TIME VALUE OF MONEY

A dollar in the hand today is worth more than a dollar to be received in the future because,
if you had it now, you could invest that dollar and earn interest. Of all the techniques used in finance,
none is more important than the concept of time value of money, also called discounted cash flow (DCF)
analysis. Future value and present value techniques can be applied to a single cash flow (lump sum),
ordinary annuities, annuities due, and uneven cash flow streams. Future and present values can be
calculated using, a regular calculator, a calculator with financial functions, or a spreadsheet program.
When compounding occurs more frequently than once a year, the effective rate of interest is greater
than the quoted rate.

Time lines are used to help visualize what is happening in time value of money problems.
Cash flows are placed directly below the tick marks, and interest rates are shown directly
above the time line; unknown cash flows are indicated by a symbol for the particular item
that is missing. Thus, to find the future value of $100 after 5 years at 5 percent interest, the
following time line can be set up:

Time: 0 1 2 3 4 5
5%

| | | | | |

Cash flows: -100 FV5 = ?

Finding the future value (FV), or compounding, is the process of going from today's values
(or present values) to future amounts (or future values). It can be calculated as

FVn = PV(1 + i)n = PV(FVIFi,n),

where PV = present value, or beginning amount; i = interest rate per year; and n = number
of periods involved in the analysis. FVIFi,n, the Future Value Interest Factor, is a short-
hand way of writing the equation. This equation can be solved in one of three ways:
numerically with a regular calculator, with a financial calculator, or with a spreadsheet
program. For calculations, assume the following data that were presented in the time line
above: present value (PV) = $100, interest rate (i) = 5%, and number of years (n) = 5.


 To solve numerically, use a regular calculator to find 1 + i = 1.05 raised to the fifth
power, which equals 1.2763. Multiply this figure by PV = $100 to get the final answer of
FV5 = $127.63 .

 With a financial calculator, the future value can be found by using the time value of
money input keys, where N = number of periods, I = interest rate per period, PV =
 present value, PMT = payment, and FV = future value. By entering N = 5, I = 5, PV = -
100, and PMT = 0, and then pressing the FV key, the answer 127.63 is displayed.
 Some financial calculators require that all cash flows be designated as either inflows
or outflows, thus an outflow must be entered as a negative number (for example,
PV = -100 instead of PV = 100).
 Some calculators require you to press a “Compute” key before pressing the FV key.

 Spreadsheet programs are ideally suited for solving time value of money problems. The
spreadsheet itself becomes a time line.

 A B C D E F G

1 Interest rate .05

2 Time 0 1 2 3 4 5

3 Cash flow -100

4 Future value 105.00 110.25 115.76 121.55 127.63

 Row 4 contains the spreadsheet formula for future value.

 The Excel formula in Cell G4 is written as =-$B$3*(1+$B$1)^G2. This gives us
flexibility to change the interest rate in Cell B1 to see how the future value changes
with changes in interest rates.
 An alternative Excel formula in Cell G4 could have been entered. This is the FV
function, and it is =FV(5%,5,0,-100,1). The first argument of this formula is the
interest rate, the second the number of periods, the third the annual payments, the
fourth is the present value, and the fifth indicates that payments are all made at the
end rather than the beginning of each year.

 Note that small rounding differences will often occur among the various solution
methods.

 In general, you should use the easiest approach.

A graph of the compounding process shows how any sum grows over time at various interest rates. The
greater the interest rate, the faster the growth rate.
Finding present values is called discounting, and it is simply the reverse of compounding.
In general, the present value of a cash flow due n years in the future is the amount which, if
it were on hand today, would grow to equal the future amount. By solving for PV in the
future value equation, the present value, or discounting, equation can be developed and
written in several forms:
n
FV n  1 
PV = = FV n   = FV n ( PVIF i, n ).
1+i 
n
(1 + i )

 PVIFi,n, the Present Value Interest Factor, is a short-hand way of writing the equation.
 To solve for the present value of $127.63 discounted back 5 years at a 5% opportunity
cost rate, one can utilize any of the four solution methods:
 Numerical solution: Divide $127.63 by 1.05 five times to get PV = $100.
 Financial calculator solution: Enter N = 5, I = 5, PMT = 0, and FV = 127.63, and
then press the PV key to get PV = -100.
 Spreadsheet solution:

