Chapter 5 - Time Value of Money

Prepared by
Ken Hartviksen and Robert Ironside

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary

Chapter 5 Time Value of Money
CHAPTER 5
Time Value of Money
CHAPTER 5 Time Value of Money 5 - 3
Lecture Agenda
Learning Objectives
Important Terms
Types of Calculations
Compounding
Discounting
Annuities and Loans
Perpetuities
Effective Rates of Return
Summary and Conclusions
Concept Review Questions
Learning Objectives
Understand the importance of the time value of money
Understand the difference between simple interest and compound
interest
Know how to solve for present value, future value, time or rate
Understand annuities and perpetuities
Know how to construct an amortization table

Important Chapter Terms
Amortize
Annuity
Annuity due
Basis point
Cash flows
Compound interest
Compound interest factor
(CVIF)
Discount rate
Discounting
Effective rate
Lessee
Medium of exchange
Mortgage
Ordinary annuities
Perpetuities
Present value interest factor
(PVIF)
Reinvested
Required rate of return
Simple interest
Time value of money

Time Value of Money
Before We Get Started
Ex Ante:
Calculations done before-the-fact
It is a forecast of what might happen
All forecasts require assumptions
It is important to understand the assumptions underlying any
formula used to ensure that those assumptions are consistent with
the problem being solved.
As a forecast, while you may be able to calculate the answer to a
high degree of accuracyit is probably best to round off the
answer so that users of your calculations are not misled.

Ex Post:
Calculation done after-the-fact
It is an analysis of what has happened
It is usually possible, and perhaps wise to express the result as
accurately as possible.
The Basic Concept
Time Value of Money
The Time Value of Money Concept
Cannot directly compare $1 today with $1 to be
received at some future date
Money received today can be invested to earn a rate of return
Thus $1 today is worth more than $1 to be received at some future date
The interest rate or discount rate is the variable that
equates a present value today with a future value at
some later date
Opportunity Cost
Opportunity cost = Alternative use

The opportunity cost of money is the interest rate that
would be earned by investing it.
It is the underlying reason for the time value of money
Any person with money today knows they can invest
those funds to be some greater amount in the future.
Conversely, if you are promised a cash flow in the
future, its present value today is less than what is
promised!
Choosing from Investment Alternatives
Required Rate of Return or Discount Rate
You have three choices:
1. $20,000 received today
2. $31,000 received in 5 years
3. $3,000 per year indefinitely

To make a decision, you need to know what
interest rate to use.
This interest rate is known as your required rate of
return or discount rate.
Simple Interest
Time Value of Money
Simple Interest
Simple interest is interest paid or received on only the
initial investment (or principal).

At the end of the investment period, the principal plus
interest is received.

0 1 2 3 n
I
1
I
2
I
3
I
n
+P

Simple Interest
Example
PROBLEM:
Invest $1,000 today for a five-
year term and receive 8
percent annual simple interest.

How much will you accumulate
by the end of five years?

Year Beginning Amount Ending Amount
1 $1,000 $1,080
2 1,080 1,160
3 1,160 1,240
4 1,240 1,320
5 1,320 $1,400
400 , 1 $
400 $ 000 , 1 $
) 80 $ 5 ( 000 , 1 $
) 08 . 000 , 1 $ 5 ( 000 , 1 $
5
=
+ =
+ =
+ =
+ =
Value
k) P (n P e n) Value (tim
Simple Interest
General Formula
k) P (n P e n) Value (tim + =
[ 5-1]
Where:
P = principal invested
n = number of years
k = interest rate
Simple Interest

Simple interest problems are rare.

In finance we are most interested in COMPOUND
INTEREST.

Compound Interest
Time Value of Money
Compound Interest
Compounding (Computing Future Values)
Compound interest is interest that is earned on the
principal amount invested and on any accrued
interest.
Compound Interest
Example
PROBLEM:
Invest $1,000 today for a five-year term and receive 8 percent
annual compound interest. How much will the accumulated
value be at time 5.

