Topic 4

Mathematics of Finance
The Role of Time Value of Money
 After studying Chapter
3, you should be able to:
1. Understand what is meant by "the time value of money."
2. Understand the relationship between present and future
value.
3. Describe how the interest rate can be used to adjust the
value of cash flows – both forward and backward – to a single
point in time.
4. Calculate both the future and present value of: (a) an amount
invested today; (b) a stream of equal cash flows (an annuity);
and (c) a stream of mixed cash flows.
5. Distinguish between an “ordinary annuity” and an “annuity
due.”
6. Use interest factor tables and understand how they provide a
shortcut to calculating present and future values.
7. Use interest factor tables to find an unknown interest rate or
growth rate when the number of time periods and future and
present values are known.
8. Build an “amortization schedule” for an installment-style
loan.
 Which would you prefer --
$10,000 today or $10,000 in 5
years?
Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!
 Why TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
 Types of Interest

 Simple Interest
• Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
(Interest is earned only on the principal amount)
 Compound Interest
• Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed
(lent).
(Interest is earned on both the principal and
accumulated interest of prior periods)
 Simple Interest and Compound
Interest (cont.)
 Example 5.1: Suppose that you
deposited $500 in your savings
account that earns 5% annual interest.
How much will you have in your
account after two years using (a)
simple interest and (b) compound
interest?
 Simple Interest and
Compound Interest (cont.)
 Simple Interest
› Interest earned
 = 5% of $500 = .05×500 = $25 per year
› Total interest earned = $25×2 = $50
› Balance in your savings account:
 = Principal + accumulated interest
 = $500 + $50 = $550
 Simple Interest and
Compound Interest (cont.)
 Compound interest
› Interest earned in Year 1
 = 5% of $500 = $25
› Interest earned in Year 2
 = 5% of ($500 + accumulated interest)
 = 5% of ($500 + 25) = .05×525 = $26.25
› Balance in your savings account:
 = Principal + interest earned
 = $500 + $25 + $26.25 = $551.25
 Present Value and Future
Value
 Time value of money calculations
involve Present value (what a cash flow
would be worth to you today) and
Future value (what a cash flow will be
worth in the future).
Future Value Equation
 Future Value
Single Deposit
(Graphic)
Assume that you deposit $1,000
at a compound interest rate of
7% for 2 years.

0 1 2
7%
$1,000
FV2
 Future Value
Single Deposit
(Formula)
FVn = PV(1+i)n = $1,000
(1.07) = $1,070
Compound Interest
You earned $70 interest on your
$1,000 deposit over the first year.
This is the same amount of interest
you would earn under simple
interest.
 General Future
Value Formula
FV1 = PV(1+i)1
FV2 = PV(1+i)2
etc.
General Future Value Formula:
FVn = PV(1 + i)n
or FVn = PV(FVIF i, n ) -- See Table II
 Valuation Using Table
II
FVIF i,n is found on Table II
at the end of the book.
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Using Future Value
Tables
FV2 = $1,000 (FVIF7%,2) =
$1,000 (1.145) =
$1,145 [Due to Rounding]
 Story Problem
Example
Julie Miller wants to know how large her
deposit of $10,000 today will become at a
compound annual interest rate of 10% for 5
years.
0 1 2 3 4 5
10%
$10,000
FV5
 Story Problem
Solution
 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
 Calculation based on Table II:
FV5 = $10,000 (FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [Due to
Rounding]
 Present Value
 What is value today of cash flow to be
received in the future?

› The answer to this question requires

computing the present value i.e. the
value today of a future cash flow, and the
process of discounting, determining the
present value of an expected future cash
flow.
 PV Equation

 The term in the bracket is known as the

Present Value Interest Factor (PVIF).

 PV = FVn (PVIF i, n)
 Present Value
Single Deposit
(Graphic)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.

