Time Value of Money (TVM)

Time value of money is the concept that the value of a dollar to be received in future is less than
the value of a dollar on hand today. One reason is that money received today can be invested
thus generating more money. Another reason is that when a person opts to receive a sum of
money in future rather than today, he is effectively lending the money and there are risks
involved in lending such as default risk and inflation. Default risk arises when the borrower does
not pay the money back to the lender. Inflation is the rise in general level of prices.
Time value of money principle also applies when comparing the worth of money to be received
in future and the worth of money to be received in further future. In other words, TVM principle
says that the value of given sum of money to be received on a particular date is more than same
sum of money to be received on a later date.
Few of the basic terms used in time value of money calculations are:

Present Value

When a future payment or series of payments are discounted at the given rate of interest up to the
present date to reflect the time value of money, the resulting value is called present value.

Future Value

Future value is amount that is obtained by enhancing the value of a present payment or a series
of payments at the given rate of interest to reflect the time value of money.
Read further: Future Value of a Single Sum of Money and Future Value of an Annuity

Interest

Interest is charge against use of money paid by the borrower to the lender in addition to the
actual money lent.

Application of Time Value of Money Principle

There are many applications of time value of money principle. For example, we can use it to
compare the worth of cash flows occurring at different times in future, to find the present worth
of a series of payments to be received periodically in future, to find the required amount of
current investment that must be made at a given interest rate to generate a required future cash
flow, etc.

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Simple vs. Compound Interest Calculation

Interest is the charge against the use of money by the borrower. The same is profit earned by the
lender of money. The amount which is invested in a bank in order to earn interest is called
principal. The interest rate is normally expressed in percentage and represents the dollar interest
earned per $100 of principal in a specific time, usually a year. Simple interest and compound
interest are the two types of interest based on the way they are calculated.

Simple Interest

Simple interest is charged only on the principal amount. The following formula can be used to
calculate simple interest:
Simple Interest (Is) = P × i × t

Where,
P is the principle amount;
i is the interest rate per period;
t is the time for which the money is borrowed or lent.

Example 1

Suppose $1,000 were invested on January 1, 2010 at 10% simple interest rate for 5 years.
Calculate the total simple interest on the amount.
Solution
We have,
Principle P = $1,000
Interest Rate i = 10% per year
Time t = 5 years
Simple Interest Is = $1,000 × 0.1 × 5 = $500

Compound Interest

Compound interest is charged on the principal plus any interest accrued till the point of time at
which interest is being calculated. In other words, compound interest system works as follows:
1. Interest for the first period charged on principle amount.
2. For the second period, its charged on the sum of principle amount and interest charged during
the first period.
3. For the third period, it is charged on the sum of principle amount and interest charged during
first and second period, and so on ...
It can be proved mathematically, that the interest calculated as per above procedure is given by
the following formula:

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Compound Interest (Ic) = P × (1 + i) n – P

Where,
P is the principle amount;
i is the compound interest rate per period;
n are the number of periods.

Example 2

Consider the same information as given in Example 1. Now calculate the total compound interest
on the amount invested.
Solution
We have,
Principle P = $1,000
Interest Rate i = 10% per year
No. of Periods n =5
Compound Interest Ic = $1,000 × ( 1 + 0.1 )^5 − $1,000
= $1,000 × 1.1^5 − $1,000
= $1,000 × 1.61051 − $1,000
= $1,610.51 − $1,000 = $610.51

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 Interest Rate

Interest rate is a percentage measure of interest, the cost of money, which accumulates to the
lender. The interest is either paid through periodic payments, for example in case of bonds, or
accumulated over the period of loan/investment such that it is paid at the maturity date together
with principal amount of loan/investment, for example in case of certificates of deposit, etc.
Other investment structures such as annuities are also based on interest. They either represent (a)
a single value today i.e. a present value that grows at an interest rate while allowing equal cash
flows after equal interval or (b) a stream of equal cash flows that grow to a certain value to a
single value in future i.e. the future value.
There are two types of interest: (a) simple interest and (b) compound interest. Simple interest is
where interest for any period is calculated based on the principal balance only and compound
interest is where the interest is charged on the principal balance plus interest accumulated to the
date of calculation.

