For Academic Use only at NIT Silchar

Fundamentals of Time Value of Money

You can refer to this books for more elaborate learning
Eugene F. Brigham, Joel F. Houston Fundamentals of financial management
Ross, Stephen A, Westerfield, and Jordan Fundamentals of corporate finance
PART I: Single Sum.
Time Value of Money: Know this terminology and notation
FV

Future Value

(1+i)t Future Value Interest Factor [FVIF]

PV

Present Value

1/(1+i)t Present Value Interest Factor [PVIF]

i
t

Rate per period

# of time periods

Question: Why are (1+i) and (1+i)t called interest factors?

Answer: 1. Start with simple arithmetic problem on interest:
How much will Rs10,000 placed in a bank account paying 5% per year be worth
compounded annually?
Answer: Principal + Interest
Rs10,000 + Rs10,000 x .05 = Rs10,500
2. Factor out the Rs10,000.
10,000 x (1.05) = Rs10,500
3. This leaves (1.05) as the factor.

1. Find the value of Rs10,000 earning 5% interest per year after two years.
Start with the amount after one year and multiply by the factor for each year.
[Amount after one year] x (1.05)
=
[Rs10,000 x (1.05)] x (1.05)
=
Rs10,000 x (1.05)2
=
Rs11,025.
So (1+i)t = (1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i) (1+i) for t times

Class Notes

A. Future Value
Find the value of Rs10,000 in 10 years. The investment earns 5% per year.
FV = Rs10,000(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)
FV = Rs10,000(1.05)(1.05)(1.05)(1.05)(1.05)(1.05)(1.05)(1.05)(1.05)(1.05)
FV = Rs10,000 x (1.05)10
= Rs10,000 x 1.62889
= Rs16,289
Find the value of Rs10,000 in 10 years. The investment earns 8% for four years and
then earns 4% for the remaining six years.
FV = Rs10,000(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)
FV = Rs10,000(1.08)(1.08)(1.08)(1.08)(1.04)(1.04)(1.04)(1.04)(1.04)(1.04)
FV = Rs10,000 x (1.08)4 x (1.04)6
FV = Rs17,214.53

B. Present Value:
Same idea, but begin at the end. Rearrange the Future value equation to look
like this:
PV = FV [(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)(1+i)]
PV = FV (1+i)t

[2]

Example: How much do I need to invest at 8% per year, in order to have Rs10,000 in__.
a. One year:
PV =10,000 (1.08) = Rs9,259.26
b. Two years:
PV = Rs10,000 (1.08) (1.08)
OR Rs10,000 (1.08)2 = Rs8,573
c. Ten years
PV = Rs10,000 (1.08)10 = Rs10,000 2.1589 = Rs4,632
C. Rate of Return
START WITH SAME RELATIONHSIP: FV = PV x (1+i)t
Solve for i.

(1+i)t =FV/PV.
1+i = (FV/PV)1/t
1/t
i = (FV/PV) -1.
Question: An investor deposits Rs10,000. Ten years later it is worth Rs17,910. What rate
of return did the investor earn on the investment?
Solution:
Rs17,910 = Rs10,000 x (1+i)10
(1+i)10 = Rs17,910/10,000 = 1.7910
(1+i) = (1.7910) 1/10 = 1.060
i = .060 = 6.0%

Class Notes

D. Finding the Future Value

Find the value of Rs10,000 today at the end of 10 periods at 5% per period.

KEY
RELATIONHSIP:

FV = PV x (1+i)t

Fundamental Idea.

Question: What is the value of any financial asset?

Answer: The present value of its expected cash flows.

Class Notes

E. Finding the Present Value

Find the present value of Rs10,000 to be received at the end of 10 periods at 8% per period.

a. Scientific Calculator
KEY
RELATIONHSIP:

PV = FV (1+i)t

Finding the [geometric average] rate of return:

KEY
RELATIONHSIP:

(1+i)t=FVPV
(1+i) = (FVPV)1/t

Question: Today your stock is worth Rs50,000. You invested Rs5,000 in the stock 18
years ago. What average annual rate of return [i] did you earn on your investment?
Answer: 13.646%.

