TIME VALUE OF MONEY

1. Discuss the role of time value in finance, the use of

computational aids, and the basic patterns of cash flows.
2. Understand the concept of future value and present value,
their calculation for single amounts, and the relationship
between them.
3. Find the future value and the present value of both an
ordinary annuity and an annuity due, and the present value
of a perpetuity.
4. Calculate both the future value and the present value of a
mixed (uneven) stream of cash flows.
5. Understand the effect that compounding interest more
frequently than annually has on future value and the
effective annual rate of interest (EAR).
6. Describe the procedures involved in (1) determining
deposits needed to accumulate to a future sum, (2) loan
amortization, (3) finding interest or growth rates, and (4)
finding an unknown number of periods.
7. Using Financial Calculator
• Most financial decisions involve costs & benefits that are spread
out over time.
• Time value of money allows comparison of cash flows from
different periods.
• Question: Your father has offered to give you some money and
asks that you choose one of the following two alternatives:
• $1,000 today, or
• $1,100 one year from now.
• What do you do?
The Role of Time Value in Finance
• The answer depends on what rate of interest you could earn on
any money you receive today.
• For example, if you could deposit the $1,000 today at 12% per
year, you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited funds, you
would be better off if you chose the $1,100 in one year.
Computational Aids
• Use the Equations

• Use the Financial Tables

• Use Financial Calculators

• Use Microsoft Excel Spreadsheets

 =RATE(NPER,PMT,PV,FV,type)
 =NPER(RATE,PMT,PV,FV,type)
 =PMT(RATE,NPER,PV,FV,type)
 =PV(RATE,NPER,PMT,FV,type)
 =FV(RATE,NPER,PMT,PV,type)
Calculator Keys
If we can measure this opportunity cost, we can:
• Translate $1 today into its equivalent in the future
(compounding).
Today Future

?
• Translate $1 in the future into its equivalent today
Today Future

?
• Compounding refers to bringing the cash flows forward on the
time line. Find Future Value (FV).
• Discounting refers to bringing the cash flows backward on the
time line. Find Present Value (PV).
• Always draw a time line.
• “0” refers to beginning of Year (Period) 1; “1” refers to end of Year
1 or beginning of Year 2; “2” refers to end of Year 2 or beginning
of Year 3.
Time Value Terms
• PV0 = present value or beginning amount
•i = interest rate
• FVn = future value at end of “n” periods
•n = number of compounding periods
• PMT = an annuity (series of equal payments
or receipts)
Four Basic Models
• FVn = PV0(1+i)n = PV x (FVIFi,n)

• PV0 = FVn[1/(1+i)n] = FV x (PVIFi,n)

• FVAn = PMT (1+i)n - 1 = PMT x (FVIFAi,n)

i

• PVA0 = PMT 1 - [1/(1+i)n] = PMT x (PVIFAi,n)

i
Future Value of a SingleAmount
Future Value – Single Amounts
If you deposit $100 in an account earning 6%, how much would
you have in the account after 1 year?
PV = -100 FV = 106

0 1
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .06, 1 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)1 = $106
Future Value – Single Amounts
If you deposit $100 in an account earning 6%, how much would
you have in the account after 5 years?
PV = -100 FV = 133.82

0 5
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .06, 5 ) (use FVIF table, or)
FV = PV (1 + i)n
FV = 100 (1.06)5 = $133.82
• The amount of interest earned annually increases each year
because we ‘earn interest on interest”.
• Interest earned in year 1 = 6% * $100 = $6
• Interest earned in year 2 = 6% * ($100+$6)
= $6.36
• Interest earned in year 3 = 6% * ($106+$6.36)
= $6.74
 Future Value Example
Example: What will be the FV of $100 in 2 years at
interest rate of 6%?
FV2= PV(1+i)2 = $100 (1+.06)2
$100 (1.06)2 = $112.36
Increasing Future Value
• Future Value can be increased by:
• Increasing number of years of compounding (n)
• Increasing the interest or discount rate (i)
• Increasing the original investment (PV)
 Changing I, N, andPV
• (a) You deposit $500 in a bank for 2 years … what is the FV at 2%? What
is the FV if you change interest rate to 6%?
• FV at 2% = 500*(1.02)2 = $520.2

• FV at 6% = 500*(1.06)2 = $561.8

• (b) Continue same example but change time to 10 years. What is the FV
now?
• FV at 6% = 500*(1.06)10= $895.42

• (c) Continue same example but change contribution to $1500. What is the
FV now?
• FV at 6% = 1,500*(1.06)10 = $2,686.27
Future Value – Using Tables
• 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 to find the
factor 1.714
• 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 – Single Amounts
• Tony Tee places $800 in a savings account paying 6% interest
compounded annually. He wants to know how much money will
be in the account at the end of five years.

