R01 Time Value of Money 2022 Level I Notes

R01 Time Value of Money

Introductory Note .......................................................................................................................................................2

1. Introduction ..............................................................................................................................................................2
2. Interest Rates ...........................................................................................................................................................3
3. Future Value of a Single Cash Flow (Lump Sum) ....................................................................................5
4. Non-Annual Compounding (Future Value) ................................................................................................7
5. Continuous Compounding, Stated and Effective Rates ........................................................................8
5.1 Stated and Effective Rates ..........................................................................................................................9
6. Future Value of a Series of Cash Flows, Future Value of Annuities ............................................. 10
6.1 Equal Cash Flows – Ordinary Annuity ............................................................................................... 10
6.2 Unequal Cash Flows .................................................................................................................................... 12
7. Present Value of a Single Cash Flow (Lump Sum) ............................................................................... 12
8. Non-Annual Compounding (Present Value)........................................................................................... 15
9. Present Value of a Series of Equal Cash Flows (Annuities) and Unequal Cash Flows........ 16
9.1 The Present Value of a Series of Equal Cash Flows ..................................................................... 16
9.2 The Present Value of a Series of Unequal Cash Flows ................................................................ 19
10. Present Value of a Perpetuity and Present Values Indexed at Times Other Than t=0 .... 20
10.1 Present Values Indexed at Times Other Than t=0 ..................................................................... 21
11. Solving for Interest Rates, Growth Rates, and Number of Periods ........................................... 22
11.1 Solving for Interest Rates and Growth Rates ............................................................................... 22
11.2 Solving for the Number of Periods.................................................................................................... 23
12. Solving for the Size of Annuity Payments (Combining Future Value and Present Value
Annuities)..................................................................................................................................................................... 23
13. Present Value and Future Value Equivalence, Additivity Principle ......................................... 23
13.1 The Cash Flow Additivity Principle .................................................................................................. 24
Summary ...................................................................................................................................................................... 25

This document should be read in conjunction with the corresponding reading in the 2022 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2021, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.
Ver 1.0

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R01 Time Value of Money 2022 Level I Notes

Introductory Note
Financial Calculator: CFA Institute allows only two calculator models during the exam:
 Texas Instruments BA II Plus (including BA II Plus Professional) and
 Hewlett Packard 12C (including the HP 12C Platinum, 12C Platinum 25th anniversary
edition, 12C 30th anniversary edition, and HP 12C Prestige)
Unless you are already comfortable with the HP financial calculator, we recommend using
the Texas Instruments financial calculator. Explanations and keystrokes in our study
materials are based on the Texas Instruments BA II Plus calculator.
Before you start using the calculator to solve problems, we recommend that you set the
number of decimal places to ‘floating decimal’.
1. Introduction
If you have $100 today, versus an option to receive $100 after three years, what would you
prefer?

Obviously, you would prefer $100 today. Even though you have the same amount ($100) in
both cases, you prefer $100 today. This means that there has to be some value associated
with time, because you are putting more value on the $100 that you are getting today,
relative to the $100 at a later point in time. This is known as ‘time value of money.’
Let us say that you are indifferent between $100 dollars today versus $ 110 after one year.

Present value (PV): The money today or the value today is called the present value (PV =
100). This could be an investment which you make at time 0.
Future value (FV): The value at a future point in time is called the future value (FV = 110).
Interest rate (I): The relationship or the link between present value and future value is
established through an interest rate (I = 10%).
In this reading, we are essentially going to talk about these concepts: present value (PV),
future value (FV), and the way we link these two concepts using interest rates (I).

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R01 Time Value of Money 2022 Level I Notes

2. Interest Rates
Let’s discuss the different interpretations of interest rates using an example. Say you lend
$900 today and receive $990 after one year (–ve sign indicates outflow).

Interest rates can be interpreted as:

1. Required rate of return: The fact that you are willing to give $900 today on the
condition that you get $990 after one year means that to engage in this transaction,
you require a return of 10%. (Simple calculation will show you that the interest rate
in this transaction is 10%).
2. Discount rate: You can discount the money that you will receive after one year i.e.
$990 at 10% to get the present value of $900 (990/1.1 = 900). Therefore, the 10%
can also be thought of as a discount rate.
3. Opportunity cost: Let’s say instead of lending the $900, you spent it on something
else. You have then forgone the opportunity to earn 10% interest. Therefore, 10% can
also be thought of as an opportunity cost.
Interest Rates: Investor Perspective
As an investor, we can think of the interest rate as a sum of the following components:
Interest rate = Real risk-free interest rate + Inflation premium + Default risk premium
+ Liquidity premium + Maturity premium
Let’s look at the different components.
 Real risk-free interest rate: This is the rate that you get on a security that has no risk
and is extremely liquid. We make an assumption here that there is no inflation.
 Inflation premium: We can then add on an inflation premium. Inflation premium is
the expected annual inflation in the upcoming period.
 Default risk premium: We can also then add a default risk premium. This is the
additional premium that investors require because of the risk of default.
Example: Let's say that you lend $100 each to person A and person B. However, B has
a high risk of default, so you are worried that he might not pay. Therefore you might
demand a higher return from B as compared to A, because of the risk of default. This
additional return that you demand is called the default risk premium.
 Liquidity premium: Liquidity premium compensates investors for the risk of
receiving less than the fair value for an investment if it must be converted to cash

