Financial Management - Chapter 05

Time Value of Money
Chapter 5
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview
Future Value
Present Value
Finding I and N
Annuities
Rates of Return
Amortization
Time Lines
▪ Show the timing of cash flows.

▪ Tick marks occur at the end of periods, so Time
0 is today; Time 1 is the end of the first period
(year, month, etc.) or the beginning of the
second period.
0 1 2 3
I%
CF0 CF1 CF2 CF3
Drawing Time Lines
$100 lump sum due in 2 years

0 1 2
I%
100
3-year $100 ordinary annuity
0 1 2 3
I%
100 100 100
Drawing Time Lines
Uneven cash flow stream
0 1 2 3
I%
-50 100 75 50
What is the future value (FV) of an initial $100 after
3 years, if I/YR = 4%?
Interest per Year
▪ Finding the FV of a cash flow or series of cash

flows is called compounding.
▪ FV can be solved by using the step-by-step,
financial calculator, and spreadsheet methods.
0 1 2 3
4%
100 FV = ?
Solving for FV:
The Step-by-Step and Formula Methods
After 1 year:
• FV1 = PV(1 + I) = $100(1.04) = $104.00
After 2 years:
• FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
After 3 years:
• FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
After N years (general case):
• FVN = PV(1 + I)N i=r
Future value Present value n=t
Solving for FV:
Calculator and Excel Methods
▪ Solves the general FV equation.

▪ Requires 4 inputs into calculator, and will solve
for the fifth. (Set to P/YR = 1 and END mode.)
INPUTS 3 4 -100 0
N I/YR PV PMT FV
OUTPUT 112.49
▪ Excel: =FV(rate,nper,pmt,pv,type)
Present Value
▪ What is the present value (PV) of $100 due in

3 years, if I/YR = 4%?
• Finding the PV of a cash flow or series of cash
flows is called discounting (the reverse of
compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.
0 1 2 3
4%
PV = ? 100
Solving for PV:
The Formula Method
▪ Solve the general FV equation for PV:

PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3

= $100/(1.04)3
= $88.90
Solving for PV:
Calculator and Excel Methods
▪ Solves the general FV equation for PV.

▪ Exactly like solving for FV, except we have
different input information and are solving for a
different variable.
INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90
▪ Excel: =PV(rate,nper,pmt,fv,type)
Solving for I
▪ What annual interest rate would cause $100 to

grow to $119.10 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 3 -100 0 119.10
N I/YR PV PMT FV
OUTPUT 6
• Excel: =RATE(nper,pmt,pv,fv,type,guess)
Solving for N
▪ If sales grow at 10% per year, how long before

sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 10 -1 0 2
N I/YR PV PMT FV
OUTPUT 7.3
• EXCEL: =NPER(rate,pmt,pv,fv,type)
What is the difference between an ordinary annuity
and an annuity due?
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT

Payment
Annuity Due
0 1 2 3
I%
PMT PMT PMT
Solving for FV
▪ Given a 3-Year Ordinary Annuity of $100 at 4%

• $100 payments occur at the end of each period,
but there is no PV.
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 312.16
• Excel: =FV(rate,nper,pmt,pv,type)
• Here type = 0.
Solving for PV
▪ Given a 3-year Ordinary Annuity of $100 at 4%

• 100 payments still occur at the end of each
period, but now there is no FV.
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -277.51
• Excel: =PV(rate,nper,pmt,fv,type)
• Here type = 0.
Solving for FV:
3-Year Annuity Due of $100 at 4%
▪ Now, $100 payments occur at the beginning of each

period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
▪ Alternatively, set calculator to “BEGIN” mode and solve
for the FV of the annuity due:
BEGIN
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 324.65
▪ Excel: =FV(rate,nper,pmt,pv,type)
▪ Here type = 1.
Solving for PV:
3-Year Annuity Due of $100 at 4%
▪ Again, $100 payments occur at the beginning of each

period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
▪ Alternatively, set calculator to “BEGIN” mode and solve
for the PV of the annuity due:
BEGIN
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -288.61
▪ Excel: =PV(rate,nper,pmt,fv,type)
▪ Here type =1
PV Calculation
▪ What is the present value of a 5-year

