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# Chapter 3

Time Value of
Money
3-1

## 2001 Prentice-Hall, Inc.

Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

3-2

## The Interest Rate

Simple Interest

Compound Interest

Amortizing a Loan

## The Interest Rate

Which would you prefer -- \$10,000
today or \$10,000 in 5 years?
Obviously, \$10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!
3-3

Why TIME?
Why is TIME such an important
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.

3-4

postulate

## All operations with money must be

compared between alternatives
to find the best result.

3-5

## Interest rate is a simple but

prominent equivalent of any
change of time value of money.
5

Types of Interest
Simple

Interest

## Interest paid (earned) on only the original

amount, or principal borrowed (lent).
Compound

Interest

## Interest paid (earned) on any previous

interest earned, as well as on the
principal borrowed (lent).
3-6

## Future value and present

value
Changing in time value of money
gets future and present
nomination
Getting from present value to
future value is called
compounding.
3-7

## Getting from future value to

present value is called

Formula

3-8

SI = P0(i)(n)

SI:

Simple Interest

P0:

i:

n:

Assume

## that you deposit \$1,000 in an

account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI

3-9

= P0(i)(n)
= \$1,000(.07)(2)
= \$140

What

deposit?
FV

Future

= P0 + SI
= \$1,000 + \$140
= \$1,140

## Value is the value at some future

time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.

3-10

What

## is the Present Value (PV) of the

previous problem?
The Present Value is simply the
\$1,000 you originally deposited.
That is the value today!

Present

3-11

## Value is the current value of a

future amount of money, or a series of
payments, evaluated at a given interest
rate.

Power of Time
Figure 5.1 Future Value and Compound Interest Illustrated

## Future value of original investment increases with time, unless

interest rate is zero.

12

3-12

FIN3000,

## Power of Interest Rate

Figure 5.1 Future Value and Compound Interest Illustrated

value.

13

3-13

FIN3000,

## Where to use simple

interest
Money

market instruments

Treasury
Local

bills (T-bill)

bills
Certificate

of deposit (CD)

Commercial
3-14

Bill

paper (CP)

of exchange

14

Money market

## Pure discount securities

Contracts up to 1 year

## Huge volume and vigorous competition

No physical place

## Essentially for professionals ( banks,institutional

investors, brokerage firms, companies)

## Liquidity ( fine spreads based on interest rate of

lending and borrowing)

3-15

Creditworthiness

15

3-16

T-bills

## Domestic instruments issued by governments to raise short

term finance balancing cashflow

auction

Negotiable

## Generally 13,26,52 weeks

Certificate of deposit - CD

deposit

16

## Money market securities 2

Commercial paper- CP
Issued

## by large, safe and wellknown companies bypassing

banks to achieve lower
borrowing rates (sometimes
below the banks prime rate)

Very
3-17

## short term (max 270 days,

most 60days or less)
17

## Trade bill, bills of exchange,

bankersacceptance
Used

purposes

The

## seller draws up a bill to

sign it

3-18

Could

be sold at a discount
18to

## Future value and present value

(1 + r) is a future value factor (FVF)
To simplify calculations of FV use table of FVF.
Years

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1,01

1,02

1,03

1,04

1,05

1,06

1,07

1,08

1,09

1,1

1,02

1,04

1,06

1,08

1,10

1,12

1,14

1,17

1,19

1,21

1,03

1,06

1,09

1,12

1,16

1,19

1,23

1,26

1,295

1,33

1,04

1,08

1,13

1,17

1,22

1,26

1,31

1,36

1,41

1,46

1,05

1,1

1,16

1,22

1,28

1,34

1,40

1,47

1,54

1,61

1,06

1,13

1,19

1,27

1,34

1,42

1,50

1,59

1,68

1,77

1,07

1,15

1,23

1,32

1,41

1,50

1,61

1,71

1,83

1,94

1,08

1,17

1,27

1,37

1,48

1,59

1,72

1,85

1,99

2,14

1,09

1,20

1,30

1,42

1,55

1,69

1,84

1,999

2,17

2,36

10

1,1

1,22

1,34

1,48

1,63

1,79

1,97

2,16

2,37

2,59

3-19

19

## Why Compound Interest?

Future Value (U.S. Dollars)

3-20

20000
10% Simple
Interest
7% Compound
Interest
10% Compound
Interest

15000
10000
5000
0
1st Year 10th
Year

20th
Year

30th
Year

Capital market

Instruments

3-21

Bonds

Government bonds

## Mortgage or other assets backed bonds

Corporate

Foreign

Junk

Shares

Preferred

Normal

Innovations

Convertibles

21

Future Value
Single Deposit (Graphic)
Assume that you deposit \$1,000 at
a compound interest rate of 7% for
2 years.