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R01 Time Value of Money 2022 Level I Notes

quickly.
Example: Think of two investments C and D which are similar in all regards. The only
difference is that investment C is extremely liquid, whereas investment D is not that
liquid. Clearly as investors, we will demand a higher return on D because it is not easy
to sell. This additional return that we demand is called the liquidity premium.
 Maturity premium: Finally, we have the maturity premium. This is the premium that
investors demand on a security with long maturity. The maturity premium
compensates investors for the increased sensitivity of the market value of debt to a
change in market interest rates as maturity is extended.
Example: Let’s say we have two securities, E and F. Security E has a maturity of 1 year
and security F has a maturity of 4 years. Because of the longer maturity, F has more
risk, in terms of its price being more sensitive to changes in interest rate.
Instructor’s Note: You will understand this concept better when you study fixed
income securities. But for now, you can take it as a given that F has higher risk
because of the longer maturity.
Obviously, investors will demand some compensation for the higher level of risk. This
additional return that investors demand is called the maturity premium.
Nominal risk free rate:
Nominal risk-free rate = Real risk-free interest rate + Inflation premium.
So if the real risk-free rate is 3% and the inflation premium is 2%, then the nominal risk-free
rate is 5%.
Instructor’s Note: On the exam if you get a term ‘risk-free rate’ with no mention of whether
the rate is real or nominal, then the assumption is that we are talking about the nominal risk-
free rate.

Example
Investments Maturity (in years) Liquidity Default risk Interest Rates(%)
A 1 High Low 2.0
B 1 Low Low 2.5
C 2 Low Low r
D 3 High Low 3.0
E 3 Low High 4.0
1. Explain the difference between the interest rates on Investment A and Investment B.
2. Estimate the default risk premium.
3. Calculate upper and lower limits for the interest rate on Investment C, r.
Solution:
1. Investments A and B have the same maturity and the same default risk. However, B has a
lower liquidity as compared to A. Hence, investors will demand a liquidity premium on B.

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R01 Time Value of Money 2022 Level I Notes

The difference between their interest rates i.e. 2.5 – 2.0 = 0.5% is equal to the liquidity
premium.
2. Consider investments D and E, they have the same maturity, but different liquidity and
different default risk. Let’s make liquidity the same and create a new low liquidity
version of D. This version will have a higher interest rate, because now investors will
demand a liquidity premium. We have already determined that the liquidity premium is
0.5%. Therefore, the low liquidity version of D will have an interest rate of 3.0 + 0.5 =
3.5%.
Now compare this version of D with investment E. The only difference between the two is
default risk. E has a higher default risk. Therefore, the difference between their interest
rates i.e. 4.0 – 3.5 = 0.5% must be equal to the default risk premium.
3. Notice that between B and C, the only difference is that C has a longer maturity.
Therefore, interest rate of C must be higher than B (2.5%).
Also notice that between C and the low liquidity version of D, the only difference is that C
has a shorter maturity. Therefore, interest rate on C has to be lower than the low
liquidity version of D (3.5%).
So the range for C is 2.5 < r < 3.5.

3. Future Value of a Single Cash Flow (Lump Sum)

Let’s understand this concept with a simple example.
Say present value (PV) = $100 and interest rate (r) = 10%.
What is the future value (FV) after one year?
What is the future value (FV) after two years?

The future value of a single cash flow can be computed using the following formula:
FVN = PV (1 + r)N
where:
FVN = future value of the investment
N = number of periods
PV = present value of the investment
r = rate of interest
Therefore,
FV1 = 100 (1 + 0.1)1 = $110
FV𝟐 = 100 (1 + 0.1)𝟐 = $121
Notice that with compound interest, after two years we have $121. Whereas, with simple

