8299 PDF Eng

that
Finance
Mihir A. Desai, Series Editor
+ INTERACTIVE ILLUSTRATIONS
Time Value
of Money
TIMOTHY A. LUEHRMAN
8299 | Published: December 22, 2015
This document is authorized for use only in Carlos Huertas Salgado's Decisiones financieras en marketing (MDM) 2023-1 at CESA - Colegio de Estudios Superiores de Administracion from
May 2023 to Nov 2023.
Table of Contents
1 Introduction ..................................................................................................................................................................................... 3
2 Essential Reading ..................................................................................................................................................................... 4
2.1 Present and Future Value Over a Single Period ................................................................. 4
2.2 Compounding and Discounting Over Multiple Periods............................................ 6
2.3 Multiple Cash Flows and Multiple Periods .................................................................................. 8
2.4 The Frequency of Compounding and Discounting..................................................... 13
2.5 Perpetuities and Annuities ........................................................................................................................... 19
Perpetuities ......................................................................................................................................................................... 19
Annuities ................................................................................................................................................................................. 21
Comparing Annuities and Perpetuities ........................................................................................ 27
Growing Perpetuities ............................................................................................................................................ 29
3 Supplemental Reading.................................................................................................................................................. 33
3.1 Using Excel Functions PV, FV, and PMT .................................................................................... 33
4 Key Terms ....................................................................................................................................................................................... 40
5 Notation............................................................................................................................................................................................. 43
6 Practice Questions.............................................................................................................................................................. 43
7 Index....................................................................................................................................................................................................... 44
This reading contains links to online interactive illustrations, denoted by the icon
above. To access these exercises, you will need a broadband Internet connection.
Verify that your browser meets the minimum technical requirements by visiting
http://hbsp.harvard.edu/tech-specs.
Former Harvard Business School professor Timothy A. Luehrman developed this
Core Reading with the assistance of writer Barbara Wall Lobosco, HBS MBA 1995.
Copyright © 2015 Harvard Business School Publishing Corporation. All rights reserved.
8299 | Core Reading: TIME VALUE OF MONEY 2

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1 INTRODUCTION
T
his chapter introduces the economics and mathematics of the time value of
money: the idea that money has earning potential, so the timing of a payment
matters. It is better to receive a sum of money today than to receive the same sum
tomorrow because it can be invested and earn interest. Given an interest rate, we can
calculate the present value of a sum to be received in the future or, alternatively, the
future value of a sum invested today.
The notion of interest-bearing loans dates back many thousands of years to ancient
agricultural societies in which “money” was grain and a farmer might borrow a portion at
planting time, repaying the “loan” with a larger amount of grain at harvest time. As gold and
other forms of money became more common mediums for exchange, basic credit and investing
practices became more common as well. A merchant or family with more than enough wealth to
meet its own immediate needs could earn a return on it by lending money at interest. By the
Middle Ages, European banking houses had amassed enormous wealth through active,
continuous borrowing and lending, and banking had become a business. Banks accepted
deposits on which they paid interest, while simultaneously lending the funds at higher rates of
interest. The bank earned the difference between the rate it received and the rate it paid. In this
way, banks financed not only agriculture, but nearly every type of large-scale endeavor
associated with human civilization, including trade, building, arts, exploration, and wars, all
enabled by loans based on the simple idea of the time value of money.
Today, compounding and discounting—the two types of calculations used to determine the
future and present value of money, respectively—are central to many applications in finance,
including, for example: (1) investment finance—the valuation of securities such as stocks,
bonds, and options; (2) corporate finance—the evaluation of corporate projects and even entire
businesses, such as analyses of mergers and acquisitions, private equity transactions, alliances,
and so forth; (3) personal finance—analyses of consumer loans such as home mortgages, car
loans, credit card debt, and savings and retirement plans; and (4) public finance—the economics
of government-sponsored plans such as pensions, healthcare, and unemployment insurance.
Despite this wide variety of issues and applications, the fundamental concepts and
mathematical tools are the same across them all. This reading presents simple examples drawn
mostly from personal finance, but the ideas and formulas are applicable to all of the areas
mentioned above.

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2 ESSENTIAL READING
2.1 Present and Future Value Over a Single Period
The notion that money has time value is a fundamental concept in finance. Someone who has
$1 may consume $1 worth of goods today, or save and invest it for consumption at a later date.
If the dollar is saved at the beginning of the period, it can earn interest at the risk-free interest
rate, r, so its value at the end of the period will be greater than $1. This extra value—the return
on risk-free investing—is time value.
To illustrate, if we invest $100 today at a risk-free rate of 5% per year, the value of our
= $100 ⋅ (1 + 0.05=
investment at the end of one year will be $100 + $100 ⋅ 0.05 ) $105. This $105 is
the future value (FV) of our investment, one period (one year) from now. Its value today ($100)
is its present value (PV). (See Exhibit 1.)
EXHIBIT 1 The Relationship Between Present and Future Values Over a One-Year
Period (assuming a risk-free rate of 5%)
More generally, for a single period:
FV = PV ⋅ (1 + r )
where FV = future value, at the end of the period

PV = present value, at the beginning of the period
r = the risk-free rate of return per period
Conversely, if we are certain to receive $105 one year from today and the risk-free rate is still
5%, then we can use the same relationship to compute its present value today. It must be

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$105 / (1 + 0.05) =
$100 . The value today of $105 to be received one year from now must be less
than $105. In the first instance, we are moving from present to future value; in the second, we
are going from future to present value. In both, we are invoking the simple relationship among
PV , FV , and r , the time value of money over a single period:
FV = PV ⋅ (1 + r )
or equivalently
FV
PV =
1+ r
This equation reflects the fundamental meaning of the familiar saying: “A dollar today is
worth more than a dollar tomorrow.” That is, if you receive the dollar today, you can invest it
and you will have more than a dollar tomorrow. Future and present values are related to one
another by their locations in time and the risk-free rate of interest over that period of time.
Let’s return for a moment to our earlier discussion of the risk-free rate, which we have
defined as the rate on an investment that is free from default risk.a Examples of risk-free
investments include US Treasury securities, which many investors consider to be the closest
thing to a default-risk-free instrument, and certain US government–insured bank deposits.
Throughout this reading the term risk-free rate refers to a nominal rate of return. The
nominal rate of return expressly ignores potential changes in the purchasing power of the
associated currency; that is, we may be certain to receive $105 one year from now, but we are
not guaranteed that the dollar will have the same purchasing power a year from now that it has
today.b We expect investors to care about real returns, so the distinction between real and
nominal returns is an important one in the real world. However, the complication of risks
involving currency values does not change the fundamental principle of time value or the
mathematics of compounding and discounting. Accordingly, in this reading, we will work solely
with nominal cash flows and nominal interest rates.
a
Risk is an important consideration in many financial analyses and will be covered in depth in other Core Readings.
However, to focus first on the basic tools needed to understand the time value of money, risk is mostly ignored in
this reading. To develop tools for discounting and compounding, we work with default-risk-free securities. [We
note, though, that even default-risk-free securities may still be subject to other risks, such as fluctuations in a
currency’s purchasing power: inflation.] Section 2.5 (Perpetuities and Annuities) presents examples in which risk is
present and reflected in interest or discount rates, but does not otherwise affect the structure of the problem or the
necessary calculations.
b
For this reason, the nominal rate is sometimes decomposed into a real rate of return and an inflation rate. The
nominal risk-free rate equals a real risk-free rate plus an inflation rate: r= rr + i , where rr denotes the real (i.e.,
inflation-adjusted) return and i denotes inflation.

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2.2 Compounding and Discounting Over Multiple Periods
If we invest $100 for two periods instead of one, at the end of the second period we will have
$100 ⋅ (1 + r )  ⋅ (1 + r ) or $100 ⋅ (1 + r ) . Not only will we earn interest on $100 for two periods
2
instead of one, but we will also earn interest on interest during the second period. If the risk-free
interest rate is 5% for both periods, we will have $100 ⋅ (1.05 ) =
2
$110.25 at the end of the
second period. After a third period, we will have $110.25 ⋅1.05 = $100 ⋅ (1.05 ) = $115.76 , and so
3
forth. Earning interest on interest, known as compounding, reflects the accumulation of time
value over multiple periods.
Interactive Illustration 1 computes the value of $100 at various points in time—one, two, or
three years into the future (the FV of $100) or one, two, or three years in the past (the PV of
$100) at various rates of interest. At points in the future, the value is greater than the initial $100
investment owing to the effects of compounding. At points in the past, the value is less than
$100 owing to the effects of discounting, the calculation of the (lesser) present value associated
with a given (greater) future value. In discounting calculations the interest rate is often referred
to as the discount rate.
Interactive Illustration 1 starts with a risk-free rate of 5%. Experiment with the effects of
discounting and compounding at different rates by moving the interest rate slider. What effects
do discounting and compounding have on the value of $100 at 0%, 5%, and 10%? When are the
effects greater—at higher or lower interest rates?
INTERACTIVE ILLUSTRATION 1 Time Value of $100 Cash
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2GgnzP5

