TIME VALUE OF MONEY

MRE

The time value of money refers to the observation that it is better to receive
money sooner than later. Money that you have in hand today can be invested to
earn a positive rate of return, producing more money tomorrow. For that reason,
a dollar today is worth more than a dollar in the future.

FUTURE VALUE VERSUS PRESENT VALUE

Suppose a firm has an opportunity to spend $15,000 today on some investment
that will produce $17,000 spread out over the next five years as follows:

Year 1 3000
Year 2 5000
Year 3 4000
Year 4 3000
Year 5 2000
17000

Is this a wise investment? It might seem that the obvious answer is yes because the
firm spends $15,000 and receives $17,000. Remember, though, that the value of
the dollars the firm receives in the future is less than the value of the dollars that
they spend today. Therefore, it is not clear whether the $17,000 inflows are
enough to justify the initial investment.

Time Line:
A time line depicts the cash flows associated with a given investment. It is a
horizontal line on which time zero appears at the leftmost end and future periods
are marked from left to right. A time line illustrating our hypothetical investment
problem appears above. The cash flows occurring at time zero (today) and
at the end of each subsequent year are above the line; the negative values represent
cash outflows ($15,000 invested today at time zero), and the positive values
represent cash inflows ($3,000 inflow in 1 year, $5,000 inflow in 2 years, and
so on).
Compounding and Discounting
Time line showing compounding to find future value and discounting to
find present value

BASIC PATTERNS OF CASH FLOW

The cash flow—both inflows and outflows—of a firm can be described by its general
pattern. It can be defined as a single amount, an annuity, or a mixed stream.

Single amount: A lump-sum amount either currently held or expected at some

future date. Examples include $1,000 today and $650 to be received at the
end of 10 years.
Annuity: A level periodic stream of cash flow. For our purposes, we’ll work
primarily with annual cash flows. Examples include either paying out or
receiving $800 at the end of each of the next 7 years.

Mixed stream: A stream of cash flow that is not an annuity; a stream of

unequal periodic cash flows that reflect no particular pattern. Examples
include the following two cash flow streams A and B.

Future value
The value at a given future date of an amount placed on deposit today and earning
interest at a specified rate. Found by applying compound interest over a specified
period of time.

Present value
The current dollar value of a future amount—the amount of money that would
have to be invested today at a given interest rate over a specified period to equal
the future amount.
 FUTURE VALUE OF A SINGLE AMOUNT

The future value of a present amount is found by applying compound interest

over a specified period of time. Savings institutions advertise compound interest
invested to returns at a rate of x percent, or x percent interest, compounded annually,
that reason, semiannually,quarterly, monthly, weekly, daily, or even continuously. The concept of
future value with annual compounding can be illustrated by following example:

Example 01 (Gitman 13th E, P 166): If Fred Moreno places $100 in a savings

account paying 8% interest compounded annually, at the end of 1 year he will
investment have $108 in the account—the initial principal of $100 plus 8% ($8) in interest.
The future value at the end of the first year is calculated by using following Equation

Future value at end of year 01 $100 * (1+.08)^1 =

Future value at end of year 02 $100 * (1+.08)^2 =
Future value at end of year 03 $100 * (1+.08)^3 =
Future value at end of year 04 $100 * (1+.08)^4 =

yes because the The general equation for the future value at the end of period n is
the value of FVn = PV * (1 + r)^n
e dollars that
Example 02 (Gitman 13th E, P 166): Jane Farber places $800 in a savings account
paying 6% interest compounded annually. She wants to know how much money will be
in the account at the end of 5 years.

Solution:
uture periods Substituting PV = $800, r = .06, and n = 5 in the above equation then we get following:
al investment FV5 = $800 * (1 + 0.06)5 = $800 * (1.33823) = $1,070.58

alues represent This analysis can be depicted on a time line as follows:

years, and
 Spreadsheet Use: This problem can be solved using excel Spreadsheet:

Preent value $800

Annual interest rate 0.06 fv(rate,nper,pmt,[pv
Number of years 5
Future Value $1,070.58 =FV(R45,R46,0,-R4

The minus sign appears before S44 because the present value
is an outflow (i.e., a deposit made by Jane Farber).

This process of leaving your money and any accumulated interest in an investment for
more than one period, thereby reinvesting the interest, is called compounding . Compoun
the interest means earning interest on interest , so we call the result compound interest .
With simple interest , the interest is not reinvested, so interest is earned each period only
on the original principal.

Example 03 (Ross, 9th E, P - 120) : Suppose you locate a two-year investment that pays 1
percent per year. If you invest $325, how much will you have at the end of the two years?
How much of this is simple interest? How much is compound interest?

At the end of the first year, $325*(1.14)^1 370.50

At the end of the 2nd year $370.5*(1.14)^2 422.37

Total Interest earned 422.37 - 325 97.37

Simple Interest for one year 325*.14 45.50

bed by its general Simple Interest for two year 45.5*2 91.00

Compound Interest 325*.14*.14 6.37

ted at some
Example 04 (Ross, 9th E, P - 120)
You’ve located an investment that pays 12 percent per year. That rate sounds good to you,
so you invest $400. How much will you have in three years? How much will you have in
 seven years? At the end of seven years, how much interest will you have earned? How
much of that interest results from compounding?

After 03 years you will have $400*(1+.12)^3 561.97

After 07 years you will have $400*(1+.12)^7 884.27

Simple interest every year $400*.12 48.00

Simple interest for 07 years $400*.12*7 336.00

ay and earning Total Interest for 07 years $884.27-$400 484.27

er a specified
Compound interest (interest $484.27 - $336 148.27
on interest)

Exercise
y that would 01. Suppose one of your more frugal ancestors had invested $5 for you at a 6 percent interest
period to equal rate 200 years ago. How much would you have today? How much simple interest and compou
interest would you yearn over 200 years

Correct Answer:
Simple interest
Compound interest 60.00
575564.52

The effect of compounding is not great over short time periods, but it really starts to add
up as the horizon grows.

