Chapter 5: Time Value of Money

Overview
This chapter introduces an important financial concept: the time value of money. The PV and FV
of a sum, as well as the present and future values of an annuity, are explained. Special
applications of the concepts include intra-year compounding, mixed cash flow streams, mixed
cash flows with an embedded annuity, perpetuities, deposits to accumulate a future sum, and
loan amortization. Numerous business and personal financial applications are used as examples.
The chapter drives home the need to understand time value of money at the professional level
because funding for new assets and programs must be justified using these techniques. Decisions
in your personal life should also be acceptable on the basis of applying time-value-of-money
techniques to anticipated cash flows.
This chapter explains the algebra of the time value of money. There are three ways to compute
time-value-of-money problems: with a financial calculator (or spreadsheet), with formulas, and
with time value factor tables. A good understanding of the formulas is necessary to value more
complex cash flow streams in later chapters; however, the understanding of financial calculators
and spreadsheets is just as important.
If you invest $C today at an interest rate of i, you will have $C + $C(i) = $C*(1 + i) in one
period.
The general form is: FV = PV(1 + i)N
where
i is the interest rate per period
PV is the value at period 0
FV is the value at period N
Compounding solves for the value at the end of the investment duration (FV), and discounting
solves for the value at the beginning of the investment duration (PV).
Similarly, PV = FV / (1 + i) N
Example 1: $10,000 at 5% interest gives $10,000 * (1.05)1 = $10,500
What will be the amount of $10,000 deposit is year 2
FV = $10,000 * (1.05)2 = $11,025.
Calculator Solution:
Please follow these steps before you start using financial calculator.
Press 2nd then press I/Y button. You will notice P/Y = 1.0000 on calculators screen. Press enter
and then press CPT.
If P/Y is not 1.0000 then you need to press 1 first and then press enter followed by CPT.
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Once it is done then you need to clear all the previous work done on this calculator.
To do this:
1) Press 2nd the Press CE|C
2) Press 2nd then press FV
3) Press 2nd then press CPT
This should clear all the previous work based on financial calculations and therefore previous
work will not create any bias in your new calculations.
Above mentioned 1), 2), and 3 steps are repeated after each financial calculation.
Follow the steps to use financial calculator to solve Example 1.

5 press I/Y
2 press N
-10,000 press PV (Remember it is not a sign on your calculator; it is +|- sign that you need
to press after you typed 10000)
CPT press FV
The reason we use +|- sign because calculator will give you positive output if your input amount
is negative and therefore we need to press +|- sign after we key-in amount for PV.
It is advisable to put small sign by pressing +|- button in front of 10,000 because calculator will
give you a positive answer if input is negative.
Same rule is applied to find PV if FV, N, and interest rate are given
Or
IF PV, FV, and N are given and you need to find I/Y
Or
IF PV, FV, and I/Y are given and you need to find N
We will do following questions to apply what we learned above.

Example 2: John D. has deposited $300 in a guaranteed investment account with a promised rate
of 6% compounded annually. He plans to leave it there for 3 full years when he will make a
payment to buy a computer. What amount he will be able to pay at that time?

This problem is asking you to estimate FV of current amount (PV) of $300 if you invest $300 at
6% for 3 years.
FV = PV * (1 + i) n
FV = 300 * (1.06) 3 = 300 * 1.19102 = $357.30
6 press I/Y
3 press N
300 press +|- (and it will show as -300) press PV
CPT FV and you will see $357.30 on your screen.

Example 3: What is the present value of $100 to be received 10 years from today, assuming an
opportunity cost of 9 percent?

9 press I/Y
10 press N
100 press +|- (and it will show as -100) press FV
CPT PV and you will see $42.24 on your screen.
(make sure that you followed steps 1), 2), and 3) above to clear the memory of the calculator
otherwise you may end up with different answer).
You can also use mathematical equation:
PV = FV / (1 + i) n
PV = 100 / (1.09) 10 = 100 / 2.367 = $42.24

Example 4: Congratulations! You have just won the lottery! However, the lottery bureau has
just informed you that you can take your winnings in one of two ways. Choice X pays
$1,000,000. Choice Y pays $1,750,000 at the end of five years from now. If the discount rate in
the economy is 4 percent per year, which would you choose?
Option X gives you money right away whereas option Y will give you cash in 5 years. You need
to compare both these options on the same scale, i.e. in todays term and therefore you need to
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estimate the PV of option Y and compare the PV of option Y with the amount offered to you in
option X.
4 press I/Y
5 press N
1750000 press +|- press FV
CPT PV and you will see $1,438,372.43 on your screen.
Since the PV of options Y is greater than the amount you will get in option X therefore you
should pick option Y, i.e. wait for 5 years and collect $1,750,000 in 5 years.

Example 5: You just deposited $4,000 in a bank that promises to pay you back $5,900 in 5
years. What is the annual rate of interest you will earn on this investment?
5 press N
4000 press +|- press PV
5900 press FV
Press CPT then press I/Y and you will see 8.083 on your screen which means I/Y should be
8.08% per year.
Remember, when both PV and FV are given then we use +|- sign only for PV.
By using regular financial equation:
FV = PV(1 + i)N
5900 = 4000 * (1+i) 5
(5900/4000) = (1+i) 5
(1.4750) 1/5 = 1+i
1.0808 = 1+i
i = 1.0808 1= 0.0808 or 8.08%.

