Financial Management: Core Concepts

Fourth Edition

Chapter 3
The Time Value of Money
(Part 1)

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3.1 Future Value and Compounding
Interest
• The value of money at the end of the stated period is
called the future or compound value of that sum of money.
– Determine the attractiveness of alternative investments.
– Figure out the effect of inflation on the future cost of assets, such
as a car or a house.

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3.1 (A) The Single-Period Scenario
FV = PV + PV × interest rate, or
FV = PV(1 + interest rate)
(in decimals)

Example 1: Let’s say John deposits $200 for a year in an

account that pays 6% per year. At the end of the year, he will
have:
FV = $200 + ($200 × 0.06) = $212
= $200(1.06) = $212

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3.1 (B) The Multiple-Period Scenario
FV = PV × (1 + r)n
Example 2: If John closes out his account after 3 years, how
much money will he have accumulated? How much of that is
the interest-on-interest component? What about after 10
years?
FV3 = $200(1.06)3 = $200 × 1.191016 = $238.20
where, 6% interest per year for 3 years = $200 × 0.06 × 3 = $36
Interest on interest = $238.20 − $200 − $36 = $2.20
FV10 = $200(1.06)10 = $200 × 1.790847 = $358.17
where, 6% interest per year for 10 years = $200 × 0.06 × 10 = $120
Interest on interest = $358.17 − $200 − $120 = $38.17

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3.1 (C) Methods of Solving Future Value
Problems (1 of 6)
• Method 1: The formula method
– Time-consuming, tedious

• Method 2: The financial calculator approach

– Quick and easy

• Method 3: The spreadsheet method

– Most versatile

• Method 4: The use of Time Value tables:

– Easy and convenient but most limiting in scope

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3.1 (C) Methods of Solving Future Value
Problems (2 of 6)
Example 3: Compounding of Interest
Let’s say you want to know how much money you will have
accumulated in your bank account after 4 years, if you
deposit all $5,000 of your high-school graduation gifts into an
account that pays a fixed interest rate of 5% per year. You
leave the money untouched for all four of your college years.

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3.1 (C) Methods of Solving Future Value
Problems (3 of 6)
Example 3: Answer
Formula method:
FV = PV × (1 + r)n → $5,000(1.05)4 = $6,077.53
Calculator method:
PV = −5,000; N = 4; I ÷ Y = 5; PMT = 0; CPT FV = $6077.53
Spreadsheet method:
Rate = 0.05; Nper = 4; Pmt = 0; PV = −5,000; Type = 0; FV = 6077.53
Time value table method:
FV = PV(FVIF, 5%, 4) = 5000 × (1.215506) = 6077.53,
where (FVIF, 5%,4) = Future value interest factor listed under the 5%
column and in the 4-year row of the Future Value of $1 table.

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3.1 (C) Methods of Solving Future Value
Problems (4 of 6)
Example 4: Future Cost due to Inflation
Let’s say that you have seen your dream house, which is
currently listed at $300,000, but unfortunately, you are not in
a position to buy it right away and will have to wait at least
another 5 years before you will be able to afford it. If house
values are appreciating at the average annual rate of
inflation of 5%, how much will a similar house cost after 5
years?

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3.1 (C) Methods of Solving Future Value
Problems (5 of 6)
Example 4: Answer
PV = current cost of the house = $300,000;
n = 5 years;
r = average annual inflation rate = 5%.
Solving for FV, we have
FV = $300,000 × (1.05)(1.05)(1.05)(1.05)(1.05)
= $300,000 × (1.276282)
= $382,884.5
So the house will cost $382,884.5 after 5 years
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3.1 (C) Methods of Solving Future Value
Problems (6 of 6)
Calculator method:
PV = −300,000; N = 5; I ÷ Y = 5; PMT = 0;
CPT FV = $382,884.5
Spreadsheet method:
Rate = 0.05; Nper = 5; Pmt = 0; PV = −$300,000;
Type = 0; FV = $382,884.5
Time value table method:
FV = PV(FVIF, 5%, 5) = 300,000 × (1.27628) = $382,884.5;
where (FVIF, 5%,5) = Future value interest factor listed under
the 5% column and in the 5-year row of the future value of $1
table = 1.276
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3.2 Present Value and Discounting
• Involves discounting the interest that would have been
earned over a given period at a given rate of interest.
• It is therefore the exact opposite or inverse of calculating
the future value of a sum of money.
• Such calculations are useful for determining today’s price
or the value today of an asset or cash flow that will be
received in the future.
• The formula used for determining PV is as follows:
PV = FV × 1 ÷ (1 + r)n

