Time Value of Money

Chapter 5

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 Overview

Future Value

Present Value

Finding I and N

Annuities

Rates of Return

Amortization

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 Time Lines

 Show the timing of cash flows.

 Tick marks occur at the end of periods, so Time
0 is today; Time 1 is the end of the first period
(year, month, etc.) or the beginning of the
second period.

0 1 2 3
I%

CF0 CF1 CF2 CF3

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 Drawing Time Lines

$100 lump sum due in 2 years

0 1 2
I%

100

3-year $100 ordinary annuity

0 1 2 3
I%

100 100 100

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 Drawing Time Lines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

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 What is the future value (FV) of an initial $100 after 3 years, if
I/YR = 4%?

 Finding the FV of a cash flow or series of cash

flows is called compounding.
 FV can be solved by using the step-by-step,
financial calculator, and spreadsheet methods.

0 1 2 3
4%

100 FV = ?

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 Solving for FV:
The Step-by-Step and Formula Methods

After 1 year:
• FV1 = PV(1 + I) = $100(1.04) = $104.00
After 2 years:
• FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
After 3 years:
• FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
After N years (general case):
• FVN = PV(1 + I)N

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 Solving for FV:
Calculator and Excel Methods

 Solves the general FV equation.

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

INPUTS
INPUTS 33 44 -100
-100 00
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 112.49
112.49

 Excel: =FV(rate,nper,pmt,pv,type)

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 Present Value

 What is the present value (PV) of $100 due in

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

0 1 2 3
4%

PV = ? 100

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 Solving for PV:
The Formula Method

 Solve the general FV equation for PV:

PV= FVN /(1 + I)N

PV= FV3 /(1 + I)3

= $100/(1.04)3
= $88.90

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 Solving for PV:
Calculator and Excel Methods

 Solves the general FV equation for PV.

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

INPUTS
INPUTS 33 44 00 100
100
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT -88.90
-88.90

 Excel: =PV(rate,nper,pmt,fv,type)

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 Solving for I

 What annual interest rate would cause $100 to

grow to $119.10 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or
spreadsheet.

INPUTS
INPUTS 33 -100
-100 00 119.10
119.10
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 66

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

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 Solving for N

 If sales grow at 10% per year, how long before

sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS
INPUTS 10
10 -1
-1 00 22
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 7.3
7.3

• EXCEL: =NPER(rate,pmt,pv,fv,type)

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 What is the difference between an ordinary annuity and an
annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

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 Solving for FV

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

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

INPUTS
INPUTS 33 44 00 -100
-100
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 312.16
312.16

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

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 Solving for PV

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

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

INPUTS
INPUTS 33 44 100
100 00
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT -277.51
-277.51

• Excel: =PV(rate,nper,pmt,fv,type)
• Here type = 0.

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 Solving for FV:
3-Year Annuity Due of $100 at 4%

 Now, $100 payments occur at the beginning of each period.

FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
 Alternatively, set calculator to “BEGIN” mode and solve for
the FV of the annuity due:

BEGIN
BEGIN
INPUTS
INPUTS 33 44 00 -100
-100
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 324.65
324.65

 Excel: =FV(rate,nper,pmt,pv,type)
 Here type = 1.

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 Solving for PV:
3-Year Annuity Due of $100 at 4%

 Again, $100 payments occur at the beginning of each period.

PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
 Alternatively, set calculator to “BEGIN” mode and solve for
the PV of the annuity due:

BEGIN
BEGIN
INPUTS
INPUTS 33 44 100
100 00
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT -288.61
-288.61

 Excel: =PV(rate,nper,pmt,fv,type)
 Here type =1

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 PV Calculation

 What is the present value of a 5-year

$100 ordinary annuity at 4%?
• Be sure your financial calculator is set
back to END mode and solve for PV:
 N = 5, I/YR = 4, PMT = -100, FV = 0.
 PV = $445.18.

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 Annuities Over Time

10-year •• N
N== 10,
10, I/YR
I/YR =
= 4,
4, PMT
PMT =
= -100,
-100, FV
FV =
= 0;
0;
annuity solve
solve for
for PV
PV =
= $811.09.
$811.09.

