2-1

Chapter 2
Time Value of Money

Future value
Present value
Rates of return
Amortization

2-2

Time lines show timing of cash flows.

0

CF1

CF2

CF3

i%

CF0

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1;
or the beginning of Period 2.

2-3

Time line for a $100 lump sum due at

the end of Year 2.

i%

2 Year
100

2-4

Time line for an ordinary annuity of

$100 for 3 years.

i%

100

100

100

2-5

Time line for uneven CFs: -$50 at t = 0

and $100, $75, and $50 at the end of
Years 1 through 3.
0

100

75

50

i%

-50

2-6

Whats the FV of an initial $100 after 3

years if i = 10%?
0

10%

100

FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.

2-7

After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = FV1(1+i) = PV(1 + i)(1+i)
= PV(1+i)2
= $100(1.10)2
= $121.00.

2-8

After 3 years:
FV3 = FV2(1+i)=PV(1 + i)2(1+i)
= PV(1+i)3
= $100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.

2-9

Three Ways to Find FVs

Solve the equation with a regular

calculator.
Use a financial calculator.
Use a spreadsheet.

2-10

Financial calculator: HP17BII

Adjust display contrast: hold down
CLR and push + or -.
Choose algebra mode: Hold down
orange key (i.e., the shift key), hit
MODES (the shifted DSP key), and
select ALG.
Set number of decimal places to
display: Hit DSP key, select FIX, then
input desired decimal places (e.g., 3).

2-11

HP17BII (Continued)
Set decimal mode: Hit DSP key, select
the . instead of the ,. Note: many
non-US countries reverse the US use
of decimals and commas when
writing a number.

2-12

HP17BII: Set Time Value Parameters

Hit EXIT until you get the menu starting
with FIN. Select FIN.
Select TVM.
Select OTHER.
Select P/YR. Input 1 (for 1 payment per
year).
Select END (for cash flows occuring at
the end of the year.)

2-13

Financial Calculator Solution

Financial calculators solve this
equation:
n

FVn PV 1i 0

There are 4 variables. If 3 are

known, the calculator will solve
for the 4th.

2-14

Heres the setup to find FV:

INPUTS

3
N

10
-100
I/YR PV

0
PMT

OUTPUT

FV
133.10

Clearing automatically sets everything

to 0, but for safety enter PMT = 0.
Set: P/YR = 1, END.

2-15

Spreadsheet Solution
Use the FV function: see spreadsheet
in Ch 02 Mini Case.xls.
= FV(Rate, Nper, Pmt, PV)
= FV(0.10, 3, 0, -100) = 133.10

2-16

Whats the PV of $100 due in 3 years if

i = 10%?
Finding PVs is discounting, and its
the reverse of compounding.
0
PV = ?

10%

3
100

2-17

Solve FVn = PV(1 + i )n for PV:

PV =

FVn
1

n = FVn
1+ i
1+ i

1.10
= $100 0.7513 = $75.13.

PV = $100

2-18

Financial Calculator Solution

INPUTS
OUTPUT

3
N

10
I/YR

PV
-75.13

0
PMT

100
FV

Either PV or FV must be negative. Here

PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.

2-19

Spreadsheet Solution
Use the PV function: see spreadsheet.
= PV(Rate, Nper, Pmt, FV)
= PV(0.10, 3, 0, 100) = -75.13

2-20

Finding the Time to Double

0
-1

20%

FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.

?
2

2-21

Financial Calculator

INPUTS
N
OUTPUT 3.8

20
I/YR

-1
PV

0
PMT

2
FV

2-22

Spreadsheet Solution
Use the NPER function: see
spreadsheet.
= NPER(Rate, Pmt, PV, FV)
= NPER(0.10, 0, -1, 2) = 3.8

2-23

Finding the Interest Rate

0
-1

?%

FV = PV(1 + i)n
$2 = $1(1 + i)3
(2)(1/3) = (1 + i)
1.2599 = (1 + i)
i = 0.2599 = 25.99%.

3
2

2-24

Financial Calculator

INPUTS
OUTPUT

3
N

I/YR
25.99

-1
PV

0
PMT

2
FV

2-25

Spreadsheet Solution
Use the RATE function:
= RATE(Nper, Pmt, PV, FV)
= RATE(3, 0, -1, 2) = 0.2599

2-26

Whats the difference between an

ordinary annuity and an annuity due?
Ordinary Annuity
0

i%

PMT

PMT

PMT

PMT

PMT

Annuity Due
0
i%
PMT
PV

FV

2-27

Whats the FV of a 3-year ordinary

annuity of $100 at 10%?
0

10%

100

100

3
100
110
121
FV = 331

2-28

FV Annuity Formula
The future value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
n

(1 i) 1
PMT
i
3

(1 0.10) 1
100
331.
0.10

2-29

Financial Calculator Formula

for Annuities
Financial calculators solve this
equation:
n
n 1
(1

i)
FVn PV 1i PMT
0.
i

There are 5 variables. If 4 are

known, the calculator will solve
for the 5th.

