Foundations of Finance: The Time Value of Money

Foundations of Finance
Arthur J. Keown John D. Martin

J. William Petty David F. Scott, Jr.
Chapter 5
The Time Value of Money
Chapter 5 The Time Value of Money
Learning Objectives
 Explain the mechanics of

compounding, which is how money
grows over a time when it is
invested.
 Be able to move money through time
using time value of money tables,
financial calculators, and
spreadsheets.
 Discuss the relationship between
compounding and bringing money
back to present.
5-2 Foundations of Finance Pearson Prentice Hall
Learning Objectives
 Define an ordinary annuity and

calculate its compound or future
value.
 Differentiate between an ordinary
annuity and an annuity due and
determine the future and present
value of an annuity due.
 Determine the future or present
value of a sum when there are
nonannual compounding periods.
Learning Objectives
• Determine the present value of an

uneven stream of payments
• Determine the present value of a

perpetuity.
• Explain how the international setting

complicates the time value of money.

Principles Used in this

Chapter
• Principle 2: The Time Value of

Money – A Dollar Received
Today Is Worth More Than a
Dollar Received in The Future.

Simple Interest
Interest is earned on principal
$100 invested at 6% per year

1st year interest is $6.00
2nd year interest is $6.00
3rd year interest is $6.00
Total interest earned: $18.00

Simple Interest
• With simple interest, you don’t

earn interest
on interest.
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125
Compound Interest
• When interest paid on an

investment during the first
period is added to the
principal;
• then, during the second
period, interest is earned on
the new sum.

Compound Interest
Interest is earned on previously earned

interest
$100 invested at 6% with annual

compounding
1st year interest is $6.00 Principal is $106.00
2nd year interest is $6.36 Principal is $112.36
3rd year interest is $6.74 Principal is $119.11
Total interest earned: $19.11

Compound Interest
• With compound interest, a depositor earns

interest on interest!
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00

Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
Simple Interest and Compound

Interest
 What is the difference between simple

interest and compound interest?
 Simple interest: Interest is earned only
on the principal amount.
 Compound interest: Interest is earned on
both the principal and accumulated
interest of prior periods.
 Example : Suppose that you deposit $500 in
your savings account that earns 5% annual
interest. How much will you have in your
account after two years using (a) simple
interest and (b) compound interest?
11
Example
 Simple Interest
 Interest earned = 5% of $500 = .05×500 = $25
per year
 Total interest earned = $25×2 = $50
 Balance in your savings account:
= Principal + accumulated interest
= $500 + $50 = $550
 Compound interest (assuming compounding once a year)
 Interest earned in Year 1 = 5% of $500 = $25
 Interest earned in Year 2 = 5% of ($500 +
accumulated interest)
= 5% of ($500 + 25) = .05×525 = $26.25
 Balance in your savings account:
= Principal + interest earned = $500 + $25 +
$26.25 = $551.25
12
Future Value
- The amount a sum will grow in

a certain number of years when
compounded at a specific rate.
5 - 13 Foundations of Finance Pearson Prentice Hall

Future Value
FV of an initial $100 after 3 years (I = 10%)
0 1 2 3
10%
100 FV = ?
Finding FVs (moving to the right
on a time line) is called compounding.
14
After 1 year
FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.10)
= $110.00
15
After 2 years
FV2 = FV1(1+I) = PV(1 + I)(1+I)

= PV(1+I)2
= $100(1.10)2
= $121.00
16
After 3 years
FV3 = FV2(1+I)=PV(1 + I)2(1+I)

= PV(1+I)3
= $100(1.10)3
= $133.10
In general,
FVn = PV0(1+k)n = PV(FVIFk,n)
17
Future Value
FVn = PV (1 + i)
Where FVn = the future of the investment at
the end of one year
i= the annual interest (or discount)
rate
PV = the present value, or original
amount invested at the beginning
of the first year

Future Value
What will an investment be

worth in 2 years?
$100 invested at 6%
FV2= PV(1+i)2 = $100 (1+.06)2
$100 (1.06)2 = $112.36

Future Value
• Future Value can be increased

by:
• Increasing number of years of
compounding
• Increasing the interest or
discount rate

Future Value Using Tables
FVn = PV (FVIFi,n)
the end of n year
PV = the present value, or original
amount invested at the beginning
of the first year
FVIF = Future value interest factor or
the compound sum of $1
i= the interest rate
n= number of compounding periods
Future Value
What is the future value of $500

invested at 8% for 7 years?
(Assume annual compounding)
Using the tables, look at 8% column, 7
time periods. What is the factor?
FVn= PV (FVIF8%,7yr)
=$500 (1.714)
= $857
Future Value Using Calculators
Using any four inputs you will find the 5th.

