Chapter 5

Time Value of
Money

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All rights reserved.
 Learning Goals

LG1 Discuss the role of time value in finance, the use of

computational tools, and the basic patterns of cash
flow.

LG2 Understand the concepts of future value and present

value, their calculation for single amounts, and the
relationship between them.

LG3 Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.

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 Learning Goals (cont.)

LG4 Calculate both the future value and the present value
of a mixed stream of cash flows.

LG5 Understand the effect that compounding interest more

frequently than annually has on future value and the
effective annual rate of interest.

LG6 Describe the procedures involved in (1) determining

deposits needed to accumulate a future sum, (2) loan
amortization, (3) finding interest or growth rates, and
(4) finding an unknown number of periods.

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 Continuous Compounding

• Continuous compounding involves the compounding of

interest an infinite number of times per year at intervals of
microseconds.
• A general equation for continuous compounding

where e is the exponential function.

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 Personal Finance Example

Find the value at the end of 2 years (n = 2) of Fred Moreno’s

$100 deposit (PV = $100) in an account paying 8% annual
interest (r = 0.08) compounded continuously.

FV2 (continuous compounding) = $100  e0.08  2

= $100  2.71830.16
= $100  1.1735 = $117.35

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 Personal Finance Example
(cont.)

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 Nominal and Effective Annual
Rates of Interest
• The nominal (stated) annual rate is the contractual annual rate of
interest charged by a lender or promised by a borrower.
• The effective (true) annual rate (EAR) is the annual rate of
interest actually paid or earned.
• In general, the effective rate > nominal rate whenever compounding
occurs more than once per year

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 Personal Finance Example

Fred Moreno wishes to find the effective annual rate

associated with an 8% nominal annual rate (r = 0.08) when
interest is compounded (1) annually (m = 1); (2)
semiannually (m = 2); and (3) quarterly (m = 4).

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 Focus on Ethics

How Fair Is “Check Into Cash”?

– There are more than 1,100 Check Into Cash centers among an estimated
22,000 payday-advance lenders in the United States.
– A payday loan is a small, unsecured, short-term loan ranging from $100 to
$1,000 (depending upon the state) offered by a payday lender.
– A borrower who rolled over an initial $100 loan for the maximum of four
times would accumulate a total of $75 in fees all within a 10-week period.
On an annualized basis, the fees would amount to a whopping 391%.
– The 391% mentioned above is an annual nominal rate [15%  (365/14)].
Should the 2-week rate (15%) be compounded to calculate the effective
annual interest rate?

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 Special Applications of Time Value: Deposits
Needed to Accumulate a Future Sum

The following equation calculates the annual cash payment (CF) that
we’d have to save to achieve a future value (FVn):

Suppose you want to buy a house 5 years from now, and you estimate
that an initial down payment of $30,000 will be required at that time.
To accumulate the $30,000, you will wish to make equal annual end-
of-year deposits into an account paying annual interest of 6 percent.

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 Personal Finance Example

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 Special Applications of Time
Value: Loan Amortization
• Loan amortization is the determination of the equal
periodic loan payments necessary to provide a lender with
a specified interest return and to repay the loan principal
over a specified period.
• The loan amortization process involves finding the future
payments, over the term of the loan, whose present value
at the loan interest rate equals the amount of initial
principal borrowed.
• A loan amortization schedule is a schedule of equal
payments to repay a loan. It shows the allocation of each
loan payment to interest and principal.
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 Special Applications of Time Value:
Loan Amortization (cont.)
• The following equation calculates the equal periodic loan payments
(CF) necessary to provide a lender with a specified interest return
and to repay the loan principal (PV) over a specified period:

• Say you borrow $6,000 at 10 percent and agree to make equal

annual end-of-year payments over 4 years. To find the size of the
payments, the lender determines the amount of a 4-year annuity
discounted at 10 percent that has a present value of $6,000.

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 Personal Finance Example

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 Table 5.6 Loan Amortization Schedule
($6,000 Principal, 10% Interest, 4-Year
Repayment Period)

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 Personal Finance Example
(cont.)

