CHAPTER
Applying Time
Value Concepts 2
$100,000
TODAY
OR…..
20 YEARS
Personal Finance
Plan and Manage
•Spending
•Financing
•Investing
•Risk
Personal Finance
• Loans
• Mortgages
• Annuities
• Insurance
• Pensions
• Bonds
• GICs
Interest
A fee charged for the use of money
• Income to the lender
• Expense to the borrower
Simple Interest
Short-term investments and loans
Determining Simple Interest
Principal
Rate
Time
1. Principal
Amount loaned
• An Investment for the Lender
Amount borrowed
• A Debt for the Borrower
2. Rate
Percentage
Expressed as an annual rate (per annum)
3. Time
The term
Expressed in years
Simple Interest Calculation
I = Interest Earned ($)
P = Principal
r = Annual Interest Rate
t = Time in Years
Simple Interest Calculation
Simple Interest Example (page 22)
• Farah deposits $1,000 in a high-interest account
paying 3 percent annual simple interest
• End of year one the bank credits Farah’s account
with $30, calculated as:
I Prt
$30 $1000 0.03 1
Compound Interest
Investments and loans
• Term exceeds one year
Interest
• Calculated periodically
• Converted to principal
• Capitalization
Compound Interest
Compound Interest
Compound Interest
Compound Interest Example (page 23)
• Farah deposits $1,000 in a compound interest
savings account paying 3 percent
• Interest compounded annually
Accumulated Account
Year Principal Interest
Interest Balance
1 $1,000.00 $30.00 $30.00 $1,030.00
2 $1,030.00 $30.90 $60.90 $1,060.90
3 $1,060.90 $31.83 $92.73 $1,092.73
Compound Interest
Solving Time Value of Money problems:
• Formulas
• Tables
• Financial calculator
Lump Sum
Annuity
Future Value of a Present Lump Sum
Calculating the maturity value of a lump sum
• Deposited today
Compounding
Future Value of a Present Lump Sum
nt
i
FV PV 1
n
FV = Future Value
PV = Present Value
i = Annual Interest Rate
n = Compounding Periods Per Year
t = Time in Years
Future Value of a Present Lump Sum
Future Value Example (page 24)
• Calculate how much money Farah will have in
her savings account if she keeps it open for 20
years (note: n =1)
nt
i
FV PV 1
n
FV PV(1 i ) $1000 (1 0.03) $1806.11
t 20
Future Value of a Present Lump Sum
Future Value Interest Factor (FVIF)
• Factor multiplied by today’s savings to determine
how the savings will accumulate over time
• Depends on the interest rate and the number of
years the money is invested
SEE FVIF Table on pages 26 and 27
• Columns list interest rates in percentages
• Rows list time periods in years
Future Value of a Present Lump Sum
Future Value Example (page 25)
• How much money will you have in five years if
you invest $5,000 now and earn an annual return
of 9 percent.
Using The Financial Calculator
Texas Instruments BA-II Plus
N I/Y PV PMT FV
N Number of Periods
I/Y Interest Rate Per Year
PV Present Value (time 0)
PMT Payments
FV Future Value
Future Value of a Present Lump Sum 29
The Rule of 72
The Rule of 72
Present Value of a Future Lump Sum
Calculating today’s value of a lump sum
• To be received at a future date
Discounting
Present Value of a Future Lump Sum
Discounting
• The process of obtaining present values
FV
PV nt
i
1
n
Present Value of a Future Lump Sum
Present Value Example (page 30)
• What amount invested today will equal $20,000 in
3 years if compounded annually at 3%?
FV
PV nt
i
1
n
$20 000
$18 302.83
(1 0.03) 3
Present Value of a Future Lump Sum
Present Value Interest Factor (PVIF)
• A factor multiplied by the future value to
determine the present value of that amount.
