UNIT ONE

CHAPTER THREE
THE TIME VALUE
OF MONEY

Lesson 5
Chapter 3
The time value of money
Unit 1
Core concepts in financial management
After reading this lesson you will be able to: Understand what is meant by "the time value of money."
Describe how the interest rate can be used to adjust the value of cash flows to a
single point in time.
Calculate the future value of an amount invested today.
Calculate the present value of a single future cash flow.
Understand the relationship between present and future values.
Understand in what period of time money doubles
Understand shorter compounding periods
Calculate & understand the relationship between effective & nominal interest
rate.
Use the interest factor tables and understand how they provide a short cut to
calculating present and future values.

You all instinctively know that money loses its value with time. Why does this happen?
What does a Financial Manager have to do to accommodate this loss in the value of
money with time? In this section, we will take a look at this very interesting issue.

Why should financial managers be familiar with the time value of money?
The time value of money shows mathematically how the timing of cash flows, combined

with the opportunity costs of capital, affect financial asset values. A thorough
understanding of these concepts gives a financial manager powerful tool to maximize
wealth.
What is the time value of money?
The time value of money serves as the foundation for all other notions in finance. It
impacts business finance, consumer finance and government finance. Time value of
money results from the concept of interest.
This overview covers an introduction to simple interest and compound interest, illustrates
the use of time value of money tables, shows a approach to solving time value of money
problems and introduces the concepts of intra year compounding, annuities due, and
perpetuities. A simple introduction to working time value of money problems on a
financial calculator is included as well as additional resources to help understand time
value of money.
Time value of money
The universal preference for a rupee today over a rupee at some future time is because of
the following reasons: Alternative uses/ Opportunity cost
Inflation
Uncertainty
The manner in which these three determinants combine to determine the rate of interest
can be represented symbolically as
Nominal or market rate of interest rate = Real rate of interest + Expected rate of
Inflation + Risk of premiums to
compensate uncertainty

Basics
Evaluating financial transactions requires valuing uncertain future cash flows. Translating
a value to the present is referred to as discounting. Translating a value to the future is
referred to as compounding
The principal is the amount borrowed. Interest is the compensation for the opportunity
cost of funds and the uncertainty of repayment of the amount borrowed; that is, it
represents both the price of time and the price of risk. The price of time is compensation
for the opportunity cost of funds and the price of risk is compensation for bearing risk.
Interest is compound interest if interest is paid on both the principal and any accumulated
interest. Most financial transactions involve compound interest, though there are a few
consumer transactions that use simple interest (that is, interest paid only on the principal
or amount borrowed).
Under the method of compounding, we find the future values (FV) of all the cash
flows at the end of the time horizon at a particular rate of interest. Therefore, in this
case we will be comparing the future value of the initial outflow of Rs. 1,000 as at the
end of year 4 with the sum of the future values of the yearly cash inflows at the end of
year 4. This process can be schematically represented as follows:
PROCESS OF DISCOUNTING
Under the method of discounting, we reckon the time value of money now, i.e. at
time 0 on the time line. So, we will be comparing the initial outflow with the sum of the
present values (PV) of the future inflows at a given rate of interest.
Translating a value back in time -- referred to as discounting -- requires determining
what a future amount or cash flow is worth today. Discounting is used in valuation
because we often want to determine the value today of future value or cash flows.
The equation for the present value is:

Present value = PV = FV / (1 + i) n
Where:
PV = present value (today's value),
FV = future value (a value or cash flow sometime in the future),
i = interest rate per period, and
n = number of compounding periods
And [(1 + i) n] is the compound factor.
We can also represent the equation a number of different, yet equivalent ways:

Where PVIFi,n is the present value interest factor, or discount factor.

In other words future value is the sum of the present value and interest:
Future value = Present value + interest
From the formula for the present value you can see that as the number of discount
periods, n, becomes larger, the discount factor becomes smaller and the present value
becomes less, and as the interest rate per period, i, becomes larger, the discount factor
becomes smaller and the present value becomes less.
Therefore, the present value is influenced by both the interest rate (i.e., the discount rate)
and the numbers of discount periods.
Example
Suppose you invest 1,000 in an account that pays 6% interest, compounded annually.
How much will you have in the account at the end of 5 years if you make no
withdrawals? After 10 years?

