Introduction
Financial Markets and Time value of Money
Define these markets
• Markets in general
Place where buyers and sellers can meet and exchange goods/services, directly or via
an intermediary
• Markets for physical assets
Assets that are physical in nature and can be employed for consumption or revenue
generation
• Markets for financial assets
Assets that are financial (providing contractual right or ownership) in nature and have
a cash flow stream attached.
• What do we call the price, or cost, of debt capital?
The interest rate
• What do we call the price, or cost, of equity capital?
Required Dividend Capital
return = yield + gain .
What four factors affect the cost of money?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
Today, you invest 7 lakh to receive 8 lakh after 5 years. Are you at a
benefit or loss? Interest rate = 10%
Today, you invest 7 lakh to receive 8 lakh after 5 years. Are you at a
benefit or loss? Interest rate = 10%
Answer:
1. bring 8 lakh to present value.
2. Compare it with the 7 lakh investment.
8/(1+0.1)^5 = 4.96 lakh
You have just won a lottery for 10 lakh. You are given 3 options:
• 1. Take 7.5 lakh today
• 2. Take 0 today, 5 lakh after 2 years, and the remaining 5 lakh after 4
years
• 3. Take the entire 10 lakh after 4 years
You have just won a lottery for 10 lakh. You are given 3 options:
• 1. Take 7.5 lakh today
• 2. Take 0 today, 5 lakh after 2 years, and the remaining 5 lakh after 4
years
• 0+[5/(1+0.1)^2]+ [5/(1+0.1)^4]
• 0 + 4.132 + 3.415 = 7.547 lakh
• 3. Take the entire 10 lakh after 4 years
• 10 / (1+0.1)^4 = 6.83 lakh
Timelines show the timing of cash flows.
0 1 2 3
i%
CF0 CF1 CF2 CF3
Tick marks at ends of periods, so Time 0
is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
Timeline for a $100 lump sum due at the
end of Year 2.
0 1 2 Year
i%
100
Types of Cash Flows
• One shot payment – PV at time 0 and FV at time t
• Cash Flow stream – Equal cash flow from time 1 to time t is called as
Ordinary Annuity – Cash flow from the end of the time period
• Cash Flow stream – Equal cash flow from time 0 to time t is called as
Annuity Due – Cash flows at the beginning of the time period
Types of Cash Flows
• Cash Flow Stream – Different cash flow in every time period starting
time 1 to time t called as mixed cash flow stream (NPV)
• Cash Flow Stream – Same cash flow forever starting time 1 to time
infinity called as Perpetuity.
• Cash Flow Stream – Constantly increasing cash flow forever starting
time 1 to time infinity called as Growing Perpetuity.
Timeline for an ordinary annuity of $100
for 3 years.
0 1 2 3
i%
100 100 100
Timeline for uneven CFs: -$50 at t = 0 and $100,
$75, and $50 at the end of Years 1 through 3.
0 1 2 3
i%
-50 100 75 50
What’s the FV of an initial $100 after 3
years if i = 10%?
0 1 2 3
10%
100 FV = ?
Finding FVs (moving to the right
on a time line) is called compounding.
After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = PV(1 + i)2
= $100(1.10)2
= $121.00.
After 3 years:
FV3 = PV(1 + i)3
= $100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.
Three Ways to Find FVs
• Solve the equation with a regular calculator.
• Use a financial calculator.
• Use a spreadsheet.
What’s the PV of $100 due in 3 years if
i = 10%?
Finding PVs is discounting, and it’s
the reverse of compounding.
0 1 2 3
10%
PV = ? 100
Solve FVn = PV(1 + i )n for PV:
n
FVn 1
PV = n = FVn
1+ i
1+ i
3
1
PV = $100
1.10
= $100 0.7513 = $75.13.
Finding the Time to Double
0 20%
1 2 ?
-1 2
FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
What’s the difference between an ordinary
annuity and an annuity due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT
Annuity Due
0 1 2 3
i%
PMT PMT PMT
PV FV
What’s the FV of a 3-year ordinary
annuity of $100 at 10%?