7%

\$1,000
FV2
3-22

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1

= \$1,000 (1.07)
= \$1,070

Compound Interest

## You earned \$70 interest on your \$1,000

deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
3-23

Future Value
Single Deposit (Formula)
FV1

= P0 (1+i)1

FV2

= FV1 (1+i)1
= P0 (1+i)(1+i) = \$1,000(1.07)(1.07)
= P0 (1+i)2
= \$1,000(1.07)2
= \$1,144.90

= \$1,000 (1.07)
= \$1,070

## You earned an EXTRA \$4.90 in Year 2 with

compound over simple interest.
3-24

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

## General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
3-25

## Valuation Using Table I

FVIFi,n is found on Table I at the end
of the book or on the card insert.

3-26

Period
1
2
3
4
5

6%
1.060
1.124
1.191
1.262
1.338

7%
1.070
1.145
1.225
1.311
1.403

8%
1.080
1.166
1.260
1.360
1.469

## Using Future Value Tables

FV2

= \$1,000 (FVIF7%,2)
= \$1,000 (1.145)
= \$1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.166
1.145
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469

3-27

## Use the highlighted row

of keys for solving any
of the FV, PV, FVA,
problems

N:
Number of periods
I/Y:Interest rate per period
PV:
Present value
PMT:
Payment per period
FV:
Future value
CLR TVM: Clears all of the inputs
into the above TVM keys
3-28

Inputs

I/Y

PV

PMT

FV

Compute

3-29

## Focus on 3rd row of keys (will be

displayed in slides as shown above)

Press:
2nd

3-30

CLR TVM

I/Y

-1000

PV

PMT

CPT

FV

## Solving the FV Problem

Inputs

Compute
N:
I/Y:
PV:
PMT:
FV:
3-31

-1,000

I/Y

PV

PMT

FV
1,144.90

2 periods (enter as 2)
7% interest rate per period (enter as 7 NOT .07)
\$1,000 (enter as negative as you have less)
Not relevant in this situation (enter as 0)

## Story Problem Example

Julie Miller wants to know how large her deposit
of \$10,000 today will become at a compound
annual interest rate of 10% for 5 years.

10%

\$10,000

FV5
3-32

## Calculation based on general formula:

FVn = P0 (1+i)n
FV5 = \$10,000 (1+ 0.10)5
= \$16,105.10

Calculation

based on Table I:
FV5 = \$10,000 (FVIF10%, 5)
= \$10,000 (1.611)
= \$16,110 [Due to Rounding]

3-33

Press:
2nd

3-34

CLR TVM

10

I/Y

-10000

PV

PMT

CPT

FV

Inputs

Compute

10

-10,000

I/Y

PV

PMT

FV
16,105.10

## The result indicates that a \$10,000

investment that earns 10% annually
for 5 years will result in a future value
of \$16,105.10.
3-35

Quick! How long does it take to
double \$5,000 at a compound rate
of 12% per year (approx.)?
We will use the Rule-of-72.

3-36

The Rule-of-72
Quick! How long does it take to
double \$5,000 at a compound rate
of 12% per year (approx.)?
Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
3-37

Inputs

N
Compute

12

-1,000

+2,000

I/Y

PV

PMT

FV

6.12 years

## The result indicates that a \$1,000

investment that earns 12% annually
will double to \$2,000 in 6.12 years.
Note: 72/12% = approx. 6 years
3-38

## Basic principles of finance

3-39

Time value of
money - a dollar
today worth more
than a dollar
tomorrow

A safe dollar is
worth more than a
risky one

39

## Theory of Present Value

3-40

Theory by John B.
Williams

Based on :
dividends and
assumes long-term
decisions

Compares actual
value and real
value

40

Basics

Yield
Rate

of return

Rate

of interest

Income

3-41

Maturity

## Future and present value

Simple interest

Compound interest

41

Present Value
Single Deposit (Graphic)
Assume that you need \$1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.

7%

\$1,000
PV0
3-42

PV1

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= FV2 / (1+i)2
0

7%

= \$1,000 / (1.07)2
= \$873.44
1

\$1,000
PV0
3-43

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.