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3.2 (A) The Single-Period Scenario
When calculating the present or discounted value of a future
lump sum to be received one period from today, we are
basically deducting the interest that would have been earned
on a sum of money from its future value at the given rate of
interest.
i.e., PV = FV ÷ (1 + r) → since n = 1
So, if FV = 100; r = 10%; and n = 1;
PV = 100 ÷ 1.1 = 90.91

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3.2 (B) The Multiple-Period Scenario
When multiple periods are involved…
The formula used for determining PV is as follows:
PV = FV × 1 ÷ (1 + r)n
where the term in brackets is the present value interest
factor for the relevant rate of interest and number of periods
involved, and is the reciprocal of the future value interest
factor (FVIF)

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3.2 Present Value and Discounting (1 of 3)
Example 5: Discounting Interest
Let’s say you just won a jackpot of $50,000 at the casino and
would like to save a portion of it so as to have $40,000 to put
down on a house after 5 years. Your bank pays a 6% rate of
interest. How much money will you have to set aside from
the jackpot winnings?

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3.2 Present Value and Discounting (2 of 3)
Example 5: Answer
FV = amount needed = $40,000
N = 5 years; Interest rate = 6%;
• PV = FV × 1 ÷ (1 + r)n
• PV = $40,000 × 1 ÷ (1.06)5
• PV = $40,000 × 0.747258
• PV = $29,890.33 → Amount needed to set aside today

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3.2 Present Value and Discounting (3 of 3)
Calculator method:
FV 40,000; N = 5; I ÷ Y = 6%; PMT = 0;
CPT PV = −$29,890.33
Spreadsheet method:
Rate = 0.06; Nper = 5; Pmt = 0; Fv = $40,000; Type = 0;
Pv = −$29,890.33
Time value table method:
PV = FV(PVIF, 6%, 5) = 40,000 × (0.7473) = $29,892
where (PVIF, 6%,5) = Present value interest factor listed
under the 6% column and in the 5-year row of the Present
Value of $1 table = 0.7473
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3.2 (C) Using Time Lines (1 of 2)
• When solving time value of money problems, especially
the ones involving multiple periods and complex
combinations (which will be discussed later) it is always a
good idea to draw a time line and label the cash flows,
interest rates and number of periods involved.

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3.2 (C) Using Time Lines (2 of 2)
Figure 3.1 Time Lines of Growth Rates (top) and Discount
Rates (bottom) Illustrate Present Value and Future Value

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3.3 One Equation and Four Variables
• Any time value problem involving lump sums—i.e., a single
outflow and a single inflow—requires the use of a single
equation consisting of four variables i.e., PV, FV, r, n
• If three out of four variables are given, we can solve the
unknown one.
FV = PV × (1 + r)n → solving for future value
PV = FV × [1 ÷ (1 + r)n] → solving for present value
r = [FV ÷ PV]1÷n − 1 → solving for unknown rate
n = [ln(FV ÷ PV) ÷ ln(1 + r)] → solving for # of periods

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3.4 Applications of the Time Value of
Money Equation
• Calculating the amount of saving required for retirement
• Determining future value of an asset
• Calculating the cost of a loan
• Calculating growth rates of cash flows
• Calculating number of periods required to reach a financial
goal.

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Example 3.3 Saving for Retirement (Present
Value) (1 of 3)
Problem: Your retirement goal is $2,000,000. The bank is
offering you a certificate of deposit that is good for 40 years at
6.0%. What initial deposit do you need to make today to reach
your $2,000,000 goal at the end of 40 years?
Solution: The following time line illustrates the problem.

