Time Value of Money

FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE THIRD CANADIAN EDITION

BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
Copyright © 2017 by Nelson Education Ltd. 4-1

CHAPTER 4
TIME VALUE OF MONEY

CHAPTER 4 OUTLINE
• 4.1 Time Lines

• 4.2 Future Values
• 4.3 Present Values
• 4.4 Finding the Interest Rate, I
• 4.5 Finding the Number of Years, N

CHAPTER 4 OUTLINE (cont'd)
• 4.6 Annuities
• 4.7 Future Value of an Ordinary Annuity
• 4.8 Future Value of an Annuity Due
• 4.9 Present Value of an Ordinary Annuity and
of an Annuity Due
• 4.10 Finding Annuity Payments, Periods, and
Interest Rates

• 4.11 Perpetuities
• 4.12 Uneven, or Irregular, Cash Flows
• 4.13 Future Value of an Uneven Cash Flow
Stream
• 4.14 Solving for I with Uneven Cash Flows
• 4.15 Semiannual and Other Compounding
Periods

• 4.16 Fractional Time Periods

• 4.17 Amortized Loans
• 4.18 Growing Annuities

Time Value of Money
• Also called discounted cash flow (DCF) analysis
• A technique dealing with cash flows at
different points in time
• Applications range from setting up schedules
for paying off loans to decisions about
whether to acquire new equipment

4.1 Time Lines
• Show timing of cash flows
• Help you visualize what’s happening
0 1 2 3
I%
CF0 CF1 CF2 CF3
Tick marks at the ends of periods, so

Time 0 is today; Time 1 is the end of
Period 1; or the beginning of Period 2.
Time Line for a $100 Lump Sum Due
at the End of Year 2
0 1 2 Year
I%
100

Time Line for an Ordinary Annuity of
$100 For 3 Years
0 1 2 3
I%
100 100 100

Time Line for Uneven Cash Flows (CFs)
0 1 2 3
I%
–50 100 75 50

Time Value of Money Terms
• CFt = Cash flow at time t, a positive (negative) number
indicates a cash inflow (outflow)
• PV = Present value, cash flow at Time 0 (today, now,
present, or beginning), that is PV = CF0
• FVN = Future value, value of PV = CF0 N periods into the
future
• I = Interest rate (%) earned per period
• INT = Dollars of interest earned during the period, that
is, INT = PV×I
• N = Number of periods (periods are usually measured
in years)

4.2 Future Values (FVs)
0 1 2 3
5%
100 FV = ?
Finding FVs of some initial cash flow

(that is, going forward from PVs to FVs or
moving to the right on a time line) is
called compounding.

After 1 Year (Formula Approach)
FV1 = PV + INT1
= PV + PV (I)
= PV(1 + I)
= $100(1.05)
= $105.00

After 2 Years (Formula Approach)
FV2 = FV1(1 + I)
= PV(1 + I)(1 + I)
= PV(1 + I)2
= $100(1.05)2
= $110.25

After 3 Years (Formula Approach)
FV3 = FV2(1 + I)
=PV(1 + I)2(1 + I)
= PV(1 + I)3
= $100(1.05)3
= $115.76
In general,
FVN = PV(1 + I)N (4-1)

Three Ways to Find FVs
• Solve the equation with a regular calculator.
• Use a financial calculator.
• Use a spreadsheet.

(Reference Only)
Financial Calculator: HP10BII
• Adjust display brightness: Hold down ON and
push + or -.
• Set number of decimal places to display:
ORANGE Shift key, then DISP key (in orange),
then desired decimal places (e.g., 3).
• To temporarily show all digits, hit ORANGE
Shift key, then DISP, then =.

(Reference Only)
HP10BII (cont'd)
• To permanently show all digits, hit ORANGE
Shift key, then DISP, then . (period key).
• Set decimal mode: Hit ORANGE shift key, then
./, key.

(Reference Only)
HP10BII: Set Time Value Parameters
• To set END (for cash flows occurring at the end
of the year), hit ORANGE shift key, then
BEG/END.
• To set 1 payment per period, hit 1, then
ORANGE shift key, then P/YR.