ROSS, 9TH EDITION, P- 124

02. To further illustrate the effect of compounding for long horizons, consider the case of Pete
Minuit and the American Indians. In 1626, Minuit bought all of Manhattan Island for about
$24 in goods and trinkets. This sounds cheap, but the Indians may have gotten the better
end of the deal. To see why, suppose the Indians had sold the goods and invested the $24
at 10 percent. How much would it be worth today?

About 383 years have passed since the transaction. At 10 percent, $24 will grow by
quite a bit over that time. How much? The future value factor is roughly:
Value after 383 years $24*(1.10)^383 1.7124E+17

Well, $170 quadrillion is a lot of money. How much? If you had it, you could buy the
United States. All of it. Cash. With money left over to buy Canada, Mexico, and the rest of
the world, for that matter.

03. The TICO Corporation currently pays a cash dividend of $5 per share. You believe the divid
will be increased by 4 percent each year indefi nitely. How big will the dividend be in eight yea

Future Value $5*(1+.04)^8 $ 6.84

Ross, 9th Edition, P - 135

04. You estimate that you will need about $80,000 to send your child to college in eight years.
You have about $35,000 now. If you can earn 20 percent per year, will you make it? At what
rate will you just reach your goal?

Solution:
If you can earn 20 percent, the future value of your $35,000 in eight years will be:

Future Value 35000*(1.2)^8 150493.59

So, you will make it easily.

What is the minimum rate ?

The minimum rate is the unknown r in the following:

FV = $35000*(1+r)^8 = 80000
(1+r)^8 = $80000/35000
(1+r)^8 = 2.285714
(1+r) = (2.285714)^1/8
(1+r) = 1.108863
r = 10.89%

Here the minimum r is 10.89%

Now you can prove it by finding future value at 10.89%

FV = 35000*(1+.1089)^8 80021.58 (Approximately 80000)

Ross, 9th Edition, P - 135

You would like to retire in 50 years as a millionaire. If you have $10,000 today, what rate of
return do you need to earn to achieve your goal?

Solutions:
The future value is $1,000,000. The present value is $10,000, and there are 50 years until
payment. We need to calculate the unknown discount rate in the following:

10000*(1+R)^50 = 1000000
(1+r)^50 = 100
(1+r) = 100^(1/50)
1+r = 1.0964782
r = 9.65% Approximately

Spreadsheet application:

Present Value = 10000

Future Value = 1000000
Period = 50
Discount Rate = RATE (nper,pmt,pv
RATE = 9.65% =RATE(Q176,0,-Q174,Q175)

Notice that pmt is zero and that pv has a negative sign on it.

Ross, 9th Edition, P - 135

If you invest $25,000 at 12 percent per year, how long until you have $50,000?

Present Value = 25000

Future Value = 50000
Discount Rate = 0.12
Number of periods = NPER(rate,pmt,pv,fv)
Number of Periods = 6.12 =NPER(Q188,0,-Q186,Q187)
Notice that pmt is zero and that pv has a negative sign on it.
Also notice that rate is entered as a decimal, not a percentage.

---------------------------------------------------------------------------------------
 MRE PRESENT VALUE OF A SINGLE AMOUNT

Present value: The current dollar value of a future amount—the amount of m

und interest that would have to be invested today at a given interest rate over a specified
to equal the future amount.
y. The concept of
g example: Discounting cash flows: The process of finding present values; the inverse of
compounding interest.

This process is actually the inverse of compounding interest. Instead of

n interest. finding the future value of present dollars invested at a given rate, discountin
owing Equation determines the present value of a future amount, assuming an opportunity t
earn a certain return on the money. This annual rate of return is variously
referred to as the discount rate, required return, cost of capital, and opportu
108.00 cost.
116.64 Gitman, 13th Edition, Page - 168
125.97 Paul Shorter has an opportunity to receive $300 one year from now. If he ca
136.05 earn 6% on his investments in the normal course of events, what is the mo
he should pay now for this opportunity?

Present Value $300/(1+.06)^1 283.019

The Equation for Present Value

savings account The present value of a future amount can be found mathematically by solving
much money will be Equation for PV. In other words, the present value, PV, of some future
amount, FVn, to be received n periods from now, assuming an interest rate (or
opportunity cost) of r, is calculated as follows:

n we get following:

Example 02: Pam Valenti wishes to find the present value of $1,700 that she
receive 8 years from now. Pam’s opportunity cost is 8%.

Future Value = 1700

Time Period = 8 years
 Opportunity Cost = 8%

Present Value $1700/(1+.08)^8

The following time line shows this analysis.

fv(rate,nper,pmt,[pv],[type])

=FV(R45,R46,0,-R44,0)

Spreadsheet Application:

an investment for Future Value 1700

pounding . Compounding Interest Rate (Compounded Annually 8%
ompound interest . Number of Years 8 PV(rate,nper,pmt,[fv
ed each period only Present Value $918.46 =-PV(AC53,AC54,0,1

The minus sign appears before PV to ch

the present value to a positive amount.
nvestment that pays 14
end of the two years? Ross, 9th Edition, P - 128
Suppose you need $400 to buy textbooks next year. You can earn 7 percent
money. How much do you have to put up today?

Solution:

Present Value $400/(1+.07)^1 373.832

Thus, $373.83 is the present value. Again, this just means that investing this
one year at 7 percent will give you a future value of $400.

Ross, 9th Edition, P - 128

You would like to buy a new automobile. You have $50,000 or so, but the ca
If you can earn 9 percent, how much do you have to invest today to buy the
ounds good to you, years? Do you have enough? Assume the price will stay the same.
will you have in
e earned? How Solutions:
Present Value $68,500 / (1+.09)^2 57655

Currently you have $50000 but you need $57655.1.

So, still you have $7,655 short (5765.1 - 50000).