We designate today as T0 and our future date 40 years later

as T40.
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Example 3.3 Saving for Retirement (Present
Value) (2 of 3)
Method 1: Using the equation

1
PV = $2,000,000  40
= $2,000,000  0.0972 = $194,444.38
1.06

Method 2: Using the TVM keys

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Example 3.3 Saving for Retirement (Present
Value) (3 of 3)
Method 3: Using a spreadsheet

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Example 3.4 Let’s Make a Deal! (Future
Value) (1 of 4)
Problem: In 1867, Secretary of State William H. Seward
purchased Alaska from Russia for the sum of $7,200,000, or
about two cents per acre. At the time, the deal was dubbed
Seward’s Folly, but from our vantage point today, did Seward
get a bargain after all? What would it cost today if the land
were in exactly the same condition as it was 148 years ago
and the prevailing interest rate over this time were 4%?

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Example 3.4 Let’s Make a Deal! (Future
Value) (2 of 4)
Solution: At first glance, it seems as if we have a present value
problem, not a future value problem, but it all depends on where
we are standing in reference to time. Phrasing this question
another way, we could ask, “What will the value of $7,200,000 be
in 148 years at an annual interest rate of 4%?” Restated this way,
we can more easily view the problem as a future value problem. A
time line is particularly helpful in this instance. We can show the
148-year span from T−148 to T0 or from T0 to T148.

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Example 3.4 Let’s Make a Deal! (Future
Value) (3 of 4)
Method 1: Using the equation

FV = PV  (1 + r ) n = $7, 200, 000 1.04148

= $7, 200, 000  313.8442 = $2, 389, 278,156

Method 2: Using the TVM keys

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Example 3.4 Let’s Make a Deal! (Future
Value) (4 of 4)
Method 3: Using a spreadsheet

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Example 3.5 What’s the Cost of That Loan?
(Interest Rate) (1 of 3)
Problem: John, a college student, needs to borrow $5,000
today for his tuition bill. He agrees to pay back the loan in a
lump-sum payment 5 years from now, after he is out of
college. The bank states that the payment will need to be
$7,012.76. If John borrows the $5,000 from the bank, what
interest rate is he paying on his loan?
Solution: A time line is helpful in this instance.

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Example 3.5 What’s the Cost of That Loan?
(Interest Rate) (2 of 3)
Method 1: Using the equation
1/ n 1/ 5
 FV   $7,012 .76 
r =  −1 =   −1
 PV   $5,000 
= 1.40255 0.2 − 1 = 0.07 or 7%

Method 2: Using the TVM keys

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Example 3.5 What’s the Cost of That Loan?
(Interest Rate) (3 of 3)
Method 3: Using a spreadsheet

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Example 3.6 Boomtown, USA (Growth
Rate) (1 of 3)
Problem: You are the planning commissioner for Boomtown, a growing
city in the Southwest. The city council has estimated that the city’s
population will increase very rapidly over the next 20 years, reaching an
estimated 250,000. Today the population is 94,222. What is the projected
growth rate of this city?
Solution: Here the present value is the current population of Boomtown:
94,222. The future value is the projected 250,000 population. The period
is 20 years. See the time line.

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Example 3.6 Boomtown, USA (Growth
Rate) (2 of 3)
Method 1: Using the equation
1/20
 250, 000 
r =  − 1 = 2.65331/20 − 1 = 1.05 − 1 = 0.05 or 5.0%
 94, 222 

Method 2: Using the TVM keys

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Example 3.6 Boomtown, USA (Growth
Rate) (3 of 3)
Method 3: Using a spreadsheet

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Example 3.7 When Will I Be Rich?
(Waiting Time) (1 of 3)
Problem: Your goal in life is to be a millionaire. Today your
financial portfolio is worth $3,733.24. Having studied this chapter
carefully and being a shrewd investor, you determine that you can
earn 15% every year on your portfolio. You do not plan to invest
any additional money in this portfolio, nor will you withdraw any
funds from it before it grows to $1 million. Given your 15% interest
rate, how long will you have to wait to become a millionaire if this
investment represents all your wealth?
Solution: See the time line.

