Time Value Future Value Present Value Rates of Return Amortization

7-1
CHAPTER 7
Time Value of Money
 Time Value
 Future value
 Present value
 Rates of return
 Amortization
Copyright © 2002 by Harcourt, Inc. All rights reserved.
7-2
What is time value of money?
 Time preference for money is called

time value of money
 Money has a time value because an
individual prefer to have a current
cash flows over a future cash if the
amount of cash flow is same
 Therefore, it is said a Taka in hand
today is worth than a Taka to be
received in the future
7-3
Determinants of time value of money?

 Consumption Preference
 Uncertainty
 Inflation
 Investment Opportunity
The value of money changes over time
depending on opportunity cost
Opportunity cost:
Return/benefit/interest from the next
best
Copyright alternative
© 2002 by Harcourt, Inc. which is forgone
All rights reserved.
7-4
What is cash flow?
 The flows of money in any business

are called cash flows
 Cash outflow: Cash deposited, cost,
or amount paid (with minus - sign)
 Cash inflow: Cash receipt (with plus+
sign)

7-5
What is Interest?
 Interest is the price paid for using

loan or debt capital in the business
and plays important role in
determining the time value of money
 Nominal Interest: Charged only on
principal amount
 Compound Interest: Charged on both
principal and accrued (previously
earned but not paid yet) interest
7-6
Values of Cash Flows:
 Every cash flow has two values:

 Future Value(FVn): The amount to
which a cash flow(s) grows over time
at given compound interest rate
 Present Value(PVo): The value of any
future amount(s) in current worth
after discounting at a given discount
rate
7-7
Cash flows over time:

 Equal cash flows at regular intervals
over a specified period of time is
called Annuity
 Ordinary: Payments made/received at
the end of each period
 Due: Payments made/received at the
beginning of each period
 Equal cash flows at regular intervals
for indefinite period of time is called
Perpetuity
7-8
Time lines show timing of cash flows.
0 1 2 3
i%
CF0 CF1 CF2 CF3
Tick marks at ends of periods, so Time 0 is

today; Time 1 is the end of Period 1; or the
beginning of Period 2.
7-9
Time line for a $100 lump sum due at

the end of Year 2.
0 1 2 Year
i%
100

7 - 10
Time line for an ordinary annuity of

$100 for 3 years.
0 1 2 3
i%
100 100 100

7 - 11
Time line for uneven CFs -$50 at t = 0

and $100, $75, and $50 at the end of
Years 1 through 3.
0 1 2 3
i%
-50 100 75 50

7 - 12
What’s the FV of an initial $100 after 3

years if i = 10%?
0 1 2 3
10%
100 FV = ?
Finding FVs is compounding.

7 - 13
After 1 year:
FV1 = PV + INT1 = PV + PV(i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = PV(1 + i)2
= $100(1.10)2
= $121.00.
7 - 14
After 3 years:
FV3 = PV(1 + i)3

= $100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.

7 - 15
Four Ways to Find FVs
 Solve the equation with a regular

calculator.
 Use tables. FVn=PVo(FVIFi,n)
 Use a financial calculator.
 Use a spreadsheet.

7 - 16
Financial Calculator Solution
Financial calculators solve this

equation:
FVn = PV(1 + i)n.
There are 4 variables. If 3 are

known, the calculator will solve
for the 4th.
7 - 17
Here’s the setup to find FV:
INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10
Clearing automatically sets everything

to 0, but for safety enter PMT = 0.
Set: P/YR = 1, END
7 - 18
What’s the PV of $100 due in 3 years if

i = 10%?
Finding PVs is discounting, and it’s

the reverse of compounding.
0 1 2 3
10%
PV = ? 100

7 - 19
Solve FVn = PV(1 + i )n for PV:
PV =
FVn
(1 + i) n
= FVn  1 n
1+i .
PV = $100  1
1.10  = $100(PVIF
3
i,n)
= $100(0.7513) = $75.13.
PVo=FVn(PVIFi,n) if we use table
7 - 20
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.
7 - 21
If sales grow at 20% per year, how long

before sales double?
Solve for n:
FVn = $1(1 + i)n;
$2 = $1(1.20)n
Use calculator to solve, see next slide.

7 - 22
INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8
Graphical Illustration:
FV
2
1 3.8
0 Year
1 2 3 4
7 - 23
What’s the difference between an

ordinary annuity and an annuity due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT

Annuity Due
0 1 2 3
i%
PMT PMT PMT

7 - 24
What’s the FV of a 3-year ordinary

annuity of $100 at 10%?
0 1 2 3
10%
100 100 100

110
121
FV = 331

7 - 25
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00
Have payments but no lump sum PV,

so enter 0 for present value.

