Time Value of Money

Learning Outcomes

After completing this module, students will be able to:

1. Compute the present and future values of varying cash payment patterns
including single payments, annuities, annuities due, annuities with growth, and
perpetuities with growth.
2. Explain the concepts of simple and compound interest and continuous
compounding.
3. Demonstrate the difference between annual percentage rates and effective
annual rates.
4. Calculate payments under different loan repayment options including discount,
interest-only, and full and partial amortization.
5. Derive the different present and future value formulas.
6. Solve future and present value problems using predefined financial functions in
Excel.

Introduction

Would a manager rather receive payment from a customer today or in one year? Being
paid today is better as that money could be invested at current interest rates generating
a larger amount in a year. Would a manager rather pay a supplier now or in one year?
Paying later is preferable as a lesser amount could be invested now so that in a year
with interest the company would have enough to pay the supplier. These are examples
of the time value of money.

Frequently managers must determine what a single cash payment or series of cash
payments is worth either today or at a future date. Being able to accurately value the
cash inflows and outflows that a business or one of its projects generates is critical in
making effective management decisions. Not correctly incorporating the time value of
money can lead to critical errors.

1.1 | Future Value and Compounding

The future value (FV) of an investment equals the initial principal plus accumulated
interest at a specific point in time. After a single period, investors will receive their
initial principal as indicated by the first component of the formula below plus interest
equal to the principal (P) times the interest rate (i).

FV =( P ) ( 1 ) + ( P ) (i ) or FV =( P ) ( 1+i )

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Over multiple periods (n), FV depends on whether the interest is paid out or reinvested.
If it is re-invested, it is added to the initial principal each period, and the interest earned
in subsequent periods increases as the principal grows. After three periods, the FV
would be calculated as:

FV =( P ) ( 1+i )( 1+i ) ( 1+ i )

This is called compound interest and investors are said to be earning interest on their
interest. The formula can be simplified, so the FV equals the initial principal times the
FV factor.
FV factor
n
FV =( P ) ( 1+i )

FV factor tables were published for different interest rate (i) and period (n) combinations
before calculators and microcomputers become available in the 1970s and 1980s, but
they are used sparingly today. Electronic calculating devices have predefined financial
functions that determine FV automatically.

Exhibit 1: Future Value with Compound Interest

Beginning Compound Interest Ending

Year
Principal (CAD) i = 5.0% Principal (CAD)
1 1,000.00 (1 + 0.05) = 1.05 1,050.00
2 1,050.00 (1 + 0.05) = 1.05 1,102.50
3 1,102.50 (1 + 0.05) = 1.05 1,157.63
FV factor = (1 + 0.05) (1 + 0.05) (1 + 0.05) = (1 + .05)3= 1.15763

If interest is paid out, the initial principal does not change so the interest earned in
future periods will be the same. This is called simple interest and is lower than
compound interest over time due to the lack of compounding.

Exhibit 2: Simple Versus Compound Interest

Simple Interest Compound Interest

Year Beginning Interest Beginning Interest
Principal (CAD) i = 5.0% Principal (CAD) i = 5.0%
1 1,000.00 50.00 1,000.00 50.00
2 1,000.00 50.00 1,050.00 52.50
3 1,000.00 50.00 1,102.50 55.13
Total interest 150.00 Total interest 157.63
Extra interest due to compounding = 157.63 -150.00 = CAD 7.63

As shown in the exhibit below, disciplined investors who re-invest their interest instead
of spending the cash can greatly increase their return especially as interest rates and the
length or term of the investment rise. This effect is sometimes called the “magic” of
compound interest and is an important concept for long-term investors such as pension
plans or life insurance companies.

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 Exhibit 3: Effect of Compound Interest Over Time
Future Value CAD 100
CAD 700

CAD 600 20%

CAD 500
Future Value

CAD 400 15%

CAD 300
10%
CAD 200
5%
CAD 100 0%

CAD -
1 2 3 4 5 6 7 8 9 10

Years

Sometimes a manager knows what FV they need from an investment but may have to
adjust the initial principal (P), interest rate (i), or the number of periods (n) to reach that
target. The FV formula can be used to conduct a “what if” analysis to determine the
appropriate P, i, or n.