A B C D E F G

1 Interest rate .05

2 Time 0 1 2 3 4 5

3 Cash flow 0 0 0 0 127.63

4 Present value 100

Any of three formulas could be entered using Excel in Cell B4:

(1) =G3/(1+$B$1)^G2, (2) =NPV($B$1,C3:G3), or (3) =PV(B1,G2,0,G3). The second formula
finds the present value of each number in the range of cells from C3 to G3, discounted at 5
percent. The third formula find the present value of G3, when discounted for G2 periods at
a rate of B1.

 A graph of the discounting process shows how the present value of any sum to be
received in the future diminishes as the years to receipt increases. At relatively high
interest rates, funds due in the future are worth very little today, and even at a relatively
low discount rate, the present value of a sum due in the very distant future is quite small.

There are four variables in the time value of money compounding and discounting
equations: PV, FV, i, and n. If three of the four variables are known, you can find the
value of the fourth.

 If we are given PV, FV, and n, we can determine i by substituting the known values into
either the present value or future value equations, and then solve for i. Thus, if you can
buy a security at a price of $78.35 which will pay you $100 after 5 years, what is the
interest rate earned on the investment?
 Numerical solution: Solve for i in the following equation using the exponential
feature of a regular calculator: $100 = $78.35(1 + i)5.
 Financial calculator solution: Enter N = 5, PV = -78.35, PMT = 0, and FV = 100,
then press the I key, and I = 5 is displayed.
 Spreadsheet solution:

A B C D E F G

1 Time 0 1 2 3 4 5

2 Cash flow -78.35 0 0 0 0 100

3 Interest rate 5%

 The Excel formula in Cell B3 is entered as =IRR(B2:G2). The formula calculates

the internal rate of return, and its argument is the range of the cash flows.
Alternatively, you could enter =Rate(G1,0,B2,G2), which finds the rate given G1
periods, a present value of B2, and a future value of G2.

 Likewise, if we are given PV, FV, and i, we can determine n by substituting the known
values into either the present value or future value equations, and then solve for n. Thus,
if you can buy a security with a 5 percent interest rate at a price of $78.35 today, how
long will it take for your investment to return $100?
 Numerical solution: Solve for n in the following equation using the natural
logarithm feature of a regular calculator: $100 = $78.35(1 + .05)n.
 Financial calculator solution: Enter I = 5, PV = -78.35, PMT = 0, and FV = 100,
then press the N key, and N = 5 is displayed.
 Spreadsheet solution: Enter the formula =NPER(.05,0,-78.35,100), which finds the
number of periods, given a rate of 5%, a present value of –78.35, and a future value
of 100.

An annuity is a series of equal payments made at fixed intervals for a specified number of
periods. If the payments occur at the end of each period, as they typically do, the annuity is
an ordinary (or deferred) annuity. If the payments occur at the beginning of each period, it
is called an annuity due.
 The future value of an annuity is the total amount one would have at the end of the
annuity period if each payment were invested at a given interest rate and held to the end
of the annuity period.
 Defining FVAn as the compound sum of an ordinary annuity of n years, and PMT as
the periodic payment, we can write

n  (1  i) n  1 
FVA n  PMT  (1 + i )n - t = PMT    PMT( FVIFAi, n ).
 i 
t =1  

 FVIFAi,n is the future value interest factor for an ordinary annuity. This is a short-
hand notation for the formula shown above.
 For example, the future value of a 3-year, 5 percent ordinary annuity of $100 per
year would be $100(3.1525) = $315.25.
 The same calculation can be made using the financial function keys of a calculator.
Enter N = 3, I = 5, PV = 0, and PMT = -100. Then press the FV key, and 315.25 is
displayed.
 Most spreadsheets have a built-in function to find the future value of an annuity. In
Excel the formula would be written as =FV(.05,3,-100).
 For an annuity due, each payment is compounded for one additional period, so the
future value of the entire annuity is equal to the future value of an ordinary annuity
compounded for one additional period. Thus:

FVAn (Annuity due) = PMT(FVIFAi,n)(1 + i).

