UNIT 2_Time Value of Money 2

Photo Credits: Google Images
UNIT 2: TIME VALUE OF MONEY
Introduction
When John D. Rockefeller was a teen during the mid-1800s, he lent $50 to a neighboring farmer. A
year later, the farmer paid him back the $50 plus $3.50 interest on the loan. The week before,
Rockefeller had earned a measly $1.12 after 30 hours of backbreaking work hoeing potatoes for
another neighbor. “From that time on,” Rockefeller wrote in his autobiography, Random
Reminiscences, “I was determined to make money work for me.”
Putting the money to work for you is the essence of investing—anyone can learn to do it well. Think
for a moment about what you envision a successful investor to look like. Maybe you picture someone
in a power suit, up at the crack of dawn checking stock quotes before he or she has even had coffee. A
real mover and shaker.
Investing is really very simple—it’s about putting your money to work for you over time. The longer
your money is parked in an investment, the more time it has to grow… and grow… and grow!
But what are you growing it for? Before you choose investments, you need to identify your investment
objectives. Are you saving to buy a home? To put [future] kids through school? For retirement? Or
all three? How much time do you have to reach those goals?
Next, you need to figure out how much risk you’re willing to take with your hard-earned cash to try
to meet those objectives. Finally, you need to take a look at what you’ve already got—and what you
owe.
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Unit Learning Objectives
By the end of this unit, you should be able to:

• illustrate how time value of concepts can be useful in financial management;
• compute the future value or the present value of cash flows with a single amount;
• compute the future value or the present value of annuities;
• compute the future value or the present value of mixed stream of cash flows; and
• draw conclusions about a firm’s investment activities.
Timing
This unit is good for more than a week—8 days at max. You can devote three hours per day on the
subject. Don’t worry, the content is abridged, which means it only includes the most salient points you
need to know relative to our module learning outcomes (MLO).
For easier monitoring of your progress, you may use the study planner attached to this module. Be
sure to make use of your planner to have a more organized and orderly studying. Plus, the planner is
a PROCRASTINATION-beater!
Warm Up
Riddle me this!
Let’s say that you’re able to save a small

sum of money and you want to invest it in
something useful for the family. Suppose
that you’ve decided to buy a rooster for
the purpose of laying eggs and you expect
to get three eggs each day for breakfast,
how many eggs will you have after three
weeks?
To continue our story, there’s a man in
the market who offered you to give you
the rooster for free if you can will help
him solve his problem about a ball inside
a bottle. Can you help him?
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Getting Started!
2.1 THE ROLE OF TIME OF VALUE IN FINANCE
The time value of money refers to the observation that it is better to receive money sooner than later.
Money that you have in hand today can be invested to earn a positive rate of return, producing more
money tomorrow. For that reason, a dollar today is worth more than a dollar in the future. This
preference for money now, as compared to future money, is called as time preference for money. The
concept of time value of money is applicable both for individuals and for business organizations.
In business, managers constantly face trade-offs in situations where actions that require outflows of
cash today may produce inflows of cash later. Because the cash that comes in the future is worth less
than the cash that firms spend up front, managers need a set of tools to help them compare cash
inflows and outflows that occur at different times. This unit introduces you to those tools.
2.1.1 But What Does It Mean to Invest?
You’ll often hear the phrase ‘‘invest for the

future.’’ Not only is this a cliche´, it’s redundant.
That’s because the act of investing necessarily
involves the future, on a couple of levels.
Obviously, the reason we invest is to be able to
meet certain goals in the future—be it going on
vacation, buying a house, sending children to
college, or building up a nest egg. But investing
also takes time. That means, by definition, it’s a
future-oriented endeavor.
While spending involves instantaneous

