Chapter Five

Time Value of Money

Chapter Outline

5.1 What is Time Value of Money?

5.2 Interest Rate.
5.3 Simple VS Compound Interest Rates.
5.4 Effective Interest Rate.
5.5 Number of Period.
5.6 Present Value Determination – The Discounting Process.
5.7 Future Value Determination – The Compounding Process.
5.8 Loan Amortization Model.
5.9 Sinking Fund.

5.1 What is Time Value of Money?

Figure 5.1 Time Value of Money.

The Time Value of Money is central to the concept of finance. It recognizes that the value of money is different
at different points of time. Since money can be put to productive use, its value is different depending upon
when it is received or paid. In simpler terms, the value of a certain amount of money today is more valuable
than its value tomorrow. It is not because of the uncertainty involved with time but purely on account of
timing. The difference in the value of money today and tomorrow is referred as time value of money.

Reasons for Time Value of Money

Money has time value because of the following reasons:

1. Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in our control as payments
to parties are made by us. There is no certainty for future cash inflows. Cash inflows are dependent out
on our Creditor, Bank etc. As an individual or firm is not certain about future cash receipts, it prefers
receiving cash now.
2. Inflation: In an inflationary economy, the money received today, has more purchasing power than the
money to be received in future. In other words, a rupee today represents a greater real purchasing power
than a rupee a year hence.
3. Consumption: Individuals generally prefer current consumption to future consumption.

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4. Investment opportunities: An investor can profitably employ a rupee received today, to give him a higher
value to be received tomorrow or after a certain period of time. Thus, the fundamental principle behind
the concept of time value of money is that, a sum of money received today, is worth more than if the same
is received after a certain period of time.

5.2 Interest Rate.

Interest is the cost of borrowing money. An interest rate is the cost stated as a percent of the amount
borrowed per period of time, usually one year. The prevailing market rate is composed of:

1. The Real Rate of Interest that compensates lenders for postponing their own spending during the term
of the loan.
2. An Inflation Premium to offset the possibility that inflation may erode the value of the money during
the term of the loan. A unit of money (dollar, peso, etc) will purchase progressively fewer goods and
services during a period of inflation, so the lender must increase the interest rate to compensate for that
loss..
3. Various Risk Premiums to compensate the lender for risky loans such as those that are unsecured made
to borrowers with questionable credit ratings, or illiquid loans that the lender may not be able to readily
resell.

The first two components of the interest rate listed above, the real rate of interest and an inflation premium,
collectively are referred to as the nominal risk-free rate. In the USA, the nominal risk-free rate can be
approximated by the rate of US Treasury bills since they are generally considered to have a very small risk.

5.3 Simple VS Compound Interest Rates.

Interest rate is generally defined as the cost for borrowing money. It is stated in percentage and set against
the original amount of the borrowed money or the principal. There are two types of interests. One is simple
interest while the other is compound interest. If you are planning to borrow money or to invest in the money
market, you should get a clear idea about the difference between simple and compound interest.

Simple Interest

Simple interest is calculated on the original principal only. Accumulated interest from prior periods is not
used in calculations for the following periods. Simple interest is normally used for a single period of less than
a year, such as 30 or 60 days.

Simple Interest = p * i * n

Where:

p = principal (original amount borrowed or loaned)

i = interest rate for one period
n = number of periods

Example: You borrow $10,000 for 3 years at 5% simple annual interest.

Interest = p * i * n = 10,000 * .05 * 3 = 1,500

Example 2: You borrow $10,000 for 60 days at 5% simple interest per year (assume a 365 day year).

Interest = p * i * n = 10,000 * .05 * (60/365) = 82.1917

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Compound Interest

Compound interest is calculated each period on the original principal and all interest accumulated during
past periods. Although the interest may be stated as a yearly rate, the compounding periods can be yearly,
semiannually, quarterly, or even continuously.

You can think of compound interest as a series of back-to-back simple interest contracts. The interest earned
in each period is added to the principal of the previous period to become the principal for the next period.
For example, you borrow $10,000 for three years at 5% annual interest compounded annually:

Interest year 1 = p * i * n = 10,000 * .05 * 1 = 500

Interest year 2 = (p2 = p1 + i1) * i * n = (10,000 + 500) * .05 * 1 = 525
Interest year 3 = (p3 = p2 + i2) * i * n = (10,500 + 525) *.05 * 1 = 551.25

Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25. Compare this to 1,500 earned
over the same number of years using simple interest.

The power of compounding can have an astonishing effect on the accumulation of wealth. This table shows
the results of making a one-time investment of $10,000 for 30 years using 12% simple interest, and 12%
interest compounded yearly and quarterly.

Type of Interest Principal Plus Interest Earned

Simple 46,000.00

Compounded Yearly 299,599.22

Compounded Quarterly 347,109.87

First of all, simple interest is computed based on the principal only or original amount of the borrowed
money. Compound interest on the other hand is computed periodically. The computations include the earned
interest from the principal plus the compounded interest earned over a period of time.
Simple interest is applied on loans for single periods such as 30 days or 60 days. So if you get a short term
loan for 60 days, the interest will be computed based on the original principal only. For long term loans,
lenders usually apply compound interest. The periods are pre-defined by the lender. These could be
quarterly, semi-annually, or annually. With compound interest, the interest earned during the previous
period will be added to the principal. This will become the new principal and it will earn an interest according
to the terms agreed.
You have to note that the growth of interest with simple interest calculation is constant. That is why it is the
preferred system for short-term loans. With compound interest, the growth is exponential because the
principal is getting bigger each period. Compounding interest is the fastest way to accumulate wealth so this
is the preferred system of lenders and investors.
Simple interest and compound interest are radically different from each other. The former is usually applied
to short-term loans while the latter is used for long term loans and investments. As a savings account holder,
I would prefer compound interest rate concept because it will give me higher future value.

