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Time Value of Money

Review of Basic Concepts

Types of problems
Single Sum. One sum ($1) will be
received or paid either in the
Present (Present Value of a Single
Sum or PV)
Future (Future Value of a Single Sum
or FV)
PV

FV

Types of Annuity Problems


Ordinary annuity (OA)
OA
A series of equal payments (or rents) received or paid at the
end of a period, assuming a constant rate of interest.

PV-OA (Present value of an ordinary annuity)

PV-OA
PMT

PMT

PMT

PMT

PMT

Types of Annuity Problems


Ordinary annuity (OA)
OA
A series of equal payments (or rents) received or paid at the
end of a period, assuming a constant rate of interest.

FV-OA (Future value of an ordinary annuity)

FV-OA
PMT

PMT

PMT

PMT

PMT

Types of Problems
Annuity Due (AD)
AD
A series of equal payments (or rents) received or
paid at the beginning of a period, assuming a
constant rate of interest.

FV-AD (future value of an annuity due)


Note: Each rent or payment is discounted
(interest removed) one less period under a FVAD.
FV-AD
PMT

PMT

PMT

PMT

PMT

Types of Problems
Annuity Due (AD)
AD
A series of equal payments (or rents) received or paid at the
beginning of a period, assuming a constant rate of interest.

PV-AD (present value of an annuity due)

PV-AD
PMT

Note: Each rent or payment compounds


(interest added) one more period in a PVAD
PMT

PMT

PMT

PMT

Deferred Annuities
0

PMT

PMT

PMT

n=3
d=2
This is an ordinary annuity of 3 periods deferred for 2
periods.
We could find either the PV or the FV of the annuity.

Calculation Variables
There will always be at least four
variables in any present or future value
problem. Three of the four will be
known and you will solve for the fourth.
Single sum problems:

n = number of compounding periods


i = interest rate
PV = Value today of a single sum ($1)
FV = Value in the future of a single sum ($1)
PMT = 0 (important it using PV calculator!)
15

Annuity Problems
n = number of payments or rents
i = interest rate
PMT = Periodic payment (rent) received or
paid
And either:

FV of an annuity (OA or AD) = Value in the


future of a series of future payments
OR
PV of an annuity (OA or AD) = Value today
of a series of payments in the future
When we know any three of the four amounts, we can
solve for the fourth!

i and n must match!


The n refers to periods not necessarily
defined as years! The period may be
annual, semi-annual, quarterly or another
time frame.
The n and the i must match. That is, if
the time period is semi-annual then so must
the interest rate.
Interest rates are assumed to be annual
unless otherwise stated so you may have to
adjust the rate to match the time period.

Single Sum Formulas

FV = (1+i)n
PV = FV
(1+i)n

Single Sum Formulas

FV = (1+i)n
PV = FV
(1+i)n
Present value calculators are generally
no more expensive than those that do
nth powers and nth roots!

Annuity Formulas

FV-OA =

PV-OA =

PMT (1 + i) - 1
i

PMT

1-

1
(1 + i)n
i

Formulas vs. Tables


Before fancy calculators, people had no
easy way to compute nth roots and raise
numbers to the nth power.
So they created tables for of sums of $1 or
annuities of $1.
The values on the table, I call the interest
factor or IF.
So we have PVIF (for n and i)
and the PVIF-OA (for n and i) and so forth

Using the tables


The tables are the result of the required
multiplications and division at various
n and i and are to be read

vertically for the


n
and
horizontally for the
i

Study the tables . .


They are very logical.
All sums in the future are worth LESS in the
present.
All factors on the present value of a single sum table
are less than one.

All present sums are worth more than


themselves in the future.
All factors on the future value of a single sum table
are greater than one.

Notice how the factors change dramatically as


the i increases and the n lengthens!
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Formulas for the IF Tables

PV = FV * IF {IF from PV of $ table}


FV = PV * IF
{IF from FV of $ table}
PV-OA = PMT * IF {IF from PV-OA table}
FV-OA = PMT * IF {IF from FV-OA table}
PMT = (PV-OA) / IF{IF from PV-OA table}
or
PMT = (FV-OA) / IF{from FV-OA table}

IF stands for interest factor from the appropriate n


row and i column of the table

Adjustments to ordinary
annuity tables
Rules for annuity dues and
deferred annuities

Conversion to Annuity Due


To find IF for FV-AD: Add one to the
number of periods and look up IF on
table. Then subtract one from the
interest factor listed.
To find IF for PV-AD: Subtract one from
the number of periods and look up IF on
table. Add one to the interest factor.
Or
look up the IF on the appropriate
table and multiply by (1 + i).