2-30

Financial Calculator Solution

INPUTS
OUTPUT

10

-100

I/YR

PV

PMT

FV

331.00

Have payments but no lump sum PV,

so enter 0 for present value.

2-31

Spreadsheet Solution
Use the FV function: see spreadsheet.
= FV(Rate, Nper, Pmt, Pv)
= FV(0.10, 3, -100, 0) = 331.00

2-32

Whats the PV of this ordinary annuity?

0

100

100

100

10%

90.91
82.64
75.13
248.69 = PV

2-33

PV Annuity Formula
The present value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
1
1n
(1 i)
PMT
i
1
13
(1 0.10)
100
248.69
0.10

2-34

Financial Calculator Solution

INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-248.69

Have payments but no lump sum FV,

so enter 0 for future value.

2-35

Spreadsheet Solution
Use the PV function: see spreadsheet.
= PV(Rate, Nper, Pmt, Fv)
= PV(0.10, 3, 100, 0) = -248.69

2-36

Find the FV and PV if the

annuity were an annuity due.

10
0

10
0

10%

10
0

2-37

PV and FV of Annuity Due

vs. Ordinary Annuity
PV of annuity due:
= (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56
FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1

2-38

Switch from End to Begin.

Then enter variables to find PVA3 =
$273.55.
INPUTS
OUTPUT

10

I/YR

PV

100

PMT

FV

-273.55

Then enter PV = 0 and press FV to find

FV = $364.10.

2-39

Excel Function for Annuities Due

Change the formula to:
=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function
there are no other cash flows. The
fifth term tells the function that it is an
annuity due. A similar function gives
the future value of an annuity due:
=FV(10%,3,-100,0,1)

2-40

What is the PV of this uneven cash

flow stream?
0

100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV

2-41

Input in CFLO register:

CF0 =

CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
Enter I = 10%, then press NPV button to
get NPV = 530.09. (Here NPV = PV.)

2-42

Spreadsheet Solution

100

300

300

-50

2
3

530.09
Excel Formula in cell A3:
=NPV(10%,B2:E2)

2-43

Nominal rate (iNom)

Stated in contracts, and quoted by banks
and brokers.
Not used in calculations or shown on time
lines
Periods per year (m) must be given.
Examples:
8%; Quarterly
8%, Daily interest (365 days)

2-44

Periodic rate (iPer )

iPer = iNom/m, where m is number of
compounding periods per year. m = 4 for
quarterly, 12 for monthly, and 360 or 365
for daily compounding.
Used in calculations, shown on time lines.
Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =
0.021918%.

2-45

Will the FV of a lump sum be larger or

smaller if we compound more often,
holding the stated I% constant? Why?
LARGER! If compounding is more
frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.

2-46

FV Formula with Different Compounding

Periods (e.g., $100 at a 12% nominal rate with
semiannual compounding for 5 years)

iNom

FVn = PV 1 +

m
FV5S

mn

0.12

= $100 1 +

2
= $100(1.06)10

2x5

= $179.08.

2-47

FV of $100 at a 12% nominal rate for 5

years with different compounding
FV(Annual)= $100(1.12)5 = $176.23.
FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.

2-48

Effective Annual Rate (EAR = EFF%)

The EAR is the annual rate which causes PV
to grow to the same FV as under multi-period
compounding Example: Invest $1 for one
year at 12%, semiannual:
FV = PV(1 + iNom/m)m
FV = $1 (1.06)2 = 1.1236.
EFF% = 12.36%, because $1 invested for one
year at 12% semiannual compounding would
grow to the same value as $1 invested for one
year at 12.36% annual compounding.

2-49

An investment with monthly

payments is different from one
with quarterly payments. Must
put on EFF% basis to compare
rates of return. Use EFF% only
for comparisons.
Banks say interest paid daily.
Same as compounded daily.

2-50

How do we find EFF% for a nominal

rate of 12%, compounded
semiannually?
m
iNom
EFF% = 1 +
-1
m

(
)
= (1 + 0.12) - 1.0
2
2

= (1.06)2 - 1.0
= 0.1236 = 12.36%.

2-51

Finding EFF with HP17BII

Go to menu starting TVM.
Select ICNV (for int.rate conversion).
Select PER (for periodic compounding).
Enter nominal rate and select NOM%.
Enter number of periods per year and
select P.
Select EFF%, which returns effective
rate.

2-52

EAR (or EFF%) for a Nominal Rate of

of 12%
EARAnnual

= 12%.

EARQ

= (1 + 0.12/4)4 - 1

= 12.55%.

EARM

= (1 + 0.12/12)12 - 1

= 12.68%.

EARD(365)

= (1 + 0.12/365)365 - 1 = 12.75%.

2-53

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.

