LECTURE 2

Time Value of Money

Brooks, (2013) Chapters 3, 4

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 Learning Objectives

1. Calculate future values and understand compounding.

2. Calculate present values and understand discounting.
3. Calculate implied interest rates and waiting time from the time value of
money equation.
4. Apply the time value of money equation.
5. Explain the Rule of 72, a simple estimation of doubling values.
6. Calculate future and present values for Annuities
7. Distinguish between the different types of loan repayments:
• discount loans
• interest-only loans
• amortized loans

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 3.1 Future Value and Compounding Interest

• The value of money at the end of the stated period is

called the future or compound value of that sum of
money.
– Determines the attractiveness of alternative investments
– Figures out the effect of inflation on the future cost of assets,
such as a car or a house.

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 3.1 (A) The Single-Period Scenario

FV = PV + PV x interest rate, or
FV = PV(1+interest rate)
(in decimals)

Example 1: Let’s say John deposits $200 for a year in an

account that pays 6% per year. At the end of the year, he
will have:

FV = $200 + ($200 x .06) = $212

= $200(1.06) = $212

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 3.1 (B) The Multiple-Period Scenario
FV = PV x (1+r)n
Example 2: If John closes out his account after 3 years, how much
money will he have accumulated? How much of that is the
interest-on-interest component? What about after 10 years?

FV3 = $200(1.06)3 = $200*1.191016 = $238.20,

where, 6% interest per year for 3 years = $200 x.06 x 3=$36
Interest on interest = $238.20 - $200 - $36 =$2.20

FV10 = $200(1.06)10 = $200 x 1.790847 = $358.17

where, 6% interest per year for 10 years = $200 x .06 x 10 = $120
Interest on interest = $358.17 - $200 - $120 = $38.17

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 3.1 (C) Methods of Solving Future Value
Problems

• Method 1: The formula method

– Time-consuming, tedious
• Method 2: The financial calculator approach
– Quick and easy
• Method 3: The spreadsheet method
– Most versatile
• Method 4: The use of Time Value tables
– Easy and convenient but maybe limiting in scope

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 3.1 (C) Methods of Solving Future Value
Problems (continued)

Example 3: Compounding of Interest

Let’s say you want to know how much money you will have
accumulated in your bank account after 4 years, if you
deposit all $5,000 of your high-school graduation gifts into
an account that pays a fixed interest rate of 5% per year.
You leave the money untouched for all four of your college
years.

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 3.1 (C) Methods of Solving Future Value
Problems (continued)
Example 3: Answer
Formula Method:
FV = PV x (1+r)n$5,000(1.05)4=$6,077.53

Time value table method:

FV = PV(FVIF, 5%, 4) = 5000*(1.215506)=6,077.53,
where (FVIF, 5%,4) = Future value interest factor listed under the 5% column
and in the 4-year row of the Future Value of $1 table.

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 3.1 (C) Methods of Solving Future Value
Problems (continued)

Example 4: Future Cost due to Inflation

Let’s say that you have seen your dream house, which
is currently listed at $300,000, but unfortunately, you
are not in a position to buy it right away and will have
to wait at least another 5 years before you will be able
to afford it. If house values are appreciating at the
average annual rate of inflation of 5%, how much will a
similar house cost after 5 years?

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 3.1 (C) Methods of Solving Future Value
Problems (continued)

Example 4 (Answer)

PV = current cost of the house = $300,000;

n = 5 years;
r = average annual inflation rate = 5%.
Solving for FV, we have
FV = $300,000*(1.05)(1.05)(1.05)(1.05)(1.05)
= $300,000*(1.276282)
= $382,884.5

So the house will cost $382,884.5 after 5 years

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 3.2 Present Value and Discounting

• Involves discounting the interest that would have been earned

over a given period at a given rate of interest.
• It is therefore the exact opposite or inverse of calculating the
future value of a sum of money.
• Such calculations are useful for determining today’s price or the
value today of an asset or cash flow that will be received in the
future.
• The formula used for determining PV is as follows:
PV = FV x 1/(1+r)n

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 3.2 (A) The Single-Period Scenario

When calculating the present or discounted value of a

future lump sum to be received one period from today,
we are basically deducting the interest that would
have been earned on a sum of money from its future
value at the given rate of interest.
i.e. PV = FV/(1+r) since n = 1
So, if FV = 100; r = 10%; and n =1;
PV = 100/1.1=90.91

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 3.2 (B) The Multiple-Period Scenario

When multiple periods are involved…

The formula used for determining PV is as follows:
PV = FV x 1/(1+r)n
where the term in brackets is the present value interest
factor (PVIF) or the relevant rate of interest and
number of periods involved, and is the reciprocal of
the future value interest factor (FVIF)

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 3.2 Present Value and Discounting
(continued)

Example 5: Discounting Interest

Let’s say you just won a jackpot of $50,000 at the
casino and would like to save a portion of it so as to
have $40,000 to put down on a house after 5 years.
Your bank pays a 6% rate of interest. How much money
will you have to set aside from the jackpot winnings?