Set to P/YR = 1 and END mode.
INPUTS OUTPUT
N 10 I/YR 6
PV -100
PMT 0
FV 179.10

Future Value Using Spreadsheets

Spreadsheets and the Time Value of Money
If we invest $500 in a bank where it will earn 8 percent compounded

annually, how much will it be worth at the end of 7 years?
rate (I) = 8%
number of periods (n) = 7
payment (PMT) = 0
present value (PV) = $500
type (0=at end of period) = 0
Future value = $856.91
Excel formula: FV = (rate, number of periods, payment, present value, type)
Entered in cell d13: = FV(d7,d8,d9,-d10,d11)

Notice that present value ($500) took a negative value
Practice
Find The future value of $500 in 5

years with annual compounding
interest rate of 5% .
Year by year compounding
YEAR PV or Interest Earned FV or

Beginning (5%) Ending Value
Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $551.25
$26.25
3 $551.25 $551.25*.05 $578.81
=$27.56
4 $578.81 $578.81*.05=$28 $607.75
.94
5 $607.75 $607.75*.05=$30 $638.14
.39
Use the Future Value Equation
 We will obtain the same answer

using the future value equation:
 FVn = PVo(1+i)n
= 500(1.05)5 = $638.14
 So the balance in savings account at the
end of 5 years will equal $638.14.
 The total interest earned on the original
principal amount of $500 will equal $138.14
(i.e. $638.14- $500.00).
Practice
Calculating the Future Value of a Cash Flow

You are put in charge of managing your firm’s
working capital.
Your firm has $100,000 in extra cash on hand

and decides to put it in a savings account
paying 7% interest compounded annually.
How much will you have in your account in 10

years?
Present Value
The current value of a future payment

PV = FVn {1/(1+i)n}
the end of n years
n= number of years until payment is
received
PV = the present value of the future sum
of money

Present Value
What will be the present value of $500

to be received 10 years from today if
the discount rate is 6%?
PV = $500 {1/(1+.06)10}
= $500 (1/1.791)
= $500 (.558)
= $279

Present Value Using Tables
PVn = FV (PVIFi,n)
Where PVn = the present value of a future sum of
money
FV = the future value of an investment at
the end of an investment period
PVIF = Present Value interest factor of $1
n= number of compounding periods

Present Value
What is the present value of $100

to be received in 10 years if the
discount rate is 6%?
PVn = FV (PVIF6%,10yrs.)
= $100 (.558)
= $55.80

Present Value Using Calculators

INPUTS OUTPUT
N 10 PV -55.84
I/YR 6
PMT 0
FV 100.00

Annuity
• Series of equal dollar payments

for a specified number of years.
• Ordinary annuity payments

occur at the end of each period

Compound Annuity
• Depositing or investing an equal

sum of money at the end of
each year for a certain number
of years and allowing it to grow.

Compound Annuity
FV5 = $500 (1+.06)4 + $500 (1+.06)3 +

$500(1+.06)2 + $500 (1+.06) + $500
= $500 (1.262) + $500 (1.191) +

$500 (1.124) + $500 (1.090) +
$500
= $631.00 + $595.50 + $562.00 +
$530.00 + $500
= $2,818.50
Illustration of a 5yr $500 Annuity

Compounded at 6%
0 1 2 3 4 5
6%
500 500 500 500 500

Future Value of an Annuity
FV = PMT {(FVIFi,n-1)/ i }
Where FV n= the future of an annuity at
the end of the nth years
FVIFi,n= future-value interest factor or sum of
annuity of $1 for n years
PMT= the annuity payment deposited or
received at the end of each year
i= the annual interest (or discount) rate
n = the number of years for which the
annuity will last