--------------------------------------------------------------------------

at a 6 percent interest
e interest and compound

ally starts to add

sider the case of Peter

n Island for about
gotten the better
d invested the $24

will grow by
ould buy the
o, and the rest of

. You believe the dividend

vidend be in eight years?

college in eight years.

you make it? At what

ars will be:

Given
(Approximately 80000)

today, what rate of

are 50 years until

RATE (nper,pmt,pv,fv)
74,Q175)

NPER(rate,pmt,pv,fv)
------------
 MRE ANNUITIES AND TYPES OF ANNUITIES

ount—the amount of money Annuity : A stream of equal periodic cash flows over a specified time p
st rate over a specified period cash flows can be inflows of returns earned on investments or outflow
invested to earn future returns.

values; the inverse of Ordinary annuity : An annuity for which the cash flow occurs at the en

Annuity due : An annuity for which the cash flow occurs at the beginni
erest. Instead of
given rate, discounting Comparison of Ordinary Annuity and Annuity
ming an opportunity to Due Cash Flows ($1,000, 5 Years)
f return is variously
f capital, and opportunity Annual cash flows
Year Annuity A (ordinary)
0 0.00
ear from now. If he can 1 1000
ents, what is the most 2 1000
3 1000
4 1000
5 1000

Totals 5000.00

matically by solving Although the cash flows of both annuities total $5,000, the annuity due
some future a higher future value than the ordinary annuity because each of its five
an interest rate (or flows can earn interest for 1 year more than each of the ordinary annu

FINDING THE FUTURE VALUE OF AN ORDINARY ANNUITY

One way to find the future value of an ordinary annuity is to calculate

lue of $1,700 that she will value of each of the individual cash flows and then add up those figure

Formula:
 In this equation r represents the interest rate, and n represents the nu
918.4571 in the annuity and CF represents the cash flow for the period

Analysis:
This situation is depicted on the following time line:

PV(rate,nper,pmt,[fv],[type])
=-PV(AC53,AC54,0,1700,0)

pears before PV to change

to a positive amount.
Gitman, 13th Edition, P - 172
As the figure shows, at the end of year 5, Fran will have $5,750.74 in
ou can earn 7 percent on your that because the deposits are made at the end of the year the first dep
interest for 4 years, the second for 3 years, and so on.

Plugging the relevant values into Equation above we have

ans that investing this amount for

Spreadsheet Use: To calculate the future value of an annuity in Excel,
the same future value function that we used to calculate the future val
lump sum, but we will add two new input values. Recall that the future
0,000 or so, but the car costs $68,500. function’s syntax is FV(rate,nper,pmt,pv,type). We have already explai
nvest today to buy the car in two terms rate, nper, and pv in this function. The term pmt refers to the an
y the same. that the annuity offers. The term type is an input that lets Excel know
whether the annuity being valued is an ordinary annuity (in which case
 value for type is 0 or omitted) or an annuity due (in which case the cor
value for type is 1). In this particular problem, the input value for pv is
because there is no up-front money received. The only cash flows are
are part of the annuity stream. The future value of the ordinary annuit
calculated as shown on the following Excel spreadsheet.

----------------- FUTURE VALUE OF AN ORDINARY ANNUITY

Annual Payment
Annual Rate of Interest, Compounded Annually
Number of years
Future value of an ordinary annuity

The minus sign appears before AO84 because

the annual payment is a cash outflow.

FINDING THE FUTURE VALUE OF AN ANNUITY DUE

We now turn our attention to annuities due. Remember that the

annuity due occur at the start of the period. In other words, if we
annual payments, each payment in an annuity due comes one ye
would in an ordinary annuity. This in turn means that each paym
extra year’s worth of interest, which is why the future value of an
exceeds the future value of an otherwise identical ordinary annui

FORMULA

The two equations are nearly identical, but for annuity due you just ne
at the end. This makes sense, because all the payments in the annuit
year’s worth of interest compared to the ordinary annuity.
Annuity due value = Ordinary annuity value x (+

Gitman, 13th Edition, P - 172

Fran Abrams wishes to determine how much money she will have at th
years if she chooses annuity B, the annuity due . She will deposit $1,00
at the beginning of each years for 5 years, into a savings account payi

1000 1000 1000 1000 1000

0 1 2 3 4
End of Year

= 6153.29

Spreadsheet Use The future value of the annuity due also can be calcu
as shown on the following Excel spreadsheet. Remember that for an an
due the type input value must be set to 1, and we must also specify th
value as 0 since the inputs are in an ordered series.

FUTURE VALUE OF AN ORDINARY ANNUITY

Annual Payment
Annual Rate of Interest, Compounded Annually
Number of years
Future value of an ordinary annuity

The minus sign appears before AO118 because

the annual payment is a cash outflow.
Comparison of an Annuity Due with an Ordinary Annuity Future Value
The future value of an annuity due is always greater than the future va
otherwise identical ordinary annuity. We can see this by comparing the
values at the end of year 5 of Fran Abrams’s two annuities:

Ordinary annuity $5,750.74 versus Annuity due $6,153.29

Because the cash flow of the annuity due occurs at the beginning of th
rather than at the end (that is, each payment comes one year sooner i
annuity due), its future value is greater.

Ross, 9th Edition, P - 181

Calculating Annuity Future Values: You are planning to make mon

deposits of $300 into a retirement account that pays 10 percent intere
compounded monthly. If your first deposit will be made one month fro
large will your retirement account be in 30 years?

Solutions:
This is a future value ordinary annuity problem, hence we can apply fo

FV (Ordinary annuity ) = CF x {[(1+r)^t - 1]/r}

= 678146.38

Note: We need to match our interest payments with the time pe

PRESENT VALUE OF AN ORDINARY ANNUITY

Quite often in finance, there is a need to find the present value of a str
cash flows to be received in future periods. One approach would be to
the present value of each cash flow in the annuity and then add up tho
values. Alternatively, the algebraic shortcut for finding the present valu
annuity
Algebraic shortcut:

Gitman, 13th Edition, P - 174

Braden Company, a small producer of plastic toys, wants to determine
should pay to purchase a particular ordinary annuity. The annuity cons
cash flows of $700 at the end of each year for 5 years. The firm requir
annuity to provide a minimum return of 8%.

This situation is depicted on the following time line:

Here what we are doing is, we are trying to simply calculate cash pay
the present value equation

We can apply the formula above to calculate the present value of all th

= (700/.08) x [ 1- (1/(1+.08)^

= 2794.90
Spreadsheet Use: The present value of the ordinary annuity also can b
calculated using excel

Annual Payment $700

Annual Rate of Interest 8%
Number of years 5

Present value (ordinary Annuity) $2,794.90

Syntex: = PV(rate,nper,pmt,fv,

The minus sign appears before pmt because

the annual payment is a cash outflow.

