Fundamentals of Financial Management, 13e

Chapter 3: Time Value of Money

After studying Chapter 3,

you should be able to:
Chapter 3 1. Understand what is meant by "the time value of money."
2. Understand the relationship between present and future value.
3. Describe how the interest rate can be used to adjust the value of

The Time Value

cash flows – both forward and backward – to a single point in
time.
4. Calculate both the future and present value of: (a) an amount
invested today; (b) a stream of equal cash flows (an annuity);

of Money 5.
6.
and (c) a stream of mixed cash flows.
Distinguish between an “ordinary annuity” and an “annuity due.”
Use interest factor tables and understand how they provide a
shortcut to calculating present and future values.
7. Use interest factor tables to find an unknown interest rate or
growth rate when the number of time periods and future and
present values are known.
8. Build an “amortization schedule” for an installment-style loan.
3.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The Time Value of Money The Interest Rate

• The Interest Rate Which would you prefer – $10,000

today or $10,000 in 5 years?
• Simple Interest
• Compound Interest Obviously, $10,000 today.
• Amortizing a Loan
You already recognize that there is
• Compounding More Than TIME VALUE TO MONEY!!
Once per Year
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Why TIME? Types of Interest

Why is TIME such an important • Simple Interest

element in your decision? Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
TIME allows you the opportunity to • Compound Interest
postpone consumption and earn Interest paid (earned) on any previous
INTEREST. interest earned, as well as on the
principal borrowed (lent).

3.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Simple Interest Formula Simple Interest Example

• Assume that you deposit $1,000 in an
Formula SI = P0(i)(n) account earning 7% simple interest for
2 years. What is the accumulated
SI: Simple Interest interest at the end of the 2nd year?
P0: Deposit today (t=0)
• SI = P0(i)(n)
i: Interest Rate per Period = $1,000(0.07)(2)
n: Number of Time Periods = $140
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Simple Interest (FV) Simple Interest (PV)

• What is the Future Value (FV) of the • What is the Present Value (PV) of the
deposit? previous problem?
FV = P0 + SI The Present Value is simply the
= $1,000 + $140 $1,000 you originally deposited.
= $1,140 That is the value today!
• Future Value is the value at some future • Present Value is the current value of a
time of a present amount of money, or a future amount of money, or a series of
series of payments, evaluated at a given payments, evaluated at a given interest
interest rate. rate.
3.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Future Value
Why Compound Interest? Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
Future Value (U.S. Dollars)

2 years.
0 1 2
7%
$1,000
FV2
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Future Value Future Value

Single Deposit (Formula) Single Deposit (Formula)
FV1 = P0 (1 + i)1 = $1,000 (1.07) FV1 = P0 (1 + i)1 = $1,000 (1.07)
= $1,070 = $1,070
Compound Interest FV2 = FV1 (1 + i)1
You earned $70 interest on your $1,000 = P0 (1 + i)(1 + i) = $1,000(1.07)(1.07)
deposit over the first year. = P0 (1 + i)2 = $1,000(1.07)2
= $1,144.90
This is the same amount of interest you
would earn under simple interest. You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
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General Future
Value Formula Valuation Using Table I
FV1 = P0(1 + i)1 FVIFi,n is found on Table I
at the end of the book.
FV2 = P0(1 + i)2
etc.

General Future Value Formula:

FVn = P0 (1 + i)n
or FVn = P0 (FVIFi,n) – See Table I
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Using Future Value Tables TVM on the Calculator

FV2 = $1,000 (FVIF7%,2) • Use the highlighted row
= $1,000 (1.145) of keys for solving any
= $1,145 [Due to Rounding] of the FV, PV, FVA,
PVA, FVAD, and PVAD
problems
N: Number of periods
I/Y:Interest rate per period
PV: Present value
PMT: Payment per period
FV: Future value
CLR TVM: Clears all of the inputs
into the above TVM keys
Source: Courtesy of Texas Instruments

3.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Using The TI BAII+ Calculator Entering the FV Problem

Inputs Press:
N I/Y PV PMT FV 2nd CLR TVM
Compute 2 N
7 I/Y
–1000 PV
0 PMT

Focus on 3rd Row of keys (will be CPT FV

displayed in slides as shown above) Source: Courtesy of Texas Instruments

3.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the FV Problem Story Problem Example

Inputs 2 7 –1,000 0 Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
N I/Y PV PMT FV annual interest rate of 10% for 5 years.
Compute 1,144.90
0 1 2 3 4 5
N: 2 Periods (enter as 2)
10%
I/Y: 7% interest rate per period (enter as 7 NOT 0.07)
PV: $1,000 (enter as negative as you have “less”) $10,000
PMT: Not relevant in this situation (enter as 0)
FV: Compute (Resulting answer is positive) FV5
3.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Story Problem Solution Entering the FV Problem