5.4 Effective Interest Rate.

The effective interest rate, effective annual interest rate, annual equivalent rate (AER) or simply effective rate
is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate

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with annual compound interest payable in arrears. It is used to compare the annual interest between loans
with different compounding terms (daily, monthly, annually, or other).

The effective interest rate differs in two important respects from the annual percentage rate (APR):
 The effective interest rate generally does not incorporate one-time charges such as front-end fees;
 The effective interest rate is (generally) not defined by legal or regulatory authorities (as APR is in
many jurisdictions).

By contrast, the effective APR is used as a legal term, where front-fees and other costs can be included, as
defined by local law. Annual percentage yield or effective annual yield is the analogous concept used for
savings or investment products, such as a certificate of deposit. Since any loan is an investment product for
the lender, the terms may be used to apply to the same transaction, depending on the point of view. Effective
annual interest or yield may be calculated or applied differently depending on the circumstances, and the
definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after
expected losses as its effective yield and include income from other fees, meaning that the interest paid by
each borrower may differ substantially from the bank’s effective yield. The effective interest rate is calculated
as if compounded annually. The effective rate is calculated in the following way, where r is the effective
annual rate, i the nominal rate, and n the number of compounding periods per year (for example, 12 for
monthly compounding):

For example, a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of
6.17%. 6% compounded monthly is credited as 6%/12 = 0.005 every month. After one year, the initial capital
is increased by the factor (1 + 0.005)12 ≈ 1.0617. When the frequency of compounding is increased up to
infinity the calculation will be:

Effective Annual Rate Based on Frequency of Compounding

Nominal Rate Semi-Annual Quarterly Monthly Daily Continuous
1% 1.002% 1.004% 1.005% 1.005% 1.005%
5% 5.062% 5.095% 5.116% 5.127% 5.127%
10% 10.250% 10.381% 10.471% 10.516% 10.517%
15% 15.563% 15.865% 16.075% 16.180% 16.183%
20% 21.000% 21.551% 21.939% 22.134% 22.140%
30% 32.250% 33.547% 34.489% 34.969% 34.986%
40% 44.000% 46.410% 48.213% 49.150% 49.182%
50% 56.250% 60.181% 63.209% 64.816% 64.872%

The effective interest rate is a special case of the internal rate of return. If the monthly interest rate j is
known and remains constant throughout the year, the effective annual rate can be calculated as follows:

5.5 Number of Period.

The variable n in Time Value of Money formulas represents the number of periods. It is intentionally not
stated in years since each interval must correspond to a compounding period for a single amount or a
payment period for an annuity. The interest rate and number of periods must both be adjusted to reflect the
number of compounding periods per year before using them in TVM formulas. For example, if you borrow
$1,000 for 2 years at 12% interest compounded quarterly, you must divide the interest rate by 4 to obtain
rate of interest per period (i = 3%). You must multiply the number of years by 4 to obtain the total number
of periods (n = 8).

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You can determine the number of periods required for an initial investment to grow to a specified amount
with this formula:

number of periods = natural log [(FV * i) / (PV * i)] / natural log (1 + i)

Where:
PV = present value, the amount you invested
FV = future value, the amount your investment will grow to
i = interest per period

Example: You put $10,000 into a savings account at a 9.05% annual interest rate compounded annually.
How long will it take to double your investment?

LN [(20,000 * .0905) / (10,000 * .0905)] / LN (1 .0905) =

LN (2) / LN (1.0905) =.69314 /. 08663 = 8 years

5.6 Present Value Determination – The Discounting Process.

Present Value is an amount today that is equivalent to a future payment, or series of payments, that has been
discounted by an appropriate interest rate. The future amount can be a single sum that will be received at the
end of the last period, as a series of equally-spaced payments (an annuity), or both. Since money has time
value, the present value of a promised future amount is worth less the longer you have to wait to receive it.
Present Value describes the process of determining what a cash flow to be received in the future is worth in
today's dollars. Therefore, the Present Value of a future cash flow represents the amount of money today
which, if invested at a particular interest rate, will grow to the amount of the future cash flow at that time in
the future. The process of finding present values is called Discounting and the interest rate used to calculate
present values is called the discount rate.

A) Present Value of a Single Amount:

PV = FV/ (1+i) n
Where:
PV = Present Value.
FV = Future Value.
i = Interest rate or required rate of return or discount rate or opportunity cost.
n = Number of years.
Example: You want to buy a house 5 years from now for $150,000. Assuming a 6% interest rate
compounded annually, how much should you invest today to yield $150,000 in 5 years?

FV = 150,000
i =.06
n=5

PV = 150,000 [ 1 / (1 + .06)5 ] = 150,000 (1 / 1.3382255776) = 112,088.73

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 End of Year 1 2 3 4 5

Principal 112,088.73 118,814.05 125,942.89 133,499.46 141,509.43

Interest 6,725.32 7,128.84 7556.57 8,009.97 8,490.57

Total 118,814.05 125,942.89 133,499.46 141,509.43 150,000.00

Example: You find another financial institution that offers an interest rate of 6% compounded
semiannually. How much less can you deposit today to yield $150,000 in five years?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a
rate per period of 3%. Since there are two compounding periods per year, you must multiply the
number of years by two to obtain the total number of periods.

FV = 150,000
i = .06 / 2 = .03
n = 5 * 2 = 10

PV = 150,000 [ 1 / (1 + .03)10] = 150,000 (1 / 1.343916379) = 111,614.09

B) Present Value of Multiple Cash Flows [ Unequal Cash Flows]

 Cash Flows received/paid at the end of period:
PV = CF1/ (1+i) + CF2/ (1+i) 2 + CF3/ (1+i) 3 + ………………………….. + CFn/(1+i)n
Example: What would be the present value of the following cash flows received at the end of period
assuming a discount rate of 11%?