May 2023 to Nov 2023.
The power of discounting or compounding over a long period is more substantial than many
people realize. Suppose we invested $100 for 30 years at 5% per year. At the end of 30 years, we
would have $100 ⋅ (1.05 ) =
30
$432.19 . The initial investment grows by a factor of more than four,
from $100 to more than $400. Where does this impressive increase come from? Note that 5%
interest on $100 is only $5 per year, and 30 years of such interest is 30 times $5, which equals
$150. But we actually earn more than twice that amount (we earn $432.19 − $100 =
$332.19 )
because of compounding: interest on interest.
Exhibit 2 decomposes the growth of $100 invested at 5% per year for 30 years, showing how
much of the total value each year comprises: (1) principal—the original $100, depicted by the
blue bars; (2) interest on principal, represented by the green bars; and (3) interest on interest,
shown by the yellow bars. The blue bars remain constant at $100. The green bars grow by $5
each year—after 30 years, the green bar has reached $150. But the yellow bars—interest on
interest—grow the fastest. The yellow bar starts at zero, but by year 30 it is larger than either the
blue or the green bars. The longer we continue to invest, the greater the power of compounding.
And at higher rates of interest, the power of compounding develops even earlier.
EXHIBIT 2 The Power of Compounding
To generalize, over T periods of time, the future value of a risk-free investment is computed
by multiplying the original investment (the PV) by a compounding factor equal to (1 + r ) :
T
FV = PV ⋅ (1 + r )
T

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Conversely, we can rearrange this formula to calculate the present value of a sum to be
received T years in the future as
FV
PV =
(1 + r )
T
For example, if we know we will receive $1,000 30 years from now and the risk-free rate is
5%, we can calculate its present value as
FV $1,000
=
PV = = $231.38
(1 + r )T (1.05)
30
In this calculation, we multiplied the future value by a discount factor equal to 1/ (1 + r )T to

calculate the present value today of an amount to be received T periods in the future:
1
Discount=
factor = 0.23138
(1.05)30
Multiplying $1,000 by 0.23138 gives a present value of $231.38.
Now consider a higher risk-free rate, 7.5%, applied to the same $1,000 over T = 30 years. The
effect on the PV is substantial:
1
PV =$1,000 ⋅ =$1,000 ⋅ 0.11422 =$114.22
(1.075)30
The present value is less than half as large at a discount rate of 7.5% as compared to 5%. In
this example, the discount factor went from 1/ (1.05)30 = 0.23138 to 1/ (1.075)30 = 0.11422 and
the PV accordingly fell by more than half, again showing the power of discounting over an
extended period.
2.3 Multiple Cash Flows and Multiple Periods
The same principle of time value and tools for compounding and discounting apply to multiple
cash flows. We simply apply the appropriate discount or compounding factor to each cash flow,
according to its location in time, and then sum the results.
Suppose you wish to buy a house five years from now, and you need to save money for a
down payment of $40,000. You initiate a program today in which you save the same amount
each year and invest it at the risk-free rate of 5%. How much do you need to save each year to
accumulate $40,000 by the end of year 5? Clearly, $8,000 would be more than enough—five

May 2023 to Nov 2023.
years of saving $8,000 per year will amount to $40,000 even without interest. But will $7,000 per
year be enough? Let’s set up the problem in a diagram and a table to find out. Let:
Cf = cash flow saved and invested at the beginning of each year = $7,000
t = yearly points in time, starting today (i.e., t takes values 0 through 5)
T = total number of periods = 5
r = 5%
It is important to be clear about whether each cash flow occurs at the beginning or end of the
period. In this example, we put aside $7,000 now ( t = 0 ) and at the beginning of each
subsequent year. That means we invest the first $7,000 for five years, the second $7,000 for four
years, and so on, with the last $7,000 invested for one year.
EXHIBIT 3 Sample Savings Plan to Buy a House in Five Years
Exhibit 3 uses timelines to depict the save-and-invest scheme. Exhibit 4 lays out the relevant
figures for each year.
EXHIBIT 4 Calculating the Future Value of a Five-Year Savings Plan
Number of Years Future Value at

Point in New Investment in Which Interest Compounding the End of the
Time (yearly) During the Year Is Earned (FV) Factor Program
t Cft T −t (1+ r )T −t FV
0 (today) $7,000 5 1.2763 $8,933.97
1 $7,000 4 1.2155 $8,508.54
2 $7,000 3 1.1576 $8,103.38
3 $7,000 2 1.1025 $7,717.50
4 $7,000 1 1.0500 $7,350.00
5 (total) $40,613.39

May 2023 to Nov 2023.
Exhibit 4 shows that the future value of our save-and-invest scheme will be $40,613 at the end
of five years—more than enough to make the desired down payment. The table shows how long
each year’s savings of $7,000 will be invested at a rate r = 5% from the time it enters the pool
until t = 5 . Each year’s $7,000 of savings is then multiplied by the appropriate compounding
factor. Summing the results gives the future value of $40,613.39.
For multiple periods and multiple cash flows, the accumulated future value at time T of a
series of periodic cash flows is given by:
T −1
Cf 0 (1 + r ) + Cf1 (1 + r ) + ... + CfT −1 (1 + r=
) ∑ Cf (1 + r )
T T −1 T −t
FV=
T t
t =0
where T = the total number of periods (the endpoint)

and t = the date at which a cash flow occurs.
If we put aside the first $7,000 at the end of the first year instead of at the beginning, our
entire save-and-invest plan would be shifted out one year—in effect, it would be a four- rather
than a five-year plan—and would give a different result ($31,679 instead of $40,613 because we
would lose the $8,933.97 associated with investing $7,000 from t = 0 to t = 5 ). This would not
meet our goal for the down payment. Not surprisingly, in time value calculations, the timing of
cash flows is important.
We could use the formula, a table like Exhibit 4, or spreadsheet software such as Excel to
answer “what if” questions, such as, What if the risk-free rate was only 3%? In that case we
would need to save more: $7,315 per year instead of $7,000. Or, What if we needed a down
payment of $50,000 instead of $40,000? At a risk-free rate of 5%, we need to save much more:
$8,618 per year.
Let’s now compute present values instead of future values. What if you are offered a security
that will pay you $100 at the end of each of the next five years, for a total of $500? Such a security
is called an annuity—a constant payment each period for a finite number of periods. How much
should you be willing to pay for it? Clearly it is worth less than $500 because of the time value of
money—you won’t receive all $500 today, so it cannot be worth $500 today.
Interactive Illustration 2 demonstrates the discounting calculations required to compute the

present value of a security that pays $100 per year for five years. When you click “Run,” the
illustration shows how each year’s $100 cash flow is multiplied by the appropriate discount
factor to obtain its present value; the present values of each are summed to give the PV for the
entire security ($432.95 at an interest rate of 5%). Now change the risk-free rate and click “Run”

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again. Higher rates result in lower present values, and vice versa, but the formulas remain the
same.
Note that the discount factor (or PV factor) used in Interactive Illustration 2, 1/ (1 + r )t , has a
value less than 1.0 for each time period. Further, this factor decreases as the rate or the length of
the period increases.
INTERACTIVE ILLUSTRATION 2
Calculating the Present Value of Multiple Cash Flows
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pKuSIo
Interactive Illustration 3 lets you choose either a discounting or a compounding process for
a set of annual cash flows, $100 per year, beginning one year from today. First click on “Present
Value.” The illustration shows each annual cash flow discounted to present value at the rate r
for periods of one to five years, according to when the cash flow is received. To begin, set the
discount rate slider to r = 5% . The illustration shows a present value of $432.95. At lower
discount rates, the present value will be higher—try 3% instead of 5% and observe the present
value rising to $457.97. At a rate of 7%, the present value falls to $410.02.
More generally, the formula for the calculation of the present value (at t = 0 ) of a finite series
of periodic cash flows is given by:
Cf1 Cf 2 Cf 3 CfT
PV= + + + ... +
2
1 + r (1 + r ) (1 + r )3
(1 + r )T

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T
Cf t
PV = ∑
(1 + r )
t
t =1
Present or Future Value of Multiple Cash Flows
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2DYwLp7
Now click on “Future Value.” The illustration computes the value of each $100 cash flow at
the end of year 6—one year after the last cash flow—by applying the appropriate compounding
factors (or FV factors) and summing the result. Just as we saw in Table 1, the compounding
factors are all greater than 1.0, and they increase as the investment horizon lengthens. As you
toggle between present and future values in Interactive Illustration 3, holding the interest rate
constant, observe that the future values are always greater than the present values.
The formulas we have developed for discounting and compounding multiple cash flows over
multiple periods are quite general. The cash flows may be uneven and/or irregular, and the
formulas can easily accommodate this. That is, within the stream of cash flows Cf1 , Cf 2 , Cf 3 ,…,
CfT , all cash flows may be the same or all may be different, and any may be missing (that is,
equal to zero). Further, note that the length of a period may be longer or shorter—a year, six
months, one month, and so forth—as long as the associated discount rate matches the period
(i.e., annual interest rates for yearly discounting, semiannual rates for semiannual discounting,
and so forth). We next turn to the problem of adjusting the length of the compounding or
discounting period.