$100 ordinary annuity at 4%?
• Be sure your financial calculator is set
back to END mode and solve for PV:
▪ N = 5, I/YR = 4, PMT = -100, FV = 0.
▪ PV = $445.18.
Annuities Over Time
10-year • N = 10, I/YR = 4, PMT = -100, FV = 0;

annuity solve for PV = $811.09.
25-year • N = 25, I/YR = 4, PMT = -100, FV = 0;

annuity solve for PV = $1,562.21.
Perpetuity • PV = PMT/I = $100/0.04 = $2,500.
The Power of Compound Interest
▪ A 20-year-old student wants to save $5 a day

for her retirement. Every day she places $5 in
a drawer. At the end of the year, she invests
the accumulated savings ($1,825) in a
brokerage account with an expected annual
return of 8%.
How much money will she have when

she is 65 years old?
Solving for FV
▪ If she begins saving today, how much will she

have when she is 65?
• If she sticks to her plan, she will have $705,373
when she is 65.
INPUTS 45 8 0 -1825
N I/YR PV PMT FV
OUTPUT 705,373
• Excel: =FV(.08,45,-1825,0,0)
Solving for FV
▪ If you don’t start saving until you are 40 years

old, how much will you have at 65?
• If a 40-year-old investor begins saving today,
and sticks to the plan, he or she will have
$133,418 at age 65. This is $571,954 less than
if starting at age 20.
• Lesson: It pays to start saving early.
INPUTS 25 8 0 -1825
N I/YR PV PMT FV
OUTPUT 133,418
• Excel: =FV(.08,25,-1825,0,0)
Solving for PMT
▪ How much must the 40-year old deposit annually to

catch the 20-year old?
• To find the required annual contribution, enter the
number of years until retirement and the final goal of
$705,372.75, and solve for PMT.
INPUTS 25 8 0 705373
N I/YR PV PMT FV
OUTPUT -9,648.64
• Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)
What is the PV of this uneven cash flow stream?
0 1 2 3 4
4%
100 300 300 -50

96.15
277.37
266.70
-42.74
597.48 = PV
Solving for PV: Uneven Cash Flow Stream
▪ Input cash flows in the calculator’s “CFLO”

register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
▪ Enter I/YR = 4, press NPV button to get NPV =

$597.48. (Here NPV = PV.)
Will the FV of a lump sum be larger or smaller if
compounded more often, holding the stated I%
constant?
LARGER, as the more frequently compounding occurs,

interest is earned on interest more often.
0 1 2 3
10%
100 112.49
Annually: FV3 = $100(1.04)3 = $112.49
0 1 2 3
0 1 2 3 4 5 6
5%
100 112.62
Semiannually: FV6 = $100(1.02)6 = $112.62
Classification of Interest Rates
Nominal rate (INOM): also Periodic rate (IPER): amount

called the quoted or stated of interest charged each
rate. An annual rate that period, e.g. monthly or
ignores compounding effects. quarterly.
IPER = INOM/M, where M is the

INOM is stated in contracts.
number of compounding
Periods must also be given,
periods per year. M = 4 for
e.g. 4% quarterly or 4% daily
quarterly and M = 12 for
interest.
monthly compounding.
Classification of Interest Rates
▪ Effective (or equivalent) annual rate (EAR = EFF%):

the annual rate of interest actually being earned,
considering compounding.
• EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
• Should be indifferent between receiving 4.04% annual
interest and receiving 4% interest, compounded
semiannually.
The Importance of Effective Rates of Return
Investments with different compounding intervals

provide different effective returns.
To compare investments with different

compounding intervals, you must look at their
effective returns (EFF% or EAR).
The Importance of Effective Rates of Return
▪ See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%
When is each rate used?
▪ INOM: Written into contracts, quoted by banks

and brokers. Not used in calculations or shown
on time lines.
▪ IPER: Used in calculations and shown on time
lines. If M = 1, INOM = IPER = EAR.
▪ EAR: Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.
Effect of Compounding on FV
▪ What is the FV of $100 after 3 years under 4%

semiannual compounding? Quarterly
compounding?
MN
 I 
FVN = PV1 + NOM 
 M 
23
 0.04 
FV3S = $1001 + 
 2 
FV3S = $100(1.02) 6 = $112.62
FV3Q = $100(1.01)12 = $112.68
Effective Rate vs Nominal Rate
▪ 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.
What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 4%, compounded semiannually?
▪ Payments occur annually, but compounding

occurs every 6 months.
▪ Cannot use normal annuity valuation
techniques.
0 1 2 3 4 5 6
2%
100 100 100
Method 1: Compound Each Cash Flow
0 1 2 3 4 5 6
2%
100 100 100

104.04
108.24
312.28
FV3 = $100(1.02)4 + $100(1.02)2 + $100

FV3 = $312.28
Method 2: Financial Calculator or Excel
▪ Find the EAR and treat as an annuity.