Financial Calculator Solution
• Financial calculators solve this

equation:
FVN + PV (1 + I)N = 0 (4-2)
• There are four variables. If three are

known, the calculator will solve for the
fourth.

Here’s the Setup to Find FV
INPUTS 3 5 -100 0
N I/YR PV PMT FV
OUTPUT 115.76
Clearing automatically sets everything to

0, but for safety enter PMT = 0.
Set: P/YR = 1, END

Keys on Financial Calculator
• N = Number of periods
• I/YR = Interest rate per period
• PV = Present value
• PMT = Payment, a series of equal, or constant,
payments in an annuity situation
• FV = Future value
• For PV, PMT, and FV, numbers must be
entered (and are to be returned by the
calculator) as positive or negative to indicate
an inflow or outflow
Spreadsheet Solution
• Use the FV function:
• = FV(I, N, PMT, PV)
• = FV(0.05, 3, 0, -100) = 115.76

The Power of Compounding: Growth
of $1

4.3 Present Values (PVs)
0 1 2 3
5%
PV=? $115.76
Finding today’s equivalent value (PVs) of some
cash flow due N periods in the future (that is,
going backward from FVs to PVs or moving to
the left on a time line) is called discounting.

Discounting a Future Value to Find
the Present Value
• The reverse of compounding
0 1 2 3
10%
PV = ? 100

Solve FVN = PV(1 + I ) N for PV
FVN N
1
PV = = FVN (4-3)
(1 + I)N 1+I
1
3
PV = $100
1.10
= $100(0.7513) = $75.13

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13
Either PV or FV must be negative. Here

PV = –75.13. Put in $75.13 today, take
out $100 after 3 years.

• Use the PV function:
• = PV(I, N, PMT, FV)
• = PV(0.10, 3, 0, 100) = –75.13

The Power of Discounting

4.4 Finding the Interest Rate, I
0 1 2 10
?%
–100 150
FVN = PV(1 + I)N
$150 = $100(1 + I)10
(1.5)(1/10) = (1 + I)
1.0414 = (1 + I)
I = 0.0414 = 4.14%

Financial Calculator
INPUTS 10 -100 0 150

N I/YR PV PMT FV
OUTPUT 4.14

• Use the RATE function:
• = RATE(N, PMT, PV, FV)
• = RATE(10, 0, –100, 150) = 0.0414

4.5 Finding the Number of Years, N
• Suppose we now have $500,000 and the
interest rate is 4.5%. How long will it take to
grow to $1 million?
0 1 2 ?
20%
–500,000 1 million
FV = PV (1 + I)N

Finding the Time
• Follow the formula approach:
• $1 million = $500,000 (1 + 0.045)N
• $1 million/$500,000 = 2 = (1.045)N
• Ln (2) = N × Ln (1.045)
• N = Ln(2)/Ln(1.045)
• N = 0.693/0.044 = 15.7473 years

INPUTS 4.5 -500 0 1000

N I/YR PV PMT FV
OUTPUTS 15.7473

• Use the NPER function:
• = NPER(I, PMT, PV, FV)
• = NPER (0.045, 0, –500,1000) = 15.7473

4.6 Annuities
Lump Sum vs. Annuity
• So far we have dealt with calculating the
present value and the future value of a single
payment, or “lump sum.”
• In many occasions, a series of payments are
involved. If these payments are equal and
made at fixed intervals, then the series is an
annuity.
• Two types of annuities: Ordinary (or deferred)
annuity and annuity due

Ordinary Annuity vs. Annuity Due
Ordinary annuity
0 1 2 3
I%
PMT PMT PMT

Annuity due
0 1 2 3
I%
PMT PMT PMT

4.7 Future Value of an Ordinary Annuity
FVAN
A 3-year ordinary annuity of $100 at an annual

interest rate of 5%.
0 1 2 3
5%
100 100 100.00

105.00
110.25
FVA3= 315.25

FV Annuity Formula
• The future value of an annuity with N periods
and an interest rate of I can be found with the
following formula:
(1 + I)N – 1
FVAN = PMT (4-4)
I
(1 + 0.05)3 –
= 100 1 = 315.25
0.05

Financial Calculator Formula for
Annuities
• Financial calculators solve this equation:
(1 + I)N – 1
FVN + PV(1 + I)N + PMT =0 (4-5)
I
• There are five variables. If four are

known, the calculator will solve for the
fifth.
INPUTS 3 5 0 -100
N I/YR PV PMT FV
OUTPUT 315.25
Have payments but no lump sum PV, so

enter 0 for present value.

