Mathematics of Finance

Time Value of Money

Future Value
Present Value
Annuities
Rates of Return
Amortization
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 Time Lines

0 1 2 3
I%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.

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 Drawing Time Lines

$100 lump sum due in 2 years

0 1 2
I%

100

3-year $100 ordinary annuity

0 1 2 3
I%

100 100 100

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 Drawing Time Lines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

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 Simple Interest Formulas

• Simple interest is the interest that is computed on

the original principal only.
• If I denotes the interest on a principal P
(in dollars) at an interest rate of r per year for t
years, then we have
I = Prt

• The accumulated amount A, the sum of the

principal and interest after t years is given by

A = P + I = P + Prt
= P(1 + rt)
and is a linear function of t.
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 Example

• A bank pays simple interest at the rate of 8% per year for certain
deposits.
• If a customer deposits $1000 and makes no withdrawals for 3 years, what
is the total amount on deposit at the end of three years?
• What is the interest earned in that period?
Solution
• Using the accumulated amount formula with P = 1000, r = 0.08,
and t = 3, we see that the total amount on deposit at the end of 3 years is
given by
A  P(1  rt )
 1000[1  (0.08)(3)]  1240

or $1240.
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 Example

• A bank pays simple interest at the rate of 8% per year for certain deposits.
• If a customer deposits $1000 and makes no withdrawals for 3 years, what
is the total amount on deposit at the end of three years?
• What is the interest earned in that period?
Solution
• The interest earned over the three year period is given by

I  Prt
 1000(0.08)(3)  240

or $240.
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 Applied Example: Trust Funds

• An amount of $2000 is invested in a 10-year trust fund that pays

6% annual simple interest.
• What is the total amount of the trust fund at the end of 10 years?
Solution
• The total amount is given by

A  P (1  rt )
 2000[1  (0.06)(10)]  3200

or $3200.

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 Compound Interest

• Frequently, interest earned is periodically added to the principal and

thereafter earns interest itself at the same rate. This is called
compound interest.
• Suppose $1000 (the principal) is deposited in a bank for a term of 3
years, earning interest at the rate of 8% per year compounded
annually.
• Using the simple interest formula we see that the accumulated
amount after the first year is

A1  P(1  rt )
 1000[1  0.08(1)]
 1000(1.08)  1080
or $1080.
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 Compound Interest

• To find the accumulated amount A2 at the end of the

second year, we use the simple interest formula again,
this time with P = A1, obtaining:

A2  P (1  rt )  A1 (1  rt )
 1000[1  0.08(1)][1  0.08(1)]
 1000(1  0.08)2  1000(1.08)2  1166.40

or approximately $1166.40.

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 Compound Interest

• We can use the simple interest formula yet again to find

the accumulated amount A3 at the end of the third year:
A3  P (1  rt )  A2 (1  rt )
 1000[1  0.08(1)]2 [1  0.08(1)]
 1000(1  0.08)3  1000(1.08)3  1259.71

or approximately $1259.71.

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 Compound Interest

• Note that the accumulated amounts at the end of each

year have the following form:
A1  1000(1.08) A1  P (1  r )
A2  1000(1.08)2 or: A2  P (1  r ) 2
A3  1000(1.08)3 A3  P (1  r )3

• These observations suggest the following general rule:

– If P dollars are invested over a term of t years earning t
A  P (1
interest at the rate of r per year compounded annually,  r )
then the accumulated amount is
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 Compounding More Than Once a Year

• The formula
A  P (1  r )t

was derived under the assumption that interest was

compounded annually.
• In practice, however, interest is usually compounded
more than once a year.
• The interval of time between successive interest
calculations is called the conversion period.

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 What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?

• Finding the FV of a cash flow or series of cash flows

is called compounding.
• FV can be solved by using the step-by-step, financial
calculator, and spreadsheet methods.

0 1 2 3
10%

100 FV = ?

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 Solving for FV:
The Step-by-Step and Formula Methods

• After 1 year:
FV1 = PV(1 + I) = $100(1.10) = $110.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.10)2 = $121.00
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case):
FVN = PV(1 + I)N

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 Solving for FV:
Calculator and Excel Methods

• Solves the general FV equation.

• Requires 4 inputs into calculator, and will solve for the
fifth. (Set to P/YR = 1 and END mode.)