Compounding Period

Interest rates are quoted annually for comparability, but the compounding period can
be annually, semi-annually, quarterly, monthly, or daily. To correctly incorporate
compound interest in the FV formula, the interest rate (i) must be per compounding
period and the number of periods (n) must be the number of compounding periods
over the life of the investment. To determine the interest rate (i) per compounding
period, the quoted annual interest rate is divided by the number of compounding
periods per year (i.e. 365 days, 12 months, 4 quarters, or 2 six-month periods, or 1 year).
The number of compounding periods is the number of compounding periods per year
times the life of the investment in years. For example, a two-year investment with a
quoted annual interest rate of 5.0%, compounded quarterly, would have an interest rate
of 1.25% (i.e. 5.0% ÷ 4 quarters per year) per compounding period and eight
compounding periods (i.e. 4 quarters per year x 2 years).

The quoted annual interest rate is referred to as the annual percentage rate (APR), but if
the compounding period is more frequent than annually then the effective annual rate
(EAR) will be higher. More frequent compounding gives investors a better return or is
more costly to borrowers. The EAR is calculated as:

( )
Number of compoun ding periods per year
APR
EAR= 1+ −1
Number of compounding periods per year

EAR provides firms with their true return or cost of borrowing per annum.

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Interest rates can also be compounded continuously which assumes an infinite number
of compounding periods that results in the highest possible EAR. It is not used in
commercial lending, but EAR does have some applications in finance such as derivative
valuation.
EAR = e APR −1

EAR with continuous compounding is a mathematical limit equal to the natural

logarithm of APR to the base of the constant e which is approximately 2.71828.

Exhibit 4: APR versus EAR

APR Calculation EAR

.05 1
5%, compounded annually (1+ ) − 1 = .0500 5.00%
1
.05 2
5%, compounded semi-annually (1+ ) − 1 = .0506 5.06%
2
.05 4
5%, compounded quarterly (1+ ) − 1 = .0509 5.09%
4
.05 12
5%, compounded monthly (1+ ) − 1 = .0512 5.12%
12
.05
5%, compounded continuously 2.71828 −1=.0513 5.13%

1.2 | Present Value and Discounting

Present value (PV) is closely related to the concept of FV. In the last section, formula 1
below was used to determine the initial principal required to achieve a certain FV
assuming a specific interest rate and term. The initial principal is also called the PV as it
is expressed in today’s dollars or, as finance people say, at time (T) = 0. PV is
substituted for P and then formula 1 is rearrange giving formula 2. PV equals FV
divided by the PV or discount factor.
n
Formula 1 FV = ( P )( 1+i )

FV
Formula 2 PV = PV or discount factor
( 1+i )n

Managers often undertake capital projects where they make a large initial cash
investment in land, plant, and equipment. The project generates positive cash flows in
the future, but managers need to know if these future benefits are greater than the
initial costs. The problem is the cash outflows and inflows do not occur at the same
time. To make them comparable, the PV of the future cash flows are determined so
they can be compared to the initial cash flows which are already at T= 0. If the PV of

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the future cash inflows exceeds the initial cash outflows, the project is undertaken.

Exhibit 5: Evaluating a Capital Project

Cash Flows Calculation Present Value

Time
(CAD) i = 8.0%, compounded annually (CAD)
−150,000
Cash outflows -150,000 ¿ -150,000
( 1+ .08 )0
75,000
Cash inflows at end of year 1 75,000 ¿ 69,444
( 1+ .08 )1
100,000
Cash inflows at end of year 2 100,000 ¿ 85,734
( 1+ .08 )2
120,000
Cash inflows at end of year 3 120,000 ¿ 95,260
( 1+ .08 )3
Total CAD 100,438

Like with the FV formula, managers can adjust FV, interest rate (i), or the number of
periods (n) in the PV formula as part of a “what if” analysis to determine the actions
needed to achieve a certain PV.