Solution
FV5 = Rs 1,000 (1 + 0.06) 5 = Rs 1,000 (1.3382) = Rs 1,338.23
FV10 = Rs 1,000 (1 + 0.06) 10 = Rs 1,000 (1.7908) = Rs 1,790.85
What if interest was not compounded interest? Then we would have a lower balance in
the account:
FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300
FV10 = Rs 1,000 + [Rs 1,000 (0.06)(10)] = Rs 1,600
Simple interest is the product of the principal, the time in years, and the annual interest
rate.
In compound interest the principal is more than once during the time of the investment.
Compound interest is another matter. It's good to receive compound interest, but not so
good to pay compound interest. With compound interest, interest is calculated not only
on the beginning interest, but also on any interest accumulated in the meantime.
I hope you have understood the concept of simple interest and compound interest. It is
explained with the help of a graph, which is self-explanatory.

Now let us solve a problem for Compound Interest vs. Simple Interest
Example
Suppose you are faced with a choice between two accounts, Account A and Account B.
Account A provides 5% interest, compounded annually and Account B provides 5.25%
simple interest. Consider a deposit of Rs 10,000 today. Which account provides the
highest balance at the end of 4 years?
Solution
Account A: FV4 = Rs 10,000 (1 + 0.05) 4 = Rs 12,155.06
Account B: FV4 = Rs 10,000 + (Rs 10,000 (0.0525)(4)] = Rs 12,100.00
Account A provides the greater future value.

Present value is simply the reciprocal of compound interest. Another way to think of
present value is to adopt a stance out on the time line in the future and look back toward
time 0 to see what was the beginning amount.
Present Value = P0 = Fn / (1+I) n
Table A-3 shows present value factors: Note that they are all less than one.
Therefore, when multiplying a future value by these factors, the future value is
discounted down to present value. The table is used in much the same way as the other
time value of money tables. To find the present value of a future amount, locate the
appropriate number of years and the appropriate interest rate, take the resulting factor and
multiply it times the future value.
How much would you have to deposit now to have Rs 15,000 in 8 years if interest is 7%?
= 15000 X .582 = 8730 Rs
Consider a case in which you want to determine the value today of $ 1,000 to be received
five years from now. If the interest rate (i.e., discount rate) is 4%,

Problem
Suppose that you wish to have Rs 20,000 saved by the end of five years. And suppose
you deposit funds today in account that pays 4% interest, compounded annually. How
much must you deposit today to meet your goal?
Solution
Given: FV = Rs 20,000; n = 5; i = 4%

PV = Rs 20,000/(1 + 0.04) 5 = Rs 20,000/1.21665

PV = Rs 16,438.54
Q. If you want to have Rs 10,000 in 3 years and you can earn 8%, how much would you
have to deposit today?
Rs 7938.00
Rs 25,771
Rs 12,597
Using Tables to Solve Future Value Problems
A-1 for future value at the end of n yrs
A-3 for present value at the beginning of the year
Compound Interest tables have been calculated by figuring out the (1+I) n values for
various time periods and interest rates. Look at Time Value of Money Future Value
Factors.
This table summarizes the factors for various interest rates for various years. To use the
table, simply go down the left-hand column to locate the appropriate number of years.
Then go out along the top row until the appropriate interest rate is located.
For instance, to find the future value of Rs100 at 5% compound interest, look up five
years on the table, and then go out to 5% interest. At the intersection of these two values,
a factor of 1.2763 appears. Multiplying this factor times the beginning value of Rs100.00
results in Rs127.63, exactly what was calculated using the Compound Interest Formula.
Note, however, that there may be slight differences between using the formula and tables
due to rounding errors.

