Session

Principles of Managerial Finance
Fifteenth Edition, Global Edition
Chapter 5
Time Value of Money
Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

5.1 The Role of Time Value in Finance
(1 of 5)
• Time Value of Money

– Refers to the observation that it is better to receive money
sooner than later
• Future Value Versus Present Value
– Suppose that a firm has an opportunity to spend $15,000
today on some investment that will produce $17,000 spread
out over the next 5 years as follows:
Year Cash flow
1 $3,000
2 $ 5,000
3 $ 4,000
4 $ 3,000
5 $ 2,000

(2 of 5)

– Is this investment a wise one?
– Timeline
 A horizontal line on which time zero appears at the leftmost
end and future periods are marked from left to right; can be
used to depict investment cash flows

Figure 5.1 Timeline

(3 of 5)

– To make the correct investment decision, managers must
compare the cash flows depicted in Figure 5.1 at a single
point in time
– Compounding
 Used to find the future value of each cash flow at the end of an
investment’s life
– Discounting
 Used to find the present value of each cash flow at time zero

Figure 5.2 Compounding and Discounting

(5 of 5)
• Basic Patterns of Cash Flow Mixed Cash Flow Stream
– Single Amount Year A B
 A lump-sum amount either 0 −$3,000 −$ 50

currently held or expected at 1 100 50
some future date 2 800 −100
– Annuity 3 1,200 280
 A level periodic stream of cash 4 1,200 −60
flows 5 1,400 Blank
– Mixed Stream 6 300 Blank
 A stream of cash flows that is
not an annuity

5.2 Single Amounts (1 of 7)
• Future Value of a Single Amount
– The Concept of Future Value
 Future Value
– The value on some future date of money that you invest
today
 Compound Interest
– Interest that is earned on a given deposit and has become
part of the principal at the end of a specified period
 Principal
– The amount of money on which interest is paid

Personal Finance Example 5.1 (1 of 2)
If Fred Moreno places $100 in an account paying 8% interest

compounded annually (i.e., interest is added to the $100
principal 1 time per year), after 1 year he will have $108 in
the account. That’s just the initial principal of $100 plus 8%
($8) in interest. The future value at the end of the first year is
Future value at end of year 1 = $100 × (1 + 0.08) = $108
If Fred were to leave this money in the account for another
year, he would be paid interest at the rate of 8% on the new
principal of $108. After 2 years there would be $116.64 in the
account. This amount would represent the principal after the
first year ($108) plus 8% of the $108 ($8.64) in interest.

The future value after 2 years is

Future value after 2 years = $108 × (1 + 0.08)
= $116.64
Substituting the expression $100 × (1 + 0.08) from the first-
year calculation for the $108 value in the second-year
calculation gives us
Future value after 2 years = $100 × (1 + 0.08) × (1 + 0.08)
= $100 × (1 + 0.08)2
= $116.64

– The Equation for Future Value
 FVn = future value after n periods
 PV0 = initial principal, or present value when time = 0
 r = annual rate of interest
 n = number of periods (typically years) that the money remains
invested
FVn  PV0  (1  r ) n (5.1)

Personal Finance Example 5.2
Jane Farber places $800 in a savings account paying 3%
interest compounded annually. She wants to know how
much money will be in the account after 5 years. Substituting
PV0 = $800, r = 0.03, and n = 5 into Equation 5.1 gives the
future value after 5 years:
FV5 = $800 × (1 + 0.03)5 = $800 × (1.15927) = $927.42
We can depict this situation on a timeline as follows:

Spreadsheet use Excel offers a mathematical function that

makes the calculation of future values easy. The format of
that function is FV(rate,nper,pmt,pv,type). The terms inside
the parentheses are inputs that Excel requires to calculate
the future value. The terms rate and nper refer to the interest
rate and the number of time periods, respectively. The term
pv represents the lump sum (or present value) that you are
investing today.

For now, we will ignore the other two inputs, pmt and type,
and enter a value of zero for each. The following Excel
spreadsheet shows how to use this function to calculate the
future value.

Changing any of the values in cells B2, B3, or B4

automatically changes the result shown in cell B5 because
the formula in that cell links back to the others. As with the
calculator, Excel reports cash inflows as positive numbers
and cash outflows as negative numbers. In the example
here, we have entered the $800 present value as a negative
number, which causes Excel to report the future value as a
positive number. Logically, Excel treats the $800 present
value as a cash outflow, as if you are paying for the
investment you are making, and it treats the future value as
a cash inflow when you reap the benefits of your investment
5 years later.

