CH 05

Introduction to Corporate
Finance:
Fifth Canadian Edition
Booth, Cleary, Rakita
Chapter 5
TIME VALUE OF MONEY
Copyright ©2020 John Wiley & Sons, Inc.

Learning Objectives
5.1 Explain the importance of the time value of money and how it is related to an
investor’s opportunity costs.
5.2 Define simple interest and explain how it works.
5.3 Define compound interest and explain how it works.
5.4 Differentiate between an ordinary annuity and an annuity due, and explain how special
constant payment problems can be valued as annuities and, in special cases, as
perpetuities.
5.5 Determine the present value of growing perpetuities and annuities.
5.6 Differentiate between quoted rates and effective rates, and explain how quoted rates
can be converted to effective rates.
5.7 Apply annuity formulas to value loans and mortgages, and set up an amortization
schedule.
5.8 Solve a basic retirement problem.
Copyright ©2020 John Wiley & Sons, Inc. 2
5.1 TIME VALUE OF MONEY
• Money has a time value because it can be invested

today and be worth more tomorrow.
• Another way of considering time value of money
• Money received today is more valuable than if the same
amount is received in the future
• Because that money can be invested to earn a return
(e.g. interest)
• Time value of money calculations are needed for
finance decisions such as capital budgeting and
security valuations
© John Wiley & Sons Canada, Ltd. Page 3
5.1 OPPORTUNITY COST
• Opportunity cost: the cost of giving something up in

exchange for something else
o Example: You are studying for an exam rather than hanging
out with friends. The opportunity cost is the time with your
friends – you are giving that up for a high grade on your exam
• Many finance decisions require that the opportunity cost and
the time value of money be well analyzed
• The opportunity cost of money is the interest rate that would
be earned by investing it.

5.1 OPPORTUNITY COST
• The interest rate used in many time value of money decisions

is the required rate of return (k)
o also known as a discount rate.
• To make time value of money decisions, you need to identify
the relevant discount

5.2 SIMPLE INTEREST
• Simple interest is interest paid or received only on the initial

investment (principal).
• The same amount of interest is earned in each year.
Value (time n)  P  (n  P  k )
Where:
n = Number of period
P = Principal (or face value)
k = Interest rate
EXAMPLE: Simple Interest
The same amount of interest is earned in each year.

5.3 COMPOUND INTEREST
• Compound interest is interest that is earned on the

principal amount and on the future interest payments.
• Calculations are done to determine how much you will

have in the future with compound interest (known as the
future value)
• Calculations are done to determine how much you would

have today if the compound interest was removed (known
as the present value)
5.3 COMPOUND INTEREST
• The future value of a single cash flow at any time ‘n’ is

calculated using Equation 5.2.
FVn  PV0 (1  k ) n [5.2]
Where:
FVn = Future value at compounding period n
PV0 = Present value at time zero
k = Discount or interest rate

EXAMPLE: Computing Future Values
(Compounding)
FVn  PV0 (1  k ) n [5.2]
Example 5 -2 Compound Interest
You invest $500 today for five years and receive 10 percent annual compound interest.
Year Beginning Amount Interest Ending Amount

1 $500 $500 × 0.1 = $50 $550
2 $550 $550 × 0.1 = $55 $605
3 $605 $605 × 0.1 = $60.50 $666
4 $666 $666 × 0.1 = $66.66 $732
5 $732 $732 × 0.1 = $73.20 $805

EXAMPLE: Computing Future Values
(Compounding) FV  PV (1  k ) [5.2] n 0
n
Solve with the formula: FVn = $500*(1+.10)5

= $500*1.610510
= $805.25
COMPOUND VERSUS SIMPLE INTEREST
• Simple interest grows principal in a linear manner.

• Compound interest grows exponentially over time.

FUTURE VALUE INTEREST FACTOR (FVIF)
• A term that represents the future value of an investment at a

given rate of interest and for a stated number of periods.
FVIFn ?,k ?  (1  k ) n
• The FVIF for 10 years at 8% would be:

FVIFn 10,k  0.08  (1  0.08)10  2.1589
• $100 invested for 10 years at 8% would equal:

FV10  $100  (1  0.08)10  $100  2.1589  $215.89

EXAMPLE: Using the FVIF
Find the FV20 of $3,500 invested at 3.25%.
FV20  P0  FVIFn  20,k  3.5% 

 $3,500  (1  0.035) 20
 $3,500  1.99
 $6,964.26

COMPUTING PRESENT VALUES (DISCOUNTING)
• The inverse of compounding is known as discounting.