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R01 Time Value of Money 2022 Level I Notes

interest, after two years we would have $120. The difference between the two values ($1)
represents the interest on interest component. In Year 2, we not only receive interest on the
$100 principal, but we also receive interest on the $10 interest earned in Year 1 that has
been reinvested.
Example
Cyndia Rojers deposits $5 million in her savings account. The account holders are entitled to
a 5% interest. If Cyndia withdraws cash after 2.5 years, how much cash would she most likely
be able to withdraw?
Solution:
FVN = PV (1 + r)N
FV2.5 = 5 (1 + 0.05)2.5 = $5.649 million
FV Calculation using a Financial Calculator
You will often use the following keys on your TI BA II Plus calculator:
N = number of periods
I/Y = rate per period
PV = present value
FV = future value
PMT = payment
CPT = compute
One important point to note is the signs used for PV and FV. If the value for PV is negative “-”,
then the value for FV is positive “+”. An inflow is often represented as a positive number,
while outflows are denoted by negative numbers.
Before you begin, set the number of decimal points on your calculator to 9 to increase
accuracy.
Keystrokes Explanation Display
[2nd] [FORMAT] [ ENTER ] Get into format mode DEC = 9
[2nd] [QUIT] Return to standard calc mode 0

Question: You invest $100 today at 10% compounded annually. How much will you have in
5 years?
The key strokes to compute the future value of a single cash flow are illustrated below.
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0
[2nd] [CLR TVM] Clears TVM Worksheet 0
5 [N] Five years/periods N=5

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R01 Time Value of Money 2022 Level I Notes

10 [I/Y] Set interest rate I/Y = 10

100 [PV] Set present value PV = 100
0 [PMT] Set payment PMT = 0
[CPT] [FV] Compute future value FV = -161.05

4. Non-Annual Compounding (Future Value)

When our compounding frequency is not annual, we use the following formula to compute
future value:
rs mN
FVN = PV (1 + )
m
where:
rs = the stated annual interest rate in decimal format
m = the number of compounding periods per year
N = the number of years
Let’s understand this concept using an example.
You invest $80,000 in a 3-year certificate of deposit. This CD offers a stated annual interest
rate of 10% compounded quarterly. How much will you have at the end of three years?
Solution:
There are two methods to solve this question.
Formula Method
PV is $80,000.
The stated annual rate is 10%.
The number of compounding periods per year is 4. The total number of periods is 4 x 3 = 12.
Therefore future value after 12 quarters (3 years) is
FV12 = $80,000 (1 + 0.025)12 = $107,591
Calculator Method
You can also solve this problem using a financial calculator; the key strokes are given below:
N = 12, I/Y = 2.5%, PV = $80,000, PMT = 0, CPT FV = -$107,591
PMT is 0 because there are no intermediate payments in this example.
Example
Donald invested $3 million in an American bank that promises to pay 4% compounded daily.
Which of the following is closest to the amount Donald receives at the end of the first year?
Assume 365 days in a year.
A. $3.003 million
B. $3.122 million
C. $3.562 million

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R01 Time Value of Money 2022 Level I Notes

Solution
The correct answer is B.
Formula Method
r mN
FVN = PV (1 + s )
m
0.04 365
FV1 year = 3 million (1 + ) = $3.122 million
365
Calculator Method
N = 365, I/Y = 4/365%, PV = $3 million, PMT = 0; CPT FV = -$3.122 million
5. Continuous Compounding, Stated and Effective Rates
We saw examples with annual compounding. Then we discussed quarterly compounding
and in the above example we looked at daily compounding. If we keep increasing the number
of compounding periods until we have infinite number of compounding periods per year,
then we can say that we have continuous compounding.
The formula for computing future values with continuous compounding is:
FVN = PVerN
where:
r = continuously compounded rate
N = the number of years
Let’s look at an example.
An investment worth $50,000 earns interest that is compounded continuously. The stated
annual interest is 3.6%. What is the future value of the investment after 3 years?
Solution:
PV = $50,000; r = 0.036; N = 3
FV = 50,000 e0.036 x 3 = $55,702
Concept Building Exercise
Assume that the stated annual interest rate is 12%. What is the future value of $100 at
different compounding frequencies? What is the return?
Frequency Future value of $100 Return
Annual 112.00 12.00%
Semiannual 112.36 12.36%
Quarterly 112.55 12.55%
Monthly 112.68 12.68%
Daily 112.75 12.75%
Continuous 112.75 12.75%

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R01 Time Value of Money 2022 Level I Notes

Instructor’s Note:
1. For the same stated annual rate, the returns keep getting better as we compound more
often.
2. If you have two banks that offer the following rates
A: 12.5% compounded annually
B: 12% compounded daily
Which offer is better?
Even though A’s 12.5% looks better, B’s 12% compounded daily will effectively give you a
return of 12.75%. Therefore, the offer from bank B is better.
5.1 Stated and Effective Rates
Now we come to the related concept of stated versus effective rates. In the above concept-
building exercise, the stated rate was 12% across the board, but the effective rate that an
investor actually earns depends on the compounding frequency. The effective rates were
different for different compounding frequencies.
If we are given a compounding frequency, we can compute effective rates using the following
formulae:
Effective annual rate for discrete compounding:
EAR = (1 + periodic interest rate)m – 1
where:
m = number of compounding periods in one year
 For daily compounding, m = 365
 For monthly compounding, m = 12
 For quarterly compounding, m = 4
 For semiannual compounding, m = 2