0 1 2 3
10%
100 100 100
110
121
FV = 331
What’s the PV of this ordinary annuity?
0 1 2 3
10%
100 100 100
90.91
82.64
75.13
248.69 = PV
Spreadsheet Solution
A B C D
1 0 1 2 3
2 100 100 100
3 248.69
Excel Formula in cell A3:
Syntax: PV(rate, nper, pmt, [fv], [type])
Special Function for Annuities
For ordinary annuities, this formula in cell A3 gives
248.96:
=PV(10%,3,-100)
A similar function gives a future value of 331.00:
=FV(10%,3,-100)
Find the FV and PV if the
annuity were an annuity due.
0 1 2 3
10%
100 100 100
Excel Function for Annuities Due
Change the formula to:
=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function that there are
no other cash flows. The fifth term tells the function
that it is an annuity due. A similar function gives
the future value of an annuity due:
=FV(10%,3,-100,0,1)
What is the PV of this uneven cash flow stream?
0 1 2 3 4
10%
100 300 300 -50
90.91
247.93
225.39
-34.15
530.08 = PV
Spreadsheet Solution
A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
Excel Formula in cell A3:
=NPV(10%,B2:E2)
What interest rate would cause $100
to grow to $125.97 in 3 years?
$100(1 + i )3 = $125.97.
(1 + i)3 = $125.97/$100 = 1.2597
1+i = (1.2597)1/3 = 1.08
i = 8%.
Will the FV of a lump sum be larger or smaller if
we compound more often, holding the stated
I% constant? Why?
LARGER! If compounding is more
frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.
0 1 2 3
10%
100 133.10
Annually: FV3 = $100(1.10)3 = $133.10.
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01.
We will deal with 3 different
rates:
iNom = nominal, or stated, or
quoted, rate per year.
iPer = periodic rate.
EAR = effective annual. rate
• iNom is stated in contracts. Periods per year (m)
must also be given.
• Examples:
8%; Quarterly
8%, Daily interest (365 days)
• Periodic rate = iPer = iNom/m, where m is number of
compounding periods per year. m = 4 for quarterly, 12
for monthly, and 360 or 365 for daily compounding.
• Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.
• Effective Annual Rate (EAR):
The annual rate that causes PV to grow to the same FV as under
multi-period compounding.
Example: EAR% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EAR% = 10.25% because (1.1025)1 = 1.1025.
Any PV would grow to the same FV at 10.25% annually or 10%
semiannually.
• An investment with monthly payments is different from one with
quarterly payments. Must put on EAR% basis to compare rates of
return.
• Use EAR% only for comparisons.
• Banks say “interest paid daily.” Same as compounded daily.
How do we find EAR% for a nominal rate of
10%, compounded semiannually?
m
iNom
(
EAR% = 1 +
m ) -1
2
= (1 + 0.10) - 1.0
2
= (1.05)2 - 1.0
= 0.1025 = 10.25%.
EAR of 10%
EARAnnual = 10%.
EARQ = (1 + 0.10/4)4 - 1 = 10.38%.
EARM = (1 + 0.10/12)12 - 1 = 10.47%.
EARD(360) = (1 + 0.10/360)360 - 1 = 10.52%.
FV of $100 after 3 years under 10%
semiannual compounding? Quarterly?
mn
FVn = PV 1 +
iNom
.
m
2x3
FV3S
= $100 1 +
0.10
2
= $100(1.05)6 = $134.01.
FV3Q = $100(1.025)12 = $134.49.
Can the effective rate ever be equal
to the nominal rate?
• Yes, but only if annual compounding is used, i.e., if
m = 1.
• If m > 1, EAR% will always be greater than the
nominal rate.
When is each rate used?
iNom: Written into contracts, quoted by
banks and brokers. Not used in
calculations or shown
on time lines.
iPer: Used in calculations, shown on
time lines.
If iNom has annual compounding,
then iPer = iNom/1 = iNom.