FINDING THE PRESENT VALUE OF AN ANNUITY

We can also find the present value of an annuity due. This calculation
easily performed by adjusting the ordinary annuity calculation. Because
flows of an annuity due occur at the beginning rather than the end of t
to find their present value, each annuity due cash flow is discounted ba
year than for an ordinary annuity. The algebraic formula for the presen
an annuity due looks like this:

The two equations are identical except that Equation for annuity due h
the end, (1+r) . In the annuity due, each payment arrives one year ea
the annuity),so each payment is worth a little more—one year’s intere

Time Line depiction of all the payments:

 700.00
648.15
600.14
555.68
514.52
3018.49
Present Value

Algebric Solutions:

= (700/.08)x[1-1/(1+08)^5] x

= 3018.49

How Much Can You Afford?

After carefully going over your budget, you have determined you can a
month toward a new sports car. You call up your local bank and find o
is 1 percent per month for 48 months. How much can you borrow?

To determine how much you can borrow, we need to calculate the pre
per month for 48 months at 1 percent per month. The loan payments
form and hence we need to apply following formula:

Whart is given
Monthly payment 632
Monthly Interest 0.01
Monthly compounding
 = (632/.01)x [ 1- (1/(1+.01)^4

= 24000

Therefore, $24,000 is what you can afford to borrow

Finding the Payment: Suppose you wish to start up a new business

latest of health food trends, frozen yak milk. To produce and market y
Doodle Dandy, you need to borrow $100,000. Because it strikes you as
this particular fad will be long-lived, you propose to pay off the loan qu
five equal annual payments. If the interest rate is 18 percent, what wil

Available Information:
Present Value 100000
No of periods 5
Interest Rate 0.18
Annual Compounding
Ordinary annuity

100000 = (CF/.18)x [ 1- (1/(1+.18)^5]

CF = 32000

Therefore, you’ll make five payments of just under $32,000 e

Excel Spreadsheet :
 CF / PMT= -$31,977.78

Finding the Number of Payments

You ran a little short on your spring break vacation, so you put $1,000 on you
You can afford only the minimum payment of $20 per month. The interest ra
card is 1.5 percent per month. How long will you need to pay off the $1,000?

Available Information:
Present Value 1000
Interest Rate 0.015
Payment per month $20
No of periods (t ) ?
Ordinary annuity

1000 = ($20/.015)x [ 1- (1/(1+.015)^

t = 93.11

Excel Spreadsheet :

No of periods $93.11

It will take you about 93.11/12 = 7.75 years to pay off the $1
 MRE MIXED STREAM:

er a specified time period. These Two basic types of cash flow streams are possible, the ann
vestments or outflows of funds stream. Whereas an annuity is a pattern of equal periodic c
stream is a stream of unequal periodic cash flows that refle

low occurs at the end of each period. FUTURE VALUE OF A MIXED STREAM
Determining the future value of a mixed stream of cash flo
occurs at the beginning of each period. We determine the future value of each cash flow at the spe
then add all the individual future values to find the total fu
ty and Annuity Gitman, 13th edition, P - 179
Shrell Industries, a cabinet manufacturer, expects to receiv
stream of cash flows over the next 5 years from one of its
sh flows End of year Cash Flow
Annuity B (annuity due) 1 $11,500
$1,000 2 14000
1000 3 12900
1000 4 16000
1000 5 18000
1000 If Shrell expects to earn 8% on its investments, how much
0.00 the end of year 5 if it immediately invests these cash flows

5000.00
This situation is depicted on the following time line:
,000, the annuity due would have
cause each of its five annual cash
of the ordinary annuity’s cash flows.

INARY ANNUITY

nnuity is to calculate the future

n add up those figures.
Spreadsheet Use: A relatively simple way to use Excel to
value of a mixed stream is to use the Excel future value (F
on page 167 combined with the net present value (NPV) fu
discussed on page 181). The trick is to use the NPV functio
 present value of the mixed stream and then find the future
d n represents the number of payments amount. The following Excel spreadsheet illustrates this ap
the period
End of year Cash Flow
1 $11,500
2 14000
3 12900
4 16000
5 18000
Total Future Value

Future vaue

Exercise
If you deposit $100 in one year, $200 in two years, and $3
you have in three years? How much of this is interest? How
if you don’t add additional amounts? Assume a 7 percent in

Correct Answer: Future Value in three years

Total Interest
ll have $5,750.74 in her account. Note Future Value in Five years
the year the first deposit will earn
PRESENT VALUE OF A MIXED STREAM
We determine the present value of each future amount and
present values together to find the total present value.
Gitman, 13th Edition, P - 180
Frey Company, a shoe manufacturer, has been offered an
the following mixed stream of cash flows over the next 5 y
End of Year Cash Flow
an annuity in Excel, we will use 1 400
lculate the future value of a 2 800
Recall that the future value 3 500
e have already explained the 4 400
m pmt refers to the annual payment 5 300
that lets Excel know If the firm must earn at least 9% on its investments, what
nnuity (in which case the input pay for this opportunity?
in which case the correct input
input value for pv is 0 or omitted This situation is depicted on the following time line:
only cash flows are those that
f the ordinary annuity can be

$1,000
0.07
5
$5,750.74
Spreadsheet Use To calculate the present value of a mixed
will make use of a new function. The syntax of that functio
FV(rate,nper,pmt,pv,type) value2,value3, . . .). The rate argument is the interest rate
=FV(AO85,AO86,-AO84,0,0) value2,value3, . . . represent the stream of cash flows. The
assumes that the first payment in the stream arrives one y
subsequent payments arrive at one-year intervals. The pre
stream of future cash flows can be calculated as shown on
emember that the cash flows of an spreadsheet:
n other words, if we are dealing with
due comes one year earlier than it End of Year Cash Flow
ans that each payment can earn an 1 400
e future value of an annuity due 2 800
tical ordinary annuity. 3 500
4 400
5 300
Total Present Value

Alternative approach

Ross, 9th Edition, P - 180

nuity due you just need to multiply (1+r ) You are offered an investment that will pay you $200 in one year, $40
yments in the annuity due earn one more the next year, and $800 at the end of the fourth year. You can earn 12
investments. What is the most you should pay for this one?
nuity value x (+ r)
Correct Answer: Total Present Value
ey she will have at the end of 5 …………………………………………………………………………………………
She will deposit $1,000 annually,
savings account paying 7% annual interest.