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Example 3.7 When Will I Be Rich?
(Waiting Time) (2 of 3)
Method 1: Using the equation

ln($1,000,000 / $3,733.24) ln(267.8638) 5.59

n= = = = 40.00
ln(1.15) ln(1.15) 0.1398

Method 2: Using the TVM keys

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Example 3.7 When Will I Be Rich?
(Waiting Time) (3 of 3)
Method 3: Using a spreadsheet

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3.5 Doubling of Money: The Rule of 72
• The Rule of 72 estimates the number of years required to
double a sum of money at a given rate of interest.
– For example, if the rate of interest is 9%, it would take 72÷9 → 8
years to double a sum of money.

• Can also be used to calculate the rate of interest needed

to double a sum of money by a certain number of years.
– For example, to double a sum of money in 4 years, the rate of
return would have to be approximately 18% (i.e., 72÷4 = 18).

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Additional Problems with Answers
Problem 1
Joanna’s Dad is looking to deposit a sum of money
immediately into an account that pays an annual interest rate
of 9% so that her first-year college tuition costs are provided
for. Currently, the average college tuition cost is $15,000 and
is expected to increase by 4% (the average annual inflation
rate). Joanna just turned 5, and is expected to start college
when she turns 18. How much money will Joanna’s Dad
have to deposit into the account?

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Additional Problems with Answers
Problem 1 (Answer) (1 of 2)
Step 1. Calculate the average annual college tuition cost
when Joanna turns 18, i.e., the future compounded value
of the current tuition cost at an annual increase of 4%.

PV = −15,000; n = 13; I = 4%; PMT = 0; CPT FV = $24,976.10

OR

FV= $15,000 × (1.04)13 = $15,000 × 1.66507 = $24,976.10

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Additional Problems with Answers
Problem 1 (Answer) (2 of 2)
Step 2. Calculate the present value of the annual tuition
cost using an interest rate of 9% per year.

FV = 24,976.10; n = 13; I = 9%; PMT = 0;

CPT PV = $8,146.67
(rounded to 2 decimals)
OR
PV = $24,976.10 × (1 ÷ (1 + 0.09)13 = $24,976.10 × 0.32618
= $8,146.67
So, Joanna’s Dad will have to deposit $8,146.67 into the
account today so that she will have her first-year tuition
costs provided for when she starts college at the age of 18.
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Additional Problems with Answers
Problem 2
Bank A offers to pay you a lump sum of $20,000 after 5
years if you deposit $9,500 with them today. Bank B, on the
other hand, says that they will pay you a lump sum of
$22,000 after 5 years if you deposit $10,700 with them
today. Which offer should you accept, and why?

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Additional Problems with Answers
Problem 2 (Answer) (1 of 2)
To answer this question, you have to calculate the rate
of return that will be earned on each investment and
accept the one that has the higher rate of return.

Bank A’s Offer:

PV = −$9,500; n = 5; FV = $20,000; PMT = 0;
CPT I = 16.054%
OR
Rate = (FV ÷ PV)1÷n − 1 = ($20,000 ÷ $9,500)1÷5 − 1
= 1.16054 − 1 = 16.054%

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Additional Problems with Answers
Problem 2 (Answer) (2 of 2)
Bank B’s Offer:

PV = −$10,700; n = 5; FV = $22,000; PMT = 0;

CPT I = 15.507%
OR

Rate = (FV÷PV)1÷n − 1 = ($22,000÷$10,700)1÷5 − 1

= 1.15507 − 1 = 15.507%
You should accept Bank A’s offer, since it provides a
higher annual rate of return, i.e., 16.05%.
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Additional Problems with Answers
Problem 3
You have decided that you will sell off your house, which is
currently valued at $300,000, at a point when it appreciates
in value to $450,000. If houses are appreciating at an
average annual rate of 4.5% in your neighborhood, for
approximately how long will you be staying in the house?

