Time Value of Money

I.
A.

Time Lines
Future Value: Compounding
Future value of $1 received today and earning interest at 6% for one period:
0

i = .06

PV =
$1
|--------------------|
$1
|-------------------
Formula:

FV1= PV (1+i) 1

Solution:

FV = $1 (1.06)

i = .06
n=1
FV1 =??

1.06

Future value of $1 received today and earning interest at 6% for two periods:
0

i = .06 1
2
$1

|------------------|------------------|
$1
|-----------------/-----------------

PV =

i = .06
n=2
FV2 =??

Formula:

FV = PV (1+i)(1+i)

PV(1+i)2

Solution:

FV = $1 (1.06)2

1.1236

Find the future value of $100 to be received ten years from now and
earning interest at 6% per year:
Calculator Keys!
TI BA II Plus Calculator
2nd, CLR TVM
2nd, CLR Work
Fin 335: Chapter 5, page 1

PV = $100
i = .06
n = 10
FV = ??

100, PV
6, I/Y
10, N
CPT, FV
(Answer: -179.08)
COMPOUND GROWTH
FUTURE VALUE OF $1,000 INVESTMENT
8 PERCENT COMPOUND RATE OF GROWTH

YEARS
1
2

FV
1,080

INTEREST
INTEREST ON
ON PRINCIPAL INTEREST
80
0
1,166
160
6
1,260

3
240

20
1,470

5
400

70
2,159

10
800

359
3,172

15
1,200

972
4,661

20
1,600

2,061
6,848

25
2,000

3,848
30
10,063
Fin 335: Chapter 5, page 2

2,400
6,663

1.

Simple Growth:
PV(1+rt)
$1000[1+ .08(10)] = $1000(1.80) = $1800

FV

2.

Compound Growth:
PV(1+r)t
=
10
$1000(1+.08)
= $1000(2.159) = $2159

FV

3.

Simple interest:
$1000[.08(10)]

SI

4.

Compound interest:
PV(1+r)t - PV
=
CI
10
$1000(1+.08) - $1000 = $1000(2.159) - $1000 = $1159

5.

Interest on principal
Simple interest = $800

SI

6.

Interest on interest
$1159 - $800 = $359

CI SI

PV(rt)
= $1000(.80) = $800

Future Value Practice:

1.

FV of $50 after 1 year at 12% per year is ______.

50, PV
12, I/Y
1, N
CPT, FV

2.

(Answer: -56)

FV of $50 after 5 years at 12% per year (annual compounding) is _____.

50, PV
12, I/Y
5, N
Fin 335: Chapter 5, page 3

CPT, FV
3.

FV of $50 after 5 years at 12% per year (semi- annual) is ______.

50, PV
6, I/Y
10, N
CPT, FV

4.

i/M = annual interest rate/compounding periods per year

NxM = number of years x compounding periods per year
(Answer: -89.54)

FV of $50 after _____ years at 12% per year (annual compounding) is $605.
50, PV
12, I/Y
-605, FV
CPT, N

5.

(Answer: -88.12)

(Answer: 22 years)

FV of $50 after _____ years at 12% per year (semi-annual) is $89.54.

50, PV
6, I/Y
-89.54, FV
CPT, N
(Answer: 10 semi-annual periods.5 years)

What about Continuous Compounding?

B.

Present Value: Discounting

Present value of $1 to be received after 1 period at 6% per period:
0

i = .06

FV1
= $1
|------------------|
$1

<-----------------|

PV

= ??

$1/(1.06)

Formula:

PV = FV1/(1+i)

Solution:

PV = FV1/(1+i)

= .06
n
=1

.9434

Fin 335: Chapter 5, page 4

Present value of $1 to be received after 2 periods if the discount rate is 6%

per period:
0

i = .06

1
2

FV2
= $1
|------------------|--------------------|

= .06
$1
n
=2

<----------------/---------------------|
Formula:

PV = FV2/(1+i)(1+i)

Solution:

PV = $1/(1.06)2

PV
=

= ??