Question: The total percentage return was 45,0005000=900%. Why doesnt the
average rate of return equal 50%, since 900%18 = 50%?

Class Notes

F. FUTURE VALUE WHEN RATES OF INTEREST CHANGE.

FV = PV x (1+i1) x (1+i2) x (1+i3) x x (1+it).
Example:
You invest Rs10,000. During the first year the investment earned 20% for the
year. During the second year, you earned only 4% for that year. How much
is your original deposit worth at the end of the two years?
FV = PV x (1+i1) x (1+i2)
= Rs10,000 x (1.20`) x (1.04) = Rs12,480.
Question:
The arithmetric average rate of return is 12%, what is the geometric average rate of
return?
Answer:
An average rate of return is a geometric average since it is a rate of growth.
The 12% is the arithmetic average. The geometric average rate of return on
the investment was 11.7%.
i
OR

= (FV/PV)1/t-1 = (12,480/10000)1/2-1 = .1171

i = (1.20) (1.04) 1 = 0.1171

Important: Although 20% and 4% average to 12%, the Rs10,000 not grow by
12%. [Rs10,000 x (1.12)2= 12,544 NOT Rs12,480].
G. COMPOUNDING PERIODS
Up to this point, we have used years as the only time period. Actually, all the
previous examples could have been quarters, months, or days.
The interest rate and time period must correspond.
Example:
Problem 1.
Find the value of Rs10,000 earning 5% interest per year after two years.
Problem 2.
Find the value of Rs10,000 earning 5% interest per quarter after two quarters.
Both problems have same answer
Rs10,000 x (1.05)2 = Rs11,025.
However:
In the first problem t refers to years and i refers to interest rate per year.
In the second problem t refer to quarters and i to interest rate per quarter.
FVt = PV x (1+i)t.
t = number of periods
i = interest for the period.

Class Notes

Alternatively,
FVtm = PV x (1+i/m)tm.
m= periods per year,
t= number of years,
i = the interest per year [APR].

Example:
What will Rs1,000 be worth at the end of one year when the annual interest rate is 12%
[This is the APR.] when interest is compounded:
Annually: t=1 i =12% FV1 = PV x (1+i)1 = Rs1,000 x (1.12)1
Rs1,120.
Quarterly: t=4 i = 3% FV4 = PV x (1+i)4 = Rs1,000 x (1.03)4
Rs1,125.51.
Monthly: t=12 i =1% FV12 = Rs1,000 x (1.01)12 = Rs1,000 x (1.126825) =
Rs1,126.825.
Daily:

=
=

t=365 i = (12%365) = 0.032877%

FV365 = Rs1,000 x (1.00032877)365= Rs1,000 x (1.12747) =
Rs1,127.47.

n [N]

i [I/YR]

PV

PMT

FV

12

1,000

1,000

12

1,000

365

.032877

1,000

Class Notes

How about compounding at every instant?

E. CONTINUOUS COMPOUNDING:
t m
lim
1 + __i__
=
m

eit

Example: What is Rs1,000 worth in one year if compounded at 12% continuously.

FV = Rs1,000 x e.12
= Rs1,000 x 1.127497 = Rs1,127.50
This is Rs.03 more than daily compounding.
Problem: What is the present value of Rs10,000 to be received 3 years from today
compounded continuously at 10%?PV = Rs10,000 x e -.10 x 3 = Rs10,000 x 0.74082=Rs7,408
Try this on your calculator. Find the ex button. e-0.3 = 0.74082

Class Notes

Practice Quiz Questions: PV and FV of a Single sum.