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 Focus on Practice

New Century Brings Trouble for Subprime Mortgages

• In 2006, some $300 billion worth of adjustable ARMs were reset to
higher rates.
• In a market with rising home values, a borrower has the option to
refinance their mortgage, using some of the equity created by the
home’s increasing value to reduce the mortgage payment.
• But after 2006, home prices started a three-year slide, so
refinancing was not an option for many subprime borrowers.
• As a reaction to problems in the subprime area, lenders tightened
lending standards. What effect do you think this had on the housing
market?

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 Special Applications of Time Value:
Finding Interest or Growth Rates
• It is often necessary to calculate the compound annual
interest or growth rate (that is, the annual rate of change
in values) of a series of cash flows.
• The following equation is used to find the interest rate (or
growth rate) representing the increase in value of some
investment between two time periods.

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 Personal Finance Example

Ray Noble purchased an investment four years ago for

$1,250. Now it is worth $1,520. What compound annual rate
of return has Ray earned on this investment? Plugging the
appropriate values into Equation 5.20, we have:

r = ($1,520 ÷ $1,250)(1/4) – 1 = 0.0501 = 5.01% per year

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 Personal Finance Example
(cont.)

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 Personal Finance Example

Jan Jacobs can borrow $2,000

to be repaid in equal annual
end-of-year amounts of $514.14
for the next 5 years. She wants
to find the interest rate on this
loan.

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 Personal Finance Example
(cont.)

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 Special Applications of Time Value:
Finding an Unknown Number of Periods

• Sometimes it is necessary to calculate the number of time

periods needed to generate a given amount of cash flow
from an initial amount.
• This simplest case is when a person wishes to determine
the number of periods, n, it will take for an initial deposit,
PV, to grow to a specified future amount, FVn, given a
stated interest rate, r.

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 Personal Finance Example

Ann Bates wishes to

determine the number of years
it will take for her initial
$1,000 deposit, earning 8%
annual interest, to grow to
equal $2,500. Simply stated, at
an 8% annual rate of interest,
how many years, n, will it take
for Ann’s $1,000, PV, to grow
to $2,500, FVn?

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 Personal Finance Example
(cont.)

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 Personal Finance Example

Bill Smart can borrow $25,000 at

an 11% annual interest rate; equal,
annual, end-of-year payments of
$4,800 are required. He wishes to
determine how long it will take to
fully repay the loan. In other
words, he wishes to determine
how many years, n, it will take to
repay the $25,000, 11% loan, PVn,
if the payments of $4,800 are
made at the end of each year.

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 Personal Finance Example
(cont.)

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 Review of Learning Goals

LG1 Discuss the role of time value in finance, the use of

computational tools, and the basic patterns of cash
flow.
– Financial managers and investors use time-value-of-money
techniques when assessing the value of expected cash flow
streams. Alternatives can be assessed by either
compounding to find future value or discounting to find
present value. Financial managers rely primarily on present
value techniques. The cash flow of a firm can be described
by its pattern—single amount, annuity, or mixed stream.

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 Review of Learning Goals
(cont.)
LG2 Understand the concepts of future value and present
value, their calculation for single amounts, and the
relationship between them.
– Future value (FV) relies on compound interest to measure
future amounts: The initial principal or deposit in one
period, along with the interest earned on it, becomes the
beginning principal of the following period.
– The present value (PV) of a future amount is the amount of
money today that is equivalent to the given future amount,
considering the return that can be earned. Present value is
the inverse of future value.

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 Review of Learning Goals
(cont.)
LG3 Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.
– The future or present value of an ordinary annuity can be
found by using algebraic equations, a financial calculator,
or a spreadsheet program. The value of an annuity due is
always r% greater than the value of an identical annuity.
The present value of a perpetuity—an infinite-lived annuity
—is found using 1 divided by the discount rate to represent
the present value interest factor.

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 Review of Learning Goals
(cont.)
LG4 Calculate both the future value and the present value
of a mixed stream of cash flows.
– A mixed stream of cash flows is a stream of unequal
periodic cash flows that reflect no particular pattern. The
future value of a mixed stream of cash flows is the sum of
the future values of each individual cash flow. Similarly,
the present value of a mixed stream of cash flows is the
sum of the present values of the individual cash flows.

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 Review of Learning Goals
(cont.)
LG5 Understand the effect that compounding interest more
frequently than annually has on future value and the
effective annual rate of interest.
– Interest can be compounded at intervals ranging from
annually to daily, and even continuously. The more often
interest is compounded, the larger the future amount that
will be accumulated, and the higher the effective, or true,
annual rate (EAR).

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 Review of Learning Goals
(cont.)
LG6 Describe the procedures involved in (1) determining deposits
needed to accumulate a future sum, (2) loan amortization, (3)
finding interest or growth rates, and (4) finding an unknown
number of periods.
– (1) The periodic deposit to accumulate a given future sum can be
found by solving the equation for the future value of an annuity for
the annual payment. (2) A loan can be amortized into equal periodic
payments by solving the equation for the present value of an annuity
for the periodic payment. (3) Interest or growth rates can be
estimated by finding the unknown interest rate in the equation for the
present value of a single amount or an annuity. (4) An unknown
number of periods can be estimated by finding the unknown number
of periods in the equation for the present value of a single amount or
an annuity.

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 Chapter Resources on
MyFinanceLab
• Chapter Cases
• Group Exercises
• Critical Thinking Problems

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 Integrative Case: Track
Software, Inc.
Table 1: Track Software, Inc. Profit, Dividends, and
Retained Earnings, 2006–2012

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 Integrative Case: Track
Software, Inc.
Table 2: Track
Software, Inc.
Income Statement
($000)for the Year
Ended December
31, 2012

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 Integrative Case: Track
Software, Inc.
Table 3a: Track Software, Inc. Balance Sheet ($000)

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 Integrative Case: Track
Software, Inc.
Table 3b: Track Software, Inc. Balance Sheet ($000)

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 Integrative Case: Track
Software, Inc.
Table 4: Track Software, Inc. Statement of Retained
Earnings ($000) for the Year Ended December 31, 2012

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 Integrative Case: Track
Software, Inc.
Table 5: Track
Software, Inc.
Profit, Dividends,
and Retained
Earnings, 2006–
2012

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 Integrative Case: Track
Software, Inc.
a. Upon what financial goal does Stanley seem to be focusing? Is it
the correct goal? Why or why not?
Could a potential agency problem exist in this firm? Explain.
b. Calculate the firm’s earnings per share (EPS) for each year,
recognizing that the number of shares of common stock
outstanding has remained unchanged since the firm’s inception.
Comment on the EPS performance in view of your response in
part a.
c. Use the financial data presented to determine Track’s operating
cash flow (OCF) and free cash flow (FCF) in 2012. Evaluate your
findings in light of Track’s current cash flow difficulties.

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 Integrative Case: Track
Software, Inc.
d. Analyze the firm’s financial condition in 2012 as it relates to (1)
liquidity, (2) activity, (3) debt, (4) profitability, and (5) market,
using the financial statements provided in Tables 2 and 3 and the
ratio data included in Table 5. Be sure to evaluate the firm on
both a cross-sectional and a time-series basis.
e. What recommendation would you make to Stanley regarding
hiring a new software developer? Relate your recommendation
here to your responses in part a.

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 Integrative Case: Track
Software, Inc.
f. Track Software paid $5,000 in dividends in 2012. Suppose an
investor approached Stanley about buying 100% of his firm. If
this investor believed that by owning the company he could
extract $5,000 per year in cash from the company in perpetuity,
what do you think the investor would be willing to pay for the
firm if the required return on this investment is 10%?
g. Suppose that you believed that the FCF generated by Track
Software in 2012 could continue forever. You are willing to buy
the company in order to receive this perpetual stream of free cash
flow. What are you willing to pay if you require a 10% return on
your investment?

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