• Calculation based on general formula: Press:
FVn = P0 (1 + i)n 2nd CLR TVM
FV5 = $10,000 (1 + 0.10)5 5 N
= $16,105.10
10 I/Y
• Calculation based on Table I: –10000 PV
FV5 = $10,000 (FVIF10%, 5)
0 PMT
= $10,000 (1.611)
= $16,110 [Due to Rounding] CPT FV
Source: Courtesy of Texas Instruments

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the FV Problem Double Your Money!!!

Inputs 5 10 –10,000 0
Quick! How long does it take to
N I/Y PV PMT FV double $5,000 at a compound rate
Compute 16,105.10 of 12% per year (approx.)?

The result indicates that a $10,000

investment that earns 10% annually We will use the “Rule-of-72”.
for 5 years will result in a future value
of $16,105.10.
3.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

The “Rule-of-72” Solving the Period Problem

Inputs 12 –1,000 0 +2,000
Quick! How long does it take to
double $5,000 at a compound rate N I/Y PV PMT FV
of 12% per year (approx.)? Compute 6.12 years

The result indicates that a $1,000

Approx. Years to Double = 72 / i%
investment that earns 12% annually
will double to $2,000 in 6.12 years.
72 / 12% = 6 Years
[Actual Time is 6.12 Years] Note: 72/12% = approx. 6 years
3.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Present Value Present Value

Single Deposit (Graphic) Single Deposit (Formula)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine PV0 = FV2 / (1 + i)2 = $1,000 / (1.07)2
how much you need to deposit today at a = FV2 / (1 + i)2 = $873.44
discount rate of 7% compounded annually.
0 1 2 0 1 2
7% 7%
$1,000 $1,000
PV0 PV1 PV0
3.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

General Present
Value Formula Valuation Using Table II
PV0 = FV1 / (1 + i)1 PVIFi,n is found on Table II
at the end of the book.
PV0 = FV2 / (1 + i)2
etc.

General Present Value Formula:

PV0 = FVn / (1 + i)n
or PV0 = FVn (PVIFi,n) – See Table II
3.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Using Present Value Tables Solving the PV Problem

PV2 = $1,000 (PVIF7%,2) Inputs 2 7 0 +1,000
= $1,000 (.873)
= $873 [Due to Rounding]
N I/Y PV PMT FV
Compute –873.44

N: 2 Periods (enter as 2)
I/Y: 7% interest rate per period (enter as 7 NOT 0.07)
PV: Compute (Resulting answer is negative “deposit”)
PMT: Not relevant in this situation (enter as 0)
FV: $1,000 (enter as positive as you “receive $”)
3.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Story Problem Example Story Problem Solution

Julie Miller wants to know how large of a
• Calculation based on general formula:
deposit to make so that the money will
PV0 = FVn / (1 + i)n
grow to $10,000 in 5 years at a discount
PV0 = $10,000 / (1 + 0.10)5
rate of 10%.
= $6,209.21
0 1 2 3 4 5
10% • Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
$10,000
= $10,000 (0.621)
PV0 = $6,210.00 [Due to Rounding]
3.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the PV Problem Types of Annuities

Inputs 5 10 0 +10,000 • An Annuity represents a series of equal
N I/Y PV PMT FV payments (or receipts) occurring over a
–6,209.21 specified number of equidistant periods.
Compute
• Ordinary Annuity: Payments or receipts
The result indicates that a $10,000 occur at the end of each period.
future value that will earn 10% annually • Annuity Due: Payments or receipts
for 5 years requires a $6,209.21 deposit occur at the beginning of each period.
today (present value).
3.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Examples of Annuities Parts of an Annuity

• Student Loan Payments (Ordinary Annuity)

End of End of End of
• Car Loan Payments Period 1 Period 2 Period 3

• Insurance Premiums 0 1 2 3
• Mortgage Payments
$100 $100 $100
• Retirement Savings
Today Equal Cash Flows
Each 1 Period Apart
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Overview of an
Parts of an Annuity Ordinary Annuity – FVA
Cash flows occur at the end of the period
(Annuity Due) 0 1 2 n n+1
Beginning of Beginning of Beginning of i% . . .
Period 1 Period 2 Period 3 R R R
R = Periodic
0 1 2 3 Cash Flow