SOLUTION:

Year
Beginning
Amount
Ending
Amount
1 $1,000.00 $1,080.00
2 1,080.00 1,166.40
3 1,166.40 1,259.71
4 1,259.71 1,360.49
5 1,360.49 1,469.33 33 . 469 , 1 $ ) 08 . 1 (
49 . 360 , 1 $ ) 08 . 1 ( ) 08 . 1 )( 08 . 1 )( 08 . 1 )( 08 . 1 (
71 . 259 , 1 $ ) 08 . 1 ( ) 08 . 1 )( 08 . 1 )( 08 . 1 (
40 . 166 , 1 $ ) 08 . 1 ( ) 08 . 1 )( 08 . 1 (
080 , 1 $ ) 08 . 1 (
1
5
5
4
4
3
3
2
2
1
1
= + =
= = =
= = + + + =
= + = + + =
= + =
+ =
P FV
P P FV
P P FV
P P FV
P FV
k) ( P Value Future
n
$1,469.33 8) $1,000(1.0 FV
1
: step simple one in solution The
5
5
0
= =
+ =
n
n
k) ( PV FV
Compound Interest
Example of Interest Earned on Interest
PROBLEM:
Invest $1,000 today for a five-year term and receive 8 percent annual
compound interest.

The Interest-earned-on-Interest Effect:
Interest (year 1) = $1,000 .08 = $80
Interest (year 2 ) =($1,000 + $80).08 = $86.40
Interest (year 3) = ($1,000+$80+$86.40) .08 = $93.31

Year Beginning Amount Ending Amount
Interest earned
in the year
1 $1,000.00 $1,080.00 $80.00
2 1,080.00 1,166.40 $86.40
3 1,166.40 1,259.71 $93.31
4 1,259.71 1,360.49 $100.78
5 1,360.49 1,469.33 $108.84
Compound Interest
General Formula
Where:
FV= future value
P = principal invested
n = number of years
k = interest rate

[ 5-2]
1
0
n
n
k) ( PV FV + =
Compound Interest
General Formula
CVIF factor interest compound the as known is 1 = +
n
k) (
[ 5-2]
1
0
n
n
k) ( PV FV + =
Compound Interest
Simple versus Compound Interest
Compounding of interest magnifies the returns on an
investment.

Returns are magnified:
The longer they are compounded
The higher the rate they are compounded

(See Figure 5-1 to compare simple and compound interest effects over time)

Compound Interest
Simple versus Compound Interest
5-1 FIGURE
D
O
L
L
A
R
S

Simple Compound
8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Compound Interest
Compound Interest at Varying Rates
Compounding of interest magnifies the returns on an
investment.

Returns are magnified:
The longer they are compounded
The higher the rate they are compounded

(See Table 5-1 that demonstrates the cumulative effect of higher rates of return
earned over time.)

Compound Interest
Compounded Returns over Time for Various Asset Classes
Annual
Arithmetic
Average (%)
Annual
Geometric
Mean (%)
Yeark-End Value,
2005 ($)
Government of Canada treasury bills 5.20 5.11 $29,711
Government of Canada bonds 6.62 6.24 61,404
Canadian stocks 11.79 10.60 946,009
U.S. stocks 13.15 11.76 1,923,692
Source: Data are from the Canadian Institute of Actuaries
Table 5-1 Ending Wealth of $1,000 Invested From 1938 to 2005 in Various Asset Classes
Compound Interest
Solution Using a Financial Calculator (TI BA II Plus)
PMT PV I/Y N
Input the following variables:
0 ; -1,000 ; 10 ; and 5
CPT FV
Press (Compute) and then

PMT refers to regular payments
FV is the future value
I/Y is the period interest rate
N is the number of periods

PV is entered with a negative sign to reflect investors must pay money now
to get money in the future.

Answer = $1,610.51
$1,610.51 0) $1,000(1.1
1
. % 10 000 , 1 $
5
0
= =
+ =
n
n
n
FV
k) ( PV FV
years f ive f or at invested of value Future
Compound Interest
Solution Using a Excel Spreadsheet
Electronic spreadsheets have built-in formulae that
can assist in the solution of problems

Electronic spreadsheets can also be created to
solve complex problems using both built-in
functions, defined mathematical algorithms and
relationships.

Compound Interest
Solution Using a Excel Spreadsheet Built-in Formula
Determining the Future Value of $1,000 invested
for forty years at 10%:
1. Place cursor in cell on spreadsheet
2. Using the pull-down menu, choose, INSERT, FUNCTION
3. Choose financial functions
4. Choose FV
5. Fill in the appropriate function arguments as follows:

=FV (rate, nper, pmt, pv, type)
=FV (0.10, 40, 0, 1000,0) which yields -45,259.26
(The answer is expressed as a negative because we entered
the investment as a positive number. )

Using Excel to Solve for FV
Built-in Formula Function Arguments and Solution
Compound Interest
Underlying Assumptions
Notice the compound interest assumptions that are
embodied in the basic formula:

FV
2
= $1,000 (1+k
1
) (1+k
2
)
FV
n
= PV
0
(1+k)
n

Assumptions:
The rate of interest does not change over the periods of
compound interest
Interest is earned and reinvested at the end of each period
The principal remains invested over the life of the
investment
The investment is started at time 0 (now) and we are
determining the compound value of the whole investment at
the end of some time period (t= 1, 2, 3, 4,)
Compound Interest
Underlying Assumptions Timing of Cash Flows
Time = 0 Time = 1 Time = 2

Time of Investment
Compound Interest Formula
(For a single cash flow)

FV
n
=PV
0
(1+k)
n

Where:
FV
n
= the future value (sum of both interest and principal) of the
investment at some time in the future
PV
0
= the original principal invested
k= the rate of return earned on the investment
n = the time or number of periods the investment is allowed to grow
CVIF
k,n

Tables of Compound Value
Interest Factors can be
created:
Period 1% 2% 3% 4% 5% 6% 7%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672
6289 . 1
) 05 . 1 (
10
10 %, 5
=
+ =
= = years n k
CVIF
CVIF
k,n

The table shows that the longer you investthe greater the amount of
money you will accumulate.
It also shows that you are better off investing at higher rates of return.
Period 1% 2% 3% 4% 5% 6% 7%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672
CVIF
k,n

How long does it take to double or triple your investment? At 5%...at
10%?
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937
11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531
12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975
15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772
16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950
The Rule of 72
If you dont have access to time value of money tables or a financial
calculator but want to know how long it takes for your money to
doubleuse the rule of 72!
years 16
4.5
72
: in double it will money your on rate 4.5% a earn expect to you If
rate interest compound Annual
72
double to years of Number
= =
=
CVIF
k,n

Let us predict what happens with an investment if it is invested at 5%
show the accumulated value after t=1, t=2, t=3, etc.
Period 1% 2% 3% 4% 5%
1 1.0100 1.0200 1.0300 1.0400 1.0500
2 1.0201 1.0404 1.0609 1.0816 1.1025
3 1.0303 1.0612 1.0927 1.1249 1.1576
4 1.0406 1.0824 1.1255 1.1699 1.2155
5 1.0510 1.1041 1.1593 1.2167 1.2763
6 1.0615 1.1262 1.1941 1.2653 1.3401
7 1.0721 1.1487 1.2299 1.3159 1.4071
8 1.0829 1.1717 1.2668 1.3686 1.4775
9 1.0937 1.1951 1.3048 1.4233 1.5513
10 1.1046 1.2190 1.3439 1.4802 1.6289
FV
0.0000
0.2000
0.4000
0.6000
0.8000
1.0000
1.2000
1.4000
1.6000
1.8000
1 2 3 4 5 6 7 8 9 10
Year
F
V

o
f

$
1
.
0
0
CVIF
k,n

Let us predict what happens with an investment if it is invested at 5% and 10%
show the accumulated value after t=1, t=2, t=3, etc.
Period 5% 10%
1 1.0500 1.1000
2 1.1025 1.2100
3 1.1576 1.3310
4 1.2155 1.4641
5 1.2763 1.6105
6 1.3401 1.7716
7 1.4071 1.9487
8 1.4775 2.1436
9 1.5513 2.3579
10 1.6289 2.5937
Future Value
0.0000
1.0000
2.0000
3.0000
4.0000
5.0000
6.0000
7.0000
8.0000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Time
F
V

o
f

$
1
.
0
0
Notice: compound interest creates an exponential curve and there will be a
substantial difference over the long term when you can earn higher rates of
return.
Types of Problems in Compounding
Time Value of Money Skills
Types of Compounding Problems
There are really only four different things you can be asked
to find using this basic equation:

FV
n
=PV
0
(1+k)
n

Find the initial amount of money to invest (PV
0
)
Find the Future value (FV
n
)
Find the rate (k)
Find the time (n)
Solving for the Rate (k)
Your have asked your father for a loan of $10,000 to get you
started in a business. You promise to repay him $20,000 in five
years time.

What compound rate of return are you offering to pay?
This is an ex ante calculation.

FV
t
=PV
0
(1+k)
n
$20,000= $10,000 (1+r)
5

2=(1+r)
5
2
1/5
=1+r
1.14869=1+r
r = 14.869%

Solving for Time (n) or Holding Periods
You have $150,000 in your RRSP (Registered Retirement Savings
Plan). Assuming a rate of 8%, how long will it take to have the plan
grow to a value of $300,000?
This is an ex ante calculation

FV
t
=PV
0
(1+k)
n
$300,000= $150,000 (1+.08)
n

2=(1.08)
n
ln 2 =ln 1.08 n
0.69314 = .07696 n
t = 0.69314 / .076961041 = 9.00 years

Solving for Time (n) using logarithms
You have $150,000 in your RRSP (Registered Retirement Savings
Plan). Assuming a rate of 8%, how long will it take to have the plan
grow to a value of $300,000?

