School of Business

Master of Business Administration

BFIN525 CORPORATE FINANCE

Chapter 4
Time Value of Money

1
Outline
◼ Timeline
◼ Future value
◼ Compounding Terms
◼ Present value
◼ Annuities
◼ Future value of an Ordinary Annuity
◼ Future value of an Annuity Due
◼ Present value of an Ordinary Annuity
◼ Present value of an Annuity Due
◼ Perpetuity
◼ Classification of Interest Rates 2
Timeline: Present value: value of money today
Future value: value of money in the future

1(End of one year) 2(End of year 2) 3(End of year 3)

0 (Now)
i%

CF0 CF1 CF2 CF3

• 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.
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 Future Value
• Future Value:
• Is the final amount of the loan or investment at the end of the last period
• Is the amount to which an investment will grow after earning interest
• Finding the FV of a cash flow when compound interest is applied is called
compounding.

• 𝐅𝐕𝐧 = 𝐏𝐕 𝟏+𝐢 𝐧 [This formula is used

FV = Future Value
when you have a single amount of money]
PV = Present Value
i = interest rate
n = Number of periods
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 Future Value
• Example:
• What is the Future value (FV) of an initial investment of $100 after 3 years, if the interest
rate is 10% compounded annually?

• Solution:

0 1 2 3
10%

100 FV = ?
• 𝐅𝐕𝐧 = 𝐏𝐕 𝟏 + 𝐢 𝐧

• 𝐅𝐕𝟑 = $𝟏𝟎𝟎 𝟏 + 𝟎. 𝟏 𝟑
= $133.10

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 FV of uneven cash flow stream (Cash flows
are unequal)

= 300*(1.12)^2

= 100*(1.12)^4

FV = [0(1+0.12)^5
+ 100(1+0.12)^4
+ 300(1+0.12)^3
+300(1+0.12)^2 6
+ 300 (1+0.12)^1
+ 500(1+0.12)^0 ] = 1,791.15$
 Compounding Terms

Compounding Periods Interested Calculated Number of times

interest paid
Compounding Annually Once a year 1
Compounding Every 6 months 2
Semiannually
Compounding Quarterly Every 3 months 4
Compounding Monthly Every month 12
Compounding Daily Every day 365

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 Tools for Calculating Compound Interest
Number of periods (n) Rate for each period (i)
Number of years Annual interest rate divided
multiplied the number by the number of times the
of times the interest is interest is compounded per
compounded per year year

If you compounded $100 for 2 years at 12% annually, semiannually,

quarterly , or monthly, What is n and i?

Periods Rate

Annually: 2 x 1 = 2 Annually: 12%/1 = 12%

Semiannually: 2 x 2 = 4 Semiannually: 12%/2 = 6%
Quarterly: 2 x 4 = 8 Quarterly: 12%/4 = 3%
Monthly: 2 x 12 = 24 Monthly: 12%/12 = 1%
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 Tools for Calculating Compound Interest
If you compounded $100 for 2 years at 12% annually, semiannually,
quarterly , or monthly, What is n and i?

Periods Rate

Annually: 2 x 1 = 2 Annually: 12%/1 = 12%

Semiannually: 2 x 2 = 4 Semiannually: 12%/2 = 6%
Quarterly: 2 x 4 = 8 Quarterly: 12%/4 = 3%
Monthly: 2 x 12 = 24 Monthly: 12%/12 = 1%

What is the future value at every case

Annual : FV = 100(1+0.12)^2
Semiannual : FV = 100(1+0.06)^4
Quarterly : FV = 100 (1+0.03)^8
Monthly : FV =100(1+0.01)^24
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 Present Value
• Present Value:
• Is the value of a loan or investment today
• Is the value today of a future cash flow

• Finding the PV of a cash flow when compound interest is applied is called

discounting (the reverse of compounding)
FV = Future Value
FV
• PV = 1+i n
[This formula is used
PV = Present Value
i = interest rate
when you have a single amount of money]
n = Number of periods
10
 Present Value Example Two: You want
• Example: to buy a car that costs
20,000$ after 5 years.
• What is the Present value (PV) of $133.10 due in 3 How much you have to
deposit today in the bank
years, if the interest rate is 10% Annual?
to buy the car after 5 years
• Solution: if interest is 10%?
PV = 20,000 / (1+0.1)^5
= 12,418.426$
0 1 2 3
10% How your answer will
change if interest in bank
PV=? 133.1 was compounded semi-
annual?
FV N = 5 x 2 = 10
• PV = 1+i n
= I = 10% / 2 = 5%
PV = 20,000/(1+0.05)^10
$133.10 =12,278.265
= $100 11

