Chapter 5 (Part 1)

Time Value of Money

Time Value of Money: is the concept that money you have now
is worth more than the identical sum in the future due to its
potential earning capacity.

To understand:
Future Value
Present Value
Annuities
Rates of Return
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 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.

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 Drawing Time Lines

$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

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 Drawing Time Lines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

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 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

is called compounding.
• FV can be solved by using the step-by-step, financial
calculator, and spreadsheet methods.

0 1 2 3
10%

100 FV = ?

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 Solving for FV:
The 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 3 years:
FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case):
FVN = PV(1 + I)N

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 Solving for FV:
Calculator and Excel Methods

• Solves the general FV equation.

• Requires 4 inputs into calculator, and will solve for the
fifth. (Set to P/YR = 1 and END mode.)
• CPT
INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

Excel: =FV(rate,nper,pmt,pv,type)
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 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

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

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 Solving for PV:
The Formula Method

• Solve the general FV equation for PV:

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.10)3
= $75.13

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 Solving for PV:
Calculator and Excel Methods

• 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. CPT

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

Excel: =PV(rate,nper,pmt,fv,type)
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 Solving for I: What annual interest rate would cause
$100 to grow to $125.97 in 3 years?

• Solves the general FV equation for I/YR.

• Hard to solve without a financial calculator or
spreadsheet. CPT

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8

Excel: =RATE(nper,pmt,pv,fv,type,guess)
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 Solving for N: If sales grow at 20% per year, how
long before sales double?

• Solves the general FV equation for N.

• Hard to solve without a financial calculator or
spreadsheet. CPT

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

EXCEL: =NPER(rate,pmt,pv,fv,type)
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 What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

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 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. CPT

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

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 0.
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 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.
• CPT
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 0.
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 Solving for FV:
3-Year Annuity Due of $100 at 10%

• Now, $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
of the annuity:

BEGIN
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10

Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
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 Solving for PV:
3-Year Annuity Due of $100 at 10%

• Again, $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 of the annuity:

BEGIN
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

Excel: =PV(rate,nper,pmt,fv,type)
Here type = 1.
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 What is the present value of a 5-year $100
ordinary annuity at 10%?

• Be sure your financial calculator is set back to END

mode and solve for PV:
– N = 5, I/YR = 10, PMT = -100, FV = 0.
– PV = $379.08.

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 What if it were a 10-year annuity? A 25-year
annuity? A perpetuity?

• 10-year annuity
– N = 10, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$614.46.
• 25-year annuity
– N = 25, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$907.70.
• Perpetuity
– PV = PMT/I = $100/0.1 = $1,000.

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