Years 1 2 3 4
Cash Flows $ 50,000 45,000 65,000 48,000

PV = CF1/ (1+i) + CF2/ (1+i) 2 + CF3/ (1+i) 3 + + CF4/ (1+i) 4

PV = $50,000/ (10.11) +45,000/ (1+0.11) 2 +65,000/ (1+0.11) 3 + + 48,000/ (1+0.11) 4
PV = $ 161, 880.14.

 Cash Flows received/paid at the beginning of period:

PV = CF0 + CF1/ (1+i) + CF2/ (1+i) 2 + CF3/ (1+i) 3 + ………………………….. + CFn/(1+i)n
Example: What would be the present value of the following cash flows received at the beginning of the
year assuming a discount rate of 11%?

Years 1 2 3 4
Cash Flows $ 50,000 45,000 65,000 48,000

PV = CF0 + CF1/ (1+i) + CF2/ (1+i) 2 + CF3/ (1+i) 3

PV = $50,000 +45,000/ (1+0.11) + 65,000/ (1+0.11) 2 +48,000/ (10.11i) 3
PV = $ 178, 393.19.

C) Present Value of Multiple Cash Flows (Equal Cash Flows – Annuity)

Annuities are essentially series of fixed payments required from you or paid to you at a specified
frequency over the course of a fixed period of time. The most common payment frequencies are yearly
(once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month).
There are two basic types of annuities: ordinary annuities and annuities due.

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  Ordinary Annuity: Payments are required at the end of each period. For example, straight bonds
usually pay coupon payments at the end of every six months until the bond's maturity date.

 Annuity Due: Payments are required at the beginning of each period. Rent is an example of
annuity due. You are usually required to pay rent when you first move in at the beginning of the
month, and then on the first of each month thereafter.

 Present Value of Annuity Ordinary:

Where,
C = Cash Flows.
i= Interest rate.
N = Number of years.

Example: Suppose you will receive $1,000 at the end of each year for the next 5 years where the
interest rate is 5%. The present value of this cash flows:

Again, calculating and adding all these values will take a considerable amount of time, especially if we
expect many future payments. As such, there is a mathematical shortcut we can use for PV of ordinary
annuity.

The formula provides us with the PV in a few easy steps. Here is the calculation of the annuity
represented in the diagram for Example 2:

= $1000*[4.33]
= $4329.48

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  Present Value of Annuity Due:

Example: Suppose you will receive $1,000 at the beginning of each year for the next 5 years where the
interest rate is 5%. The present value of this cash flows:

Therefore,

= $1000*4.33*1.05
= $4545.95

D) Present Value of Growing Annuity:

A growing annuity, is a stream of cash flows for a fixed period of time, t, where the initial cash flow, C, is
growing (or declining, i.e., a negative growth rate) at a constant rate g. If the interest rate is denoted
with r, we have the following formula for the present value (=price) of a growing annuity:

PV = C [1/(r-g) - (1/(r-g))*((1+g)/(1+r))t ],
where:

PV = Present Value of the growing annuity

C = Initial cash flow
r = Interest rate
g = Growth rate
t = # of time periods

Example: Suppose you have just won the first prize in a lottery. The lottery offers you two possibilities
for receiving your prize. The first possibility is to receive a payment of $10,000 at the end of the year,
and then, for the next 15 years this payment will be repeated, but it will grow at a rate of 5%. The
interest rate is 12% during the entire period. The second possibility is to receive $100,000 right now.
Which of the two possibilities would you take?

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 You want to compare the PV of the growing annuity to the PV of receiving $100,000 right now (which is,
obviously just $100,000). So, here are the numbers:

C = $10,000
r = 0.12
g = 0.05
t = 16

PV = 10,000 [(1/0.07) - (1/0.07)*(1.05/1.12)16] = $91,989.41 < $100,000, therefore, you would prefer to
be paid out right now.
E) Perpetuity:

Perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are
few actual perpetuities in existence (the United Kingdom (UK) government has issued them in the past;
these are known and still trade as consols). A number of types of investments are effectively
perpetuities, such as real estate and preferred stock, and techniques for valuing perpetuity can be
applied to establish price. Perpetuities are but one of the time value of money methods for valuing
financial assets. Perpetuities are a form of ordinary annuities.
PV = C/r
Example: What would you be willing to pay (given that you could live forever and hence could receive
all the cash flows) for a preferred share of stock in the University of Pittsburgh that promises you to pay
a cash dividend to you at the end of the year of $25 forever? The interest rate is fixed at 4.75%.

PV = $25 / 0.0475
PV = $526.32

F) Growing Perpetuity:

A growing perpetuity is the same as a regular perpetuity (C/r), but just like we saw above, the cash flow
is growing (or declining) each year. Perpetuity has no limit to the number of cash flows, it will go
indefinitely. The growing perpetuity is in that way just the same as a growing annuity with an
extremely large t.

PV = C / (r-g),
where:

PV = Present Value of the growing perpetuity

C = Initial cash flow
r = Interest rate
g = Growth rate

Example: What would you be willing to pay (given that you could live forever, and hence could receive
all the cash flows) for a preferred share of stock in the University of Pittsburgh, that promises you to pay
a cash dividend to you at the end of the year of $25, which will increase every year by 1%, forever. The
interest rate is fixed at 4.75%.

PV = 25 / (0.0475 - 0.01) = $666.67

5.7 Future Value Determination – The Compounding Process.

Future Value is the amount of money that an investment with a fixed, compounded interest rate will grow to
by some future date. The investment can be a single sum deposited at the beginning of the first period, a
series of equally-spaced payments (an annuity), or both. Since money has time value, we naturally expect the

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future value to be greater than the present value. The difference between the two depends on the number of
compounding periods involved and the going interest rate.

A) Future Value of a Single Amount:

FV = PV (1+i)n

Example: You can afford to put $10,000 in a savings account today that pays 6% interest compounded
annually. How much will you have 5 years from now if you make no withdrawals?

