Powerpoint Presentation Traven Reed Canadore College: Prepared by

PowerPoint Presentation
prepared by
Traven Reed
Canadore College
chapter 4
Time Value of Money
Corporate Valuation and the
Time Value of Money
CH4
Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-3

Time Value Topics
CH4
• Time lines
• Future value
• Present value
• Effective rates of return
• Amortization

Time lines show timing of
cash flows
CH4
0 1 2 3
I%
CF0 CF1 CF2 CF3

Tick marks at the ends of periods, so
Time 0 is today; Time 1 is the end of
Period 1; or the beginning of Period 2.
Time line for a $100 lump sum
due at the end of Year 2
CH4
0 1 2 Year
I%
100

Time line for an ordinary
annuity of $100 for 3 years
CH4
0 1 2 3
I%
100 100 100

Time line for uneven CFs
CH4
0 1 2 3
I%
-50 100 75 50

FV of an initial $100 after
3 years (i = 5%)
CH4
0 1 2 3
5%
100 FV = ?
Finding FVs (moving to the right

on a time line) is called compounding.

After 1 year
(Formula Approach)
CH4
FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.05)
= $105.00

After 2 years
(Formula Approach)
CH4
FV2 = FV1(1+I) = PV(1+I)(1+I)

= PV(1+I)2
= $100(1.05)2
= $110.25

After 3 years
(Formula Approach)
CH4
FV3 = FV2(1+I)=PV(1 + I)2(1+I)

= PV(1+I)3
= $100(1.05)3
= $115.76
In general,
FVN = PV(1 + I)N
Growth of $1
CH4
Three Ways to Find FVs
CH4
• Solve the equation with a regular

calculator.
• Use a financial calculator.
• Use a spreadsheet.

(Reference Only)
Financial calculator: HP10BII
CH4
• Adjust display brightness: hold

down ON and push + or -.
• Set number of decimal places to
display: Orange Shift key, then
DISP key (in orange), then desired
decimal places (e.g., 3).
• To temporarily show all digits, hit
Orange Shift key, then DISP, then =
(Reference Only)
HP10BII (cont’d)
CH4
• To permanently show all digits, hit

ORANGE shift, then DISP, then .
(period key)
• Set decimal mode: Hit ORANGE
shift, then ./, key.

(Reference Only) HP10BII:
Set Time Value Parameters
CH4
• To set END (for cash flows

occurring at the end of the year), hit
ORANGE shift key, then BEG/END.
• To set 1 payment per period, hit 1,
then ORANGE shift key, then P/YR

Financial Calculator Solution
CH4
Financial calculators solve this

equation:
FVN + PV (1+I)N = 0
There are 4 variables. If 3 are

known, the calculator will solve for
the 4th.

Here’s the setup to find FV
CH4
INPUTS
3 5 -100 0
N I/YR PV PMT FV
OUTPUT 115.76
Clearing automatically sets everything to

0, but for safety enter PMT = 0
Set: P/YR = 1, END
Spreadsheet Solution
CH4
• Use the FV function:
• = FV(I, N, PMT, PV)
• = FV(0.05, 3, 0, -100) = 115.76

What’s the PV of $100 due in
3 years if i = 10%?
CH4
Finding PVs is discounting, and it’s the

reverse of compounding.
0 1 2 3
10%
PV = ? 100
Solve FVN = PV(1 + I )N for PV
CH4
FVN N
1
PV = = FVN
(1+I)N 1+I
3
1
PV = $100
1.10
= $100(0.7513) = $75.13
CH4
INPUTS
3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13
Either PV or FV must be negative. Here

PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
CH4
• Use the PV function:
• = PV(I, N, PMT, FV)
• = PV(0.10, 3, 0, 100) = -75.13

Finding the Interest Rate
CH4
0 1 2 10
?%
-100 150
FV = PV(1 + I) N
$150 = $100(1 + I)10

(1.5)(1/10) = (1 + I)
1.0414 = (1 + I)
I = 0.0414 = 4.14%
Financial Calculator
CH4
INPUTS
10 -100 0 150
N I/YR PV PMT FV
OUTPUT 4.14

CH4
• Use the RATE function:
• = RATE(N, PMT, PV, FV)
• = RATE(10, 0, -100, 150) = 0.0414

Find the Number of Years, N
CH4
• Suppose we now have $100 and

the interest rate is 20%. How long
will it take to grow to $200?
0 1 2 ?
20%
-100 200
FV = PV (1 + I)N

Finding the Time
CH4
• Follow the formula approach:

• $200 = $100 ( 1 + 0.20)N
• $200/$100 = 2 = (1.2)N
• Ln (2) = N × Ln (1.2)
• N = Ln(2) / Ln(1.2)
• N = 0.693 / 0.182 = 3.8 years

CH4
•INPUTS 20 -100 0 200

• N I/YR PV PMT FV
3.8
•OUTPUTS

CH4
• Use the NPER function:

• = NPER(I, PMT, PV, FV)
• = NPER (0.2, 0, -100, 200) = 3.8

Ordinary Annuity vs. Annuity Due
CH4
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT

Annuity Due
0 1 2 3
I%
PMT PMT PMT

What’s the FV of a 3-year ordinary
annuity of $100 at 5%?
CH4
0 1 2 3
5%
100 100 100.00

105.00
110.25
FV = 315.25
FV Annuity Formula
CH4
• The future value of an annuity with N

periods and an interest rate of I can be
found with the following formula:
(1+I)N-1
= PMT
I
(1+0.05)3-1
= 100 = 315.25
0.05
Financial Calculator Formula
for Annuities
CH4
• Financial calculators solve this equation:
(1+I)N-1
FVN + PV(1+I)N + PMT =0
I
There are 5 variables. If 4 are known,

the calculator will solve for the 5th.

CH4
INPUTS
3 5 0 -100
N I/YR PV PMT FV
OUTPUT 315.25
Have payments but no lump sum PV, so

enter 0 for present value.
CH4
• Use the FV function: see

spreadsheet.
• = FV(I, N, PMT, PV)

• = FV(0.05, 3, -100, 0) = 315.25

Future Value of an Annuity
CH4
Due
• When payments occur at the beginning
of the period rather than at the end,
those cash flows have more time to earn
extra interest.
• FVAdue = FVAordinary (1 + I)
• FVAdue = ($315.25)(1.05) = $331.01
• Set the calculator to Begin Model
• In Excel, FV(I, N, PMT, PV, Type) =
FV(0.05, 3, -100, 0, 1)
What’s the PV of this ordinary
annuity?
CH4
0 1 2 3
5%
100 100 100

95.24
90.70
86.38
272.32 = PV
PV Annuity Formula
CH4
• The present value of an annuity with N

periods and an interest rate of I can be
found with the following formula:
1 1
= PMT −
I I (1+I)N
1 1
= 100 − = $272.32
0.05 0.05(1+0.05)3
CH4
INPUTS
3 5 100 0
N I/YR PV PMT FV
OUTPUT -272.32
Have payments but no lump sum FV, so

enter 0 for future value.
CH4
• Use the PV function: see

spreadsheet.
• = PV(I, N, PMT, FV)

• = PV(0.05, 3, 100, 0) = -272.32

Find the PV if the
annuity were an annuity due
CH4
0 1 2 3
10%
100 100 100

PV of Annuity Due
CH4
• Since each payment for an annuity

due occurs one period earlier, the
payments will all be discounted for
one less period.
• Therefore, PVAdue > PVA
• PV of annuity due (PVAdue) :
• = (PV of ordinary annuity) (1+I)
• = (272.32) (1+ 0.05) = $285.94
PV of Annuity Due: Switch
from “End” to “Begin
CH4
INPUTS
3 5 100 0
N I/YR PV PMT FV
OUTPUT -285.94

Excel Function
CH4
for Annuities Due
• Change the formula to:
• =PV(10%,3,-100,0,1)
• The fourth term, 0, tells the function

there are no other cash flows. The
fifth term (i.e. type) tells the function
that it is an annuity due. A similar
function gives the future value of an
annuity due. Refer to the previous
slide 4-38.
Find Annuity Payment for Ordinary Annuity
(End Mode) & Annuity Due (Begin Mode)
CH4
INPUTS
5 6 0 10,000
OUTPUT -1,773.96
INPUTS
N I/YR PV PMT FV
OUTPUT
5 6
INPUTS 0 10,000
OUTPUT -1,673.55

Find Period Number and Interest
for Ordinary Annuity (End Mode)
CH4
INPUTS6 0 -1,200 10,000

OUTPUT
6.96
INPUTS
N I/YR PV PMT FV
OUTPUT
5
INPUTS 0 -1,200 10,000
OUTPUT25.78

Perpetuities
CH4
• A perpetuity is simply an annuity with an

extended life.
• Since the payments go on forever, you
cannot apply the step-by-step approach.
• PV of a perpetuity = PMT/I
• Example: A British consol with a face
value of $1,000 that pays $50 per year
forever. What is its value today? The
going interest rate is 2.5%.
• PV(P) = $50/0.025 = $2,000

What is the PV of this
uneven cash flow stream?
CH4
0 1 2 3 4
10%
100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
(Reference Only)
Financial calculator: HP10BII
CH4
• Clear all: Orange Shift key, then C