FV
t
=PV
0
(1+k)
n
$300,000= $150,000 (1+.08)
n

2=(1.08)
n
log 2 =log 1.08 n
0.301029995 = 0.033423755 n
t = 9.00 years

Solving for the Future Value (FV
n
)
You have $650,000 in your pension plan today. Because you have
retired, you and your employer will not make any further
contributions to the plan. However, you dont plan to take any
pension payments for five more years so the principal will continue
to grow.
Assuming a rate of 8%, forecast the value of your pension plan in 5
years.

FV
t
=PV
0
(1+k)
n
FV
5
= $650,000 (1+.08)
5

FV
5
= $650,000 1.469328077
FV
5
= $955,063.25

Finding the amount of money to invest (PV
0
)
You hope to save for a down payment on a home. You hope
to have $40,000 in four years time; determine the amount
you need to invest now at 6%
This is a process known as discounting
This is an ex ante calculation

FV
n
=PV
0
(1+k)
n
$40,000= PV
0
(1.1)
4

PV
0
= $40,000/1.4641=$27,320.53

Compound Interest
Discounting (Computing Present Values)

1
1
) 1 (
0
n
n
n
n
k) (
FV
k
FV
PV
+
=
+
=
[ 5-3]
Annuities
Time Value of Money Concepts
Annuity
An annuity is a finite series of equal and periodic
cash flows.
Annuities and Perpetuities
Ordinary Annuity Formula

) 1 (
1
1
0
(
(
(
(
=
k
k
PMT PV
n
[ 5-5]
Ordinary Annuity
Involve end-of-period payments First cash flow occurs at n=1
An annuity is a finite series of equal and periodic cash flows
where PMT
1
=PMT
2
=PMT
3
==PMT
n

Time = n
PMT
n

Time = 0

Time of Investment
n=0
Time = 1
PMT
1

Time = 2
PMT
2

Time = 3
PMT
3

Future Value of An Ordinary Annuity
An example of a compound annuity would be where
you save an equal sum of money in each period
over a period of time to accumulate a future sum.
Ordinary Annuities
Compound Value Annuity Formula (CVAF)

1 1
PMT(CVAF)
k
k) (
PMT FV
n
n
=
+
=
[ 5-4]
Future Value of An Annuity
Example:
How much will you have at the end of three years if you save
$1,000 each year for three years at a rate of 10%?

FV
3
= $1,000 {[(1.1)
3
- 1].1} =$1,000 3.31 = $3,310

1 1
k
k) (
PMT FV
n
n
+
=
Example:
How much will you have at the end of three years if you save
$1,000 each year for three years at a rate of 10%?

FV
3
= $1,000 {[(1.1)
3
- 1] / .1} =$1,000 3.31 = $3,310

What does the formula assume?

$1,000
1
(1.1) (1.1) = $1,210
+ $1,000
2
(1.1) = $1,100
+ $1,000
3
= $1,000
Sum = = $3,310
Assumptions
FVA
3
= $1,000 {[(1.1)
3
- 1].1} =$1,000 3.31 = $3,310

What does the formula assume?

$1,000
1
(1.1) (1.1) = $1,210
+ $1,000
2
(1.1) = $1,100
+ $1,000
3
= $1,000
Sum = = $3,310
The CVAF assumes that time zero (t=0) (today) you decide to invest, but
you dont make the first investment until one year from today. The Future
Value you forecast is the value of the entire fund (a series of investments
together with the accumulated interest) at the end of some year n = 1 or n
= 2 in this case n = 3. NOTE: the rate of interest is assumed to remain
unchanged throughout the forecast period.
If these
assumptions
dont
holdyou cant
use the
formula.
Adjusting your solution to the
circumstances of the problem
The time value of money formula can be applied to any
situationwhat you need to do is to understand the
assumptions underlying the formulathen adjust your
approach to match the problem you are trying to solve.
In the foregoing problemt isnt too logical to start a savings
programand then not make the first investment until one
year later!!!
Example of Adjustment
(An Annuity Due)
You plan to invest $1,000 today, $1,000 one year
from today and $1,000 two years from today.

What sum of money will you accumulate at time 3 if
your money is assumed to earn 10%.

This is known as an annuity due rather than a regular annuity.

