The Time Value of Money

(Part Two)

LEARNING OBJECTIVES
1. Explain and illustrate an annuity.
2. Determine the future value of an annuity.
3. Determine the present value of an annuity.
4. Adjust the annuity equation for present value
and future value for an annuity due.
5. Distinguish between the different types of
loan repayments.
6. Build and analyze amortization schedules.
7. Calculate waiting time and interest rates for
an
annuity.
4-2

4.1 Future Value of Multiple

Payment Streams
With unequal periodic cash flows, treat

each of the cash flows as a lump sum and

calculate its future value over the relevant
number of periods.
Sum up the individual future values to get

the future value of the multiple payment

streams.
4-3

Fig. 4.1 The time-line of a

nest egg

4-4

4.2 Future Value of an Annuity

Stream

4-5

4.2 Future Value of an Annuity

Stream
Example: Future Value of an Ordinary
Annuity Stream
Jill has been faithfully depositing $2,000 at the
end of each year over the past 10 years into
an account that pays a guaranteed 8% per
year. How much money has she have
accumulated in the account?

4-6

4.2 Future Value of an Annuity

Stream
Example Answer (via the long way)
Future
Future
Future
Future
Future
Future
Future
Future
Future
Future

Value
Value
Value
Value
Value
Value
Value
Value
Value
Value

of
of
of
of
of
of
of
of
of
of

Payment
Payment
Payment
Payment
Payment
Payment
Payment
Payment
Payment
Payment

One = $2,000 x 1.08 9 =

Two = $2,000 x 1.08 8 =
Three = $2,000 x 1.08 7 =
Four = $2,000 x 1.086 =
Five = $2,000 x 1.08 5 =
Six = $2,000 x 1.08 4 =
Seven = $2,000 x 1.08 3 =
Eight = $2,000 x 1.08 2 =
Nine = $2,000 x 1.08 1 =
Ten = $2,000 x 1.080 =

$3,998.01
$3,701.86
$3,427.65
$3,173.75
$2,938.66
$2,720.98
$2,519.42
$2,332.80
$2,160.00
$2,000.00

Total Value of Account at the end of 10 years

$28,973.13

4-10

4.2 Future Value of an

Annuity Stream

4-11

4.2 Future Value of an Annuity

USING AN EXCEL SPREADSHEET
Stream

Enter =FV(8%, 10, -2000, 0, 0); Output = $28,973.13

Rate = 0.08, Nper = 10, Pmt = -2,000, PV =0,
and
Type is 0, for ordinary annuities
USING FVIFA TABLE (A-3), page 575
Find the FVIFA in the 8% column and the 10 period
row; FVIFA = 14.4866
FV = 2000 x 14.4866 = $28.973.20 (off by 7 cents)

4-9

FIGURE 4.3 Interest and principal

growth with different interest rates
for $100 annual payments.

4-10

4.3 Present Value of an

Annuity
To calculate the value of a series of equal
periodic cash flows at the current point in time,
we can use the following simplified formula:

1
1
n

PV PMT
r

The last portion of the equation is the

Present Value Interest Factor of an Annuity (PVIFA

Practical applications include figuring out the nest egg n

prior to retirement or lump sum needed for college expe
4-11

FIGURE 4.4 Time line of present

value of annuity stream.

4-12

4.3 Present Value of an

Annuity

Example problem for the four solution methods

You are now holding the winning lottery ticket that
will pay the holder of the ticket $10,000 per year for
the next 20 years. A friend has offered to buy the
winning ticket from you. What should you sell the
ticket for assuming you have a discount rate of 6%
on future dollars (this is your opportunity rate for the
future cash flow)?
Four ways to solve
Formula
Calculator
Spreadsheet
Table

4-#

4.3 Present Value of an

Annuity
Formula
Inputs? N = 20, r = 0.06, PMT = $10,000 and
Compute PV,
PV = $10,000 x [1 1/(1.06)20] / 0.06 =

$114,699.21

Calculator
Inputs? N = 20, I/Y = 6.0, PMT = 10,000, FV = 0
Compute PV
PV = -$114,699.21
4-#

4.3 Present Value of an

Annuity
Spreadsheet, use PV function
Inputs? Rate = 0.06, Nper = 20, Pmt = 10,000,

Fv = 0
PV = -$114,699.21

Table
First find the PVIFA with n = 20 and r = 6.0% on

page 576, PVIFA = 11.4699

Calculate PV = $10,000 x 11.4699 =
$114,699.00 (off
by 21 cents)
(
4-#

4.4 Annuity Due and

Perpetuity
A cash flow stream such as rent, lease, and
insurance payments, which involves equal
periodic cash flows that begin right away or at
the beginning of each time interval is known
as an annuity due.

