2-1

Chapter 2
Time Value of Money

 Future value
 Present value
 Rates of return
 Amortization
 2-2

Time Value of Money

 The principles of time value analysis

have many applications, ranging
from setting up schedules for paying
off loans to decisions about whether
to acquire new equipment.
 The time value of money or
discounted cash flow (DCF) is the
most important concept in finance.
 2-3

Time lines show timing of cash flows.

0 1 2 3
i%

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1; or
the beginning of Period 2.
 2-4

Time line for a $100 lump sum due at

the end of Year 2.

0 1 2 Year
i%

100
 2-5

Time line for an ordinary annuity of

$100 for 3 years.

0 1 2 3
i%

100 100 100

 2-6

Time line for uneven CFs: -$50 at t = 0

and $100, $75, and $50 at the end of
Years 1 through 3.

0 1 2 3
i%

-50 100 75 50
 2-7

What’s the FV of an initial $100 after 3

years if i = 10%?

0 1 2 3
10%

100 FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.
 2-8

After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = FV1(1+i) = PV(1 + i)(1+i)
= PV(1+i)2
= $100(1.10)2
= $121.00.
 2-9

After 3 years:
FV3 = FV2(1+i)=PV(1 + i)2(1+i)
= PV(1+i)3
= $100(1.10)3
= $133.10.
In general,

FVn = PV(1 + i)n.

 2-10

What’s the PV of $100 due in 3 years if

i = 10%?

Finding PVs is discounting, and it’s

the reverse of compounding.

0 1 2 3
10%

PV = ? 100
 2-11

Solve FVn = PV(1 + i )n for PV:

n
FVn  1 
PV = n = FVn  
 1+ i
1+ i

3
 1 
PV = $100  
 1.10 
= $100 0.7513  = $75.13.
 2-12

Finding the Time to Double

0 1 2 ?
20%

-1 2
FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
 2-13

Finding the Interest Rate

0 1 2 3
?%

-1 2
FV = PV(1 + i)n
$2 = $1(1 + i)3
(2)(1/3) = (1 + i)
1.2599 = (1 + i)
i = 0.2599 = 25.99%.
 2-14

What’s 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

PV FV
 2-15

What’s the FV of a 3-year ordinary

annuity of $100 at 10%?

0 1 2 3
10%

100 100 100

110
121
FV = 331
 2-16

FV Annuity Formula
 The future value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
n
(1 i)  1
PMT
i
3
(1 0.10)  1
100 331.
0.10
 2-17

What’s the PV of this ordinary annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV
 2-18

PV Annuity Formula
 The present value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
1
1- n
(1 i)
PMT
i
1
1- 3
(1 0.10)
100 248.69
0.10
 2-19

Find the FV and PV if the

annuity were an annuity due.

0 1 2 3
10%

100 100 100

 2-20

PV and FV of Annuity Due

vs. Ordinary Annuity

 PV of annuity due:
 = (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56
 FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1
 2-21

Excel Function for Annuities Due

Change the formula to:

=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function
there are no other cash flows. The
fifth term tells the function that it is an
annuity due. A similar function gives
the future value of an annuity due:
=FV(10%,3,-100,0,1)
 2-22

What is the PV of this uneven cash

flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
 2-23

 Input in “CFLO” register:

CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
 Enter I = 10%, then press NPV button to
get NPV = 530.09. (Here NPV = PV.)
 2-24

Spreadsheet Solution

A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
Excel Formula in cell A3:
=NPV(10%,B2:E2)
 2-25

Nominal rate (iNom)

 Stated in contracts, and quoted by banks
and brokers.
 Not used in calculations or shown on time
lines
 Periods per year (m) must be given.
 Examples:
8%; Quarterly
8%, Daily interest (365 days)
 2-26

Periodic rate (iPer )

 iPer = iNom/m, where m is number of
compounding periods per year. m = 4 for
quarterly, 12 for monthly, and 360 or 365
for daily compounding.
 Used in calculations, shown on time lines.
 Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =
0.021918%.
 2-27

Will the FV of a lump sum be larger or

smaller if we compound more often,
holding the stated I% constant? Why?

LARGER! If compounding is more

frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.
 2-28
FV Formula with Different Compounding
Periods (e.g., $100 at a 12% nominal rate with
semiannual compounding for 5 years)
mn
 iNom 
FVn = PV  1 +  .
 m 
2x5
 0.12 
FV5S = $100  1 + 
 2 
= $100(1.06)10 = $179.08.
 2-29
FV of $100 at a 12% nominal rate for 5
years with different compounding
FV(Annual)= $100(1.12)5 = $176.23.
FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.
 2-30
Effective Annual Rate (EAR = EFF%)
 The EAR is the annual rate which causes PV
to grow to the same FV as under multi-period
compounding Example: Invest $1 for one
year at 12%, semiannual:
FV = PV(1 + iNom/m)m
FV = $1 (1.06)2 = 1.1236.
 EFF% = 12.36%, because $1 invested for one
year at 12% semiannual compounding would
grow to the same value as $1 invested for one
year at 12.36% annual compounding.
 2-31

 An investment with monthly

payments is different from one
with quarterly payments. Must
put on EFF% basis to compare
rates of return. Use EFF% only
for comparisons.
 Banks say “interest paid daily.”
Same as compounded daily.
 2-32

How do we find EFF% for a nominal

rate of 12%, compounded
semiannually?
( )
m
iNom
EFF% = 1 + -1
m

= (1 + 0.12) - 1.0
2

2
= (1.06)2 - 1.0
= 0.1236 = 12.36%.
 2-33
EAR (or EFF%) for a Nominal Rate of
of 12%

EARAnnual = 12%.

