Finance 1 – Tutorial 2

The three rules of time travel

v Rule 1: Only values at the same point in time can be compared or combined

v Rule 2: To move a cash flow forward in time, you must compound it.
o Future value of a Cash Flow:
"
𝐹𝑉! = 𝐶× 1 + 𝑟
v Rule 3: To move a cash flow back in time, you must discount it.
o Present Value of a Cash Flow:

𝐶
𝑃𝑉 = "
1+𝑟

v Future Value of a Cash Flow Stream with a Present Value of PV:

!
𝐹𝑉! = 𝑃𝑉× 1 + 𝑟
4.4 0 1 2 3 n

What is the present value

of $13000 received PV = ? $13,000

a) Fourteen years from

today when the interest a) Calculation
rate is 10% per year? $13,000
b) Twenty-eight years PV = !" = $3,423.31
1.1
from today when the
interest rate is 20% per
b) Calculation
year? $13,000
PV = #$ = $78.86
c) Seven years from 1.2
today when the interest c) Calculation
rate is 5% per year? $13,000
PV = % = $9,238.86
1.05
4.8 𝑃𝑉 =
$108,000
= $71,826.17
Your daughter is currently 1.06%
11 years old. You
anticipate that she will be
going to college in seven
years. You would like to
have $108,000 in savings
account to fund her
education at that time. If
the account promises to
pay a fixed interest rate of
6% per year, how much
money do you need to put
into the account today to
ensure that you will have
$108,000 in seven years?
4.12 a) Calculation
You have just received a
windfall from an investment $46,819 $93,638 $140,457
PV = ! + " + # = $208,751.56
you made in a friend’s 1.138 1.138 1.138
business. He will be paying
you $46,819 at the end of this
year, $93,638 at the end of
the following year, and b) Calculation
$140,457 at the end of the
𝐹𝑉 = $208,751.56×1.138# = $307,649.71
year after that (three years
from today). The interest rate § Alternative approach:
is 13.8% per year.
a) What is the present value FV
of your windfall? = $46,819×1.138" + $93,638×1.138!
b) What is the future value of + $140,457×1.138$ = $307,649.71
your windfall in three
years (on the date of the
last payment)?
4.14 a) Calculation:
You have been offered a 𝑁𝑃𝑉 = −𝑃𝑉 𝑐𝑜𝑠𝑡𝑠 + 𝑃𝑉 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
unique investment
$750 $2250 $15000
opportunity. If you invest NPV = −$15,000 + + + = −$7,707.07
$15,000 today, you will 1.12! 1.12" 1.12!#
receive $750 one year from § No. The NPV is negative, therefore it’s not profitable to
now, $2250 two years from invest.
now, and $15,000 ten years
from now.
a) What is the NPV of the b) Calculation
investment opportunity if
$750 $2250 $15000
the interest rate is 12% NPV = −$15,000 + + + = −$5,428.64
1.08! 1.08" 1.08!#
per year? Should you take
the opportunity? § No. The NPV is negative, therefore it’s not profitable to
b) What is the NPV of the invest.
investment opportunity if
the interest rate is 8% per
year? Should you take the
opportunity?
4.20 § First, we need to find the 4-year effective
You are head of the interest rate.
Schwarz Family
%
Endowment for the Arts. 1 + 𝑟%& = 1 + 0.041
You have decided to fund %
𝑟%& = 1 + 0.041 − 1 = 0.1744
an arts school in the San
Francisco Bay area in
perpetuity. Every four
years, you will give the § Using the 4-year effective interest rate, we can
school $600,000. The first
find the present value of a perpetuity:
payment will occur four
years from today. If the 𝐶%&
interest rate is 4.1% per 𝑃𝑉 𝐶%& 𝑖𝑛 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
year, what is the present 𝑟%&
value of your gift? $600,000
𝑃𝑉 = = $3,440,367
0.1744
Annuities

v Present value of an annuity:

v Intuitively, the value of the annuity is the initial investment in the bank account (P) minus the present value of the principal that
will be left in the account after N periods.
𝑃 = 𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 𝐶 𝑓𝑜𝑟 𝑁 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 + 𝑃𝑉(𝑃 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑁)
𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 𝐶 𝑓𝑜𝑟 𝑁 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 = 𝑃 − 𝑃𝑉 𝑃 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑁
𝑃 1
=𝑃− !
=𝑃 1− !
1+𝑟 1+𝑟

𝐶
𝐶 = 𝑟×𝑃 ⇒ 𝑃 =
𝑟
1 1
𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑜𝑓 𝐶 𝑓𝑜𝑟 𝑁 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑤𝑖𝑡ℎ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟 = 𝐶× (1 − !
)
𝑟 1+𝑟

! " !
v Future value of an annuity: 𝐹𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑉× 1 + 𝑟 , Alternatively: 𝐹𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐶× ( 1 + 𝑟 − 1)
#

v For non-annual cash flows, the interest (r) and number of periods (N) must be adjusted to reflect the new time period.
4.22 § a) Time line:
You are 23 years old and
decide to start saving for your
retirement. You plan to save
$5000 at the end of each
year (so the first deposit will
be one year from now), and
will make the last deposit
when you retire at age 68.
Suppose you earn 9% per
year on your retirement 𝐶 1 $5,000 1
savings. 𝑃𝑉 = ⋅ 1 − & = 1−
𝑟 (1 + 𝑟) 0.09 1.09"'
= $54,405.99
a) How much will you have
saved for retirement?

