Chapter 2

Time Value of Money

5-1
 Outline

Time Value of Money Rationale

Future Value
Present Value
Annuities
Classification of Interest Rates and Rates of Return

3-2
 Time Value of Money Rationale

Time Value of Money

The Purchasing power money might differ with the
passage of time.
The rational investors prefer to receive money today
rather than the same amount of money in the future
because of money's potential to grow in value over a
given period. For example, money deposited into a
savings account earns a certain interest rate and is
therefore said to be compounding in value. 

3-3
 Time Lines

0 1 2 3
I%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.

5-4
 Drawing Timelines

$100 lump sum due in end of 2 years

0 1 2
I%

100

The future value of $ 100 three years from now at

5% interest rate

5-5
 Drawing Timelines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

5-6
 Future Value

Future Value
This term refers to the value of a cash flow (or series
of them) at some specific future time. Any cash flow
that is scheduled to occur sometime later than today is
referred to as a “future value.”
In other words, future value means “what will it be
worth at some future point in time?” For example, if an
investment promises to pay $100 one year from now,
then the $100 is the future value of the investment
because that investment will be worth $100 at that
point in time.
3-7
What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?

• Finding the FV of a cash flow or series of cash flows

is called compounding.
• FV can be solved by using the step-by-step, formula,
financial calculator, and spreadsheet methods.

0 1 2 3
5%

100 FV = ?

5-8
 Solving for FV:
The Step-by-Step and Formula Methods
1. Step by Step Method
We start with $100 in the account, which is shown at t = 0.
We then multiply the initial amount, and each succeeding
beginning-of-year amount, by (1 + I) = (1.05). You earn
$100(0.05) = $5 of interest during the first year, so the
amount at the end of Year 1 (or at t = 1) is

5-9
 Solving for FV: Formula Approach

2. Formula Approach
In the step-by-step approach, we multiplied the amount
at the beginning of each period by (1 + I) = (1.05). Notice
that the value at the end of Year 2 is

If N = 3, then we multiply PV by (1 + I) three different

times, which is the same as multiplying the beginning
amount by (1 + I)3. This concept can be extended, and the
result is this key equation:
After N years (general case):
FVN = PV(1 + I)N
3-10
 Solving for FV:
Calculator and Excel Methods

3. Financial Calculators
•Requires 4 inputs into calculator, and will solve for the
fifth. (Set to P/YR = 1 and END mode.)

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

4. Spreadsheet/Excel
Excel: =FV(rate,nper,pmt,pv,type)
5-11
What is the present value (PV) of $100 due in
3 years, if I/YR = 10%?

• Finding the PV of a cash flow or series of cash flows

is called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.

0 1 2 3
10%

PV = ? 100

5-12
 Solving for PV:
The Formula Method

• Solve the general FV equation for PV:

FVN = PV(1 + I)N

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.10)3
= $75.13

5-13
 Difference Between Simple and compound Rate

Simple and compound Rate

When interest is earned on the interest earned in prior periods,
we call it compound interest. If interest is earned only on the
principal, we call it simple interest.
The total interest earned with simple interest is equal to the
principal multiplied by the interest rate times the number of
periods: PV(I)(N).
The future value is equal to the principal plus the interest: FV = PV
+ PV(I)(N). For example, suppose you deposit $100 for 3 years and
earn simple interest at an annual rate of 5%. Your balance at the
end of 3 years would be

3-14
 Finding interest rate?

Finding interest rate:

Let’s start with Formula: FVN= PV(1 + I)N

divide both sides by PV:

Take the “n ” root of both sides. By taking the “n ” root of
both sides of the equation shown above, we end up with

Subtract “1" from both sides of the equation:

3-15
 Finding Time Period N?

