Chapter 5 Notes

Simple Interest
• Interest is earned only on the original investment
• Example: You invest $1,000 in an account paying simple interest at the rate of 5% per
year. How much will the account be worth after 10 years?
o Interest each year = .05 * 1,000 = $50
o Total interest earned in 10 years = $50/year * 10 years = $500
o Balance at the end of 10 years = 1,000 + 500 = $1,500
• FV = I + I * r * t = I * (1 + r * t), where
o FV = Future Value
o I = Investment amount
o r = interest rate per period
o t = number of periods

Compound Interest
• Interest is earned on the value of money that is in the account at the beginning of the
period. Thus, the previous period’s earned interest can also earn interest in the next
period
• FV = I * (1 + r)t
• Example: You invest $1,000 in an account paying compound interest at the rate of 5%
per year. How much will the account be worth after 10 years?
o FV = I * (1 + r)t = 1,000 * (1.05)10 = $1,628.89
• (1 + r)t is known as the Future Value Factor = the future value of $1 invested for t
periods at a rate of r per period, compounded.
• Example: You borrow $2,000 from the bank, which charges compound interest at the
rate of 8% per year. How much will you owe in 5 years?
o FV = 2,000 * (1.08)5 = $2,938.66
• Note that the future value increases as either the interest rate, r, or the amount of time
invested, t, increases

Present Values
• Present value is the value today of a future cash flow
• Example: How much do you need to invest today into an account paying compound
interest at the rate of 6% per year in order to receive $5,000 at the end of 8 years?
o Note that now we know the future value and are trying to find the amount
invested
o FV = I * (1 + r)t
o 5,000 = I * (1.06)8
o I = 5,000/(1.06)8 = $3,137.06
• In general, PV = FV/(1 + r)t = FV * (1 + r)-t
• Finding the present value is called discounting, and r is referred to as the discount rate
 • (1 + r)-t is known as the Present Value Factor = the present value of $1 to be received in
t periods at a rate of r per period = 1/Future Value Factor
• We can also find the discount rate by rearranging the formula
• Example: Suppose that a discount bond sells for $681 and will pay out $1,000 in 5 years.
What is the rate of return on this investment?
o FV = PV * (1 + r)t
o 1,000 = 650 * (1 + r)5
o (1 + r)5 = 1,000/650 = 1.5385
o 1 + r = (1.5385)1/5 = 1.0900
o r = .0900 or 9.00%
• We can also find the investment period, but it is a bit more difficult
• Example: How long will it take for your money to double if you can earn an interest rate
of 6%?
o FV = PV * (1 + r)t
o 2 = 1 * (1.06)t (note, use any value for PV and twice that value for FV)
o We can solve this equation by taking the log or ln of both sides (it doesn’t matter
which)
o log 2 = log (1.06)t = t * log(1.06)
o t = log(2)/log(1.06) = .3010/.0253 = 11.90 years
• The Rule of 72 states that the time it will take for an investment to double in value
equals approximately 72/r, where r is expressed as a percentage
o In our example, 72/6 = 12 years

