INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Chapter 4

Time Value of Money

INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Time Lines

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the first
period (year, month, etc.) or the beginning of
the second period.
0 1 2 3
I%

CF0 CF1 CF2 CF3

INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What is the future value (FV) of an initial $100

after 3 years, if I/YR = 4%?

• Finding the FV of a cash flow or series of cash

flows is called compounding.
• FV can be solved by using the step-by-step,
financial calculator, and spreadsheet methods.

0 1 2 3
4%

100 FV = ?
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV:

The Step-by-Step and Formula Methods

• After 1 year:
FV1 = PV(1 + I) = $100(1.04) = $104.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
• After N years (general case):
FVN = PV(1 + I)N
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV:

Calculator and Excel Methods

• Solves the general FV equation.

• Requires 4 inputs into calculator, and will solve
for the fifth. (Set to P/YR = 1 and END mode.)

INPUTS 3 4 -100 0
N I/YR PV PMT FV
OUTPUT 112.49

Excel: =FV(rate,nper,pmt,pv,type)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Present Value

• What is the present value (PV) of $100 due in

3 years, if I/YR = 4%?
 Finding the PV of a cash flow or series of cash
flows is called discounting (the reverse of
compounding).
 The PV shows the value of cash flows in terms
of today’s purchasing power.

0 1 2 3
4%

PV = ? 100
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PV:

The Formula Method

• Solve the general FV equation for PV:

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.04)3
= $88.90
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PV:

Calculator and Excel Methods

• Solves the general FV equation for PV.

• Exactly like solving for FV, except we have
different input information and are solving for a
different variable.
INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90

Excel: =PV(rate,nper,pmt,fv,type)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for I: What annual interest rate would

cause $100 to grow to $119.10 in 3 years?

• Solves the general FV equation for I/YR.

• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 3 -100 0 119.10

N I/YR PV PMT FV
OUTPUT 6

Excel: =RATE(nper,pmt,pv,fv,type,guess)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for N: If sales grow at 10% per year,

how long before sales double?

• Solves the general FV equation for N.

• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 10 -1 0 2
N I/YR PV PMT FV
OUTPUT 7.3

EXCEL: =NPER(rate,pmt,pv,fv,type)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Excel

Please watch the following YouTube videos, take notes (questions

if there are any), and then just read the rest of this file (slides 12-
35).

• https://www.youtube.com/watch?v=JOqEpxNGQjk

• https://www.youtube.com/watch?v=nBth1ljkBRk

• https://www.youtube.com/watch?v=qAhV3xG0i8s

• https://www.youtube.com/watch?v=fOS_08DEx9Y
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What is the difference between an ordinary

annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV:

3-Year Ordinary Annuity of $100 at 4%

• $100 payments occur at the end of each

period, but there is no PV.

INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 312.16

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 0.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PV:

3-year Ordinary Annuity of $100 at 4%

• $100 payments still occur at the end of each

period, but now there is no FV.

INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -277.51

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 0.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV:

3-Year Annuity Due of $100 at 4%

• Now, $100 payments occur at the beginning of

each period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
• Alternatively, set calculator to “BEGIN” mode and
solve for the FV of the annuity due:
BEGIN
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 324.65

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PV:

3-Year Annuity Due of $100 at 4%

• Again, $100 payments occur at the beginning of

each period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
• Alternatively, set calculator to “BEGIN” mode and
solve for the PV of the annuity due:
BEGIN
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -288.61

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 1.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What is the present value of a 5-year $100

ordinary annuity at 4%?

• Be sure your financial calculator is set back to

END mode and solve for PV:
 N = 5, I/YR = 4, PMT = -100, FV = 0.
 PV = $445.18.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

The Power of Compound Interest

A 19-year-old student wants to save $5 a day for

her retirement. Every day she places $5 in a
drawer. At the end of every year, she invests the
accumulated savings ($1,825) in a brokerage
account with an expected annual return of 8%.

How much money will she have when she is 65

years old?
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV: If she begins saving today, how

much will she have when she is 65?

• If she sticks to her plan, she will have $705,373

when she is 65.

INPUTS 45 8 0 -1825
N I/YR PV PMT FV
OUTPUT 705,373

Excel: =FV(.08,45,-1825,0,0)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for FV: If you don’t start saving until you are
40 years old, how much will you have at 65?