All key (in orange).
• Enter number, then hit the CFj key.
• Repeat for all cash flows, in order.
• To find NPV: Enter interest rate
(I/YR). Then Orange Shift key, then
NPV key (in orange).
51
(Reference Only)
Financial calculator: HP10BII (cont’d)
CH4
• To see current cash flow in list, hit

RCL CFj CFj
• To see previous CF, hit RCL CFj –
• To see subsequent CF, hit RCL CFj
+
• To see CF 0-9, hit RCL CFj 1 (to
see CF 1). To see CF 10-14, hit
RCL CFj . (period) 1 (to see CF 11).
(Reference Only)
Financial calculator: HP10BII (cont’d)
CH4
• Input in “CFLO” register:

– CF0 = 0
– CF1 = 100
– CF2 = 300
– CF3 = 300
– CF4 = -50
• Enter I = 10%, then press NPV
button to get NPV = 530.09. (Here
NPV = PV.)
Excel Formula in cell A3:
=NPV(10%,B2:E2)
CH4

Nominal or Quoted Rate
(INOM)
CH4
• Stated in contracts, and quoted by

banks and brokers.
• Not used in calculations or shown
on time lines
• Compounding periods per year (M)
must be given. Examples:
– 8%; Quarterly
– 8%, Daily interest (365 days)

Periodic rate (IPER )
CH4
• I
PER = INOM/M, where M is number of
compounding periods per year. M = 4 for

quarterly, 12 for monthly, and 365 for daily
compounding.
• Used in calculations, shown on time lines.
• Examples:
– 8% quarterly: I
PER = 8%/4 = 2%.

–
The Impact of Compounding
CH4
• Will the FV of a lump sum be larger

or smaller if we compound more
often, holding the stated I%
constant?
• Why?

The Impact of Compounding
(Answer)
CH4
• LARGER!
• If compounding is more frequent

than once a year--for example,
semiannually, quarterly, or daily--
interest is earned on interest more
often.

FV Formula with Different
Compounding Periods
CH4
(M)(N)
INOM
FVN = PV 1 +
M

$100 at a 12% nominal rate with
quarterly compounding for 2 years
CH4
MN
INOM
FVN = PV 1 +
M
4x2
0.12
FV5S = $100 1 +
4
= $100(1.03)8 = $126.68

FV of $100 at a 12% nominal rate for
5 years with different compounding
CH4
FV(Ann.) = $100(1.12)5 = $176.23

FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19

Effective Annual Rate
(EAR = EFF%)
CH4
• The EAR is the annual rate that

produces the same result as if we
had compounded at a given
periodic rate M times per year.
• The effective percentage (EFF%) is
the interest rate expressed as if it
were compounded once per year.

Effective Annual Rate
Example
CH4
• Example: Invest $1 for one year at 12%,

semiannual:
FV = PV(1 + INOM/M)M
FV = $1× (1.06)2 = 1.1236
• EFF% = 12.36%, because $1 invested
for one year at 12% semiannual
compounding would grow to the same
value as $1 invested for one year at
12.36% annual compounding.
Comparing Rates
CH4
• An investment with monthly

payments is different from one with
quarterly payments. Must put on
EFF% basis to compare rates of
return. Use EFF% only for
comparisons.
• Banks say “interest paid daily.”
Same as compounded daily.
EFF% for a nominal rate of
12%, compounded monthly
CH4
M
INOM
EFF% = 1 + −1
M
12
0.12
= 1 + −1
12
= (1.01)12 - 1.0
= 0.126825 = 12.6825%
(Reference)
Finding EFF with HP10BII
CH4
• Type in nominal rate, then Orange

Shift key, then NOM% key (in orange).
• Type in number of periods, then
Orange Shift key, then P/YR key (in
orange).
• To find effective rate, hit Orange Shift
key, then EFF% key (in orange).

EAR (or EFF%) for a
Nominal Rate of 12%
CH4
EARAnnual = 12.00%
EARQuarterly = (1 + 0.12/4)4 - 1 = 12.55%
EARMonthly = (1 + 0.12/12)12 - 1 = 12.68%
EARDaily(365) = (1 + 0.12/365)365 - 1= 12.75%

Can the effective rate ever be
equal to the nominal rate?
CH4
• Yes, but only if annual

compounding is used, i.e., if M = 1
• If M > 1, EFF% will always be
greater than the nominal rate.

When is each rate used?
CH4
INOM: Written into contracts, quoted

by banks and brokers. Not used
in actual calculations or shown
on time lines.

