INTRODUCTION TO

CORPORATE FINANCE
Fourth Edition

BOOTH CLEARY RAKITA

CHAPTER 5: TIME VALUE OF MONEY

Learning Objectives
5.1 Explain the importance of the time value of money and how it is related to an
investor’s opportunity costs.
5.2 Define simple interest and explain how it works.
5.3 Define compound interest and explain how it works.
5.4 Differentiate between an ordinary annuity and an annuity due, and explain
how special constant payment problems can be valued as annuities and, in special
cases, as perpetuities.
5.5 Determine the present value of growing perpetuities and annuities.
5.6 Differentiate between quoted rates and effective rates, and explain how
quoted rates can be converted to effective rates.
5.7 Apply annuity formulas to value loans and mortgages and set up an
amortization table.
5.8 Solve a basic retirement problem.

© John Wiley & Sons Canada, Ltd. Page 2

 5.1 OPPORTUNITY COST

• Money is a medium of exchange.

• Money has a time value because it can be
invested today and be worth more tomorrow.
• The opportunity cost of money is the interest
rate that would be earned by investing it.

© John Wiley & Sons Canada, Ltd. Page 3

 5.1 OPPORTUNITY COST

• Required rate of return (k) is also known as a

discount rate.
• To make time value of money decisions, you will
need to identify the relevant discount rate you
should use.

© John Wiley & Sons Canada, Ltd. Page 4

 5.2 SIMPLE INTEREST

• Simple interest is interest paid or received only

on the initial investment (principal).
• The same amount of interest is earned in each
year.

Value (time n)  P  (n  P  k )

© John Wiley & Sons Canada, Ltd. Page 5

 EXAMPLE: Simple Interest

The same amount of interest is earned in each year.

© John Wiley & Sons Canada, Ltd. Page 6

 5.3 COMPOUND INTEREST

• Compound interest is interest that is earned on

the principal amount and on the future interest
payments.
• The future value of a single cash flow at any
time ‘n’ is calculated using Equation 5.2.

FVn  PV0 (1  k ) n [5.2]

© John Wiley & Sons Canada, Ltd. Page 7

 COMPOUND VERSUS SIMPLE INTEREST

• Simple interest grows principal in a linear manner.

• Compound interest grows exponentially over time.

© John Wiley & Sons Canada, Ltd. Page 8

 EXAMPLE: Computing Future Values
(Compounding)

FVn  PV0 (1  k ) n [5.2]

Example 5 -2 Compound Interest

You invest $500 today for five years and receive 10 percent annual compound interest.

Year Beginning Amount Interest Ending Amount

1 $500 $500 × 0.1 = $50 $550
2 $550 $550 × 0.1 = $55 $605
3 $605 $605 × 0.1 = $60.50 $666
4 $666 $666 × 0.1 = $66.66 $732
5 $732 $732 × 0.1 = $73.20 $805

© John Wiley & Sons Canada, Ltd. Page 9

 FUTURE VALUE INTEREST FACTOR (FVIF)

• A term that represents the future value of an

investment at a given rate of interest and for a
stated number of periods.
FVIFn ?,k ?  (1  k ) n

• The FVIF for 10 years at 8% would be:

FVIFn 10,k  0.08  (1  0.08)10  2.1589

• $100 invested for 10 years at 8% would equal:

FV10  $100  (1  0.08)10  $100  2.1589  $215.89

© John Wiley & Sons Canada, Ltd. Page 10

 EXAMPLE: Using the FVIF

Find the FV20 of $3,500 invested at 3.25%.

FV20  P0   FVIFn  20,k  3.5% 

 $3,500  (1  0.035) 20
 $3,500  1.99
 $6,964.26

© John Wiley & Sons Canada, Ltd. Page 11

COMPUTING PRESENT VALUES (DISCOUNTING)

• The inverse of compounding is known as

discounting.
• You can find the present value of any future
single cash flow using equation 5.3.

© John Wiley & Sons Canada, Ltd. Page 12

PRESENT VALUE INTEREST FACTOR (PVIF)

PVIF is the inverse of the FVIF.

1
PVIFn ?,k ? 
(1  k ) n

© John Wiley & Sons Canada, Ltd. Page 13

 EXAMPLE: Using the PVIF

Find the PV0 of receiving $100,000 in 10 years time if

the opportunity cost is 5%.

