I

t
I

1..
I

Tflme Value of

Money

3
I\4CDULE

L
thr

--

...--

TOPIC

TIME VALIJtr OF MGNtrY

TINIE, LII{ES AI.ID NOTATION
The simplest tools

in finance are often the most porverful.

intuitively appeaiing.

'i,npje

Present value is a concept that is

to conrrrute, arrd has a rvide range cf applications. It is useful in

decision rnaking, ranging fi'om simple personal decisions that include buying a house, saving lor

chirtt's education, esrirnating incorne in retirerneni-to rnore cclu,plex corporate financial

decisions lik-e picking projects in whicli to invest as rvell as the right financing mix fcr these
proj ects.

Dealing rviih cash flou's that are at different poinis in time is lnacle :asier using a tinte line rhat
shows both the tirring a.nd the amcunt of each cash florv in a streanr. Thus, a cash-flow stream of
$100 at tl-re end of each of the next for:r years can be depicted on a tirne Iine Iike tlre one Cepicted
in Figure i .l
in the figr-ire, 0 refers to right nolv. A cash tlow that occurs at time 0 is therefore already in present
.,,alue terms and does not need to be ailjusted for time value. A distinction rrust be rnade here
betrveen a period of titne and a point in tinte. The porlicn of the time line betrveen 0 and I refers to
.l

period , rvhich, in this exarnple, is tire fir'st year. The cash flor^, rhat occurs at lhe poirtt in tirne
"l" refers to tlre cash florv ihat occLrrs at the end of'the perioci L Finally, the discount rate, rvhich
is i.0%o in this exarnple, is specified for each period on the timeline 4nd may be different for each
period. Had the cash florvs bern ar the bcgirrning ofeach year instead ofat the errd ofoach )ear.
the time Iine wouid ha','e been rccira'.vn as i.t aplrcrrs irr FigLlre l.l.
Figure 1.1. A time line ior cash florvs: end of each period

<--10%

t0%

10%

10%

Figr.rre 1.2. A tiine line for clsh florvs: beginning of eaclr pei-iod

1A%

10%

- -IIJY+

Nnte that, in present value iertns, a cash flow ti,at occLlis at the beginning of .,ear 2 is the
equivalent of a cash flor.v that occLlrs at the end of year 1.
Cash flows can be erther positive or negative; positive caslr flor','s are called cash inL'lov's. and
negati\/e cash flows are called cash outfiov,.i. For notational pur'pose3. \ve will assuinc the

follcwing for the cliapter that follows:

@
i

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t

59

I
I

Stanrl,s

Notation

[or

PV

Presenr value

FV

Future value
Cash flolv at the end of Period

Annuity-Constant cash flows orrer se"'eral pericds

r
c

Discount rate
Expected growth rate in cash florvs
Nurnber of periods over which cash tlorvs are
receiveJ or paid

cf

t'l

THE INTUITIVE BASIS F'OII PRE,SENT \/ALUE

A cash flolv in the future is u,orth less than a sirnilar cash llow today because:

to

1.

Individuals pr*r presctlt cottsutrplir.ttt to .itrlw'e con.stuttlttion. People ri'ould Ilave

oflered tnore in tlte tiriure tu cive up plescnl cull:,tllnption.

2.

When there is n.;onetct")t infl:.tiio;t, the valr-re of ctrrrency decreases over tinre. The gleater the
inflation, the greater the dilference in value betr'r'een a Collar toclay and a dollar in the future.

3.

Any tmcertainty Q.isk) associated ri,ith the casir

flou in the fr rt'"rre

redr-tces the value

olthe

be

cash

flow.
Tlre process bl, lvhich futr.rre cash florvs are adjr-rsted to reflect these factors is called cii.scotltrittg,
and the magnitude of these facto;s is reflected in tile cliscount rate.

Discount ll-ate - is a rate at uhicit present and tirtLrre cash florvs are trudeci off. It

1.
2.
l.

orporates

Tirc preference for current ccnsr:tnption (greater pre'ference...higher discount rate).

Expected inflation (higher inflation.. .higher discor-rnt late)
?he uiloertairriy in the future cash flori's(hlgher tlre risk...higher cliscor-rnt raie).

A higher discount raie will

Figure

Iea.d

to a lower plesent valLle for futute cash flows.

i.3. Endorlrrtents ancl consumption

--

L1

tlndividual C:

!ndividual ,.i:86,

Individual

60

ine

Er-

(l

have the satne endorvments in each period: Eo, Et' '

Individual A cottsutres his e::dowment itr each period'
Individual B consuntes tttore tlran his endowment in peri'ld 0 by borrorvirlg'
Inciividuai C lencls out a portiott of her initial endorvrrerri'
A : borrowing r : real rate of interest

All individuals

t
i/'

Tradeoff in Real Consumption Across Time

Althougli individr-rals prefer present consurnption to future consurnption, the degree of this
pref"reice valies across indiviciuais. This tradeoff between i,rresent consumptioil (Co) aild fluture
consurnption (C1) is presented in Figure 1.3. In the sinrple u,ord described in this graph,
individrials are endowed witli wealth in each period and carr'either consLllrle it or save it zrnd iend rt
oyt.r Individual A cl-rooses to ccnslure all of his endorvrrent in each period anci neither saves nor
bcrror.vs in eiiher period. Inciividual B consumes A units rnore than his enCo\\'l'nent irr the current
period L,y boriowing against his next-perioC endowitient; accordingiy, he has to pay it back in the
next period with rnterest [A 11 r r)]. Individr-ral C con-curnes less tltan her endor.vment in the
.rrr.nt period and lends or-rt the balance, enabling her to consuttte lrore tharl her endorvrnent in the
next period.