1.3 | Annuities and Perpetuities

Annuities

Finite series of equal payments are common in business with different cost or revenue
streams such as loan payments or investment returns. If the payments occur at the end
of each period, they are called an ordinary annuity or just an annuity. If they occur at
the beginning of each period, they are called an annuity due.

Exhibit 6: Future Value of an Annuity or Annuity Due

Annuity (CAD) Annuity Due (CAD)

i = 5.0%, compounded annually i = 5.0%, compounded annually
Payment FV Factor FV Payment FV Factor FV
5,000 (1 + .05)2 5,512.50 5,000 (1 + .05)3 5,788.12
5,000 (1 + .05)1 5,250.00 5,000 (1 + .05)2 5,512.50
5,000 (1 + .05) 0
5,000.00 5,000 (1 + .05)1 5,250.00
Total 15,762.50 Total 16,550.62
Note: The exponents vary depending on whether the payments occur at
the beginning (ordinary annuity) or ending (annuity) of the year.

Exhibit 7: Present Value of an Annuity or Annuity Due

Annuity (CAD) Annuity Due (CAD)

i = 5.0%, compounded annually i = 5.0%, compounded annually
Payment PV Factor PV Payment PV Factor PV

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 5,000 (1 + .05)1 4,761.90 5,000 (1 + .05)0 5,000.00
5,000 (1 + .05)2 4,535.15 5,000 (1 + .05)1 4,761.90
5,000 (1 + .05)3 4,319.19 5,000 (1 + .05)2 4,535.15
Total 13,616.24 Total 14,297.05

The PV or FV of each annuity payment can be calculated individually and summed to

give the value of the annuity or formulas can be used.
−n
1−( 1+i )
Present value of an annuity (PVA) P( )
i
−n
1−( 1+i )
Present value of an annuity due (PVAD) P ( ¿(1 + i)
I
( 1+ i )n −1
Future value of an annuity (FVA) P( )
i
( 1+ i )n −1
Future value of an annuity due (FVAD) P( ¿(1 + i)
i
Perpetuities

An infinite series of equal payments is called a perpetuity. Perpetuities are less common
than annuities in business but there are examples such as common or preferred share
dividends which are paid out regularly forever. Perpetual bonds also make fixed interest
payments each period, but the bonds never mature.

Trying to determine the FV of a perpetuity is illogical as the series never ends. The PV
of a perpetuity (PVP) can be calculated because the PV of future payments eventually
becomes so small because of the long discounting period that the PVP reaches a
mathematical limit which means it does not rise past a certain point.

P
Present value of a perpetuity (PVP) PVP =
i

1.4 | Growing Annuities or Perpetuities

Some business applications have a finite or infinite series of payments, but they are not
equal as they grow at a constant rate due to inflation or real growth. The formulas for
the PV of an annuity or perpetuity with growth are:

( ) ( )
n
P 1+ g
Present value of an annuity with growth (PVAG) (1 – )
i−g 1+i

P
Present value of a perpetuity with growth (PVPG)
i–g

To use either of these formulas, the growth rate (g) must be constant and be less than
the interest rate (i) as a negative number in the denominator is illogical. This may be

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the case for mature companies, but for high-growth companies, it may be necessary to
use a two or three-stage model with a higher growth rate for the initial period(s) before
the growth rate falls to a long-term level that is less than the interest rate. During the
high-growth stages when the growth rate exceeds interest, the PV of each cash flow is
calculated separately for each period. For subsequent periods, the PVP with growth
formula can be used. This approach is commonly used when valuing common shares.

1.5 | Commercial Lending

Commercial lending is an important application of the time value of money concept,

especially present value. Businesses that borrow funds must pay interest and repay the
principal in the future. The three basic types of loans are discount, interest-only, and
amortized.

Discount loans. For short-term loans under a year, the borrower typically receives a
fraction of the loan’s face value today but then pays back the full amount at
maturity. The difference between the two amounts is the interest expense. Issuing
loans this way is administratively more convenient for the lender as they do not have
to calculate and collect multiple interest and principal payments. For example, a
business agreed to repay CAD 25,000 in one year when a loan matures. If the loan
has an interest rate of 5.5%, compounded monthly, the borrower would receive CAD
23,665.10 today. The extra CAD 1,334.90 paid at maturity is the interest on the loan.