Compounding Annuity
What will $500 deposited in the bank

every year for 5 years at 6% be
worth?
FV = PMT {(FVIFi,n-1)/ i }
Simplified this equation is:
FV5 = PMT(FVIFAi,n)
= $500(5.637)
= $2,818.50
Future Value of Annuity
FVn = PMT x (FVIFAi,n)

= PMT x [ (1+i)n -1 ]

Future Value of an Annuity

Using Calculators
INPUTS OUTPUT
N 5 FV -2,818.55
PV 0
I/YR 6
PMT 500

Present Value of an Annuity
• Pensions, insurance obligations,

and interest received from
bonds are all annuities. These
items all have a present value.
• Calculate the present value of
an annuity using the present
value of annuity table.

PV = PMT x (PVIFAi,n)
= PMT x ( 1 – [1/ (1+i)n ])

Calculate the present value of a $500

annuity received at the end of the
year annually for five years when the
discount rate is 6%.
PV = PMT(PVIFAi,n)
= $500(4.212)
= $2,106

Impact of Interest Rates on PV
 If the interest rate (or discount rate) is higher

(say 9%), the PV will be lower.
 PV = 5000*(1/(1.09)10) = 5000*(0.4224)
=$2,112.00
 If the interest rate (or discount rate) is lower
(say 2%), the PV will be higher.
 PV = 5000*(1/(1.02)10) = 5000*(0.8203)
= $4,101.50
 Note the slight variation in which the formula
is written.
Solving for the Number of Periods
 Key Question: How long will it take to accumulate

a specific amount in the future?
 It is easier to solve for “n” using the financial
calculator or Excel rather than mathematical
formula:
 FV=PV(1+i)n
 (FV/PV)=(1+i)n  Move PV to the left.
 ln(FV/PV)=n ln(1+i)  Take natural logs (ln)
on both sides
 n=[ln(FV/PV)]/[ln(1+i)]  Move ln(1+i) to the
left, switch sides.
Example
 Example 5.6 How many years will it take

for an investment of $7,500 to grow to
$23,000 if it is invested at 8% annually?
 N=ln(FV/PV)/ln(1+i)
=[ln(2300/7500)]/[ln(1.08)] =1.12/0.077
=14.56
47 FIN3000, Liuren Wu
Practice
Solving for the Number of Periods, n

Let’s assume that the Toyota Corporation has
guaranteed that the price of a new Prius will always
be $20,000, and you’d like to buy one but currently
have only $7,752. How many years will it take for your
initial investment of $7,752 to grow to $20,000 if it is
invested so that it earns 9% compounded annually?
How many years will it take for $10,000 to grow to
$200,000 given a 15% compound growth rate?
 Verify the answers: 11years; 21.43 years.

Solving for Rate of Interest
 Key Question: What rate of interest will

allow your investment to grow to a desired
future value?
 FV=PV(1+i)n
 (FV/PV)=(1+i)n  Move PV to the left
 (FV/PV)(1/n)=1+i  Take (1/n) root on
both sides
 i=(FV/P)(1/n)-1.  Move 1 to the left,
switch sides.
Practice
 Example 5.8 At what rate of interest

must your savings of $10,000 be
compounded annually for it to grow
to $22,000 in 8 years?
 i=(FV/PV)(1/n)-1
 = (22000/10000)(1/8)-1 =0.1036=10.36%.
Practice
Solving for the Interest Rate, i

Let’s go back to that Prius example
Recall that the Prius always costs $20,000.
In 10 years, you’d really like to have $20,000
to buy a new Prius, but you only have $11,167
now. At what rate must your $11,167 be
compounded annually for it to grow to
$20,000 in 10 years?
At what rate will $50,000 have to grow to
reach $1,000,000 in 30 years?
Verify the answers: 6%; 10.5%.

Annuities Due
• Ordinary annuities in which all

payments have been shifted
forward by one time period.