As rroied earlier, rvhen tlte prelcrence for cilrretrt cortsLllxption is stl'ong, inCi'iidirals lvill l-rave to
be oifered t.nuclt rnore ip iern,s of firture co:'tsr.ttt.tption to give Llp cLlrl'cnt ccnsrrmption. This
tradeoff is capttired by a high "real" rate ol retr-trn or discor-rnt rate. Conversely, when the
prelerence for current consr,rrnptiotr is weaker, indivjduals will settle for trr-lch less in terms 01
future consr:ntption and by ertensiLrrr, a lorv real rate of retLlrn or disccr-tnt rate.
Effects of Inflation

F
.i'

ln aciciition to the prelerence for cllnent cver fltture constlrltiltion, ancii-,er.factoi'enrerges w]len we
mrJve from reai consull.!ption to cash florvs. A clear rationale for prelerring a casll flow now io a
sirnilar cash flow in the futLrre rs irrflation, vvhich redr-tces the purchasing polver ol future cash
flows. Other things being eqr-ral, the discount rlte tvrti increase .',ith the inflaticn raie, theleb;'
reducing tlte preseni value of future cash flows.
The effect of inflation on plesent r,alr-,e is evident rvhen futurc casll florvs are adjr-rsted for expeuted
inflation a1d stated in "real" tertns. TItis acijustment i'educes tile value of luture cash flows, btlt

these rea.l caslt flov;s will itave to be reduced fi,rr1her to reflect real feturns (i.e.. the tradeoff
-h i-ir-rrv5 i6
betr,r'een current an.l llltlrre consltmption) and anl, Ltncetaintl' associated rvitl-r the s;
arrive at the present..,a-lue Thus, an investor \tuhc expects io make i0.-5 miilion i\4e>lican pesos a
year frorn noiv rviil have to reduce this expected cash flov,'to reflect the e>lpecicd inflaticn rate in
il,lexico. Iltltat inflation rate is expected tc be'l-i%, for instance, tlre real cas1l flcw rviti be only
7.77 iniliion Mexican Pesos.
Effects cf Rislt

Althougit both the prelerence for cur:'ent corrsLlrnption, and erpecled inflation affect the present
.,,aiue of ail cash flci,,,,s, not aii casi.] i-lows ale eqr-ially predictablc. A p;,rrnised cash f'1c"v might not
be delivered ior a numbel of reasons: the prorrise tnight delault on the payment, the promise
might not be around to receive pa),ulent; or some other contingency might intelvene to prevent the
prornised payment cr.to reduce it. The greater the uncertainty associated with a cash florv in the
iurure, the higher the discount i-ate rrsed to calculate the present va)ue of this cash flolv rvrli be, aild
consequently, the Iower the present valr-re of that cash flow will be;

6l

Compotrnding a cash flow

Current cash flows can be rnove,l to the future by compounding the cash florv at the appropriate
discount rate:

f*q

Future Valrr; of Sirrple Cash

tss/

Florv:

CFg

(l

Again, the compounding effect increases with both the discount rate anrl the cotnpounding period'

Comoounciing is the proccss by which cash flor.vs are colrveried frotri present value to future
value dollals.

As the length of the holding penod is extended, small diflerences in discount rates can lead to
large diflerences in future value. In a study ofretltrn on stocks and bonds between 1926 and 1992'
Ibbotson and Sinquefield for-rnd that stocks on the average made l2.4ok, Treasury bonds made
5.2ok, anC Treasury bills 3.6%. Assuming that these retums continue irrto the future, Table 3.i
provicies the future o Sl00 invested in each category at the end of a nurnber of holding periods--l
year, 5 vears" 10 years,20 years. 30 years, and 40 years.

The cliflerences in future value front investing at these differerrt rates of retllrn are smali 1or shorl
cop.rpounding periods (such as one year) br,rt become larger as the cornpounding period is
extended. For instance. with a 40-year tirne horizon, the ftrture value of investing in stocks, at an
average return of 1,2.4oA, is rnore than l2 tirnes larger than the firture value cf investing in
Tleasury bonds at an average return of 5.20/o and more than 25 times the futrlre value of investing

in Treasury bills at an average return of

3,604.

Table 1.1: F'UTURE VALUES OF INVESTilIIINTS-ASSET CL.\SSES

+i

E,i
AJ

Holding Period
5

Stocks
$ 1 12.40
119.40

t0

JZ !.OU

20
30
40

I.Bills

T. Bonds
$10s.20

$r03 50

128.E5

1,19.34

166.02

1,1),.43

s.62

202.86

27

,03 5.92

J,JJ+.I6

451 .59

28 8.93

10.73 r .30

159.68

4i t.s2

Effective Inter.e:t Rate: Tltis is tlte trure ratc of interest, tal-ing into account the compounding
eff-ects of more frequent interest payinents,
The frequency oi cliscounting tncl compounding The freqr,iency of conrpout,ding aflects bt-rtlr
tire luture and present values of casit flows. in tite exarrp)es abo"'e,'iile,:asll flow we,'e assLttned t'.r
be discounted and cornpounded annually-that is, !nterest Dallnenls altd incotne u'ere compLrted at
the end of each 1,ear, based on the balzrnce at_the beginning of the year. In scllle cases, the present
anri future vaiues may be very diflerent lrom those- cotr-rputed orr arl annual basis; tlre stated
interest rate, on an arl-iual basis, can deviate significantly fi"om the elfective or truc iliierest rzlte.
'Ilre effective interest rate can be computed

as follows:

Elfective interest Rate = I i -: StateJ.rr,irrr:l Interest P.z',te)"-

63

where

I2:rnonthly)

r?=nurnberofcompouncJ 'ngperiodsdr,rringtheyear(2-serniannual;

For instance, a

10o/o

annual interest rate.

effective interest rate of

Effective intere:i Rate

"

.05'

-I

if
=

there is serniannual compounding, works ot-lt to an

I

.10125 or 10.2:tok

As compouncling becornes continuous, the effective intercst rate can be computed as foliolvs:

Effective Interest Rate = exp'.-

u,'here

:
:
r

exp

exponential lunctio,r
stated annual interest rate

Tacle 1.2 proviCes the etfectir,'e rates

as a function

oithe coinporrnding Irequerrr;'.

