Review of Present Value Calculations

1.

Future value of an amount P collecting interest at a rate r for n periods

Future Value Interest Factor =

Example:

Future value of $1000 after 6 years, r=10% (Annual Compounding) =

Alternatively:

= 1000[] =1000[1.7716]

2. Present value of a single amount, F payable n years from now:

Present value interest factor is tabulated.

Example:

Present value of $1000 receivable after 10 years, if the interest rate is 12% is:

Alternatively:

= 1000*0.3220 = $322

3. Future value of an annuity of $A at the end of each year:

For a three year annuity,

For an “n” year annuity,

Using the sum of a geometric series formula,

The term in square brackets is tabulated.

Example:

If a person saves $1000 per year for 10 years, and deposits the money at the end of each year in a bank which pays 8%interest, he will have, after 10 years

n=10 years; r=0.08; A=$1000

Alternatively,

1.  Present value of an annuity

for a three year annuity

for an n year annuity

Using the sum of a geometric series formula,

The term in square brackets is tabulated.

If , where an infinite annuity is called a “Perpetuity.”

Example:

Find the present value of the following ordinary annuity:

$200 per year for 10 years at 10%

A = $200

n=10 years; r=10%

Example:

The present value of $200 per year forever with r=10% annually is:

(A=200; r=0.1)

2.  Compounding and Discounting more than once a year

If compounding is done “m” times a year, at a nominal interest rate, R per year, for T years:

n= number of periods = mT

r= interest rate (effective) per period = R/m

Future value,

Present value of an amount F received T years from now,

Example:

How much does a deposit of $5000 grow at the end of 6 years if nominal rate of interest is 12% and compounding frequently is 4 times per year?

R=0.12;

, number of periods

3.  Continuous compounding and discounting

We know that,

When

Thus, as .

(Future value under continuous compounding)

Conversely, the present value of an amount F received T years from now an annual interest rate (nominal) R, if discounting is done continuously is:

Example:

Under continuous compounding $5000 grows to (R=12%), after 6 years:

Example:

If someone offers to “double” your money in 6 years, what is the interest rate you are getting (under annual compounding)?

4.  Present value of a growing annuity:

g = annual growth rate

A is the first payment, second payment is A(1+g), third is … when g = 0, we get:

which is the standard PV of an annuity formula.