PV = 10,000
i = .06
n=5

FV = 10,000 (1 + .06)5 = 10,000 (1.3382255776) = 13,382.26

End of Year 1 2 3 4 5

Principal 10,000.00 10,600.00 11,236.00 11,910.16 12,624.77

Interest 600.00 636.00 674.16 714.61 757.49

Total 10,600.00 11,236.00 11,910.16 12,624.77 13,382.26

Example: Another financial institution offers to pay 6% compounded semiannually. How much will
your $10,000 grow to in five years at this rate?

Interest is compounded twice per year so you must divide the annual interest rate by two to obtain a
rate per period of 3%. Since there are two compounding periods per year, you must multiply the
number of years by two to obtain the total number of periods.

PV = 10,000
i = .06 / 2 = .03
n = 5 * 2 = 10

FV = 10,000 (1 + .03)10 = 10,000 (1.343916379) = 13,439.16

B) Future Value of Multiple Cash Flows [Unequal Cash Flows]:

 Cash Flows received/paid at the end of period:

FV = CF1(1+i)n-1 + CF2(1+i)n-2 + CF3(1+i)n-3 +………………………..+ CFn(1+i)n-n

Example: Consider the following year-end cash flows & calculate the future value assuming an interest
rate of 12%.

Years 1 2 3 4
Cash Flows $7,500 $ 8,000 $ 12,000 $ 9,000

FV = CF1(1+i)n-1 + CF2(1+i)n-2 + CF3(1+i)n-3 + CF4(1+i)n-4

FV = $ 7,500(1+0.12)4-1 +$8,000(1+0.12)4-2 + $ 12,000(1+0.12)4-3 + $ 9,000(1+0.12)4-4
FV = $ 43,012.16.

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  Cash Flows received/paid at the beginning of the period:

FV = CF1(1+i)n + CF2(1+i)n-1 + CF3(1+i)n-2 + CF4(1+i)n-3 +………………………..+ CFn(1+i)1

Example: Consider the following flows received at the beginning of each year & calculate the future
value assuming an interest rate of 12%.
FV = CF1(1+i)n + CF2(1+i)n-1 + CF3(1+i)n-2 + CF4(1+i)n-3
FV = $ 7,500(1+0.12)4 +$ 8,000(1+0.12)4-1 +$ 12,000(1+0.12)4-2 + $ 9,000(1+0.12)4-3
FV = $ 48,173.62.

C) Future Value of Multiple Cash Flows [Equal Cash Flows – Annuity]:

 Cash Flows received/paid at the end of period (Future Value of an Annuity Ordinary)

FVA = CF [ { (1+i) n - 1}/i]

Example: What amount will accumulate if we deposit $5,000 at the end of each year for the next 5
years? Assume an interest of 6% compounded annually.

PV = 5,000
i = .06
n=5

FVoa = 5,000 [ (1.3382255776 - 1) /.06 ] = 5,000 (5.637092) = 28,185.46

Year 1 2 3 4 5

Begin 0 5,000.00 10,300.00 15,918.00 21,873.08

Interest 0 300.00 618.00 955.08 1,312.38

Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00

End 5,000.00 10,300.00 15,918.00 21,873.08 28,185.46

 Cash Flows Received/Paid at the beginning of Period (Future Value of an Annuity Due):

FVA = CF [ { (1+i) n - 1}/i] X (1+i)

Example: What amount will accumulate if we deposit $5,000 at the beginning of each year for the next
5 years? Assume an interest of 6% compounded annually.

PV = 5,000
i = .06
n=5

FVoa = 28,185.46 (1.06) = 29,876.59

Year 1 2 3 4 5

Begin 0 5,300.00 10,918.00 16,873.08 23,185.46

Deposit 5,000.00 5,000.00 5,000.00 5,000.00 5,000.00

Interest 300.00 618.00 955.08 1,312.38 1,691.13

End 5,300.00 10,918.00 16,873.08 23,185.46 29,876.59

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D) Future Value of Growing Annuity:

Example: An example of the future value of a growing annuity formula would be an individual who is
paid biweekly and decides to save one of her extra paychecks per year. One of her net paychecks
amounts to $2,000 for the first year and she expects to receive a 5% raise on her net pay every year. For
this example, we will use 5% on her net pay and not involve taxes and other adjustments in order to
hold all other things constant. In an account that has a yield of 3% per year, she would like to calculate
her savings balance after 5 years. The growth rate in this example would be the 5% increase per year,
the initial cash flow or payment would be $2,000, the number of periods would be 5 years, and rate per
period would be 3%. Using these variables in the future value of growing annuity formula would show

After solving this equation, the amount after the 5th cash flow would be $11,700.75.

E) Continuously Compounding:
FV = ei.t
Example: An amount of $2,340.00 is deposited in a bank paying an annual interest rate of 3.1%,
compounded continuously. Find the balance after 3 years.

FV = $2,340 e 0.031 X 3
FV = $ 2,568.06.

5.8 Loan Amortization Model.

In lending, amortization is the distribution of payment into multiple cash flow installments, as determined by
an amortization schedule. Unlike other repayment models, each repayment installment consists of both
principal and interest. Amortization is chiefly used in loan repayments (a common example being a mortgage
loan) and in sinking funds. Payments are divided into equal amounts for the duration of the loan, making it
the simplest repayment model. A greater amount of the payment is applied to interest at the beginning of the
amortization schedule, while more money is applied to principal at the end. Commonly it is known as EMI or
Equated Monthly Installment.

The formula for calculating the payment amount is shown below.

Where
 A = payment Amount per period
 P = initial Principal (loan amount)
 r = interest rate per period
 n = total number of payments or periods

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Example: What would the monthly payment be on a 5-year, $20,000 car loan with a nominal 7.5% annual
interest rate? We'll assume that the original price was $21,000 and that you've made a $1,000 down payment.

