Republic of the Philippines

SORSOGON STATE UNIVERSITY

Sorsogon Campus
Sorsogon City
LEARNING MODULE
FINANCIAL MANAGEMENT
Module 5: TIME VALUE OF MONEY – Continuation

LEARNING EXPERIENCE

Future Value of an Ordinary Annuity

The future value of an annuity can be found using the step-by-step approach or using a formula, a financial
calculator, or a spreadsheet. Consider the ordinary annuity diagrammed earlier, where you deposit $100 at
the end of each year for 3 years and earn 5% per year. How much will you have at the end of the third year?
The answer, $315.25, is defined as the future value of the annuity, FVAN, shown in Table 5.3.

As shown in the step-by-step section of the table, we compound each payment out to Time 3, then sum those
compounded values to find the annuity’s FV, FVA3 = $315.25. The first payment earns interest for two
periods, the second payment earns interest for one period, and the third payment earns no interest at all
because it is made at the end of the annuity’s life. This approach is straightforward, but if the annuity extends
out for many years, the approach is cumbersome and time consuming.

For the step-by-step approach, the following equation is used, with N = 3 and I = 5%:

FVAN = PMT(1 + l)N-1 + PMT(1 + l)N-2 + PMT(1 + l)N-3

= $100(1.05)2 + $100(1.05)1 + $100(1.05)0
= $315.25
The first line shows the equation in its long form. It can be transformed to the second form on the last line,
which can be used to solve annuity problems with a nonfinancial calculator. This equation is also built into
financial calculators and spreadsheets. With an annuity, we have recurring payments; hence, the PMT key is
used. Here’s the calculator setup for our illustrative annuity:

Future Value of an Annuity Due

Because each payment occurs one period earlier with an annuity due, all of the payments earn interest for
one additional period. Therefore, the FV of an annuity due will be greater than that of a similar ordinary
annuity. If you went through the step-by-step procedure, you would see that our illustrative annuity due has
an FV of $331.01 versus $315.25 for the ordinary annuity.

With the formula approach, we first use Equation 5.3; however, because each payment occurs one period
earlier, we multiply the Equation 5.3 result by (1 + I):

FVAdue = FVAordinary(1 + l)

Thus, for the annuity due, FVAdue = $315.25(1.05) = $331.01, which is the same result when the period-by-
period approach is used.

Present Value of an Ordinary Annuity

The present value of an annuity, PVAN, can be found using the step-by-step, formula, calculator, or
spreadsheet method. Let’s go back to Table 5.3. To find the FV of the annuity, we compounded the deposits.
To find the PV, we discount them, dividing each payment by (1 + I)t. The step-by-step procedure is as follows:

The formula for the step-by-step procedure is:

Calculators are programmed to solve the above equation, so we merely input the variables and press the PV
key, making sure the calculator is set to End Mode. The calculator setup follows for both an ordinary annuity
and an annuity due. Note that the PV of the annuity due is larger because each payment is discounted back
one less year. Note too that you can find the PV of the ordinary annuity and then multiply by (1 + I) = 1.05,
calculating $272.32(1.05) = $285.94, the PV of the annuity due.

Finding Annuity Payments, Periods, and Interest Rates

We can find payments, periods, and interest rates for annuities. Here five variables come into play: N, I,
PMT, FV, and PV. If we know any four, we can find the fifth.

Finding Annuity Payments, PMT

Suppose we need to accumulate $10,000 and have it available 5 years from now. Suppose further that we can
earn a return of 6% on our savings, which are currently zero. Thus, we know that FV = 10,000, PV = 0, N =
5, and I/YR = 6. We can enter these values in a financial calculator and press the PMT key to find how large
our deposits must be. The answer will, of course, depend on whether we make deposits at the end of each
year (ordinary annuity) or at the beginning (annuity due). Here are the results for each type of annuity:

Excel’s PMT function can also be used:

Because the deposits are made at the end of the year, we can leave “type” blank. Here we find that an annual
deposit of $1,773.96 is needed to reach your goal.

Annuity Due

Because the deposits are now made at the beginning of the year, enter 1 for type. Here we find that an annual
deposit of $1,673.55 is needed to reach your goal.

Thus, you must save $1,773.96 per year if you make deposits at the end of each year, but only $1,673.55 if
the deposits begin immediately. Note that the required annual deposit for the annuity due can also be
calculated as the ordinary annuity payment divided by (1 + I): $1,773.96/1.06 = $1,673.55.

Finding the Number of Periods, N

Suppose you decide to make end-of-year deposits, but you can save only $1,200 per year. Again, assuming
that you would earn 6%, how long would it take to reach your $10,000 goal? Here is the calculator setup:
Finding the Interest Rate, I

Now suppose you can save only $1,200 annually, but you still need the $10,000 in 5 years. What rate of
return would enable you to achieve your goal? Here is the calculator setup:

Excel’s RATE function will arrive at the same answer:

=RATE(5,–1200,0,10000)
RATE(nper, pmt, pv, [fv], [type], [guess])

Here we find that the interest rate is 25.78%.