25-year •• N
N== 25,
25, I/YR
I/YR =
= 4,
4, PMT
PMT =
= -100,
-100, FV
FV =
= 0;
0;
annuity solve
solve for
for PV
PV =
= $1,562.21.
$1,562.21.

Perpetuity •• PV
PV =
= PMT/I
PMT/I =
= $100/0.04
$100/0.04 =
= $2,500.
$2,500.

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 The Power of Compound Interest

 A 20-year-old student wants to save $5 a day

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

How much money will she have when

she is 65 years old?

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 Solving for FV

 If she begins saving today, how much will she

have when she is 65?
• If she sticks to her plan, she will have $705,373
when she is 65.

INPUTS
INPUTS 45
45 88 00 -1825
-1825
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 705,373
705,373

• Excel: =FV(.08,45,-1825,0,0)

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 Solving for FV

 If you don’t start saving until you are 40 years

old, how much will you have at 65?
• If a 40-year-old investor begins saving today,
and sticks to the plan, he or she will have
$133,418 at age 65. This is $571,954 less than
if starting at age 20.
• Lesson: It pays to start saving early.
INPUTS
INPUTS 25
25 88 00 -1825
-1825
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 133,418
133,418

• Excel: =FV(.08,25,-1825,0,0)
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 Solving for PMT

 How much must the 40-year old deposit annually to

catch the 20-year old?
• To find the required annual contribution, enter the
number of years until retirement and the final goal of
$705,372.75, and solve for PMT.
INPUTS
INPUTS 25
25 88 00 705373
705373
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT -9,648.64
-9,648.64

• Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)

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 What is the PV of this uneven cash flow stream?

0 1 2 3 4
4%

100 300 300 -50

96.15
277.37
266.70
-42.74
597.48 = PV

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 Solving for PV: Uneven Cash Flow Stream

 Input cash flows in the calculator’s “CFLO”

register:

CF0 = 0

CF1 = 100

CF2 = 300

CF3 = 300

CF4 = -50

 Enter I/YR = 4, press NPV button to get NPV =

$597.48. (Here NPV = PV.)

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 Will the FV of a lump sum be larger or smaller if compounded
more often, holding the stated I% constant?

LARGER, as the more frequently compounding occurs,

interest is earned on interest more often.
0 1 2 3
10%

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

0 1 2 3
0 1 2 3 4 5 6
5%

100 112.62

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

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 Classification of Interest Rates

Nominal rate (INOM

NOM
): also Periodic rate (IPER
PER
): amount
called the quoted or stated of interest charged each
rate. An annual rate that period, e.g. monthly or
ignores compounding effects. quarterly.

IIPER = I NOM/M,
PER = INOM /M, where
where M M isis the
the
IINOM is stated in contracts.
NOM is stated in contracts. number
number of of compounding
compounding
Periods
Periods must
must also
also be
be given,
given, periods
periods perper year.
year. MM == 44 for
for
e.g.
e.g. 4%
4% quarterly
quarterly or
or 4%
4% daily
daily quarterly
quarterly and
and MM == 12
12 for
for
interest.
interest. monthly
monthly compounding.
compounding.

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 Classification of Interest Rates

 Effective (or equivalent) annual rate (EAR = EFF%):

the annual rate of interest actually being earned,
considering compounding.
• EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
• Should be indifferent between receiving 4.04% annual
interest and receiving 4% interest, compounded
semiannually.

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 The Importance of Effective Rates of Return

Investments with different compounding intervals

provide different effective returns.

To compare investments with different

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

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 The Importance of Effective Rates of Return

 See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.

EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%

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 When is each rate used?

 INOM: Written into contracts, quoted by banks

and brokers. Not used in calculations or shown
on time lines.
 IPER: Used in calculations and shown on time
lines. If M = 1, INOM = IPER = EAR.
 EAR: Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.