For example, for a stated annual rate of 12% and quarterly compounding, the EAR will be
equal to:
EAR = (1 + 0.12/4)4 – 1 = 1.1255 – 1 = 0.1255 = 12.55%
Instructor’s Note:
A lot of people get confused about the -1 at the end of the formula. The idea is actually fairly
straight forward. Basically, we have 1.034 which is telling us how much $1 will become at the
end of 4 periods. $1 is going to become $1.1255. But this is not a rate. To figure out the rate
we have to subtract the original $1 that we invested. So, we are left with 0.1255 which is our
effective rate.
Effective Annual Rate for continuous compounding:
EAR = ers − 1

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R01 Time Value of Money 2022 Level I Notes

where rs = stated annual interest rate

For example, for a stated annual rate of 12% and continuous compounding, the EAR will be
equal to:
EAR = e0.12 – 1 = 1.1275 – 1 = 0.1275 = 12.75%

6. Future Value of a Series of Cash Flows, Future Value of Annuities

The different types of cash flows based on the time periods over which they occur include:
 Annuity: A finite set of equal sequential cash flows. The two types are
o Ordinary annuity: Cash flows occur at the end of each period and the first cash
flow occurs one period from now (indexed at t = 1).
o Annuity due: Cash flows occur at the beginning of each period and the first cash
flow occurs immediately (indexed at t = 0).
 Perpetuity: A set of equal never-ending sequential cash flows with the first cash flow
occurring one period from today. (The period is finite in case of an annuity whereas in
perpetuity it is infinite.)
6.1 Equal Cash Flows – Ordinary Annuity
Let’s say that we have an ordinary annuity with A = $1,000, r = 5% and N = 5, i.e. we are
going to receive a payment of $1,000 at the end of each year for the next 5 years and our
discount rate is 5%. We can compute the FV of this annuity using the following three
methods:
Brute-Force Method
We can take each individual cash flow and see how much each of these will be worth at the
end of five years. Then we can add all the values to compute the total FV of the annuity.

For instance, the first $1,000 deposit made at t = 1 will compound over four periods; the
second deposit of $1,000 will compound over three periods and so on. We then add the

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R01 Time Value of Money 2022 Level I Notes

future values of all payments to arrive at the future value of the annuity which is $5,525.63.
Formula Method
The future value of an annuity can also be computed using the following formula:
(1 + r)N – 1
FVN = A [ ]
r
where:
A = annuity amount
N = number of years
The term in square brackets is known as the ‘future value annuity factor’ (FVAF). This factor
gives the future value of an ordinary annuity of $1 per period. Hence the formula given
above can also be written as: FV = A x FVAF.
Therefore, using the formula:
(1.05)5 – 1
FV5 = 1,000 [ ] = $5,525.63
0.05

Calculator Method
Given below are the keystrokes for computing the future value of an ordinary annuity.
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard calc mode 0
[2nd] [CLR TVM] Clears TVM Worksheet 0
5 [N] Five years/periods N=5
5 [I/Y] Set interest rate I/Y = 5
0 [PV] 0 because there is no initial investment PV = 0
1000 [PMT] Set annuity payment PMT = 1000
[CPT] [FV] Compute future value FV = -5525.63

On the exam you should use the calculator method, because this is the fastest method and
does not require you to memorize the annuity formula.
Example
Haley deposits $24,000 in her bank account at the end of every year. The account earns 12%
per annum. If she continues this practice, how much money will she have at the end of 15
years?
Solution:
N = 15, I/Y = 12%, PV = 0, PMT = $24,000; CPT  FV = -$894,713.15

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R01 Time Value of Money 2022 Level I Notes

6.2 Unequal Cash Flows

If cash flow streams are unequal, the future value annuity factor cannot be used. In this case,
we find the future value of a series of unequal cash flows by compounding the cash flows one
at a time.
This concept is illustrated in the figure below. We need to find the future value of five cash
flows: $1,000 at the end of Year 1; $2,000 at the end of Year 2; $3,000 at the end of Year 3;
$4,000 at the end of Year 4; and $5,000 at the end of Year 5.

The future value is $5,000 + $4,000 x 1.05 + $3,000 x 1.05 2 +$ 2,000 x 1.053 + $1,000 x 1.054
= $16,038.

7. Present Value of a Single Cash Flow (Lump Sum)

Let's say that one year from today you will receive a cash flow of $110. What is the value of
that $110 today? (Assume that the interest rate is 10%)

FV1 $110
PV = = = $100
(1 + 0.1)1 (1 + 0.1)1
The $110 one year from today has a present value of $100. In other words, you will be
indifferent between $100 today and $110 one year from today.
What if you were going to receive $121 at the end of two years, what is its present value?

