TIME VALUE OF MONEY

The stated annual rate, or quoted rate, is the interest rate on an investment if an
institution were to pay interest only once a year. In practice, institutions
compound interest more frequently, either quarterly, monthly, daily and even
continuously. However, stating a rate for those small periods would involve
quoting in small fractions and wouldn't be meaningful or allow easy comparisons
to other investment vehicles; as a result, there is a need for a standard convention
for quoting rates on an annual basis.

The effective annual yield represents the actual rate of return, reflecting all of the
compounding periods during the year. The effective annual yield (or EAR) can
be computed given the stated rate and the frequency of compounding. We'll
discuss how to make this computation next.

Formula
Effective annual rate (EAR) = (1 + Periodic interest rate)m - 1
Where: m = number of compounding periods in one year, and
periodic interest rate = (stated interest rate) / m

Example: Effective Annual Rate

Suppose we are given a stated interest rate of 9%, compounded monthly, here is
what we get for EAR:

EAR = (1 + (0.09/12))12 - 1 = (1.0075) 12 - 1 = (1.093807) - 1 = 0.093807 or 9.38%

Keep in mind that the effective annual rate will always be higher than the stated
rate if there is more than one compounding period (m > 1 in our formula), and
the more frequent the compounding, the higher the EAR.

PROBLEM: To find out stated interest rate of 45%, compounded years, here is
what we get for EAR:

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Solving Time Value of Money Problems
Approach these problems by first converting both the rate r and the time period
N to the same units as the compounding frequency. In other words, if the problem
specifies quarterly compounding (i.e. four compounding periods in a year), with
time given in years and interest rate is an annual figure, start by dividing the rate
by 4, and multiplying the time N by 4. Then, use the resulting r and N in the
standard PV and FV formulas.

Example: Compounding Periods

Assume that the future value of $10,000 five years from now is at 8%, but
assuming quarterly compounding, we have quarterly r = 8%/4 = 0.02, and periods
N = 4*5 = 20 quarters.

FV = PV * (1 + r)N = ($10,000)*(1.02)20 = ($10,000)*(1.485947) = $14,859.47

Assuming monthly compounding, where r = 8%/12 = 0.0066667, and N = 12*5

= 60.

FV = PV * (1 + r)N = ($10,000)*(1.0066667)60 = ($10,000)*(1.489846) =

$14,898.46

Compare these results to the figure we calculated earlier with annual

compounding ($14,693.28) to see the benefits of additional compounding
periods.

Present Value of a Perpetuity

A perpetuity starts as an ordinary annuity (first cash flow is one period from today) but has
no end and continues indefinitely with level, sequential payments. Perpetuities are more a
product of the CFA world than the real world - what entity would obligate itself making to
payments that will never end? However, some securities (such as preferred stocks) do come
close to satisfying the assumptions of a perpetuity, and the formula for PV of a perpetuity is
used as a starting point to value these types of securities.

The formula for the PV of a perpetuity is derived from the PV of an ordinary annuity, which
at N = infinity, and assuming interest rates are positive, simplifies to:

Formula

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PV of a perpetuity = annuity payment A
interest rate r

Therefore, a perpetuity paying $1,000 annually at an interest rate of 8% would be worth:

PV = A/r = ($1000)/0.08 = $12,500

FV and PV of a SINGLE SUM OF MONEY

If we assume an annual compounding of interest, these problems can be solved with the
following formulas:

Formula
(1) FV = PV * (1 + r)N
(2) PV = FV * { 1 }
(1 + r)N

Where: FV = future value of a single sum of money,

PV = present value of a single sum of money, R = annual interest rate,
and N = number of years

Example: Present Value

At an interest rate of 8%, we calculate that $10,000 five years from now will be:

FV = PV * (1 + r)N = ($10,000)*(1.08)5 = ($10,000)*(1.469328)

FV = $14,693.28

At an interest rate of 8%, we calculate today's value that will grow to $10,000 in five years:

PV = FV * (1/(1 + r)N) = ($10,000)*(1/(1.08)5) = ($10,000)*(1/(1.469328))

PV = ($10,000)*(0.680583) = $6805.83

Example: Future Value

An investor wants to have $1 million when she retires in 20 years. If she can earn a 10%
annual return, compounded annually, on her investments, the lump-sum amount she would
need to invest today to reach her goal is closest to:

A. $100,000
B. $117,459
C. $148,644
D. $161,506

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Answer:
The problem asks for a value today (PV). It provides the future sum of money (FV) =
$1,000,000; an interest rate (r) = 10% or 0.1; yearly time periods (N) = 20, and it indicates
annual compounding. Using the PV formula listed above, we get the following:

PV = FV *[1/(1 + r) N] = [($1,000,000)* (1/(1.10)20)] = $1,000,000 * (1/6.7275) =

$1,000,000*0.148644 = $148,644

Using a calculator with financial functions can save time when solving PV and FV problems.
At the same time, the CFA exam is written so that financial calculators aren't required.
Typical PV and FV problems will test the ability to recognize and apply concepts and avoid
tricks, not the ability to use a financial calculator. The experience gained by working through
more examples and problems increase your efficiency much more than a calculator.

FV and PV of an Ordinary Annuity and an Annuity Due

To solve annuity problems, you must know the formulas for the future value annuity factor
and the present value annuity factor.

