Time Value of Money: Future Value Present Value Annuities Rates of Return Amortization

Chapter 5
Time Value of Money
Future Value
Present Value
Annuities
Rates of Return
Amortization
5-1
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Time Lines
0 1 2 3
I%
CF0 CF1 CF2 CF3
• 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.
5-2
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

5-3
Drawing Time Lines
Uneven cash flow stream
0 1 2 3
I%
-50 100 75 50
5-4
What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?
• 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
10%
100 FV = ?
5-5
Solving for FV:
The Step-by-Step and Formula Methods
• After 1 year:
FV1 = PV(1 + I) = $100(1.10) = $110.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.10)2 = $121.00
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case):
FVN = PV(1 + I)N
5-6
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 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10
Excel: =FV(rate,nper,pmt,pv,type)
5-7
What is the present value (PV) of $100 due in
3 years, if I/YR = 10%?
• 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
10%
PV = ? 100
5-8
Solving for PV:
The Formula Method
• Solve the general FV equation for PV:

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

= $100/(1.10)3
= $75.13
5-9
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 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13
Excel: =PV(rate,nper,pmt,fv,type)
5-10
Solving for I: What annual interest rate would cause
$100 to grow to $125.97 in 3 years?
• Solves the general FV equation for I/YR.

• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8
Excel: =RATE(nper,pmt,pv,fv,type,guess)
5-11
Solving for N: If sales grow at 20% per year, how
long before sales double?
• Solves the general FV equation for N.

• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8
EXCEL: =NPER(rate,pmt,pv,fv,type)
5-12
What is the difference between an ordinary
annuity and an annuity due?
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT
Annuity Due
0 1 2 3
I%
PMT PMT PMT
5-13
Solving for FV:
3-Year Ordinary Annuity of $100 at 10%
• $100 payments occur at the end of each period, but

there is no PV.
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331
Here type = 0.
5-14
Solving for PV:
3-year Ordinary Annuity of $100 at 10%
• $100 payments still occur at the end of each period,

but now there is no FV.
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69
Here type = 0.
5-15
Solving for FV:
3-Year Annuity Due of $100 at 10%
• Now, $100 payments occur at the beginning of each

period.
FVAdue= FVAord(1 + I) = $331(1.10) = $364.10
• Alternatively, set calculator to “BEGIN” mode and solve
for the FV of the annuity:
BEGIN
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10
Here type = 1.
5-16
Solving for PV:
3-Year Annuity Due of $100 at 10%
• Again, $100 payments occur at the beginning of each

period.
PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55
• Alternatively, set calculator to “BEGIN” mode and solve
for the PV of the annuity:
BEGIN
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55
Here type = 1.
5-17
What is the present value of a 5-year $100
ordinary annuity at 10%?
• Be sure your financial calculator is set back to END

mode and solve for PV:
– N = 5, I/YR = 10, PMT = -100, FV = 0.
– PV = $379.08.
5-18
What if it were a 10-year annuity? A 25-year
annuity? A perpetuity?
• 10-year annuity
– N = 10, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$614.46.
• 25-year annuity
– N = 25, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$907.70.
• Perpetuity
– PV = PMT/I = $100/0.1 = $1,000.
5-19
The Power of Compound Interest
A 20-year-old student wants to save $3 a day for her

retirement. Every day she places $3 in a drawer. At the
end of the year, she invests the accumulated savings
($1,095) in a brokerage account with an expected
annual return of 12%.
How much money will she have when she is 65 years

old?
5-20
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 $1,487,261.89

when she is 65.
INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,262
Excel: =FV(.12,45,-1095,0,0)
5-21
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 $146,000.59
at age 65. This is $1.3 million less than if starting at
age 20.
• Lesson: It pays to start saving early.
INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,001
Excel: =FV(.12,25,-1095,0,0)
5-22
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 $1,487,261.89, and solve for PMT.
INPUTS 25 12 0 1487262
N I/YR PV PMT FV
OUTPUT -11,154.42
Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.12,25,0,1487262,0)
5-23
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
5-24
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 = 10, press NPV button to get NPV =
$530.087. (Here NPV = PV.)
5-25
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%
100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
5-26
Classification of Interest Rates
• Nominal rate (INOM): also called the quoted or

