The Time Value of Money

CHAPTER ORIENTATION
In this chapter, the concept of a time value of money is introduced; that is, a dollar today is worth
more than a dollar received a year from now. Thus, if we are to compare projects and financial
strategies logically, we must either move all dollar flows back to the present or out to some
common future date.

CHAPTER OUTLINE
I. Compound interest results when the interest paid on the investment during the first period is
added to the principal and during the second period the interest is earned on the original
principal plus the interest earned during the first period.
A. Mathematically, the future value of an investment if compounded annually at a rate
of i for n years will be
FVn = PV (l + i)n
where n = the number of years during which the compounding occurs
i = the annual interest (or discount) rate
PV = the present value or original amount invested at the
beginning of the first period
FVn = the future value of the investment at the end of n years
1. The future value of an investment can be increased either by increasing the
number of years we let it compound or by compounding it at a higher rate.
2. If the compounded period is less than one year, the future value of an
investment can be determined as follows:

 i  mn
FVn  PV1  
 m
where m = the number of times compounding occurs during the year

Page 1 of 10
II. Determining the present value, that is, the value in today’s dollars of a sum of money to be
received in the future, involves nothing other than inverse, compounding. The differences in
these techniques come about merely from the investors point of view.
A. Mathematically, the present value of a sum of money to be received in the future can
be determined with the following equation:

 1 
 
 1  i  n 
PV = FVn  
where n = the number of years until payment will be received,
i = the opportunity rate or discount rate
PV = the present value of the future sum of money
FVn = the future value of the investment at the end of n years
1. The present value of a future sum of money is inversely related to both the
number of years until the payment will be received and the opportunity rate.
III. An annuity is a series of equal dollar payments for a specified number of years. Because
annuities occur frequently in finance—for example, bond interest payments—we treat them
specially.
A. A compound annuity involves depositing or investing an equal sum of money at the
end of each year for a certain number of years and allowing it to grow.
1. This can be done by using our compounding equation and compounding
each one of the individual deposits to the future or by using the following
compound annuity equation:

 n 1 
  1  i  t 
FVn = PMT  t  0 

where PMT = the annuity value deposited at the end of each year

i = the annual interest (or discount) rate

n = the number of years for which the annuity will last

FVn = the future value of the annuity at the end of the nth
year

Page 2 of 10
 B. Pension funds, insurance obligation, and interest received from bonds all involve
annuities. To compare these financial instruments, we would like to know the
present value of each of these annuities.
1. This can be done by using our present value equation and discounting each
one of the individual cash flows back to the present or by using the following
present value of an annuity equation:
 n 1 
  
 t  1 1  i  t 
PV = PMT  
where PMT = the annuity withdrawn at the end of each year
i = the annual interest or discount rate
PV = the present value of the future annuity
n = the number of years for which the annuity will last
C. This procedure of solving for PMT, the annuity value when i, n, and PV are known,
is also the procedure used to determine what payments are associated with paying
off a loan in equal installments. Loans paid off in this way, in periodic payments, are
called amortized loans. Here again, we know three of the four values in the annuity
equation and are solving for a value of PMT, the annual annuity.
IV. A perpetuity is an annuity that continues forever; that is, every year from now on, this
investment pays the same dollar amount.
A. An example of a perpetuity is preferred stock which yields a constant dollar
dividend infinitely.
B. The following equation can be used to determine the present value of a perpetuity:
pp
PV = i
where PV = the present value of the perpetuity
pp = the constant dollar amount provided by the perpetuity
i = the annual interest or discount rate
V. To aid in the calculations of present and future values, tables are provided at the back of the
text.
A. To aid in determining the value of FVn in the compounding formula
FVn = PV (l + i)n
tables have been compiled for values of (l + i)n, or FVIFi,n in Appendix B,
"Compound Sum of $1," in the back of the text.

Page 3 of 10
B. To aid in the computation of present values

FVn 1  i 
n
PV =

tables have been compiled for values of

1
1  i  n , or PVIFi,n

and appear in Appendix C in the back of the text.

C. Because of the time-consuming nature of compounding an annuity,

n 1
 1  i  t
FVn = PMT t  0

Tables are provided in Appendix D of the text for

n 1
 1  i  t
t0 or PVIFAi,n

for various combinations of n and i.

