2008 John Wiley and Sons

IMPORTANT PRINCIPLE OF FINANCE:

Money has a time valuemoney can grow
or increase over time and money today is
worth less than money received in the
future
TIME VALUE OF MONEY:
Math of finance whereby interest is earned
over time by saving or investing money
SIMPLE INTEREST:
Interest earned only on the principal of the
initial investment
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 PRESENT VALUE:
Value of an investment or savings
amount today or at the present time
FUTURE VALUE:
Value of an investment or savings
amount at a specified future time
BASIC EQUATION:
Future value = Present value + (Present
value x Interest rate)
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Four Ways to Solve Time Value of
Money Problems:
By Hand Using Equations
Financial Calculators
Spreadsheet Programs
Tables-Based Methods

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 BASIC INFORMATION:
You have $1,000 to save or invest for one
year and a bank will pay you 8% for use
of your money. What will be the value of
your savings after one year?
BASIC EQUATION:
Future value = Present value + (Present
value x Interest rate) Future
value = $1,000 + ($1,000 x .08) = $1,000
+ $80 = $1,080
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 ALTERNATIVE BASIC EQUATION:
Future value = Present value x (1 +
Interest rate) Future
value = $1,000 x (1 + .08) = $1,000 x
1.08 = $1,080

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 COMPOUNDING:
Arithmetic process whereby an initial
value increases at a compound
interest rate over time to reach a
value in the future
COMPOUND INTEREST:
Earning interest on interest in addition
to interest on the principal or initial
investment
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 BASIC INFORMATION:
You plan to invest $1,000 now for two years
and a bank will pay you compound
interest of 8% per year. What will be the
value after two years?
BASIC EQUATION:
Future value = Present value x [(1 +
Interest rate) x (1 + Interest rate)]
Future value = $1,000 x (1.08 x 1.08) =
$1,000 x 1.1664 = $1,166.40
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 The compounding concept also can be
expressed in equation form as:
FV=PV(1+r)n
FV=Future Value
PV=Present Value
r= Interest rate
n= no. of periods in years

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 For our $1,000 If we extend the time
deposit, 8%, two- period to ten years,
year example, we the $1,000 deposit
have: would grow to:
FV= $1,000(1+0.08)2 FV=$1,000(1+0.08)10
=$1,000(1.1164) = $1,000(2.1589)
=$1,166.40 =$2,158.90

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 3. FV 2. Financial
1.Excel Financial wizard

4. OK

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 5. Input the data

Nper= no. of periods

Pmt= periodic payments
6. OK

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FV

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 Simple Interest Compound Interest

Note that in comparing growth graphs of simple and compound

interest, investments with simple interest grow in a linear fashion and
compound interest results in geometric growth. So with compound
interest, the further in time an investment is held the more dramatic
the growth becomes.

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 FUTURE VALUE (FVn) = PV(FVIFr,n)
Where: PV = present value amount
FVIFr,n = pre-calculated future value
interest factor for a specific interest
rate (r) and specified time period (n)
EXAMPLE:
What is the future value of $1,000 invested
now at 8% interest for 10 years?
FV10 = $1,000(2.1589) = $2,158.90
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 You deposit $2000 today at 6% interest.
How much will you have in 5 years?

FV=$2000 1.3382
= $2676.40

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 You have $450,000 to invest. If you think
you can earn 7%, how much could you
accumulate in 10 years?
(Pick the closest answer.)
A.$25,415
B.$885,218
C.$722,610

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 DISCOUNTING:
An arithmetic process whereby a
future value decreases at a
compound interest rate over time to
reach a present value
BASIC EQUATION:
Present value = Future value x {[1/(1 +
Interest rate)] x [1/(1 + Interest rate)]}

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 BASIC INFORMATION: a bank agrees to
pay you $1,000 after two years when
interest rates are compounding at 8%
per year. What is the present value of
this payment?
BASIC EQUATION:
Present value = Future value x {[1/(1+
Interest rate)] x [1/(1 + Interest rate)]}
Present value = $1,000 x (1/1.08 x
1/1.08) = $1,000 x 0.8573 = $857.30
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 PV= FVn/(1+r)n or
PV= FVn/[1/(1+r)n]

If we extend the time period to ten years,

the $1,000 future value would decrease
to:
PV= $1,000[1/(1+0.08)10 ]
=$1,000(1/2.1589)
=$1,000(0.4632)
=$463.20

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 Spreadsheet Solution:
1.Excel Financial wizard

2. Financial

3.PV

4. OK

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5. Input the data

6. OK

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7. Final Answer (PV)

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 PRESENT VALUE (PV) = FVn(PVIFr,n)
Where: FVn = future value amount
PVIFr,n = pre-calculated present value
interest factor for a specific interest
rate (r) and specified time period (n)
EXAMPLE:
What is the present value of $1,000 to be
received 10 years from now if the interest
rate is 8%?
PV = $1,000(0.4632) = $463.20
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 How much would you have to deposit
now to have $15,000 in 8 years if interest
is 7%?