## General Present Value Formula:

PV0 = FVn / (1+i)n
or
3-44

## Valuation Using Table II

PVIFi,n is found on Table II at the end
of the book or on the card insert.
Period
1
2
3
4
5
3-45

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

## Using Present Value Tables

PV2

3-46

= \$1,000 (PVIF7%,2)
= \$1,000 (.873)
= \$873 [Due to Rounding]
Period
6%
7%
8%
1
.943
.935
.926
2
.890
.873
.857
3
.840
.816
.794
4
.792
.763
.735
5
.747
.713
.681

## 2. Future value and present value

Table of present value factor

3-47

Years

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0,99

0,98

0,97

0,96

0,95

0,94

0,935

0,93

0,92

0,91

0,98

0,96

0,94

0,92

0,91

0,89

0,87

0,86

0,84

0,83

0,97

0,94

0,92

0,89

0,86

0,84

0,82

0,79

0,77

0,75

0,96

0,92

0,89

0,85

0,82

0,79

0,76

0,74

0,71

0,68

0,95

0,91

0,87

0,82

0,78

0,75

0,71

0,68

0,65

0,62

0,94

0,89

0,84

0,79

0,75

0,70

0,67

0,63

0,596

0,56

0,93

0,87

0,81

0,76

0,71

0,67

0,62

0,58

0,55

0,51

0,92

0,85

0,79

0,73

0,68

0,63

0,58

0,54

0,50

0,47

0,914

0,84

0,77

0,70

0,64

0,59

0,54

0,50

0,46

0,42

10

0,905

0,82

0,74

0,68

0,61

0,56

0,51

0,46

0,42

0,39

47

## Solving the PV Problem

Inputs

Compute
N:
I/Y:
PV:
PMT:
FV:
3-48

I/Y

PV

+1,000

PMT

FV

-873.44

2 periods (enter as 2)
7% interest rate per period (enter as 7 NOT .07)
Compute (Resulting answer is negative deposit)
Not relevant in this situation (enter as 0)
\$1,000 (enter as positive as you receive \$)

## Story Problem Example

Julie Miller wants to know how large of a
deposit to make so that the money will
grow to \$10,000 in 5 years at a discount
rate of 10%.

10%
\$10,000
PV0
3-49

## Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0 = \$10,000 / (1+ 0.10)5
= \$6,209.21

## Calculation based on Table I:

PV0 = \$10,000 (PVIF10%, 5)
= \$10,000 (.621)
= \$6,210.00 [Due to Rounding]

3-50

Inputs

Compute

10

I/Y

PV

+10,000

PMT

FV

-6,209.21

## The result indicates that a \$10,000

future value that will earn 10% annually
for 5 years requires a \$6,209.21 deposit
today (present value).
3-51

Types of Annuities
An

## Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.

Ordinary

## Annuity: Payments or receipts

occur at the end of each period.

Annuity

## Due: Payments or receipts

occur at the beginning of each period.

3-52

Examples of Annuities

3-53

## Car Loan Payments

Mortgage Payments

Retirement Savings

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

Today
3-54

End of
Period 2

End of
Period 3

\$100

\$100

\$100

## Equal Cash Flows

Each 1 Period Apart

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

\$100

\$100

\$100

Today
3-55

Beginning of
Period 2

Beginning of
Period 3

## Equal Cash Flows

Each 1 Period Apart

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

i%

. . .
R

R = Periodic
Cash Flow

FVAn =

R(1+i)n-1 +

R(1+i)n-2 +

## ... + R(1+i)1 + R(1+i)0

3-56

FVAn

n+1

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

\$1,000

\$1,000

7%
\$1,000

\$1,070
\$1,145
FVA3 = \$1,000(1.07)2 +
\$1,000(1.07)1 + \$1,000(1.07)0 \$3,215 = FVA3
= \$1,145 + \$1,070 + \$1,000
= \$3,215
3-57

## Hint on Annuity Valuation

The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
3-58

## Valuation Using Table III

FVAn
FVA3

= R (FVIFAi%,n)
= \$1,000 (FVIFA7%,3)
= \$1,000 (3.215) = \$3,215
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.246
3.215
4
4.375
4.440
4.506
5
5.637
5.751
5.867

