Time Value of Money
• Future Value
• Present Value
• Finding I and N
• Annuities
• Rates of Return
• Amortization
Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA 1
Time Lines
Show the timing of cash flows.
Tick marks occur at the end of periods, so Time 0 is today; Time
1 is the end of the first period (year, month, etc.) or the beginning
of the second period.
0 1 2 3
I%
CF0 CF1 CF2 CF3
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Drawing Time Lines
$100 lump sum due in 2 years
0 1 2
I%
100
3-year $100 ordinary annuity
0 1 2 3
I%
100 100 100
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Drawing Time Lines
Uneven cash flow stream
0 1 2 3
I%
-50 100 75 50
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
What is the future value (FV) of an initial $100
after 3 years, if I/YR = 4%?
Finding the FV of a cash flow or series of cash flows is called
compounding.
FV can be solved by using the step-by-step, financial calculator, and
spreadsheet methods.
0 1 2 3
4%
100 FV = ?
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV
The Step-by-Step and Formula Methods
After 1 year:
• FV1 = PV(1 + I) = $100(1.04) = $104.00
After 2 years:
• After 1 year:
• FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
After 3 years:
• FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
After N years (general case):
• FVN = PV(1 + I)N
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV
Calculator and Excel Methods
Solves the general FV equation.
Requires 4 inputs into calculator, and will solve for the
fifth. (Set to P/YR = 1 and END mode.)
INPUTS 3 4 -100 0
N I/YR PV PMT FV
OUTPUT 112.49
Excel: =FV(rate,nper,pmt,pv,type)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Present Value
What is the present value (PV) of $100 due in 3 years, if I/YR = 4%?
• Finding the PV of a cash flow or series of cash flows is called discounting
(the reverse of compounding).
• The PV shows the value of cash flows in terms of today’s purchasing power.
0 1 2 3
I 4%
PV = ? 100
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PV
The Formula Method
Solve the general FV equation for PV:
PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3
= $100/(1.04)3
= $88.90
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PV:
Calculator and Excel Methods
Solves the general FV equation for PV.
Exactly like solving for FV, except we have different input information
and are solving for a different variable.
INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90
Excel: =PV(rate,nper,pmt,fv,type)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for I
What annual interest rate would cause $100 to grow to $119.10 in 3
years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or spreadsheet.
INPUTS 3 -100 0 119.10
N I/YR PV PMT FV
OUTPUT 6
• Excel: =RATE(nper,pmt,pv,fv,type,guess)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for N
If sales grow at 10% per year, how long before sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or spreadsheet.
INPUTS 10 -1 0 2
N I/YR PV PMT FV
OUTPUT 7.3
• EXCEL: =NPER(rate,pmt,pv,fv,type)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
What is the difference between an ordinary annuity
and an annuity due?
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT
Annuity Due
0 1 2 3
I%
PMT PMT PMT
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV
Given a 3-Year Ordinary Annuity of $100 at 4%
• $100 payments occur at the end of each period, but there is no PV.
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 312.16
• Excel: =FV(rate,nper,pmt,pv,type)
• Here type = 0.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PV
Given a 3-year Ordinary Annuity of $100 at 4%
• 100 payments still occur at the end of each period, but now there is no FV.
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -277.51
• Excel: =PV(rate,nper,pmt,fv,type)
• Here type = 0.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV:
3-Year Annuity Due of $100 at 4%
Now, $100 payments occur at the beginning of each period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
Alternatively, set calculator to “BEGIN” mode and solve for the FV of the annuity due:
BEGIN
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 324.65
Excel: =FV(rate,nper,pmt,pv,type)
Here type = 1.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PV
3-Year Annuity Due of $100 at 4%
Again, $100 payments occur at the beginning of each period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
Alternatively, set calculator to “BEGIN” mode and solve for the PV of the annuity due:
BEGIN
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -288.61
Excel: =PV(rate,nper,pmt,fv,type)
Here type =1
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
PV Calculation
What is the present value of a 5-year $100 ordinary annuity at
4%?
• Be sure your financial calculator is set back to END mode and
solve for PV:
N = 5, I/YR = 4%, PMT = -100, FV = 0.
PV = $445.18.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Annuities Over Time
10-year • N = 10, I/YR = 4, PMT = -100, FV = 0;
annuity solve for PV = $811.09.
25-year • N = 25, I/YR = 4, PMT = -100, FV = 0;
annuity solve for PV = $1,562.21.
Perpetuity • PV = PMT/I = $100/0.04 = $2,500.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
The Power of Compound Interest
A 20-year-old student wants to save $5 a day for her retirement.
Every day she places $5 in a drawer. At the end of the year, she
invests the accumulated savings ($1,825) in a brokerage account
with an expected annual return of 8%.
How much money will she have when she is 65 years old?
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV
If she begins saving today, how much will she have when she is 65?
• If she sticks to her plan, she will have $705,373 when she is 65.
INPUTS 45 8 0 -1825
N I/YR PV PMT FV
OUTPUT 705,373
• Excel: =FV(.08,45,-1825,0,0)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for FV
If you don’t start saving until you are 40 years old, how much will you
have at 65?
• If a 40-year-old investor begins saving today, and sticks to the plan, he or
she will have $133,418 at age 65. This is $571,954 less than if starting at
age 20.
• Lesson: It pays to start saving early.
INPUTS 25 8 0 -1825
N I/YR PV PMT FV
OUTPUT 133,418
• Excel: =FV(.08,25,-1825,0,0)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PMT
How much must the 40-year old deposit annually to catch the 20-year old?
