Financial Management: Core Concepts

Fourth Edition

Chapter 4
The Time Value of Money
(Part 2)

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Learning Objectives (1 of 2)
4.1 Compute the future value of multiple cash flows.
4.2 Determine the future value of an annuity.
4.3 Determine the present value of an annuity.
4.4 Adjust the annuity equation for present value and future
value for an annuity due and understand the concept of a
perpetuity.
4.5 Distinguish between the different types of loan
repayments: discount loans, interest-only loans, and
amortized loans.

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Learning Objectives (2 of 2)
4.6 Build and analyze amortization schedules.
4.7 Calculate waiting time and interest rates for an annuity.
4.8 Apply the time value of money concepts to evaluate the
lottery cash flow choice.
4.9 Summarize the 10 essential points about the time value
of money.

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4.1 Future Value of Multiple Payment
Streams (1 of 2)
• With unequal periodic cash flows, treat each of the cash
flows as a lump sum and calculate its future value over the
relevant number of periods.
• Sum up the individual future values to get the future value
of the multiple payment streams.

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Figure 4.1 The Time Line of a Nest Egg

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4.1 Future Value of Multiple Payment
Streams (2 of 2)
Example 1: Future Value of an Uneven Cash Flow
Stream
Jim deposits $3,000 today into an account that pays 10%
per year, and follows it up with three more deposits at the
end of each of the next 3 years. Each subsequent deposit is
$2,000 higher than the previous one. How much money will
Jim have accumulated in his account by the end of 3 years?

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4.1 Future Value of Multiple Payment
Streams (Example 1 Answer) (1 of 2)

FV = PV × (1 + r)n
FV of cash flow at T0 = $3,000 × (1.10)3 = $3,000 × 1.331 = $3,993.00
FV of cash flow at T1 = $5,000 × (1.10)2 = $5,000 × 1.210 = $6,050.00
FV of cash flow at T2 = $7,000 × (1.10)1 = $7,000 × 1.100 = $7,700.00
FV of cash flow at T3 = $9,000 × (1.10)0 = $9,000 × 1.000 = $9,000.00
Total = $26,743.00

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4.1 Future Value of Multiple Payment
Streams (Example 1 Answer) (2 of 2)
Alternative method:

Using the cash flow (CF) key of the calculator, enter the
respective cash flows.
CF0 = −$3000; CF1 = −$5000; CF2 = −$7000;
CF3 = −$9000;
Next calculate the NPV using I = 10%; NPV = $20,092.41;
Finally, using PV = −$20,092.41; n = 3; I = 10%; PMT = 0;
CPT FV = $26,743.00

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4.2 Future Value of an Annuity Stream (1 of 5)
• Annuities are equal, periodic outflows/inflows, e.g. rent, lease,
mortgage, car loan, and retirement annuity payments.
• An annuity stream can begin at the start of each period (annuity due)
as is true of rent and insurance payments or at the end of each period,
(ordinary annuity) as in the case of mortgage and loan payments.
• The formula for calculating the future value of an annuity stream is as
follows:

(1 + r )n − 1
FV = PMT 
r

• where PMT is the term used for the equal periodic cash flow, r is the
rate of interest, and n is the number of periods involved.

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4.2 Future Value of an Annuity Stream (2 of 5)
Example 2: Future Value of an Ordinary Annuity Stream
Jill has been faithfully depositing $2,000 at the end of each
year since the past 10 years into an account that pays 8%
per year. How much money will she have accumulated in the
account?

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4.2 Future Value of an Annuity Stream (3 of 5)
Example 2: Answer
Future Value of Payment One = $2,000 × 1.089 = $3,998.01
Future Value of Payment Two = $2,000 × 1.088 = $3,701.86
Future Value of Payment Three = $2,000 × 1.087 = $3,427.65
Future Value of Payment Four = $2,000 × 1.086 = $3,173.75
Future Value of Payment Five = $2,000 × 1.085 = $2,938.66
Future Value of Payment Six = $2,000 × 1.084 = $2,720.98
Future Value of Payment Seven = $2,000 × 1.083 = $2,519.42
Future Value of Payment Eight = $2,000 × 1.082 = $2,332.80
Future Value of Payment Nine = $2,000 × 1.081 = $2,160.00
Future Value of Payment Ten = $2,000 × 1.080 = $2,000.00
Total Value of Account at the end of 10 years $28,973.13

