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# ALAN ANDERSON, Ph.D.

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along with worked-out solutions, write to
training opportunities in finance and risk
management, visit www.ecirisktraining.com

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The time value of money is one of the most
fundamental concepts in finance; it is based
on the notion that receiving a sum of money
in the future is less valuable than receiving
that sum today.

## This is because a sum received today can be

invested and earn interest.

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The four basic time value of
money concepts are:

## future value of a sum

present value of a sum
future value of an annuity
present value of an annuity

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If a sum is invested today, it will earn interest
and increase in value over time. The value that
the sum grows to is known as its future value.

as compounding.

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The future value of a sum depends on
the interest rate earned and the time
horizon over which the sum is invested.

FVN = PV(1+I)N

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where:

## FVN = future value of a sum

invested for N periods
I = periodic rate of interest
PV = the present or current
value of the sum invested

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Suppose that a sum of \$1,000 is invested for
four years at an annual rate of interest of 3%.
What is the future value of this sum?

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In this case,

N=4
I=3
PV = \$1,000

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Using the future value formula,

FVN = PV(1+I)N
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.125509)
FV4 = \$1,125.51

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The present value of a sum is the amount
that would need to be invested today in
order to be worth that sum in the future.

## Computing the present value of a sum is

known as discounting.

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The formula for computing the
present value of a sum is:

FVN
PV =
(1 + I ) N

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How much must be deposited in a bank
account that pays 5% interest per year in
order to be worth \$1,000 in three years?

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In this case,

N=3
I=5
FV3 = \$1,000

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FVN 1, 000
PV = =
(1 + I ) N
(1.05) 3

1, 000
= = \$863.84
1.1576

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An annuity is a periodic stream of
equally-sized payments.

ordinary annuity
annuity due

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With an ordinary annuity, the first
payment takes place one period in
the future.

## With an annuity due, the first

payment takes place immediately.

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The formulas used to compute the
future value and present value of a
sum can be easily extended to the
case of an annuity.

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The formula for computing the future
value of an ordinary annuity is:

(1 + I ) 1 N
FVAN = PMT
I

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where:

## FVAN = future value of an

N-period ordinary annuity

periodic payment

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Suppose that a sum of \$1,000 is invested at
the end of each of the next four years at an
annual rate of interest of 3%. What is the
future value of this ordinary annuity?

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In this case,

N=4
I=3
PMT = \$1,000

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Using the formula,

(1 + I ) 1 N
FVAN = PMT
I

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(1 + .03) 1
4
FVA4 = 1,000 = \$4,183.63
.03

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The future value of the annuity can
also be obtained by computing the
future value of each term and then
combining the results:

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1,000(1.03)3 + 1,000(1.03)2 +
1,000(1.03)1 + 1,000(1.03)0

= 1,092.73 + 1,060.90 +
1,030.00 + 1,000.00

= \$4,183.63

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The future value of an annuity due
is computed as follows:

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Referring to the previous example, the
future value of an annuity due would be:

4,183.63(1+.03) = \$4,309.14

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The formula for computing the present
value of an ordinary annuity is:

1
1
(1 + I )N
PVAN = PMT
I

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where:

## PVAN = future value of an

N-period ordinary annuity

periodic payment

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How much must be invested today in a bank
account that pays 5% interest per year in order
to generate a stream of payments of \$1,000 at
the end of each of the next three years?

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In this case,

N=3
I=5
PMT = \$1,000

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Using the formula,

1
1
(1 + I )N
PVAN = PMT
I

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1
1
(1 + .05)3
PVA3 = 1, 000 = \$2, 723.25
.05

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The present value of the annuity can
also be obtained by computing the
present value of each term and then
combining the results:

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1,000(1.05)-3 + 1,000(1.05)-2 + 1,000(1.05)-1
= 863.84 + 907.03 + 952.38
= \$2723.25

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The present value of an annuity
due is computed as follows:

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Referring to the previous example, the
present value of an annuity due would be:

2,723.25(1+.05) = \$2,859.41

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