3-59

Inputs

Compute
N:
I/Y:
PV:
PMT:
FV:
3-60

-1,000

I/Y

PV

PMT

FV
3,214.90

## 3 periods (enter as 3 year-end deposits)

7% interest rate per period (enter as 7 NOT .07)
Not relevant in this situation (no beg value)
\$1,000 (negative as you deposit annually)

Overview View of an
Cash flows occur at the beginning of the period

## FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
3-61

. . .

i%
R

n-1
R

Example of an
Cash flows occur at the beginning of the period

\$1,000

\$1,000

\$1,070

7%
\$1,000

\$1,145
\$1,225
2
1
\$1,000(1.07) + \$1,000(1.07)
= \$1,225 + \$1,145 + \$1,070
= \$3,440
3-62

## Valuation Using Table III

= R (FVIFAi%,n)(1+i)
= \$1,000 (FVIFA7%,3)(1.07)
= \$1,000 (3.215)(1.07) = \$3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.246
3.215
4
4.375
4.440
4.506
5
5.637
5.751
5.867

3-63

Inputs

-1,000

I/Y

PV

PMT

FV
3,439.94

Compute

## Complete the problem the same as an ordinary annuity

problem, except you must change the calculator setting
to BGN first. Dont forget to change back!
Step 1:
Press
2nd
BGN
keys

3-64

Step 2:

Press

2nd

SET

keys

Step 3:

Press

2nd

QUIT

keys

Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

i%

n+1

. . .
R

R = Periodic
Cash Flow

PVAn

## PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

3-65

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

\$1,000

\$1,000

7%
\$1,000
\$ 934.58
\$ 873.44
\$ 816.30
\$2,624.32 = PVA3

3-66

PVA3 =

\$1,000/(1.07)1 +
\$1,000/(1.07)2 +
\$1,000/(1.07)3

= \$2,624.32

## Hint on Annuity Valuation

The present value of an ordinary
annuity can be viewed as
occurring at the beginning of the
first cash flow period, whereas
the present value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.
3-67

## Valuation Using Table IV

PVAn
PVA3

= R (PVIFAi%,n)
= \$1,000 (PVIFA7%,3)
= \$1,000 (2.624) = \$2,624
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.577
2.624
4
3.465
3.387
3.312
5
4.212
4.100
3.993

3-68

## Future and present value of

stream of cash flow
Table of future value factor of
annuity

Years

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1,00

1,00

1,00

1,00

1,00

1,00

1,00

1,00

1,00

1,00

2,01

2,02

2,03

2,04

2,05

2,06

2,07

2,08

2,09

2,1

3,03

3,06

3,09

3,12

3,15

3,18

3,22

3,25

3,28

3,31

4,06

4,12

4,2

4,25

4,31

4,38

4,44

4,51

4,57

4,64

5,1

5,2

5,3

5,42

5,53

5,64

5,75

5,87

5,99

6,11

6,2

6,3

6,5

6,63

6,8

6,98

7,15

7,34

7,52

7,72

7,2

7,4

7,7

7,898

8,14

8,39

8,65

8,92

9,2

9,49

8,3

8,6

8,9

9,21

9,55

9,897

10,26

10,64

11,03

11,45

9,4

9,8

10,16

10,58

11,03

11,49

11,98

12,49

13,02

13,58

10

10,5

10,95

11,46

12,01

12,58

13,18

13,82

14,49

15,19

15,94

3-69

69

annuity factor
Years

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0,99

0,98

0,97

0,96

0,95

0,94

0,93

0,925

0,917

0,91

1,97

1,94

1,91

1,89

1,86

1,83

1,81

1,78

1,76

1,74

2,94

2,88

2,83

2,76

2,72

2,67

2,62

2,58

2,53

2,49

3,90

3,81

3,72

3,63

3,55

3,47

3,39

3,31

3,24

3,17

4,85

4,71

4,58

4,45

4,33

4,21

4,10

3,99

3,89

3,79

5,796

5,60

5,42

5,24

5,08

4,91

4,77

4,62

4,49

4,36

6,73

6,47

6,23

6,00

5,79

5,58

5,39

5,21

5,03

4,87

7,65

7,33

7,02

6,73

6,46

6,21

5,97

5,75

5,53

5,33

8,57

8,16

7,79

7,44

7,11

6,8

6,52

6,25

5,99

5,76

10

9,47

8,98

8,73

8,11

7,72

7,36

7,02

6,71

6,42

6,14

3-70

70

Inputs

Compute
N:
I/Y:
PV:
PMT:
FV:
3-71

I/Y

PV

-1,000

PMT

FV

2,624.32

## 3 periods (enter as 3 year-end deposits)

7% interest rate per period (enter as 7 NOT .07)
\$1,000 (negative as you deposit annually)
Not relevant in this situation (no ending value)