Calculation Formulas

Simple interest rate

Given a present value and a future value based on simple interest, interest rate can be found out
by solving the following equation for r:
FV=PV×(1+r×t)

r=FVPV×1t

FV is the value in future, PV is the value today i.e. at t=0, r is the simple interest rate and t is the
number of periods.
Simple interest rate can also be calculated using Excel INTRATE function.

Compound interest rate

Given a present value, a series of equal values that occur after equal intervals in future and/or a
single value at some future date that are subject to compound interest, the interest rate can be
worked out using either of the following equations:
PV=PMT×1−(1+RATE)−NPERRATE+FV(1+RATE)NPER

FV=PV×(1+RATE)NPER+PMT×(1+RATE)NPER−1RATE

Where PV is the present value i.e. a single sum at t=0, FV is the future value i.e. a single sum at
t=NPER, PMT is the periodic equal cash flow that occurs after equal interval, NPER is the total
number of periods between PV and FV and RATE is the periodic compound interest rate.
The above equations look over-whelming even though they are just different forms of one
relationship . We can only solve them using the hit-and-trial method. We plug different values

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and keep notching it up and down till we get a value that best fits the equations. Alternatively,
we can use Excel RATE function.

Example

Your company has obtained a $20 million worth of equipment on a 5-year lease. You are
required to pay $1 million quarterly and $5 million at the end of the lease term. You need to
calculate the interest rate implicit in the lease.
We have a value at t=0, the present value of $20 million, a future value after 5 years of $5
million and 20 (=5 years multiplied by 4 payments per year) quarterly payments of $1 million
constituting an annuity. Further, we know that leases are subject to compound interest. We need
to plug the above values in the equation for present value of an annuity and a single sum in
future:
$20,000,000=$1,000,000×1−(1+RATE)−20RATE+$5,000,000(1+RATE)20

We need to find the value of RATE that balances the equation. Let’s try 10% annual interest rate.
Because there are four quarterly payment per year, the interest rate we enter is 2.5% (=10%/4).
At 2.5%, the value of the right side of the above equation is $18,640,517. We know that there is
inverse relationship between interest rate and present value. If interest rate rises, the present
value falls and vice versa. We need to get $20 million as the solution, so we must reduce the
interest rate. Let’s try 9% per annum which translates to 2.25% quarterly interest rate. At 2.25%
the value of the right side of the equation is $19,167,795. We know we are getting closer to
$20,000,000. We keep trying until we get to 7.50% annual interest rate (and 1.87% quarterly
interest rate) which balances the equation.
Instead of going through the hassle, we can use Excel RATE function. We can get the rate by
entering the following in any Excel cell “=RATE(20,-1000000,20000000,-5000000). The result
we get is the quarterly interest rate which we must multiply by 4, the number of payment periods
per year, to get the annual rate.

5
 Effective Annual Interest Rate

Effective annual interest rate is the annual interest rate that when applied to the opening balance
of a loan amount results in a future value that is the same as the future value arrived at through
the multi-period compounding based on nominal interest rate (i.e. the stated interest rate).
A loan agreement states at least the following three things: the loan balance, the interest rate to
be charged i.e. the nominal interest rate and the number of times in each year the interest shall be
calculated and applied to the loan i.e. the number of compounding periods per year.
Let’s say you have a $100,000 loan on which you must pay 10% interest rate and the interest rate
shall be calculated once a year. The outstanding balance of the loan after one year shall be
$110,000 (=$100,000 × (1 + 10%)1). It is straight forward because the interest is calculated and
added to the loan at the end of the year. However, bankers are smart, and they would most likely
recalculate your loan balance more than once in a year.
Now, let’s say the interest on the above loan is calculated semiannually and added to the loan.
After the first six months, your loan balance will be $105,000 (=$100,000 × (1 + 5%)). Since the
loan balance is being calculated after half-year, we have used the half-yearly rate of interest.
After the second-half of the year, your loan balance will stand at $110,250 (=$105,000 × (1 +
5%)). If we apply 10% interest to the initial loan balance of $100,000, we get only $110,000
(=$100,000 × (1 + 10%)). You can see that if interest is calculated and applied more than one a
year, the loan balance at the end of the year is higher than the balance we arrive at by simply
applying the annual interest rate quoted by the bank to the initial loan balance. This is where the
concept of effective interest rate applies. To give a complete picture, we need to calculate the
annual rate that captures the magnifying effect of multiple compounding periods in one year. It
equals 10.25% (=($110,250–$100,000)/$100,000).

