Lecture Note On Present Value by JTB

Chapter 2
Time Value of
Money
Calculations
Copyright 2013 John Wiley & Sons, Inc.

Discussion Questions
1. What do you suppose a man is attempting to do with his
investment portfolio by selecting multiple forms of
investments?
2. Although retirement may seem like a long time away, why
is it important to start saving early for your “golden
years?”
3. If interest rates end up being lower than a man assumes,
what must he do to build his goal “nest egg?”
4. What impacts will a change in your family status (such as
getting married or having a child) have on your
investment decisions?

2-2
Learning Objectives
1. Construct a cash flow diagram (CFD) depicting the cash inflows and
outflows for an investment alternative. (Section 2.1)
2. Perform time value of money calculations for single cash flows with annual
compounding. (Section 2.2)
3. Distinguish between uniform, irregular, gradient and geometric series of
cash flows. (Section 2.3)
4. Perform time value of money calculations for multiple cash flows including:
• Irregular series of cash flows with annual compounding. (Section 2.3.1)
• Uniform series of cash flows with annual compounding. (Section 2.3.2)
• Gradient series of cash flows with annual compounding. (Section 2.3.3)
• Geometric series of cash flows with annual compounding. (Section 2.3.4)
5. Perform time value of money calculations for multiple compounding
periods per year using the period interest rate and the effective annual
interest rate. (Section 2.4)

2-3
Four Cash Flow Diagram (DCF)
Rules

2-4
Learning Objectives
1. Construct a cash flow diagram (CFD) depicting

the cash inflows and outflows for an investment
alternative. (Section 2.1)

2-5
Cash Flow Diagram (CFD)
Figure 2.1 Copyright 2013 John Wiley & Sons, Inc.

2-6
Example 2.1 – A Simple Illustration
of the TVOM
Which cash flow in Figure 2.2 is preferred?

2-7
Learning Objectives
2. Perform time value of money calculations for

single cash flows with annual compounding.
(Section 2.2)

2-8
Single Cash Flows
 Future Worth Calculations (F|P)

– When compound interest is used, the
interest rate (i) is interpreted as the rate of
change in the accumulated value of money,
and In is the accumulated interest over n
years, given by
Equation 2.1

2-9
Single Cash Flows
 Future Worth Calculations (F|P) (cont.)

– where t increments the years from 1 to n, F0
= P where P is the current or present value
of a single sum of money, Fn is the
accumulated value of P over n years, and
Equation 2.2

2-10
Example 2.2 – Compounding
Interest for 5 Years
Suppose you loan $10,000 for 1 year to an individual who
agrees to pay you interest at a compound rate of 10
percent/year. At the end of 1 year, the individual asks to
extend the loan period an additional year. The borrower
repeats the process several more times. Five years after
loaning the person the $10,000, how much would the
individual owe you?

2-11
Interest for 5 Years (cont.)
Suppose you loan $10,000 for 1 year to an individual who
agrees to pay you interest at a compound rate of 10
percent/year. At the end of 1 year, the individual asks to
extend the loan period an additional year. The borrower
repeats the process several more times. Five years after
loaning the person the $10,000, how much would the
individual owe you?
Given: Loan amount = $10,000; interest rate = 10%/year;

length of loan = 5 years
Find: Value of the loan amount after 5 years

2-12
Interest for 5 Years (cont.)
As shown in Table 2.1, the $10,000 owed, compounded
over a 5-year period at 10 percent annual interest, totals
$16,105.10.

2-13
Single Cash Flows
 Future Worth Calculations (F|P) (cont.)

– We can generalize the loan example and
develop an equation to determine the
amount owed after n periods, based on a
compound interest rate of i% per period, if P
is borrowed.
Equation 2.3
Equation 2.4
2-14
Example 2.3 – Repaying a 5-Year
Loan with a Single Payment
Dia St. John borrows $1,000 at 12 percent

compounded annually. The loan is to be paid
back after 5 years. How much should she repay?

