Explain the Following Concepts with Formulas:

1. Future value:
Definition:
Future value (terminal value) the value at some future time of a present amount of
money, or a series of payments, evaluated at a given interest rate.
Formula:
FV = PV (1 + r) n
Explanation:
Future value is the value of an asset at a specific date. It measures the nominal future sum
of money that a given sum of money is "worth" at a specified time in the future assuming a
certain interest rate, or more generally, rate of return; it is the present value multiplied by the
accumulation function. The value does not include corrections for inflation or other factors that
affect the true value of money in the future. This is used in time value of money calculations.
The time value of money tells us what the present value of an investment will grow to by
a given date. This is its future value. The difference between the present value and the future
value depends on how many compounding periods are involved in the investment, and on the
interest rate.

2. Present Value:
Definition:
The current value of a future amount of money, or a series of payments, evaluated at a
given interest rate.
Formula:
PV = FV / (1+r) n

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Explanation:
The current worth of a future sum of money or stream of cash flows given a specified rate
of return. Future cash flows are discounted at the discount rate, and the higher the discount rate,
the lower the present value of the future cash flows. Determining the appropriate discount rate is
the key to properly valuing future cash flows, whether they be earnings or obligations.
Also referred to as "discounted value".

Annuity and its Types:

Definition:
Annuity a series of equal payments or over a specified number of periods in an ordinary
annuity, payments or receipts occurs at the end of each period; in an annuity due, payments or
receipts occur at the beginning of each period.
There are two types of annuity:
Ordinary Annuity:
An ordinary annuity is a series of payments having the following three characteristics:

All payments are in the same amount (such as a series of payments of $1,000).
All payments are made at the same intervals of time (such as once a month or quarter,

over a period of a year).

All payments are made at the end of each period (such as payments being made only the
last day of the month).

Formulas:
Present value Annuity = PMT [((1 + r) n - 1) / r]
Future value Annuity = PMT [(1 + i) n - 1) / i]

P = The future value of the annuity stream to be paid in the future

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PMT = The amount of each annuity payment

r = The interest rate
n = The number of periods over which payments are made

Annuity Due:
An annuity due is a repeating payment that is made at the beginning of each period. It has the
following characteristics:

All payments are in the same amount (such as a series of payments of $500).

All payments are made at the same intervals of time (such as once a quarter or year).

All payments are made at the beginning of each period (such as payments being made
only on the first day of the month).

Formula:
Present value Annuity = Ordinary Annuity * (1 + i)
Future value Annuity = Ordinary Annuity * (1 + i)

Amortization:
Amortization is the process of decreasing or accounting for an amount, over a period. The
word comes from Middle English amortisen which means to kill. so an amortized loan is one
that is killed off over time.
Amortization of loans:
In lending, amortization is the distribution of payment into multiple cash flow
installments, as determined by an amortization schedule. Unlike other repayment models, each
repayment installment consists of both principal and interest. Amortization is chiefly used in loan
repayments (a common example being a mortgage loan) and in sinking funds. Payments are
divided into equal amounts for the duration of the loan, making it the simplest repayment model.
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A greater amount of the payment is applied to interest at the beginning of the amortization
schedule, while more money is applied to principal at the end.
Steps for Amortization:
Step 1: Find the required payments. (Annuity Formula)
Step 2: Find interest charge for Year 1.( Beginning balance * interest)
Step 3: Find repayment of principal in Year 1. (PMT Interest)
Step 4: Find ending balance after Year 1. (Beg. Balance Repayment)
Amortization Table:
Example:Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal
payments.

Nominal Interest:
The nominal interest rate is the rate of interest that is reported on loan documents and
investment accounts that are not adjusted for inflation. You should keep in mind, however, that a
sophisticated lender takes the expected rate of inflation into account when determining the
interest rate it will charge on a loan. Nevertheless, the expected inflation rate and the actual rate
of inflation usually is not the same.
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Following are the main characteristics of Nominal Rate:

Stated in contracts, and quoted by banks and brokers.

Not used in calculations or shown on time lines
Periods per year (M) must be given.
The interest rate before taking inflation into account.

Examples:

8%; Quarterly
8%, Daily interest (365 days)

Periodic Interest:
The rate of interest assessed on a loan or investment over a set time period when
compounding occurs more than once per year. It is used in calculations and is also shown on time
lines.
Formula:
Periodic rate = IPER = INOM/M
M = number of compounding periods per year
INOM = Nominal rate

Example:
8% quarterly: IPER = 8%/4 = 2%.
8% daily (365): IPER = 8%/365 = 0.021918%.