Review Problems
1. How much must you deposit today in a bank account paying interest compounded quarterly:
a. if you wish to have Rs10,000 at the end of 3 months, if the bank pays 5.0% APR?
Answer: Rs9,877
b. if you wish to have Rs50,000 at the end of 24months, if the bank pays 8.0%APR?
Answer: Rs42,675
c. if you wish to have Rs6,000 at the end of 12 months, if the bank pays 9.0% APR?
Answer: Rs5,489
2. a. What rate of interest [APR] is the bank charging you if you borrow Rs77,650 and must repay
Rs80,000 at the end of 2 quarters, if interest is compounded quarterly?
Answer: 6.0% APR

b. What rate of interest [APR] is the bank charging you if you borrow Rs49,000 and must repay
Rs50,000 at the end of 3 months, if interest is compounded monthly?
Answer: 8.0% APR

3. How much must you deposit today in a bank account paying interest compounded monthly:
a. if you wish to have: Rs10,000 at the end of 1 months, if the bank pays 5.0% APR ?
Answer: Rs9,959
b. if you wish to have: 6,000 at the end of 6 months, if the bank pays 9.0% APR ?
Answer: 5,737
c. if you wish to have: Rs12,000 at the end of 12 months, if the bank pays 6.0% APR ?
Answer: Rs11,303
4. If interest is compounded quarterly, how much will you have in a bank account:
a. if you deposit today 8,000 at the end of 3 months, if the bank pays 5.0% APR ?
Answer: 8,100
b. if you deposit today Rs10,000 at the end of 6 months, if the bank pays 9.0% APR ?
Answer: Rs10,455
c. if you deposit today 80,000 at the end of 12 months, if the bank pays 8.0% APR ?
Answer: 86,595
d. if you deposit today Rs5,000 at the end of 24 months, if the bank pays 5.0% APR ?
Answer: Rs5,522
5. If interest is compounded monthly, how much will you have in a bank account,
a. if you deposit today 8,000 at the end of 3 months, if the bank pays 5.0% APR ?
Answer: 8,100
b. if you deposit today Rs10,000 at the end of 6 months, if the bank pays 9.0% APR ?
Answer: Rs10,459
c. if you deposit today 80,000 at the end of 12 months, if the bank pays 8.0% APR ?
Answer: 86,640
d. if you deposit today 5,000 at the end of 24 months, if the bank pays 5.0% APR ?
Answer: 5,525

Class Notes

6. You borrowed Rs1,584 and must repay Rs2,000 in exactly 4 years from today. Interest is
compounded annually.
a. What is the interest rate [APR] of the loan?
Answer 6.0%
b. What effective annual rate [EAR] are you paying?
Answer 6.0%
7. You now have Rs8,000 in a bank account in which you made one single deposit Rs8,000 monthly
of Rs148.97 exactly 40 years ago. Interest is compounded monthly.
a. What rate of interest [APR] is the bank paying?
Answer 10.0%
b. What effective annual rate [EAR] is the bank paying?
Answer 10.47%
Possibly New Problems.
8. Suppose you make an investment of Rs1,000. This first year the investment returns 12%, the
second year it returns 6%, and the third year in returns 8%. How much would this investment be
worth, assuming no withdrawals are made?
Answer:
= Rs1,282

9. Why is (1+i) called an interest factor?

10. Suppose you make an investment of Rs1,000. This first year the investment returns 5%, the

second year it returns i. Write an expression, using i, that represents the future value of the
investment at the end of two years.
11. An investment is worth Rs50,000 today. This first year the investment returns 9%, the second
year it returns i. Write an expression using i that represents the original value of the investment.
12. Suppose you make an investment of RsA. This first year the investment returns 10%, the second
year it returns 16%, and the third year in returns 2%. How much would this investment be worth,
assuming no withdrawals are made?
11. Suppose you make an investment of Rs10,000. This first year the investment returns 15%, the
second year it returns 2%, and the third year in returns 10%. How much would this investment be
worth at the end of three years, assuming no withdrawals are made?

Rs12,903

12. Refer to the above problem. What is the geometric average rate of return?

8.9%

Class Notes

10

Review Fundamentals of Time Value of Money

Part II Multiple Periods: Uneven and Even (Annuities)
Periodic Uneven Cash Flows
What is the value of the following set of cash flows today? The interest rate is 8% for all cash
flows.
Year and Cash Flow
1: Rs 300
2:

Rs 500

3: Rs 700

4:

Rs 1000

Solution: Find Each Present Value and Add

300
500
+
1
1 . 08
1 . 08
277.78

428.67

700
1000
+
=
3
1 . 08
1 . 08 4
555.68

735.03

= 1997.16

Periodic Cash Flow: Even Payments

An annuity is a level series of payments. For example, four annual payments, with the
first payment occurring exactly one period in the future is an example of an ordinary
annuity.

