Chapter 4

Time Value of Money

To Thi Thanh Truc
Faculty of Finance and Banking
University of Economics and Law

4-1
 Learning outcomes
After finishing this chapter you should be able to:
 Calculate the present value and future value of lump
sums.
 Identify the different types of annuities.

 Calculate the present value and future value of an

annuity.
 Be able to use a financial calculator and a spreadsheet to

solve time value of money problems

 Explain the difference between nominal, periodic, and

effective interest rates.

4-2
Outline
 Type of interest
 Future value and Present value of
lump sums
 Annuities
 Rates of return
 Amortization

4-3
Time value to money
Which would you prefer -- $10,000
today or $10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!

4-4
Why Time?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.

4-5
 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).

4-6
 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

4-7
 Simple Interest Example

 Suppose you invest $1,000 for one year at 5% per

year. What is the future value in one year?
 Interest = 1,000(.05) = 50

 Value in one year = principal + interest = 1,000

+ 50 = 1,050
 Future Value (FV) = 1,000(1 + .05) = 1,050

4-8
Compound Interest
 Suppose you leave the money in for another
year. How much will you have two years from
now?
 FV = 1,000(1.05)(1.05) = 1,000(1.05) =
2

1,102.50

4-9
 Effects of Compounding
 Consider the previous example
 FV with simple interest = 1,000 + 50 + 50 =
1,100
 FV with compound interest = 1,102.50
 The extra 2.50 comes from the interest of
.05(50) = 2.50 earned on the first interest
payment

4-10
 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.
4-11
 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

4-12
 Drawing time lines
Uneven cash flow stream
0 1 2 3
I%

-50 100 75 50

4-13
 Basic Definitions
 Present Value – earlier money on a time line
 Future Value – later money on a time line
 Interest rate – “exchange rate” between earlier
money and later money
 Discount rate

 Cost of capital

 Opportunity cost of capital

 Required return

4-14
Future value and Present
Value of lump sum

4-15
 Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at a
compound interest rate of 7% (per
year) for 2 years.

0 1 2
7%
$1,000
FV2
4-16
Future Value
Single Deposit
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.

4-17
 General Future Value Formula
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)(1.07)
= P0 (1+i)2 = $1,000(1.07)2
= $1,144.90
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
4-18
General Future Value Formula
FV1 = PV0(1+i)1
FV2 = PV0(1+i)2
etc.
General Future Value Formula:
FVn = PV0 (1+i)n

4-19
 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.

0 1 2 3 4 5
10%
$10,000

FV5
4-20
 Example Solution

 Calculation based on general formula:

FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10) 5
= $16,105.10

4-21
Present Value
Single Deposit
Assume that you need $1,000 in 2 years. Let’s
examine the process to determine how much you
need to deposit today at a discount rate of 7%
compounded annually.
0 1 2
7%
$1,000
PV0 PV1
4-22
 Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2
= FV2 / (1+i)2 = $873.44

0 1 2
7%
$1,000
PV0
4-23
 Present Value
Single Deposit (Formula)
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
PV = FV (1+i)-n
0 n

4-24
Example of Present Value
Calculation
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%.

0 1 2 3 4 5
10%
$10,000
PV0
4-25
 Example of Present Value
Calculation
 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 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
4-26
Annuity

4-27
 Types of annuity

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity: Payments or receipts
occur at the end of each period.
 Annuity Due: Payments or receipts occur at
the beginning of each period.

4-28
 Examples of Annuity
 Student Loan Payments
 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings

4-29
 Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Equal Cash Flows
Today Each 1 Period Apart 4-30
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Equal Cash Flows
Today Each 1 Period Apart 4-31
 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

4-32
Future value of an Annuity

4-33
 Future Value of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n
i%

PMT PMT
. . .
PMT
PMT = Periodic
Cash Flow

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

+ ... + PMT(1+i)1 + PMT(1+i)0

4-34
Future Value of an Annuity
formula
 Ordinary Annuity
(1  i)  1
n
FVA  PMT
i

4-35
 Future Value of an Ordinary
Annuity
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
4-36
 Future Value of an
Annuity Due - FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n

PMT
i%
PMT PMT PMT
. . PMT
.