We want to know how many periods it takes to turn $1,000

into $2,000 at 10% interest, we can rearrange the basic
formula.
Start with: FV = PV (1+i)n
Swap sides: PV (1+i)n = FV
Divide both sides by PV: (1+i)n = FV / PV
Use logarithms: ln(1+i) × n = ln( FV / PV )
Divide both sides by ln(1+i):n = ln( FV / PV)
n = ln( FV / PV )/ln(1+i)

n = ln( $2,000 / $1,000 ) / ln( 1 + 0.10 ) = 7.27

3-16
 Solving for PV:
Calculator and Excel Methods

• Solves the general FV equation for PV.

• Exactly like solving for FV, except we have different
input information and are solving for a different
variable.

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Excel: =PV(rate,nper,pmt,fv,type)
5-17
Solving for I: What annual interest rate would cause
$100 to grow to $125.97 in 3 years?

• Solves the general FV equation for I/YR.

• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8

Excel: =RATE(nper,pmt,pv,fv,type,guess)
5-18
 Solving for N: If sales grow at 20% per year,
how long before sales double?

• Solves the general FV equation for N.

• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

EXCEL: =NPER(rate,pmt,pv,fv,type)
5-19
 Concept of Annuity

An annuity
It is a series of equal cash flows paid at equal time
intervals for a finite number of periods.
A lease that calls for payments of $1000 each month
for a year would be referred to as a “12-period, $1000
annuity.”
Note that, strictly speaking, in order for a series of
cash flows to be considered an annuity, each cash flow
must be identical and the amount of time between
each cash flow must be the same in all cases. There are
two types of annuities that vary only in the timing of
the first cash flow (Ordinary annuity and due annuity).
3-20
What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

5-21
 Discussion Question?

• Would you prefer to receive an annuity due with

payments of $10,000 per year for 10 years or
otherwise similar ordinary annuity?

3-22
 Ordinary annuity: Computation

Step by Step or Formula Approach

3-23
 FUTURE VALUE OF AN ANNUITY DUE

Each payment occurs one period earlier with an

annuity due, the payments will all earn interest for one
additional period.

3-24
Present Value Of An Ordinary Annuity: Computation

Step by Step or Formula Approach

3-25
 Present Value Of Annuity Due: Computation

Present Value of Annuities Due

3-26
 Solving for FV:
3-Year Ordinary Annuity of $100 at 10%

• $100 payments occur at the end of each period, but there is

no PV.

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 0.
5-27
 Solving for PV:
3-year Ordinary Annuity of $100 at 10%

• $100 payments still occur at the end of each period,

but now there is no FV.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 0.
5-28
 Solving for FV:
3-Year Annuity Due of $100 at 10%

• Now, $100 payments occur at the beginning of each period.

FVAdue= FVAord(1 + I) = $331(1.10) = $364.10
• Alternatively, set calculator to “BEGIN” mode and solve for the FV
of the annuity:

BEGIN
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
5-29
 Solving for PV:
3-Year Annuity Due of $100 at 10%

• Again, $100 payments occur at the beginning of each period.

PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55
• Alternatively, set calculator to “BEGIN” mode and solve for the PV
of the annuity:

BEGIN
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55
Excel: =PV(rate,nper,pmt,fv,type)
Here type = 1.

5-30
UNEVEN, OR IRREGULAR, CASH FLOWS
 Many financial decisions do involve constant payments, many
others involve cash flows that are uneven or irregular. For example,
the dividends on common stocks are typically expected to increase
over time, and investments in capital equipment almost always
generate cash flows that vary from year to year.
 There are two important classes of uneven cash flows: (1) those in
which the cash flow stream consists of a series of annuity payments
plus an additional final lump sum in Year N, and (2) all other
uneven streams. Bonds are an instance of the first type, while
stocks and capital investments illustrate the second type. Here’s an
example of each type.

