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CFA Exam Level 1

2016 Guided Notes

Time Value of Money


Sample Chapter

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Guided Notes for CFA® Level 1 – 2016


Copyright © 2016 by GoStudy LLC.® All Rights Reserved. Published in 2016

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Contents
Time Value of Money ................................................................................................................................ 2
TVM Overview....................................................................................................................................... 3
Three interpretations of interest rates ............................................................................................. 3
Components of the Interest Rate ..................................................................................................... 4
Compound interest rates .................................................................................................................. 4
The Mechanics in Action ............................................................................................................... 5
Calculating TVM using your financial calculator ................................................................................... 6
Effective Annual Interest Rate & non-annual compounding ................................................................ 7
The Future Value of a Series of Cash Flows .......................................................................................... 9
Ordinary Annuities – Equal Cash Flows......................................................................................... 9
Annuity Due ............................................................................................................................ 10
Perpetuities ................................................................................................................................. 11

Time Value of Money


Reading 5
For the Level 1 exam, you’re going to really need to grind out the mechanics of solving TVM
problems. It is plug and play on your calculator, 90 seconds per multiple choice question. You
are guaranteed to have TVM constitute a good portion of problems, both in standalone situations
and as a core concept within other problems (particularly related to fixed income). When you’re
lucky enough to be guaranteed a certain type of problem, you make sure you learn it well.

But while some study guides suggest you focus only on the mechanics of solving TVM problems
we think that’s short-sighted…both for the CFA curriculum writ large and for L1 itself.

TVM is at the heart of a lot of financial concepts that are found in all three levels of the exam. It
is the basic tool in corporate finance and in the estimation of the fair value of fixed income,
equity, and other securities. Thus mastering the calculations AND the concepts is time well
spent.

So bear with us in the lengthy chapter. The payoff is worth it and we promise the notes get more
concise again after.
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TVM Overview
TVM is a cornerstone financial concept for the exams. Don’t slack here. Grind a LOT of TVM
practice problems until you can do it in your sleep. You need to be able to look at a problem and
solve for PV, FV, or I/Y depending on what information is given. You should also be able to
handle uneven cash flows or payments and compare values at different points in time. Note, if
you want you can jump straight to the calculation section.

The basic concept of TVM is that a dollar today is worth more than a dollar you receive in the
future. Put differently, in order to give up a dollar today you have to get more than a dollar back
later.

This should make sense. If you offered us $1 a year from now for $1 today we wouldn’t make
that trade. But if you offered us $1.20 a year from now we might think that was a good return.

The exact relationship between the value of money in the future and money today money
depends on how much you think you can earn on it over that time period—it reflects opportunity
costs.

We measure this using a compound interest rate.

But what is an interest rate?


Before we go into how to use a compound interest rate in TVM calculations we need to
understand (1) what an interest rate represents and (2) what goes into actually determining that
interest rate.

Three interpretations of interest rates


So what exactly does an interest rate represent? Interest rates can be thought of in three different
ways. You should be familiar with each, and expect to be tested on this concept.

1. Required rate of return – The required rate of return is the minimum rate of return at
which an investor or saver is willing to lend their funds

2. Discount rates – Often used interchangeably with the required rate of return, the discount
rate is the rate at which an investment should be discounted back to the present. So if you
can earn 5% on your money, that is the rate at which you should discount any future
dollar to get the equivalent present value

3. Opportunity costs – An opportunity cost reflects a trade-off between activities and is


usually defined as the most valuable foregone alternative. In this context, there is a trade-
off between spending money today vs. investing it for the future. The interest rate
represents that tradeoff.
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Components of the Interest Rate


An interest rate actually consists of several different components.

1. The real risk free rate – The theoretical rate of return assuming no risk and no inflation1
2. Expected inflation – Generally we expect inflation to increase prices, thereby decreasing
the value of a dollar in the future. The sum of the risk free rate and expected inflation is
the NOMINAL risk-free interest rate (SEE ECON MATERIAL REAL VS NOMINAL)
3. Default-risk – The risk that a borrower will not pay on time (or at all)
4. Liquidity-risk - The risk of receiving less than fair value if you have to sell quickly2
5. Maturity risk – The longer you borrow for, the more risk there is

Ultimately the required interest rate, or the interest rate you would use in a TVM question, is
equal to:

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒


= 𝑟𝑒𝑎𝑙 𝑟𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑟𝑖𝑠𝑘 + 𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
+ 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

Each security we evaluate will have a slightly different equilibrium interest rate. Why?
Because that interest rate will reflect the different characteristics, or risk factors, of the
underlying security.