Annuity Due
First cash flow occurs at n=0
An annuity due is a finite series of equal and periodic cash
flows where PMT
1
=PMT
2
=PMT
3
==PMT
n
but the first payment
occurs at time=0.
Time = n
PMT
n

Time = 0 Time = 1
PMT
1

Time = 2
PMT
2

Time = 3
PMT
3
No PMT
Example of Adjustment
An Annuity Due
You plan to invest $1,000 today, $1,000 one year from today and $1,000 two
years from today.
What sum of money will you accumulate in three years if your money is
assumed to earn 10%.

You should know that there is a simple way of adjusting a normal annuity
to become an annuity duejust multiply the normal annuity result by (1+k)
and you will convert to an annuity due!

FV
3
(Annuity due)= $1,000 {[(1.1)3 - 1].1} (1+ k)
=$1,000 3.31 1.1
= $3,310 1.1 = $3,641

$1,000
1
(1.1) (1.1) (1.1) = $1,331
+ $1,000
2
(1.1) (1.1) = $1,210
+ $1,000
3
(1.1) = $1,100
Sum = = $3,641
Future Value of an Annuity Due Formula
) 1
1 1
k (
k
k) (
PMT FV
n
n
+
(
+
=
[ 5-6]
Present Value of an Annuity Due
k) (1
) 1 (
1
1
0
+
(
(
(
(
=
k
k
PMT PV
n
[ 5-7]
Discounting Cash Flows
Time Value of Money
What is Discounting?
Discounting is the inverse of compounding.
n
n k
n k
k CVIF
PVIF
) 1 (
1 1
,
,
+
= =
Example of Discounting
You will receive $10,000 one year from today. If you had the
money today, you could earn 8% on it.

What is the present value of $10,000 received one year from now
at 8%?

PV
0
=FV
1
PVIF
k,n
= $10,000 (1/ 1.08
1
)
PV
0
= $10,000 0.9259 = $9,259.26

NOTICE: A present value is always less than the absolute value of the
cash flow unless there is no time value of money. If there is no rate of
interest then PV = FV
PVIF
k,n

Tables of present value interest factors can be created:
Period 1% 2% 3% 4% 5% 6% 7%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083
n
n k
k
PVIF
) 1 (
1
,
+
=
PVIF
k,n

Notice the farther away the receipt of the cash flow from todaythe lower the
present value
Notice the higher the rate of interestthe lower the present value.
Period 1% 2% 3% 4% 5% 6% 7%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083
5083 . 0
) 07 . 1 (
1
10
10 %, 7
=
+
=
= = n k
PVIF
PVIF
k,n

If someone offers to pay you a sum 50 or 60 years hencethat promise is
pretty-much worthless!!!
n
n k
k
PVIF
) 1 (
1
,
+
=
Period 5% 10% 15% 20% 25% 30% 35%
60 0.0535 0.0033 0.0002 0.0000 0.0000 0.0000 0.0000
70 0.0329 0.0013 0.0001 0.0000 0.0000 0.0000 0.0000
80 0.0202 0.0005 0.0000 0.0000 0.0000 0.0000 0.0000
90 0.0124 0.0002 0.0000 0.0000 0.0000 0.0000 0.0000
100 0.0076 0.0001 0.0000 0.0000 0.0000 0.0000 0.0000
110 0.0047 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
The present value of $10 million promised 100 years from
today at a 10% discount rate is = $10,000,000 * 0.0001 = $1,000!!!!
The Reinvestment Rate
The Nature of Compound Interest
When we assume compound interest, we are implicitly assuming
that any credited interest is reinvested in the next period, hence, the
growth of the fund is a function of interest on the principal, and a
growing interest upon interest stream.
This principal is demonstrated when we invest $10,000 at 8% per
annum over a period of say 4 yearsthe future value of this
investment can be decomposed as follows...
FV
4
of $10,000 @ 8%
Rate of Interest = 8.00%
Time
Principal at
Beginning
of the Year Interest
End of Period
Value of the
Fund (Principal
plus Interest)
1 $10,000.00 $800.00 $10,800.00
2 $10,800.00 $864.00 $11,664.00
3 $11,664.00 $933.12 $12,597.12
4 $12,597.12 $1,007.77 $13,604.89
Of course we can find the
answer using the
formula:
FV
4
=$10,000(1+.08)
4
=$10,000(1.36048896)
=$13,604.89
Annuity Assumptions
When using the unadjusted formula or table values
for annuities (whether future value or present value)
we always assume:
the focal point is time 0
the first cash flow occurs at time 1
intermediate cash flows are reinvested at the rate of interest for
the remaining time period
the interest rate is unchanging over the period of the analysis.
FV of an Annuity Demonstrated
When determining the Future Value of an Annuitywe
assume we are standing at time zero, the first cash flow
will occur at the end of the year and we are trying to
determine the accumulated future value of a series of five
equal and periodic payments as demonstrated in the
following time line...
0 1 2 3 4 5
$2,000 $2,000 $2,000 $2,000 $2,000
We could be trying find out how much we would
accumulate in a savings fundif we saved $2,000 per year
for five years at 8%but we wont make the first deposit
in the fund for one year...
0 1 2 3 4 5
$2,000 $2,000 $2,000 $2,000 $2,000
The time value of money formula assumes that each
payment will be invested at the going rate of interest for the
remaining time to maturity.
This final $2,000 is
contributed to the
fund, but is assumed
not to earn any
interest.
$2,000 invested at 8% for 4 years
$2,000 invested at 8%
for 3 years
$2,000 invested at
8% for 2 years
$2,000 invested at 8% for 1 year
0 1 2 3 4 5
$2,000 $2,000 $2,000 $2,000 $2,000

