Chapter 5: Time Value of Money

I. Introduction
A. Why does finance worry about time value of money?
1. Most financial decisions involve costs and benefits that are
spread out over time = => Need to adjust cash flows for time
value of money
2. Firms have to decide between projects that generate cash
flows in different periods of times. Time value of money
allows comparison of these cash flows.
B. Main ideas
1. Future value (FV) of a cash flow
a. Shows compounding or growth over time
b. Shows what periodic payments have to be made at
given interest rate so that desired sum of money can
be obtained at specified future date
c. Notation:
i. Let PV0 be present value or the beginning
amount at time 0 (measured in dollars)
ii. Let FVn = future value at the end of “n” periods
(measured in dollars)
iii. Let k be interest rate
iv. Let n be number of periods interest is
compounded.
d. Formula to determine FVn

FVn =PV0 (1+k)n

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 Financial tables list FVIFk,N = future value interest for
one dollar compounded annually at k percent for n
periods. FVIFk,N = (1+k)N
2. Present value (PV) of cash flow
a. Present value is current dollar value of a future
amount of money
b. Main idea: a dollar today is worth more than a $1
tomorrow
c. It is amount today that must be invested at given
interest rate to reach future amount
d. Known as discounting = Reverse of compounding.
Future value is discounted back to present value
e. Interest rate = discount rate = opportunity cost =
required return = cost of capital
f. Formula to determine present value

FVn
PV0 =
(1+k)n

Financial tables list PVIFk,N = present values interest

factors for one dollar discounted at k percent for N
periods. PVIFk,N = 1/(1+k)N
3. Example: Cash flow received over 5 years. k = 5%

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Year 0 1 2 3 4 5
Cash Flow $50 $100 $150 $200 $250 $300

Cash Flow Present Value Cash Flow Future Value

Year 0 $50/(1.05)0= $50.00 Year 0 $50(1.05)5= $63.81
Year 1 $100/(1.05)1= $95.24 Year 1 $100(1.05)4= $121.55
2 3
Year 2 $150/(1.05) = $136.05 Year 2 $150(1.05) = $173.64
Year 3 $200/(1.05)3= $172.77 Year 3 $200(1.05)2= $220.50
Year 4 $250/(1.05)4 $238.10 Year 4 $250(1.05)1= $262.50
5 0
Year 5 $300/(1.05) = $235.06 Year 5 $300(1.05) = $300.00
PV0= $927.21 FV5= $1,142.01

II. Annuities, perpetuities, and mixed stream cash flows

A. Annuities
1. Comments
a. Annuities are equally-spaced cash flows of equal size

b. Annuities can be either cash inflows or cash outflows

c. An ordinary (deferred) annuity has cash flows that
occur at the end of each period
d. An annuity due has cash flows that occur at the
beginning of each period
2. Ordinary annuities
a. Notation:
i. Let C be the equal-sized cash inflow
ii. Let N be the number of periods
iii. Let k be the interest rate
b. Present value of ordinary annuity

Year 0 1 2 3 ... N
Cash flow 0 C C C C

i. Math:

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 C C C C
Key Equation: PV0 = 1
+ 2
+ 3
+L +
(1+k) (1+k) (1+k) (1+k)N

N N
1
PV0 =C i
=C (1+k)-i
i=1 (1+k) i=1

Now some mathematical manipulation of above equation:

First factor out C to get:

1 1 1 1
PV0 = C[ 1
+ 2
+ 3
+L + ]
(1+k) (1+k) (1+k) (1+k)N

1
Now factor out (1+k) to obtain:

1 1 1 1
PV0 =C [1 + 1
+ 2
+L + ]
(1+k) (1+k) (1+k) (1+k)N-1

1
Next set d = (1+k) to get:

PV0 =Cd [1 + d + d 2 + L + d N-1 ] (†)

Note 0 < d < 1.

