Integrated Case

5-42
First National Bank
Time Value of Money Analysis
You have applied for a job with a local bank. As part of its evaluation process,
you must take an examination on time value of money analysis covering the
following questions.

A. Draw time lines for (1) a $100 lump sum cash flow at the end of Year
2, (2) an ordinary annuity of $100 per year for 3 years, and (3) an
uneven cash flow stream of -$50, $100, $75, and $50 at the end of
Years 0 through 3.

ANSWER: [Show S5-1 through S5-4 here.] A time line is a graphical

representation that is used to show the timing of cash flows. The
tick marks represent end of periods (often years), so time 0 is today;
Time 1 is the end of the first year, or 1 year from today; and so on.

0 1 2 Year
I/YR%
| | | Lump sum
100 Cash flow

0 1 2 3
I/YR%
| | | | Annuity
100 100 100

0 1 2 3
I/YR%
| | | | Uneven cash flow stream
-50 100 75 50

A lump sum is a single flow; for example, a $100 inflow in Year

2, as shown in the top time line.

Chapter 5: Time Value of Money Integrated Case 1

 An annuity is a series of equal cash flows occurring over equal
intervals, as illustrated in the middle time line.
An uneven cash flow stream is an irregular series of cash flows
that do not constitute an annuity, as in the lower time line. -50
represents a cash outflow rather than a receipt or inflow.

B. (1) What’s the future value of $100 after 3 years if it earns 10%, annual
compounding?

ANSWER: [Show S5-5 through S5-7 here.] Show dollars corresponding to

question mark, calculated as follows:

0 1 2 3
10%
| | | |
100 FV = ?

After 1 year:

FV1 = PV + I1 = PV + PV(I) = PV(1 + I) = $100(1.10) = $110.00.

Similarly:

FV2 = FV1 + I2 = FV1 + FV1(I)

= FV1(1 + I) = $110(1.10) = $121.00
= PV(1 + I)(1 + I) = PV(1 + I)2.

FV3 = FV2 + I3 = FV2 + FV2(I)

= FV2(1 + I) = $121(1.10) = $133.10
= PV(1 + I)2(1 + I) = PV(1 + I)3.

In general, we see that:

FVN = PV(1 + I)N,

So FV3 = $100(1.10)3 = $100(1.3310) = $133.10.

2 Integrated Case Chapter 5: Time Value of Money

 Note that this equation has 4 variables: FVN, PV, I/YR, and N. Here,
we know all except FVN, so we solve for FVN. We will, however, often
solve for one of the other three variables. By far, the easiest way to
work all time value problems is with a financial calculator. Just plug
in any three of the four values and find the fourth.
Finding future values (moving to the right along the time line) is
called compounding. Note that there are 3 ways of finding FV3:

 Regular calculator:
1. $100(1.10)(1.10)(1.10) = $133.10.
2. $100(1.10)3 = $133.10.

 Financial calculator:
This is especially efficient for more complex problems, including
exam problems. Input the following values: N = 3, I/YR = 10, PV
= -100, PMT = 0, and solve for FV = $133.10.

 Spreadsheet:
Spreadsheet programs are ideally suited for solving time value of
money problems. The spreadsheet can be set up using the
specific FV spreadsheet function or by entering a FV
formula/equation.

B. (2) What’s the present value of $100 to be received in 3 years if the

interest rate is 10%, annual compounding?

Answer: [Show S5-8 through S5-10 here.] Finding present values, or

discounting (moving to the left along the time line), is the reverse of
compounding, and the basic present value equation is the reciprocal
of the compounding equation:

Chapter 5: Time Value of Money Integrated Case 3

 0 1 2 3
| 10% | | |
PV = ? 100

FVN = PV(1 + I)N transforms to:

N
FVN  1  N
PV = N
= FVN   = FVN (1 + I )
(1 + I)  1+I 

Thus:
3
 1 
PV = $100   = $100(0.7513) = $75.13.
 1.10 

The same methods (regular calculator, financial calculator, and

spreadsheet program) used for finding future values are also used to
find present values, which is called discounting.
Using a financial calculator input: N = 3, I/YR = 10, PMT = 0,
FV = 100, and then solve for PV = $75.13.