Amortized Loans
• Loans paid off in equal

installments over time
– Typically Home Mortgages
– Auto Loans

Payments and Annuities
If you want to finance a new

machinery with a purchase
price of $6,000 at an interest
rate of 15% over 4 years, what
will your payments be?

PV = PMT x (PVIFAi,n)
= PMT x ( 1 – [1/ (1+i)n ])

Future Value Using Calculators

INPUTS OUTPUT
N 4 PMT -2,101.59
PV 6,000
I/YR 15
FV 0

Amortization of a Loan
• Reducing the balance of a loan via

annuity payments is called
amortizing.
• A typical amortization schedule looks
at payment, interest, principal
payment and balance.

Amortization Schedule
Yr. Annuity Interest Principal Balance
1 $2,101.58 $900.00 $1,201.58 $4,798.42
2 $2,101.58 719.76 1,381.82 3,416.60
3 $2,101.58 512.49 1,589.09 1,827.51
4 $2,101.58 274.07 1,827.51

Compounding Interest with

Non-annual periods
If using the tables, divide the percentage by
the number of compounding periods in a
year, and multiply the time periods by the
number of compounding periods in a year.
Example:
8% a year, with semiannual compounding for
5 years.
8% / 2 = 4% column on the tables
N = 5 years, with semiannual compounding
or 10
Use 10 for number of periods, 4% each
Compound Interest with Shorter (Other) Compounding

Periods
Banks frequently offer savings

account that compound interest
every day, month, or quarter.
More frequent compounding will
generate higher interest income
for the savers if the annual
interest rate is the same.
Compounding More Frequently

Than Annually
• Compounding more frequently than once a

year results in a higher effective interest
rate because you are earning on interest on
interest more frequently.
• As a result, the effective interest rate is
greater
than the nominal (annual) interest rate.
• Furthermore, the effective rate of interest
will increase the more frequently interest
is compounded.
Compound Interest with Shorter (Other) Compounding

Periods
Example You invest $500 for seven years to

earn an annual interest rate of 8%, and the
investment is compounded semi-annually.
What will be the future value of this
investment?
Use the more general formula:
FV=PV(1+rate per period)Number of periods
Rate per half year period is 8%/2=4%.
Number of half-year periods in 7 years is 7x2=14
half years.
FV=500x(1+0.04)14=865.84
Compound Interest with Shorter Compounding Periods
Another way to write the future value

equation, in terms of annual rates and
years:
 Example again:
 FV = PV(1+i/2)m*2 = 500(1+.08/2)7*2
=
500x(1.04)14=865.84.

Than Annually
• Example 2,
• what would be the difference in future value
if I deposit $100 for 5 years and earn 12%
annual interest compounded (a) annually, (b)
semiannually, (c) quarterly, and (d) monthly?
Annually: 100 x (1 + .12)5 = $176.23
Semiannually: 100 x (1 + .06)10 = $179.09
Quarterly: 100 x (1 + .03)20 = $180.61


Than Annually
Practice
If you deposit $1,000 with Plaza National

Bank at an interest rate of 12%, what will your
account balance be in five years?
If you deposit $50,000 in an account that pays

an annual interest rate of 10% compounded
monthly, what will your account balance be in
10 years?

Verify the answers: [1]$1790.85; [2]$135,352.07
Perpetuity
• An annuity that continues forever is

called perpetuity
• The present value of a perpetuity is
PV = PP/i
PV = present value of the perpetuity
PP = constant dollar amount
provided by the of perpetuity
i = annuity interest (or discount
rate)
Present Value for

complex cash flow
End period of Cash Flow
1 200
2 200
3 200
4 200
5 200
6 -300
7 500
8 500
9 500
Present Value for

complex cash flow
Present Value for

complex cash flow
Akhir periode Ke- Cash Flow
1 100
2 100
3 100
4 100
5 100
6 -100
7 200
8 200
9 200
Present Value for

complex cash flow
Tk.bunga 6%
Tentukan nilai di akhir tahun ke-5!