– A Graphical View of Future Value
 Figure 5.4 illustrates how the future value of $1 depends on
the interest rate and the number of periods that money is
invested
 It shows that (1) the higher the interest rate, the higher the
future value, and (2) the longer the money remains invested,
the higher the future value

Figure 5.4 Future Value Relationship

– Compound Interest versus Simple Interest
 Simple Interest
– Interest that is earned only on an investment’s original
principal and not on interest that accumulates over time

Table 5.1 Simple Interest versus Compound
Interest
Blank Account Balance
Time (year) Simple Interest Compound Interest
0 (initial deposit) $1,000 $1,000.00
1 1,050 1,050.00
2 1,100 1,102.50
3 1,150 1,157.62
4 1,200 1,215.51
5 1,250 1,276.28
10 1,500 1,628.89

• Present Value of a Single Amount
– The Concept of Present Value
 Present Value
– The value in today’s dollars of some future cash flow
 Discounting Cash Flows
– The process of finding present values; the inverse of
compounding interest

Paul Shorter has an opportunity to receive $300 one year

from now. What is the most that Paul should pay now for this
opportunity? The answer depends in part on what Paul’s
current investment opportunities are (i.e., what his
opportunity cost is). Suppose Paul can earn a return of 2%
on money that he has on hand today. To determine how
much he’d be willing to pay for the right to receive $300 one
year from now, Paul can think about how much of his own
money he’d have to set aside right now to earn $300 by next
year. Letting PV0 equal this unknown amount and using the
same notation as in the future value discussion, we have
PV0 × (1 + 0.02) = $300
$300
Solving for PV0 gives us PV0 
(1  0.02)
 $294.12
The value today (“present value”) of $300 received 1 year
from today, given an interest rate of 2%, is $294.12. That is,
investing $294.12 today at 2% would result in $300 in 1 year.
Given his opportunity cost (or his required return) of 2%,
Paul should not pay more than $294.12 for this investment.
Doing so would mean that he would earn a return of less
than 2% on this investment. That’s unwise if he has other
similar investment opportunities that pay 2%. However, if
Paul could buy this investment for less than $294.12, he
would earn a return greater than his 2% opportunity cost.
– The Equation for Present Value
 FVn = future value after n periods
 PV0 = initial principal, or present value when time = 0
 r = annual rate of interest
 n = number of periods (typically years) that the money remains
invested
FVn
PV0  (5.2)
(1  r ) n

Pam Valenti has been offered an investment opportunity that

will pay her $1,700 eight years from now. Pam has other
investment opportunities available to her that pay 4%, so she
will require a 4% return on this opportunity. How much
should Pam pay for this opportunity? In other words, what is
the present value of $1,700 that comes in 8 years if the
opportunity cost is 4%? Substituting FV8 = $1,700, n = 8, and
r = 0.04 into Equation 5.2 yields
$1, 700 $1, 700
PV0    $1, 242.17
(1  0.04) 1.36857
8
The following timeline shows this analysis.

Spreadsheet use The format of Excel’s present value

function is very similar to the future value function covered
earlier. The appropriate syntax is PV(rate,nper,pmt,fv,type).
The input list inside the parentheses is the same as in
Excel’s future value function with one exception. The present
value function contains the term fv, which represents the
future lump sum payment (or receipt) whose present value
you are trying to calculate. The following Excel spreadsheet
illustrates how to use this function to calculate the present
value.


– A Graphical View of Present Value
 Figure 5.5 illustrates how the present value of $1 depends on
the interest rate and the number of periods an investor must
wait to receive $1
 The figure shows that, everything else being equal, (1) the
higher the discount rate, the lower the present value; and (2)
the longer the waiting period, the lower the present value

Figure 5.5 Present Value Relationship

5.3 Annuities (1 of 8)
• Types of Annuities
– Annuity
 A stream of equal periodic cash flows over a specified time
period
 These cash flows can be inflows or outflows of funds
– Ordinary Annuity
 An annuity for which the cash flow occurs at the end of each
period
– Annuity Due
 An annuity for which the cash flow occurs at the beginning of
each period

Fran Abrams is evaluating two annuities. Both annuities pay

$1,000 per year, but annuity A is an ordinary annuity, while
annuity B is an annuity due. To better understand the
difference between these annuities, she has listed their cash
flows in Table 5.2. The two annuities differ only in the timing
of their cash flows: The cash flows occur sooner with the
annuity due than with the ordinary annuity.