1402.55
1310.80
1225.04
1144.90
1070.00
6153.29

x (1+r)

due also can be calculated

member that for an annuity
must also specify the pv input

$1,000
7%
5
$6,153.29

FV(rate,nper,pmt,pv,type)
=FV(AO144,AO145,-AO143,0,1)
 nnuity Future Value
ter than the future value of an
his by comparing the future

e $6,153.29

at the beginning of the period

mes one year sooner in the

lanning to make monthly

ays 10 percent interest
made one month from now, how

hence we can apply following formulas:

x {[(1+r)^t - 1]/r}

ts with the time period.

NNUITY

present value of a stream of

pproach would be to calculate
and then add up those present
ding the present value of an ordinary
 wants to determine the most it
ity. The annuity consists of
ears. The firm requires the

y calculate cash payments using

present value of all the annuities

[ 1- (1/(1+.08)^5]
ry annuity also can be

V(rate,nper,pmt,fv,type)

F AN ANNUITY DUE

due. This calculation can be

y calculation. Because the cash
her than the end of the period,
flow is discounted back one less
ormula for the present value of

on for annuity due has an extra term at

t arrives one year earlier (compared to
re—one year’s interest more.
1/(1+08)^5] x (1+.08)

determined you can afford to pay $632 per

ocal bank and find out that the going rate
can you borrow?

d to calculate the present value of $632

The loan payments are in ordinary annuity

This two needs to agree

in-terms of time
1- (1/(1+.01)^48]

n afford to borrow and repay.

rt up a new business that specializes in the

roduce and market your product, the Yakkee
ause it strikes you as unlikely that
o pay off the loan quickly by making
18 percent, what will the payment be?

(1/(1+.18)^5]

st under $32,000 each.

 PMT(RATE,NPER,PV,FV,TYPE)

you put $1,000 on your credit card.

month. The interest rate on the credit
to pay off the $1,000?

1- (1/(1+.015)^t]

NPER(RATE,PMT,PV,FV,TYPE)

ears to pay off the $1,000 at this rate.

 MRE COMPOUNDING AND AND EFFECTI
Interest is often compounded more freque
streams are possible, the annuity and the mixed compound interest semiannually, quarterly
s a pattern of equal periodic cash flows, a mixed continuously.
periodic cash flows that reflect no particular pattern.
SEMIANNUAL COMPOUNDING
D STREAM Semiannual compounding of interest involv
of a mixed stream of cash flows is straightforward. the year. Instead of the stated interest rate
e of each cash flow at the specified future date and stated interest rate is paid twice a year.
ure values to find the total future value.
Future Value from Investing $100 at 8
anufacturer, expects to receive the following mixed Semiannually over 24 Months (2 Year
next 5 years from one of its small customers. Period Beginning Principl
Cash Flow 6 Months $100.00
12 Months $104.00
18 Months $108.16
24 Months $112.49

Fred Moreno has decided to invest $100 in

n its investments, how much will it accumulate by paying 8% interest compounded semiannu
tely invests these cash flows when they are received? money in the account for 24 months (2 yea

over four periods, each of which is 6 mont

he following time line: at the end of 12 months (1 year) with 8%
have $108.16; at the end of 24 months (2

A GENERAL EQUATION FOR COMPOUN

FREQUENTLY THAN ANNUALLY
The future value formula can be rewritten
takes place more frequently. If m equals th
interest is compounded, the formula for th

ly simple way to use Excel to calculate the future

use the Excel future value (FV) function discussed The preceding examples calculated the am
he net present value (NPV) function (which will be Moreno would have at the end of 2 years i
rick is to use the NPV function to first find the at 8% interest compounded semiannually a
eam and then find the future of this present value compounding, m would equal 2 ; for quart
preadsheet illustrates this approach: m would equal 4. Substituting the appropr
and quarterly compounding into Equation ,
Cash Flow Future Value
15645.62304
17635.968
15046.56
17280
18000
ure Value 83608.151
CONTINUOUS COMPOUNDING
Future vaue $83,608.15 Continuous compounding involves compou
=-FV(0.08,5,0,NPV(0.08,AW42:AW46),0) period imaginable.

ar, $200 in two years, and $300 in three years, how much will
much of this is interest? How much will you have in fi ve years Gitman, 13th Edition, P - 185
ounts? Assume a 7 percent interest rate throughout. To find the value at the end of 2 years (n = 2 )
in an account paying 8% annual interest (r = .

ue in three years 628.49

28.49
ue in Five years 719.56

ED STREAM
ue of each future amount and then add all the individual NOMINAL AND EFFECTIVE ANNUA
d the total present value.
The nominal, or stated, annual rate is t
acturer, has been offered an opportunity to receive by a lender or promised by a borrower.
cash flows over the next 5 years: annual rate of interest actually paid or
Cash Flow

Gitman, 13th Edition, P - 185

Fred Moreno wishes to find the eff
nominal annual rate (r = .08) wh
9% on its investments, what is the most it should = 1) ; (2) semiannually (m = 2)
.
he following time line:

These values demonstrate two impo

the present value of a mixed stream in Excel, we effective annual rates are equivalent
on. The syntax of that function is NPV(rate,value1, the effective annual rate increases w
argument is the interest rate, and value1, a limit that occurs with continuous c
he stream of cash flows. The NPV function
t in the stream arrives one year in the future, and all ………………………………………
t one-year intervals. The present value of the mixed
n be calculated as shown on the following Excel

Cash Flow Present Value

366.97
673.34
386.09
283.37
194.98
sent Value 1904.76

ve approach $1,904.76

will pay you $200 in one year, $400 the next year, $600
of the fourth year. You can earn 12 percent on very similar
should pay for this one?