P = $20,000
r = 7.5% per year / 12 months = 0.625% per period
n = 5 years * 12 months = 60 total periods

A = $ 20,000 X [0.00625 (1 + 0.00625)60] / (1 + 0.00625)60 – 1

A = $ 400.76.

Table 5.1 Loan Amortization Schedule.

5.9 Sinking Fund.

A sinking fund is a fund established by a government agency or business for the purpose of reducing debt by
repaying or purchasing outstanding loans and securities held against the entity. It helps keep the borrower
liquid so it can repay the bondholder. In modern finance, a sinking fund is a method by which an organization
sets aside money over time to retire its indebtedness. More specifically, it is a fund into which money can be
deposited, so that over time its preferred stock, debentures or stocks can be retired. The amount invested in a
sinking fund can also be used for purchasing various assets for the company. The companies put some money
into sinking fund account and after some years when the asset (like machinery) becomes old the company
can use this money for purchasing the new asset.
A sinking fund may operate in one or more of the following ways:
I. The firm may repurchase a fraction of the outstanding bonds in the open market each year.
II. The firm may repurchase a fraction of outstanding bonds at a special call price associated with the
sinking fund provision (they are callable bonds).
III. The firm has the option to repurchase the bonds at either the market price or the sinking fund price,
whichever is lower. To allocate the burden of the sinking fund call fairly among bondholders, the
bonds chosen for the call are selected at random based on serial number. The firm can only
repurchase a limited fraction of the bond issue at the sinking fund price. At best some indentures
allow firms to use a doubling option, which allows repurchase of double the required number of
bonds at the sinking fund price.
A less common provision is to call for periodic payments to a trustee, with the payments invested so that the
accumulated sum can be used for retirement of the entire issue at maturity: instead of the debt amortizing
over the life, the debt remains outstanding and a matching asset accrues. Thus the balance sheet consists of
Asset = Sinking fund, Liability = Bonds.

FVA = CF [{(1+i)-n - 1}/i]

CF = [{(1+i)-n - 1}/i]/ FVA

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Example: If a loan amount of $ 10,000 will be repaid within 5 years at 10% interest rate, prepare a Sinking
Fund Table.

CF = [{(1+i)-n - 1}/i]/ FVA

CF = [{(1 + 0.10)5 - 1}/ 0.10] $10,000
CF = $ 1637.97.

Yearly interest on principal amount = $ 10,000 X 10% = $ 1,000.

Sinking Fund For A $10,000 5 Year Loan At 10% Interest

Year Interest Paid On Sinking Fund Interest Sinking Fund Net Loan
Loan Deposit Earned On
Sinking Fund
0 ------- ------- ------- ------- 10,000.00

1 1,000.00 1,637.97 ------- 1,637.97 8,362.03

2 1,000.00 1,637.97 163.80 3,439.75 6,560.25

3 1,000.00 1,637.97 343.97 5,421.70 4,578.30

4 1,000.00 1,637.97 542.17 7,601.84 2,398.16

5 1,000.00 1,637.97 760.18 10,000.00 0.00

Example: If a loan amount of $ 10,000 will be repaid within 5 years at 10% interest rate but sinking fund
earning is 8%, prepare a Sinking Fund Table.

Sinking Fund For A $10,000 5 Year Loan At 10% Interest But Sinking Fund Earning 8%

Year Interest Paid On Sinking Fund Interest Sinking Fund Net Loan
Loan Deposit Earned On
Sinking Fund
0 ------- ------- ------- ------- 10,000.00

1 1,000.00 1,704.56 1,704.56 8,295.44

2 1,000.00 1,704.56 136.37 3,545.49 6,454.51

3 1,000.00 1,704.56 283.64 5,533.70 4,466.30

4 1,000.00 1,704.56 442.70 7,680.96 2,319.04

5 1,000.00 1,704.56 614.48 10,000.00 0.00

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 Self-Test Questions
5.1 Explain the relationship between present value & compound value.
5.2 Define an Annuity. Distinguish between an ordinary annuity & an annuity due.
5.3 Explain why all present value factors must be less than 1.0.
5.4 Explain the effects of time & discount rates on present value.
5.5 Under what condition is the future value always equal to its present value no matter when the sum is
received?
5.6 Distinguish between ‘stated annual interest rate’ & ‘effective annual interest rate’.
5.7 How is perpetuity related to an annuity?
5.8 Explain the relationship between ek & (1 + k).
5.9 In most time value of money problems, we add 1.0 to the interest rate before doing anything else.
What is the exception to this procedure?
5.10 Define & distinguish between Loan Amortization & Sinking Fund model.

PROBLEMS
5.1 If an investor deposits $100,000 today, how much will she have 10 years from today if she earns an
annual interest rate of (A) 6%, (B) 8%, and (C) 10%?
5.2 What is the present value of a $750,000 payment that is expected to be received 20 years from today
assuming an annual discount rate of (a) 6%, (b) 8%, and (c) 10%?
5.3 To settle a legal dispute, Lemon Inc. has agreed to pay damages to a competitor of $1.25 million one
year from today, $1.5 million two years from today, and $1.75 million three years from today. At a
discount rate of 6%, what is the present value of the settlement payments?
5.4 Janzen Corp plans to deposit $2 million at the end of each of the next 15 years into a sinking fund
account in order to have sufficient funds to retire a large bond issue. If Janzen can earn 8% per year
on these funds, how much will the firm have in the sinking fund account 15 years from today?
5.5 To fund a future large capital expenditure, Lexor Inc. deposited $1 million today and plans to also
deposit $500,000 at the end of each year for the next eight years. If Lexor can earn 9% annual return
on these deposits, how much will the firm accumulate eight years from today?
5.6 Xylar Company promises to pay a retiring employee $10,000 at the end of each year for the next four
years followed by $15,000 at the end of each year for six more years. What is the present value of
these future cash flows assuming a discount rate of 9%?
5.7 A small firm has recently invested $50,000. If the firm expects to receive a return of 10% per year,
compounded semi-annually, on this investment, what will be the future value of the investment five
years from today? What if interest is compounded quarterly?
5.8 An investor currently has $25,000 in his investment account. He plans to deposit an additional $1,000
at the end of each month for the next four years. If he can earn 9% per year, compounded monthly,
how much will the account be worth four years from now?
5.9 Generous Motors is offering its customers two financing choices on its popular line of Ventura
automobiles. Under Option A, customers receive a $1,000 rebate. Under Option B, customers receive a
special financing rate of 2.4% per year, compounded monthly. Assume a customer who chooses
Option A can finance the full purchase price of the car over a four-year period at an interest rate of 9%
per year, compounded monthly. Assume the customer will purchase the car and keep it for four years
and can finance the entire purchase price.
i. Assume the purchase price of the new car is $20,000 and the customer plans to keep the car
for the entire four years. Which option should you choose?
ii. What rebate amount would make the customer indifferent between Option A and Option B?
5.10 Find the future value of the following income stream as of Year 30, assuming that the appropriate
interest rate is 15% per year.