Multiple Cash Flows

• To take the present and future values of multiple cash flows, you can take the present
or future value of each of the cash flows and sum them
• Example: Suppose you deposit $1,000 into your savings account today, and expect to
deposit an additional $1,200 a year from now and $1,400 two years from now. How
much will you have in your account, which pays 8% interest, at the end of three years?
o Calculate the future value of each of your deposits and sum them
o 1,000 * (1.08)3 = $1,260 (the initial deposit will be in the account for 3 years)
o 1,200 * (1.08)2 = $1,400 (the time 1 deposit will be in the account for 2 years)
1
o 1,400 * (1.08) = $1,512 (the time 2 deposit will be in the account for 1 year)
o Total in the account at time 3 = 1,260 + 1,400 + 1,512 = $4,172
• Example: Suppose an investment promises to pay you $5,000 a year from now, $8,000
in two years ,and $10,000 in three years. If your cost of money is 6%, what would you
be willing to pay for this investment?
o Calculate the present value of each of the payments and sum them
o 5000/(1.06) = $4,716.98
o 8,000/(1.06)2 = $7,119.97
o 10,000/(1.06)3 = $8,396.19
o Total present value = 4716.98 + 7119.97 + 8396.19 = $20,233.14
 • If interest rates are expected to change, you can the periods with different interest rates
separately
• Example: Suppose in the previous example, the interest rate is expected to rise to 8% a
year from now, and stay at 8% after that.
o The time one cash flow is not affected. The cash flow in two years will be
discounted for one period at 8% (to get back to time 1) and one period at 6%.
The time three cash flow will be discounted for two periods at 8% (again to get
back to time 1) and then discounted for one period at 6%.
o 5,000/(1.06) = $4,716.98
o 8,000/(1.08) = $7,407.41; 7,407.41/(1.06) = $6,988.12
o Or, in one step: 8,000/((1.08)*(1.06)) = $6,988.12
o 10,000/(1.08)2 = $8,573.39; 8,573.39/(1.06) = $8,088.10
o Or, in one step: 10,000/((1.08)2 * (1.06)) = $8,088.10
o Total present value = 4,716.98 + 6,988.12 + 8,088.10 = $19,793.20
o Note that the present value is now lower. That is because the interest rate (at
least for part of the time) has increased

Perpetuities
• A perpetuity is a stream of level cash payments that never ends
• The present value of a perpetuity with the first payment in one year is calculated by
dividing the level cash flow, C, by the interest rate, r
o PV of perpetuity = C/r
• Example: Suppose you want to create a scholarship fund that will provide $15,000 each
year to a deserving student, and you would like this scholarship to be paid indefinitely.
The funds will be invested to earn 5%. How much money must you give the university
to establish this scholarship if the first payment will be one year from now?
o PV = C/r
o PV = 15,000/.05 = $300,000
o Note that once the fund is established, the $300,000 will earn .05 * 300,000 =
$15,000. That $15,000 will be used to pay the scholarship, leaving $300,000 in
the fund to earn another $15,000 the next year. This can go on forever
• Example: Suppose you would like the first payment to be made right away. How much
will you need to put in the fund?
o You just need to add the first payment to the amount you gave before
o PV = 15,000 + 300,000 = $315,000
• Example: Suppose it will take a while for the scholarships to be advertised and awarded
so that the first scholarship will payment will not be made until year 4. Now how much
will you need to put in the fund?
o This is a combination of a perpetuity problem and a present value of a single
cash flow.
o The first perpetuity payment will be made at time 4, so that the fund will need to
have the $300,000 at time 3 (one year before the first payment will be made)
 o In order to have $300,000 at time 3, how much do you need today? The present
value of $300,000
o PV = 300,000/(1.05)3 = $259,151.28