gratification—you’re giving up something today
in exchange for something else immediately—
investing is just the opposite. It’s all about
delaying one’s gratification. It involves giving up
something today—i.e., the use of your money—
in hopes of getting something greater back in the
future. That ‘‘something greater,’’ of course, is
Photo Credits: Google Images more money.
The interesting thing is, there is a relationship between spending money and investing it. When you
invest, you are often interacting with would-be spenders. For example, if you are a stock investor and
buy shares of a company, you are giving the firm your capital (i.e., your cash), which it will use to
spend on various projects. The hope is that the company will not only survive, but thrive to the point
where its value (and the value of your shares) will increase substantially down the road.
Investing in bonds works the same way. When you buy a U.S. Treasury bond, for example, you are
handing over your money—and all the potential uses you might have for that cash—so the
government can gratify its needs by spending your money. In return, you are making a calculated bet
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that the federal government will not only survive but will be able to pay you back your investment at
a future date, along with an agreed-upon amount of interest.
The greater the length of time you’re willing to delay that gratification, the greater the odds of being
rewarded for your patience. Sometimes, to invest properly and safely, you may need to tie up your
money for months, if not years, if not decades—if not longer. Anyone who has purchased a home with
a 30-year mortgage will appreciate just how long some investments are designed to ripen. But as any
homeowner is likely to tell you, the rewards are well worth the wait.
2.1.2 Reasons for Time Preference for Money
Normally people would want to receive money today rather than after some time. The important
reasons for time preference for money are as outlined below:
• Uncertainty and Loss

Future is uncertain. If you expect to receive a certain amount in future, there is always an
uncertainty with regard to its receipt in future. The future is subject to risks. A person may
incur loss due to not getting the expected amount in future.
• Present Needs are Considered as More Important
People consider present needs as more important than their future needs. Purchase of clothes,
television, car and luxurious articles for their present use feels more urgent than saving for
tomorrow.
• Investment Opportunities Available

If you pay P10, 000 to a person today, and if he invests it at 12% per annum, he would receive
P11, 200 (P10, 000 plus P10, 000 x 12/100 interest) at the end of the year. Whereas if he is to
receive the same amount after one year, he would receive only P10, 000. Sometimes, by
investing in shares, one can even double the money in a short period.
Investment Opportunities, Wealth Academy, https://www.wealthacademyglobal.com/understanding-

investment-opportunities/
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2.1.3 Time Lines
The first step in time value analysis is to set up a time line, which will help you visualize what’s
happening in a particular problem. As an illustration, consider the following diagram, where PV
represents $100 that is on hand today and FV is the value that will be in the account on a future date:
The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is today,
and it is the beginning of Period 1; Time 1 is one period from today, and it is both the end of Period 1
and the beginning of Period 2; and so forth. Although the periods are often years, periods can also be
quarters or months or even days. Note that each tick mark corresponds to both the end of one period
and the beginning of the next one. Thus, if the periods are years, the tick mark at Time 2 represents
the end of Year 2 and the beginning of Year 3.
Cash flows are shown directly below the tick marks, and the relevant interest rate is shown just above
the timeline. Unknown cash flows, which you are trying to find, are indicated by question marks. Here
the interest rate is 5%; a single cash outflow, $100, is invested at Time 0; and the Time 3 value is an
unknown inflow. In this example, cash flows occur only at Times 0 and 3, with no flows at Times 1 or
2. Note that in our example, the interest rate is constant for all 3 years. That condition is generally
true; but if it were not, we would show different interest rates for the different periods.
The concept of time value of money involves in arriving at the comparable value of the different
amounts which is arising at different points of time into equivalent values of a particular point of time
either present or future. The cash flows arising at different periods of time can be made comparable
by using any one of the following two ways:
• by compounding the present money to a future date i.e., by finding out the future value
(FV) of the present money; and
• by discounting the future money to present date i.e., by finding out present value (PV)
of the future money.
Self-Check:
Test Yourself:
□ Do time lines deal only with years, or can other periods be used?
□ Set up a time line to illustrate the following situation: You currently have $2,000 in a 3-year
certificate of deposit (CD) that pays a guaranteed 4% annually.
2.2 FUTURE VALUE VERSUS PRESENT VALUE
Suppose a firm has an opportunity to spend $15,000 today on some investment that will produce
$17,000 spread out over the next five years as follows:
Year 1 $3,000
Year 2 $5,000
Year 3 $4,000
Year 4 $3,000
Year 5 $2,000
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Is this a wise investment? It might seem that the obvious answer is yes because the firm spends
$15,000 and receives $17,000. Remember, though, that the value of the dollars the firm receives in
the future is less than the value of the dollars that they spend today. Therefore, it is not clear whether
the $17,000 inflows are enough to justify the initial investment.
Time-value-of-money analysis helps managers answer questions like these. The basic idea is that
managers need a way to compare cash today versus cash in the future. There are two ways of doing
this. One way is to ask the question, what amount of money in the future is equivalent to $15,000 today?
In other words, what is the future value of $15,000? The other approach asks, what amount today is
equivalent to $17,000 paid out over the next 5 years as outlined above? In other words, what is the
present value of the stream of cash flows coming in the next 5 years?
Future Value (FV) is the amount to which a cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest rate while Present Value (PV) is the value today
of a future cash flow or series of cash flows. Later on, you’ll learn how to compute for such items.
2.2.1 Basic Patterns of Cash Flows
The cash flow—both inflows and outflows—of a firm can be described by its general pattern. It can
be defined as a single amount, an annuity, or a mixed stream.
• Single Amount
A lump-sum amount either currently held or expected at some future date. Examples include
$1,000 you have today or the $650 that you will have to receive at the end of 10 years.
• Annuity (or Even Cash Flows)