Case Study:
Assume that you are nearing graduation and that you have applied for a job with a local bank.
As part of the bank's evaluation process, you have been asked to take an examination which
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covers several financial analysis techniques. The first section of the test addresses discounted
cash flow analysis. See how you would do by answering the following questions.
A. Draw time lines for (a) a $100 lump sum cash flow at the end of year 2, (b) an
ordinary annuity of $100 per year for 3 years, and (c) an uneven cash flow stream of
-$50, $100, $75, and $50 at the end of years 0 through 3.
Solution:
Lump sum:0

|--------------|------------|
$100
Ordinary Annuity:0

|--------------|------------|-----------|
$100

$100

$100

Un-even cash flow stream:0

|--------------|------------|-----------|
$-50

$100

$75

$50

B. 1. What is the future value of an initial $100 after 3 years if it is invested in an

account paying 10 percent annual interest?
Solution:
PV=$100
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i = 10% = 0.1
n = 3 years
FV=

PV(1 + i)n

$100(1.10)3

$100(1.3310)

$133.10

The future value will be $133.10 if we invest $100 today.

2. What is the present value of $100 to be received in 3 years if the appropriate
interest rate is 10 percent?
Solution:
FV=$100
i = 10% = 0.1
n = 3 years

FVn
PV =

(1 i ) n
$100
(1 0.10) 3

$100
(1.331)

= $75.13

C. We sometimes need to find how long it will take a sum of money (or anything else) to
grow to some specified amount. For example, if a company's sales are growing at a
rate of 20 percent per year, how long will it take sales to double?
Solution:
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To solve this problem let us assume that our companys present sales are $2 and
we want to double it to $4.Our growing rate is 20%.
PV
= $2
FV
= $4
i
= 20% = 0.20
n
=?
So, by using formula of Future Value
FV= PV(1 + i)n
4

=2(1 + 0.20)n

4/2

= (1 + 0.20)n

= (1 + 0.20)n

Taking LOG on both sides,

Log 2 =nLog1.20
n

= Log 2/ Log1.20

= 0.3010/0.0791

= 3.8 Years

So, it would take a period of 3.8 years to double the sales.

D. If you want an investment to double in 3 years, what interest rate must it earn?
Solution:
To solve this problem let us assume that our investments present value is $2 and
we want to double it in 3 Years to $4.

PV
FV
n
i

= $2
= $4
= 3 years
=?

So, by using formula of Future Value

FV=
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PV(1 + i)n
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=2(1 + i)3

4/2

= (1+i)3

= (1+i)3

Taking cube root on both sides

(2)1/3

= (1+i) 3*1/3

(2)0.33 = 1+i
1.2570 = 1+i
1.2570-1 = i
i

= 25.70%

So, 25.70% approximate interest rate it must earn if want to double an investment in 3 years.
E. What is the difference between an ordinary annuity and an annuity due? What type
of annuity is shown below? How would you change it to the other type of annuity?
0

2
|

100

3
|

100

100

Solution:
The main difference between Ordinary Annuity and Annuity Due is that, Ordinary
Annuity has its payments at the end of each period while Annuity Due has its payment at the
beginning of the period.
Time line for other type of annuity:
0
|

2
|

100
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100
Page 9

3
|

100

F.1.What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest
rate is 10 percent?
Solution:
Pmt

= $100

= 3 year

= 10% = 0.1
FVA = Pmt [(1 + i) n - 1) / i]
= 100 [(1 + 0.1)3- 1) / 0.1]
= 100 [0.331 / 0.1]
= 100 [3.331]
= $331

The future value for 3 year annuity at 10% is $331.

2. What is the present value of the annuity?

PVA = Pmt [(1 + i)n-1/i(1 + i)n]
= 100 [(1 + 0.1)3-1/0.1(1 + 0.1)3]
= 100 [0.331 /0.1(1.331)]
= 100 [0.331 /0.1331]
= 100 [2.4869]
= $248.69

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3. What would the future and present values be if the annuity were an annuity due?
FVA (Annuity Due) = Future value Annuity * (1 + i)
= 331* (1 + 0.1)
= 331 * 1.10
= $364.1
PVA (Annuity Due) = Present value Annuity * (1 + i)
= 248.69 * (1 + 0.1)
= $273.559
G. What is the present value of the following uneven cash flow stream? The appropriate
interest rate is 10 percent, compounded annually.
0
|

2
|

100

3
|

300

4
|

300

-50

Solution:
PV = FV1/(1 + i)1 + FV2/(1 + i)2 + FV3/(1 + i)3 + FV4/(1 + i)4
= 100/(1 + 0.1)1 + 300/(1 + 0.1)2 + 300/(1 + 0.1)3 + (-50)/(1 + 0.1)4
= [100/1.1] + [300/1.21] + [300/1.331] + [-50/1.4641]
= 90.9091 + 247.9339 + 225.3944 + (-34.1507)
= $530.0867
H. Define the stated or Nominal rate as well as the Periodic Rate.