𝐹𝑉 = $54,405.99×1.09"' = $2,629,293.67
4.22 § b) Timeline:
You are 23 years old and
decide to start saving for your 32 33 34 35 68
retirement. You plan to save 0 1 2 3 36
$5000 at the end of each
year (so the first deposit will
be one year from now), and 5,000 5,000 5,000 5,000
will make the last deposit
when you retire at age 68.
Suppose you earn 9% per
𝐶 1 $5,000 1
𝑃𝑉 = ⋅ 1 − & = 1−
year on your retirement 𝑟 (1 + 𝑟) 0.09 1.09()
savings.
= $53,058.81
b) How much will you have
saved if you wait until age
32 to start saving (again, 𝐹𝑉 = $53,058.81×1.09() = $1,180,623.61
with your first deposit at
the end of the year)?
4.32 § Approach 1: Use monthly interest, adjust
Suppose you currently have
$5000 in your savings the periods.
account, and your bank pays
interest at a rate of 0.46% per
𝑁 = 5×12 = 60
month. If you make no further 𝐹𝑉 = $5,000×1.0046)* = $6585.07
deposits or withdrawals, how
much will you have in the
account in five years?
§ Approach 2: Convert to annual interest
rate.
1 + 𝑟!+ = 1 + 𝑟!, !#

𝑟!+ = 1.0046!# − 1 = 0.0566

𝐹𝑉 = $5,000×1.0566' = $6585.07
4.41 § First, calculate the 2-year interest rate:
You are thinking about buying 1 + 𝑟"@ = (1 + 𝑟!@ )" ⇒
a piece of art that costs
𝑟"@ = 1.06" − 1 = 0.1236
$20,000. The art dealer is
proposing the following deal:
He will lend you the money,
and you will repay the loan by § We can now calculate the payment for a bi-annual
making the same payment annuity for 30 years (15 payments)
every two years for the next 𝐶 1
30 years (i.e., a total of 15 𝑃 = 𝑃𝑉 = (1 − )
𝑟 1+𝑟 A
payments). If the interest rate
is 6% per year, how much will
𝑃
you have to pay every two 𝐶=
years? 1 1
(1 − A)
𝑟 1+𝑟

$20,000
= = $2,993.14
1 1
0.1236 1 −
1.1236!B
4.41 𝐶 1
You are thinking about buying 𝑃 = (1 − &)
a piece of art that costs 𝑟 1+𝑟
$20,000. The art dealer is
proposing the following deal: 1 1
He will lend you the money, 𝑃 = 𝐶 ∗ (1 − &)
and you will repay the loan by
𝑟 1+𝑟
making the same payment
every two years for the next 𝑃
=𝐶
30 years (i.e. a total of 15 1 1
payments). If the interest rate 𝑟 (1 − &)
is 6% per year, how much will
1+𝑟
you have to pay every two
years? 𝑃
𝐶=
1 1
𝑟 (1 − &)
Mathematical Elaboration 1+𝑟
 § Timeline:
4.A1
Your grandmother bought an
annuity from Rock Solid Life
Insurance Company for
$200,000 when she retired.
In exchange for the • She breaks even when the NPV of the cash flows is zero. The value of
N that solves this is:
$200,000, Rock Solid will pay
her $25,000 per year until $25,000 1
𝑁𝑃𝑉 = −$200,000 + 1− =0
0.05 1.05!
she dies. The interest rate is
5%. How long mush she live 1 200,000×0.05
⇒ 1− = = 0.4
after the day she retired to 1.05! 25,000
come out ahead (that is, to 1
= 0.6
get more in value than what 1.05!
she paid in)? 1
⇒ 1.05! =
0.6
1
ln(1.05)! = l𝑛
0.6
𝑁 ⋅ 𝑙𝑛 1.05 = − l𝑛 0.6

l𝑛 0.6
𝑁=− = 10.5
l𝑛 1.05
• So if she lives 10.5 or more years, she comes out ahead.
 $25,000 1
−$200,000 + 1− 9 =0
0.05 1.05
4.A1 $25,000 1
Your grandmother bought an 1− = $200,000
0.05 1.059
annuity from Rock Solid Life
Insurance Company for 1 $200,000
$200,000 when she retired. 1− =
1.059 $25,000/0.05
In exchange for the
$200,000, Rock Solid will pay 1
her $25,000 per year until 1− = 0.4
1.059
she dies. The interest rate is
5%. How long mush she live 1
= 0.6
after the day she retired to 1.059 Alternatively, using log instead of ln:
"
come out ahead (that is, to 1 𝑁 = 𝑙𝑜𝑔".%& (%.') = 10.5
get more in value than what 1.059 =
she paid in)? 0.6
1
ln(1.05)9 = l𝑛
Mathematical Elaboration 0.6
𝑁 ⋅ 𝑙𝑛 1.05 = − l𝑛 0.6