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

Excel: =FV(rate,nper,pmt,pv,type)
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 What is the present value (PV) of $100 due in
3 years, if I/YR = 10%?

• Finding the PV of a cash flow or series of cash flows

is called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.

0 1 2 3
10%

PV = ? 100

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 Solving for PV:
The Formula Method

• Solve the general FV equation for PV:

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.10)3
= $75.13

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 Solving for PV:
Calculator and Excel Methods

• Solves the general FV equation for PV.

• Exactly like solving for FV, except we have different
input information and are solving for a different
variable.

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Excel: =PV(rate,nper,pmt,fv,type)
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 Solving for I: What annual interest rate would cause
$100 to grow to $125.97 in 3 years?

• Solves the general FV equation for I/YR.

• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8

Excel: =RATE(nper,pmt,pv,fv,type,guess)
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 Solving for N: If sales grow at 20% per year, how
long before sales double?

• Solves the general FV equation for N.

• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

EXCEL: =NPER(rate,pmt,pv,fv,type)
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 What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

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 Solving for FV:
3-Year Ordinary Annuity of $100 at 10%

• $100 payments occur at the end of each period, but there is

no PV.

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 0.
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 Solving for PV:
3-year Ordinary Annuity of $100 at 10%

• $100 payments still occur at the end of each period,

but now there is no FV.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 0.
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 Solving for FV:
3-Year Annuity Due of $100 at 10%

• Now, $100 payments occur at the beginning of each period.

FVAdue= FVAord(1 + I) = $331(1.10) = $364.10
• Alternatively, set calculator to “BEGIN” mode and solve for the FV
of the annuity:

BEGIN
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
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 Solving for PV:
3-Year Annuity Due of $100 at 10%

• Again, $100 payments occur at the beginning of each period.

PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55
• Alternatively, set calculator to “BEGIN” mode and solve for the
PV of the annuity:

BEGIN
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 1.
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 What is the present value of a 5-year $100
ordinary annuity at 10%?

• Be sure your financial calculator is set back to END

mode and solve for PV:
– N = 5, I/YR = 10, PMT = -100, FV = 0.
– PV = $379.08.

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 What if it were a 10-year annuity? A 25-year
annuity? A perpetuity?

• 10-year annuity
– N = 10, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$614.46.
• 25-year annuity
– N = 25, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$907.70.
• Perpetuity
– PV = PMT/I = $100/0.1 = $1,000.

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 The Power of Compound Interest

A 20-year-old student wants to save $3 a day for her

retirement. Every day she places $3 in a drawer. At the
end of the year, she invests the accumulated savings
($1,095) in a brokerage account with an expected
annual return of 12%.

How much money will she have when she is 65 years

old?

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 Solving for FV: If she begins saving today, how much
will she have when she is 65?

• If she sticks to her plan, she will have $1,487,261.89

when she is 65.

INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,262

Excel: =FV(.12,45,-1095,0,0)

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 Solving for FV: If you don’t start saving until you are
40 years old, how much will you have at 65?

• If a 40-year-old investor begins saving today, and sticks to

the plan, he or she will have $146,000.59 at age 65. This is
$1.3 million less than if starting at age 20.
• Lesson: It pays to start saving early.

INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,001

Excel: =FV(.12,25,-1095,0,0)
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 Solving for PMT: How much must the 40-year old
deposit annually to catch the 20-year old?

• To find the required annual contribution, enter the

number of years until retirement and the final goal of
$1,487,261.89, and solve for PMT.

INPUTS 25 12 0 1487262
N I/YR PV PMT FV
OUTPUT -11,154.42

Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.12,25,0,1487262,0)
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 What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

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 Solving for PV:
Uneven Cash Flow Stream

• Input cash flows in the calculator’s “CFLO” register:

– CF 0 =0
– CF 1 = 100
– CF 2 = 300
– CF 3 = 300
– CF 4 = -50
• Enter I/YR = 10, press NPV button to get NPV =
$530.087. (Here NPV = PV.)

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 Will the FV of a lump sum be larger or smaller if
compounded more often, holding the stated I% constant?