Formula
Future Value Annuity Factor = ((1 + r)n - 1)/r

Formula 2.5
Present Value Annuity Factor = (1 - (1 + r)-n /r

Where r = interest rate and N = number of payments

FV Annuity Factor
The FV annuity factor formula gives the future total dollar amount of a series of $1
payments, but in problems there will likely be a periodic cash flow amount given (sometimes
called the annuity amount and denoted by A). Simply multiply A by the FV annuity factor to
find the future value of the annuity. Likewise for PV of an annuity: the formula listed above
shows today's value of a series of $1 payments to be received in the future. To calculate the
PV of an annuity, multiply the annuity amount A by the present value annuity factor.

The FV and PV annuity factor formulas work with an ordinary annuity, one that assumes the
first cash flow is one period from now, or t = 1 if drawing a timeline. The annuity due is
distinguished by a first cash flow starting immediately, or t = 0 on a timeline. Since the
annuity due is basically an ordinary annuity plus a lump sum (today's cash flow), and since it
can be fit to the definition of an ordinary annuity starting one year ago, we can use the
ordinary annuity formulas as long as we keep track of the timing of cash flows. The guiding

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principle: make sure, before using the formula, that the annuity fits the definition of an
ordinary annuity with the first cash flow one period away.

Example: FV and PV of ordinary annuity and annuity due

An individual deposits $10,000 at the beginning of each of the next 10 years, starting today,
into an account paying 9% interest compounded annually. The amount of money in the
account of the end of 10 years will be closest to:

A. $109,000
B. $143.200
C. $151,900
D. $165,600

Answer:
The problem gives the annuity amount A = $10,000, the interest rate r = 0.09, and time
periods N = 10. Time units are all annual (compounded annually) so there is no need to
convert the units on either r or N. However, the starting today introduces a wrinkle. The
annuity being described is an annuity due, not an ordinary annuity, so to use the FV annuity
factor, we will need to change our perspective to fit the definition of an ordinary annuity.
Drawing a timeline should help visualize what needs to be done:

Figure 2.1: Cashflow Timeline

The definition of an ordinary annuity is a cash flow stream beginning in one period, so the
annuity being described in the problem is an ordinary annuity starting last year, with 10 cash
flows from t0 to t9. Using the FV annuity factor formula, we have the following:

FV annuity factor = ((1 + r)N - 1)/r = (1.09)10 - 1)/0.09 = (1.3673636)/0.09 = 15.19293

Multiplying this amount by the annuity amount of $10,000, we have the future value at time
period 9. FV = ($10,000)*(15.19293) = $151,929. To finish the problem, we need the value
at t10. To calculate, we use the future value of a lump sum, FV = PV*(1 + r)N, with N = 1, PV
= the annuity value after 9 periods, r = 9.

FV = PV*(1 + r)N = ($151,929)*(1.09) = $165,603.

The correct answer is "D".

Notice that choice "C" in the problem ($151,900) agrees with the preliminary result of the
value of the annuity at t = 9. It's also the result if we were to forget the distinction between
ordinary annuity and annuity due, and go forth and solve the problem with the ordinary

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annuity formula and the given parameters. On the CFA exam, problems like this one will get
plenty of takers for choice "C" - mostly the people trying to go too fast!!

PV and FV of Uneven Cash Flows

The FV and PV annuity formulas assume level and sequential cash flows, but if a problem
breaks this assumption, the annuity formulas no longer apply. To solve problems with uneven
cash flows, each cash flow must be discounted back to the present (for PV problems) or
compounded to a future date (for FV problems); then the sum of the present (or future) values
of all cash flows is taken. In practice, particularly if there are many cash flows, this exercise
is usually completed by using a spreadsheet. On the CFA exam, the ability to handle this
concept may be tested with just a few future cash flows, given the time constraints.

It helps to set up this problem as if it were on a spreadsheet, to keep track of the cash flows
and to make sure that the proper inputs are used to either discount or compound each cash
flow. For example, assume that we are to receive a sequence of uneven cash flows from an
annuity and we're asked for the present value of the annuity at a discount rate of 8%. Scratch
out a table similar to the one below, with periods in the first column, cash flows in the
second, formulas in the third column and computations in the fourth.

Time Cash Present Value Result of

Period Flow Formula Computation
1 $1,000 ($1,000)/(1.08)1 $925.93
2 $1,500 ($1,500)/(1.08)2 $1,286.01
3
3 $2,000 ($2,000)/(1.08) $1,587.66
4
4 $500 ($500)/(1.08) $367.51
5
5 $3,000 ($3,000)/(1.08) $2,041.75

Taking the sum of the results in column 4, we have a PV = $6,208.86.

Suppose we are required to find the future value of this same sequence of cash flows after
period 5. Here's the same approach using a table with future value formulas rather than
present value, as in the table above:

Time Cash Future Value Result of

Period Flow Formula computation
1 $1,000 ($1,000)*(1.08)4 $1,360.49
2 $1,500 ($1,500)*(1.08)3 $1,889.57
3 $2,000 ($2,000)*(1.08)2 $2,332.80
4 $500 ($500)*(1.08)1 $540.00
5 $3,000 ($3,000)*(1.08)0 $3,000.00

Taking the sum of the results in column 4, we have FV (period 5) = $9,122.86.

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Check the present value of $9,122.86, discounted at the 8% rate for five years:

PV = ($9,122.86)/(1.08)5 = $6,208.86. In other words, the principle of equivalence applies

even in examples where the cash flows are unequal.