PV0  FV10   PVIFn 10,k 5% 

1
 $100,000 
(1  0.05)10
1
 $100,000 
1.629
 $100,000  0.6139
 $61,391.33

© John Wiley & Sons Canada, Ltd. Page 14

 USING EQUATION 5.2

• Given three known values, you can solve for the

one unknown in equation 5.2

• Solve for:
• FV - given PV, k, n (finding a future value)
• PV - given FV, k, n (finding a present value)
• k - given PV, FV, n (finding a compound rate)
• n - given PV, FV, k (find holding periods)
© John Wiley & Sons Canada, Ltd. Page 15
SOLVING FOR TIME OR “HOLDING PERIODS”

Equation 5.3 is reorganized to solve for n:

FV0
PV0  [5-3]
(1  k ) n

ln  FVn / PV0 
n
ln 1  k 

© John Wiley & Sons Canada, Ltd. Page 16

 EXAMPLE: Solving for ‘n’

How many years will it take $8,500 to grow to $10,000 at a

7% rate of interest?

ln  FVn / PV0 
n
ln 1  k 
ln  $10,000 / $8,500 ln[1.17647 ]
n 
ln 1  .07 ln[1.07]
0.1625
n  2.4 years
0.06766

© John Wiley & Sons Canada, Ltd. Page 17

SOLVING FOR COMPOUND RATE OF RETURN

Equation 5.3 is reorganized to solve for k:

FV0
PV0  [5-3]
(1  k ) n

1/ n
 FVn 
k  1
PV
 0

© John Wiley & Sons Canada, Ltd. Page 18

 EXAMPLE: Solving for ‘k’

Your investment of $10,000 grew to $12,500 after 12 years.

What compound rate of return (k) did you earn on your
money?

1/ n
 FVn 
k  1
PV
 0
1
 $12,500  12
k   1  1. 25 0.083
1
 $10,000 
k  0.01877  1.88%

© John Wiley & Sons Canada, Ltd. Page 19

 5.4 ANNUITIES AND PERPETUITIES

• An annuity is a finite series of equal and periodic

cash flows.
• A perpetuity is an infinite series of equal and
periodic cash flows.

© John Wiley & Sons Canada, Ltd. Page 20

 ANNUITIES AND ANNUITIES DUE

• An ordinary annuity offers payments at the end

of each period.

• An annuity due offers payments at the beginning

of each period.

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 ANNUITY FORMULA

The formula for the future sum of an ordinary

annuity is:

 (1  k ) n  1
FVn  PMT   [5.4]
 k 

© John Wiley & Sons Canada, Ltd. Page 22

EXAMPLE: Find the Future Value of an Ordinary
Annuity

You plan to save $1,000 each year for 10 years.

At 11% how much will you have saved if you make
your first deposit one year from today?

FVA10  PMT   FVIFA n ,k 

 1  k  n  1 
FVA10  $1,000   
 k 
 1.11 10  1
FVA10  $1,000   
 0. 11 
FVA10  $1,000  16.722  $16,722.01

© John Wiley & Sons Canada, Ltd. Page 23

 ANNUITY DUE FORMULA

The formula for the future sum of an annuity due is:

 (1  k ) n  1
FVn  PMT   (1  k) [5.6]
 k 

© John Wiley & Sons Canada, Ltd. Page 24

 EXAMPLE: Find the Future Value of an Annuity
Due
You plan to save $1,000 each year for 10 years.
At 11% how much will you have saved if you make
your first deposit today?

FVA10  PMT   FVIFAn ,k   1  k 

 1  k  n  1 
FVA10  $1,000    (1  k )
 k 
 1.11 10  1
FVA10  $1,000    (1.11)
 0.11 
FVA10  $1,000  16.722  1.11  $18,561.43

© John Wiley & Sons Canada, Ltd. Page 25

 PRESENT VALUE OF ANNUITY FORMULA

The formula for the present value of an annuity is:

 1 
1 
 (1  k ) n 
PV0  PMT   [5.5]
 k 
 

© John Wiley & Sons Canada, Ltd. Page 26

 EXAMPLE: Find the Present Value of an Ordinary
Annuity

What is the present value of an investment that

offers to pay you $12,000 each year for 20 years if
the payments start one year from day? Your
opportunity cost is 6%.