stated rate. An annual rate that ignores
compounding effects.
– INOM is stated in contracts. Periods must also be
given, e.g. 8% quarterly or 8% daily interest.
• Periodic rate (IPER): amount of interest charged
each period, e.g. monthly or quarterly.
– IPER = INOM/M, where M is the number of
compounding periods per year. M = 4 for quarterly
and M = 12 for monthly compounding.
5-27
Classification of Interest Rates
• Effective (or equivalent) annual rate (EAR = EFF%):

the annual rate of interest actually being earned,
considering compounding.
– EFF% for 10% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.10/2)2 – 1 = 10.25%
– Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.10,2)
– Should be indifferent between receiving 10.25%
annual interest and receiving 10% interest,
compounded semiannually.
5-28
Why is it important to consider 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).
5-29
Why is it important to consider effective rates
of return?
• See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
5-30
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.
5-31
What is the FV of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?
MN
 INOM 
FVN  PV 1  
 M 
23
 0.10 
FV3S  $100 1  
 2 
FV3S  $100(1.05)6  $134.01
FV3Q  $100(1.025)12  $134.49
5-32
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.
5-33
What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?
• Payments occur annually, but compounding occurs

every 6 months.
• Cannot use normal annuity valuation techniques.
0 1 2 3 4 5 6
5%
100 100 100
5-34
Method 1:
Compound Each Cash Flow
0 1 2 3 4 5 6
5%
100 100 100

110.25
121.55
331.80
FV3 = $100(1.05)4 + $100(1.05)2 + $100
FV3 = $331.80
5-35
Method 2:
Financial Calculator or Excel
• Find the EAR and treat as an annuity.

• EAR = (1 + 0.10/2)2 – 1 = 10.25%.
INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80
Excel: =FV(.1025,3,-100,0,0)
5-36
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 10.25 100 0

N I/YR PV PMT FV
OUTPUT -247.59
Excel: =PV(.1025,3,100,0,0)
5-37
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, 10% annual rate loan with 3 equal
payments.
5-38
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 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
Excel: =PMT(.10,3,-1000,0,0)
5-39
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(0.10) = $100
5-40
Step 3:
Find the Principal Repaid in Year 1
• If a payment of $402.11 was made at the end of the

first year and $100 was paid toward interest, the
remaining value must represent the amount of
principal repaid.
PRIN = PMT – INT

= $402.11 – $100 = $302.11
5-41
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 – $302.11
= $697.89
5-42
Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL

1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL – $1,206 $206 $1,000 –
• Interest paid declines with each payment as the

balance declines. What are the tax implications of
this?
5-43
Illustrating an Amortized Payment:
Where does the money go?
$
402.11
Interest
302.11
Principal Payments
0 1 2 3
• Constant payments
• Declining interest payments
• Declining balance
5-44

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Chapter 5

Time Value of Money

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

$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 flows

• Solves the general FV equation.

• Finding the PV of a cash flow or series of cash flows

• Solve the general FV equation for PV:

PV = FV3 /(1 + I)3

• Solves the general FV equation for PV.

• Solves the general FV equation for I/YR.

INPUTS 3 -100 0 125.97

• Solves the general FV equation for N.

PMT PMT PMT

PMT PMT PMT

• $100 payments occur at the end of each period, but

• $100 payments still occur at the end of each period,

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

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

• Be sure your financial calculator is set back to END

A 20-year-old student wants to save $3 a day for her

How much money will she have when she is 65 years

• If she sticks to her plan, she will have $1,487,261.89

• If a 40-year-old investor begins saving today, and

• To find the required annual contribution, enter the

100 300 300 -50

• Input cash flows in the calculator’s “CFLO” register:

• LARGER, as the more frequently compounding

• Nominal rate (INOM): also called the quoted or

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

• Investments with different compounding intervals

• See how the effective return varies between

• INOM: Written into contracts, quoted by banks and

• Yes, but only if annual compounding is used, i.e., if

• Payments occur annually, but compounding occurs

100 100 100

100 100 100

• Find the EAR and treat as an annuity.

INPUTS 3 10.25 0 -100

• Could solve by discounting each cash flow, or…

INPUTS 3 10.25 100 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 $402.11 was made at the end of the

PRIN = PMT – INT

• To find the balance at the end of the period,

END BAL = BEG BAL – PRIN

YEAR BEG BAL PMT INT PRIN END BAL

• Interest paid declines with each payment as the

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