0 1 2
7%
$1,000
PV0 PV1
 Present Value
Single Deposit
(Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2
= FV2 / (1+i)2 = $873.44

0 1 2
7%
$1,000
PV0
 General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table I
 Valuation Using
Table I
PVIFi,n is found on Table I
at the end of the book.
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 Using Present Value
Tables
PV2 = $1,000 (PVIF7%,2) =
$1,000 (.873) = $873
[Due to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 Story Problem
Example
Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a
discount rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
 Story Problem
Solution
 Calculation based on general
formula: PV0 = FVn / (1+i)n
PV0 = $10,000 /
(1+ 0.10)5 =
$6,209.21
 Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00
 Multiple
Multiple Cash
Cash Flows
Flows

Steps
Steps to
to Solve
Solve Time
Time
Value
Value of
of Money
Money
Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF,
annuity stream(s), or mixed flow
6. Solve the problem
7. Check with financial calculator (optional)
 Mixed Flows Example
Julie Miller will receive the set of
cash flows below. What is the
Present Value at a discount rate of
10%.
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
 How to Solve?

1. Solve a “piece-at-a-time” by
discounting each piece back to
t=0.
2. Solve a “group-at-a-time” by
first breaking problem into
groups of annuity streams and
any single cash flow groups.
Then discount each group back
to t=0.
 “Piece-At-A-Time”

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
 “Group-At-A-Time”
(#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) = $600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) = $100 (0.621) = $62.10
 “Group-At-A-Time”
(#2)
0 1 2 3 4

$400 $400 $400 $400

$1,268.00
0 1 2 PV0 equals
Plus
$200 $200 $1677.30.
$347.20
0 1 2 3 4 5
Plus
$100
$62.10
 Types of Annuities

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity: Payments or
receipts occur at the end of each
period.
 Annuity Due: Payments or receipts
occur at the beginning of each period.
 Examples of
Annuities
 Student Loan Payments
 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Overview of an
Ordinary Annuity --
FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn

... + R(1+i)1 + R(1+i)0
 Example of an
Ordinary Annuity --
FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
 Hint on Annuity
Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the
last cash flow period, whereas
the future value of an annuity
due can be viewed as
occurring at the beginning of
the last cash flow period.
 Valuation Using Table
III
FVAn = R (FVIFAi%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215) =
Period
$3,215 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
 Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 FVADn

+ ... + R(1+i)2
+ R(1+i)1 = FVAn
(1+i)
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070
$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$3,440 = FVAD3
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440
 Valuation Using Table
III
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) =
Period
$3,440 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
 Overview of an
Ordinary Annuity --
PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
 Example of an
Ordinary Annuity --
PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2
+
$1,000/(1.07)3
= $934.58 + $873.44 +
 Hint on Annuity
Valuation
The present value of an
ordinary annuity can be
viewed as occurring at the
beginning of the first cash flow
period, whereas the future
value of an annuity due can be
viewed as occurring at the end
of the first cash flow period.
 Valuation Using Table
IV
PVAn = R (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) =
Period
$2,624 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
 Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... +

R/(1+i)n-1 = PVAn (1+i)
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
 Valuation Using
Table IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) =
Period
$2,808 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
 Frequency of
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods
per Year i: Annual Interest Rate
FVn,m: FV at the end
of Year n
PV0: PV of the Cash Flow today
 Impact of Frequency
Julie Miller has $1,000 to invest for 2 Years
at an annual interest rate of 12%.
Annual FV2 = 1,000(1+ [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2)(2)
= 1,262.48
 Impact of Frequency
Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+ [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+[.12/365])
(365)(2)
= 1,271.20
 Effective Annual
Interest Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the
number of compounding periods
per year.

(1 + [ i / m ] )m - 1
 BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000 CD
at the bank. The interest rate is 6%
compounded quarterly for 1 year.
What is the Effective Annual Interest
Rate (EAR)?
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
 Steps to Amortizing a
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i
% / m)
3. Compute principal payment in Period
t. (Payment - Interest from Step 2)
4. Determine ending balance in Period
t. (Balance - principal payment
from Step 3)
5. Start again at Step 2 and repeat.
 Amortizing a Loan
Example
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments
are made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA )
12%,5

$10,000 = R (3.605)
R = $10,000 /
3.605 = $2,774
 Amortizing a Loan
Example
End of Payment Interest Principal Ending
Year Balance

0 --- --- --- $10,000

1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

 Usefulness of
Amortization
1. Determine Interest Expense
-- Interest expenses may
reduce taxable income of the
2.firm.
Calculate Debt Outstanding -- The
quantity of outstanding debt may
be used in financing the day-to-
day activities of the firm.