV of Annuity = 1,000,000 , N= 30 years, I= 6%
Option 2: $15,000,000 today
Perpetuities
A stream of equal payments at fixed intervals expected to continue
forever.
Perpetuities (Example )
You buy preferred stock in a company that pays you a fixed dividend of
$2.50 each year the company is in business. If we assume that the
company will go on indefinitely, the preferred stock can be valued as a
perpetuity. "
If the discount rate on the preferred stock is 10%, what is the present
value of the perpetuity, the preferred stock ?
Perpetuities
A stream of equal payments at fixed intervals expected to continue
forever.
Uneven Cash Flows
We can find the PV of either stream by discounting each cash flow and
then sum them to find the PV of the stream:
PV of Uneven Cash Flows (Example)