Chapter 5: ● Compound interest - interest earned on a given
deposit ad has become part of the principal at
❖ Time Value of Money - observation that it is better the end of a specified period
to receive money sooner than later
➢ Invest money now = earn positive rate of return ● Principal - amount of money on which interest is paid
= more money tomorrow FVn = PV0 x (1+r)n
➢ Money now is worth more than money in the
future FVn = future value r = annual rate of interest
❖ Timeline - horizontal line on which time zero PV0 = initial principal n= number of periods
approaches at the leftmost end and future periods
are marked from left to right ● Simple Interest - earned only on an investment’s
➢ Used to depict investment cash flows original principal and not on interest that
accumulated over time
➢ Compounding - future value technique to find ● Present value - value of today’s dollars of some future
future value of each cash flow at the end of cash flow
investment’s life and sum these values to find PV0 = FVn / (1+r)n
the future value
■ Adding interest to an investment’s ❖ Annuity - stream of equal periodic cash flow over a
principal and paying interest on the specified time period
new higher balance ➢ Can be inflows or outflows
➢ Discounting - technique to find the present ➢ Ordinary annuity - cash flow occurs at the
value at time zero and sums these value to find end of each period
the value today ➢ Annuity due - cash flow occurs at the
■ Used by investors to make investing beginning of each period
decisions
■ Inverse of compounding Future Value of an Ordinary Annuity:
❖ Computational Tools
➢ Financial Calculators - numerous
preprogrammed financial routines
➢ Electronic Spreadsheet - built-in routines that
Present Value of an Ordinary Annuity:
simplify time-value calculations
❖ Basic Pattern of Cash Flow
➢ Single amount - lump sum amount either
currently held or expected at some future date
➢ Annuity - level of periodic stream of cash flow
Future Value of an Annuity Due:
➢ Mixed-stream - not an annuity; stream of
unequal periodic cash flows that reflect no
particular pattern
SINGLE AMOUNTS: Present Value of an Annuity Due:
● Future value - value at some future date of
money you invest today
○ Terminal value, sum, the amount,
amount, accumulated amount
Always:
FV of Annuity Due > FV of Ordinary Annuity
PV of Annuity Due > Pv of Ordinary Annuity ● Effective (true) annual rate (EAR) - annual rate of
interest actually paid or earned
❖ Perpetuity - annuity with an infinite life, providing
continual annual cash flow
➢ PV0 = CF1 / r ● Annual percentage rate (APR) - nominal annual rate
➢ PV of a growing perpetuity: of interest, found by multiplying the periodic rate by
■ PV0 = CF1 / (r -g) the number of periods in one year, that must be
■ Applies only when discount rate is disclosed to consumers on credit cards and loans as
greater than the growth rate a result of “truth-in-lending laws”
■ If r ≤ g, cash flows grow so fast that PV ● Annual percentage yield (APY) - effective annual
= INFINITE rate of interest that must be disclosed to consumers
● r = interest rate; g = by banks on their savings products as a result of
growth rate “truth-in-savings laws”
❖ Mixed Stream - stream of unequal periodic cash SPECIAL APPLICATIONS OF TIME VALUE
flows that reflect no particular pattern
❖ FV of mixed stream - compute FV of each cash flow ● Determining deposits needed to accumulate a
at the specified FV and add all the individual FVs to future sum:
find the total FV
❖ PV of mixed stream - compute PV of each cash flow
and add all the individual PVs to find the total FV
COMPOUNDING INTEREST MORE FREQUENTLY THAN ● Loan amortization - determination of equal periodic
ANNUALLY loan payments necessary to provide a lender with a
specified interest return and to repay the loan
● Semiannual Compounding - compounding of interest principal over a specified period
over two periods within the year ● Loan amortization schedule - schedule of equal
● Quarterly Compounding - compounding of interest payments to repay a loan
over four periods within the year ○ Shows the allocation of each loan payment
to interest and principal
General Equation for Compounding:
To solve for payment:
● Continuous compounding - compounding of interest,
literally, all the time To solve for interest or growth rate:
○ Infinite number of times in a year
○ e=exponential function
To solve for the unknown number of periods:
● Nominal (stated) annual rate - contractual annual rate
of interest charged by a lender or promised by a
borrower
