Chapter 4

The Time Value of Money

© 2007 Thomson/South-Western 1
Essentials of
Chapter 4
Why is it important to understand and apply time
value to money concepts?
What is the difference between a present value
amount and a future value amount?
What is an annuity?
What is the difference between the Annual
Percentage Rate and the Effective Annual Rate?
What is an amortized loan?
How is the return on an investment determined?

2
Time Value of Money

The most important concept in finance

Used in nearly every financial decision
Business decisions
Personal finance decisions

3
Cash Flow Time Lines
Graphical representations used to
show timing of cash flows
Time: 0 1 2 3
6%

FV = ?
Cash Flows: PV=100

Time 0 is today
Time 1 is the end of Period 1 or the beginning
of Period 2.

4
Future Value

The amount to which a cash flow or

series of cash flows will grow over a
period of time when compounded at a
given interest rate.

5
Terms Used in Calculating Future Value
PV = Present value, or the beginning amount
that is invested
r = Interest rate the bank pays on the account
each year
INT = Dollars of interest you earn during the
year
FVn = Future value of the account at the end
of n periods
n = number of period interest is earned

6
Future Value

In general, FVn = PV (1 + r)n

7
Four Ways to Solve Time Value of
Money Problems
Use Cash Flow Time Line
Use Equations
Use Financial Calculator
Use Electronic Spreadsheet

8
 Time Line Solution
The Future Value of $100 invested at 10% per
year for 3 years

Time(t): 0 1 2 3
10%

x (1.10) x (1.10) x (1.10)

Account balance: 100.00 110.00 121.00 133.10

9
Numerical (Equation) Solution
n
FVn  PV(1  r)

FV3 =$100(1.10)3
=$100(1.331)

=133.10

10
Financial Calculator Solution

INPUTS 3 10 -100 0 ?
N I/YR PV PMT FV
OUTPUT 133.10

11
Spreadsheet Solution

Set up Problem Click on Function Wizard and

choose Financial/FV

12
Spreadsheet Solution
Reference cells:
Rate = interest
rate, r
Nper = number of
periods interest is
earned
Pmt = periodic
payment
PV = present value
of the amount

13
Present Value

Present value is the value today of a future

cash flow or series of cash flows.

Discounting is the process of finding the

present value of a future cash flow or series
of future cash flows; it is the reverse of
compounding.

14
What is the PV of $100 due in 3 years
if r = 10%?

Time(t): 0 1 2 3
10%

x (1.10) x (1.10) x (1.10)

Account balance: 75.13 82.64 90.90 100.00

15
What is the PV of $100 due in 3 years
if r = 10%?
 1 
PV = FVn  n 
(1+ r) 
 1 
PV = $100  3 
(1.10) 

= $1000.7513= $75.13



16
Financial Calculator Solution

INPUTS 3 10 ? 0 100
N I/YR PV PMT FV
OUTPUT -75.13

17
Spreadsheet Solution

18
What interest rate would cause $100
to grow to $125.97 in 3 years?

0 1 2 3
r=?

100 (1 + r )3 = 125.97

PV = 100 ] 100 = 125.97/ (1 + r )3 [

100.00 = FV

19
What interest rate would cause $100
to grow to $125.97 in 3 years?

$100 (1 + r )3 = $125.97

INPUTS 3 ? -100 0 125.97

N I/YR PV PMT FV
OUTPUT
8%

20
Spreadsheet Solution

21
How many years will it take for
$68.30 to grow to $100
at an interest rate of 10%?
0 1 2 n-1 n=?
10%
...

68.30 (1.10 )n = 100.00

PV = 68.30 ] 68.30 = $100.00 (1.10 )n [

100.00 = FV

22
How many years will it take for
$68.30 to grow to $100 if interest of
10% is paid each year?

FVn = PV(1+r)n

$100.00 = $68.30 (1.10)n

FV4 = 68.30(1.10)4 = $100.00

23
How many years will it take for
$68.30 to grow to $100 if interest of
10% is paid each year?

INPUTS ? 10 -68.30 0 100.00

N I/YR PV PMT FV
OUTPUT
4.0

24
Spreadsheet Solution

25
Future Value of an Annuity
Annuity: A series of payments of equal
amounts at fixed intervals for a specified
number of periods.
Ordinary (deferred) Annuity: An annuity whose
payments occur at the end of each period.
Annuity Due: An annuity whose payments
occur at the beginning of each period.