May 2023 to Nov 2023.
2.4 The Frequency of Compounding and Discounting
So far, all of our examples have utilized annual compounding or discounting. What if we
performed the compounding or discounting more (or less) frequently?
Consider again investing $1,000 for one year—say, in a guaranteed bank deposit—at a rate of
5%. But suppose that instead of paying 5% interest at the end of the year, the bank will pay
interest semiannually. Specifically, the bank agrees to pay 2.5% interest every six months. This is
beneficial, because we will now begin to receive interest on interest after six months instead of
having to wait a whole year. At the end of one year, our deposit is worth $1,000 ⋅1.025 ⋅1.025 or
$1,000 ⋅ (1.025 ) =
2
$1,050.63 . The effective interest rate is 5.063% (i.e., (1.025)2 − 1 =5.063% )
rather than the quoted 5.00% (the 5% rate is often referred to as a simple interest rate). If the
bank offered monthly compounding, we would receive 0.05 /12 = 0.4167% per month for an
annual total of
$1,000 ⋅ (1.004167 ) =$1,000 ⋅1.05117 =$1,051.17

12
Compounding daily, we would receive

365
 0.05 
$1,000 ⋅  1 +  =
$1,051.27.
 365 
For compounding periods less than one year, the formula for the effective annual interest rate is
m
 r 
Effective interest rate =+
1 m  − 1
 
where r is the simple annual rate, and m is the number of compounding periods per year.
As m approaches infinity, the length of each compounding period approaches zero, and the
value of (1 + r m ) approaches e r , where e is the base of the natural logarithm, approximately
m
2.7183.c
When the compounding interval converges to zero, we say that we are compounding
continuously. As always, there is an analogous expression for discounting continuously. One
c
The base of the natural logarithm, e, is an important natural constant, sometimes referred to as Euler’s number. It
was discovered by Jacob Bernoulli in the course of his work on compound interest. It can be defined in many ways,
perhaps most compactly as the sum of the infinite series:
∞
1
e=∑
n
n=0 !

May 2023 to Nov 2023.
dollar received at the end of a year and discounted continuously at the annual rate r has a
present value equal to e −r .
These simple expressions are easily adjusted to reflect continuous compounding and
discounting over longer periods. The future value of $1 compounded continuously for T years
at an annual interest rate r is given by FV = e rT . Suppose r = 5% per year and we want to
compound continuously for 10 years. Then e rT equals 1.649 (i.e., e 0.05×10 = 1.649 ) and the future
value of $1,000 compounded continuously at 5% for 10 years is $1,000 ⋅1.649 =
$1,649 .
The present value of $1 discounted continuously for T years at the annual rate r is given
by PV = e − rT . Accordingly, the continuous discount factor for 5% over 10 years is 0.60653
( = e −0.05×10 ) and the PV of $1,000 to be received at the end of year 10 is
$1,000 ⋅ 0.60653 =
$606.53 .
Why is this useful? Some investments actually are compounded or discounted continuously.
More broadly, continuous compounding/discounting is often a convenient approximation,
because it simplifies mathematics without significantly distorting the economics of the problem
at hand. Perhaps the best example of such use is in option pricing models, some of which are
much simpler mathematically because key variables are compounded or discounted
continuously rather than discretely over time.
Exhibit 5 shows effective annual interest rates at different compounding frequencies, but
now applied to a higher interest rate; r = 10% instead of 5% (the higher rate of 10% magnifies
the compounding factor to highlight differences across interval lengths). As you would expect,
the shorter the compounding interval, the more closely discrete compounding approximates
continuous compounding. In Exhibit 5 the effect of more frequent compounding is greatest
when the compounding period, m , changes from annual to semiannual. Beyond that, the
effective annual rate increases as m increases, but at a diminishing rate. As the frequency goes
from daily to continuous compounding, the difference in the effective annual rate is very small
indeed, even at the higher annual rate of 10%.

May 2023 to Nov 2023.
EXHIBIT 5
The Future Value of $1 Million in One Year at Various Compounding Frequencies
Simple Number of
Interest Compounding m Value of
Rate Periods/Year ⎛ 1+ r ⎞ $1,000,000 at
Compounding Effective Annual
⎝ m⎠
r Frequency m Interest Rate T =1
10% Annual 1 1.100000 10.0000% 1,100,000
10% Semiannual 2 1.102500 10.2500% 1,102,500
10% Quarterly 4 1.103813 10.3813% 1,103,813
10% Monthly 12 1.104713 10.4713% 1,104,713
10% Daily 365 1.105156 10.5156% 1,105,156
10% Continuous ∞ 1.105171 10.5171% 1,105,171
Interactive Illustration 4 lets you observe the discounted or compounded values of $100 at
earlier or later points in time at varying interest rates. Here you can change both the discount
rate and the compounding interval to observe present and future values at different
compounding or discounting frequencies. When does the length of the compounding period
have the greatest effect on future value—at lower or higher interest rates?
Time Value of $100 with Compounding Frequencies
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pKuV72

May 2023 to Nov 2023.
Interactive Illustration 5 lets you compare compounding intervals for a hypothetical bank
balance of $100 earning a specified simple annual interest rate for a single period. Begin with the
annual interest rate slider set at 20% per year and check the “Annual” box for compounding
frequency. The graph shows a future value of $120 after one year (and no interim payments of
interest). Now click “Semiannual” compounding frequency (without deselecting “Annual”). You
can observe an interim interest payment of $10 halfway through the year, which results in a
balance of $110 and interest on interest for the next six months, resulting in an ending value of
$121. Click on each of the compounding frequency boxes in order and observe the
corresponding set of interim interest payments and the resulting higher year-end value. Finally,
try out different interest rates to see how much more significant the compounding frequency is
at higher rates.
INTERACTIVE ILLUSTRATION 5 Effect of Compounding Frequency
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2DXDPmd

May 2023 to Nov 2023.
Equivalent Interest Rate Conversions
We have just seen how a simple annual interest rate implies a higher effective annual
interest rate when the compounding frequency increases. For example, a simple annual
rate of 5% implies an effective annual rate of 5.063% when compounded semiannually.
Given a simple annual rate and a compounding frequency, we can always calculate a
corresponding effective annual rate using the formula in the text.
However another, different, calculation is also common. We can convert a simple annual
interest rate to an equivalent interest rate (for example, a semiannual rate) such that
the future value (or present value if we are discounting) remains unchanged despite the
different compounding (discounting) interval. Put another way, we can set the simple
annual rate equal to the effective annual rate, and then solve for the implied
(“equivalent”) semiannual rate.
To be concrete, let’s return to the example of a bank that pays simple interest of 5.0%
annually on a deposit of $1,000. Suppose we ask the bank to pay us semiannually
instead of annually (we are hoping to receive 2.5% every six months, which we know is
more valuable than 5.0% paid at the end of the year). But the bank understands our
hope and instead offers the following proposition: you, the customer, may name any
compounding frequency you like and we, the bank, will tell you what rate we offer at
that frequency.
The bank can convert its simple 5.0% annual rate to an equivalent rate for any
compounding frequency we may name. If we request semiannual compounding, the
bank will offer a lower interest rate—specifically, 2.4695% per six months instead of 2.5%.
Then at the end of one year our $1,000 deposit will be worth
$1,000 ⋅ (1.024695 ) =
2
$1,050.00 , exactly the same amount as if we had been paid 5.0%
simple interest. The bank can calculate an equivalent semiannual rate that gives exactly
the same future value for our deposit as its simple annual rate. In other words, the bank
can choose a semiannual rate such that the simple rate equals the effective rate. The
equivalent semiannual rate is given by:
1
equivalent semiannual rate =(1 + r ) 2 − 1
where r equals the simple annual rate.
More generally, for higher frequency compounding, the equivalent rate is given by:
1
equivalent rate =(1 + r ) m − 1
where r is again the simple annual rate and m is the number of compounding periods
per year. So if we asked for daily compounding, the bank’s equivalent daily rate will be:
1 1
equivalent daily rate = (1 + r ) m − 1 = (1.05) 365 − 1 = 0.01337%

May 2023 to Nov 2023.
In each case, compounding the equivalent rate at the specified frequency will result in
the simple annual rate of 5%:
semiannual: (1.024695 ) − 1 =
2
5%
daily: (1.0001337)365 − 1 =5%
To summarize, equivalent rates for higher frequency compounding are lower than the
simple annual rates. In contrast, effective annual rates are higher than the simple annual
rates whenever the compounding frequency is greater than once per year.
It may be tempting to ask at this point: Which rate is right? Which should we use? It
depends on what we’re trying to figure out and on how a given rate has been quoted. In
the bank deposit example, it is essential to know how much interest the bank will
actually pay: Is it going to pay half of 5% semiannually, or will it pay 2.4695%? For some
financial instruments, such as corporate bonds or home mortgages, long-standing
conventions and/or regulations may dictate the basis on which interest rates are
quoted or disclosed. For others, there is no substitute for reading the contract carefully
and working out the numbers yourself.
Performing calculations for present and future values by hand or with a handheld calculator
becomes cumbersome for more than a few time periods, but the necessary formulas are easily
programmed in Excel or are accessible as Excel functions. The convenience of Excel’s
preprogrammed functions have made them ubiquitous in many real-world financial analyses,
but using them properly and avoiding errors requires an understanding of the concepts that
underlie them. The concepts are the subject of this reading; see the Supplemental Reading for
notes on compounding and discounting using Excel.