Annuities
• An annuity is a stream of equal payments made at equal intervals for a finite amount of
time
• The present value of a t-period annuity with payments of C and an interest rate of r is:
1 1
𝑃𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐶 , − 4
𝑟 𝑟(1 + 𝑟)3
• Note: This formula gives the present value of an annuity that starts one period from
now. This is called a regular or ordinary annuity
• Example: Suppose you are buying a car and you are given a loan that will require you to
pay $8,400 each year for the next 5 years, first payment one year from now. If the
interest rate is 6%, what are you paying for your car?
o This is an annuity with C = 8,400, r = .06, and t = 5
: :
o 𝑃𝑉 = 8,400 9 − .<=
?
> = $35,383.86
.<=(:.<=)
• This is an amortizing loan. Part of the yearly payment is used to pay interest on the loan
and part is used to reduce the amount of the loan.
o In the first year, the interest portion of the loan will be .06 * 35,383.86 =
$2,123.03
o The remaining amount of the payment, 8,400 – 2,123.03 = $6,276.97, will go to
paying off the loan
o In the second year, the value of the loan has been reduced by $6,276.997to
35,383.86 – 6,672.97 = $29,106.89
o Thus, the interest portion of the loan in the second year will be .06 * 29,106.89 =
$1,746.41
o The remaining amount of the payment, 8,400 – 1,746.41 = $6,653.59 will go to
reducing the amount of the loan.
o As you can see, the interest portion of the payment falls each year, as some of
the loan gets paid off, and the principal portion of the loan increases
o Note that the amount due on a loan at any point in time is the present value of
the remaining payments
• Suppose the payments on this annuity were monthly rather than yearly. We can still
calculate the present value of the loan, we just need to change our frame of reference
• Example: Your car loan requires you to pay $700 per month (8,400/12) for 5 years. If
the interest rate is 6% per year, what are you paying for your car?
o The annuity now has payments, C = 700/month, interest rate r = .06/12 = .005
per month, for t = 12 * 5 = 60 months
: :
o 𝑃𝑉 = 700 9.<<E − .<<E(:.<<E)FG ? = $36,207.89
• To calculate the future value of an annuity, take the present value of an annuity and
multiply it by the future value factor for a single cash flow
 1 1 3
(1 + 𝑟)3 − 1
𝐹𝑉 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐶 , − 4 (1 + 𝑟) = 𝐶 K L
𝑟 𝑟(1 + 𝑟)3 𝑟
• Example: Suppose you save $4,000 per year for 20 years. If interest rates are 10%, how
much will you have saved when you retire in 20 years?
o This is asking for the future value of an annuity of C = $4,000 per year, for t = 20
years, at a rate r = .10
(:.:<)MGN:
o 𝐹𝑉 = 4,000 9 <.:<
? = $229,100
• Now that you know what you will have when you retire, let’s think about what you will
be able to spend during your retirement
• Example: If you have $229,100 when you retire, how much can you spend each year in
perpetuity?
o For this perpetuity, we know the present value ($229,100) and the interest rate
(.10), and we are trying to find the cash flow C
o PV = C/r
o 229,100 = C/.10
o C = .10 * 229,100 = $22,910
• Example: What if you only expect to live for 20 years after retirement? What will you
be able to spend each year in that case?
o Now we have an annuity where we know the present value and we want to find
the payment
: :
o 229,100 = 𝐶 9 − .:< MG
?
.:<(:.:<)
o 𝐶 = $26,910
• An Annuity Due is a level stream of cash flows starting immediately, i.e., the payments
are at the beginning of the year rather than at the end of the year.
• One way to think about valuing an annuity due, is to think of it as a payment today,
followed by an ordinary annuity of t-1 periods. Then:
1 1
𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 = 𝐶 + 𝐶 , − 4
𝑟 𝑟(1 + 𝑟)(3N:)
• Another way to think of the value is that since the cash flow starts earlier, there is one
extra compounding period, so both the present value and future value of an annuity will
be higher
o PV Annuity Due = PV of ordinary annuity * (1 + r)
o FV Annuity Due = FV of ordinary annuity * (1 + r)
• Example: Suppose with the car loan from the earlier example the 5 payments of $8,400
are due at the beginning of each year. If the interest rate is 6%, what does the car cost?
o You can treat this as being a payment today, followed by a 4-year ordinary
annuity:
: :
o 𝑃𝑉 = 8,400 + 8,400 9 − .<=
?
R = $37,506,89
.<=(:.<=)
o Or you can take the PV of the ordinary annuity and multiply by 1 + r:
: :
o 𝑃𝑉 = 8,400 9 − >
? (1.06) = $37,506.89
.<= .<=(:.<=)
o Both methods give the same result
 o Note that the value is higher than for an ordinary annuity, because the payments
are sooner

