Foundations of Finance: Tenth Edition, Global Edition

Foundations of Finance
Tenth Edition, Global Edition
Chapter 5
The Time Value of Money
Copyright © 2020 Pearson Education Ltd. All Rights Reserved

Learning Objectives
5.1 Explain the mechanics of compounding, and bringing the
value of money back to the present.
5.2 Understand annuities.
5.3 Determine the future or present value of a sum when
there are nonannual compounding periods.
5.4 Determine the present value of an uneven stream of
payments and understand perpetuities.

Compound Interest, Future, and
Present Value

Using Timelines to Visualize Cash
Flows
Timeline of cash flows

Compound Interest (1 of 2)
• Compounding is when interest paid on an investment
during the first period is added to the principal; then, during
the second period, interest is earned on the new sum (that
includes the principal and interest earned so far).

Compound Interest (2 of 2)
• Example: Compute compound interest on $100 invested
at 6% for three years with annual compounding.
– First year interest is $6.00; principal now is $106.00.
– Second year interest is $6.36; principal now is $112.36.
– Third year interest is $6.74; principal now is $119.10.
– Total interest earned: $19.10

Future Value
• Future value is the amount a sum will grow to in a certain
number of years when compounded at a specific rate.
FVN = PV (1+ r )
n
• FVN = the future of the investment at the end of “n” years

• r = the annual interest (or discount) rate
• n = number of years
• PV = the present value, or original amount invested at the
beginning of the first year

Future Value Example
• Example: What will be the FV of $100 in 2 years at
interest rate of 6%?
FV2 = PV (1 + r ) = $100 (1 + 0.06 )

2 2
= $100 (1.06 )
2
= $112.36

How to Increase the Future Value?
• Future value can be increased by
– Increasing number of years of compounding (N)
– Increasing the interest or discount rate (r)
– Increasing the original investment (PV)
• See example on next slide.

Changing R, N, and PV
a. You deposit $500 in bank for 2 years. What is the FV at
2%? What is the FV if you change interest rate to 6%?
FV at 2% = 500  (1.02 ) = $520.20
2
FV at 6% = 500  (1.06 ) = $561.80

2
b. Continue the same example but change time to 10 years.

What is the FV now?
FV = 500  (1.06 ) = $895.42
10
c. Continue the same example but change contribution to

$1,500. What is the FV now?
FV = 1,500  (1.06 ) = $2, 686.27
10

Figure 5.1 $100 Compounded at 6
Percent over 20 Years

Figure 5.2 The Future of $100 Initially
Deposited and Compounded at 0, 5,
10, and 15 Percent (1 of 2)

Figure 5.2 The Future of $100 Initially
Deposited and Compounded at 0, 5,
• Figure 5.2 illustrates that we can increase the FV by
– Increasing the number of years for which money is
invested
– Investing at a higher interest rate

Computing Future Values Using
Calculator or Excel
• Review discussion in the textbook.
• Excel Function for FV: = FV(rate, nper, pmt, pv)

Present Value (1 of 2)
• Present value reflects the current value of a future
payment or receipt.

Present Value (2 of 2)
 1 
PV = FVn  n 
 (1 + r ) 
FVn = the future value of the investment at the end of n

years
n = number of years until payment is received
r = the interest rate
PV = the present value of the future sum of money

Present Value Example
• What will be the present value of $500 to be received 10
years from today if the discount rate is 6%?
 1 
PV = $500  10 
 (1 + 0.06 ) 
 1 
= $500  
 1.791 
= $500 ( 0.558 )
= $279.00

Figure 5.3 The Present Value of $100 to
Be Received at a Future Date and
Discounted Back to the Present at 0, 5,
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Figure 5.3 The Present Value of $100 to
Be Received at a Future Date and
Discounted Back to the Present at 0, 5,
• Figure 5.3 illustrates that PV is lower if
– Time period is longer, or
– Interest rate is higher.

Using Excel
• Excel Function for PV: = PV(rate,nper,pmt,fv)

Annuities

Annuities
• An annuity is a series of equal dollar payments for a
specified number of years.
• Ordinary annuity payments occur at the end of each
period.