C. What annual interest rate would cause $100 to grow to $125.97 in 3

years?

ANSWER: [Show S5-11 here.]

0 1 2 3
| | | |
-100 125.97
$100(1 + I) $100(1 + I)2 $100(1 + I)3
FV = $100(1 + I)3 = $125.97.

Using a financial calculator; enter N = 3, PV = -100, PMT = 0, FV =

125.97, then press the I/YR button to find I/YR = 8%.
Calculators can find interest rates quite easily, even when
periods and/or interest rates are not whole numbers, and when

4 Integrated Case Chapter 5: Time Value of Money

 uneven cash flow streams are involved. (With uneven cash flows,
we must use the “CFLO” function, and the interest rate is called the
IRR, or “internal rate of return;” we will use this feature in capital
budgeting.)

D. If a company’s sales are growing at a rate of 20% annually, how

long will it take sales to double?

ANSWER: [Show S5-12 here.] We have this situation in time line format:

0 1 2 3 3.8 4
20%
| | | | | |
-1 2

Say we want to find out how long it will take us to double our money
at an interest rate of 20%. We can use any numbers, say $1 and $2,
with this equation:

FVN = $2 = $1(1 + I)N = $1(1.20)N.

We would plug I/YR = FV

20, PV = -1, PMT = 0,

2
and FV = 2 into our
calculator, and then
press the N button to
find the number of 1

years it would take 1

3.8
(or any other beginning
amount) to double
when growth occurs 0 1 2 3 4
Year
at a 20% rate. The answer is 3.8 years, but some calculators will
round this value up to the next highest whole number. The graph
also shows what is happening.

Chapter 5: Time Value of Money Integrated Case 5

 Optional Question

A farmer can spend $60/acre to plant pine trees on some marginal land. The
expected real rate of return is 4%, and the expected inflation rate is 6%. What
is the expected value of the timber after 20 years?

ANSWER: FV20 = $60(1 + 0.04 + 0.06)20 = $60(1.10)20 = $403.65 per acre.

We could have asked: How long would it take $60 to grow to

$403.65, given the real rate of return of 4% and an inflation rate of
6%? Of course, the answer would be 20 years.

E. What’s the difference between an ordinary annuity and an annuity

due? What type of annuity is shown here? How would you change it
to the other type of annuity?

0 1 2 3
| | | |
0 100 100 100

ANSWER: [Show S5-13 here.] This is an ordinary annuity—it has its payments
at the end of each period; that is, the first payment is made 1 period
from today. Conversely, an annuity due has its first payment today.
In other words, an ordinary annuity has end-of-period payments,
while an annuity due has beginning-of-period payments.
The annuity shown above is an ordinary annuity. To convert it
to an annuity due, shift each payment to the left, so you end up with
a payment under the 0 but none under the 3.

F. (1) What is the future value of a 3-year, $100 ordinary annuity if the
annual interest rate is 10%?

6 Integrated Case Chapter 5: Time Value of Money

ANSWER: [Show S5-14 here.]

0 1 2 3
10%
| | | |
100 100 100
110
121
$331

Go through the following discussion. One approach would be to

treat each annuity flow as a lump sum. Here we have

FVAN = $100(1) + $100(1.10) + $100(1.10)2

= $100[1 + (1.10) + (1.10)2] = $100(3.3100) = $331.00.

Future values of annuities may be calculated in 3 ways: (1) Treat the

payments as lump sums. (2) Use a financial calculator. (3) Use a
spreadsheet.

F. (2) What is its present value?

ANSWER: [Show S5-15 here.]

0 1 2 3
10%
| | | |
100 100 100
90.91
82.64
75.13
248.68

The present value of the annuity is $248.68. Here we used the lump
sum approach, but the same result could be obtained by using a
calculator. Input N = 3, I/YR = 10, PMT = 100, FV = 0, and press
the PV button.

