Chapter 5

Time Value of
Money

Copyright 2012 Pearson Prentice Hall.

All rights reserved.

Time Value of Money

The principles and computations used

to revalue cash payoffs from different
times so they are stated in dollars of
the same time period.
Methods of calculation:
Formula
Table
Financial Calculator

Cash Flow Time Lines

Graphical representations used to show timing of cash
flows

PV = Present Value the beginning amount that

can be invested. PV also represents the current value
of some future amount.
FV = Future Value the value to which an amount
invested today will grow at the end of n periods.

Types of Cash Flow Patterns

Lump Sum Amount a single payment

(received or made) that occurs either today or
at some date in the future.
Annuity Multiple payments of the same
amount over equal time periods.
Ordinary Annuity CF occurs at end of period
Annuity Due CF occurs at beginning of period

Uneven Cash Flows or Mixed Stream Multiple

payments of different amounts over a period
of time.

Future Value Uses compounding to

determine value at end of projects
life

Compounding To compute the future value

of an amount we push forward the current
amount by adding interest for each period in
which the money can earn interest in the
future.
This is simply interest earning interest

Future Value of a Lump-Sum Amount

FV

= future value
PV = present value
r = interest rate or rate of return
n = number of time periods

Future Value of a Lump-Sum Amount

Want

to find future value of $700 invested for 3

years earning 10 percent per year.
Year 1 FV = $770
Year 2 FV = $847
Year 3 FV = $931.70
OR

FV

at end of Year 3 =

=
Notice how this matches the
formula used for the FV of a
Lump Sum in previous slide
7

Equation Solution

FV3

= $700(1.10)3
= $700(1.33100)
= $931.70
8

Time Value of Money Tables FV of Lump Sum

Future value interest factor of $1 per period at i% for n periods, FVIF(i,n).
Period