Overview of an
Cash flows occur at the beginning of the period

i%
R

n-1

. . .
R

R: Periodic
Cash Flow

## PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
3-72

Example of an
Cash flows occur at the beginning of the period

\$1,000

\$1,000

7%
\$1,000.00
\$ 934.58
\$ 873.44

## PVADn = \$1,000/(1.07)0 + \$1,000/(1.07)1 +

\$1,000/(1.07)2 = \$2,808.02
3-73

## Valuation Using Table IV

= \$1,000 (2.624)(1.07) = \$2,808
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.577
2.624
4
3.465
3.387
3.312
5
4.212
4.100
3.993
3-74

Inputs

I/Y

PV

-1,000

PMT

FV

2,808.02

Compute

## Complete the problem the same as an ordinary annuity

problem, except you must change the calculator setting
to BGN first. Dont forget to change back!
Step 1:
Press
2nd
BGN
keys

3-75

Step 2:

Press

2nd

SET

keys

Step 3:

Press

2nd

QUIT

keys

## Steps to Solve Time Value

of Money Problems
2. Determine if it is a PV or FV problem
3. Create a time line
4. Put cash flows and arrows on time line
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow

## 6. Solve the problem

7. Check with financial calculator (optional)
3-76

## Mixed Flows Example

Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%?

1
10%
\$600

PV0
3-77

## \$600 \$400 \$400 \$100

How to Solve?
1. Solve a piece-at-a-time by
discounting each piece back to t=0.
2. Solve a group-at-a-time by first
breaking problem into groups of
annuity streams and any single
cash flow group. Then discount
each group back to t=0.
3-78

Piece-At-A-Time
0

1
10%
\$600

\$545.45
\$495.87
\$300.53
\$273.21
\$ 62.09

## \$1677.15 = PV0 of the Mixed Flow

3-79

Group-At-A-Time (#1)
0

10%
\$600

## \$600 \$400 \$400 \$100

\$1,041.60
\$ 573.57
\$ 62.10
\$1,677.27 = PV0 of Mixed Flow [Using Tables]
\$600(PVIFA10%,2) =
\$600(1.736) = \$1,041.60
\$400(PVIFA10%,2)(PVIF10%,2) = \$400(1.736)(0.826) = \$573.57
\$100 (PVIF10%,5) =
\$100 (0.621) =
\$62.10
3-80

Group-At-A-Time (#2)
0

\$400

\$400

\$400

\$200

\$200

4
\$400

\$1,268.00

Plus

PV0 equals
\$1677.30.

\$347.20

Plus

5
\$100

\$62.10
3-81

## Solving the Mixed Flows

Problem using CF Registry
Use

the highlighted
key for starting the
process of solving a
mixed cash flow
problem

Press

3-82

the CF key
and down arrow key
through a few of the
keys as you look at
the definitions on
the next slide

## Solving the Mixed Flows

Problem using CF Registry
Defining the calculator variables:
For CF0:
This is ALWAYS the cash flow occurring
at time t=0 (usually 0 for these problems)
For Cnn:* This is the cash flow SIZE of the nth
group of cash flows. Note that a group may only
contain a single cash flow (e.g., \$351.76).
For Fnn:*
This is the cash flow FREQUENCY of the
nth group of cash flows. Note that this is always a
positive whole number (e.g., 1, 2, 20, etc.).
3-83

## * nn represents the nth cash flow or frequency. Thus, the

first cash flow is C01, while the tenth cash flow is C10.

