Level I - Quantitative Methods

Time Value of Money

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
www.ift.world

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
Graphs, charts, tables, examples, and figures are copyright 2020, CFA Institute.
nstitute.

99 ah
Reproduced and republished with permission from CFA Institute. All rights
ghts reserved.
reser ed.

M
1
 Contents
1. Introduction
2. Interest Rates: Interpretation
3. The Future Value of a Single Cash Flow
4. The Future Value of a Series of Cash Flows
5. The Present Value of a Single Cash Flows

om 1
.c 60
oo 6 r
6. The Present Value of a Series of Cash Flows

ib 20 te
ks 65
al 98 en
ak / C
7. Solving for Rates, Number of Periods, or Size

ah 58 ok
.m 1 o
w 11 B
of Annuity Payments

w 4 li
w 20 aka
99 ah
M
www.ift.world 2
 1. Introduction
• Time value of money

• Interest rates

• Present value

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
• Future value

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 3
 2. Interest Rates: Interpretation
Interest rates can be interpreted as:
1. Required rate of return
2. Discount rate
3. Opportunity cost

Say you lend $900 today and receive $990 after one year

om 1
.c 60
oo 6 r
Required Rate of Return Discount Rate st
Opportunity Cost

ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 4
 Interest Rates: Investor Perspective

As investors, we can view an interest rate as:

Nominal Real risk-free interest rate +

Risk-free
Rate Inflation premium +
Default risk premium +

om 1
.c 60
oo 6 r
ib 20 te
ks 65
Liquidity premium +

al 98 en
ak / C
ah 58 ok
Maturity premium

.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 5
 Practice Question 1
Jill Smith wishes to compute the required rate of return. Which of the
following premiums is she least likely to include?
A. Inflation premium
B. Maturity premium
C. Nominal premium

Answer: C

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Required rate of return includes inflation premium, maturity premium, default
ut

ak / C
ah 58 ok
risk premium, and liquidity premium. There is no such component as a

.m 1 o
w 11 B
nominal premium.

w 4 li
w 20 aka
99 ah
M
www.ift.world 6
 Practice Question 2
Which of the following is least likely true?
A. Discount rate is the rate needed to calculate present value
B. Opportunity cost represents the value an investor forgoes
C. Required rate of return is the maximum rate of return an investor
must receive to accept an investment

Answer: C

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Required rate of return is the minimum rate of return an investor must st

ak / C
ah 58 ok
receive to accept an investment. Therefore, option C is least likely to be the
the

.m 1 o
w 11 B
interpretation of interest rates.

w 4 li
w 20 aka
99 ah
M
www.ift.world 7
 Practice Question 3
Investments Maturity Liquidity Default risk Interest Rates (%)
(in years)
A 1 High Low 2.0
B 1 Low Low 2.5
C 2 Low Low r
D 3 High Low 3.0
E 3 Low High 4.0

om 1
1. Explain the difference between the interest rates on

.c 60
oo 6 r
ib 20 te
ks 65
Investment A and Investment B.

al 98 en
ak / C
ah 58 ok
2. Estimate the default risk premium.

.m 1 o
w 11 B
w 4 li
3. Calculate upper and lower limits for the interest rate on

w 20 aka
Investment C, r.

99 ah
M
www.ift.world 8
3. Future Value of a Single Cash Flow
PV = 100 and r = 10%
FVN = PV (1 + r)N What is the FV after one year?
What is the FV after two years?

0 1 2

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 9
 Practice Question 4
Cyndia Rojers deposits $5 million in her savings account. The account holders are
entitled to a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash
would she most likely be able to withdraw?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 10
 FV Calculation Using a Financial Calculator
Keystrokes Explanation Display
Set to floating decimal
[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9
[2nd] [QUIT] Return to standard calc mode 0

You invest $100 today at 10% compounded annually. How

much will you have in 5 years?
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0

om 1
.c 60
oo 6 r
[2nd] [CLR TVM] Clears TVM Worksheet 0

ib 20 te
ks 65
al 98 en
5 [N] Five years/periods N=5

ak / C
ah 58 ok
10 [I/Y] Set interest rate I/Y = 10

.m 1 o
w 11 B
100 [PV] Set present value PV = 100

w 4 li
w 20 aka
0 [PMT] Set payment PMT
MT = 0

99 ah
[CPT] [FV] Compute future value FV = -161.05

M
www.ift.world 11
 3.1 Frequency of Compounding
You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated
annual interest rate of 10% compounded quarterly. How much will you
have at the end of three years?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 12
 Multiple Compounding Periods - Calculator
You invest 80,000 in a 3-year certificate of deposit. This CD offers a stated annual
interest rate of 10% compounded quarterly. How much will you have at the end of
three years?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 13
 Practice Question 5
Donald invested $3 million in an American bank that promises to pay 4% compounded daily. Which
of the following is closest to the amount Donald receives at the end of the first year? Assume 365
days in a year.
A. $3.003 million
B. $3.122 million
C. $3.562 million

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 14
 3.2 Continuous Compounding
Infinite compounding periods per year Æ continuous compounding

FVN = PV e r N

An investment worth $50,000 earns interest that is compounded

continuously. The stated annual interest is 3.6%. What is the
future value of the investment after 3 years?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 5 8 ok
.m 1 o
w 11 B
w 4 li
w 2 0 a ka
99 ah
M
www.ift.world 15
 Concept Building Exercise
Assume the stated annual interest rate is 12%. What is the future value of $100 at
different compounding frequencies?