• If a 40-year-old investor begins saving today,

and sticks to the plan, he or she will have
$133,418 at age 65. This is $571,954 less than
if starting at age 20.
• Lesson: It pays to start saving early.

INPUTS 25 8 0 -1825
N I/YR PV PMT FV
OUTPUT 133,418

Excel: =FV(.8,25,-1825,0,0)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PMT: How much must the 40-year

old deposit annually to catch the 20-year old?

• To find the required annual contribution, enter

the number of years until retirement and the
final goal of $705,372.75, and solve for PMT.

INPUTS 25 8 0 705373
N I/YR PV PMT FV
OUTPUT -9,648.64

Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What is the PV of this uneven cash flow

stream?

0 1 2 3 4
4%

100 300 300 -50

96.15
277.37
266.70
-42.74
597.48 = PV
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Solving for PV:

Uneven Cash Flow Stream

• Input cash flows in the calculator’s “CFLO”

register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
• Enter I/YR = 4, press NPV button to get NPV =
$597.48. (Here NPV = PV.)
 INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Will the FV of a lump sum be larger or smaller if

compounded more often, holding the stated I% constant?

• LARGER, as the more frequently compounding

occurs, interest is earned on interest more
often.
0 1 2 3
10%

100 112.49
Annually: FV3 = $100(1.04)3 = $112.49
0 1 2 3
0 1 2 3 4 5 6
5%

100 112.62
Semiannually: FV6 = $100(1.02)6 = $112.62
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Classification of Interest Rates

• Nominal rate (INOM): also called the quoted or

stated rate. An annual rate that ignores
compounding effects.
 INOM is stated in contracts. Periods must also be
given, e.g. 4% quarterly or 4% daily interest.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Classification of Interest Rates

• Effective (or equivalent) annual rate (EAR =

EFF%): the annual rate of interest actually
being earned, considering compounding.
 EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
 Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
 Should be indifferent between receiving 4.04%
annual interest and receiving 4% interest,
compounded semiannually.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Why is it important to consider effective rates

of return?

• Investments with different compounding

intervals provide different effective returns.
• To compare investments with different
compounding intervals, you must look at their
effective returns (EFF% or EAR).
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Why is it important to consider effective rates

of return?

• See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

When is each rate used?

• INOM: Written into contracts, quoted by banks

and brokers. Not used in calculations or shown
on time lines.

• EAR: Used to compare returns on investments

with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What is the FV of $100 after 3 years under 4%

semiannual compounding? Quarterly compounding?

MN
 I 
FVN  PV1 NOM 
 M 

23
 0.04 
FV3S  $1001 
 2 
FV3S  $100(1.02)6  $112.62

FV3Q  $100(1.01)12  $112.68

INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Can the effective rate ever be equal to the

nominal rate?

• Yes, but only if annual compounding is used,

i.e., if M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

What’s the FV of a 3-year $100 annuity, if the quoted

interest rate is 4%, compounded semiannually?

• Payments occur annually, but compounding

occurs every 6 months.
• Cannot use normal annuity valuation
techniques.
0 1 2 3 4 5 6
2%

100 100 100

INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Method 1:
Compound Each Cash Flow

0 1 2 3 4 5 6
2%

100 100 100

104.04
108.24
312.28

FV3 = $100(1.02)4 + $100(1.02)2 + $100

FV3 =$312.28
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Method 2:
Financial Calculator or Excel

• Find the EAR and treat as an annuity.

• EAR = (1 + 0.04/2)2 – 1 = 4.04%.

INPUTS 3 4.04 0 -100

N I/YR PV PMT FV
OUTPUT 312.28

Excel: =FV(.0404,3,-100,0,0)
INTRO FUTUREVALUE PRESENTVALUE I&N ANNUITIES RATES/RETURN AMORTIZATION

Find the PV of This 3-Year Ordinary Annuity

• Could solve by discounting each cash flow,

or…
• Use the EAR and treat as an annuity to solve
for PV.

INPUTS 3 4.04 100 0

N I/YR PV PMT FV
OUTPUT -277.30

Excel: =PV(.0404,3,100,0,0)