Annuity Assumptions: A demonstration
- focal point is time zero
- the first cash flow occurs at time one
Future value of a $2,000 annuity at the end of five years at 8%:

Time Cashflow CVIF Future Value
0
1 $2,000 1.3605 $2,720.98
2 $2,000 1.2597 $2,519.42
3 $2,000 1.1664 $2,332.80
4 $2,000 1.0800 $2,160.00
5 $2,000 1.0000 $2,000.00
Future Value of Annuity = FV(5) $11,733.20
CVIF for 4 years at 8% (4
years is the remaining
time to maturity.)
Notice that the final
cashflow is just
received, it doesn't
receive any interest.

You can always discount or compound the individual cash flowshowever it may be quicker to use an annuity formula.
Future value of a $2,000 annuity at the end of five years at 8%:

Time Cashflow CVIF Future Value
0
1 $2,000 1.3605 $2,720.98
2 $2,000 1.2597 $2,519.42
3 $2,000 1.1664 $2,332.80
4 $2,000 1.0800 $2,160.00
5 $2,000 1.0000 $2,000.00
Future Value of Annuity = FV(5) $11,733.20
Using the formula: FV(5) = PMT(CVAF t=5, r=8%) = $2,000 [(((1 + r)t)-1) / r] = $2,000(5.8666) = $11,733.20
CVIF for 4 years at 8% (4
years is the remaining
time to maturity.)
Notice that the final
cashflow is just
received, it doesn't
receive any interest.
In summary the assumptions are:

focal point is time zero
we assume the cash flows occur at the end of every
year
we assume the interest rate does not change during
the forecast period
the interest received is reinvested at that same rate of
interest for the remaining time until maturity.
PV of an Annuity Demonstrated

You can always discount or compound the individual cash flowshowever it may be quicker to use an annuity formula.
Present value of a five year $2,000 annual annuity at 8%:

Time Cashflow PVIF Present Value
0
1 $2,000 0.9259 $1,851.85
2 $2,000 0.8573 $1,714.68
3 $2,000 0.7938 $1,587.66
4 $2,000 0.7350 $1,470.06
5 $2,000 0.6806 $1,361.17
Present Value of Annuity = $7,985.42
Using the formula: PV = PMT(PVIFA n=5, k=85) = $2,000 [1- 1/(1 + k)n] / k = $2,000(3.9927) = $7,985.40
PVIF for 1 year at 8%
The Reinvestment Rate Assumption
It is crucial to understand the reinvestment rate assumption that is
built-in to the time value of money.
Obviously, when we forecast, we must make
assumptionshowever, if that assumption not realisticit is
important that we take it into account.
This reinvestment rate assumption in particular, is important in the
yield-to-maturity calculations in bondsand in the Internal Rate of
Return (IRR) calculation in capital budgeting.
Perpetuities
Perpetuities
Perpetuities
A perpetuity is an infinite annuity
An infinite series of payments where each payment
is equal and periodic.
Examples of perpetuities in financial markets
includes:
Common stock (with a no growth in dividend
assumption)
Preferred stock
Consol bonds (bonds with no maturity date)
Perpetuity
Involve end-of-period payments First cash flow occurs at n=1
A perpetuity is an infinite series of equal and periodic cash
flows where PMT
1
=PMT
2
=PMT
3
==PMT