$100 $100 $100 FVAn = R(1 + i)n-1 + R(1 + i)n-2 + FVAn

Equal Cash Flows ... + R(1 + i)1 + R(1 + i)0

Today
Each 1 Period Apart
3.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of an
Ordinary Annuity – FVA Hint on Annuity Valuation
Cash flows occur at the end of the period
0 1 2 3 4 The future value of an ordinary
7% annuity can be viewed as
$1,000 $1,000 $1,000 occurring at the end of the last
$1,070 cash flow period, whereas the
$1,145 future value of an annuity due
FVA3 = $1,000(1.07)2 + can be viewed as occurring at
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
the beginning of the last cash
= $1,145 + $1,070 + $1,000
= $3,215 flow period.
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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Valuation Using Table III Solving the FVA Problem

FVAn = R (FVIFAi%,n) Inputs 3 7 0 –1,000
FVA3 = $1,000 (FVIFA7%,3)
N I/Y PV PMT FV
= $1,000 (3.215) = $3,215
Compute 3,214.90

N: 3 Periods (enter as 3 year-end deposits)

I/Y: 7% interest rate per period (enter as 7 NOT 0.07)
PV: Not relevant in this situation (no beg value)
PMT: $1,000 (negative as you deposit annually)
FV: Compute (Resulting answer is positive)
3.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Overview View of an Example of an

Annuity Due – FVAD Annuity Due – FVAD
Cash flows occur at the beginning of the period Cash flows occur at the beginning of the period
0 1 2 3 n–1 n 0 1 2 3 4
i% . . . 7%
R R R R R $1,000 $1,000 $1,000 $1,070
$1,145
$1,225

FVADn = R(1 + i)n + R(1 + i)n-1 + FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3

FVADn $1,000(1.07)2 + $1,000(1.07)1
... + R(1 + i)2 + R(1 + i)1
= FVAn (1 + i) = $1,225 + $1,145 + $1,070
= $3,440
3.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Valuation Using Table III Solving the FVAD Problem

FVADn = R (FVIFAi%,n)(1 + i) Inputs 3 7 0 –1,000
FVAD3 = $1,000 (FVIFA7%,3)(1.07) N I/Y PV PMT FV
= $1,000 (3.215)(1.07) = $3,440
Compute 3,439.94
Complete the problem the same as an “ordinary annuity”
problem, except you must change the calculator setting
to “BGN” first. Don’t forget to change back!
Step 1: Press 2nd BGN keys
Step 2: Press 2nd SET keys
Step 3: Press 2nd QUIT keys
3.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Overview of an Example of an
Ordinary Annuity – PVA Ordinary Annuity – PVA
Cash flows occur at the end of the period
Cash flows occur at the end of the period
0 1 2 n n+1 0 1 2 3 4
7%
i% . . .
R R R $1,000 $1,000 $1,000
$934.58
$873.44
R = Periodic
$816.30
Cash Flow
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
PVAn $1,000/(1.07)2 +
PVAn = R/(1 + i)1 + R/(1 + i)2 $1,000/(1.07)3
+ ... + R/(1 + i)n = $934.58 + $873.44 + $816.30
= $2,624.32
3.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Hint on Annuity Valuation Valuation Using Table IV

The present value of an ordinary PVAn = R (PVIFAi%,n)
annuity can be viewed as PVA3 = $1,000 (PVIFA7%,3)
occurring at the beginning of the = $1,000 (2.624) = $2,624
first cash flow period, whereas
the future value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.
3.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Overview of an
Solving the PVA Problem Annuity Due – PVAD
Cash flows occur at the beginning of the period
Inputs 3 7 –1,000 0 0 1 2 n–1 n
N I/Y PV PMT FV i% . . .
R R R R
Compute 2,624.32

N: 3 Periods (enter as 3 year-end deposits) R: Periodic

I/Y: 7% interest rate per period (enter as 7 NOT .07) PVADn Cash Flow
PV: Compute (Resulting answer is positive)
PMT: $1,000 (negative as you deposit annually) PVADn = R/(1 + i)0 + R/(1 + i)1 + ... + R/(1 + i)n–1
FV: Not relevant in this situation (no ending value) = PVAn (1 + i)
3.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Example of an
Annuity Due – PVAD Valuation Using Table IV
Cash flows occur at the beginning of the period
0 1 2 3 4
PVADn = R (PVIFAi%,n)(1 + i)
7% PVAD3 = $1,000 (PVIFA7%,3)(1.07)
$1,000.00 $1,000 $1,000 = $1,000 (2.624)(1.07) = $2,808
$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
3.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Steps to Solve Time Value

