What it the Time Value of Money?

The principle of time value of money - the notion that a given sum of money is more valuable the sooner it is
received, due to its capacity to earn interest - is the foundation for numerous applications in investment finance.
Central to the time value principle is the concept of interest rates. A borrower who receives money today for
consumption must pay back the principal plus an interest rate that compensates the lender. Interest rates are set
in the marketplace and allow for equivalent relationships to be determined by forces of supply and demand. In
other words, in an environment where the market-determined rate is 10%, we would say that borrowing (or
lending) $1,000 today is equivalent to paying back (or receiving) $1,100 a year from now. Here it is stated
another way: enough borrowers are out there who demand $1,000 today and are willing to pay back $1,100 in a
year, and enough investors are out there willing to supply $1,000 now and who will require $1,100 in a year, so
that market equivalence on rates is reached.
The Five Components of Interest Rates
1. Real Risk-Free Rate - This assumes no risk or uncertainty, simply reflecting differences in timing: the
preference to spend now/pay back later versus lend now/collect later.
2. Expected Inflation - The market expects aggregate prices to rise, and the currency's purchasing power is
reduced by a rate known as the inflation rate. Inflation makes real dollars less valuable in the future and
is factored into determining the nominal interest rate (from the economics material: nominal rate = real
rate + inflation rate).
3. Default-Risk Premium - What is the chance that the borrower won't make payments on time, or will be
unable to pay what is owed? This component will be high or low depending on the creditworthiness of
the person or entity involved.
4. Liquidity Premium- Some investments are highly liquid, meaning they are easily exchanged for cash
(U.S. Treasury debt, for example). Other securities are less liquid, and there may be a certain loss
expected if it's an issue that trades infrequently. Holding other factors equal, a less liquid security must
compensate the holder by offering a higher interest rate.
5. Maturity Premium - All else being equal, a bond obligation will be more sensitive to interest rate
fluctuations the longer to maturity it is.
Time Value Of Money Calculations
Here we will discuss the effective annual rate, time value of money problems, PV of a perpetuity, an ordinary
annuity, annuity due, a single cash flow and a series of uneven cash flows. For each, you should know how to
both interpret the problem and solve the problems on your approved calculator. These concepts will cover LOS'
5.b and 5.c.
The Effective Annual Rate
CFA Institute's LOS 5.b is explained within this section. We'll start by defining the terms, and then presenting
the formula.
The stated annual rate, or quoted rate, is the interest rate on an investment if an institution were to pay interest
only once a year. In practice, institutions compound interest more frequently, either quarterly, monthly, daily
and even continuously. However, stating a rate for those small periods would involve quoting in small fractions

and wouldn't be meaningful or allow easy comparisons to other investment vehicles; as a result, there is a need
for a standard convention for quoting rates on an annual basis.
The effective annual yield represents the actual rate of return, reflecting all of the compounding periods during
the year. The effective annual yield (or EAR) can be computed given the stated rate and the frequency of
compounding. We'll discuss how to make this computation next.
Formula 2.1
Effective annual rate (EAR) = (1 + Periodic interest rate)m - 1
Where: m = number of compounding periods in one year, and
periodic interest rate = (stated interest rate) / m
Example: Effective Annual Rate
Suppose we are given a stated interest rate of 9%, compounded monthly, here is what we get for EAR:
EAR = (1 + (0.09/12))12 - 1 = (1.0075) 12 - 1 = (1.093807) - 1 = 0.093807 or 9.38%
Keep in mind that the effective annual rate will always be higher than the stated rate if there is more than one
compounding period (m > 1 in our formula), and the more frequent the compounding, the higher the EAR.
Solving Time Value of Money Problems
Approach these problems by first converting both the rate r and the time period N to the same units as the
compounding frequency. In other words, if the problem specifies quarterly compounding (i.e. four
compounding periods in a year), with time given in years and interest rate is an annual figure, start by dividing
the rate by 4, and multiplying the time N by 4. Then, use the resulting r and N in the standard PV and FV
formulas.
Example: Compounding Periods
Assume that the future value of $10,000 five years from now is at 8%, but assuming quarterly compounding, we
have quarterly r = 8%/4 = 0.02, and periods N = 4*5 = 20 quarters.
FV = PV * (1 + r)N = ($10,000)*(1.02)20 = ($10,000)*(1.485947) = $14,859.47
Assuming monthly compounding, where r = 8%/12 = 0.0066667, and N = 12*5 = 60.
FV = PV * (1 + r)N = ($10,000)*(1.0066667)60 = ($10,000)*(1.489846) = $14,898.46
Compare these results to the figure we calculated earlier with annual compounding ($14,693.28) to see the
benefits of additional compounding periods.
Exam Tips and Tricks
On PV and FV problems, switching the time units - either by calling for quarterly or monthly compounding
or by expressing time in months and the interest rate in years - is an often-used tactic to trip up test takers
who are trying to go too fast. Remember to make sure the units agree for r and N, and are consistent with
the frequency of compounding, prior to solving.
Present Value of a Perpetuity
A perpetuity starts as an ordinary annuity (first cash flow is one period from today) but has no end and
continues indefinitely with level, sequential payments. Perpetuities are more a product of the CFA world than
the real world - what entity would obligate itself making to payments that will never end? However, some