• Discounting is essentially removing all compound interest from
some future amount
• You can find the present value of any future single cash flow
using equation 5.3.

PRESENT VALUE INTEREST FACTOR (PVIF)
PVIF is the inverse of the FVIF.
1
PVIFn ?,k ? 
(1  k ) n

EXAMPLE: Using the PVIF
Find the PV0 of receiving $100,000 in 10 years time if the

opportunity cost is 5%.
PV0  FV10  PVIFn 10,k 5% 
1
 $100,000 
(1  0.05)10
1
 $100,000 
1.629
 $100,000  0.6139
 $61,391.33

USING EQUATION 5.2
• Given three known values, you can solve for the one unknown in
equation 5.2
• Solve for:
• FV - given PV, k, n (finding a future value)
• PV - given FV, k, n (finding a present value)
• k - given PV, FV, n (finding a compound rate)
• n - given PV, FV, k (find holding periods)
SOLVING FOR ‘n’ OR “COMPOUNDING PERIODS”
Equation 5.3 is reorganized to solve for n:
FV0 [5-3]
PV0 
(1  k ) n
ln FVn / PV0 
n
ln 1  k 

EXAMPLE: Solving for ‘n’
How many years will it take $8,500 to grow to $10,000 at a 7%

rate of interest?
ln FVn / PV0 
n
ln 1  k 
ln $10,000 / $8,500 ln[1.17647 ]
n 
ln 1  .07 ln[1.07]
0.1625
n  2.4 years
0.06766

SOLVING FOR COMPOUND RATE OF RETURN
Equation 5.3 is reorganized to solve for k:
FV0
PV0  [5-3]
(1  k ) n
1/ n
 FVn 
k  1
PV
 0

EXAMPLE: Solving for ‘k’
Your investment of $10,000 grew to $12,500 after 12 years.

What compound rate of return (k) did you earn on your money?
1/ n
 FVn 
k  1
PV
 0
1
 $12,500  12
k   1  1 . 25 0.083
1
 $10,000 
k  0.01877  1.88%

USING FINANCIAL CALCULATOR
• Examples are based on using a BAII Plus by

Texas Instruments
• The key variables are individually inputted into
the calculator
• So long as at least 3 variables are known,
you can solve for the remaining variable
© 2015 John Wiley & Sons, Inc. All rights reserved. 23

EXAMPLE: Solving for ‘n’
How many years will it take $8,500 to grow to

$10,000 at a 7% rate of interest?
Variable Inputs:
8500 +/- PV
10000 FV
7.0 I/Y
CPT n = 2.40 years
When you have both PV and FV, the PV must be made to be negative

EXAMPLE: Solving for ‘k’
Your investment of $10,000 grew to $12,500 after

12 years. What compound rate of return (k) did
you earn on your money?
Variable Inputs:
10000 +/- PV
12500 FV
12 n
CPT I/Y = 1.88%

5.4 ANNUITIES AND PERPETUITIES
• Previous examples were all single sum future values.

• An annuity is a finite series of equal, periodic and
uninterrupted cash flows.
o Example: You will receive $20,000 every year for 20 years
• A perpetuity is an infinite series of equal, periodic and
o Example: You won a dream life lottery and will receive $10,000
every year for life

ANNUITIES AND ANNUITIES DUE
• An ordinary annuity has payments at the end of each period.
• An annuity due has payments at the beginning of each

period.

ANNUITY FORMULA
The formula for the future sum of an ordinary annuity is:
 (1  k ) n  1
FVn  PMT   [5.4]
 k 
Where:
FVn = Future value at compounding period n
PMT = Individual annuity payment amount
n = Number of compounding periods
EXAMPLE: Find the Future Value of an Ordinary
Annuity with Financial Calculator
You plan to save $1,000 each year for 10 years. At 11% how
much will you have saved if you make your first deposit one year
from today?
FVA10  PMT  FVIFA n ,k 

 1  k n  1
FVA10  $1,000   
 k 
 1.1110  1
FVA10  $1,000   
 0 .11 
FVA10  $1,000  16.722  $16,722.01

EXAMPLE: Find the Future Value of an Ordinary
much will you have saved if you make your first deposit one year
from today?
Variable Inputs:
1000 PMT
10 n
11 I/Y
CPT FV = $16,722.01

PRESENT VALUE OF ORDINARY ANNUITY FORMULA
The formula for the present value of an ordinary annuity is:

 1  [5.5]
1 
 (1  k ) n 
PV0  PMT  
 k 
 
Where:
PV0 = Present value of the ordinary annuity
n = Number of compounding period

EXAMPLE: Find the Present Value of an Ordinary
Annuity
What is the present value of an investment that offers to pay
you $12,000 each year for 20 years if the payments start one
year from today? Your opportunity cost is 6%.
PVA0  PMT  PVIFA n  20,k 0.06

 1 
1 
 (1.06) 20 
PVA0  $12,000   
 0. 06 
 
PVA0  $12,000 11 .47  $137,639.06

EXAMPLE: Find the Present Value of an Ordinary
you $12,000 each year for 20 years if the payments start one
year from today? Your opportunity cost is 6%.
Variable Inputs:
12000 PMT
20 n
6 I/Y
CPT PV = $137,639.05

ANNUITY DUE FORMULA
The formula for the future sum of an annuity due is:
 (1  k ) n  1
FVn  PMT   (1  k) [5.6]
 k 
Where:
PV0 = Present value of the ordinary annuity
n = Number of compounding period
EXAMPLE: Find the Future Value of an Annuity Due
much will you have saved if you make your first deposit today?
FVA10  PMT  FVIFA n ,k  1  k 

 1  k n  1
FVA10  $1,000    (1  k )
 k 
 1.1110  1
FVA10  $1,000    (1.11)
 0.11 
FVA10  $1,000  16.722 1.11  $18,561.43

EXAMPLE: Find the Future Value of an Annuity Due
much will you have saved if you make your first deposit today?
First step: Change your calculator to BEGIN or BGN (with BAII

Plus: 2ND PMT/BGN 2ND ENTER
Variable Inputs:
1000 PMT
10 n
11 I/Y
CPT FV = $18,561.43

PRESENT VALUE OF ANNUITY DUE FORMULA
The formula for the present value of an annuity due is:

 1  [5.7]
1 
 (1  k ) n 
PV0  PMT   (1  k)
 k 
 
Where:
PV0 = Present value of the annuity
n = Number of compounding periods

EXAMPLE: Find the Present Value of an Annuity Due

you $12,000 each year for 20 years if the payments start today?
Your opportunity cost is 6%.
PVA0  PMT  PVIFA n ,k  1  k 

 1 
1 
 (1.06) 20 
PVA0  $12,000    (1  .06)
 0.06 
 
PVA0  $12,000 11 .47  1.06  $145,897.40

EXAMPLE: Find the Present Value of an Annuity Due
with Financial Calculator
you $12,000 each year for 20 years if the payments start today?
Your opportunity cost is 6%.
First step: Change your calculator to BEGIN or BGN (with BAII

Plus: 2ND PMT/BGN 2ND ENTER
Variable Inputs:
12000 PMT
20 n
6 I/Y
CPT PV = $145,897.40

NOTE ON FINANCIAL CALCULATOR
• While most of the basic time value calculations are
done the same way on financial calculators
• Always check your instruction manual; specifically
for:
• How your specific financial calculator switches from ordinary to
annuity due
• How to correctly clear your calculator between time value
calculations

FORMULA FOR A THE PRESENT VALUE OF A
PERPETUITY
A perpetuity is an infinite series of equal, periodic and
PMT
PV0  [5.8]
k
Where:

EXAMPLE: Find the Present Value of a Perpetuity
What is the present value of a business that promises to offer

you an after-tax profit of $100,000 for the foreseeable future if
your opportunity cost is 10%?
P1 $100,000
PV0    $1,000,000
k 0.1

5.5 GROWING ANNUITIES & PERPETUITIES
• A growing perpetuity is an infinite series of periodic cash

flows where each cash flow grows larger at a constant rate.
• The Present Value of a growing perpetuity is found with:
PMT0 (1  g ) PMT1 [5.10]

PV0  
kg kg
Where:
g = constant rate of growth
5.5 GROWING PERPETUITY EXAMPLE
• You have just won a lottery where you will receive
annual payments for as long as you live, with the first
payment of $5,000 to be received at the end of each
year. The payment will grow by 4.5% each year and
the opportunity cost is 7.5%
• The Present Value of this growing perpetuity is :
PMT0 (1  g ) PMT1
PV0   [5.10]
kg kg
PV0 = 5,000 = 5,000 = $166,667

