Time Value of Money - The $ amount of interest earned

each period is based on the

- The principles and computations used to
balance in the account at the
revalue cash payoffs from different times
beginning of each period, and we
so they are stated in dollars of the same
assume that it is paid at the end of
time period
the period
- A basic financial principle states that, all
o Opportunity cost rate
else =, the sooner cash is received, the
- The rate of return on the best
more valuable it is because the more
available alternative
quickly it can be “put into work”
investment of = risk
(invested) to increase its value
- To determine which payoff is more
• Number of Periods (n)
valuable, the $ payoffs of each option
- “interest payments”
must be compared at the same point in
- Number of periods interest is earned
time
- Rule: $ amounts from different time
periods should never be compared only 4-1 Cash Flow Patterns
when they are stated in dollars at the
• Lump-sum amount
same point in time, such as December
- A single payment (received or
31 of a particular year.
made) that occurs either today or
o Dollars from different time periods
at some date in the future
have opportunities to earn
different amounts (number of
• Annuity
periods) of interest
- Multiple payments of the same
amount over equal time periods
Cash Flow Timeline - Series of equal payments
o Ordinary Annuity
- Graphical representations used to show
- An annuity with payments
timing of cash flows
that occur at the end of each
period

o Annuity Due
- An annuity with payments
that occur at the beginning
• Present Value (PV) of each period
- Beginning amount that can be
invested • Uneven cash flows
- Current value of some future - Multiple payments of different
amount amounts over a period of time

• Future Value (FV)

- Value to which an amount invested
today will grow at the end of n
periods (i.e. years), after accounting
for interest that can be earned
during the investment period
• Rate of Return (r)
- Interest rate paid each period
4-2 Future Value (FV)
- The amount to which a cash flow a
series of cash flows will grow over a
given period of time when
compounded at a given interest rate
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 - We “push forward” the current amount FV3 = $700(1.10)3
by adding interest for each period the
= $700(1.33100)
money can earn interest in the future
o Compounding = $931.70
- the process of determining
the value of which an • Financial Calculator
amount or series of cash flows
will grow in the future when
compound interest is applied
- interest that is earned in prior
years is left to grow along Where:
with the amount that was
originally invested, the N = number of periods interest is paid
interest that is earned in each I/Y = interest rate paid each period
future year increases PV = present (today’s) value of some amount
FV = future value of an amount
PMT = amount of an annuity payment (if the
problem includes such a cash flow pattern)

❖ (Cash outflow) – to pay money

❖ Cash inflow – to receive a benefit
4-2a FV of a Lump-Sum Amount – FVn
• Electronic Spreadsheet

Where:

FV = future value of amount invested today

PV = amount invested today
r = interest rate
n = length of time interest is earned

❖ greater when r is higher or n is greater or

both

Four Ways to Solve Time Value of Money

Problems

• Cash Flow Time Line 1. Set up a table that contains

The FV of $700 invested at 10% per year the data used to solve the problem
for 3 years 2. Click fx and choose function

3. Click the cells containing the

appropriate data to calculate the
answer

Rate (B2)
• Equations Number of periods (B1)
Present value (B3)
Payment (B4) (not used)
Type (B5) (not used)

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4-2b FV of an Ordinary Annuity – FVAn • Financial Calculator

o Ordinary Annuity
- “deferred”
- Payment made at the end of the
period

4-2d FV of an Uneven Cash Flow Strem – FVCFn

What’s the FV of a 3-year Ordinary Annuity of o Annuity
$400 at 5%? - constant/equal amount, payments
that are the same for every period
• Cash Flow Timeline
o Uneven cash flow stream
- uneven/nonconstant cashflows
o Payment (PMT)
- term that designates constant cash
flows – that is, the amount of an
annuity payment
o Cash Flow (CF)
- Cash flows in general
• Equation - includes both uneven cash flows
and annuities
o Terminal Value
- The future value of an uneven cash
flow stream
- Found by compounding each
payment to the end of the stream
and then summing up the future
values
• Financial Calculator
• Cash Flow Timeline

4-2c FV of an Annuity Due – FVA(DUE)n

• Cash Flow Timeline

• Equation Solution

• Equation Solution

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4-3 Present Value (PV)

- The value today – that is, the current • Cash Flow Timeline
value of a future cash flow or series of
What is the PV of $400 due in 3 years if r = 5%?
cash flows
- To compute the PV of a future amount,
we “bring back” the future amount by
taking interest out for each future period
that the money has the opportunity to
earn interest
o Discounting
- “de-interest” the future
amount
• Equation Solution
- The process of determining
the PV of a cash flow or
series of cash flows to be
received (paid) in the
future
- Reverse of compounding

