06 - Slide Time Value of Money #2 Share

THE TIME VALUE OF
MONEY—ANNUITIES AND
OTHER TOPICS
Manajemen Keuangan – I.K. Gunarta
Learning Objectives
1. Distinguish between an ordinary annuity and
an annuity due, and calculate the present and
future values of each.
2. Calculate the present value of a level perpetuity
and a growing perpetuity.
3. Calculate the present and future values of
complex cash flow streams.
Principles Applied in This Chapter
• Principle 1: Money Has a Time Value
• Principle 3: Cash Flows Are the Source of Value.
6.1 ANNUITIES
Ordinary Annuities (1 of 2)
Anuitas adalah serangkaian pembayaran rupiah
yang sama yang dilakukan pada akhir waktu yang
sama (seperti bulanan, triwulanan, atau tahunan)
selama periode waktu yang terbatas (seperti tiga
tahun). Jika pembayaran dilakukan pada akhir
setiap periode, anuitas tersebut disebut sebagai
ordinary annuity (anuitas biasa).
Ordinary Annuities (2 of 2)
• Example How much money will you accumulate
by the end of year 10 if you deposit $3,000 each
year for the next ten years in a savings account
that earns 5% per year?
• Determine the answer by using the equation for
computing the FV of an ordinary annuity.
The Future Value of an Ordinary Annuity
(1 of 3)
 (1 + i )n − 1 …. Eq 6-1c
FVn = PMT  
 i 
• FVn = FV of annuity at the end of nth period.

• PMT = annuity payment deposited or received at
the end of each period
• i = interest rate per period
• n= number of periods for which annuity will last
(2 of 3)
Using equation 6-1c,

FV = $3000 {[ (1+.05)10 − 1] ÷ (.05)}
= $3,000 { [0.63] ÷ (.05) }
= $3,000 {12.58}
= $37,740
(3 of 3)
• Using a Financial Calculator • Using an Excel Spreadsheet

– N=10 = FV(rate, nper,pmt, pv)
– 1/y = 5.0 = FV(.05,10, − 3000,0)
– PV = 0 = $37,733.68
– PMT = −3000
– FV = $37,733.67
Figure 6.1 Future Value of a Five—Year Annuity—Saving for
Grad School
Solving for the Payment in an Ordinary
Annuity
You may like to know how much you need to save
each period (i.e. PMT) in order to accumulate a
certain amount at the end of n years.
 (1 + i )n − 1
FVn = PMT  
 i 
CHECKPOINT 6.1: CHECK YOURSELF
Solving for PMT
If you can earn 12 percent on your investments, and you would like to accumulate
$100,000 for your newborn child’s education at the end of 18 years, how much must
you invest annually to reach your goal?
Solving for the Interest Rate in an
Ordinary Annuity (1 of 3)
• You can also solve for “interest rate” you must
earn on your investment that will allow your
savings to grow to a certain amount of money by a
future date.
• In this case, we know the values of n, PMT, and
FVn in equation 6-1c and we need to determine
the value of i.
• Example: In 20 years, you are hoping to have
saved $100,000 towards your child’s college
education. If you are able to save $2,500 at the
end of each year for the next 20 years, what rate
of return must you earn on your investments in
order to achieve your goal?

– N = 20 = Rate (nper, PMT, pv, fv)
– PMT = −$2,500 = Rate (20, 2500,0, 100000)
– FV = $100,000 = 6.77%
– PV = $0
– i = 6.77
Solving for the Number of Periods in an
• You may want to calculate the number of periods it
will take for an annuity to reach a certain future
value, given interest rate.
• It is easier to solve for number of periods using
financial calculator or Excel spreadsheet, rather
than mathematical formula.
• Example: You are planning to invest $6,000 at the
end of each year in an account that pays 5%. How
long will it take before the account is worth
$50,000?

– 1/y = 5.0 = NPER(rate, pmt, pv, fv)
– PV = 0 = NPER(5%,−6000,0,50000)
– PMT = −6,000 = 7.14 years
– FV = 50,000
– N = 7.14
The Present Value of an Ordinary
Annuity (1 of 2)
• The Present Value (PV) of an ordinary annuity
measures the value today of a stream of cash
flows occurring in the future.
The Present Value of an Ordinary
Annuity (2 of 2)
 