Now a digression about infinite geometric series and truncated geometric

series:
1. First, infinite geometric series. Let d be a fraction such that 0 < d < 1.

1
Theorem: 1 + d + d + d  d  L =
2 3 4

1-d

Proof:
X = 1 + d + d 2 + d 3  d4  L (*)

Multiply both sides of equation (*) by d to get:

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 dX = d + d 2 + d 3 + d 4  d 5  L (**)

Subtract left-hand side of (**) from left-hand side of (*), subtract right-hand
side of (**) from right-hand side of (*) to obtain:

X - dX = 1

Dividing both sides by 1 – d obtains:

1
X = 1+d+d 2 +d 3 +d 4 +L = QED!
1-d
2. Next truncated geometric series.

1-d N
Theorem: Let 0 < d < 1, then 1+d+d 2 +K +d N-1 =
1-d

Proof:

1
=1+d+d 2 +d 3 +L +d N-1 +d N +d N+1 +L (*)
1-d

Multiply both sides of equation (*) by dN to obtain:

dN
=d N +d N+1 +d N+2 +d N+3 +L +d 2N-1 +d 2N +d 2N+1 +L (**)
1-d

Again subtract left-hand side of (**) from left-hand side of (*) and
right-hand side of (**) from right-hand side of (*) to get:

1-d N
=1+d+d 2 +d 3 +L +d N-1
1-d

Equation (†) on page 4 and the above theorem on truncated geometric series
implies that:

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 N N
� 1 � �1 �
1- � 1- � �
1 �(1+k) �
� 1+k
2 N-1
PV0 =Cd [1 + d + d + L + d ]=C =C � �
(1+k) 1- 1 k
(1+k)

ii. Financial tables:

On page 118 of the text the author writes that
PVAN = PMT x (PVIFAk,N) where PVAN is the
present value of the annuity, PMT = C or the
equal-sized cash flow, and PVIFAk,N is the
present value interest factor for a one-dollar
annuity discounted at k percent for N years.
Note:
N
 1 
N
1-  
PVIFA k,N =  (1+k)-i = 
1+k 
i=1 k

For example: PVIFA5%,10 = 7.722

10
 1 
1-  
 1.05  =7.721735
.05

iii. Using Microsoft Excel Function:

=PV(rate, Nper, pmt, FV, type) where
rate = interest rate (10% = 0.10)
Nper = N
pmt = C = equal sized cash flow
FV = future value (no value given in this case)
type = 1 if annuity due. = 0 or omitted if
ordinary annuity
Example: PV(0.05, 10, -1, , )=$7.72

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 c. Example: What is the present value of an ordinary
annuity paying $2,000 each of three years using an
annual interest rate of 10%?

Year 0 1 2 3
Cash flow $2,000 $2,000 $2,000

i. Math:

$2000 $2000 $2000

PVA 3 = + +
(1.10) (1.10)2 (1.10)3

PVA 3 =$1818.18+1652.89+1502.63=$4,973.70
ii. Financial table
PVA3=pmt x PVIFA10%,3 = (2000)x(2.487)=$4,974
iii. Microsoft Excel function:
=PV(0.10,3,-2000, , )=$4,973.70
d. Future value of annuity
i. Math

Year 0 1 2 3 ... N-1 N

Cash flow C C C C C

FVA N =C(1+k)N-1 +C(1+k)N-2 +C(1+k) N-3 +L +C(1+k)+C

N
FVA N =C (1+k)N-t
t=1

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 ii. Financial tables: See page 116 of text
FVAN = PMT x FVIFAi,N
PMT = C = equal-sized annuity payment
FVIFAk,N = future value interest factor for an
annuity.
N
Note : FVIFA k,N =  (1+k)
N-t

t=1

Can show that:

1
FVIFA k,N = [(1+k)N -1]
k

iii. Microsoft Excel Function

=FV(rate, Nper, pmt, PV, type) where
rate = interest rate in decimal form
Nper = N
pmt = C
PV = present value, omitted in this case
Type = 1 if annuity due, 0 or omitted if not
e. Example of future value: Assume an annuity pays
$2,000 at the end of every year for a three year period.
Using a 10% interest rate, what is the future value of
this cash flow at the end of the third year?