Ordinary Annuity Example

Page 480

Suppose I must make three payments of


$500, each at the end of each of the
next three years. The interest rate is
8%. How much should I set aside today
to have the required payments?
This is an ordinary annuity:
PV-OA = PMT * (PVIF-OA n,i) where n =
3 payments and i = 8%
PV-OA = $500 * 2.5771 = $1,289

Stop and think . . .


If the first payment comes
immediately instead of at the end
of the first year,
Will the present value be
MORE or
LESS?

Annuity Due Example


If the first payment comes immediately,
this would be an annuity due problem.
We can use one of the formulas to adjust
the IF the easiest to memorize is the
multiply by (1+i) rule:
PV-AD = PMT (PVIF-OA n,i)(1+i) where n
= 3 payments and i = 8%
PV-AD = $500 (2.5771)(1 + .08) = $1,391
36

Annuity Due Example


Alternative adjustment to the IF table
is even easier at least if you write
the method at the top of your table!
Look up IF for (n-1) and add 1:
PVIF-OA (n=2, i=8%) = 1.7833 + 1 = 2.7833

PV-AD = $500 (2.7833) = $1,392


36

Annuity Due Example


This second method is also the
logical decision you would make
from looking at the time-line.

FV-AD
PMT

PMT

PMT

PMT

PMT

This is an ordinary annuity of 4 periods (n-1)

The first payment comes immediately


and therefore is NOT discounted!

Deferred Annuities
0

PMT

PMT

PMT

n=3
d=2
When using the tables, there are some short-cuts for
doing deferred annuities

Using PV Tables Deferred


Annuity
Let d = number of periods deferred and n =
number of periodic payments
Look up (d+n) on the appropriate table. Look up
d on the same table. Subtract the smaller
interest factor from the larger to get the
deferred annuity IF.
Or look up interest factor for n periods on
appropriate annuity table. Then look up interest
factor from the corresponding lump sum table
for d. Multiply the two interest factors together
to get the deferred annuity IF.

Deferred Annuity Example


0

$100

$100

$100

n=3
d=2

Let i = 12%
Find the present value of the
annuity due:

$100

$100

$100

d=2

n=3

Alternative 1 Work as two part problem


Find present value of ordinary annuity at end of year
2. Then discount it back to beginning of year 1
PV-OA IF(n=3, i=12%) = 2.4018
2.4018 * $100 = $240.18
PVIF (n=2, i=12%) = .7972
$240.18 * .7972 = $191.47

d=2

$100

$100

$100

n=3

Alternative 2 Adjust the ordinary annuity table IF:


Look up PV-OA IF for (d+n) and then subtract the PVOA IF for d
PV-OA IF(n=5,i=12%) =
PV-OA IF(n=2,i=12%) =
Adjusted IF =
$100 * 1.9147 = $191.47

3.6048
-1.6901
1.9147

d=2

$100

$100

$100

n=3

Alternative 3 Adjust the ordinary annuity table IF:


Look up PV-OA IF for n and then multiply by the PV
IF for d
PV-OA IF(n=3,i=12%) =
PV IF (n=2,i=12%) =
Adjusted IF =
$100 * 1.9147 = $191.47

2.4018
0.7972
1.9147

Deferred Annuities
0

FV
3

PMT

PMT

PMT

n=3
d=2
If it is a FV problem, this is pretty much the only
way to analyze the facts.
However . . . .

Deferred Annuities
PV
0

PMT

PMT

PMT

n=3
d=2
We could do it the same way if we wanted to
compute the present value, but we could also
analyze it as an annuity due problem.

Deferred
PV
0

Note that in the last


period we have zero left
which earns no interest
Annuities
at any interest rate
2

PMT

PMT

PMT

n=3
d=3
Then it would be 3 annuity due payments and the
period before the annuity starts would be 3 periods
instead of 2.

Deferred Annuities
PV
0

PMT

PMT

PMT
n=3

d=3
Now see if you can work the problem (with the
tables) if you analyzed the annuity as having the
first payment happen immediately.

Spreadsheet demo
Well look at using
Excel functions to
solve lease
problems
=NPV
=IRR
=PMT
=PV
=FV