It means that you must earn a whopping 25.78% to reach your goal. It might be appropriate to seek a
somewhat higher return, but trying to earn 25.78% in a 6% market would require taking on more risk than
would be prudent.

Perpetuities

A perpetuity is simply an annuity with an extended life. Because the payments go on forever, you can’t
apply the step-by-step approach. However, it’s easy to find the PV of a perpetuity with a formula found by
solving Equation 5.5 with N set at infinity:

PV of a perpetuity = PMT
I
For example, you buy preferred stock in a company that pays you a fixed dividend of $2.50 each year the
company is in business. If we assume that the company will go on indefinitely, the preferred stock can be
valued as a perpetuity. If the discount rate on the preferred stock is 10%, the present value of the perpetuity,
the preferred stock, is $25:

PV of a perpetuity = $2.50 = $25

0.10

Uneven Cash Flows

Although many financial decisions involve constant payments, many others involve uneven, or nonconstant,
cash flows. For example, the dividends on common stocks typically increase over time, and investments in
capital equipment almost always generate uneven cash flows.

Uneven (Nonconstant) Cash Flows. A series of cash flows where the amount varies from one period to the
next.

Payment (PMT.) This term designates equal cash flows coming at regular intervals.

Cash Flow (CFt). This term designates a cash flow that’s not part of an annuity.
Two Important Classes of Uneven Cash Flows:

(1) a stream that consists of a series of annuity payments plus an additional final lump sum (Example:
bond), and
(2) all other uneven streams (Examples: stock, capital investments).

Numerical examples of the two types of flows:

We can find the PV of either stream by using Equation 5.7 and following the step-by-step procedure, where
we discount each cash flow and then sum them to find the PV of the stream:

If we did this, we would find the PV of Stream 1 to be $927.90 and the PV of Stream 2 to be $1,016.35.

Financial calculators speed up the process considerably. First, consider Stream 1; notice that we have a 5-
year, 12% ordinary annuity plus a final payment of $1,000. We could find the PV of the annuity, and then
find the PV of the final payment and sum them to obtain the PV of the stream. Financial calculators do this
in one simple step—use the five TVM keys; enter the data as shown below and press the PV key to obtain
the answer, $927.90.

The solution procedure is different for the second uneven stream. Here we must use the step-by-step
approach, as shown in Figure 5.3. Even calculators and spreadsheets solve the problem using the step-by-
step procedure, but they do it quickly and efficiently. First, you enter all of the cash flows and the interest
rate; then the calculator or computer discounts each cash flow to find its present value and sums these PVs
to produce the PV of the stream. You must enter each cash flow in the calculator’s “cash flow register,” enter
the interest rate, and then press the NPV key to find the PV of the stream. NPV stands for “net present value.”
Future Value of an Uneven Cash Flow Stream

We find the future value of uneven cash flow streams by compounding rather than discounting. Consider
Cash Flow Stream 2 in the preceding section. We discounted those cash flows to find the PV, but we would
compound them to find the FV. Figure 5.4 illustrates the procedure for finding the FV of the stream, using
the step-by-step approach.

The values of all financial assets—stocks, bonds, and business capital investments—are found as the present
values of their expected future cash flows. Therefore, we need to calculate present values very often, far more
often than future values. As a result, all financial calculators provide automated functions for finding PVs,
but they generally do not provide automated FV functions. On the relatively few occasions when we need
to find the FV of an uneven cash flow stream, we generally use the step-by-step procedure shown in Figure
5.4. That approach works for all cash flow streams, even those for which some cash flows are zero or
negative.10

Solving for I with Uneven Cash Flows

Before financial calculators and spreadsheets existed, it was extremely difficult to find I when the cash flows
were uneven. With spreadsheets and financial calculators, however, it’s relatively easy to find I. If you have
an annuity plus a final lump sum, you can input values for N, PV, PMT, and FV into the calculator’s TVM
registers and then press the I/YR key. Here is the setup for Stream 1 from the previous section, assuming we
must pay $927.90 to buy the asset. The rate of return on the $927.90 investment is 12%.
When we enter those cash flows into the calculator’s cash flow register and press the IRR key, we get the
rate of return on the $1,000 investment, 12.55%. You get the same answer using Excel’s IRR function.

Semiannual and Other Compounding Periods

Annual Compounding. The arithmetic process of determining the final value of a cash flow or series of cash
flows when interest is added once a year.

Semiannual Compounding. The arithmetic process of determining the final value of a cash flow or series of
cash flows when interest is added twice a year.