25,000
FV 12
PV = = .055 = 23,655.10
( 1+ i )n (1+ )
12

Interest-only loans. For long-term loans, interest is paid regularly on the

outstanding balance, but principal repayment procedures vary. Interest-only (IO)
loans stipulate that the borrower pays interest on the principal during the life of the
loan and repays the principal when the loan matures. IO loans are risky for lenders
as most loans are backed up by collateral. Collateral is property pledged by the
borrower that the lender can take if the borrower fails to make their payments. The
collateral is typically the assets purchased with the borrowed funds such as new
equipment. These assets can depreciate quickly, so it is important to start repaying
the principal right away to ensure that the value of the collateral remains safely
above the balance of the loan. Only more creditworthy borrowers will likely qualify
for IO loans as they have strong operating cash flows and other unpledged collateral
that can be used to service the loan.

Amortized loan. These loans are normally repaid in blended, equal monthly
payments of interest and principal over the amortization period or life of the loan.
Some amortized loans repay principal on a straight-line basis with interest paid on
the remaining balance. Other loans may not require principal repayment initially as
the project or company becomes established, but then have increased or “stepped”

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 principal payments in subsequent periods as cash flows increase with potentially a
large “balloon” or “bullet” payment at maturity.

Amortized loans being repaid in blended, equal monthly payments of interest and
principal are annuities. When the PVA is calculated using the current market interest
rate, it removes the interest component of each payment. What remains is the initial
principal of the loan.

Initial Loan Principal = Payment (

( 1 – ( 1+i )−n ) )
i

Using the principal, monthly interest rate, and monthly payment, an amortization
table can be prepared with the beginning and ending principal for each period
along with the interest and principal component of each payment. As the
amortization period is extended, the payments become smaller and the principal
component of each payment falls relative to the interest component. Borrowers will
benefit from smaller payments but will pay more interest over the life of the loan.
The remaining principal is always zero by the end of the amortization period.

Exhibit 8: Amortization Table with Blended, Equal Monthly Payments

Amount of loan: CAD 100,000 Interest rate: 6%, compounded monthly

Amortization period: 25 years Monthly payment:1 CAD 644.30
Beginning Interest Ending
Period Principal
Principal (.005) Principal
1 100,000.00 500.00 144.30 99,855.70
2 99,855.70 499.28 145.02 99,710.68
3 99,710.68 498.55 145.75 99,564.93
Periods 4 through 299
300 642.06 3.21 641.09 0.97

( )
−(25 x12)
.06
1− 1+
12
1
100,000 = P( ) P = 644.30
.06
12

Goal Seek

When conducting a “what-if” analysis with the more complicated annuity and perpetuity
formulas, it is sometimes difficult to isolate for interest (i). Goal Seek is a tool in Excel
that allows users to solve for one unknown that appears in multiple places in an
equation. For example:
( 1+ i )n −1
PVA = P ( )
i

Goal Seek can be found in Excel by selecting Data across the top menu and then What-
if Analysis. The dialogue box for Goal Seek prompts the user for three inputs:

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 Exhibit 9: Using Goal Seek

Set Cell Indicate the cell location of the formula that incorporates all
variables except the unknown variable interest rate (i). Only enter
the equation to the right of the equal sign. Do not enter “i” as
Excel does not recognize this character but instead use a cell
address such as A1.
To Value Excel automatically substitutes interest rates (i) in the formula until
it equals this value which is the PVA. The actual value must be
entered into Goal Seek, so a cell address cannot be used.
By Changing Cell The cell contains the interest (i) that equates the Set Cell and To
Value, but it is per compounding period, so it needs to be
converted into an APR or EAR. Enter a number in A1 before
selecting OK to start Goal Seek otherwise, Excel will not be able to
determine if A1 is a letter or a number.

Commercial lending is examined in greater detail in Module: Maturity Matching and

Module: Permanent Debt and Equity Financing.

1.6 | Present and Future Value Formulas

Understanding how the different present and future value formulas are derived
mathematically enhances a user’s ability to apply the time value of money in different
business situations.