2-15
Loan with a Single Payment (cont.)
Dia St. John borrows $1,000 at 12 percent

compounded annually. The loan is to be paid
back after 5 years. How much should she repay?
Given: Loan amount = $1,000; interest rate =

12% compounded annually; length of loan = 5
years
Find: Value of the loan amount after 5 years

2-16
Loan with a Single Payment (cont.)
Using the compound interest tables in Appendix A

for 12 percent and 5 periods, the value of the
single sum, future worth factor (F|P 12%,5) is
shown to be 1.76234. Thus,
Using the Excel® FV worksheet function,

2-17
Example 2.4 – Doubling Your Money
How long does it take for an investment to double

in value if it earns (a) 2 percent, (b) 4 percent, or
(c) 12 percent annual compound interest?

2-18
(cont.)
How long does it take for an investment to double in

value if it earns (a) 2 percent, (b) 4 percent, or (c) 12
percent annual compound interest?
Consider six different ways to solve this problem

1.Use the Rule of 72
2.Use the interest tables; look for F|P factor equal to 2.0
3.Solve numerically; n = log(2)/log (1+i)
4.Solve using Excel® NPER function: = NPER(i%,,-1,2)
5.Solve using Excel® GOAL SEEK tool
6.Solve using Excel® SOLVER tool
2-19
(cont.)

in value if it earns an interest of (a) 2%, (b) 4%, or
(c) 12% compounded annually?
1. Rule of 72 – the quotient of 72 and the interest provides

a reasonably good approximation of the number of interest
periods required to double the value of the investment.
a. n ≈ 72/2 = 36 yrs
b. n ≈ 72/4 = 18 yrs
c. n ≈ 72/12 = 6 yrs
2-20
(cont.)

2. Use the interest tables in Appendix A; look for F|P

factor equal to 2.0 (to double)
a. n ≈ 30 + 6(2.0000 – 1.81136)/(2.03989 – 1.81136) = 34.953 yrs
b. n ≈ 17 + (2.0000 – 1.94790)/(2.02582 – 1.94790) = 17.669 yrs
c. n ≈ 6 + (2.0000 – 1.97382)/(2.21068 – 1.97382) = 6.111 yrs

2-21
(cont.)

3. Solve numerically; n = log 2/log (1+i)

a. n = log 2/log 1.02 = 35.003 yrs
b. n = log 2/log 1.04 = 17.673 yrs
c. n = log 2/log 1.12 = 6116 yrs

2-22
n
and

(cont.)

4. Solve using Excel® NPER function: = NPER(i%,,-1,2)

a. n = NPER(2%,,-1,2) = 35.003 yrs
b. n = NPER(4%,,-1,2) = 17.673 yrs
c. n = NPER(12%,,-1,2) = 6116 yrs

2-23
(cont.)

5. Solve using Excel® GOAL SEEK tool

2-24
(cont.)

(c) 12%compounded annually?
6. Solve using Excel® SOLVER tool

2-25
Single Cash Flows
 Present Worth Calculations (P|F)

– Since we can determine values of F when
given values of P, i, and n, it is a simple
matter to determine the values of P when
given values of F, i, and n. In particular, from
Equation 2.3,
Equation 2.5

2-26
Single Cash Flows
 Present Worth Calculations (P|F) (cont.)

– Dividing both sides of Equation 2.5 by (1+ i)n,
we have the relation,
Equation 2.6
– or
Equation 2.7
– where (1 + i)-n and (P|F i%;n) are referred to as
the single sum, present worth factor.
2-27
Example 2.5 – Saving Money
To illustrate the computation of P given F, i, and

n, suppose you wish to accumulate $10,000 in a
savings account 4 years from now, and the
account pays interest at a rate of 5 percent
compounded annually. How much must be
deposited today?