Formula
n
1 + Nominal Annual Interest Rate
Effective Interest Rate = –1
n

Where n is the number of compounding periods per year.

Let’s see how we arrived at this formula so you don’t have to memorize it.
We aim to find a single annual rate with one compounding per year that would give us the same
future value of $1 as the nominal interest rate quoted by the bank over the multiple compounding
periods. The left-hand side of the equation below captures the effect of effective annual interest
rate and the right-hand side calculates future value using the nominal interest rate and number of
compounding periods (n) per year.
n
$1 × (1 + Effective Interest Rate) = $1 1 + Nominal Annual Interest Rate

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× n

Let’s remove $1 from both sides:

n
1 + Nominal Annual Interest Rate
1 + Effective Interest Rate
=
n

We just need to subtract 1 from both sides to get:

n
1 + Nominal Annual Interest Rate
Effective Interest Rate = –1
n

We can use EFFECT formula in Microsoft Excel to calculate effective interest rate. The formula
syntax is EFFECT(nominal_rate, npery). Nominal rate is the stated annual rate quoted by the
bank we discussed above and npery is the number of compounding periods per year. In case of
the example above, you need to enter EFFECT(10%, 2) in the formula bar to get 10.25%.
BONUS: effective interest rate in case of continuous compounding is calculated using the
following formula:
Effective interest rate (continuous compounding) = ei – 1
Where e = 2.71828

Example

Calculate effective interest rate for a loan with a nominal interest rate of 10% for (a) semiannual,
(b) quarterly, (c) monthly and (d) daily and (e) continuous compounding.
Solution
Effective interest rate for semiannual compounding = (1 + 10%/2)2 – 1 = 10.25%
Effective interest rate for quarterly compounding = (1 + 10%/4)4 – 1 = 10.38%
Effective interest rate for monthly compounding = (1 + 10%/12)12 – 1 = 10.47%
Effective interest rate for daily compounding = (1 + 10%/365)365 – 1 = 10.5156%
Effective interest rate for continuous compounding = e0.1 – 1 = 2.718280.1 – 1 = 10.5171%

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 Annual Percentage Rate (APR)

Annual percentage rate (APR) is the annualized interest rate on a loan or investment which
doesn’t account for the effect of compounding. It is the annualized form of the periodic rate
which when applied to a loan or investment balance gives the interest expense or income for the
period. In most cases it is the interest rate quoted by banks and other financial intermediaries on
various products i.e. loans, mortgages, credit cards, deposits, etc. It is also called the nominal
annual interest rate or simple interest rate.
Annual percentage rate (APR) is a useful measure when comparing different loans and
investments because it standardizes the interest rates with reference to time. It is useful to quote
an annual rate instead of quoting a 14-day rate for a 14-day loan or 30-year rate for a 30-year
mortgage. Due to its simplicity, annual percentage rate is arguably the most commonly quoted
rate even though effective annual interest rate is a better measure when there are more than one
compounding periods per year.
Let’s say you obtained two loans, one for $150,000 requiring 6% interest rate for six months and
another for $200,000 requiring 3.5% interest rate for three months. Annual percentage rate is
helpful in this situation because it helps us compare the cost of loans. Annual percentage rate for
the first loan is 12% (periodic rate of 6% multiplied by number of relevant periods in a year i.e.
2). Similarly, annual percentage rate for the second loan is 14% (periodic rate of 3.5% multiplied
by number of periods in a year of 4). It helps us conclude that the second loan is expensive.

Formula

Even though annual percentage rate (APR) is simple in concept, its calculation might be tricky
when it is not specifically quoted. When periodic rate is given, we can use the following formula
to calculate APR:
APR = periodic rate for m months × 12/m
It also depends on whether the loan is based on simple interest or discount. If the interest amount
is deducted from the loan amount at the start of the loan period as in discount loans, the periodic
rate is calculated by dividing the finance charge by the amount financed.
APR (discount loan) = finance charge/amount financed × 12/term of loan in months
Finance charge = principal × periodic rate × term of loan in months/12
Amount financed = principal – principal × periodic rate × term of loan in months/12
If you know the effective annual interest rate, you can find APR as follows:
APR = m × ((1 + EAR) ^ (1/m) – 1)
Where m is the number of compounding periods per year and n is number of years.

