CHAPTER 4.

TIME VALUE OF MONEY

Learning outcomes

• After finishing this chapter, you should be able to:

▫ Explain how the time value of money works and
discuss why it is such an important concept
▫ Calculate the present value and future value of
lump sums
▫ Identify the different types of annuities. Calculate
the present value and future value of an annuity
▫ Be able to use a spreadsheet to solve time value
of money problems
▫ Explain the difference between nominal, periodic,
and effective interest rates
▫ Discuss the basics of loan amortization and
develop a loan amortization schedule
1. Some definitions

▫ Present value - earlier money on a time line

(today)
▫ Future value - later money on a time line (in the
future)
▫ Interest rate – “exchange rate” between earlier
money and later money
 Discount rate
 Cost of capital
 Opportunity cost of capital
 Required return
Video
1. Some definitions

• The interest rate

▫ Which would you prefer - $10,000 today or
$10,000 in 5 years?
▫ Obviously, $10,000 today
▫ You already recognize that there is
TIME VALUE OF MONEY !!!
• Why time?
▫ Why is TIME such an important element in your
decision?
▫ TIME allows you the opportunity to postpone
consumption and earn INTEREST
1. Some definitions

• Types of interest
▫ Simple interest – interest paid (earned) on only
the original amount or principal borrowed (lent)
▫ Compound interest – interest paid (earned) on
any previous interest earned as well as on the
principal borrowed (lent)
1. Some definitions

• Types of interest
▫ Simple interest
FVN = PV x (1 + N x I)
▫ Suppose you invest $1,000 for two year at 5% per
year. What is the future value in two year?
 Interest = 1,000 x 2 x (0.05) = 100
 Value in two year (Future Value (FV))
= principal + interest = 1,000 + 100 = 1,100
= 1,000 (1 + 2 x 0.05) = 1,100
1. Some definitions

• Types of interest
▫ Compound interest
FVN = PV x (1 + I)N
▫ Suppose you invest $1,000 for two year at 5% per
year. What is the future value in two year?
 Value in two year (Future Value (FV))
= 1,000(1 + 0.05)(1+ 0.05) = 1,000(1.05)2 = 1,102.5

The extra 2.5 comes from the interest of 50x0.05 =

2.5 earned on the first interest payment
1. Some definitions

• Time lines
0 1 2 3
I%

CF0 CF1 CF2 CF3

▫ It ís a graphical representation used to show the
timing of cash flows
▫ Help visualize what’s happening in a particular
problem
▫ Tick marks occur at the end of periods (such as years
or months), so Time 0 is today; Time 1 is the end of
the first period or the beginning of the second period
1. Some definitions

• Drawing time lines

▫ $100 lump sum due in 2 years
0 1 2
I%

100

▫0 3 year $100 ordinary

1 annuity2 3
I%

100 100 100

1. Some definitions

• Drawing time lines

▫ Uneven cash flow stream
0 1 2 3
I%

-50 100 75 50
2. Lump sum

• Future value (FV) - The process of going to FV from PV

is called compounding
▫ Assume you plan to deposit $100 in a bank that
pays a guaranteed 5% interest each year. How
much would you have at the end of year 3?
 PV = $100
 I (I/YR) = 5%
 N =3
 FV3 =?
0 1 2 3
5%

$100 FV = ?
2. Lump sum

• Future value (FV)

▫ Step by step approach – shows exactly what is
happening but time consuming

▫ Formula approach – easy to find FVs no matter

how many years are involved
FVN = PV x (1 + I)N
▫ FV3 = $100(1.05)3 = $115.76
2. Lump sum

• Future value (FV)

▫ Financial calculators

▫ Spreadsheets – easy to change inputs and see

the effects on the output
Future value (FV)

• Graphic view of the compounding process

▫ $1 investment grows over time (N) at different I
2. Lump sum

• Present value (PV) – finding PV is called discounting,

the reverse of finding FV
▫ Assume a broker offers to sell you a bond that will
pay $115.76 three years from now. If interest rate
is 5%, what is the most you should pay?
 FV3 = $115.76
 I (I/YR) = 5%
 N =3
 PV =?
0 1 2 3

PV = ? $115.76
2. Lump sum

• Present value (PV)

▫ Step by step approach

▫ Formula approach – easy to find FVs no matter how

many years are involved
PV = FVN / (1 + I)N
▫ FV3 = $115.76/(1.05)3 = $100
2. Lump sum

• Present value (PV)

▫ Financial calculators

▫ Spreadsheets
Present value (PV)

• Graphic view of the discounting process

▫ PV of $1 given various N and I
2. Lump sum

• Interest rate (I)

▫ A given bond has a cost of $100 and will return
$150 after 10 years. What is its rate of return?
 FV = PV(1+I)N
 $150 = $100(1+I)10
 I = 4.14%
2. Lump sum