For an illustration of semiannual compounding, assume that we deposit $100 in an account that pays 5% and
leave it there for 10 years. First, consider again what the future value would be under annual compounding:

FVN = PV(1 + l)N = $100(1.05)10 = $162.89

How would things change in this example if interest was paid semiannually rather than annually? First,
whenever payments occur more than once a year, you must make two conversions: (1) Convert the stated
interest rate into a “periodic rate.” (2) Convert the number of years into “number of periods.” The conversions
are done as follows, where I is the stated annual rate, M is the number of compounding periods per year, and
N is the number of years:
Under semiannual compounding, our $100 investment will earn 2.5% every 6 months for 20 semiannual
periods, not 5% per year for 10 years. The periodic rate and number of periods, not the annual rate and
number of years, must be shown on time lines and entered into the calculator or spreadsheet whenever you
are working with nonannual compounding.

The future value under semiannual compounding, $163.86, exceeds the FV under annual compounding,
$162.89, because interest starts accruing sooner; thus, you earn more interest on interest.

Comparing Interest Rates

Different compounding periods are used for different types of investments. For example, bank accounts
generally pay interest daily; most bonds pay interest semiannually; stocks pay dividends quarterly; and
mortgages, auto loans, and other instruments require monthly payments.

• The nominal interest rate (INOM), also called the annual percentage rate (APR), is the quoted, or stated,
rate that credit card companies, student loan officers, auto dealers, and other lenders tell you they are
charging on loans.
• The effective annual rate, abbreviated EFF%, is also called the equivalent annual rate (EAR). This
is the rate that would produce the same future value under annual compounding as would more frequent
compounding at a given nominal rate.

• If a loan or an investment uses annual compounding, its nominal rate is also its effective rate. However,
if compounding occurs more than once a year, the EFF% is higher than INOM.

• To illustrate, a nominal rate of 10% with semiannual compounding is equivalent to a rate of 10.25% with
annual compounding because both rates will cause $100 to grow to the same amount after 1 year. The
top line in the following diagram shows that $100 will grow to $110.25 at a nominal rate of 10.25%. The
lower line shows the situation if the nominal rate is 10% but semiannual compounding is used.

We can also use the EFFECT function in Excel to solve for the effective rate:
Fractional Time Period

Thus far we have assumed that payments occur at the beginning or the end of periods but not within periods.
However, we often encounter situations that require compounding or discounting over fractional periods. For
example, suppose you deposited $100 in a 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? The answer is $107.79, found as follows:

Periodic rate = IPER = 0.10/365 = 0.000273973 per day

Number of days = (9/12)(365) = 0.75(365) = 273.75, rounded to 274
Ending amount = $100(1.000273973)274 = $107.79

Now suppose you borrow $100 from a bank whose nominal rate is 10% per year simple interest, which means
that interest is not earned on interest. If the loan is outstanding for 274 days, how much interest would you
have to pay? Here we would calculate a daily interest rate, IPER, as just shown, but multiply it by 274 rather
than use the 274 as an exponent:

Interest owed = $100(0.000273973)(274) = $7.51

You would owe the bank a total of $107.51 after 274 days. This is the procedure that most banks use to
calculate interest on loans, except that they require borrowers to pay the interest on a monthly basis rather
than after 274 days.

Amortized Loans

Amortized Loan. A loan that is repaid in equal payments over its life.

Illustration: A homeowner borrows $100,000 on a mortgage loan, and the loan is to be repaid in five equal
payments at the end of each of the next 5 years. The lender charges 6% on the balance at the beginning of
each year. Our first task is to determine the payment the homeowner must make each year. Here’s a picture
of the situation:

We could insert values into a calculator to get the required payments, $23,739.64:
IV.SUMMARY

In this module, we worked with single payments, ordinary annuities, annuities due. One fundamental
equation, Equation 5.1, is used to calculate the future value of a given amount. The equation can be
transformed to Equation 5.2 and then used to find the present value of a given future amount. We used time
lines to show when cash flows occur, and we saw that time value of money problems can be solved in a step-
by-step manner when we work with individual cash flows, with formulas that streamline the approach, with
financial calculators, and with spreadsheets.

As we noted at the outset, TVM is the single most important concept in finance. Time value analysis is used
to find the values of stocks, bonds, and capital budgeting projects. It is also used to analyze personal finance
problems, such as the retirement issue set forth in the opening vignette.

V. ASSESSMENT ACTIVITIES: (Posted in Google Classroom)

Adopted from:
E. F. Brigham and P. R. Daves, Intermediate Financial Management, 13th edition (Mason, OH: Cengage
Learning, 2019)

Prepared by:

MARIA LUISA P. MIRASOL

Assistant Professor II