Table 1.2 EFFECT OF COMPOUNDING FREQUENCY ON EFFECTIVF. INTEREST

RATES
Frequency

iiate

i7o)

'Formula

Annual

t0

Semiannual

1C

Monrhly

r0

12

Daily

t0

365

Contin'rous

tc

Efiective Annual !.ate (7o)

0.r0

t0

(l+.r0/2)r*t
t0

(l +.10i l 2)" (l +.10/36i)r6i-l

1

-i

10.2s
10.47

i5
i0.5i7t
10.5

As you can see, as corxpcunding becomes irore fi'eqrrent, t]re ellective rate inci'eases, atrd
olfuture t-ash {lous decreases.

i,ire

Dresent value

To illustrate, most horne mofigage Ioans in the United States requilc rncnlhiy pa1'ments an,J,
consequently, have monthly compounding. ThLrs, ti;e annr:al interesi rates quoted on lo:ns can be
deceptive becaLrse the){ ale actr-raiiy too lou,. A loan u,ith an annual interest rate ol 8.00%, ior
erample, ,viren aCjusieC fcr the monthll,corrpounding, ,vill have an effective interest rate of:
l')

tl'lective lntcrest Rlte

- (,

-H)

-r=83%

AI{I{UITIES
An arrnrrity is a constant cash flow occurring at regular intervals foi a fixed perio.l of tine.
Definir,g A to be ilre air:ttil.. ihe tirle line for rn annuity may be drarvn as iolicws:
A

itl

64

AAA

An annuity can occur at the end of eacir periocl,

as in this tirne line, or at the beginning of each

::riod.
Present v.llue of

rn end-of-the-rreriod annuity.

pre:r:.irvalue cf an ann,rity can be calculated by taking each cash flow and discourliing 'lck
pi-er,cnt anC then adding r-rp the present values. Aiternatively, a formula can'De useo il, the
calculatior;. In tlie case of annuities that occur at the end of each pe:'iod, this formula ;ar be

Tl.re

rc

thl

written

as

PV of an Annuity = PV

1--l

1-ll

(A,

i !rl,'

l_'_.1
rvhere

,{
rr

Anr-ruit'l

Discouni Rate
Number of Years

Accordingly, the notation u,e u,ill r-rse in the rest of thrs book for the pt'eserlt i'alues of an annLlity
r,.iili be PV (4, r, n).
Sr:ppose you rlln an adveftising agency and you have a chcice of buying a copier for $10,00C casil
dorvn o. paying 53,000 a year for five years for the sarne copier. if the oppcrtunity ccst is i29/0,
u,hich would you rather do?

lrl
li--i

--r

I rr.iz)'
i--l:sto,stt
I

P/of

$3,000 each 1'ear lor nexi five yeats = $3,000

lrzl
L--J

present value of the installntent payrxents exceeds the casl.i-doivn pi'ice; tllei-elore, ycu would
\\ ant io nay tlte S 10.000 in caslt rtorl
TI-re

Amortization factors-annuities given presen t vaIue.

some cases, the present vaiue of the caslr flo.:vs is knor,,n ard tlle annuiiy r-reeds to'i-rc'csiin,aietl,
Tl,is is often tire case rvith hoire anci autorrobile loans, for e;:ample, wllerebv ihe borror'ver
receives the loan tociay and pays it back rn eqr,ral rnontl.tiy tnstallnteltts ovei an extended.period cf
ii6e. This prccess'of tinding an annuitv rvhen the present value is known is eian.rined below:
Tn

Annuiiy given Present Value

:,4

(Pl/, r, n)

PV

'f-,
I
l_l

,,!,

_l

65

To illurtratc, supilose you are trying to borrorv 5200.000 to buy a house ol] a conventional 3O-year
morlgarle rvith rnonthly payrnents and the annual percentage rate olt the lor:n is E%. The monthly
paymeiits on this loan can be estirnated usirrg tlre annuity due forlrr-rla:

lr

Monthly Interest Rate on Loan :

APR/12 = 0.08112 = 0.0067

o0067

Molltl:l1Pa.vtncntoIlMoI1gJge:$200.000|-:-|sr.+u;.ir

1t oo67ri"i_l

This monthly paymenr is an increasing function of interest rates. When intel'est rates drop,
l.romeow,ners usualll,have a ciroice of refinancing. though there is an up-fl'ont cost to doing so.
Norv suppose yoLr are trying to b,ry a nerv cai-tlrat has a sticl<er price ol$15.000.'[he dealer oflers
you tr.,,o deals:

You can bo:'rorv $15,000 at a special financing annLtal percentage rate ol39lo, for

3C.

nrortths,

or

You

of

get $1,000 of1'the sticl<cr price ancl borrorv $14.000 fi'ont tlte nort,,ral finar,'cirlg rete
pcr artntlln. lor 36 morrths.

ca.n

1?,"h

To exainine which is tlrelcetter deal. you,nLrst calcrrlate the Incrtthly payrnerrts cn eacl'i o:te:

;","r"