Solving the PVAD Problem of Money Problems
Inputs 3 7 –1,000 0 1. Read problem thoroughly
N I/Y PV PMT FV 2. Create a time line

2,808.02 3. Put cash flows and arrows on time line

Compute
4. Determine if it is a PV or FV problem
Complete the problem the same as an “ordinary annuity”
problem, except you must change the calculator setting 5. Determine if solution involves a single
to “BGN” first. Don’t forget to change back! CF, annuity stream(s), or mixed flow
Step 1: Press 2nd BGN keys 6. Solve the problem
Step 2: Press 2nd SET keys 7. Check with financial calculator (optional)
Step 3: Press 2nd QUIT keys
3.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Mixed Flows Example How to Solve?

Julie Miller will receive the set of cash
flows below. What is the Present Value 1. Solve a “piece-at-a-time” by
at a discount rate of 10%. discounting each piece back to t=0.
2. Solve a “group-at-a-time” by first
0 1 2 3 4 5 breaking problem into groups of
10%
annuity streams and any single
$600 $600 $400 $400 $100 cash flow groups. Then discount
PV0 each group back to t=0.

3.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

“Piece-At-A-Time” “Group-At-A-Time” (#1)

0 1 2 3 4 5
0 1 2 3 4 5 10%
10%
$600 $600 $400 $400 $100
$600 $600 $400 $400 $100 $1,041.60
$545.45 $ 573.57
$495.87 $ 62.10
$300.53 $1,677.27 = PV0 of Mixed Flow [Using Tables]
$273.21
$ 62.09 $600(PVIFA10%,2) = $600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$1677.15 = PV0 of the Mixed Flow $100 (PVIF10%,5) = $100 (0.621) = $62.10
3.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the Mixed Flows

“Group-At-A-Time” (#2) Problem using CF Registry
• Use the highlighted
0 1 2 3 4 key for starting the
$400 $400 $400 $400
process of solving a
mixed cash flow
$1,268.00
problem
0 1 2 PV0 equals
Plus • Press the CF key
$200 $200 $1677.30. and down arrow key
$347.20
through a few of the
0 1 2 3 4 5
Plus keys as you look at
$100 the definitions on
$62.10 the next slide
Source: Courtesy of Texas Instruments
3.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Mixed Flows Solving the Mixed Flows

Problem using CF Registry Problem using CF Registry
Defining the calculator variables: Steps in the Process
For CF0: This is ALWAYS the cash flow occurring Step 1: Press CF key
at time t=0 (usually 0 for these problems) Step 2: Press 2nd CLR Work keys
For Cnn:* This is the cash flow SIZE of the nth Step 3: For CF0 Press 0 Enter ↓ keys
group of cash flows. Note that a “group” may only Step 4: For C01 Press 600 Enter ↓ keys
contain a single cash flow (e.g., $351.76).
Step 5: For F01 Press 2 Enter ↓ keys
For Fnn:* This is the cash flow FREQUENCY of the
nth group of cash flows. Note that this is always a Step 6: For C02 Press 400 Enter ↓ keys
positive whole number (e.g., 1, 2, 20, etc.). Step 7: For F02 Press 2 Enter ↓ keys
* nn represents the nth cash flow or frequency. Thus, the
first cash flow is C01, while the tenth cash flow is C10.
3.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the Mixed Flows Frequency of

Problem using CF Registry Compounding
Steps in the Process General Formula:
Step 8: For C03 Press 100 Enter ↓ keys
FVn = PV0(1 + [i/m])mn
Step 9: For F03 Press 1 Enter ↓ keys
Step 10: Press ↓ ↓ keys n: Number of Years
Step 11: Press NPV key m: Compounding Periods per Year
Step 12: For I =, Enter 10 Enter ↓ keys i: Annual Interest Rate
Step 13: Press CPT key FVn,m: FV at the end of Year n
Result: Present Value = $1,677.15 PV0: PV of the Cash Flow today
3.69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Impact of Frequency Impact of Frequency

Julie Miller has $1,000 to invest for 2 Qrtly FV2 = 1,000(1 + [0.12/4])(4)(2)
Years at an annual interest rate of 12%. = 1,266.77

Annual FV2 = 1,000(1 + [0.12/1])(1)(2) Monthly FV2 = 1,000(1 + [0.12/12])(12)(2)

= 1,254.40 = 1,269.73
Daily FV2 = 1,000(1 + [0.12/365])(365)(2)
Semi FV2 = 1,000(1 + [0.12/2])(2)(2)
= 1,271.20
= 1,262.48