Table 5.2 Comparison of Ordinary Annuity
and Annuity Due Cash Flows ($1,000, 5
Years)
blank Annual cash flows
Year Annuity A (ordinary) Annuity B (annuity due)
0 $ 0 $1,000
1 1,000 1,000
2 1,000 1,000
3 1,000 1,000
4 1,000 1,000
5 1,000 0
Totals $5,000 $5,000

Although the cash flows of both annuities in Table 5.2 total

$5,000, the annuity due would have a higher future value
than the ordinary annuity because each of its five annual
cash flows can earn interest for 1 year more than each of the
ordinary annuity’s cash flows. In general, as we will
demonstrate later in this chapter, the value (present or
future) of an annuity due is always greater than the value of
an otherwise identical ordinary annuity.

• Finding the Future Value of an Ordinary Annuity
 1  r n  1 
FVn  CF1    (5.3)
 r 

Fran Abrams wishes to determine how much money she will

have after 5 years if she chooses annuity A, the ordinary
annuity. She will deposit the $1,000 annual payments that
the annuity provides at the end of each of the next 5 years
into a savings account paying 7% annual interest. This
situation is depicted on the following timeline.

As the figure shows, after 5 years, Fran will have $5,750.74

in her account. Note that because she makes deposits at the
end of the year, the first deposit will earn interest for 4 years,
the second for 3 years, and so on. Plugging the relevant
values into Equation 5.3, we have
[(1  0.07)5  1] 
FV5  $1, 000     $5, 750.74
 0.07 

Spreadsheet use To calculate the future value of an

annuity in Excel, we will use the same future value function
that we used to calculate the future value of a lump sum,
but we will add two new input values. Recall that the future
value function’s syntax is FV(rate,nper,pmt,pv,type). We
have already explained the terms rate, nper, and pv in this
function. The term pmt refers to the annual payment the
annuity offers. The term type is an input that lets Excel
know whether the annuity being valued is an ordinary
annuity (in which case the input value for type is 0 or
omitted) or an annuity due (in which case the correct input
value for type is 1).

In this particular problem, the input value for pv is 0 because

there is no up-front money received that is separate from the
annuity. The only cash flows are those that are part of the
annuity stream. The following Excel spreadsheet demonstrates
how to calculate the future value of the ordinary annuity.

• Finding the Present Value of an Ordinary Annuity
 CF1   1 
PV0     1  n 
(5.4)
 r   1  r  

Example 5.8 (1 of 3)
Braden Company, a small producer of plastic toys, wants to
determine the most it should pay for a particular ordinary
annuity. The annuity consists of cash inflows of $700 at the
end of each year for 5 years. The firm requires the annuity to
provide a minimum return of 4%. The following timeline
depicts this situation.

Spreadsheet use The following spreadsheet shows how to
calculate present value of the ordinary annuity.

Table 5.3 Long Method for Finding the
Present Value of an Ordinary Annuity

• Finding the Future Value of an Annuity Due
 1  r n  1 
    (1  r ) (5.5)
FVn  CF0    
 r 

Recall from an earlier example, illustrated in Table 5.2, that

Fran Abrams wanted to choose between an ordinary annuity
and an annuity due, both offering similar terms except for the
timing of cash flows. We calculated the future value of the
ordinary annuity in Example 5.7, but we now want to calculate
the future value of the annuity due. The timeline on the next
slide depicts this situation. Take care to notice on the timeline
that when we use Equation 5.5 (or any of the shortcuts that
follow) we are calculating the future value of Fran’s annuity due
after 5 years even though the fifth and final payment in the
annuity due comes after 4 years (which is equivalent to the
beginning of year 5). We can calculate the future value of an
annuity due using a calculator or a spreadsheet.
Spreadsheet use The following Excel spreadsheet

illustrates how to calculate the future value of the annuity
due. Remember that for an annuity due the type input value
must be set to 1, and we must also specify the pv input value
as 0 because there is no upfront cash other than what is part
of the annuity stream.