*.",

lnte'e>t:

llonthiy

Payrnent on Special Financing Deal

i5,0rl0
i

tl

oo2s)i6

Vontlriv Rate of Intei'est = 12%l 12:

it'l__
lr
I

IiI Vonthlv

l,'L

Pavrre ni. on Discount Deai = Sll.0,)0

,
I -,

The monthly payments are lor.ver cn ihe special firrancing cleal, rrral:ing it thel;etter cne..'\nrlher
rvay of lcoking at these choices is to ccrrrpale the prt::nt rrlLIe oi the sa"'ings yc'"i get irom tlre
lorver rate agaii,st the doiiai value of the discount. In this case. for instance. tl-:e rnonthll'pavment
on a $15,000 loan at an annual rale ol 3% is $436.22, whercas tlte rnonthly payixenl on tlte sarne
ioair at an annual rate of )2o/"is S.198.21. Thc nronihly saviirgs is 56l 99, yielding a prcsent value
savings

of

tPresent Value of N{onthly Savings = $61.99

66

ilfo

$I

I,

,866.34

would
The present value of the sar.ings is greater than thc price iliscount of $1,000. The dealer
deal.
therefore Save to offer a uruch ia;.-:er discount (>$1,856.3'1 ) fr;r you to take the second

;ndiviclual ,nuy piun to set aside

Future value of end-of-the-period annuities. In some cascs. an
mucil he or sile
a fixed annuity each period ioi : number of periocis and rvtlr want Io know holv
be
rvill have at the end of the pe::od. The future value of ''i end-:lthe-p:ric'd annriiiy can
calculated as follows.

if
FV of an Annuin = ?i/

L'1,

*,r'-

rI

L,

r, n) = A

_]

Consider individual retireineri::.ounts (lRAs), rvhich alluuv some taxDayels to set aside $2,000

year lor retirement and e.i::t,:- the income earned on these accouilts from taxation lf an
lndividual starts seiting aside ni:.er in an IRA early in his working life, the value at retirelllent
can be substantialll,,hi!her th;:r: norninal alrount actr-raJly put in. For instance, assuire ihat this
individual sets asicie SZ,OOO a: :-r: end of eyery year, starting rvherl she is 25 years oltl. for an
expected retirernent at the age o: 55- and that she expects to trake.Eo% a year on her investments'
Tlie expected value of the accou:.: on her retiretnent date can be estimated as foliorvs:

lrlos;'oE.xpected Value of iR.A

.:t

aside at 55 = $2,000

r I=lssts tt;

pretax
The tav. exerrption adds substan::::,r to the vaiLte becattse i'i allows IIl.' investoi'to l:eep tile
the
after-tax
10Yo,
at
say
taxed
had
been
the
income
If
i:r3sttnent.
IR-,,
the
return of 8o% nraCe on
returrr rvouid Itave ciropped to -1.Si,. :esuliirrg in a rrtrtch lower expected value:
l-

rl

E,xpecied Value oi iRA sei

-l;:

ai 55 is taxed = $2'0C0

o+ g)to-

t0tq

$23C,127

As yo,-r can see, the available :u:,:s at retirement dropoed by rrore tiran 559'o as a consequenoe
the loss of the trr exernPtion.

oi

Annuity gi.,,en luture value.

some
IndividLrals or businesses uho .::'.: fired obligatioi or a target to i,.ieet (in terms of savings)
target.
this
If
tirne in the future need to knc.,, .-..,.r rnLrch they shoulC set aside each pericC t.o.5
you ale given the f,rturv valr:e ai- :le iooking lor an a,inuity-A (l''l/, r, n) in ternls oiirotation:

.rrnuity given Future

\'.ll:
I

= A (FV, r, n) =

FV

+ r)

''-

I
I

_l

To illustrate, in any balloon pa]'ment loan, only interest paytnents are lnade during the Iife of the
using
loan, while the principat is paia 3r the end of the period. Companies ti.rat borrow rnoney

61

balloon payment Ioans or conventional bonds (,,,ihiclt share the sarne features) often set aside
money in sinking funds during the life of the loen fo ensLrre that they'have enough at maturity to
pay the principal on the loan or the face vair-te of Ll'rr bonds. Thus, a cotnpany with bonds that have
a face value of Sl00 million coming due in l0 year: u,ould need to set aside the follouing anlount
each year (assurning an interest rate of 89/o);

Sinking. Fund Provision each year =

10,000,000

.08

L.t.08)ro-

$690,295

The cornpany',r,ould need to set aside S690,295 at the end of each year to ensure that tirere would
be enough funds (S10 miilion) to retire the bonds at IraILrrity.

Effect of annuities at the beginning of each 1'ear. The annr-rities consiclered thr-rs lar in this
c)rapter are end-of-the-period cash flor.vs. Both present and fltr-ire values arc affected if the cash
flows occur at the beginning of each pericd i:rsteaC of the end. To illust:'ate this effect, consicier an
annuity of $100 at the end of each year for the nert fbr-rr'years. ivith a ciscount rate of 1002.
$r00

100

1,}yo

t0%

r)'/o

Contr'ast this with an annuitv

the sarre discourit rate:

s 100

r00

lja,'o

of $100 al Ihe begirtning of each year lor the nexi four years.

r.i'iih

Because cf titc first of these annujties occurs right norv, arrd the rer,raii,ing cash flows take the
forrl of an end-of-the-pericd annu!i1, over three ),par'!. the nl'esent valLre of this annrrjiy can be
r'.

r'it1en as fo I Ior',

Ptrlof $100 at beginning of each olnext

In peneral, the present i,al,.re

ola

fr-rr-tr

yerrs

S100 + $100

beginnine-of:the-per"rod :rnnLrity o\/er /? l,/ears can be *'ritten

as

fcllows:

PZ cf Beginning ui PerioC Annuities over r, )iears

- A +A

I
I

_l
Titis present value
period.