3.71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Solving the Frequency Solving the Frequency

Problem (Quarterly) Problem (Quarterly Altern.)
Press:
Inputs 2(4) 12/4 –1,000 0
2nd P/Y 4 ENTER
N I/Y PV PMT FV
2nd QUIT
Compute 1266.77
12 I/Y
The result indicates that a $1,000 –1000 PV
investment that earns a 12% annual 0 PMT
rate compounded quarterly for 2 years
2 2nd xP/Y N
will earn a future value of $1,266.77.
CPT FV
Source: Courtesy of Texas Instruments
3.73 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Solving the Frequency Solving the Frequency

Problem (Daily) Problem (Daily Alternative)
Press:
Inputs 2(365) 12/365 –1,000 0
2nd P/Y 365 ENTER
N I/Y PV PMT FV
2nd QUIT
Compute 1271.20
12 I/Y
The result indicates that a $1,000 –1000 PV
investment that earns a 12% annual 0 PMT
rate compounded daily for 2 years will
2 2nd xP/Y N
earn a future value of $1,271.20.
CPT FV
Source: Courtesy of Texas Instruments
3.75 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.76 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Effective Annual BWs Effective

Interest Rate Annual Interest Rate
Effective Annual Interest Rate Basket Wonders (BW) has a $1,000 CD
at the bank. The interest rate is 6%
The actual rate of interest earned
compounded quarterly for 1 year.
(paid) after adjusting the nominal
What is the Effective Annual Interest
rate for factors such as the number
Rate (EAR)?
of compounding periods per year.
EAR = ( 1 + 0.06 / 4 )4 – 1
= 1.0614 - 1 = 0.0614 or 6.14%!
(1 + [ i / m ] )m – 1

3.77 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.78 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Converting to an EAR Steps to Amortizing a Loan

Press:
1. Calculate the payment per period.
2nd I Conv 2. Determine the interest in Period t.
(Loan Balance at t – 1) x (i% / m)
6 ENTER
↓ ↓
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4 ENTER
4. Determine ending balance in Period t.
↑ CPT (Balance - principal payment from Step 3)
2nd QUIT
5. Start again at Step 2 and repeat.
Source: Courtesy of Texas Instruments
3.79 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.80 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Amortizing a Loan Example Amortizing a Loan Example

Julie Miller is borrowing $10,000 at a End of Payment Interest Principal Ending
compound annual interest rate of 12%. Year Balance
Amortize the loan if annual payments are 0 — — — $10,000
made for 5 years. 1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
Step 1: Payment
3 2,774 800 1,974 4,689
PV0 = R (PVIFA i%,n) 4 2,774 563 2,211 2,478
$10,000 = R (PVIFA 12%,5) 5 2,775 297 2,478 0
$13,871 $3,871 $10,000
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774 [Last Payment Slightly Higher Due to Rounding]
3.81 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.82 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Using the Amortization

Solving for the Payment Functions of the Calculator
Inputs 5 12 10,000 0 Press:
2nd Amort
N I/Y PV PMT FV
1 ENTER
Compute –2774.10
1 ENTER
The result indicates that a $10,000 loan Results:
BAL = 8,425.90* ↓
that costs 12% annually for 5 years and
PRN = –1,574.10* ↓
will be completely paid off at that time INT = –1,200.00* ↓
will require $2,774.10 annual payments. Year 1 information only
Source: Courtesy of Texas Instruments *Note: Compare to 3-82
3.83 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.84 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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© Pearson Education Limited 2009 Carroll University
 Fundamentals of Financial Management, 13e
Chapter 3: Time Value of Money

Using the Amortization Using the Amortization

Functions of the Calculator Functions of the Calculator
Press: Press:
2nd Amort 2nd Amort
2 ENTER 1 ENTER
2 ENTER 5 ENTER
Results: Results:
BAL = 6,662.91* ↓ BAL = 0.00 ↓
PRN = –1,763.99* ↓ PRN = – 10,000.00 ↓
INT = –1,011.11* ↓ INT = –3,870.49 ↓
Year 2 information only Entire 5 Years of loan information
*Note: Compare to 3-82
(see the total line of 3-82)
Source: Courtesy of Texas Instruments Source: Courtesy of Texas Instruments
3.85 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. 3.86 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Usefulness of Amortization

1. Determine Interest Expense –

Interest expenses may reduce
taxable income of the firm.
2. Calculate Debt Outstanding –
The quantity of outstanding
debt may be used in financing
the day-to-day activities of the
firm.
3.87 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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© Pearson Education Limited 2009 Carroll University