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4.2 Future Value of an Annuity Stream (4 of 5)
Example 2: Answer
Formula method

(1 + r )n − 1
FV = PMT 
r
where, PMT = $2,000; r = 8%; and n = 10
FVIFA → [((1.08)10 − 1) ÷ 0.08] = 14.486562,
FV = $2000 × 14.486562 → $28,973.13
Using a financial calculator
N = 10; PMT = −2,000; I = 8; PV = 0; CPT FV = 28,973.13

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4.2 Future Value of an Annuity Stream (5 of 5)
Using an excel spreadsheet
Enter = FV(8%,10, −2000, 0, 0); Output = $28,973.13

Rate, Nper, Pmt, PV, Type

Type is 0 for ordinary annuities and 1 for annuities due

Using FVIFA table (A-3)

Find the FVIFA in the 8% column and the 10 period row;
FVIFA = 14.486
FV = 2000 × 14.4865 = $28.973.13

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Figure 4.3 Interest and Principal Growth with
Different Interest Rates for $100-Annual Payments

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4.3 Present Value of an Annuity (1 of 5)
To calculate the value of a series of equal periodic cash flows at
the current point in time, we can use the following simplified
formula:
  1 
1 −  n 

  (1 + r )  
PV = PMT 
r
The last portion of the equation, is the present value interest
factor of an annuity (PVIFA).
Practical applications include figuring out the nest egg needed
prior to retirement or lump sum needed for college expenses.

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Figure 4.4 The Time Line of a Present Value
of an Annuity Stream

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4.3 Present Value of an Annuity (2 of 5)
Example 3: Present Value of an Annuity
John wants to make sure that he has saved up enough
money prior to the year in which his daughter begins college.
Based on current estimates, he figures that college
expenses will amount to $40,000 per year for 4 years
(ignoring any inflation or tuition increases during the 4 years
of college). How much money will John need to have
accumulated in an account that earns 7% per year, just prior
to the year that his daughter starts college?

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4.3 Present Value of an Annuity (3 of 5)
Example 3: Answer
Using the following equation:
  1 
1 −  n 

  (1 + r )  
PV = PMT 
r
1. Calculate the PVIFA value for n = 4 and r = 7%
→ 3.387211.
2. Then, multiply the annuity payment by this factor
to get the PV,
PV = $40,000 × 3.387211 = $135,488.45
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4.3 Present Value of an Annuity (4 of 5)
Example 3: Answer (continued)

Financial calculator method:

Set the calculator for an ordinary annuity (END mode) and
then enter:
N = 4; PMT = 40,000; I = 7; FV = 0; CPT PV = 135,488.45

Spreadsheet method:
Enter = PV(7%, 4, 40,000, 0, 0); Output = $135,488.45

Rate, Nper, Pmt, FV, Type

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4.3 Present Value of an Annuity (5 of 5)
Example 3: Answer (continued)

PVIFA table (Appendix A-4) method

For r = 7% and n = 4; PVIFA = 3.3872
PVA = PMT × PVIFA = 40,000 × 3.3872
= $135,488 (Notice the slight rounding error!)

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4.4 Annuity Due and Perpetuity (1 of 6)
A cash flow stream such as rent, lease, and insurance
payments, which involves equal periodic cash flows that
begin right away or at the beginning of each time interval is
known as an annuity due.

Figure 4.5 An Ordinary Annuity Versus an Annuity Due

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4.4 Annuity Due and Perpetuity (2 of 6)
PV annuity due = PV ordinary annuity × (1 + r)
FV annuity due = FV ordinary annuity × (1 + r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why?
Financial calculator
Mode → BGN for annuity due
Mode → END for an ordinary annuity
Spreadsheet
Type = 0 or omitted for an ordinary annuity
Type = 1 for an annuity due
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4.4 Annuity Due and Perpetuity (3 of 6)
Example 4: Annuity Due versus Ordinary Annuity
Let’s say that you are saving up for retirement and decide to
deposit $3,000 each year for the next 20 years into an
account which pays a rate of interest of 8% per year. By how
much will your accumulated nest egg vary if you make each
of the 20 deposits at the beginning of the year, starting right
away, rather than at the end of each of the next 20 years?

