Time Value of Money
Compounding – The process of determining the value of a cash flow or series of cash
flows at some point in the future when compound interest is applied.
Discounting – The process of finding the present value of a cash flow or series of cash
flows; the reverse of compounding.
Time Line – A graphical representation used to show the timing of cash flows. If not
otherwise stated, assume that the cash flow(s) occur at the end of the period indicated.
Terminology
PV0 = present value (normally at t = 0)
FVn = future value at the end of n periods
i = interest rate, discount rate, required rate of return, etc.
n = number of periods interest is earned
m = the number of compounding (discounting) periods per year
FVIFi,n = future value interest factor for i and n (Table A-3)
PVIFi,n = present value interest factor for i and n (Table A-1)
FVIFAi,n = future value interest factor for an annuity of n payments at i interest
(Table A-4)
PVIFAi,n = present value interest factor for an annuity of n payments at i interest
(Table A-2)
FVA = future value of an annuity of n years
PVA = present value of an annuity of n years
PMT = the periodic level (equal) payment or deposit of an annuity
e = Euler’s constant = 2.71828… (repeating decimal; approximately 2.7183)
ln = natural logarithm
EAR = effective annual rate of interest
Created by Jim Keys
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Solving for the Future Value and Present Value of Lump Sums
Future value of a lump sum (annual compounding)
 equation 1(a) on formula sheet
Future value of a lump sum (non-annual compounding)
 equation 1(b) on formula sheet
Future value of a lump sum (continuous compounding)
 equation 1(c) on formula sheet
Present value of a lump sum (annual discounting)
 equation 2(a) on formula sheet
Present value of a lump sum (non-annual discounting)
 equation 2(b) on formula sheet
Present value of a lump sum (continuous discounting)
 equation 2(c) on formula sheet
Created by Jim Keys
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Solving for Time and Interest Rates in Lump Sum Situations
Solving for n (annual compounding)
 equation 7(a) on formula sheet
Solving for n (non-annual compounding)
 equation 7(b) on formula sheet
Solving for i (annual compounding)
 equation 8(a) on formula sheet
Solving for i (non-annual compounding)
 equation 8(b) on formula sheet
Future Value of an Annuity
Future value of an annuity (annual payments or deposits)
 equation 3(a) on formula sheet
Future value of an annuity (non-annual payments or deposits)
 equation 3(b) on formula sheet
Created by Jim Keys
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Present Value of an Annuity
Present value of an annuity (annual payments or deposits)
 equation 4(a) on formula sheet
Present value of an annuity (non-annual payments or deposits)
 equation 4(b) on formula sheet
Solving for Time and Interest Rates in Annuities
 Use Tables A-2 and A-4 to estimate the unknown variable. Financial
calculator is required to obtain exact answers.
Solving for the Payment in Annuities
 Solve equations 3 and 4 on the formula sheet for the PMT.
Perpetuities
 A series of equal payments/deposits occurring at equal intervals that continue forever
 It only makes sense to find the present value of a perpetuity
 Preferred stocks are valued as perpetuities
Uneven Cash Flow Streams





Find future value and present value of uneven cash flow streams
Embedded annuities
Combine annuity and lump sum calculations
FVA formula gives us the future value of the annuity as of the last period’s payment
PVA formula gives us the present value of the annuity one period before first
payment
Created by Jim Keys
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Solving for i with Uneven Cash Flow Streams
 Trial and error procedure or financial calculator (IRR function)
Effective Annual Rate (EAR)
 Considers the compounding of interest
 equation 5 on formula sheet
Amortized Loans
 A loan which is repaid in equal installments over its life
 The payment is determined by using the PVA formula and solving for the payment
 In an amortized loan, the periodic payment remains the same, the amount of interest
declines, and the amount of each payment that is applied to principle increases as the
loan approaches maturity
PROBLEMS (answers on pages 12-13)
1. Compute the future value of $1,580 if the appropriate rate is 5.4% and you invest the
money for four years? What is the future value if you invest for eight years?