EARQ = (1 + 0.12/4)4 - 1 = 12.55%.

EARM = (1 + 0.12/12)12 - 1 = 12.68%.

EARD(365) = (1 + 0.12/365)365 - 1 = 12.75%.

 2-34

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.
 2-35

When is each rate used?

iNom: Written into contracts, quoted

by banks and brokers. Not
used in calculations or shown
on time lines.
 2-36

iPer: Used in calculations, shown on

time lines.

If iNom has annual compounding,

then iPer = iNom/1 = iNom.
 2-37

EAR = EFF%: Used to compare

returns on investments
with different payments
per year.

(Used for calculations if and only if

dealing with annuities where
payments don’t match interest
compounding periods.)
 2-38

Amortization

Construct an amortization schedule

for a $1,000, 10% annual rate loan
with 3 equal payments.
 2-39

Step 1: Find the required payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
 2-40

Step 2: Find interest charge for Year 1.

INTt = Beg balt (i)

INT1 = $1,000(0.10) = $100.

Step 3: Find repayment of principal in

Year 1.
Repmt = PMT - INT
= $402.11 - $100
= $302.11.
 2-41

Step 4: Find ending balance after

Year 1.

End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.
 2-42

BEG PRIN END

YR BAL PMT INT PMT BAL

1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest declines. Tax implications.

 2-43
$
402.11
Interest

302.11

Principal Payments

0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
 2-44

 Amortization tables are widely

used--for home mortgages, auto
loans, business loans, retirement
plans, and so on. They are very
important!
 Financial calculators (and
spreadsheets) are great for
setting up amortization tables.
 2-45

On January 1 you deposit $100 in an

account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
How much will you have on October
1, or after 9 months (273 days)?
(Days given.)
 2-46
iPer = 11.33463%/365
= 0.031054% per day.
0 1 2 273
0.031054%

-100 FV=?

273
FV273 = $1001.00031054
= $1001.08846 = $108.85.

Note: % in calculator, decimal in equation.

 2-47

iPer = iNom/m
= 11.33463/365
= 0.031054% per day.

INPUTS 273 -100 0

N I/YR PV PMT FV
OUTPUT 108.85

Enter i in one step.

Leave data in calculator.
 2-48

What’s the value at the end of Year 3 of

the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?

0 1 2 3 4 5 6 6-mos.
5% periods

100 100 100

 2-49

 Payments occur annually, but

compounding occurs each 6
months.
 So we can’t use normal annuity
valuation techniques.
 2-50

1st Method: Compound Each CF

0 1 2 3 4 5 6
5%

100 100 100.00

110.25
121.55
331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100

= $331.80.
 2-51

2nd Method: Treat as an Annuity

Could you find the FV with a

financial calculator?
Yes, by following these steps:

a. Find the EAR for the quoted rate:

EAR = ( 0.10
1+ 2 ) - 1 = 10.25%.
2
 2-52

b. Use EAR = 10.25% as the annual rate

in your calculator:

INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80
 2-53

What’s the PV of this stream?

0 1 2 3
5%

100 100 100

90.70
82.27
74.62
247.59
 2-54

You are offered a note which pays

$1,000 in 15 months (or 456 days)
for $850. You have $850 in a bank
which pays a 6.76649% nominal rate,
with 365 daily compounding, which
is a daily rate of 0.018538% and an
EAR of 7.0%. You plan to leave the
money in the bank if you don’t buy
the note. The note is riskless.
Should you buy it?
 2-55
iPer = 0.018538% per day.

0 365 456 days

-850 1,000

3 Ways to Solve:

1. Greatest future wealth: FV

2. Greatest wealth today: PV
3. Highest rate of return: Highest EFF%
 2-56

1. Greatest Future Wealth

Find FV of $850 left in bank for
15 months and compare with
note’s FV = $1,000.

FVBank = $850(1.00018538)456
= $924.97 in bank.

Buy the note: $1,000 > $924.97.

 2-57

Calculator Solution to FV:

iPer = iNom/m
= 6.76649%/365
= 0.018538% per day.

INPUTS 456 -850 0

N I/YR PV PMT FV
OUTPUT 924.97

Enter iPer in one step.

 2-58

2. Greatest Present Wealth

Find PV of note, and compare

with its $850 cost:

PV = $1,000/(1.00018538)456
= $918.95.
 2-59

6.76649/365 =
INPUTS 456 .018538 0 1000
N I/YR PV PMT FV

OUTPUT -918.95

PV of note is greater than its $850

cost, so buy the note. Raises your
wealth.
 2-60

3. Rate of Return

Find the EFF% on note and

compare with 7.0% bank pays,
which is your opportunity cost of
capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456

Now we must solve for i.

 2-61

INPUTS 456 -850 0 1000

N I/YR PV PMT FV
OUTPUT 0.035646%
per day

Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.

EAR = EFF% = (1.00035646)365 - 1

= 13.89%.
 2-62

Using interest conversion:

P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89

Since 13.89% > 7.0% opportunity cost,

buy the note.