Principles of

Managerial Finance
9th Edition

Chapter 5

Time Value of Money

 Learning Objectives
• Discuss the role of time value in finance and the use
of computational aids used to simplify its application.
• Understand the concept of future value, its calculation
for a single amount, and the effects of compounding
interest more frequently than annually.
• Find the future value of an ordinary annuity and an
annuity due and compare these two types of annuities.
• Understand the concept of present value, its
calculation for a single amount, and its relationship to
future value.
 Learning Objectives
• Calculate the present value of a mixed stream of cash
flows, an annuity, a mixed stream with an embedded
annuity, and a perpetuity.

• Describe the procedures involved in:

– determining deposits to accumulate a future sum,

– loan amortization, and

– finding interest or growth rates

 The Role of Time Value in Finance
• Most financial decisions involve costs & benefits that
are spread out over time.
• Time value of money allows comparison of cash flows
from different periods.

Question?
Would it be better for a company to invest
$100,000 in a product that would return a total of
$200,000 in one year, or one that would return
$500,000 after two years?
 The Role of Time Value in Finance
• Most financial decisions involve costs & benefits that
are spread out over time.
• Time value of money allows comparison of cash flows
from different periods.

Answer!
It depends on the interest rate!
 Basic Concepts
• Future Value: compounding or growth over time

• Present Value: discounting to today’s value

• Single cash flows & series of cash flows can be

considered

• Time lines are used to illustrate these relationships

Computational Aids

• Use the Equations

• Use the Financial Tables

• Use Financial Calculators

• Use Spreadsheets
 Computational Aids

Time Line
Time line depicting an investment’s cash flows
 Computational Aids

Compounding and Discounting

Time line showing compounding to find future value and
discounting to find present value
 Computational Aids

Financial Table
 Computational Aids

Calculator Keys
Important financial keys on the typical calculator
 Simple Interest
With simple interest, you don’t earn interest on
interest.

• Year 1: 5% of $100 = $5 + $100 = $105

• Year 2: 5% of $100 = $5 + $105 = $110

• Year 3: 5% of $100 = $5 + $110 = $115

• Year 4: 5% of $100 = $5 + $115 = $120

• Year 5: 5% of $100 = $5 + $120 = $125

 Compound Interest
With compound interest, a depositor earns interest
on interest!

• Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00

• Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25

• Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76

• Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55

• Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

 Time Value Terms

• PV0 = present value or beginning amount

• r = interest rate

• FVn = future value at end of “n” periods

• n = number of compounding periods

• CF = an annuity (series of equal payments or

receipts)
 Basic Models

• FVn = 𝑃𝑉0 1 + 𝑟 𝑛 = PV(FVIFk,n)

𝐹𝑉𝑛
• PV0 = = FV(PVIFk,n)
1+𝑟 𝑛

• Ordinary Annuities

𝐶𝐹
• FVAn = 𝑟
× 1+𝑟 𝑛
−1 = A(FVIFAk,n)

𝐶𝐹 1
• PVAn = × 1− = A(PVIFAk,n)
𝑟 1+𝑟 𝑛
 Basic Models

• FVn = 𝑃𝑉0 1 + 𝑟 𝑛 = PV(FVIFk,n)

𝐹𝑉𝑛
• PV0 = = FV(PVIFk,n)
1+𝑟 𝑛

• Annuity Dues

𝐶𝐹
• FVAn = 𝑟
× 1+𝑟 𝑛
−1 × 1+𝑟

𝐶𝐹 1
• PVAn = × 1− × 1+𝑟
𝑟 1+𝑟 𝑛
 Future Value Example
Algebraically and Using FVIF Tables

You deposit $2,000 today at 6%

interest. How much will you have in 5
years?

$2,000 x (1.06)5 = $2,000 x FVIF6%,5

$2,000 x 1.3382 = $2,676.40
 Future Value Example
Using Excel

You deposit $2,000 today at 6%

interest. How much will you have in 5
years?