FV5 = $800 X (1 + 0.06)5 = $800 X (1.338)

= $1,070.40
Future Value of a Single Amount: Using a
Financial Calculator
Future Value – Single Amounts
If you deposit $100 in an account earning 6% with quarterly
compounding, how much would you have in the accountafter
5 years?
PV = -100 FV = 134.68

0 20
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .015, 20 ) (can’t use FVIF table)
FV = PV (1 + i/m) m x n
FV = 100 (1.015)20 = $134.68
Future Value – Single Amounts
If you deposit $100 in an account earning 6% with monthly
compounding, how much would you have in the accountafter
5 years?
PV = -100 FV = 134.89

0 60
Mathematical Solution:
FV = PV (FVIF i, n )
FV = 100 (FVIF .005, 60 ) (can’t use FVIF table)
FV = PV (1 + i/m) m x n
FV = 100 (1.005)60 = $134.89
Present Value of aSingle Amount
• Present value is the current dollar value of a future amount of
money.
• It is based on the idea that a dollar today is worth more than a
dollar tomorrow.
• It is the amount today that must be invested at a given rate to
reach a future amount.
• The discount rate is often also referred to as the opportunity
cost, the discount rate, the required return, or the cost of
capital.
Present Value – Single Amounts
If you receive $100 one year from now, what is the PV of that $100 if
your opportunitycost is 6%?

PV = -94.34 FV = 100

0 1
Mathematical Solution:
PV = FV (PVIF i, n )
PV = 100 (PVIF .06, 1 ) (use PVIF table, or)
PV = FV / (1 + i)n
PV = 100 / (1.06)1 = $94.34
Present Value – Single Amounts
What is the PV of $1,000 to be received 15 years from now if your
opportunity cost is7%?

PV = -362.45 FV = 1000

0 15
Mathematical Solution:
PV = FV (PVIF i, n )
PV = 1,000 (PVIF .07, 15 ) (use PVIF table, or)
PV = FV / (1 + i)n
PV = 1,000 / (1.07)15 = $362.45
Present Value – Single Amounts
• Tony Tee wishes to find the present value of $1,700 that will
be received 8 years from now. Tony’s opportunity cost is 8%.

PV = $1,700/(1 + 0.08)8 = $1,700/1.851

= $918.42
Present Value of a Single Amount: Using
a Financial Calculator
Annuities
• Annuity: a sequence of equally-spaced cash flows of equal
size occurring each period for a specified number of periods.
• Annuities can be either inflows or outflows.
• An ordinary (deferred) annuity has cash flows that occur at
the end of each period for a specified number of periods.
• An annuity due has cash flows that occur at the beginning of
each period for a specified number of periods.
• An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound for
an additional period.
Examples of Annuities:
• If you buy a bond, you will receive equal semi-annual
coupon interest payments over the life of the bond.
• If you borrow money to buy a house or a car, you will pay
a stream of equal installment payments.
Future Value - Annuity
If you invest $1,000 each year at 8%, how much would you have
after 3years?
Mathematical Solution:
FV = PMT (FVIFA i, n )
FV = 1,000 (FVIFA .08, 3 ) (use FVIFA table, or)

FV = PMT (1 + i)n - 1
i
FV = 1,000 (1.08)3 - 1 = $3246.40
.08
Finding the FV of an Ordinary Annuity
• Fran Abrams wishes to determine how much money she will
have at the end of 5 years if he chooses to deposit $1,000 at
the end of each of the 5 years (ordinary annuity) and it earns
7% annually. Annuity a is depicted graphically below:
Future Value of an Ordinary Annuity:
Using a Financial Calculator
 FV Annuity - Example
What will be the FV of 5-year $500 annuity compounded at 6%?