2-28
Example 2.5 – Saving Money (cont.)
To illustrate the computation of P given F, i, and n,

suppose you wish to accumulate $10,000 in a
savings account 4 years from now, and the account
pays interest at a rate of 5 percent compounded
annually. How much must be deposited today?
Given: F = $10,000; i = 5% compounded annually;

n = 4 years
Find: P
2-29
Using the compound interest tables in Appendix A

for 5 percent and 4 periods, the value of the
single sum, present worth factor, (P|F 5%,4), is
shown to be 0.82270. Thus,
P = F(P|F 5%,4)
= $10,000(0.82270)
= $8,227.00

2-30
As shown in Figure 2.7, using the Excel® PV
worksheet function,
Figure 2.7

2-31
Learning Objectives
3. Distinguish between uniform, irregular, gradient

and geometric series of cash flows. (Section
2.3)
multiple cash flows including:
• Irregular series of cash flows with annual compounding.
(Section 2.3.1)

2-32
Multiple Cash Flows
 Irregular Cash Flows

– If we let At denote the magnitude of a cash
flow (receipt or disbursement) at the end of
time period t, then
P = A1(1 + i)-1 + A2(1 + i)-2 + A3(1 + i)-3 + …. + An-1(1 + i)-(n-1) + An(1 + i)-
n
Equation 2.8

2-33
Multiple Cash Flows
 Irregular Cash Flows (cont.)

– or, using summation notation,
Equation 2.9
– or, equivalently,
Equation 2.10

2-34
Example 2.6 – Computing the Present
Worth of a Series of Cash Flows
Consider the series of cash flows depicted by the

CFD given in Figure 2.8. Using an interest rate of
6 percent per interest period, what is the present
worth equivalent of cash flows?

2-35
Worth of a Series of Cash Flows (cont.)
Consider the series of cash flows depicted by the

CFD given in Figure 2.8. Using an interest rate of
6 percent per interest period, what is the present
worth equivalent of cash flows?
Given: Cash flow series in Figure 2.8; i = 6% per

interest period.
Find: P

2-36
Worth of a Series of Cash Flows (cont.)
The present worth equivalent is given by

P = $300(P|F 6%,1) – $300(P|F 6%,3) + $200(P|F
6%,4) + $400(P|F 6%, 6) + $200(P|F 6%,8)
= $300(0.94340) – $300(0.83962) + $200(0.79209)
+ $400(0.70496) + $200(0.62741)
= $597.02

2-37
Example 2.8 – Using the EXCEL
NPV Function
Recall Example 2.6, depicted in Figure 2.8. The Excel®
NPV worksheet function is well suited for such a problem.
However, as shown in Figure 2.9, no blank cells can be
included in the range of cash flows, and every time period
must be accounted for. Finally, since the cash flow at time
zero is, in fact, zero, there is no need to add the value of
C3 to the NPV calculation. As before, the future worth can
be obtained by using the NPV value. Notice, the value
obtained for the present worth, $597.02, is within 2¢ of the
value obtained in Example 2.6 using the interest tables in
Appendix A, and the value obtained for the future worth,
$951.56, is identical to the value obtained in Example 2.7
using the interest tables in Appendix A.
2-38
Example 2.8 – Using the EXCEL
NPV Function (cont.)
Figure 2.9

2-39
Learning Objectives

2.3)
• Uniform series of cash flows with annual compounding.
(Section 2.3.2)

2-40
Multiple Cash Flows
 Uniform Series of Cash Flows

– A uniform series of cash flows exists when all
cash flows in a series are equally sized and
spaced. In the case of a uniform series the
present worth equivalent is given by
Equation 2.16
– alternatively,
Equation 2.20
2-41
Worth of a Uniform Series of Cash Flows
A man wishes to deposit a single sum of money

in a savings account so that five equal annual
withdrawals of $2,000 can be made before
depleting the fund. If the first withdrawal is to
occur 1 year after the deposit and the fund pays
interest at a rate of 5 percent compounded
annually, how much should he deposit?