Growing Perpetuities and Annuities

• Growing Perpetuity: An infinite stream of cash flows growing at a constant rate
o PV of a growing perpetuity = C1/(r – g)
o Note: it must be the case the r > g
• Growing Annuity: A finite stream of cash flows growing at a constant rate
TS :XV 3
o PV of a growing annuity = UNV ,1 − W :XU Y 4
• Example: Suppose you are contemplating investing in a rental property that is expected
to provide income of $100,000 in the first year, and that income is expected to increase
at 6% per year, indefinitely. What would you be willing to pay for this investment, if the
appropriate discount rate is 11%?
o This is a growing perpetuity
o PV = C1/(r - g) = 100,000/(.11 - .06) = 100,000/.05 = $2,000,000
• Example: Suppose the building is expected to have a 20 year life and then be worthless.
What would you be willing to pay?
o This is now a growing annuity
:<<,<<< :.<= Z<
o 𝑃𝑉 = (.::N .<=)
,1 − W:.:: Y 4 = $1,204,412.91
• Example: Suppose you expect to be able to sell the building for $1,000,000 in 20 years.
Now what would you be willing to pay?
o The rental income stays the same as in the previous problem, but you now get
an additional lump sum at the end of the 20 years
o Take the present value of the lump sum (a single cash flow) and add it to the
rental income
o PV = 1,204,412.91 + 1,000,000/(1.11)20 = 1,204,412.91 + 124,033.91 =
$1,328,446.82

Inflation and the Time Value of Money

• Inflation: The rate at which prices as a whole are increasing
• Real value of $1: Purchasing power-adjusted value of a dollar
• Nominal Interest Rate: Rate at which money invested grows
• Real Interest Rate: Rate at which the purchasing power of an investment increases
• The real rate of interest is calculated by:
:X]^_`abc db3e
o 1 + 𝑅𝑒𝑎𝑙 𝑅𝑎𝑡𝑒 = :Xfagcb3`^a dh3e
• The real rate can be approximated by:
o Real Rate of Interest = Nominal Rate of Interest – Inflation Rate
• Example: In the year 2000, short-term Canadian government bond returns were 5.8%
and the inflation rate was 3%. What was the real rate of interest?
o Real Rate = (1.058/1.03) – 1 = .0272, or 2.72%
o Using the approximation, Real Rate @ 5.8 – 3 = 2.8
Effective Annual Interest Rates
• Sometimes interest is compounded more frequently than once a year
• To deal with this situation, you just need to change your frame of reference and adjust
the interest rate and amount of time to conform to periods rather than years
• Suppose compounding takes place m times per year, then the interest rate per period
will be the annual interest rate, r, divided by m, and the number of periods will be the
number of years, t, times m.
• Annual Percentage Rate (APR): interest rate that is annualized using simple interest
(i.e., the stated annual interest rate)
• For a single cash flow:
hid _j3
o 𝐹𝑉 = 𝑃𝑉 W1 + _
Y
hid N_j3
o 𝑃𝑉 = 𝐹𝑉 W1 + _
Y
• Effective Annual Rate (EAR): Interest rate that is annualized using compound interest
o This is equal to the interest that would be earned on a $1 investment in one year
hid _
o 𝐸𝐴𝑅 = W1 + _
Y −1
• Example: Suppose you invest $1,000 at 12%, compounded monthly for 5 years. How
much will you have after 5 years?
o With monthly compounding, m = 12
o The interest rate per month will be 12% per year/12 months per year = 1% per
month
o The total investment period will be 5 years x 12 months per year = 60 months
.:Z :Z j E
o 𝐹𝑉 = 1000 W1 + :Z Y = 1000(1.01)=< = $1,816.70
• Example: What is the effective annual rate in the above example?
.:Z :Z
o 𝐸𝐴𝑅 = W1 + :Z Y − 1 = .1268 or 12.68%
o Note, that you could use the EAR as the annual rate to find the future value:
o FV = 1,000(1.1268)5 = $1,816.70
• Note that with more frequent compounding, the future value and the effective annual
rate increase (and the present value would correspondingly decrease)
• If the compounding frequency were increased indefinitely, then in the limit, interest
would be paid continuously, and we would have continuous compounding
• With continuous compounding:
o FV = PV x erxt, where e = 2.718
o PV = FV x e-rxt
o EAR = er – 1
• Example: Suppose you invest $1,000 for 5 years at 12% interest, continuously
compounded. What will the value be after 5 years?
o FV = 1000e..12x5 = 1000e0.6 = $1,722.12
o EAR = e.12 – 1 = .1275 or 12.75%
o Using the EAR, FV = 1000(1.1275)5 = $1,822.12