Chapter 4

Time Value of Money

(Part 1)

Copyright © 2023 Cengage Learning Canada, Inc. 4-1

Topics
• Time Lines
• Future Values
• Present Values
• Interest Rate & Number of Years

Copyright © 2023 Cengage Learning Canada, Inc. 4-2

 Time Lines

Copyright © 2023 Cengage Learning Canada, Inc. 1-3

 Time Lines
• Time lines are a very helpful tool for solving time
value of money problems (good practice).
• Show timing of cash flows.
• Help you visualize what’s happening.
0 1 2 3
I%

CF0 CF1 CF2 CF3

Tick marks are at the ends of periods, so Time 0 is today;
Time 1 is the end of Period 1 or the beginning of Period 2…

Copyright © 2023 Cengage Learning Canada, Inc. 4-4

Example 1 - Time Line for a $100
Lump Sum Due at the End of Year 2

0 1 2 Year
I%

CF2 = 100

Copyright © 2023 Cengage Learning Canada, Inc. 4-5

Example 2 - Time Line for $100 each
year for 3 Years (end of period)

0 1 2 3
I%

100 100 100

Copyright © 2023 Cengage Learning Canada, Inc. 4-6

Example 3 - Time Line for Uneven
Cash Flows (CFs)

0 1 2 3
I%

−50 100 75 50

Copyright © 2023 Cengage Learning Canada, Inc. 4-7

Time Value of Money Terms
• CFt = Cash flow at time t; a positive (negative)
number indicates a cash inflow (outflow).
• PV = Present value, cash flow at Time 0 (today, now,
or present); i.e., PV = CF0.
• FVN = Future value, value of PV = CF0 N periods into
the future.
• I = Interest rate (%) earned per period.
• INT = Dollars of interest earned during the period;
i.e., INT = PV×I.
• N = Number of periods (periods are usually
measured in years, although could be months, or
other unit). Copyright © 2023 Cengage Learning Canada, Inc. 4-8
Future Values

Copyright © 2023 Cengage Learning Canada, Inc. 1-9

Future Values (FVs)

0 1 2 3
5%

(100) FV = ?

Finding FVs of some initial cash flow (i.e., going

forward from PVs to FVs or moving to the right on
a time line) is called compounding.

Copyright © 2023 Cengage Learning Canada, Inc. 4-10

 Future Values - Step-by-Step
Approach
0 1 2 3
5%

(100) 105 110.25 115.76

FV1 = PV + INT FV2 = FV1 + INT FV3 = FV2 + INT
= PV + PV(I) = FV1 + FV1 (I) = FV2 + FV2 (I)
= PV(1 + I) = FV1 (1 + I) = FV2 (1 + I)
= 100(1 + 5%) = 105(1 + 5%) = 110.25(1 + 5%)
= 105 = 110.25 = 115.76
Copyright © 2023 Cengage Learning Canada, Inc. 4-11
Future Values - Formula Approach
• In general, we can apply the formula to directly
calculate the FV at time N.

N
FVN = PV(1 + I) (4-1)

FV3 = PV(1 + I)3

3
= $100(1.05)
= 115.76

Copyright © 2023 Cengage Learning Canada, Inc. 4-12

Keys on Financial Calculator

• N = Number of periods.
• I/YR or I/Y = Interest rate per period.
• PV = Present value.
• PMT = Payment, a series of equal, or constant,
payments.
• FV = Future value.
• For PV, PMT, and FV, numbers to be entered (and to
be returned by the calculator) as positive (inflow) or
negative (outflow).
• P/YR or P/Y = indicates number of payments per year.
• Mode END / BGN = when cash flows are happening -
END of period or BGN of period.
Copyright © 2023 Cengage Learning Canada, Inc. 4-13
Example - Financial Calculator
Press CPT
INPUTS 3 5 -100 0 and FV
N I/YR PV PMT FV
OUTPUT 115.76

Tips:
- Clearing memory automatically sets everything to 0,
but for safety, enter PMT = 0 when there are no
payments - i.e. lump sums.
- Set P/YR = 1 and END mode END of period.
- N and I/YR need to be in the same time unit (i.e.
annual, quarterly, monthly, etc.), in this case annual.
Copyright © 2023 Cengage Learning Canada, Inc. 4-14
Example - Excel Spreadsheet

• Use the FV function from excel formulas or type it

following the formula order as per below:
– Formula = FV(I, N, PMT, PV).
– Type
= FV(0.05, 3, 0, -100) and press enter to get the FV
115.76.