Compound interest rates


The idea of compound interest is also a key concept underpinning TVM.

The idea is that any returns you earn in one period compound in the next. This happens because
the interest you earned in one period begins to earn its own interest in the next. As this process
repeats over and over the impact on investment returns can be significant.

When we think about the basic relationship between money today and money in the future they
are connected via the concept of compound interest. Just remember time is money.3

To bring it back to the language of the CFA curriculum, we know that the future value (FV) of a
dollar is higher than its present value (PV), or FV > PV.

And to figure out exactly how much higher, we project the value forward using a compound
interest rate to calculate each period’s cash flows. Conversely, if we were given the FV of a
dollar, we would have to discount that dollar back to today in order to calculate its present value
based on a rate of return.

1
The nominal risk-free interest rate = real risk free interest rate + expected rate of inflation
2
Think about it this way. If you had to sell your house tomorrow you’d probably have to price it at a steep discount
in order to sell fast.
3
In finance when we measure the value of a security what we’re really doing is estimating the value of its future
cash flows.
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The Mechanics in Action


Let’s say that the interest rate is 10%, and we are talking about a 5 year period. How much is a
$1,000 loan worth?

Using compound interest, we take the interest rate for the first period, add it to the initial total,
and then calculate the interest for the next period. For our 5 year, $1000 loan it looks like this:4

Plot it on a timeline
If it helps to visualize the sequencing of cash flows you can use a timeline. Any cash flow that
happens today happens at t=0, subsequent cash payments (outflows) use a negative sign, whereas
cash receipts (inflows) are entered with a positive sign. We can then discount or compound each
cash flow back or forward depending on what we need. This process will be very similar to using
our calculator to enter uneven cash flows.

Note that in our previous example the cash flows occurred at the end of a period. We can
interpret t=3 as the end of the third year or beginning of the fourth. This is the typical
convention for TVM problems, however, there are problems where the exam makers will try to
trick you by stating that cash flows actually occur at the beginning of a period. This will require
you to change from END to BGN on your calculator (see annuity due).

4
Image from this blog post on the topic: https://www.mathsisfun.com/money/compound-interest.html
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The timeline and step-by-step model is helpful conceptually and we will return to it. But first,
let’s formalize the relationship between PV and FV with an equation that makes the actual
mechanical step-by-step calculation in the above example unnecessary:

One takeaway from this equation is that the higher the interest rate or the more time we are
taking into consideration the higher the FV of an investment will be (and the lower the PV if
we’re working the other way).

You should know this equation and the logic behind it, but for calculations on the exam we’ll
always be using our financial calculator. Make sure you can work in either direction to solve for
PV or FV.

Calculating TVM using your financial calculator


TVM problems invariably require you to use your financial calculator. As a Candidate you are
assumed to have strong working knowledge of the calculator. And if you want to pass L1, you
better make sure that’s true. There is an excellent series of videos about using your TI BAII Plus
which you can see here.5

There are two default settings you should switch now that will stand you in good stead for the
vast majority of L1 problems.

 First, you want to set the number of decimal places to 6 instead of 2. This will give you
the specificity often asked for. To do this hit [2nd][.] to get to ‘Format.’ Then enter 6 for
decimals.
 Second, you want to change the periods per year [P/Y] from 12 to 1 to move from
monthly to annual interest rates. To do this hit [2nd][I/Y] hit ‘1’ then enter. Then
[2nd][CPT] to exit.

By setting P/Y equal to 1, any interest rate you calculate is now the effective interest rate for a
given period, while N becomes the number of compounding periods in a given problem.6

For TVM problems the important keys on the BA II are:


5
If you have the older HP 12C you are more on your own, as the vast majority of Candidates use the HP.
6
Usually we’re dealing with semi-annual bonds, so you need to double the # of years for N and divide the annual
interest rate by two.
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N = number of compounding periods


I/Y = Interest rate per compounding period (often will be semi-annual)
PV = Present Value
PMT = Cash flow or annuity per period
FV = Future Value

You hit CPT to compute the answer.