Chapter 5: Time Value of Money Integrated Case 7

F. (3) What would the future and present values be if it was an annuity
due?

ANSWER: [Show S5-16 and S5-17 here.] If the annuity were an annuity due,
each payment would be shifted to the left, so each payment is
compounded over an additional period or discounted back over one
less period.
In our situation, the future value of the annuity due is $364.10:

FVA3 Due = $331.00(1.10)1 = $364.10.

This same result could be obtained by using the time line:

$133.10 + $121.00 + $110.00 = $364.10.

The best way to work annuity due problems is to switch your

calculator to “beg” or beginning or “due” mode, and go through the
normal process. Note that it’s critical to remember to change back to
“end” mode after working an annuity due problem with your
calculator.
In our situation, the present value of the annuity due is
$273.55:

PVA3 Due = $248.68(1.10)1 = $273.55.

This same result could be obtained by using the time line:

$100 + $90.91 + $82.64 = $273.55.

G. A 5-year $100 ordinary annuity has an annual interest rate of 10%.

(1) What is its present value?

8 Integrated Case Chapter 5: Time Value of Money

ANSWER: [Show S5-18 here.]

0 1 2 3 4 5
10%
| | | | | |
100 100 100 100 100
90.91
82.64
75.13
68.30
62.09
379.08

The present value of the annuity is $379.08. Here we used the lump
sum approach, but the same result could be obtained by using a
calculator. Input N = 5, I/YR = 10, PMT = 100, FV = 0, and press
the PV button.

G. (2) What would the present value be if it was a 10-year annuity?

ANSWER: [Show S5-19 here.] The present value of the 10-year annuity is
$614.46. To solve with a financial calculator, input N = 10, I/YR =
10, PMT = 100, FV = 0, and press the PV button.

G. (3) What would the present value be if it was a 25-year annuity?

ANSWER: The present value of the 25-year annuity is $907.70. To solve with a
financial calculator, input N = 25, I/YR = 10, PMT = 100, FV = 0,
and press the PV button.

G. (4) What would the present value be if this was a perpetuity?

ANSWER: The present value of the $100 perpetuity is $1,000. The PV is solved
by dividing the annual payment by the interest rate: $100/0.10 =
$1,000.

Chapter 5: Time Value of Money Integrated Case 9

H. A 20-year-old student wants to save $3 a day for her retirement.
Every day she places $3 in a drawer. At the end of each year, she
invests the accumulated savings ($1,095) in a brokerage account
with an expected annual return of 12%.

(1) If she keeps saving in this manner, how much will she have
accumulated at age 65?

ANSWER: [Show S5-20 and S5-21 here.] If she begins saving today, and sticks
to her plan, she will have saved $1,487,261.89 by the time she
reaches 65. With a financial calculator, enter the following inputs: N
= 45, I/YR = 12, PV = 0, PMT = -1095, then press the FV button to
solve for $1,487,261.89.

H. (2) If a 40-year-old investor began saving in this manner, how much

would he have at age 65?

ANSWER: [Show S5-22 here.] This question demonstrates the power of

compound interest and the importance of getting started on a regular
savings program at an early age. The 40-year old investor will have
saved only $146,000.59 by the time he reaches 65. With a financial
calculator, enter the following inputs: N = 25, I/YR = 12, PV = 0, PMT
= -1095, then press the FV button to solve for $146,000.59.

H. (3) How much would the 40-year-old investor have to save each year to
accumulate the same amount at 65 as the 20-year-old investor?

ANSWER: [Show S5-23 here.] Again, this question demonstrates the power of
compound interest and the importance of getting started on a
regular savings program at an early age. The 40-year old investor
will have to save $11,154.42 every year, or $30.56 per day, in order

10 Integrated Case Chapter 5: Time Value of Money

 to have as much saved as the 20-year old investor by the time he
reaches 65. With a financial calculator, enter the following inputs: N
= 25, I/YR = 12, PV = 0, FV = 1487261.89, then press the PMT
button to solve for $11,154.42.