Time =
PMT

Time = 0

Time of Investment
n=0
Time = 1
PMT
1

Time = 2
PMT
2

Time = 3
PMT
3

Perpetuities
Perpetuity Formula

0
k
PMT
PV =
[ 5-8]
Where:
PV
0
= Present value of the perpetuity
PMT = the periodic cash flow
k = the discount rate
Perpetuity: An Example
While acting as executor for a distant relative, you
discover a $1,000 Consol Bond issued by Great Britain
in 1814, issued to help fund the Napoleonic War. If the
bond pays annual interest of 3.0% and other long U.K.
Government bonds are currently paying 5%, what would
each $1,000 Consol Bond sell for in the market?
Perpetuity: Solution
( )
0
$1, 000 0.03
0.05
$30
0.05
$600
PMT
PV
k
=
=
=
=
Nominal Versus Effective Rates
Nominal Versus Effective Interest Rates
So far, we have assumed annual compounding
When rates are compounded annually, the quoted
rate and the effective rate are equal
As the number of compounding periods per year
increases, the effective rate will become larger than
the quoted rate
Nominal versus Effective Rates
General Formula for Effective Annual Rate
1 ) 1 ( + =
m
m
QR
k
[ 5-9]
Calculating the Effective Rate
1 1
m
Effective
QR
k
m
| |
= +
|
\ .
Where:
k
Effective
= Effective annual interest rate
QR = the quoted interest rate
M = the number of compounding periods per year
Example: Effective Rate Calculation
A bank is offering loans at 6%, compounded monthly. What is
the effective annual interest rate on their loans?
12
1 1
.06
1 1
12
6.17%
m
Effective
QR
k
m
| |
= +
|
\ .
| |
= +
|
\ .
=
Continuous Compounding Formula
1 =
QR
e k
[ 5-10]
Continuous Compounding
When compounding occurs continuously, we
calculate the effective annual rate using e, the base
of the natural logarithms (approximately 2.7183)
1
QR
Effective
k e =
10% Compounded At Various Frequencies
Compounding
Frequency
Effective Annual
Interest Rate
2 10.25%
4 10.3813%
12 10.4713%
52 10.5065%
365 10.5156%
Continuous 10.5171%
Calculating the Quoted Rate
If we know the effective annual interest rate, (k
Eff
) and we
know the number of compounding periods, (m) we can
solve for the Quoted Rate, as follows:
( )
1
1 1
m
Eff
QR k m
(
= +
(

When Payment & Compounding Periods Differ
When the number of payments per year is different
from the number of compounding periods per year,
you must calculate the interest rate per payment
period, using the following formula
1 1
m
f
Per
Period
QR
k
m
| |
= +
|
\ .
Where:
f = the payment frequency per year
Formula for Effective Rates for Any Period
1 1 - )
m
QR
( k
f
m
+ =
[ 5-11]
Loans and Loan Amortization Tables
Loan Amortization
A blended payment loan is repaid in equal periodic
payments
However, the amount of principal and interest varies
each period
Assume that we want to calculate an amortization
table showing the amount of principal and interest
paid each period for a $5,000 loan at 10% repaid in
three equal annual instalments.
Blended Interest and Principal Loan
Payments - formula
(
(
(
(
=
=
k
k) (1
1
1
PMT Principal
) PMT(PVAF Principal
n
n k,
Where:
Pmt = the fixed periodic payment
t= the amortization period of the loan
r = the rate of interest on the loan
Blended Interest and Principal Loan
Payments - example
52 . 018 , 1 $
818147 . 9
000 , 10 $
Pmt
.08
) 08 . 1 (
1
1
Pmt 000 , 10 $
r
) 1 (
1
1
PMT Principal
20
= =
(
(
(
(