May 2023 to Nov 2023.
2.5 Perpetuities and Annuities
Some cash flow streams have special properties that give rise to simple mathematical formulas
for their present values. We will examine three of them in this section.
Perpetuities
You have already computed the value of an annuity, a fixed amount of cash paid or received
every period for a finite number of periods. Now suppose we received a periodic cash flow, say
$100 per year, forever. Such a stream of payments is called a perpetuity: a perpetual stream of
periodic cash flows. How much would such a stream of cash flows be worth today?
Although perpetual securities are not common, there are some historical examples. As far
back as the eighteenth century and continuing into the twentieth, the British government issued
perpetual bonds called consols (the name is derived from the term “consolidated annuities”).
Consols were used to raise funds immediately for substantial urgent needs, such as waging a
war, but they allowed the government to pay for the funds over the longest possible horizon.
Although few governments or institutions issue such securities today,d the construct of a
perpetuity is quite widely used in finance.
Let’s say we are considering investing in a security that will pay $50 per year forever and that
the risk-free rate is 5%. From our discussion above we know how to express the present value of
this security. We simply apply the correct discount factor to each future payment of $50 and
sum the results:
$50 $50 $50 $50

PV= + + + ... +
1.05 (1.05 ) (1.05 )
2 3
(1.05)
∞
Unfortunately, because the cash flows never stop, neither do the calculations! Fortunately, we
can use the mathematics of an infinite series to derive a compact expression for this sum. See the
accompanying sidebar, “Derivation of the Present Value of a Perpetuity”.
d
In October 2014 the United Kingdom announced it would redeem a portion of the outstanding perpetual debt
issued in connection with World War I.

May 2023 to Nov 2023.
Derivation of the Present Value of a Perpetuity
Suppose a security will pay Cf dollars every year forever. The present value of that
security is calculated by applying the correct discount factor to each future payment, as
usual. We can write this as follows (ignore the color differences for now):
Cf Cf Cf Cf ∞
1
=PV = + + + + Cf ∑ (1)
1 + r (1 + r ) (1 + r )
2 3
(1 + r )
∞
t =1 (1 + r )
t
We can simplify this equation using a math trick. First, multiply each side of the
equation by (1 + r ) , shown in Equation 2 below. Note what happens to the infinite series
when each term is multiplied by (1 + r ) . In the first term, (1 + r ) in the numerator and
denominator cancel, leaving only Cf . In subsequent terms, the exponent in the
denominator is reduced by one.
Cf Cf Cf Cf ∞
1
(1 + r )PV =
Cf + + +
1 + r (1 + r ) (1 + r )
+  + =
Cf + Cf ∑ (2)
(1 + r )
2 3 ∞ t
t =1 (1 + r )
Then we subtract Equation 1 from Equation 2. Note that all the terms in blue cancel,
leaving
(1 + r )PV − PV =
Cf
PV ( (1 + r ) − 1) =
Cf
Therefore, the present value of the security is:
Cf
PV =
r
Using the formula for the present value of a perpetuity,
Cf
PV =
r
it is now easy to calculate that a security paying $50 per year forever has a present value of
$50 / 0.05 = $1,000 . That is, we would be willing to pay $1,000 to own the security.
This result is useful for two reasons. First, there are often situations in finance in which the
simple perpetuity formula is used as an approximation or benchmark. For example, consider a
corporation that continually refinances its debt at maturity and plans to do so indefinitely. (This

May 2023 to Nov 2023.
is not uncommon.) The corporation will receive a corresponding stream of tax benefits
indefinitely because of the deductibility of its interest payments year after year. The value of
these tax benefits is commonly estimated using the simple perpetuity formula. The annual tax
savings is the numerator in the formula; dividing by the discount rate gives the present value of
reducing the company’s taxes by this amount every year indefinitely.
The second reason is that once again we have an interesting property of the time value of
money: Even though the stream of perpetual payments is infinite, its present value is finite.
Payments extremely far in the future have a present value that approaches zero, which results in
a finite value for the perpetuity.
Annuities
Now that we have a simple formula for the present value of a perpetuity, we can derive another
one for an annuity—the finite stream of periodic payments we have already considered. An
annuity is like a perpetuity except that it is missing the infinite “tail” of a perpetuity. But the
infinite tail is itself just another perpetuity, one that starts at a different (later) point in time.
Conceptually, therefore, the present value of an annuity is the difference between the present
values of two perpetuities with different start dates. (See Exhibit 6.)
EXHIBIT 6 An Annuity Is the Difference Between Two Perpetuities

May 2023 to Nov 2023.
To construct an annuity, we begin with a perpetuity. As we have already seen, a perpetuity
has a present value PV = Cf / r , where Cf is the periodic cash flow and r is the discount rate.
To create, say, a 10-year annuity, we subtract all but the first 10 years from the perpetuity.
The annuity’s present value is therefore given by:
Cf
PV (10-year annuity ) = − PV ( perpetuity payments for years 11 − ∞ )
r
Note that the last term is itself a perpetuity, but one that begins in year 11 instead of year 1.
At time T = 10 , this perpetuity has a value equal to Cf / r . Therefore, its present value at time
zero must be (Cf / r ) / (1 + r )10 . Thus, the 10-year annuity has a present value of:
Cf
Cf r
PV (10-year annuity=
) −
r (1 + r )10
More generally, the value of a T-period annuity is given by
Cf
Cf
PV (T -period annuity=
) − r
r (1 + r )T
Sometimes this formula is written:
1 1 
PV (T -period annuit
= y ) Cf  − 
 r r (1 + r )T 
 
The term in brackets is referred to as the annuity factor, which then is simply multiplied by
the periodic cash flow, Cf . Many financial calculators and spreadsheet software programs such
as Excel have been preprogrammed with this annuity factor or formula. See the Supplemental
Reading for notes on using the annuity formula in Excel.
To illustrate, we can use the annuity formula to calculate the present value of the same
annuity we examined above: one that pays $100 every year for five years. Therefore,
Cf
Cf
=
PV − r
r (1 + r )T
where Cf = $100 , r = 5% , and T = 5 years. Substituting, we determine the present value of this
annuity:

May 2023 to Nov 2023.
 $100 
$100  0.05 
PV = − =
$432.95
0.05 (1.05)5
This is the same answer we got in Interactive Illustration 3.
Example: Mortgages
A common type of annuity is a mortgage: a loan secured by a real asset, such as a house, a
building, or commercial equipment. If the borrower fails to make the required payments of
principal and interest, s/he forfeits the asset to the lender. (This risk of nonpayment is an
important consideration for the lender, who will seek both to mitigate it [by investigating the
borrower’s financial health, demanding collateral for the mortgage, assessing the property’s
value, etc.] and to be compensated for bearing it [by charging a higher interest rate for making
riskier loans]. We do not need to worry about exactly how the interest rate reflects the riskiness
of the mortgage—we’ll just use the stipulated rate.)
Many consumer mortgages are fixed-rate amortizing loans. That is, the interest rate, r , and
periodic payments, Cf , remain constant over the life of the loan. Part of each payment to the
lender represents interest for the period and the remainder is a repayment of part of the
principal. These periodic payments of principal amortize the loan, continually reducing the
outstanding principal balance until it is zero at the end of the term. The fixed payments of such
a mortgage make it a type of annuity, just as we’ve described above. But now we’ll use the
annuity formula to find not the PV (which is the known loan amount) but the monthly payment
( Cf ) a borrower must make to cover interest and fully amortize the loan, given a stipulated
annual interest rate. The stipulated rate is analogous to the simple annual rate ( r ) we have been
using; for mortgages it is often called the annual percentage rate, or APR.
Consider a borrower who wishes to purchase a home for $250,000 and will make a down
payment of 20%, or $50,000. The borrower obtains a fixed-rate, 15-year mortgage for the
balance of $200,000. The fixed APR is 4.25%. How much will each monthly payment be?
Because mortgage payments are made each month for 15 years, we have an annuity with
15 ⋅12 =
180 periods. And the interest rate per month will be 1/12th of the APR, or
4.25% ÷ 12 =
0.35417% per month.e
e
This is the standard convention for home mortgages—that the borrower will make payments based on a monthly
interest rate computed as 1/12th of the APR—that will be stated explicitly in the contract. Accordingly, the effective
annual rate will be higher than the APR (the simple annual rate).