26
 Ordinary Annuity Versus Annuity Due

Ordinary Annuity
0 1 2 3
r%

PMT PMT PMT

Annuity Due
0 1 2 3
r%

PMT PMT PMT

27
What’s the FV of a 3-year Ordinary
Annuity of $100 at 5%?
0 1 2 3
5%

100 100 100

105

110.25
FV = 315.25

28
 Numerical Solution:

n1  
(1  r) n
1
FVA n  PMT (1  r)  PMT
n

t 0   r 

(1.05)3 1
FVA3  $100 
  0.05 
 $100(3.15250)  $315.25


29
Financial Calculator Solution

INPUTS 3 5 0 -100 ?
N I/YR PV PMT FV
OUTPUT
315.25

30
Spreadsheet Solution

31
Find the FV of an Annuity Due

0 1 2 3
5%

100 100 100

x[(1.05)0](1.05)
105.00
x[(1.05)1](1.05)
110.25
x[(1.05) ](1.05)
2
115.76

FVA(DUE)3 = 331.01

32
 Numerical Solution
 n  
(1+ r) n
1  
FVA(DUE) n  PMT (1 r) t  PMT x(1 r)
t1   r  
(1.05)3 1 
FVA(DUE)3  $100 x(1.05)
 0.05  

= $100[3.15250x1.05]
= $100[3.310125] = 331.01


33
Financial Calculator Solution
Switch from “End” to “Begin”.

INPUTS 3 5 0 -100 ?
N I/YR PV PMT FV
OUTPUT 331.01

34
Spreadsheet Solution

35
Present Value of an Annuity
PVAn = the present value of an annuity
with n payments.

Each payment is discounted, and the

sum of the discounted payments is the
present value of the annuity.

36
What is the PV of this Ordinary
Annuity?
0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV

37
 Numerical Solution
 n 1  
1 - 1 

PVA n  PMT t 
 PMT (1 r) n

t1 (1  r)   r 
 

1 - 1 3 
(1.10)
PVA 3  $100  
  0.10 
 
 $100(2.48685)  $248.69

38
Financial Calculator Solution

INPUTS 3 10 ? -100 0
N I/YR PV PMT FV
OUTPUT -248.69

39
Spreadsheet Solution

40
 Find the PV of an Annuity Due

0 1 2 3
5%

100 100 100

(1.05)x[1/(1.05) ]x
1

100.00
(1.05)x[1/(1.05)2]x
95.24
(1.05)x[1/(1.05)3]x
90.70
PVA(DUE)3= 285.94

41
Financial Calculator Solution

INPUTS 3 5 ? -100 0
N I/YR PV PMT FV
OUTPUT 285.94

42
Solving for Interest Rates
with Annuities
You pay $864.80 for an investment that promises
to pay you $250 per year for the next four years,
with payments made at the end of each year.
What interest rate will you earn on this
investment?
0 1 2 3 4
r=?

- 864.80 250 250 250 250

43
Numerical Solution

Use trial-and-error by substituting different values

of r into the following equation until the right side
equals $864.80.

1 - 1 4 
(1r)
$864.80  $250 
 r 
 


44
Financial Calculator Solution

INPUTS 4 ? -846.80 250 0

N I/YR PV PMT FV
OUTPUT 7.0

45
Spreadsheet Solution

46
Perpetuities

Annuities that go on indefinitely

Payment PMT
PVP  
Interest rate r



47
Uneven Cash Flow Streams

A series of cash flows in which the amount

varies from one period to the next:
Payment (PMT) designates constant cash flows—
that is, an annuity stream.
Cash flow (CF) designates cash flows in general,
both constant cash flows and uneven cash flows.

48
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

49
Numerical Solution
 1   1   1 
PV  CF1   CF2 
1  2 
 ... CFn  n 
(1  r)  (1  r)  (1  r) 
 1   1   1   1 
PV  100  1
 300  2
 300  3
 (50)  4
 (1.10)   (1.10)   (1.10)   (1.10) 
 $100(0.90909) $300(0.82645) $300(0.75131) ($50)(0.68301)
 $530.09

50
Financial Calculator Solution

Input in “CF” 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)

51
Spreadsheet Solution

52
Semiannual and Other Compounding
Periods
Annual compounding is the process of
determining the future value of a cash flow or
series of cash flows when interest is added
once a year.
Semiannual compounding is the process
of determining the future value of a cash flow
or series of cash flows when interest is added
twice a year.

53
Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated r constant? Why?
LARGER!

If compounding is more frequent than once a

year—for example, semi-annually, quarterly,
or daily—interest is earned on interest—that
is, compounded—more often.