• Use the FV function: See spreadsheet.
• = FV(I, N, PMT, PV)

• = FV(0.05, 3, –100, 0) = 315.25

4.8 Future Value of an Annuity Due
• When payments occur at the beginning of the
period rather than at the end, those cash flows
have more time to earn extra interest.
• FVAdue = FVAordinary (1 + I) (4-6)
• FVAdue = ($315.25)(1.05) = $331.01
• Set the calculator to Begin Mode.
• In Excel, FV(I, N, PMT, PV, Type*) = FV(0.05, 3, –
100, 0, 1)
*Type = 1 tells the financial calculator it is an annuity due.

4.9 Present Value of an Ordinary
Annuity and of an Annuity Due
PVAN
0 1 2 3
5%
100 100 100

95.24
90.70
86.38
272.32 = PVA3

PV Annuity Formula
• The present value of an annuity with N
periods and an interest rate of I can be found
with the following formula:
1 1
PVAN = PMT − (4-7)
I I (1 + I)N
1 1
= 100 − = $272.32
0.05 0.05(1 + 0.05)3

INPUTS 3 5 -100 0
N I/YR PV PMT FV
OUTPUT 272.32
Have payments but no lump sum FV, so

enter 0 for future value.

• Use the PV function: See spreadsheet.
• = PV(I, N, PMT, FV)

• = PV(0.05, 3, –100, 0) = 272.32

PV of Annuities Due
0 1 2 3
10%
100 100 100

Present Value of an Annuity Due
• Since each payment for an annuity due occurs

one period earlier, the payments will all be
discounted for one less period.
• Therefore, PVAdue > PVA
• PV of annuity due (PVAdue) :
= (PV of ordinary annuity) (1 + I) (4-8)
= (272.32) (1 + 0.05) = $285.94

• Switch from “End” to “Begin.”
INPUTS 3 5 -100 0
N I/YR PV PMT FV
OUTPUT 285.94

Excel Function for Annuities Due
• Change the formula to:
= PV(0.05,3,-100,0,1)
• The fourth term, 0, tells the function there are

no other cash flows. The fifth term (i.e., type)
tells the function that it is an annuity due. A
similar function gives the future value of an
annuity due.

4.10 Finding Annuity Payments, Periods
and Interest Rates
Ordinary Annuity (End Mode) and Annuity Due
(Begin Mode)
INPUTS 5 6 0 10,000
N I/YR PV PMT FV
OUTPUT -1,773.96
INPUTS 5 6 0 10,000
N I/YR PV PMT FV
OUTPUT -1,673.55

Finding Period Number and Interest
for Ordinary Annuity (End Mode)
INPUTS 6 0 -1,200 10,000
N I/YR PV PMT FV
OUTPUT 6.96
INPUTS 5 0 -1,200 10,000

N I/YR PV PMT FV
OUTPUT 25.78

• To find annuity payments, use the PMT function:
= PMT(I,N,PV,FV,Type)
• With Type = 1 indicating an annuity due
• To find the number of periods, use the NPER function:

= NPER(I,PMT,PV,FV,Type)
• To find the interest rate, use the RATE function:

= RATE(N,PMT,PV,FV,Type)

4.11 Perpetuities
• A perpetuity is simply an annuity extending
out forever.
• Since the payments go on forever, you cannot
apply the step-by-step approach.
(4-9)
• PV of a perpetuity = PMT/I
• Example: A British consol with a face value of
$1,000 that pays $50 per year forever. What is
its value today? The going interest rate is
2.5%.
• PV(P) = $50/0.025 = $2,000