Example

You are a personal finance expert advising three clients:

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 Angela, who must choose between two payday loans, each for $3,000 and 14-days: Loan A with
financial charge of $100 payable at the end of 14th day and Loan B with finance charge of $90
deducted from the principal balance at the start of the loan.
 Ahsan, who must decide between two credit cards: Card C with 2.5% monthly charge and Card
D with 7.1% quarterly charge.
 Antonio, who wants to identify better investment for his $50,000 for 5 years: Investment E
paying APR of 10.6% compounded semiannually and Investment F with effective interest rate of
11% compounded monthly.
In case of Angela, Loan B is better. This is because annual percentage rate (APR) of Loan B is
lower than APR for the Loan A. APR of Loan A is 86.9% worked out through the following
steps: (a) calculating periodic interest rate, which equals 3.33% (=$100/$3,000) for 14-day
period, (b) annualizing the rate by dividing it by the term of the loan (i.e. 14) and multiplying by
the number of days in a year (i.e. 3.33%/14×365 = 86.9%). APR of Loan B is 80.63% calculated
as follows: (a) finding financial charge for 14 days which is $90, (b) finding amount financed,
which is $2,910 ($3,000 total amount minus $90 interest because it is paid at the start of the
loan), (c) finding periodic rate for the 14-days which is 3.093% (=$90/$2,910) and (d)
annualizing the rate (i.e. 3.093%/14×365=80.63%).
In case of Ahsan, Card D is better because APR for Card C is 30% (=periodic rate of 2.5% ×
12/1) and APR for Card D is 28.4% (= periodic rate of 7.1% * 12/3), which is lower.
In case of Antonio, we need to find out APR for Investment F to make a comparison.
Annual percentage rate (APR) – Investment F = 12 × ((1 + 11%)^(1/12) – 1) = 10.48%
We may quickly conclude that Investment E is better because it has higher annual percentage
rate. However, this is exactly where the weakness of APR lies: it ignores the effect of
compounding. In such a situation, we need to make a comparison based on effective annual
interest rate. Effective annual interest rate (EAR) in case of Investment E is just 10.88% (as
shown below) which is lower than the effective interest rate on Investment F i.e. 11%. Antonio
should choose Investment F paying 11% effective rate instead of Investment E paying 10.6%
annual percentage rate (APR) compounded semiannually.
Effective annual interest rate = (1 + 10.60%/2)^2 – 1 = 10.88%

9
 Amortization Schedule

Amortization schedule is a table that shows total payments to be made on an amortizing loan, the
loan balance at the start of each period, total payment during each period bifurcated into (a)
interest payment and (b) principal repayment and the closing balance of the loan at the end of
each period.
Loan and debt instruments take different forms: some, such as bonds, require only interest
payment periodically and the principal is paid at maturity; others, mainly money-market
instruments such as promissory notes, pay both the interest and principal at maturity date.
Amortizing loans, on the other hand, require periodic payments comprising of (a) the interest
expense accrued on the loan for the period, and (b) an amount representing repayment of the
principal. Leases and mortgages are typical examples of amortizing loans.
Amortization schedule is a valuable tool that helps us understand cash flows requirements, work
out periodic interest expense and find out loan balance to report on the balance sheet. An
amortization schedule normally shows periods in rows and the columns show the following
items (a) opening balance, (b) total payment, (c) interest expense, (d) principal repayment and (e)
closing balance.
There are two types of amortization structures, the most common is where the total payment is
fixed in each period and the interest component and principal repayment components fall over
time; another structure is where the principal repayment is fixed for all periods and the interest
and total payment figures change. We will discuss the loan amortization schedule that requires
fixed total periodic payment.

