Contemporary Financial Management: Time Value of Money

Contemporary Financial Management
Chapter 4:
Time Value of Money
© 2004 by Nelson, a division of Thomson Canada Limited

Introduction
● This chapter introduces the concepts and skills

necessary to understand the time value of money
and its applications.
© 2004 by Nelson, a division of Thomson Canada Limited 2

Payment of Interest
● Interest is the cost of money
● Interest may be calculated as:

● Simple interest
● Compound interest

Simple Interest
● Interest paid only on the initial principal
Example: $1,000 is invested to earn 6% per year,

simple interest.
0 1 2 3
-$1,000 $60 $60 $60

Compound Interest
● Interest paid on both the initial principal and on

interest that has been paid & reinvested.
Example: $1,000 invested to earn 6% per year,

compounded annually.
0 1 2 3
-$1,000 $60.00 $63.60 $67.42

Future Value
● The value of an investment at a point in the

future, given some rate of return.
Simple Interest Compound Interest
FVn = PV0+(PV0  i  n) FVn = PV0(1 + i)n
FV = future value FV = future value

PV = present value PV = present value
i = interest rate i = interest rate
n = number of periods n = number of periods

Future Value: Simple Interest
Example: You invest $1,000 for three years at

6% simple interest per year.
0 6% 1 6% 2 6% 3
-$1,000
FV3 = PV0+(PV0  i  n)
= $1,000   $1,000  0.06  3 
= $1,180.00

Future Value: Compound Interest

6%, compounded annually.
0 6% 1 6% 2 6% 3
-$1,000
FV3 = PV0 (1 + i)n

= $1,000  1  0.06 
3
= $1,191.02

● Future values can be calculated using a table

method, whereby “future value interest factors”
(FVIF) are provided.
● See Table 4.1 (page 135)
FVn = PV0 (FVIFi,n ), where: FVIFi,n =  1+i

n
FV = future value
PV = present value
FVIF = future value interest factor
i = interest rate
n = number of periods


6% compounded annually.
Table 4.1 Excerpt: FVIFs for $1

End of Period (n) 5% 6% 8%
2 1.102 1.124 1.166
3 1.158 1.191 1.260
4 1.216 1.262 1.360
FV3 = PV0 (FVIF6%,3 )

=$1,000(1.191) =$1,191.00

Present Value
● What a future sum of money is worth today, given
a particular interest (or discount) rate.
FVn
PV0 
 1+i
n
FV = future value
PV = present value
i = interest (or discount) rate

Present Value
Example: You will receive $1,000 in three years.

If the discount rate is 6%, what is the present
value?
0 6% 1 6% 2 6% 3
$1,000
FV3 $1,000
PV0    $839.62
 1+i  1  0.06 
n 3

Present Value
● Present values can be calculated using a table method,
whereby “present value interest factors” (PVIF) are provided.
● See Table 4.2 (page 139)
1
PV0 = FVn(PVIFi,n ), where: PVIFi,n =
 1+i
n
FV = future value
PV = present value
PVIF = present value interest factor
i = interest rate

Present Value
Example: What is the present value of $1,000 to

be received in three years, given a discount rate
of 6%?
PV0 = FV3(FVIF6%,3 )
=$1,000(0.840) =$840.00
A Note of Caution
● Note that the algebraic solution to the present

value problem gave an answer of 839.62
● The table method gave an answer of $840.
Caution:
Tables provide approximate answers only.
If more accuracy is required, use algebra!

Annuities
● The payment or receipt of an equal cash flow

per period, for a specified number of periods.
Examples: mortgages, car leases, retirement

income.

Annuities
● Ordinary annuity: cash flows occur at the end

of each period
Example: 3-year, $100 ordinary annuity
0 1 2 3
$100 $100 $100

Annuities
● Annuity Due: cash flows occur at the beginning

of each period
Example: 3-year, $100 annuity due
0 1 2 3
$100 $100 $100

Difference Between Annuity Types
Ordinary Annuity
0 1 2 3
$100 $100 $100
Annuity Due
0 1 2 3
$100 $100 $100 $100

Annuities: Future Value
● Future value of an annuity - sum of the future

values of all individual cash flows.
0 1 2 3
$100 $100 $100 FV

FV
FV
FV of Annuity

Annuities: Future Value – Algebra
● Future value of an ordinary annuity
  1+i n -1 
FVOrdinary= PMT  
Annuity  i 
 
FV = future value of the annuity

PMT = equal periodic cash flow
i = the (annually compounded) interest rate
n = number of years

Annuities: Future Value
Example: What is the future value of a three

year ordinary annuity with a cash flow of $100
per year, earning 6%?
  1+i n -1 
FVOrdinary= PMT  
Annuity  i 
 
  1.06  3  1 
 100  
 .06 
 
 $318.36

● Future value of an annuity due:
  1+i n -1 
FVAnnuity= PMT    1 + i
Due  i 
 
FV = future value of the annuity

n = number of years

Example: What is the future value of a three

year annuity due with a cash flow of $100 per
year, earning 6%?
  1+i n -1 
FVAnnuity = PMT    1+i
Due  i 
 