FV of Annuity
Compound Annuity
• Depositing or investing an equal sum of money at the end
of each year for a certain number of years and allowing it
to grow

FV Annuity Example
What will be the FV of a 5-year, $500 annuity compounded
at 6%?
FV5 = $500 (1 + 0.06 ) + $500 (1 + 0.06 ) + $500 (1 + 0.06 )

4 3 2
+ $500 (1.262 ) + $500 (1.191) + $500 (1.124 ) + $500 (1.090 )

+ $500 = $631.00 + $595.5 + $562.00 + $530.00 + $500
= $2, 818.50

Table 5.1 Growth of a 5-Year, $500
Annuity Compounded at 6 Percent

FV of an Annuity – Using the
Mathematical Formulas (1 of 2)
FVn = the future of an annuity at the end of the nth year

PMT = the annuity payment deposited or received at the end
of each year
r = the annual interest (or discount) rate
n = the number of years

FV of an Annuity – Using the
Mathematical Formulas (2 of 2)
• What will $500 deposited in the bank every year for 5
years at 6% be worth?
 (1 + r )n − 1 
• FV = PMT   
 r 
 
= $500 ( 5.637 )
= $2, 818.50

FV of Annuity: Changing PMT, N, and
r (1 of 2)
1. What will $5,000 deposited annually for 50 years be worth
at 7%?
− FV = $2,032,644
− Contribution = $250,000 (= 5000×50)
2. Change PMT = $6,000 for 50 years at 7%
− FV = $2,439,173
− Contribution = $300,000 (= 6000×50)

FV of Annuity: Changing PMT, N, and
r (2 of 2)
3. Change time = 60 years, $6,000 at 7%
− FV = $4,881,122
− Contribution = $360,000 (= 6000×60)
4. Change r = 9%, 60 years, $6,000
– FV = $11,668,753
– Contribution = $360,000 (= 6000×60)

Present Value of an Annuity
• Pensions, insurance obligations, and interest owed on
bonds are all annuities. To compare these three types of
investments we need to know the present value (PV) of
each.

Table 5.2 Illustration of a 5-Year, $500
Annuity Discounted to the Present at
6 Percent

PV of Annuity – Using the
Mathematical Formulas
PV of Annuity = PMT
 
1 − (1 + r )−1 

-n

r
= 500 ( 4.212 )
= $2,106

Annuities Due (1 of 2)
• Annuities due are ordinary annuities in which all payments
have been shifted forward by one time period. Thus, with
annuity due, each annuity payment occurs at the beginning
of the period rather than at the end of the period.

Annuities Due (2 of 2)
• Continuing the same example: If we assume that $500
invested every year for 5 years at 6% to be annuity due,
the future value will increase due to compounding for one
additional year.
 (1 + r )n − 1 
  
• FV5 ( annuity due ) = PMT  
 r 
= 500 ( 5.637 )(1.06 )
= $2, 987.61
(versus $2,818.80 for ordinary annuity)

Amortized Loans (1 of 2)
• Loans paid off in equal installments over time are called
amortized loans.
Examples: Home mortgages, auto loans
• Reducing the balance of a loan via annuity payments is
called amortizing.

Amortized Loans (2 of 2)
• The periodic payment is fixed. However, different amounts
of each payment are applied toward the principal and
interest. With each payment, you owe less toward
principal. As a result, the amount that goes toward interest
declines with every payment (as seen in Figure 5.4).

Figure 5.4 The Amortization Process

Amortization Example
• Example: If you want to finance a new machinery with a
purchase price of $6,000 at an interest rate of 15% over 4
years, what will your annual payments be?

Finding PMT – Using the
Mathematical Formulas
• Finding Payment: Payment amount can be found by
solving for PMT using PV of annuity formula.
PV of Annuity = PMT
 1 − (1 + r )
−4

r
6, 000 = PMT
1 − (1 + 0.15 )
−4

0.15
6, 000 = PMT ( 2.855 )
6, 000
PMT =
2.855
= $2,101.59
Table 5.3 Loan Amortization Schedule
Involving a $6,000 Loan at 15 Percent to
Be Repaid in 4 Years
Interest
portion of Repayment of the Outstanding loan
the principal portion of Balance After the
Year Annuity Annuitya the Annuityb Annuity Payment
0 0 0 0 $6,000.00
1 $2,101.59 $900.00 $1,201.59 4,798.41
2 2,101.59 719.76 1,381.83 3,416.58
3 2,101.59 512.49 1,589.10 1,827.48
4 2,101.59 274.12 1,827.48 Blank
aThe interest portion of the annuity is calculated by multiplying the outstanding loan balance at the
beginning of the year by the interest rate of 15%. Thus, for year 1 it was $6,000 × 0.15 = $900.00; for
year 2 it was $4,798.41 × 0.15 = $719.76; and so on.
bRepayment of the principal portion of the annuity was calculated by subtracting the interest portion of
the annuity (column 2) from the annuity (column 1).
Making Interest Rates Comparable

Making Interest Rates Comparable
• We cannot compare rates with different compounding
periods. For example, 5% compounded annually is
not the same as 5% percent compounded quarterly.
• To make the rates comparable, we compute the
annual percentage rate (APR) and the effective
annual rate (EAR).

