Time Value of Money Chapter 3

Chapter 3 -
Support
The
The Time
Time Value
Value of
of
Money
Money
3b.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Remember? Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
0 1
7%
$1,000
FV2
Future Value Excel Formula
[Calculates a single value in the future based on current ex-
pectations]
• Excel function is =FV(rate,nper,pmt,pv,type)

• rate: the interest rate per period
• nper: the total number of compounding periods
• pmt: the payment made each period and cannot
change over the life of the annuity ($0 in a single
cash flow)
• pv: the present value you begin with
• type: is the number 0 (normal period-end) or 1
(beginning of the period) and indicates when
payments are due/occur
Future Value Example
B C D E F
2 Inputs Explanations
3 rate: 7.00%  Compound 7% per year
4 nper: 2  2 periods in the problem
5 pmt: $ -  $0 per year invested
6 pv: $ (1,000.00)  Start with $1,000 today
7 type: 0  Not relevant in single flow
8 Outputs
9 Future Value (FV): $1,144.90  =FV(D3,D4,D5,D6,D7)
FV = P (1+i)^n
FV = $1,000 (1.07)^2
Story Problem Revisited
Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound an-
nual interest rate of 10% for 5 years.
0 1 2 3 4 5
10%
$10,000
FV5
Future Value Example
B C D E F
5 pmt: $ -  No payment as single flow
6 pv: $ (10,000.00)  Invests $10,000 today
8 Outputs
$10,000 (1.10^5)
Another Future
Value Story Problem
• John and Mary are saving for retirement and
currently have $127,833.56 as a nest egg.
• John indicates that they plan to retire 25
years from today while Mary expects that a
6% rate of return is appropriate for their risk
level given historical returns.
• Calculate how large the account is expected
to grow.
“New” FV Story Problem
B C D E F
6 pv: $ (127,833.56)  Invests $127,833.56 today
8 Outputs
$127,833.56 (1.06^25)
“New” FV Story Problem
• John and Mary will have their $ 127,833.56
investment grow to $ 548,645.11 in 25 years
if they earn exactly 6% each year.
• Note that the Excel answer is a ‘positive’
amount. This indicates that John and Mary
DEPOSITED $ 127,833.56 (the negative
amount as they have less cash) to receive
the positive $548,645.11 (when they receive
cash at retirement when they WITHDRAW the
funds).
Remember? Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
7%
$1,000
PV0 PV1
Present Value Excel Formula
[Calculates a single current value based on future expecta-
tions]
• Excel function is =PV(rate,nper,pmt,fv,type)

• nper: the total number of discounted periods
• pmt: the payment made each period and cannot
change over the life of the annuity ($0 in a single
cash flow)
• fv: the future value you expect to attain
Present Value Example
B C D E F
3 rate: 7.00%  Discount 7% per period
6 fv: $ 1,000  Want $1,000 in future
8 Outputs
9 present value (pv) ($873.44)  =PV(D3,D4,D5,D6,D7)
PV = P [1/(1+i)^n]
PV = $1,000 [1/(1.07)^2]
Story Problem Revisited
Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a discount
rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
Present Value Example
B C D E F
6 fv: $ 10,000  Want $10,000 in future
8 Outputs
9 present value (pv) ($6,209.21)  =PV(D3,D4,D5,D6,D7)
PV = $10,000 [1.10^-5]
Another Present Value
Story Problem
• John and Mary are expecting to build a
$100,000 nest egg to use to travel the world
upon retirement. They would like to know
how much they need to set aside today to
reach this goal.
• John indicates that they will retire 20 years
from today while Mary thinks that a 6% rate
of return is appropriate for their risk level.
Calculate how much they need to set aside
today.
“New” PV Story Problem
B C D E F
6 fv: $ 100,000  Want $100,000 in future
8 Outputs
PV = $100,000 [1/(1+0.06)^20
“New” PV Story Problem
• John and Mary need to set aside $31,180.47
today if they earn exactly 6% each year for
the next 20 years to reach their goal.
• Note that the Excel answer is a ‘negative’
amount. This indicates that John and Mary
will need to DEPOSIT this amount of money
(they have less cash) to receive the positive
$100,000 (when they receive cash) they would
WITHDRAW monies.
Remember? Double
Your Money!!!
Quick! How long does it take to double