 For example, the future value of a 3-year, 5 percent annuity due of $100 per year is
$100(3.1525)(1.05) = $331.01.
 Most financial calculators have a switch, or key, marked “DUE” or “BEG” that
permits you to switch from end-of-period payments (an ordinary annuity) to
beginning-of-period payments (an annuity due). Switch your calculator to “BEG”
mode, and calculate as you would for an ordinary annuity. Do not forget to switch
your calculator back to “END” mode when you are finished.
 For an annuity due, the spreadsheet formula is written as =FV(.05,3,-100,0,1). The
fourth term in the formula, 0, means that no extra payment is made at t = 0, and the
last term, 1, tells the computer that this is an annuity due.

 The present value of an annuity is the single (lump sum) payment today that would be
equivalent to the annuity payments spread over the annuity period. It is the amount today
that would permit withdrawals of an equal amount (PMT) at the end (or beginning for an
annuity due) of each period for n periods.
  Defining PVAn as the present value of an ordinary annuity of n years and PMT as the
periodic payment, we can write
 1 
t  1 
n
 1   (1  i) n 
PVA n  PMT     PMT    PMT(PVIFA i,n ).
t =1  1 + i  
i

 

 PVIFAi,n is the present value interest factor for an ordinary annuity. This is a short-
hand notation for the formula shown above.
 For example, an annuity of $100 per year for 3 years at 5 percent would have a
present value of $100(2.7232) = $272.32.
 Using a financial calculator, enter N = 3, I = 5, PMT = -100, and FV = 0, and then
press the PV key, for an answer of $272.32.
 Spreadsheet solution:

A B C D E

1 Interest rate .05

2 Time 0 1 2 3

3 Cash flow 100 100 100

4 Present value $272.32

 Two formulas can be used to solve this problem. Excel’s NPV formula can be
entered in Cell B4: =NPV($B$1,C3:E3). The second formula that can be used is
Excel’s PV annuity function: =PV(.05,3,-100).
 The present value for an annuity due is

PVAn (Annuity due) = PMT(PVIFAi,n)(1 + i).

 For example, the present value of a 3-year, 5 percent annuity due of $100 is
$100(2.7232)(1.05) = $285.94.
 Using a financial calculator, switch to the “BEG” mode, and then enter N = 3, I = 5,
PMT = -100 , and FV = 0, and then press PV to get the answer, $285.94. Again, do
not forget to switch your calculator back to “END” mode when you are finished.
 For an annuity due, the spreadsheet formula is written as =PV(.05,3,-100,0,1). The
fourth term in the formula, 0, means that you are not making any additional
payments at t = 3, and the last term, 1, tells the computer that this is an annuity due.

An annuity that goes on indefinitely is called a perpetuity. The payments of a perpetuity

constitute an infinite series.

 The present value of a perpetuity is:

PV (Perpetuity) = Payment/Interest rate = PMT/i.

 For example, if the interest rate were 12 percent, a perpetuity of $1,000 a year would
have a present value of $1,000/0.12 = $8,333.33.

Many financial decisions require the analysis of uneven, or nonconstant, cash flows rather
than a stream of fixed payments such as an annuity.

 The present value of an uneven stream of income is the sum of the PVs of the individual
cash flow components. Similarly, the future value of an uneven stream of income is the
sum of the FVs of the individual cash flow components.
 With a financial calculator, enter each cash flow (beginning with the t = 0 cash flow)
into the cash flow register, CFj, enter the appropriate interest rate, and then press the
NPV key to obtain the PV of the cash flow stream.
 Spreadsheets are especially useful for solving problems with uneven cash flows.

A B C D E F G H I

1 Interest rate .06

2 Time 0 1 2 3 4 5 6 7

3 Cash flow 100 200 200 200 200 0 1,000

4 Present value 1,413.19

 The Excel spreadsheet formula in Cell B4 is written as =NPV(B1,C3:I3).

 Some calculators have a net future value (NFV) key which allows you to obtain the
FV of an uneven cash flow stream.