D. To simplify the process of determining the present value of an annuity

 n 1 
 
 t 
PV = PMT  t  1 1  i  

tables are provided in Appendix E of the text for various combinations of n and i for
the value

n 1

t  1 1  i 
t
or PVIFAi,n

Page 4 of 10
 ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS

5-1A. (Compound Interest) To what amount will the following investments accumulate?
a. $4,000 invested for 11 years at 9% compounded annually
b. $8,000 invested for 10 years at 8% compounded annually
c. $800 invested for 12 years at 12% compounded annually
d. $21,000 invested for 6 years at 5% compounded annually
5-2A. (Compound Value Solving for n) How many years will the following take?
a. $550 to grow to $1,043.90 if invested at 6% compounded annually
b. $40 to grow to $88.44 if invested at 12% compounded annually
c. $110 to grow to $614.79 if invested at 24% compounded annually
d. $60 to grow to $73.80 if invested at 3% compounded annually
5-3A. (Compound Value Solving for i) At what annual rate would the following have to be
invested?
a. $550 to grow to $1,898.60 in 13 years
b. $275 to grow to $406.18 in 8 years
c. $60 to grow to $279.66 in 20 years
d. $180 to grow to $486.00 in 6 years
5-4A. (Present Value) What is the present value of the following future amounts?

a. $800 to be received 10 years from now discounted back to present at 10%

b. $400 to be received 6 years from now discounted back to present at 6%

c. $1,000 to be received 8 years from now discounted back to present at 5%

d. $900 to be received 9 years from now discounted back to present at 20%

5-5A. (Compound Annuity) What is the accumulated sum of each of the following streams of
payments?

a. $500 a year for 10 years compounded annually at 6%

b. $150 a year for 5 years compounded annually at 11%

c. $35 a year for 8 years compounded annually at 7%

d. $25 a year for 3 years compounded annually at 2%

5-6A. (Present Value of an Annuity) What is the present value of the following annuities?
Page 5 of 10
 a. $3,000 a year for 10 years discounted back to the present at 8%

b. $50 a year for 3 years discounted back to the present at 3%

c. $280 a year for 8 years discounted back to the present at 7%

d. $600 a year for 10 years discounted back to the present at 10%

5-7A. (Compound Value) Trish Nealon, who recently sold her Porsche, placed $20,000 in a
savings account paying annual compound interest of 7%.

a. Calculate the amount of money that will have accrued if she leaves the money in the
bank for 1, 5, and 15 years.

b. If she moves her money into an account that pays 9% or one that pays 11%, rework
part a using these new interest rates.

c. What conclusions can you draw about the relationships between interest rates, time,
and future sums from the calculations you have done above?
5-8A. (Compound Interest with Nonannual Periods) Calculate the amount of money that will be in
each of the following accounts at the end of the given deposit period:

Compounding
Period
Annual (Compounded Deposit
Amount Interest Every Period
Account Deposited Rate Month) (Years)
Korey Stringer$2,000 12 % 2 2
Eric Moss 50,000 12 1 1
Ty Howard 7,000 18 2 2
Rob Kelly 130,000 12 3 2
Matt Christopher 20,000 14 6 4
Juan Porter 15,000 15 4 3
5-9A. (Compound Interest with Nonannual Periods)
a. Calculate the future sum of $6,000, given that it will be held in the bank 5 years at
an annual interest rate of 6%.
b. Recalculate part a using a compounding period that is (1) semiannual and (2)
bimonthly.
c. Recalculate parts a and b for a 12% annual interest rate.
d. Recalculate part a using a time horizon of 12 years (annual interest rate is still 6%).
e. With respect to the effect of changes in the stated interest rate and holding periods
on future sums in parts c and d, what conclusions do you draw when you compare
these figures with the answers found in parts a and b?

5-10A. (Solving for i in Annuities) Ellen Denis, a sophomore mechanical engineering student,
receives a call from an insurance agent, who believes that Ellen is an older woman ready to
Page 6 of 10
 retire from teaching. He talks to her about several annuities that she could buy that would
guarantee her an annual fixed income. The annuities are as follows:

Initial
Payment into Duration
Annuity Amount of Money of Annuity
Annuity (at t = 0) Received per year (Years)
A $50,000 $8500 12
B $60,000 $7000 25
C $70,000 $8000 20

If Ellen could earn 12% on her money by placing it in a savings account, should she place it
instead in any of the annuities? Which ones, if any? Why?
5-11A. (Future Value) Sales of a new marketing book were 10,000 copies this year and were
expected to increase by 15% per year. What are expected sales during each of the next three
years? Graph this sales trend and explain.

