6-1

CHAPTER 5
Time Value of Money

 Read Chapter 6 (Ch. 5

in the 4th edition)
 Future value
 Present value
 Rates of return
 Amortization
 6-2

Time Value of Money Problems

 Use a financial calculator

 Bring your calculator to class
 Will need on exams
 We will not use the tables
 6-3
 Time lines show timing of cash
flows.

0 1 2 3
i%

CF0 CF1 CF2 CF3

 Tick marks at ends of periods, so

Time 0 is today; Time 1 is the end
of Period 1; or the beginning of
Period 2.
 6-4
A. (1) a. Time line for a
$100 lump sum due at the
end of Year 2.

0 1 2 Year
i%

100
 6-5
A. (1) b. Time line for an
ordinary annuity of $100 for
3 years.

0 1 2 3
i%

100 100 100

 6-6

A. (1) c. Time line for

uneven CFs -$50 at t=0 and
$100, $75, and $50 at the
end of Years 1 through 3.

0 1 2 3
i%

-50 100 75 50
 6-7

What’s the FV of an initial

$100 after 3 years if i = 10%?

0 1 2 3
10%

100 FV = ?

Finding FVs is Compounding.

 6-8

After 1 year:
FV1 = PV + I1 = PV + PV (i)
= PV(1 + i)
= $100 (1.10)
= $110.00.

After 2 years:

FV2 = PV(1 + i)2

= $100 (1.10)2
= $121.00.
 6-9

After 3 years:

FV3 = PV(1 + i)3

= 100 (1.10)3
= $133.10.

In general,

FVn = PV (1 + i)n
 6-10

Three ways to find FVs:

1. ‘Solve’ the Equation with a

Scientific Calculator
2. Use Tables (the book describes
this but not for use in this class)
3. Use a Financial Calculator
4. Spreadsheet (has built-in
formulas) -- won’t work on exams
 6-11
Here’s the setup to find FV:

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

Clearing automatically sets everything to

0, but for safety enter PMT = 0.

Check your calculator. Set: P/YR = 1 and

END (“BEGIN” should not show on the display)
 6-12

What’s the PV of $100 due

in 3 years if i = 10%?

Finding PVs is discounting,

and it’s the reverse of
compounding.
0 1 2 3
10%

PV = ? 100
 6-13

Financial Calculator Solution:

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

Either PV or FV must be negative. Here

PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
 6-14

If sales grow at 20% per year,

how long before sales double?

Solve for n:

FVn = 1(1 + i)n; In our case

2 = (1.20)n .
Take the log of both sides:
ln(2) = n ln(1.2)
n = ln(2)/ln(1.2)=.693…/0.1823..
=3.8017
 6-15
Financial calculator solution
INPUTS
20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

Graphical Illustration:
FV
2

1 3.8

0 Year
1 2 3 4
 6-16

What’s the difference

between an ordinary
annuity and an annuity
due?
 6-17

Ordinary vs. Annuity Due

0 1 2 3
i%

PMT PMT PMT

0 1 2 3
i%

PMT PMT PMT

 6-18
What’s the FV of a 3-year
ordinary annuity of $100 at
10%?

0 1 2 3
10%

100 100 100

110

121
FV = 331
 6-19

Financial Calculator Solution:

INPUTS
3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00

If you enter PMT of 100, you get FV of

-331.
Get used to the fact that you have to figure
out the sign.
 6-20

What’s the PV of this ordinary

annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV
 6-21

Financial Calculator Solution:

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

Have payments but no lump sum FV,

so enter 0 for future value.
 6-22
Technical Aside:
Your calculator really is assuming a NPV
equation, with PV as a time zero cash flow
as follows:

1  (1  i)n  n
NPV  PV  PMT    FV (1  i)
 i 

When you use the top row of calculator keys,

the calculator assumes NPV=0 and solves for
one variable.
 6-23

Find the FV and PV if the

annuity were an annuity due.