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 3.2 Present Value and Discounting
(continued)
Example 5 (Answer)
FV = amount needed = $40,000
N = 5 years; Interest rate = 6%;
• PV = FV x 1/ (1+r)n
• PV = $40,000 x 1/(1.06)5
• PV = $40,000 x 0.747258
• PV = $29,890.33 Amount needed to be set aside
today

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 3.2 (C) Using Time Lines

• When solving time value of money problems, especially

the ones involving multiple periods and complex
combinations (which will be discussed later) it is always
a good idea to draw a time line and label the cash
flows, interest rates and number of periods involved.

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 3.2 (C) Using Time Lines (continued)

FIGURE 3.1 Time lines of growth rates (top) and discount rates (bottom) illustrate
present value and future value.

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 3.3 One Equation and Four Variables

• Any time value problem involving lump sums -- i.e., a single

outflow and a single inflow--requires the use of a single equation
consisting of 4 variables i.e. PV, FV, r, n
• If 3 out of 4 variables are given, we can solve for the unknown one.
FV = PV x (1+r)n solving for future value
PV = FV X [1/(1+r)n] solving for present value
r = [FV/PV]1/n – 1 solving for unknown rate
n= [ln(FV/PV)/ln(1+r)] solving for number of periods

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 3.4 Applications of the Time Value of Money
Equation
• Calculating the amount of saving required for
retirement
• Determining future value of an asset
• Calculating the cost of a loan
• Calculating growth rates of cash flows
• Calculating number of periods required to reach a
financial goal.

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 3.5 Doubling of Money: The Rule of 72 (works well
for r=4%-30%)

• The Rule of 72 estimates the number of years required

to double a sum of money at a given rate of interest.
– For example, if the rate of interest is 9%, it would take 72/9
 8 years to double a sum of money
• Can also be used to calculate the rate of interest
needed to double a sum of money by a certain number
of years.
– For example, to double a sum of money in 4 years, the rate of
return would have to be approximately 18% (i.e. 72/4=18).

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 4.1 Future Value of Multiple Payment Streams

• With unequal periodic cash flows, treat each of the

cash flows as a lump sum and calculate its future value
over the relevant number of periods.
• Sum up the individual future values to get the future
value of the multiple payment streams.

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 Figure 4.1 The time line of a nest egg

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 4.1 Future Value of Multiple Payment
Streams (continued)
Example 1: Future Value of an Uneven Cash Flow Stream:
Jim deposits $3,000 today into an account that pays 10% per
year, and follows it up with 3 more deposits at the end of each
of the next three years. Each subsequent deposit is $2,000
higher than the previous one. How much money will Jim have
accumulated in his account by the end of three years?

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 4.1 Future Value of Multiple Payment Streams
(Example 1 Answer)

FV = PV x (1+r)n
FV of Cash Flow at T0 = $3,000 x (1.10)3 = $3,000 x 1.331= $3,993.00
FV of Cash Flow at T1 = $5,000 x (1.10)2 = $5,000 x 1.210 = $6,050.00
FV of Cash Flow at T2 = $7,000 x (1.10)1 = $7,000 x 1.100 = $7,700.00
FV of Cash Flow at T3 = $9,000 x (1.10)0 = $9,000 x 1.000 = $9,000.00
Total = $26,743.00

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 4.2 Future Value of an Annuity Stream

• Annuities are equal, periodic outflows/inflows., e.g. rent, lease, mortgage,

car loan, and retirement annuity payments.
• An annuity stream can begin at the start of each period (annuity due) as is
true of rent and insurance payments or at the end of each period, (ordinary
annuity) as in the case of mortgage and loan payments.
• The formula for calculating the future value of an annuity stream is as
follows:
FV = PMT * (1+r)n -1
r
• where PMT is the term used for the equal periodic cash flow, r is the rate of
interest, and n is the number of periods involved.

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 4.2 Future Value of an Annuity Stream
(continued)

Example 2: Future Value of an Ordinary Annuity Stream

Jill has been faithfully depositing $2,000 at the end of each year
since the past 10 years into an account that pays 8% per year.
How much money will she have accumulated in the account?