## Solving the Mixed Flows

Problem using CF Registry
Steps in the Process

3-84

Step 1:
Press
Step 2:
Press
Step 3: For CF0 Press

CF
2nd
0

CLR Work
Enter

Step 4:
Step 5:
Step 6:
Step 7:

600
2
400
2

Enter
Enter
Enter
Enter

For F01 Press
For C02 Press
For F02 Press

key
keys
keys
keys
keys
keys
keys

## Solving the Mixed Flows

Problem using CF Registry
Steps in the Process

3-85

100

Enter

keys

Enter

keys

Step 10:
Step 11:

Press
Press

keys
key

NPV
Enter

10

Step 13:

Press

CPT

Result:

## Present Value = \$1,677.15

keys
key

Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn

3-86

n:
m:
i:
FVn,m:

Number of Years
Compounding Periods per Year
Annual Interest Rate
FV at the end of Year n

PV0:

## PV of the Cash Flow today

Impact of Frequency
Julie Miller has \$1,000 to invest for 2
years at an annual interest rate of
12%.
Annual

FV2

= 1,000(1+ [.12/1])(1)(2)
= 1,254.40

Semi

FV2

= 1,000(1+ [.12/2])(2)(2)
= 1,262.48

3-87

Impact of Frequency
Qrtly

FV2

= 1,000(1+ [.12/4])(4)(2)
= 1,266.77

Monthly

FV2

= 1,000(1+ [.12/12])(12)(2)
= 1,269.73

Daily

FV2

= 1,000(1+[.12/365])(365)(2)
= 1,271.20

3-88

## Solving the Frequency

Problem (Quarterly)
Inputs

Compute

2(4)

12/4

-1,000

I/Y

PV

PMT

FV
1266.77

## The result indicates that a \$1,000

investment that earns a 12% annual
rate compounded quarterly for 2 years
will earn a future value of \$1,266.77.
3-89

## Solving the Frequency

Problem (Quarterly Altern.)
Press:

2nd P/Y
2nd

QUIT

12

I/Y

-1000

PV

PMT

2
3-90

CPT

ENTER

2nd xP/Y N
FV

Problem (Daily)
Inputs

N
Compute

I/Y

PV

PMT

FV
1271.20

## The result indicates that a \$1,000

investment that earns a 12% annual
rate compounded daily for 2 years will
earn a future value of \$1,271.20.
3-91

## Solving the Frequency

Problem (Daily Alternative)
Press:

## 2nd P/Y 365 ENTER

2nd

QUIT

12

I/Y

-1000

PV

PMT

2
3-92

CPT

2nd xP/Y N
FV

Effective Annual
Interest Rate
Effective Annual Interest Rate
The actual rate of interest earned
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1
3-93

BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a \$1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
3-94

Converting to an EAR
Press:

3-95

2nd

I Conv

ENTER

ENTER

CPT

2nd

QUIT

1.

2.

## Determine the interest in Period t.

(Loan balance at t-1) x (i% / m)

3.

## Compute principal payment in Period t.

(Payment - interest from Step 2)

4.

## Determine ending balance in Period t.

(Balance - principal payment from Step 3)

5.

3-96

## Amortizing a Loan Example

Julie Miller is borrowing \$10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
Step 1: Payment
PV0
= R (PVIFA i%,n)
\$10,000
= R (PVIFA 12%,5)
\$10,000
= R (3.605)
R = \$10,000 / 3.605 = \$2,774
3-97

End of
Year
0

Payment

Interest

Principal

---

---

---

Ending
Balance
\$10,000

\$2,774

\$1,200

\$1,574

8,426

2,774

1,011

1,763

6,663

2,774

800

1,974

4,689

2,774

563

2,211

2,478

2,775

297

2,478

\$13,871

\$3,871

\$10,000

3-98

Inputs

Compute

12

10,000

I/Y

PV

PMT

FV

-2774.10

## The result indicates that a \$10,000 loan

that costs 12% annually for 5 years and
will be completely paid off at that time will
require \$2,774.10 in annual payments.
3-99

## Using the Amortization

Functions of the Calculator
Press:
2nd

Amort

ENTER

ENTER

Results:
BAL = 8,425.90

PRN = -1,574.10

INT =

-1,200.00

3-100

## Using the Amortization

Functions of the Calculator
Press:
2nd

Amort

ENTER

ENTER

Results:
BAL = 6,662.91

PRN = -1,763.99

INT =

-1,011.11

3-101

## Using the Amortization

Functions of the Calculator
Press:
2nd

Amort

ENTER

ENTER

Results:
0.00

PRN =-10,000.00

INT =

BAL =

-3,870.49

## Entire 5 Years of loan information

3-102

Usefulness of Amortization

3-103

1.

## Determine Interest Expense -Interest expenses may reduce

taxable income of the firm.

2.

## Calculate Debt Outstanding -- The

quantity of outstanding debt
may be used in financing the
day-to-day activities of the firm.