3-31
What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

5-32
 Classification of Interest Rates

SEMIANNUAL AND OTHER COMPOUNDING PERIODS

•In most of our examples thus far, we assumed that interest is
compounded once a year, or annually (This is annual compounding).
Note also that virtually all bonds pay interest semiannually; most stocks
pay dividends quarterly; most mortgages, student loans, and auto loans
involve monthly payments; and most money fund accounts pay interest
daily. Therefore, it is essential that you understand how to deal with
nonannual compounding.
•Suppose, however, that you put $1,000 into a bank that pays a 6% annual
interest rate, but credits interest each 6 months. This is semiannual
compounding. If you leave your funds in the account, how much would you
have at the end of 1 year under semiannual compounding? Note that you will
receive $60 of interest for the year, but you will receive $30 of it after only 6
months and the other $30 at the end of the year. You will earn interest on the
first $30 during the second 6 months, so you will end the year with more than
the $60 you would have had under annual compounding.

5-33
 Classification of Interest Rates

SEMIANNUAL AND OTHER COMPOUNDING PERIODS

•How would things change if interest was paid semi annually rather than
annually?. In case if payments occur more than once a year two
conversions are required : 1) Convert the stated interest rate into a
periodic rate , and 2) convert the number of years into number of periods.

•We find the periodic rate as follows:

•where INOM is the nominal annual rate and M is the number of
compounding periods per year.

•Thus, a 6% nominal rate with semiannual payments results in a periodic

rate of If only one payment is made per year then M = 1, in which case
the periodic rate would equal the nominal rate: 6%/1 = 6%.
Cont….
5-34
Classification of Interest Rates: compounded more
often

 Number of Periods = (Number of years) (Periods per year)

 To illustrate, suppose you invest $100 in an account that pays a
nominal rate of 12%, compounded quarterly, or 3% per period.
How much would you have after 2 years if you leave the funds on
deposit? First, here is the time line for the problem.

3-35
 Classification of Interest Rates

• Nominal rate (INOM): also called the quoted or

stated rate. An annual rate that ignores
compounding effects.
–I NOM is stated in contracts. Periods must also be
given, e.g. 8% quarterly or 8% daily interest.
– If two banks offers a loan with stated rate of 8% but
one requires monthly payments and other the
quarterly payments, they are not charging the same
rate—the one that requires monthly payments is
charging more than one with quarterly payments
because it will receive your money sooner. In order
to calculate loans one should calculate the effective
annual rate. 5-36
 Classification of Interest Rates: Effective (or
Equivalent) Annual Rate

Effective (or Equivalent) Annual Rate (EAR or EFF

%): The annual rate of interest actually being
earned, as opposed to the quoted rate, also called
“Equivalent Annual Rate”
This is the annual (interest once a year) rate that
produces the same final result as compounding at
the periodic rate for M times per year. The EAR,
also called EFF% (for effective percentage rate), is
found as follows

3-37
 Classification of Interest Rates

• Effective (or equivalent) annual rate (EAR = EFF%): the

annual rate of interest actually being earned
considering compounding.
– EFF% for 10% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.10/2)2 – 1 = 10.25%
– Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.10,2)
– Implication: Should be indifferent between receiving
10.25% annual interest and receiving 10% interest,
compounded semiannually.

5-38
Why is it important to consider effective rates
of return?

 Investments with different compounding intervals

provide different effective returns.
 To compare investments with different
compounding intervals, you must look at their
effective returns (EFF% or EAR).

5-39
Why is it important to consider effective rates
of return?

• See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

5-40
 When is each rate used?

• INOM: Written into contracts, quoted by banks and

brokers. Not used in calculations or shown on time
lines.
• IPER: Used in calculations and shown on time lines.
If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments with
different payments per year. Used in calculations
when annuity payments don’t match compounding
periods.

5-41
 What is the FV of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?

MN
 INOM 
FVN  PV 1  
 M 

23
 0.10 
FV3S  $100 1  
 2 
FV3S  $100(1.05)6  $134.01
FV3Q  $100(1.025)12  $134.49

5-42
Question: Can the effective rate ever be equal to the
nominal rate?

