Hypothetical Situation...

1
Hypothetical Situation...

• Suppose you win the Publishers Clearinghouse
  Sweepstakes and are given a choice of taking
• 10,000 today or
• 12,000 three years from today
• Which should you choose?
• Re-stated, what is the promise of 12,000 three
  years from now worth to you today?

2
Present Value Calculations

• Present value calculation - assessing what a
  future dollar amount is worth to you today.
• Present value of a future lump sum PV
• Present value of future periodic payments PVA

3
Present value of a future lump sum...

• where
• r interest rate per period
• n number of periods
• FV the future value of the investment

4
Back to our example...

• FV 12,000
• Use r .08
• Get your money in 3 years
• 9,525.99
• Implies that, based on economic considerations,
  you should take the 10,000 today

5
Present Value of a lump sum
Period 1 2 3 4 5 6 7 8
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292
6
Implications...

• _____ frequency of compounding ___ PV
• _____ length of investment ____ PV
• _____ interest rate _____ PV

7
How do these calculations change if the payment
is repeated periodically?

• Suppose you want to know how much a retirement
  annuity is worth to you today if it claims
• 20,000 annual payment
• 5 year time period
• r.03
• Need to calculate the present value of future
  periodic payments (also called the present value
  of annuity payments ? PVA)

8
Present Value of an Annuity

• All terms defined as previously
• Please note That really is
• a negative n -n

9

• Previous Example
• 20,000 annual payment
• 5 year time period
• r.03

10

• PVA 91,594.14

11
Present value of an annuity
Period 1 2 3 4 5 6 7 8
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710
12
Lets try it some more...

• Your work is offering an incentive for you to
  retire early. Should you take 500,000 now or
  30,000 per year for the next 20 years?
• PVA
• PVA 446,324.25
• So, take the 500,000 now

13
Present Value of an Annuity
Period 1 2 3 4 5
1 0.990 0.980 0.971 0.962 0.952
2 1.970 1.942 1.913 1.886 1.859
3 2.941 2.884 2.829 2.775 2.723
4 3.902 3.808 3.717 3.630 3.546
5 4.853 4.713 4.580 4.452 4.329
6 5.795 5.601 5.417 5.242 5.076
7 6.728 6.472 6.230 6.002 5.786
8 7.652 7.325 7.020 6.733 6.463
9 8.566 8.162 7.786 7.435 7.108
10 9.471 8.983 8.530 8.111 7.722
11 10.368 9.787 9.253 8.760 8.306
12 11.255 10.575 9.954 9.385 8.863
13 12.134 11.348 10.635 9.986 9.394
14 13.004 12.106 11.296 10.563 9.899
15 13.865 12.849 11.938 11.118 10.380
16 14.718 13.578 12.561 11.652 10.838
17 15.562 14.292 13.166 12.166 11.274
18 16.398 14.992 13.754 12.659 11.690
19 17.226 15.678 14.324 13.134 12.085
20 18.046 16.351 14.877 13.590 12.462
14
The Only Two Certainties in Life are Death and
Taxes

• Costs and benefits of alternative resource
  allocation options should only be assessed net of
  taxes.
• Some choices of how to spend resources are
  nontaxable and therefore they are worth more than
  taxable options.
• Some choices reduce your amount of taxable income
  while others do not.

15
Example

• Finance the purchase of a car using
• a 7 loan from your credit union, or
• a 7 home equity loan
• On the surface, the financing options appear to
  be equivalent, but interest paid on a home equity
  loan can be deducted from taxable income while
  interest paid on a credit union loan cannot.

16
2009 Federal Tax Rates Single
Income between Marginal Tax Bracket
0 - 8,350 10
8,351 - 33,950 15
33,951 - 82,250 25
82,251 - 171,550 28
171,551 - 372,950 33
gt 372,951 35
17
2009 Federal Tax Rates Married Filing Jointly
Income between Marginal Tax Bracket
0 - 16,700 10
16,701 - 67,900 15
67,901 - 137,050 25
137,051 - 208,850 28
208,851 - 372,950 33
gt 372,951 35
18
Federal Tax Brackets
19
A Bird in the Hand is (sometimes) Better than two
in the Bush

• The future is riddled with uncertainty
• future income
• future inflation
• But, some resource allocation options involve
  more risk than others.
• All other things being equal, households
  typically like to avoid risk and uncertainty.