A level or even periodic stream of cash flow. (For our purposes, we’ll work primarily with
annual cash flows.) Examples include either paying out or receiving $800 at the end of each of
the next 7 years.
• Mixed Stream (or Uneven Cash Flows)

A stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that reflect
no particular pattern.
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2.2.1 Some Standard Calculations Based on Time Value of Money
In this module, we will apply time value of money concepts to compute for the following items:
• Future Value of a Single Amount

The value of an asset or cash at a specified date in the future, based on the value of that asset
in the present.
• Future Value of an Annuity

The future value of a stream of payments (annuity), assuming the payments are invested at a
given rate of interest.
• Future Value of Mixed Streams

The future value uneven cash flows.
Note:
The definition of an annuity includes the words constant payment—in other words, annuities
involve payments that are equal in every period. Although many financial decisions involve
constant payments, many others involve uneven, or non-constant, cash flows. For example, the
dividends on common stocks typically increase over time, and investments in capital equipment
almost always generate uneven cash flows.
There are two important classes of uneven cash flows: (1) a stream that consists of a series of
annuity payments plus an additional final lump sum and (2) all other uneven streams. Bonds
represent the best example of the first type, while stocks and capital investments illustrate the
second type. Here are numerical examples of the two types of flows:
• Present Value of a Single amount

The current worth of a future money—a lump sum amount, given a specified rate of return.
Future cash flow (whether an inflow or an outflow) is "discounted" at the discount rate; the
higher the discount rate, the lower the present value of the future cash flows.
• Present Value of an Annuity

The current worth of a future sum of money or stream of cash flows, given a specified rate of
return. Future cash flows (whether inflows or outflows) are "discounted" at the discount rate;
the higher the discount rate, the lower the present value of the future cash flows.
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Note:
An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases
and rental payments are examples. The payments or receipts occur at the end of each period for
an ordinary annuity while they occur at the beginning of each period for an annuity due.
Here are the timelines for a $100, 3-year, 5% ordinary annuity and for the same annuity on an
annuity due basis. With the annuity due, each payment is shifted to the left by one year. A $100
deposit will be made each year, so we show the payments with minus signs:
• Present Value of a Perpetuity

The current worth of an infinite and constant stream of identical cash flows.
2.3 COMPOUNDING VERSUS DISCOUNTING
The process used to resolve the future value of the present investment is known as Compounding.
It is the procedure of earning interest over time. And the technique used to decide the present
value of future cash flows is known as Discounting. It is the procedure of converting future cash
flows to what its present value is.
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The difference between discounting and compounding are discussed below:
COMPOUNDING DISCOUNTING
Definition Compounding is the process Discounting is the process of
of finding the future value of finding the present value of
cash flow or a series of cash future cash flow or series of
flows. cash. In other words, the
present value is the current
value of the future cash flows
that are discounted at an
appropriate interest rate.
Use For calculation of future For calculation of recent
value. “If we invest some value. “What should be the
money today, what will be amount we need to invest
the amount we get at a future today, to get a specific
date?” amount in the future?”
Amount of Money Amount of money is By this method, the amount
increased. Compounding of money is decreased.
finds the future value of
present value using a
compound interest rate.
Value of Money In lower rate, future value is In lower rate, present value is
decreased and a higher rate of increased and in higher rate
future value is increased. present value is decreased.
Discounting finds the present
value of some future value,
using a discount rate.
Time Line Timeline goes to right side Time lie goes to the left side
from left-hand side. from the right-hand side.
Calculation Present value is multiplied by Future values are divided by
the interest factor. interest factor.
Result Future or compounded value. Present or a discounted
Future Value Factor. value. Present Value Factor.
Time value of money problems involve the net value of cash flows at different points in time. In a
typical case, the variables might be the following:
1. Series of Cash Flows (the amount you invest)