An example shows how simple it is to use the tables to calculate future amounts.
You deposit Rs2000 today at 6% interest. How much will you have in 5 years?
=2000*1.338=2676

The following exercise should aid in using tables to solve future value problems. Please
answer the questions below by using tables
1. You invest Rs 5,000 today. You will earn 8% interest. How much will you have in 4
years? (Pick the closest answer)
Rs 6,802.50
Rs 6,843.00
Rs 3,675
2.You have Rs 450,000 to invest. If you think you can earn 7%, how much could you
accumulate in 10 years? ? (Pick the closest answer)
Rs 25,415
Rs 722,610
Rs 722,610
3.If a commodity costs Rs500 now and inflation is expected to go up at the rate of 10%
per year, how much will the commodity cost in 5 years?
Rs 805.25
Rs 3,052.55
Cannot tell from this information

Now we will talk about the cases when the interest is given semi annually, quarterly,
monthly.
The interest rate per compounding period is found by taking the annual rate and dividing
it by the number of times per year the cash flows are compounded. The total number of
compounding periods is found by multiplying the number of years by the number of
times per year cash flows is compounded.
The formula for this shorter compounding period is
FVn

= PV0 (1+i/m)n*m

Consider the following example. You deposited Rs 1000 for 5 yrs in a bank that offers
10% interest p.a. compounded semiannually, what will be the future value.
=1000 (1+. 10/2) 5*2
For instance, suppose someone were to invest Rs 5,000 at 8% interest, compounded
semiannually, and hold it for five years.
The interest rate per compounding period would be 4%, (8% / 2)
The number of compounding periods would be 10 (5 x 2)
To solve, find the future value of a single sum looking up 4% and 10 periods in the
Future Value table.
FV = PV (FVIF)
FV = Rs 5,000(1.480)
FV = Rs 7,400
Now let us solve a problem for Frequency of Compounding

Problem
Suppose you invest Rs 20,000 in an account that pays 12% interest, compounded
monthly. How much do you have in the account at the end of 5 years?
Solution
FV = Rs 20,000 (1 + 0.01) 60 = Rs 20,000 (1.8167) = Rs 36,333.93
In what period of time money will be doubled?
Investor most of the times wants to know that in what period of time his money will be
doubled. For this the rule of 72 is used.
Suppose the rate of interest is 12%, the doubling period will be 72/12=6 yrs.
Apart from this rule we do use another rule, which gives better results, is the rule of 69
= .35 + 69
int rate
= .35 + 69
12
= .35 + 5.75 = 6.1 yrs
Practice Problems
What is the balance in an account at the end of 10 years if Rs 2,500 is deposited today
and the account earns 4% interest, compounded annually? Quarterly?
If you deposit Rs10 in an account that pays 5% interest, compounded annually, how
much will you have at the end of 10 years? 50 years? 100 years?
How much will be in an account at the end of five years the amount deposited today is Rs
10,000 and interest is 8% per year, compounded semi-annually?

Answers
1.Annual compounding: FV = Rs 2,500 (1 + 0.04) 10 = Rs 2,500 (1.4802) = Rs 3,700.61
Quarterly compounding: FV = Rs 2,500 (1 + 0.01) 40 = Rs 2,500 (1.4889) = Rs3,722.16
2.
10 years:
FV = Rs10 (1+0.05) 10 = Rs10 (1.6289) = Rs16.29
50 years:
FV = Rs10 (1 + 0.05) 50 = Rs10 (11.4674) = Rs114.67
100 years:
FV = Rs10 (1 + 0.05) 100 = Rs10 (131.50) = Rs 1,315.01
3. FV = Rs 10,000 (1+0.04) 10 = Rs10,000 (1.4802) = Rs14,802.44
For example, assume you deposit Rs. 10,000 in a bank, which offers 10% interest per
annum compounded semi-annually which means that interest is paid every six months.
Now, amount in the beginning = Rs. 10,000
Rs.
Interest @ 10% p.a. for first six

Months 10000 x

0.1
2

= 500

=10500

Interest for second

6 months = 10500 x

0.1
2

Amount at the end of the year

= 525

= 11,025

Instead, if the compounding is done annually, the amount at the end of the year will be
10,000 (1 + 0.1) = Rs, 11000. This difference of Rs. 25 is because under semi-annual
compounding, the interest for first 6 moths earns interest in the second 6 months.
The generalized formula for these shorter compounding periods is

FVn = PV 1 +
M

mxn

Where

FVn = future value after n years

PV = cash flow today
K = Nominal Interest rate per annum
M = Number of times compounding is done during a year
N = Number of years for which compounding is done.
Example

Under the Vijaya Cash Certificate scheme of Vijaya Bank, deposits can be made for
periods ranging from 6 months to 10 years. Every quarter, interest will be added on to the
principal. The rate of interest applied is 9% p.a. for periods form 12 to 13 months and
10% p.a. for periods form 24 to 120 months.
An amount of Rs. 1,000 invested for 2 years will grow to