May 2023 to Nov 2023.
Now we can use the formula for the value of annuity from above:
1 1 
PV (T -period annuit
= y ) Cf  − 
 r r (1 + r )T 
 
We know the PV is $200,000, r is 4.25% ÷ 12 =

0.35417% , and T is 180 months.
Rearranging to solve for Cf , the monthly mortgage payment, we get:
PV (T -period annuity ) $200,000

=Cf =
1 1 1 1
− −
r r (1 + r )T  4.25%   4.25%  4.25% 180
 12   1+
   12   12 
PV (T -period annuity ) $200,000

=Cf = = $1,504.56
1 1 1 1
− −
r r (1 + r )T
0.0035417 0.0035417 ⋅ (1.0035417)180
The monthly payment of $1,504.56 is fixed, but the proportion of each payment applied to
interest and to principal changes over time. As shown in Exhibit 7, interest will constitute a
higher portion of the annual payment in the earlier years of the loan, when the loan balance is
highest. Over time, as the unpaid balance decreases, the interest expense will decrease and a
higher proportion of the payment will be applied to pay down the principal until the loan is
repaid in full.
EXHIBIT 7
Constant Mortgage Payment Split Between Interest and Principal Payments

May 2023 to Nov 2023.
Interactive Illustration 6 shows how the monthly payment required to service a $100,000
mortgage depends on the term of the loan and interest rate. Start with a 20-year mortgage with a
fixed interest rate of 5%. The monthly payment is $659.96. Notice that the interest portion of
each payment is highest at the beginning and declines over the life of the 20-year loan, starting
at about $400 and declining toward zero at the end of 20 years. Why is this? As the loan is paid
down over time, the amount of interest owed each period also declines; therefore, the portion of
each payment allotted to principal increases from roughly $240 at the start of the loan to almost
100% of the final payment in year 20.
Now increase the interest rate to 7.5% by moving the interest rate slider, and then increase it
to 10%. Note the increase in both the overall amount of the mortgage payment and the higher
proportion of interest in each payment in the early years. At higher interest rates, the curve
separating interest from principal steepens significantly. Experiment by changing the term as
well as the interest rate. What happens to the payment amount when you shorten the term of
the mortgage? To the relationship between principal and interest? To the total amount of
interest paid?
Finally, many home mortgages give the homeowner the option to pay more than the required
monthly amount, with the extra money each month being applied to reduce the principal.
Return the settings to a 5% interest rate and a 20-year term. Use the slider on the vertical axis to
boost the monthly payment from $660 to $1,000. (The illustration assumes this higher amount
is paid every month—in reality, homeowners can choose to pay it some months and not others,
or to change the size of the extra payment each month.) With the higher monthly payment, this
20-year mortgage is actually paid off much faster—in 10 years and 10 months. The actual term
of the loan is much shorter than the 20 years stipulated by the contract. In addition, the total
amount of interest paid over the life of the loan falls from more than $58,000 to less than
$30,000 because the life of the loan is so much shorter.

May 2023 to Nov 2023.
INTERACTIVE ILLUSTRATION 6 Mortgage as an Annuity
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2DYwMtb
Example: Employee Buyout Offer
A company wishing to reduce its headcount has decided to offer certain employees the
opportunity to take early retirement. One of the eligible employees has decided he would indeed
like to retire early. He is 50 years old and has a base salary of $250,000. As an incentive to retire
early, the company has offered him a choice between (A) a lump-sum payment equal to two
years’ base salary, payable today, or (B) a series of monthly payments beginning at age 65 and
lasting 180 months (15 years); during each year, the monthly payments will total 30% of the
employee’s base salary at retirement (that is, $250,000 ⋅ 0.3 =
$75,000 per year, and
$75,000 /12 = $6,250 per month). Assume the correct discount rate for this problem is 4% per
year, and that if the employee dies before age 80, the remaining payments will be made to his
heirs. Should the employee select the lump sum or the deferred annuity?
Let’s assume the retiree will choose the option with the higher present value. (Note, though,
that he might reasonably consider other factors, such as a pressing near-term need for funds to
pay medical bills.) The present value of option A, the lump sum, is easy: it’s
$250,000 ⋅ 2 =$500,000 . Option B is more difficult, because the payments are both delayed (15
years) and spread over time (another 15 years). If not for time value, option B clearly would be
better than option A: It offers $75,000 annually for 15 years for a total of $1,125,000—more than

May 2023 to Nov 2023.
double the lump sum. But its present value must be considerably less; without some calculations
we can’t tell which option is more valuable today.
To find the present value of option B, let’s first use the annuity formula to find the value at
age 65 of the deferred annuity. We need Cf ( = $6,250 ), T ( = 180 months), and r . The value
we use for r must be a monthly rate; if 4% is the correct annual rate, the equivalent monthly
= (1.04)1/12 − 1 . (For more on converting an annual rate to an equivalent monthly
rate is 0.3274%
rate, see the sidebar “Equivalent Interest Rate Conversions.”) Substituting in the annuity
formula:
1 1   1 1 
Cf  −
PV = =$6,250 ⋅  − =$849,059
 r r (1 + r )T   (0.003274) (0.003274) ⋅ (1 + 0.003274 )180 
   
The formula gives a value for the annuity at age 65 of nearly $850,000, still quite a bit more
than the lump sum offered. But the employee must wait 15 years before receiving it. How much
further does this reduce its value? All that’s left is a simple present value calculation. We
discount the annuity’s value at age 65 for 15 years to find its value when the employee retires at
age 50, the same point at which he would receive the lump sum:
$849,059
=PV = $471, 452
(1 + 0.04)15
The present value at age 50 is only about $470,000, which is less than the lump sum.f The
example shows the significance of time value: The present value of the deferred annuity is
nowhere near the total payments of $1.125 million. And now that we have set up the problem,
we can consider other scenarios: What if the payments started at age 60 instead of 65? What if
they were extended or were based on a higher fraction of base salary? And so forth.
Comparing Annuities and Perpetuities
Now that we have some familiarity with both perpetuities and annuities, it is easy to see a
relationship between them: As the term of an annuity increases, its value approaches that of a
perpetuity. Interactive Illustration 7 lets us compare a perpetuity to annuities of varying
lengths. The Illustration shows that the value of a $1,000-per-year annuity converges to the
value of a $1,000-per-year perpetuity as the term of the annuity increases, moving to the right in
the graph. This makes sense, given that an annuity is simply a perpetuity minus part of the
infinite “tail”—the infinite stream of payments.
f
Note we are discounting annually here. We could perform the discounting over 180 months at the equivalent
monthly rate of 0.3274% and arrive at the same result.

May 2023 to Nov 2023.
As you explore the Illustration, begin with the default discount rate of 5%. At 5%, the values
of a 90-year annuity and a perpetuity are about the same, $20,000. What happens as you
increase the discount rate? First, the value of the perpetuity must fall (watch the value in the
yellow box on the left), and second, the convergence between perpetuity and annuity happens
earlier. That is, an annuity with a shorter term will approximate the perpetuity value. Why?
Because as the discount rate rises, cash flows that are far in the future, for both securities,
contribute less to the present value. To see this, raise the discount rate from 5% to 10% to 25%.
At 10%, the value of the perpetuity is only $10,000, which is about the same as the value of a 50-
year annuity. At 25%, the perpetuity is worth only $4,000, about the same as a 20-year annuity.
The opposite happens when the discount rate falls. At a rate of 2%, the perpetuity value is much
higher—$50,000—and even a 100-year annuity still falls well short of this value, at about
$43,000. The two do not converge at all within the 100-year scale of the graph.
Present Values of Perpetuity and Annuities by Term
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2GibV6s

May 2023 to Nov 2023.
Growing Perpetuities
Now let’s return to perpetuities and consider one for which the periodic payment, initially equal
to Cf , increases by a growth rate g per period. As long as g is known and constant and g < r ,
this growing perpetuity also has a convenient compact mathematical formula for its present
value:
Cf
PV =
r−g
Note the similarity between this formula and the one presented above with constant periodic
payments. g When g = 0 the two formulas are identical. Another convenient property of this
formula is that it also works when g < 0 ; that is, when the periodic cash flow is shrinking at a
constant rate. Note that the formula makes no economic sense when g ≥ r . When g = r , the
denominator equals zero and the present value is undefined; when g > r , it gives a negative
present value, which is clearly illogical. Fortunately, this latter circumstance can’t actually occur
in the real world—it is not economically possible for any cash flow to grow faster than the risk-
free rate forever. It would take over the world!
To illustrate the application of the growing perpetuity formula, imagine you are advising a
group of generous alumni who wish to endow a fund for MBA scholarships at their university.
The group envisions awarding a scholarship every year indefinitely. In the first year, the amount
of the scholarship is to be $25,000, but the alumni want it to increase each year by 2% to
partially offset likely increases in tuition. How large a donation must they make? Assume a risk-
free rate of 5%. Using the formula for the present value of a growing annuity, the problem is
simple. The cash flow, Cf , is the beginning scholarship of $25,000 and the growth rate is 2%:
Cf $25,000
=
PV = = $833,333.
r − g 0.05 − 0.02
The alumni will need to donate $833,333 to fully endow the scholarship fund. This
calculation assumes the endowment can be invested in long-term, risk-free securities yielding a
5% return. What if returns are expected to be lower—say, 4%? Then the required endowment
rises significantly, to $1.25 million.
Cf $25,000
=
PV = = $1,250,000.
r − g 0.04 − 0.02
g
You can derive this formula using the same math trick shown in the sidebar “Equivalent Interest Rate Conversions”,
in which we derived the formula for the present value of a non-growing perpetuity. Rewrite the basic PV equation to
account for growth at rate g in the numerator. Then, instead of multiplying both sides of the PV equation by
(1 + r ) , multiply by (1 + g ) / (1 + r ) . Then proceed as in the sidebar to derive the new expression.