$1,432.93
…………………………………………………………………………………….
G AND AND EFFECTIVE ANNUAL RATE: MRE SPECIAL APPLICATION IN T
mpounded more frequently than once a year. Savings institutions
semiannually, quarterly, monthly, weekly, daily, or even L
The term loan amortization refe
payments. These payments pro
OMPOUNDING repay the loan principal over a
unding of interest involves two compounding periods within involves finding the future paym
f the stated interest rate being paid once a year, one-half of the value at the loan interest rate e
is paid twice a year. Lenders use a loan amortization
and the allocation of each paym
m Investing $100 at 8% Interest Compounded
er 24 Months (2 Years)
Beginning PrinciplFuture Value Calculation Future Value
100*(1+.04) $ 104.00
104.00*(1.04) $ 108.16
108.16*(1.04) $ 112.49 Loan Amount
112.49*(1.04) $ 116.99 Interest
Term
ecided to invest $100 in a savings account
compounded semiannually. If he leaves his Loan Amortiza
unt for 24 months (2 years), he will be paid 4% interest compounded

each of which is 6 months long. Table 5.3 shows that

onths (1 year) with 8% semiannual compounding, Fred will End of Beginning
he end of 24 months (2 years), he will have $116.99. Year Balance

ATION FOR COMPOUNDING MORE 0 n/a

AN ANNUALLY 1 $6,000
rmula can be rewritten for use when compounding 2 $4,707
requently. If m equals the number of times per year 3 $3,285
nded, the formula for the future value of a lump sum becomes 4 $1,721
n = No of Years
m = Number of compounding
FINDING THE PRESENT VAL
mples calculated the amount that Fred
e at the end of 2 years if he deposited $100 A perpetuity is an annuity with
pounded semiannually and compounded quarterly. For semiannual never stops providing its holde
 ould equal 2 ; for quarterly compounding, example, the right to receive $
Substituting the appropriate values for semiannual It is sometimes necessary to fin
pounding into Equation , we find that the calculation for the present
finance. If a perpetuity pays an
now, the present value of the c

Ross Clark wishes to endow a c

indicated that it requires $200,
endowment would earn 10% p
MPOUNDING university to fund the chair, we
unding involves compounding over every nanosecond—the smallest time perpetuity discounted at 10%.

We can determine that the pre

$200,000 per year is $2 million

PV
he end of 2 years (n = 2 ) of Fred Moreno’s $100 deposit (PV = $100)
8% annual interest (r = .08) compounded continuously To generate $200,000 every ye
$2,000,000 today if Ross Clark’
the university earns 10% intere
$200,000 per year indefinitely.

Exercise:
For example, an investment off
EFFECTIVE ANNUAL RATES OF INTEREST you require on such an investm

tated, annual rate is the contractual annual rate of interest charged Value of perpetuity
omised by a borrower. The effective, or true, annual rate (EAR) is the
terest actually paid or earned.
Amortization Schedule Prac
Loan Amount
Interest
dition, P - 185 Nember of Period
ishes to find the effective annual rate associated with an 8%
rate (r = .08) when interest is compounded (1) annually (m Beginning
iannually (m = 2) ; and (3) quarterly (m = 4) Year Balance
0 n/a
 1 $5,000
2 $4,165
3 $3,254
4 $2,261
5 $1,179

Suppose you borrow $10,00

annual payments for five ye
Prepare an amortization sch
the life of the loan?

monstrate two important points: The first is that nominal and Loan Amount
rates are equivalent for annual compounding. The second is that Interest
nual rate increases with increasing compounding frequency, up to Nember of Period
rs with continuous compounding
Beginning
…………………………………………………………………………………………………. Year Balance
0 n/a
1 $10,000
2 $8,487
3 $6,763
4 $4,796
5 $2,555
 L APPLICATION IN TIME VALUE OF MONEY MRE

LOAN AMORTIZATION
m loan amortization refers to the determination of equal periodic loan
s. These payments provide a lender with a specified interest return and
e loan principal over a specified period. The loan amortization process
finding the future payments, over the term of the loan, whose present
the loan interest rate equals the amount of initial principal borrowed.
use a loan amortization schedule to determine these payment amounts
allocation of each payment to interest and principal.

$6,000
10% Payment = $1,892.82
4 Years

Loan Amortization Schedule ($6000 Principle, 10% Interest,

4 - Year Repayment Period

Beginning Loan Payments Ending

Balance Payment Interest Principle Balance

n/a n/a n/a n/a $6,000

$6,000 $1,892.82 $600.00 $1,292.82 $4,707.18
$4,707 $1,892.82 $470.72 $1,422.11 $3,285.07
$3,285 $1,892.82 $328.51 $1,564.32 $1,720.75
$1,721 $1,892.82 $172.07 $1,720.75 $0.00

G THE PRESENT VALUE OF A PERPETUITY

uity is an annuity with an infinite life—in other words, an annuity that

ops providing its holder with a cash flow at the end of each year (for
, the right to receive $500 at the end of each year forever).
etimes necessary to find the present value of a perpetuity. Fortunately,
lation for the present value of a perpetuity is one of the easiest in all of
If a perpetuity pays an annual cash flow of CF, starting one year from
present value of the cash flow stream is

rk wishes to endow a chair in finance at his alma mater. The university

that it requires $200,000 per year to support the chair, and the
ent would earn 10% per year. To determine the amount Ross must give the
y to fund the chair, we must determine the present value of a $200,000
y discounted at 10%.

determine that the present value of a perpetuity paying

0 per year is $2 million when the interest rate is 10%:

=200000/.10 2000000

ate $200,000 every year for an indefinite period requires

00 today if Ross Clark’s alma mater can earn 10% on its investments. If
ersity earns 10% interest annually on the $2,000,000, it can withdraw
0 per year indefinitely.

mple, an investment offers a perpetual cash fl ow of $500 every year. The return
ire on such an investment is 8 percent. What is the value of this investment?

perpetuity = $6,250

ation Schedule Practice Exercise:

$5,000 Payment = $1,285.46
9%
of Period 5 Years

Beginning Total Interest Principal Ending

Payment Paid Paid Balance
n/a n/a n/a $5,000
 $1,285.46 $450.00 $835.46 $4,164.54
$1,285.46 $374.81 $910.65 $3,253.88
$1,285.46 $292.85 $992.61 $2,261.27
$1,285.46 $203.51 $1,081.95 $1,179.32
$1,285.46 $106.14 $1,179.32 $0.00

e you borrow $10,000. You are going to repay the loan by making equal
payments for five years. The interest rate on the loan is 14 percent per year.
an amortization schedule for the loan. How much interest will you pay over
of the loan?

