Chapter 5: ● Compound interest - interest earned on a given

deposit ad has become part of the principal at

❖ Time Value of Money - observation that it is better the end of a specified period
to receive money sooner than later
➢ Invest money now = earn positive rate of return ● Principal - amount of money on which interest is paid
= more money tomorrow FVn = PV0 x (1+r)n
➢ Money now is worth more than money in the
future FVn = future value r = annual rate of interest
❖ Timeline - horizontal line on which time zero PV0 = initial principal n= number of periods
approaches at the leftmost end and future periods
are marked from left to right ● Simple Interest - earned only on an investment’s
➢ Used to depict investment cash flows original principal and not on interest that
accumulated over time
➢ Compounding - future value technique to find ● Present value - value of today’s dollars of some future
future value of each cash flow at the end of cash flow
investment’s life and sum these values to find PV0 = FVn / (1+r)n
the future value
■ Adding interest to an investment’s ❖ Annuity - stream of equal periodic cash flow over a
principal and paying interest on the specified time period
new higher balance ➢ Can be inflows or outflows
➢ Discounting - technique to find the present ➢ Ordinary annuity - cash flow occurs at the
value at time zero and sums these value to find end of each period
the value today ➢ Annuity due - cash flow occurs at the
■ Used by investors to make investing beginning of each period
decisions
■ Inverse of compounding Future Value of an Ordinary Annuity:
❖ Computational Tools
➢ Financial Calculators - numerous
preprogrammed financial routines
➢ Electronic Spreadsheet - built-in routines that
Present Value of an Ordinary Annuity:
simplify time-value calculations
❖ Basic Pattern of Cash Flow
➢ Single amount - lump sum amount either
currently held or expected at some future date
➢ Annuity - level of periodic stream of cash flow
Future Value of an Annuity Due:
➢ Mixed-stream - not an annuity; stream of
unequal periodic cash flows that reflect no
particular pattern

SINGLE AMOUNTS: Present Value of an Annuity Due:

● Future value - value at some future date of
money you invest today
○ Terminal value, sum, the amount,
amount, accumulated amount
Always:
FV of Annuity Due > FV of Ordinary Annuity
 PV of Annuity Due > Pv of Ordinary Annuity
❖ Perpetuity - annuity with an infinite life, providing
continual annual cash flow
➢ PV0 = CF1 / r
➢ PV of a growing perpetuity:
■ PV0 = CF1 / (r -g)
■ Applies only when discount rate is
greater than the growth rate
■ If r ≤ g, cash flows grow so fast that PV
= INFINITE
● r = interest rate; g =
growth rate
❖ Mixed Stream - stream of unequal periodic cash
flows that reflect no particular pattern
❖ FV of mixed stream - compute FV of each cash flow
at the specified FV and add all the individual FVs to
find the total FV
❖ PV of mixed stream - compute PV of each cash flow
and add all the individual PVs to find the total FV
COMPOUNDING INTEREST MORE FREQUENTLY THAN
ANNUALLY
● Semiannual Compounding - compounding of interest
over two periods within the year
● Quarterly Compounding - compounding of interest
over four periods within the year
General Equation for Compounding:
● Continuous compounding - compounding of interest,
literally, all the time
○ Infinite number of times in a year
○ e=exponential function
● Nominal (stated) annual rate - contractual annual rate
of interest charged by a lender or promised by a
borrower
● Effective (true) annual rate (EAR) - annual rate of
interest actually paid or earned
● Annual percentage rate (APR) - nominal annual rate
of interest, found by multiplying the periodic rate by
the number of periods in one year, that must be
disclosed to consumers on credit cards and loans as
a result of “truth-in-lending laws”
● Annual percentage yield (APY) - effective annual
rate of interest that must be disclosed to consumers
by banks on their savings products as a result of
“truth-in-savings laws”
SPECIAL APPLICATIONS OF TIME VALUE
● Determining deposits needed to accumulate a
future sum:
● Loan amortization - determination of equal periodic
loan payments necessary to provide a lender with a
specified interest return and to repay the loan
principal over a specified period
● Loan amortization schedule - schedule of equal
payments to repay a loan
○ Shows the allocation of each loan payment
to interest and principal
To solve for payment:
To solve for interest or growth rate:
To solve for the unknown number of periods: