Time Value of Money

FIN 502: Managerial Finance

George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
W. P. Carey Executive MBA Program Slide 2
Simple Interest
W. P. Carey Executive MBA Program Slide 3
More Simple Interest
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Compound Interest:
A FV Perspective
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Compounding
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Time Line: $78.35 Invested (5 Years, 5%
Interest)
0 1 2 3 4 5
PV = $78.35
FV
5
= $100
End of Year
W. P. Carey Executive MBA Program Slide 7
Future Value of $200
(4 Years, 8% Interest )
0 1 2 3 4
PV = $200
End of Year
FV
1
= $216
FV
2
= $233.28
FV
3
= $251.94
FV
4
= $272.10
Compounding the process of earning
interest in each successive year
W. P. Carey Executive MBA Program Slide 8
FV of a Mixed Cash Flow Stream (5
Years, 5.5% Interest)
FV
5
= $16,689.06
0 1 2 3 4 5
$3,500 $3,800 $2,000 $3,000 $2,500
$4,335.89
$4,462.12
$2,226.06
$3,165.00
$2,500.00
End of Year
W. P. Carey Executive MBA Program Slide 9
Future Value Example
W. P. Carey Executive MBA Program Slide 10
Power Of Compound Interest
Periods
0%
1.00
0 2 4 6 8 10 12 14 16 18 20 22 24
10.00
15.00
20.00
25.00
30.00
5.00
10%
5%
15%
20%
W. P. Carey Executive MBA Program Slide 11
Format of a Future Value Interest
Factor (FVIF) Table
Period 1% 2% 3% 4% 5% 6%
1 1.010 1.020 1.030 1.040 1.050 1.060
2 1.020 1.040 1.061 1.082 1.102 1.124
3 1.030 1.061 1.093 1.125 1.158 1.191
4 1.041 1.082 1.126 1.170 1.216 1.262
5 1.051 1.104 1.159 1.217 1.276 1.338
6 1.062 1.126 1.194 1.265 1.340 1.419
7 1.072 1.149 1.230 1.316 1.407 1.504

W. P. Carey Executive MBA Program Slide 12
Computing Future Values Using
Excel
PV 1,000 $
r 3.00%
n 5
FV? $1,159.3
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.03, 5, ,1000)
You deposit $1,000 today at 3% interest.
How much will you have in 5 years?
W. P. Carey Executive MBA Program Slide 13
Present Value with Compounding
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Present Value of $500
(7 Years, 6% Discount Rate)
0 1 2 3 4 5 6 7
PV = $332.53
FV
7
= $500
End of Year
W. P. Carey Executive MBA Program Slide 15
Present Value of Future Amounts (4
Years, 7% Interest )
What if the interest rate goes up to 8% ?
0 1 2 3 4
Discounting

PV = $200

FV1 = $214 FV2 = $228.98 FV3 = $245 FV4 = $262.16
End of Year
W. P. Carey Executive MBA Program Slide 16
PV of a Mixed Stream
(5 Years, 6% Interest)
$1,500,000 $3,000,000 $2,000,000 $5,000,000
End of Year
PV
5
= $9,724,500
$1,415,100
$2,669,700
$1,679,200
$3,960,500
0 1 2 3 4
W. P. Carey Executive MBA Program Slide 17
Present Value Examples
W. P. Carey Executive MBA Program Slide 18
Power Of High Discount Rates: PV
of $1
Periods
0 2 4 6 8 10 12 14 16 18 20 22 24
0.5
0.75
1.00
0.25
10%
5%
15%
20%
0%
W. P. Carey Executive MBA Program Slide 19
Format of a Present Value Interest
Factor (PVF) Table
Period 1% 2% 3% 4% 5% 6%
1 0.990 0.980 0.971 0.962 0.952 0.943
2 0.980 0.961 0.943 0.925 0.907 0.890
3 0.971 .942 0.915 0.889 0.864 0.840
4 0.961 0.924 0.888 0.855 0.823 .792
5 0.951 0.906 0.863 0.822 0.784 0.747
6 0.942 0.888 0.837 0.790 0.746 0.705
7 0.933 0.871 0.813 0.760 0.711 0.665

W. P. Carey Executive MBA Program Slide 20
Calculating PV Of A Single Amount
Using Excel
Example: How much must you deposit today in order
to have $500 in 7 years if you can earn 6% interest on
your deposit?
FV 500 $
r 6.00%
n 7
PV? $332.5
Excel Function
=PV (interest, periods, pmt, FV)
=PV (.06, 7,,500)
W. P. Carey Executive MBA Program Slide 21
FV & PV of Mixed Stream
(5 Years, 4% Interest Rate)

PV
$5,271.7

0 1 2 3 4 5
-$10,000 $3,000 $5,000 $4,000 $3,000 $2,000.0
Discounting
End of Year

