Time value of money is based on the belief

that a dollar today is worth more than a dollar

that will be received at some future date
because the money it now can be invested &
earn positive return.
Time 0 is today; Time 1 is one period from today

Time 0 1 2 3 4 5
Cash Flows
-100
5%
Outflow
Interest rate
105
Inflow
Compounding
The process of determining the value of a cash flow
or series of cash flows some time in the future
when compound interest is applied.
The amount to which a cash flow or series of cash
flows will grow over a given period of time when
compounded at a given interest rate

Interest earned on interest
n
n
i) PV(1 FV + =

Time 0 1 2 3 4 5
Interest
-100
5%
5.00
Total Value 105.00
5.25
110.25
5.51
115.76
5.79
121.55
6.08
127.63
FV
n
= PV(1 + i)
n
= PV(FVIF
i,n
)
Period (n) 4% 5% 6%
1 1.0400 1.0500 1.0600
2 1.0816 1.1025 1.1236
3 1.1249 1.1576 1.1910
4 1.1699 1.2155 1.2625
5 1.2167 1.2763 1.3382
6 1.2653 1.3401 1.4185
For $100 at i = 5% and n = 5 periods
FV
n
= PV(1 + i)
n
= PV(FVIF
i,n
)
Period (n) 4% 5% 6%
1 1.0400 1.0500 1.0600
2 1.0816 1.1025 1.1236
3 1.1249 1.1576 1.1910
4 1.1699 1.2155 1.2625
5 1.2167 1.2763 1.3382
6 1.2653 1.3401 1.4185
For $100 at i = 5% and n = 5 periods
$100 (1.2763) = $127.63
Five keys for variable input
N = the number of periods
I = interest rate per period
may be I, INT, or I/Y
PV = present value
PMT = annuity payment
FV = future value
Find the future value of $100 at 5% interest
per year for five years
1. Numerical Solution:
Time 0 1 2 3 4 5
Cash
Flows
-100
5%
5.00
Total Value 105.00
5.25
110.25
5.51
115.76
5.79
121.55
6.08
127.63
FV
5
= $100(1.05)
5
= $100(1.2763) = $127.63
2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PV = -100 PMT = 0 FV = ?
Output: = 127.63
Relationship among Future Value, Growth
or Interest Rates, and Time
0
1
2
3
4
5
1
i= 15%
i= 10%
i= 5%
i= 0%
2 4 6 8 10
Periods
Future Value of $1
0
The present value is the value today of a
future cash flow or series of cash flows
The process of finding the present value is
discounting, and is the reverse of
compounding
Opportunity cost becomes a factor in
discounting
Start with future value:
FV
n
= PV(1 + i)
n

( )
(

+
=
+
=
n
n
n
n
i 1
1
FV
i) (1
FV
PV
Find the present value of $127.63 in five
years when the opportunity cost rate is 5%
1. Numerical Solution:

110.25 115.76 121.55
5%
0 1 2 3 4 5
PV = ?
127.63
105.00
1.05 1.05 1.05 1.05
-100.00
( )
100 $ ) 7835 . 0 ( 63 . 127 $
2763 . 1
$127.63
05 . 1
$127.63
PV
5
= = = =
Find the present value of $127.63 in five
years when the opportunity cost rate is 5%
2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PMT = 0 FV = 127.63 PV = ?
Output: = -100
Relationship among Present Value, Interest
Rates, and Time
0
0.2
0.4
0.6
0.8
1
i= 15%
i= 10%
i= 5%
i= 0%
2 4 6 8 10
Periods
Present Value of $1
12 14 16 18 20
An annuity is a series of payments of an
equal amount at fixed intervals for a
specified number of periods
Ordinary (deferred) annuity has payments
at the end of each period
Annuity due has payments at the
beginning of each period
FVA
n
is the future value of an annuity over
n periods
The future value of an annuity is the amount
received over time plus the interest earned
on the payments from the time received until
the future date being valued
The future value of each payment can be
calculated separately and then the total
summed
If you deposit $100 at the end of each year
for three years in a savings account that pays
5% interest per year, how much will you have
at the end of three years?
100 100.00 = 100 (1.05)
0

105.00 = 100 (1.05)
1

110.25 = 100 (1.05)
2

315.25
0 1 2 3 5%
100
( )
=
+ = + + + + + + =
1 - n
0 t
t 1 - n 1 0
n
i 1 PMT i) PMT(1 i) PMT(1 i) PMT(1 FVA
( )
( )
(

+
=
(

+ =
=

i
i 1
PMT i 1 PMT
n
n
t
t n
1
1
( )
25 315 1525 3 100
1
100 . $ ) . ( $
0.05
1.05
$ FVA
3
3
= =
(

=
If the three $100 payments had been made at
the beginning of each year, the annuity would
have been an annuity due.
Each payment would shift to the left one year
and each payment would earn interest for an
additional year (period).
$100 at the start of each year
0 1 2 3 5%
100 100 100
105.00 = 100 (1.05)
1

110.25 = 100 (1.05)
2

331.0125
115.7625 = 100 (1.05)
3

Numerical solution:
( )
( ) ( )
( )
( )
(
(

+
)
`

+
=
(

+
)
`

+ =
(

+ =

=
=
i 1
i
1 i 1
PMT
i 1 i 1 PMT
i 1 PMT FVA(DUE)
n
n
1 t
t - n
n
1 t
t
n
Numerical solution:
( )
( )
( ) | |
0125 331
05 1 1525 3 100
05 1
1 05 1
100
. $
. . $
.
0.05
.
$ FVA(DUE)


3
n
=
=
(
(

)
`

=
If you were offered a three-year annuity
with payments of $100 at the end of each
year
Or a lump sum payment today that you
could put in a savings account paying 5%
interest per year
How large must the lump sum payment be
to make it equivalent to the annuity?