1+0.1 3
PV of uneven cash flow stream

= 300/(1.12)^3

= 500/(1.12)^5

0 100 300 300 300 500

+ + + + + 12
(1 + 0.12)^0 (1 + 0.12)^1 (1 + 0.12)^2 (1 + 0.12)^3 (1 + 0.12)^4 (1 + 0.12)^5
 Annuities
• Annuity:
• A stream of equal cash flows over n periods. “n is finite, limited”
• FV of an annuity:
• The future dollar amount of a series of payments plus interest
• PV of an annuity:
• The amount of money needed to invest today in order to receive a stream of equal payments for a given number
of years in the future

• Classification of annuities:
1. Contingent annuities: Have no fixed number of payments but depend on an uncertain event.
• (Example: Life insurance payments that cease when the insured passes away)
2. Annuities certain: Have a specific stated number of payments.
• (Example: Mortgage payments)

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 Annuities
Ordinary annuity: Annuity due:
Regular deposits/payments Regular
made at the end of the deposits/payments
period. Periods could be made at the beginning
months, quarters, years, of the period
and so on

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

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 Future Value of an Ordinary Annuity
[ 1+i n ]−1
FVAnnuity = PMT
i

Example: What will be the value in a bank account, if you deposit $1,000 at the end of each year for 4
years at an interest rate of 12% compounded annually?

Solution: 0 1 2 3 4
12%

1,000 1,000 1,000 1,000

FVA=?

1+i n −1 1+0.12 4 −1
FVAnnuity = PMT = 1,000 = $4,779.33
i 0.12
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 Future Value of an Annuity Due
FVAnnuity due = FVOrdinary Annuity x 1 + i

Example: What will be the value in a bank account, if you deposit $1,000 at the beginning of each year
for 4 years at an interest rate of 12% compounded annually?

Solution: 4
0 1 2 3
12%

1,000 1,000 1,000 1,000

FVA(due)=?

FVAnnuity due = FVOrdinary Annuity x 1 + i = $4,779.33 x (1 +0.12) = $5,352.85

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 Present Value of an Ordinary Annuity
1 1
PVAnnuity = PMT −
i i(1+i)n

Example: How much must you invest today, if you want to receive $8,000 at the end of each year for 3
years if the interest rate is 8% compounded annually?

0 1 2 3
Solution: 8%

PVA=? 8,000 8,000 8,000

1 1 1 1
PVAnnuity = PMT − = 8,000 − = $20,616.78
i i(1+i)n 0.08 0.08(1+0.08)3
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 Present Value of an Annuity Due
PVAnnuity due = PVOrdinary Annuity x 1 + i

Example: How much must you invest today, if you want to receive $8,000 at the beginning of each
year for 3 years if the interest rate is 8% compounded annually?

Solution:
0 1 2
8%

8,000 8,000 8,000

PVA(due)=?

PVAnnuity due = PVOrdinary Annuity x 1 + i = $20,616.78 x (1 +0.08) = $22,266.12

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 Perpetuity
• Perpetuity:
• A stream of equal payments at fixed intervals expected to continue forever.
PMT
• PVPerpetuity =
i

• Example: How much should you pay today for a financial instrument that pays a fixed
amount of $25 each year indefinitely, if the discount rate is 10%?
• Solution: 0 1 2 3 ∞
10%

PV=? 25 25 25 25

PMT 25
• PVPerpetuity =
i
=
0.1
= $250 19
 Classifications of Interest Rates
• Nominal Annual Rate: Given the symbol “𝑖𝑁𝑂𝑀 ”
• This is the rate quoted by banks, brokers, and other financial institutions.
• The contracted or quoted or stated interest rate

• Effective Annual Rate: Given the symbol “EAR” or “EFF%”

• This is the annual (interest once a year) rate that produces the same final result as
compounding at the periodic rate for M times per year.
• The annual rate of interest being earned as opposed to the quoted rate
iNOM M
• EAR = 1 +
M
−1
M = Number of compounding periods
• Semiannual => M = 2
• Quarterly => M = 4
• Monthly => M = 12 20
 Classifications of Interest Rates
Example 1: Calculate the Effective Annual Rate (EAR) if the stated interest rate is 8% compounded
semiannually.
Solution:
Semiannually => M = 2
iNOM M 0.08 2
EAR = 1 + −1= 1+ − 1 = 8.16%
M 2

Example 2: Calculate the Effective Annual Rate (EAR) if the stated interest rate is 8% compounded
quarterly.
Solution:
Quarterly => M = 4

iNOM M 0.08 4
EAR = 1 + −1= 1+ − 1 = 8.24%
M 4 21
End of chapter