Foundations and Applications of the Time Value of Money

321 Pages·2009·3.56 MB·English

by  Pamela Peterson Drake

( continued from front flap ) PETERSON $60.00 USA/$72.00 CAN
THE FRANK J. FABOZZI SERIES
DRAKE
• Focuses on deferred annuities—which are
typically used within the retirement arena—and FOUNDATIONS and APPLICATIONS FABOZZI
other “saving-for-future-spending” scenarios
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in which there is more than one withdrawal of O
of the TIME VALUE of MONEY
funds in the future U
• Addresses the valuation of stocks and bonds N Understanding fi nancial transactions—whether
using TVM mathematics D involving investing, borrowing, or lending—
In this latest collaboration from Pamela Peterson Drake and Frank
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Rounding out this detailed discussion, Peterson Fabozzi, the authors provide comprehensive coverage of the time value of T money (TVM), as well as the fi nancial mathematics that
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Drake and Fabozzi examine the applications of money and fully expand upon related concepts that are usually presented O go along with it. And while TVM is an essential aspect
the TVM mathematics with regard to: evaluating as part of an overview in other general fi nance books. N of fi nance, there aren’t many resources that take the time
whether to get an MBA, deciding whether to lease S to fully explain it.

or buy a car, and whether gold is a good investment. a
And while this is not a personal fi nance book, the Chapter by chapter, various time value of money concepts and principles n In this book, the experienced author team of Pamela
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authors chose examples that might interest you in are discussed and many examples are used to reinforce the tools and Peterson Drake and Frank Fabozzi fully expand upon
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immediately applying the techniques outlined here. techniques covered. Problems and detailed solutions—demonstrated the type of TVM concepts usually presented as part
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of an overview given in other general fi nance books.
using two different fi nancial calculators, as well as Excel—are also P
Making more informed financial decisions relies L Throughout these pages, various TVM concepts and
provided at the end of each chapter, while glossary terms are included in
on a firm grasp of the time value of money. This I principles are discussed, with the authors offering
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book has the insights and advice needed to achieve an appendix, to familiarize you with basic terms. examples in each chapter to reinforce the tools
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such a goal. T and techniques covered. Problems and detailed
I solutions—demonstrated using two different fi nancial
Divided into two comprehensive parts, this reliable resource: O
PAMELA PETERSON DRAKE, PHD, CFA, is the J. N calculators, as well as Excel—are also provided at the
Gray Ferguson Professor of Finance and Department • Provides the basic foundations of the time value of money S FOUNDATIONS end of each chapter, while glossary terms are included
Head of Finance and Business Law at James Madison • O utlines the fi nancial mathematics you need to know in order to make o and in an appendix, to familiarize you with basic terms.
University. Prior to joining James Madison University, f
more informed fi nancial decisions
she was an associate dean and professor of fi nance at th Divided into two comprehensive parts—The Basics of
Florida Atlantic University, and, previous to that, a • C overs issues ranging from calculating present/future values to loan e the Time Value of Money and A Few Applications—
professor at Florida State University. amortization T APPLICATIONS this comprehensive guide can help you analyze almost
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M of any fi nancial transaction and evaluate cash fl ows to
• And much more
FRANK J. FABOZZI, PHD, CFA, CPA, is E determine values at different points in time or returns
Professor in the Practice of Finance and Becton on investments. Written with both the aspiring and
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Fellow at the Yale School of Management, Editor of Understanding the time value of money is essential, and with this reliable A TIME VALUE experienced fi nancial professional in mind, Foundations
the Journal of Portfolio Management, and Associate resource as your guide, you’ll quickly gain a fi rm grasp of its many aspects L the and Applications of the Time Value of Money:
Editor of the Journal of Structured Finance and the U
and real-world applications.
Journal of Fixed Income. E • Deals with the compounding and discounting of
o M lump sums—translating single values through time
Jacket Illustration: Jupiter Images f ONEY • Shows how valuing series of cash flows
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is a simple extension of discounting or
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compounding lump sums
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• Demonstrates how to calculate the annual
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percentage rate, the effective annual rate,
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and the internal rate of return for financial
transactions
• Looks at loans and how they may be amortized
PAMELA PETERSON DRAKE, FRANK J. FABOZZI
( continued on back flap )
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Foundations and
Applications of the
Time Value of Money
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TheFrankJ.FabozziSeries
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TheExchange-TradedFundsManualbyGaryL.Gastineau