l𝑛 0.6
𝑁=− = 10.5
l𝑛 1.05
5.7 v The annual percentage rate (APR), indicates the
Suppose the interest rate is amount of simple interest earned in one year.
7.1% APR with monthly
v Simple interest is the amount of interest earned without
compounding. What is the
present value of an annuity the effect of compounding.
that pays $95 every six
months for seven years?
v Monthly interest rate:
0.071
𝑟: = = 0.0059
12
v Effective rate for 6 months:
𝑟;: = 1 + 0.0059 ; − 1 = 0.036
v Present Value:
1 1
𝑃𝑉 = 95× × 1− <= = $1030.32
0.036 1.036
 v Effective interest rate for 8 months:

5.8 $34
You can earn $34 in interest 𝑟"# = = 0.034
$1000
on a $1000 deposit for eight
months. If the EAR is the
v Calculating the effective annual rate (EAR):
same regardless of the length
of the investment, determine
12 𝑚𝑜𝑛𝑡ℎ𝑠
how much interest you will 𝑁$%&'()* = = 1.5
8 𝑚𝑜𝑛𝑡ℎ𝑠
earn on a $1000 deposit for
+.-
a) 6 months. 𝐸𝐴𝑅 = 1 + 0.034 − 1 = 0.051

b) 1 year.
0 #(123*
c) 1.8 years. a) 𝑁.%/& = +4 #(123* = 0.5
5.-
1 + 0.051 − 1 ×$1000 = $25.39
b)
( 1 + 0.051 + −1)×$1000 = $51.43
c)
+."
1 + 0.051 − 1 ×$1000 = $94.47

v Generally, it’s possible to convert ANY effective rate to ANY effective

rate without going through the EAR
5.14 vSince the payments are monthly, we need to
convert all the variables to a monthly basis
You have decided to
refinance your mortgage. You
plan to borrow whatever is vNumber of periods remaining for the mortgage
outstanding on your current (in months):
mortgage. The current
monthly payment is $2646
and you have made every 𝑁 = 30×12 − 4×12 + 8 = 304
payment on time. The original
term of the mortgage was 30 vMonthly rate:
years, and the mortgage is
0.057
exactly four years and eight 𝑟' = = 0.0048
months old. You have just 12
made your monthly payment.
The mortgage interest rate is vPresent value of the mortgage:
5.672% (APR). How much do
$2646 1
you owe on the mortgage 𝑃𝑉 = × 1−
today? 0.0048 1 + 0.0048 #$%
= $426,291.12
5.25 1 + 𝑟E =
1 + 𝑟F
⇒
In 1975, interest rates were 1+𝜋
7.95% and the rate of
1 + 𝑟F 𝑟F − 𝜋
inflation was 12.35% in the 𝑟E = −1= ⇒
United States. What was the 1+𝜋 1+𝜋
real interest rate in 1975? 0.0795 − 0.1235
How would the purchasing 𝑟E = = −0.0392
1 + 0.1235
power of your savings have
changed over the year? v Approximation:
𝑟E = 𝑟F − 𝜋 = 7.95% − 12.35% = −4.4%

v The purchasing power of my savings decreased by

3.92% over the year.

v I have more (nominal) money, but the money can buy

less
5.35 vAfter tax home equity loan:
Your uncle Fred just
purchased a new boat. 7.9%× 1 − 27% = 5.8% < 6.9%
He brags to you about
the low 6.9% interest vAfter tax home equity loan is cheaper than
rate (APR, monthly
compounding) he the boat loan, for which interest is not tax
obtained from the deductible
dealer. The rate is even
lower than the rate he
could have obtained on
his home equity loan
(7.9% APR, monthly
compounding). If his tax
rate is 27% and the
interest on the home
equity loan is tax
deductible, which loan
is truly cheaper?
5.39 § Because the prize is in pounds and the U.K. interest
In the summer of 2008, at rate is better, we should deposit with the pound
Heathrow Airport in London, interest rate (the best available expected return
Bestofthebest (BB), a private
company, offered a lottery to offered in the market on an investment of comparable
win a Ferrari or 90,000 British risk and term).
pounds, equivalent at the
time to about $180,000. Both
the Ferrari and the money, in <
100-pound notes, were on 1 + 0.05 <N − 1 ×90,000 = 366.67 𝐵𝑟𝑖𝑡𝑖𝑠ℎ 𝑝𝑜𝑢𝑛𝑑s
display. If the U.K. interest
rate was 5% per year, and
the dollar interest rate was
2% per year (EARs), how § Convert the cash to USD at the current exchange rate
much did it cost the company (assuming exchange rate does not change over the
in dollars each month to keep month).
the cash on display? That is,
what was the opportunity cost 180,000
of keeping it on display rather 366.67× = $733.34
90,000
than in bank account?
(Ignore taxes.)