• Number of years (N)

▫ How long to acquire $1 million, assuming you now
have $0.5 million invested at 4.5%
 FV = PV(1+I)N
 $1 = $0.5(1+0.045)N
 N = 15.7473 years

Video
3. Annuities

• A series of equal payments at fixed intervals for a

specified number of periods
▫ Ordinary (deferred) annuity – Payments or
receipts occur at the end of each period
▫ Annuity due – Payments or receipts occur at the
beginning of each period
▫ Examples of Annuity
 Student Loan Payments
 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
3. Annuities

• 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

3. Annuities

• FV of an Ordinary annuity
▫ You deposit $100 at the end of each year for three
years and earn 5% per year. How much will you
have at the end of the third year?
▫ Step by step approach
3. Annuities

• FV of an Ordinary annuity
▫ Formula approach

▫ Calculator approach

▫ Excel function approach

3. Annuities

• PV of an Ordinary annuity
▫ You want to withdraw $100 at the end of each
year for the next three years. How much should
you deposit in bank account today if the interest
rate is 5%?
▫ Step by step approach
3. Annuities

• PV of an Ordinary annuity
▫ Formula approach

▫ Calculator approach

▫ Excel function approach

3. Annuities

• FV & PV of an Annuity due

▫ You deposit $100 at the beginning of each year for
three years and earn 5% per year. How much will
you have at the end of the third year?
FVAdue = FVAordinary(1+I)

▫ You want to withdraw $100 at the beginning of

each year for the period of three years. How much
should you deposit in bank account today if the
interest rate is 5%?
PVAdue = PVAordinary(1+I)
3. Annuities

• Perpetuities - A stream of equal payments at fixed

intervals expected to continue forever
▫ You buy a preferred stock that pays a fixed
dividend of $2.5 each year. If the company will go
on indefinitely, and if the discount rate is 10%,
what is the present value of the preferred stock?
4. Uneven (Mixed) Cashflows

• Uneven CFs: A series of cash flows where the amount

varies from one period to the next
0 1 2 3 4
10%
100 300 300 -50
90.91
247.93
225.39
-34.15
530.08 = PV
4. Uneven (Mixed) Cashflows

• How to solve?
▫ Solve a “piece-at-a-time” by discounting each
piece back to t = 0
▫ Solve a “group-at-a-time” by first breaking
problem into groups of annuity streams and any
single cash flow group. Then discount each group
back to t = 0
Questions

• 5–10. Find the following values. Compounding / discounting occurs

annually
• a. An initial $200 compounded for 10 years at 4%
• b. An initial $200 compounded for 10 years at 8%
• c. The PV of $200 due in 10 years at 4%
• d. The PV of $1,870 due in 10 years at 8% and at 4%
• e. Define PV and illustrate it using a time line with data from part d.
How are PVs affected by interest rates?
• 5-31. Starting next year, you will need $5,000 annually for 4
years to complete your education. (One year from today you will
withdraw the first $5,000.) Your uncle deposits an amount today
in a bank paying 6% annual interest, which will provide the
needed $5,000 payments
• a. How large must the deposit be?
• b. How much will be in the account immediately after you make the
first withdrawal?
Questions

• 5–19. Your client is 26 years old. She wants to begin

saving for retirement, with the first payment to come one
year from now. She can save $8,000 per year, and you
advise her to invest it in the stock market, which you
expect to provide an average return of 10% in the future
• a. If she follows your advice, how much money will she
have at 65?
• b. How much will she have at 70?
• c. She expects to live for 20 years if she retires at 65 and
for 15 years if she retires at 70. If her investments
continue to earn the same rate, how much will she be
able to withdraw at the end of each year after retirement
at each retirement age?
• 5-20; 5-21 page 186 (226/866)
Questions

• 5–32. Six years from today you need $10,000. You plan to deposit
$1,500 annually, with the first payment to be made a year from today,
in an account that pays a 5% effective annual rate. Your last deposit,
which will occur at the end of Year 6, will be for less than $1,500 if
less is needed to reach $10,000. How large will your last payment
be?
• 5-39. Your father is 50 years old and will retire in 10 years. He
expects to live for 25 years after he retires, until he is 85. He wants a
fixed retirement income that has the same purchasing power at the
time he retires as $50,000 has today. (The real value of his retirement
income will decline annually after he retires.) His retirement income
will begin the day he retires, 10 years from today, at which time he will
receive 24 additional annual payments. Annual inflation is expected to
be 4%. He currently has $90,000 saved, and he expects to earn 8%
annually on his savings. How much must he save during each of the
next 10 years (end-of-year deposits) to meet his retirement goal?
• 5-40. page 189 (229/866)
5. Semiannual & Other compounding periods