Going through the steps


On the exam you will usually have enough information in a problem to input 4 of the 5 variables
above, allowing you to solve for the missing number. The trick is not making a mistake while
breaking down the given information into the variables for your calculator.

1. The first thing you want to do is convert the given interest rate (r) and time period (N)
into the same units as the compounding frequency.

So if a problem gives you the interest rate as an annual number and the time in years, but
the loan has quarterly compounding you would divide r by 4 to get your quarterly interest
rate (I/Y) and you would multiply the number of years by 4 to get N. This is the secret
behind dealing with non-annual compounding.

2. You would then input the FV or PV that was given.

When solving for PV, you either input the FV as a positive number and ignore the negative sign
on PV, or you input FV as a negative number.

3. If there is an annual payment (PMT), you would enter that, usually with a negative sign.
4. Hit CPT and the key for the variable that is missing.

It is also extremely important to clear your calculator in between problems on the exam. If you
don’t you are likely to forget to erase a variable and cause yourself to answer incorrectly.

Effective Annual Interest Rate & non-annual compounding


To facilitate comparison, most quoted interest rates are given as a stated annual rate, which is
equivalent to the interest rate if you only paid interest once a year (i.e. it ignores compounding).
In practice, however, most loans compound interest more often—ranging from continuously, to
daily, to monthly, quarterly, or most commonly, semi-annual.

We use the effective annual yield to convert the stated annual interest rate so that it takes into
consideration all of the compounding periods within a year.
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𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 (𝐸𝐴𝑅) = (1 + 𝑠𝑡𝑎𝑡𝑒𝑑 𝑟𝑎𝑡𝑒⁄𝑚)𝑚 − 1

Where:
M = number of compounding periods in one year
stated rate = the periodic (annual) interest rate given.

EAR is an important formula to memorize so let’s run through it with numbers.

Say we have a 10% annual yield, compounded monthly. Inputting this we get:

EAR = (1 + (0.10/12))12 – 1 = 1.00833312 – 1 = 1.104713 – 1 = .104713 or 10.4713%.

Note that the EAR will always be higher than the stated rate if m > 1. And the more frequently
money compounds, the higher EAR will be.

If we wanted to extend the concept of EAR and apply it to our equation for FV it would look like
this:

𝑟𝑠 𝑚𝑁
𝐹𝑉𝑁 = 𝑃𝑉(1 + )
𝑚

Where:
M = number of compounding periods in one year
rs = the stated annual interest rate
N = the number of years

You could memorize the above FV equation for non-annual compounding and/or always
remember the following:

If a problem gives you the interest rate as an annual number and the time in years, but the
loan has quarterly compounding you would divide r by 4 to get your quarterly interest rate
(I/Y) and you would multiply the number of years by 4 to get N. If it was monthly
compounding you would divide r by 12 and multiply N by 12.

With those principles in mind you should be well equipped to handle most problems.

The exception is if a problem indicates continuous compounding. In this case you would use the
following equation:
𝐹𝑉 = 𝑃𝑉𝑒 𝑟𝑠 𝑁
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As Table 1 shows, the more frequently compounding occurs, the greater the future value will be.

Table 1. The Effect of Compounding Frequency on Future Value7


Frequency rs/m8 mN Future Value of $1
Annual 8%/1 = 8% 1×1=1 $1.00(1.08) = $1.08
2
Semiannual 8%/2 = 4% 2×1=2 $1.00(1.04) = $1.081600
4
Quarterly 8%/4 = 2% 4×1=4 $1.00(1.02) = $1.082432
Monthly 8%/12 = 0.6667% 12 × 1 = 12 $1.00(1.006667)12 = $1.083000
Daily 8%/365 = 0.0219% 365 × 1 = 365 $1.00(1.000219)365 = $1.083278
Continuous $1.00e0.08(1) = $1.083287

The Future Value of a Series of Cash Flows


This section is all about extending the principle of future value to account for multiple cash flows
during the life of an investment.