Year 0 1 2 3
Cash flow $2,000 $2,000 $2,000

i. Math:

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 FVA 3 =2000(1.10)2 +2000(1.10)1 +2000

FVA 3 =2420.00+2200+2000=$6,620.00

ii. Financial tables:

FVA3=pmt x FVIFA10%,3 = (2000)
(3.310)=$6,620.00
iii. Excel function: = FV(0.10,3,-2000, , ) =$6,620.00
3. Annuity Due vs. Ordinary Annuity
Compare present values and future values of both a annuity
due and an ordinary annuity with periodic payments of
$1,000, annual interest rate of 7%, and 5 year maturity.

0 1 2 3 4 5
Cash flow:
$0 $1,000 $1,000 $1,000 $1,000 $1,000
Ordinary annuity
Cash flow:
$1,000 $1,000 $1,000 $1,000 $1,000 $0
Annuity due

Ordinary annuity Annuity due

Present value at year 0 $4,100.20 $4,387.21
Future value at end of year 5 $5,750.74 $6,153.29

For the ordinary annuity:

$1000 $1000 $1000 $1000 $1000
PVA 5 = + + + + =$4,100.20
(1.07)1 (1.07)2 (1.07)3 (1.07)4 (1.07)5

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FVA 5 =$1000(1.07)4 +$1000(1.07)3 +$1000(1.07)2 +$1000(1.07)1 +$1000=$5,750.74

For the annuity due:

$1000 $1000 $1000 $1000
PVA 5 =$1000+ + + + =$4,387.21
(1.07)1 (1.07)2 (1.07)3 (1.07)4

FVA 5 =$1000(1.07)5 +$1000(1.07)4 +$1000(1.07)3 +$1000(1.07)2 +$1000(1.07)1 =$6,153.29

C. Perpetuities
1. Perpetuity is special kind of annuity that never matures.
With a perpetuity, the periodic cash flow continues forever.
2. Calculate the present value of a perpetuity paying C dollars
at the end of every year

C C C C C
PV= + + + + +L
(1+k) (1+k)2 (1+k)3 (1+k)4 (1+k)5

C
Factor out from right-hand side of above equation to obtain:
1+k

C  1 1 1 1 
PV= 1+ + + + + L
(1+k)  (1+k)1 (1+k)2 (1+k)3 (1+k)4 


Term in brackets on right-hand side of above equation is infinite geometric

1 1 1+k
= =
series that simplifies to 1 1+k-1 k . Plugging this into bracket of
1-
1+k 1+k

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above equation obtains:
C (1+k) C
PV= =
(1+k) k k

3. Key result: Present value of perpetuity equals periodic

payment divided by interest rate or PV= C k .

4. Ex: How much would I have to deposit today in order to

withdraw $1,000 each year forever if I earn an annual
interest rate of 8% on my deposit?
Answer: PV = $1,000/0.08=$12,500.00
D. Present value of uneven cash flows or a mixed stream
1. A mixed stream is a series of cash flows that exhibits no
particular pattern.
2. Let FVi be future cash flow received at the end of year i, i =
1, . . . , N.
3. Given interest rate k, present value (PV) of mixed stream
cash flow is equal to:

FV1 FV2 FV3 FVN

PV= 1
+ 2
+ 3
+L +
(1+k) (1+k) (1+k) (1+k)N

4. Example: What is present value of following mixed stream

assuming interest rate was 5%? 8%?