Copyright © 2023 Cengage Learning Canada, Inc. 17-15

Summary - FVs Calculations

Copyright © 2023 Cengage Learning Canada, Inc. 4-16

Practice - FVs Calculations

• Practice 1: Invest $200 in a GIC at 3.75% annual

interest rate for 5 years. How much would your
investment be at the end of year 5 (FV)?
– $240.42
• Practice 2: Invest $1,500 in your bank high interest
account at 4.50% annual interest rate for 8 years. How
much would your investment be at the end of year 8
(FV)?
– $2,133.15

Copyright © 2023 Cengage Learning Canada, Inc. 17-17

Simple Interest Versus Compound
Interest
• Interest earned only on the principal amount is
called simple interest - INT = PVx(I)x(N).
• Interest earned on the interest earned in prior
periods is called compound interest, you are
reinvesting the interests - INT = PV(1 + I)N – PV.
• Future values with compound interest are greater
than with simple interest and it is more popular in
finance and business. Why?
– Because you earn interest on interest from previous
periods.
Copyright © 2023 Cengage Learning Canada, Inc. 4-18
Example - Simple Interest Versus
Compound Interest for $100
• Example – Invest $100 today at 8% annual interest
rate for 30 years. What is the FV under simple or
compounded interests methods?

Copyright © 2023 Cengage Learning Canada, Inc. 4-19

 Graphic View of the Compounding
Process
• Future values calculated by using Equation 4-1 with
different values for N and I constitute curves, with the
X-axis representing N.
• Note that the compounding process can be applied to
anything that grows, with the interest rate being the
growth rate:
– Investment in GICs, retirement plan, etc.
– Future salary factoring inflation.
– Sales, population, etc.—

Copyright © 2023 Cengage Learning Canada, Inc. 4-20

The Power of Compounding:
Growth of $100

Copyright © 2023 Cengage Learning Canada, Inc. 4-21

Present Values

Copyright © 2023 Cengage Learning Canada, Inc. 1-22

Present Values (PVs)

0 1 2 3
5%

PV=? $115.76

Finding today’s equivalent value (PV) of some cash

flow due N periods in the future (i.e., going
backward from FVs to PVs or moving to the left on
a time line) is called discounting.

Copyright © 2023 Cengage Learning Canada, Inc. 4-23

 Present Values - Step-by-Step
Approach
0 1 2 3
5%

100 105 110.25 115.76

PV = FV1/(1+I) FV1 = FV2/(1+I) FV2 = FV3/(1+I)

= 105/(1+5%) = 110.25/(1+5%) = 115.76/(1+5%)
= 100 = 105 = 110.25

Copyright © 2023 Cengage Learning Canada, Inc. 4-24

Present Values - Formula Approach
• Recall the FV formula? We need to determine PV.
N (4-1)
FVN = PV(1 + I)
• We can apply the formula to directly calculate the
PV at time N.

PV = FV3/(1+I)3
(4-3) = 115.76/(1+5%)3
= 100

Copyright © 2023 Cengage Learning Canada, Inc. 4-25

Example - Financial Calculator
Press CPT
and PV
INPUTS 3 5 0 115.76
N I/YR PV PMT FV
OUTPUT −100

Either PV or FV must be negative. Here PV = −100.

Put in $100 today, take out $115.76 after 3 years.
Remember inflow (positive) and outflow
(negative) signs.