0 1 2 3
10%

100 100 100

 6-24

Switch from “End” to “Begin”.

Then enter variables to find PVA3 = $273.55.

INPUTS
3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

Then enter PV = 0 and press FV to find

FV = $364.10.
 6-25
Alternative:

 The first payment is in the present and

thus has a PV of 100.
 The next two payments comprise a two
period ordinary annuity -- use the formula
with n=2, PMT=100, and i=.10.
 Sum the above two for the present value.

 If you already have the PV, multiply by (1  i)3

To get FV
 6-26

Perpetuities
 A perpetuity is a stream of regular payments that goes on forever
An infinite annuity
 Future value of a perpetuity
Makes no sense because there is no end point
 Present value of a perpetuity
A diminishing series of numbers
• Each payment’s present value is smaller than the one
before

PMT
PVp 
k
 6-27

Perpetuities—Example
Q: The Longhorn Corporation issues a security that promises to pay its holder $5
per quarter indefinitely. Money markets are such that investors can earn about
8% compounded quarterly on their money. How much can Longhorn sell this
special security for?
A: Convert the k to a quarterly k and plug the values into the equation.
PMT $5 You may also work this by inputting a
PVp    $250
Example

k 0.02 large n into your calculator (to

simulate infinity), as shown below.
N 999
I/Y 2
PMT 5
FV 0
PV 250 Answer
 6-28

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
 6-29

 Input in “CFLO” register ( CFj ):

CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
 Enter I = 10%, then press NPV button to
get NPV = 530.09. (Here NPV = PV.)
 6-30

What’s Project L’s NPV?

Project L:
0 1 2 3
10%

-100.00 10 60 80
1
1 .1
9.09
2
49.59
1 .1
60.11
1.13
18.79 = NPVL
 6-31

Calculator Solution:

Enter in CFLO for L:

-100 CF0

10 CF1

60 CF2

80 CF3

10 i NPV = 18.78 = NPVL

 6-32
TI Calculators
•BA-35 doesn’t appear to do uneven
cash flows (NPV and IRR)

CF BA II PLUS

CF0= -100 Enter 

C01= 10 Enter  F01= 1.00 
C02= 60 Enter  F02= 1.00 
C03= 80 Enter  F03= 1.00 NPV
I=10 Enter  CPT NPV= 18.78
IRR CPT IRR= 18.13
 6-33

The Sinking Fund Problem

 Companies borrow money by issuing bonds for lengthy
time periods
No repayment of principal is made during the bonds’
lives
• Principal is repaid at maturity in a lump sum
– A sinking fund provides cash to pay off a
bond’s principal at maturity
• Problem is to determine the periodic deposit
to have the needed amount at the bond’s
maturity—a future value of an annuity
problem
 6-34
The Sinking Fund Problem –Example

Q: The Greenville Company issued bonds totaling $15 million for 30 years. The
bond agreement specifies that a sinking fund must be maintained after 10
years, which will retire the bonds at maturity. Although no one can accurately
predict interest rates, Greenville’s bank has estimated that a yield of 6% on
deposited funds is realistic for long-term planning. How much should Greenville
plan to deposit each year to be able to retire the bonds with the money put
aside?
Example

A: The time period of the annuity is the last 20 years of the bond issue’s life. Input
the following keystrokes into your calculator.
N 20

I/Y 6

FV 15,000,000

PV 0

PMT 407,768.35 Answer

 6-35
What interest rate would
cause $100 to grow to
$125.97 in 3 years?

$100 (1 + i )3 = $125.97.

INPUTS
3 -100 0 125.97
N I/YR PV PMT FV

OUTPUT 8%
 6-36
Will the FV of a lump sum be
larger or smaller if we
compound more often, holding
the stated i% constant? Why?

LARGER! If compounding is more

frequent than once a year--for
example, semi-annually, quarterly,
or daily--interest is earned on interest
more often.
 6-37
0 1 2 3
10%

100
133.10

Annually: FV3 = 100(1.10)3 = 133.10.