securities (such as preferred stocks) do come close to satisfying the assumptions of a perpetuity, and the formula
for PV of a perpetuity is used as a starting point to value these types of securities.
The formula for the PV of a perpetuity is derived from the PV of an ordinary annuity, which at N = infinity, and
assuming interest rates are positive, simplifies to:
Formula 2.2
PV of a perpetuity = annuity payment A
interest rate r
Therefore, a perpetuity paying $1,000 annually at an interest rate of 8% would be worth:
PV = A/r = ($1000)/0.08 = $12,500
FV and PV of a SINGLE SUM OF MONEY
If we assume an annual compounding of interest, these problems can be solved with the following formulas:
Formula 2.3
(1) FV = PV * (1 + r)N
(2) PV = FV * { 1 }
(1 + r)N
Where: FV = future value of a single sum of money,
PV = present value of a single sum of money, R = annual interest rate,
and N = number of years
Example: Present Value
At an interest rate of 8%, we calculate that $10,000 five years from now will be:
FV = PV * (1 + r)N = ($10,000)*(1.08)5 = ($10,000)*(1.469328)
FV = $14,693.28
At an interest rate of 8%, we calculate today's value that will grow to $10,000 in five years:
PV = FV * (1/(1 + r)N) = ($10,000)*(1/(1.08)5) = ($10,000)*(1/(1.469328))
PV = ($10,000)*(0.680583) = $6805.83
Example: Future Value
An investor wants to have $1 million when she retires in 20 years. If she can earn a 10% annual return,
compounded annually, on her investments, the lump-sum amount she would need to invest today to reach her
goal is closest to:
A. $100,000
B. $117,459
C. $148,644
D. $161,506

Answer:
The problem asks for a value today (PV). It provides the future sum of money (FV) = $1,000,000; an interest
rate (r) = 10% or 0.1; yearly time periods (N) = 20, and it indicates annual compounding. Using the PV formula
listed above, we get the following:
PV = FV *[1/(1 + r) N] = [($1,000,000)* (1/(1.10)20)] = $1,000,000 * (1/6.7275) = $1,000,000*0.148644 =
$148,644
Using a calculator with financial functions can save time when solving PV and FV problems. At the same time,
the CFA exam is written so that financial calculators aren't required. Typical PV and FV problems will test the
ability to recognize and apply concepts and avoid tricks, not the ability to use a financial calculator. The
experience gained by working through more examples and problems increase your efficiency much more than a
calculator.
FV and PV of an Ordinary Annuity and an Annuity Due
To solve annuity problems, you must know the formulas for the future value annuity factor and the present
value annuity factor.
Formula 2.4
Future Value Annuity Factor = ((1 + r)n - 1)/r
Formula 2.5
Present Value Annuity Factor = (1 - (1 + r)-n /r
Where r = interest rate and N = number of payments
FV Annuity Factor
The FV annuity factor formula gives the future total dollar amount of a series of $1 payments, but in problems
there will likely be a periodic cash flow amount given (sometimes called the annuity amount and denoted by A).
Simply multiply A by the FV annuity factor to find the future value of the annuity. Likewise for PV of an
annuity: the formula listed above shows today's value of a series of $1 payments to be received in the future. To
calculate the PV of an annuity, multiply the annuity amount A by the present value annuity factor.
The FV and PV annuity factor formulas work with an ordinary annuity, one that assumes the first cash flow is
one period from now, or t = 1 if drawing a timeline. The annuity due is distinguished by a first cash flow
starting immediately, or t = 0 on a timeline. Since the annuity due is basically an ordinary annuity plus a lump
sum (today's cash flow), and since it can be fit to the definition of an ordinary annuity starting one year ago, we
can use the ordinary annuity formulas as long as we keep track of the timing of cash flows. The guiding
principle: make sure, before using the formula, that the annuity fits the definition of an ordinary annuity with
the first cash flow one period away.
Example: FV and PV of ordinary annuity and annuity due
An individual deposits $10,000 at the beginning of each of the next 10 years, starting today, into an account
paying 9% interest compounded annually. The amount of money in the account of the end of 10 years will
be closest to:
A. $109,000
B. $143.200
C. $151,900
D. $165,600

Answer:
The problem gives the annuity amount A = $10,000, the interest rate r = 0.09, and time periods N = 10. Time
units are all annual (compounded annually) so there is no need to convert the units on either r or N. However,
the starting today introduces a wrinkle. The annuity being described is an annuity due, not an ordinary annuity,
so to use the FV annuity factor, we will need to change our perspective to fit the definition of an ordinary
annuity.
Drawing a timeline should help visualize what needs to be done:

Figure 2.1: Cashflow Timeline

The definition of an ordinary annuity is a cash flow stream beginning in one period, so the annuity being
described in the problem is an ordinary annuity starting last year, with 10 cash flows from t0 to t9. Using the FV
annuity factor formula, we have the following:
FV annuity factor = ((1 + r)N - 1)/r = (1.09)10 - 1)/0.09 = (1.3673636)/0.09 = 15.19293
Multiplying this amount by the annuity amount of $10,000, we have the future value at time period 9. FV =
($10,000)*(15.19293) = $151,929. To finish the problem, we need the value at t10. To calculate, we use the
future value of a lump sum, FV = PV*(1 + r)N, with N = 1, PV = the annuity value after 9 periods, r = 9.
FV = PV*(1 + r)N = ($151,929)*(1.09) = $165,603.
The correct answer is "D".
Notice that choice "C" in the problem ($151,900) agrees with the preliminary result of the value of the annuity
at t = 9. It's also the result if we were to forget the distinction between ordinary annuity and annuity due, and go
forth and solve the problem with the ordinary annuity formula and the given parameters. On the CFA exam,
problems like this one will get plenty of takers for choice "C" - mostly the people trying to go too fast!!
PV and FV of Uneven Cash Flows
The FV and PV annuity formulas assume level and sequential cash flows, but if a problem breaks this
assumption, the annuity formulas no longer apply. To solve problems with uneven cash flows, each cash flow
must be discounted back to the present (for PV problems) or compounded to a future date (for FV problems);
then the sum of the present (or future) values of all cash flows is taken. In practice, particularly if there are
many cash flows, this exercise is usually completed by using a spreadsheet. On the CFA exam, the ability to
handle this concept may be tested with just a few future cash flows, given the time constraints.
It helps to set up this problem as if it were on a spreadsheet, to keep track of the cash flows and to make sure
that the proper inputs are used to either discount or compound each cash flow. For example, assume that we are
to receive a sequence of uneven cash flows from an annuity and we're asked for the present value of the annuity
at a discount rate of 8%. Scratch out a table similar to the one below, with periods in the first column, cash
flows in the second, formulas in the third column and computations in the fourth.
Time Period

Cash Flow

Present Value Formula

Result of Computation

$1,000

($1,000)/(1.08)1

$925.93

$1,500

($1,500)/(1.08)2

$1,286.01

$2,000

($2,000)/(1.08)3

$1,587.66

$500

($500)/(1.08)4

$367.51

$3,000

($3,000)/(1.08)5

$2,041.75

Taking the sum of the results in column 4, we have a PV = $6,208.86.

Suppose we are required to find the future value of this same sequence of cash flows after period 5. Here's the
same approach using a table with future value formulas rather than present value, as in the table above:
Time Period

Cash Flow

Future Value Formula

Result of computation

$1,000

($1,000)*(1.08)4

$1,360.49

$1,500

($1,500)*(1.08)3

$1,889.57

$2,000

($2,000)*(1.08)2

$2,332.80

$500

($500)*(1.08)1

$540.00

$3,000

($3,000)*(1.08)0

$3,000.00

Taking the sum of the results in column 4, we have FV (period 5) = $9,122.86.

Check the present value of $9,122.86, discounted at the 8% rate for five years:
PV = ($9,122.86)/(1.08)5 = $6,208.86. In other words, the principle of equivalence applies even in examples
where the cash flows are unequal.
Time Value Of Money Applications
I. MORTGAGES
Most of the problems from the time value material are likely to ask for either PV or FV and will provide the
other variables. However, on a test with hundreds of problems, the CFA exam will look for unique and creative
methods to test command of the material. A problem might provide both FV and PV and then ask you to solve
for an unknown variable, either the interest rate (r), the number of periods (N) or the amount of the annuity (A).
In most of these cases, a quick use of freshmen-level algebra is all that's required. We'll cover two real-world
applications - each was the subject of an example in the resource textbook, so either one may have a reasonable
chance of ending up on an exam problem.
Annualized Growth Rates
The first application is annualized growth rates. Taking the formula for FV of a single sum of money and
solving for r produces a formula that can also be viewed as the growth rate, or the rate at which that sum of
money grew from PV to FV in N periods.
Formula 2.6
Growth rate (g) = (FV/PV)1/N - 1
For example, if a company's earnings were $100 million five years ago, and are $200 million today, the
annualized five-year growth rate could be found by:

growth rate (g) = (FV/PV)1/N - 1 = (200,000,000/100,000,000) 1/5 - 1 = (2) 1/5 - 1 = (1.1486984) - 1 = 14.87%
Monthly Mortgage Payments
The second application involves calculating monthly mortgage payments. Periodic mortgage payments fit the
definition of an annuity payment (A), where PV of the annuity is equal to amount borrowed. (Note that if the
loan is needed for a $300,000 home and they tell you that the down payment is $50,000, make sure to reduce
the amount borrowed, or PV, to $250,000! Plenty of folks will just grab the $300,000 number and plug it into
the financial calculator.) Because mortgage payments are typically made monthly with interest compounded
monthly, expect to adjust the annual interest rate (r) by dividing by 12, and to multiply the time periods by 12 if
the mortgage loan period is expressed in years.
Since PV of an annuity = (annuity payment)*(PV annuity factor), we solve for annuity payment (A), which will
be the monthly payment:
Formula 2.7
Monthly mortgage payment = (Amount of the loan)/(PV annuity factor)
Example: Monthly Mortgage Payments
Assuming a 30-year loan with monthly compounding (so N = 30*12 = 360 months), and a rate of 6% (so r = .
06/12 = 0.005), we first calculate the PV annuity factor:
PV annuity factor = (1 - (1/(1 + r)N)/r = (1 - (1/(1.005)360)/0.005 = 166.7916
With a loan of $250,000, the monthly payment in this example would be $250,000/166.7916, or $1,498.88 a
month.
Exam Tips and Tricks
Higher-level math functions usually don\'t end up on the test, partly because
they give an unfair advantage to those with higher-function calculators and
because questions must be solved in an average of one to two minutes each at
Level I. Don\'t get bogged down with understanding natural logs or
transcendental numbers.
II. RETIREMENT SAVINGS
Savings and retirement planning are sometimes more complicated, as there are various life-cycles stages that
result in assumptions for uneven cash inflows and outflows. Problems of this nature often involve more than
one computation of the basic time value formulas; thus the emphasis on drawing a timeline is sound advice, and
a worthwhile habit to adopt even when solving problems that appear to be relatively simple.
Example: Retirement Savings
To illustrate, we take a hypothetical example of a client, 35 years old, who would like to retire at age 65 (30
years from today). Her goal is to have enough in her retirement account to provide an income of $75,000 a year,
starting a year after retirement or year 31, for 25 years thereafter. She had a late start on saving for retirement,
with a current balance of $10,000. To catch up, she is now committed to saving $5,000 a year, with the first
contribution a year from now. A single parent with two children, both of which will be attending college starting
in five years, she won't be able to increase the annual $5,000 commitment until after the kids have graduated.
Once the children are finished with college, she will have extra disposable income, but is worried about just
how much of an increase it will take to meet her ultimate retirement goals. To help her meet this goal, estimate
how much she will need to save every year, starting 10 years from now, when the kids are out of college.
Assume an average annual 8% return in the retirement account.

Answer:
To organize and summarize this information, we will need her three cash inflows to be the equivalent of her one
cash outflow.
1.The money already in the account is the first inflow.
2. The money to be saved during the next 10 years is the second inflow.
3. The money to be saved between years 11 and 30 is the third inflow.
4.The money to be taken as income from years 31 to 50 is the one outflow.
All amounts are given to calculate inflows 1 and 2 and the outflow. The third inflow has an unknown annuity
amount that will need to be determined using the other amounts. We start by drawing a timeline and specifying
that all amounts be indexed at t = 30, or her retirement day.

Next, calculate the three amounts for which we have all the necessary information, and index to t = 30.
(inflow 1) FV (single sum) = PV *(1 + r)N = ($10,000)*(1.08)30 = $100,627
(inflow 2) FV annuity factor = ((1 + r)N - 1)/r = ((1.08)10 - 1)/.08 = 14.48656
With a $5000 payment, FV (annuity) = ($5000)*(14.48656) = $72,433
This amount is what is accumulated at t = 10; we need to index it to t = 30.
FV (single sum) = PV *(1 + r)N = ($72,433)*(1.08)20 = $337,606
(cash PV annuity factor = (1 - (1/(1 + r)N)/r = (1 - (1/(1.08)25/0.08 = 10.674776.outflow)
With payment of $75,000, PV (annuity) = ($75,000)*(10.674776) = $800,608.
Since the three cash inflows = cash outflow, we have ($100,627) + ($337,606) + X = $800,608, or X =
$362,375 at t = 30. In other words, the money she saves from years 11 through 30 will need to be equal to
$362,375 in order for her to meet retirement goals.
FV annuity factor = ((1 + r)N - 1)/r = ((1.08)20 - 1)/.08 = 45.76196
A = FV/FV annuity factor = (362,375)/45.76196 = $7919
We find that by increasing the annual savings from $5,000 to $7,919 starting in year 11 and continuing to year
30, she will be successful in accumulating enough income for retirement.
How are Present Values, Future Value and Cash Flows connected?
The cash flow additivity principle allows us to add amounts of money together, provided they are indexed to the
same period. The last example on retirement savings illustrates cash flow additivity: we were planning to
accumulate a sum of money from three separate sources and we needed to determine what the total amount
would be so that the accumulated sum could be compared with the client's retirement cash outflow requirement.