ProfessionalPerspectivesonFixedIncomePortfolioManagement,Volume3editedbyFrankJ.Fabozzi
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HandbookofAlternativeAssetsbyMarkJ.P.Anson
TheGlobalMoneyMarketsbyFrankJ.Fabozzi,StevenV.Mann,andMooradChoudhry
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FinancialManagementandAnalysis,SecondEditionbyFrankJ.FabozziandPamelaP.Peterson
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StevenV.Mann,andMooradChoudhry
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TheHandbookofEuropeanFixedIncomeSecuritieseditedbyFrankJ.FabozziandMooradChoudhry
TheHandbookofEuropeanStructuredFinancialProductseditedbyFrankJ.FabozziandMooradChoudhry
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TheRealEstateInvestmentHandbookbyG.TimothyHaightandDanielSinger
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StevenV.Mann
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FinancialModelingoftheEquityMarket:FromCAPMtoCointegrationbyFrankJ.Fabozzi,SergioM.Focardi,
andPetterN.Kolm
AdvancedBondPortfolioManagement:BestPracticesinModelingandStrategieseditedbyFrankJ.Fabozzi,
LionelMartellini,andPhilippePriaulet
AnalysisofFinancialStatements,SecondEditionbyPamelaP.PetersonandFrankJ.Fabozzi
CollateralizedDebtObligations:StructuresandAnalysis,SecondEditionbyDouglasJ.Lucas,
LaurieS.Goodman,andFrankJ.Fabozzi
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IntroductiontoStructuredFinancebyFrankJ.Fabozzi,HenryA.Davis,andMooradChoudhry
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TeoJasic
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LaurieS.Goodman,FrankJ.Fabozzi,andRebeccaJ.Manning
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DessislavaA.Pachamanova,andSergioM.Focardi
AdvancedStochasticModels,RiskAssessment,andPortfolioOptimizationsbySvetlozarT.Rachev,
StoganV.Stoyanov,andFrankJ.Fabozzi
HowtoSelectInvestmentManagersandEvaluatePerformancebyG.TimothyHaight,StephenO.Morrell,
andGlennE.Ross
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TheHandbookofMunicipalBondseditedbySylvanG.FeldsteinandFrankJ.Fabozzi
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Zimmerman,andFrankJ.Fabozzi
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FrankJ.Fabozzi
HandbookofFinance:VolumeI:FinancialMarketsandInstrumentseditedbyFrankJ.Fabozzi
HandbookofFinance:VolumeII:FinancialManagementandAssetManagementeditedbyFrankJ.Fabozzi
HandbookofFinance:VolumeIII:Valuation,FinancialModeling,andQuantitativeToolseditedby
FrankJ.Fabozzi
Finance:CapitalMarkets,FinancialManagement,andInvestmentManagementbyFrankJ.Fabozziand
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ActivePrivateEquityRealEstateStrategybyDavidJ.LynnwithTimWang,PhD,MatsonHolbrook,
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ii
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Foundations and
Applications of the
Time Value of Money
PAMELA P. DRAKE
FRANK J. FABOZZI
John Wiley & Sons, Inc.
iii
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LibraryofCongressCataloging-in-PublicationData
PetersonDrake,Pamela,1954–
Foundationsandapplicationsofthetimevalueofmoney/PamelaP.Drake
andFrankJ.Fabozzi.
p. cm.—(TheFrankJ.Fabozziseries)
Includesindex.
ISBN978-0-470-40736-3(cloth)
1.Finance—Mathematicalmodels. 2.Money—Mathematicalmodels.
3.Businessmathematics. 4.Time—Economicaspects. I.Fabozzi,FrankJ. II.Title.
HG106.P482009
332.4(cid:2)1—dc22
2009014330
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
iv
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Contents
Preface ix
AbouttheAuthors xi
Introduction xiii
PARTONE
TheBasicsoftheTimeValueofMoney 1
CHAPTER1
TheValueofCompounding 3
Compounding 7
CalculatorandSpreadsheetSolutions 11
FrequencyofCompounding 14
Summary 20
“TryIt”Solutions 21
Problems 22
CHAPTER2
Don’tDiscountDiscounting 23
Discounting 23
DiscountingMoreThanOneFutureValue 31
DeterminingtheNumberofCompoundingPeriods 35
Summary 38
“TryIt”Solutions 38
Problems 39
CHAPTER3
CashHappens 41
ValuingaStreamofFutureCashFlows 42
ValuingaPerpetuity 51
Annuities 54
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vi CONTENTS
Summary 61
“TryIt”Solutions 62
Problems 62
CHAPTER4
YieldingforYields 65
AnnualizedRatesofInterest 65
DeterminingtheUnknownInterestRate 77
Rules 88
Summary 89
“TryIt”Solutions 90
Problems 90
PARTTWO
AFewApplications 93
CHAPTER5
Loans 95
LoanAmortization 95
InterestRatesonLoans 104
DeterminingtheNumberofPeriods 108
VariationsontheTheme 109
Summary 114
“TryIt”Solutions 114
Problems 115
CHAPTER6
SavingtoSpend 119
ValuingaDeferredAnnuity 119
AnnuitieswithAnnuities 126
ABitofRealism 135
Summary 138
“TryIt”Solutions 139
Problems 139
CHAPTER7
ValuesTiedtoBonds 141
BondBasics 142
CalculatingtheYieldtoMaturity 154
Issues 157
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Contents vii
InterestRates 163
YieldCurves 164
Summary 169
“TryIt”Solutions 170
Problems 171
CHAPTER8
TakingStock 173
What’sinaValue?TheBasicsofStockValuation 174
ReturnonStocks 187
Summary 192
“TryIt”Solutions 193
Problems 195
CHAPTER9
ACapitalIdea 197
TheNetPresentValue 198
TheProfitabilityIndex 201
TheInternalRateofReturn 204
Summary 214
“TryIt”Solutions 215
Problems 216
CHAPTER10
FinanceFactorFiction? 219
FactorFiction:ItPaystoGetanMBA 219
FactorFiction:LeasingaCarCostsLessthanBuyingaCar 222
FactorFiction:GoldHasAlwaysBeenaGoodInvestment 225
Summary 230
APPENDIXA
UsingFinancialCalculators 231
PreparingtheCalculator 232
TheBasics 235
FinancialFunctions 237
Tips 242
TroubleshootingProblems 243
APPENDIXB
UsingSpreadsheetsinFinancialCalculations 247
TheBasics 247
TimeValueofMoneyFunctions 248
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viii CONTENTS
CashFlowFunctions 252
OtherUsefulFunctionsforFinancialMathematics 253
APPENDIXC
Formulas 255
APPENDIXD
Glossary 261
APPENDIXE
SolutionstoEnd-of-ChapterProblems 265
Index 281