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

+ ... + PMT(1+i)2 + PMT(1+i)1
= FVAn (1+i)
4-37
 Future Value of an
Annuity Due - FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070

$1,145
$1,225

FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3

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

= $1,225 + $1,145 + $1,070

= $3,440
4-38
Future Value of an Annuity
formula
 Ordinary Annuity
(1  i)  1
n
FVA  PMT
i
 Annuity Due

(1 i)  1
n
FVAD  PMT (1  i)
i
4-39
The Present value of an
Annuity

4-40
 Present Value of an Ordinary
Annuity - overview
Cash flows occur at the end of the period
0 1 2 n n+1
i%

PMT PMT
. . PMT
.
PMT = Periodic
Cash Flow
PVAn
PVAn = PMT/(1+i)1 +
PMT/(1+i)2 + ... + PMT/(1+i)n

4-41
Present Value Formula
 Ordinary Annuity
1  (1  i) -n
PVA  PMT
i

3 years $1000 annuity, I =7%

PV = 1000* (1-1.07-3)/0.07

4-42
 Present Value of an Ordinary
Annuity - example
Cash flows occur at the end of the period
0 1 2 3 4
7%

$1,000 $1,000 $1,000

$ 934.58
$ 873.44
$ 816.30
$2,624.32 = PVA3 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 4-43
 Present Value of an Annuity
Due - overview
Cash flows occur at the beginning of the period
0 1 2 n-1 n

PMT
i%
PMT PMT
. . PMT
.

PMT: Periodic
PVADn Cash Flow

PVADn = PMT/(1+i)0 + PMT/(1+i)1 + ... +

PMT/(1+i)n-1 = PVAn (1+i)
4-44
 Present Value of an Annuity
Due - example
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 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
4-45
 Present Value Formula

Ordinary Annuity 1  (1  i) -n

PVA  PMT
i
Annuity Due
1  (1  i)
 -n
PVAD  PMT (1  i)
i
 Perpetuity PV = PMT/i

4-46
 Steps to solve the time value
of money problem
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)

4-47
Mixed Cash Flows

4-48
 Mixed Cash Flow Example

Julie Miller will receive the set of cash

flows below. What is the Present Value at
a discount rate of 10%?
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
4-49
How to solve?

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

4-50
 Piece -at –a- time
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
4-51
 Group-at –a- time
0 1 2 3 4 5
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
4-52
 Group -at –a- time
0 1 2 3 4

$400 $400 $400 $400

$1,268.00
0 1 2 PV0 equals
Plus
$200 $200 $1677.30.
$347.20
0 1 2 3 4 5
Plus
$100
$62.10
4-53
 PV of an 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
4-54
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.)
4-55
Frequency of Compounding –
Classification of Interest rate

4-56
 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
4-57
 Frequency of Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FVn: FV at the end of Year n
PV0: PV of the Cash Flow today

4-58
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)
= 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2)(2)
= 1,262.48

4-59
 Impact of Frequency
Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+ [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+[.12/365])(365)(2)
= 1,271.20

4-60
 Quarterly Compounding
Inputs 2(4) 12/4 -1,000 0
N I/Y PV PMT FV
Compute 1266.77

The result indicates that a $1,000

investment that earns a 12% annual rate
compounded quarterly for 2 years will
earn a future value of $1,266.77.
4-61
 Daily Compounding
Inputs 2(365) 12/365 -1,000 0
N I/Y PV PMT FV
Compute 1271.20

The result indicates that a $1,000

investment that earns a 12% annual rate
compounded daily for 2 years will earn a
future value of $1,271.20.
4-62
 Classifications of interest rates
 Nominal rate (iNOM) – also called the quoted or
state 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.
4-63
 Classifications of interest rates
 Effective (or equivalent) annual rate (EAR =
EFF%) – the annual rate of interest actually being
earned (paid) after adjusting the nominal rate for
factors such as the number of compounding
periods per year.
 EAR % for 10% semiannual investment
EFF% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 – 1 = 10.25%
 Should be indifferent between receiving 10.25%
annual interest and receiving 10% interest,
compounded semiannually. 4-64
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).
 See how the effective return varies between
investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
4-65
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.
4-66
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.

4-67
 What’s the FV of a 3-year $100
annuity, if the quoted interest rate is
10%, compounded semiannually?

0 1 2 3 4 5 6
5%

100 100 100

 Payments occur annually, but compounding

occurs every 6 months.
 Cannot use normal annuity valuation
techniques.

4-68
 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
4-69
Method 2:
Financial calculator
 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

4-70
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

4-71
Loan amortization

4-72
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.
PMT = 1000/((1-1.1-3)/0.1) = 402.11
PMT: (1) Interest; (2) Principal
Interest = interest rate * beginning balance
T=1: Interest = 10% * 1000 = $100 4-73
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

4-74
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

4-75
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

4-76
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
4-77
Constructing an amortization table:
Repeat steps 1 – 4 until end of loan
END
Year BEG BAL PMT INT PRIN BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTAL 1,206.34 206.34 1,000 -

 Interest paid declines with each payment as

the balance declines. What are the tax
implications of this?
4-78
 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.
4-79
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?

4-80
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

4-81
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

4-82
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 1,487,262

N I/YR PV PMT FV
OUTPUT -11,154.42

4-83