FV2/(1+i)2

.8900

Find the Present value of $100 to be received in 10 years at 6% per year:

FV10 = $100
i = .06
n = 10
PV = ??

100, FV
6, I/Y
10, N
CPT, PV

(Answer: -55.84)

Present Value Practice:

1.

PV of $50 after 1 year at 12% per year is _____.

50, FV
Fin 335: Chapter 5, page 5

12, I/Y
1, N
CPT, PV
2.

(Answer: _______)

PV of $50 after 5 years at 12% per year (annual compounding) is _______.

50, FV
12, I/Y
5, N
CPT, PV

3.

(Answer: ______)

PV of $50 after 5 years at 12% per year (semi- compounding) is ______.

50, FV
6, I/Y
10, N

i/M = annual interest rate/compounding periods per year

NxM = number of years x compounding periods per year

CPT, PV

(Answer: ________)

Bonus Questions:
4.

Suppose that you have $5,000 to invest today. What will it be worth in 5
years if there is no inflation and you can earn 10 percent on your money?

5.

Now suppose that a 3 percent inflation rate will eat away at your 10 percent
annual return. How will this change your growth rate????

C.

Annuities

Annuity: A series of equal payments at equal intervals for a finite period of time
Examples: School loan payment, apartment rent, car payment, and interest on
bonds
Fin 335: Chapter 5, page 6

Types of Annuities:
Ordinary annuity: Each payment comes at the end of the period (auto loan)
Annuity due: Each payment comes at the beginning of the period (apartment rent)
Future value of a 6%, $1,000, 3-year ordinary annuity:
0 i= .06

2
3

|--------------------|----------------|------------------|
1,000
1,000
1,000
|
|
|
|------------->
1,060
|
|---------------------------> 1,124
3,184
Pmt = $1000
i = .06
n=3
FVA =??

1000, PMT
6, I/Y
3, N
CPT, FV

(Answer: -3,184)

Future value of a 6%, $1,000, 3-year annuity due:

0 i= .06

2
3

|--------------------|----------------|------------------|
1,000
1,000
1,000---------> 1,060
|
|
|
|--------------------------------->1,124
|
|----------------------------------------------> 1,191
3,375

Note: See bottom of next page for instructions for resetting the BAII+.
Fin 335: Chapter 5, page 7

Present value of a 6%, $1,000, 3-year ordinary annuity:

0 i= .06

1
2
3

|------------------|-----------------|------------------|
1,000

1,000
1,000
|

1,000/(1+.06) <-------|

|
|
|
|

1,000/(1+.06)2 <------------------------ |
|
1,000/(1+.06)3 <-------------------------------------------|
2,673

Pmt = $10001000, PMT

i = .06
6, I/Y
n=3
3, N
PVA =??
CPT, PV

(Answer: -2,673)

Present value of a 6%, $1,000, 3-year annuity due:

0 i= .06

1
2
3

|----------------------|---------------|----------------|
1,000
1,000
1,000
1,000/(1+.06) <----------|
1,000/(1+.06)2 <------------------------- |
2,833

|
|

also, 2,673(1.06) = 2,833

Resetting the calculator for payments to come at the beginning (BGN) of each
period.
Fin 335: Chapter 5, page 8

2nd, BGN, 2nd, CLR Work sets it to END (default) for ordinary annuity
2nd, BGN, 2nd, SET sets it to BGN for annuity due

D.

Pmt = $10001000, PMT

i = .06
6, I/Y
n=3
3, N
PVA = ??
CPT, PV
(Answer: -2,833)
Multiple Uneven Cash Flows

1.

Present Values:

Present value of a 6%, 3-year cash flow:

0 i= .06

1
2
3

|------------------|-----------------|------------------|
600
600/(1+.06) --------|

900
1,000
|
|
PV =
$566.04
|
|

900/(1+.06)2 <-------------------------- |
|
PV =
$801.00
|
1,000/(1+.06)3 <-------------------------------------------|
2,206.66

PV = $839.62

Simply discount each cash-flow back individually.