6%

7%

1.010

1%

1.020

2%

1.030

3%

1.040

4%

1.050

5%

1.060

1.070

1.080

8%

1.090

9%

1.100

10%

1.110

11%

1.120

12%

1.130

13%

1.140

14%

1.150

15%

1.160

16%

1.170

17%

1.180

1.190

1.200

1.020

1.040

1.061

1.082

1.103

1.124

1.145

1.166

1.188

1.210

1.232

1.254

1.277

1.300

1.323

1.346

1.369

1.392

1.416

1.440

1.030

1.061

1.093

1.125

1.158

1.191

1.225

1.260

1.295

1.331

1.368

1.405

1.443

1.482

1.521

1.561

1.602

1.643

1.685

1.728

1.041

1.082

1.126

1.170

1.216

1.262

1.311

1.360

1.412

1.464

1.518

1.574

1.630

1.689

1.749

1.811

1.874

1.939

2.005

2.074

1.051

1.104

1.159

1.217

1.276

1.338

1.403

1.469

1.539

1.611

1.685

1.762

1.842

1.925

2.011

2.100

2.192

2.288

2.386

2.488

1.062

1.126

1.194

1.265

1.340

1.419

1.501

1.587

1.677

1.772

1.870

1.974

2.082

2.195

2.313

2.436

2.565

2.700

2.840

2.986

1.072

1.149

1.230

1.316

1.407

1.504

1.606

1.714

1.828

1.949

2.076

2.211

2.353

2.502

2.660

2.826

3.001

3.185

3.379

3.583

1.083

1.172

1.267

1.369

1.477

1.594

1.718

1.851

1.993

2.144

2.305

2.476

2.658

2.853

3.059

3.278

3.511

3.759

4.021

4.300

1.094

1.195

1.305

1.423

1.551

1.689

1.838

1.999

2.172

2.358

2.558

2.773

3.004

3.252

3.518

3.803

4.108

4.435

4.785

5.160

10

1.105

1.219

1.344

1.480

1.629

1.791

1.967

2.159

2.367

2.594

2.839

3.106

3.395

3.707

4.046

4.411

4.807

5.234

5.695

6.192

11

1.116

1.243

1.384

1.539

1.710

1.898

2.105

2.332

2.580

2.853

3.152

3.479

3.836

4.226

4.652

5.117

5.624

6.176

6.777

7.430

12

1.127

1.268

1.426

1.601

1.796

2.012

2.252

2.518

2.813

3.138

3.498

3.896

4.335

4.818

5.350

5.936

6.580

7.288

8.064

8.916

13

1.138

1.294

1.469

1.665

1.886

2.133

2.410

2.720

3.066

3.452

3.883

4.363

4.898

5.492

6.153

6.886

7.699

8.599

9.596

10.699

14

1.149

1.319

1.513

1.732

1.980

2.261

2.579

2.937

3.342

3.797

4.310

4.887

5.535

6.261

7.076

7.988

9.007

10.147

11.420

12.839

15

1.161

1.346

1.558

1.801

2.079

2.397

2.759

3.172

3.642

4.177

4.785

5.474

6.254

7.138

8.137

9.266

10.539

11.974

13.590

15.407

16

1.173

1.373

1.605

1.873

2.183

2.540

2.952

3.426

3.970

4.595

5.311

6.130

7.067

8.137

9.358

10.748

12.330

14.129

16.172

18.488

17

1.184

1.400

1.653

1.948

2.292

2.693

3.159

3.700

4.328

5.054

5.895

6.866

7.986

9.276

10.761

12.468

14.426

16.672

19.244

22.186

18

1.196

1.428

1.702

2.026

2.407

2.854

3.380

3.996

4.717

5.560

6.544

7.690

9.024

10.575

12.375

14.463

16.879

19.673

22.901

26.623

18%

19%

20%

Time Value of Money Tables FV of Lump Sum

Notice

the interest rates across the top

and the periods down the left side
The numbers in this table are called
Future Value Interest Factors (FVIF)
These are simply this part, of the total
future value formula we looked at
earlier, which is FV
To calculate FV using the table the
formula is FV = PV[FVIF(i,n)].

10

Time Value of Money Tables FV of Lump Sum

Example
Take

a look at our first FV of Lump Sum

example
PV = $700, n = 3, r = 10%
To calculate the FV using the table we would
Go across the top to 10%
Go down to period 3
The FVIF is 1.331
FV = $700 (1.331) = $931.70
This matches the solution we found using the
formula
11

Financial Calculator Check A Few

Things
Set

to 4 decimal places

Press 2nd key and decimal point

Will probably see DEC = 2.00
Press the 4 key and the ENTER key
Press CE/C (CLEAR) button in bottom right
corner two or three times and you should
see 0.0000

12

Financial Calculator Check A Few

Things
Payments

Per Year (P/Y)

For now make sure payments per year are

set to 1
Press 2nd key and I/Y key
Should see P/Y = 1.0000
If notpress the 1 key and the ENTER key
Press the CE/C button two or three time
until 0s are showing

13

Financial Calculator Check A Few

Things
How

To Clear Inputs After Each Problem

Press the 2nd key then CLR TVM (above FV)

Press 2nd key then CLR WORK (above CE/C)
Get in the habit of doing this after you have
cleared the screen to 0s and are ready to
work the next problem

14

Using the Calculator

For

a basic TVM problem you will enter

three variables and solve for the fourth
Doesnt matter what order you enter
the variables
As long as you have three you can solve
for the fourthwhich is much easier
that using the formula or table

15

The + or key is to the left of

the = keypress this key
after you enter 700 then
press the PV key

Financial Calculator Solution

I\Y entered as a whole number

PV technically entered as negative, but can
skip the negative as long as you realize the
solution is not negative
Can skip the PMT entry
Press Compute (CPT) and then FV to find
solution

16

FV of Lump Sum Example

You

have just graduated

Wealthy relative wants to reward you
Offers either $15,000 Rolex watch now
or $15,000 cash that has to be invested
for at least 20 years
Make an educated decision as to which
you will choose.

17

Spreadsheet Solution - MS Excel

1.

Set up a table that

contains
the data used to solve the
problem

2.

Click fx and choose function

3.