A. Present value of an annuity:

The present value of each of the cash flows is the value of the annuity. This could be
done one at a time, but this might be tedious.
Annuity Present Value Interest Factor

PVIFA = [1/(1+i) + 1/(1+i)2 + ... + 1/(1+i)t]

t

PVIFA

1 / (1 + i )

j= 1
t

PVIFA

1 1 / (1 + i )
.
i

Class Notes

11

Example:
What is the present value of a 4-year annuity, if the annual interest is 5%, and the
annual payment is Rs1,000?
i = 5%; PMT = Rs1,000; t =4; PV = ?
PV = 1,000 /(1.05) + 1,000/(1.05)2 + 1,000/(1.05)3+ 1,000/(1.05)4

Long way.

Factor out the single sum interest rate factors:

PV = 1,000 x [1/(1.05) + 1/(1.05)2+1/(1.05)3+ 1/(1.05)4] =

Short Way

PV = 1,000 x [PVIFA (4,5%)] =

Calculate: PVIFA(4,5%) = 1-1/(1+i)t = 1- PVIF4,5% 1- 0.8227 = 3.54595.

i
5%
.05
PV = 1,000 x [3.5460] = Rs3,546.

B. Future value of an annuity:

Annuity Future Value Interest Factor

FVIFA = [1+ (1+i) + (1+i)2 + ... + (1+i)t-1].
t 1

FVIFA =

(1 + i )
j=0

(1 + i )t 1
FVIFA =
i

Note: Last Payment earns

no interest in ordinary
annuity. The interest factor
on that payment is 1. The
first payment earns interest
for t-1 periods, not t
periods.

Example: What is the future value of a 4-year annuity, if the annual interest is 5%, and
the annual payment is Rs1,000?
i = 5%; PMT = Rs1,000; t =4; FV = ?
Rs1,000x [1+ (1.05) + (1.05)2 + (1.05)3] =
Rs1,000 x [FVIFA (4,5%)] =
Rs1,000 x [4.3101] = Rs4,310.1

Question: How much would you need to deposit every month in an account paying 6% a
year to accumulate by Rs1,000,000 by age 65 beginning at age 20?
Data: FV = Rs1,000,000
i = 6%12 = 0.5% per month
n = (65-20) x 12 = 45 x 12 = 540 months.

PMT = ?
Answer: PMT = Rs362.85

C. RATE OF RETURN OF AN ANNUITY

You borrow Rs60,000 and repay in 8 equal annual installments of Rs12,935 with the first
payment made exactly 1 year later. To the nearest percent, what rate of interest are you

Class Notes

12

paying on your loan? Difficult without financial calculator. Can use table to find
answer to the nearest percent.
Data:
i = ? PV = Rs60,000

PMT=Rs12,935

Relationship: PV = PMT x PVIFA(t, i)

1. Solution: (Trial and Error with Table)
PVIFA(t, i) = PV/PMT= Rs60,000/12,935 = 4.6386
T a b le
..... 1 4 % ....
:
8 .. 4 .6 3 8 9 ..

Therefore: PVIFA = 4.6386. So> i = 14%

2. (Trial and Error using a spreadsheet program)

t = 8 years

Class Notes

13

D. Example of Annuity with quarterly compounding:

An investment of Rs3000 per quarter for 6 years at annual interest rate of 8%,
compounded quarterly, will accumulate by the end of year 6 to:
Solution:
FV = ? PMT = Rs3,000 t = 24 i = 2%
FV = PMT x FVIFA (t, i).
FV = Rs3,000 x [30.422] = Rs91,266.

Review Problems with solutions.