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4.4 Annuity Due and Perpetuity (4 of 6)
Example 4: Answer
Given information: PMT = −$3,000; n = 20; i = 8%; PV = 0;

(1 + r )n − 1
FV = PMT   
r
FV ordinary annuity = $3,000 × [((1.08)20 − 1) ÷ 0.08]
= $3,000 × 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity × (1 + r)
FV of annuity due = $137,285.89 × (1.08) = $148,268.76
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4.4 Annuity Due and Perpetuity (5 of 6)
Perpetuity
A perpetuity is an equal periodic cash flow stream that will
never cease.
The PV of a perpetuity is calculated by using the following
equation:

PMT
PV =
r

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4.4 Annuity Due and Perpetuity (6 of 6)
Example 5: PV of a Perpetuity
If you are considering the purchase of a consol that pays
$60 per year forever, and the rate of interest you want to
earn is 10% per year, how much money should you pay for
the consol?
Answer:
r = 10%, PMT = $60; and PV = ($60 ÷ 0.1) = $600
$600 is the most you should pay for the consol.

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4.5 Three Loan Payment Methods (1 of 6)
Loan payments can be structured in one of three ways:
1) Discount loan
– Principal and interest is paid in lump sum at end

2) Interest-only loan
– Periodic interest-only payments, principal due at end

3) Amortized loan
– Equal periodic payments of principal and interest

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4.5 Three Loan Payment Methods (2 of 6)
Example 6: Discount versus Interest-Only versus
Amortized Loans
Roseanne wants to borrow $40,000 for a period of 5 years.
The lenders offers her a choice of three payment structures:
1) Pay all of the interest (10% per year) and principal in one lump
sum at the end of 5 years;
2) Pay interest at the rate of 10% per year for 4 years and then a
final payment of interest and principal at the end of the 5th
year;
3) Pay five equal payments at the end of each year inclusive of
interest and part of the principal.

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4.5 Three Loan Payment Methods (3 of 6)
Under which of the three options will Roseanne pay the least
interest and why? Calculate the total amount of the
payments and the amount of interest paid under each
alternative.

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4.5 Three Loan Payment Methods (4 of 6)
Method 1: Discount Loan.
Since all the interest and the principal is paid at the end of 5
years we can use the FV of a lump sum equation to
calculate the payment required, i.e.,
FV = PV × (1 + r)n
FV5 = $40,000 × (1+0.10)5
= $40,000 × 1.61051
= $64, 420.40
Interest paid = Total payment − Loan amount
Interest paid = $64,420.40 − $40,000 = $24,420.40

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4.5 Three Loan Payment Methods (5 of 6)
Method 2: Interest-Only Loan.
Annual Interest Payment (Years 1–4)
= $40,000 × 0.10 = $4,000
Year 5 payment
= Annual interest payment + Principal payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $20,000

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4.5 Three Loan Payment Methods (6 of 6)
Method 3: Amortized Loan.
n = 5; I = 10%; PV = $40,000; FV = 0; CPT PMT = $10,551.9
Total payments = 5 × $10,551.8 = $52,759.5
Interest paid = Total Payments − Loan Amount
= $52,759.5 − $40,000
Interest paid = $12,759.5

Loan Type Total Payment Interest Paid

Discount Loan $64,420.40 $24,420.40
Interest-only Loan $60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.5

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4.6 Amortization Schedules (1 of 3)
Tabular listing of the allocation of each loan payment towards
interest and principal reduction
Helps borrowers and lenders figure out the payoff balance on
an outstanding loan.
Procedure:
1) Compute the amount of each equal periodic payment (PMT).
2) Calculate interest on unpaid balance at the end of each
period, minus it from the PMT, reduce the loan balance by
the remaining amount,
3) Continue the process for each payment period, until we get a
zero loan balance.