 1 
Present Value = PMT 1 − 
 (1 + i )n

 i 
• PMT = annuity payment deposited or received

• i = discount rate (or interest rate)
• n = number of periods
• Figure 6.2 shows the PV of ordinary annuity of receiving
$500 every year for the next 5 years at an interest rate of
6%?
Figure 6.2 Timeline of a Five—Year, $500 Annuity
Discounted Back to the Present at 6 Percent
The PV of Ordinary Annuity
What is the present value of an annuity of $10,000 to be received at the end of each
year for 10 years given a 10 percent discount rate?
Amortized Loans (1 of 3)
An amortized loan is a loan paid off in equal
payments – consequently, the loan payments are
an annuity. Examples: Home mortgage loans, Auto
loans
Example You plan to obtain a $6,000 loan from a
furniture dealer at 15% annual interest rate that you
will pay off in annual payments over four years.
Determine the annual payments on this loan and
complete the amortization table.
• Using a Financial Calculator
– N=4
– i/y = 15.0
– PV = 6000
– FV = 0
– PMT = −$2,101.59
The Loan Amortization Schedule
Table 6.1 The Loan Amortization Schedule for a $6,000
Loan at 15% to Be Repaid in Four Years
Year Amount Owed on Annuity Interest Repayment of the Outstanding Loan
the Principal at the Payment Portion Principal Portion Balance at Year End,
Beginning of the (2) of the of the Annuity = After the
Year (1) Annuity (2) − (3) = (4) Annuity Payment =
= (1) × 15% (1) − (4) = (5)
= (3)
1 $6,000.00 $2,101.59 $900.00 $1,201.59 $4,798.41
2 4,798.41 2,101.59 719.76 1,381.83 3,416.58
3 3,416.58 2,101.59 512.49 1,589.10 1,827.48
4 1,827.48 2,101.59 274.12 1,827.48 0.00

Amortized Loans with Monthly Payments
Many loans such as auto and home loans require
monthly payments. This requires converting n to
number of months and computing the monthly
interest rate.
Determining the Outstanding Balance of a Loan
Let’s assume you took out a $300,000, 30-year mortgage with an annual interest rate
of 8% and monthly payments of $2,201.29. Because you have made 15 years worth of
payments (that’s 180 monthly payments) there are another 180 monthly payments left
before your mortgage will be totally paid off. How much do you still owe on your
mortgage?
Annuities Due
Annuity due is an annuity in which all the cash
flows occur at the beginning of each period. For
example, rent payments on apartments are typically
annuities due because the payment for the month’s
rent occurs at the beginning of the month.
Annuities Due: Future Value
Computation of future value of an annuity due
requires compounding the cash flows for one
additional period, beyond an ordinary annuity.
 (1 + i )n − 1
FVn (annuity due) = PMT   (1 + i )
 i 
Annuities Due: Present Value
Since with annuity due, each cash flow is received
one year earlier, its present value will be discounted
back for one less period.
 
 1 
PV (annuity due) = PMT 1 −  (1 + i )
 (1 + i )n

 i 
6.2 PERPETUITIES
Perpetuities
A perpetuity is an annuity that continues forever or
has no maturity. For example, a dividend stream on
a share of preferred stock. There are two basic
types of perpetuities:
– Level perpetuity in which the payments are constant
over time.
– Growing perpetuity in which cash flows grow at a
constant rate from period to period over time.
Calculating the Present Value of a Level
Perpetuity
PMT
PV =
i
PV = the present value of a level perpetuity
PMT = the constant dollar amount provided by the
perpetuity
i = the interest (or discount) rate per period
The Present Value of a Level Perpetuity
What is the present value of stream of payments equal to $90,000 paid annually and
discounted back to the present at 9 percent?
Calculating the Present Value of a
Growing Perpetuity
In growing perpetuities, the periodic cash flows
grow at a constant rate each period.
PMTperiod 1
PV =
i −g
The Present Value of a Growing Perpetuity
What is the present value of a stream of payments where the Year 1 payment is
$90,000 and the future payments grow at a rate of 5 percent per year? The interest
rate used to discount the payments is 9 percent.
6.3 COMPLEX CASH FLOW STREAMS
Complex Cash Flow Streams
The cash flows streams in the business world may
not always involve one type of cash flows. The cash
flows may have a mixed pattern of cash inflows and
outflows, single and annuity cash flows.
Figure 6-4 summarizes the complex cash flow
stream for Marriott.
Figure 6-4 Present Value of Single Cash Flows and an
Annuity ($ millions)
The Present Value of a Complex Cash Flow Stream
What is the present value of cash flows of $300 at the end of years 1 through 5, a
cash flow of negative $600 at the end of year 6, and cash flows of $800 at the end of
years 7-10 if the appropriate discount rate is 10%?
Key Terms (1 of 2)
• Amortized loan
• Annuity
• Annuity due
• Annuity future value interest factor
• Annuity present value interest factor
• Growing perpetuity
• Level perpetuity
Key Terms (2 of 2)
• Loan amortization schedule
• Ordinary annuity
• Perpetuity

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THE TIME VALUE OF

• FVn = FV of annuity at the end of nth period.

Using equation 6-1c,

• Using a Financial Calculator • Using an Excel Spreadsheet

• Using a Financial Calculator • Using an Excel Spreadsheet

• Using a Financial Calculator • Using an Excel Spreadsheet

• PMT = annuity payment deposited or received

2 4,798.41 2,101.59 719.76 1,381.83 3,416.58

3 3,416.58 2,101.59 512.49 1,589.10 1,827.48

4 1,827.48 2,101.59 274.12 1,827.48 0.00

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