1. This one: is a typical mortgage problem. You borrow Rs80,000 to be repaid in equal
monthly installments for 30 years. The APR is 9%. What is the monthly payment?
PV = Rs80,000
i =0.75%,
t=360
PMT = ?
Ans: Rs643.70

2. Try this one. You make equal Rs400 monthly payments on a loan. The interest rate
equals 15% APR, compounded monthly. The loan is for 12 years. What is the amount of
the loan?
Answer: Rs26,651
3. Retire with a million: How much would must you deposit monthly in an account paying 6% a year
[APR], compounded monthly, to accumulate Rs1,000,000 by age 65 beginning at age 30?
Answer: PMT = Rs701.90

8. Problem on inflation.
You will receive Rs100,000 when you retire, forty years from today. If inflation averages

3% per year for the next forty years, how much would that amount be worth measured in
today's Rupees? (Note, this is not a time value of money problem, but it solved with a
similar calculation. Such adjustments are necessary to overcome money illusion]

Solution:
Rs100,000 (1.03)40 =100,000 3.26204 = Rs 30,655

D. Annuity Due
$1,000 $1,000
0

$1,000
2

$1,000
3

Class Notes

14

Question: Compare the payments of the annuity due, above, with those of the ordinary
annuity earlier. What is the difference? How does this difference affect its value?
Answer: Each payment in an annuity due occurs one period earlier than it would in
ordinary annuity. Both present value and future value of each payment in an
annuity due if (1+i) times greater than it would be for an ordinary annuity.
Question: What is the present value of the above four-year annuity due?
Rs1,000 x [1 + 1/(1+i) + 1/(1+i)2 + 1/(1+i)3]
=
Rs1,000 x (1+i) x [1/(1+i) + 1/(1+i)2 + 1/(1+i)3+1/(1+i)4]
=
Rs1,000 x (1+i) x PVIFA i,4
PV interest factor of an annuity due is: (1+i)PVIFA
FV interest factor of an annuity due is: (1+i)FVIFA

Problem.

What is the present value of an annuity due of five Rs800 annual payments
discounted at 10%? 800 x (1.10)xPVIVA10%,5 =
800 x(1.10)x 3.79079 x =
800 x 4.16987 = Rs3,335.9

Problem.

What is the present value of an annuity of five annual Rs800 payments

discounted at 10%? The first payment is due in one-half year from today.
800 x (1.10)1/2 xPVIVA10%,5 =
800 x(1.04881)x 3.79079 x =
800 x 3.97581 = 3,180.7

Class Notes

15

Try the following practice questions:

Review Problems
1. Suppose you are trying to find the present value of two different cash flows. One is Rs100 two periods from
now, the other a Rs100 flow three periods from now. Which of the following is/are true about the discount
factors used to value the cash flows?
a. The factor for the flow three periods away is always less than the factor for the flow that is received two
periods from now.
b. The factor for the flow three periods away is always more than the factor for the flow that is received two
periods from now.
c. Whether one factor is larger than the other will depend on the interest rate.
d. Since the payments are for the same amount, the factors will yield present values that are the same.
e. None of the above statements are true.

2.

What is the present value of a stream of Rs2,500 semiannual payments received at the end of
each period for the next 10 years? The APR is 6%.
a. 37,194
b. 38,310
c. 35,810
d. 36,885

3. What is the future value in 10 years of Rs1,500 payments received at the end of each year for the next 10
years? Assume an interest rate of 8%.
a. Rs25,260
b. Rs23,470
c. Rs21,730
d. Rs18,395
e. Rs15,000
4. You are given the option of receiving Rs1,000 now or an annuity of Rs85 per month for 12 months.
Which of the following is correct?
a. You cannot choose between the two without computing present values.
b. You cannot choose between the two without computing future values.
c. You will always choose the lump sum payment.
d. You will always choose the annuity.
e. The choice you would make when comparing the future value of each would be the same as the
choice you would make when comparing present values.
5.

You open a savings account that pays 4.5% annually. How much must you deposit each year in order
to have Rs50,000 five years from now?
a. Rs8,321
b. Rs9,629
c. Rs8,636
d. Rs9,140
e. Rs6,569

6. You are considering an investment in a 6-year annuity. At the end of each year for the next six years you
will receive cash flows of Rs90. The initial investment is Rs414.30. To the nearest percent, what rate
of return are you expecting from this investment? (Annual Compounding)
a. 8%
b. 9%
c. 12%
d. 21%
e. 10%

Class Notes

16

7.