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
Growth of a 5yr $500 Annuity
Compounded at 6%
 Annuities Due
• Annuities due are ordinary annuities in which all
payments have been shifted forward by one time
period. Thus with annuity due, each annuity payment
occurs at the beginning of the period rather than at the
end of the period.
 Finding the Future Value of an
Annuity Due
• Fran Abrams wishes to determine how much money she will
have at the end of 5 years if he chooses to deposit $1,000 at
the beginning of each of the 5 years (annuity due) and it earns
7% annually.
• FV of annuity due = FV of ordinary annuity  (1 + i)
= PMT  FVIFAi,n  (1 + i)
Financial Calculator: Press 2nd PMT and you will see END.
Then, Press 2nd [SET] and it changed to BGN. Then, Press 2nd
[QUIT] and prepare to key in inputs.
(Note: after solving this question, repeat the same procedure to
change BGN back to END.)
Future Value of an Annuity Due: Using a
Financial Calculator
Present Value of an Annuity
• Pensions, insurance obligations, and interest owed on
bonds are all annuities. To compare these three types of
investments we need to know the present value (PV) of
each.
• PV can be computed using calculator, tables,
spreadsheet or formula.
Present Value - Annuity
What is the PV of $1,000 at the end of each of the next 3 years, if
the opportunity cost is8%?
Mathematical Solution:
PV = PMT (PVIFA i, n )
PV = 1,000 (PVIFA .08, 3 ) (use PVIFA table, or)
1
PV = PMT 1 - (1 + i)n
i
1
PV = 1000 1 - (1.08 )3 = $2,577.10
.08
Finding the Present Value of an
Ordinary Annuity
• Braden Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of $700 at the end
of each year for 5 years. The required return is 8%.
Finding the Present Value of an
Ordinary Annuity: The Long Method
Present Value of an Ordinary Annuity:
Using a Financial Calculator
 Finding the Present Value of an
Annuity Due
• Braden Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of $700 at the
beginning of each year for 5 years. The required return is 8%.
• PV of annuity due = PV of ordinary annuity  (1 + i)
= PMT  PVIFAi,n  (1 + i)
Financial Calculator: Press 2nd PMT and you will see END.
Then, Press 2nd [SET] and it changed to BGN. Then, Press 2nd
[QUIT] and prepare to key in inputs.
(Note: after solving this question, repeat the same procedure to
change BGN back to END.)
Present Value of an Annuity Due: Using a
Financial Calculator
5-year, $500 Annuity Discounted tothe
Present at 6%
Perpetuities
• Suppose you will receive a fixed payment every period
(month, year, etc.) forever. This is an example of a perpetuity.
• You can think of a perpetuity as an annuity that goes on.
Present Value of a Perpetuity

PMT
PV =
i
What should you be willing to pay in order to receive
annually forever, if you require per year on the investment?

PV = PMT = $10,000
i 0.08
= $125,000
Growing Cash Flows
• Growing Perpetuity
• Assume you expect the amount of your perpetual payment
to increase at a constant rate, g.

• Present Value of a Growing Perpetuity

C
PV (growing perpetuity) 
r  g
Growing Cash Flows
• Growing Annuity
• The present value of a growing annuity with the initial cash
flow c, growth rate g, and interest rate r is defined as:
• Present Value of a Growing Annuity

1   1  g  
N

PV  C  1    
(r  g)   (1  r)  
 
Retirement Savings with a Growing
Annuity
• Ellen considered saving $10,000 per year for her retirement.
Although $10,000 is the most she can save in the first year,
she expects her salary to increase each year so that she
will be able to increase her savings by 5% per year. With
this plan, if she earns 10% per year on her savings, how
much will Ellen have saved at age 65?
 Example: Retirement Savings with a
Growing Annuity
• You want to begin saving for your retirement. You plan to contribute
$12,000 to the account at the end of this year. You anticipate you
will be able to increase your annual contributions by 3% each year
for the next 45 years. If your expected annual return is 8%, how
much do you expect to have in your retirement account when you
retire in 45 years?
Perpetuities and Annuities
• Suppose that a young couple has just had their first baby, a
daughter, and they wish to ensure that enough money will be
available to pay for her college education. Currently, college
tuition, books, fees, and other costs, average $12,500 per year.
On average, tuition and other costs have historically increased
at a rate of 4% per year.
• Assuming that college costs continue to increase an average
of 4% per year and that all her college savings are invested in
an account paying 7% interest, determine the amount of
money she will need to have available at age 18 to pay for all
four years of her undergraduate education.
• FV = PV(1 + i)^N = $12,500(1.04)^18 = $25,322.71
• PV of a growing annuity due