Our example involved uneven cash flows from two separate annuity streams and one single lump sum that has
already accumulated. Comparing these inputs requires each amount to be indexed first, prior to adding them
together. In the last example, the annuity we were planning to accumulate in years 11 to 30 was projected to
reach $362,375 by year 30. The current savings initiative of $5,000 a year projects to $72,433 by year 10. Right
now, time 0, we have $10,000. In other words, we have three amounts at three different points in time.
According to the cash flow additivity principle, these amounts could not be added together until they were
either discounted back to a common date, or compounded ahead to a common date. We chose t = 30 in the
example because it made the calculations the simplest, but any point in time could have been chosen. The most
common date chosen to apply cash flow additivity is t = 0 (i.e. discount all expected inflows and outflows to the
present time). This principle is frequently tested on the CFA exam, which is why the technique of drawing
timelines and choosing an appropriate time to index has been emphasized here.
Net Present Value and the Internal Rate of Return
This section applies the techniques and formulas first presented in the time value of money material toward
real-world situations faced by financial analysts. Three topics are emphasized: (1) capital budgeting decisions,
(2) performance measurement and (3) U.S. Treasury-bill yields.
Net Preset Value
NPV and IRR are two methods for making capital-budget decisions, or choosing between alternate projects and
investments when the goal is to increase the value of the enterprise and maximize shareholder wealth. Defining
the NPV method is simple: the present value of cash inflows minus the present value of cash outflows, which
arrives at a dollar amount that is the net benefit to the organization.
To compute NPV and apply the NPV rule, the authors of the reference textbook define a five-step process to be
used in solving problems:
1.Identify all cash inflows and cash outflows.
2.Determine an appropriate discount rate (r).
3.Use the discount rate to find the present value of all cash inflows and outflows.
4.Add together all present values. (From the section on cash flow additivity, we know that this action is
appropriate since the cash flows have been indexed to t = 0.)
5.Make a decision on the project or investment using the NPV rule: Say yes to a project if the NPV is positive;
say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would prefer the investment
with the higher positive NPV.
Companies often use the weighted average cost of capital, or WACC, as the appropriate discount rate for capital
projects. The WACC is a function of a firm's capital structure (common and preferred stock and long-term debt)
and the required rates of return for these securities. CFA exam problems will either give the discount rate, or
they may give a WACC.
Example:
To illustrate, assume we are asked to use the NPV approach to choose between two projects, and our company's
weighted average cost of capital (WACC) is 8%. Project A costs $7 million in upfront costs, and will generate
$3 million in annual income starting three years from now and continuing for a five-year period (i.e. years 3 to
7). Project B costs $2.5 million upfront and $2 million in each of the next three years (years 1 to 3). It generates
no annual income but will be sold six years from now for a sales price of $16 million.
For each project, find NPV = (PV inflows) - (PV outflows).
Project A: The present value of the outflows is equal to the current cost of $7 million. The inflows can be

viewed as an annuity with the first payment in three years, or an ordinary annuity at t = 2 since ordinary
annuities always start the first cash flow one period away.
PV annuity factor for r = .08, N = 5: (1 - (1/(1 + r)N)/r = (1 - (1/(1.08)5)/.08 = (1 - (1/(1.469328)/.08 = (1 - (1/
(1.469328)/.08 = (0.319417)/.08 = 3.99271
Multiplying by the annuity payment of $3 million, the value of the inflows at t = 2 is ($3 million)*(3.99271) =
$11.978 million.
Discounting back two periods, PV inflows = ($11.978)/(1.08)2 = $10.269 million.
NPV (Project A) = ($10.269 million) - ($7 million) = $3.269 million.
Project B: The inflow is the present value of a lump sum, the sales price in six years discounted to the present:
$16 million/(1.08)6 = $10.083 million.
Cash outflow is the sum of the upfront cost and the discounted costs from years 1 to 3. We first solve for the
costs in years 1 to 3, which fit the definition of an annuity.
PV annuity factor for r = .08, N = 3: (1 - (1/(1.08)3)/.08 = (1 - (1/(1.259712)/.08 = (0.206168)/.08 =
2.577097. PV of the annuity = ($2 million)*(2.577097) = $5.154 million.
PV of outflows = ($2.5 million) + ($5.154 million) = $7.654 million.
NPV of Project B = ($10.083 million) - ($7.654 million) = $2.429 million.
Applying the NPV rule, we choose Project A, which has the larger NPV: $3.269 million versus $2.429 million.
Exam Tips and Tricks
Problems on the CFA exam are frequently set up so that it is tempting to pick a choice that seems
intuitively better (i.e. by people who are guessing), but this is wrong by NPV rules. In the case we used,
Project B had lower costs upfront ($2.5 million versus $7 million) with a payoff of $16 million, which is
more than the combined $15 million payoff of Project A. Don\'t rely on what feels better; use the process to
make the decision!
The Internal Rate of Return
The IRR, or internal rate of return, is defined as the discount rate that makes NPV = 0. Like the NPV process, it
starts by identifying all cash inflows and outflows. However, instead of relying on external data (i.e. a discount
rate), the IRR is purely a function of the inflows and outflows of that project. The IRR rule states that projects
or investments are accepted when the project's IRR exceeds a hurdle rate. Depending on the application, the
hurdle rate may be defined as the weighted average cost of capital.
Example:
Suppose that a project costs $10 million today, and will provide a $15 million payoff three years from now, we
use the FV of a single-sum formula and solve for r to compute the IRR.
IRR = (FV/PV)1/N -1 = (15 million/10 million)1/3 - 1 = (1.5) 1/3 - 1 = (1.1447) - 1 = 0.1447, or 14.47%
In this case, as long as our hurdle rate is less than 14.47%, we green light the project.
NPV vs. IRR
Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. The NPV
rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use

when allocating capital.