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 Effect of Compounding on FV

 What is the FV of $100 after 3 years under 4%

semiannual compounding? Quarterly
compounding?
MN
 I 
FVN  PV1  NOM 
 M 

23
 0.04 
FV3S  $1001  
 2 
FV3S  $100(1.02) 6  $112.62

FV3Q  $100(1.01) 12  $112.68

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 Effective Rate vs Nominal Rate

 Can the effective rate ever be equal to the

nominal rate?
• Yes, but only if annual compounding is used, i.e.,
if M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.

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 What’s the FV of a 3-year $100 annuity, if the quoted interest
rate is 4%, compounded semiannually?

 Payments occur annually, but compounding

occurs every 6 months.
 Cannot use normal annuity valuation
techniques.

0 1 2 3 4 5 6
2%

100 100 100

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 Method 1: Compound Each Cash Flow

0 1 2 3 4 5 6
2%

100 100 100

104.04
108.24
312.28

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

FV3 = $312.28

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 Method 2: Financial Calculator or Excel

 Find the EAR and treat as an annuity.

 EAR = (1 + 0.04/2)2 – 1 = 4.04%.

INPUTS
INPUTS 33 4.04
4.04 00 -100
-100
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 312.28
312.28

 Excel: =FV(.0404,3,-100,0,0)

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 Find the PV of This 3-Year Ordinary Annuity

 Could solve by discounting each cash flow, or…

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

INPUTS
INPUTS 33 4.04
4.04 100
100 00
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT -277.30
-277.30

 Excel: =PV(.0404,3,100,0,0)

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 Loan Amortization

 Amortization tables are widely used for home

mortgages, auto loans, business loans,
retirement plans, etc.
 Financial calculators and spreadsheets are great
for setting up amortization tables.

EXAMPLE: Construct an amortization schedule for a

$1,000, 4% annual rate loan with 3 equal payments.

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 Step 1: Find the Required Annual Payment

 All input information is already given, just

remember that the FV = 0 because the reason
for amortizing the loan and making payments is
to retire the loan.

INPUTS
INPUTS 33 44 -1000
-1000 00
N
N I/YR
I/YR PV
PV PMT
PMT FV
FV
OUTPUT
OUTPUT 360.35
360.35

 Excel: =PMT(.04,3,-1000,0,0)

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 Step 2: Find the Interest Paid in Year 1

 The borrower will owe interest upon the initial

balance at the end of the first year. Interest to
be paid in the first year can be found by
multiplying the beginning balance by the
interest rate.

INTt = Beg balt(I)

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

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 Step 3: Find the Principal Repaid in Year 1

 If a payment of $360.35 was made at the end

of the first year and $40 was paid toward
interest, the remaining value must represent
the amount of principal repaid.

PRIN = PMT – INT

= $360.35 – $40 = $320.35

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 Step 4: Find the Ending Balance after Year 1

 To find the balance at the end of the period,

subtract the amount paid toward principal from
the beginning balance.

END BAL= BEG BAL – PRIN

= $1,000 – $320.35
= $679.65

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 Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan

YEAR BEG BAL PMT INT PRIN END BAL

1 $1,000 $ 360 $40 $ 320 $680
2 680 360 27 333 347
3 347 360 14 347 0
TOTAL – $1,081 $81 $1,000 –

 Interest paid declines with each payment as the

balance declines. What are the tax implications
of this?

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 Illustrating an Amortized Payment:
Where does the money go?

$
360.35
Interest

320.35

Principal Payments

0 1 2 3
 Constant payments
 Declining interest payments
 Declining balance

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 End of Chapter 5

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2019 Cengage
Cengage Learning®.
Learning®. May
May not
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be scanned,
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copied oror duplicated,
duplicated, or
or posted
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in whole
whole or
or in
in part,
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except for
for use
use as
as permitted
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Cover
Coverimage
imageattribution:
attribution:“Finance
“FinanceDistrict”
District”by
byJoan
JoanCampderrós-i-Canas
Campderrós-i-Canas(adapted)
(adapted)https://flic.kr/p/6iVMd5
https://flic.kr/p/6iVMd5