2-42
Example 2.9 – Computing the Present Worth
of a Uniform Series of Cash Flows (cont.)
A man wishes to deposit a single sum of money in a

savings account so that five equal annual withdrawals
of $2,000 can be made before depleting the fund. If
the first withdrawal is to occur 1 year after the deposit
and the fund pays interest at a rate of 5 percent
compounded annually, how much should he deposit?
Given: A = $2,000; i = 5%; n = 5
Find: P
2-43
Example 2.9 – Computing the Present Worth
Because of the relationship of P and A, as

depicted in Figure 2.10, in which P occurs one
period before the first A, we see that
P = $2,000(P|A 5%, 5)
= $2,000(4.32948)
= $8,658.96
Figure 2.10
Thus, if $8,658.96 is deposited in a fund paying 5 percent
compounded annually, then five equal annual withdrawals
of $2,000 can be made. After the fifth withdrawal, the fund
will be depleted. 2-44
Example 2.11 – What Size Uniform
Withdrawals Can Occur?
Suppose a lady deposits $10,000 into an account

that pays 8 percent interest compounded
annually. If she withdraws 10 equal annual
amounts from the account, with the first
withdrawal occurring 1 year after the deposit, how
much can she withdraw each year in order to
deplete the fund with the last withdrawal?

2-45
Withdrawals Can Occur? (cont.)
Suppose a lady deposits $10,000 into an account that
pays 8 percent interest compounded annually. If she
withdraws 10 equal annual amounts from the account,
with the first withdrawal occurring 1 year after the deposit,
how much can she withdraw each year in order to deplete
the fund with the last withdrawal?
Given: P = $10,000; i = 8% compounded annually; n = 10
Find: A

2-46
Withdrawals Can Occur? (cont.)
Since we know that A and P are related by
Equation 2.22
then
A = $10,000(A|P 8%,10)
= $10,000(0.14903)
= $1490.30

2-47
Example 2.13 – Determining the Future
Worth of a Uniform Series of Cash Flows
If a man makes annual deposits of $1,000 into a

savings account for 30 years, how much will be in
the fund immediately after his last deposit if the
fund pays 6 percent interest compounded
annually?

2-48
Example 2.13 – Determining the Future Worth
If a man makes annual deposits of $1,000 into a

savings account for 30 years, how much will be in
the fund immediately after his last deposit if the
fund pays 6 percent interest compounded
annually?
Given: A = $1,000; i = 6% compounded annually;

n = 30
Find: F
2-49
Example 2.13 – Determining the Future Worth
F = $1,000(F|A 6%,30)
= $1,000(79.05819)
= $79,058.19

2-50
Learning Objectives

2.3)
• Gradient series of cash flows with annual compounding.
(Section 2.3.3)

2-51
Multiple Cash Flows
 Gradient Series of Cash Flows
Figure 2.14

2-52
Multiple Cash Flows
 Gradient Series of Cash Flows

– Occurs when the value of a given cash flow
is greater than the value of the previous cash
flow by a constant amount, G.
– The present worth equivalent of a gradient
series is obtained by recalling
Equation 2.29
– alternatively,
Equation 2.33
2-53
Example 2.15 – Determining the
Present Worth of a Gradient Series
Maintenance costs for a particular production

machine increase by $1,000/year over the 5-year
life of the equipment. The initial maintenance cost
is $3,000. Using an interest rate of 8 percent
compounded annually, determine the present
worth equivalent for the maintenance costs.

2-54
Example 2.15 – Determining the Present
Worth of a Gradient Series (cont.)
Given: The maintenance costs--a composite
series of cash flows as shown in Figure 2.15
Find: P of the composite series
Figure 2.15

2-55
Worth of a Gradient Series (cont.)
Converting the gradient series to an equivalent uniform series

given
Adding the “converted” uniform series to the “base” uniform

series gives
Therefore, converting the uniform series to its present worth

equivalent,

2-56
Learning Objectives

2.3)
• Geometric series of cash flows with annual compounding.
(Section 2.3.4)

2-57
Multiple Cash Flows
 Geometric Series of Cash Flows
Figure 2.16

2-58
Multiple Cash Flows
 Geometric Series of Cash Flows

– The present worth equivalent of a geometric
series is obtained by recalling
Equation 2.36
– or, equivalently,
Equation 2.38

2-59
Worth of a Geometric Series
A company is considering purchasing a new machine tool.