4.12 Uneven, or Irregular, Cash Flows
• Different from an annuity, some series of
payments involve cash flows that are not all
the same.
• Two important classes of uneven cash flows:
─ Annuity plus additional final payment;
bonds are the best example.
─ Irregular cash flows

PV of Uneven Cash Flows: Step-by-
Step Procedure
0 1 2 3 4
10%
100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

PV of Annuity Plus Additional Final
Payment
0 1 2 3 4
5%
100 100 100 100

1000
1100
In addition to the step-by-step procedure,
the financial calculator (TVM keys) and
the PV function in Excel can also be used.
INPUTS 4 5 100 1000

N I/YR PV PMT FV
OUTPUT -1177.30

• Use the PV function:
= PV(I,N,PMT,FV)
= PV(0.05,4,100,1000) = –1177.30

PV of Irregular Cash Flows
• For the second class of uneven cash flows,
TVM keys in a financial calculator are no
longer usable.
• However, many financial calculators do have a
feature that allows you to find the present
value of a series of uneven cash flows. See the
following slides for more information.

(Reference Only)
Financial Calculator: HP10BII
• Clear all: ORANGE Shift key, then C All key (in
orange).
• Enter number, then hit the CFj key.
• Repeat for all cash flows, in order.
• To find NPV: Enter interest rate (I/YR). Then
ORANGE Shift key, then NPV key (in orange).

(Reference Only) Financial Calculator:
HP10BII (cont'd)
• To see current cash flow in list, hit RCL CFj CFj.
• To see previous CF, hit RCL CFj –.
• To see subsequent CF, hit RCL CFj +.
• To see CF 0-9, hit RCL CFj 1 (to see CF 1). To
see CF 10-14, hit RCL CFj. [period] 1 (to see CF
11).

(Reference Only) Financial Calculator:
HP10BII (cont'd)
• Input in “CFLO” register:
– CF0 = 0
– CF1 = 100
– CF2 = 300
– CF3 = 300
– CF4 = -50
• Enter I = 10%, then press NPV button to get
NPV = 530.09. (Here NPV = PV.)
• Use the NPV function in Excel:
• Excel formula in cell A3:
= NPV(10%,B2:E2)

4.13 Future Value of an Uneven Cash
Flow Stream

4.14 Solving for I with Uneven Cash
Flows
• For the first class of uneven cash flows, you use a
financial calculator’s TVM keys:
INPUTS 5 -927.90 100 1000
N I/YR PV PMT FV
OUTPUT 12
• For both classes of uneven cash flows, you can

use the IRR function in Excel.
• This function needs only one parameter, that is,
the data range.

4.15 Semiannual and Other
Compounding Periods
• In our examples so far, only annual
compounding (that is, interest is compounded
once a year, or annually) has been used.
• Interest can also be credited each 6 months,
called semiannual compounding.
• Other compounding periods are also common.

Types of Interest Rates
• Nominal annual rates, INOM
• Annual percentage (APR) rates
• Periodic rates, IPER
• Effective annual rates, EAR or EFF%

Nominal or Quoted Rate (INOM)
• Stated in contracts, and quoted by banks and
brokers
• Nominal rate may also be called APR.
• Not used in calculations or shown on time
lines
• Compounding periods per year (M) must be
given. Examples:
– 8%; quarterly
– 8%, daily interest (365 days)
Periodic Rate (IPER )
• IPER = INOM/M, where M is number of compounding
periods per year. M = 4 for quarterly, 12 for monthly, and
365 for daily compounding.
• A rate charged by a lender or paid by a borrower each
period
• Used in calculations; shown on time lines
• Examples:
– 8% quarterly: IPER = 8%/4 = 2%.
– 8% daily (365): IPER = 8%/365 = 0.021918%.

The Impact of Compounding
• Will the FV of a lump sum be larger or smaller
if we compound more often, holding the
stated I% constant?
• Why?

The Impact of Compounding (Answer)
• LARGER!
• If compounding is more frequent than once

a year—for example, semiannually,
quarterly, or daily—interest is earned on
interest more often.