Fn = PV 1 +
M

mn

Where m = frequency of compounding during a year

0.10

= 1000 1 +

= 1000 (1.025)8
= 1000 x 1.2184 = Rs. 1218
Effective vs. Nominal Rate of interest

We have seen above that the accumulation under the semi-annual compounding scheme
exceeds the accumulation under the annual compounding scheme compounding scheme,
the nominal rate of interest is 10% per annum, under the scheme where compounding is
done semi annually, the principal amount grows at the rate of 10.25 percent per annum.
This 1025 percent is called the effective rate of interest which is the rate of interest per
annum under annual compounding that produces the same effect as that produced by an
interest rate of 10 percent under semi annual compounding.
The general relationship between the effective an nominal rates of interest is as follows:
m

= 1 + 1
m

where r

= effective rate of interest

k

= nominal rate of interest

= frequency of compounding per year.

Example

Find out the effective rate of interest, if the nominal rate of interest is 12% and is
quarterly compounded?

Effective rate of interest

= (1 +

= (+

k m
) 1
m

0.12 4
) 1
4

= (1 + 0.03)4 -1 = 1.126 -1
= 0.126 = 12.6% p.a. compounded quarterly

By now you should have clear understanding of

Compounding
Discounting
Doubling period (Rule of 72)
Doubling period (Rule of 69)
Shorter compounding periods
Effective vs. Nominal Rate of interest

By now you should be an expert in using the following two tables:

A-1 The Compound Sum of one rupee FVIF
A-3 The Present Value of one rupee PVIF

IMPORTANT
The inverse of FVIF is PVIF i.e. inverse of FVIF is PVIF.

IMPORTANT
Slide 1

Chapter 3
Time
Time Value
Value of
of
Money
Money
3-1

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Slide 2

The Time Value of Money

The Interest Rate
Simple Interest
Compound Interest
Amortizing a Loan
3-2

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Slide 3

The Interest Rate

Which would you prefer -- $10,000
today or $10,000 in 5 years?
years
Obviously, $10,000 today.
today
You already recognize that there is
TIME VALUE TO MONEY!!
MONEY
3-3

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Slide 4

Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST

3-4

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Slide 5

Types of Interest
Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).

Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
3-5

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Slide 6

Simple Interest Formula

Formula

SI = P0(i)(n)

SI:

Simple Interest

P0:

Deposit today (t=0)

i:

Interest Rate per Period

n:

Number of Time Periods

3-6

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Slide 7

Simple Interest Example

Assume that you deposit $1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI

= P0(i)(n)
= $1,000(.07)(2)
= $140

3-7

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Slide 8

Simple Interest (FV)

What is the Future Value (FV
FV) of the
deposit?
FV

3-8

= P0 + SI
= $1,000 + $140
= $1,140

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.

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Slide 9

Simple Interest (PV)

What is the Present Value (PV
PV) of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!

3-9

Present Value is the current value of a

future amount of money, or a series of
payments, evaluated at a given interest
rate.

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Slide 10

Why Compound Interest?

Future Value (U.S. Dollars)

Future Value of a Single $1,000 Deposit

20000

10% Simple
Interest
7% Compound
Interest
10% Compound
Interest

15000
10000
5000
0

1st Year 10th

Year

20th
Year

30th
Year

3-10

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Slide 11

Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
years

7%

$1,000
FV2
3-11

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Slide 12

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1

= $1,000 (1.07)
= $1,070

Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
3-12

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Slide 13

Future Value
Single Deposit (Formula)
FV1

= P0 (1+i)1

FV2

= FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)(1.07)
$1,000
2
2
= P0 (1+i)
= $1,000(1.07)
$1,000
= $1,144.90

= $1,000 (1.07)
= $1,070

You earned an EXTRA $4.90 in Year 2 with

compound over simple interest.
3-13

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Slide 14

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
3-14

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Slide 15

Valuation Using Table I

FVIFi,n is found on Table I at the end
of the book or on the card insert.