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R01 Time Value of Money 2022 Level I Notes

FV2 $121
PV = 2
= = $100
(1 + 0.1) (1 + 0.1)2
Using these two examples we can write a general formula for computing PV. Given a cash
flow that is to be received in N periods and an interest rate of r per period, the PV can be
computed as:
FVN
PV =
(1 + r)N
where:
N = number of periods
r = rate of interest
FV = future value of investment
Instructor’s Note
Notice that this formula can also be obtained by simply rearranging the formula for FV that
we studied earlier.
FV
FVN = PV (1 + r)N  PV = (1+r)NN

Based on this formula we can make two observations

1. For a given discount rate, the farther in the future the amount to be received, the
smaller the amount’s present value.

Mathematical explanation: In the first case the PV is $110/1.1, whereas in the second
case PV is $110/1.12. Since we are dividing by a larger number the PV will be lower in
the second case.
Intuitive explanation: Clearly receiving a certain amount of money sooner is better
than receiving the same amount of money latter.
2. Holding time constant, the larger the discount rate, the smaller the present value of a
future amount.

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R01 Time Value of Money 2022 Level I Notes

In the first case PV is $110/1.1, whereas in the second case PV is $110/1.2. Clearly the PV
is going to be lower in the second case, because we are dividing by a larger number.
Example
Liam purchases a contract from an insurance company. The contract promises to pay
$600,000 after 8 years with a 5% return. What amount of money should Liam most likely
invest? Solve using the formula and TVM functions on the calculator.
Solution:
Formula Method
FVN $600,000
PV = 𝑁 = = $406,104
(1 + r) (1.05)8
Calculator Method
N = 8, I/Y = 5%, PMT = 0, FV = $600,000; CPT PV PV = - $406,104

Example
Mathews wishes to fund his son, Nathan’s, college tuition fee. He purchases a security that
will pay $1,000,000 in 12 years. Nathan’s college begins 3 years from now. Given that the
discount rate is 7.5%, what is the security’s value at the time of Nathan’s admission?
Solution:

$1,000,000
PV3 = = $521,583.47
(1.075)9

Example
Orlando is a manager at an Australian pension fund. 5 years from today he wants a lump sum
amount of AUD40, 000. Given that the current interest rate is 4% a year, compounded

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R01 Time Value of Money 2022 Level I Notes

monthly, how much should Orlando invest today?

Solution:
We have monthly compounding, therefore the inputs to our calculator will be
N = 5 x 12 = 60
I = 4 /12%
PMT = 0
FV = $40,000
CPT PV = - $32,760.12

8. Non-Annual Compounding (Present Value)

When our compounding frequency is not annual, we use the following formula to compute
present value:
rs −mN
PV = FVN (1 + )
m
where:
rs = the stated annual interest rate in decimal format
m = the number of compounding periods per year
N = the number of years
Let’s understand this concept using an example.
You want to know how much to deposit today to receive a lump-sum payment of $100,000
after 5 years. This amount will be invested in a 5-year certificate of deposit that offers a
stated annual interest rate of 10% compounded quarterly. How much should you invest
today?
Solution:
There are two methods to solve this question.
Formula Method:
FV is $100,000.
The number of compounding periods per year is 4.
The stated annual rate is 10%. So, the interest rate per period is 10%/4 = 2.5%
The total number of periods is 4 x 5 = 20.
Therefore, the present value today is:
PV = $100,000 (1 + 0.025)−20 = $61,027.09
Calculator Method:
You can also solve this problem using a financial calculator; the key strokes are given below:

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R01 Time Value of Money 2022 Level I Notes

N = 20, I/Y = 2.5%, FV = $100,000, PMT = 0, CPT PV = -$61,027.09

PMT is 0 because there are no intermediate payments in this example.
9. Present Value of a Series of Equal Cash Flows (Annuities) and Unequal
Cash Flows
9.1 The Present Value of a Series of Equal Cash Flows
Ordinary Annuity
An ordinary annuity is a series of equal payments at equal intervals for a finite period of
time. Examples of ordinary annuity: mortgage payments, pension income etc.
Consider an ordinary annuity with A = $10, r = 5% and N = 5.

We can compute the PV of this annuity using three methods

Brute-Force Method:
Simply take each cash flow and compute the PV. Add all values to get the PV for the annuity.