Calculations

The principal balance at the start of the loan term is straight-forward, it just equals the loan
amount or present value of minimum lease payments. In each subsequent period, the opening
loan balance equals the loan balance at the end of previous period.
Where the total payment in fixed for each period, the periodic payment can be found out using
the present value of annuity formula. We need to find PMT in the following formula
Opening Loan Principal (PV)=PMT×1−(1+APRm)n×mAPRm

Alternatively, we can use Excel PMT function.

The interest expense for a period equals the opening balance of the loan multiplied by the
periodic interest rate. Periodic interest rate equals the annual percentage rate (APR) divided by
the total number of compounding periods per year.
The principal repayment for a period equals total periodic payment minus the interest expense
for the period.
The closing loan balance equals the opening balance of the loan minus the principal repayment
during the period.

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Example

You work at eZ publishing, Inc., a printing business. On 1 January 2017, your company signed a
lease for printing equipment for 6 years at 8% per annum. Lease payments are to be made
semiannually. The present value of the minimum lease payments is $10 million. Your CEO has
asked you to calculate the interest expense related to the lease in financial year ended December
2019, the amount by which lease liability is reduced during the year, the lease liability balance as
at the year end and relevant cash outflows for the year.
We can solve this problem by preparing an amortization schedule.
Solution
Your opening balance at the start of the lease is equal to the loan principal, i.e. $10 million.
The periodic lease payment equals $1,065,622 obtained by PMT(8%/2,6*2,-10000000) or
solving the following equation for PMT:
$10,000,000=PMT×1−(1+8%2)6×28%2

Please note that interest rate for the half-year i.e. 4% (=8%/2) is included in the calculation.
Interest expense for the first period equals $400,000 (=$10,000,000 × 8% × ½) and principal
repayment equals $665,522 (=$1,065,622 - $400,000).
Closing balance at the end of first period equals $9,334,478 (=$10,000,000 - $665,522).
Total payment for the second period ending 31 December 2017 equals the same as in first period
because it is constant for all periods. The interest expense for the second period equals $373,379
(=$9,334,478 × 8% × ½) and the principal repayment equals $692,143 (=$1,065,522 - $373,379)
and so on.
Following the same process, we can work out total payment, interest expense, repayment of
principal and closing balance for each period and create the following amortization schedule:
Payment Payment Opening Total Interest Principal Closing
No. Date Balance Payment Expense Repayment Balance

C =
A B D=B-C E=A-D
A×8%/2

0 1-Jan-17 10,000,000 0 0 10,000,000

1 30-Jun-17 10,000,000 1,065,522 400,000 665,522 9,334,478

2 31-Dec- 9,334,478 1,065,522 373,379 692,143 8,642,336

17

3 30-Jun-18 8,642,336 1,065,522 345,693 719,828 7,922,507

4 31-Dec- 7,922,507 1,065,522 316,900 748,621 7,173,886

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Payment Payment Opening Total Interest Principal Closing
No. Date Balance Payment Expense Repayment Balance

C =
A B D=B-C E=A-D
A×8%/2

18

5 30-Jun-19 7,173,886 1,065,522 286,955 778,566 6,395,320

6 31-Dec- 6,395,320 1,065,522 255,813 809,709 5,585,611

19

7 30-Jun-20 5,585,611 1,065,522 223,424 842,097 4,743,513

8 31-Dec- 4,743,513 1,065,522 189,741 875,781 3,867,732

20

9 30-Jun-21 3,867,732 1,065,522 154,709 910,812 2,956,920

10 31-Dec- 2,956,920 1,065,522 118,277 947,245 2,009,675

21

11 30-Jun-22 2,009,675 1,065,522 80,387 985,135 1,024,540

12 31-Dec- 1,024,540 1,065,522 40,982 1,024,540 0

22

Since the principal balance of an amortizing loan falls with each periodic payment, interest
expense falls, and consequently, principal repayment component increases.
Looking at the table above, we can work out the amount of interest to be charged in financial
year ended 31 December 2019, which equals $542,768 (=$286,955 + $255,813); total amount by
which lease payable is reduced during the year, which is $1,588,275 (=$778,566 + $809,709);
lease payable as at the year-end is $5,585,611 and total lease cash outflows for the year equals
$2,131,043 (=2 × $1,065,522).