5-12A. (Future Value) Reggie Jackson, formerly of the New York Yankees, hit 41 home runs in
1980. If his home-run output grew at a rate of 12% per year, what would it have been over
the following 5 years?

5-13A. (Loan Amortization) Sefani Moore purchased a new house for $150,000. She paid $30,000
down and agreed to pay the rest over the next 25 years in 25 equal annual payments that
included principal payments plus 10% compound interest on the unpaid balance. What will
these equal payments be?

5-14A. (Solving for PMT in an Annuity) To pay for your child’s education, you wish to have
accumulated $25,000 at the end of 15 years. To do this, you plan on depositing an equal
amount in the bank at the end of each year. If the bank is willing to pay 7% compounded
annually, how much must you deposit each year to obtain your goal?

5-15A. (Solving for i in Compound Interest) If you were offered $2,376.50 ten years from now in
return for an investment of $700 currently, what annual rate of interest would you earn if
you took the offer?

5-16A. (Present Value and Future Value of an Annuity) In 10 years, you plan to retire and buy a
house in Marco Island, Florida. The house you are looking at currently costs $125,000 and
is expected to increase in value each year at a rate of 5%. Assuming you can earn 10%
annually on your investment, how much must you invest at the end of each of the next 10
years to be able to buy your dream home when you retire?

Page 7 of 10
5-17A. (Compound Value) The Knutson Corporation needs to save $15 million to retire a $15
million mortgage that matures on December 31, 2002. To retire this mortgage, the company
plans to put a fixed amount into an account at the end of each year for 10 years, with the
first payment occurring on December 31, 1993. The Knutson Corporation expects to earn
10% annually on the money in this account. What annual contribution must it make to this
account to accumulate the $15 million by December 31, 2002?

5-18A. (Compound Interest with Nonannual Periods) After examining the various personal loan
rates available to you, you find that you can borrow funds from a finance company at 24%
compounded monthly or 26% compounded annually. Which alternative is the most
attractive?
5-19A. (Present Value of an Uneven Stream of Payments) You are given three investment
alternatives to analyze. The cash flows from these three investments are as follows:
Investment
End of
Year A B C
1 $15,000 $20,000
2 15,000
3 15,000
4 15,000
5 15,000 $15,000
6 15,000 60,000
7 15,000
8 15,000
9 15,000
10 15,000 20,000

Assuming a 20% discount rate, find the present value of each investment.

5-20A. (Present Value) The Shin Corporation is planning to issue bonds that pay no interest but can
be converted into $1,000 at maturity, 8 years from their purchase. To price these bonds
competitively with other bonds of equal risk, it is determined that they should yield 9%,
compounded annually. At what price should the Shin Corporation sell these bonds?

5-21A. (Perpetuities) What is the present value of the following?

Page 8 of 10
5-22A. (Solving for n with Nonannual Periods) About how many years would it take for your
investment to grow sevenfold if it were invested at 10% compounded annually?

5-23A. (Complex Present Values) How much do you have to deposit today so that beginning 11
years from now you can withdraw $10,000 a year for the next 5 years (periods 11 through
15) plus an additional amount of $15,000 in that last year (period 15)? Assume an interest
rate of 7%.

