Chapter 5

Time Value of Money

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 Overview

• Future Value

• Present Value

• Finding I and N

• Annuities

• Rates of Return

• Amortization

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 Time Lines

• 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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 Drawing Time Lines (1 of 2)

$100 lump sum due in 2 years

3-year $100 ordinary annuity

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 Drawing Time Lines (2 of 2)

Uneven cash flow stream

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What is the future value (FV) of an initial $100
after 3 years, if I/YR = 4%?
• Finding the FV of a cash flow or series of cash flows is called compounding.
• FV can be solved by using the step-by-step, financial calculator, and
spreadsheet methods.

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 Solving for FV: The Step-by-Step and
Formula Methods
After 1 year:

• FV1 = PV(1 + I) = $100(1.04) = $104.00

After 2 years:
• FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
After 3 years:
• FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
After N years (general case):
• FVN = PV(1 + I)N

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Solving for FV: Calculator and Excel Methods

• Solves the general FV equation.

• Requires 4 inputs into calculator, and will solve for the fifth. (Set to P/YR = 1
and END mode.)

• Excel: =FV(rate,nper,pmt,pv,type)
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 Present Value

• What is the present value (PV) of $100 due in 3 years, if I/YR = 4%?
• Finding the PV of a cash flow or series of cash flows is called discounting (the reverse of
compounding).
• The PV shows the value of cash flows in terms of today’s purchasing power.

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 Solving for PV: The Formula Method

• Solve the general FV equation for PV:

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.04)3

= $88.90

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Solving for PV: Calculator and Excel Methods

• Solves the general FV equation for PV.

• Exactly like solving for FV, except we have different input information and are
solving for a different variable.

• Excel: =PV(rate,nper,pmt,fv,type)
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 Solving for I

• What annual interest rate would cause $100 to grow to $119.10 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or spreadsheet.

• Excel: =RATE(nper,pmt,pv,fv,type,guess)
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 Solving for N

• If sales grow at 10% per year, how long before sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or spreadsheet.

• Excel: =NPER(rate,pmt,pv,fv,type)
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What is the difference between an ordinary
annuity and an annuity due?

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 Solving for FV (1 of 3)

• Given a 3-Year Ordinary Annuity of $100 at 4%

• $100 payments occur at the end of each period, but there is no PV.

• Excel: =FV(rate,nper,pmt,pv,type)
• Here type = 0.
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 Solving for PV

• Given a 3-year Ordinary Annuity of $100 at 4%

• 100 payments still occur at the end of each period, but now there is no FV.

• Excel: =PV(rate,nper,pmt,fv,type)
• Here type = 0.
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 Solving for FV: 3-Year Annuity Due of $100
at 4%
• Now, $100 payments occur at the beginning of each period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
• Alternatively, set calculator to “BEGIN” mode and solve for the FV of the
annuity due:

• Excel: = FV(rate,nper,pmt,pv,type)
• Here type = 1.
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 Solving for PV: 3-Year Annuity Due of $100
at 4%
• Again, $100 payments occur at the beginning of each period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
• Alternatively, set calculator to “BEGIN” mode and solve for the PV of the
annuity due:

• Excel: = PV(rate,nper,pmt,fv,type)
• Here type = 1.
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 PV Calculation

• What is the present value of a 5-year $100 ordinary annuity at 4%?

• Be sure your financial calculator is set back to END mode and solve for PV:

• N = 5, I/YR = 4, PMT = -100, FV = 0.

• PV = $445.18.

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 Annuities Over Time

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 The Power of Compound Interest

• A 20-year-old student wants to save $5 a day for her

retirement. Every day she places $5 in a drawer. At the end of
the year, she invests the accumulated savings ($1,825) in a
brokerage account with an expected annual return of 8%.

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 Solving for FV (2 of 3)

• If she begins saving today, how much will she have when she is 65?
• If she sticks to her plan, she will have $705,373 when she is 65.

• Excel: = FV(.08,45,-1825,0,0)

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 Solving for FV (3 of 3)

• If you don’t start saving until you are 40 years old, how much will you have at
65?
• If a 40-year-old investor begins saving today, and sticks to the plan, he or she will have
$133,418 at age 65. This is $571,954 less than if starting at age 20.
• Lesson: It pays to start saving early.

• Excel: = FV(.08,45,-1825,0,0)
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 Solving for PMT

• How much must the 40-year old deposit annually to catch the 20-year old?
• To find the required annual contribution, enter the number of years until retirement and the
final goal of $705,372.75, and solve for PMT.

• Excel: = PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)
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What is the PV of this uneven cash flow
stream?

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 Solving for PV: Uneven Cash Flow Stream

• Input cash flows in the calculator’s “CFLO” register:

CF0 = 0

CF1 = 100

CF2 = 300

CF3 = 300

CF4 = -50

• Enter I/YR = 4, press NPV button to get NPV = $597.48. (Here NPV = PV.)
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 Will the FV of a lump sum be larger or smaller if
compounded more often, holding the stated I% constant?