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4.6 Amortization Schedules (2 of 3)
Example 7: Loan Amortization Schedule
Prepare a loan amortization schedule for the amortized loan
option given in Example 6 above. What is the loan payoff
amount at the end of 2 years?

PV = $40,000; n = 5; I = 10%; FV = 0;
CPT PMT = $10,551.89

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4.6 Amortization Schedules (3 of 3)

Year Beg. Bal Payment Interest Prin. Red End. Bal

1 40,000.00 10,551.89 4,000.00 6,551.89 33,448.11

2 33,448.11 10,551.89 3,344.81 7,207.08 26,241.03

3 26,241.03 10,551.89 2,264.10 7,927.79 18,313.24

4 18,313.24 10,551.89 1,831.32 8,720.57 9,592.67

5 9,592.67 10,551.89 959.27 9,592.67 0

The loan payoff amount at the end of 2 years is

$26,241.03

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4.7 Waiting Time and Interest Rates for
Annuities (1 of 3)
Problems involving annuities typically have four variables,
i.e., PV or FV, PMT, r, n
If any three of the four variables are given, we can easily
solve for the fourth one.
This section deals with the procedure of solving problems
where either n or r is not given.
For example:
– Finding out how many deposits (n) it would take to reach a
retirement or investment goal;
– Figuring out the rate of return (r) required to reach a retirement
goal given fixed monthly deposits.

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4.7 Waiting Time and Interest Rates for
Annuities (2 of 3)
Example 8: Solving for the Number of Annuities Involved
Martha wants to save up $100,000 as soon as possible so
that she can use it as a down payment on her dream house.
She figures that she can easily set aside $8,000 per year
and earn 8% annually on her deposits. How many years will
Martha have to wait before she can buy that dream house?

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4.7 Waiting Time and Interest Rates for
Annuities (3 of 3)
Example 8: Answer
Method 1: Using a financial calculator
INPUT ? 8.0 0 −8,000 100000
TVM KEYS N I÷Y PV PMT FV
Compute 9.00647
Method 2: Using an Excel spreadsheet
Using the “=NPER” function we enter the following:
Rate = 8%; Pmt = −8000; PV = 0;
FV = 100000; Type = 0 or omitted;
i.e. = NPER(8%, −8000,0,100000,0)
The cell displays 9.006467.
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4.8 Solving a Lottery Problem (1 of 3)
In the case of lottery winnings, two choices
1) Annual lottery payment for fixed number of years, OR
2) Lump-sum payout.
How do we make an informed judgment?
Need to figure out the implied rate of return of both options
using TVM functions.

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4.8 Solving a Lottery Problem (2 of 3)
Example 9: Calculating an Implied Rate of Return Given
an Annuity
Let’s say that you have just won the state lottery. The
authorities have given you a choice of either taking a lump
sum of $26,000,000 or a 30-year annuity of $1,625,000. Both
payments are assumed to be after-tax. What will you do?

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4.8 Solving a Lottery Problem (3 of 3)
Example 9: Answer
Using the TVM keys of a financial calculator, enter:
PV = 26,000,000; FV = 0; N = 30; PMT = −1,625,000;
CPT I = 4.65283%
4.65283% = rate of interest used to determine the 30-year
annuity of $1,625,000 versus the $26,000,000 lump-sum
pay out.
Choice: If you can earn an annual after-tax rate of
return higher than 4.65% over the next 30 years, go
with the lump sum.
Otherwise, take the annuity option.

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4.9 Ten Important Points About the TVM
Equation (1 of 3)
1. Amounts of money can be added or subtracted only if
they are at the same point in time.
2. The timing and the amount of the cash flow are what
matters.
3. It is very helpful to lay out the timing and amount of the
cash flow with a timeline.
4. Present value calculations discount all future cash flow
back to current time.
5. Future value calculations value cash flows at a single
point in time in the future.

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4.9 Ten Important Points About the TVM
Equation (2 of 3)
6. An annuity is a series of equal cash payments at regular
intervals across time.
7. The time value of money equation has four variables but
only one basic equation, and so you must know three of
the four variables before you can solve for the missing or
unknown variable.
8. There are three basic methods to solve for an unknown
time value of money variable:
1) Using equations and calculating the answer;
2) Using the TVM keys on a calculator;
3) Using financial functions from a spreadsheet.

