CHAPTER 2

Time Value of Money

 Future value
 Present value
 Annuities
 Rates of return
 Amortization
2-1
 Time lines
0 1 2 3
i%

CF0 CF1 CF2 CF3

 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.
2-2
 Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity

$100 lump sum due in 2 years

0 1 2
i%

100
3 year $100 ordinary annuity
0 1 2 3
i%

100 100 100

2-3
 Drawing time lines:
Uneven cash flow stream; CF0 = -$50,
CF1 = $100, CF2 = $75, and CF3 = $50

Uneven cash flow stream

0 1 2 3
i%

-50 100 75 50

2-4
 What is the future value (FV) of an initial
$100 after 3 years, if I/YR = 10%?
 Finding the FV of a cash flow or series of
cash flows when compound interest is
applied is called compounding.
 FV can be solved by using the arithmetic,
financial calculator, and spreadsheet
methods.
0 1 2 3
10%

100 FV = ?
2-5
Solving for FV:
The arithmetic method
 After 1 year:
 FV = PV ( 1 + i ) = $100 (1.10)
1
= $110.00
 After 2 years:
 FV = PV ( 1 + i )2 = $100 (1.10)2
2
=$121.00
 After 3 years:
 FV = PV ( 1 + i )3 = $100 (1.10)3
3
=$133.10
 After n years (general case):
 FV = PV ( 1 + i )n
n
2-6
Solving for FV:
The calculator method
 Solves the general FV equation.
 Requires 4 inputs into calculator, and will
solve for the fifth. (Set to P/YR = 1 and
END mode.)

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

2-7
 What is the present value (PV) of $100
due in 3 years, if I/YR = 10%?
 Finding the PV of a cash flow or series of
cash flows when compound interest is
applied is called discounting (the reverse of
compounding).
 The PV shows the value of cash flows in
terms of today’s purchasing power.
0 1 2 3
10%

PV = ? 100
2-8
Solving for PV:
The arithmetic method
 Solve the general FV equation for PV:
 PV = FVn / ( 1 + i )n

 PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

2-9
Solving for PV:
The calculator method
 Solves the general FV equation for PV.
 Exactly like solving for FV, except we
have different input information and are
solving for a different variable.

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

2-10
Solving for FV:
3-year ordinary annuity of $100 at 10%
 $100 payments occur at the end of
each period, but there is no PV.

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331

2-11
Solving for PV:
3-year ordinary annuity of $100 at 10%
 $100 payments still occur at the end of
each period, but now there is no FV.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

2-12
Solving for PV:
3-year ordinary annuity of $100 at 10%
 Brute force method

 Annuity formula:

PV = PMT/I x (1 – 1/(1 + I)n)

PV = PMT x PVIFAi,n

2-13
 What is the PV of this uneven
cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
2-14
Solving for PV:
Uneven cash flow stream
 Input cash flows in the calculator’s “CFLO”
register:
 CF0 = 0
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = -50
 Enter I/YR = 10, press NPV button to get NPV
= $530.09. (Here NPV = PV.)
2-15
Solving for I:
What interest rate would cause $100 to
grow to $125.97 in 3 years?
 Solves the general FV equation for I.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8

2-16
The Power of Compound
Interest
A 20-year-old student wants to start saving for
retirement. She plans to save $3 a day. Every
day, she puts $3 in her drawer. At the end of
the year, she invests the accumulated savings
($1,095) in an online stock account. The stock
account has an expected annual return of 12%.

How much money will she have when she is 65

years old?
2-17
Solving for FV:
Savings problem
 If she begins saving today, and sticks to
her plan, she will have $1,487,261.89
when she is 65.

INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,262

2-18
Solving for FV:
Savings problem, if you wait until you are
40 years old to start
 If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $146,000.59
at age 65. This is $1.3 million less than if starting
at age 20.
 Lesson: It pays to start saving early.

INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,001

2-19
Solving for PMT:
How much must the 40-year old deposit
annually to catch the 20-year old?
 To find the required annual contribution,
enter the number of years until retirement
and the final goal of $1,487,261.89, and
solve for PMT.

INPUTS 25 12 0 1,487,262

N I/YR PV PMT FV
OUTPUT -11,154.42

2-20
Perpetuity
 PV = PMT / I

2-21
Growing Perpetuity
 PV = PMT / (I – g)

2-22