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Stated or Nominal Rate:

A rate of interest quoted for a year that has not been adjusted for frequency of
compounding. If interest is compounded more than once a year, the effective interest rate will be
higher than the nominal rate.
Periodic Rate:
The periodic rate is the rate charged by a lender or paid by a borrower each period.
Formula:
IPER = INOM/M
Where,
M = No. of compounding periods per year.
I

= Interest

I. Will the future value be larger or smaller if we compound an initial amount more often
than annually- for example, every 6 months, or semiannually, holding the stated interest
rate constant? Why?

Answer:
Yes! The future value be larger if we compound an initial amount more often than
annually because interest is charged more frequent and higher on the deposits than that of annual
deposits.
J. What is the future value of $100 after 5 years under 12 percent annual compounding?
Solution:
PV

=$100

=5 years

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=12% = 0.12
FV = PV(1 + i)n
= 100(1+ 0.12)5
= 100(1.7623)
= $176.23

K. What is the effective annual rate (EAR)? What is the EFF% for a nominal rate of 12
percent, compounded semiannually? Compounded quarterly? Compounded daily?
Solution:
Effective Annual Rate:
The rate that produces the same final result as compounding at the periodic rate for M
times per year. The EAR also called EFF%.

EAR = Effective Annual Rate =

i
1 Nom
m

IF iNom = 12% and interest is compounded semiannually, then:

EAR=

i
1 Nom
m

0.12
1

= (1 + 0.06)2 1
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= 1.1236 1
= 0.1236 * 100
= 12.36%
Quarterly:

EAR=

i
1 Nom
m

0.12

= (1.03)4 1
= 0.1255 * 100
= 12.55%
Daily:

EAR=

i
1 Nom
m

0.12
1

365

365

= (1.0003)365 1
= 0.1274 * 100
= 12.74%
I. Will the effective annual rate ever be equal to the nominal (quoted) rate?
Answer:
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If there will be an annual compounding than the effective annual rate ever be equal to the
nominal (quoted) rate.
J. Construct an amortization schedule for a $1000,000, 10 percent annual rate loan with 3
equal installments.
Solution:
PVA = Pmt [(1 + i)n-1/i(1 + i)n]
1000,000=Pmt[(1+0.1)3/0.1(1 + .1)3
1000,000=Pmt [2.4869]
Pmt

= $402,114

Amortization Table
Year

Beginning
Bal.
1000,000
697,886
365,560

1
2
3
Total

Pmt
402,114
402,114
402,114
1,206,342

Interest

Principal

Ending

100,000
69,788
36,556
206,334

Amount
302,114
332,325
365,560
1000,000

Bal.
697,886
365,560
0

N. During year 2, what is the annual interest expense for the borrower, and the annual
interest income for the lender?
Solution:
2nd year interest = i beginning balance
= 0.1 $697,886

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= $69,788

Same is the income for lender.

O. Suppose that on January 1 you deposit $100 in an account that pays a nominal interest
rate of 11.33463 percent, with interest added compounded daily. How much will you have
in your account on October 1, or after 9 months?
Solution:
PV

=$100

=11.33463% = 0.113346

= 9 * 30 = 270 Days
IPER = INOM/M
= 0.113346/365
= 0.0003105*100
= 0.03105%
FV =PV( 1+i )n
=100(1+ 0.0003105)270
=100(1.0874)
= $108.74

P. Suppose someone offered to sell you a note calling for the payment of $1,000 15 months
from today. They offer to sell it to you for $850. You have $850 in a bank time deposit that
pays a 6.76649 percent nominal rate with daily compounding, which is a 7 % effective
annual rate, and you plan to leave the money in the bank unless you buy the note. The note
is not risky--you are sure it will be paid on schedule. Should you buy the note? Check the
decision in three ways: (1) by comparing your future value if you buy the note versus

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leaving your money in the bank, (2) by comparing the PV of the note with your current
bank account, and (3) by comparing the EFF% on the note with that of the bank account.
Solution:
PV

=$850

= 7% = 0.07

=15/12 = 1.25 Years

FV =PV( 1+i )n
= $850(1+0.07)1.25
=850(1.088) =$925

I will go for the note as the deposit in the bank worth $925 after 15 month whiles the note calling
for payment of &1000 in 15 months.

PV =

FVn
(1 i ) n
1000
(1 0.07)1.25

= $918.90
As to buy the note the cost is $850 while to get $1000 in 15 months the present value is $918.90.
So, I will go for the note.

1
EFF% =
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1
=

0.0677

450

450

= (1.000150)450 - 1
= 7.8%.

The Effective Annual Rate for the investment in bank is 7% while that of note is 7.8%.Hence
note will be the better choice.

References:
http://www.financeformulas.net/Future_Value_of_Annuity.html
Read more: http://www.investopedia.com/terms/p/presentvalue.asp#ixzz3b4qchlKb
Follow us: @Investopedia on Twitter
http://study.com/academy/lesson/nominal-interest-rate-definition-equation-quiz.html
http://en.wikipedia.org/wiki/Time_value_of_money
http://www.accountingtools.com/questions-and-answers/what-is-an-annuity-due.html

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