68

lvill

be higher than the p!'cseni ralue cf an equivalent a:rnuity at the end of each

The future value of a beginning-of-a-period annuity typically can be estirnated by allowing for one
aciciitionai period of compounding for each cash flow:

<w
FVof

a Beeinning-of-the-Period Annuity =

*,')'-ll

L.
l-ft

(l +r)

_l

Consider again the exarnple of an indiviCual rviro sets aside $2,000 at the end of each year for next
40 years in an IRA account at 8Yo. The futr-rre value of these deposits arrounted to $518,113 at the
end of year 40. If the deposits had been made at lhe beginning of each year instead c.f the end, tl-le
future vaiue would irave been hicher.

q+JS

Erpected Vairre of IRA (beginning of ycar) = $2.0U0

(i.U8; I

rio-

l_oos

--.1

S55q.562

_i

As you can see. the gains fi'orn rnaking deposits at the beginning of each period can be substantial.

Tire process of discounting. The present value of a grorving annuity can usually be estirnated by
using the 1'ollorving forrrrula;

trr

t^i,i*a

&/
?V oi a Crowing Annr-rity = A

(1,

+ s)

The present value of growing annuity can be eslirnated in ali cases bLrt one-if the grorvtir rate is
equai to tl-re disco';rrt rate. In thai case, the preserrt value is equai to the rrorninal surrrs of tl^,e
annuities over ihe pericd, withcLit the grorvth efiect.

PV

of aGrorving AnnLrity tbr ir years (v,,hen r = g) = rr A

Note also tliot llte erpundetlformulatiott w,orits even vtltut

tJre

growilt rate is grcalqr lhqn the

clisccurtl:'ttle.

To illustrate, suppose ycu have the rights to a goiu mjne for thc ;ext 20 years, over rvhicir pencd
ycu pian lc extract 5,000 oLrnces of gold every year. The cur;ent price per ounce is $300, hut it is
expected to inc,ease 3o/o a ycar. The appi'opriaie disccr;rrt rate is lUTo The present vaiue of the
goid that will be extrlcteJ [,orn tlris,r]intr can bt e:t;rlrted a: lcllows:

s\
8,)

[-.-( 1.ur)-"
,n -l'

|
rl-l
PVofextracredgold =$i00 * s.000 *(1.03)'i,,.rf
I T[rT]-

t_

lS,u,l4s,980
|

_l

Prcblems:

if the discount

1.

What is the presenr v..lue

rate is 8 percent?

2.

Vhat is the iutr-rre vaiue of an investmeirt of $18, 000 that will earn interest at 6 pcrccnt ald
fall dr-re in seven years,)

J.

Jason was promised $48,000

olri $20,000

sum to be given six ),ears from now

in l0 years if

he r,,,or-rld deposit

Sl4,000 toclay. What

u'oLrlC his

cornpounded annual return be?

4.

Horv rrany ),ears u,oi-ild

it take for a dollar to triple in valLte if it

earns a

6 percent rate of

return ?
5.

for her daughter's college

did
slte accutnttlate by hcr
was
1...,'o.
How
inuclr
when
l;cr
daughter
She
started
education.
N,{arcy placed S3,00C into an in',estr.nent lcturnir.rg 9 percent a year

daughter's
6.

E'1'

birthday?

Todd was asked u,hat he u,ould pay for an investrrent that ofi-ereC Sl, 500 a year for the
Iie required an 11 percent return to rral<e that investment. What shculd he bid?

nc:<i

.10 y,ears.
1.

Ann was offered an annuity of $20.000 a year for tl.re rest of her life. Sire rvas 55 at the tirre
and her lile expectancv \vas 84. The investrnent rvoitld cost her $180,000. What,vcr-rld the
retlrrn on her rnvestrnent be?

Ilorv rnany Iears',vo,rld it take

arnount to 560. 0C0?
9.

,\arcn has $50,000 in clebt outstanding r.i,ith interest payable at 12 percent anniially. iiAaron
intends to pa)' off the ioan 1l-,roLlgh fcui years of ir,terest and principal payrrent. hot'r rruch
shouid

10.

11.

lor $2.0C0-a year in savings earning interest at 6 percent to

l.re

pa1 annualli

Whar is the differense in arrount accurnulateci betrveerr a $10, 000 s,-rrn .,i ith l2 nercent
interest compounded annualil'and one compor-rnded month)y over a one-)ear pericci?
What is the difference rn future value betu,een savings in rvhich 53,000 is depositecl each.,ear
at the beginning of the period and the .sarne amourri cleposited a't tlre er:C of the period?
Assuine an interest rate of 8 L.,ercent an,,l that both are dr-re at tltc end of i9 yeais.

12. Kenneth made a $20, 000 in year l, received a $5, 000 retLii'n in 1'ear 2, made an $8, 000 caslr
payrxent in l ear 3, and received his 520. 000back in year a. if his reqLrired rate of returit is S
the ner present valLrc cf l.iis in',esttrent'l
per0errt, wirat
"vas

il.

14.

if this salar-v is grorvir,g 4 pcrceui anrrLraliy and infiat;..tr

percent
Der','eai
. caicLrlate the arnotttrt ol i.etiir'tt l,e "viil r'eceir.c ir,
is projected ir; risc 3
lite
fifth
i'eal
dollars
in
rrorninal and
)'ear
John had $50.000 in saiary this year.

Becky madc a $3C, CCd investment in year l, received a $i0.000 retui'n in 1"ear 2. 58,000 rn
, r,1 in
--'. S: I.
;::r' -1. and Sq. 000 in i e ar 5. \Vhrl ',vlis he internil rate oi' rcirlrri o\ er tite
f,;'e-year peri,r.i?

. car

10

CASE APPLICATION

#B$

George emaileJ you that he and Laura differed about the irnpact of his extra spending r,rver the
past l5 years. He calculated it at abolrt 53, 000 a year. He said the total cost of $45, 000 :','as well
u,ithin his capability to make up. Laura said the cost was much greater and asked trrat they
compure it. They u,ere oifered an investment of $20, 000 that would pa1,$70, u00 ir, ,..) years.
They want to kno"v if they should take it. Finally, there is an annuitl,that Geoige u-ould ;gl up for
at work. lt would cost $100, 000 at age 55 and provide payments of $8, 000 per year over his
expected 17 - year Iife span. He rvants to know if it is attractive. The appropriate rrarket rate of
return on investments is 7 percent after tax.
Case Application Questions

l.