.075-.045 .03
GROWING ANNUITIES
• An annuity is a finite series of periodic cash flows where

each subsequent cash flow is greater than the previous by a
constant growth rate.
• The formula for a growing annuity is:
PMT1   1  g   [5.12]
n
PV0   1    
k  g   1  k  
Where:
g = Constant growth rate
GROWING ANNUITY EXAMPLE
• You have just won a lottery where you will receive annual
payments for 30 years, with the first payment of $5,000 to
be received at the end of each year. The payment will grow
by 4.5% each year and the opportunity cost is 7.5%
• The Present Value of this growing annuity is :
PMT1   1  g  
n
PV0   1    
k  g   1  k  
PV0 = 5,000 * 1-(1+.045)30 = $166,667 * (1-.427794)

(1+.075)
PV0 = $166,667 * 0.572206
PV0 = $95,368
5.6 QUOTED VERSUS EFFECTIVE RATES
• A nominal rate of interest is a ‘stated rate’ or quoted
rate (QR).
• An effective annual rate (EAR) rate takes into account
the frequency of compounding (m).
• The EAR will always be higher than the nominal rate of
interest
m
 QR 
EAR  k  1   1 [5.13]
 m 

EXAMPLE: Find an Effective Annual Rate
Your personal banker has offered you a mortgage rate of 5.5

percent compounded semi-annually. What is the effective
annual rate (EAR) on this loan?
QR m 0.055 2
EAR  (1  ) - 1  (1  ) -1
m 2
EAR  1.02752 - 1  5.58%

EXAMPLE: Find an Effective Annual Rate
Your personal banker has offered you a mortgage rate of 5.5

percent compounded semi-annually MONTHLY. What is the
effective annual rate (EAR) on this loan?
EAR = (1 + 0.055 )12 - 1

12
EAR = 5.64%

EXAMPLE: Effective Annual Rates
EARs increase as the frequency of compounding increase.

5.7 LOAN OR MORTGAGE ARRANGEMENTS
• A mortgage loan is a borrowing arrangement where
the principal amount of the loan borrowed is typically
repaid (amortized) over a given period of time making
equal and periodic payments.
• Amortization period = the period of time it will take for the
mortgage to be repaid in full
• Mortgage term = the time period before the next renewal
option for the mortgage; interest rate and payment
amount will change with each mortgage term
• A blended payment is one where both interest and
principal are retired in each payment.

EXAMPLE: Loan Amortization
Determine the annual blended payment on a five –year $10,000

loan at 8% compounded semi-annually.
 1 
1 
 (1  k ) n
PV0  PMT   [5.5]
 k 
 
 1 
1 
 (1  0.0816) 5 
$10,000  PMT   
 0.0816 
 
$10,000
PMT   $2,515.14
3.9759

EXAMPLE: Loan Amortization with Financial Calculator
Determine the annual blended payment on a five –year $10,000

loan at 8% compounded semi-annually.
First find the EAR

= (1+[.08/2])2 – 1
= .0816 or 8.16%
Variable Inputs:
10000 PV
5n
8.16 I/Y
CPT PMT = $2,515.14
EXAMPLE: Loan Amortization Schedule
The loan is amortized over five years with annual payments beginning
at the end of year 1.

Example: Mortgage Amortization
• Determine the monthly blended payment on a $200,000

mortgage amortized over 25 years at a QR = 4.5%
compounded semi-annually.
Number of monthly payments = 25 × 12 = 300
0.045
• Find EAR:   )  1  4.550625%
2
(1
2
• Find EMR: 4.550625%  (1  EMR )  1 12
1.04550625 12  (1  EMR)
1
EMR  0.3715318%
$200,000
PMT   $1,106.85
 1 
1  (1  0.003715) 300 
• Determine monthly payment: 
0.003715

 
 

Example: Mortgage Amortization with Financial
Calculator
Determine the monthly blended payment on a $200,000
mortgage amortized over 25 years at a QR = 4.5% compounded
semi-annually.
Number of monthly payments = 25 × 12 = 300
4.550625%  (1  EMR )12  1
Find EMR: 1.04550625 12  (1  EMR)
1
EMR  0.3715318%
Variable Inputs:
200000 PV
300 n
0.3715318 I/Y
CPT PMT = $1,106.95
EXAMPLE: Mortgage Amortization

5.8 COMPREHENSIVE EXAMPLES
• Time Value of Money (TMV) is a tool that can be applied

whenever you analyze a cash flow series over time.
• Because of the long time horizon, TMV is ideally suited to
solve retirement problems.

COMPREHENSIVE EXAMPLE: Retirement Problem
• Kelly, age 40 wants to retire at age 65.