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4.9 Ten Important Points About the TVM
Equation (3 of 3)
9. There are three basic ways to repay a loan:
1) Discount loans,
2) Interest-only loans, and
3) Amortized loans.

10. Despite the seemingly accurate answers from the time

value of money equation, in many situations not all the
important data can be classified into the variables of
present value, i.e., time, interest rate, payment, or future
value.

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Additional Problems with Answers
Problem 1
Present Value of an Annuity Due. Julie has just been
accepted into Harvard and her father is debating whether he
should make monthly lease payments of $5,000 at the
beginning of each month, on her flashy apartment or to prepay
the rent with a one-time payment of $56, 662. If Julie’s father
earns 1% per month on his savings should he pay by month or
take the discount by making the single annual payment?

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Additional Problems with Answers
Problem 1 (Answer)
P ÷ Y = 12; C ÷ Y = 12; MODE = BGN
INPUT 12 12% 56,838 5,000 0
TVM KEYS N I÷Y PV PMT FV
OUTPUT −56,838.14
Jill’s father would have to deposit $56,838 today at 1% per month to
be able to withdraw $5000 per month to make the lease payments.
The one time payment of $56,662 constitutes a discount of $176.14
or conversely a monthly lease payment of $4,984.51 as shown
below.

INPUT 12 12 −56,662 0
TVM KEYS N I÷Y PV PMT FV
OUTPUT 4,984.51
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Additional Problems with Answers
Problem 2
Future Value of Uneven cash flows. If Mary deposits
$4000 a year for three years, starting a year from today,
followed by 3 annual deposits of $5000, into an account that
earns 8% per year, how much money will she have
accumulated in her account at the end of 10 years?

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Additional Problems with Answers
Problem 2 (Answer) (1 of 2)
Future Value in Year 10 = $4000 × (1.08)9 + $4000 × (1.08)8 +
$4000×(1.08)7 + $5000 × (1.08)6 + $5000 × (1.08)5 + $5000 ×
(1.08)4
= $4000 × 1.999 + $4000 × 1.8509 + $4000 × 1.7138
+ $5000 × 1.5868 + $5000 × 1.4693 + $5000 ×
1.3605
= $7,996 + $7,403.6 + $6,855.2 + $7,934 + $7,346.5
+ 6,802.5
= $44,337.8

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Additional Problems with Answers
Problem 2 (Answer) (2 of 2)
Alternative method:
Using the cash flow (CF) key of the calculator, enter the
respective cash flows.
CF0 = 0;CF1 = −$4000; CF2 = −$4000; CF3 = −$4000;
CF4 = −$5000; CF5 = −$5000; CF6 = −$5000
Next calculate the NPV using I = 8%; → NPV = $20,537.30;
Finally, using PV = −$20,537.30; n = 10; i = 8%; PMT = 0;
CPT FV→$44,338

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Additional Problems with Answers
Problem 3
Present Value of Uneven Cash Flows. Jane Bryant has
just purchased some equipment for her beauty salon. She
plans to pay the following amounts at the end of the next
5 years: $8,250, $8,500, $8,750, $9,000, and $10,500. If
she uses a discount rate of 10%, what is the cost of the
equipment that she purchased today?

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Additional Problems with Answers
Problem 3 (Answer)

$8, 250 $8,500 $8, 750 $9, 000 $10,500

PV = + 2
+ 3
+ 4
+
(1.10) (1.10) (1.10) (1.10) (1.10)5
= $7,500 + $7, 024.79 + $6,574 + $6,147.12 + $6,519.67
= $33, 765.58

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Additional Problems with Answers
Problem 4
Computing Annuity Payment. The Corner Bar & Grill is in the
process of taking a 5-year loan of $50,000 with First Community
Bank. The bank offers the restaurant owner his choice of three
payment options:
1) Pay all of the interest (8% per year) and principal in one lump
sum at the end of 5 years;
2) Pay interest at the rate of 8% per year for 4 years and then a final
payment of interest and principal at the end of the fifth year;
3) Pay five equal payments at the end of each year inclusive of
interest and part of the principal.
Under which of the three options will the owner pay the least interest
and why?