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 Present Value of a Single Sum of Money

Present value of a future single sum of money is the value that is obtained when the future value
is discounted at a specific given rate of interest. In the other words present value of a single sum
of money is the amount that, if invested on a given date at a specific rate of interest, will equate
the sum of the amount invested and the compound interest earned on its investment with the face
value of the future single sum of money.

Formula

The formula to calculate present value of a future single sum of money is:
Future Value (FV)
Present Value (PV) =
(1 + i)n

Where,
i is the interest rate per compounding period;
And
n are the number of compounding periods.

Example 1: Calculate the present value on Jan 1, 2011 of $1,500 to be received on Dec 31,
2011. The market interest rate is 9%. Compounding is done on monthly basis.
Solution
We have,
Future Value FV = $1,500
Compounding Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Present Value PV = $1,500 / (1 + 0.75%) ^12
= $1,500 / 1.0075^12
≈ $1,500 / 1.093807
≈ $1,371.36

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Example 2: A friend of you has won a prize of $10,000 to be paid exactly after 2 years. On the
same day, he was offered $8,000 as a consideration for his agreement to sell the right to receive
the prize. The market interest rate is 12% and the interest is compounded on monthly basis. Help
him by determining whether the offer should be accepted or not.

Solution

Here you will compute the present value of the prize and compare it with the amount offered to
your friend. It will be good to accept the offer if the present value of the prize is less than the
amount offered.

So,

Future Value FV = $10,000

Compounding Periods n = 2 × 12 = 24

Interest Rate i = 12%/12 = 1%

Present Value PV = $10,000 / ( 1 + 1% )^24

= $10,000 / 1.01^24

≈ $10,000 / 1.269735

≈ $7,875.66

Since the present value of the prize is less than the amount offered, it is good to accept the offer.

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 Present Value of an Annuity

n annuity is a series of evenly spaced equal payments made for a certain amount of time. There
are two basic types of annuity known as ordinary annuity and annuity due. Ordinary annuity is
one in which periodic payments are made at the end of each period. Annuity due is the one in
which periodic payments are made at the beginning of each period.
The present value an annuity is the sum of the periodic payments each discounted at the given
rate of interest to reflect the time value of money. Alternatively defined, the present value of an
annuity is the amount which if invested at the start of first period at the given rate of interest will
equate the sum of the amount invested and the compound interest earned on the investment with
the product of number of the periodic payments and the face value of each payment.

Formula

Although the present value (PV) of an annuity can be calculated by discounting each periodic
payment separately to the starting point and then adding up all the discounted figures, however,
it is more convenient to use the 'one step' formulas given below.
1 − (1 + i)-n
PV of an Ordinary Annuity = R ×
i

1 − (1 + i)-n
PV of an Annuity Due = R × × (1 + i)
i

Where,
i is the interest rate per compounding period;
n are the number of compounding periods;
R is the fixed periodic payment.

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Example 1: Calculate the present value on Jan 1, 2011 of an annuity of $500 paid at the end of each
month of the calendar year 2011. The annual interest rate is 12%.
Solution

Periodic Payment R = $500

Number of Periods n = 12

Interest Rate i = 12%/12 = 1%

Present Value PV = $500 × (1-(1+1%)^(-12))/1%

= $500 × (1-1.01^-12)/1%

≈ $500 × (1-0.88745)/1%

≈ $500 × 0.11255/1%

≈ $500 × 11.255

≈ $5,627.54

Example 2: A certain amount was invested on Jan 1, 2010 such that it generated a periodic payment of
$1,000 at the beginning of each month of the calendar year 2010. The interest rate on the investment
was 13.2%. Calculate the original investment and the interest earned.
Solution

Periodic Payment R = $1,000

Number of Periods n = 12

Interest Rate i = 13.2%/12 = 1.1%

Original Investment = PV of annuity due on Jan 1, 2010

= $1,000 × (1-(1+1.1%)^(-12))/1.1% × (1+1.1%)

= $1,000 × (1-1.011^-12)/0.011 × 1.011

≈ $1,000 × (1-0.876973)/0.011 × 1.011

≈ $1,000 × 0.123027/0.011 × 1.011

≈ $1,000 × 11.184289 × 1.011

≈ $11,307.32

Interest Earned ≈ $1,000 × 12 − $11,307.32

≈ $692.68

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 Present Value of Perpetuity

Perpetuity is an infinite series of periodic payments of equal face value. In other words,
perpetuity is a situation where a constant payment is to be made periodically for an infinite
amount of time. It as an annuity having no end and that is why the perpetuity is sometimes called
as perpetual annuity.
Although the total face value of perpetuity is infinite and undeterminable, its present value is not.
According to the time value of money principle, the present value of perpetuity is the sum of the
discounted value of each periodic payment of the perpetuity. Present value of perpetuity is finite
because the discounted value of far future payments of the perpetuity reduces considerably and
reaches close to zero.