Exhibit 10: Proofs for PV and FV Formulas

Formula Explanation
The detailed formula for a PVP is:

P P P
PVP = 1
+ 2
+… +
( 1+ i ) ( 1+i ) ( 1+ i )∞
Both sides of the formula are multiplied by (1+i) and then simplified:

P P P
PVP (1+i) (PVP) = P+ +… +
i ( 1+ i )1
( 1+ i )∞
PVP + (i) (PVP) = P + PVP

(i) (PVP) = P

P
PVP =
i

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 PVP beginning in n periods is discounted for n periods and subtracted
from a PVP beginning today. The difference is a PVA for n periods
−n beginning today.
1−( 1+i )
PVA P( )
i P P
( )( 1
)
−n
− 1−( 1+i )
=P( )
i i ( 1+i )n i
PVA is multiplied by (1+i) since the payments are at the beginning of the
period with an annuity due, so they were discounted for one too many
periods. An alternative formula is:

1−( 1+i )
−n 1−( 1+i )−(n −1 )
P( )(1 + P+P( )
PVAD i i
i) The first payment does not have to be discounted as it occurs at the
beginning of the period. Only the remaining payments (n−1) are
discounted. A payment occurring at the beginning of the second period
is equivalent to one occurring at the end of the first period in terms of
time so the PVA formula can be used.
FVA is calculated by determining the PVA, finding the future value of
this single amount by compounding it for the life of the annuity, and
( 1+ i )n −1 then simplifying the formula.
FVA P( )
i −n n
1−( 1+i ) ( 1+ i ) −1
P( )( 1+i )n = P ( )
i i
( 1+ i )n −1 FVA is multiplied by (1+i) since the payments occur at the beginning of
FVAD
P( ) (1 + the period with an annuity due, so one additional compounding period
i is required.
i)
The formula for PVP is:

P P ( 1+ g ) P
PVP = + +…+
( 1+ i ) ( 1+ i )2
( 1+ i )∞

This is an infinite geometric series that has the standard formula:

P P ( 1+ g )
PVPG
i−g PVP = a (1 + x + x2+ …), where a = and x = .
( 1+ i ) ( 1+i )

a
The sum of an infinite geometric series is PVP = .
1−x

P
Substituting a and x and simplifying, PVP = .
i–g

( )
PVAG P 1+ g
n PVPG beginning today minus the PVPG in n periods discounted to today
(1 – ) equals the PVAG for n periods beginning today.
i–g 1+i

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 ( )( )
n
P ( 1+ g )
( )
n
P 1 P 1+ g
− = (1 – )
i−g i−g ( 1+i )n i–g 1+i

1.7 | Predefined Future Value and Present Value Functions in Excel

Financial calculators and spreadsheet software such as Excel include predefined financial
functions (fx) that perform many of the PV and FV operations examined in this module.
Studying the mathematical formulas gives analysts a better understanding of the time
value of money concept, but the functions can save time. The exhibit below contains
some of the financial functions available in Excel. Its Help feature provides a more
thorough explanation.

Exhibit 11: Predefined Functions in Excel

Predefined Function Explanation

=FV (rate, nper, pmt, pv, type) Calculates the FV of an annuity or annuity due
=PV (rate, nper, pmt, fv, type) Calculates the PV of an annuity or annuity due
Interest rate required given a certain number of periods, payment
=RATE (nper, pmt, pv, fv, type)
size, and present or future value
Number of periods required given a certain interest rate, payment
=NPER (rate, pmt, pv, fv, type)
size, and present or future value
Converts an annual percentage rate (APR) into an effective annual
=EFFECT (nominal_rate, npery)
rate (EAR)
Converts an effective annual rate (APR) into an annual percentage
=NOMINAL (effect_rate, npery)
rate (APR)
=PMT (rate, nper, pv, fv, type) Calculates a blended equal loan payment
=IPMT (rate, per, nper, pv, fv, type) Calculates the interest component of a blended equal loan payment
=PPMT (rate, per, nper, pv, fv, type) Calculates the principal component of blended equal loan payment

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