i=5%
Akhir Tahun Cash Cash Cash

Ke- Inflow Outflow Flow
($) ($)
1 5000 1000
2 5000 3000
3 5000 3000
4 15.000 5.000
5 15.000 10.000
SOAL
Anda diberikan 3 alternatif investasi yang harus dianalisa.
Arus kas dari ketiga investasi tersebut adalah sebagai berikut:
Akhir Tahun A B C
Ke- ($) ($) ($)
1 5000 1000 10.000
2 5000 3000 10.000
3 5000 5000 -7.000
4 -15.000 10.000 5.000
5 15.000 -10.000 5.000
a. Buatlah time line!
b. Hitung nilai sekarang investasi jika suku bunga yang
diinginkan oleh investor adalah 10%!
SOAL
1. Berapakah nilai sekarang dari $800 yang akan

diterima 10 tahun dari sekarang yang didiskontokan
kembali ke masa sekarang dengan bunga 10%?
2. Stefani membeli rumah baru seharga $150,000. Dia

membayar uang muka $20,000 dan setuju akan
membayar sisanya selama 25 tahun ke muka
dengan 25 kali pembayaran yang sama yang terdiri
dari pembayaran pinjaman pokok ditambah bunga
majemuk 10% atas pinjaman yang belum dibayar.
Berapa uang yang harus dibayarkan per tahun?
The Multinational Firm
• Principle 1- The Risk Return Tradeoff – We

Won’t Take on Additional Risk Unless We
Expect to Be Compensated with Additional
Return
• The discount rate is reflected in the rate of
inflation.
• Inflation rate outside US difficult to predict
• Inflation rate in Argentina in 1989 was
4,924%, in 1990 dropped to 1,344%, and in
1991 it was only 84%.

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Foundations of Finance

Arthur J. Keown John D. Martin

 Explain the mechanics of

 Define an ordinary annuity and

• Determine the present value of an

• Determine the present value of a

• Explain how the international setting

5-4 Foundations of Finance Pearson Prentice Hall

Principles Used in this

• Principle 2: The Time Value of

5-5 Foundations of Finance Pearson Prentice Hall

Interest is earned on principal

$100 invested at 6% per year

5-6 Foundations of Finance Pearson Prentice Hall

• With simple interest, you don’t

• When interest paid on an

5-8 Foundations of Finance Pearson Prentice Hall

Interest is earned on previously earned

$100 invested at 6% with annual

5-9 Foundations of Finance Pearson Prentice Hall

• With compound interest, a depositor earns

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

Simple Interest and Compound

 What is the difference between simple

- The amount a sum will grow in

5 - 13 Foundations of Finance Pearson Prentice Hall

FV of an initial $100 after 3 years (I = 10%)

FV1 = PV + INT1 = PV + PV (I)

FV2 = FV1(1+I) = PV(1 + I)(1+I)

FV3 = FV2(1+I)=PV(1 + I)2(1+I)

5 - 18 Foundations of Finance Pearson Prentice Hall

What will an investment be

5 - 19 Foundations of Finance Pearson Prentice Hall

• Future Value can be increased

5 - 20 Foundations of Finance Pearson Prentice Hall

Future Value Using Tables

What is the future value of $500

Future Value Using Calculators

Using any four inputs you will find the 5th.

5 - 23 Foundations of Finance Pearson Prentice Hall

Future Value Using Spreadsheets

If we invest $500 in a bank where it will earn 8 percent compounded

Future value = $856.91

Excel formula: FV = (rate, number of periods, payment, present value, type)

Entered in cell d13: = FV(d7,d8,d9,-d10,d11)

Find The future value of $500 in 5

Year by year compounding

YEAR PV or Interest Earned FV or

Use the Future Value Equation

 We will obtain the same answer

Calculating the Future Value of a Cash Flow

Your firm has $100,000 in extra cash on hand

How much will you have in your account in 10

The current value of a future payment

5 - 29 Foundations of Finance Pearson Prentice Hall

What will be the present value of $500

5 - 30 Foundations of Finance Pearson Prentice Hall

Present Value Using Tables

5 - 31 Foundations of Finance Pearson Prentice Hall

What is the present value of $100

5 - 32 Foundations of Finance Pearson Prentice Hall

Present Value Using Calculators