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.

c interest rate) m - 1
ods in one year, and
e) / 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

me units - either by calling for quarterly or monthly compounding or by expressing time in months and the interest rate in ye
ng to go too fast. Remember to make sure the units agree for r and N, and are consistent with the frequency of compoundi

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:

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:
of money,
ney, R = annual interest rate,

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.
/r

- n /r

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.
Cash Flow Present Value Formula R
$1,000 ($1,000)/(1.08)1
$1,500 ($1,500)/(1.08)2
$2,000 ($2,000)/(1.08)3
$500 ($500)/(1.08)4
$3,000 ($3,000)/(1.08)5

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:

Cash Flow Future Value Formula R

$1,000 ($1,000)*(1.08)4
$1,500 ($1,500)*(1.08)3
$2,000 ($2,000)*(1.08)2
$500 ($500)*(1.08)1
$3,000 ($3,000)*(1.08)0

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.

Read more: Time Value Of Money Calculations - CFA Level 1 |

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