2. Periodic Rate of Interest (rate of return you earn)
3. Number of Periods (length of time you allow the money to compound)
Timelines are essential when you are first learning time value concepts, but even experts use them to
analyze complex finance problems. But one may also use a regular calculator, a financial calculator,
and a spreadsheet to find the answers to compounding and discounting problems.
A fifth procedure, using tables that show “interest factors,” was used before financial calculators
and computers became available. Now, though, calculators and spreadsheets such as Excel are
programmed to calculate the specific factor needed for a given problem and then to use it to find the
FV or the PV. This is more efficient than using the tables. Moreover, calculators and spreadsheets can
handle fractional periods and fractional interest rates, such as the FV of $100 after 3.75 years when
the interest rate is 5.375%, whereas tables provide numbers only for whole periods and rates.
In this module, however, we will be focusing on solving for the future values and present values of
cash flows using only our regular calculators and/or interest factors tables.
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2.4 FUTURE VALUES
A dollar in hand today is worth more than a dollar to be received tomorrow because of the interest it
could earn from putting it in a savings account or placing it in an investment account. Compounding
interest means that interest earns interest.
2.4.1 Future Value of a Single Amount
Formula:
FV = PV (1 + i)ⁿ
Where,
FV (Future Value): what the investment will be worth in the future.
PV (Present Value): the amount you are investing today.
I (Interest Rate): the after-tax return you expect to earn on your investment.
N (Number of Periods): the number of years you expect to have the money invested without
touching it.
To illustrate:
Assume that your friends invited you to dinner and a movie and you expect that it will cost you
approximately $50. Assume further that you are only 30 years old and decided instead that
you will invest the money, $50, you have today for 35 years until retirement at 65. You plan
on placing all of your funds in stocks and expect to earn an after-tax return of 12%. How much
would be its future value?
Solution:
FV = PV (1 + i)ⁿ
FV = $50 (1 + 0.12)35
FV = $50 (1.12) 35
FV = $50 (52.79962)
FV = $2,639.98
If you have decided to go out with your friends and spent the $50 in one night instead of investing it,
you have given up $2,639.98 in future wealth!
Now, assume that the same investment had been made by you who is only 20 years old. How much is the
future value?
FV = PV (1 + i)ⁿ
FV = $50 (1 + 0.12)45
FV = $50 (1.12) 45
FV = $50 (163.98760)
FV = $8,199.38
Self-Check:
How about if the investment had been made by someone who is only 10 years away from
retirement? How much is the future value? (Try to compute using the formula given above and see
if you will be able to get $155.29)
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Note:
See Appendix A for the Table of Future Value Interest Factors of a Single Amount (FVIFi,n). To
find 52.7996 FVIF, find the point where 12% rate column and period 35 row meets. Same process
applies in finding the other interest factors.
2.4.2 Future Value of Ordinary Annuity
Formula:
FV = PV (FVIFAi,n)
Where,
touching it.
FVIFAi,n (Future Value Interest Factor of an Annuity): the decimal equivalent for
an interest rate on a unit amount for a time period.
To illustrate:
Mondler Bing choose to receive 5-year $1,000 annuities with a rate of return of 7%.
Solution:
FV = $1,000 (FVIFA, 7%, 5)

= $1,000 (5.751)
= $5,751
Or you may multiply each payment by (1+i)n-t and sum these FVs to find FVOA.
FVOA = $1,000 (1+0.07)5-1 + $1,000 (1+0.07)5-2 + $1,000 (1+0.07)5-3 + $1,000 (1+0.07)5-4 +