• Finding the Future Value of an Annuity Due
– Comparison of an Annuity Due with an Ordinary Annuity
Future Value
 The future value of an annuity due is always greater than the
future value of an otherwise identical ordinary annuity

• Finding the Present Value of an Annuity Due
 CF0   1 
PV0     1  n 
 (1  r ) (5.6)
 r   1  r  

In Example 5.8 involving Braden Company, we found the
present value of Braden’s $700, 5-year ordinary annuity
discounted at 4% to be $3,116.28. We now assume that
Braden’s $700 annual cash inflow occurs at the start of each
year and is thereby an annuity due. The following timeline
illustrates the new situation.

calculate the present value of the annuity due.

• Finding the Present Value of an Annuity Due
– Comparison of an Annuity Due with an Ordinary Annuity
Present Value
 The present value of an annuity due is always greater than the
present value of an otherwise identical ordinary annuity

• Finding the Present Value of a Perpetuity
– Perpetuity
 An annuity with an infinite life, providing continual annual cash
flow
PV0  CF1  r (5.7)
– Growing Perpetuity
 An annuity with an infinite life, providing continual annual cash
flow, with the cash flow growing at a constant annual rate
 CF1 
PV0    (5.8)
rg
Ross Clark wishes to endow a chair in finance at his alma

mater. In other words, Ross wants to make a lump sum
donation today that will provide an annual stream of cash
flows to the university forever. The university indicated that
the annual cash flow required to support an endowed chair is
$400,000 and that it will invest money Ross donates today in
assets earning a 5% return. If Ross wants to give money
today so that the university will begin receiving annual cash
flows next year, how large must his contribution be? To
determine the amount Ross must give the university to fund
the chair, we must calculate the present value of a $400,000
perpetuity discounted at 5%.

Using Equation 5.7, we can determine that this present value

is $8 million when the interest rate is 5%:
PV0 = $400,000 ÷ 0.05 = $8,000,000
In other words, to generate $400,000 every year for an
indefinite period requires $8,000,000 today if Ross Clark’s
alma mater can earn 5% on its investments. If the university
earns 5% interest annually on the $8,000,000, it can
withdraw $400,000 per year indefinitely without ever
touching the original $8,000,000 donation.

Suppose, after consulting with his alma mater, Ross Clark

learns that the university requires the endowment to provide
a $400,000 cash flow next year, but subsequent annual cash
flows must grow by 2% per year to keep up with inflation.
How much does Ross need to donate today to cover this
requirement? Plugging the relevant values into Equation 5.8,
we have:
$400, 000
PV0   $13,333,333
0.05  0.02

Compared to the level perpetuity providing $400,000 per

year, the growing perpetuity requires Ross to make a much
larger initial donation, $13.3 million versus $8 million.

5.4 Mixed Streams (1 of 2)
• Mixed Stream
– A stream of unequal periodic cash flows that reflect no
particular pattern
• Future Value of a Mixed Stream
– To determine the future value of a mixed stream of cash
flows, compute the future value of each cash flow at the
specified future date and then add all the individual future
values to find the total future value

Shrell Industries, a cabinet manufacturer, expects to receive the
following mixed stream of cash flows over the next 5 years from
one of its small customers.
Time Cash flow
If Shrell expects to earn 8% on its 0 $ 0
investments, how much will it accumulate 1 11,500
after 5 years if it immediately invests these 2 14,000
3 12,900
cash flows when they are received? This
4 16,000
situation is depicted on the following timeline. 5 18,000

Spreadsheet use A relatively simple way to use Excel to
calculate the future value of a mixed stream is to use the
Excel net present value (NPV) function combined with the
future value (FV) function discussed on page 197. The
syntax of the NPV function is NPV(rate, value1, value2,
value 3, . . .). The rate argument is the interest rate, and
value1, value2, value3, . . . represent a stream of cash flows.
The NPV function assumes that the first payment in the
stream arrives 1 year in the future and that all subsequent
payments arrive at 1-year intervals.

To find the future value of a mixed stream, the trick is to use
the NPV function to first find the present value of the mixed
stream and then find the future of this present value lump
sum amount. The Excel spreadsheet below illustrates this
approach (notice that the NPV appears as an outflow
because it represents the net present value of the stream of
investment costs).