2. Your uncle plans to buy a piano and can afford to set aside $1,930 toward the
purchase today. If the annual interest rate is 14.8%, how much can he spend in four
years on the purchase? If the interest rate is 7.4%, how much can he spend?
Created by Jim Keys
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3. You plan to buy a lawn tractor and can afford to set aside $1,470 toward the purchase
today. If the annual interest rate is 5.5% compounded every quarter, how much can
you spend in two and half years on the purchase? If you invest for five years, how
much can you spend?
4. Joe plans to buy an antique lamp set and can afford to set aside $980 toward the
purchase today. If the annual interest rate is 11.7% compounded every week, how
much can Joe spend in half a year on the purchase? How much can he spend if the
interest rate is compounded daily?
5. You deposit $10,000 in a five-year Certificate of Deposit that offers a 6.5% rate of
interest compounded continuously. What will your CD be worth at maturity?
6. If the discount rate is 14.1%, find the present value of $1,768 received after three
years. What is the present value if the cash flow is ten years in the future?
7. Compute the present value of $895 received after one and a half years if the
appropriate annual rate is 12.7% compounded every week. What is the present value
if the interest rate is compounded daily?
Created by Jim Keys
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8. Mr. Jones proposes to invest $1,880 today and expects to accumulate $2,537 in three
years. What is the underlying rate of return on the investment? What is the return if
it takes five years to accumulate $2,537?
9. Calculate the compound annual rate of return if an investment of $1,380 compounded
every quarter yields $1,858 after four years. What is the rate of return if the
investment is compounded monthly?
10. Some companies offer "single premium" policies. One company advertises that if
you give them $60,000 today, they will pay you $1,000,000 in 35 years. What rate of
return is this company offering?
11. How long does it take to double your money if you can earn 15% per year? How
long will it take for $2,000 to grow to $50,000 at an interest rate of 11% per year?
12. How long does it take to double your money if you can earn 15% per year if the
interest rate is compounded quarterly? How long will it take for $2,000 to grow to
$50,000 at an interest rate of 11% per year if the interest rate is compounded
monthly?
Created by Jim Keys
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13. If the interest rate is 9.6%, find the future value of $12,000 invested every year for 15
years with the first payment made one year from now. What is the future value of
$2,000 invested every year for 40 years if the interest rate is 10%?
14. What is the future value of $1,060 invested every month for the next 20 years starting
one month from now at 9.2%? How much would you accumulate in your retirement
account after 40 years if you deposited $500 each quarter in a mutual fund earning a
10% rate of return?
15. You have just won the lottery and will receive an annual payment of $150,000 every
year for the next 20 years starting one year from today. If the annual interest rate is
6.65%, what is the present value of your winnings? If the annual interest rate is
7.50%, what is the present value of your winnings?
16. What is the present value of an annuity of $880 invested every month for the next 19
years starting one month from now at 11.4% compounded monthly? You have just
won the lottery and will receive quarterly payments of $37,500 for the next 20 years.
If the annual interest rate is 6.65%, what is the present value of your winnings?
Created by Jim Keys
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17. If you repay a 15-year, $85,000 loan by making payments of $10,000 every year,
what is the interest rate on the loan? If the interest rate on the loan is 12%, how long
would it take you to repay the loan if the payments remain the same?
18. What payment made every year starting one year from now would be required to
repay a $78,218 loan in 20 years if the interest rate is 9.7%? What payment would be
required if the interest rate were 7.5%?
19. Wally has just bought a house by taking a 30-year, $127,500 mortgage from the bank.
The interest rate is 8.25%. The mortgage is to be retired by payments made every
month starting next month. How much does Wally have to pay each month to repay
the mortgage? What would the monthly payments be if Wally opts for a 15-year
mortgage at the same interest rate?