$10,000 Payment = $2,912.84

14%
of Period 5 Years

Beginning Total Interest Principal Ending

Payment Paid Paid Balance
n/a n/a n/a $10,000
2912.8355 $1,400.00 $1,512.84 $8,487.16
2912.8355 $1,188.20 $1,724.63 $6,762.53
2912.8355 $946.75 $1,966.08 $4,796.45
2912.8355 $671.50 $2,241.33 $2,555.12
2912.8355 $357.72 $2,555.12 $0.00

………………………………………………………………………………………………….
Simple Interest versus Compound Interest: First City Bank pays 8 percent
simple interest on its savings account balances, whereas Second City Bank pays
8 percent interest compounded annually. If you made a $5,000 deposit in each
bank, how much more money would you earn from your Second City Bank account
at the end of 10 years?

1. The simple interest per year is:

$5,000 × .08 = $400
So after 10 years you will have:
$400 × 10 = $4,000 in interest.
The total balance will be $5,000 + 4,000 = $9,000
With compound interest we use the future value formula:
FV = PV(1 +r)^t
FV = $5,000(1.08)^10 = $10,794.62
The difference is:
$10,794.62 – 9,000 = $1,794.62

Calculating Future Values: For each of the following, compute the future value:

Present Value Years Interest Rate Future Value

2250 11 10% ?
8752 7 8 ?
76355 14 17 ?
183796 8 7 ?

To find the FV of a lump sum, we use:

FV = PV(1 + r)^t
FV = $2,250(1.10)^11 = $ 6,419.51
FV = $8,752(1.08)^7 = $ 14,999.39
FV = $76,355(1.17)^14 = $687,764.17
FV = $183,796(1.07)^8 = $315,795.75
Calculating Present Values : Suppose you are still committed to owning a
$170,000 Ferrari. If you believe your mutual fund can achieve a
12 percent annual rate of return and you want to buy the car in 9 years on the day
you turn 30, how much must you invest today?

Answer:
To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $170,000 / (1.12)9 = $61,303.70

Calculating Future Values: You have just made your fi rst $4,000
contribution to your retirement account. Assuming you earn an 11 percent rate of
return and make no additional contributions, what will your account be worth when
you retire in 45 years? What if you wait 10 years before contributing? (Does this
suggest an investment strategy?)

To find the FV of a lump sum, we use:

FV = PV(1 + r)^t
FV = $4,000(1.11)^45 = $438,120.97
FV = $4,000(1.11)^35 = $154,299.40
Better start early!

Calculating Future Values: You are scheduled to receive $20,000 in two

years. When you receive it, you will invest it for six more years at 8.4 percent per
year. How much will you have in eight years?

We need to find the FV of a lump sum. However, the money will only be invested
for six years, so the number of periods is six.
FV = PV(1 + r)t
FV = $20,000(1.084)6 = $32,449.33
Calculating the Number of Periods: You expect to receive $10,000 at
graduation in two years. You plan on investing it at 11 percent until you have
$75,000. How long will you wait from now?

To answer this question, we can use either the FV or the PV formula. Both will
give the same answer since they are the inverse of each other. We will use the
FV formula, that is: FV = PV(1 + r)^t
Solving for t, we get:
t = ln(FV / PV) / ln(1 + r)
t = ln($75,000 / $10,000) / ln(1.11) = 19.31
So, the money must be invested for 19.31 years. However, you will not receive the
another two years. From now, you’ll wait:
2 years + 19.31 years = 21.31 years

Future Value with Multiple Cash Flows: You plan to make a series of deposits
an individual retirement account. You will deposit $1,000 today, $2,000 in two
years, and $2,000 in fi ve years. If you withdraw $1,500 in three years and $1,000
seven years, assuming no withdrawal penalties, how much will you have after eigh
years if the interest rate is 7 percent? What is the present value of these cash fl ow
Annuity Present Value: You are looking into an investment that will pay you
$12,000 per year for the next 10 years. If you require a 15 percent return, what is
the most you would pay for this investment?

The most you would be willing to pay is the present value of $12,000 per year for
10 years at a 15 percent discount rate. The cash fl ows here are in ordinary annuity
form, so the relevant present value factor is:

APR versus EAR: The going rate on student loans is quoted as 8 percent APR. Th
terms of the loans call for monthly payments. What is the effective annual rate
(EAR) on such a student loan?

A rate of 8 percent APR with monthly payments is actually 8%_x0002_12 _x0003_

month. The EAR is thus:
EAR = [1 + (.08/12)]^12 - 1 = 8.30%

Calculating Annuity Present Value: An investment offers $5,300 per year

for 15 years, with the fi rst payment occurring one year from now. If the required
return is 7 percent, what is the value of the investment? What would the value be i
the payments occurred for 40 years? For 75 years? Forever?

To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)]t } / r )
PVA@15 yrs: PVA = $5,300{[1 – (1/1.07)15 ] / .07} = $48,271.94
PVA@40 yrs: PVA = $5,300{[1 – (1/1.07)40 ] / .07} = $70,658.06
PVA@75 yrs: PVA = $5,300{[1 – (1/1.07)75 ] / .07} = $75,240.70
To find the PV of a perpetuity, we use the equation:
PV = C / r
PV = $5,300 / .07 = $75,714.29
Notice that as the length of the annuity payments increases, the present value of th
present value of the perpetuity. The present value of the 75 year annuity and the p
perpetuity imply that the value today of all perpetuity payments beyond 75 years is

Calculating Annuity Cash Flows : If you put up $34,000 today in exchange

for a 7.65 percent, 15-year annuity, what will the annual cash fl ow be?