5.4 Mixed Streams (2 of 2)
• Present Value of a Mixed Stream
– To determine the present value of a mixed stream of cash
flows, compute the present value of each cash flow and
then add all the individual present values to find the total
present value

Frey Company, a shoe manufacturer, has the opportunity to receive
the following mixed stream of cash flows over the next 5 years.
If the firm must earn at least 9% on its Time Cash flow
0 $ 0
investments, what is the most it should 1 400
pay for this opportunity? This situation is 2 800
3 500
depicted on the following timeline. 4 400
5 300

Spreadsheet use To calculate the present value of a mixed
stream in Excel, we will use the NPV function. The present
value of the mixed stream of future cash flows can be
calculated as shown on the following Excel spreadsheet.

5.5 Compounding Interest More
Frequently Than Annually (1 of 7)
• Semiannual Compounding
– Compounding of interest over two periods within the year

Fred Moreno has decided to invest $100 in a savings account
paying 8% interest compounded semiannually. If he leaves
his money in the account for 24 months (2 years), he will
receive 4% interest compounded over four periods, each of
which is 6 months long. Table 5.4 shows that after 12 months
(1 year) with 8% semiannual compounding, Fred will have
$108.16; after 24 months (2 years), he will have $116.99.

Table 5.4 Future Value from Investing
$100 at 8% Interest Compounded
Semiannually over 24 Months (2 Years)
Beginning Future value at end
Period principal Future value calculation of period
6 months $100.00 $100.00 × (1 + 0.04) = $104.00
12 months 104.00 $104.00 × (1 + 0.04) = $108.16
18 months 108.16 $108.16 × (1 + 0.04) = $112.49
24 months 112.49 $112.49 × (1 + 0.04) = $116.99

• Quarterly Compounding
– Compounding of interest over four periods within the year

Fred Moreno has found an institution that will pay him 8%
interest compounded quarterly. If he leaves his money in
this account for 24 months (2 years), he will receive 2%
interest compounded over eight periods, each of which is 3
months long. Table 5.5 shows the amount Fred will have at
the end of each period. After 12 months (1 year), with 8%
quarterly compounding, Fred will have $108.24; after 24
months (2 years), he will have $117.17.

Table 5.5 Future Value from Investing $100
at 8% Interest Compounded Quarterly over
24 Months (2 Years)
Period Beginning principal Future value calculation Future value at end of period
3 months $100.00 $100.00 × (1 + 0.02) = $102.00
6 months 102.00 $102.00 × (1 + 0.02) = $104.04
9 months 104.04 $104.04 × (1 + 0.02) = $106.12
12 months 106.12 $106.12 × (1 + 0.02) = $108.24
15 months 108.24 $108.24 × (1 + 0.02) = $110.41
18 months 110.41 $110.41 × (1 + 0.02) = $112.62
21 months 112.62 $112.62 × (1 + 0.02) = $114.87
24 months 114.87 $114.87 × (1 + 0.02) = $117.17

Table 5.6 Future Value at the End of Years
1 and 2 from Investing $100 at 8% Interest,
Given Various Compounding Periods
blank Compounding period
End of year Annual Semiannual Quarterly
1 $108.00 $108.16 $108.24
2 116.64 116.99 117.17

• A General Equation for Compounding
mn
 r
FVn  PV0  1   (5.9)
 m

The preceding examples calculated the amount that Fred

Moreno would have after 2 years if he deposited $100 at 8%
interest compounded semiannually or quarterly. For
semiannual compounding, m would equal 2 in Equation 5.9;
for quarterly compounding, m would equal 4. Substituting the
appropriate values for semiannual and quarterly
compounding into Equation 5.9, we find that
1. For semiannual compounding:
22
 0.08 
FV2  $100  1    $100  (1  0.04) 4  $116.99
 2 

2. For quarterly compounding:
4 2
 0.08 
FV2  $100  1    $100  (1  0.02)8  $117.17
 4 
These results agree with the values for FV2 in Tables 5.4 and
5.5.

• We can simplify the computation process by using a
calculator or spreadsheet program

Spreadsheet use The future value of the single amount with

semiannual and quarterly compounding also can be
calculated as shown on the following Excel spreadsheet.