When is each rate used? (cont’d)
CH4
IPER: Used in actual calculations, shown

on time lines.
If INOM has annual compounding,
then IPER = INOM/1 = INOM.
Otherwise, adjust with the
number of periods involved.

When is each rate used? (cont’d)
CH4
• EAR (or EFF%): Used to compare

returns on investments with
different payments per year.
• Used for calculations if and only if
dealing with annuities where
payments don’t match interest
compounding periods.

Fractional Time Periods
CH4
• On January 1 you deposit $100 in

an account that pays a nominal
interest rate of 11.33463%, with
daily compounding (365 days).
• How much will you have on October
1, or after 9 months (273 days)?
(Days given.)

Convert interest to daily rate
CH4
IPER = 11.33463%/365
= 0.031054% per day.
FV 273 = $100 (1.00031054)273
= $100 (1.08846) = $108.85
0 1 2 273
0.031054%
-100 FV=?

Calculator Solution
CH4
• IPER = INOM/M = 11.33463%/365

=0.031054% per day
• With inputs: N = 273, I/Y =
0.031054, PV = -100, PMT = 0
• Find FV = 108.85

Amortized Loans
CH4
• Construct an amortization schedule

for a $1,000, 10% annual rate loan
with three equal payments.

Step 1: Find the required
payments
CH4
0 1 2 3
10%
-1,000 PMT PMT PMT
3
INPUTS 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
Step 2: Find interest charge
for Year 1
CH4
INTt = Beginning balancet (I)
INT1 = $1,000(0.10) = $100

Step 3: Find repayment of
principal in Year 1
CH4
Repmt = PMT - INT

= $402.11 - $100
= $302.11

Step 4: Find ending balance
after Year 1
CH4
Ending balance = Beginning bal - Repmt

= $1,000 - $302.11 = $697.89
Repeat these steps for Years 2 and 3

to complete the amortization table.

Amortization Table
CH4
BEG PRIN END

YEAR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest declines because
outstanding balance declines
CH4
$450
$400
$350
$300
$250 Interest
$200 Principal
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3

Interest declines because
outstanding balance declines (cont’d)
CH4
• Amortization tables are widely

used--for home mortgages,
auto loans, business loans,
retirement plans, and more.
They are very important!
• Financial calculators (and
spreadsheets) are great for
setting up amortization tables.
Growing Annuities
and Growing Perpetuities
CH4
• Cash flows are likely to grow over

time, due to either to real growth or
to inflation.
• Growing annuity is a series of finite
cash flows that grow at a fixed rate.
• Growing perpetuity is a constant
stream of cash flows without end
that is expected to rise indefinitely
Real Rate
CH4
• Rr = [(1 + INOM)/(1 + inflation)] – 1

• Example: If the nominal annual
interest rate is 10% and the
expected inflation rate is 5% per
annum, what is the expected real
rate of return?
• Rr = [1.10/1.05] – 1 = 0.0476 =
4.76%

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Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-3

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-4

CF0 CF1 CF2 CF3

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-6

100 100 100

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-7

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-8

Finding FVs (moving to the right

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-9

FV1 = PV + INT1 = PV + PV (I)

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-10

FV2 = FV1(1+I) = PV(1+I)(1+I)

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-11

FV3 = FV2(1+I)=PV(1 + I)2(1+I)

• Solve the equation with a regular

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-14

• Adjust display brightness: hold

• To permanently show all digits, hit

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-16

• To set END (for cash flows

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-17

Financial calculators solve this

There are 4 variables. If 3 are

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-18

Clearing automatically sets everything to

• Use the FV function:

• = FV(I, N, PMT, PV)

• = FV(0.05, 3, 0, -100) = 115.76

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-20

Finding PVs is discounting, and it’s the

Either PV or FV must be negative. Here

• Use the PV function:

• = PV(I, N, PMT, FV)

• = PV(0.10, 3, 0, 100) = -75.13

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-24

$150 = $100(1 + I)10

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-26

• Use the RATE function:

• = RATE(N, PMT, PV, FV)

• = RATE(10, 0, -100, 150) = 0.0414

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-27

• Suppose we now have $100 and

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-28

• Follow the formula approach:

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-29

•INPUTS 20 -100 0 200

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-30

• Use the NPER function:

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-31

PMT PMT PMT

PMT PMT PMT

100 100 100.00

• The future value of an annuity with N

• Financial calculators solve this equation:

There are 5 variables. If 4 are known,

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-35

Have payments but no lump sum PV, so

• Use the FV function: see

• = FV(I, N, PMT, PV)

Copyright © 2011 by Nelson Education Ltd. All rights reserved. 4-37

100 100 100

• The present value of an annuity with N