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Additional Problems with Answers
Problem 4 (Answer) (1 of 4)
Under Option 1: Principal and Interest Due at End
Payment at the end of year 5 = FVn = PV × (1 + r)n
FV5 = $50,000 × (1 + 0.08)5
= $50,000 × 1.46933
= $73,466.5
Interest paid = Total payment − Loan amount
Interest paid = $73,466.5 − $50,000 = $23,466.50

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Additional Problems with Answers
Problem 4 (Answer) (2 of 4)
Under Option 2: Interest-Only Loan
Annual Interest Payment (Years 1–4)
= $50,000 × 0.08 = $4,000
Year 5 payment = Annual interest payment + Principal
payment
= $4,000 + $50,000 = $54,000
Total payment = $16,000 + $54,000
= $70,000
Interest paid = $20,000
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Additional Problems with Answers
Problem 4 (Answer) (3 of 4)
Option 3: Amortized Loan
To calculate the annual payment of principal and interest
we can use the PV of an ordinary annuity equation and
solve for the PMT value using n = 5; I = 8%; PV = $50,000
and FV = 0.
PMT → $12,522.82
Total payments = 5 × $12,522.82 = $62,614.11
Interest paid = Total Payments − Loan Amount
= $62,614.11 − $50,000
Interest paid = $12,614.11

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Additional Problems with Answers
Problem 4 (Answer) (4 of 4)
Comparison of total payments and interest paid under each
method
Loan Type Total Payment Interest Paid

Discount loan $73,466.5 $23,466.50

Interest-only loan $70,000.00 $20,000.00

Amortized loan $62,614.11 $12,614.11

So, the amortized loan is the one with the lowest interest
expense, since it requires a higher annual payment, part of
which reduces the unpaid balance on the loan and thus
results in less interest being charged over the 5-year term.
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Additional Problems with Answers
Problem 5
Loan Amortization. Let’s say that the restaurant owner in
Problem 4 above decides to go with the amortized loan
option and after having paid two payments decides to pay
off the balance. Using an amortization schedule calculate his
payoff amount.
Amount of loan = $50,000; Interest rate = 8%;
Term = 5 years; Annual payment = $12,522.82

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Additional Problems with Answers
Problem 5 (Answer)
AMORTIZATION SCHEDULE

Year Beg. Bal. Payment Interest Prin. Red. End Bal.

1 50,000.00 12,522.82 4,000.00 8,522.82 41,477.18

2 41,477.18 12,522.82 3,318.17 9,204.65 32,272.53

3 2,272.53 12,522.82 2,581.80 9,941.02 22,331.51

4 22,331.51 12,522.82 1,786.52 10,736.30 11,595.21

5 11,595.21 12,522.82 927.62 11,595.21 0

The loan payoff amount at the end of 2 years is

$32,272.53
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Figure 4.2 The Time Line of a $1,000-per-
Year Nest Egg

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Table 4.1 Repayment Plans and Total
Interest on a Loan

Annual Total Principal Total

Repayment Plan Payment Interest Repayment Repayment
Discount loan $0 $14,671.86 $25,000.00 $39,671.86
Interest-only loan $2,000.00 $12,000.00 $25,000.00 $37,000.00
Amortized loan $5,407.88 $7,447.28 $25,000.00 $32,447.28

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Table 4.2 Amortization Schedule for a $25,000
Loan at 8% with Six Annual Payments
Year Beginning Annual Interest Principal Remaining
Principal Payment Expense Reduction Principal
1 $25,000.00 $5,407.88 $2,000.00 $3,407.88 $21,592.12
2 $21,592.12 $5,407.88 $1,727.37 $3,680.51 $17,911.61
3 $17,911.61 $5,407.88 $1,432.93 $3,974.95 $13,936.66
4 $13,936.66 $5,407.88 $1,114.93 $4,292.95 $9,643.71
5 $9,643.71 $5,407.88 $771.50 $4,636.38 $5,007.33
6 $5,007.33 $5,407.92 $400.59 $5,007.33 $0
Total Blank $32,447.32 $7,447.32 $25,000.00 Blank

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Copyright

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