7 - 26
What’s the PV of this ordinary annuity?
0 1 2 3
10%
100 100 100

90.91
82.64
75.13
248.68 = PV
7 - 27
Using Annuity Value Table
 FVAn(ordinary)=PMT(FVIFAi,n)
 FVAn(due)=FVAn(ordinary)(1+i)
 PVAo(ordinary)=PMT(PVIFAi,n)
 PVAo(due)=PVAo(ordinary)(1+i)

7 - 28
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69
Have payments but no lump sum FV,

so enter 0 for future value.

7 - 29
Find the FV and PV if the

annuity were an annuity due.
0 1 2 3
10%
100 100 100

7 - 30
Switch from “End” to “Begin.”

Then enter variables to find
PVA3 = $273.55.
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55
Then enter PV = 0 and press FV to find

FV = $364.10.
7 - 31
What is the PV of this uneven cash

flow stream?
0 1 2 3 4
10%
100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
7 - 32
 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.)
7 - 33
What interest rate would cause $100 to

grow to $125.97 in 3 years?
$100 (1 + i )3 = $125.97.
INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8%

7 - 34
The Power of Compound Interest
A 20-year old student wants to start

saving for retirement. She plans to
save $3 a day. Every day, she puts
$3 in her drawer. At the end of the
year, she invests the accumulated
savings ($1,095) in an online stock
account. The stock account has an
expected annual return of 12%.

7 - 35
How much money by the age of 65?
INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,261.89
If she begins saving today, and

sticks to her plan, she will have
$1,487,261.89 by the age of 65.
7 - 36
How much would a 40-year old

investor accumulate by this method?
INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,000.59
Waiting until 40, the investor will only

have $146,000.59, which is over $1.3
million less than if saving began at
20. So it pays to get started early.
7 - 37
How much would the 40-year old

investor need to save to accumulate as
much as the 20-year old?
INPUTS 25 12 0 1487261.89
N I/YR PV PMT FV
OUTPUT -11,154.42
The 40-year old investor would have to

save $11,154.42 every year, or $30.56
per day to have as much as the
investor beginning at the age of 20.
7 - 38
Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated I% constant? Why?
LARGER! If compounding is more

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

7 - 39
0 1 2 3
10%
100 133.10
Annually: FV3 = $100(1.10)3 = $133.10.
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01.
7 - 40
We will deal with 3 different

rates:
iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate.
effective annual
EAR = EFF% = rate .

7 - 41
 iNom is stated in contracts. Periods per

year (m) must also be given.
 Examples:
 8%; Quarterly
 8%, Daily interest (365 days)

7 - 42
 Periodic rate = iPer = iNom/m, where m is

number of compounding periods per
year. m = 4 for quarterly, 12 for
monthly, and 360 or 365 for daily
compounding.
 Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =
0.021918%.
7 - 43
 Effective Annual Rate (EAR = EFF%):
The annual rate that causes PV to grow to
the same FV as under multi-period
compounding.
Example: EFF% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EFF% = 10.25% because
(1.1025)1 = 1.1025.
Any PV would grow to same FV at 10.25%
annually or 10% semiannually.
7 - 44
 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.

7 - 45
How do we find EFF% (effective rate)
for a nominal rate of 10%,
compounded
semiannually?
EFF = 1 +
iNom m
m
–1  
=1 + 0.10  – 1.0
2
2
= (1.05)2 – 1.0
= 0.1025 = 10.25%.
Or use a financial calculator.
7 - 46
EAR = EFF% of 10%
EARAnnual = 10%.
EARQ = (1 + 0.10/4)4 – 1 = 10.38%.
EARM = (1 + 0.10/12)12 – 1 = 10.47%.
EARD(365) = (1 + 0.10/365)365 – 1 = 10.52%.

7 - 47
Can the effective rate ever be equal to

the nominal rate?
 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.

7 - 48
When is each rate used?
iNom: Written into contracts, quoted

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

7 - 49
iPer: Used in calculations, shown on

time lines.
If iNom has annual compounding,

then iPer = iNom/1 = iNom.

7 - 50
EAR = 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.)
7 - 51
FV of $100 after 3 years under 10%

semiannual compounding? Quarterly?
mn
 iNom
FVn = PV 1 +  .
 m
2x3
 0.10 
FV3S = $100 1 + 
 2 
= $100(1.05)6 = $134.01.
FV3Q = $100(1.025)12 = $134.49.
7 - 52
What’s the value at the end of Year 3
of the following CF stream if the
quoted interest rate is 10%,
compounded semiannually?
0 1 2 3 4 5 6 6-mos.
5% periods
100 100 100

7 - 53
 Payments occur annually, but

compounding occurs each 6
months.
 So we can’t use normal annuity
valuation techniques.

