TIME VALUE OF MONEY
Interest - Money paid (earned) for the use of money.
Rate of interest - allow us to adjust the value of cash flows, whenever they occur, to a particular
point in time.
Simple interest - Interest paid (earned) on only the original amount, or principal, borrowed
(lent).
SI = P0(i)(n)
where
SI = simple interest in dollars
P0 = principal, or original amount borrowed (lent) at time period 0
i = interest rate per time period
n = number of time periods
Future value (terminal value) - The value at some future time of a present amount of money, or
a series of payments, evaluated at a given interest rate.
For any simple interest rate, the future value of an account at the end of n periods is:
FVn = P0 + SI = P0 + P0(i)(n)
or, equivalently,
FVn = P0[1 + (i)(n)]
Present value - The current value of a future amount of money, or a series of payments,
evaluated at a given interest rate.
PV0 = P0 = FVn /[1 + (i)(n)]
Compound interest - Interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent).
Single Amounts
Future (or Compound) Value - FVn = P0(1 + i)^n Or FVn = P0(FVIFi,n)
where we let FVIFi,n (i.e., the future value interest factor at i% for n periods) equal (1 + i)^n.
Compound Growth - For example, in gas prices, tuition fees, corporate earnings, or dividends.
Suppose that a corporation’s most recent dividend was $10 per share but that we expect this
dividend to grow at a 10 percent compound annual rate.
Present (or Discounted) Value - PV0 = FVn(PVIFi,n)
Discount rate (capitalization rate) - Interest rate used to convert future values to present values.
Unknown Interest (or Discount) Rate - Sometimes we are faced with a time-value-of-money
situation in which we know both the future and present values, as well as the number of time
periods involved. What is unknown, however, is the compound interest rate (i) implicit in the
situation.
FVn = P0(FVIFi,n)
Annuity - A series of equal payments or receipts occurring over a specified number of periods.
In an ordinary annuity, payments or receipts occur at the end of each period; in an annuity due,
payments or receipts occur at the beginning of each period.
Ordinary Annuity - payments or receipts occur at the end of each period.
FVAn = R(FVIFAi,n)
where FVIFAi,n stands for the future value interest factor of an annuity at i% for n periods.
Unknown Interest (or Discount) Rate - A rearrangement of the basic future value (present
value) of an annuity equation can be used to solve for the compound interest (discount) rate
implicit in an annuity if we know:
(1) the annuity’s future (present) value,
(2) the periodic payment or receipt, and
(3) the number of periods involved.
Perpetuity - An ordinary annuity whose payments or receipts continue forever.
PVA∞ = R[(1 − 0)/i] = R(1/i) or simply PVA∞ = R/i
Thus the present value of a perpetuity is simply the periodic receipt (payment) divided by the
interest rate per period.
Annuity due calls for a series of equal payments occurring at the beginning of each period.
Future value of an annuity due -- FVADn = R(FVIFAi,n)(1 + i)
Present value of an annuity due –
PVADn = R(PVIFAi,n−1) + R
= R(PVIFAi,n−1 + 1)
Compounding More Than Once a Year
Semiannual and Other Compounding Periods
Future (or Compound) Value - assume that interest is paid annually.
The general formula for solving for the future value at the end of n years where interest is
paid m times a year is FVn = PV0(1 + [i/m])^mn
Present (or Discounted) Value. When interest is compounded more than once a year, the
formula for calculating present value must be revised along the same lines as for the calculation
of future value. Instead of dividing the future cash flow by (1 + i)^n as we do when annual
compounding is involved, we determine the present value by
PV0 = FVn /(1 + [i /m])^mn
Continuous Compounding - interest is sometimes compounded continuously.
FVn = PV0(1 + [i /m])^mn
Effective annual interest rate - The actual rate of interest earned (paid) after adjusting the
nominal rate for factors such as the number of compounding periods per year.
Amortization schedule - A table showing the repayment schedule of interest and principal
necessary to pay off a loan by maturity.
• Most financial decisions, personal as well as business, involve the time value of money.
We use the rate of interest to express the time value of money.
• Simple interest is interest paid (earned) on only the original amount, or principal, borrowed
(lent).
• Compound interest is interest paid (earned) on any previous interest earned, as well as on
the principal borrowed (lent). The concept of compound interest can be used to solve a
wide variety of problems in finance.
• Two key concepts – future value and present value – underlie all compound interest
problems. Future value is the value at some future time of a present amount of money, or
a series of payments, evaluated at a given interest rate. Present value is the current value of
a future amount of money, or a series of payments, evaluated at a given interest rate.
• An annuity is a series of equal payments or receipts occurring over a specified number of
periods.
• There are some characteristics that should help you to identify and solve the various types
of annuity problems:
1. Present value of an ordinary annuity – cash flows occur at the end of each period,
and present value is calculated as of one period before the first cash flow.
2. Present value of an annuity due – cash flows occur at the beginning of each period,
and present value is calculated as of the first cash flow.
3. Future value of an ordinary annuity – cash flows occur at the end of each period,
and future value is calculated as of the last cash flow.
4. Future value of an annuity due – cash flows occur at the beginning of each period,
and future value is calculated as of one period after the last cash flow.
• Various formulas were presented for solving for future values and present values of single
amounts and of annuities. Mixed (uneven) cash-flow problems can always be solved by
adjusting each flow individually and then summing the results. The ability to recognize
certain patterns within mixed cash flows will allow you to take calculation shortcuts.