However, it requires an assumed discount rate, and also assumes that this percentage rate will be stable over the
life of the project, and that cash inflows can be reinvested at the same discount rate. In the real world, those
assumptions can break down, particularly in periods when interest rates are fluctuating. The appeal of the IRR
rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the
internal inflows and outflows of that particular investment. However, IRR does not assess the financial impact
on a firm; it only requires meeting a minimum return rate.
The NPV and IRR methods can rank two projects differently, depending on thesize of the investment. Consider
the case presented below, with an NPV of 6%:
Project

Initial outflow Payoff after one year

IRR

NPV

$250,000

$280,000

12%

+$14,151

$50,000

$60,000

20%

+6604

By the NPV rule we choose Project A, and by the IRR rule we prefer B. How do we resolve the conflict if we
must choose one or the other? The convention is to use the NPV rule when the two methods are inconsistent, as
it better reflects our primary goal: to grow the financial wealth of the company.
Consequences of the IRR Method
In the previous section we demonstrated how smaller projects can have higher IRRs but will have less of a
financial impact. Timing of cash flows also affects the IRR method. Consider the example below, on which
initial investments are identical. Project A has a smaller payout and less of a financial impact (lower NPV), but
since it is received sooner, it has a higher IRR. When inconsistencies arise, NPV is the preferred method.
Assessing the financial impact is a more meaningful indicator for a capital-budgeting decision.
Project Investment

Income in future periods

t1

$100k

$100k

IRR

NPV

25.0%

$17,925

$0 $0 $0 $200k 14.9%

$49,452

t4

t5

$125k $0 $0 $0

$0

$0

t2

t3

Money Vs. Time-Weighted Return

Money-weighted and time-weighted rates of return are two methods of measuring performance, or the rate of
return on an investment portfolio. Each of these two approaches has particular instances where it is the preferred
method. Given the priority in today's environment on performance returns (particularly when comparing and
evaluating money managers), the CFA exam will be certain to test whether a candidate understands each
methodology.
Money-Weighted Rate of Return
A money-weighted rate of return is identical in concept to an internal rate of return: it is the discount rate on
which the NPV = 0 or the present value of inflows = present value of outflows. Recall that for the IRR method,
we start by identifying all cash inflows and outflows. When applied to an investment portfolio:
Outflows
1. The cost of any investment purchased
2. Reinvested dividends or interest
3. Withdrawals

Inflows
1.The proceeds from any investment sold
2.Dividends or interest received
3.Contributions
Example:
Each inflow or outflow must be discounted back to the present using a rate (r) that will make PV (inflows) = PV
(outflows). For example, take a case where we buy one share of a stock for $50 that pays an annual $2 dividend,
and sell it after two years for $65. Our money-weighted rate of return will be a rate that satisfies the following
equation:
PV Outflows = PV Inflows = $2/(1 + r) + $2/(1 + r)2 + $65/(1 + r)2 = $50
Solving for r using a spreadsheet or financial calculator, we have a money-weighted rate of return = 17.78%.
Exam Tips and Tricks
Note that the exam will test knowledge of the concept of money-weighted
return, but any computations should not require use of a financial calculator
It's important to understand the main limitation of the money-weighted return as a tool for evaluating managers.
As defined earlier, the money-weighted rate of return factors all cash flows, including contributions and
withdrawals. Assuming a money-weighted return is calculated over many periods, the formula will tend to place
a greater weight on the performance in periods when the account size is highest (hence the label moneyweighted).
In practice, if a manager's best years occur when an account is small, and then (after the client deposits more
funds) market conditions become more unfavorable, the money-weighted measure doesn't treat the manager
fairly. Here it is put another way: say the account has annual withdrawals to provide a retiree with income, and
the manager does relatively poorly in the early years (when the account is larger), but improves in later periods
after distributions have reduced the account's size. Should the manager be penalized for something beyond his
or her control? Deposits and withdrawals are usually outside of a manager's control; thus, a better performance
measurement tool is needed to judge a manager more fairly and allow for comparisons with peers - a
measurement tool that will isolate the investment actions, and not penalize for deposit/withdrawal activity.
Time-Weighted Rate of Return
The time-weighted rate of return is the preferred industry standard as it is not sensitive to contributions or
withdrawals. It is defined as the compounded growth rate of $1 over the period being measured. The timeweighted formula is essentially a geometric mean of a number of holding-period returns that are linked together
or compounded over time (thus, time-weighted). The holding-period return, or HPR, (rate of return for one
period) is computed using this formula:
Formula 2.8
HPR = ((MV1 - MV0 + D1 - CF1)/MV0)
Where: MV0 = beginning market value, MV1 = ending
market value,
D1 = dividend/interest inflows, CF1 = cash flow received at
period end (deposits subtracted, withdrawals added back)

