Chapter 3 – Important Stuff
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Transcript of Chapter 3 – Important Stuff
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Chapter 3 – Important Stuff
• Mechanics of compounding / discounting
• PV, FV, PMT – lump sums and annuities
• Relationships – time, interest rates, etc
• Calculations: PV’s, FV’s, loan payments, interest rates
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Time Value of Money (TVM)
• Time Value of Money – relationship between value at two points in time– Today versus tomorrow; today versus
yesterday– Because an invested dollar can earn interest,
its future value is greater than today’s value
• Problem types: monthly loan payments, growth of savings account; time to goal
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Financial Calculator Keys
• PV - Present value
• FV - Future value
• PMT- Amount of the payment
• N - Number of periods (years?)
• I/Y - Interest rate per period
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TI Calculator ManualStrongly Suggested Readings
• Getting Started – page 6 and 7
• Overview – page 1-4, 1-10 and 1-20
• Worksheets – pages 2-14 and 2-15
• TVM – 3-1 to 3-9
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Calculator Tips
Decimals and Compounding Periods
• 2nd (gray), Format (bottom row), 4, enter, CE/C (lower left) - hit twice
• Compounding: 2nd , I/Y, 1, enter, CE/C – extremely important !!
• Right arrow key fixes “misteaks”
• One cash flow must be negative or error
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Concept of Compounding
• Compound Interest – basically interest paid on interest
• Takes interest earned on an investment and reinvests it– Earn interest on the principal and reinvested
interest
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Compound Interest @ 6%
Year Begin InterestFutureVal
1 $100.00 $6.00 $106.00
2 106.00 6.36 112.36
3 112.36 6.74 119.10
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Future Value (FV)
Algebraically FVn = PV (1 + i)n
Underlies all TVM calculations
Keystrokes: 100 +/- PV; 3 N; 0 PMT;
6 I/Y; CPT FV = 119.10
One cash flow must be negative
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FV – Other Keystrokes
• How long for an investment to grow from $15,444 to $20,000 if earn 9% when compounded annually? Must solve for N.
• 15444 +/- PV; 20000 FV; 0 PMT; I/Y 9; CPT N = 3 years
• What rate earned if start at $15,444 to reach $20,000 in 3 years? Solve for I/Y.
• 15444 +/- PV; 20000 FV; 0 PMT; 3 N; CPT I/Y = 9%
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Future Value Interest Factor
Year @2% @6% @10%
1 1.020 1.060 1.100
2 1.040 1.124 1.210
3 1.104 1.191 1.611
10 1.219 1.791 2.594
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FV Can Be Increased By
1. Increasing the length of time it is compounded
2. Compounding at a higher rate
And/or
3. Compounding more frequently
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Present Value (PV)
If I earn 10%, how much must I deposit
today to have $100 in three years? $75.10
This is “inverse compounding”
Discount rate – interest rate used to bring (discount) future money back to present
For lump sums (only) PV and FV are reciprocals
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Present Value Interest Factor
@2% @5% @10%
Year 1 .980 .952 .909
Year 2 .961 .907 .826
Year 3 .942 .864 .751
Year 10 .820 .614 .386
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Present Value Formula
[ 1 ]
PV = FVn [ (1 + i) n ]
PVIF and FVIF for lump sums only are reciprocals. For 5% over ten years
FVIF = 1.629 = 1 / .614PVIF = .614 = 1 / 1.629
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Keystrokes$100 @5% for ten years
• For PV 100 FV; 0 PMT; 5 I/Y; 10 N;
CPT PV = 61.39
• For I/Y 100 FV; 0 PMT; +/-61.39 PV;
10 N; CPT I/Y = 5
• For N 100 FV; +/-61.39 PV; 0 PMT;
5 I/Y; CPT N = 10 years
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PV Decreases If
1. Number of compounding periods (time) increases,
2. The discount rate increases,
And/or
3. Compounding frequency increases
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Annuities
• Series of equal dollar payments– Usually at the end of the year/period
• If I deposit $100 in the bank each year starting a year from now, how much will I have at the end of three years if I earn 6%? $318.36
• We are solving for the FV of the series by summing FV of each payment.
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FV of $100 Annuity @ 6%
End of
PMT FVIF $
Year 3 $100 1.0000 * $100.00
Year 2 100 1.0600 106.00
Year 1 100 1.1236 112.36
$318.36
* The payment at end Year 3 earns nothing
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Annuity Keystrokes
What will I have if deposit $100 per year starting at the end of the year for three years and earn 6%?
0 PV; 100+/- PMT; 3 N; 6 I/Y;
CPT FV = 318.36
PV is zero - nothing in the bank today
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Present Value of an Annuity
Amount we must put in bank today to
withdraw $500 at end of next three years
with nothing left at the end?
Present valuing each of three payments
Keystrokes: 500+/- PMT; 0 FV; 3 N;
6 I/Y; CPT PV = 1,336.51
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Nonannual Compounding
• Invest for ten years at 12% compounded quarterly. What are we really doing?– Investing for 40 periods (10 * 4) at 3%
(12%/4)
• Make sure 2nd I/Y is set to 1.
• Need to adjust rate per period downward which is offset by increase in N
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Nonannual Compounding
• FVn = PV ( 1 = i/m) m * n
• m = number of compounding periods per year so per period rate is i/m
• And m * n is the number of years times the compounding frequency which adjusts to the rate per period
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Compounding $100 @10%
Compounding One Year 10 Years
Annually $110.00 $259.37
Semiannually 110.25 265.33
Quarterly 110.38 268.51
Monthly 110.47 270.70
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Amortizing Loans
• Paid off in equal installments– Makes it an annuity
• Payment pays interest first, remainder goes to principal (which declines)
• $600 loan at 15% over four years with equal annual payments of $210.16
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$600 Loan Amortization
Total To Int To Prin End Bal
Year 1 210.16 90.00 120.16 479.84
Year 2 210.16 71.98 138.18 341.66
Year 3 210.16 51.25 158.91 182.75
Year 4 210.16 27.41 182.75 0
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Calculate a Loan Payment
• $8,000 car loan payable monthly over three years at 12%. What is your payment?
How many monthly periods in 3 yrs? 36 NMonthly rate? 12%/12 = 1%/mo = I/YWhat is FV? Zero because loan paid out8000+/- PV; 0 FV; 1.0 I/Y; 36 N; CPT PMT=265.71
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Perpetuities
• Equal payments that continue forever– Like Energizer Bunny and preferred stock
• Present Value = Payment Amount
Interest Rate
Preferred stock pays $8/yr, int rate- 10%
Payment fixed at $8/ .10 = $80 market price