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 Year 0 1 2 3 4 5
Cash flow $0 $400 $800 $500 $400 $300

Present value of mixed stream cash flow @ 5%:

$400 $800 $500 $400 $300

PV= + + + + =$2,102.63
(1.05)1 (1.05)2 (1.05)3 (1.05)4 (1.05)5

Present value of mixed stream cash flow @ 8%:

$400 $800 $500 $400 $300

PV= + + + + =$1,951.34
(1.08) (1.08) (1.08) (1.08) (1.08)5
1 2 3 4

III. Compounding more frequently than annually

A. General formula for more frequent compounding
1. i = annual interest rate
m = number of times per year interest is compounded

i m×n
2. FVn =PV×(1+ )
m

i
3. Semiannual compounding: FVn =PV×(1+ )2×n
2

i
4. Quarterly compounding: FVn =PV×(1+ )4×n
4

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 i 12×n
5. Monthly compounding: FVn =PV×(1+ )
12
6. Example: 12% interest rate compounded either annually,
semiannually, quarterly, or monthly. Initial $1,000 deposit
and end of month balance over two year period

Annual Semiannual Quarterly Monthly

interest factor 1.12 1.06 1.03 1.01
Month
0 1,000.00 1,000.00 1,000.00 1,000.00
1 1,010.00
2 1,020.10
3 1,030.00 1,030.30
4 1,040.60
5 1,051.01
6 1,060.00 1,060.90 1,061.52
7 1,072.14
8 1,082.86
9 1,092.73 1,093.69
10 1,104.62
11 1,115.67
12 1,120.00 1,123.60 1,125.51 1,126.83
13 1,138.09
14 1,149.47
15 1,159.27 1,160.97
16 1,172.58
17 1,184.30
18 1,191.02 1,194.05 1,196.15
19 1,208.11
20 1,220.19
21 1,229.87 1,232.39
22 1,244.72
23 1,257.16

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24 1,254.40 1,262.48 1,266.77 1,269.73

B. Nominal and effective interest rates

1. Nominal interest rate (k) = stated or contractual rate of
interest charged by lender or promised by borrower
2. effective (annual) interest rate (EAR) = rate actually paid or
earned
3. EAR = (1+k/m)m – 1
4. In general: effective rate is greater than nominal rate
whenever compounding occurs more than once per year
5. Example: What is effective rate of interest on credit card if
its nominal rate is 18% per year, compounded monthly?
Answer: EAR = (1+0.18/12)12 – 1 = 19.56%
C. Continuous compounding
1. With continuous compounding, then FVn = PV x ei x n, where
e is the exponential function or e approximately equals =
2.7183.
2. Example: What is the future value of an initial $200 deposit
(PV = $200) after two years (n = 2) in an account paying 8%
interest (i = 0.08), compounded continuously?
Answer: FV2 = $200e2x0.08=$200e0.16=$200(1.1735)=$234.70
IV. Loan amortization
A. Suppose a person wanted to borrow $6,000. He or she will repay
the loan in equal annual end of the year payments over a 4 year
period at an annual interest rate of 10%. Let X = loan payment.

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 X X X X
$6,000= + + +
1.10 1.10 1.10 1.104
2 3

�1 1 1 1 �
$6,000=X � + + +
1.10 1.10 1.10 1.104 �
�
2 3
�

�1 1 1 1 �
$6,000=X � + + + =X(3.169865)
1.10 1.10 1.10 1.104 �
�
2 3
�

X=$6,000/3.169865=$1,892.83
B. Loan amortization schedule:

end beginning end-of-year

end of year loan interest principal principal
of balance payment 0.10x(1) (2)-(3) (1)-(4)
year (1) (2) (3) (4) (5)
1 $6,000.00 $1,892.83 $600.00 $1,292.83 $4,707.17
2 4,707.17 1,892.83 470.72 1,422.11 3,285.06
3 3,285.06 1,892.83 328.51 1,564.32 1,720.73
4 1,720.73 1,892.83 172.07 1,720.76 -0.02

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