Copyright © 2023 Cengage Learning Canada, Inc. 4-26

Example - Excel Spreadsheet
• Use the PV function from excel formulas or type it
following the formula order as per below:
– Formula = PV(I, N, PMT, FV).
– Type
= PV(0.05, 3, 0, 115.76) and press enter to get the
PV = -100

Copyright © 2023 Cengage Learning Canada, Inc. 4-27

Summary: PVs Calculations

Copyright © 2023 Cengage Learning Canada, Inc. 4-28

Practice - PVs Calculations

• Practice 1: Your bank is offering a security that will pay

you $1,250 at end of year 4 and market interest rates
are 2.25%, how much should you pay now? To our
simplification, what is the PV of $1,250 that will be
received in 4 years discounted at 2.25% annual
interest rate?
– $1,143.55
• Practice 2: What is the PV of $500 that will be
received in 6 years discounted at 4% annual int. rate?
– $395.16
Copyright © 2023 Cengage Learning Canada, Inc. 17-29
Graphic View of the Discounting
Process
• Present values calculated by using Equation 4-3 with
different values of N and I constitute curves with the X-
axis representing N.
• As Figure 4-3 shows, the present value of a sum to be
received in the future decreases and approaches zero
as the payment date is extended further and further
into the future.
• The present value falls faster the higher the interest
rate.

Copyright © 2023 Cengage Learning Canada, Inc. 4-30

The Power of Discounting $100

Copyright © 2023 Cengage Learning Canada, Inc. 4-31

Interest Rate (I) and Number of
Years (N)

Copyright © 2023 Cengage Learning Canada, Inc. 1-32

Finding the Interest Rate (I)
0 1 2 10
I=?

–100 150
• We need to solve the equation for I from the
formula FVN= PV(1 + I)N
– $150 = $100(1 + I)10
– (1.5)(1/10) = (1 + I)
– 1.0414 = (1 + I)
– I= 0.0414 = 4.14%
• Is there an easier way? Yes!
Copyright © 2023 Cengage Learning Canada, Inc. 4-33
Example - Financial Calculator

INPUTS 10 −100 0 150

N I/YR PV PMT FV
OUTPUT 4.14

Press CPT
and I/YR

Copyright © 2023 Cengage Learning Canada, Inc. 4-34

Example - Excel Spreadsheet
• Use the RATE function from excel formulas or type it
following the formula order as per below:
– Formula = RATE(N, PMT, PV, FV)
– Type
= RATE(10, 0, -100, 150) and press enter to get I =
0.0414 or 4.14%.

Copyright © 2023 Cengage Learning Canada, Inc. 4-35

Practice - Rate Calculations

• Practice 1: Bank offers you a security. You invest

$1,250 today and receive $1,500 in 8 years. What is
the interest rate that you will earn in this investment
opportunity? To our simplification, what is the interest
rate if PV =-$1,250, FV =$1,500, and N = 8 years?
– 2.31%
• Practice 2: What is the interest rate if PV =-$5,275, FV
=$7,500, and N = 3 years?
– 12.45%

Copyright © 2023 Cengage Learning Canada, Inc. 17-36

Finding the Number of Years, N
0 1 2 ?
4.50%

−500,000 1 million

• Suppose we now have $500,000 and the interest

rate is 4.5%. How long will it take to grow to $1
million?
• We also need to solve the equation for N from the
formula FVN= PV(1 + I)N.
• Is there an easier way? Yes!
Copyright © 2023 Cengage Learning Canada, Inc. 4-37
Example - Financial Calculator

INPUTS 4.5 −500,000 0 1,000,000

N I/YR PV PMT FV
OUTPUTS 15.7473

Press CPT
and N

Copyright © 2023 Cengage Learning Canada, Inc. 4-38

Example - Excel Spreadsheet
• Use the NPER function from excel formulas or type it
following the formula order as per below:
– Formula = NPER(I, PMT, PV, FV)
– Type
= NPER(0.045, 0, -500,000, 1,000,000) and press
enter to get N = 15.7473 years.

Copyright © 2023 Cengage Learning Canada, Inc. 4-39

Practice – Number of Years
Calculations
• Practice 1: You are planning to purchase a new laptop
that costs $1,500. You have $1,250 today and interest
rates is 5%. How long it will take to have $1,500 if you
invest at I = 5%?
– 3.74 years
• Practice 2: How long it will take to have $7,500 if you
invest $5,275 at I = 2.75%?
– 12.97 years

Copyright © 2023 Cengage Learning Canada, Inc. 17-40