Click the cells containing

the appropriate data to
calculate the answer
Rate (B2)
Number of periods
(B1)
Present value (B3)
Payment (B4) (not used)
Type (B5) (not used)
18

Future Value of an Annuity

Annuity

- A series of payments or cash

flows of equal amounts at fixed intervals
for a specified number of periods.
Ordinary (deferred) Annuity - An
annuity whose payments (CFs) occur at
the end of each period.
Annuity Due - An annuity whose
payments (CFs) occur at the beginning
of each period.
19

Whats the FV of a 3-year Ordinary

Annuity of $400 at 5%?

20

Equation Solution:

21

Financial Calculator Solution

Notice the PMT key is associated with an

annuity
Can skip the PV entry
Dont have to make the PMT negative as long
as you realize the solution is not negative

22

FV of Annuity Example

You have just graduated and started you first

job
Have opportunity to participate in your
employers 401K plan
You remember something from your finance
class about this being a smart thing to do
Calculate a few what if scenarios to see how
much money you would have at retirement if
you deposit monthly into your account
The word monthly indicates you should
change your calculator to 12 payments per
year2nd key then I/Yinput 12 and press the
enter key and then the C\CE key

23

Find the FV of an Annuity Due

Notice CFs occur at the
beginning of each period and
have extra growth period

24

Equation Solution

25

Change
period p
inputting

Financial Calculator Solution

For annuity due, set calculator to beginning of period

payments
To do this press 2nd key then PMT (BGN) keynotice it is
currently set to END of period payments
Next press 2nd key then the ENTER (SET) keythe SET
key is toggle switch to go from BGN to END and back
IMPORTANTdont forget to change back to END when
finished using the same key strokes

26

Find the FV of an Uneven Cash Flow

Stream or Mixed Stream of Cash
Flows

Most

basic way to calculate is to find

the FV of each CF and add together

27

Equation Solution
FVCFn CF1(1 r)n1 ... CFn (1 r)0
n

CFt (1 r)n t

t 1

28

Present Value

Present value is the value today of a future

cash flow or series of cash flows.
Discounting is the process of finding the
present value of a future cash flow or series of
future cash flows; it is the reverse of
compounding.

29

Present Value of a Lump-Sum

Amount

OR

PV

30

PV of a Lump-Sum Amount
Financial Calculator
FV

= 935, N = 3, and r = 10%

$935 to be received 3 periods

in the future is worth $702.48 today

Keep in mind the actual solution

is not a negative number but that
this is just the way your
calculator views CFs

31

Present Value of Lump Sum Example

You are to receive $100,000 in a lump sum from an

inheritance when you turn 30
You would like the money now so you want to sell the
future lump sum of cash
Assume you are currently 21 years old
You call JG Wentworth (you have probably seen their
commercials)
You need to determine your appropriate discount rate
but the purchaser may have a different discount rate in
mind
Calculate the PV using a discount of 6% and 30%
What happens to the PV as the discount rate increases?
Why does this happen?

32

Present Value of an Annuity

(Ordinary)

PVAn = the present value of an annuity

with n payments.

Each payment is discounted, and the

sum of the discounted payments is the
present value of the annuity.

33

What is the PV of $400 due in each

of the next 3 years if r = 5%?

34

Equation Solution

35

Financial Calculator Solution

Be sure to press the CPT
key and then the PV key to
arrive at the solution

36

Present Value of an Annuity Due

37

Equation Solution

38

Financial Calculator Solution

Change

your calculator to BGN as in the

FV of an Annuity Due exampleand be
sure to change back to END when
finished

39

Perpetuity
A perpetuity is a stream of equal payments
that are expected to go on forever.