0 1 2 3 5%
100 100 100
( )
( )
( )
384 . 86
05 . 1
100
703 . 90
05 . 1
100
238 . 95
05 . 1
100
3
2
1
=
=
=
272.325
Numerical solution:
( ) ( ) ( )
( )
(

+
=
(

+
+ +
(

+
+
(

+
=

=
n
1 t
t
n 2 1
n
i
PMT
i
PMT
i
PMT
i
PMT PVA
1
1
1
1
1
1
1
1

( ) ( ) ( )
( )
( )
( )
32 272 7232 2 100
1
1
1
1
1
1
1
1
1
1
1
1
1
1
. $ ) . ( $
0.05
.05
$100
i
i
PMT
i
PMT
i
PMT
i
PMT
i
PMT PVA
3
n
n
1 t
t

n 2 1
n
= =
(
(
(
(

=
(
(
(
(

=
(

+
=
(

+
+ +
(

+
+
(

+
=

Payments at the beginning of each year

Payments all come one year sooner
Each payment would be discounted for one
less year
Present value of annuity due will exceed
the value of the ordinary annuity by one
years interest on the present value of the
ordinary annuity

0 1 2 3 5%
100
100
( )
( )
( )
( )
( )
( )
( )
( )
( )
703 90
05 1
100
05 1
05 1
100
238 95
05 1
100
05 1
05 1
100
000 100
05 1
100
05 1
05 1
100
2 2
1 1
0 1
.
.
.
.
.
.
.
.
.
.
.
.
= =
= =
= =
285.941
Numerical solution:
( ) ( )
( )
( )
( )
(
(
(
(

=
(

+
)
`

+
=
(

+
=

= =
i
i
i
PMT
i
i
PMT
i
PMT PVA(DUE)
n
n
1 t
t
1 - n
0 t
1
n
1
1
1
1
1
1
1
1
1

( )
( )
$285.941
(2.85941) $100
(1.05)] [(2.72325) $100
.
.
.
$ PV(DUE)
3
=
=
=
(
(
(
(

= 05 1
05 0
05 1
1
1
100
3
Perpetuity - a stream of equal payments
expected to continue forever
Consol - a perpetual bond issued by the
British government to consolidate past debts;
in general, and perpetual bond
i
PMT
Rate Interest
Payment
PVP = =
Uneven cash flow stream is a series of cash
flows in which the amount varies from one
period to the next
Payment (PMT) designates constant cash
flows
Cash Flow (CF) designates cash flows in
general, including uneven cash flows
PV of uneven cash flow stream is the sum of
the PVs of the individual cash flows of the
stream
( ) ( ) ( )
( )

=
(

+
=
(

+
+ +
(

+
+
(

+
=
n
1 t
t
t
n
n 2 1
i
CF
i
CF
i
CF
i
CF PV
1
1
1
1
1
1
1
1
2 1

Terminal value is the future value of an
uneven cash flow stream
( ) ( ) ( )
( )

=
+ =
+ + + + + + =
n
1 t
t - n
t
0
n
2 - n
2
1 - n
1 n
i CF
i CF i CF i CF FV
1
1 1 1
Loans that are repaid in equal payments over
its life
Borrow $15,000 to repay in three equal
payments at the end of the next three years,
with 8% interest due on the outstanding loan
balance at the beginning of each year

0 1 2 3 8%
PMT PMT PMT 15,000
( ) ( ) ( )
( )
( )

=
=
=
+
=
+
+
+
+
+
=
3
3
000 15
1 t
t
1 t
t
3 2 1
3
1.08
PMT
, $
i 1
PMT
i 1
PMT
i 1
PMT
i 1
PMT
PVA
Numerical Solution:
( ) ( )
( )
( )
$5,820.50
2.5771
$15,000
PMT
2.5771 PMT $15,000
0.08
1.08
1
- 1
PMT
1.08
1
PMT
1.08
PMT
$15,000
3
3
1 t
t
3
1 t
t
= =
=
(
(
(
(

=
(

= =

= =
Amortization Schedule shows how a loan will
be repaid with a breakdown of interest and
principle on each payment date
Year
Beginning
Amount
(1)
Payment
(2)
Interest
a
(3)
Repayment
of Principal
b
(2)-(3)=(4)
Remainin
g Balance
(1)-(4)=(5)
1 15,000.00 $ 5,820.50 $ 1,200.00 $ 4,620.50 $ 10,379.50 $
2 10,379.50 5,820.50 830.36 4,990.14 5,389.36
3 5,389.36 5,820.50 431.15 5,389.35 0.01
c
a
Interest is calculated by multiplying the loan balance at the beginning
of the year by the interest rate. Therefore, interest in Year 1 is
$15,000(0.08) = $1,200; in Year 2, it is $10,379.50(0.08)=$830.36;
and in Year 3, it is $5,389.36(0.08) = $431.15 (rounded).
b
Repayment of principal is equal to the payment of $5,820.50 minus
the interest charge for each year.
c
The $0.01 remaining balance at the end of Year 3 results from
rounding differences.