Bryan Tay

Time Value of Money

Timelines, Present and Future Values
 Timelines are important tools used in time value analysis and is a graphical representation
used to show the timing of cash flows.
 Future Value (FV): Amount to which a cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest rate.
 Present Value (PV): Value today of a future cash flow or series of cash flows.
o Note: The process of going from present values to future values is called
compounding.
o Finding Present Values is called discounting and is the reverse of compounding.

 Linking back to the big picture  The fundamental goal of financial management is to
maximize the firm’s value and the value of a business is the present value of its expected
future cash flows. Therefore, calculating present value is central to the valuation process.

***Terminology***
1. PV = Present Value/Beginning Amount
2. FVN = Future Value/Ending Amount after N periods and after interest earned has been
added to the account
3. CFt = Cash flow (can be positive or negative), where t is the period.
4. I/i = Interest rate earned per year, based on the balance at the beginning of the year.
5. INT = Dollars of interest earned during the year
6. N/n = Number of periods involved in the analysis.

Single/Lump-Sum Payments
The Formula Approach
N
1) Future Value: FVN = PV (1 + i)
Where: N = Number of Periods and i = Interest Rate

FV N
2) Present Value: PV =
(1+i) N

 As long as we have three out of the four variables included in the formula, it can be used to
find for FV, PV, interest rates and the number of periods.

The Calculator Approach

Eg: Sample of a Lump Sum worth $100 today that has 3 periods and a 5% interest rate
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Annuities
 Annuities are a series of equal payments at fixed intervals for a specified number of periods.
o Ordinary/Deferred Annuities  Payments occur at the end of the year
o Annuity Due  Payments made at the beginning of the year

Timelines:

Future Value of an Ordinary Annuity

N (1+i) N −1
Future Value of an Ordinary Annuity = FVA = PMT [ ]
i
Note: The PMT function is used because with an annuity, we have recurring payments.

Calculator Method:

Eg: Sample of calculating the future value of an ordinary annuity of $100, for 3 periods and 5% interest rate.

Note: PV is 0 because we start off with nothing and PMT is -100 because we make a deposit/payment of $100
at the end of each period.

Future Value of an Annuity Due

Note: Each payment occurs one period earlier with an annuity due, so all the payments earn interest
for one additional period. In other words, the FV of an annuity due is larger than that of a similar
ordinary annuity.

The Formula Approach

 As each payment occurs one period earlier, the FV ordinary is multiplied by (1 + i)

FVAdue = FVAordinary (1 + i)

Note: For the calculator approach, set the calculator to Begin Mode for calculating annuities due.
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Present Value of an Ordinary Annuity

 The Present Value of an Annuity (PVA N) is the present value of an annuity of N periods.

1
1−
Present Value of an Annuity = PVAN = PMT [ (1+i) N ]
i

Present Value of an Annuity Due

 Similar to the Future Value of an Annuity Due, to calculate the PV of the annuity due, we
take the PV of the Ordinary Annuity and multiply it by (1+i).

PVAdue = PVAordinary (1 + i)

Calculator Method  If we know 4 out of 5 variables (N, I, PMT, FV, PV), we can find the fifth
variable.

Perpetuities
 Perpetuities are annuities with extended lives, i.e. the payment goes on forever.
 To find the PV of a perpetuity, we use the general formula with N set at infinity.

PMT
PV of a perpetuity =
i
 If the payments on the annuity began immediately, we would take the PV of the perpetuity
and multiply it by (1 + i).

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Uneven Cash Flows

 Where some financial decisions involve constant payments (annuities), many others involve
uneven, or nonconstant, cash flows.
o Terminology: The term cash flow (CFt) is used to denote uneven cash flows, where t
designates the period in which the cash flow occurs.

 There are two important classes of uneven cash flows:

o A stream that consists of a series of annuity payments plus an additional final lump
sum (like bonds)
o All other uneven streams (like stocks and capital investments)

1. Present Value of Streams that have a series of annuity and a final lump sum:

 The PV of those types of cash flows can be calculated by:

PV = PVAnnuity + PVLump Sum

 Calculator method:
o FV  Would be the value of the final lump sum given

2. Present Value of all other uneven streams

 The step-by-step approach must be used.

