Time Value of
Money
3-1
4.
5.
6.
7.
8.
3-2
Simple Interest
Compound Interest
Amortizing a Loan
3-3
Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
3-5
Types of Interest
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
3-6
3-7
SI = P0(i)(n)
SI:
Simple Interest
P0 :
i:
n:
SI
3-8
= P0(i)(n)
= $1,000(.07)(2)
= $140
3-9
= P0 + SI
= $1,000 + $140
= $1,140
3-10
3-11
20000
10% Simple
Interest
7% Compound
Interest
10% Compound
Interest
15000
10000
5000
0
20th
Year
30th
Year
Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
years
7%
$1,000
FV2
3-12
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1
= $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
3-13
Future Value
Single Deposit (Formula)
FV1
= $1,070
General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.
3-16
Period
1
2
3
4
5
6%
1.060
1.124
1.191
1.262
1.338
7%
1.070
1.145
1.225
1.311
1.403
8%
1.080
1.166
1.260
1.360
1.469
3-17
FV2
= $1,000 (FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.145
1.166
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469
N:
Number of periods
I/Y:Interest rate per period
PV:
Present value
PMT:
Payment per period
FV:
Future value
CLR TVM: Clears all of the inputs
into the above TVM keys
3-18
I/Y
PV
PMT
FV
Compute
3-19
3-20
CLR TVM
I/Y
-1000
PV
PMT
CPT
FV
-1,000
I/Y
PV
PMT
FV
1,144.90
2 Periods (enter as 2)
7% interest rate per period (enter as 7 NOT .07)
$1,000 (enter as negative as you have less)
Not relevant in this situation (enter as 0)
Compute (Resulting answer is positive)
10%
$10,000
FV5
3-22
3-23
3-24
CLR TVM
10
I/Y
-10000
PV
PMT
CPT
FV
10
-10,000
I/Y
PV
PMT
FV
16,105.10
3-26
The Rule-of-72
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
N
Compute
12
-1,000
+2,000
I/Y
PV
PMT
FV
6.12 years
Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
7%
$1,000
PV0
3-29
PV1
Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= $1,000 / (1.07)2
= FV2 / (1+i)2
= $873.44
0
7%
$1,000
PV0
3-30
General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
6%
.943
.890
.840
.792
.747
7%
.935
.873
.816
.763
.713
8%
.926
.857
.794
.735
.681
3-33
PV2
= $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]
Period
6%
7%
1
.943
.935
2
.890
.873
3
.840
.816
4
.792
.763
5
.747
.713
8%
.926
.857
.794
.735
.681
I/Y
PV
+1,000
PMT
FV
-873.44
2 Periods (enter as 2)
7% interest rate per period (enter as 7 NOT .07)
Compute (Resulting answer is negative deposit)
Not relevant in this situation (enter as 0)
$1,000 (enter as positive as you receive $)
10%
5
$10,000
PV0
3-35
3-36
3-37
10
I/Y
PV
+10,000
PMT
FV
-6,209.21
Types of Annuities
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Annuity Due:
Due Payments or receipts
occur at the beginning of each period.
3-38
Examples of Annuities
3-39
Insurance Premiums
Mortgage Payments
Retirement Savings
Parts of an Annuity
(Ordinary Annuity)
End of
Period 1
Today
3-40
End of
Period 2
End of
Period 3
$100
$100
$100
Parts of an Annuity
(Annuity Due)
Beginning of
Period 1
$100
$100
$100
Today
3-41
Beginning of
Period 2
Beginning of
Period 3
Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
. . .
i%
R
R = Periodic
Cash Flow
3-42
n-2
FVAn
n+1
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
$1,000
$1,000
7%
$1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
$3,215
3-43
$3,215 = FVA3
=
3-45
= R (FVIFAi%,n)
= $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867
-1,000
I/Y
PV
PMT
FV
3,214.90
Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
i%
R
. . .
n-1
FVADn
Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
$1,000
$1,000
$1,070
7%
$1,000
$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
$3,440
3-48
$3,440 = FVAD3
=
3-49
= R (FVIFAi%,n)(1+i)
= $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867
-1,000
I/Y
PV
PMT
FV
3,439.94
Compute
3-50
Step 2:
Press
2nd
SET
keys
Step 3:
Press
2nd
QUIT
keys
Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
n+1
. . .