• At age 65 Kelly wants enough money to purchase a 30 year annuity that
will pay $5,000 per month.
• Monthly payments should start one month after she reaches age 65.
• Today Kelly has accumulated retirement savings of $230,000.
• Assume a 4% annual rate of return on both the fixed term annuity and
on her savings.
• How much will she have to save each month starting one month from
now to age 65 in order for her to reach her retirement goal?
NOTE – these are ordinary annuities
How Much will the Fixed Term Annuity Cost at age 65?
Steps in Solving the Comprehensive Retirement Problem
1. Calculate the present value of the retirement annuity as at Kelly’s
age 65.
2. Estimate the value at age 65 of her current accumulated savings.
3. Calculate gap between accumulated savings and required funds at
age 65.
4. Calculate the monthly payment required to fill the gap.

Example Solution – Preliminary Calculations
• Monthly rate of return when annual APR is 4%

4%  (1  k m )12  1
1
1  k m  1  .04   (1.04).083  1.00326
12
k m  0.326%
• Number of months during savings period
n  25 12  300

Time Line & Analysis Required to Identify Savings Gap
GAP  $1,058,524  $613,142 30 year fixed-term retirement

 $445,382 annuity = 30 ×12 =360 months
$1,058,524
Additional
 1 
monthly 1  (1  k ) n 
savings PV25  PMT   (1  k)
 k 

 

FV25  P0 (1  k annual ) 25  $230,000(1.04) 25

Existing
Savings  $613,142
Age 40 65 95
25 year asset accumulation 30 year asset depletion phase (retirement)

phase

Monthly Savings Required to fill Gap
FVA25 $445,382
GAP  $1,058,524  $613,142 Monthly PMT  
(1  k )  1 (1.00326) 300  1
n
 $445,382 savings to
k 0.00326
fill gap? $445,382
  $877.36
Additional 507.64
monthly
savings Your
Answer
FV25  P0 (1  k annual )  $230,000(1.04) 25
25
Existing  $613,142
Savings
Age 40 65 95
25 year asset accumulation 30 year asset depletion

phase phase (retirement)

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Introduction to Corporate

TIME VALUE OF MONEY

Copyright ©2020 John Wiley & Sons, Inc.

• Money has a time value because it can be invested

• Opportunity cost: the cost of giving something up in

Copyright ©2020 John Wiley & Sons, Inc. 4

• The interest rate used in many time value of money decisions

Copyright ©2020 John Wiley & Sons, Inc. 5

• Simple interest is interest paid or received only on the initial

The same amount of interest is earned in each year.

Copyright ©2020 John Wiley & Sons, Inc. 7

• Compound interest is interest that is earned on the

• Calculations are done to determine how much you will

• Calculations are done to determine how much you would

• The future value of a single cash flow at any time ‘n’ is

FVn  PV0 (1  k ) n [5.2]

Copyright ©2020 John Wiley & Sons, Inc. 9

Example 5 -2 Compound Interest

Year Beginning Amount Interest Ending Amount

Copyright ©2020 John Wiley & Sons, Inc. 10

Solve with the formula: FVn = $500*(1+.10)5

• Simple interest grows principal in a linear manner.

Copyright ©2020 John Wiley & Sons, Inc. 12

• A term that represents the future value of an investment at a

• The FVIF for 10 years at 8% would be:

• $100 invested for 10 years at 8% would equal:

Copyright ©2020 John Wiley & Sons, Inc. 13

Find the FV20 of $3,500 invested at 3.25%.

FV20  P0  FVIFn  20,k  3.5% 

Copyright ©2020 John Wiley & Sons, Inc. 14

• The inverse of compounding is known as discounting.

Copyright ©2020 John Wiley & Sons, Inc. 15

PVIF is the inverse of the FVIF.

Copyright ©2020 John Wiley & Sons, Inc. 16

Find the PV0 of receiving $100,000 in 10 years time if the

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Equation 5.3 is reorganized to solve for n:

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How many years will it take $8,500 to grow to $10,000 at a 7%

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Equation 5.3 is reorganized to solve for k:

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Your investment of $10,000 grew to $12,500 after 12 years.

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• Examples are based on using a BAII Plus by

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How many years will it take $8,500 to grow to

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Your investment of $10,000 grew to $12,500 after

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• Previous examples were all single sum future values.

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• An ordinary annuity has payments at the end of each period.

• An annuity due has payments at the beginning of each

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The formula for the future sum of an ordinary annuity is:

FVA10  PMT  FVIFA n ,k 

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The formula for the present value of an ordinary annuity is:

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PVA0  PMT  PVIFA n  20,k 0.06

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