 Calculator method:
o Enter all of the cash flows in the calculator’s “cash flow register”,
o Enter the interest rate,
o Press NPV (net present value) key to find the PV of the stream.

Entering all cash flows into cash flow register:

Presentation in Exam:

CF 1 CF 2 CF 3
NPV = 1 + 2 + 3 …
(1+i) (1+i) (1+i)
5000 7000 7000
= 1 + 2 + 3 …
(1.1) (1.1) (1.1)
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3. Future Value of an Uneven Cash Flow Stream

 Future values of uneven cash flow streams are calculated by compounding rather than
discounting.

1 ($100)  N = 4,
compounded for 4 periods
after, PV=$100, i = 12%

2($300)  N=3,
compounded for 3 periods…

 The values of all financial assets, such as stocks, bonds and business capital investments are
found as the present values of their expected future cash flows. Therefore, present values
are more likely to be needed to be calculated.

4. Calculating I/R with Uneven Cash Flows

 If there is an annuity with a final lump sum payment:

o The calculator method is used to input values for N, PV, PMT and FV to find the I/R.
 If its an uneven cash flow stream:
o Finding the rate requires a trial-and-error process.
o With a calculator:
 Enter the CFs into the cash flow register
 Press the IRR key (internal rate of return  rate of return the investment
provides)
 The investment/cost of asset initially made is the cash flow at Time 0 (CF0)
and is entered as a negative value.

Semi-Annual and Other Compounding Periods

 If interest is compounded once a year, it is called annual compounding.
 If the interest credits every 6 months, it would be called semi-annual compounding.

Where interest payments occur more than once a year:

1) Convert the stated interest rate into a “periodic rate”  IPER =

Stated Annual Rate
Number of payments per year

2) Convert the number of years into “number of periods”  (Number of Years)(Periods per
year)

Comparing Interest Rates

 Nominal Rate (also called the quoted or stated rate) = iNOM = APR (Annual Percentage Rate)
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o An annual rate that ignores compounding effects

o iNOM is stated in contracts, periods must also be given (8% Quarterly/Daily)

 Periodic Rate = iPER

o Amount of interest charged each period (monthly/quarterly for example)
o iPER = iNOM /M, where M is the number of compounding periods per year
 M = 4 (for quarterly) and M = 12 (for monthly)

 Effective (Equivalent) Annual Rate (EAR = EFF%)  annual rate of interest actually being
earned, considering the effects of compounding.

i NOM M
EAR = EFF% = (1 + ) –1
M

Where M is the number of compounding periods in a year

o Note: If the interest uses annual compounding, the EAR and APR are the same. If
not, the EFF is higher than the APR.

Fractional Time Periods

 There are situations that require compounding or discounting over fractional periods.

Example:

You deposit $100 in the bank that pays a nominal rate of 10% but adds interest daily, based on a
365-day year. How much would you have after 9 months?

A: Periodic Rate = IPER = 0.10/365 days = 0.000273973 per day

Number of days = 9/12months x 365 days = 273.75 days, rounded to 274 days.

Ending Amount = ($100)(1+Periodic Rate)Number of Days = $100(1.000273973)274 = $107.79

Conversely, if we borrow $100 from the bank, whose nominal rate is 10% per year simple interest,
and the loan is outstanding for 274 days, to calculate the interest we need to pay:

Calculate the Daily Interest Rate (IPER) and multiply it by the number of days outstanding.

IPER = 0.000273973 x 274 days x $100 (original loan) = $7.51

Amortized Loans
 Loans that are paid off in instalments over time involves compounded interest.
 A loss that is to be repaid in equal amounts on a monthly, quarterly, or annual basis is called
an amortized loan.
o Each payment consists of two parts: Interest and Repayment of Principal
o The breakdown is reflected on an amortization schedule.
 Note the interest component is relatively high in the first year but declines
as the loan balance decreases.
 To determine the loan repayment per year:
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