BU5201

Business Finance

• Time Value of Money

• Loan Amortisation

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Learning Objectives
➢Explain how time value of money works and why it is important in Finance
➢Calculate the present value (PV) and future value (FV) of:
 A lump sum
 Annuity
 Uneven cash flow stream
 Perpetuity (PV only)

➢Differentiate between annuity due and ordinary annuity

➢Explain the difference between nominal, periodic, and effective interest
rates
 Understand how to compare alternative investments with different compounding periods

➢Understand loan amortisation and be able to calculate the relevant outputs

(e.g. payments, principal outstanding)
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Time Value of Money

• Future and Present Values

• Annuities

• Uneven Cash Flows

• interest Rates
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Time Value of Money
What is time value of money?
• The idea that money • Time value of money is important in
available today is worth finance. Its analysis is used in many
more than the same amount ways such as:
in the future because you
• Valuing stocks and bonds
can invest the money. For
example: • Planning retirement
• Deposit the money in a • Setting up loan payment schedule
bank to earn interest • Making corporate decisions
• Invest in stocks and regarding investment in new plant
bonds and equipment

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Time Lines
➢Show the timing of cash flows

➢Tick marks occur at the end of periods, so Time 0 is today, Time 1 is the
end of the first period (year, month, etc.) or the beginning of the second
period

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Drawing Time Lines

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Future and Present
Values

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Future Value
➢What is the future value (FV) of an initial $100 after three years, if the
interest per year, 𝑖, is 10%?
 Finding the FV of a cash flow or series of cash flows is called compounding
 FV can be solved using the following methods: step-by-step, financial calculator, and
spreadsheet

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Solving for FV
➢Step-by-step and Formula methods
 After 1 year: 𝐹𝑉1 = 𝑃𝑉 1 + 𝑖 = $100 1.10 = $110.00

 After 2 years: 𝐹𝑉2 = 𝑃𝑉 1 + 𝑖 2 = $100 1.10 2 = $121.00

 After 2 years: 𝐹𝑉2 = 𝐹𝑉1 (1 + 𝑖) = $110(1.10) = $121.00

 After 3 years: 𝐹𝑉3 = 𝑃𝑉 1 + 𝑖 3 = $100 1.10 3 = $133.10

 After 3 years: 𝐹𝑉3 = 𝐹𝑉2 (1 + 𝑖) = $121(1.10) = $133.10

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General Formula for FV

𝐹𝑉𝑁 = 𝑃𝑉 × 1 + 𝑖 𝑁

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Solving for FV
➢Calculator method
 Solves the general FV equation
 Requires four inputs into calculator, and will solve for fifth (set P/YR = 1
and END mode)

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Present Value
➢What is the present value (PV) of $133.10 due in three years, if the
interest per year, 𝑖, is 10%?
 Finding the PV of a cash flow or series of cash flows is called discounting (the reverse
of compounding)
 PV tells us how much a stream of future cash flows are worth today

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Solving for PV
➢The Formula method
Rewriting the general formula for FV:
𝐹𝑉𝑁
𝑃𝑉 = 1+𝑖 𝑁

𝐹𝑉3 $133.10
𝑃𝑉 = 1+𝑖 3
= 1.10 3
= $100

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Solving for PV
➢Calculator method
 Exactly like solving for FV, except we have different input information and
are solving for a different variable

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Annuities

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Annuity
➢Series of equal cash flows at fixed intervals for a specified no. of periods

➢Ordinary Annuity

Cash flows occur at

the end of the period

➢Annuity Due
Cash flows occur at
the beginning of the
period

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Solving for FV of an Annuity
➢Find the FV of a 3-year ordinary annuity of $100 at 10%

➢$100 payments occur at the end of each period

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Solving for PV of an Annuity
➢Find the PV of a 3-year ordinary annuity of $100 at 10%

➢$100 payments still occur at the end of each period

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Annuity Due
➢Howwill things change if we want to solve the FV and PV of a 3-year
annuity due of $100 at 10%?

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Solving for FV of an Annuity Due
➢Find the FV of a 3-year annuity due of $100 at 10%

➢$100 payments occur at the beginning of each period

➢𝐹𝑉𝐴𝑑𝑢𝑒 = 𝐹𝑉𝐴𝑜𝑟𝑑 1 + 𝑖 = $331 1.10 = $364.10

➢Alternatively, set calculator to “BEGIN” mode and solve for the FV

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Solving for PV of an Annuity Due
➢Find the PV of a 3-year annuity due of $100 at 10%

➢$100 payments occur at the beginning of each period

➢𝑃𝑉𝐴𝑑𝑢𝑒 = 𝑃𝑉𝐴𝑜𝑟𝑑 1 + 𝑖 = $248.69 1.10 = $273.55

➢Alternatively, set calculator to “BEGIN” mode and solve for the PV

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Solving for PV of a Perpetuity
➢Perpetuity: An annuity that lasts forever (perpetual)

➢Find the PV of a perpetuity that pays $100 per year at 10%

𝑃𝑀𝑇
𝑃𝑉 =
𝑖
$100
➢𝑃𝑉 = = $1,000
0.1

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Uneven Cash Flows

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Uneven Cash Flows
➢What is the PV of this uneven stream of cash flows

1. 530
2. 590
3. 598
4. Impossible to solve

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Solving for PV of Uneven Cash Flows
➢Step-by-step method

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Solving for PV of Uneven Cash Flows
➢Calculator method

➢Input cash flows in the calculator’s “CFLO” register:

 𝐶𝐹0 = 0
 𝐶𝐹1 = 100
 𝐶𝐹2 = 300
 𝐶𝐹3 = 300
 𝐶𝐹4 = −50

➢Press NPV button, enter I/YR = 10, press CPT button to get NPV =
$530.087 (here NPV = PV)

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Interest Rates

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Compounding Frequency
➢Willthe FV of a lump sum be larger or smaller if compounded more often,
holding the stated interest rate 𝑖% constant?