PV $ 2,000 Excel Function

k 6.00%
=FV (interest, periods, pmt, PV)
n 5
FV? $2,676 =FV (.06, 5, , 2000)
Future Value Example
A Graphic View of Future Value
 Present Value
• Present value is the current dollar value of a future
amount of money.
• It is based on the idea that a dollar today is worth
more than a dollar tomorrow.
• It is the amount today that must be invested at a given
rate to reach a future amount.
• It is also known as discounting, the reverse of
compounding.
• The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return,
and the cost of capital.
 Present Value Example
Algebraically and Using PVIF Tables

How much must you deposit today in order to

have $2,000 in 5 years if you can earn 6%
interest on your deposit?

$2,000 x [1/(1.06)5] = $2,000 x PVIF6%,5

$2,000 x 0.74758 = $1,494.52
 Present Value Example
Using Excel

How much must you deposit today in order to

have $2,000 in 5 years if you can earn 6%
interest on your deposit?

FV $ 2,000 Excel Function

k 6.00%
=PV (interest, periods, pmt, FV)
n 5
PV? $1,495 =PV (.06, 5, , 2000)
Present Value Example
A Graphic View of Present Value
 Annuities
• Annuities are equally-spaced cash flows of equal size.

• Annuities can be either inflows or outflows.

• An ordinary (deferred) annuity has cash flows that

occur at the end of each period.

• An annuity due has cash flows that occur at the

beginning of each period.

• An annuity due will always be greater than an

otherwise equivalent ordinary annuity because interest
will compound for an additional period.
Annuities
Future Value of an Ordinary Annuity
Using the FVIFA Tables

• Annuity = Equal Annual Series of Cash Flows

• Example: How much will your deposits grow to if you
deposit $100 at the end of each year at 5% interest for
three years.
FVA = 100(FVIFA,5%,3) = $315.25

Year 1 $100 deposited at end of year = $100.00

Year 2 $100 x .05 = $5.00 + $100 + $100 = $205.00
Year 3 $205 x .05 = $10.25 + $205 + $100 = $315.25
Future Value of an Ordinary Annuity
Using Excel

• Annuity = Equal Annual Series of Cash Flows

• Example: How much will your deposits grow to if you
deposit $100 at the end of each year at 5% interest for
three years.

PMT $ 100 Excel Function

k 5.0% =FV (interest, periods, pmt, PV)
n 3
FV? $ 315.25 =FV (.06, 5,100, )
 Future Value of an Annuity Due
Using the FVIFA Tables

• Annuity = Equal Annual Series of Cash Flows

• Example: How much will your deposits grow to if you
deposit $100 at the beginning of each year at 5%
interest for three years.

FVA = 100(FVIFA,5%,3)(1+k) = $330.96

FVA = 100(3.152)(1.05) = $330.96

 Future Value of an Annuity Due
Using Excel

• Annuity = Equal Annual Series of Cash Flows

• Example: How much will your deposits grow to if you
deposit $100 at the beginning of each year at 5%
interest for three years.
PMT $ 100.00 Excel Function
k 5.00% =FV (interest, periods, pmt, PV)
n 3
=FV (.06, 5,100, )
FV $315.25
FVA? $ 331.01 =315.25*(1.05)
Present Value of an Ordinary Annuity
Using PVIFA Tables
• Annuity = Equal Annual Series of Cash Flows
• Example: How much could you borrow if you could
afford annual payments of $2,000 (which includes
both principal and interest) at the end of each year for
three years at 10% interest?

PVA = 2,000(PVIFA,10%,3) = $4,973.70

Present Value of an Ordinary Annuity
Using Excel
• Annuity = Equal Annual Series of Cash Flows
• Example: How much could you borrow if you could
afford annual payments of $2,000 (which includes
both principal and interest) at the end of each year for
three years at 10% interest?