No financial calculator inputsjust plug in the numbers

and calculate
Many of you are the beneficiaries of a perpetuity and
many not know it

40

Perpetuity Example

You
would like to receive $1,000 per year
forever
You can earn a 10% interest rate on your
investment
Plugging these numbers into the perpetuity
formula would result in the following:
PVP = = = $10,000
Dont overcomplicate thisthe $1,000 PMT is
simply the interest generated by the $10,000
at a 10% interest rate

41

Perpetuity Example

It is 20 years after graduation and you are

sitting in your big office thinking fondly of your
years at MSU
You think about how much you learned in your
FIN 330 class and want to create a $5,000
scholarship honoring your FIN professor
Thus, you pick up the phone, call the
development office, and ask them how much
you need to write the check forhow much
will create a $5,000 payment forever based on
a 5% rate of return? What is the rate
decreases to 3%?
42

Uneven or a Mixed Stream of Cash

Flows
A

series of cash flows in which the

amount varies from one period to the
next:
Payment (PMT) designates constant cash
flowsthat is, an annuity stream.
The cash flow register (CF) designates cash
flows in general, both constant cash flows
and uneven cash flows, and can be used to
calculate the PV of the mixed stream of CFs.

43

PV of an Uneven Cash Flow Stream

PVCFn

44

Equation Solution

45

Financial Calculator Solution

Press the CF key to enter the CF register

Press the 2nd key and then the C/CE (CLR WORK) key to clear the CF
register
You will see CF0this is the CF at time period 0
Since we dont have a CF at time period 0 simply press the down arrow
key and you will see C01
C01 is the CF that occurs during the first time period400 and press
the ENTER key and then the down arrow key
Next you will see F01the frequency that C01 occurs IN A ROWwhich
defaults to 1and press the down arrow key
Keep entering the CFs and their frequency until they are all in
(remember to press the ENTER key after each input or it will go back to
0)
Once all the CFs are in, press the NPV keythis stands for Net Present
Value
Enter I = 5, press the ENTER key, and then the down arrow key
Finally, press the CPT key to get NPV = 869.02
Thus, the PV of these three future CFs totaling $950 in the future is
$869.02
46

Solving for Other Missing Variables

You

can use your calculator to solve for

any missing variable
This is MUCH easier than using
formulas, tables, etc.
For example you can solve for the
interest rate, r, (I/Y) or time (N)

47

Solving for Interest Rates (r or I/Y)

You pay $78.35 for an investment that
promises to pay you $100 in five years.
What annual rate of return will you earn on
this investment?

48

Financial Calculator Solution

Remember to
press CPT and
then I/Y

The PV MUST be entered as a

negative or you will get an
Error 5 on your display

49

Solving for Time (n)

A security costing $68.30 will provide a
return of 10% per year and you want to
keep the investment until it grows to a value
of $100. How long will it take the
investment to grow to $100?

50

Financial Calculator Solution

By now you are probably
realizing the whenever you
see the ? you should press
the CPT key and then N

51

Semiannual and Other Compounding

Periods
Annual

compounding is the process of

determining the future value of a cash
flow or series of cash flows when
interest is added once a year.
Semiannual compounding is the process
of determining the future value of a
cash flow or series of cash flows when
interest is added twice a year.

52

The FV of a lump sum will be larger if

we compound more often, holding
the stated r constant? Why?
If compounding is more frequent than
once a yearfor example, semiannually, quarterly, or dailyinterest is
earned on interestthat is,
compoundedmore often.

53

TVM Using More Frequent Than Annual

Compounding
Often

faced with semiannual, quarterly,

etc. compounding
# of compounding periods per year
given as m
Leave calculator set to 1 PMT per year
Divide I/Y by m and multiply n by m
Enter these, along with the PV or FV
depending on type of problem, as you
normally would and solve

54

More Frequent Than Annual Compounding

Example
PV = $1,000
N = 5
I/Y = 10
Compute the FV assuming semiannual and
quarterly compounding.
Semiannual PV=$1,000, N =5 x2=10, I/Y=10/2=5 CPT FV
Quarterly PV=$1,000,N=5x4=20,I/Y=10/4=2.5 CPT FV
Which is larger?
Why?
Not responsible for anything to do with Continuous
Compounding

55

Comparison of Different Types of Interest Rates

rNOMINAL : Written into contracts, quoted by

banks and brokers.
rEFFECTIVE: Rate actually paid or earned
Need to be able to convert between nominal
rate to effective rate
If annual compounding, nominal rate will equal
effective rate
If more frequent than annual compounding the
effective rate will be greater than nominal rate

56

Effective Annual Rate

The annual rate that causes PV to grow to the
same
FV as under multi-period compounding.