4-3a Present Value of a Lump-Sum Amount –

PV
• Financial Calculator
• Cash Flow Timeline

4-3c PV of an Annuity Due – PVA(DUE)n

• Equation Solution • Cash Flow Timeline

• Financial Calculator

• Equation Solution
4-3b PV of an Ordinary Annuity – PVAn

- PVAn = the present value of an

annuity with n payments
- Each payment is discounted, and
the sum of the discounted payments
is the present value of the annuity

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 • Financial Calculator
4-3b Perpetuities
- Streams of equal payments that are
expected to go on forever
4-3e PV of an Uneven Cash Flow Stream –
PVCFn
• Cash Flow Timeline
• Equation Solution
• Financial Calculator
1. Input in “CF” register:
o CF0 = 0
o CF1 = 400
o CF2 = 300
o CF3 = 250
2. Enter I = 5, then press NPV button to
get NPV = -869.02.
4-3f Comparison of FV with PV – Understanding
the Numbers
- FV amount contains interest while PV
amount does not
4-4 Solving for Interest Rates (r) or Time (n)
4-4a Solving for r
You pay $78.35 for an investment that promises
to pay you $100 per year for the next five
years. What annual rate of return will you earn
on this investment?
• Cash Flow Timeline
• Financial Calculator
4-4b Solving for n
A security costing $68.30 will provide a return
of 10% per year and you want to keep the
investment until it grows to a value of $100.
How long will it take the investment to grow to
$100?
• Cash Flow Timeline
• Financial Calculator
4-5 Annual Percentage Rate (APR) and
Effective Annual Rate (EAR)
o Annual Compounding
- The process of determining the
future (or present) value of a cash
©AAP
 flow or series of cash flows when
interest is paid once per year
o Semiannual Compounding
- The process of determining the
future (or present) value of a cash
flow or series of cash flows when
interest is paid twice per year
4-5a Semiannual and Other Compounding
Periods
The FV of a lump sum be larger if we
compound more often, holding the stated r
constant? Why?
If compounding is more frequent than once a
year—for example, semi-annually, quarterly, or
daily—interest is earned on interest—that is,
compounded—more often.
𝑟𝑆𝐼𝑀𝑃𝐿𝐸
𝑟𝑃𝐸𝑅 =
𝑚 360/365
Where:
rPER = periodic rate, rate of interest paid each
compounding period
rSIMPLE = stated annual interest rate, simple
(noncompounded) annual interest rate
m = number of interest payments per year
𝑛𝑃𝐸𝑅 = 𝑛𝑌𝑅𝑆 𝑥 𝑚
nPER = total number of interest payment during
nYRS years
nYRS = number of periods
m = number of interest payments per year
❖ rPER = rSIMPLE and nPER = nYRS when interest
is compounded annually
❖ rPER < rSIMPLE and nPER > nYRS when interest
is compounded more than once per
year
4-5b Comparison of Different Interest Rates
- $ interest earned on an investment is
greater when the interest is computed
(compounded) more than once per
year
- Effective return earned on an investment
is higher than the stated rate (rSIMPLE)
• Simple (Quoted) Rate (rSIMPLE)
- “periodic rate”
- used to compute the interest paid
per period
- Written/stated into contracts, quoted
by banks and brokers. Not used in
calculations or shown on time lines
- Periods per year (m) must also be
given
𝑟
- Periodic rate = rPER = 𝑆𝐼𝑀𝑃𝐿𝐸
𝑚
o m = number of compounding periods
per year
m Compounding
4 Quarterly
12 Monthly
daily
- Examples:
8%, compounded quarterly
rPER = 8/4 = 2%
8%, compounded daily (365 days)
rPER = 8/365 = 0.021918%
• Effective Annual Rate (rEAR)
- the annual rate of interest actually
being earned
- Used to compare returns on
investments with different payments
per year
- The annual rate that causes PV to
grow to the same FV as under multi-
period compounding
- The rate that would produce the
same future value when annual
interest compounding exists
How do we find rEAR for a simple rate of 10%,
compounded semi-annually?
©AAP
 𝑟𝑆𝐼𝑀𝑃𝐿𝐸 𝑚 • Financial Calculator
𝑟𝐸𝐴𝑅 = (1 + ) −1
𝑚
0.10 2
= (1 + ) −1
2
= 10.25%

• Annual Percentage Rate (APR)

𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑟𝑎𝑡𝑒 • Amortization Schedule
𝑟𝑆𝐼𝑀𝑃𝐿𝐸 = - A schedule showing precisely how a
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
- “simple rate" loan will be repaid
- One of the rates reported to you by - Gives the payment required on
lenders when you borrow money each payment date and a
- Noncompounded interest rate breakdown of the payment,
because it does not consider the showing how much is interest and
effect of compounding when how much is repayment of principal
interest is paid more than once per
year
o rPER: Used in calculations, shown
on time lines.
❖ if compounding occurs more than once
per year, the effective annual rate is o To find payment
greater than the simple interest rate 𝑟
𝑅 = 𝐴[ ]
(rEAR>rSIMPLE) 1 − (1 + 𝑟)−𝑛
Where:
4-6 Amortized Loans R = monthly payment
- A loan that is repaid in equal payments A = loan’s initial amount
over its life r = monthly interest rate
- Payments include both interest and n = total number of payments
repayment of debt
- Payments represent an ordinary annuity o To find interest
because each payment is made at the 𝐼 = 𝑃𝑖
end of the year
- Amortization tables are widely used for Where:
𝑟
home mortgages, auto loans, business 𝒊=
𝑚
loans, retirement plans, and so forth to
determine how much of each payment m = annually (1), semiannually (2),
represents principal repayment and quarterly (4), monthly (12)
how much represents interest ❖ For succeeding periods use remaining
balance
An amortization schedule for a $15,000, ❖ To get remaining balance
8 percent loan that requires three equal annual = 𝑃𝐵𝐸𝐺 − 𝑃𝑇𝐴𝐵𝐿𝐸
payments.
o To find principal
• Cash Flow Timeline 𝑃 = 𝑃𝑚𝑡 − 𝐼

Where:

Pmt = payment

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Future Value Uneven Cash Flow Stream

Lump-Sum Amount 1 1 0
𝑃𝑉𝐶𝐹𝑛 = 𝐶𝐹1 ( ) + ⋯ + 𝐶𝐹𝑛 ( )
(1 + 𝑟)1 (1 + 𝑟)𝑛
𝐹𝑉𝐿𝑆 = 𝑃𝑉(1 + 𝑟)𝑛
Rate

Ordinary Annuity 𝑛 𝐹𝑉
𝑟= √ −1
𝑟 𝑛𝑚 𝑃𝑉
(1 + ) −1
𝐹𝑉𝑂𝐴 = 𝑃𝑀𝑇 [ 𝑚 ]
𝑟 Time
𝑚
𝐹𝑉
log [ ]
𝑛= 𝑃𝑉
Annuity Due log(1 + 𝑟)

𝑟 𝑛𝑚
(1 + ) −1 𝑟
𝐹𝑉𝐴𝐴𝐷 = 𝑃𝑀𝑇 {[ 𝑚 ] 𝑥 (1 + )}
𝑟 𝑚 Annual Interest Rate to Periodic Rate
𝑚 Conversion
𝑟𝑆𝐼𝑀𝑃𝐿𝐸
𝑟𝑃𝐸𝑅 =
𝑚
Uneven Cash Flow Stream
𝑛𝑃𝐸𝑅 = 𝑛𝑌𝑅𝑆 𝑥 𝑚
𝐹𝑉𝐶𝐹𝑛 = 𝐶𝐹1 (1 + 𝑟)𝑛−1 + ⋯ + 𝐶𝐹𝑛 (1 + 𝑟)0

Effective Annual Rate

Present Value
𝑟𝑆𝐼𝑀𝑃𝐿𝐸 𝑚
Lump-Sum Amount 𝑟𝐸𝐴𝑅 = (1 + ) −1
𝑚
= (1 + 𝑟𝑃𝐸𝑅 )𝑚 − 1
𝑃𝑉𝐿𝑆 = 𝐹𝑉(1 + 𝑟)−𝑛

Amortization
Ordinary Annuity
Payment
𝑟 −𝑛𝑚
1 − (1 + )
𝑃𝑉𝑂𝐴 = 𝑃𝑀𝑇 [ 𝑚 ] 𝑟
𝑟 𝑅 = 𝐴[ ]
𝑚 1 − (1 + 𝑟)−𝑛

Interest

Annuity Due 𝐼 = 𝑃𝑖

𝑟 −𝑛𝑚 Principal
1 − (1 + ) 𝑟
𝑃𝑉𝐴𝐷 = 𝑃𝑀𝑇 [ 𝑚 ] 𝑥 (1 + )
𝑟 𝑚 𝑃 = 𝑃𝑚𝑡 − 𝐼
𝑚

Perpetuities
𝑃𝑀𝑇
𝑃𝑉𝑃 =
𝑟

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