PMT $ 2,000 Excel Function

I 10.0% =PV (interest, periods, pmt, FV)
n 3
PV? $4,973.70 =PV (.10, 3, 2000, )
 Present Value of a Mixed Stream
Using Tables
• A mixed stream of cash flows reflects no particular
pattern
• Find the present value of the following mixed stream
assuming a required return of 9%.
Year Cash Flow PVIF9%,N PV
1 400 0.917 $ 366.80
2 800 0.842 $ 673.60
3 500 0.772 $ 386.00
4 400 0.708 $ 283.20
5 300 0.650 $ 195.00
PV $1,904.60
 Present Value of a Mixed Stream
Using EXCEL
• A mixed stream of cash flows reflects no particular
pattern
• Find the present value of the following mixed stream
assuming a required return of 9%.
Year Cash Flow
1 400
2 800
Excel Function
3 500
4 400 =NPV (interest, cells containing CFs)
5 300
=NPV (.09,B3:B7)
NPV $1,904.76
 Present Value of a Perpetuity
• A perpetuity is a special kind of annuity.

• With a perpetuity, the periodic annuity or cash flow

stream continues forever.
PV = CF/r
• For example, how much would I have to deposit today
in order to withdraw $1,000 each year forever if I can
earn 8% on my deposit?

PV = $1,000/.08 = $12,500
 Compounding More Frequently
than Annually
• Compounding more frequently than once a year
results in a higher effective interest rate because you
are earning on interest on interest more frequently.

• As a result, the effective interest rate is greater than

the nominal (annual) interest rate.

• Furthermore, the effective rate of interest will increase

the more frequently interest is compounded.
Compounding More Frequently
than Annually

𝑟 𝑚×𝑛
𝐹𝑉𝑛 = 𝑃𝑉 × 1 +
𝑚

General equation for compounding more

frequently than annually

m = number of times per year interest is compounded

 Compounding More Frequently
than Annually
• For example, what would be the difference in future
value if I deposit $100 for 5 years and earn 12%
annual interest compounded (a) annually, (b)
semiannually, (c) quarterly, an (d) monthly?

Annually: 100 x (1 + .12)5 = $176.23

Semiannually: 100 x (1 + .06)10 = $179.09
Quarterly: 100 x (1 + .03)20 = $180.61
Monthly: 100 x (1 + .01)60 = $181.67
 Compounding More Frequently
than Annually

On Excel
Annually Sem iAnnually Quarterly Monthly
PV $ 100.00 $ 100.00 $ 100.00 $ 100.00
k 12.0% 0.06 0.03 0.01
n 5 10 20 60
FV $176.23 $179.08 $180.61 $181.67
 Continuous Compounding
• With continuous compounding the number of
compounding periods per year approaches infinity.
• Through the use of calculus, the equation thus
becomes:

FVn (continuous compounding) = 𝑃𝑉 × 𝑒 𝑟×𝑛

where “e” has a value of 2.7183.
• Continuing with the previous example, find the Future
value of the $100 deposit after 5 years if interest is
compounded continuously.
 Continuous Compounding
• With continuous compounding the number of
compounding periods per year approaches infinity.
• Through the use of calculus, the equation thus
becomes:

FVn (continuous compounding) = 𝑃𝑉 × 𝑒 𝑟×𝑛

where “e” has a value of 2.7183.

FVn = 100 x (2.7183).12x5 = $182.22

 Nominal & Effective Rates
• The nominal interest rate is the stated or contractual
rate of interest charged by a lender or promised by a
borrower.

• The effective interest rate is the rate actually paid or

earned.

• In general, the effective rate > nominal rate whenever

compounding occurs more than once per year
𝑟 𝑚
𝐸𝐴𝑅 = 1 + −1
𝑚
 Nominal & Effective Rates
• For example, what is the effective rate of interest on
your credit card if the nominal rate is 18% per year,
compounded monthly?