=
(
(
(
(
=
n
k
Where:
Pmt = unknown
t= 20 years
r = 8%
Calculator Approach:
10,000 PV
0 FV
20 N
8 I/Y
CPT PMT $1,018.52
How are Loan Amortization Tables Used?
To separate the loan repayments into their constituent components.
Each level payment is made of interest plus a repayment of
some portion of the principal outstanding on the loan.
This is important to do when the loan has been taken out for the
purposes of earning taxable incomeas a result, the interest is a
tax-deductible expense.
Loan Amortization Tables
Using an Excel Spreadsheet
Principal = $100,000
Rate = 8.0%
Term = 5
PVAF = 3.99271
Payment = $25,045.65
Retired Ending
Year Principal Interest Payment Principal Balance
1 100,000.00 8,000.00 25,045.65 17,045.65 82,954.35
2 82,954.35 6,636.35 25,045.65 18,409.30 64,545.06
3 64,545.06 5,163.60 25,045.65 19,882.04 44,663.02
4 44,663.02 3,573.04 25,045.65 21,472.60 23,190.41
5 23,190.41 1,855.23 25,045.65 23,190.41 0.00
Loan or Mortgage Arrangements
Effective Rate for Any Period Formula
1 1 - )
m
QR
( k
f
m
Eff
+ =
[ 5-11]
Loan Amortization
Example with Solution
First calculate the annual payments
( )
( )
( )
3
1 1
1 1
5, 000
1 1.10
0.10
$2, 010.57
n
Annuity
Annuity
n
k
PV PMT
k
PV
PMT
k
k
| |
+
= |
|
\ .
=
| |
+
|
|
\ .
=
| |
|
|
\ .
=
5,000 PV
0 FV
3 N
10 I/Y
CPT PMT $2,010.57
Amortization Table
Period Principal:
Start of
Period
Payment Interest Principal Principal:
End of
Period
1
5,000.00 2,010.57 500.00 1,510.57 3,489.43
2
3,489.43 2,010.57 348.94 1,661.63 1,827.80
3
1,827.80 2,010.57 182.78 1,827.78 0
Calculating the Balance O/S
At any point in time, the balance outstanding on the
loan (the principal not yet repaid) is the PV of the
loan payments not yet made.
For example, using the previous example, we can
calculate the balance outstanding at the end of the
first year, as shown on the next page
Calculating the Balance O/S after the 1
st
Year
( )
( )
1
2
1 1
1 1.10
2, 010.57
.10
$3, 489.42
n
t
k
PV PMT
k
(
+
= (
(

(
= (
(

=
Canadian Residential Mortgages
A Canadian residential mortgage is a loan with one
special feature
By law, banks in Canada can only compound the
interest twice per year on a conventional mortgage,
but payments are typically made at least monthly
To solve for the payment, you must first calculate
the correct periodic interest rate
Canadian Residential Mortgages
For example, suppose we want to calculate the monthly
payment on a $100,000 mortgage amortized over 25 years
with a 6% annual interest rate.
First, calculate the monthly interest rate:
2
12
1 1
.06
1 1
2
.004938622 0.4938622%
m
f
Per
Period
QR
k
m
or
| |
= +
|
\ .
| |
= +
|
\ .
=
Calculating the Monthly Payment
Now, calculate the monthly payment on the mortgage
( )
( )
( )
0
0
300
1 1
1 1
100, 000
1 1.004938622
.004938622
$639.81
n
t
t
n
k
PV PMT
k
PV
PMT
k
k
=
=
(
+
= (
(

=
(
+
(
(

=
(
(
(

=
100,000 PV
0 FV
300 N
.4938622 I/Y
CPT PMT $639.81
Monthly Mortgage Loan Amortization
Table
Principal = $100,000
Quoted rate = 6.0%
Effective annual Rate = 6.090% (Assuming semi-annual compounding)
Effective monthly Rate = 0.49386%
Term = 25 years
Term in months = 300
PVAF = 156.297225
Payment = $639.81
Retired Ending
Month Principal Interest Payment Principal Balance
1 100,000.00 493.86 639.81 145.94 99,854.06
2 99,854.06 493.14 639.81 146.67 99,707.39
3 99,707.39 492.42 639.81 147.39 99,560.00
4 99,560.00 491.69 639.81 148.12 99,411.88
5 99,411.88 490.96 639.81 148.85 99,263.03
Summary and Conclusions
In this chapter you have learned:

To compare cash flows that occur at different points in time
To determine economically equivalent future values from values
that occur in previous periods through compounding.
To determine economically equivalent present values from cash
flows that occur in the future through discounting
To find present value and future values of annuities, and
To determine effective annual rates of return from quoted
interest rates.

Concept Review Questions
Time Value of Money
Concept Review Question 1
Quoted versus Effective Rates
Why can effective rates often be very different from
quoted rates?

The more frequently interest is compounded the higher the effective
rate of return.

Because financial institutions are legally only required to quote APR
(Annual Percentage Rates) that are stated (nominal) the published
rate is often much lower than the actual rate charged depending on
the frequency of compounding.

This is why reading the fine print is so important!

Internet Links
Planning tools and online courses through TD Canada Trust
Online tools and calculators through RBC Royal Bank

Copyright
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
copies for his or her own use only and
not for distribution or resale. The author
and the publisher assume no
responsibility for errors, omissions, or
damages caused by the use of these files
or programs or from the use of the
information contained herein.

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Chapter 5 - Time Value of Money

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