Frequency Future value of $100 Return

Annual 112 12.00%

Semiannual 112.36 12.36%

om 1
Quarterly

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Monthly

ak / C
ah 58 ok
Daily

.m 1 o
w 11 B
w 4 li
Continuous

w 20 aka
99 ah
M
www.ift.world 16
 3.3 Stated and Effective Rates
With a discrete number of compounding periods:
EAR = (1 + Periodic interest rate)m – 1

With continuous compounding:

om 1
.c 60
oo 6 r
EAR = er – 1

ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 17
 4. The Future Value of a Series of Cash Flows
• Annuity: finite set of level sequential cash flows

ƒ Ordinary annuity: an annuity where the first cash flow occurs one period from today

0 1 2

ƒ Annuity due: an annuity where the first cash flow occurs immediately

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
0 1 2

ah 58 ok
.m 1 o
w 11 B
• Perpetuity: set of level never-ending sequential cash flows with thee firs

w 4 li
firstt cas
cashh flo
flow

w 20 aka
occurring one period from today

99 ah
M
www.ift.world 18
4.1 Future Cash Flows – Ordinary Annuity

Ordinary annuity with A = 1,000 r = 5% and N = 5

0 1 2 3 4 5

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 19
 Ordinary Annuity - Formula

Ordinary annuity with A = 1,000 r = 5% and N = 5

0 1 2 3 4 5

om 1
.c 60
oo 6 r
FVN = A {[(1+r)N – 1]/r}

ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
FVN = A {Future Value Annuity Factor}

w 11 B
w 4
w 20
99
www.ift.world 20
 Ordinary Annuity - Calculator
Ordinary annuity with A = 1,000 r = 5% and N = 5

N=5

I/Y = 5

PV = 0

om 1
PMT = 1,000

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
CPT FV

ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 21
 Practice Question 6
Haley deposits $24,000 in her bank account at the end of every year. The account
earns 12% per annum. If she continues this practice, how much money will she have
at the end of 15 years?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 22
 Practice Question 7
Iago wishes to compute the future value of an annuity worth $120,000. He is aware
that the FV annuity factor is 21.664 and the interest rate is 4.5%. Which of the
following is least likely to be useful for the future value computation?
A. Annuity worth
B. Future value annuity factor
C. Interest rate

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Answer: C

ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 23
 4.2 Unequal Cash Flows

Time Cash Flow ($)

1 1,000
2 2,000
3 3,000
4 4,000
5 5,000

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
What is the future value at year 5?

ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 24
www.ift.world
End of Segment

M
99 ah
w 20 aka
w 4 li
w 11 B
.m 1 o
ah 58 ok
ak / C
al 98 en
ib 20 te
oo 6 r
25

ks 65
.c 60
om 1
5. Finding the Present Value of a Single Cash Flow

PV = FVN (1+r)-N

om 1
For a given discount rate, the farther in the future the amount to be received,

.c 60
oo 6 r
ib 20 te
ks 65
the small the amount’s present value.

al 98 en
ak / C
ah 58 ok
Holding time constant, the larger the discount rate, the smaller the present
sent

.m 1 o
w 11 B
value of a future amount.

w 4
w 20
99
www.ift.world 26
 Practice Question 8
Liam purchases a contract from an insurance company. The contract promises to pay
$600,000 after 8 years with a 5% return. What amount of money should Liam most
likely invest? Solve using the formula and TVM functions on the calculator.

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 406,104

w 4
w 20
99
www.ift.world 27
 Practice Question 9
Mathews wishes to fund his son, Nathan’s, college tuition fee. He purchases a security
that will pay $1,000,000 in 12 years. Nathan’s college begins 3 years from now. Given
that the discount rate is 7.5%, what is the security’s value at the time of Nathan’s
admission?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 521,583

w 4
w 20
99
www.ift.world 28
 Practice Question 10
Orlando is a manager at an Australian pension fund. 5 years from today he wants a
lump sum amount of AUD40, 000. Given that the current interest rate is 4% a year,
compounded monthly, how much should Orlando invest today?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 32,760

w 4 li
w 20 aka
99 ah
M
www.ift.world 29
 6. Present Value of a Series of Cash Flows
• Present value of a series of equal cash flows (annuity)

• Present value of a perpetuity

• Present value indexed at times other than zero

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
• Present value of a series of unequal cash flows

ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 30
6.1 Present Value of a Series of Equal Cash Flows
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 31
PV of an Ordinary Annuity: Using the Formula
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

om 1
PV = A {[1 – 1/(1+r)N]/r}

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 32
PV of an Ordinary Annuity: Using the Calculator
Ordinary annuity with A = 10 r = 5% and N = 5

0 1 2 3 4 5

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 5 8 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 33
 Annuity Due – The Concept
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 34
 PV of an Annuity Due: Using the Formula
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5