EAR: Used to compare returns on
investments with different
payments per year.
(Used for calculations if and only if dealing with
annuities where payments don’t match interest
compounding periods.)
What’s the value at the end of Year 3 of the
following CF stream if the quoted interest rate
is 10%, compounded semiannually?
0 1 2 3 4 5 6 6-mos.
5% periods
100 100 100
• Payments occur annually, but compounding occurs each 6
months.
• So we can’t use normal annuity valuation techniques.
1st Method: Compound Each CF
0 1 2 3 4 5 6
5%
100 100 100.00
110.25
121.55
331.80
FVA3 = $100(1.05)4 + $100(1.05)2 + $100
= $331.80.
2nd Method: Treat as an Annuity
Could you find the FV with EAR?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
2
EAR = ( 0.10
1+ 2 ) - 1 = 10.25%.
b. Use EAR = 10.25% as the annual rate in your formula:
What’s the PV of this stream?
0 1 2 3
5%
100 100 100
90.70
82.27
74.62
247.59
On January 1 you deposit $100 in an account
that pays a nominal interest rate of 11.33463%,
with daily compounding (365 days).
How much will you have on October 1, or after
9 months (273 days)? (Days given.)
iPer = 11.33463%/365
= 0.031054% per day.
0 1 2 273
0.031054%
-100 FV=?
FV273 = $1001.00031054
273
= $1001.08846 = $108.85.
Note: % in calculator, decimal in equation.
Now suppose you leave your money
in the bank for 21 months, which is
1.75 years or 273 + 365 = 638 days.
How much will be in your account at
maturity?
Answer: Override N = 273 with N =
638. FV = $121.91.
iPer = 0.031054% per day.
0 365 638 days
-100 FV = 121.91
FV = $100(1 + 0.1133463/365)638
= $100(1.00031054)638
= $100(1.2191)
= $121.91.
You are offered a note that pays $1,000 in 15 months (or 456
days) for $850. You have $850 in a bank, which pays a
6.76649% nominal rate, with 365 daily compounding, which is
a daily rate of 0.018538%, and an EAR of 7.0%. You plan to
leave the money in the bank if you don’t buy the note. The
note is riskless.
Should you buy it?
iPer =0.018538% per day.
0 365 456 days
-850 1,000
3 Ways to Solve:
1. Greatest future wealth: FV
2. Greatest wealth today: PV
3. Highest rate of return: Highest EAR%
1. Greatest Future Wealth
Find FV of $850 left in bank for
15 months and compare with
note’s FV = $1,000.
FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.
2. Greatest Present Wealth
Find PV of note, and compare
with its $850 cost:
PV = $1,000/(1.00018538)456
= $918.95.
3. Rate of Return
Find the EFF% on note and
compare with 7.0% bank pays,
which is your opportunity cost of
capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456
Now we must solve for i.
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR % = (1.00035646)365 - 1
= 13.89%.
Using interest conversion:
P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89
Since 13.89% > 7.0% opportunity cost,
buy the note.
Amortization
Construct an amortization schedule
for a $1,000, 10% annual rate loan
with 3 equal payments.
Step 1: Find the required payments.
0 1 2 3
10%
-1,000 PMT PMT PMT
Step 2: Find interest charge for Year 1.
INTt = Beg balt (i)
INT1 = $1,000(0.10) = $100.
Step 3: Find repayment of principal in
Year 1.
Repmt = PMT - INT
= $402.11 - $100
= $302.11.
Step 4: Find ending balance after Year 1.
End bal = Beg bal - Repmt
= $1,000 - $302.11 = $697.89.
Repeat these steps for Years 2 and 3
to complete the amortization table.
BEG PRIN END
YR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
Interest declines. Tax implications.
$
402.11
Interest
302.11
Principal Payments
0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
• Amortization tables are widely used--for home mortgages,
auto loans, business loans, retirement plans, and so on.
They are very important!
• Financial calculators (and spreadsheets) are great for setting
up amortization tables.
