Chapter 3

Time
Time Value
Value of
of
Money
Money
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
1
 Types
Types of
of Annuities
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
 Annuity Due:
Due Payments or receipts
occur at the beginning of each period.

2
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
3
 Parts
Parts of
of an
an Annuity
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

4
Each 1 Period Apart
 Parts
Parts of
of an
an Annuity
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
5
 Overview
Overview of
of an
an
Ordinary
Ordinary Annuity
Annuity --
-- FVA
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
6
 Example
Example of
of an
an
Ordinary
Ordinary Annuity
Annuity --
-- FVA
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
7
 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.
8
 Valuation
Valuation Using
Using Table
Table III
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
9
 Overview
Overview View
View ofof an
an
Annuity
Annuity Due
Due --
-- FVAD
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)
10
 Example
Example of
of an
an
Annuity
Annuity Due
Due --
-- FVAD
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
11
 Solving
Solving the
the FVAD
FVAD Problem
Problem
Inputs 3 7 0 -1,000
N I/Y PV PMT FV
Compute 3,439.94
Complete the problem the same as an “ordinary annuity”
problem, except you must change the calculator setting
to “BGN” first. Don’t forget to change back!
Step 1: Press 2nd BGN keys
Step 2: Press 2nd SET keys
Step 3: Press 2nd QUIT keys
12
 Overview
Overview of
of an
an
Ordinary
Ordinary Annuity
Annuity --
-- PVA
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
13
 Example
Example of
of an
an
Ordinary
Ordinary Annuity
Annuity --
-- PVA
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 + $816.30
14
= $2,624.32
 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.
15
 Valuation
Valuation Using
Using Table
Table IV
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
16
 Overview
Overview of
of an
an
Annuity
Annuity Due
Due --
-- PVAD
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)
17
 Example
Example of
of an
an
Annuity
Annuity Due
Due --
-- PVAD
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
18
 Valuation
Valuation Using
Using Table
Table IV
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
19
 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)
20
 Mixed
Mixed Flows
Flows Example
Example
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%.
10%

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
21
 How
How to
to Solve?
Solve?

1. Solve a “piece-at-a-time”
piece-at-a-time by
discounting each piece back to
t=0.
2. Solve a “group-at-a-time”
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.
22
 ““Piece-At-A-Time”
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
23
 ““Group-At-A-Time”
Group-At-A-Time” (#1)
(#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
24
 ““Group-At-A-Time”
Group-At-A-Time” (#2)
(#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
25
 Frequency
Frequency of
of
Compounding
Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per
Yeari: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
26
 Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+
1,000 [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
1,000 [.12/2])(2)(2)
= 1,262.48
27
 Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1+
1,000 [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+
1,000 [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+
1,000 [.12/365])(365)
(2)
= 1,271.20
28
 Solving
Solving the
the Frequency
Frequency
Problem
Problem (Quarterly)
(Quarterly)
Inputs 2(4) 12/4 -1,000 0
N I/Y PV PMT FV
Compute 1266.77

The result indicates that a $1,000

investment that earns a 12% annual
rate compounded quarterly for 2 years
will earn a future value of $1,266.77.
29
 Solving
Solving the
the Frequency
Frequency
Problem
Problem (Daily)
(Daily)
Inputs 2(365) 12/365 -1,000 0
N I/Y PV PMT FV
Compute 1271.20

The result indicates that a $1,000

investment that earns a 12% annual
rate compounded daily for 2 years will
earn a future value of $1,271.20.
30
 Effective
Effective Annual
Annual
Interest
Interest Rate
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

31
 BWs
BWs Effective
Effective
Annual
Annual Interest
Interest Rate
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
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
32
 Steps
Steps to
to Amortizing
Amortizing aa Loan
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)
33 5. Start again at Step 2 and repeat.
 Amortizing
Amortizing aa Loan
Loan Example
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)
34
R = $10,000 / 3.605 = $2,774
 Amortizing
Amortizing aa Loan
Loan Example
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]

35
 Solving
Solving for
for the
the Payment
Payment
Inputs 5 12 10,000 0
N I/Y PV PMT FV
Compute -2774.10

The result indicates that a $10,000 loan

that costs 12% annually for 5 years and
will be completely paid off at that time
will require $2,774.10 annual payments.
36
 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
37
firm.