Semi-annually:
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
FV6/2 = 100(1.05)6 = 134.01.
 6-38

We will deal with 3

different rates:

iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate. The literal rate
applied each period
EAR = EFF% = effective
annual rate.
 6-39

 iNom is stated in contracts. Periods per year

(m) must also be given. Sometimes
(incorrectly) referred to as the “simple”
interest rate.
 Examples:
• 8%, Daily interest (365 days)
• 8%; Quarterly
 6-40

 Periodic rate = iPer = iNom/m, where m

is periods per year. m = 4 for
quarterly, 12 for monthly, and 360 or
365 for daily compounding.
 Examples:
8% quarterly: iper = 8/4 = 2%
8% daily (365): iper = 8/365 = 0.021918%
 6-41
 Effective Annual Rate (EAR = EFF%):
The annual rate which cause PV to grow to
the same FV as under multiperiod
compounding.
Example: EFF% for 10%, semiannual:
FV = (1 + inom/m)m
= (1.05)2 = 1.1025.
Any PV would grow to same FV at 10.25%
annually or 10% semiannually:
(1.1025)1 = 1.1025
(1.05)2 = 1.1025
 6-42

Comparing Financial Investments

 An investment with monthly
payments is different from
one with quarterly payments.
Must put on EFF% basis to
compare rates of return. Use
EFF% only for comparisons.
 Banks say “interest paid
daily.” Same as compounded
daily.
 6-43

How do we find EFF% for a

nominal rate of 10%, compounded
semi-annually?
m
 inom 
EFF% =  1 +  - 1
 m

2
 0.10
=  1+  - 1.0
 2 
2
= 1.05 - 1.0
= 0.1025 = 10.25%.
 6-44

EAR = EFF% of 10%

EARAnnual = 10%.

EARQ = (1 + 0.10/4)4 - 1 = 10.38%.

EARM = (1 + 0.10/12)12 - 1 = 10.47%.

EARD = (1 + 0.10/360)360 - 1= 10.5155572%.

.10
Continuous : e  1.105170918
 6-45

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.
 6-46

When is each rate used?

inom: Written into contracts,

quoted by banks and
brokers. Not used in
calculations or shown
on time lines.
 6-47

iper: Used in calculations,

shown on time lines.

If inom has annual compounding,

then iper = inom/1 = inom.
 6-48

EAR = EFF%: Used to compare returns

on investments with different payments
per year and in advertising of deposit interest
rates.

(Used for calculations if and only if

dealing with annuities where payments
don’t match interest compounding
periods.)
 6-49
FV of $100 after 3 years
under 10% semi-annual
compounding? Quarterly?
mn
 inom 
FVn = PV 1 + 
 m
2x3
 0.10
FV3s = $100 1 + 
 2 
= $100(1.05)6 = $134.01
FV3Q = $100(1.025)12 = $134.49
 6-50
What’s the value at the end
of Year 3 of the following CF
stream if the quoted interest
rate is 10%, compounded
semi-annually?

0 1 2 3 4 5 6
5%

100 100 100

6-month periods
 6-51

 Payments occur annually,

but compounding occurs
each 6 months.
 So we can’t use normal
annuity valuation
techniques.
 6-52

1st method: Compound each CF

0 1 2 3 4 5 6
5%

100 100 2
100.00
100(1.05)
4
110.25
100(1.05)
121.55
331.80

FVA3 = 100(1.05)4 + 100(1.05)2 + 100

= 331.80
 6-53

What’s the PV of this stream?

0 1 2 3 Years
5%

100 100 100

2
100 (1 . 05 )
90.70
4
100 (1 . 05 )
82.27
6
100 (1 . 05 )
74.62
247.59
 6-54

Second Method: use your

financial calculator!