5-43
Can the effective rate ever be equal to the nominal
rate?

• Yes, but only if annual compounding is used, i.e., if

M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.

5-44
What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?

• Payments occur annually, but compounding occurs

every 6 months.
• Cannot use normal annuity valuation techniques.

0 1 2 3 4 5 6
5%

100 100 100

5-45
 Method 1:
Compound Each Cash Flow

0 1 2 3 4 5 6
5%

100 100 100

110.25
121.55
331.80
FV3 = $100(1.05)4 + $100(1.05)2 + $100
FV3 = $331.80

5-46
 Class Exercise 5.20

 A rookie quarterback is negotiating his first NFL

contract. His opportunity cost is 10%. He has been
offered three possible 4-year contracts. Payments are
guaranteed, and they would be made at the end of each
year. Terms of each contract are as follows:

3-47
 Exercise 5.20

$3,000 ,000 $3,000 ,000 $3,000 ,000 $3,000 ,000

Contract 1: PV =   
1.10 (1.10 ) 2 (1.10) 3 (1.10) 4
= $2,727,272.73 + $2,479,338.84 + $2,253,944.40 + $2,049,040.37
= $9,509,596.34.

$2,000 ,000 $3,000 ,000 $4 ,000 ,000 $5,000 ,000

Contract 2: PV =   
1.10 (1.10 ) 2
(1.10) 3
(1.10) 4
= $1,818,181.82 + $2,479,338.84 + $3,005,259.20 + $3,415,067.28
= $10,717,847.14.

$7,000 ,000 $1,000 ,000 $1,000 ,000 $1,000 ,000

Contract 3: PV =   
1.10 (1.10) 2 (1.10 ) 3 (1.10 ) 4
= $6,363,636.36 + $826,446.28 + $751,314.80 + $683,013.46
= $8,624,410.90.

3-48
 Class Exercise 5.21

Crissie just won the lottery, and she must choose between
three award options. She can elect to receive a lump sum
today of $61 million, to receive 10 end-of-year payments
of $9.5 million, or to receive 30 end-of-year payments of
$5.5 million.

a. If she thinks she can earn 7% annually which should

she choose?
a. If she thinks she can earn 8% annually which should
she choose?
a. If she thinks she can earn 9% annually which should
she choose?
3-49
 Exercise 5.21

5-21 a. If Crissie expects a 7% annual return on her investments:

1 payment 10 payments 30 payments
N = 10 N = 30
I/YR = 7 I/YR = 7
PMT = 9500000 PMT = 5500000
FV = 0 FV = 0
PV = $61,000,000 PV = $66,724,025 PV = $68,249,727

Crissie should accept the 30-year payment option as it carries the highest present value
($68,249,727).

b. If Crissie expects an 8% annual return on her investments:

1 payment 10 payments 30 payments
N = 10 N = 30
I/YR = 8 I/YR = 8
PMT = 9500000 PMT = 5500000
FV = 0 FV = 0
PV = $61,000,000 PV = $63,745,773 PV = $61,917,808

Crissie should accept the 10-year payment option as it carries the highest present value
($63,745,773).

c. If Crissie expects a 9% annual return on her investments:

1 payment 10 payments 30 payments
N = 10 N = 30
I/YR = 9 I/YR = 9
PMT = 9500000 PMT = 5500000
FV = 0 FV = 0
PV = $61,000,000 PV = $60,967,748 PV = $56,505,097

Crissie should accept the lump-sum payment option as it carries the highest present value
($61,000,000).

d. The higher the interest rate, the more useful it is to get money rapidly, because it can be invested
at those high rates and earn lots more money. So, cash comes fastest with #1, slowest with #3,
so the higher the rate, the more the choice is tilted toward #1. You can also think about this
another way. The higher the discount rate, the more distant cash flows are penalized, so again,
#3 looks worst at high rates, #1 best at high rates.

3-50