Calculate ',vhat the Si, 000 - per - year cief rcit. l,acl !t been invesred. rvould ha..,e arncLlnted to
at the end of the 1 5 - year pelicd.
Explain to George'what ccrnpcr-rncling js and how' jt affected tl.ie curnr-riaiivc an.rount leceived

2.

in question L

3.

Caiculate the return on t)re propcsed $20,000 investment and indicate ilre factcrs errtering into
your recomntendaticn to accept or reject it.
Indicate tlre expected retllrn on the annr-rity and rvhetl.rer it should be accepied cr rejecte.i.
Construct an explanation of the time value of money for the financial plan u-sing yolrr answers
to qucstions 1 through 4 in this pail of the finenciai plan to help you comrnunicate the time
value inforntalion to George and Laura.

4.
5.

Appendix
E,xcel Exarnples+

Annual Conrpounding
We rvill calculate the principal resLriting aitcr one-per-iod and trvo-p..1o6 ccrnpounciing. Notrce ihe
difference tvhen rve conrpot:nd for mcre than one periocl. (See FigLrrc l.ul antl Figure i.5)

Brtlllitig Iltis trto;!cl in E.rccl

l.
2.

Inputs. Enter the input dara in tite ranges 86:88 and 815:B17,
[iomporinCing. \\'e Llse tl]e fcrnrula for annuai cornpounding 1o calcr-ilate the principaJ at tire
end of the compounding perioci:

'
'

Presen
\.r,ze

(l

+ lnterest rate) Nlrr,beroi'\'.ars

One-pericd ccrrpounCi:rg. Enter: B6*(1+87) irr cell 89. This ;s cne-)'ear;.,ci'ioJ, and
v','e don'i put a power to tlte expression in the parentltesrs because ii is l.
Ttl'c-perioC compcuntiing. Eritei.= 814-(1+815)^2 in cell 817. "l'his ti;nc \,,e ule tire
porver of 2 fcr the two-year perioC.

Princlpal end of cornpounding period = Principal X

l Vr lue

r.vlll caiculate the present valire of a single cash fiorv in tr.i,o rvays: rrsing the fornrrrra ior

pi'esent .',airre

of a single cash flolv and Lrsing the bLrilt-in Exeel fuirction pv.

B
7t

i
i

Figure i..1. Excel NIodel for One-Perio{ r'ersus Trvo-Period Compoun,'ittg

e-Period Compoundin

=86*(1+87)

rincipal end of Year I

12

lfrvo-PeriodCompoundi

incipal beeinnins of

-vear

umber cf 1'ears

incipal end of Year

:Bl5*(1+816)^2
2

Erample 1.1. \,Vhat is the present i'alue of $223,

c)11

to be receivecl :C yeais fi-orn rorv

ii

ihe

interest rate is 9 percenl? (See FigLire 1 .5.),

Builtling tltis nrude! in E-rccl

1.
2.
i.

Inputs. Enier the inpLrt data in the range Il'{:86.

Present value using the formula. Enter =Bl/(1+b5)^86 in cell 89. We Llse the foliowing
lormula to calculate the present valr-ie of a single ca:h flo'Y;
N"
"b'' ''rneri.ds
Present value : cash flow/( l+Disccunt l{ate)
Present value using the E,xcel PV function. The Exeel PV funcilon Iras fi.,e paralneters:
PY 1rate, nper, pn1t,.fu,

ry"Pe)

The first parameter i'ate ts the discor-rnt rale per period (year. rrottth, Cav. ctc.). rzpe;'i: tlle
number of periods, and/i,'is the fr-rtLrre valr-ie of the cash flow pnrt artd iylte are itsed to handle
annuities. In this case. ive put O fttr pni and r,oiiring ior ly1a. witiclt Excel Lakes as 0.Tlte r'pe
paralrcter has irvo value-s - 0 and I - r','htch indjci';e',r'jrcther the r;asll flo\r/ cccrrl'!:t the end
(0) or at tlte beginning (l) of the pcriod. Tl,e E.xuel PV ftrrrction can be usecl tc calculaie the
pfesent value of a sirrgle caslt flc'",r.
)

12

Figure 1.5. Excel N{odel for Present Value of a Single Cash Flow
A

Value of a Single Cash Florv

I

nnuts

. $n319.7;

ruture cash florv

scount rate
urnber

',r";,',;,,,;,9o1
t:,

of

l'': :i5(

resent Value using the Formula

)resent Value

$3.00(

nt Value using the Excel PV Functio

)resent Value

l2

: $J.

t3

= B4l(I+85)^86

Figure 1.6. Excel Mociel for Future Value of a single Cash

iuture Value of

a Single

Crsh Fiorv
=

PV (B5, Brr, 0, 84)

mounr Ceposited
rrierest rate

iure !'alue using the forniula

uture Vaiue usirrg the Excel PV Punction

= 84tl(l+85)^86

-FV (B5, 86, o, 84)

'uture Vaiue

ilre present value of an annuity, and the present value of a bond plice. We put a negative sign in
frorrt ol the PV firnction because othei'wise it retur'ns a rregative result. egain, tliis is sontewhat
irritating, but it is the rvay of hand)ing t'hat problem.
Entei' = - PV (8,s, 86, 0. 84) in cell B 12.
Notice tirat

r.r'e

gei the sarne iesuit ($3, 00C) both ways.

Future Value

uill

calculate the future value of a single caslr flow In two ways: ,-r-sing the lorrnula lor future
value of a single cash flow and Lrsing ihe bLrilt-irr Excel functiorr FV.