$1,000 (1+0.07)5-5
FVOA = $1,000 (1.07)4 + $1,000 (1.07)3 + $1,000 (1.07)2 + $1,000 (1.07)1 + $1,000 (1.07)0
FVOA= $5,751
Note:
See Appendix A for the Table of Future Value Interest Factors of Annuity (FVIFAi,n). To find 5.751
FVIFA, find the point where 7% rate column and period 5 row meets. Same process applies in
finding the other interest factors.
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Self-Check:
Assume that a friend of yours wishes to determine the sum of money she will have in her savings
account at the end of 6 years by depositing $1,000 at the end of each year for the next 6 years. The
annual interest rate is 8 percent. (Try to compute using the formula given above and see if you will
be able to get $7,336.)
2.4.3 Future Value of Annuity Due
Formula:
FV = PV (FVIFAi,n)(1+I)
Where,
touching it.
FVIFAi,n (Future Value Interest Factor of an Annuity): the decimal equivalent for
To illustrate:
Mondler Bing choose to receive 5-year $1,000 annuities with a rate of return of 7%. First
annuity will be received at the beginning of the period immediately.
Solution:
FV = $1,000 (FVIFA, 7%, 5) (1 + 0.07)

= $1,000 (5.751) (1.07)
= $1,000 (6.154)
= $6,154
Note:
See Appendix A for the Table of Future Value Interest Factors of Annuity (FVIFAi,n). To find 6.154
FVIFA, find the point where 7% rate column and period 5 row meets where you can find 5.751—
then multiply it to 1.07. Same process applies in finding the other interest factors.
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Self-Check:
If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you have
at the end of year 3? (Try to compute using the formula given above and see if you will be able to get
$3,506.)
2.4.4 Future Value of Mixed Streams
Formula:
FV = PV (1 + i)ⁿ
Note:
Use the formula to compute for each cash flow every year/period and get the sum of all computed
FVs.
Where,
touching it.
To illustrate:
Below is the timeline for the uneven cash flows of All Might Company for five years.
Solution:
FV = PV (1 + i)ⁿ Future Value
Year 5 FV = $500 (1) 500.00

Year 4 FV = $300 (1 x 0.12)1 336.00
Year 3 FV = $300 (1 x 0.12)2 376.32
Year 2 FV = $300 (1 x 0.12)3 421.48
Year 1 FV = $100 (1 x 0.12)4 157.35
Year 0 FV = 0 (1 x 0.12)5 0
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FV of Uneven CF Stream 1,791.15
Self-Check:
Sabog Industries, a cabinet manufacturer, expects to receive the following mixed stream of cash
flows on the end of each year over the next 5 years from one of its small customers: Year 1, $11,500;
Year 2, $14,000; Year 3, $12,900; Year 4, $16,000; and Year 5, $18,000. If Sabog expects to earn 8%
on its investments, how much will it accumulate by the end of year 5 if it immediately invests these
cash flows when they are received? (Try to compute using the formula given above and see if you
will be able to get $83,608.15.)
2.5 PRESENT VALUES
Present value is the present worth of future sums of money. The process of calculating present
values, or discounting, is actually the opposite of finding the compounded future value.
2.5.1 Present Value of a Single Amount
Formula:
PV = FV [1/(1+i)n]
PV = FV x (PVIFi,n)
Where,
touching it.
PVIF (Present Value Interest Factor): the decimal equivalent for an interest rate on a unit
amount for a time period.
To illustrate:
Yang Ki wishes to find the present value of $1,700 that will be received
8 years from now. Yang’s opportunity cost is 8%.
Note:
Opportunity Cost is the rate of return you could earn on an alternative investment of similar risk.
Solution:
PV = FV [1/(1 + i)ⁿ]
PV = $1,700 [1/(1 + 0.08)8]
PV = $1,700 [1/0.5403]
PV = $1,700 /1.851
PV = $918.42
Or
PV = FV x (PVIFi,n)
PV = $1,700 x 0.5403
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PV = $918.51
Note:
Differences in the decimals of the final amounts can be attributed to the rounding off of figures.
Note:
See Appendix A for the Table of Present Value Interest Factors of a Single Amount (PVIFi,n). To
find 0.5403 PVIF, find the point where 8% rate column and period 8 row meets. Same process
applies in finding the other interest factors.
Self-Check:
Suppose a U.S. government bond promises to pay $2,249.73 three years from now. If the going
interest rate on three-year government bonds is 4%, how much is the bond worth today? How
would your answer change if the bond matured in 5 years rather than 3? What if the interest rate
on the 5-year bond was 6% rather than 4%? (Try to compute using the formula given above and see
if you will be able to get $2,000; $1,849.11; $1,681.13, respectively.)
2.5.2 Present Value of Ordinary Annuity
Formula:
PV = FV x (PVIFAi,n)
Where,
touching it.
PVIFA (Present Value Interest Factor of an Annuity): the decimal equivalent for
To illustrate:
Quit-Playing-Games-With-My-Heart Company, a small producer of plastic toys, wants to