3-15

Period
1
2
3
4
5

6%
1.060
1.124
1.191
1.262
1.338

7%
1.070
1.145
1.225
1.311
1.403

8%
1.080
1.166
1.260
1.360
1.469

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Slide 16

Using Future Value Tables

FV2

3-16

= $1,000 (FVIF
FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.166
1.145
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469

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Slide 17

Story Problem Example

Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

10%

$10,000

FV5
3-17

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Slide 18

Story Problem Solution

Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
Calculation based on Table I:
FVIF10%, 5)
FV5 = $10,000 (FVIF
= $10,000 (1.611)
= $16,110 [Due to Rounding]
3-18

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Slide 19

Double Your Money!!!

Quick! How long does it take to
double $5,000 at a compound rate
of 12% per year (approx.)?
We will use the RuleRule-ofof-72
72.

3-19

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Slide 20

The Rule
-of-72
Rule-of-72
Quick! How long does it take to
double $5,000 at a compound rate
of 12% per year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
3-20

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Slide 21

Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.

7%

$1,000
PV0

PV1

3-21

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Slide 22

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= FV2 / (1+i)2
0

7%

= $1,000 / (1.07)2
= $873.44
1

$1,000
PV0
3-22

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Slide 23

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

General Present Value Formula:

PV0 = FVn / (1+i)n
or

PV0 = FVn (PVIFi,n) -- See Table II

3-23

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Slide 24

Valuation Using Table II

PVIFi,n is found on Table II at the end
of the book or on the card insert.
Period
1
2
3
4
5

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

3-24

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Slide 25

Using Present Value Tables

PV2

3-25

= $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]
Period
6%
7%
8%
1
.943
.935
.926
2
.890
.857
.873
3
.840
.816
.794
4
.792
.763
.735
5
.747
.713
.681

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Slide 26

Story Problem Example

Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a discount
rate of 10%.

10%

5
$10,000

PV0
3-26

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Slide 27

Story Problem Solution

Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Calculation based on Table I:
PV0 = $10,000 (PVIF
PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
3-27

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Slide 28

Types of Annuities
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Annuity Due:
Due Payments or receipts
occur at the beginning of each period.
3-28

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Slide 29

Examples of Annuities
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
3-29

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Slide 30

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

Today
3-30

End of
Period 2

End of
Period 3

$100

$100

$100

Equal Cash Flows

Each 1 Period Apart

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Slide 31

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

$100

$100

$100

Today
3-31

Beginning of
Period 2

Beginning of
Period 3

Equal Cash Flows

Each 1 Period Apart

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Slide 32

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

n+1

. . .

i%

R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 +

... + R(1+i)1 + R(1+i)0

FVAn

3-32

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Slide 33

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

$1,000

$1,000

7%
$1,000

$1,070
$1,145
$1,000(1.07)2 +

FVA3 =
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
3-33

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Slide 34

Hint on Annuity Valuation

The future value of an ordinary
annuity can be viewed as
occurring at the end of the
last cash flow period, whereas
the future value of an annuity
due can be viewed as
occurring at the beginning of
the last cash flow period.
3-34

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Slide 35

Valuation Using Table III

FVAn
FVA3

3-35

= R (FVIFAi%,n)
= $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.246
3.215
4
4.375
4.440
4.506
5
5.637
5.751
5.867

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Slide 36

Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

i%
R

. . .

FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)

n -1

FVADn

3-36

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Slide 37

Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

$1,000

$1,000

$1,070

7%
$1,000

$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$3,440 = FVAD3
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440
3-37

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Slide 38

Valuation Using Table III

FVADn
FVAD3

3-38

= R (FVIFAi%,n)(1+i)
= $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.246
3.215
4
4.375
4.440
4.506
5
5.637
5.751
5.867

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Slide 39

Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

n+1

. . .

i%

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

3-39

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Slide 40

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

$1,000

$1,000

7%
$ 934.58
$ 873.44
$ 816.30

$1,000

$2,624.32 = PVA3

3-40

PVA3 =

$1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3

= $934.58 + $873.44 + $816.30

= $2,624.32

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Slide 41

Hint on Annuity Valuation

The present value of an ordinary
annuity can be viewed as
occurring at the beginning of
the first cash flow period,
whereas the present value of an
annuity due can be viewed as
occurring at the end of the first
cash flow period.
3-41

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Slide 42

Valuation Using Table IV

3-42

PVAn = R (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.577
2.624
4
3.465
3.387
3.312
5
4.212
4.100
3.993