May 2023 to Nov 2023.
Example: Credit Card Debt
As a final application, let’s explore credit card debt, a form of consumer borrowing that many
personal finance experts warn can be difficult to escape when overused. Like the home mortgage
we examined above, credit card debt requires monthly payments. But credit card balances aren’t
secured by a parcel of real estate, and the interest rates are generally much higher than mortgage
rates. In the United States, average APRs for all types of consumer credit cards have been about
15% for a long time (though rates for specific cards vary widely), so we’ll assume an APR of 15%
per year. If you pay off your entire balance each month, the credit card issuer (typically a bank)
charges you no interest. But if you don’t pay it off entirely, you owe interest on the unpaid
balance of 15% ÷ 12 =
1.25% per month.h
Since you would quickly be overwhelmed by a debt growing at 15% per year (and
compounding monthly!), most credit card agreements require you to make some minimum
payment each month, part of which covers the interest you owe and the remainder of which
goes toward reducing the principal. The minimum monthly payment is often a percentage—say,
2% of the outstanding balance. Let’s suppose you have a balance of $500 that you would like to
pay off. Your required monthly payment is $10 (2% of $500). If you pay $10 every month, how
long will it take you to pay off the entire $500?
This problem is very much like the mortgage example we looked at earlier: Both are
annuities. Now, though, the constant monthly payment is $10, the monthly interest rate is
1.25%, and we already know the present value of the annuity is $500 (equal to your outstanding
balance). What we don’t know is T , the term of the annuity (i.e., the number of $10 monthly
payments you will need to make to pay off the debt), but we can use the annuity formula to solve
for T , either directly or by trial and error:
1 1 
PV (T -period annuity
= ) Cf  − 
r r (1 + r )T 
 
 1 1 
$500 =⋅$10  − 
 0.0125 0.0125 ⋅ (1.0125 )T 
 
T = 79 months
h
Calculating credit card interest is more complicated than this—it usually requires the calculation of an average daily
balance and corresponding daily interest rates—but the calculations in the text still capture the essence of the
problem and are simpler. The figures in the text also ignore other real-world complications, such as fees and
penalties.

May 2023 to Nov 2023.
Paying off this $500 debt at $10 per month will take 79 months, almost seven years! No
wonder financial advisers warn about carrying large credit card balances and paying only
minimal amounts of principal. Over the 79 months this debt remains outstanding, you will pay
a total of nearly $300 in interest. What if you want to pay it off sooner? Choosing any value for
T , we can use the annuity formula to calculate the required monthly payment to pay off the
loan in T months, just as we did earlier for the 180-month (15-year) mortgage. Exhibit 8 below
shows the result.
EXHIBIT 8
Required Monthly Credit Card Payment for Loan Periods of Varying Lengths
Time to Required
Repay Credit Card Monthly
(months) Balance Payment
Accumulated
(T ) ( PV ) (Cf ) Interest
60 $500 $11.89 $213.70

48 $500 $13.92 $167.94
36 $500 $17.33 $123.98
24 $500 $24.25 $81.84
12 $500 $45.13 $41.55
Paying off the balance faster requires a significantly higher monthly payment. To pay it off in
three years, for example, you have to boost your monthly payment from $10 to $17.33. The
good news, though, is that the total interest you will pay over the now-three-year life of the loan
is only $124, less than half the accumulated interest associated with the $10-per-month plan.
Not surprisingly, the faster you repay the outstanding balance, the less total interest you end up
paying.
So far, so good—we have set up and solved a problem essentially identical to the mortgage
example above. But some credit card agreements don’t require you to pay a fixed dollar amount
each month; instead, they require a minimum payment equal to a fixed percentage—say, 2%—
of the outstanding balance. Your initial minimum payment of $10 represents 2% of $500. Of the
$10 you pay, only $6.25
= ( $500 ⋅ 0.0125 ) represents interest. The remaining $3.75 reduces your
outstanding balance from $500 to $496.25. So next month (assuming you make no new credit
card purchases), your new minimum payment will be 2% of $496.25, or $9.93. Of this $9.93,
part will represent interest (1.25% of $496.25 is $6.20) and the rest principal
( $9.93 − $6.20 =
$3.73 ). So the following month, your outstanding balance goes down again, to

May 2023 to Nov 2023.
$492.53, and so does your minimum payment, to $9.85. This continues as long as you have an
unpaid balance.
Now we can ask a new question: If you make only the 2% minimum payment each month,
how long will it take to pay off the loan? A very long time—forever, in fact! Your outstanding
balance goes down each month, but so does the following month’s payment. You always pay a
small percentage of the loan, but never all of it. In effect, we are looking at a shrinking
perpetuity.
To see this, recall that your first payment was $10, computed as 2% of your balance. Interest
on the loan is likewise computed as a percentage (1.25%) of the balance; if you made no pay-
ment, your balance would grow by 1.25% per month. Put differently, your balance doesn’t
shrink by the 2% you paid but by the net of +1.25% and −2% , or negative 0.75%. To test this
assertion, note that your first payment of $10 was followed by a payment of $9.93. The percent-
age change in the payment is ( $9.93 − $10.00 ) / $10.00 =
−0.0075 , or −0.75% . The following
payment of $9.85 is 0.75% less than $9.93, and so forth. In short, your credit card payments are a
perpetual stream of monthly cash flows with a constant “growth” rate of −0.75% .
We can use the formula for the present value of a growing perpetuity to compute the value of
your shrinking stream of payments:
Cf
PV =
r−g
where now Cf = $10 , r = 1.25% , and g =

1.25% − 2.00% =
−0.75% . Therefore:
Cf $10
=
PV = = $500
r − g 0.0125 − (−0.0075)
This simple calculation does two things. First, it ties perfectly to your loan balance of $500.
This is what we would expect—the present value of all your future payments should equal the
loan balance. Second, it also confirms that the payment policy we’ve proposed means you will
never fully pay it off—it is indeed a perpetuity. Even after making 30 years of minimum monthly
payments, you will still have an outstanding balance of more than $30. And your initial balance
of $500 will have generated accumulated interest payments of about $770!
The considerable amount of accumulated interest points to one of the elements of profit for
the credit card company. The company can earn significant profits if its creditworthy
customers—those who will not miss their payments—carry outstanding balances for long
periods of time.

May 2023 to Nov 2023.
3 SUPPLEMENTAL READING
3.1 Using Excel Functions PV, FV, and PMT
Present or Future Value of Multiple Cash Flows in Excel
Spreadsheet software such as Excel performs compounding and discounting calculations very
quickly and efficiently, in one of two basic ways. First, you can simply type the formulas we
developed above directly into cells in the spreadsheet, using numbers or cell addresses. In this
way, you are programming the analysis yourself and will always be able to check and edit your
formulas.
Alternatively, you can use preprogrammed Excel “functions.” In Excel the mathematics of
compounding and discounting are built into five basic elements that embody the mathematical
formulas for calculating present value, future value, the amount of an annuity payment, the
discounting/compounding interest rate, and the number of periods. As Excel functions, their
symbols are, respectively: PV, FV, PMT, RATE, and NPER. You must input three (or,
optionally, four) terms, and the remaining term is calculated for you by the spreadsheet.
Each element is represented in the timeline below: PV represents the value today of a series of
future cash flows ( Cf t ) occurring at regular intervals from t = 1 to t = T and discounted at a
constant rate of interest. FV represents the future value of that same series of cash flows,
compounded at a constant rate of interest. The Excel function NPER represents the number of
compounding periods.
To use the functions in Excel correctly, it is important to configure the inputs properly over
time, as you might using the timeline discussed above. (Note that the discounting/compounding
rate is not shown on the timeline but is a required input for Excel.)
Exhibit 9 presents the Excel functions used to calculate the future value or present value of a
series of cash flows or the amount of an annuity payment. It also shows how the terms used in
the formulas from this reading map onto the terms employed in the Excel functions. Note that
to use the FV and PV functions in Excel, the periodic cash flows must be constant (i.e., a level-

May 2023 to Nov 2023.
payment annuity); otherwise, each cash flow must be separately valued in Excel and the results
summed to arrive at a final answer. It’s also important to input the interest rate on a basis that
matches the payment period (i.e., monthly rate for monthly payments, annual rate for annual
payments, etc.).
Last, note that in addition to the PV, FV, and PMT functions detailed in Exhibit 9, it is also
possible to solve for NPER (number of periods) or RATE (the periodic
compounding/discounting interest rate).
Excel functions and terms are displayed in red in Exhibit 9.

May 2023 to Nov 2023.
EXHIBIT 9 Selected Excel Functions for Present and Future Value Calculations
Formula Equivalent Excel Function
Future Value: FV(RATE,NPER,PMT,[PV],

For multiple periods and multiple cash flows, the formula for calculating the [Type])i
future value at time T of a series of T periodic cash flows, where r is the where
discount rate and Cf denotes the cash flow or payment, is given by:
T −1
FV = FVT
Cf 0 (1 + r ) + Cf1 (1 + r ) + ... + CfT −1 (1 + r=
) ∑ Cf (1 + r )
T T −1 T −t
FV=
T t
t =0 RATE = r
NPER = T
PMT = Cf t
Present Value: PV(RATE,NPER,PMT,[FV],

The formula for calculating the present value (at t = 0 ) of a series of T [Type])j
periodic cash flows is given by:
where
Cf Cf 2 Cf 2 CfT T
Cf t
PV0 = 1 + 2
+
1 + r (1 + r ) (1 + r )2
+ +
(1 + r )T ∑
=
t =1 (1 + r )
t PV = PV0
RATE = r
NPER = T
PMT = Cf t , beginning at the
end of period 1
Annuity: PMT(RATE,NPER,PV,[FV],
The periodic cash flow associated with an annuity or loan payment is given [Type])k
by:
where
PV (T -year annuity ) PMT = Cf
Cf =
1 1
− RATE = r
r r (1 + r )T
NPER = T
PV = PV (T -year annuity)
i
Where the present value (PV) and Type (“1” for beginning of the period payment or “0” for end of the
period payment) are optional inputs.
j
Where the future value (FV) and Type (“1” for beginning of the period payment or “0” for end of the
k
Where the future value (FV) and Type (“1” for beginning of the period payment or “0” for end of the

