Business Finance

(MGT 232)

Lecture 5

4-1
Time
Time Value
Value of
of Money
Money

4-2
 Overview of the Last Lecture
• Time Value of Money
• Simple Interest rate
• Compounding Interest rate
• Future Value
• Graphical Representation
• Why we use Compounding
• Present Value
• Graphical Representation

4-3
 Types of Annuities

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
• Ordinary Annuity:
Annuity Payments or receipts occur
at the end of each period.
• Annuity Due:
Due Payments or receipts occur at the
beginning of each period.

4-4
 Examples of Annuities

• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings

4-5
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.100

Today
Equal Cash Flows
Each 1 Period Apart 4-6
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.100

Today Equal Cash Flows
Each 1 Period Apart 4-7
 Future Value Annuity - FVA
• Future Value annuity is the future value of the
series of equal payments for specified
equidistant periods
Ordinary Annuity Annuity Due

4-8
 Ordinary Annuity - FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn = R(1+i) + R(1+i) +

n-1 n-2 ... + FVA n

R(1+i)1 + R(1+i)0
4-9
 Example of an
Ordinary Annuity - FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose a bank is offering 7% interest rate at an equal amount of
deposit of Rs. 1000 at the end of each year for the next 3 years. What
amount you will have at the end of 3 years if you deposit equal
payments of Rs. 1000 each.

4-10
 Valuation Using Table
FVAn = R (FVIFAi%,n)
FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 (3.215)=Rs.3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867 4-11
 Future Value Annuity Due
FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
. . .
i%
R R R R R

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

... + R(1+i)2 + R(1+i)1 =
FVAn (1+i)
4-12
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose a bank is offering 7% interest rate at an equal amount of
deposit of Rs. 1000 at the beginning of each year for the next 3 years.
What amount you will have at the end of 3 years if you deposit equal
payments of Rs. 1000 each.

4-13
 Valuation Using Table
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = Rs.1,000 (FVIFA7%,3)(1.07)
= Rs.1,000 (3.215)(1.07)= Rs.3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
4-14
 Present Value Annuity - PVA
• Present Value annuity is the present value of
the series of equal payments for specified
equidistant periods
Ordinary Annuity Annuity Due

4-15
 Present Value Ordinary
Annuity - PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
4-16
 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose you will need Rs. 10,000 after 3 years that will require equal
amount of deposit of Rs. 1000 at the end of each year for the next 3
years. What lump sum amount you should deposit today if the bank is
offering an interest rate of 7%?

4-17
 Valuation Using Table
PVAn = R (PVIFAi%,n)
PVA3 = Rs.1,000 (PVIFA7%,3)
= Rs.1,000 (2.624) =Rs.2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993 4-18
 Present Value Annuity Due
PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .

R R R R

R: Periodic
PVADn Cash Flow

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

PVAn (1+i)
4-19
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000

Suppose you will need Rs. 10,000 after 3 years that will require equal
amount of deposit of Rs. 1000 at the beginning of each year for the
next 3 years. What lump sum amount you should deposit today if the
bank is offering an interest rate of 7%?

4-20
 Valuation Using Table
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = Rs.1,000 (PVIFA7%,3)(1.07)
= Rs.1,000 (2.624)(1.07) = Rs.2,808
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
4-21
 Steps
Steps to
to Solve
Solve Time Value of
Money
Money Problems
Problems
1. Read problem thoroughly
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

4-22
 Summary
• Annuity
• Types of Annuity
• Future Value Annuity
• Ordinary Annuity
• Annuity Due
• Present Value Annuity
• Ordinary Annuity
• Annuity Due
• Steps to Solve Time Value of Money Problems

4-23