▫ Assume you deposit $100 in an account that pays

10% annually and leave it there for 3 years. FV?
FVN = PV(1+I)N = $100(1.1)3 = $133.1
▫ Assume you deposit $100 in an account that pays
10% semiannually and leave it there for 3 years.
FV?
 Convert the stated interest rate into a “periodic rate”
 Convert the number of years into “number of periods”
FVN = PV(1+I)N = $100(1.05)6 = $134.01

How would things change if interest was compounded quarterly

or monthly or daily?
5. Semiannual & Other compounding periods

▫ 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
Annually
0 1 2 3
10%

100 133.10

Semiannually
0 1 2 3 4 5 6
5%

100 134.01
5. Semiannual & Other compounding periods

• Nominal rate or quoted or state rate or annual

percentage rate (APR / INOM) – An annual rate that
ignores compounding effects, which is stated in
contracts. Periods must also be given (8% quarterly or
8% daily interest)
• Periodic rate (IPER) – amount of interest charged each
period (monthly or quarterly)
IPER = INOM / M
where M is the number of compounding periods per
year (M = 4 for quarterly and M = 12 for monthly
compounding)
5. Semiannual & Other compounding periods

• Effective (or equivalent) annual rate (EAR / EFF%) –

the rate that would produce the same FV under annual
compounding or the annual rate of interest actually being
earned, accounting for compounding
▫ EFF% for 10% semiannual investment
EFF% = ( 1 + INOM / M )M - 1
= ( 1 + 0.10 / 2 )2 – 1 = 10.25%
5. Semiannual & Other compounding periods

• Effective (or equivalent) annual rate

▫ Should be indifferent between receiving 10.25%
annual interest and receiving 10% interest,
compounded semiannually
▫ Can the effective rate ever be equal to the
nominal rate?
 Yes, but only if annual compounding (if M = 1)
 If M > 1, EAR will always be greater than the iNOM
5. Semiannual & Other compounding periods

• What’s the FV of a 3-year $100 annuity, if the quoted

interest rate is 10%, compounded semiannually?
0 1 2 3 4 5 6
5%

100 100 100

▫ Payments occur annually, but compounding
occurs every 6 months.
▫ Cannot use normal annuity valuation techniques
5. Semiannual & Other compounding periods

• Method 1 – compound each cash flow

0 1 2 3 4 5 6
5%

100 100 100

110.25
121.55
331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100

FV3 = $331.80
5. Semiannual & Other compounding periods

• Method 2 - Use the EAR

Find the EAR and treat as an annuity
EAR = ( 1 + 0.10 / 2 )2 – 1 = 10.25%

FV3 = $100[(1.1025)3 – 1]/0.1025

FV3 = $331.80
5. Semiannual & Other compounding periods

• Fractional time periods

▫ Suppose you deposited $100 in a bank that pays a nominal
rate of 10% but adds interest daily, based on a 365-day
year. How much would you have after 9 months?
Periodic rate = IPER = 0.1/365 = 0.000273973 per day
Number of days = (9/12)*(365) = 273.75, rounded to 274
FV = $100(1.000273973)274 = $107.79
Questions

• 5-27. Bank A pays 2% interest compounded annually on

deposits, while Bank B pays 1.75% compounded daily
• a. Based on the EAR (or EFF%), which bank should you
use?
• b. Could your choice of banks be influenced by the fact
that you might want to withdraw your funds during the
year as opposed to at the end of the year? Assume that
your funds must be left on deposit during an entire
compounding period in order to receive any interest
• 5-36. page 188 (228/866)
6. Amortized loans

▫ Amortized loan: A loan that is repaid in equal

payments over its life
▫ Amortization tables are widely used for home
mortgages, auto loans, business loans, retirement
plans…
▫ EXAMPLE: Construct an amortization schedule
for a $1,000, 10% annual rate loan with 3 equal
payments during 3 years
6. Amortized loans

▫ 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
PMT = 402.11
▫ 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 (0.10) = $100
6. Amortized loans

▫ Step 3 - Find the principal repaid in Year 1

 If a payment of $402.11 was made at the end of the
first year and $100 was paid toward interest, the
remaining value must represent the amount of
principal repaid
PRIN = PMT – INT
= $402.11 - $100 = $302.11
▫ 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 - $302.11 = $697.89
6. Amortized loans

▫ Constructing an amortization table:

Repeat steps 1 – 4 until end of loan
BEG END
Year BAL PMT INT PRIN BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTAL 1,206.34 206.34 1,000 -
6. Amortized loans

▫ Illustrating an amortized payment:

Where does the money go?
$
402.11
Interest

302.11

Principal Payments

0 1 2 3
 Constant payments
 Declining interest payments
 Declining balance
Questions

• 5-34; 5-35 page 188 (228/866)