Here we have the PVA, the length of the annuity, and the interest rate. We want to
payment. Using the PVA equation:
PVA = C({1 – [1/(1 + r)]t } / r )
PVA = $34,000 = $C{[1 – (1/1.0765)15 ] / .0765}
We can now solve this equation for the annuity payment. Doing so, we get:
C = $34,000 / 8.74548 = $3,887.72

Calculating Annuity Values: If you deposit $4,000 at the end of each of the
next 20 years into an account paying 11.2 percent interest, how much money will
you have in the account in 20 years? How much will you have if you make deposits
for 40 years?

Here we need to find the FVA. The equation to find the FVA is:
FVA = C{[(1 + r)t – 1] / r}
FVA for 20 years = $4,000[(1.11220 – 1) / .112] = $262,781.16
FVA for 40 years = $4,000[(1.11240 – 1) / .112] = $2,459,072.63
Notice that because of exponential growth, doubling the number of periods does no
merely double the FVA.

Calculating Perpetuity Values: The Maybe Pay Life Insurance Co. is

trying to sell you an investment policy that will pay you and your heirs $25,000 per
year forever. If the required return on this investment is 7.2 percent, how much wi
you pay for the policy?

This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:
PV = C / r
PV = $25,000 / .072 = $347,222.22
Calculating EAR: First National Bank charges 14.2 percent compounded
monthly on its business loans. First United Bank charges 14.5 percent compounded
semiannually. As a potential borrower, which bank would you go to for a new
loan?

For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1
So, for each bank, the EAR is:
First National: EAR = [1 + (.1420 / 12)]12 – 1 = .1516 or 15.16%
First United: EAR = [1 + (.1450 / 2)]2 – 1 = .1503 or 15.03%
Notice that the higher APR does not necessarily mean the higher EAR.
The number of compounding periods within a year will also affect the EAR.

EAR versus APR: Big Dom’s Pawn Shop charges an interest rate of 30 percent
per month on loans to its customers. Like all lenders, Big Dom must report an APR
consumers. What rate should the shop report? What is the effective annual rate?

The APR is simply the interest rate per period times the number of periods in a yea
interest rate is 30 percent per month, and there are 12 months in a year, so we ge
APR = 12(30%) = 360%
To find the EAR, we use the EAR formula:
EAR = [1 + (APR / m)]m – 1
EAR = (1 + .30)12 – 1 = 2,229.81%
Notice that we didn’t need to divide the APR by the number of compounding period
division to get the interest rate per period, but in this problem we are already given
period.

Calculating Loan Payments: You want to buy a new sports coupe for
$68,500, and the fi nance offi ce at the dealership has quoted you a 6.9 percent AP
loan for 60 months to buy the car. What will your monthly payments be? What is
the effective annual rate on this loan?

We first need to find the annuity payment. We have the PVA, the length of the ann
rate. Using the PVA equation:
PVA = C({1 – [1/(1 + r)]t } / r)
$68,500 = $C[1 – {1 / [1 + (.069/12)]60} / (.069/12)]
Solving for the payment, we get:
C = $68,500 / 50.622252 = $1,353.15
To find the EAR, we use the EAR equation:
EAR = [1 + (APR / m)]m – 1
EAR = [1 + (.069 / 12)]12 – 1 = .0712 or 7.12%

Calculating Annuity Future Values : You are planning to make monthly

deposits of $300 into a retirement account that pays 10 percent interest
compounded monthly. If your fi rst deposit will be made one month from now, how
large will your retirement account be in 30 years?

This problem requires us to find the FVA. The equation to find the FVA is:
FVA = C{[(1 + r)t – 1] / r}
FVA = $300[{[1 + (.10/12) ]360 – 1} / (.10/12)] = $678,146.38

Calculating Annuity Present Values : Beginning three months from now,

you want to be able to withdraw $2,300 each quarter from your bank account to
cover college expenses over the next four years. If the account pays .65 percent
interest per quarter, how much do you need to have in your bank account today to
meet your expense needs over the next four years?

The cash flows are simply an annuity with four payments per year for four years, o
payments. We can use the PVA equation:
PVA = C({1 – [1/(1 + r)]t } / r)
PVA = $2,300{[1 – (1/1.0065)16] / .0065} = $34,843.71

-----------------------------------------------------------------------------------
 Bank pays 8 percent
econd City Bank pays
,000 deposit in each
econd City Bank account

mpute the future value:

Future Value
mitted to owning a

ar in 9 years on the day

st $4,000
n an 11 percent rate of
account be worth when
ntributing? (Does this

e $20,000 in two
ears at 8.4 percent per

y will only be invested

 ive $10,000 at
ent until you have

V formula. Both will

her. We will use the

you will not receive the money for

ake a series of deposits in

oday, $2,000 in two
three years and $1,000 in
will you have after eight
value of these cash fl ows?
ent that will pay you
percent return, what is

of $12,000 per year for

e are in ordinary annuity

ed as 8 percent APR. The

effective annual rate

8%_x0002_12 _x0003_ .67% per

,300 per year

m now. If the required
hat would the value be if
 s, the present value of the annuity approaches the
5 year annuity and the present value of the
ments beyond 75 years is only $473.59.

0 today in exchange
ash fl ow be?

nterest rate. We want to calculate the annuity

Doing so, we get:

e end of each of the

how much money will
ave if you make deposits

mber of periods does not

d your heirs $25,000 per

2 percent, how much will

y, we use the equation:

 t compounded
4.5 percent compounded
ou go to for a new

higher EAR.
affect the EAR.

rate of 30 percent
om must report an APR to
effective annual rate?

mber of periods in a year. In this case, the

nths in a year, so we get:

r of compounding periods per year. We do this

em we are already given the interest rate per

orts coupe for

ed you a 6.9 percent APR
payments be? What is

A, the length of the annuity, and the interest

 o make monthly
rcent interest
ne month from now, how

ind the FVA is:

months from now,

your bank account to
ount pays .65 percent
r bank account today to

er year for four years, or 16

---------------------