FV
$6,413.8

Compounding
- $12,166.5
$3,509.6
$5,624.3
$4,326.4
$3,120.0
$4,622.8
$3,556.0
$2,564.4
$1,643.9
$2,884.6
W. P. Carey Executive MBA Program Slide 22
Change the Flows
Assume constant flows
Over an explicit period
Forever called perpetuity.
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Annuity Cash Flows
W. P. Carey Executive MBA Program Slide 24
FV of Ordinary Annuity
(End of 5 Years, 5.5% Interest Rate)
0 1 2 3 4 5
$1,000 $1,000 $1,000 $1,000 $1,000
$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000.00
End of Year
08 . 581 , 5 $
1 ) 1 (
=
+
=
r
r
PMT FV
n
W. P. Carey Executive MBA Program Slide 25
FV of an Ordinary Annuity Using
Excel
PMT 1,000 $
r 4.3%
n 5
FV? $5,448.8
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.043, 5,1000 )
How much will your deposits grow to at the end of five years if you
deposit $1,000 at the end of each year at 4.3% interest for 5 years?
How is annuity due different ?
W. P. Carey Executive MBA Program Slide 26
$1,000 $1,000 $1,000 $1,000 $1,000
End of Year
$947.87
$898.45
$851.61
$807.22
0 1 2 3 4 5
$765.13
PV of Ordinary Annuity
(5 Years, 5.5% Interest)
28 . 270 , 4 $
) 1 (
1
1 =
(

+
=
n
r r
PMT
PV
W. P. Carey Executive MBA Program Slide 27
Annuity Examples
W. P. Carey Executive MBA Program Slide 28
Ordinary Annuity vs. An Annuity
Due
Annual Cash Flows
0 $ 0 $1,000
1 1,000 1,000
2 1,000 1,000
3 1,000 1,000
4 1,000 1,000
5 1,000 0
Total $5,000 $5,000
End of year
a
Annuity A (ordinary) Annuity B (annuity due)
a
The ends of years 0, 1,2, 3, 4 and 5 are equivalent to the beginnings of years
1, 2, 3, 4, 5, and 6 respectively
W. P. Carey Executive MBA Program Slide 29
Calculating the Future Value of an
Annuity Due
) 1 ( ) 1 ( due) annuity (
1
1
r r PMT FVA
t
n
t
n
+ + =

=

t
n
t
r PMT ) 1 (
1
+ =

=
Equation for the FV of an ordinary annuity can be converted
into an expression for the future value of an annuity due,
FVA
n
(annuity due), by merely multiplying by (1 + r)
( ) r
r
r
PMT FV
n
+
+
= 1
1 ) 1 (

W. P. Carey Executive MBA Program Slide 30
FV of an Annuity Due Using Excel
How much will your deposits grow to at the end of five years
if you deposit $1,000 at the beginning of each year at 4.3%
interest for 5 years?
PMT $1,000
r 4.30%
n 5
FV $5,448.89
FVA? $5,683.19
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.043, 5, 1000)
=$5,448.89*(1.043)
W. P. Carey Executive MBA Program Slide 31
PV of Perpetuity
($1,000 Payment, 7% Interest Rate)
t
t
r
PMT PV
) 1 (
1
1
+
=

=
Stream of equal annual cash flows that lasts forever
71 . 285 , 14 $
1
= =
r
PMT PV
What if the payments grow at 2% / year?
W. P. Carey Executive MBA Program Slide 32
PV of Growing Perpetuity
g r
g r
CF
PV >

=
1
Growing perpetuity

CF
1
= $1,000
r = 7% per year
g = 2% per year

000 , 20 $ = PV
$1,000 $1,020 $1,040.4 $1,061.2 $1,082.4
0 1 2 3 4 5
W. P. Carey Executive MBA Program Slide 33
Frequency of Compounding
Discussion so far
Assumed annual flows
No need to be the case.
W. P. Carey Executive MBA Program Slide 34
Compounding More Frequently than
Annually
Can compute interest with semi-annual, quarterly,
monthly (or more frequent) compounding periods
Semi-annual interest computed twice per year
Quarterly interest computed four times per year
To change basic FV formula to m compounding
periods:
Divide interest rate r by m and
Multiply number of years n by m
Basic FV formula becomes:

n m
n
m
r
PV FV

|
.
|

\
|
+ = 1
W. P. Carey Executive MBA Program Slide 35
Compounding More Frequently than
Annually
687 . 415 , 138 $
4
0513 . 0
1 000 , 125 $
2 4
2
=
|
.
|

\
|
+ =

FV
For quarterly compounding, m = 4:
93 . 326 , 138 $
4
0513 . 0
1 000 , 125 $
2 2
2
=
|
.
|