Let’s start with a few key vocab words:

Annuities – Is a set of equal cash flows that occur at regular intervals over a given period of time
Ordinary annuity – The most common type of annuity, cash flows occur at the end of each
period (so the first cash flow happens in one period at t=1). Examples: mortgages & loans
Annuity due - aAn annuity has a cash flow that occurs immediately at t = 0
Perpetuity – This is a perpetual annuity or a set of even never-ending sequential cash flows with
the first cash flow at t=1

Ordinary Annuities – Equal Cash Flows


Calculating PV or FV of an ordinary annuity is straightforward. You’ll have 4 of the 5 TVM
variables and will need to solve for the last one. The difference is that we are now solving for a
stream of equal periodic cash flows.

To calculate the FV of an annuity we would set the PV = 0 and input the other variables. To
calculate the present value we set the FV equal to zero.

We think you’ll use the calculator and be just fine, however, the curriculum also gives us an
equation to calculate the FV of an annuity:

(1+𝑟)𝑁 −1
𝐹𝑉𝑁 = 𝐴[ ]
𝑟
Where:
A = the amount of the annuity
r = the interest rate
N = the number of periods

7
Institute, CFA. 2015 CFA Level I Volume 1 Ethical and Professional Standards and Quantitative Methods. Wiley
Global Finance, 2014-07-14
8
This is the periodic interest rate
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The term in brackets is the future value annuity factor which gives us the FV of a $1 ordinary
annuity per period. Again while the CFA curriculum gives this equation and a long series of
examples we recommend relying on your financial calculator (and not memorization) in this
section.

You may also be asked to calculate the present value of an annuity that starts in a year or two. In
this case you would calculate the PV of the annuity at its start date, and then discount that value
to the present day. It’s not complicated, but it is another step that you should pay attention to.
Note that when your calculator is set to END (the default) it will return the present value one
period before the annuity begins (i.e. a period before you get your first cash flow).

So say we are asked to calculate the PV of an annuity that begins in three years. Once we’ve
calculated the PV at t=3, we would actually only discount it back 2 periods (i.e. N=2) to get the
value at t=0.

Annuity Due
If you are asked to calculate an annuity due, where the cash flow occurs immediately, the
principle is the same but you need to adjust your calculator to deal with the difference in timing
on the cash flows. To switch from END mode to BGN hit [2nd][BGN][2nd][Set]. Once the
display shows the mode you want hit [2nd][Quit].

Since the VAST majority of problems require your calculator to be in end mode, be sure
you reset this after each problem where you change it.

Alternatively, you can calculate the annuity due the same way we did with an ordinary annuity
and then multipy the resultant value by (1+I/Y) to get the correct value. Logically then, the PV of
an annuity due > the PV of an ordinary annuity. In fact you can think of the value of an annuity
due as the the lump sum received today + the ordinary annuity.

One of the major keys in this section is to be comfortable indexing the cash flows to the
appropriate segment of the time line. You need to keep annuities, ordinary annuities, and the
amount of years to enter to discount back to t=0 clear in your head. The best way to nail this is
by endless repetition of TVM problems.

Note that Level 1 problems will often try to add an additional wrinkle into TVM problems. They
may ask you how long it takes an investment to compound from one value to another for
example. Or maybe they will require you to bring FVs from multiple time periods back to
calculate a single PV.

Whatever the case, as long as you keep track of the timeline you can construct a series of TVM
calculations to get the final answer. That’s because of the cash flow additivity principle which
states that amounts of money indexed to the same point in time are additive.
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Perpetuities
A perpetuity is an annuity that never ends. The formula to calculate its present value is:

𝑃𝑀𝑇
𝑃𝑉𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑟

Where PMT is the periodic payment to be received. Be sure to remember this formula, it will be
tested at least once and it should be “free” points.

Using the Calculator for Uneven Cash Flows


See NPV

Recap
 The interest rate, r, is the required rate of return, discount rate, or opportunity cost
 An interest rate is the sum of the risk free rate, inflation, and other premiums
 The compound interest rate is what connects PV and FV over time
 𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑁
 The cash flow additivity principle lets us combine uneven cash flows
 TVM problems involve inputting 4 of 5 variables and computing the fifth
 The stated annual rate doesn’t reflect compounding so you may have to convert the rate
to the effective annual rate
 The annuity due (CF @ t=0) and ordinary annuity (CF @ t=1) are differentiated by the
date of their first cash flow. It helps to use a timeline to sequence the cash flows in order
to not make a mistake with the # of periods to use in a TVM problem
 The present value of an annuity is A/r where A is the periodic payment

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