4-16

4.4 Annuity Due and

Perpetuity
Formula Adjustment
PV annuity due = PV ordinary annuity x (1+r)
FV annuity due = FV ordinary annuity x (1+r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why? (Excel Spreadsheet Example)

Financial calculator
Mode set to BGN for annuity due
Mode set to END for an ordinary annuity

Spreadsheet
Type = 0 or omitted for an ordinary annuity
Type = 1 for an annuity due.
4-17

4.4 Annuity Due and

Perpetuity
Example: Annuity Due versus Ordinary
Annuity
Lets say that you are saving up for retirement
and decide to deposit $3,000 each year for the
next 20 years into an account which pays a
rate of interest of 8% per year. By how much
will your accumulated nest egg vary if you
make each of the 20 deposits at the beginning
of the year, starting right away, rather than at
the end of each of the next twenty years?
4-18

4.4 Annuity Due and

Perpetuity
Example Answer
20
FV ordinary
annuity PMT==
$3,000
x [((1.08)
Given
information:
-$3,000;
n=20;
i=
1)/.08]
8%; PV=0;
= $3,000 x 45.76196
= $137,285.89

FV of annuity due = FV of ordinary annuity x

(1+r)
FV of annuity due = $137,285.89 x (1.08) =

$148,268.76
Difference is $10,982.87

4-19

4.4
Annuity Due and
Perpetuity
A Perpetuity is an equal periodic cash flow
Perpetuity

stream that will never cease.

The PV of a perpetuity is calculated by using
the following equation:

PMT
PV
r

4-20

4.4 Annuity Due and

Perpetuity
Example: PV of a perpetuity

If you are considering the purchase of a consol that

pays $60 per year forever, and the rate of interest
you want to earn is 10% per year, how much money
should you pay for the consol?
Answer:

r=10%, PMT = $60; and PV = ($60/0.10) = $600

$600 is the most you should pay for the consol.
You can think of it this way, if you put $600 in the
bank earning 10% you can withdraw the annual
interest of $60 every year forever without
touching the principal.
4-21

4.5 Three Payment

Methods

Loan payments can be structured in one of 3

ways:
1) Discount loan

Principal and interest is paid in lump sum at

end
2) Interest-only loan

Periodic interest-only payments, principal

due at end.
3) Amortized loan

Equal periodic payments of principal and

interest
4-22

4.5 Three Payment

Methods

Example: Discount versus Interest-only versus Amortized

loans
Roseanne wants to borrow $40,000 for a period of 5 years.
The lenders offers her a choice of three payment structures:
1) Pay all of the interest (10% per year) and principal in one
lump
sum at the end of 5 years;
2) Pay interest at the rate of 10% per year for 4 years and then a
final payment of interest and principal at the end of the 5 th
year;
3) Pay 5 equal payments at the end of each year inclusive of
interest and part of the principal.
Under which of the three options will Roseanne pay the least interest
and why? Calculate the total amount of the payments and the
amount
of interest paid under each alternative.

4-23

4.5 Three Payment Methods

Method 1: Discount Loan.
Since all the interest and the principal is paid at the
end of 5 years we can use the FV of a lump sum
equation to calculate the payment required, i.e.
FV = PV x (1 + r)n
FV5 = $40,000 x (1+0.10)5
= $40,000 x 1.61051
= $64, 420.40
Interest paid = Total payment - Loan amount
Interest paid = $64,420.40 - $40,000 = $24,420.40

4-24

4.5 Three Payment Methods

Method 2: Interest-Only Loan.

Annual Interest Payment (Years 1-4)

= $40,000 x 0.10 = $4,000 each year ($16,000)
Year 5 payment
= Annual interest payment + Principal
payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $60,000 - $40,000 = $20,000
4-25

4.5 Three Payment Methods

Method 3: Amortized Loan.
n = 5; I/Y = 10.0; PV=$40,000; FV = 0;
CPT PMT= $10,551.89923
Total payments = 5 x $10,551.89923 = $52,759.50
Interest paid
= Total Payments - Loan Amount
Interest paid
= $52,759.50 - $40,000
Interest paid = $12,759.50
4-26

4.5 Three Payment Methods

Loan Type Total Payment Interest Paid
Discount Loan
$64,420.40 $24,420.40
Interest-only Loan
$60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.31
Why does the equal annual payments of principal and
interest each period have the lowest total interest?

4-#

4.6 Amortization Schedules

Tabular listing of the allocation of each loan payment
towards interest and principal reduction
Helps borrowers and lenders figure out the payoff balance
on an outstanding loan.
Procedure:
1) Compute the amount of each equal periodic
payment (PMT) using the ordinary annuity formula.
2) Calculate interest on unpaid balance at the end of
each period, minus it from the PMT, reduce the loan
balance by the remaining amount,
3) Continue the process for each payment period, until we
get a zero loan balance.
4-28

4.6 Amortization Schedules

Example: Loan amortization schedule.
Prepare a loan amortization schedule for the
amortized loan option given in the previous
Example with the five annual payments for the
$40,000 at 10% annual interest rate. What is the
loan payoff amount at the end of 2 years?
Step One, determine the annual payment:
PV = $40,000; n=5; I/Y=10.0; FV=0;
CPT PMT = $10,551.90 (rounded to nearest
whole cent)
4-29