You are saving up for a down payment on a house. You will deposit Rs600 a month for the next 24
months in a money market fund. How much will you have for your down payment in 24 months if the
fund earns 10% APR compounded monthly?
a. Rs14,480
b. Rs15,870
c. Rs12,930
d. Rs10,560
e. Rs 9,890

8.

Your mortgage payment is Rs600 per month. There is exactly 180 payments remaining on
the mortgage. The interest rate s 8.0%, compounded monthly. The first payment is due in
exactly one month. What is the balance of the loan? [Balance = PV of remaining payments.]
a. Rs62,784
b. Rs77,205
c. Rs63,203
d. Rs82,502
e. Rs85,107

9.

Your mortgage payment is Rs755 per month. It is a 30-year mortgage at 9.0% compounded
monthly. How much did you borrow?
a. Rs93,800
b. Rs97,200
c. Rs92,500
d. Rs85,100
e. Rs89,400

Possibly New Problems.

10. What is the value of the following set of cash flows today? The interest rate is 8.5%.
Year Cash Flow
0: -Rs1,000
a.
b.
c.
d.
e.

1: Rs 200

2:

Rs 400

3:

Rs 600

4:

Rs 800

Rs 800
Rs 571
Rs1072
Rs 987
Rs 520

11. The present value interest factor of an annuity due for 3 years at 8% equals:
a. 1/(1.08)3
b. 1/(1.24)
c. [1 + 1/(1.08) + 1/(1.08)2]
d. [1/(1.08) + 1/(1.08)2 + 1/(1.08)3]
e. None of the above.
12.

What is the present value of Rs2,500 semiannual payments received at the beginning of each
period for the next 10 years? The APR is 6%.
a. 37,194.70
b. 38,309.50
c. 35,809.50
d. 36,884.80

Class Notes

17

13. Your mortgage payment is Rs600 per month. There are exactly 180 payments remaining on the
mortgage. The interest rate s 8.0%, compounded monthly. The next payment is due
immediately. What is the balance of the loan? [Hint: This is an annuity due.]
a. Rs63,203
b. Rs77,205
c. Rs62,784
d. Rs82,502
e. Rs85,107
14. Your mortgage payment is Rs600 per month. There are exactly 180 payments remaining on the
mortgage. The interest rate s 8.0%, compounded monthly. The next payment is due in 15 days.
What is the balance of the loan? [Hint: Assume 30 days per month.]
a

Rs62,993

Rs76,949

Rs62,576

Rs82,228

Rs84,825

15. The present value interest factor of an annual ordinary annuity for 3 years at 8% equals:
a. 1/(1.08)3
b. 1/(1.24)
c. [1 + 1/(1.08) + 1/(1.08)2]
d. [1/(1.08) + 1/(1.08)2 + 1/(1.08)3]
e. None of the above.
16. The present value interest factor of a semiannual ordinary annuity for 3 years at 8% equals:
a [1/(1.04) + 1/(1.04)2 + 1/(1.04)3]
b. [1/(1.08) + 1/(1.08)2 + 1/(1.08)3 +1/(1.08)4 + 1/(1.08)5 + 1/(1.08)6]
c. [1/(1.04) + 1/(1.04)2 + 1/(1.04)3 + 1/(1.04)4 + 1/(1.04)5 + 1/(1.04)6]
d. [1/(1.08) + 1/(1.08)2 + 1/(1.08)3]
e. None of the above.
17. The future value interest factor of an ordinary annuity for 3 years at 8% equals:
a. (1.08)3
b. (1.24)
c. [1 + (1.08) + 1.08)2]
d. [(1.08) + (1.08)2 + (1.08)3]
e. None of the above.
18.

Suppose an annuity costs Rs40,000 and produces cash flows of Rs10,000 over each of the
following eight years. What is the rate of return on the annuity?
a. 0%
b. 10.5%
c. 18.6%
d. 25.0%
e. 50.0%