20. If the discount rate were 12.0%, what would you be willing to pay to receive a
payment of $588 every year forever starting one year from now? What would you be
willing to pay if the payments did not begin until five years from now?
21. Year
1
2
3
4
5
6
7
8
9
10
Cash Stream 1
$ 500
700
700
700
700
900
0
0
0
0
Created by Jim Keys
Cash Stream 2
$
0
0
0
800
600
600
600
600
600
400
Cash Stream 3
$ 300
300
300
300
300
400
400
400
400
400
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What is the present value of each cash flow stream at time zero if the appropriate
interest rate is 8%? 10%?
What is the future value of each cash flow stream at the end of year ten if the
appropriate interest rate is 6%? 15%?
What is the future value of each cash flow stream at the end of year fifteen if the
appropriate interest rate is 5%? 12%?
22. You are considering a one-year CD for your tuition money and have surveyed three
local banks. If you wish to maximize your yield (EAR), in which of the following
banks would you open up a CD?
BANK
A
B
C
Created by Jim Keys
QUOTED
RATE
6.05%
6.00%
5.95%
COMPOUNDING
METHOD
Monthly
Daily
Continuously
EAR
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23. Create an amortization schedule for the following loan:
Amount Borrowed:
Interest Rate:
Payment Frequency:
Loan Term:
$25,000
8%
Yearly
5 years
(Hint: Determine the yearly payment by using the PVA formula and solving for
the payment)
Year
Beginning
Balance
Payment
Interest
Repayment
of Principal
Ending
Balance
1
2
3
4
5
24. If you save $2,000 per year for 40 years in a mutual fund that earns a rate of 11%,
how much will you have in your retirement fund? If you earn 10%, what will your
investment be worth after 40 years?
25. Reconsider problem #24, assuming that you invest for only 30 years instead of 40.
Created by Jim Keys
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ANSWERS TO PROBLEMS
1) $1,949.93; $2,406.48
2) $3,352.16; $2,567.88
3) $1,685.10; $1,931.68
4) $1,038.97; $1,039.03
5) $13,840.31
6) $1,190.21; $472.74
7) $739.93; $739.78
8) 10.5064%; 6.1775%
9) 7.505%; 7.4585%
10) 8.3702%
11) 4.9595 years; 30.844 years
12) 4.7071 years; 29.3964 years
13) $369,388.46; $885,185.11
14) $726,216.19; $1,019,557.36
15) $1,633,263.70; $1,529,173.70
16) $81,903.61; $1,652,514.85
17) 8.1144%; The loan would never be repaid since the interest exceeds the payment.
18) $9,000.05; $7,672.58
19) $957.86; $1,236.93
20) $4,900.00; $3,114.04
Created by Jim Keys
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21) Cash Stream 1: $3,176.86; $2,979.76
$6,078.92; $10,363.47
$7,300.68; $15,330.03
Cash Stream 2: $2,534.16; $2,254.12
$5,120.01; $6,902.69
$6,321.71; $11,011.41
Cash Stream 3: $2,284.76; $2,078.75
$4,517.95; $6,765.35
$5,521.11; $10,397.65
22) Bank A: 6.2206%
Bank B: 6.1831%
Bank C: 6.1306%
23)
Year
Beginning
Balance
Payment
1
2
3
4
5
$25,000.00
20,738.59
16,136.27
11,165.76
5,797.61
Totals
Interest
Repayment
of Principal
Ending
Balance
$6,261.41
6,261.41
6,261.41
6,261.41
6,261.41
$2,000.00
1,659.09
1,290.90
893.26
463.80
$4,261.41
4,602.32
4,970.51
5,368.15
5,797.60
$20,738.59
16,136.27
11,165.76
5,797.61
0.00*
$31,307.05
$6,307.05
$25,000.00
* $0.01 rounding error for year 5 numbers
24) $1,163,652.13; $885,185.11
25) $398,041.76; $328,988.05
Created by Jim Keys
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