determine the most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is 8%.
Solution:
PV = $700 x 3.993
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PV = $2,795.10
Note:
See Appendix A for the Table of Present Value Interest Factors of Annuity (PVIFAi,n). To find
3.993 PVIFA, find the point where 8% rate column and period 5 row meets. Same process applies
in finding the other interest factors.
2.5.3 Present Value of Annuity Due
Formula:
PV = FV x (PVIFAi,n) (1 + i)
Where,
touching it.
PVIFA (Present Value Interest Factor of an Annuity): the decimal equivalent for
To illustrate:
Assume that the annuity cash flows of $700 of Quit-Playing-Games-With-My-Heart Company,

a small producer of plastic toys, occurs at the beginning of each year for 5 years. The
management wants to determine the most it should pay to purchase that particular annuity.
The required return is 8%.
Solution:
PV = FV x (PVIFAi,n) (1+i)
PV = $700 x (3.993) (1.08)
PV = $700 (4.3124)
PV = $3,018.68
Note:
See Appendix A for the Table of Present Value Interest Factors of Annuity (PVIFAi,n). To find
4.3124 PVIFA, find the point where 8% rate column and period 5 row meets where you can find
3.993—then multiply it to 1.08. Same process applies in finding the other interest factors.
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5. <Press> +/-
6. <Press> +1
Self-Check:
Assume that you are offered an annuity that pays $100 at the end of each year for 10 years. You
could earn 8% on your money in other investments with equal risk. What is the most you should
pay for the annuity? If the payments began immediately, how much would the annuity be worth?
(Try to compute using the formula given above and see if you will be able to get $671.01 & $724.69,
respectively.)
2.5.4 Present Value of a Perpetuity
Formula:
PV = Annuity/Interest Rate
To illustrate:
A friend of yours asked for your advice. He asked you, “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?” What
will be your answer?
Solution:
PV = $1,000/0.08
PV = $12,500
2.5.5 Present Value of Mixed Streams
Formula:
PV = FV x (PVIFi,n)
Note:
Use the formula to compute for each cash flow every year/period and get the sum of all
computed PVs.
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Where,
touching it.
To illustrate:
Below is the time line for the uneven cash flows of All Might Company for five years.
Solution:
PV = FV x (PVIFi,n) Present Value
Year 5 PV = $500 (0.5674) 283.70

Year 4 PV = $300 (0.6355) 190.65
Year 3 PV = $300 (0.7118) 213.54
Year 2 PV = $300 (0.7972) 239.16
Year 1 PV = $100 (0.8929) 89.29
Year 0 PV = 0 0
PV of Uneven CF 1,016.34
Stream
Self-Check:
What’s the present value of a 5-year ordinary annuity of $100 plus an additional $500 at the end
of Year 5 if the interest rate is 6%? What is the PV if the $100 payments occur in Years 1 through
10 and the $500 comes at the end of Year 10? (Try to compute using the formula given above and
see if you will be able to get $794.87 and $1,015.21, respectively.)
2.6 COMPOUNDING INTEREST MORE FREQUENTLY THAN ANNUALLY
Compound Interests Formulas and Shortcuts Tricks, Question Paper,

