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One of the most fundamental concepts in finance is that money has a time value. That is
to say that money in hand today is worth more than money that is expected to be received in the
future. The reason is straightforward: A dollar that you receive today can be invested such that you
will have more than a dollar at some future time. This leads to the saying that we often use to
summarize the concept of time value: A dollar today is worth more than a dollar tomorrow."
For example, problems involving retirement planning will often give pre-retirement and
post-retirement interest rates. Frequently, when you are being asked to solve for the interest
rate, you will be asked to find the compound average annual growth rate (CAGR).
Number of Periods
The number of periods is the total length of time that the investment will be held. Typically, it
is given as a number of years, though it will often need to be adjusted to some other time
scale. For example, if you are told that the investment pays interest quarterly (4 times per
year) then you must adjust N so that it reflects the total number of quarterly (not annual) time
periods.
NOTE: The interest rate, number of periods, and annuity payment variables must all agree on the
length of a time period (a day, a week, a month, a year, etc). That is, i is always the interest rate
per period, N is always the total number of periods, and PMT is always the amount of the
payment per period. Very often, it is necessary to make adjustments to the values given in a
problem. For example, interest rates are usually given as annual rates. However, if payments
occur monthly, then the interest rate must be adjusted to a monthly rate (typically by dividing the
annual rate by 12). Similarly, the number of years would have to be changed to the number of
months.
When you are first learning to solve time value problems, drawing time lines is a very good idea.
In the picture above, you can easily see that the problem consists of a five-year $100 annuity
(PMT), and a $1,000 cash flow (FV) that occurs at the end of the investment. The time line
helps you to see exactly when each cash flow occurs, and therefore how many periods it needs
to be moved (either forward or backwards in time). As the problems that you are solving
become more complex, the importance of drawing time lines increases.
The Rule of 72
The Rule of 72 is an often useful tool that can be used to approximate how long it will take to
double your money at a particular interest rate:
Years to double money = 72 interest rate
So, using the rule we can see that at 8% it will take about 9 years to double your money:
Years to double money = 72 8% = 9 years:
Example:
venture that expects to pay investors 750 at the end of each month for the next eight
years. You believe that a reasonable return on your investment should be 17 percent
compounded monthly. What will be the final value?
SOLUTION: SET=END
N = 8 12 = 96,
I = 17,
PMT = 750,
P/Y = 12,
FV = 0 39,222.96.
EXAMPLE2:
Suppose you deposit 5,000 into an account earning 4 percent interest, compounded monthly.
How many years will it take for your account to be worth 7,500?
SOLUTION: PV = 5,000,
I = 4,
PMT = 0,
FV = 7,500
C/Y = 12,
N = 121.84, or 10.15 YEARS
EXAMPLE3:
You have just borrowed 10,000 and will be required to make monthly payments of 227.53 for the
next five years in order to fully repay the loan. What is the implicit interest rate on this loan?
SOLUTON: N = 5 12 = 60,
PV = 10,000,
PMT = 227.53,
FV = 0
P/Y = 12,
I = 13%
Using the example shown in the time line (above), and a 9% per period interest rate, we get:
FVA = 100*(1.09)2 + 100*(1.09) + 100 = 327.81
EXAMPLE:
If one saves Rs.1000/- a year at end of every year for three years in an account earning 7% intrest,
compounding annually, how much will one have at the end of thried year?
SOLUTION:
N=3
I=7
PMT=-1000
FV=3215
EXAMPLE:
If suppose an investment promises a cash flow of Rs.500 in one year,Rs.600 at the end of
two years and Rs.10,700 at the end of thired year. If discount rate is 5%, what is the value of this
investment today?
SOLUTION:
I=5
FLOW=0=EXE
FLOW1= 500=EXE
FLOW2=600=EXE
FLOW3=10,700=EXE
ESE
NPV=SLOVE=10,263.47
BY
Arun Chowdary
CFP Practioner