 If one knows the relevant cash flows, the effective interest rate can be calculated
efficiently with either a financial calculator or a spreadsheet program. Using a financial
calculator, enter each cash flow (beginning with the t = 0 cash flow) into the cash flow
register, CFj, and then press the IRR key to obtain the interest rate of an uneven cash flow
stream.

Semiannual, quarterly, and other compounding periods more frequent than an annual
basis are often used in financial transactions. Compounding on a nonannual basis requires
an adjustment to both the compounding and discounting procedures discussed previously.

 The effective annual rate (EAR or EFF%) is the rate that would have produced the final
compounded value under annual compounding. The effective annual percentage rate is
given by the following formula:

Effective annual rate (EAR) = EFF% = (1 + iNom/m)m  1.0,

 where iNom is the nominal, or quoted, interest rate and m is the number of compounding
periods per year. The EAR is useful in comparing securities with different compounding
periods.
 For example, to find the effective annual rate if the nominal rate is 6 percent and
semiannual compounding is used, we have:

EAR = (1 + 0.06/2)2 – 1.0 = 6.09%.

 For annual compounding use the formula to find the future value of a single payment
(lump sum):
FVn = PV(1 + i)n.

 When compounding occurs more frequently than once a year, use this formula:
FVn = PV(1 + iNom/m)mn.

 Here m is the number of times per year compounding occurs, and n is the number of
years.
 The amount to which $1,000 will grow after 5 years if quarterly compounding is applied
to a nominal 8 percent interest rate is found as follows:

FVn = $1,000(1 + 0.08/4)(4)(5) = $1,000(1.02)20 = $1,485.95.

 Financial calculator solution: Enter N = 20, I = 2, PV = -1000, and PMT = 0, and

then press the FV key to find FV = $1,485.95.
 Spreadsheet solution: The spreadsheet developed to find the future value of a lump
sum under quarterly compounding would look like the one for annual compounding,
with two changes: The interest rate would be quartered, and the timeline would
show four times as many periods.
 The present value of a 5-year future investment equal to $1,485.95, with an 8 percent
nominal interest rate, compounded quarterly, is found as follows:

$1,485.95  PV1  0.08 / 4

( 4 )( 5)

$1,485.95
PV  20 = $1,000.
(1.02 )
  Financial calculator solution: Enter N = 20, I = 2, PMT = 0, and FV = 1485.95, and
then press the PV key to find PV = -$1,000.00.
 Spreadsheet solution: The spreadsheet developed to find the present value of a lump
sum under quarterly compounding would look like the one for annual compounding,
with two changes: The interest rate would be quartered, and the time line would
show four times as many periods.
The nominal rate is the rate that is quoted by borrowers and lenders. Nominal rates can
only be compared with one another if the instruments being compared use the same
number of compounding periods per year. Note also that the nominal rate is never shown
on a time line, or used as an input in a financial calculator, unless compounding occurs
only once a year. In general, nonannual compounding can be handled one of two ways.
 State everything on a periodic rather than on an annual basis. Thus, n = 6 periods rather
than n = 3 years and i = 3% instead of i = 6% with semiannual compounding.

 Find the effective annual rate (EAR) with the equation below and then use the EAR as
the rate over the given number of years.

m
 
EAR = 1 + i Nom   1.0.
 m 

Fractional time periods are used when payments occur within periods, instead of at either
the beginning or the end of periods. Solving these problems requires using the fraction of
the time period for n, number of periods, and then solving either numerically, with a
spreadsheet program, or with a financial calculator. (Some older calculators will produce
incorrect answers because of their internal “solution” programs.)

An important application of compound interest involves amortized loans, which are paid
off in equal installments over time.

 The amount of each payment, PMT, is found as follows: PV of the annuity =

PMT(PVIFAi,n), so PMT = PV of the annuity/PVIFAi,n.

 With a financial calculator, enter N (number of years), I (interest rate), PV (amount

borrowed), and FV = 0, and then press the PMT key to find the periodic payment.
 The spreadsheet is ideal for developing amortization tables. The set up is similar to the
table in the text, but you would want to include “input” cells for the interest rate,
principal value, and the length of the loan.
 Each payment consists partly of interest and partly of the repayment of principal. This
breakdown is often developed in a loan amortization schedule.
 The interest component is largest in the first period, and it declines over the life of
the loan.