• Depends on the interest rate and the number of years
the money is invested
SEE PVIF Table on pages 31 and 32
• Columns list interest rates in percentages
• Rows list time periods in years
Present Value of a Future Lump Sum
Present Value Example (page 33)
• Accumulate $50,000 in five years by making a
single deposit today
• Projected rate of return is 8% annually
Using The Financial Calculator
Texas Instruments BA-II Plus
N I/Y PV PMT FV
N Number of Periods
I/Y Interest Rate Per Year
PV Present Value (time 0)
PMT Payments
FV Future Value
Present Value of a Future Lump Sum 33
Annuity
Series of equal $ cash flow payments
Paid or received at equal intervals of time
Future Value of an Annuity
Sum of the future values of each payment
• Calculated at end of the last payment period
Payment stream is NOT an annuity if:
• Amounts are not equal or
• Payment intervals are not the same
Future Value of an Annuity
Ordinary Annuity
• Series of equal cash flows received or paid at
equal intervals at the end of each period
Annuity Due
• Series of equal cash flows received or paid at
equal intervals at the beginning of each period
Future Value of an Annuity
Timelines
• Diagrams illustrating payments received or paid
periodically over time
Timeline Example (page 34)
• Planned investment of $100 at the end of every
year for three years
• Annual interest rate expectation of 10 percent
compounded annually
Future Value of an Ordinary Annuity 34
Future Value of an Ordinary Annuity
(1 i ) 1 n
FV PMT
i
(1 0.10) 1 3
$331 $100
0.10
Future Value of an Annuity Due
Annuity due formula
• Multiply the future value of an annuity by (1+i)
Future Value of an Annuity Due 35
$100 invested at the beginning of each year
Future Value of an Annuity Due
Future Value of an Annuity
Future Value Interest Factor for an Annuity
• FVIFA
• Factor multiplied by the periodic savings level
(annuity) to determine future accumulation
• Depends on the interest rate and the number of
years the money is invested
SEE FVIFA Table on pages 36 and 37
• Columns list interest rates
• Rows list time periods
Future Value of an Annuity
Future Value of Annuity Example (page 35)
• A lottery winner will receive $150,000 at the end
of every year for the next 20 years
• The payments represent an ordinary annuity
• Invested at an interest rate of 7 percent
FVA PMT FVIFAi ,n
FVA PMT FVIFA7%,20
$6 149 250 $150 000 40.995
Using The Financial Calculator
Texas Instruments BA-II Plus
N I/Y PV PMT FV
N Number of Periods
I/Y Interest Rate Per Year
PV Present Value (time 0)
PMT Payments
FV Future Value
Future Value of an Annuity 38
Present Value of an Ordinary Annuity
Sum of present values of each payment
Evaluated at start of first payment period
Present Value of an Ordinary Annuity 40
Present value of annuity calculated by
adding the discounted individual cash
flows
Present Value of an Ordinary Annuity
1
1 n
( 1 i )
P V P M T
i
1
1 3
(1 0 .1 0 )
$ 2 4 8 .6 9 $ 1 0 0
0 .1 0
•For an Annuity Due multiply by (1 + i)
Present Value of an Ordinary Annuity
Present Value Interest Factor for an Annuity
• PVIFA
• Factor multiplied by a periodic cash flow
(annuity) to determine the present value of the
annuity
• Depends on the interest rate and the number of
years of cash flow
SEE PVIFA Table on pages 41 and 42
• Columns list interest rates
• Rows list time periods
Present Value of an Ordinary Annuity
Present Value Example (page 43)
• A lottery winner will receive $82,000 at the end of
every year for the next 25 years
• A financial firm offers a lump sum of $700,000 in
exchange for these payments
• If the lump sum can be invested at 9%
compounded annually should winner accept the
offer?
Present Value of an Ordinary Annuity
Present Value Example (page 43)
PVA PMT PVIFAi , n
PVA PMT PVIFA9%,25
$805 486 $82 000 9.823
Using The Financial Calculator
Texas Instruments BA-II Plus
N I/Y PV PMT FV
N Number of Periods
I/Y Interest Rate Per Year
PV Present Value (time 0)
PMT Payments
FV Future Value
Present Value of an Ordinary Annuity 43-44
B
Cash Flow Worksheet
Computing Irregular & Uneven Cash Flows
• Net present value (NPV)
• Total present value of all cash flows, including inflows
(cash received) and outflows (cash paid out). A
positive NPV value indicates a profitable investment.
• Internal rate of return (IRR)
• Interest rate at which the net present value of the cash
flows is equal to 0.
Cash Flow Worksheet
For unequal cash flows
• To access the Cash Flow worksheet and initial cash flow
value (CFo), press: CF
• To access the cash flow amount and frequency variables
(Cnn/Fnn), press: or
• To access the discount rate variable (I), press: NPV
• To compute net present value (NPV), press: or:
and: CPT for each variable.
• To compute the internal rate of return (IRR), press: IRR
Using The Financial Calculator
Texas Instruments BA-II Plus
2ND CF NPV IRR
CF Cash Flow Worksheet
NPV Net Present Value
IRR Internal Rate of Return
Cash Flow Worksheet
Example 1: Solve for Unequal Cash Flows
• Enter and edit unequal cash flow data to calculate:
• Net present value (NPV)
• Internal rate of return (IRR)
• A company pays $7,000 for a new machine, plans a 20%
annual return on the investment, and expects these
annual cash flows over the next six years:
Year Cash Flow Number Cash Flow Estimate
Purchase CFo -$7,000
1 C01 $3,000
2–5 C02 $5,000
6 C03 $4,000
• Cash flows are equal and unequal.
• Initial cash flow (CFo) is negative (outflow).
Entering Cash Flow Data
Entering Cash Flow Data
Compute NPV and IRR
7,625.99
$7,625.99.
55.63
55.63%.
Interest Rate Conversion
Nominal Interest Rate
• Stated, quoted, published or advertised
• Annual Percentage Rate (APR)
• Does not reflect the effect of compounding
Interest Rate Conversion
Effective Interest Rate
• Actual rate of interest earned or paid
• Effective Yield (EY)
• Reflects the effect of compounding
Interest Rate Conversion
Convert nominal interest rates to effective
interest rates using the following formula:
i
n
EY 1 1
n
Interest Rate Conversion
Effective yield of 10 percent compounded
semi-annually:
0.10 2
.1025 1 1
2
= 10.25%
Interest Rate Conversion
Equivalent effective interest rates for various
nominal interest rates:
Nominal Interest Rate Effective Interest Rate
10% compounded annually 10.00%
10% compounded semi-annually 10.25%
10% compounded quarterly 10.38%
10% compounded monthly 10.47%
10% compounded weekly 10.51%
10% compounded daily 10.52%
Interest Rate Conversion 46
