More Time Value of Money

Module 3, Lecture 2

Dr. Annette Poulsen

Sterne Professor of Banking and Finance
Josiah Meigs Distinguished Teaching Professor
Multiple compounding periods
• Interest may be compounded more frequently than once per
year.

• Compounding more frequently means we are paid interest

more frequently. How will this affect future value?

• Typically, interest rates are expressed as a nominal or annual

rate followed by the compound frequency. This stated annual
rate is referred to as the APR or the Annual Percentage Rate.

• How do we approach a compounding problem? We need to

adjust our period length (N) and our discount rate (r).

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Compounding
• Let m = number of times that interest is compounded per
year

• Use m to adjust the time period and the discount rate to

match the compounding frequency.

• r’ = APR / m = the sub-annual discount rate

• N’ = N * m = the number of sub-annual time periods

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Example
• An account pays 8% APR with quarterly compounding. If
I invest for 5 years, what is the quarterly interest rate and
the number of quarters of investment?

• r’ = APR / m = 8% / 4 = 2% per quarter

• N’ = N * m = 5 * 4 = 20 quarters

• If the present value is $100, what is the future value?

• N=20, I=2, PV = 100, PMT = 0  FV = -148.59

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Example
Put $1000 in the bank for a year at 9% APR compounded as indicated
below.

• What is the value of $1000 after a year if interest is compounded

once a year? (Fill in the blanks!)
• N= 1 I= 9 PV= 1000 PMT= 0  FV= -1090.00

• Quarterly
• N= 4 I= 9/4=2.25 PV= 1000 PMT= 0  FV= -1093.08

• Monthly?
• N= 12 I= 9/12 =.75 PV= 1000 PMT= 0  FV= -1093.81

• Daily?
• N=365 I= 9/365 PV= 1000 PMT= 0  FV= -1094.16

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Effective annual interest rate (EAR)
• The EAR is the rate of annually compounded interest
that is equivalent to some nominal rate of interest
compounded more frequently.

• E.g., in the above example, with quarterly compounding,

the interest is $93.08 per $1000
• Therefore, EAR = 9.308%

• With monthly compounding, the interest is $93.81 per

$1000
• Therefore, EAR = 9.381%

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Effective annual rate (EAR)

• What is the EAR on a savings account with 12% APR and

quarterly compounding?

• EAR = (1 + (.12 / 4))^4 – 1

• EAR = .1255 or 12.55%

• Note: APR might also be called the “nominal” or “stated” rate

• Many loan rates are stated as APRs with monthly

compounding – especially car loans and home mortgages

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Effective annual interest rate
• Financial Calculator helps on this also
• Look for correct menu  “iconv” on TI BA II Plus
• Arrow keys scroll through menu items are NOM, EFF,
C/Y
• NOM = 12 Enter, ↓, ↓
• C/Y = 4 Enter, ↓, ↓
• EFF CPT 

• And Excel…
• = EFFECT (APR, m)
• = EFFECT (.12, 4) 

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Example: Present value with compounding
• A newly engaged man wants to accumulate $5,000 for
his honeymoon two years from today. He will earn 9%
APR with monthly compounding on his investments over
the next two years. How much does he need to invest
today to reach his honeymoon goal?

• r’ = 9% / 12 = 0.75% per month (or .0075 in Excel)

• N’ = 2 * 12 = 24 months

• N= 24, I= .75, PV = ?, PMT = 0, FV = 5000 

• PV = - 4179.16

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Cash flow streams
• Most investments have multiple, different cash flows paid
to the investor.

• We can use our tools to find the PV or the FV of these

cash flows

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PV of cash flow stream
• The present value of a stream of cash flows is simply the
present value of each cash flow.

• Mathematically:

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Example
• Suppose you sign a contract that will pay $100,000 in the
first year, $125,000 in year 2, and $150,000 for the third
year. If your discount rate is 10%, what is the PV of the
contract?

• PV = $90,909.09 + $103,305.79 + $112,697.22 =

$306,912.10

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PV of cash flow stream with TI – BA II Plus
Use the CF menu (2nd row) – Be sure to clear work
• CF key, 2nd, CLR WORK
• CF0 = 0, Enter, ↓
• CF1 = 100000, Enter, ↓
• F1 = 1, Enter, ↓
• CF2 = 125000, Enter, ↓
• F2 = 1, Enter, ↓
• CF3 = 150000, Enter, ↓
• F3 = 1, Enter, ↓
• NPV Key, I= 10, Enter, ↓
• CPT NPV =
• NPV = 306912.10

• Note that it no longer uses opposite signs!

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PV of cash flow stream with excel
• Enter the cash flows and interest rate

• Use the NPV function  =NPV(rate, CF1, CF2, … CFN)

• =NPV(.10, 100000, 125000, 150000)

• = 306912.0

• Note that you no longer use the opposite signs!

• Why?
• TVM menu assumes you are looking at a transaction. You give
up this, to get that.
• Cash flow menu finds the value of given CFs. We will see more
examples that helps to explain.

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Future value of a cash flow stream
• The future value of a cash flow stream is simply the
future value of each cash flow compounded to time T

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Example: Future value
• Suppose you sign a contract that will pay $100,000 in the
first year, $125,000 in year 2, and $150,000 for the third
year.