May 2023 to Nov 2023.
Finally, a point of clarification is needed regarding the difference between the Excel functions
PV and NPV (for “net present value”). PV calculates the present value of a stream of constant
future cash flows. NPV, which has not been covered in this reading, measures something else. In
finance, NPV measures the wealth created by an investment opportunity, which is equal to the
present value of all future cash inflows and outflows minus the initial investment outlay. In
Excel, the NPV function calculates the present value of a stream of future cash inflows/outflows
at the rate you specify, but it does not reflect the initial investment (unless it is included in the
specified cell range). In the context of this reading, Excel’s NPV function is best used as a way to
calculate the present value of a stream of unequal (or irregular) cash flows (see the examples).
To calculate the present values of constant (equal) cash flows at a constant discount rate, it is
simpler to use the PV function in Excel. NPV is covered in greater detail in Core Reading: Net
Present Value and Capital Budgeting (HBP No. 5176).
Examples
PV or FV of an Annuity (Multiple Cash Flows of Equal Amount)
In Interactive Illustrations 2 and 3, you calculated the present value of a set of annual cash flows
of $100 received over a five-year period (or alternatively, the future value of that stream of cash
flows). Now let’s see how to calculate present and future values using Excel.
Assume you invested $100 per year for ten years at an annual rate of 5%. The chart shows
you the inputs into Excel for RATE, NPER, and PMT, using the FV formula.
Excel syntax =FV(RATE,NPER,PMT,[PV],[Type])
FV RATE NPER PMT [PV] [Type]

?? 5% 10 100 [blank] 0 or [blank]
Inputting these values will return an FV of $1,257.59, because we assumed each cash flow
takes place at the end of the period. (Excel actually returns a value of −$1,257.59 and shows it in
red to reflect the compounded outflow needed to exactly offset the periodic inflows reflected by
“PMT.” Reversing the sign of PMT from positive to negative will reverse the sign of FV from
negative to positive.) Inserting a “1” for “Type” will change the assumption to the beginning of
the period cash flows, which changes the FV result to $1,320.68. The second result is higher
because the funds are invested sooner—at the beginning of the year rather than at the end.

May 2023 to Nov 2023.
Next, let’s calculate the present value of $100 annually over 10 years at 5%. The chart shows
you the inputs into Excel for RATE, NPER, and PMT using the PV formula and assuming an
annual rate of 5%.
Excel syntax =PV(RATE,NPER,PMT,[FV],[Type])
PV RATE NPER PMT [FV] [Type]

?? 5% 10 –100 [blank] 0 or [blank]
Plugging in these values will return a PV of $772.17. (Once again, note that Excel will return
the PV as a negative value, in red, unless you input PMT as a negative number, −100.)
PV or FV of a Series of (Unequal) Multiple Cash Flows
To calculate the PV or FV of a series of unequal cash flows in Excel, simply find the PV or FV of
each individual cash flow and sum them.
Let’s say you have the series of cash flows shown in the chart over five years, each received at
the end of the year, and you want to calculate the present value at the risk-free rate of 5%:
t 1 2 3 4 5
Cft 100 200 300 400 500
EXHIBIT 10
Excel Spreadsheet: Calculating the PV of a Series of (Unequal) Multiple Cash Flows
(1) (2) (3) (4) (5)
PV factor PV
t r Cft 1
Cft × PV factor
(1+ r)t
1 5% 100 0.9524 95.24
2 5% 200 0.9070 181.41
3 5% 300 0.8638 259.15
4 5% 400 0.8227 329.08
5 5% 500 0.7835 391.76
Total $1,256.64

May 2023 to Nov 2023.
In Excel, you would type formulas in the cells of columns 4 and 5, as shown in Exhibit 10.
Summing the PVs in column 5 gives the total PV.
Alternatively, you could use the NPV function to calculate the PV of the cash flows. The
main difference between the PV and NPV functions in Excel is that NPV assumes each cash
flow takes place at the end of the period, whereas the PV function gives you the option of either
beginning or end-of-the-period cash flows. The function NPV (rate, value 1, value 2, etc.) would
be applied like this:
= NPV (5%, 100, 200, 300, 400, 500) = $1,256.64.
Excel’s NPV function can be a convenient way to calculate the present value of unequal cash
flows, but you need to remember that the function isn’t calculating net present value, as this
term is often used in corporate capital budgeting. (You still need to subtract the initial
investment to arrive at NPV.)
Now let’s turn to calculating future values in Excel. To find the future value of our stream of
cash flows using Excel, you would program cell formulas as shown in Exhibit 11 (note that the
first cash flow, received at the end of year 1, will be compounded for four years, while the last
cash flow will be received at the end of year 5 and will not earn any interest):
EXHIBIT 11
Excel Spreadsheet: Calculating the FV of a Series of (Unequal) Multiple Cash Flows
(1) (2) (3) (4) (5)
FV factor FV
t r Cf t
(1 + r )t Cf t × FV factor
4 5% 100 1.2155 121.55
3 5% 200 1.1576 231.53
2 5% 300 1.1025 330.75
1 5% 400 1.0500 420.00
0 5% 500 1.0000 500.00
Total $1,603.83

May 2023 to Nov 2023.
Calculating an Annuity Payment
Next let’s revisit our mortgage example. Let’s say you took out a $200,000, 15-year mortgage
bearing a 4.25% annual percentage rate (APR). What will the monthly payment be? For this
problem, we need to convert the rate and number of periods into their monthly equivalents to
be consistent with the calculation of a monthly payment.
Excel syntax =PMT(RATE,NPER,PV,[FV],[Type])
PMT RATE NPER PV [FV] [Type]

?? 4.25% / 12 15 * 12 200,000 [blank] 0 or [blank]
Excel gives the monthly payment for this mortgage as $1,504.56, exactly as we found earlier.
How could you double-check the answer? You could calculate either the present value of the
loan using the payment amount we just calculated or, since this is a loan that will be paid off in
full by the last monthly payment, you could check to see that the FV of the stream of payments
equals zero. (Be sure to include the principal amount of $200,000 as the PV in your formula.)
Calculating the Number of Annuity (Loan or Credit Card) Payments

to Pay Off an Outstanding Balance
Next let’s revisit our credit card example. Let’s say you had a $500 credit card balance bearing a
15% annual interest rate (APR) and plan to pay $10 per month. How long would it take to pay
off your balance? First we convert the annual interest rate into a monthly rate to be consistent
with the monthly repayment plan and then solve for the number of periods as follows:
Excel syntax =NPER(RATE,PMT,PV,[FV],[Type])
PMT RATE NPER PV [FV] [Type]

–10 15% / 12 ?? 500 0 or [blank] 0 or [blank]
Excel returns a value of 78.96 months—it will take 79 months to pay down your credit card
balance in full.

May 2023 to Nov 2023.
Additional Excel Functions
In addition to the functions discussed above, a few other Excel functions perform calculations
related to the discounting and compounding problems covered in the reading.
FV SCHEDULE calculates the future value of an initial principal amount after applying a series
of (potentially unequal) compound interest rates over equal periods. It is therefore useful if
interest rates are expected to change over the investment horizon.
IPMT and PPMT are used to determine the interest and principal payments, respectively, for an
amortizing loan over a given period. That is, these functions divide a constant periodic payment
into components of interest and principal on the basis of the given interest rate.
NOMINAL returns the annual nominal interest rate for a loan (also known as the APR, or
annual percentage rate) given the effective rate and compounding frequency. Conversely, the
EFFECT function returns the effective interest rate given the nominal rate and compounding
frequency. For example, a loan with a nominal rate (APR) of 10% and monthly compounding
has an effective interest rate of 10.47%.
4 KEY TERMS
amortizing loan A type of loan in which the principal is repaid over the life of the loan, via
periodic payments containing both interest and repayment of a portion of the outstanding
principal balance.
annual percentage rate (APR) The simple rate of interest on a loan (before compounding).
Also referred to as the nominal rate of return.
annuity A stream of constant periodic payments paid or received every period for a finite
number of periods.
annuity factor (PV factor) The mathematical factor applied to the periodic cash flow of an
annuity to determine its present value:
1 1 
 − 
 r r (1 + r )T 
 

May 2023 to Nov 2023.
compounding The process of reinvesting the return earned on an investment, which causes
value to accumulate, or grow, over time.
compounding factor (FV factor) The mathematical factor applied to determine the future
value of a single amount T years in the future: (1 + r )T .
discount rate The rate at which future cash flows are discounted to determine their present
value.
discounting The process of calculating the present value of an amount to be received in the
future. The application of a discount rate in this calculation causes the present value to be less
than the future value.
discount factor (PV factor) The mathematical factor applied to determine the present value
of a single amount T years in the future: 1/ (1 + r )T . See also annuity factor.
effective interest rate The annual rate of interest implied when compounding takes place
more than once per year, calculated as
m
 r 
1 + m  − 1
 
where r is the simple annual rate and m is the number of compounding periods per year.
equivalent interest rate A rate corresponding to a given compounding/discounting

frequency (say, semiannual) that has been expressly calculated to give the same FV or PV as a
rate corresponding to a different frequency (say, annual), calculated as
1
(1 + r ) m − 1
That is, one may speak of “converting” an annual rate to an equivalent rate on a semiannual,
monthly, or weekly basis.
future value The value at a specific point in the future of a stipulated amount of cash today.
Future value includes the stipulated amount as well as interest earned and compounded over the
appropriate period.
growing (shrinking) perpetuity A perpetuity in which the periodic payment increases (or
decreases) by a constant rate of growth (or decay).
inflation rate The rate at which the general level of prices for goods and services, measured in
a certain currency, is rising. Implicitly, this reflects the rate at which the currency’s purchasing
power is falling.