LARGER, as the more frequently compounding occurs, interest is earned on

interest more often.

Annually: FV3 = $100(1.04)3 = $112.49

Semiannually: FV6 = $100(1.02)6 = $112.62

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 Classification of Interest Rates (1 of 2)
Nominal rate (INOM): also called Periodic rate (IPER): amount of
the quoted or stated rate. An interest charged each period,
annual rate that ignores e.g. monthly or quarterly.
compounding effects.

INOM is stated in contracts. IPER = INOM/M, where M is the

Periods must also be given, e.g. number of compounding periods
4% quarterly or 4% daily per year. M = 4 for quarterly
interest. and M = 12 for monthly
compounding.
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 Classification of Interest Rates (2 of 2)

• Effective (or equivalent) annual rate (EAR = EFF%): the annual rate of interest
actually being earned, considering compounding.
• EFF% for 4% semiannual interest

EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
• Should be indifferent between receiving 4.04% annual interest and receiving 4% interest,
compounded semiannually.

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The Importance of Effective Rates of Return
(1 of 2)

Investments with different compounding intervals provide

different effective returns.

To compare investments with different compounding intervals,

you must look at their effective returns (EFF% or EAR).

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 The Importance of Effective Rates of Return
(2 of 2)
• See how the effective return varies between investments with the same
nominal rate, but different compounding intervals.

EARANNUAL 4.00%

EARSEMIANNUALLY 4.04%

EARQUARTERLY 4.06%

EARMONTHLY 4.07%

4.08%
EARDAILY (365)
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 When is each rate used?

• INOM: Written into contracts, quoted by banks and brokers. Not used in
calculations or shown on time lines.

• IPER: Used in calculations and shown on time lines. If M = 1, INOM = IPER = EAR.

• EAR: Used to compare returns on investments with different payments per

year. Used in calculations when annuity payments don’t match compounding
periods.

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 Effect of Compounding on FV
• What is the FV of $100 after 3 years under 4%
semiannual compounding? Quarterly compounding?

MN
 I 
FVN  PV 1  NOM 
 M 
23
 0.04 
FV3S  $100  1  
 2 
FV3S  $100(1.02)6  $112.62
FV3Q  $100(1.01)12  $112.68

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 Effective Rate vs Nominal Rate

• 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.

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 What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 4%, compounded semiannually?
• Payments occur annually, but compounding occurs every 6 months.

• Cannot use normal annuity valuation techniques.

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 Method 1: Compound Each Cash Flow

FV3 = $100(1.02)4 + $100(1.02)2 + $100

FV3 = $312.28

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 Method 2: Financial Calculator or Excel

• Find the EAR and treat as an annuity.

• EAR = (1 + 0.04/2)2 – 1 = 4.04%.

• Excel: =FV(.0404,3,-100,0,0)

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 Find the PV of This 3-Year Ordinary Annuity

• Could solve by discounting each cash flow, or…

• Use the EAR and treat as an annuity to solve for PV.

• Excel: = PV(.0404,3,100,0,0)

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 Loan Amortization

• Amortization tables are widely used for home mortgages, auto loans, business
loans, retirement plans, etc.
• Financial calculators and spreadsheets are great for setting up amortization
tables.

EXAMPLE: Construct an amortization schedule for a $1,000, 4% annual rate loan with 3
equal payments.

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 Step 1: Find the Required Annual Payment

• All input information is already given, just remember that the FV = 0 because
the reason for amortizing the loan and making payments is to retire the loan.

• Excel: = PMT(.04,3,-1000,0,0)

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 Step 2: Find the Interest Paid in Year 1

• The borrower will owe interest upon the initial balance at the end of the first
year. Interest to be paid in the first year can be found by multiplying the
beginning balance by the interest rate.

INTt = Beg balt(I)

INT1 = $1,000(0.04) = $40

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 Step 3: Find the Principal Repaid in Year 1

• If a payment of $360.35 was made at the end of the first year and $40 was
paid toward interest, the remaining value must represent the amount of
principal repaid.

PRIN = PMT – INT

= $360.35 – $40 = $320.35

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 Step 4: Find the Ending Balance after Year 1

• To find the balance at the end of the period, subtract the amount paid toward
principal from the beginning balance.

END BAL = BEG BAL – PRIN

= $1,000 – $320.35
= $679.65

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 Constructing an Amortization Table: Repeat
Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 360 $40 $ 320 $360
2 680 360 27 333 347
3 347 360 14 347 0
TOTAL – $1,081 $81 $1,000 –

• Interest paid declines with each payment as the balance declines. What are the
tax implications of this?
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 Illustrating an Amortized Payment: Where
does the money go?

• Constant payments
• Declining interest payments
• Declining balance
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