• To find the required annual contribution, enter the number of years until
retirement and the final goal of $705,372.75, and solve for PMT.
INPUTS 25 8 0 705373
N I/YR PV PMT FV
OUTPUT -9,648.64
• Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
What is the PV of this uneven cash flow stream?
0 1 2 3 4
4%
100 300 300 -50
96.15
277.37
266.70
-42.74
597.48 = PV
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Solving for PV: Uneven Cash Flow Stream
Input cash flows in the calculator’s “CFLO” register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
Enter I/YR = 4, press NPV button to get NPV = $597.48. (Here NPV = PV.)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Will the FV of a lump sum be larger or smaller if compounded
more often, holding the stated I% constant?
LARGER, as the more frequently compounding occurs, interest is earned on interest
more often.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Classification of Interest Rates
Nominal rate (INOM): also
Periodic rate (IPER): amount
called the quoted or stated
of interest charged each
rate. An annual rate that
period, e.g. monthly or
ignores compounding
quarterly.
effects.
IPER = INOM/M, where M is the number
INOM is stated in contracts. Periods
of compounding periods per year. M
must also be given, e.g. 4% quarterly
= 4 for quarterly and M = 12 for
or 4% daily interest.
monthly compounding.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Classification of Interest Rates
Effective (or equivalent) annual rate (EAR = EFF%): the annual rate of
interest actually being earned, considering compounding.
• EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Excel: =EFFECT(nominal_rate,npery)
=EFFECT(.04,2)
• Should be indifferent between receiving 4.04% annual interest and
receiving 4% interest, compounded semiannually.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
The Importance of Effective Rates of Return
Investments with different compounding intervals provide
different effective returns.
To compare investments with different compounding
intervals, you must look at their effective returns (EFF% or
EAR).
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
The Importance of Effective Rates of Return
See how the effective return varies between investments with the same
nominal rate, but different compounding intervals.
EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
When is each rate used?
INOM: Written into contracts, quoted by banks and brokers.
Not used in calculations or shown on time lines.
IPER: Used in calculations and shown on time lines. If M = 1,
INOM = IPER = EAR.
EAR: Used to compare returns on investments with
different payments per year. Used in calculations when
annuity payments don’t match compounding periods.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Effect of Compounding on FV
What is the FV of $100 after 3 years under 4% semiannual
compounding? Quarterly compounding?
MN
INOM
FVN PV 1
M
23
0.04
FV3S $100 1
2
FV3S $100(1.02) 6 $112.62
FV3Q $100(1.01) 12 $112.68
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Effective Rate vs Nominal Rate
Can the effective rate ever be equal to the nominal rate?
• Yes, but only if annual compounding is used, i.e., if M = 1.
• If M > 1, EFF% will always be greater than the nominal rate.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
What’s the FV of a 3-year $100 annuity, if the quoted interest rate is 4%,
compounded semiannually?
Payments occur annually, but compounding occurs every 6 months.
Cannot use normal annuity valuation techniques.
0 1 2 3 4 5 6
2%
100 100 100
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Method 1: Compound Each Cash Flow
0 1 2 3 4 5 6
2%
100 100 100
104.04
108.24
312.28
FV3 = $100(1.02)4 + $100(1.02)2 + $100
FV3 = $312.28
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Method 2: Financial Calculator or Excel
Find the EAR and treat as an annuity.
EAR = (1 + 0.04/2)2 – 1 = 4.04%.
INPUTS 3 4.04 0 -100
N I/YR PV PMT FV
OUTPUT 312.28
Excel: =FV(.0404,3,-100,0,0)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Loan Amortization
Amortization tables are widely used for home mortgages, auto
loans, business loans, retirement plans, etc.
Financial calculators and spreadsheets are great for setting up
amortization tables.
EXAMPLE: Construct an amortization schedule for a $1,000, 4% annual rate
loan with 3 equal payments.
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Step 1: Find the Required Annual Payment
All input information is already given, just remember that the FV = 0
because the reason for amortizing the loan and making payments
is to retire the loan.
INPUTS 3 4 -1000 0
N I/YR PV PMT FV
OUTPUT 360.35
Excel: =PMT(.04,3,-1000,0,0)
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Step 2: Find the Interest Paid in Year 1
The borrower will owe interest upon the initial balance at
the end of the first year. Interest to be paid in the first year
can be found by multiplying the beginning balance by the
interest rate.
INTt = Beg balt(I)
INT1 = $1,000(0.04) = $40
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Step 3: Find the Principal Repaid in Year 1
If a payment of $360.35 was made at the end of the first year and
$40 was paid toward interest, the remaining value must represent the
amount of principal repaid.
PRIN = PMT – INT
= $360.35 – $40 = $320.35
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Step 4: Find the Ending Balance after Year 1
To find the balance at the end of the period, subtract the
amount paid toward principal from the beginning balance.
END BAL = BEG BAL – PRIN
= $1,000 – $320.35
= $679.65
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 360 $40 $ 320 $680
2 680 360 27 333 347
3 347 360 14 347 0
TOTAL – $1,081 $81 $1,000 –
Interest paid declines with each payment as the balance declines.
What are the tax implications of this?
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Managerial Finance 701 Prepared by: Meer Sajed-ul Basher FCA
Thank You
and
Discussion
DISCLAIMER
This Document has been prepared and issued by Meer Sajed-ul Basher FCA on the basis of the public information available in the market and other sources
believed to be reliable. Moreover, none of the paper presenter and university in any way be responsible about the genuineness, accuracy, completeness,
authenticity and correctness of the contents of the sources that are publicly available to prepare the Document.
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