FINANCIAL MANAGEMENT, SPRING 2023

TOPIC 5 – Time Value of

Money Application
5.1 Types of Interest Rates
5.2 Single Cash flow
5.3 Multiple Cash flow
 5.1 Types of Interest Rates

◻ Nominal rate (iNOM) – also called the quoted or state

rate. An annual rate that ignores compounding effects.
iNOM is stated in contracts. Periods must also be given,
e.g. 8% Quarterly or 8% Daily interest.
◻ Periodic rate (iPER) – amount of interest charged each
period, e.g. monthly or quarterly.
iPER = iNOM / m, where m is the number of compounding
periods per year. m = 4 for quarterly and m = 12 for
monthly compounding.

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Effective Annual Rate
◻ Effective (or equivalent) annual rate – the annual
rate of interest actually being earned, taking into
account compounding.
EAR% for 10% semiannual investment
EAR% = ( 1 + iNOM / m )m - 1
= ( 1 + 0.10 / 2 )2 – 1 = 10.25%
An investor would be indifferent between an
investment offering a 10.25% annual return and one
offering a 10% annual return, compounded
semiannually.

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Why is it important to consider effective rates of
return?
◻ An investment with monthly payments is different from
one with quarterly payments. Must put each return on
an EAR% basis to compare rates of return. Must use
EAR% for comparisons. See following values of EAR%
rates at various compounding levels.

EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

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Can the effective rate ever be equal to the
nominal rate?

◻ Yes, but only if annual compounding is used,

i.e., if m = 1.
◻ If m > 1, EAR% will always be greater than
the nominal rate.

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When is each rate used?

◻ iNOM written into contracts, quoted by banks and

brokers. Not used in calculations or shown on time
lines.
◻ iPER Used in calculations and shown on time lines. If
m = 1, iNOM = iPER = EAR.
◻ EAR Used to compare returns on investments with
different payments per year. Used in calculations
when annuity payments don’t match
compounding periods.

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APR

◻ APR: Annual Percentage Rate

◻ Let N be the number of times a bank pays interest per

year
Example: if the bank pays interest annually N=12
APR = iPER * 12

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You can’t move directly
From EAR to APR or
vice-versa without
finding r (periodic
interest) first.

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 EAR and APR
◻ The EAR is 15%
◻ What is effective 1-month rate? What is the APR?
Assume interest accrues monthly.

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5.2 Single Cash flow
❑ These are cash flows in specified future period.
❑ Example of simple cash flow is a lump sum.
0 i t

CFt

❑ There is only one cash flow at the end of period.

❑ Present value of this cash flow is: PV = CFt / (1+i)t
❑ Future value of this cash flow is: FV = CFt / (1+i)t

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Will the FV of a lump sum be larger or smaller if
compounded more often, holding the stated I%
constant?

◻ LARGER, as the more frequently compounding occurs,

interest is earned on interest more often.
0 1 2 3
10%

100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
6
Semiannually: FV6 = $100(1.05) = $134.01
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 5.3 Multiple Cash flow
◻ Uneven cash flows: A series of cash flows where the
amount varies from one period to the next.
0 1 2 3 4
10%

100 300 300 -50

Even cash flows: A series of cash flows where the amount

does not vary from one period to the next or follow a
pattern.
0 1 2 3 4
10%

100 100 100 100

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Uneven Cash Flows

Example: finding present value of the below cash flow

stream.
0 1 2 3 4
10%

100 300 300 -50

90.91

247.93

225.39

-34.15

530.08 = PV

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 Annuity
❑ Annuity: A series of equal cash flows at fixed
intervals for a specified number of periods.
❑ Equal cash flow is called payment (PMT)
❑ Two types of annuity according to when the
payments is made:
❑ Ordinary annuity: payments are made at the end of
each period.
❑ Annuity due: payments are made at the beginning of
each period. (i.e. first payment is made immediately).
❑ Example:

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 Annuity
Ordinary Annuity

0 1 2 3
i%

PMT PMT PMT

Annuity Due

0 1 2 3
i%

PMT PMT PMT

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Ordinary Annuity
Example: You have just won a lottery. You can choose
to
Option 1: receive $8,000 now
Option 2: receive $1,000 each year for the next 10
years.
What is your decision? Given the interest rate is 10%
per annum.

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Ordinary Annuity
❑ Step 1: Draw timeline

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Ordinary Annuity
❑ Step 2: Compare cash flows – finding present value or
future value.
❑ Cash flow in option 1 occurs at the current time whereas
cash flows in option 2 occur at different times. As such we
cannot directly compare two cash flow streams of two
options. We then decide to convert cash flows to ONE
POINT IN TIME. We calculate present value of the two cash
flow streams at present (t=0) or their future values in year
10 (t=10).
❑ Option 1, cash flow happens at current time. For easy
comparison between the two options, we calculate
present value of the two.
❑ I will present the alternative future value in other slides.