In addition to the initial purchase and installation costs,
management is concerned about the machine's
maintenance costs, which are expected to be $1,000 at
the end of the first year of the machine's life and increase
8 percent/year thereafter. The machine tool's expected life
is 15 years. Company management would like to know the
present worth equivalent for expected costs. If the firm's
time value of money is 10 percent/year compounded
annually, what is the present worth equivalent?

2-60
Worth of a Geometric Series (cont.)
Given: Machine maintenance costs – a geometric series

with A1 = $1000, j = 8%, i =10%, n =15
Find: P – the present worth equivalent of all maintenance
costs

2-61
Worth of a Geometric Series (cont.)
P  $1, 000  P | A110%,8%,15

 $1, 000  12.03040
 $12, 030.40

2-62
Learning Objectives

multiple compounding periods per year using
the period interest rate and the effective annual
interest rate. (Section 2.4)

2-63
Compounding Frequency
 Period Interest Rate Approach
Nominal rate
Period interest rate =
Number of interest periods per year

2-64
Ex. 2.19 – Determining Car
Payments (An example of a problem for
Ordinary Annuity)
A woman purchases a car for $25,000 and

finances her purchase by borrowing the money at
8% compounded monthly; she pays off the loan
with equal monthly payments for 5 years. What
will be the size of her monthly loan payment?

2-65
Example 2.19 – Determining Car
Payments (cont.)
Given: P = $25,000; nominal rate = 8% cpd.

monthly; duration of loan = 5 years; number of
interest periods/year = 12 months/year

Find: Period interest rate; number of interest
periods; A

2-66
Payments (cont.)
Number of interest periods = 5 years (12 months/year) =

60 months
0.0066667  1.0066667
60
A = $25, 000  A | P 0.66667%, 60 = = $506.91/month

 1.0066667 60
1

2-67
Payments (cont.)
Using the Excel® PMT worksheet function,
A = PMT  0.08/12, 60, 25000 = $506.91

2-68
 Effective Annual Interest Rate

– The general equation for the effective annual
interest rate, ieff, is,
Equation 2.43
– where r is the nominal annual interest rate

and m is the number of interest periods per
year.
2-69
Example 2.20 – Calculating the
Effective Annual Interest Rate
Calculate the effective annual interest rate

for each of the following cases: (a) 12%
compounded quarterly; (b) 12%
compounded monthly; (c) and 12% per
year compounded every minute.

2-70
Example 2.20 – Calculating the Effective
Annual Interest Rate (cont.)
Calculate the effective annual interest rate for

each of the following cases: (a) 12 percent per
year compounded quarterly
a.Twelvepercent per year compounded quarterly: r =
12%; m = 4. From Equation 2.43,
ieff = (1 + 0.12/4)4 – 1
= (1.03)4 – 1
= 0.12551 = 12.551%
Using the Excel® EFFECT worksheet function gives the
same result:

2-71

each of the following cases: (b) 12 percent per
year compounded monthly
b.Twelvepercent per year compounded monthly: r = 12%;
m = 12. From Equation 2.43,
ieff = (1 + 0.12/12)12 – 1
= (1.01)12 – 1
= 0.12683 = 12.683%

2-72

each of the following cases: (c) 12 percent per
year compounded every minute
c.Twelvepercent per year compounded monthly: r = 12%;
m = 525,600. From Equation 2.43,
ieff =  1  0.12/525, 600 525,600
1
= 0.12749684 = 12.749684%

2-73
 When Compounding and Cash Flow

Frequencies Differ
– Let r denote the nominal annual interest rate for
money and m denote the number of compounding
periods in a year; let k denote the number of cash
flows in a year, and let i denote the interest rate per
cash flow period. The value of i is obtained as
follows:
Equation 2.44

2-74
Example 2.22 – When Cash Flow Frequency
Does Not Match Compounding Frequency
What size monthly payments should occur

when $10,000 is borrowed at 8 percent per
year compounded quarterly and the loan is
repaid with 36 equal monthly payments?