PV = $43.29.
Formula Method:
The present value can also be computed using the following formula:

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R01 Time Value of Money 2022 Level I Notes

1
1 − ((1+r)N )
PV = A [ ]
r
where:
A = annuity amount
r = interest rate per period corresponding to the frequency of annuity payments
N = number of annuity payments
The term in square brackets is called the present value annuity factor (PVAF). Hence
the equation above can also be written as: PV = A x PVAF.
Therefore, using the formula we get,

1
1 − ((1+0.05)5 )
PV = 10 [ ] = $43.29
0.05

Calculator Method:
The keystrokes to solve this using a financial calculator are given below:

Keystrokes Explanation Display

[2nd] [QUIT] Return to standard calc mode 0
[2nd] [CLR TVM] Clears TVM Worksheet 0
5 [N] Five years/periods N=5
5 [I/Y] Set interest rate I/Y = 5
Set to 0 because there is no final payment
0 [FV] FV = 0
other than the periodic annuity amounts
10 [PMT] Set annuity payment PMT = 10
[CPT] [PV] Compute present value PV = -43.29

Annuity Due
With an annuity due the first payment is received at the start of the first period. So if we have
an annuity due with A = $10, r = 5% and N = 5. The cash flows will be

Again, there are three methods to calculate the PV of this annuity due.

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R01 Time Value of Money 2022 Level I Notes

Brute-Force method
Take each cash flow and compute the PV. Add all values to get the PV for the annuity.

PV = $45.46.
Notice that with an annuity due you are receiving money faster, which means that the
PV annuity due ($45.46) > PV ordinary annuity ($43.29).
Formula method:
We can also use the following formula:
1
1 − (1+r)N
PV = A [ ] (1 + r)
r

where:
A = annuity amount
r = interest rate per period corresponding to the frequency of annuity payments
N = number of annuity payments
Therefore, using the formula,
1
1 − (1+0.05)5
PV = 10 [ ] (1 + 0.05) = $45.46
0.05

Instructor’s Note:
1
1−(1+r) N
Notice that A [ ] is basically the formula for computing the PV of an ordinary annuity.
r

If you use the ordinary annuity formula the PV that you get will be at time period -1. So this
needs to be taken forward one period by multiplying it by (1 + r)

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R01 Time Value of Money 2022 Level I Notes

Calculator Method:
Set the calculator to BGN mode. This tells the calculator that payments happen at the start of
every period. (The default calculator setting is END mode which means that payments
happen at the end of every period). The keystrokes are shown below:

Keystrokes Explanation Display

[2nd] [BGN] [2nd] [SET] Set payments to be received at BGN
beginning rather than end
[2nd] [QUIT] Return to standard calc mode BGN 0
[2nd] [CLR TVM] Clears TVM Worksheet BGN 0
5 [N] Four years/periods BGN N=5
5 [I/Y] Set interest rate BGN I/Y = 5
10 [PMT] Set payment BGN PMT = 10
0 [FV] Set future value BGN FV = 0
[CPT] [PV] Compute present value BGN PV = -45.46
Set payments to be received at
[2nd] [BGN] [2nd] [SET] END
the end
[2nd] [QUIT] Return to standard calc mode 0
Always remember to put your calculator back in the END mode after you are done with the
calculations.
9.2 The Present Value of a Series of Unequal Cash Flows
When we have unequal cash flows, we can first find the present value of each individual cash
flow and then sum the respective present values.
Let’s say that we have the following cash flows:
Time period Cash Flow
1 $100
2 $200
3 $300
Assuming a discount rate of 10%, the PV of these cash flows can be computed as:

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R01 Time Value of Money 2022 Level I Notes

PV = 100/1.1 + 200/1.12 + 300/ 1.13 = $481.59

Example
Andy makes an investment with the expected cash flow shown in the table below. Assuming
a discount rate of 9% what is the present value of this investment?
Time Period Cash Flow($)
1 50
2 100
3 150
4 200
5 250
Solution:
PV = 50/1.09 + 100/1.092 + 150/1.093 + 200/1.094 + 250/1.095 = $550.03
We can also use the cash flow register on our financial calculator to solve this problem
quickly. The key strokes are as follows:
Keystrokes Explanation Display
[2nd] [QUIT] Return to standard mode 0
[CF] [2nd] [CLR WRK] Clear CF Register CF = 0
0 [ENTER] No cash flow at t = 0 CF0 = 0
[↓] 50 [ENTER] Enter CF at t = 1 C01 = 50
[↓] [↓] 100 [ENTER] Enter CF at t = 2 C02 = 100
[↓] [↓] 150 [ENTER] Enter CF at t = 3 C03 = 150
[↓] [↓] 200 [ENTER] Enter CF at t = 4 C04 = 200
[↓] [↓] 250 [ENTER] Enter CF at t = 5 C05 = 250
[↓] [NPV] [9] [ENTER] Enter discount rate I =9
[↓] [CPT] Compute NPV 550.03

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R01 Time Value of Money 2022 Level I Notes

10. Present Value of a Perpetuity and Present Values Indexed at Times

Other Than t=0
A perpetuity is a series of never-ending equal cash flows; it can be thought of an everlasting
annuity. The present value of perpetuity can be calculated by using the following formula:
A
PV =
r
where:
A = annuity amount
r = discount rate
Let’s say that we have a really simple perpetuity where we receive $10 at the end of every
year forever, and let’s say that the interest rate is 5%.