Follow these two steps:

a. Find the EAR for the quoted rate:

2
 0.10
EAR =  1 +  - 1 = 10.25%.
 2 
This is the iper for a period of one
year. Use in formula (or calculator)
with the period equal to a year.
 6-55

Time line

0 1 2 3
10.25%

100 100 100

 6-56
b. Calculator inputs
INPUTS 3 10.25 0 -100
N I/YR PV PMT FV
OUTPUT 331.80
 Calculator Workout: fill in the blanks 6-57

N I PV PMT FV

10 10 100 0  

5 8   0 100

7  -500 100 0

15  -750 100 1000

240 8/12 -100,000   0

50 10 100 10  
 6-58

Fractional Time Periods

Example: $100 deposited in a bank
at 10% interest for 0.75 of the year

0 0.25 0.50 0.75 1.00

10%

- 100 FV = ?

INPUTS
0.75 10 - 100 0 ?
N I/YR PV PMT FV
OUTPUT =107.41
 6-59

AMORTIZATION

Construct an amortization schedule

for a $1,000, 10% annual rate loan
with 3 equal payments.
 6-60

This is what an amortization schedule looks like.

Amortization Table

Beginning Ending
Principal Total Interest Principal Principal
Period Balance Payment Payment Payment Balance
1 $1,000.00 $402.11 $100.00 $302.11 $697.89
2 $697.89 $402.11 $69.79 $332.33 $365.56
3 $365.56 $402.11 $36.56 $365.56 $0.00
 6-61

Step 1: Find the required payment.

0 1 2 3
10%

-1000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/YR PV PMT FV

OUTPUT 402.11
 6-62

Step 2: Find interest charge

for Year 1.

INTt = Beg balt (i)

INT1 = 1000(0.10) = $100.

Step 3: Find repayment of

principal in Year 1.
Repmt. = PMT - INT
= 402.11 - 100
= $302.11.
 6-63

Step 4: Find ending balance

after Year 1.

End bal = Beg bal - Repmt

= 1000 - 302.11 = $697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.
 6-64

Amortization Table

Beginning Ending
Principal Total Interest Principal Principal
Period Balance Payment Payment Payment Balance
1 $1,000.00 $402.11 $100.00 $302.11 $697.89
2 $697.89 $402.11 $69.79 $332.33 $365.56
3 $365.56 $402.11 $36.56 $365.56 $0.00

Interest declines. Tax Implications.

 6-65

 Amortization tables are widely

used-- for home mortgages,
auto loans, business loans,
retirement plans, etc. They are
very important!
 Financial calculators (and
spreadsheets) are great for
setting up amortization tables.
 6-66

Amortized Loans—Example
Q: Suppose you borrow $10,000 over four years at 18% compounded
monthly repayable in monthly installments. How much is your loan
payment?
A: Adjust your interest rate and number of periods for monthly
compounding and input the following keystrokes into your calculator.
Example

N 48

I/Y 1.5 This can also be calculated

using the PVA formula of
PV 10,000 PVA = PMT[PVFAk, n] with
FV 0 an n of 48 and a k of 1.5%,
resulting in $10,000 =
PMT 293.75 Answer PMT[34.0426] = $293.75.
 6-67

Amortized Loans—Example
Q: Suppose you want to buy a car and can afford to make payments of
$500 a month. The bank makes three-year car loans at 12%
compounded monthly. How much can you borrow toward a new car?
A: Adjust your k and n for monthly compounding and input the following
calculator keystrokes.
N
Example

36

I/Y 1 This can also be calculated

FV 0 using the PVA formula of
PVA = PMT[PVFAk, n] with
PMT 500 an n of 36 and a k of 1%,
resulting in PVA =
PV 15,053.75 Answer
$500[30.1075] = $15,053.75.
 6-68
Loan Amortization Schedules—Example

Q: Develop an amortization schedule for the

loan demonstrated in Example 5.12.
Example

Note that the Interest portion of

the payment is decreasing
while the Principal portion is
increasing.