Chapter 5 – Time Value of Money
Inflation vs Deflation
- Past inflation = 3%/year 2 decades ago
- Inflation now 7%/year
o Money value decreases
Less purchasing powers
- Deflation is worse than inflation
- Hyperinflation
o Causes: massive debt, printing money, other
Future Value of Lump Sums
- FV = PV * (1 + r) ^n
o FV = future value
o PV = present value
o r = interest rate
o n = # of period
Present Value of Lump Sums
- PV = FV/(1+r)^n
Example: You are looking at buying a condo that costs $500000 today. Inflation rate is 3% per
year. What will be the future value of the condo in 5 years?
- 500000 * (1 + 0.03) ^5
- = $579637
Simple vs Compound Interest
- FV = PV * (1 + r) ^n
Example: You must invest $100000 in GIC that pays 4% interest annually for 5 years. What is
the value of this in 5 years?
FV = $100000 * (1 + 0.04) ^5
FV = $121665
- When interest is paid it is reinvested. Therefore, interest is earning interest
- What if this GIC compounds monthly
o n changes months not years
o Example: # of years * 12 = # of months
o R changes monthly rate = annual rate/ 12
- Example: PV= $100000
- N = 5 * 12 = 60
- R = 0.04/12
o FV = $100000 (1+0.04/12)^60
- What if this GIC paid 9% annual interest compounded monthly?
o PV = $100000
o N = 5yrs * 12 months = 60 periods
o R = 0.09/12 = 0.00333
o FV = $100000 * (1 + 0.00333)^60 $ 122100
- PV of lump sums ($1)
o Amount invested today to have a specific portfolio value in the future
R = Investment return
- FV of annuity (A stream of equal payments)
o Ending value of your portfolio if you save a regular and equal amount
R = Investment return