Year 1 2 through 9 10 11 through 30

Income $450 $ 560 per year $875 $ 670 per year

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5.11 Calculate the present value & then future value at the end of period 6 for each of the following cash
flows streams. Assume an interest rate of 8%.

Period 1 2 3 4 5 6
A $400 $400 $400 $400 $500 $500
B $375 $375 $375 $375 $375 $375
C $150 $240 $220 $175 $230 $180
D $450 $450 -$185 $90 $240 $270

5.12 Having just won a crossword puzzle contest, you may take your prize in any of three cash flow
patterns. If money is worth 20% per year to you, which pattern would you most prefer? Which
pattern would you least prefer?

Year
Pattern 1 2 3 4 5
A $200 $200 $200 $200 $200
B 0 0 $1,000 0 0
C 0 0 $400 $400 $400

5.13 Benison & Hedges manufactures & sells a popular chewing tobacco. The company receives about a
$20,000 cash flow each year from the product after all expenses, including taxes. Harris Cigars
recently offered to buy the product for $160,000. assuming Benison & Hedges’ discount rate is 10%,
should they sell the product if they think its estimated life expectancy is:
i. 15 years.
ii. Indefinitely long?
5.14 How much money must be invested each year in a sinking fund earning 7% per annum in order to
have $30,000 accumulated after 15 years?
5.15 A man must pay back a debt of $40,000 in a lump sum after five years. Suppose, instead, the loan
were repaid in semiannual payments, the first due six months from now & the last at loan termination.
What would be the amount of each installment if money is worth 12% compounded semiannually?
5.16 Your great-uncle Claude is 82 years old. Over the years, he has accumulated savings of $80,000. He
estimates that he will live another 10 years at the most and wants to spend his savings by then. (If he
lives longer than that, he figures you will be happy to take care of him.) Uncle Claude places his
$80,000 into an account earning 10 percent annually and sets it up in such a way that he will be
making 10 equal annual withdrawals (the first one occurring 1 year from now) such that his account
balance will be zero at the end of 10 years. How much will he be able to withdraw each year?
5.17 Your mother is planning to retire this year. Her firm has offered her a lump sum retirement payment
of $50,000 or a $6,000 lifetime ordinary annuity-whichever she chooses. Your mother is in reasonably
good health and expects to live for at least 15 more years. Which option should she choose, assuming
that an 8 percent annual interest rate is appropriate to evaluate the annuity?
5.18 A life insurance company has offered you a new "cash grower" policy that will be fully paid up when
you turn 45. At that time, it will have a cash surrender value of $18,000. When you turn 65, the policy
will have a cash surrender value of $37,728. What annual rate of interest is the insurance company
promising you on your investment?
5.19 John is considering the purchase of a lot. He can buy the lot today and expects the price to rise to
$15,000 at the end of 10 years. He believes that he should earn an investment yield of 10 percent
annually on this investment. The asking price for the lot is $7,000. Should he buy it? What is the
annual yield (internal rate of return) of the investment if John purchases the property for $7,000 and
is able to sell it 10 years later for $15,000?
The Dallas Development Corporation is considering the purchase of an apartment project for
$100,000. They estimate that they will receive $15,000 at the end of each year for the next 10 years.
At the end of the 10th year, the apartment project will be worth nothing. If Dallas purchases the
project, what will be its internal rate of return? If the company insists on a 9 percent return
compounded annually on its investment, is this a good investment?
5.20 You are considering the purchase of an investment that is expected to generate cash flows of $15,000
per year for the next five years. After that, cash flows are expected in increase at the rate of 5 percent
per year for the indefinite future. Thus, in year 6 the cash flow will be $15,750, etc. How much is this
investment worth to you today if your required return is 15 percent?