The PV of this perpetuity can be computed as:

10
PV = = $200
0.05
Instructor’s Note:
Keep in mind that the present value of $200 is one period before the first cash flow. Many
students show the present value of $200 at the same time as the first cash flow, which is
incorrect.
10.1 Present Values Indexed at Times Other Than t=0
An annuity or perpetuity beginning sometime in the future can be expressed in present value
terms one period prior to the first payment. That value can then be discounted back to
today’s present value.
Let’s say you are offered a cash flow of $10 at the end of year 5, end of year 6, and so on
forever. What is the PV of these cash flows, assuming a discount rate of 10%?

The PV of the perpetuity at the end of year 4 can be computed as:

10
PV4 = = $100
0.1
This value has to be discounted back four periods to get the PV at time period 0.

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R01 Time Value of Money 2022 Level I Notes

PV0 = $100/1.14 = $68.30

Example
Bill Graham is willing to pay for a perpetual preferred stock that pays dividends worth $100
per year indefinitely. The first payment will be received at t = 4. Given that the required rate
of return is 10%, how much should Mr. Graham pay today?
Solution:
The time line for this scenario is

The PV of the perpetuity at the end of year 3 can be computed as

100
PV3 = = $1,000
0.1
This value has to be discounted back 3 periods to get the PV at time period 0.
PV0 = $1,000/1.13 = $751.31

11. Solving for Interest Rates, Growth Rates, and Number of Periods
11.1 Solving for Interest Rates and Growth Rates
An interest rate can also be considered a growth rate. We can compute the rate using the
formula method or the calculator method.
Example:
A $100 deposit today grows to $121 in 2 years. What is the interest rate? Use both the
formula and the calculator method.
Using the formula 100(1+r) 2 = 121. Therefore r = 0.1 or 10%
Using the calculator method, inputs to the calculator are
PV = -$100 (When we enter both PV and FV, they should be given opposite signs to avoid a
calculator error.)
FV = $121
N=2
PMT = 0
CPT I  I = 10%

Example:
The population of a small town is 100,000 on 1 Jan 2000. On 31 December 2001 the
population is 121,000. What is the growth rate?
Inputs to the calculator are
PV = -$100,000

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R01 Time Value of Money 2022 Level I Notes

FV = $121,000
N=2
PMT = 0
CPT I  I = 10%

Example:
You invest $900 today and receive a $100 coupon payment at the end of every year for 5
years. In addition, you receive $1,000 and the end of year 5. What is the interest rate?
Inputs to the calculator are
PV = -$900
FV = $1,000
N=5
PMT = 100
CPT I  I = 12.83%
11.2 Solving for the Number of Periods
Similarly, we can determine the number of periods given other information such as future
value, present value and interest rate.
Example:
You invest $2,500. How many years will it take to triple the amount given that the interest
rate is 6% per annum compounded annually? Use both the formula and the calculator
method.
Formula Method:
FV = PV (1 + r)N
7,500 = 2,500 (1 + 0.06)N
1.06N = 3
N x ln 1.06 = ln 3
ln 3
N=( ) = 18.85
ln 1.06
Calculator Method:
Using the calculator: I/Y = 6%, PV = $2,500, PMT = 0, FV = -$7,500, CPT N = 18.85.

12. Solving for the Size of Annuity Payments (Combining Future Value and
Present Value Annuities)
Given the number of periods, interest rate per period, present value, and future value, it is
easy to solve for the annuity payment amount. This concept can be applied to mortgages and
retirement planning. Consider the following example.
Example:
Freddie bought a car worth $42,000 today. He was required to make a 15% down payment.
The remainder was to be paid as a monthly payment over the next 12 months with the first
payment due at t = 1. Given that the interest rate is 8% per annum compounded monthly,

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R01 Time Value of Money 2022 Level I Notes

what is the approximate monthly payment?

Loan amount = 85% of $42,000 = 0.85 x 42,000 = $35,700
PV = $35,700
N = 12
I/Y = 8/12%
FV = 0 CPT PMT  PMT = $3,105.48
13. Present Value and Future Value Equivalence, Additivity Principle
Let’s say that we have an ordinary annuity with A = 10, r = 5% and N = 5.