FV Formula with Different
Compounding Periods
(M)(N)
INOM
FVN = PV 1 + (4-14)
M

$100 at a 12% Nominal Rate
with Quarterly Compounding for 2 Years
MN
INOM
FVN = PV 1 +
M
4 ×2
0.12
FV2 = $100 1 +
4
= $100(1.03)8 = $126.68

FV of $100 at a 12% Nominal Rate for 5
Years with Different Compounding
FV(Ann.) = $100(1.12)5 = $176.23

FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19

Effective Annual Rate (EAR = EFF%)
• The EAR is the annual rate that produces
the same result as if we had compounded
at a given periodic rate M times per year.
• The effective percentage (EFF%) is the
interest rate expressed as if it were
compounded once per year.

Effective Annual Rate: An Example
• Example: Invest $1 for one year at
12%, semiannually:
FV = PV(1 + INOM/M)M
FV = $1 × (1.06)2 = 1.1236
• EFF% = 12.36%, because $1 invested
for one year at 12% semiannual
compounding would grow to the same
value as $1 invested for one year at
12.36% annual compounding.
Comparing Rates
• An investment with monthly payments is
different from one with quarterly
payments. Must be put on EFF% basis to
compare rates of return. Use EFF% only
for comparisons.
• Banks say “interest paid daily.” Same as
compounded daily.

EFF% for a Nominal Rate of 12%,
Compounded Monthly
M
INOM
EFF% = 1 + −1 (4-15)
M
12
0.12
= 1 + −1
12
= (1.01)12 – 1.0
= 0.126825 = 12.6825%
The Result of Frequent Compounding

(Reference)
Finding EFF with HP10BII
• Type in nominal rate, then ORANGE Shift
key, then NOM% key (in orange).
• Type in number of periods, then ORANGE
Shift key, then P/YR key (in orange).
• To find effective rate, hit ORANGE Shift
key, then EFF% key (in orange).

Can the Effective Rate Ever Be Equal to
the Nominal Rate?
• Yes, but only if annual compounding is used,

i.e., if M = 1.
• If M > 1, EFF% will always be greater than
the nominal rate.

When Is Each Rate Used?
INOM: Written into contracts, quoted

by banks and brokers. Not used
in actual calculations or shown
on time lines.

When Is Each Rate Used? (cont'd)
IPER: Used in actual calculations, shown

on time lines.
If INOM has annual compounding,
then IPER = INOM/1 = INOM.
Otherwise, adjust with the
number of periods involved.

When Is Each Rate Used? (cont'd)
• EAR (or EFF%): Used to compare

returns on investments with different
payments per year
• Used for calculations if and only if
dealing with annuities where
payments don’t match interest
compounding periods

4.16 Fractional Time Periods
• On January 1, you deposit $100 in an account
that pays a nominal interest rate of 10%, with
daily compounding (365 days).
• How much will you have on October 1, or
after 9 months (274 days)? (Days given.)

Convert Interest to Daily Rate
IPER = 10%/365
= 0.0273973% per day.
FV 274 = $100 (1.000273973)274
= $100 (1.077947) = $107.79
0 1 2 274
0.0273973%
–100 FV =?

Calculator Solution
• IPER = INOM/M = 10%/365
=0.0273973% per day
• With inputs: N = 274, I/Y = 0.0273973, PV = –
100, PMT = 0
• Find FV = 107.79

4.17 Amortized Loans
• Construct an amortization schedule for
a $1,000, 10% annual rate loan with
three equal payments.

Step 1: Find the Required Payments
0 1 2 3
10%
–1,000 PMT PMT PMT
INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11

Step 2: Find Interest Charge for Year 1
INTt = Beginning balancet (I)
INT1 = $1,000(0.10) = $100

Step 3: Find Repayment of Principal In
Year 1
Repmt = PMT – INT

= $402.11 – $100
= $302.11

Step 4: Find Ending Balance After Year
1
Ending balance = Beginning bal – Repmt
= $1,000 – $302.11 = $697.89
Repeat these steps for Years 2 and 3

to complete the amortization table.