$5,000 at a compound rate of 12% per
year (approx.)?
We will use the “Rule-of-72”.
Remember? Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/
(1.07)3
= $934.58 + $873.44 + $816.30 =
3b.19
$2,624.32
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Present Value of an Annuity
[Calculates a single current value based on future expectations]
• Excel function is =PV(rate,nper,pmt,fv,type)

• nper: the total number of payments or periods
• pmt: the payment that is made/received each period
and cannot change over the life of the annuity
• fv: a single future value you expect to receive (can be
$0)
• type: is the number 0 (normal period-end) or 1 (begin-
ning of the period) and indicates when payments are
due/occur
PV Annuity Example
(Ordinary Annuity)
B C D E F
5 pmt: $ 1,000  $10,000 invested per yr
6 fv: $ -  No future amount in additon
7 type: 0  Ordinary Annuity
8 Outputs
PV = P [1- (1/(1+i)^n / i)]

PV = $1,000 [1- (1/1.07)^3 /.07
“New” PV Annuity Example
(Ordinary Annuity)
• John and Mary are trying to build a nest egg to use
in the future. They would like to know how much
they need to set aside in a single lump sum today to
be equivalent to investing $10,000 each year starting
one year from today to reach this goal.
• John indicates that they will use the money 25 years
from today while Mary thinks that a 6% rate of return
is appropriate for their risk level.
• Calculate the equivalent present value of this ordi-
nary annuity stream.
(Ordinary Annuity)
B C D E F
5 pmt: $ (10,000)  $10,000 invested per yr
8 Outputs
9 present value (pv) $127,833.56  =PV(D3,D4,D5,D6,D7)
PV = $10,000 [1-(1/1.06^25/.06)]
(Ordinary Annuity)
• John and Mary need to set aside $127,833.56
today to be equivalent to setting aside
$10,000 per year at exactly 6% each year for
the next 25 years.
• In this case, John and Mary need to decide
which is their preference. This sum will grow
to exactly the same as the future value of an
ordinary annuity (see slides 7 to 9).
Remember? Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$3,215 = FVA3
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
= $3,215
Future Value of an Annuity
[Calculates a single current value based on future expectations]
• Excel function is = FV(rate,nper,pmt,pv,type)

• nper: the total number of payments or periods
• pmt: the payment that is made/received each pe-
riod and cannot change over the life of the annu-
ity
• pv: a single present amount you begin with (can
be $0)
Future Value Annuity Exam-
ple (Ordinary Annuity)
B C D E F