Formula

The following formula is used to calculate the present value of perpetuity:

A
Present Value (PV) of Perpetuity =
r

Where,
A is the fixed periodic payment;
r is the interest rate or discount rate per compounding period.

Example 1: Calculate the present value on Jan 1, 20X0 of a perpetuity paying $1,000 at the end
of each month starting from January 20X0. The monthly discount rate is 0.8%.

Solution

Periodic Payment A = $1,000

Discount Rate i = 0.8%

Present Value PV = $1,000 ÷ 0.8%

= $125,000

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 Future Value of a Single Sum of Money

Future value of a present single sum of money is the amount that will be obtained in future if the
present single sum of money is invested on a given date at the given rate of interest. The future
value is the sum of present value and the compound interest.

Formula

The future value of a single sum of money is calculated by using the following formula.
Future Value (FV) = Present Value (PV) × (1 + i)n

Where,
i is the interest rate per compounding period;
n are the number of compounding periods.

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Example 1: An amount of $10,000 was invested on Jan 1, 2011 at annual interest rate of 8%.
Calculate the value of the investment on Dec 31, 2013. Compounding is done on quarterly basis.

Solution
We have,
Present Value PV = $10,000
Compounding Periods n = 3 × 4 = 12
Interest Rate i = 8%/4 = 2%
Future Value FV = $10,000 × ( 1 + 2% )^12
= $10,000 × 1.02^12
≈ $10,000 × 1.268242
≈ $12,682.42

Example 2: An amount of $25,000 was invested on Jan 1, 2010 at annual interest rate of 10.8%
compounded on quarterly basis. On Jan 1, 2011 the terms or the agreement were changed such
that compounding was to be done twice a month from Jan 1, 2011. The interest rate remained the
same. Calculate the total value of investment on Dec 31, 2011.

Solution
The problem can be easily solved in two steps:
STEP 1: Jan 1 - Dec 31, 2010
Present Value PV1 = $25,000
Compounding Periods n = 4
Interest Rate i = 10.8%/4 = 2.7%
Future Value FV1 = $25,000 × ( 1 + 2.7% )^4
= $25,000 × 1.027^4
≈ $25,000 × 1.112453
≈ $27,811.33
STEP 1: Jan 1 - Dec 31, 2011
Present Value PV2 = FV1 = $27,811.33
Compounding Periods n = 2 × 12 = 24
Interest Rate i = 10.8%/24 = 0.45%
Future Value FV2 = $27,811.33 × ( 1 + 0.45% )^24
= $27,811.33 × 1.0045^24
≈ $27,811.33 × 1.113778
≈ $30.975.64

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 Future Value of an Annuity

The future value of an annuity is the value of its periodic payments each enhanced at a specific
rate of interest for given number of periods to reflect the time value of money. In other words,
future value of an annuity is equal to the sum of face value of periodic annuity payments and the
total compound interest earned on all periodic payments till the future value point.

Formula

There are two types of annuity. The one in which payments occur at the end of each period is
called ordinary annuity and the other in which payments occur at the beginning of each period is
called annuity due. Both types have different formulas for future value calculation:
(1 + i)n − 1
FV of Ordinary Annuity = R ×
i

(1 + i)n − 1
FV of Annuity Due = R × × (1 + i)
i

In the above formulas,

i is the interest rate per compounding period;

n are the number of compounding periods;
R is the fixed periodic payment.

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Example 1: Mr A deposited $700 at the end of each month of calendar year 2010 in an
investment account of 9% annual interest rate. Calculate the future value of the annuity on Dec
31, 2011. Compounding is done on monthly basis.