▪ EAR = (1 + 0.04/2)2 – 1 = 4.04%.
INPUTS 3 4.04 0 -100

N I/YR PV PMT FV
OUTPUT 312.28
▪ Excel: =FV(.0404,3,-100,0,0)
Find the PV of This 3-Year Ordinary Annuity
▪ Could solve by discounting each cash flow, or…

▪ Use the EAR and treat as an annuity to solve for
PV.
INPUTS 3 4.04 100 0

N I/YR PV PMT FV
OUTPUT -277.30
▪ Excel: =PV(.0404,3,100,0,0)
Loan Amortization
▪ Amortization tables are widely used for home

mortgages, auto loans, business loans,
retirement plans, etc.
▪ Financial calculators and spreadsheets are great
for setting up amortization tables.
EXAMPLE: Construct an amortization schedule for a

$1,000, 4% annual rate loan with 3 equal payments.
Step 1: Find the Required Annual Payment
▪ All input information is already given, just

remember that the FV = 0 because the reason
for amortizing the loan and making payments is
to retire the loan.
INPUTS 3 4 -1000 0
N I/YR PV PMT FV
OUTPUT 360.35
▪ Excel: =PMT(.04,3,-1000,0,0)
Step 2: Find the Interest Paid in Year 1
▪ The borrower will owe interest upon the initial

balance at the end of the first year. Interest to
be paid in the first year can be found by
multiplying the beginning balance by the
interest rate.
INTt = Beg balt(I)

INT1 = $1,000(0.04) = $40
Step 3: Find the Principal Repaid in Year 1
▪ If a payment of $360.35 was made at the end

of the first year and $40 was paid toward
interest, the remaining value must represent
the amount of principal repaid.
PRIN = PMT – INT

= $360.35 – $40 = $320.35
Step 4: Find the Ending Balance after Year 1
▪ To find the balance at the end of the period,

subtract the amount paid toward principal from
the beginning balance.
END BAL = BEG BAL – PRIN

= $1,000 – $320.35
= $679.65
Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL

1 $1,000 $ 360 $40 $ 320 $680
2 680 360 27 333 347
3 347 360 14 347 0
TOTAL – $1,081 $81 $1,000 –
▪ Interest paid declines with each payment as the

balance declines. What are the tax implications
of this?
Illustrating an Amortized Payment:
Where does the money go?
$
360.35
Interest
320.35
Principal Payments
0 1 2 3
▪ Constant payments
▪ Declining interest payments
▪ Declining balance
End of Chapter 5
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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Time Value of Money

▪ Show the timing of cash flows.

CF0 CF1 CF2 CF3

$100 lump sum due in 2 years

3-year $100 ordinary annuity

100 100 100

Uneven cash flow stream

▪ Finding the FV of a cash flow or series of cash

▪ Solves the general FV equation.

▪ What is the present value (PV) of $100 due in

▪ Solve the general FV equation for PV:

PV = FV3 /(1 + I)3

▪ Solves the general FV equation for PV.

▪ What annual interest rate would cause $100 to

▪ If sales grow at 10% per year, how long before

PMT PMT PMT

PMT PMT PMT

▪ Given a 3-Year Ordinary Annuity of $100 at 4%

▪ Given a 3-year Ordinary Annuity of $100 at 4%

▪ Now, $100 payments occur at the beginning of each

▪ Again, $100 payments occur at the beginning of each

▪ What is the present value of a 5-year

10-year • N = 10, I/YR = 4, PMT = -100, FV = 0;

25-year • N = 25, I/YR = 4, PMT = -100, FV = 0;

Perpetuity • PV = PMT/I = $100/0.04 = $2,500.

▪ A 20-year-old student wants to save $5 a day

How much money will she have when

▪ If she begins saving today, how much will she

▪ If you don’t start saving until you are 40 years

▪ How much must the 40-year old deposit annually to

100 300 300 -50

▪ Input cash flows in the calculator’s “CFLO”

▪ Enter I/YR = 4, press NPV button to get NPV =

LARGER, as the more frequently compounding occurs,

Semiannually: FV6 = $100(1.02)6 = $112.62

Nominal rate (INOM): also Periodic rate (IPER): amount

IPER = INOM/M, where M is the

▪ Effective (or equivalent) annual rate (EAR = EFF%):

Investments with different compounding intervals

To compare investments with different

▪ See how the effective return varies between

▪ INOM: Written into contracts, quoted by banks

▪ What is the FV of $100 after 3 years under 4%

FV3Q = $100(1.01)12 = $112.68

▪ Can the effective rate ever be equal to the

▪ Payments occur annually, but compounding

100 100 100

100 100 100

FV3 = $100(1.02)4 + $100(1.02)2 + $100

▪ Find the EAR and treat as an annuity.

INPUTS 3 4.04 0 -100

▪ Could solve by discounting each cash flow, or…

INPUTS 3 4.04 100 0

▪ Amortization tables are widely used for home

EXAMPLE: Construct an amortization schedule for a

▪ All input information is already given, just

▪ The borrower will owe interest upon the initial

INTt = Beg balt(I)

▪ If a payment of $360.35 was made at the end