Amortization Table
Year

Beg. Bal

Payment

Interest

Prin. Red End. Bal

40,000.00 10,551.90 4,000.00

6,551.90

33,448.10

33,448.10 10,551.90 3,344.81

7,207.09

26,241.01

26,241.01 10,551.90 2,264.10

7,927.80

18,313.21

18,313.21 10,551.90 1,831.32

8,720.58

9,592.64

9,592.64

0.00

9,592.64 10,551.90

959.26

The loan payoff amount at the end of 2 years is

$26,241.01
4-30

4.7 Waiting Time and Interest

Rates for Annuities
Problems involving annuities typically have 4
variables, i.e. PV or FV, PMT, r, n
If any 3 of the 4 variables are given, we can easily
solve for the fourth one.
This section deals with the procedure of solving
problems where either n or r is not given.
For example:
Finding out how many deposits (n) it would take to
reach a retirement or investment goal;

Figuring out the rate of return (r) required to reach a

retirement goal given fixed monthly deposits,

4-31

4.7 Waiting Time and Interest

Rates for Annuities
Example: Solving for the number of
annuities involved
Martha wants to save up $100,000 as soon as
possible so that she can use it as a down
payment on her dream house. She figures
that she can easily set aside $8,000 per year
and earn 8% annually on her deposits. How
many years will Martha have to wait before
she can buy that dream house?

4-32

4.7 Waiting Time for

Annuities
Method 2: Using a financial calculator
INPUT
?
8.0 0 -8000
100000
TVM KEYS
N
I/Y
PV PMT
FV
Compute
9.006467
Method 3: Using an Excel spreadsheet
Using the NPER function we enter the following:
Rate = 8%; Pmt = -8000; PV = 0; FV = 100000;
Type = 0 or omitted;
display in excel = NPER(8%,-8000,0,100000,0)
The cell displays 9.006467.
4-33

4.7 Waiting Time for

Annuities
Method 1: Formula (uses natural logs)
N = ln ([FV x r]/PMT + 1) / ln (1+r)
N = ln ([100,000 x 0.08]/8.000 + 1) / ln 1.08
N = ln 2 / ln 1.08 = 0.693147181 / 0.07691041 =
9.006467
Method 4: Tables
You need to interpret from the tables
Take FV / PMT to find the FVIFA, 12.50
Look for 12.50 under the 8% column, find its close
to n = 9 (its between 9 and 10 but very close to 9)
4-#

4.8
Finding
the
interest
Solving a Lottery Problem
rateIn the case of lottery winnings, 2 choices

1) Annual lottery payment for fixed

number of years, OR
2) Lump sum payout.
How do we make an informed judgment?
Need to figure out the implied rate of return of
both options using TVM functions.

4-35

4.8 Finding the

Example: Calculating an implied rate of
interest
rate
return given an
annuity
Lets say that you have just won the state
lottery. The authorities have given you a
choice of either taking a lump sum of
$26,000,000 or a 30-year annuity of
$1,500,000. Both payments are assumed to
be after-tax. What will you do?
The missing variable is the implied interest
rate on the two payment choices.
4-36

4.8 Finding the interest

rate
Using the TVM keys of a financial calculator,
enter:
PV=26,000,000; FV=0; N=30; PMT = -1,500,000;
CPT I/Y = 3.98%
3.98% = rate of interest used to determine the
30-year annuity of $1,500,000 versus the
$26,000,000 lump sum pay out.
Choice: If you can earn an annual after-tax rate
of return higher than 4.0% over the next 30
years, go with the lump sum.
Otherwise, take the annuity option.

4-37

4.8 Finding the interest

rate
We could use the Spreadsheet functions (Rate

function) to find the 3.98%.

We could use the Tables to estimate the
interest rate by looking at the PVIFA at 30 years
with the PVIFA calculated as PV / PMT but again
we will need to estimate between to interest
rates although in this case it will be very close
to 4.0% (PVIFA is 17.3333)
We can not use the formula to solve for interest
rate, it is an iterative process (trial and error)
4-#

4.9 Ten Important Points about

the TVM Equation
1. Amounts of money can be added or subtracted
2.
3.
4.
5.

only if they are at the same point in time.

The timing and the amount of the cash flow
are what matters.
It is very helpful to lay out the timing and
amount of the cash flow with a timeline.
Present value calculations discount all future
cash flow back to current time.
Future value calculations value cash flows at a
single point in time in the future
4-39

4.9 Ten Important Points about

the TVM Equation
6. An annuity is a series of equal cash payments at

regular intervals across time.

7. The time value of money equation has four
variables but only one basic equation, and so
you must know three of the four variables before
you can solve for the missing or unknown
variable.
8. There are three basic methods to solve for an
unknown time value of money variable:
(1) Using equations and calculating the answer;
(2) Using the TVM keys on a calculator;
(3) Using financial functions from a spreadsheet.
4-40

4.9 Ten Important Points about

the TVM Equation
9. There are 3 basic ways to repay a loan:
(1)
(2)
(3)

Discount loans,
Interest-only loans, and
Amortized loans.

10. Despite the seemingly accurate answers from

the time value of money equation, in many

situations not all the important data can be
classified into the variables of present value,
i.e., time, interest rate, payment, or future
value.
4-41