\r/e

OCC in a cerlificirte cieposit fcr six years earning 5 percent

you
qlthe end of the pcriod? (See Figure 1.3).
l.rave
accumulated
annually, horv much would

Example i.2. If you were tc deposit $7,

B
13

i
I
I
I

Building tltis ntodel in Excel

I
I

l.
2.
3.

Inputs. Entcr 1)re input ciara in tlre range BJ:86.

Future value using the formula. Enter = B{*(!+85)"86 in cell 89' We use the following
formula for calculating the futr,rre value of a single cash flow:,
N'' irber ol'periods
Future ,ulua : Cash florv X 1i +llrtere-'t rate)
Future value using the Excel FV function. The Excel FV function has the same forliiai and
paratneters as the PV function, except for the fourtll pararneter, rvhich ispv:
FY (rate, nper, pmt, Pv, t))Pe)
The built-in FV function can be used to calculate the fr-rture value of a single casi'r flor^r. the
future value of an anni-rity, and the future value of a bond price. Again, we pLlt a negative sign
in flont of the FV ir-rnction so that the futLrre resirlt rvill be positive.
l:nter: - FV (85, Bti. 0, B'1) in ce]l Bi2.

Noiice that Igairr we {et the satre result (59.381) Lising both inethods
Solving ior the Discount Rate

icr tlte discount rate. Tllere ir no

closed-foln solr-rtion for that particular problerr, but it rnakes ortr wcrk easier by offering a hr-riltin funciion that rvill solve lor the discor-rnt rate. The ltrnclion Rate has the following forrnat and
Sometimes, we cotre across problerns tliat rr.,e havc to solve

parameters:

Rate (rtper, pmt, pv,.fv, tYPe, gLies.\)

parameter's were dellned earlier ior gaesr,'uhich refels
correct ans\ver. Generally, you can otnit :t.

Ali

to yolLr optional first guess at the

Figrrre 1.7. Excel N{oCei fcr Solving for the Discourrt Rlte
ts=-

rL

r the Discount Ratc

iscount Rste Using the Excei Rate Fu

L..**;Exarriple 1.3. SLrsan itas protnised to pay Paul 540,00U ln nine )'ea,rs if ire gives her S20. 000,iorv,
Wirat discor,rnt rate is Sitsan using? (Se c F i!.Lrre I .8.).

Buil:ling tltis noiel in Excel

i.
2.

1A
ta

InptLts. Enter thc inpr-rt data in the range BJ:86.

Discount rate r-ising the Excel P-ate furrciion. Eirter = Rate (ts6' 0, -Bd, B:) in ccii 89.
We put 0 for the secoird p3ralneter,prrt, becaitse it is Lised fcr annuittes. The trick here is that
the function rvolks only.,vhen the present value and fitture vairre l.rave oppcsitc signs. Tl,is is
the reason we put a negative sign in fiont of the pre:rnt valut. \Vhiie irritating, this stcp is
neG'lssary lo get ihe nroper res'.tit

_i
E

Solving for the Nuntber of Compounding periods

I
$.

Sometinles we corne.upon prcblerns rlrli u'e have to solve for the nurrber
of cornpounding
periods. That particular probl'rn has ic closed-fonit sciLrtion. Howcver,
Excel makes the
calculation easier because Excel has a burltin lunction that solves lor the
nurnber of periods. 'l-hi"

function; Nper, has the lollowirr.g forrnat and parameters:

Nper (rate, pntt, pv,.fi,, type)
We alread-v know the defir:irion

ol-rllthe

Example 1.'1. Horv long will

it

percent? (See Figure 1.8)

Building this ntodel in excel

.
2.
1

Dararnetcrs.

take for $10, 000 to reach $1g,672

if the rate of

interest is 7

Inputs. E.nter the input data in rangc 84:B6.

Number of periods using the Excel ].iper function. Eriter

Nper (86, 0, -B.1, 85) in celi

B9. Again. we llse a negative sign for the present value in oider to get proper resLrlt.

Figure 1.8. Excel Nloclel for Solving for the Number of compouncling periods
A
ftrr the Nuntber of Per

nputs
value cf a cash floi.r
uture value

..,$10;0c(

ofa cash flow

$19,6:1.2

.:_:,. 1!1

terest rate

rrnt Rate Using tlie Excel Nper Fu

urrr

ber

of

NPER (35; 0, -B1, B:)

t(

Figure 1.9. Excel Model for Future Value of an Annuitv

-jqq!rir4:l!l4

A
.au,qity

E
L

,,;,.

.,,,ij:l

l0
1l

ture value using the Excel FV function

ItUre.,/alUe

qq?

s?

r---l

_,_-l

I
I

,</l

rutLrre value

___

,7i

Future value using the formula

12

--

__]

=st

4 _'",':i1l1,l
I

l3

75

I
I

Future Value of an Annuitv

I

We will calculate the future value ol an annuity in tri'o rvays: using the formula for the future
value of an annuity and using the built-in Excel function FV.
Example 1.5. Jack and Alice ivant to deposit $1, 000 at the end of each year to accurnulate rnoney
for a college fund for- their nervborn daughter. They expect a return of 7 percent on their rnoney.
How rnuch will they have at the end of the l7'l' year? (See figLrre I ^ 1 0).

tsuiitiittg tltis tnodel irt Exce!

1.
2.

Input. Errter the input data in tl.re range BJ:86.

Futurc value of an annuity, using the formula. We
tlre lulure vaiLre or an annuilv:
*"
Furure value = Payrnent X ((( l+ DR)

r-rse

the lollorving forrnLrla fcr calculating

),'DR;

Wl'rere

DR = Discount rate
NP = NLrrnber of periods

Enter: B.l*(((1+R5)"86 - 1)/B5) in cell 89.