• Continuous Compounding
– Compounding of interest, literally, all the time
– Equivalent to compounding interest an infinite number of
times per year
FVn  PV0  e rn (5.10)

To find the value after 2 years (n = 2) of Fred Moreno’s $100

deposit (PV0 = $100) in an account paying 8% annual
interest (r = 0.08) compounded continuously, we can
substitute into Equation 5.10:
FV2  continuous compounding   $100  e0.082

 $100  2.71830.16
 $100 1.1735  $117.35

As expected, Fred’s deposit grows more with continuous

compounding than it does with semiannual ($116.99) or
quarterly ($117.17) compounding. In fact, continuous
compounding produces a greater future value than any other
compounding frequency.
• Nominal and Effective Annual Rates of Interest
– Nominal (Stated) Annual Rate
 Contractual annual rate of interest charged by a lender or
promised by a borrower
– Effective (True) Annual Rate (EAR)
 The annual rate of interest actually paid or earned
m
 r
EAR  1    1 (5.11)
 m

• Nominal and Effective Annual Rates of Interest
– Annual Percentage Rate (APR)
 The nominal annual rate of interest, found by multiplying the
periodic rate by the number of periods in one year, that must
be disclosed to consumers on credit cards and loans as a
result of “truth-in-lending laws.”
– Annual Percentage Yield (APY)
 The effective annual rate of interest that must be disclosed to
consumers by banks on their savings products as a result of
“truth-in-savings laws.”

Fred Moreno wishes to find the effective annual rate

associated with an 8% nominal annual rate (r = 0.08) when
interest is compounded (1) annually (m = 1), (2) semiannually
(m = 2), and (3) quarterly (m = 4). Substituting these values
into Equation 5.11, we get
1. For annual compounding:
1
 0.08 
EAR  1    1  (1  0.08)1
 1  1  0.08  1  0.08  8%
 1 

2. For semiannual compounding:

2
 0.08 
EAR  1    1  (1  0.04) 2
 1  1.0816  1  0.0816  8.16%
 2 
3. For quarterly compounding:
4
 0.08 
EAR  1    1  (1  0.02) 4
 1  1.0824  1  0.0824  8.24%
 4 

Spreadsheet use You can convert nominal interest rates to

effective rates (or vice versa) using Excel’s EFFECT and
NOMINAL functions. To find the EAR, the EFFECT function
asks you to input the nominal annual rate and the
compounding frequency. If you input an EAR and the
compounding frequency, the NOMINAL function provides the
nominal annual rate or the annual percentage rate (APR).
Interest rate conversions from the 8% APR to the
semiannual EAR and from the quarterly EAR back to the 8%
APR are shown on the following Excel spreadsheet.


These examples demonstrate two important points. First, the

nominal rate equals the effective rate if compounding occurs
annually. Second, the effective annual rate increases with
increasing compounding frequency, up to a limit that occurs
with continuous compounding.

5.6 Special Applications of Time Value
(1 of 4)
• Determining Deposits Needed to Accumulate a Future

Sum
 1  r n  1 
   (5.12)
CF1  FVn    
 r 

Spreadsheet use In Excel, solving for the annual cash flow

that helps you reach the $30,000 means using the payment
function. Its syntax is PMT (rate,nper,pv,fv,type). We have
previously discussed all the inputs in this function. The
following Excel spreadsheet illustrates how to use this
function to find the annual payment required to save
$30,000.


(2 of 4)
• Loan Amortization
– The determination of the equal periodic loan payments
necessary to provide a lender with a specified interest return
and to repay the loan principal over a specified period
– Loan Amortization Schedule
 A schedule of equal payments to repay a loan
 It shows the allocation of each loan payment to interest and
principal
 1 
CF1   PV0  r   1  n 
(5.13)
 1  r  

Spreadsheet use The first spreadsheet below shows how to

calculate the annual loan payment, and the second
spreadsheet illustrates the construction of an amortization
schedule.


Table 5.7 Loan Amortization Schedule
($6,000 Principal, 10% Interest, 4-Year
Repayment Period)
blank Payments blank
Beginning-of- Loan Interest Principal End-of-year

year principal payment [0.10 × [(2) − (3)] principal [(1) − (4)]
End-of-year (1) (2) (1)] (3) (4) (5)
1 $6,000.00 $1,892.8 $600.00 $1,292.82 $4,707.18
2
2 4,707.18 1,892.82 470.72 1,422.10 3,285.08
3 3,285.08 1,892.82 328.51 1,564.31 1,720.77
4 1,720.77 1,892.82 172.08 1,720.74 ______a
a
Because of rounding, a slight difference ($0.03) exists between the beginning-of-year-4
principal (in column 1) and the year-4 principal payment (in column 4).