• You decide to wait on receiving cash until the end of year

3. If your discount rate is 10%, what is the FV of the
contract at the end of year 3?

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Example: Value of each CF at t=3
• FV of CF1 = $100,000 * (1+.10)^2 = $121,000

• FV of CF2 = $125,000 * (1.10)^1 = $137,500

• FV of CF3 = $150,000 = $150,000

• FV of all three CFs as of t=3 = $408,500

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Calculator solution
• The calculator requires an extra step. First, find the NPV
of cash flows using the CF menu. Then find the FV of
that amount using the TVM keys.

• 1) Find NPV as above  NPV = $306,912.10

• 2) Move to year 3:
• N=3, I=10, PV = $306,912.10, PMT =0
• CPT FV  FV = $408,500

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Excel solution
• The excel solution uses the same technique as the calculator.
First, find the NPV and then find the FV.

• Find value as of t=0

• =NPV(10%, 100000, 125000, 150000) = $306,912.10

• Then find the FV of this amount as of t=3

• =FV(10%, 3, 0, -306912.10,0) = $408,500

• (Note that you can enter the interest rate as .10 or 10%, i.e.,
include the percentage sign)

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Annuities
• An “ordinary annuity” is an annuity with a cash flow
stream in which an equal payment occurs at the end of
every period for n periods.
• Loans, rent, lease agreements

• Most annuities have an end date (if they don’t, called a

perpetuity).

• An “annuity due” (or “annuity in advance”) is an annuity

where the cash flow occurs at the beginning of every
period.

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Formula for FV of an annuity

• where all of the cash flows are equal. Thus, CF is

frequently labeled as the “payment” or PMT.

• The above formula is equivalent to:

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Example: FV of an annuity
• You deposit $1,000 a year at the end of each year in an
account which pays 12% compounded annually.

• If you make 6 deposits (one at the end of each of the

next 6 years), how much will you have at the end of the
6th year?

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Solution
• = $8,115.19

• Using a calculator (check your settings!):

• N=6, I=12, PV=0, PMT = -1000, CPT FV  $8115.19

• (Keystrokes: 6 N, 12 I, 0 PV, 1000 +/- PMT, CPT FV)

• Note that the payments and the future value have the
opposite sign

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Solution with excel
• Similar to calculator – use the FV formula

• =FV (rate, nper, pmt, pv, type)

• = FV (.12, 6, -1000, 0, 0)
• (type=0 indicates a regular annuity)

• =$8115.19

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Present value of an annuity

Arithmetic the long way, where T is the length of the

annuity…

The following formula is equivalent….

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Example: PV of an annuity
• You desire to set up an account that allows a person to
withdraw $500 per year at the end of each of the next
four years.

• The money in the account will earn 10% a year,

compounded annually.

• How much must you deposit now to cover the four

withdrawals?

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Solution
• = $1584.93

• With financial calculator:

• N=4, I=10, PMT=500, FV=0, CPT PV  -$1584.93

• With excel:

• =PV(.10, 4, -500, 0, 0)  $1584.93

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Example: Annuity due
• You are renting a storage warehouse for 5 years. The
rent is $6000 per year payable at the beginning of each
year.

• You want to set aside the money necessary to meet

these payments.

• If the money you deposit in the “payment account” earns

10% a year, compounded annually, how much do you
have to deposit in the account?

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PV of an annuity due
• The regular annuity formulas are adjusted to show the earlier timing
of the CFs by multiplying by (1 + r)

• * (1+.10) = $25,019.19

• If using the financial calculator, set the timing to BGN (above the
PMT) key

• Set to BGN, N=5, I=10, PMT = -6000, FV =0, CPT PV  $25,019.19

• Don’t forget to switch back to end

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PV of an annuity due on excel
• Using the PV function:

• =PV(rate, nper, PMT, FV, type)

• = PV(10%,5,-6000,0,1)=$25,019.19

• Where type = 1 since this is an annuity due or beginning

of the period annuity.

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Example – Future Value
Suppose after graduating from UGA, you decide to start investing in money
market funds with some of your new income. You decide to invest $250 a
month in a fund that pays 6% APR compounded monthly.

a) If you invest for ten years, how much will you have after your last payment?

b) Now, suppose you invest for ten years, and then you let the money sit in
the money market fund for three more years. How much will you have at
this time?

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Example – Interest rate calculation
After starting a new job, you go out to buy a new Explorer from Gailey Motors.
The sticker price on the Explorer with the options you want is $28,000.
Unfortunately, you don’t have the cash to pay for the car and decide to
completely finance your purchase. The dealer offers you a 10-year loan with
monthly payments of $350.

a) What is the monthly interest rate for this loan?

b) What is the APR for the loan?

c) What is the EAR for the loan?

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Example – Annuity Due
You sign a one-year lease with a local apartment complex. The lease calls for
12 equal payments of $500 at the first of each month.

If you can earn a return of 12% APR compounded monthly on your investments,
how much would you be willing to pay today (a one-time payment) to cover the
full year’s rent?

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