Financial Management:

Principles & Applications

Thirteenth Edition

Chapter 5
The Time Value of
Money—The Basics

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 Chapter Outline

Timelines to Visualize Cash Flows.

uct cash flow timelines to organize your analysis of
ms involving the time value of money. Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
 Time Value Concepts
Time value of money is a critical consideration in
financial and investment decisions. The time value of
money refers to the idea that money received today is
worth more than the same sum received in the future.
An old saying is that “A bird in the hand is worth two in
the bush”.
Reasons for time preference of money
Risk (Uncertainty)
Preference for present consumption
Inflation
Investment opportunities
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5.1 Using Timelines to Visualize Cash flows

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 Principles Applied in this Chapter
Principle 1: Money Has a Time Value
• A timeline identifies the timing and amount of a
stream of payments – both cash received and cash
spent - along with the interest rate earned.
Timelines are a critical first step that financial
analysts use to solve financial problems.
• A timeline is typically expressed in years, but it
could also be expressed as months, days or any
other unit of time.

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 Creating a Timeline
Suppose you lend a friend $10,000 today to help him finance
a new Jimmy John’s Sandwiches franchise and in return he
promises to give you $12,155 at the end of the fourth year.
How can one represent this as a timeline? Note that the
interest rate is 5 percent.
STEP 1: Picture the problem
A timeline provides a tool for visualizing cash flows and
time:

STEP 2: Decide on a solution strategy

To complete the timeline, we simply record the cash
flows on the template. Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
 Creating a Timeline
STEP 3: Solve
We can input the cash flows for this investment on the
timeline as shown below.

STEP 4: Analyze
Using timelines to visualize cash flows is useful in
financial problem solving. From analyzing the timeline,
we can see that there are two cash flows, an initial
$10,000 cash outflow and a $12,155 cash inflow at the
end of Year 4.

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 Creating a Timeline
STEP 5: Check yourself
Draw a timeline for an investment of $40,000 today that
returns nothing in Year 1, $20,000 at the end of Year 2,
nothing in Year 3, and $40,000 at the end of Year 4; the
interest rate is 13.17 percent.

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5.2 Compounding and Future Value

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 Compounding and Future Value
Time value of money calculations involve Present value
(what a cash flow would be worth to you today) and Future
value (what a cash flow will be worth in the future).
Compounding : The process of determining the final
value of a cash flow or series of cash flows when
compound interest is applied.
Future Value: compounding or growth over time
Future Value Number of Years (n)
Present  Annual 
in Year n =  1+ 
Value (PV)  Interest Rate (i) 
(FVn )

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 Compound Interest and Time
The Future value of an investment grows with the
number of periods we let it compound.
FV PV 1  i 
n

n.m
 i 
FV PV  1  
 m
Example: Suppose that you deposited $500 in your
savings account that earns 5% annual interest. How
much will you have in your account after two years?
After five years?
FV 500(1.05) 2 $551.25
FV 500(1.05)5 $638.14
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 Compound Interest and Time
YEAR PV or Interest Earned (5%) FV or
Beginning Value Ending Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $26.25 $551.25
3 $551.25 $551.25*.05 = $27.5 $578.81
4 $578.81 $578.81*.05 = $28.94 $607.75
5 $607.75 $607.75*.05 = $30.39 $638.14

Using Equation : FV PV 1  i 

n

FV 500(1.05)5 $638.14

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 Applying Compounding to Things Other
Than Money
Example A car rental firm is currently renting 8,000 cars
per year. How many cars will the firm be renting in 10
years if the demand for car rentals is expected to
increase by 7% per year?
• Using Equation
– FV = 8000(1.07)10 = 15,737.21 Cars
Check Yourself
Calculating the FV of a Cash Flow What is the FV of
$10,000 compounded at 12% annually for 20 years?

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Step 1: Picture the Problem
i = 12%

Years 0 1 2… 20
Cash flow −$10,000 Blank Blank Blank

Future
Value
=?

Step 2: Decide on a Solution Strategy

This is a simple future value problem. We can find the
future value using Equation 5-1a.
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 Step 3: Solve
Solve Using a Mathematical Formula
Future Value Number of Years ( n )
Present  Annual 
in Year n =  1+ 
Value (PV )  Interest Rate ( i ) 
(FVn )

FV = $10,000(1.12)20
= $10,000(9.6463)
= $96,462.93

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Step 3: Solve
Solve Using a Solve Using an Excel
Spreadsheet
Financial Calculator
= FV(rate,nper,pmt,pv)
N = 20
= FV(0.12,20, 0, − 10000)
I/Y = 12%
PV = −10,000 = $96,462.93
PMT = 0

FV = $96,462.93

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 Compound Interest with Shorter
Compounding Periods
Banks frequently offer savings account that compound
interest every day, month, or quarter. More frequent
compounding will generate higher interest income and
lead to higher future values.
m × (Number of Years ( n ))
 Annual 
Future Value  
Present Interest Rate ( i )
in Year n =  1+ 
Value (PV )  Compounding 
(FVn )  Periods per Year ( m) 
 

n.m
 i 
FV PV  1  
 m
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 Table 3-2 The Value of $100 Compounded at
Various Non—Annual Periods and Various Rates
For 10 Years at i Percent i = 2% 5% 10% 15%
Compounded annually $121.90 $162.89 $259.37 $404.56
Compounded semiannually 122.02 163.86 265.33 424.79
Compounded quarterly 122.08 164.36 268.51 436.04
Compounded monthly 122.12 164.70 270.70 444.02
Compounded weekly (52) 122.14 164.83 271.57 447.20
Compounded daily (365) 122.14 164.87 271.79 448.03

Calculating Future Values Using

Non-Annual Compounding Periods
If you deposit $50,000 in an account that pays an annual
interest rate of 10% compounded monthly, what will your
account balance be in 10 years?
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Step 1: Picture the Problem
i = 10%

Months 0 1 2… 120
Cash flow −$50,000 Blank Blank Blank

FV of $50,000
Compounded for
120 months @
10%/12

Step 2: Decide on a Solution Strategy

This involves solving for future value of $50,000. Since the
interest is compounded monthly, we will use equation 3-1b.