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5.21 A company raises $75,000 loan at a 10% annual interest rate. The interest payment is $10,000 each
year. The principal of the loan – i.e. $75,000, must be repaid at the end of 5 years. The company
decides to provide for this repayment by setting up a sinking fund, into which it can afford to put
$12,000 per annum every year for 5 years, starting at the end of the first year. Interest earned in the
sinking fund will be 9%.
i. Will the sinking fund be large enough at the end of 5 years to repay the loan?
ii. If not, what should be the annual payment into the fund?
5.22 Mr. Joy is 60 years old, & a life insurance agent is trying to interest him in an annuity that would pay
$1,000 per year (payable once a year) for 15 years.
i. What would be the maximum amount Mr. Joy should pay for this annuity today, assuming his
time value of money is 8% & the first payment begins in one year?
ii. How much should Mr. Joy spend if his first payment arrives in five years?
iii. Suppose that Mr. Joy buys the annuity that begins paying after one year. Immediately after
receiving the eighth payment, he attempts to sell the remainder of the annuity to a third
party. What is the maximum price Mr. Joy should accept if his time value of money is
unchanged?
iv. What minimum rice would be acceptable if he decided instead to sell the remainder of the
annuity immediately before the eighth payment?
5.23 Calculate the Present Value of the following mixed Streams assuming discount rate is 12%,
Years Cash Flows
1 through 5 $6,000 per year
6 through 9 $5,000 per year
10 through 15 $8,000 per year
5.24 You are planning to save for retirement over the next 30m years. To do this, you will invest $700 a
month in a stock account and $300 a month in a bond account. The return of the stock account is
expected to be 10 %, and the bond account will pay 6%. When you retire you will combine your
money into an account with an 8% return. How much can you withdraw each month from your
account assuming a 25 year withdrawal period?
5.25 Mark Weinstein has been working on a advanced technology in laser eye surgery. His technology will
be available in the near term. He anticipates his first annual cash flow from the technology to be
$215,000, received two years from today. Subsequent annual cash flows will grow at 4% in
perpetuity. What is the present value of the technology if the discount rate is 10%?
5.26 Audrey Sanborn has just arranged to purchase a $450,000 vacation home in the Bahamas with a 20%
down payment. The mortgage has a 7.5% stated annual interest rate, compounded monthly, and calls
for equal monthly payments over the next 30 years. Her first payment will be due one month from
now. However the mortgage has an eight year balloon payment, meaning that the balance of the loan
must be paid off at the end of year 8. There were no other transaction costs or finance charges. How
much will Audrey’s balloon payment be in eight years?
5.27 Southern California Publishing Company is trying to decide whether to revise its popular textbook,
Financial Psychoanalysis Made Simple. The company has estimated that the revision will cost $65,000.
Cash flows from increased sales will be $18,000 the first year. These cash flows will increase by 4%
per year. The book will go out of print five years from now. Assume that the initial cost is paid now
and revenues are received at the end of each year. If the company requires an 11% return for such an
investment, should it undertake the revision?
5.28 Your job pays you only once a year for all the work you did over the previous 12 months. Today,
December 31, you just received your salary of $60,000 and you plan to spend all of it. However, you
want to start saving for retirement beginning next year. You have decided that one year from today
you will begin depositing 5% of your annual salary in an account that will earn 9% per year. Your
salary will increase at 4% per year throughout your career. How much money will you have on the
date of your retirement 40 years from today?
5.29 You need a 30 year, fixed rate mortgage to buy a new home for $250,000. Your mortgage bank will
lend you the money at a 6.8% APR for this 360 month load. However you can only afford monthly
payments of $1,200, so you offer to pay off any remaining loan balance at the end of the loan in the
form of a single balloon payment. How large will this balloon payment have to be for you to keep your
monthly payments at $1,200?
5.30 Suppose you are going to receive $10,000 per year for five years. The appropriate interest rate is 11%.
a) What is the present value of the payments if they are in the form of an ordinary

17
 annuity? What is the present value if the payments are an annuity due?
b) Suppose you plan to invest the payments for five years. What is then future value if
the payments are an ordinary annuity? What if the payments are an annuity due?
c) Which has the highest present value, the ordinary annuity or annuity due? Which has
the highest future value? Will this always be true?
5.31 You are saving for the college education of your two children. They are two years apart in age; one
will begin college 15 years from today and the other will begin 17 years from today. You estimate
your children’s college expenses to be $35,000 per year per child, payable at the beginning of each
school year. The annual interest rate is 8.5%. How much money must you deposit in an account each
year to fund your children’s education? Your deposits will begin one year from today. You will make
your last deposit when your oldest child enters college. Assume four years of college.
5.32 Tom Adams has received a job offer from a large investment bank as a clerk to an associate banker.
His base salary will be $ 45,000.He will receive his first annual salary payment one year from the day
he begins to work. In addition, he will get an immediate $10,000 bonus for joining the company. His
salary will grow at 3.5% each year. Each year he will receive a bonus equal to 10% of his salary. Mr.
Adams is expected to work for 25 years. What is the present value of the offer if the discount rate is
12%?
5.33 You have recently won the super Jackpot in the Washington State Lottery. On reading the fine print,
you discover that you have the following two options:
d) You will receive 31 annual payments of $175,000, with the first payment being
delivered today. The income will be taxed at a rate of 28%.Taxes will be withheld
when the checks are issued.
e) You will receive $530,000 now, and you will not have to pay taxes on this amount. In
addition, beginning one year from today, you will receive $125,000 each year for 30
years. The cash flows from this annuity will be taxed at 28%.
Using a discount rate of 10%, which option should you select?
5.34 You have 30 years left until retirement and want to retire with $1.5 million. Your salary is paid
annually and you will receive $70,000 at the end of the current year. Your salary will increase at 3%
per year, and you can earn a 10% return on the money you invest. If you safe a constant percentage of
your salary, what percentage of your salary must you save each year?
5.35 On September 1, 2007, Susan Chao bought a motorcycle for $25,000. She paid $1,000 down and
financed the balance with a five year loan at a stated annual interest rate of 8.4%, compounded
monthly. She started the monthly payments exactly one month after the purchase (i.e., October 1,
2007). Two years later at the end of October 2009, Susan got a new job and decided to pay off the
loan. If the bank charges her a 1% prepayment penalty based on the loan, how much must she pay the
bank on November 1, 2009?
5.36 Bilbo Baggins wants to save money to meet three objectives. First, he would like to be able to retire 30
years from now with a retirement income of $20,000per month for 20 years, with the first payment
received 30 years and 1 month from now. Second, he would like to purchase a cabin in Rivendell in 10
years at an estimated cost of $320,000. Third, after he passes on at the end of the 20 years of
withdrawals, he would like to leave an inheritance of $1,000,000 to his nephew Frodo. He can afford
to save $1,900 per month for the next 10 years. If he can earn an 11% EAR, before he retires and an
8% EAR after he retires, how much will he have to save each month in years 11 through 30?
5.37 Mr. Jeffrey has taken a loan from Natwest bank amounting $500,000 for 5 years to buy a luxury car.
Annual interest rate for the loan is 14%. Prepare a “Loan Amortization Schedule” for 5 years
assuming the installments are paid on annual basis.
5.38 Your brother has just completed A-level & he is seeking for your advice to choose his best career. He
has following two options:
 He could enroll in B.Sc in Architecture where he will have to spend $18,000 per year for the
next 4 years. After that, he will have to work as a trainee Architecture in a firm for three years
which will give him $21,000 per year as honorarium. Then he will pursue for M.Sc in
Architecture where he will have to spend $19,000 per year for another 2 years. After
completing his Masters, he is expecting to join in an Architecture firm in a full-time position
which will give him $35,000 per year for the next 25 years. His annual salary as a full-time
employee will grow at a rate of 6% per year for the next 25 years.
 He could enroll in the ACCA program which will cost him $12,000 per year for the next 3
years. After successful completion of ACCA program, he will have to work as a trainee