EAR = (1 + .18/12) 12 -1
EAR = 19.56%
Special Applications of Time Value

1. Determining deposits needed to

accumulate a future sum
2. Loan amortization
3. Finding interest or growth rates
4. Finding an unknown number of periods
Determining Deposits Needed to
Accumulate a Future Sum
𝐹𝑉𝑛
𝐶𝐹 =
1+𝑟 𝑛−1
𝑟
Note:
This is a derivation from the formula for
future value of an ordinary annuity

𝐶𝐹 𝑛
𝐹𝑉𝑛 = × 1+𝑟 −1
𝑟
Loan Amortization
 Loan Amortization

𝑃𝑉 × 𝑟
𝐶𝐹 =
1
1− 𝑛
1+𝑟
Note:
This is a derivation from the formula for
present value of an ordinary annuity

𝐶𝐹 1
𝑃𝑉𝑛 = × 1− 𝑛
𝑟 1+𝑟
 Determining Interest or Growth Rates
• At times, it may be desirable to determine the
compound interest rate or growth rate implied by a
series of cash flows.

• For example, you invested $1,000 in a mutual fund in

1994 which grew as shown in the table below?
1994 $ 1,000 It is first important to note
1995 1,127 that although there are 7
1996 1,158 years show, there are only 6
1997 2,345
time periods between the
1998 3,985
initial deposit and the final
1999 4,677
value.
2000 5,525
 Determining Interest or Growth Rates
• At times, it may be desirable to determine the
compound interest rate or growth rate implied by a
series of cash flows.

• For example, you invested $1,000 in a mutual fund in

1994 which grew as shown in the table below?
1994 $ 1,000
1995 1,127 Thus, $1,000 is the present
1996 1,158 value, $5,525 is the future
1997 2,345 value, and 6 is the number
1998 3,985 of periods. Using Excel,
1999 4,677 we get:
2000 5,525
 Determining Interest or Growth Rates
• At times, it may be desirable to determine the
compound interest rate or growth rate implied by a
series of cash flows.

• For example, you invested $1,000 in a mutual fund in

1994 which grew as shown in the table below?
1994 $ 1,000
1995 1,127 PV $ 1,000
1996 1,158
1997 2,345
FV $ 5,525
1998 3,985 n 6
1999 4,677
k? 33.0%
2000 5,525
 Determining Interest or Growth Rates
• At times, it may be desirable to determine the
compound interest rate or growth rate implied by a
series of cash flows.

• For example, you invested $1,000 in a mutual fund in

1994 which grew as shown in the table below?
1994 $ 1,000
1995 1,127 Excel Function
1996 1,158
1997 2,345 =Rate(periods, pmt, PV, FV)
1998 3,985
=Rate(6, ,1000, 5525)
1999 4,677
2000 5,525
Determining Interest or Growth Rates

1
𝐹𝑉𝑛 𝑛
𝑟= −1
𝑃𝑉
Note:
This is a derivation from the general formula for
future value at the end of period n

𝑛
𝐹𝑉𝑛 = 𝑃𝑉 × 1 + 𝑟
 Finding an Unknown Number of
Periods, n, Single Amount
• Sometimes it is necessary to calculate the number of
time periods needed to generate a certain future
amount from an initial investment

Years for a Present Value to Grow to a Specified Future Value

Present value (deposit) $ 1,000
Annual rate of interest, compounded annually 8%
Future value $ 2,500
Number of years 11.91
 Finding an Unknown Number of
Periods, n, Single Amount
𝐹𝑉𝑛
log
𝑛= 𝑃𝑉
log 1 + 𝑟
Note:
This is a derivation from the general formula for
future value at the end of period n

𝐹𝑉𝑛 = 𝑃𝑉 × 1 + 𝑟 𝑛
 Finding an Unknown Number of
Periods, n, Ordinary Annuity
• Sometimes it is necessary to calculate the number of
time periods needed to reach an amount equivalent to
an initial investment from a series of cash flows.

Years to Pay Off a Loan

Annual payment $ 4,800
Annual rate of interest, compounded annually 11%
Present value (loan principal) $ 25,000
Number of years to pay off the loan 8.15
 Finding an Unknown Number of
Periods, n, Ordinary Annuity
1
log 𝑟
1 − 𝑃𝑉𝑛 ×
𝑛= 𝐶𝐹
log 1 + 𝑟
Note:
This is a derivation from the formula for
present value of an ordinary annuity

𝐶𝐹 1
𝑃𝑉𝑛 = × 1− 𝑛
𝑟 1+𝑟