'1.

Future value of an annuity using the Ercel FY function. E,xcept lor futr-rre valr:e of a singie
cash florv. the Excel Fv lunction can be used to calculate the firture val,-re of an annuity. The
forir-iat cf the lunction in tl'ris case is
FY (.rote. nper, pmt, ())

Figure 1.10. Ercel N{odel for Present Value of an Annuity

A
t Yalu

uf an Annuir

resent valuc usiR the Excel PV funciiorr

E-rllz

lPreserit value

Vv'e p,-:t

0 lor the fourlh paramcter becalrse

r'r,e

don'r

}ra.Ve

a caslr flo,r at tlre beginning cf tit:

period; hence, ihe present value is 0. We pLrt a nesati!e sign in fi'on1, of iltc F\,/ iLrnction so that tlte
future value result will be positive.
Enter = -FV (B5, 85, 84, 0) in cell B12.
get the sarne resr-rlt (S92,521) both rvavs.
Notice tl:at
"r,e

Present Value of an Annu-it1,

We wiii calculate tl-re present valure of an annuity in trvo ways: r-rsing t)te forrnr-rla for the present
value of an annuity and using the bLrilt-in Excel function-PV.

16

Erample 1.6. ivlalia rvas offered annuity payments of $6, 000 at the beginning of each 1'ear for 30
years. The discount rate was 7 percent. What shouid she pay now? (See Figure 1.7).
Buildin3 this mcdel irt Excel
1.

2.

Inputs. Fnter the inpL,i data in the range B4:I16.

Present value of an annuity using the formula. We use the following forirula for
calculating the present value of an annr-rity:
present value = paymenr

x ((l

_ (1 + DR)

-*.;loR; x

(1 + DR)

We add the last p,aft, (1+ DR), because payirenis are inade at the beginning of each 1'ear. ln
our case, \ve have an annuity due. Basically, the lormula for the present value of a regi:lar
annuity is
Preseni vaiue = Payrnent X
Enter =

i.

84*((t -

(1

* B5)"(-

((l - (l + DR) -tto;/Dn;

)

85))/85)*(1 + 85) in cell B9.

Present vaiue of an annuity using the Ercel PV function. Ercept ior ihe present val,le of a
singie caslr flow, the Excel PV function can be useC to calcr,tiate ihe present value of an
an;ruity. Tlre forrnat ol.lte f unctiorr irr our case is
PY (rate, nper, pmt, 0, 1)

The lorrrat of this function is sirnilar to the lorrnat of the function lor the hrture value of an
annr:ity, except for the fifth parameter. If you recal l, the PV anci FV functions have five
pararleters, the iast of rvhich is type In our case, \ve set tlte type paftr'i.erer to I because
payments are tnade at the beginning cf each year. If we have a resular annr-lity, rvhen the
paylxerrts are Irade at tlte end of the pcriod. we pr-it nothing for type. r,r,l.ricir E.xcel takes as 0.

Figure 1.11. Excel }{odel for Cornparing Various Nonannual Cornpcuncl!ng .Feriods

nnual Compoundin

om

parison of Various

onannual CompounCing Period

Periotls per Year

= -P'v (Sts$S/BI0, 810,

$ I ,0E't
._--f-

.60

i,082.43

$r,083.r5
$

r.083,28

s
17

t,

$"*)l

Figule 1.12. FV as Compounding Frequency Increases

$1,084 00
$1,083.00

:r
(!

$1.082.00

$1,081.C0

f
P

':

it,l'

m--:t t

hJri

6/
n6n
^^
,)
I,UOU.UU

LL

$1,079 00

.I

'

Ir.n

0)

...'.

',.i:

.'

"':t:"

.t

t.

::r.

[f+r

sl,078

00

"-':"""-

r-r""n,."""N

l,''''

"'S" ",.'".

-"""

epo\

Frequency

No:rannua I Com pounding

We know thai investrtrents pay caslt flor*.,s not cnly annualiy br-rt also serrianrrr.rally, qurarlerly,
monthly, daily and so on. l.vonannr-ral cornpounding deals willi pericCs shorter than a year. As you
,r,ill see, E,xcel can handle tlte Nonannr-ral cornpounding.

Erample 1.7. What is the iuture value of $1, 000 if the annual interest rate is 8 percent and we
have various frequencies of corrprrunding: aitn'lal. setniannual. quarterly, bintonthiy, monthly.
biwcekly, weekly and daii,v? (See Figure I 8).
Using thc results obtained, rve build a graph that shorvs ho,,v the futr-rre value
increases as irequency of compor-rnding incieases (See Figure i.9)

ol an ini.estntent

Buildirtg tlris rnoclel in Excel

1.
2.

Inputs. Enter tlre inpr-rt Cata in the range B,l:85.

Future'.'alue of the investment for various conrpouncing per:cds. pir_st rve construct lire
tab1e, filliitg or-lt the data fci' f,'eq,rcrrcy anC corresponding nLlirber ci perioCs per vear.. .l.h:n
rve calculaie the future values cf our investrnenr fblzario,-rs period leneths in the rztnge
CIC:CL1 . Recali the fcrrntria for NonannLral cornpcrlnding:
FLlture value: Present ValLre X (l + (DR//i7))

NX"'

Whei'e
..J

,r4

Nriirtber nf years
Nurrrbcr oi per if'd-s pJi" y(Jr

Llsing this foi'irula, we rnake ihc i,ccessarl, changes in tire parameters

interest rate is divided by the nurnber ol per-iods ,r., i,."r.

oithe FV lunction. The

Enter': -F\'($Bss/Blc, 810, c, $BSJ) i,i ce ll Cl0 and copy ii iiown ro ceI
Note rhat the more frequent the colnpoundirrg. rhe higher the rLrturc vAlue.'

cl7.

78