Example 6: In how many years you will double your money if interest rate is 5% per year?
Assume PV =1 then FV will be double, i.e. 2
5 press I/Y
1 press +|- press PV
2 press FV
Press CPT then press N and you will see 14.20 on your screen which means it will take 14.20
years to double your money if interest rate is 5% per year.
You may use financial equation:
FV = PV (1 + i)N
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2 = 1 (1 .05)N
2 = (1 .05)N
LN (2) = N * LN (1.05)
N = LN (2) / LN (1.05)
N

= 0.6931 / 0.0488 = 14.20 years.

b) How many years will it take to quadruple the same money?

PV and FV of a Stream of Cash Flow

The future value of a mixed stream of cash flows is calculated by multiplying each years cash flow by
the appropriate future value interest factor. To find the present value of a mixed stream of cash flows
multiply each years cash flow by the appropriate present value interest factor. There will be at least as
many calculations as the number of cash flows (CFs).

Example 1: $100 is received at year 1, $200 is received at year 2, and $300 is received at year 3.
If these cash flows are deposited at 12 percent, their combined future value at the year 3 is
________.
In this example, you will need to estimate FV of each CF separately and then add them together
to get the FV of this stream of CFs.
Type 12 press I/Y
Type 100 press +|- then press PV
Type 2 press N (a word of caution: in this case you are depositing $100 at year 1 and you want to
know the FV at year 3 that means number of compounding periods N = end period start period
that is 3 -1 = 2)
CPT FV and you will see: $125.44
Similarly, estimate FV of other two CFs
Type 12 press I/Y
Type 200 press +|- then press PV
Type 1 press N
CPT FV $224
Since you deposit $300 at year 3 and want to know its value at year 3 therefore FV is $300
FV of the stream of CFs = 125.44 + 224 + 300 = $649.44
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Example 2: The present value of $1,000 received at the end of year 1, $1,200 received at the end
of year 2, and $1,300 received at the end of year 3, assuming an opportunity cost of 7 percent,
is_________________.

In this question, you need to find PV. Follow what we have done in the previous section to
estimate PV of individual CFs and then add all those PVs to estimate PV of this stream of cash
flows.

Type 7 press I/Y

Type 1000 press +|- then press FV
Type 1 press N (a word of caution: in this case you are depositing $1000 at year 1 and you want
to know the PV today (today means at year 0) that means number of compounding periods N =
end period start period that is 1 - 0 = 1)
CPT PV and you will see: $934.58
Similarly, estimate PV of other two CFs
Type 7 press I/Y
Type 1200 press +|- then press PV
Type 2 press N
CPT PV $1,048.13
Type 7 press I/Y
Type 1300 press +|- then press PV
Type 3 press N
CPT PV $1,061.19
FV of the stream of CFs = 934.58 + 1048.13 + 1061.19 = $3,043.89

Example 3: $1,200 is received today, $2,200 is received at the end of year 1, and $3,300 is
received at the end of year 2. If these cash flows are deposited at 12 percent, their combined
future value at the end of year 3 is ________.

Remember, in this case you need to find FV at year 3 and your first cash flow starts today
therefore N = 3-0=3 for first CF, N = 3-1 = 2 for 2nd and N= 3-2 =1 for 3rd cash flow
respectively.

Example 4: The present value of $100 received at the end of year 1, $200 received at the end of
year 2, and $300 received at the end of year 3, assuming an opportunity cost of 13 percent,
is_________________.
N= 1-0 = 1 for first CF.
N= 2- 0 = 2 for second CF
N = 3-0 =3 for third CF.
13 press I/Y
100 press +|- press FV
1 press N
CPT PV

13 press I/Y
200 press +|- press FV
2 press N
CPT PV

13 press I/Y
300 press +|- press FV
3 press N
CPT PV

$88.50

$156.63

$207.92

PV of this stream of CFs = 88.50 + 156.63 + 207.92 = $453.04

Annuity
An ordinary annuity is one for which payments occur at the end of each period. An annuity due
is one for which payments occur at the beginning of each period.
The ordinary annuity is the more common. For otherwise identical annuities and interest rates,
the annuity due results in a higher FV because cash flows occur earlier and have more time to
compound.

A perpetuity is an infinite-lived annuity. The factor for finding the present value of a perpetuity
can be found by dividing the discount rate into 1.0. The resulting quotient represents the factor
for finding the present value of an infinite-lived stream of equal annual cash flows.

In case of annuity, you can estimate FV and PV of stream of CFs directly unlike the case given
above where you need to estimate FV and PV of each individual CF and then add them.
Example 1: Bill plans to fund his individual retirement account (IRA) with the maximum
contribution of $2,000 at the end of each year for the next 20 years. If Bill can earn 12 percent on
his contributions, how much will he have at the end of the twentieth year?

Annuity means same CF occurring at even time interval and it is called PMT on the financial
Calculator.
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Solution:
Type 12 press I/Y
Type 20 press N
Type 2000 then press +|- then press PMT
CPT FV and the answer is $144,104.88
Example 2: The present value of an ordinary annuity of $350 each year for five years, assuming
an opportunity cost of 4 percent, is ________________.

Solution:
Type 4 press I/Y
Type 5 press N
Type 350 then press +|- then press PMT
CPT PV and the answer is $1,558.14

Example 3: The future value of an ordinary annuity of $2,000 each year for 10 years, deposited
at 12 percent, is___________.

Answer is $35,097.47 (please check your answer).

Example 5: The present value of an ordinary annuity of $2,350 each year for eight years,
assuming an opportunity cost of 11 percent, is__________________.

Answer is $12,093.39

Example 6: A generous benefactor to the local ballet plans to make a one-time endowment which
would provide the ballet with $150,000 per year into perpetuity. The rate of interest is expected
to be 5 percent for all future time periods. How large must the endowment be?

PV of Perpetuity = PMT / i
PV = 150,000 / .05 = $3,000,000