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 4.2 Future Value of an Annuity Stream
(continued)
Example 2 Answer

Future Value of Payment One = $2,000 x 1.089 = $3,998.01

Future Value of Payment Two = $2,000 x 1.088 = $3,701.86
Future Value of Payment Three = $2,000 x 1.087 = $3,427.65
Future Value of Payment Four = $2,000 x 1.086 = $3,173.75
Future Value of Payment Five = $2,000 x 1.085 = $2,938.66
Future Value of Payment Six = $2,000 x 1.084 = $2,720.98
Future Value of Payment Seven = $2,000 x 1.083 = $2,519.42
Future Value of Payment Eight = $2,000 x 1.082 = $2,332.80
Future Value of Payment Nine = $2,000 x 1.081 = $2,160.00
Future Value of Payment Ten = $2,000 x 1.080 = $2,000.00
Total Value of Account at the end of 10 years $28,973.13

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 4.2 Future Value of an Annuity Stream
(continued)
Example 2 (Answer)
FORMULA METHOD
FV = PMT * (1+r)n -1
r
where, PMT = $2,000; r = 8%; and n=10.
FVIFA [((1.08)10 - 1)/.08] = 14.486562,
FV = $2000*14.486562  $28,973.13

USING A FINANCIAL CALCULATOR

N= 10; PMT = -2,000; I = 8; PV=0; CPT FV = 28,973.13

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 4.3 Present Value of an Annuity

To calculate the value of a series of equal periodic cash

flows at the current point in time, we can use the following
simplified formula:
  1 
1   
   n

PV  PMT  
1 r
r
The last portion of the equation, is the
Present Value Interest Factor of an Annuity (PVIFA).

Practical applications include figuring out the nest egg needed prior to
retirement or lump sum needed for college expenses.

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 FIGURE 4.4 Time line of present value of annuity
stream.

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 4.3 Present Value of an Annuity (continued)

Example 3: Present Value of an Annuity.

John wants to make sure that he has saved up enough money
prior to the year in which his daughter begins college. Based
on current estimates, he figures that college expenses will
amount to $40,000 per year for 4 years (ignoring any inflation
or tuition increases during the 4 years of college). How much
money will John need to have accumulated in an account that
earns 7% per year, just prior to the year that his daughter
starts college?

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 4.3 Present Value of an Annuity (continued)

Example 3 Answer
Using the following equation:

  1 
1  
n 
  1 r  
PV  PMT 
r

1. Calculate the PVIFA value for n=4 and r=7%3.387211.

2. Then, multiply the annuity payment by this factor to get the PV,
PV = $40,000 x 3.387211 = $135,488.45

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 4.4 Annuity Due and Perpetuity

A cash flow stream such as rent, lease, and insurance payments,

which involves equal periodic cash flows that begin right away or
at the beginning of each time interval is known as an annuity
due.

Figure 4.5 An ordinary annuity versus an annuity due.

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 4.4 Annuity Due and Perpetuity

PV annuity due = PV ordinary annuity x (1+r)

FV annuity due = FV ordinary annuity x (1+r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why?

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 4.4 Annuity Due and Perpetuity (continued)

Example 4: Annuity Due versus Ordinary Annuity

Let’s say that you are saving up for retirement and decide
to deposit $3,000 each year for the next 20 years into an
account which pays a rate of interest of 8% per year. By
how much will your accumulated nest egg vary if you make
each of the 20 deposits at the beginning of the year,
starting right away, rather than at the end of each of the
next twenty years?

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 4.4 Annuity Due and Perpetuity (continued)

Example 4 Answer
Given information: PMT = -$3,000; n=20; i= 8%; PV=0;

FV  PMT 
1 r   1
n

FV ordinary annuity = $3,000 * [((1.08)20 - 1)/.08]

= $3,000 * 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity * (1+r)
FV of annuity due = $137,285.89*(1.08) = $148,268.76

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 4.4 Annuity Due and Perpetuity (continued)

Perpetuity
A Perpetuity is an equal periodic cash flow stream that
will never cease.
The PV of a perpetuity is calculated by using the
following equation:

PMT
PV 
r

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 4.4 Annuity Due and Perpetuity (continued)

Example 5: PV of a perpetuity
If you are considering the purchase of a consol that pays $60 per
year forever, and the rate of interest you want to earn is 10%
per year, how much money should you pay for the consol?
Answer:
r=10%, PMT = $60; and PV = ($60/.1) = $600
$600 is the most you should pay for the consol.