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 Step 3: Solve
Using a Mathematical Formula Using a Financial Calculator
FV = PV (1+i/12)m*12 N = 120
= $50,000 (1+0.10/12)10*12 I/Y = .833%
= $50,000 (1.00833)*120 PV = −50,000
PMT = 0
= $135,352.07
FV = $135,352

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Step 3: Solve
Using an Excel Spreadsheet
= FV(rate, nper, pmt, pv)
= FV(0.00833,120, 0,−50000)
= $135,346.71

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5.3 Discounting and Present Value

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 Discounting and Present Value
Discounting : The process of finding the present value
of a cash flow or a series of cash flows; discounting is
the reverse of compounding.
Present Value (PV) - the value today of a future cash
flow - and the process of discounting, determining the
present value of an expected future cash flow.
Present Value: discounting to today’s value.
FV FV
PV  PV 
1  i n  i 
nm

1  
 m

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Step 1: Picture the Problem
i = 5%

Years 0 1 2… 25
Cash flow Blank Blank Blank $100,000

Present
Value = ?

Step 2: Decide on a Solution Strategy

Here we are solving for the present value (PV) of $100,000
to be received at the end of 25 years using a 5% interest
rate. We can solve using equation 3-2.
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Step 3: Solve
Using a Mathematical Formula Using a Financial Calculator
PV N = 25
= $100,000 [1/(1.05)25) I/Y = 5
= $100,000 [0.2953] PMT = 0
FV = 100,000
= $29,530
PV = −$29,530

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Two Additional Types of Discounting
Problems
Solving for: (1) Number of Periods; and
(2) Rate of Interest

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Solving for the Number of Periods
How long will it take to accumulate a specific amount in
the future?
• It is easier to solve for “n” using the financial calculator
or Excel rather than mathematical formula. (See
checkpoint 5.5)

Check Yourself : Solving for Number of Periods, n

How many years will it take for $10,000 to grow to
$200,000, given a 15% compound growth rate?

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Step 1: Picture the Problem
i = 15%

Years 0 1 2… N=?
Cash flow Blank −$10,000 Blank $200,000

We know FV,
PV, and i and
are solving for
N

Step 2: Decide on a Solution Strategy

In this problem, we are solving for “n”. We know the interest
rate, the present value and the future value. We can compute
“n” using a financial calculator or an Excel spreadsheet.
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 Step 3: Solve
• Using a Financial Calculator • Using an Excel Spreadsheet
I/Y = 15 N = NPER(rate,pmt,pv,fv)
PMT = 0 = NPER(.15,0, −10000,200000)
PV = −10,000 = 21.4 years
FV = 200,000
N = 21.4 years

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 Solving for the Rate of Interest
What rate of interest will allow your investment to grow
to a desired future value?
We can determine the rate of interest using
mathematical equation, the financial calculator or the
Excel spread sheet.

Check Yourself : Solving for the Interest Rate, i

At what rate will $50,000 have to grow to reach
$1,000,000 in 30 years?

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Step 1: Picture the Problem

i = ?%
Years 0 1 2… 30
Cash flow Blank −$50,000 Blank $1,000,000

We know FV, PV
and N and are
Solving for
“interest rate”

Step 2: Decide on a Solution Strategy

Here we are solving for the interest rate. We can compute
the interest rate using mathematical formula, a financial
calculator or an Excel spreadsheet.
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 Step 3: Solve
Using a Mathematical Formula Using an Excel Spreadsheet
I = (FV/PV)1/n −1 = Rate (nper, pmt, pv, fv)
= (1000000/50000)1/30 −1 = Rate(30,0, −50000,1000000)
= (20)0.0333 −1 = 10.50%
= 1.1050 −1
= .1050 or 10.50%

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5.4 Making Interest Rates Comparable

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 Effective Annual Rate
Effective Annual Rate (EAR) indicates the interest rate
paid or earned in one year without compounding. APR
is also known as the nominal or quoted (stated) interest
rate. It is the rate of interest earned when return or
interest is calculated more than once a year. The
nominal interest rate is the stated or contractual rate of
interest charged by a lender or promised by a borrower.
m
 i 
EAR  1    1
 m
EAR = Effective Annual Rate
r = the stated, nominal or quoted rate
m = the number of compounding periods per year.
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 Effective Annual Rate
Example: You have a choice of borrowing money from a
finance company at 24 percent compounded monthly or
from a bank at 26 percent compounded annually. Which
alternative is the more attractive?
Solution
12
 0.24 
EAR 1   1  26.8%
 12 
The loan at 26% compounded annually is more attractive.
Example : Your grandmother asks for your help in
choosing a certificate of deposit (CD) from a bank with a
one year maturity and a fixed interest rate. The first
certificate of deposit, CD #1, pays 4.95 percent APR
compounded daily, and the second certificate of deposit,
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 Effective Annual Rate
CD #2, pays 5.0 percent APR compounded monthly. What
is the effective annual rate (the EAR) of each CD, and
which CD do you recommend to your grandmother?
Solution
365
 0.0495 
EAR 1   1  5.07%
 365 
12
 0.05 
EAR 1   1  5.06%
 12 
The certificate with monthly compounding has the better rate.

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Chapter 5

The
The End
End

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