(3 of 4)
• Finding Interest or Growth Rates

1/ n
 FVn 
r    1 (5.14)
PV
 0

Consumers across the United States are familiar with Dollar Tree
stores, which offer a vast array of items that cost just $1. Most
shoppers at Dollar Tree probably do not know that the company’s
stock was one of the best-performing stocks during the decade
that ended in 2016. An investor who purchased a $10 share of
Dollar Tree stock at the end of 2006 saw the firm’s stock price
grow to $70 by 2016’s close. What compound annual growth rate
does that increase represent? Or, equivalently, what average
annual rate of interest did shareholders earn over that period? Let
the initial $10 price represent the stock’s present value in 2006,
and let $70 represent the stock’s future value 10 years later.
Plugging the appropriate values into Equation 5.13, we find that
Dollar Tree stock increased almost 21.5% per year over this
decade.

find Dollar Tree’s growth rate using Excel’s RATE function. The
syntax of that function is RATE(nper,pmt,pv,fv,type,guess). We
have encountered the function’s arguments nper, pmt, pv, fv,
and type previously. In this problem, $10 is the present value,
and $70 is the future value. We set the arguments pmt and
type to zero because those arguments are needed to work with
annuities, but we are calculating the growth rate by comparing
two lump sums. The new argument in this function is guess,
which in nearly all applications you can set to zero.


Jan Jacobs can borrow $2,000 today, and she must repay the
loan in equal end-of-year payments of $482.57 over 5 years.
Notice that Jan’s payments will total $2,412.85 (i.e., $482.57
per year × 5 years). That’s more than she borrowed, so she is
clearly paying interest on this loan, as we’d expect. The
question is, what annual interest rate is Jan paying? You
could calculate the percentage difference between what Jan
borrowed and what she repaid as follows:
$2, 412.85  $2, 000

 0.206  20.6%
$2, 000

Unfortunately, for two reasons this calculation does not tell us

what interest rate Jan is paying. First, this calculation sums Jan’s
payments over 5 years, so it does not reveal the interest rate on
her loan per year. Second, because each of Jan’s payments
comes at a different time, it is not valid to simply add them up.
Time-value-of-money principles tell us that even though each
payment is for $482.57, the payments have different values
because they occur at different times. The key idea in this problem
is that there is some interest rate at which the present value of the
loan payments is equal to the loan principal. It’s this interest rate
that equates the loan principal to the present value of payments
that we want to find. Solving for that algebraically is very difficult,
so we rely on a calculator or spreadsheet to find the solution.


(4 of 4)
• Finding an Unknown Number of Periods
 FVn 
log  
 PV0 
n (5.15)
log 1  r 

Ann Bates wishes to determine how long it will take for her
initial $1,000 deposit, earning 8% annual interest, to grow to
$2,500. Applying Equation 5.15, at an 8% annual rate of
interest, how many years, n, will it take for Ann’s $1,000,
PV0, to grow to $2,500, FVn?
 $2,500 
log   0.39794
 $1, 000 
n  11.9
log(1.08) 0.03342
Ann will have to wait almost 12 years to reach her savings

goal of $2,500.


Spreadsheet use The number of years to pay off the loan

also can be calculated as shown on the following Excel
spreadsheet.

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Principles of Managerial Finance

Fifteenth Edition, Global Edition

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

• Time Value of Money

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• Future Value Versus Present Value

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• Future Value Versus Present Value

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• Basic Patterns of Cash Flow Mixed Cash Flow Stream

– Single Amount Year A B

 A lump-sum amount either 0 −$3,000 −$ 50

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If Fred Moreno places $100 in an account paying 8% interest

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The future value after 2 years is

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FVn  PV0  (1  r ) n (5.1)

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Spreadsheet use Excel offers a mathematical function that

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Changing any of the values in cells B2, B3, or B4

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Paul Shorter has an opportunity to receive $300 one year

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Pam Valenti has been offered an investment opportunity that

The following timeline shows this analysis.

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Spreadsheet use The format of Excel’s present value

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Fran Abrams is evaluating two annuities. Both annuities pay

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Although the cash flows of both annuities in Table 5.2 total

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Fran Abrams wishes to determine how much money she will

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As the figure shows, after 5 years, Fran will have $5,750.74

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Spreadsheet use To calculate the future value of an

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In this particular problem, the input value for pv is 0 because

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