  1.06  3  1 
 100    1.06 
 . 06 
 
 $337.46

Annuities: Future Value – Table
● The future value of an ordinary annuity can be

calculated using Table 4.3 (p. 145), where “future
value of an ordinary annuity interest factors”
(FVIFA) are provided.
FVANn = PMT(FVIFAi,n ), where:

 1  i
n
1
FVIFAi,n =
i
FVAN = future value (ordinary annuity)
FVIFA = future value interest factor

Ordinary Annuity: Future Value
Example: What is the future value of a 3-year

$100 ordinary annuity if the cash flows are
invested at 6%, compounded annually?
FVANn = PMT(FVIFAi,n )
=$100  3.184   $318.40

Annuity Due: Future Value
● Calculated using Table 4.3 (p. 145), where

FVIFAs are found. Ordinary annuity formula is
adjusted to reflect one extra period of interest.
FVANDn = PMT FVIFAi,n  1  i  , where:

 1  i  1
n
FVIFAi,n =
i
FVAND = future value (annuity due)
FVIFA = future value interest factor

Annuity Due: Future Value
Example: What is the future value of a 3-year

$100 annuity due if the cash flows are invested
at 6% compounded annually?
FVANDn = PMT FVIFA i,n  1  i  

 $100 3.184(1.06)  $337.50
Annuities: Present Value
● The present value of an annuity is the sum of

the present values of all individual cash flows.
0 1 2 3
PV $100 $100 $100

PV
PV
PV of Annuity

Annuities: Present Value – Algebra
● Present value of an ordinary annuity
 1-  1+i -n 
PVOrdinary= PMT  
Annuity  i 
 
PV = present value of the annuity

i = the (annually compounded) interest or discount rate
n = number of years

Example: What is the present value of a three

year, $100 ordinary annuity, given a discount
rate of 6%?
 1-  1+i -n 
PVOrdinary=PMT  
Annuity  i 
 
 1 -  1.06  -3 
 100  
 .06 
 
 $267.30

● Present value of an annuity due:
 1-  1+i -n 
PVAnnuity= PMT    1+i 
Due  i 
 
PV = present value of the annuity

n = number of years

Example: What is the present value of a three

year, $100 annuity due, given a discount rate
of 6%?
 1-  1+i -n 
PVAnnuity = PMT    1+i
Due  i 
 
 1   1.06  3 
 100    1.06 
 .06 
 
 $283.34

Annuities: Present Value – Table
● The present value of an ordinary annuity can be

calculated using Table 4.4 (p. 149), where
“present value of an ordinary annuity interest
factors” (PVIFA) are found.
PVAN0 = PMT(PVIFA i,n ), where:

1-  1+i -n 
PVIFAi,n =  
i
PMT = cash flow
PVAN = present value (ordinary annuity)
PVIFA = present value interest factor

Example: What is the present value of a 3-year

$100 ordinary annuity if current interest rates
are 6% compounded annually?
PVAN0 = PMT(PVIFAi,n )
=$100  2.673   $267.30
● Calculated using Table 4.4 (p. 149), where

PVIFAs are found. Present value of ordinary
annuity formula is modified to account for one
less period of interest.
PVAND0 = PMT PVIFAi,n(1  i)

1-  1+i n 
PVIFAi,n =  
i
PMT = cash flow
PVAND = present value (annuity due)
PVIFA = present value interest factor
Example: What is the present value of a 3-year

$100 annuity due if current interest rates are
6% compounded annually?
PVAND0 = PMT PVIFAi,n(1  i)

 $100 2.673  1.06    $283.34
Other Uses of Annuity Formulas
● Sinking Fund Problems: calculating the annuity

payment that must be received or invested each
year to produce a future value.
Ordinary Annuity Annuity Due
FVANn FVANn
PMT= PMT=
FVIFAi,n FVIFAi,n  1  i

Other Uses of Annuity Formulas
● Loan Amortization and Capital Recovery

Problems: calculating the payments necessary
to pay off, or amortize, a loan.
PVAN0
PMT=
PVIFAi,n

Perpetuities
● Financial instrument that pays an equal cash flow

per period into the indefinite future (i.e. to
infinity).
Example: dividend stream on common and

preferred stock
0 1
$60
2
$60
3
$60
4
$60

Perpetuities
● Present value of a perpetuity equals the sum of

the present values of each cash flow.
● Equal to a simple function of the cash flow (PMT)

and interest rate (i).
PMT 
PMT
PVPER 0   n
PVPER 0 
t 1 (1+i) i

Perpetuities
Example: What is the present value of a $100

perpetuity, given a discount rate of 8%
compounded annually?
PMT $100
PVPER 0    $1,250.00
i 0.08

More Frequent Compounding
● Nominal Interest Rate: the annual percentage

interest rate, often referred to as the Annual
Percentage Rate (APR).
Example: 12% compounded semi-annually
12%
0 6% 0.5 6% 1 6% 1.5
-$1,000 $60.00 $63.60 $67.42