I. What is the present value of the following uneven cash flow stream?
The annual interest rate is 10%.

0 1 2 3 4 Years
| | | | |
0 100 300 300 -50

ANSWER: [Show S5-24 and S5-25 here.] Here we have an uneven cash flow
stream. The most straightforward approach is to find the PVs of each
cash flow and then sum them as shown below:

0 1 2 3 4 Years
10%
| | | | |
0 100 300 300 -50
90.91
247.93
225.39
(34.15)
530.08

Note that the $50 Year 4 outflow remains an outflow even when
discounted. There are numerous ways of finding the present value
of an uneven cash flow stream. But by far the easiest way to deal
with uneven cash flow streams is with a financial calculator.
Calculators have a function that on the HP-17B is called “CFLO,” for
“cash flow.” Other calculators could use other designations such as
CF0 and CFj, but they explain how to use them in the manual.
Anyway, you would input the cash flows, so they are in the

Chapter 5: Time Value of Money Integrated Case 11

 calculator’s memory, then input the interest rate, I/YR, and then
press the NPV or PV button to find the present value.

J. (1) Will the future value be larger or smaller if we compound an initial

amount more often than annually (e.g., semiannually, holding the
stated (nominal) rate constant)? Why?

ANSWER: [Show S5-26 here.] Accounts that pay interest more frequently than
once a year, for example, semiannually, quarterly, or daily, have
future values that are higher because interest is earned on interest
more often. Virtually all banks now pay interest daily on passbook
and money fund accounts, so they use daily compounding.

J. (2) Define (a) the stated (or quoted or nominal) rate, (b) the periodic
rate, and (c) the effective annual rate (EAR or EFF%).

ANSWER: [Show S5-27 and S5-28 here.] The quoted, or nominal, rate is
merely the quoted percentage rate of return, the periodic rate is the
rate charged by a lender or paid by a borrower each period (periodic
rate = INOM/M), and the effective annual rate (EAR) is the rate of
interest that would provide an identical future dollar value under
annual compounding.

J. (3) What is the EAR corresponding to a nominal rate of 10% compounded

semiannually? Compounded quarterly? Compounded daily?

ANSWER: [Show S5-29 through S5-31 here.] The effective annual rate for
10% semiannual compounding, is 10.25%:
M
 1 + I NOM 
EAR = Effective annual rate =  
 – 1.0.
 M 

12 Integrated Case Chapter 5: Time Value of Money

 If INOM = 10% and interest is compounded semiannually, then:
2
 0.10 
EAR =  1 +  – 1.0 = (1.05)2 – 1.0
 2 
= 1.1025 – 1.0 = 0.1025 = 10.25%.

For quarterly compounding, the effective annual rate is 10.38%:

(1.025)4 – 1.0 = 1.1038 – 1.0 = 0.1038 = 10.38%.

Daily compounding would produce an effective annual rate of

10.52%.

J. (4) What is the future value of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?

ANSWER: [Show S5-32 here.] Under semiannual compounding, the $100 is

compounded over 6 semiannual periods at a 5.0% periodic rate:

INOM = 10%.

MN 2 (3 )
 I   0.10 
FVN =  1 + NOM  = $100  1 + 
 M   2 
= $100(1.05)6 = $134.01.

Quarterly: FVN = $100(1.025)12 = $134.49.

The return when using quarterly compounding is clearly higher.

Another approach here would be to use the effective annual rate
and compound over annual periods:

Semiannually: $100(1.1025)3 = $134.01.

Quarterly: $100(1.1038)3 = $134.49.

Chapter 5: Time Value of Money Integrated Case 13

K. When will the EAR equal the nominal (quoted) rate?

ANSWER: [Show S5-33 here.] If annual compounding is used, then the

nominal rate will be equal to the effective annual rate. If more
frequent compounding is used, the effective annual rate will be
above the nominal rate.

L. (1) What is the value at the end of Year 3 of the following cash flow
stream if interest is 10%, compounded semiannually? (Hint: You
can use the EAR and treat the cash flows as an ordinary annuity or
use the periodic rate and compound the cash flows individually.)