\
|
+ =

FV
For semiannual compounding, m = 2:
FV at end of 2 years of $125,000 deposited at 5.13% interest
2
W. P. Carey Executive MBA Program Slide 36
Continuous Compounding
In Extreme Case, Interest is compounded continuously
FV
n
= PV x (e
r x n
)
e = 2.7183
FV at end of 2 years of $125,000 at 5.13 % annual interest,
compounded continuously
FV
n
= $138,506.01
W. P. Carey Executive MBA Program Slide 37
More Frequent Compounding, Larger
the FV
FV of $100 at end of 2 years, invested at 8% annual interest,
compounded at the following intervals:
Annually: FV = $100 (1.08)
2
= $116.64
Semi-annually: FV = $100 (1.04)
4
= $116.99
Quarterly: FV = $100 (1.02)
8
= $117.17
Monthly: FV = $100 (1.0067)
24
= $117.30
Continuously: FV = $100 (e
0.16
) = $117.35
W. P. Carey Executive MBA Program Slide 38
Whats the True Interest Rate?
Quoted or otherwise?
Otherwise!
W. P. Carey Executive MBA Program Slide 39
APR vs. EAR
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APR vs. EAR
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APR vs. EAR
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Effective Rates Nominal Rates
For annual compounding, effective = nominal



For semi-annual compounding



For quarterly compounding
% 0 . 8 08 . 0 ) 08 . 0 1 ( 1
1
08 . 0
1
1
= + =
|
.
|

\
|
+ = EAR
% 16 . 8 0816 . 0 1 0816 . 1 1
2
08 . 0
1
2
= = =
|
.
|

\
|
+ = EAR
% 24 . 8 0824 . 0 1 0824 . 1 1
4
08 . 0
1
4
= = =
|
.
|

\
|
+ = EAR
W. P. Carey Executive MBA Program Slide 43
Applications of TVM

W. P. Carey Executive MBA Program Slide 44
Deposits Needed to Accumulate a
Future Sum
A person wishes to buy a house 5 years from now
and estimates an initial down payment of $35,000 will be
required at that time
She wishes to make equal annual end-of-year deposits in an
account paying annual interest of 4 percent, so she must
determine what size annuity will result in a lump sum equal to
$35,000 at the end of year 5
Find the annual deposit required to accumulate FVAn dollars,
given an interest rate, r, and a certain number of years, n by
solving equation PMT:
98 . 461 , 6 $
4163 . 5
000 , 35 $
5 %, 4
5
= = =
FVIFA
FVA
PMT
W. P. Carey Executive MBA Program Slide 45
Loan Amortization Table
(10% interest, 4 Year Term)
Payments
1 $1,892.82 $6,000.00 $600.00 $1,292.82 $4,707.18
2 1,892.82 4,707.18 470.72 1,422.10 3,285.08
3 1,892.82 3,285.08 328.51 1,564.31 1,720.77
4 1,892.82 1,720.77 172.08 1,720.74 -
a

End
of
year
a
Due to rounding, a slight difference ($.03) exists between beginning-of-year 4
principal (in column 2) and the year-4 principal payment (in column 4)
Loan
Payment
(1)
Beginning-
of-year
principal
(2)
Interest
[.10 x (2)]
(3)
Principal
[(1) (3)]
(4)
End-of-year
principal
[(2) (4)]
(5)
W. P. Carey Executive MBA Program Slide 46
Finding Growth Rates
1997 1,000 $
1998 1,127
1999 1,158
2000 2,345
2001 3,985
2002 4,677
2003 5,525
It is first important to note
that although there are 7
years show, there are only 6
time periods between the
initial deposit and the final
value.
At times, it may be desirable to determine the compound interest rate or
growth rate implied by a series of cash flows.
For example, assume you invested $1,000 in a mutual fund in 1997 which grew
as shown in the table below.
What compound growth rate did this investment achieve?
W. P. Carey Executive MBA Program Slide 47
Determining Growth Rates Using
Excel
This chart shows that $1,000 is the present value, the future value is $5,525,
and the number of periods is 6
Want to find the rate, r, that would cause $1,000 to grow to $5,525 over a
six-year compounding period
Use FV formula: FV= PV x (1+r)
n
$5,525=$1,000 x (1+r)
6

Simplify & rearrange: (1+r)
6
= $5,525 $1,000 = 5.525
Find sixth root of 5.525 (Take y
x
, where x=0.16667), subtract 1
Find r = 0.3296, so growth rate = 32.96%.
Excel Function
=Rate(periods, pmt, PV, FV)
=Rate(6, ,1000, 5525)
1997 1,000 $
1998 1,127
1999 1,158
2000 2,345
2001 3,985
2002 4,677
2003 5,525