18
 accountant for three years which will give him $12,000 per year. Then he can start his own
Audit firm which will earn $35,000 (expected) per year for the next 30 years.

The difficulty level for both the programs are assumed to be the same & your brother is only
considering the net benefit. If the opportunity cost is 11%, determine which of the above option
would you recommend?
5.39 You are 35 today & are expecting to retire at the age of 60. A physic told you would die at the age of
75. You want to have a retirement plan today so that it will give you a retirement benefit of $30,000
per year for 15 years between your retirement & death.
i. How much money will you need at the time of retirement to get that $30,000 per year
benefits? Your opportunity cost is 12%.
ii. How much money you need today as a single amount to have that money at the time of
retirement? You will earn 9% interest rate.
iii. How much money you need to deposit every year to get that amount at the time of
retirement? The opportunity cost is 10%.
5.40 Hal Thomas, a 25-year old college graduate, wishes to retire at age 65. To supplement other sources
of retirement income, he can deposit $2,000 each year into a tax-deferred individual retirement
arrangement. The IRA will be invested to earn an annual return of 10%, which is assumed to be
attainable over the next 40 years:
I. If Hal makes annual end-of-year $2,000 deposits into the IRA, how much will he have
accumulated by the end of his 65th year?
II. If Hal decides to wait until age 35 to begin making annual end-of-year $2,000 deposits into the
IRA, how much will he have accumulated by the end of his 65th year.
III. Using your findings in part I & II, discuss the impact of delaying making deposits into the IRA
for 10 years.

Mini Case

Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the
bank’s evaluation process, you have been asked to take an examination that covers several financial analysis
techniques. The first section of the test addresses discounted cash flow analysis. See how you would do by
answering the following questions.

(A) Draw time lines for (a) a $100 lump sum cash flow at the end of Year 2, (b) an ordinary annuity of
$100 per year for 3 years, and (c) an uneven cash flow stream of _$50, $100, $75, and $50 at the end
of Years 0 through 3.
(B) (1) What is the future value of an initial $100 after 3 years if it is invested in an account paying 10
percent annual interest?
(2) What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10
percent?
(C) We sometimes need to find how long it will take a sum of money (or anything else) to grow to some
specified amount. For example, if a company’s sales are growing at a rate of 20 percent per year,
how long will it take sales to double?
(D) If you want an investment to double in three years, what interest rate must it earn?
(E) What is the difference between an ordinary annuity and an annuity due? What type of annuity is
shown below? How would you change it to the other type of annuity?
(F) (1) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is
10 percent?
(2) What is the present value of the annuity?
(3) What would the future and present values be if the annuity were an annuity due?
(G) What is the present value of the following uneven cash flow stream? The appropriate interest rate is
10 percent, compounded annually.
(H) (1) Define (a) the stated, or quoted, or nominal rate and (b) the periodic rate .

19
 (2) Will the future value be larger or smaller if we compound an initial amount more often than
annually, for example, every 6 months, or semiannually, holding the stated interest rate constant?
Why?
(3) What is the future value of $100 after 5 years under 12 percent annual compounding?
Semiannual compounding? Quarterly compounding? Monthly compounding? Daily compounding?
(4) What is the effective annual rate (EAR)? What is the EAR for a nominal rate of 12 percent,
compounded semiannually? Compounded quarterly? Compounded monthly? Compounded daily?
(I) Will the effective annual rate ever be equal to the nominal (quoted) rate?
(J) (1) Construct an amortization schedule for a $1,000, 10 percent annual rate loan with 3 equal
installments.
(2) What is the annual interest expense for the borrower, and the annual interest income for the
lender, during Year 2?
(K) k. Suppose on January 1 you deposit $100 in an account that pays a nominal, or quoted, interest rate
of 11.33463 percent, with interest added (compounded) daily. How much will you have in your
account on October 1, or after 9 months?
(L) (1) What is the value at the end of Year 3 of the following cash flow stream if the quoted interest rate
is 10 percent, compounded semiannually?
(2) What is the PV of the same stream?
(3) Is the stream an annuity?
(4) An important rule is that you should never show a nominal rate on a time line or use it in
calculations unless what condition holds? What would be wrong with your answer to Questions l (1)
and l (2) if you used the nominal rate (10%) rather than the periodic rate (iNom/2 _ 10%/2 _ 5%)?
(M) Suppose someone offered to sell you a note calling for the payment of $1,000 fifteen months from
today. They offer to sell it to you for $850. You have $850 in a bank time deposit which pays a
6.76649 percent nominal rate with daily compounding, which is a 7 percent effective annual interest
rate, and you plan to leave the money in the bank unless you buy the note. The note is not risky—you
are sure it will be paid on schedule. Should you buy the note? Check the decision in three ways: (1)
by comparing your future value if you buy the note versus leaving your money in the bank, (2) by
comparing the PV of the note with your current bank account, and (3) by comparing the EAR on the
note versus that of the bank account.

20