For time-weighted performance measurement, the total period to be measured is broken into many sub-periods,
with a sub-period ending (and portfolio priced) on any day with significant contribution or withdrawal activity,
or at the end of the month or quarter. Sub-periods can cover any length of time chosen by the manager and need
not be uniform. A holding-period return is computed using the above formula for all sub-periods. Linking (or
compounding) HPRs is done by
(a) adding 1 to each sub-period HPR, then
(b) multiplying all 1 + HPR terms together, then
(c) subtracting 1 from the product:
Compounded time-weighted rate of return, for N holding periods
= [(1 + HPR1)*(1 + HPR2)*(1 + HPR3) ... *(1 + HPRN)] - 1.
The annualized rate of return takes the compounded time-weighted rate and standardizes it by computing a
geometric average of the linked holding-period returns.
Formula 2.9
Annualized rate of return = (1 + compounded rate)1/Y - 1
Where: Y = total time in years
Example: Time-Weighted Portfolio Return
Consider the following example: A portfolio was priced at the following values for the quarter-end dates
indicated:
Date

Market Value

Dec. 31, 2003

$200,000

March 31, 2004

$196,500

June 30, 2004

$200,000

Sept. 30, 2004

$243,000

Dec. 31, 2004

$250,000

On Dec. 31, 2004, the annual fee of $2,000 was deducted from the account. On July 30, 2004, the annual
contribution of $20,000 was received, which boosted the account value to $222,000 on July 30. How would we
calculate a time-weighted rate of return for 2004?
Answer:
For this example, the year is broken into four holding-period returns to be calculated for each quarter. Also,
since a significant contribution of $20,000 was received intra-period, we will need to calculate two holdingperiod returns for the third quarter, June 30, 2004, to July 30, 2004, and July 30, 2004, to Sept 30, 2004. In total,
there are five HPRs that must be computed using the formula HPR = (MV1 - MV0 + D1 - CF1)/MV0. Note that
since D1, or dividend payments, are already factored into the ending-period value, this term will not be needed
for the computation. On a test problem, if dividends or interest is shown separately, simply add it to endingperiod value. The ccalculations are done below (dollar amounts in thousands):
Period 1 (Dec 31, 2003, to Mar 31, 2004):
HPR = (($196.5 - $200)/$200) = (-3.5)/200 = -1.75%.
Period 2 (Mar 31, 2004, to June 30, 2004):

HPR = (($200 - $196.5)/$196.5) = 3.5/196.5 = +1.78%.

Period 3 (June 30, 2004, to July 30, 2004):
HPR = (($222 - $20) - $200)/$200) = 2/200 = +1.00%.
Period 4 (July 30, 2004, to Sept 30, 2004):
HPR = ($243 - $222)/$222 = 21/222 = +9.46%.
Period 5 (Sept 30, 2004, to Dec 31, 2004):
HPR = (($250 - $2) - $243)/$243 = 5/243 = +2.06%
Now we link the five periods together, by adding 1 to each HPR, multiplying all terms, and subtracting 1 from
the product, to find the compounded time- weighted rate of return:
2004 return = ((1 + (-.0175))*(1 + 0.0178)*(1 + 0.01)*(1 + 0.0946)*(1 + 0.0206)) - 1 =
((0.9825)*(1.0178)*(1.01)*(1.0946)*(1.0206)) - 1 = (1.128288) - 1 = 0.128288, or 12.83% (rounding to the
nearest 1/100 of a percent).
Annualizing: Because our compounded calculation was for one year, the annualized figure is the same
+12.83%. If the same portfolio had a 2003 return of 20%, the two-year compounded number would be ((1 +
0.20)*(1 + 0.1283)) - 1, or 35.40%. Annualize by adding 1, and then taking to the 1/Y power, and then
subtracting 1: (1 + 0.3540)1/2 - 1 = 16.36%.
Note: The annualized number is the same as a geometric average, a concept covered in the statistics section.
Example: Money Weighted Returns
Calculating money-weighted returns will usually require use of a financial calculator if there are cash flows
more than one period in the future. Earlier we presented a case where a money-weighted return for two periods
was equal to the IRR, where NPV = 0.
Answer:
For money-weighted returns covering a single period, we know PV (inflows) - PV (outflows) = 0. If we pay
$100 for a stock today, and sell it in one year later for $105, and collect a $2 dividend, we have a moneyweighted return or IRR = ($105)/(1 + r) + ($2)/(1 + r) - $100 = $0. r = ($105 + $2)/$100 - 1, or 7%.
Money-weighted return = time-weighted return for a single period where the cash flow is received at the end. If
the period is any time frame other than one year, take (1 + the result), raised to the power 1/Y and subtract 1 to
find the annualized return.
Calculating Yield
Calculating Yield for a U.S. Treasury Bill
A U.S. Treasury bill is the classic example of a pure discount instrument, where the interest the government
pays is the difference between the amount it promises to pay back at maturity (the face value) and the amount it
borrowed when issuing the T-bill (the discount). T-bills are short-term debt instruments (by definition, they have
less than one year to maturity), and there is zero default risk with a U.S. government guarantee. After being
issued, T-bills are widely traded in the secondary market, and are quoted based on the bank discount yield (i.e.
the approximate annualized return the buyer should expect if holding until maturity). A bank discount yield
(RBD) can be computed as follows:

Formula 2.10
RBD = D/F * 360/t
Where: D = dollar discount from face value, F = face value,
T = days until maturity, 360 = days in a year
By bank convention, years are 360 days long, not 365. If you recall the joke about banker's hours being shorter
than regular business hours, you should remember that banker's years are also shorter.
For example, if a T-bill has a face value of $50,000, a current market price of $49,700 and a maturity in 100
days, we have:
RBD = D/F * 360/t = ($50,000-$49,700)/$50000 * 360/100 = 300/50000 * 3.6 = 2.16%
On the exam, you may be asked to compute the market price, given a quoted yield, which can be accomplish by
using the same formula and solving for D:
Formula 2.11
D = RBD*F * t/360
Example:
Using the previous example, if we have a bank discount yield of 2.16%, a face value of $50,000 and days to
maturity of 100, then we calculate D as follows:
D = (0.0216)*(50000)*(100/360) = 300
Market price = F - D = 50,000 - 300 = $49,700
Holding-Period Yield (HPY)
HPY refers to the un-annualized rate of return one receives for holding a debt instrument until maturity. The
formula is essentially the same as the concept of holding-period return needed to compute time-weighted
performance. The HPY computation provides for one cash distribution or interest payment to be made at the
time of maturity, a term that can be omitted for U.S. T-bills.
Formula 2.12
HPY = (P1 - P0 + D1)/P0
Where: P0 = purchase price, P1 = price at maturity, and D1= cash distribution at maturity
Example:
Taking the data from the previous example, we illustrate the calculation of HPY:
HPY = (P1 - P0 + D1)/P0 = (50000 - 49700 + 0)/49700 = 300/49700 = 0.006036 or 0.6036%
Effective annual yield (EAY)
EAY takes the HPY and annualizes the number to facilitate comparability with other investments. It uses the
same logic presented earlier when describing how to annualize a compounded return number: (1) add 1 to the
HPY return, (2) compound forward to one year by carrying to the 365/t power, where t is days to maturity, and
(3) subtract 1.
Here it is expressed as a formula:

Formula 2.13
EAY = (1 + HPY)365/t - 1
Example:
Continuing with our example T-bill, we have:
EAY = (1 + HPY)365/t - 1 = (1 + 0.006036)365/100 - 1 = 2.22 percent.
Remember that EAY > bank discount yield, for three reasons: (a) yield is based on purchase price, not face
value, (b) it is annualized with compound interest (interest on interest), not simple interest, and (c) it is based on
a 365-day year rather than 360 days. Be prepared to compare these two measures of yield and use these three
reasons to explain why EAY is preferable.
The third measure of yield is the money market yield, also known as the CD equivalent yield, and is denoted by
rMM. This yield measure can be calculated in two ways:
1. When the HPY is given, rMM is the annualized yield based on a 360-day year:
Formula 2.14
rMM = (HPY)*(360/t)
Where: t = days to maturity
For our example, we computed HPY = 0.6036%, thus the money market yield is:
rMM = (HPY)*(360/t) = (0.6036)*(360/100) = 2.173%.
2. When bond price is unknown, bank discount yield can be used to compute the money market yield, using this
expression:
Formula 2.15
rMM = (360* rBD)/(360 - (t* rBD)
Using our case:
rMM = (360* rBD)/(360 - (t* rBD) = (360*0.0216)/(360 - (100*0.0216)) = 2.1735%, which is identical to the result
at which we arrived using HPY.
Interpreting Yield
This involves essentially nothing more than algebra: solve for the unknown and plug in the known quantities.
You must be able to use these formulas to find yields expressed one way when the provided yield number is
expressed another way.
Since HPY is common to the two others (EAY and MM yield), know how to solve for HPY to answer a
question.
Effective Annual Yield

EAY = (1 + HPY)365/t - 1

HPY = (1 + EAY)t/365 - 1

Money Market Yield

rMM = (HPY)*(360/t)

HPY = rMM * (t/360)

Bond Equivalent Yield

The bond equivalent yield is simply the yield stated on a semiannual basis multiplied by 2. Thus, if you are
given a semiannual yield of 3% and asked for the bond equivalent yield, the answer is 6%.