Chapter 3

Time
Time Value
Value of
of
Money
Money
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 Frequency
Frequency of
of
Compounding
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per
Yeari: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
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 Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2
years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+
1,000 [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
1,000 [.12/2])(2)(2)
= 1,262.48
3
 Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1+
1,000 [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+
1,000 [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+
1,000 [.12/365])(365)
(2)
= 1,271.20
4
 Effective
Effective Annual
Annual
Interest
Interest Rate
Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1

5
 BW’s
BW’s Effective
Effective
Annual
Annual Interest
Interest Rate
Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate is
6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
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 5-23 FUTURE VALUE FOR VARIOUS
COMPOUNDING PERIODS

Find the amount to which $500 will grow under each of

these conditions:
a. 12% compounded annually for 5 years
b. 12% compounded semiannually for 5 years
c. 12% compounded quarterly for 5 years
d. 12% compounded monthly for 5 years
e. 12% compounded daily for 5 years
f. Why does the observed pattern of FVs occur?
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 5-23 compounding

8
 Impact
Impact of
of Frequency
Frequency
Find the amount to which $500 will grow under
each of these conditions:12% compounded
annually for 5 years
Annual FV5 = 500(1+
500 [.12/1])(1)(5)
= 881
Semi FV5 = 500(1+
500 [.12/2])(2)
(5)
= 895.42
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 Impact
Impact of
of Frequency
Frequency
Qrtly FV5 = 500(1+
500 [.12/4])(4)(5)
= 903.06
Monthly FV5 = 500(1+
500 [.12/12])(12)(5)
= 908.35
Daily FV5 = 500(1+
500 [.12/365])(365)(5)
= 910.97

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Why does the observed pattern of FVs occur?
 Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step
3)
11 5. Start again at Step 2 and repeat.
 Amortizing
Amortizing aa Loan
Loan Example
Example
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PVA = PMT [1- (1/(1+i)n]
i
$10,000 = PMT [1- (1/(1.12)5]
0.12

$10,000 = PMT (3.605)

12 PMT = $10,000 / 3.605 = $2,774
 Amortizing
Amortizing aa Loan
Loan Example
Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

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 Usefulness of Amortization

1. Determine Interest Expense

-- Interest expenses may
reduce taxable income of the
2.firm.Calculate Debt Outstanding --
The quantity of outstanding debt
may be used in financing
the day-to-day activities of the firm.

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 5-8 LOAN AMORTIZATION
AND EAR
You want to buy a car, and a local bank will lend
you $40,000. The loan will be fully amortized over 5
years (60 months), and the nominal interest rate will
be 8% with interest paid monthly.
What will be the monthly loan payment?
What will be the loan’s EAR?

15
 5-8
i= 8% /12 = 0.0066
n=5x 12 = 60

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 5-17 EFFECTIVE
INTEREST RATE

17
18
 5-17 EFFECTIVE
INTEREST RATE

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 5-26 PV AND LOAN
ELIGIBILITY
You have saved $4,000 for a down payment on a
new car. The largest monthly payment you can
afford is $350. The loan will have a 12% APR based
on end-of-month payments.
What is the most expensive car you can afford if you
finance it for 48 months?
For 60 months?

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  Down Payment = 4000
 Installment = 350 / month
 N = 48 months
 i= 12% (Annually)
 i= 12%/12 = 1%

21
 5-26 PV AND LOAN ELIGIBILITY

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 5-31 REQUIRED LUMP
SUM PAYMENT
Starting next year, you will need $5,000 annually for
4 years to complete your education. (One year from
today you will withdraw the first $5,000.) Your
uncle deposits an amount today in a bank paying 6%
annual interest, which will provide the needed
$5,000 payments. How large must the deposit be?

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 5-31 REQUIRED LUMP SUM PAYMENT

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 5-31 Continued
How much will be in the account immediately after you
make the first withdrawal?

6%
0 1 2 3 4
5000 5000 5000 5000
17,325.53
b) FV at year 1= 17,325.53 x (1.06)
FV at year 1 = 18,365.06
1st withdrawal = 5000
Remaining Balance after 1st withdrawal = 18,365.06 – 5000
Remaining Balance after 1st withdrawal= 13,365.06
Remaining Balance after 2nd withdrawal =13,365.06 (1.06)
=14,166.96 -5000
= 9166.96
Remaining Balance after 3rd withdrawal= 9166.96 (1.06) =9716.97 -5000

25 = 4716.97
 5-34 Set up an amortization schedule for a $19,000 loan to
be repaid in equal installments at the end of each of the
next 3 years. The interest rate is 8% compounded annually

Years Installment Interest principal Balance

(8%)
0 19,000
1 7,372.64 1520 5852.64 13,147.36
2 7,372.64 1051.79 6320.85 6826.51
26 3 7,372.64 546.12 6826.52 0
 Amortization Schedule/
Table

Years Installment Interest Principal Balance

(8%) Repayment
0 19,000
1 7372.64 1520 5852.64 13147.36
2 7372.64 1051.78 6320.85 6826.51

3 7372.64 546.12 6826.51 0

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 Set up an amortization schedule for a $19,000 loan to be
repaid in equal installments at the beginning of each of
the next 3 years. The interest rate is 8% compounded
annually

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 5-30 REACHING A
FINANCIAL GOAL
Allison and Leslie, who are twins, just received $10,000 each for
their 25th birthday. They both have aspirations to become
millionaires. Each plans to make a $5,000 annual contribution to
her “early retirement fund” on her birthday, beginning a year from
today.
Allison opened an account with the Safety First Bond Fund, a
mutual fund that invests in high-quality bonds whose investors
have earned 8% per year in the past.
Leslie invested in the New Issue Bio-Tech Fund, which invests in
small, newly issued bio-tech stocks and whose investors have
earned an average of 13% per year in the fund’s relatively short
history.
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 5-30 Continued
a. If the two women’s funds earn the same returns in
the future as in the past, how old will each be when she
becomes a millionaire?
b. How large would Allison’s annual contributions have
to be for her to become a millionaire at the same age as
Leslie, assuming their expected returns are realized?
c. Is it rational or irrational for Allison to invest in the
bond fund rather than in stocks?

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