PVA0  PMT  PVIFA n 20,k 0.06

 1 
1 
 (1.06) 20 
PVA0  $12,000   
 0 . 06 
 
PVA0  $12,000  11 .47  $137,639.06

© John Wiley & Sons Canada, Ltd. Page 27

PRESENT VALUE OF ANNUITY DUE FORMULA

The formula for the present value of an annuity is:

 1 
1 
 (1  k ) n 
PV0  PMT   (1  k) [5.7]
 k 
 

© John Wiley & Sons Canada, Ltd. Page 28

EXAMPLE: Find the Present Value of an Annuity Due

What is the present value of an investment that

offers to pay you $12,000 each year for 20 years if
the payments start one today? Your opportunity
cost is 6%.
PVA0  PMT   PVIFA n ,k   1  k 
 1 
1 
 (1.06) 20 
PVA0  $12,000    (1  .06)
 0.06 
 
PVA0  $12,000  11 .47  1.06  $145,897.40

© John Wiley & Sons Canada, Ltd. Page 29

 FORMULA FOR A THE PRESENT VALUE OF A
PERPETUITY

A perpetuity is an infinite series of equal and periodic

cash flows.

PMT
PV0  [5.8]
k

© John Wiley & Sons Canada, Ltd. Page 30

 EXAMPLE: Find the Present Value of a Perpetuity

What is the present value of a business that

promises to offer you an after-tax profit of
$100,000 for the foreseeable future if your
opportunity cost is 10%?

P1 $100,000
PV0    $1,000,000
k 0.1

© John Wiley & Sons Canada, Ltd. Page 31

 5.5 GROWING ANNUITIES & PERPETUITIES

• A growing perpetuity is an infinite series of

periodic cash flows where each cash flow grows
larger at a constant rate.
• The Present Value of a growing perpetuity is
found:

PMT0 (1  g ) PMT1
PV0   [5.10]
kg kg

© John Wiley & Sons Canada, Ltd. Page 32

 GROWING ANNUITIES

• An annuity is a finite series of periodic cash

flows where each subsequent cash flow is
greater than the previous by a constant growth
rate.
• The formula for a growing annuity is:

PMT1  1 g  
n

PV0   1     [5.12]
k  g   1  k  

© John Wiley & Sons Canada, Ltd. Page 33

 5.6 QUOTED VERSUS EFFECTIVE RATES

• A nominal rate of interest is a ‘stated rate’ or

quoted rate (QR).
• An effective annual rate (EAR) rate takes into
account the frequency of compounding (m).

m
 QR 
EAR  k  1   1 [5.13]
 m 

© John Wiley & Sons Canada, Ltd. Page 34

 EXAMPLE: Find an Effective Annual Rate

Your personal banker has offered you a mortgage

rate of 5.5 percent compounded semi-annually.
What is the effective annual rate (EAR) charged on
this loan?

QR m 0.055 2
EAR  (1  ) - 1  (1  ) -1
m 2
EAR  1.02752 - 1  5.58%

© John Wiley & Sons Canada, Ltd. Page 35

 EXAMPLE: Effective Annual Rates

EARs increase as the frequency of compounding

increase.
Effective Annual Rates

QR = 8%

Frequency of
Compounding Effective Annual Rate
Annual 8.0%
Semi-annual 8.16%
Quarterly 8.24322%
Monthly 8.29995%
Daily 8.32776%
Continuous 8.32781%

© John Wiley & Sons Canada, Ltd. Page 36

5.7 LOAN OR MORTGAGE ARRANGEMENTS

• A mortgage loan is a borrowing arrangement

where the principal amount of the loan borrowed
is typically repaid (amortized) over a given
period of time making equal and periodic
payments.
• A blended payment is one where both interest
and principal are retired in each payment.

© John Wiley & Sons Canada, Ltd. Page 37

 EXAMPLE: Loan Amortization Table

Determine the annual blended payment on a five –

year $10,000 loan at 8% compounded semi-annually.