PV = $15,000 .582
= $8730

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 If you think you can sell an asset for
$25,000 in five years and you think the
appropriate discount rate is 5%, how
much would you be will to pay for the
asset today?

A.$25,000
B.$19,588.15

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 FOUR BASIC VARIABLES:
FV = future value
PV = present value
r = interest rate
n = number of periods
KEY CONCEPT:
Knowing the values for any three of these
variables allows solving for the fourth or
unknown variable
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 (FVn) = PV(FVIFr,n) (PV) = FVn(PVIFr,n)
$1,403=$1,000(FVIFr.5 $1,000=$1,403(PVIFr,5
) )
FVIFr.5 =1.403 (Find it in PVIFr,5=0.713
the interest factor table
r=7%
of future value)

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 ANNUITY:
A series of equal payments that occur
over a number of time periods
ORDINARY ANNUITY:
Exists when the equal payments occur at
the end of each time period (also
referred to as a deferred annuity)

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 BASIC EQUATION:
FVAn = PMT{[(1 + r)n - 1]/r}
Where:
FVA = future value of ordinary annuity
PMT = periodic equal payment
r = compound interest rate, and
n = total number of periods

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 BASIC INFORMATION:
You plan to invest $1,000 each year
beginning next year for three years at an
8% compound interest rate. What will be
the future value of the investment?
BASIC EQUATION:
FVAn = PMT{[(1 + r)n - 1]/r}
FVA3 = $1,000{[(1 +0.08)3 - 1]/0.08} =
$1,000[(1.2597 - 1)/0.08] =
$1,000(3.246) = $3,246
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 You plan to invest $1,000 each year beginning next
year for three years at an 8% compound interest
rate. What will be the future value of the
investment?

FVA3 =$1,000(3.246)
=$3,246

You deposit $300 each year for 15 years at 6%. How

much will you have at the end of that time?
$300 23.276 = $6982.80

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 If you deposit $4,500 each year into an
account paying 8% interest, how much
will you have at the end of 3 years?

A.$13,500
B.$14,608.80
C.$11,596.95

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 BASIC EQUATION:
PVAn = PMT{[1 - (1/(1 +r)n)]/r}
Where:
PVA = present value of ordinary annuity
PMT = periodic equal payment
r = compound interest rate, and
n = total number of periods

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 BASIC INFORMATION:
You will receive $1,000 each year
beginning next year for three years at an
8% compound interest rate. What will be
the present value of the investment?
BASIC EQUATION:
PVAn = PMT{[1 - (1/(1 + r)n)]/r}
PVA3 = $1,000{[1 - (1/(1.08)3)]/0.08}
= $1,000{[1 - 0.7938]/0.08} =
$1,000(0.2062/0.08) =
$2,577
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 AMORTIZED LOAN:
A loan repaid in equal payments over a
specified time period
PROCESS:
Solve for the amount of the annual
payment
LOAN AMORTIZATION SCHEDULE:
A schedule of the breakdown of each
payment between interest and principal,
as well as the remaining balance after
each payment
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 Gathering Data
1. Identify the terms of your annuity

2. Identify the principal amount and duration of the

annuity

3. Find the period interest rate.

Annual percentage rate no. of payments made
each year payments

4. Calculate the number of payments

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 Calculating Annuity Payments
1. Know the correct formula for finding annuity
payments
p=P r(1+r)^n
_________
(1+r)^n-1
Where:
p= annuity payment
P=principal
r= interest rate
n= total no. of payments

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2. Make sure your variables are in the
correct form

3. Input your variables

4. Solve equation

5. Calculate the annual annuity payments

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 Let us assume that a lender offers $20,000,10-
percent interest rate,3-year loan that is to be
amortized with 3-annual payments.

PVAn =PMT(PVIFA 10%,3)

$20,000=PMT(2.487)
PMT=$8,041.82

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BASIC EQUATION:
FVn = PV(1 + r/m)nxm
Where: m = number of compounding periods
per year and the other variables are as
previously defined
EXAMPLE: What is the future value of a two-
year, $1,000, 8% interest loan with semiannual
compounding?
FVn = $1,000( 1 + 0.08/2)2x2
= $1,000(1.04)4
= $1,000(1.1699)
= $1,169.90
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 ANNUAL PERCENTAGE RATE (APR):
Determined by multiplying the interest rate
charged (r) per period by the number of
periods in a year (m)
APR EQUATION:
APR = r x m
EXAMPLE:
What is the APR on a car loan that charges
1% per month?
APR = 1% x 12 months = 12%
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 EFFECTIVE ANNUAL RATE (APR):
true interest rate when
compounding occurs more frequently
than annually
EAR EQUATION: EAR = (1 + r)m - 1
EXAMPLE: What is the EAR on a credit
card loan with an 18% APR and with
monthly payments?
Rate per month = 18%/12 = 1.5%
EAR = (1 + 0.015)12 - 1
= 1.1956 - 1 = 19.56%
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