3
TUTORIAL
Time Value of
Money
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TUTORIAL 3 OUTLINE
3.1 TVM Formulas
3.2 Effective Annual Rate
3.3 Nominal & Effective Annual Rate
3.4 Yield to Maturity
3.5 Bonds
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Professor R. Jassim Engineering Economy
3.1 TVM FORMULAS
Given an interest rate of 8% and a 6 year period, calculate:
i) The future value of a $312 payment at year 2.
ii) The present value of a $826 payment at year 5.
iii) The future value of a $50 annuity.
iv) The annuity of a $950 payment at year 6.
v) The present value of $50 annuity.
vi) The annuity of a $790 payment at year 0.
vii) The annuity of a yearly payments that start with $900 at year 1 and
increase by $150 every year.
viii) The present value of yearly payments that start with $10 at year 1 and
increase by 5% every year.
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Professor R. Jassim Engineering Economy
3.1 TVM FORMULAS
i) The future value of a $312 payment at year 2
FV = $312 * (F/P, 0.08, 4) = $312 * 1.36 = $424.47.
2nd CLR TVM, 4, N, 8, I/Y, 312, PV, 0,
PMT; CPT FV -424.47
ii) The present value of a $826 payment at year 5
PV = $826 * (P/F, 0.08, 5) = $826 * 0.68 = $562.16.
2nd CLR TVM, 5, N, 8, I/Y, 0, PMT, 826,
FV; CPT PV -562.16
iii) The future value of a $50 annuity.
FV = $50 * (F/A, 0.08, 6) = $50 * 7.336 = $366.80.
2nd CLR TVM, 6, N, 8, I/Y, 0, PV, 50,
PMT; CPT FV -366.80
iv) The annuity of a $950 payment at year 6.
A = $950 * (A/F, 0.08, 6) = $950 * 0.136 = $129.50.
2nd CLR TVM, 6, N, 8, I/Y, 0, PV, 950,
FV; CPT PMT -129.50
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Professor R. Jassim Engineering Economy
3.1 TVM FORMULAS
v) The present value of $50 annuity.
PV = $50 * (P/A, 0.08, 6) = $50 * 4.62 = $231.14.
2nd CLR TVM, 6, N, 8, I/Y, 50, PMT, 0,
FV; CPT PV -231.14
vi) The annuity of a $790 payment at year 0.
A = $790 * (A/P, 0.08, 6) = $790 * 0.216 = $170.89.
2nd CLR TVM, 6, N, 8, I/Y, 790, PV, 0,
FV; CPT PMT -170.89
vii) The annuity of a yearly payments that start with $900 at year 1 and
increase by $150 every year.
A = $900 + $150 * (A/G, 0.08, 6) = $900 + $150 * 2.276 = $1 241.45.
viii) The present value of yearly payments that start with $10 at year 1 and
increase by 5% every year.
PV = $10 * (P/C, 0.08, 0.05, 6) = $10 * 5.184 = $51.84.
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Professor R. Jassim Engineering Economy
3.2 EFFECTIVE ANNUAL RATE
Shady Deal Finance Ltd. claims to charge a very reasonable interest rate of
1.7 percent per month. Accordingly, it proposes the following terms on a loan
of $1000:
Repayment period: 30 months
Credit investigation charge: $20
Total interest due: 1000 (0.017) (30) = 510
Total amount to repay: 1000 + 20 + 510 = 1530
Monthly payment: 1530 / 30 = $51
If $1000 was borrowed and repaid in 30 monthly payments of $51, what
effective annual rate does Shady Deal really charge?
The interest rate charged per month (i) is found by solving:
1000 = 51 (P/A,i,30) 2nd CLR TVM, 30, N, 1000, +/-, PV, 51,
1000 = 51 [1 – (1 + i)-30] / i PMT, 0, FV; CPT I/Y 3.00
Solve using equation solver on University calculator
i = 0.02997 = 3%
Nominal Rate: 3.0 (12) = 36%
Effective Rate: (1 + 0.03)12 - 1 = 0.4258 or 42.6%
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Professor R. Jassim Engineering Economy
3.3 NOMINAL & EFFECTIVE ANNUAL RATE
A loan of $4000 is to be reimbursed over a two-year period as follows:
Four end-of-quarter payments of $400 over the first year
Four end-of-quarter payments of $1000 over the second year
Determine the nominal as well as the effective annual interest rate that is
charged.
$4000
1 2 3 4 5 6 7 8
0
$400
$1000
At the interest rate charged, the PV of payments equals the amount borrowed.
Therefore,
4000 = 400 (P/A,i,4) + 1000 (P/A,i,4) (P/F,i,4)
At t=0 At t=4
in which i is the rate per quarter. At t=0
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Professor R. Jassim Engineering Economy
3.3 NOMINAL & EFFECTIVE ANNUAL RATE
4000 = 400 * [1 – (1 + i)-4] / i + 1000 * [1 – (1 + i)-4] / i * [1 / (1 + i)4]
Solve using equation solver on University calculator
i=0.066745 = 6.67%
Nominal Rate: 6.67 (4) = 26.7%
Effective Rate: (1 + 0.0668)4 - 1 = 29.5%
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Professor R. Jassim Engineering Economy
3.4 YIELD TO MATURITY
A bond with a face value of $1000 is purchased at a discount for $900 and
kept to maturity, i.e. for a period of 10 years. The bond has a coupon rate of
12 percent with semi-annual interest payments. Determine the bond's yield to
maturity.
Some definitions...
Face Value: Nominal amount indicated on bond; represents amount invested by
initial purchaser, unless a discount was offered by the issuer. If bond is kept to
maturity, it is redeemed for this value.
Coupon Rate: Nominal annual interest rate paid on face value.
Yield to Maturity (YTM): Interest rate earned by bondholder, i.e. return on
investment, when bond is kept to maturity, stated as a nominal annual interest
rate.
Purchase price: 900
Semi-annual interest payments: [(0.12/2) (1000)] = 60
Number of payments: 2 (10) = 20
Amount received at maturity: 1000
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Professor R. Jassim Engineering Economy
3.4 YIELD TO MATURITY
The return on investment (i) per 6-month period is found by solving:
900 = 60 (P/A,i,20) + 1000 (P/F,i,20)
Use financial calculator with PV=-900, PMT=60, FV=1000 and N=20.
2nd CLR TVM, 20, N, 900, +/-, PV, 60, PMT, 1000, FV;
CPT I/Y 6.939
YTM: 6.939 (2) = 13.9%
Note: A return on investment is best stated as an effective annual interest rate.
EIR: (1 + 0.06939)2 - 1 = 0.1436 or 14.4%
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Professor R. Jassim Engineering Economy
3.5 BONDS
A bond with a face value of $2500 has a coupon rate of 8 percent with semi-
annual interest payments. If it matures in 15 years, what maximum price
should an investor pay for the bond today if he wants a return on investment
of 10 percent (effective annual rate)?
The maximum purchase price is the PV of future monetary flows received by
the investor.
Semi-annual rate which has an effective annual rate of 10%:
(1 + i)2 - 1 = 0.10
i = 0.0488 or 4.88%
PV of interest payments (4% of $2500, i.e. $100) and face value received at
maturity:
PV = 100 (P/A,4.88%,30) + 2500 (P/F,4.88%,30)
= 100 (15.5850) + 2500 (0.2395) = $2157.13
2nd CLR TVM, 30, N, 4.88, I/Y, 100, PMT, 2500, FV;
CPT PV -2157.13
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