Amortization Schedule
BEG PRIN END
YEAR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest Declines Because Outstanding
Balance Declines
$450
$400
$350
$300 Interest
$250 Principal
$200
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3
Interest Declines Because Outstanding
Balance Declines (cont'd)
• Amortization schedules are widely used–– for
home mortgages, auto loans, business loans,
retirement plans, and more—and are very
important.
• Financial calculators (and spreadsheets) are
great for setting up amortization schedules.

Canadian Mortgage Loans
• The previous example illustrates an annual
amortized loan.
• However, in Canada, mortgage loans are a
bit more complicated.
• While a borrower is required to make
monthly payments, the annual rate is
semiannual compounding.

Canadian Mortgage Loans (cont'd)
• A two-step procedure is applied to calculate
the monthly rate in order to calculate the
monthly payment:
• First, convert the APR to EAR:
• EAR = (1 + 6%/2)2 – 1 = 6.09%
• Second, calculate the monthly rate (r) that
has the same EAR as 6.09%:
• 6.09% = (1 + r)12 – 1
• Solve the above equation, r = 0.00494
4.18 Growing Annuities
• Cash flows are likely to grow over time,
due either to real growth or to inflation.
• Growing annuity is a series of finite cash
flows that grow at a fixed rate.
• Growing perpetuity is a constant stream of
cash flows without end that is expected to
rise indefinitely.

Real Rate
• Rr = [(1 + INOM)/(1 + inflation)] – 1 (4-16)
• Example: If the nominal annual interest rate is

8% and the expected inflation rate is 3% per
annum, what is the expected real rate of
return?
• Rr = [1.08/1.03] – 1 = 0.048544 = 4.85%

Summary
• Most financial decisions involve receiving and
paying money at different points in time.
• Time value of money (TVM) analysis is used to
deal with this reality.
• Cash flows can be classified into a single
payment (lump sum) and a series of equal
(annuity) or uneven periodic payments.
• Compounding (determining the future value)
and discounting (finding the present value) are
the two basic processes in TVM analysis.
Summary (cont’d)
• Calculations can be done by applying the
formulas, using a financial calculator, or using
Excel spreadsheets including built-in
functions.
• There are two types of annuities: ordinary
annuity and annuity due.
• Formulas can be used to convert the PV and
FV of an ordinary annuity to an annuity due.

Summary (cont’d)
• Given any three of the four variables about a
lump sum—N, I, PV, or FV—the fourth variable
can be found.
• Given any three of the four variables about an
annuity—N, I, PMT, PV or FV—the fourth
variable can also be determined.
• Interest rates play a critically important role in
financial decision making.

Summary (cont’d)
• When compounding occurs more frequently
than once a year, the equivalent (or effective)
rates of return must be calculated and used to
compare different investments or loans.
• An amortization schedule can be set up to show
how an amortized loan is paid off in equal
payments over a specified period, including
interest paid, principal repaid, and the unpaid
balance at each point in time.

Time Value of Money

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FINANCIAL MANAGEMENT

THEORY & PRACTICE

ADAPTED FOR THE THIRD CANADIAN EDITION

Copyright © 2017 by Nelson Education Ltd. 4-1

TIME VALUE OF MONEY

Copyright © 2017 by Nelson Education Ltd. 4-2

• 4.1 Time Lines

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• 4.16 Fractional Time Periods

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CF0 CF1 CF2 CF3

Tick marks at the ends of periods, so

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100 100 100

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Finding FVs of some initial cash flow

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• Financial calculators solve this

FVN + PV (1 + I)N = 0 (4-2)

• There are four variables. If three are

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Clearing automatically sets everything to

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• = FV(I, N, PMT, PV)

• = FV(0.05, 3, 0, -100) = 115.76

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Either PV or FV must be negative. Here

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• = PV(I, N, PMT, FV)

• = PV(0.10, 3, 0, 100) = –75.13

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INPUTS 10 -100 0 150

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• = RATE(N, PMT, PV, FV)

• = RATE(10, 0, –100, 150) = 0.0414

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INPUTS 4.5 -500 0 1000

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PMT PMT PMT

PMT PMT PMT

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A 3-year ordinary annuity of $100 at an annual