➢LARGER, as the more frequently compounding occurs, the more often

interest is earned on interest within the year
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 Classifications of Interest Rates
Nominal Rate 𝐼𝑁𝑂𝑀 Periodic Rate 𝐼𝑃𝐸𝑅
• Also called the quoted or stated • Amount of interest charged each
rate period
• An annual rate that ignores • e.g. monthly or quarterly
compounding effects within the 𝐼𝑁𝑂𝑀
• 𝐼𝑃𝐸𝑅 =
year 𝑀

• Stated in contracts. Periods must • 𝑀 is the number of

also be given compounding periods per year
• e.g. 8% quarterly compounding • 𝑀 = 4 for quarterly
or 8% daily interest • 𝑀 = 12 for monthly
compounding

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Classifications of Interest Rates
➢Effective (or equivalent) annual rate (EAR = EFF%) – the annual rate of
interest actually being earned, accounting for compounding

➢EFF% for 10% semiannual compounding investment

𝑀
𝐼𝑁𝑂𝑀
𝐸𝐹𝐹% = 1 + −1
𝑀

0.10 2
➢𝐸𝐹𝐹% = 1+ − 1 = 10.25%
2

➢Should be indifferent between receiving 10.25% annual interest and

receiving 10% interest compounded semiannually

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Effective Interest Rate
➢Why is is important to consider effective rates of return?

➢Investments with different compounding intervals provide different effective

returns

➢To compare investments with different compounding intervals, you must

look at their effective returns
 EFF% or EAR
 This forms an equivalent basis of comparison

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Effective Interest Rate
➢Let’s
explore how the effective return varies between investments with the
same nominal rate (10%), but different compounding intervals
 EARANNUALLY = 10.00%
 EARQUARTERLY = 10.38%
 EARMONTHLY = 10.47%
 EARDAILY = ?? %

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 Types of Interest Rates
𝐼𝑁𝑂𝑀 𝐼𝑃𝐸𝑅 𝐸𝐴𝑅
• Written into contracts, • Used in calculations • Used to compare
quoted by banks and and shown on time returns on
brokers lines investments with
different payments per
• Not used in • If M = 1, 𝐼𝑁𝑂𝑀 =
year
calculations or shown 𝐼𝑃𝐸𝑅 = 𝐸𝐴𝑅
on time lines

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Example of Interest Rates
➢Whatis the FV of $100 after three years under 10% semiannual
compounding?

➢With quarterly compounding?

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Example of Interest Rates
➢What is the FV of a 3-year $100 ordinary annuity, if the quoted interest
rate is 10%, compounded semiannually
 Payments occur annually, but compounding occurs every 6 months
 Cannot use normal annuity valuation techniques covered previously

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Example of Interest Rates
➢Compound each cash flow

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Loan Amortisation

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Loan Amortisation
➢A loan that is repaid in equal payments over its life

➢Amortised loans are widely used for home mortgages, auto loan, business
loans, retirement plans, etc.

➢Example

 You take out a $1,000 loan to buy a used car. The loan is to be repaid in three equal
payments at the end of each of the next three years. Construct an amortisation schedule
with an annual rate of 10%

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Amortisation Schedule
➢Step 1: Find the required annual payment

➢All input information is already given, just remember that the FV = 0

because the reason for amortising the loan and making payments is to
retire the loan

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Amortisation Schedule
➢Step 2: Find the interest paid in Year 1

➢The borrower will owe interest, on the initial balance, at the end of the first
year. Interest to be paid in the first year can be found by multiplying the
beginning balance by the interest rate

➢INT = Beginning Balance × 𝑖

➢INT = $1,000 × 0.10 = $100

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Amortisation Schedule
➢Step 3: Find the principal repaid in Year 1

➢Ifa payment of $402.11 was made at the end of the first year and $100
goes toward interest payment, this means that the remaining value must
represent the amount of principal repaid

➢Principal Repayment = PMT – INT

➢Principal Repayment = $402.11 – $100 = $302.11

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Amortisation Schedule
➢Step 4: Find the ending balance after Year 1

➢To find the balance at the end of the period, subtract the amount paid
toward the principal from the beginning balance

➢Ending Balance = Beginning Balance – Principal Repayment

➢Ending Balance = $1,000 – $302.11 = $697.89

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Amortisation Schedule
➢Repeat Steps 1 – 4 until the end of the loan

➢Interest paid declines with each payment as the balance declines

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Where do we stand?

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