• LARGER, as the more frequently compounding

occurs, interest is earned on interest more often.
0 1 2 3
10%

100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
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 Classification of Interest Rates

• Nominal rate (INOM): also called the quoted or

stated rate. An annual rate that ignores
compounding effects.
–I NOMis stated in contracts. Periods must also be
given, e.g. 8% quarterly or 8% daily interest.
• Periodic rate (IPER): amount of interest charged each
period, e.g. monthly or quarterly.
–I = INOM/M, where M is the number of compounding
PER
periods per year. M = 4 for quarterly and M = 12 for
monthly compounding.

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 Classification of Interest Rates

• Effective (or equivalent) annual rate (EAR = EFF%):

the annual rate of interest actually being earned,
considering compounding.
– EFF% for 10% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.10/2)2 – 1 = 10.25%
– Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.10,2)
– Should be indifferent between receiving 10.25%
annual interest and receiving 10% interest,
compounded semiannually.
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 Why is it important to consider effective rates
of return?

• Investments with different compounding intervals

provide different effective returns.
• To compare investments with different
compounding intervals, you must look at their
effective returns (EFF% or EAR).

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 Why is it important to consider effective rates
of return?

• See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

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 When is each rate used?

• INOM: Written into contracts, quoted by banks and

brokers. Not used in calculations or shown on time
lines.
• IPER: Used in calculations and shown on time lines.
If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments with
different payments per year. Used in calculations
when annuity payments don’t match
compounding periods.

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 What is the FV of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?

MN
 INOM 
FVN  PV 1  
 M 

23
 0.10 
FV3S  $100 1  
 2 
FV3S  $100(1.05)6  $134.01
FV3Q  $100(1.025)12  $134.49

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 Can the effective rate ever be equal to the nominal
rate?

• Yes, but only if annual compounding is used, i.e., if

M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.

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 What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?

• Payments occur annually, but compounding occurs

every 6 months.
• Cannot use normal annuity valuation techniques.

0 1 2 3 4 5 6
5%

100 100 100

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 Method 1:
Compound Each Cash Flow

0 1 2 3 4 5 6
5%

100 100 100

110.25
121.55
331.80
FV3 = $100(1.05)4 + $100(1.05)2 + $100
FV3 = $331.80

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 Method 2:
Financial Calculator or Excel

• Find the EAR and treat as an annuity.

• EAR = (1 + 0.10/2)2 – 1 = 10.25%.

INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80

Excel: =FV(.1025,3,-100,0,0)
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 Find the PV of This 3-Year Ordinary Annuity

• Could solve by discounting each cash flow, or…

• Use the EAR and treat as an annuity to solve for PV.

INPUTS 3 10.25 100 0

N I/YR PV PMT FV
OUTPUT -247.59

Excel: =PV(.1025,3,100,0,0)
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 Loan Amortization

• Amortization tables are widely used for home

mortgages, auto loans, business loans, retirement
plans, etc.
• Financial calculators and spreadsheets are great for
setting up amortization tables.

EXAMPLE: Construct an amortization schedule for a

$1,000, 10% annual rate loan with 3 equal
payments.

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 Step 1:
Find the Required Annual Payment

• All input information is already given, just remember

that the FV = 0 because the reason for amortizing
the loan and making payments is to retire the loan.

INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11

Excel: =PMT(.10,3,-1000,0,0)
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 Step 2:
Find the Interest Paid in Year 1

• The borrower will owe interest upon the initial

balance at the end of the first year. Interest to be
paid in the first year can be found by multiplying
the beginning balance by the interest rate.

INTt = Beg balt(I)

INT1 = $1,000(0.10) = $100

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 Step 3:
Find the Principal Repaid in Year 1

• If a payment of $402.11 was made at the end of the

first year and $100 was paid toward interest, the
remaining value must represent the amount of
principal repaid.

PRIN = PMT – INT

= $402.11 – $100 = $302.11

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 Step 4:
Find the Ending Balance after Year 1

• To find the balance at the end of the period,

subtract the amount paid toward principal from the
beginning balance.

END BAL = BEG BAL – PRIN

= $1,000 – $302.11
= $697.89

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 Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan

YEAR BEG BAL PMT INT PRIN END BAL

1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL – $1,206 $206 $1,000 –

• Interest paid declines with each payment as the

balance declines. What are the tax implications of
this?

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 Illustrating an Amortized Payment:
Where does the money go?

$
402.11
Interest
302.11

Principal Payments

0 1 2 3
• Constant payments
• Declining interest payments
• Declining balance
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