May 2023 to Nov 2023.
mortgage A collateralized loan, typically secured by real estate, which also exhibits the
characteristics of an annuity (periodic payments of an equal amount) and an amortizing loan.
nominal rate of return The quoted simple rate of interest paid (or received) on a loan (or
deposit). When the nominal rate is an annual rate, it is also sometimes called the annual
percentage rate or APR. (It also can be be expressed as a periodic rate by dividing the annual
rate, r , by a number of periods per year, m —i.e., r / m .) Nominal rates do not reflect
compounding (see also simple interest rate). In different usage, the term nominal may also be
used to reflect a contrast with a “real” (i.e., inflation-adjusted) rate of return.
perpetuity Usually a stream of periodic, constant cash flows paid or received forever. See
also growing (shrinking) perpetuity.
present value The value today of a cash flow to be paid or received in the future; the
discounted value of a series of future cash flows.
principal The amount lent to a borrower, to be repaid at a future date or dates, and on which
the borrower pays a stated rate of interest.
real rate of return The inflation-adjusted rate of return, approximated by the nominal rate of
return less the rate of inflation.
risk-free interest rate The rate of interest earned on a security for which promised cash flows
are certain to be paid/received.
simple interest rate An interest rate for which the compounding interval and the payment
period are the same (most commonly annual). For example, a simple annual interest rate of 5%
denotes 5% interest per year, compounded annually.
time value of money The return investors can earn over a period of time without taking any
risk of loss of their money.

May 2023 to Nov 2023.
5 NOTATION
Cf Cash flows
FV Future Value
g Growth rate
m Number of compounding periods per year
PV Present Value
r Discounting or compounding rate
t Date; time period
T Number of time periods (date of the endpoint)
6 PRACTICE QUESTIONS
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2IVaP21

May 2023 to Nov 2023.
7 INDEX
amortizing loan, 23, 40 fixed-rate amortizing loan, 23
annual percentage rate (APR), 23, 30, 40 future value, compounding frequencies
annuity, in buyout offer example, 26 and, 15
annuity, compared with perpetuity, 27 future value, compounding power and, 7
annuity, construction of, 21 future value, definition of, 41
annuity, definition of, 10, 21, 40 future value, Excel calculations for, 33
annuity, mortgage as, 23 future value, multiple cash flow calculations
annuity, present value derivation for, 10, 21, with, 12
22 future value, over one-year period, 4
annuity factor (PV factor), 22, 40 future value, saving plan sample example
with, 10
bank loans, 3 FV (Excel function), 33
buyout offer example, 26 FV SCHEDULE (Excel function), 40
compounding, 3, 6, 7, 8, 41 growing perpetuity, 19, 41

compounding calculations in Excel, 33
compounding continuously, 13, 14 inflation rate, 42
compounding factor (FV factor), 7, 41 interest payments, in credit card debt, 30
compounding frequency, 13 interest payments, in mortgages, 24
consols, 19 interest rate, 3, 4, 6
corporate finance, 3 investment finance, 3
credit card debt example, 30 IPMT (Excel function), 40
deferred annuity, in buyout offer example, loans, 3, 23

26 lump-sum payment, in buyout offer
discount factor (PV factor), 8, 11, 41 example, 26
discounting, 3, 6, 7, 8, 41
discounting, Excel calculations for, 33 monthly payment calculations, for credit
card debt, 30
discounting continuously, 13, 14
monthly payment calculations, for
discounting frequency, 13
mortgages, 23, 25
discount rate, 6, 41
mortgage, 23, 42
multiple cash flows, Excel calculations for,
early retirement calculations, 26
33
effective interest rate, 13, 14, 18, 41
multiple cash flows, present value
equivalent interest rate, 17, 18, 41 calculation, 10

May 2023 to Nov 2023.
multiple cash flows, saving plan sample principal payment calculations, in
example, 8 mortgages, 24
public finance, 3
NOMINAL (Excel function), 40 PV (Excel function), 33
nominal rate of return, 5, 40, 42
NPER (Excel function), 33, 34, 36, 37, 41 RATE (Excel function), 33, 34, 36, 37, 41
real rate of return, 42
option pricing models, 14 risk-free interest rate, 4, 5, 6, 42
perpetual bonds (consols), 19 risk, 5
perpetuity, compared with annuity, 27
perpetuity, definition of, 19, 42 saving plan sample timeline and
perpetuity, present value derivation for, 20 calculations, 9
personal finance, 3 scholarship endowment example, 29
PMT (Excel function), 33 shrinking perpetuity, 19, 41
PPMT (Excel function), 42 simple interest rate, 13, 42
present value, compounding power and, 7
present value, definition of, 42 time value of money, 3, 4, 8, 42
present value, Excel calculations for, 33
present value, multiple cash flow what if questions, 10
calculations with, 11
present value, over one-year period, 4
present value, perpetuity investment
calculations and, 19, 20
present value, saving plan sample example
with, 10
principal, 7, 42

May 2023 to Nov 2023.

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8299 | Published: December 22, 2015

2 Essential Reading ..................................................................................................................................................................... 4

2.1 Present and Future Value Over a Single Period ................................................................. 4

2.2 Compounding and Discounting Over Multiple Periods............................................ 6

2.3 Multiple Cash Flows and Multiple Periods .................................................................................. 8

2.4 The Frequency of Compounding and Discounting..................................................... 13

2.5 Perpetuities and Annuities ........................................................................................................................... 19

Comparing Annuities and Perpetuities ........................................................................................ 27

Growing Perpetuities ............................................................................................................................................ 29

3.1 Using Excel Functions PV, FV, and PMT .................................................................................... 33

4 Key Terms ....................................................................................................................................................................................... 40

8299 | Core Reading: TIME VALUE OF MONEY 2

8299 | Core Reading: TIME VALUE OF MONEY 3

More generally, for a single period:

where FV = future value, at the end of the period

8299 | Core Reading: TIME VALUE OF MONEY 4

8299 | Core Reading: TIME VALUE OF MONEY 5

INTERACTIVE ILLUSTRATION 1 Time Value of $100 Cash

8299 | Core Reading: TIME VALUE OF MONEY 6

EXHIBIT 2 The Power of Compounding

8299 | Core Reading: TIME VALUE OF MONEY 7

In this calculation, we multiplied the future value by a discount factor equal to 1/ (1 + r )T to

Multiplying $1,000 by 0.23138 gives a present value of $231.38.

2.3 Multiple Cash Flows and Multiple Periods

8299 | Core Reading: TIME VALUE OF MONEY 8

EXHIBIT 3 Sample Savings Plan to Buy a House in Five Years

EXHIBIT 4 Calculating the Future Value of a Five-Year Savings Plan

Number of Years Future Value at

8299 | Core Reading: TIME VALUE OF MONEY 9

where T = the total number of periods (the endpoint)

Interactive Illustration 2 demonstrates the discounting calculations required to compute the

8299 | Core Reading: TIME VALUE OF MONEY 10

8299 | Core Reading: TIME VALUE OF MONEY 11

8299 | Core Reading: TIME VALUE OF MONEY 12

$1,000 ⋅ (1.004167 ) =$1,000 ⋅1.05117 =$1,051.17

Compounding daily, we would receive

8299 | Core Reading: TIME VALUE OF MONEY 13

8299 | Core Reading: TIME VALUE OF MONEY 14

8299 | Core Reading: TIME VALUE OF MONEY 15

INTERACTIVE ILLUSTRATION 5 Effect of Compounding Frequency

8299 | Core Reading: TIME VALUE OF MONEY 16

where r equals the simple annual rate.

8299 | Core Reading: TIME VALUE OF MONEY 17

8299 | Core Reading: TIME VALUE OF MONEY 18

$50 $50 $50 $50

8299 | Core Reading: TIME VALUE OF MONEY 19

Therefore, the present value of the security is:

Using the formula for the present value of a perpetuity,

8299 | Core Reading: TIME VALUE OF MONEY 20

EXHIBIT 6 An Annuity Is the Difference Between Two Perpetuities

8299 | Core Reading: TIME VALUE OF MONEY 21

More generally, the value of a T-period annuity is given by

Sometimes this formula is written:

8299 | Core Reading: TIME VALUE OF MONEY 22

This is the same answer we got in Interactive Illustration 3.

8299 | Core Reading: TIME VALUE OF MONEY 23

We know the PV is $200,000, r is 4.25% ÷ 12 =

PV (T -period annuity ) $200,000

PV (T -period annuity ) $200,000

8299 | Core Reading: TIME VALUE OF MONEY 24

8299 | Core Reading: TIME VALUE OF MONEY 25

Example: Employee Buyout Offer