57

FormulaHow do we find rEAR for a

simple rate of 10%, compounded
semi-annually?
m

rS IMPLE
rEAR = 1 +
- 1

0.10
= 1+

- 1.0

= 1.05 - 1.0= 0.1025 = 10.25%

2

58

CalculatorHow do we find rEAR for a

simple rate of 10%, compounded semiannually?

Use the interest conversion function

Press 2nd key and the number 2 (ICONV)
Press 2nd and C/CE (CLR WORK)
Input the nominal rate and press ENTER
Press the down arrow key TWICE
Input compounding periods per year
(C/Y) and press ENTER
Press the up arrow key ONCE and press
CPT

59

Amortized Loans

Amortized Loan - A loan that is repaid in equal

payments over its lifepayments can be annually,
quarterly, monthly, etc. Most are monthlysuch as car
loans and home loans.
Of the total loan payment, a portion goes to interest
(what you pay for using someone elses money) and a
portion goes to principal (the amount you originally
borrowed)
With each payment a little more goes to principal and a
little less to interest
Amortization tables are widely used for home
mortgages, auto loans, etc. and show how much of each
payment goes to principal and interest and the
remaining balance after payment is made

60

Loan Payment Calculation

The

amount you borrow, the principal, =

PV
The interest rate = I/Y
The number of loan payments = N
You are solving for the PMT
You calculator should be on 1 PMT per
year or 12 PMTS per yearnothing else
Thus, if the loan payment is due
monthly you would press 2nd I/Y, input
12 for P/Y and press the ENTER key
61

Annual Loan Payment Example

Calculate

the payment for a $15,000,

8 percent loan that requires three equal
annual payments.

62

Monthly Car Loan Payment Example

You

plan to purchase a $25,000 car and

have $5,000 cash as a down payment
The interest rate is 7% per year
You will finance the car for 4 years or 48
months
Calculate the monthly loan payment

63

Monthly Home Loan (Mortgage)

Example

Two most popular mortgage loans are 30 years

and 15 years
You plan to purchase a $200,000 house and
have the required 20% down paymenthow
much will you borrow?
The interest rate is 5% per year
You will finance the house for 30 years or 360
monthswhat is the monthly payment of P&I?
You will finance the house for 15 years or 180
paymentswhat is the monthly payment of
P&I?
64

Amortization Schedule
The

amortization schedule below shows

a three year annual pay loan:

We

can also calculate amortization

using the financial calculator

65

Amortization Schedule Using the

Calculator

To access the Amortization Schedule press 2nd then PV (AMORT)

You will see P1 and, by pressing the down arrow key, P2P stands
for period or payment
Lets go back and make sure we have the payment for the 30 year
mortgage loan showing and then access the amortization schedule
If we want to know how much interest and principal is paid related
to a single payment set P1 and P2 equal to that payment number
If we want to know how much interest and principal is paid related
to a series of payments set P1 equal to the beginning payment in
the series and P2 equal to the ending payment in the series
Using your down arrow key you can scroll through the remaining
balance (BAL), principal (PRN), and interest (INT)

66

30 vs. 15 Year Mortgage

For the 30 year mortgage, how much principal and interest, along
with the remaining balance, is related to:
1st monthly payment
2nd monthly payment
First 12 payments
First 180 payments
All 360 payments
Do the same calculations for the 15 year mortgageexcept for
the 360
What is the total cost of each?
Which would you prefer?
What to do if you cant afford a 15 year mortgage but want to pay
your house off in less than 30 years?

67

Growth Rates

You can calculate growth rates also

For example, lets say you invested in the following and the CFs
are:
2007 $1250
2008 $1300
Growth periods =4not 5
2009 $1400
2010 $1475
2011 $1520

PV=-1250,

FV=1520, N=# of growth

periods=4
CPT I/Y = % growth = 5.01%

68

Questions???
Practice,

practice, practice with your

calculator.
Work as many practice problems as you
can.
Much of this info can be used
immediately in your personal financial
life.

69