5-24A. (Loan Amortization) On December 31, Loren Billingsley bought a yacht for $60,000,
paying $15,000 down and agreeing to pay the balance in 10 equal annual installments that
include both principal and 9% interest on the declining balance. How big would the annual
payments be?
5-25A. (Solving for i in an Annuity) You lend a friend $45,000, which your friend will repay in 5
equal annual payments of $9,000 with the first payment to be received one year from now.
What rate of return does your loan receive?
5-26A. (Solving for i in Compound Interest) You lend a friend $15,000, for which your friend will
repay you $37,313 at the end of 5 years. What interest rate are you charging your “friend”?
5-27A. (Loan Amortization) A firm borrows $30,000 from the bank at 13% compounded annually
to purchase some new machinery. This loan is to be repaid in equal annual installments at
the end of each year over the next 4 years. How much will each annual payment be?
5-28A. (Present Value Comparison) You are offered $1,000 today, $10,000 in 12 years, or $25,000 in 25
years. Assuming that you can earn 11% on your money, which should you choose?
5-29A. (Compound Annuity) You plan to buy some property in Florida five years from today. To do
this, you estimate that you will need $30,000 at that time for the purchase. You would like
to accumulate these funds by making equal annual deposits in your savings account, which
pays 10% annually. If you make your first deposit at the end of this year and you would like
your account to reach $30,000 when the final deposit is made, what will be the amount of
your deposit?
5-30A. (Complex Present Value) You would like to have $75,000 in 15 years. To accumulate this
amount, you plan to deposit each year an equal sum in the bank, which will earn 8% interest
compounded annually. Your first payment will be made at the end of the year.
a. How much must you deposit annually to accumulate this amount?
b. If you decide to make a lump-sum deposit today instead of the annual deposits, how large
should this lump-sum deposit be? (Assume you can earn 8% on this deposit.)
c. At the end of 5 years you will receive $20,000 and deposit this in the bank toward
your goal of $75,000 at the end of 15 years. In addition to this deposit, how much
must you deposit in equal annual deposits to reach your goal? (Again, assume that
you can earn 8% on this deposit.)

Page 9 of 10
5-31A. (Comprehensive Present Value) You are trying to plan for retirement in 10 years, and
currently you have $150,000 in a savings account and $250,000 in stocks. In addition, you
plan to add to your savings by depositing $8,000 per year in your savings account at the end
of each of the next 5 years and then $10,000 per year at the end of each year for the final 5
years until retirement.
a. Assuming your savings account returns 8% compounded annually while your
investments in stocks will return 12% compounded annually, how much will you
have at the end of 10 years? (Ignore taxes.)
b. If you expect to live for 20 years after you retire, and at retirement you deposit all of
your savings in a bank account paying 11 percent, how much can you withdraw each
year after retirement (20 equal withdrawals beginning one year after you retire) to
end up with a zero balance at death?
5-32A. (Loan Amortization) On December 31, Eugene Chung borrowed $200,000, agreeing to
repay this sum in 20 equal annual installments that included both the principal and 10%
interest on the declining balance. How large will the annual payments be?

5-33A. (Loan Amortization) To buy a new house, you must borrow $250,000. To do this, you take
out a $250,000, 30-year, 9% mortgage. Your mortgage payments, which are made at the
end of each year (one payment each year), include both principal and 9% interest on the
declining balance. How large will your annual payments be?

5-34A. (Present Value) The state lottery’s million-dollar payout provides for one million dollars to
be paid over 24 years in $40,000 amounts. The first $40,000 payment is made immediately
with the remaining 24 payments occurring at the end of each of the next 24 years. If 10% is
the appropriate discount rate, what is the present value of this stream of cash flows? If 20%
is the appropriate discount rate, what is the present value of the cash flows?

5-35A. (Solving for i in Compound Interest—Financial Calculator Needed) In March 1963, issue
number 39 of Tales of Suspense was issued. The original price for that issue was 12 cents.
By March of 1997, 34 years later, the value of this comic book had risen to $2,000. What
annual rate of interest would you have earned if you had bought the comic in 1963 and sold
it in 1997?

5-36A. (Comprehensive Present Value) You have just inherited a large sum of money and you are
trying to determine how much you should save for retirement and how much you can spend
now. For retirement, you will deposit today (January 1, 1997) a lump sum in a bank account
paying 10% compounded annually. You do not plan to touch this deposit until you retire in
5 years (January 1, 2002), and you plan to live for 20 additional years and then to drop dead
on December 31, 2021. During your retirement, you would like to receive income of
$60,000 per year to be received on the first day of each year, with the first payment on
January 1, 2002, and the last payment on January 1, 2021. Complicating this objective is
your desire to have one final 3-year fling during which time you’d like to track down all the
original members of the “Mr. Ed Show” and “The Monkeys” and get their autographs. To
finance this you want to receive $300,000 on January 1, 2017 and nothing on January 1,
2018, and January 1, 2019, as you will be on the road. In addition, after you pass on
(January 1, 2022), you would like to have a total of $100,000 to leave to your children.
a. How much must you deposit in the bank at 10% on January 1, 1997 in order to
achieve your goal? (Use a time line in order to answer this question.)
b. What kinds of problems are associated with this analysis and its assumptions?

Page 10 of 10