Solution
We have,
Periodic Payment R = $700
Number of Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Future Value PV = $700 × {(1+0.75%)^12-1}/1%
= $700 × {1.0075^12-1}/0.01
≈ $700 × (1.0938069-1)/0.01
≈ $700 × 0.0938069/0.01
≈ $700 × 9.38069
≈ $6,566.48

Example 2: Calculate the future value of 12 monthly deposits of $1,000 if each payment is made
on the first day of the month and the interest rate per month is 1.1%. Also calculate the total
interest earned on the deposits if the whole amount is withdrawn on the last day of 12th month.

Solution

Periodic Payment R = $1,000

Number of Periods n = 12
Interest Rate i = 1.1%
Future Value = $1,000 × {(1+1.1%)^12-1}/1.1% × (1+1.1%)
= $1,000 × {1.011^12-1}/0.011 × (1+0.011)
= $1,000 × (1.140286-1)/0.011 × 1.011
≈ $1,000 × 0.140286/0.011 × 1.011
≈ $1,000 × 12.75329059 × 1.011
≈ $12,893.58
Interest Earned ≈ $12,893.58 - $1,000 × 12
≈ $893.58

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 Compound Annual Growth Rate

CAGR stands for compound annual growth rate, a single annual rate that captures the
compounded growth of an investment or loan over multiple years. Given an investment’s value
at time 0 called the present value, its value at certain future date called the future value and the
time duration between the two values, we can calculate CAGR.
Investments, revenues, expenses, etc. grow at different rates in different periods, which makes
comparison between them difficult. CAGR, being a standardized measure of annual compound
growth regardless of the time duration, reflects the cumulative effect of multiple periods and
enables us to make comparisons.
CAGR can be calculated only when we have present value, future value and time duration of a
single sum. It can’t be calculated for a stream of cash flows, revenues, etc. CAGR is different
from the holding period return, the cumulative total growth rate on an investment between two
dates.

Formula

CAGR can be calculated using the following formula:

CAGR=(FVPV)1n−1

PV stands for present value, the value at t=0

FV stands for future value, the ending value at t=n
N is the total number of years between PV and FV.
The formula for CAGR is just algebraic manipulation of the equation for future value of a single
sum. Let’s derive the above equations so you don’t have to memorize it.
The future value (FV) of a single sum today (PV) is as follows:
FV=PV×(1+RATE)n

Rate stands for the annual compound growth rate and n is total number of years. Let’s substitute
RATE with CAGR:
FV=PV×(1+CAGR)n

Let’s divide both sides by PV and raise both sides to (1/n):

(FVPV)1n=((1+CAGR)n)1n

N and 1/N cancel each other, and we get:

(FVPV)1n=1+CAGR

Subtracting 1 from both sides we get:

(FVPV)1n−1=CAGR
Alternatively, we can use Excel RATE and/or RRI functions.

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Example

You work in an accounting firm that has three divisions: audit, tax and advisory. Audit division
revenues were $12 million 5 years back and $15 million now. Tax department revenues were $20
million two years back and they grew by 5% and 7% in the past two years respectively. Advisory
revenues in the last three years were $5 million, $5.5 million and $6.2 million respectively. Your
partner-in-charge has asked you to find out how much each division grew on average per year.
Solution
You need to find out compound annual growth rate for each division.
In case of Audit, CAGR is:
CAGR of Audit Division= ($15$12)15−1=4.56%

You can also calculate it by entering the following in any Excel cell “=RATE(5,0,-12,15)”
In case of the Tax Division, we need to first find the revenues today given the revenue two years
back and two-year growth rates. Revenue today equals $22.47 million (=$20 million × (1 + 5%)
× (1 + 7%)). This can also be calculated using FVSCHEDULE function.
Now, we can calculate CAGR for Tax Division:
CAGR of Tax Division= ($22.47$20)12−1=6%

Alternatively, you can work out CAGR for tax by using the following Excel formula: “=RRI (2,
20,-22.47)”
In case of Advisory Division, we have actual revenue figures but since we are making
comparison between the start date and end date, we base CAGR on $5 million, the earliest
revenue value and $7 million, the latest revenue.
CAGR of Advisory Division= ($6.2$5)12−1=11.36%

The comparison shows that the Advisory Division is the biggest growth area.

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