0 2 4 6 Periods
| | | | | | |
0 100 100 100

ANSWER: [Show S5-34 through S5-36 here.]

0 2 4 6 Periods
| 5% | | | | | |
100 100 100.00
110.25 = $100(1.05)2
121.55 = $100(1.05)4
$331.80

Here we have a different situation. The payments occur annually,

but compounding occurs each 6 months. Thus, we cannot use
normal annuity valuation techniques.

14 Integrated Case Chapter 5: Time Value of Money

L. (2) What is the PV?

ANSWER: [Show S5-37 here.]

0 2 4 6 Periods
5%
| | | | | | |
100 100 100
$ 90.70
82.27 PV = 100(1.05)-4
74.62
$247.59

To use a financial calculator, input N = 3, I/YR = 10.25, PMT = 100,

FV = 0, and then press the PV key to find PV = $247.59.

L. (3) What would be wrong with your answer to Parts L(1) and L(2) if you
used the nominal rate, 10%, rather than the EAR or the periodic
rate, INOM/2 = 10%/2 = 5% to solve the problems?

ANSWER: INOM can be used in the calculations only when annual compounding
occurs. If the nominal rate of 10% were used to discount the
payment stream, the present value would be overstated by $272.32
– $247.59 = $24.73.

M. (1) Construct an amortization schedule for a $1,000, 10% annual

interest loan with 3 equal installments.

(2) What is the annual interest expense for the borrower and the annual
interest income for the lender during Year 2?

ANSWER: [Show S5-38 through S5-44 here.] To begin, note that the face
amount of the loan, $1,000, is the present value of a 3-year annuity
at a 10% rate:

Chapter 5: Time Value of Money Integrated Case 15

 0 1 2 3
10%
| | | |
-1,000 PMT PMT PMT
1 2 3
 1   1   1 
PVA3 = PMT   + PMT   + PMT  
1+I 1+I 1+I
$1,000 = PMT(1 + I)-1 + PMT(1 + I)-2 + PMT(1 + I)-3.

We have an equation with only one unknown, so we can solve it to

find PMT. The easy way is with a financial calculator. Input N = 3,
I/YR = 10, PV = -1000, FV = 0, and then press the PMT button to get
PMT = 402.1148036, rounded to $402.11.

Amortization Schedule:

Beginning Payment of Ending

Period Balance Payment Interest Principal Balance
1 $1,000.00 $402.11 $100.00 $302.11 $697.89
2 697.89 402.11 69.79 332.32 365.57
3 365.57 402.13* 36.56 365.57 0.00
*Due to rounding, the third payment was increased by $0.02 to cause the ending
balance after the third year to equal $0.

Now make the following points regarding the amortization

schedule:

 The $402.11 annual payment includes both interest and principal.

Interest in the first year is calculated as follows:

1st year interest = I  Beginning balance = 0.1  $1,000 = $100.

 The repayment of principal is the difference between the $402.11

annual payment and the interest payment:

1st year principal repayment = $402.11 – $100 = $302.11.

16 Integrated Case Chapter 5: Time Value of Money

  The loan balance at the end of the first year is:
1st year ending balance = Beginning balance – Principal repayment
= $1,000 – $302.11 = $697.89.

 We would continue these steps in the following years.

 Notice that the interest each year declines because the beginning
loan balance is declining. Since the payment is constant, but the
interest component is declining, the principal repayment portion
is increasing each year.

 The interest component is an expense that is deductible to a

business or a homeowner, and it is taxable income to the lender.
If you buy a house, you will get a schedule constructed like ours,
but longer, with 30  12 = 360 monthly payments if you get a 30-
year, fixed-rate mortgage.

 The payment may have to be increased by a few cents in the final

year to take care of rounding errors and make the final payment
produce a zero ending balance.

 The lender received a 10% rate of interest on the average

amount of money that was invested each year, and the $1,000
loan was paid off. This is what amortization schedules are
designed to do.

 Most financial calculators have amortization functions built in.

Chapter 5: Time Value of Money Integrated Case 17