2-54

When is each rate used?

iNom:

Written into contracts, quoted

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

2-55

iPer: Used in calculations, shown on

time lines.
If iNom has annual compounding,
then iPer = iNom/1 = iNom.

2-56

EAR = EFF%:

Used to compare
returns on investments
with different payments
per year.

(Used for calculations if and only if

dealing with annuities where
payments dont match interest
compounding periods.)

2-57

Amortization

Construct an amortization schedule

for a $1,000, 10% annual rate loan
with 3 equal payments.

2-58

Step 1: Find the required payments.

0

PMT

PMT

PMT

10%

-1,000
INPUTS
OUTPUT

10

-1000

I/YR

PV

0
PMT
402.11

FV

2-59

Step 2: Find interest charge for Year 1.

INTt = Beg balt (i)
INT1 = $1,000(0.10) = $100.
Step 3: Find repayment of principal in
Year 1.
Repmt = PMT - INT
= $402.11 - $100
= $302.11.

2-60

Step 4: Find ending balance after

Year 1.
End bal = Beg bal - Repmt
= $1,000 - $302.11 = $697.89.
Repeat these steps for Years 2 and 3
to complete the amortization table.

2-61

YR

BEG
BAL

1 $1,000
2
698
3
366
TOT

PMT

INT

$402
$100
402
70
402
37
1,206.34 206.34

PRIN
PMT

END
BAL

$302 $698
332
366
366
0
1,000

Interest declines. Tax implications.

2-62

402.11

Interest

302.11

Principal Payments

Level payments. Interest declines because

outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.

2-63

Amortization tables are widely

used--for home mortgages, auto
loans, business loans, retirement
plans, and so on. They are very
important!
Financial calculators (and
spreadsheets) are great for setting
up amortization tables.

2-64

On January 1 you deposit $100 in an

account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
How much will you have on October
1, or after 9 months (273 days)?
(Days given.)

2-65

iPer = 11.33463%/365
= 0.031054% per day.
0

273

0.031054%
FV=?

-100

FV273 = $1001.00031054
= $1001.08846 = $108.85.
273

Note: % in calculator, decimal in equation.

2-66

iPer = iNom/m
= 11.33463/365
= 0.031054% per day.
INPUTS

273
N

OUTPUT

I/YR

-100
PV

FV

PMT

108.85

Enter i in one step.

Leave data in calculator.

2-67

Whats the value at the end of Year 3 of

the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?
0

5%

100

100

6-mos.
periods

100

2-68

Payments occur annually, but

compounding occurs each 6
months.
So we cant use normal annuity
valuation techniques.

2-69

1st Method: Compound Each CF

0

5%

2
100

4
100

6
100.00
110.25
121.55
331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100

= $331.80.

2-70

2nd Method: Treat as an Annuity

Could you find the FV with a
financial calculator?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
EAR =

0.10
1+ 2

) - 1 = 10.25%.
2

2-71

b. Use EAR = 10.25% as the annual rate

in your calculator:

INPUTS
OUTPUT

10.25

-100

I/YR

PV

PMT

FV
331.80

2-72

Whats the PV of this stream?

0

5%

90.70
82.27
74.62
247.59

100

100

100

2-73

You are offered a note which pays

$1,000 in 15 months (or 456 days)
for $850. You have $850 in a bank
which pays a 6.76649% nominal
rate, with 365 daily compounding,
which is a daily rate of 0.018538%
and an EAR of 7.0%. You plan to
leave the money in the bank if you
dont buy the note. The note is
riskless.
Should you buy it?

2-74

iPer = 0.018538% per day.

0
-850

365

456 days
1,000

3 Ways to Solve:
1. Greatest future wealth: FV
2. Greatest wealth today: PV
3. Highest rate of return: Highest EFF%

2-75

1. Greatest Future Wealth

Find FV of $850 left in bank for
15 months and compare with
notes FV = $1,000.
FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.

2-76

Calculator Solution to FV:

iPer = iNom/m
= 6.76649%/365
= 0.018538% per day.
INPUTS

456
N

I/YR

-850

PV

PMT

OUTPUT

Enter iPer in one step.

FV

924.97

2-77

2. Greatest Present Wealth

Find PV of note, and compare
with its $850 cost:
PV = $1,000/(1.00018538)456
= $918.95.

2-78

INPUTS

6.76649/365 =
456 .018538
N

OUTPUT

I/YR

PV

0
PMT

1000
FV

-918.95

PV of note is greater than its $850

cost, so buy the note. Raises your
wealth.

2-79

3. Rate of Return
Find the EFF% on note and
compare with 7.0% bank pays,
which is your opportunity cost of
capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456
Now we must solve for i.

2-80

INPUTS
OUTPUT

456
N

-850
I/YR
PV
0.035646%
per day

1000

PMT

FV

Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)365 - 1
= 13.89%.

2-81

Using interest conversion:

P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89
Since 13.89% > 7.0% opportunity cost,
buy the note.