As per our discussion so far, we can compute the PV and FV of this annuity
PV (at time 0) = $43.29 and FV (at time 5) = $55.26
According to the concept of present and future value equivalence, a lump sum of $43.29 at
time 0 is equivalent to an annuity of $10 over five years. Further, both these options are
equivalent to a lump sum of $55.26 at time 5. Given an interest rate of 5%, you would be
indifferent between these choices.
13.1 The Cash Flow Additivity Principle
Amounts of money indexed at the same point in time are additive. For example, if you have
the following cash flows:

You cannot simply add these three numbers. You have to take each of these numbers and
bring them to a particular point in time. Let’s say that we find the present values at time zero
for each of these cash flows. According to this principle, these present values that are all
indexed to time zero can be added.

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R01 Time Value of Money 2022 Level I Notes

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R01 Time Value of Money 2022 Level I Notes

Summary
LO.a: Interpret interest rates as required rates of return, discount rates, or
opportunity costs.
An interest rate is the required rate of return. If you invest $100 today on the condition that
you get $110 after one year, the required rate of return is 10%.
If the future value (FV) at the end of Year 1 is $110, you can discount at 10% to get the
present value (PV) of $100. Hence, 10% can also be thought of as a discount rate.
Finally, if you spent $100 on taking your spouse out for dinner you gave up the opportunity
to earn 10%. Thus, 10% can also be interpreted as an opportunity cost.
LO.b: Explain an interest rate as the sum of a real risk-free rate, and premiums that
compensate investors for bearing distinct types of risk.
Interest rate = Real risk-free interest rate + Inflation premium + Default risk premium +
Liquidity premium + Maturity premium.
Nominal risk free rate= real risk free rate + inflation premium
LO.c: Calculate and interpret the effective annual rate, given the stated annual interest
rate and the frequency of compounding.
The stated annual interest rate is a quoted interest rate that does not account for
compounding within the year. The effective annual rate (EAR) is the amount by which a unit
of currency will grow in a year when we do consider compounding within the year.
Example: If the stated annual rate is 12% with monthly compounding, the periodic or
monthly rate is 1%. Since $1 invested at the start of the year will grow to 1.01 12 = 1.1268,
the EAR is 12.68%.
LO.d: Calculate the solution for time value of money problems with different
frequencies of compounding.
When our compounding frequency is not annual, we use the following formula to compute
future value:
rs mN
FVN = PV (1 + )
m
where:
rs = the stated annual interest rate in decimal format
m = the number of compounding periods per year
N = the number of years
If we keep increasing the number of compounding periods until we have infinite number of
compounding periods per year, then we can say that we have continuous compounding. The
formula to compute future value is:
FVN = PVerN

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R01 Time Value of Money 2022 Level I Notes

where:
r = continuously compounded rate
N = the number of years
LO.e: Calculate and interpret the future value (FV) and present value (PV) of a single
sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and a
series of unequal cash flows.
The future value and present value for a single sum of money can be calculated using the
following formulae:
FV = PV (1 + r)N and PV = FV/ (1 + r)N
An annuity is a finite set of equal sequential cash flows occurring at equal intervals. There
are two types of annuities:
 Ordinary annuity: Cash flows occur at the end of every period.
 Annuity due: Cash flows occur at the start of every period (hence, the Period 1 cash
flow occurs immediately).
The future value of an ordinary annuity can be computed using the following formula:
(1 + r)N – 1
FVN = A [ ]
r
where:
A = annuity amount
N = number of years
The present value of ordinary annuity can be computed using the following formula:
1
1 − ((1+r)N )
PV = A [ ]
r
where:
A = annuity amount
r= interest rate per period corresponding to the frequency of annuity payments
N = number of annuity payments
With an annuity due the first payment is received at the start of the first period. The formula
to calculate present value of annuity due is as follows:
1
1 − (1+r)N
PV = A [ ] (1 + r)
r

where:
A = annuity amount
r = interest rate per period corresponding to the frequency of annuity payments
N = number of annuity payments

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R01 Time Value of Money 2022 Level I Notes

Alternatively, you may also use the TVM keys on the calculator instead of the formulas to
compute the present values and the future values of annuities.
A perpetuity is a series of never-ending equal cash flows. The present value of perpetuity can
be calculated by using the following formula:
A
PV =
r
where:
A = annuity amount
r = discount rate
LO.f: Demonstrate the use of a timeline in modeling and solving time value of money
problems.
You can solve time value of money questions by showing cash flows on a timeline such as the
one shown below:

Say you will receive $150 at the end of Year 4, Year 5, and Year 6 and you want to calculate
the PV at time 0. You can treat the three payments as an annuity and calculate the PV at the
end of year 3. This value, assuming a 10% discount rate, is: $373.03. We can then further
discount $373.03 to time 0. Plug: FV = $373.03, N = 3, I = 10%, PMT = 0. Compute PV. You
should get $280.26.

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