PV (annuity due) = A {[1 – 1/(1+r)N]/r} (1+r)

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 35
 PV of an Annuity Due: Using the Calculator
Annuity due with A = 10 r = 5% and N = 5

0 1 2 3 4 5
Key Strokes Display
[2nd] [BGN] [2nd] [SET] BGN
[2nd] [QUIT] BGN 0
[2nd] [CLR TVM] BGN 0
5 [N] BGN N=5
5 [I/Y] BGN I/Y = 5

om 1
.c 60
oo 6 r
10 [PMT] BGN PMT = 10

ib 20 te
ks 65
al 98 en
0 [FV] BGN FV
V=0

ak / C
ah 58 ok
[CPT] [PV] BGN
N

.m 1 o
w 11 B
[2nd] [BGN] [2nd] [SET] EEND
D

w 4 li
w 20 aka
[2nd] [QUIT] 0

99 ah
M
www.ift.world 36
 6.2 Present Value of a Perpetuity

PV = A/r

Present value is one period before the first

cash flow

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
Simple example to understand the formula:

ak / C
ah 58 ok
You invest $100 and get 5% for ever. What is

.m 1 o
w 11 B
the cash flow?

w 4 li
w 20 aka
99 ah
M
www.ift.world 37
 6.3 Present Values Indexed at Times Other Than t=0

An annuity or perpetuity beginning sometime in the future can be expressed in present

value terms one period prior to the first payment

om 1
Discount back to today’s present value

.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 38
 Practice Question 11
Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth
$100 per year indefinitely. The first payment will be received at t = 4. Given that the
required rate of return is 10%, how much should Mr. Graham pay today?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 751.31

w 4 li
w 20 aka
99 ah
M
www.ift.world 39
6.4 The Present Value of a Series of Unequal Cash Flows

Find the present value of each individual cash

Sum the respective present values

0 1 2 3

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4
w 20
99
www.ift.world 40
 Practice Question 12
Andy makes an investment with the expected cash flow shown in the table below.
Assuming a discount rate of 9% what is the present value of this investment?
Time Period Cash Flow($)
1 50
2 100
3 150
4 200
5 250

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 550

w 4 li
w 20 aka
99 ah
M
www.ift.world 41
 7. Solving for Rates, Number of Periods, or Size of
Annuity Payments

• Solving for Interest Rates and Growth

• Solving for Number of Periods
• Solving for the Size of Annuity Payments
• Review of Present Value and Future Value Equivalence

om 1
.c 60
oo 6 r
ib 20 te
•

ks 65
The Cash Flow Additivity Principle

al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 42
 7.1 Solving for Interest Rates and Growth Rates
A $100 deposit today grows to $121 in 2 years.
What is the interest rate? Use both the formula and the
calculator method.

The population of a small town is 100,000 on 1 Jan

2000. On 31 December 2001 the population is
121,000. What is the growth rate?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
You invest $900 today and receive a $100 coupon

ah 58 ok
.m 1 o
payment at the end of every year for 5 years. In

w 11 B
addition, you receive $1,000 and the end of year 5.
What is the interest rate?

w 4
w 20
99
www.ift.world 43
 7.2 Solving for the Number of Periods
You invest $2,500. How many years will it take to triple the amount given that
the interest rate is 6% per annum compounded annually? Use both the formula
and the calculator method.

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 18.85 years

w 4
w 20
99
www.ift.world 44
 7.3 Solving for the Size of Annuity Payments
Freddie bought a car worth $42,000 today. He was required to make a 15% down payment. The
remainder was to be paid as a monthly payment over the next 12 months with the first payment
due at t=1. Given that the interest rate is 8% per annum compounded monthly, what is the
approximate monthly payment?

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
Answer: 3,106

w 4
w 20
99
www.ift.world 45
 7.4 Review of Present and Future Value Equivalence

Ordinary annuity with A = 10 r = 5% and N = 5 Æ PV = 43.29

A lump sum can be considered equivalent 0 1 2 3 4 5

to an annuity

Lump sum = PV = 43.29

An annuity can be considered equivalent

to a future value

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
FV = 55.26

ak / C
ah 58 ok
.m 1 o
A lump sum can be considered equivalent

w 11 B
w 4 li
to a future value

w 20 aka
99 ah
M
www.ift.world 46
 7.5 The Cash Flow Additivity Principle

Amounts of money indexed at the same point in time are additive

0 1 2 3

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 47
 Summary
1. Interest Rates

2. Future Value

3. Present Value

om 1
.c 60
oo 6 r
ib 20 te
ks 65
al 98 en
ak / C
4. Solving for Rates, Number of

ah 58 ok
.m 1 o
w 11 B
Periods, or Size of Annuity
Payments

w 4
w 20
99
www.ift.world 48
 Conclusion

• Review learning objectives

• Examples and practice problems from the

curriculum

om 1
.c 60
oo 6 r
ib 20 te
• Practice questions from other sources

ks 65
al 98 en
ak / C
ah 58 ok
.m 1 o
w 11 B
w 4 li
w 20 aka
99 ah
M
www.ift.world 49