Quoted Rate versus Effective Rate
(1 of 2)
interest rate per compounding

Annual Percentage
= period (for example, × periods per
Rate (APR)
per month or week) year (m)
m
 APR or quoted 
 
annual rate
Effective Annual Rate (EAR) = 1 +  −1
 compounding periods 
 
 per year ( m ) 

Quoted Rate versus Effective Rate
(2 of 2)
• Quoted rate could be very different from the effective rate if

compounding is not done annually.
• If the APR of a quoted loan is 7.85%, but it is compounded
quarterly, the EAR is actually 8.084%.
4
 0.0785 
EAR = 1+  − 1 = 0.08084 or 8.084%
 4 

Table 5.4 The Value of $100
Compounded at Various Intervals
(1 of 2)
For 1 Year at r Percent
r= 2% 5% 10% 15%
Compounded annually $102.00 $105.00 $110.00 $115.00
Compounded semiannually 102.01 105.06 110.25 115.56
Compounded quarterly 102.02 105.09 110.38 115.87
Compounded monthly 102.02 105.12 110.47 116.08
Compounded weekly (52) 102.02 105.12 110.51 116.16
Compounded daily (365) 102.02 105.13 110.52 116.18

Table 5.4 The Value of $100
Compounded at Various Intervals
(2 of 2)
For 10 Years at r Percent
r= 2% 5% 10% 15%
Compounded annually $121.90 $162.89 $259.37 $404.56
Compounded semiannually 122.02 163.86 265.33 424.79
Compounded quarterly 122.08 164.36 268.51 436.04
Compounded monthly 122.10 164.70 270.70 444.02
Compounded weekly (52) 122.14 164.83 271.57 447.20
Compounded daily (365) 122.14 164.87 271.79 448.03

Finding PV and FV with Nonannual
Periods
• If interest is not paid annually, we need to change the
interest rate and time period to reflect the nonannual
periods when computing PV and FV.
– r = stated rate/# of compounding periods
– N = # of years×# of compounding periods in a year
• Example: If your investment earns 10% a year, with
quarterly compounding for 10 years, what should we use
for “r” and “N”?
0.10
r= = 0.025 or 2.5%
4
N = 10  4 = 40 periods
The Present Value of an Uneven
Stream and Perpetuities

The Present Value of an Uneven
Stream
• Some cash flow stream may not follow a conventional
pattern. For example, the cash flows may be erratic (with
some positive cash flows and some negative cash flows)
or cash flows may be a combination of single cash flows
and annuity (as illustrated in Table 5.5).

Table 5.5 The Present Value of an
Uneven Stream Involving One
Annuity Discounted to the Percent at
6 Percent: An Example

Table 5.6 Determining the Present
Value of an Uneven Stream Involving
One Annuity Discounted to the
Present at 6 Percent: An Example
1. Present value of $200 received at the end of 2 years at 6% = $ 178.00
2. Present value of a $400 outflow at the end of 3 years at 6% = −335.85
3. (a) Value at end of year 3 of a $500 annuity, years 4–10 at 6% = $ 2,791.19

(b) Present value of $2,791.19 received at the end of year 3 at 6% = 2,343.54
4. Total present value = $2,185.69

Perpetuity (1 of 2)
• A perpetuity is an annuity that continues forever.
• The present value of a perpetuity is given by
PP
PV =
r
• PV = present value of the perpetuity
• PP = constant dollar amount provided by the perpetuity
• r = annual interest (or discount) rate

Perpetuity (2 of 2)
• Example: What is the present value of $2,000 perpetuity
discounted back to the present at 10% interest rate?
2000
=
0.10
= $20, 000

Table 5.7 Summary of Time Value of
Money Equation

Key Terms (1 of 2)
• Amortized loan
• Annual percentage rate (APR)
• Annuity
• Annuity due
• Annuity future value factor
• Annuity present value factor
• Compound annuity
• Compound interest

Key Terms (2 of 2)
• Effective annual rate (EAR)
• Future value
• Future value factor
• Ordinary annuity
• Nominal or stated interest rate
• Present value
• Present value factor
• Perpetuity
• Simple interest

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Tenth Edition, Global Edition

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• FVN = the future of the investment at the end of “n” years

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FV2 = PV (1 + r ) = $100 (1 + 0.06 )

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FV at 6% = 500  (1.06 ) = $561.80

b. Continue the same example but change time to 10 years.

c. Continue the same example but change contribution to

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FVn = the future value of the investment at the end of n

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FV5 = $500 (1 + 0.06 ) + $500 (1 + 0.06 ) + $500 (1 + 0.06 )

+ $500 (1.262 ) + $500 (1.191) + $500 (1.124 ) + $500 (1.090 )

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FVn = the future of an annuity at the end of the nth year

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(versus $2,818.80 for ordinary annuity)

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interest rate per compounding

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• Quoted rate could be very different from the effective rate if

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Compounded semiannually 102.01 105.06 110.25 115.56

Compounded quarterly 102.02 105.09 110.38 115.87

Compounded monthly 102.02 105.12 110.47 116.08