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Present Value of Ordinary Annuity
❑ Finding present value

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Present Value of Ordinary Annuity
❑ Finding present value of option 2

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Present Value of Ordinary Annuity
◻  

PMT = the constant cash flow

(first cash flow one period in the
future)
i = the interest rate per period
n = the number of periods
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Present Value of Ordinary Annuity
◻  

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Future Value of Ordinary Annuity
❑ The above exercise can be solved using future value
method.
❑ Step 1: Draw timeline (see above)
❑ Step 2: Compare FV of two option
❑ FV option 1:
❑ FV10 = PV0 (1+i)n = 8,000 x (1+10%)10 = $20,749.94
❑ FV option 2:
❑ FV10 = 1,000 x (1+0.1)10 + 1,000 x (1+0.1)9 +…+ 1,000
= 2,593.74 + 2,357.95 + … + 1,000 = $15,937.42
❑ Compare: option 1 has higher value in year 10, you should pick
option 1.
Note: you can use answer from the above PV calculation to find FV of option
2: FV = 6,144.57 x (1+0.1)10 = $15,937.42

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Future Value of Ordinary Annuity
◻  

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Present Value & Future Value of
Annuity Due
◻  
Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

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On the application of Ordinary Annuity
- Loan Amortization
❑ Amortization tables are widely used for home
mortgages, auto loans, business loans, retirement plans,
etc.
❑ Financial calculators and spreadsheets are great for
setting up amortization tables.

❑ EXAMPLE: Construct an amortization schedule for a

$1,000, 10% annual rate loan with 3 equal payments.
❑ PV = $1,000
❑ PMT = unknown
❑ n=3
❑ i = 10%
❑ Cash flow is made at the end of each period

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Loan Amortization
0 1 2 3
10%

PVA =1,000 PMT PMT PMT

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 Step 1:
Find the required annual payment

❑ Applying formula (6)

❑ Rearrange it and find PMT

◻ Answer: PMT = 402.11

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Step 2:
Find the interest paid in Year 1

◻ The borrower will owe interest upon the initial

balance at the end of the first year. Interest to be
paid in the first year can be found by multiplying
the beginning balance by the interest rate.

INTt = Beg balt x i

INT1 = $1,000 (0.10) = $100

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Step 3:
Find the principal repaid in Year 1

◻ If a payment of $402.11 was made at the end of the

first year and $100 was paid toward interest, the
remaining value must represent the amount of
principal repaid.

PRIN = PMT – INT

= $402.11 - $100 = $302.11

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Step 4:
Find the ending balance after Year 1

◻ To find the balance at the end of the period,

subtract the amount paid toward principal from
the beginning balance.

END BAL = BEG BAL – PRIN

= $1,000 - $302.11
= $697.89

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Constructing an amortization table:
Repeat steps 1 – 4 until end of loan

Year BEG BAL PMT INT PRIN END BAL

(1) (2) (3) (4)
= (1) * i (2) – (3) (1) – (4)
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTAL 1,206.34 206.34 1,000 -

◻ Interest paid declines with each payment as the

balance declines.

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Illustrating an amortized payment:
Where does the money go?

$
402.11
Interest

302.11

Principal Payments

0 1 2 3
◻ Constant payments.
◻ Declining interest payments.
◻ Declining balance.
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Perpetuity
❑ Many applications of financial mathematics involve periodic
cash flows where the size of the cash flow remains constant,
or grows at a constant rate
❑ Valuing these cash flows would be tedious, using the
techniques in the previous section, but fortunately there are
some short-cuts which enable these valuations to be done
with just one or two calculations
❑ One such application involves a perpetuity, which is constant
stream of equal cash flows continuing forever
0 1 2 3

CF CF CF 5-34
Perpetuity
❑ It makes no sense to talk about the future value of a
perpetuity – this would be an infinite number that would
occur an infinite period of time in the future – but we can
calculate the present value of a perpetuity
❑ This is because cash flows in the far distant future are
discounted so heavily so that their contribution to the
present value of the perpetuity approaches zero
PV = the present value
CF = the constant cash flow (with the first
cash flow occurring one period in the future)
r = the interest rate per period

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Perpetuity
◻ Example: What is the present value of $200 to be paid every
six months in perpetuity, with the first payment six months
from now, if the interest rate is 12% p.a., compounded
semi-annually?
◻ Answer:

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Growing perpetuity
❑ Sometimes we need to find the present value of an infinite
stream of cash flows that will grow at a constant rate in
perpetuity
❑ The most common application is the valuation of shares
based on constantly growing dividends (covered in Topic 3)
❑ We can find the present value as long as the future cash
flows are being discounted at a greater rate than their
growth rate

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Growing Perpetuity
❑ The formula for the present value of a growing perpetuity is

where
CF1 = Cash flow in one period
r = the interest rate per period
g = the growth rate (where r > g)
◻ Example: What is the present value of a growing perpetuity with
semi-annual payments, an initial payment of $200 in six months and
growing at 2% every six months, if the interest rate is 12% p.a.?

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