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Slide 43

Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

PVADn

n -1

. . .

i%

R: Periodic
Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
3-43

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Slide 44

Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

$1,000

$1,000

7%
$1,000.00
$ 934.58
$ 873.44

$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
3-44

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Slide 45

Valuation Using Table IV

3-45

PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.577
2.624
4
3.465
3.387
3.312
5
4.212
4.100
3.993

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Slide 46

Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Determine if it is a PV or FV problem
3. Create a time line
4. Put cash flows and arrows on time line
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow
6. Solve the problem
7. Check with financial calculator (optional)
3-46

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Slide 47

Mixed Flows Example

Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%?
10%

10%
$600

$600 $400 $400 $100

PV0
3-47

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Slide 48

How to Solve?
1. Solve a piece
piece--atat-a-time
time by
discounting each piece back to t=0.
2. Solve a group
group--atat-a-time
time by first
breaking problem into groups of
annuity streams and any single
cash flow group. Then discount
each group back to t=0.
3-48

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Slide 49

Piece
-At-A-Time
Piece-At-A-Time
0

10%
$600

$600 $400 $400 $100

$545.45
$495.87
$300.53
$273.21
$ 62.09
3-49

$1677.15 = PV0 of the Mixed Flow

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Slide 50

Group
-At-A-Time (#1)
Group-At-A-Time
0

10%

$600

$600 $400 $400 $100

$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) =
$600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) =
$100 (0.621) =
$62.10
3-50

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Slide 51

Group
-At-A-Time (#2)
Group-At-A-Time
0
$1,268.00

Plus
$347.20

Plus
$62.10

$400

$400

$400

$200

$200

4
$400

PV0 equals
$1677.30.
3

5
$100

3-51

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Slide 52

Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n:
m:
i:
FVn,m:

Number of Years
Compounding Periods per Year
Annual Interest Rate
FV at the end of Year n

PV0:

PV of the Cash Flow today

3-52

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Slide 53

Impact of Frequency
Julie Miller has $1,000 to invest for 2
years at an annual interest rate of
12%.
Annual

FV2

= 1,000(1+
[.12/1])(1)(2)
1,000
= 1,254.40

Semi

FV2

= 1,000(1+
[.12/2])(2)(2)
1,000
= 1,262.48

3-53

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Slide 54

Impact of Frequency
Qrtly

FV2

= 1,000(1+
[.12/4])(4)(2)
1,000
= 1,266.77

Monthly

FV2

= 1,000(1+
[.12/12])(12)(2)
1,000
= 1,269.73

Daily

FV2

= 1,000(1+
1,000 [.12/365])(365)(2)
= 1,271.20

3-54

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Slide 55

Effective Annual
Interest Rate
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.

(1 + [ i / m ] )m - 1
3-55

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Slide 56

BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
3-56

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Slide 57

Steps to Amortizing a Loan

1.

Calculate the payment per period.

2.

Determine the interest in Period t.

(Loan balance at t-1) x (i% / m)

3.

Compute principal payment in Period t.

(Payment - interest from Step 2)

4.

Determine ending balance in Period t.

(Balance - principal payment from Step 3)

5.

Start again at Step 2 and repeat.

3-57

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Slide 58

Amortizing a Loan Example

Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment

3-58

= R (PVIFA i%,n)
PV0
$10,000
= R (PVIFA 12%,5)
$10,000
= R (3.605)
R = $10,000 / 3.605 = $2,774

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Slide 59

Amortizing a Loan Example

End of
Year
0

Paym ent

In te re s t

P rin c ip a l

---

---

---

E n d in g
B a la n c e
$ 1 0 ,0 0 0

$ 2 ,7 7 4

$ 1 ,2 0 0

$ 1 ,5 7 4

8 ,4 2 6

2 ,7 7 4

1 ,0 1 1

1 ,7 6 3

6 ,6 6 3

2 ,7 7 4

800

1 ,9 7 4

4 ,6 8 9

2 ,7 7 4

563

2 ,2 1 1

2 ,4 7 8

2 ,7 7 5

297

2 ,4 7 8

$ 1 3 ,8 7 1

$ 3 ,8 7 1

$ 1 0 ,0 0 0

[Last Payment Slightly Higher Due to Rounding]

3-59

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