 1 
1 
 (1  k ) n
PV0  PMT   [5.5]
 k 
 
 1 
1 
 (1  0.0816)5 
$10,000  PMT   
 0.0816 
 
$10,000
PMT   $2,515.14
3.9759

© John Wiley & Sons Canada, Ltd. Page 38

 EXAMPLE: Loan Amortization Table

The loan is amortized over five years with annual payments beginning
at the end of year 1.

© John Wiley & Sons Canada, Ltd. Page 39

 Example: Mortgage Amortization

• Determine the monthly blended payment on a $200,000 mortgage

amortized over 25 years at a QR = 4.5% compounded semi-
annually.

Number of monthly payments = 25 × 12 = 300

0.045 2
 (1  )  1  4.550625%
• Find EAR: 2

4.550625%  (1  EMR )12  1

• Find EMR:
1.04550625 112  (1  EMR)
EMR  0.3715318%
$200,000
PMT   $1,106.85
 1 
• Determine monthly payment: 1  (1  0.003715)300 
 
 0. 003715 
  Page 40
EXAMPLE: Mortgage Amortization

Page 41
 5.8 COMPREHENSIVE EXAMPLES

• Time Value of Money (TMV) is a tool that can

be applied whenever you analyze a cash flow
series over time.
• Because of the long time horizon, TMV is ideally
suited to solve retirement problems.

© John Wiley & Sons Canada, Ltd. Page 42

 COMPREHENSIVE EXAMPLE:
Retirement Problem

• Kelly, age 40 wants to retire at age 65 and currently has no savings.

• At age 65 Kelly wants enough money to purchase a 30 year annuity
that will pay $5,000 per month.
• Monthly payments should start one month after she reaches age
65.
• Today Kelly has accumulated retirement savings of $230,000.
• Assume a 4% annual rate of return on both the fixed term annuity
and on her savings.
• How much will she have to save each month starting one month
from now to age 65 in order for her to reach her retirement goal?

NOTE – these are ordinary annuities

© John Wiley & Sons Canada, Ltd. Page 43

 COMPREHENSIVE EXAMPLE:
Retirement Problem

How Much will the Fixed Term Annuity Cost at age 65?

Steps in Solving the Comprehensive Retirement Problem

1. Calculate the present value of the retirement annuity as

at Kelly’s age 65.
2. Estimate the value at age 65 of her current accumulated
savings.
3. Calculate gap between accumulated savings and
required funds at age 65.
4. Calculate the monthly payment required to fill the gap.

© John Wiley & Sons Canada, Ltd. Page 44

 COMPREHENSIVE EXAMPLE: Retirement
Problem

Example Solution – Preliminary Calculations

Preliminary calculations Required

• Monthly rate of return when annual APR is 4%
4%  (1  k m )12  1
1
1  k m  1  .04 12  (1.04).083  1.00326
k m  0.326%

• Number of months during savings period

n  25  12  300

© John Wiley & Sons Canada, Ltd. Page 45

COMPREHENSIVE EXAMPLE: Retirement
Problem

Time Line & Analysis Required to Identify Savings Gap

GAP  $1,058,524  $613,142 30 year fixed-term retirement
 $445,382 annuity = 30 ×12 =360 months

$1,058,524
Additional  1 
monthly 1  (1  k ) n 
PV25  PMT   (1  k)
savings  k 

 


FV25  P0 (1  k annual ) 25  $230,000(1.04) 25

Existing
Savings
 $613,142

Age 40 65 95

25 year asset accumulation phase 30 year asset depletion phase (retirement)

© John Wiley & Sons Canada, Ltd. Page 46

 COMPREHENSIVE EXAMPLE:
Retirement Problem

Monthly Savings Required to fill Gap

FVA25 $445,382
GAP  $1,058,524  $613,142 Monthly PMT  
(1  k )  1 (1.00326) 300  1
n

 $445,382 savings to fill

k 0.00326
gap? $445,382
  $877.36
Additional 507.64
monthly
savings Your Answer

FV25  P0 (1  k annual ) 25  $230,000(1.04) 25

Existing  $613,142
Savings

Age 40 65 95

25 year asset accumulation 30 year asset depletion phase

phase (retirement)

© John Wiley & Sons Canada, Ltd. Page 47

 COPYRIGHT

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