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 4.5 Three Loan Payment Methods

Loan payments can be structured in one of 3 ways:

1) Discount loan
• Principal and interest is paid in lump sum at end
2) Interest-only loan
• Periodic interest-only payments, principal due at end.
3) Amortized loan
• Equal periodic payments of principal and interest

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 4.5 Three Loan Payment Methods
(continued)
Example 6: Discount versus Interest-only versus Amortized loans

Roseanne wants to borrow $40,000 for a period of 5 years.

The lender offers her a choice of three payment structures:
1)Pay all of the interest (10% per year) and principal in one lump sum at the end of 5
years;
2)Pay interest at the rate of 10% per year for 4 years and then a final payment of interest
and principal at the end of the 5th year;
3)Pay 5 equal payments at the end of each year inclusive of interest and part of the
principal.

Under which of the three options will Roseanne pay the least interest and why? Calculate
the total amount of the payments and the amount of interest paid under each
alternative.

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 4.5 Three Loan Payment Methods
(continued)
Method 1: Discount Loan.
Since all the interest and the principal is paid at the end of 5
years we can use the FV of a lump sum equation to calculate
the payment required, i.e.
FV = PV x (1 + r)n
FV5 = $40,000 x (1+0.10)5
= $40,000 x 1.61051
= $64, 420.40
Interest paid = Total payment - Loan amount
Interest paid = $64,420.40 - $40,000 = $24,420.40

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 4.5 Three Loan Payment Methods
(continued)
Method 2: Interest-Only Loan.
Annual Interest Payment (Years 1-4)
= $40,000 x 0.10 = $4,000
Year 5 payment
= Annual interest payment + Principal payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $20,000

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 4.5 Three Loan Payment Methods
(continued)

Method 3: Amortized Loan.

n = 5; I = 10%; PV=$40,000; FV = 0;CPT PMT=$10,551.86
Total payments = 5*$10,551.8 = $52,759.31
Interest paid = Total Payments - Loan Amount
= $52,759.31-$40,000
Interest paid = $12,759.31
Loan Type Total Payment Interest Paid
Discount Loan $64,420.40 $24,420.40
Interest-only Loan $60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.31

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 4.6 Amortization Schedules

Tabular listing of the allocation of each loan payment towards

interest and principal reduction
Helps borrowers and lenders figure out the payoff balance on an
outstanding loan.

Procedure:
1) Compute the amount of each equal periodic payment (PMT).
2) Calculate interest on unpaid balance at the end of each period,
minus it from the PMT, reduce the loan balance by the
remaining amount,
3) Continue the process for each payment period, until we get a
zero loan balance.

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 4.6 Amortization Schedules (continued)

Example 7: Loan amortization schedule.

Prepare a loan amortization schedule for the amortized
loan option given in the previous example. What is the
loan payoff amount at the end of 2 years?

PV = $40,000; n=5; i=10%; FV=0;

CPT PMT = $10,551.89

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 4.6 Amortization Schedules (continued)

Year Beg. Bal Payment Interest Prin. Red End. Bal

1 40,000.00 10,551.89 4,000.00 6,551.89 33,448.11

2 33,448.11 10,551.89 3,344.81 7,207.08 26,241.03

3 26,241.03 10,551.89 2,264.10 7,927.79 18,313.24

4 18,313.24 10,551.89 1,831.32 8,720.57 9,592.67

5 9,592.67 10,551.89 959.27 9,592.67 0

The loan payoff amount at the end of 2 years is

$26,241.03
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 4.9 Important Points about the TVM
Equation
1. Amounts of money can be added or subtracted only if they are
at the same point in time.
2. The timing and the amount of the cash flow are what matters.
3. It is very helpful to lay out the timing and amount of the cash
flow with a timeline.
4. Present value calculations discount all future cash flow back to
current time.
5. Future value calculations value cash flows at a single point in
time in the future

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 4.9 Important Points about the TVM
Equation (continued)

6. An annuity is a series of equal cash payments at regular

intervals across time.
7. The time value of money equation has four variables but only
one basic equation, and so you must know three of the four
variables before you can solve for the missing or unknown
variable.
8. There are four basic methods to solve for an unknown time
value of money variable:
(1) Using equations and calculating the answer;
(2) Using the TVM keys on a calculator;
(3) Using financial functions from a spreadsheet.
(4) Using Tables with FVIF & PVIF

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 4.9 Important Points about the TVM
Equation (continued)

9. There are 3 basic ways to repay a loan:

(1) Discount loans,
(2) Interest-only loans, and
(3) Amortized loans.

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