7 - 54
1st Method: Compound Each CF
0 1 2 3 4 5 6
5%
100 100 100.00

110.25
121.55
331.80
FVA3 = $100(1.05)4 + $100(1.05)2 + $100

= $331.80.
7 - 55
2nd Method: Treat as an Annuity
Could you find FV with a

financial calculator?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
EAR = ( 0.10
1+ 2 ) – 1 = 10.25%.
2

7 - 56
Or, to find EAR with a calculator:
NOM% = 10.
P/YR = 2.
EFF% = 10.25.

7 - 57
b. The cash flow stream is an annual

annuity. Find kNom (annual) whose
EFF% = 10.25%. In calculator,
EFF% = 10.25
P/YR = 1
NOM% = 10.25
c.
INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80

7 - 58
What’s the PV of this stream?
0 1 2 3
5%
100 100 100
90.70
82.27
74.62
247.59
7 - 59
Amortization
Amortization is a process of repaying

a loan in equal installmets over the life
of a loan
Construct an amortization schedule
for a $1,000, 10% annual rate loan
with 3 equal payments.S

7 - 60
Step 1: Find the required annual

payments.
0 1 2 3
10%
-1,000 PMT PMT PMT
INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11

7 - 61
Step 2: Find the interest paid in

Year 1.
INTt = Beg balt (i)
INT1 = $1,000(0.10) = $100.
Step 3: Find repayment of principal

in Year 1.
Repmt = PMT – INT
= $402.11 – $100
= $302.11.
7 - 62
Step 4: Find ending balance after

Year 1.
End bal = Beg bal – Repmt

= $1,000 – $302.11 = $697.89.
Repeat steps 2-4 for Years 2 and 3

to complete the amortization table.

7 - 63
Calculation of Installment:
 PVAo=PMT(PVIFAi,n)
 $1000=PMT(PVIFA@10% for 3years)
 $1000=PMT(2.4869)
 PMT=$1000/2.4869=$402.10(annually)

7 - 64
BEG PRIN END

YR 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. Tax implications.

The above schedule is called Amortization
Schedule
7 - 65
$
402.11
Interest
302.11
Principal Payments
0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
7 - 66
 Amortization tables are widely used--

for home mortgages, auto loans,
business loans, retirement plans, etc.
They are very important!
 Financial calculators (and
spreadsheets) are great for setting up
amortization tables.

7 - 67
Amortization– Depreciation - Depletion

 Amortization is a process of repaying a
loan in equal installments in regular
over the loan life
 Depreciation is an accounting process
of reducing the value of an tangible or
fixed assets over the life due to wear
and tear
 Depletion is also an accounting process
of reducing the value of natural
resources like timber, minerals, and oil
from
Copyright the
© 2002 earth
by Harcourt, Inc. All rights reserved.
7 - 68
Study Work:
 ST-1,2,3
 Starter problems: 6-1,2,3,4,5,6,7,8,9
 Exam-type problems:
6-11,12,14,16,17,18,19,23
 Problems:6-34,39

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7-1

What is time value of money?

 Time preference for money is called

Determinants of time value of money?

What is cash flow?

 The flows of money in any business

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 Interest is the price paid for using

Values of Cash Flows:

 Every cash flow has two values:

Cash flows over time:

Time lines show timing of cash flows.

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0 is

Time line for a $100 lump sum due at

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Time line for an ordinary annuity of

100 100 100

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Time line for uneven CFs -$50 at t = 0

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the FV of an initial $100 after 3

Finding FVs is compounding.

FV3 = PV(1 + i)3

FVn = PV(1 + i)n.

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Four Ways to Find FVs

 Solve the equation with a regular

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Financial Calculator Solution

Financial calculators solve this

FVn = PV(1 + i)n.

There are 4 variables. If 3 are

Here’s the setup to find FV:

Clearing automatically sets everything

What’s the PV of $100 due in 3 years if

Finding PVs is discounting, and it’s

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Solve FVn = PV(1 + i )n for PV:

Financial Calculator Solution

Either PV or FV must be negative. Here

If sales grow at 20% per year, how long

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the difference between an

PMT PMT PMT

PMT PMT PMT

What’s the FV of a 3-year ordinary

100 100 100

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Financial Calculator Solution

Have payments but no lump sum PV,

Copyright © 2002 by Harcourt, Inc. All rights reserved.

What’s the PV of this ordinary annuity?

100 100 100

Using Annuity Value Table

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Have payments but no lump sum FV,

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Find the FV and PV if the

100 100 100

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Switch from “End” to “Begin.”

Then enter PV = 0 and press FV to find