● Increased interest payment frequency requires

future and present value formulas to be
adjusted to account for the number of
compounding periods per year (m).
Future Value Present Value
FVn
 inom 
mn
PV0  mn
FVn  PV0 1    inom 
 m  1+ m 
 

Example: What is a $1,000 investment worth in

five years if it earns 8% interest, compounded
quarterly?
mn
 inom 
FVn  PV0 1  
 m 
(4)(5)
 0.08 
 $1,000 1  
 4 
 $1, 485.95

Example: How much do you have to invest

today in order to have $10,000 in 20 years, if
you can earn 10% interest, compounded
monthly?
FVn
PV0  mn
 inom 
1+ m 
 
$10,000
 (12)(20)
 $1,364.62
 0.10 
1+ 12 
 
Impact of Compounding Frequency
$1,000 Invested at Different

10% Nominal Rates for One Year
$1,106
$1,105
$1,104
$1,103
$1,102
$1,101
$1,100
$1,099
$1,098
$1,097
Annual Semi- Quarterly Monthly Daily
Annual

Effective Annual Rate (EAR)
● The annually compounded interest rate that is

identical to some nominal rate, compounded
“m” times per year.
m
 inom 
ieff  1+  1
 m 
ieff  effective annual rate

inom  nominal interest rate
m = compounding frequency per year

Effective Annual Rate (EAR)
● EAR provides a common basis for comparing

investment alternatives.
Example: Would you prefer an investment

offering 6.12%, compounded quarterly or one
offering 6.10%, compounded monthly?
m m
 inom   inom 
ieff  1+  1 ieff   1+  1
 m   m 
4 12
 0.0612   0.061 
  1+  1  1+  1
 4   12 
 6.262%  6.273%
Major Points
● The time value of money underlies the valuation of

almost all real & financial assets
● Present value – what something is worth today
● Future value – the dollar value of something in the

future
● Investors should be indifferent between:

● Receiving a present value today
● Receiving a future value tomorrow
● A lump sum today or in the future
● An annuity

Contemporary Financial Management: Time Value of Money

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Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited

● This chapter introduces the concepts and skills

© 2004 by Nelson, a division of Thomson Canada Limited 2

● Interest is the cost of money

● Interest may be calculated as:

© 2004 by Nelson, a division of Thomson Canada Limited 3

● Interest paid only on the initial principal

Example: $1,000 is invested to earn 6% per year,

-$1,000 $60 $60 $60

© 2004 by Nelson, a division of Thomson Canada Limited 4

● Interest paid on both the initial principal and on

Example: $1,000 invested to earn 6% per year,

-$1,000 $60.00 $63.60 $67.42

© 2004 by Nelson, a division of Thomson Canada Limited 5

● The value of an investment at a point in the

Simple Interest Compound Interest

FVn = PV0+(PV0  i  n) FVn = PV0(1 + i)n

FV = future value FV = future value

© 2004 by Nelson, a division of Thomson Canada Limited 6

Example: You invest $1,000 for three years at

© 2004 by Nelson, a division of Thomson Canada Limited 7

Example: You invest $1,000 for three years at

FV3 = PV0 (1 + i)n

© 2004 by Nelson, a division of Thomson Canada Limited 8

● Future values can be calculated using a table

● See Table 4.1 (page 135)

FVn = PV0 (FVIFi,n ), where: FVIFi,n =  1+i

© 2004 by Nelson, a division of Thomson Canada Limited 9

Example: You invest $1,000 for three years at

Table 4.1 Excerpt: FVIFs for $1

FV3 = PV0 (FVIF6%,3 )

© 2004 by Nelson, a division of Thomson Canada Limited 10

© 2004 by Nelson, a division of Thomson Canada Limited 11

Example: You will receive $1,000 in three years.

© 2004 by Nelson, a division of Thomson Canada Limited 12

● See Table 4.2 (page 139)

© 2004 by Nelson, a division of Thomson Canada Limited 13

Example: What is the present value of $1,000 to

● Note that the algebraic solution to the present

● The table method gave an answer of $840.

© 2004 by Nelson, a division of Thomson Canada Limited 15

● The payment or receipt of an equal cash flow

Examples: mortgages, car leases, retirement

© 2004 by Nelson, a division of Thomson Canada Limited 16

● Ordinary annuity: cash flows occur at the end

Example: 3-year, $100 ordinary annuity

$100 $100 $100

© 2004 by Nelson, a division of Thomson Canada Limited 17

● Annuity Due: cash flows occur at the beginning

Example: 3-year, $100 annuity due

$100 $100 $100

© 2004 by Nelson, a division of Thomson Canada Limited 18

$100 $100 $100

$100 $100 $100 $100

© 2004 by Nelson, a division of Thomson Canada Limited 19

● Future value of an annuity - sum of the future

$100 $100 $100 FV

© 2004 by Nelson, a division of Thomson Canada Limited 20

● Future value of an ordinary annuity

FV = future value of the annuity

© 2004 by Nelson, a division of Thomson Canada Limited 21

Example: What is the future value of a three