Or.use the CF functions of your calculator!!!
CFo = 0
CO1 = 600
FO1 =1
CO2 = 900
FO2 =1
Fin 335: Chapter 5, page 9

CO3 = 1000
FO3 =1
CPT NPV: $2,206.66
However, what if the first cash-flow occurs today, and each cash-flow thereafter
also occurs one period earlier?
Present value of a 6%, 3-year cash flow:
0 i= .06

1
2
3

|------------------|-----------------|------------------|
600
900
1,000
PV = $600
|
|
|

900/(1+.06)-----|

PV =
$849.06
|
1000/(1+.06)2 <------------------------- |

PV =
$890.00

2,339.06

Answer:
2.

Just use your CF function and put the cash flows in the appropriate
register!

Future Values:

Future value of a 6%, 3-year cash flow:

0 i= .06

2
3

|--------------------|----------------|------------------|
600
900
1,000
|
|
|
Fin 335: Chapter 5, page 10

|------------->
954.00
|
|---------------------------> 674.16
2,628.16

However, what if the first cash-flow occurs today, and each cash-flow thereafter
also occurs one period earlier?
Future value of a 6%, 3-year cash flow:
0 i= .06

2
3

|--------------------|----------------|------------------|
600
900
1,000---------> 1,060.00
|
|
|
|--------------------------------->
1,011.24
|
|----------------------------------------------> 714.61
2,785.85

Loan Amortization Schedule

Practice Problem: Present Value for an Uneven Cash Flow

1.

CF = cash flow button

Fin 335: Chapter 5, page 11

2.
3.

Down arrow button= move to the next function

Up arrow button = go back to the previous function

Your company is considering investing in a new machine. The cost is $100,000.

You can borrow money at 12 percent. The expected cash-flows for the machine:
Time

1
2
3
4
5
6
10K

CF

10K
20K
30K
30K
40K
1.

2nd CLR TVM, 2nd CLR Work

Fin 335: Chapter 5, page 12

2.

CF = 0.0

(IF NUMBER IN REGISTER, CLR Work!)

3.

CFo =

4.

CO1 =
10,000
down arrow

enter

5.

FO1 =
2
down arrow

enter

6.

CO2 =
20,000
down arrow

enter

7.

FO2 =
1
down arrow

enter

8.

CO3 =
30,000
down arrow

enter

9.

FO3 =
2
down arrow

enter

10.

CO4 =
40,000
down arrow

enter

11.

FO4 =

12.
13.

-100,000
enter down arrow

enter down arrow

CPT NPV I = 12.5

down arrow
NPV =

CPT

enter

answer: -14,055.70891

E.

APR (nominal rate) versus EAR (Effective rate)

1.

Nominal (stated) annual interest rate or annual percentage rate (APR)

Fin 335: Chapter 5, page 13

The stated annual rate without considering the effect of compounding

2.

Effective annual interest rate (EAR) or effective annual yield (EAY)

The annual rate after considering the effect of compounding
EAR=APR if interest is compounded annually; otherwise, EAR > APR

Example:
If APR is 6% compounded monthly, what is the EAR?
(1+.06/12)12 1 = .061678 = 6.1678 percent
If a bank changes 6 percent annual interest, but this interest is compounded
monthly, then the actual interest charge is 6.1678 percent

Using the BAII+ calculator to change nominal to effective annual rate:

Step 1: Hit 2nd button (grey), then hit the CONV (the number 2) button
Step2: Hit the down arrow button until you see NOM=
Step 3: Enter 6 and then hit the ENTER or SET button
Step 4: Hit the down arrow button until you see C/Y
Step 5: Enter 12 and then hit the ENTER or SET button
Step 6: hit the down arrow button until you see EFF =
Final step: Hit the CPT button. Answer is: 6.1678%

Fin 335: Chapter 5, page 14