=C× (1 + r)

= $25,322.71 × (1 + .07)
= $97,110.01
Amortized Loans
• Loans paid off in equal installments over time are called
amortized loans.
• For example, home mortgages and auto loans.
• Reducing the balance of a loan via annuity payments is called
amortizing.
• The periodic payment is fixed. However, different amounts of
each payment are applied towards the principal and interest.
With each payment, you owe less towards principal. As a
result, amount that goes toward interest declines with every
payment.
Amortized Loans
Amortized Loans
Amortized Loans
Messi Berhad bought a machinery costing $10,000 on
hire purchase from Robinho Berhad. Interest rate
charged is 10%. Find the installment paid at the end
of each year for the next 3 years.

Find the principal and interest portions of each year’s

installment and the balance owed at the end of each
year.
Amortized Loans
• Find Installment paid at the end of each year (PMT)
• Mathematical Solution:
PV = PMT * PVIFA10%,3
$10,000 = PMT (2.4869)
PMT = $4,021.15
• Installment payment each period consists of two components:
Interest portion and Principal Repayment portion.
• Interest paid each period
= Interest rate * Beginning balance owed
 Amortized Loans
Year Beginning Installment Interest Principal Ending
• Balance Payment Portion Repayment Balance
Portion
1 10,000.00 4,021.15 1,000 3,021.15 6,978.85

2 6,978.85 4,021.15 697.89 3,323.26 3,655.59

3 3,655.59 4,021.15 365.56 3,655.59 0

Amortized Loans
• Ending Balance
= Beginning Balance – Principal Repayment
• Interest portion is higher during earlier years and reduces
yearly thereafter.
• Principal Repayment portion is lower during earlier years and
increases yearly thereafter.
• Using Financial Calculator:
To find installment paid at end of each year
3 N; 10 I/Y; 10000 PV; 0 FV; CPT PMT
PMT = $4,021.15
 Amortizing Loan and Hire Purchase
 To find interest portion, principal repayment portion and ending balance at
end of Year 1:
Press 2nd [AMORT]
P1 = 1 ENTER and arrow down P2 = 1 ENTER and arrow down
BAL = 6,978.85 is the balance owed end of Year 1, PRN = 3,021.15
is principal repayment portion in Year 1, INT = 1,000.00 is interest
portion in Year 1.
 To find interest portion, principal repayment portion and ending balance
at end of Year 2:
P1 = 2 ENTER and arrow down P2 = 2 ENTER and arrow down
BAL = 3,655.59 is the balance owed end of Year 2, PRN = 3,323.26
is principal repayment portion in Year 2, INT = 697.89 is interest
portion in Year 2.
 Amortized Loans
• To find total interest portion paid from Year 1 to Year 3:
P1 = 1 ENTER
P2 = 3 ENTER
Scroll down to INT, INT = 2,063.45
Total interest payments over the 3 years is $2,063.45. Check by
summing up interest portion from Year 1 to Year 3 in previous
table.
• P1 denotes start at beginning of which year. P2 denotes end at
ending of which year.
 Mixed Stream of CashFlows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4
• Is this an annuity?
• How do we find the PV of a cash flow stream when all of
the cash flows are different? (Use a 10% discount rate.)
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4
Period CF PV (CF)
0 -10,000 -10,000.00
1 2,000 1,818.18
2 4,000 3,305.79
3 6,000 4,507.89
4 7,000 4,781.09
PV of Cash Flow Stream: $ 4,412.95
Present Value of a Mixed Stream of Cash
Flows (i=9%)
Future Value of a Mixed Stream of Cash
Flows (i=8%)
Compounding Interest More Frequently
Than Annually
• Compounding more frequently than once a year results in a
higher effective interest rate because you are earning 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.
Compounding Interest More Frequently
Than Annually
Using Financial Calculator: P/Y and C/Y
• P/Y = number of payments per year
• C/Y = number of compounding per year
• If question does not specifically mention interest is compounding yearly,
quarterly or monthly, C/Y follows P/Y.
• E.g. An investor deposit RM500 per month. Interest rate is 8%.
Compute Future value at end of Year 3.
Financial Calculator setting and input:
Press 2nd I/Y. P/Y = 12 ENTER and C/Y = 12 ENTER
Press 2nd [QUIT]
36 N; 8 I/Y; 500 PMT; 0 PV; CPT FV
(Note: all interest rates in practice are per annum. Here I/Y interest per
year is 8%)
(Note: After solving this question, press 2nd I/Y and reset P/Y = 1 and
C/Y = 1)
Continuous Compounding
• With continuous compounding the number of compounding
periods per year approaches infinity.
• Through the use of calculus, the equation thus becomes:
FVn (continuous compounding)
= PV x (ekxn) where “e” has a value of 2.7183.
• Continuing with the previous example, find the Future value of
the $100 deposit after 5 years if interest is compounded
continuously.
FVn = 100 x (2.7183).08x2 = $117.35
Nominal & Effective Annual Rates of
Interest
• The nominal interest rate is the stated or contractual rate of
interest charged by a lender or promised by a borrower.
• The effective interest rate is the rate actually paid or earned.
• In general, the effective rate > nominal rate whenever
compounding occurs more than once per year
Nominal & Effective Annual Rates of
Interest
• Fred Moreno wishes to find the effective annual rate associated
with an 8% nominal annual rate (I = .08) when interest is
compounded (1) annually (m=1); (2) semiannually (m=2); and (3)
quarterly (m=4).
Effective Annual Rate (EAR) or Annual
Percentage Yield(APY)
Which is the better loan:
• 8% compounded annually, or
• 7.85% compounded quarterly?
• We can’t compare these nominal (quoted) interest rates,
because they don’t include the same number of
compounding periods per year!
We need to calculate the APY.
Banks usually quote nominal rate per annum. E.g. 3-month
fixed deposit rate 3.28%, 6-month fixed deposit rate 3.40%,
12-month fixed deposit rate 3.70%
Effective Annual Rate (EAR) or Annual
Percentage Yield(APY)
(
APY = 1 +
quoted rate
m
) m - 1
• Find the APY for the quarterly loan:

APY = ( 1+ .0785
4
) 4 - 1

APY = .0808, or 8.08%

• The quarterly loan is more expensive than the 8% loan
with annual compounding!
Steps
• Step 1: Read the question/case and identify where to
stand on the time line and when the cash flows occur.
Draw a time line. Plot the period, cash flows and
opportunity costs.

• Step 2: Bring all the cash flows to where you stand on

the time line. Determine whether it is discounting (find
PV) or compounding (find FV).
Steps
• Step 3: Check the number of payments per year (P/Y)
and compounding period per year (C/Y), i.e. yearly,
quarterly, monthly or continuous.

• Step 4: Check the type of cash flows: single amount,

ordinary annuity, annuity due, perpetuity or uneven cash
flow stream.

• Step 5: Plug in the correct formula or use

financial calculator.
Deferred Annuity
• Cash flows from an investment are expected to be $40,000
per year at the end of years 4, 5, 6, 7, and 8. If you require a
20% rate of return, what is the PV of these cash flows?

$0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8
•PV0= PV3 / (1+i)3 = 119,624 / (1+0.20)3
= $69,227
House Payment
If you borrow RM100,000 at 7% fixed interest for 30 years
in order to buy a house, what will be your monthly house
payment?
Mathematical Solution:
PV = PMT (PVIFA i, n )
100,000 = PMT (PVIFA .07/12, 360 ) (can’t use PVIFA table)

1
PV = PMT 1- (1 + i)n
i

1
100,000 = PMT 1 - (1.005833 )360 =PMT= RM665.28

0.005833
Funds for Machine Replacement
• BF Berhad plans to deposit RM400,000 per year in order to
fund for replacement of its machineries in 10 years time from
today. Deposit rate is expected to be 5% per annum for the
next 10 years. What is the accumulated amount available to
BF Berhad for replacing its machineries 10 years later?
 400K 400K 400K 400K

0 1 2 3 . . . 10
FV = PMT (FVIFAi,n)
= 400,000 (FVIFA5%,10)
= 400,000 * (1+0.05)10 – 1
0.05
= 400,000 * 12.5779
= RM 5,031,157
Deposits Needed to Accumulate to a
Future Sum
• Suppose you want to buy a house 5 years from now and you
estimate that the down payment needed will be $30,000. How
much would you need to deposit at the end of each year for the
next 5 years to accumulate $30,000 if you can earn 6% on your
deposits?

PMT = $30,000/5.637 = $5,321.98