5 pmt: $ (1,000)  $1,000 per year invested (negative)
6 pv:  Start with $0 today in account
8 Outputs
PV([(1+i)^n-1]/i)
$1,000([(1.07)^3-1]/.07)
“New” Future Value Annuity
Example (Ordinary Annuity)
• John and Mary are trying to build a nest egg to use
in the future. They would like to know how much
they would accumulate by investing $10,000 each
year to reach this goal. (See slides 21 to 23 and also
7 to 9)
• John indicates that they will use the money 25
years from today while Mary thinks that a 6% rate of
return is appropriate for their risk level.
• Calculate the equivalent future value of this ordi-
nary annuity stream.
B C D E F
5 pmt: $ (10,000)  $10,000 per year invested
6 pv: $ -  No additional monies today
8 Outputs
PV([(1+i)^n-1]/i)
$10,000([(1.06)^25-1]/.06)
• John and Mary will accumulate nearly
$550,000 by investing $10,000 per year
at exactly 6% each year for the next 25
years.
• In this case, note that this result is
equivalent to the future value of a single
sum where John and Mary needed to
set aside over $127,000 to generate this
sum.
Remember? Example of
an Annuity Due – PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn
PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
PV Annuity Exam-
ple (Annuity Due)
B C D E F
5 pmt: $ (1,000)  $1,000 invested per yr (negative)
6 fv:  No future amount in additon
7 type: 1  Annuity DUE!!!!
8 Outputs
PV = $1,000 [1-(1/(1.07)^3/.07)][1.07]
“New” PV Annuity Exam-
ple (Annuity Due)
• John and Mary are trying to build a nest egg to
use in the future. They would like to know how
much they need to set aside in a single lump
sum today to be equivalent to investing $10,000
each year starting today to reach this goal.
• John indicates that they will use the money 25
years from today while Mary thinks that a 6%
rate of return is appropriate for their risk level.
• Calculate the equivalent present value of this
annuity due stream.
ple (Annuity Due)
B C D E F
5 pmt: $ (10,000)  $10,000 invested per yr
8 Outputs
PV = $10,000 [1-(1/(1.06)^25/.06)][1.06]
ple (Annuity Due)
• John and Mary need to set aside $135,503.58 to-
day to be equivalent to setting aside $10,000 per
year at exactly 6% each year for the next 25
years.
• In this case, John and Mary need to decide which
is their preference. This sum will grow to exactly
the same as the future value of an ordinary annu-
ity (see slides 24 to 26) plus EXTRA interest.
• EXTRA INTEREST: So the amount is one years in-
terest higher for each payment or $127,833.56*6%
= $7,670.01 higher PV!
Annuity Due
• An annuity due is used when the cash flow
occurs at the beginning of the period
• As before, you see the value is higher by an
amount equal to i% times the ordinary annuity
value.
• Present values of annuities will be larger be-
cause each cash flow is “discounted” one less
period. See previous examples.
• Future values of annuities will be larger be-
cause each cash flow gets compounded one
“extra” period. No examples shown here.
Mixed Flows Example
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%.
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
Solve a “mixed flows” problem
using the NPV function
Period Cash Flows
1 $ 600.00
2 $ 600.00 Interest Rate:
10%
3 $ 400.00 (discount rate)
4 $ 400.00
5 $ 100.00 Present Value*: $1,677.15
=NPV(F3,C3:C22)
PV = FV[1/(1+i)^n]
PV = $600 [1/(1.10^1)] = 545.45
PV = $600 [1/(1.10^2)] = 495.87
PV = $400 [1/(1.10^3)] = 300.53
PV = $400 [1/(1.10^4)] = 273.21
PV = $100 [1/(1.10^5)] = 62.09
Remember? BWs Effective
Annual Interest Rate

Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate is
6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or
6.14%!
Remember? Amortizing
a Loan Example
Julie Miller is borrowing $10,000 at a com-
pound annual interest rate of 12%. Amor-
tize the loan if annual payments are made
for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Remember? Amortizing
a Loan Example
1. The first step is to use the “PMT” function to determine the
yearly (in this case) payment on the loan
2. Now you can use Excel to easily create the table you see below!
Refer to ‘VW13E-03.xlsx’ on the ‘Effect and Loan’ tab.
Amortizing a loan
Step 1: Calculating the loan amount
Rate: 12.00% ï Interest rate per period (year in this case)
nper: 5 ï Number of periods (5 years in this case)
pv $ 10,000.00 ï Beginning loan balance today (positive)
fv $ - ï Ending loan balance at end of periods
payment: ($2,774.10) ï Payment needed (negative)
Step 2: Create a table BB*12% P-IP BB-PP

Period Beginning Bal Payment Interest in Period Principal in Period Ending Balance
0 $ 10,000.00
1 $ 10,000.00 $2,774.10 $ 1,200.00 $1,574.10 $ 8,425.90
2 $ 8,425.90 $2,774.10 $ 1,011.11 $1,762.99 $ 6,662.91
3 $ 6,662.91 $2,774.10 $ 799.55 $1,974.55 $ 4,688.37
4 $ 4,688.37 $2,774.10 $ 562.60 $2,211.49 $ 2,476.87
5 $ 2,476.87 $2,774.10 $ 297.22 $2,476.87 $ 0.00

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Chapter 3 -

• Excel function is =FV(rate,nper,pmt,pv,type)

• Excel function is =PV(rate,nper,pmt,fv,type)

Quick! How long does it take to double

We will use the “Rule-of-72”.

• Excel function is =PV(rate,nper,pmt,fv,type)

PV = P [1- (1/(1+i)^n / i)]

• Excel function is = FV(rate,nper,pmt,pv,type)

3 rate: 7.00%  Compound 7% per year

$1,000.00 $1,000 $1,000

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

Annual Interest Rate

Step 2: Create a table BB*12% P-IP BB-PP

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