i%
R
R
R = Periodic
Cash Flow
PVAn
3-51
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
$1,000
$1,000
7%
$934.58
$873.44
$816.30
$1,000
$2,624.32 = PVA3
PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 + $1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
3-52
3-54
= R (PVIFAi%,n)
= $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.624
2.577
4
3.465
3.387
3.312
5
4.212
4.100
3.993
I/Y
PV
-1,000
PMT
FV
2,624.32
Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
PVADn
. . .
i%
R
n-1
R: Periodic
Cash Flow
Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
$1,000
$1,000
7%
$1,000.00
$ 934.58
$ 873.44
$2,808.02 = PVADn
3-58
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Period
6%
7%
8%
1
0.943
0.935
0.926
2
1.833
1.808
1.783
3
2.673
2.624
2.577
4
3.465
3.387
3.312
5
4.212
4.100
3.993
I/Y
PV
-1,000
PMT
FV
2,808.02
Compute
3-59
Step 2:
Press
2nd
SET
keys
Step 3:
Press
2nd
QUIT
keys
PV0
3-61
10%
$600
How to Solve?
1. Solve a piece-at-a-time
piece-at-a-time by
discounting each piece back to t=0.
2. Solve a group-at-a-time
group-at-a-time by first
breaking problem into groups
of annuity streams and any single
cash flow groups. Then discount
each group back to t=0.
3-62
Piece-At-A-Time
0
10%
$600
$545.45
$495.87
$300.53
$273.21
$ 62.09
3-63
Group-At-A-Time (#1)
0
10%
$600
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) =
$600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) =
$100 (0.621) =
$62.10
3-64
Group-At-A-Time (#2)
0
$1,268.00
Plus
$347.20
Plus
$62.10
3-65
$400
$400
$400
$200
$200
4
$400
PV0 equals
$1677.30.
3
5
$100
3-66
3-68
Step 1:
Press
Step 2:
Press
Step 3: For CF0 Press
CF
2nd
0
CLR Work
Enter
key
keys
keys
Step 4:
Step 5:
Step 6:
Step 7:
600
2
400
2
Enter
Enter
Enter
Enter
keys
keys
keys
keys
100
Enter
keys
Enter
keys
Step 10:
Step 11:
Press
Press NPV
3-69
10
key
Enter
keys
Step 13:
Press CPT
key
Result:
keys
Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
3-70
n:
m:
i:
FVn,m:
Number of Years
Compounding Periods per Year
Annual Interest Rate
FV at the end of Year n
PV0:
Impact of Frequency
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual
FV2
= 1,000(1+
[.12/1])(1)(2)
1,000
= 1,254.40
Semi
FV2
= 1,000(1+
[.12/2])(2)(2)
1,000
= 1,262.48
3-71
Impact of Frequency
Qrtly
FV2
= 1,000(1+
[.12/4])(4)(2)
1,000
= 1,266.77
Monthly
FV2
= 1,000(1+
[.12/12])(12)(2)
1,000
= 1,269.73
Daily
FV2
= 1,000(1+
1,000 [.12/365])(365)(2)
= 1,271.20
3-72
3-73
2(4)
12/4
-1,000
I/Y
PV
PMT
FV
1266.77
2nd P/Y
2nd
QUIT
12
I/Y
-1000
PV
PMT
2 2nd xP/Y N
3-74
CPT
FV
ENTER
N
Compute
I/Y
PV
PMT
FV
1271.20
QUIT
12
I/Y
-1000
PV
PMT
2 2nd xP/Y N
3-76
CPT
FV
Effective Annual
Interest Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.
(1 + [ i / m ] )m - 1
3-77
BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
3-78
Converting to an EAR
Press:
3-79
2nd
I Conv
ENTER
ENTER
CPT
2nd
QUIT
2.
3.
4.
5.
3-80
3-81
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Payment
Interest
Principal
---
---
---
Ending
Balance
$10,000
$2,774
$1,200
$1,574
8,426
2,774
1,011
1,763
6,663
2,774
800
1,974
4,689
2,774
563
2,211
2,478
2,775
297
2,478
$13,871
$3,871
$10,000
12
10,000
I/Y
PV
PMT
FV
-2774.10
Amort
ENTER
ENTER
Results:
BAL = 8,425.90*
PRN = -1,574.10*
INT =
-1,200.00*
Amort
ENTER
ENTER
Results:
BAL = 6,662.91*
PRN = -1,763.99*
INT =
-1,011.11*
Amort
ENTER
ENTER
Results:
BAL =
3-86
0.00
PRN =-10,000.00
INT =
-3,870.49
Usefulness of Amortization
1.
2.
3-87