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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

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.

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.

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

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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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:

= 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.

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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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.

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

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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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

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.

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.

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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Where:

M = number of compounding periods in one year

stated rate = the periodic (annual) interest rate given.

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

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.

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

This section is all about extending the principle of future value to account for multiple cash flows

during the life of an investment.

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

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.

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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