https://questionpaper.org/compound-interests/
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Interest is often compounded more frequently than once a year. Savings institutions compound
interest semiannually, quarterly, monthly, weekly, daily, or even continuously. This section discusses
various issues and techniques related to these more frequent compounding intervals.
In all of our examples thus far, we assumed that interest was compounded once a year, or annually.
This is called annual compounding. Suppose, however, that you deposit $100 in a bank that pays a
5% annual interest rate but credits interest each 6 months. So in the second 6-month period, you earn
interest on your original $100 plus interest on the interest earned during the first 6 months. This is
called semiannual compounding. Note that banks generally pay interest more than once a year;
virtually all bonds pay interest semiannually; and most mortgages, student loans, and auto loans
require monthly payments. Therefore, it is important to understand how to deal with non-annual
compounding
For this purpose, the future value formula can be rewritten for use when compounding takes place
more frequently. If m equals the number of times per year interest is compounded, the formula for the
future value of a lump sum becomes
Where,
FV = future value r = interest rate
PV = present value n = number of year
To Illustrate:
A. Frankie Presto has decided to invest $100 in a savings account paying 8% interest
compounded semiannually—compounding of interest over two periods within the year.
If he leaves his money in the account for 24 months (2 years), he will be paid 4% interest
compounded over four periods, each of which is 6 months long. The table below shows that
at the end of 12 months (1 year) with 8% semiannual compounding, Frankie will have
$108.16; at the end of 24 months (2 years), he will have $116.99.
Using the formula, getting $116. 99 looks like this:
B. Frankie Presto has found an institution that will pay him 8% interest compounded
quarterly—compounding of interest over four periods within the year.
If he leaves his money in this account for 24 months (2 years), he will be paid 2% interest
compounded over eight periods, each of which is 3 months long. The table below shows
the amount Frankie will have at the end of each period. At the end of 12 months (1 year),
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with 8% quarterly compounding, Frankie will have $108.24; at the end of 24 months (2
years), he will have $117.17.
Using the formula, getting $117.17 looks like this:
Therefore, our computations above goes to show that the more frequently interest is compounded, the
greater the amount of money accumulated. This is true for any interest rate for any period of time.
The same logic applies when we find present values under semiannual, quarterly, monthly
compounding. We may use the formula:
𝑟
PV = FV/ (1+𝑚) m x n
C. Suppose that you will receive $100 after 10 years from a bank that pays a 5% annual
interest rate but credits interest each 6 months. Using the formula above, we can find now
the present value of $100 due after 10 years with a stated annual rate of 5% with
semiannual compounding.
We can then use the periodic rate and number of periods in the calculations as shown
below:
Self-Check:
What’s the future value of $100 after 3 years if the appropriate interest rate is 8% compounded
annually? Compounded monthly? (Try to compute using the formula given above and see if you will
be able to get $125.97; $127.02, respectively.)
What’s the present value of $100 due in three years if the appropriate interest rate is 8%
compounded annually? Compounded monthly? (Try to compute using the formula given above and
see if you will be able to get $79.38; $78.73, respectively.)
Page 39 of 186
2.7 COMPARING INTEREST RATES
(Nominal vs. Effective Annual Rates)
Different compounding periods are used for different types of investments. For example, bank
accounts generally pay interest daily; most bonds pay interest semiannually; stocks pay dividends
quarterly; and mortgages, auto loans, and other instruments require monthly payments. If we are to
compare investments or loans with different compounding periods properly, we need to put them on
a common basis. Here are some of the things you need to understand:
• Nominal (Quoted, or Stated) Interest Rate or INOM is the contractual annual rate of
interest charged by a lender or promised by a borrower. It is also called the annual
percentage rate (APR).
Note that if two banks offer loans with a stated rate of 8% but one requires monthly
payments and the other quarterly payments, they are not charging the same “true” rate—
the one that requires monthly payments is charging more than the one with quarterly
payments because it will get your money sooner. So to compare loans across lenders, or
interest rates earned on different securities, you should calculate effective annual rates as
described here.
• Effective (Equivalent) Annual Rate (EFF% or EAR) is the annual rate of interest actually
paid or earned as opposed to the quoted rate. This is the rate that would produce the same
future value under annual compounding as would more frequent compounding at a given
nominal rate.
• If a loan or an investment uses annual compounding, its nominal rate is also its effective
rate. However, if compounding occurs more than once a year, the EFF% is higher than
INOM.
Compounding more frequently than once a year results in a higher effective interest rate
because you are earning on interest on interest more frequently.
To Illustrate:
A. A nominal rate of 10% with semiannual compounding is equivalent to a rate of 10.25%