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Additional Problems with Answers
Problem 3 (Answer)
PV = −300,000; FV = 450,000; I = 4.5%; PMT = 0;
CPT n = 9.21 years or 9 years and 3 months

OR

n = [ln(FV ÷ PV)] ÷ [ln(1 + i)]

n = [ln(450,000 ÷ (300,000]) ÷ [ln(1.045)]
= 0.40547 ÷ 0.04402 = 9.21 years

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Additional Problems with Answers
Problem 4
Your arch-nemesis, who happens to be an accounting major,
makes the following remark, “You finance types think you
know it all…well, let’s see if you can tell me, without using a
financial calculator, what rate of return would an investor
have to earn in order to double $100 in 6 years?” How would
you respond?

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Additional Problems with Answers
Problem 4 (Answer) (1 of 2)
Use the rule of 72 to silence him once and for all, and
then prove the answer by compounding a sum of money
at that rate for 6 years to show him how close your
response was to the actual rate of return…Then ask him
politely if he would like you to be his “lifeline” on “Who
Wants to be a Millionaire?”
Rate of return required to double a sum of money = 72÷N
= 72÷6 = 12%
Verification: $100(1.12)6 = $197.38…which is pretty close
to double

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Additional Problems with Answers
Problem 4 (Answer) (2 of 2)
The accurate answer would be calculated as follows:

PV = −100; FV = 200; n = 6; PMT = 0; I = 12.246%

OR
r = (FV ÷ PV)1÷n − 1 = (200 ÷ 100)1÷6 − 1
= 1.12246 −1 = 0.12246 or 12.246%

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Additional Problems with Answers
Problem 5
You want to save $25,000 for a down payment on a house.
Bank A offers to pay 9.35% per year if you deposit $11,000
with them, while Bank B offers 8.25% per year if you invest
$10,000 with them. How long will you have to wait to have
the down payment accumulated under each option?

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Additional Problems with Answers
Problem 5 (Answer)
Bank A

FV = $25,000; I = 9.35%; PMT = 0; PV = −11,000;

CPT N = 9.18 years

Bank B

FV = $25,000; I = 8.25%; PMT = 0; PV = −10,000;

CPT N = 11.558 years

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Table 3.1 Annual Interest Rates at 10% for $100
Initial Deposit (Rounded to Nearest Penny)
Blank Beginning Accumulated Interest on Interest on Ending
Balance Interest Principal Interest Balance
Year 1 $100.00 — $10.00 — $110.00
Year 2 $110.00 $10.00 $10.00 $1.00 $121.00
Year 3 $121.00 $21.00 $10.00 $2.10 $133.10
Year 4 $133.10 $33.10 $10.00 $3.31 $146.41
Year 5 $146.41 $46.41 $10.00 $4.64 $161.05
Year 6 $161.05 $61.05 $10.00 $6.11 $177.16
Year 7 $177.16 $77.16 $10.00 $7.71 $194.87
Year 8 $194.87 $94.87 $10.00 $9.49 $214.36
Year 9 $214.36 $114.36 $10.00 $11.43 $235.79

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Table 3.2 Variable Match for Calculator
and Spreadsheet

Excel Spreadsheet
Variable TI Calculator TVM Keys Variable Names
Number of periods N Nper
Interest rate I/Y (annual rate) Rate (periodic rate)
Present value PV Pv
Payment PMT Pmt
Future value FV Fv

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Table 3.3 Doubling Time in Years for Given
Interest Rates
Doubling by Rule of Doubling by
Interest Rate 72 Equation Difference
2% 36.00 35.00 1.00
4% 18.00 17.67 0.33
6% 12.00 11.90 0.10
8% 9.00 9.01 0.01
10% 7.20 7.27 −0.07
12% 6.00 6.12 −0.12
14% 5.14 5.29 −0.15
16% 4.50 4.67 −0.17
18% 4.00 4.18 −0.18
20% 3.60 3.80 −0.20
24% 3.00 3.22 −0.22
30% 2.40 2.64 −0.24

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Copyright

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