2-75
Example 2.22 – When Cash Flow Frequency Does Not
Match Compounding Frequency (cont.)
What size monthly payments should occur

when $10,000 is borrowed at 8 percent per
year compounded quarterly and the loan is
repaid with 36 equal monthly payments?
Given: P = $10,000; r = 8% (compounded

quarterly); n = 36
Find: A
2-76
Example 2.22 – When Cash Flow Frequency Does Not
Match Compounding Frequency (cont.)
From Equation 2.44, r = 0.08, k = 12, and m = 4.

Therefore,
Knowing the monthly interest rate, the monthly

payment can be determined:

2-77
Key Terms
Capital Recovery Factor, p. 42 Interest Rate, p. 26

Cash Flow Diagram (CFD), p. Nominal Annual Interest
24 Rate, p. 55
Compounding, p. 26 Period Interest Rate, p. 56
Effective Annual Interest Present Value, p. 27
Rate, p. 58
Sinking Fund Factor, p. 45
Future Value, p. 28
Uniform Series, p. 26
Geometric Series, p. 51
Gradient Series, p. 46

2-78

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Chapter 2

Copyright 2013 John Wiley & Sons, Inc.

Copyright 2013 John Wiley & Sons, Inc.

Copyright 2013 John Wiley & Sons, Inc.

Copyright 2013 John Wiley & Sons, Inc.

1. Construct a cash flow diagram (CFD) depicting

Copyright 2013 John Wiley & Sons, Inc.

Figure 2.1 Copyright 2013 John Wiley & Sons, Inc.

Which cash flow in Figure 2.2 is preferred?

2. Perform time value of money calculations for

Copyright 2013 John Wiley & Sons, Inc.

 Future Worth Calculations (F|P)

Copyright 2013 John Wiley & Sons, Inc.

 Future Worth Calculations (F|P) (cont.)

Copyright 2013 John Wiley & Sons, Inc.

Copyright 2013 John Wiley & Sons, Inc.

Given: Loan amount = $10,000; interest rate = 10%/year;

Find: Value of the loan amount after 5 years

Copyright 2013 John Wiley & Sons, Inc.

 Future Worth Calculations (F|P) (cont.)

Dia St. John borrows $1,000 at 12 percent

Copyright 2013 John Wiley & Sons, Inc.

Dia St. John borrows $1,000 at 12 percent

Given: Loan amount = $1,000; interest rate =

Find: Value of the loan amount after 5 years

Using the compound interest tables in Appendix A

Using the Excel® FV worksheet function,

Copyright 2013 John Wiley & Sons, Inc.

How long does it take for an investment to double

Copyright 2013 John Wiley & Sons, Inc.

How long does it take for an investment to double in

Consider six different ways to solve this problem

How long does it take for an investment to double

1. Rule of 72 – the quotient of 72 and the interest provides

How long does it take for an investment to double

2. Use the interest tables in Appendix A; look for F|P

Copyright 2013 John Wiley & Sons, Inc.

How long does it take for an investment to double

3. Solve numerically; n = log 2/log (1+i)

Copyright 2013 John Wiley & Sons, Inc.

Example 2.4 – Doubling Your Money

How long does it take for an investment to double

4. Solve using Excel® NPER function: = NPER(i%,,-1,2)

Copyright 2013 John Wiley & Sons, Inc.

How long does it take for an investment to double

Copyright 2013 John Wiley & Sons, Inc.

How long does it take for an investment to double

Copyright 2013 John Wiley & Sons, Inc.

 Present Worth Calculations (P|F)

Copyright 2013 John Wiley & Sons, Inc.

 Present Worth Calculations (P|F) (cont.)

To illustrate the computation of P given F, i, and

Copyright 2013 John Wiley & Sons, Inc.

To illustrate the computation of P given F, i, and n,

Given: F = $10,000; i = 5% compounded annually;

Using the compound interest tables in Appendix A

Copyright 2013 John Wiley & Sons, Inc.

Copyright 2013 John Wiley & Sons, Inc.

3. Distinguish between uniform, irregular, gradient

Copyright 2013 John Wiley & Sons, Inc.

 Irregular Cash Flows

Copyright 2013 John Wiley & Sons, Inc.

 Irregular Cash Flows (cont.)