54
Compounding
Annually vs. Semi-Annually
0 1 2 3
10%

100
133.10
Annually: FV3 = 100(1.10)3 = 133.10
0 1 2 3 4 5 6
5%

100 134.01
Semi-annually: FV6/2 = 100(1.05)6 = 134.01

55
Distinguishing Between
Different Interest Rates
rSIMPLE = Simple (Quoted) Rate
used to compute the interest paid per period

rEAR = Effective Annual Rate

the annual rate of interest actually being
earned

APR = Annual Percentage Rate = rSIMPLE

periodic rate X the number of periods per year

56
Comparison of Different Types of
Interest Rates
rSIMPLE: Written into contracts, quoted by
banks and brokers. Not used in calculations
or shown on time lines.
rPER: Used in calculations, shown on time
lines.
rEAR: Used to compare returns on investments
with different payments per year.

57
Simple (Quoted) Rate

rSIMPLE is stated in contracts

Periods per year (m) must also be given

Examples:
8%, compounded quarterly
8%, compounded daily (365 days)

58
Periodic Rate

Periodic rate = rPER = rSIMPLE/m, where m is

number of compounding periods per year. m
= 4 for quarterly, 12 for monthly, and 360 or
365 for daily compounding.

Examples:
8% quarterly: rPER = 8/4 = 2%
8% daily (365): rPER = 8/365 = 0.021918%

59
Effective Annual Rate

The annual rate that causes PV to grow to the same

FV as under multi-period compounding.
Example: 10%, compounded semiannually:
rEAR = (1 + rSIMPLE/m)m - 1.0
= (1.05)2 - 1.0 = 0.1025 = 10.25%

60
How do we find rEAR for a simple rate
of 10%, compounded semi-annually?
m
 rSIMPLE 
rEAR = 1 +  -1
 m 
2
 0.10 
= 1 +  - 1.0
 2 
= 1.05  - 1.0 = 0.1025 = 10.25%
2

61
FV of $100 after 3 years if interest is
10% compounded semi-annual?
Quarterly?
mn
 rSIMPLE 
FVn = PV1 + 
 m 
23
 0.10 
FV32 = $100 1 +   $100(1.340 10)  $134.01
 2 
43
 0.10 
FV34 = $100 1 +   $100(1.344 89)  $134.49
 4 

62
Fractional Time Periods
Example: $100 deposited in a bank at
EAR = 10% for 0.75 of the year
0 0.25 0.50 0.75 1.00
10%

- 100 FV = ?

INPUTS 0.75 10 -100 0 ?

N I/YR PV PMT FV
OUTPUT
107.41

63
Spreadsheet Solution

64
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, and so forth to determine
how much of each payment represents
principal repayment and how much
represents interest

65
Construct an amortization schedule for a
$1,000, 10 percent loan that requires
three equal annual payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

66
Step 1: Determine the required
payments
0 1 2 3
10%

-1000 PMT PMT PMT

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

67
Step 2: Find interest charge for Year 1

INTt = Beginning balancet (r)

INT1 = 1,000(0.10) = $100.00

68
Step 3: Find repayment of principal
in Year 1

Repayment = PMT - INT

= $402.11 - $100.00
= $302.11.

69
Step 4: Find ending balance after
Year 1
Ending bal. = Beginning bal. - Repayment
= $1,000 - $302.11 = $697.89.

Repeat these steps for the remainder of

the payments (Years 2 and 3 in this case)
to complete the amortization table.

70
Spreadsheet Solution

71
Loan Amortization Table
10 Percent Interest Rate
YR Beg Bal PMT INT Prin PMT End Bal
1 $1000.00 $402.11 $100.00 $302.11 $697.89

2 697.89 402.11 69.79 332.32 365.57

3 365.57 402.11 36.56 365.55 0.02

Total 1,206.33 206.35 999.98 *

* Rounding difference

72
Chapter 4 Essentials
Why is it important to understand and apply time
value to money concepts?
 To be able to compare various investments

What is the difference between a present value

amount and a future value amount?
 Future value adds interest - present value subtracts interest

What is an annuity?
 A series of equal payments that occur at equal time intervals

73
Chapter 4 Essentials
What is the difference between the Annual
Percentage Rate and the Effective Annual Rate?
 APR is a simple interest rate quoted on loans. EAR is the
actual interest rate or rate of return.
What is an amortized loan?
 A loan paid off in equal payments over a specified period
How is the return on an investment determined?
 The amount to which the investment will grow in the future
minus the cost of the investment

74