with annual compounding because both rates will cause $100 to grow to the same amount
after 1 year. The top line in the following diagram shows that $100 will grow to $110.25 at
a nominal rate of 10.25%. The lower line shows the situation if the nominal rate is 10% but
semiannual compounding is used.
Given the nominal rate and the number of compounding periods per year, we can find the
effective annual rate with this equation:
m
EAR = (1 + r/m) - 1
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Solution:
EAR = (1 + i/m) m – 1
= (1 + 5%)2 – 1
= 1.1025 -1
= 0.1025 or 10.25%
In general, the effective rate > nominal rate whenever compounding occurs more than once
per year. In this case, the true rate of EFF% is 10.25%.
B. Francesca wishes to find the effective annual rate associated with an 8% nominal annual
rate (I = .08) when interest is compounded (1) annually (m=1); (2) semiannually (m=2);
and (3) quarterly (m=4). Find the EAR or EFF% under the different circumstances.
Solution:
These values demonstrate two important points:]. The first is that nominal and effective annual rates
are equivalent for annual compounding. The second is that the effective annual rate increases with
increasing compounding frequency, up to a limit that occurs with continuous compounding—
compounding of interest an infinite number of times per year at intervals of microseconds or the
compounding over every nanosecond, the smallest time period imaginable.
Unit Summary
• The time value of money refers to the observation that it is better to receive money
sooner than later. Money that you have in hand today can be invested to earn a positive
rate of return, producing more money tomorrow.
• The reasons for time preference for money are: uncertainty of the receipt of money
and possible loss, present needs are considered as more important and investment
opportunities available.
• The concept of time value of money involves in arriving at the comparable value of the
different amounts which is arising at different points of time into equivalent values of
a particular point of time either present or future.
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• Future Value (FV) is the amount to which a cash flow or series of cash flows will grow
over a given period of time when compounded at a given interest rate while Present
Value (PV) is the current value of future cash flow or series of cash flows discounted at
a given interest rate.
• Cash flows have the following basic patterns: single amount, annuity (or even cash
flows), and mixed stream (or uneven cash flows).
• An annuity is a series of equal payments or receipts that occur at evenly spaced

intervals. Leases and rental payments are examples. The payments or receipts occur at
the end of each period for an ordinary annuity while they occur at the beginning of each
period for an annuity due.
• The process used to resolve the future value of the present investment is known as
Compounding. It is the procedure of earning interest over time. And the technique used
to decide the present value of future cash flows is known as Discounting. It is the
procedure of converting future cash flows to what its present value is.
• There are various procedures that could be done to compute for the future value and
present value amounts. But in this unit, we focused more in the use of interest factor
tables and regular calculators. In using the latter, certain steps must be followed.
• Formula for the computation of the future value of a single amount: FV = PV (1 + i)ⁿ
• Formula for the computation of the future value of an ordinary annuity:

FV = PV (FVIFAi,n)
• Formula for the computation of the future value of an annuity due:

FV = PV (FVIFAi,n)(1+I)
• Formula for the computation of the future value of a mixed stream of cash flows:
FV = PV (1 + i)ⁿ (for each cash flow every year/period)
• Formula for the present value of a single amount: PV = FV x (PVIFi,n)
• Formula for the computation of the present value of an ordinary annuity:

• Formula for the computation of the present value of an annuity due:

PV = FV x (PVIFAi,n) (1 + i)
• Formula for the computation of the present value of a perpetuity:

• Formula for the computation of the present value of a mixed stream of cash flows:
PV = FV x (PVIFi,n) (for each cash flow every year/period)
• Interests can be compounded more frequently than once in a year. If ever that is the
𝑟
case, future value can be computed by using this formula: FV = PV x (1+𝑚) m x n
• When interests are compounded more than once a year, the formula for getting the
𝑟
present value is: PV = FV/ (1+𝑚) m x n
• The more frequently interest is compounded, the greater the amount of money
accumulated.
Page 42 of 186

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