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CHAPTER 3
TIME VALUE OF MONEY
BBK2213| FINANCIAL
MANAGEMENT 1

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Introduction
This chapter introduces the concepts
and skills necessary to understand the
time value of money and its
applications.

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Payment of Interest
Interest is the cost of money
Interest may be calculated as:
Simple interest
Compound interest

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Simple Interest
Interest paid only on the initial principal
Example: $1,000 is invested to earn 6% per year,
simple interest.
0

-$1,000

$60

$60

$60

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Compound Interest
Interest paid on both the initial principal and on
interest that has been paid & reinvested.
Example: $1,000 invested to earn 6% per year,
compounded annually.
0

-$1,000

$60.00

$63.60

$67.42

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Future Value
The value of an investment at a point in the future, given some rate of
return.

Simple Interest

Compound Interest

FVn = PV0+(PV0 i n)

FVn = PV0 (1 + i)n

FV = future value
PV = present value
i = interest rate
n = number of periods

FV = future value
PV = present value
i = interest rate
n = number of periods

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Future Value: Simple Interest

Example: You invest $1,000 for three years at
6% simple interest per year.
6%

6%

6%

-$1,000

FV3 = PV0+(PV0 i n)

= $1,000 $1,000 0.06 3

= $1,180.00

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Future Value: Compound Interest

Example: You invest $1,000 for three years at 6%, compounded
annually.

6%

6%

6%

-$1,000

FV3 = PV0 (1 + i)n

= $1,000 1 0.06

= $1,191.02
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Future Value: Compound Interest

Future values can be calculated using a table
method, whereby future value interest factors
(FVIF) are provided.

FVn = PV0 (FVIFi,n ), where: FVIFi,n = 1+i

FV = future value
PV = present value
FVIF = future value interest factor
i = interest rate
n = number of periods
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Future Value: Compound Interest

Example: You invest $1,000 for three years at
6% compounded annually.

FV3 = PV0 (FVIF6%,3 )

=$1,000(1.191) =$1,191.00
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Present Value
What a future sum of money is worth today, given
a particular interest (or discount) rate.

PV0

FVn

1+i

FV = future value
PV = present value
i = interest (or discount) rate
n = number of periods

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Present Value
Example: You will receive $1,000 in three years.
If the discount rate is 6%, what is the present
value?
0

6%

6%

6%

3
$1,000

PV0

FV3

1+i

$1,000

1 0.06

$839.62

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Present Value
Present values can be calculated using a table
method, whereby present value interest factors
(PVIF) are provided.

PV0 = FVn(PVIFi,n ), where: PVIFi,n =

1+i

FV = future value
PV = present value
PVIF = present value interest factor
i = interest rate
n = number of periods
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Present Value
Example: What is the present value of $1,000 to
be received in three years, given a discount rate
of 6%?

PV0 = FV3(FVIF6%,3 )
=$1,000(0.840) =$840.00
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A Note of Caution
Note that the algebraic solution to the present
value problem gave an answer of 839.62
The table method gave an answer of $840.

Caution:
Tables provide approximate answers only.
If more accuracy is required, use algebra!

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Annuities
The payment or receipt of an equal cash
flow per period, for a specified number of
periods.
Examples: mortgages, car leases,
retirement income.

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Annuities
Ordinary annuity: cash flows occur at the end
of each period
Example: 3-year, $100 ordinary annuity
0

$100

$100

$100

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Annuities
Annuity Due: cash flows occur at the
beginning of each period
Example: 3-year, $100 annuity due
0

$100

$100

$100

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Difference Between Annuity Types

Ordinary Annuity
0

$100

$100

$100

Annuity Due
0

$100

$100

$100

$100

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Annuities: Future Value

Future value of an annuity - sum of the future
values of all individual cash flows.
0

$100

$100

$100

FV
FV
FV
FV of Annuity

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Annuities: Future Value Algebra

Future value of an ordinary annuity

1+i n -1
FVOrdinary= PMT

i
Annuity

FV = future value of the annuity

PMT = equal periodic cash flow
i = the (annually compounded) interest rate
n = number of years

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Annuities: Future Value

Example: What is the future value of a three
year ordinary annuity with a cash flow of $100
per year, earning 6%?
1+i n -1
FVOrdinary= PMT

i
Annuity

1.06 3 1
100

.06

$318.36
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Annuities: Future Value Algebra

Future value of an annuity due:

1+i n -1
FVAnnuity= PMT
1 + i

i
Due

FV = future value of the annuity

PMT = equal periodic cash flow
i = the (annually compounded) interest rate
n = number of years
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Annuities: Future Value Algebra

Example: What is the future value of a three year
annuity due with a cash flow of $100 per year,
earning 6%?
1+i n -1
FVAnnuity= PMT
1+i

i
Due

1.06 3 1
100
1.06

.06

$337.46
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Annuities: Future Value Table

The future value of an ordinary annuity can be
calculated using table where future value of an
ordinary annuity interest factors (FVIFA) are
provided.

FVANn = PMT(FVIFAi,n ) where:

FVIFAi,n =
PMT = equal periodic cash flow
i = the (annually compounded) interest rate
n = number of periods
FVAN = future value (ordinary annuity)
FVIFA = future value interest factor

1 i

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Ordinary Annuity: Future Value

Example: What is the future value of a 3-year
$100 ordinary annuity if the cash flows are
invested at 6%, compounded annually?

FVANn = PMT(FVIFAi,n )
=$100 3.184 $318.40
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Annuity Due: Future Value

Calculated using Table, where FVIFAs are found.
Ordinary annuity formula is adjusted to reflect
one extra period of interest.

FVANDn = PMT FVIFAi,n 1 i

, where:

FVIFAi,n =

1 i

PMT = equal periodic cash flow

i = the (annually compounded) interest rate
n = number of periods
FVAND = future value (annuity due)
FVIFA = future value interest factor
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Annuity Due: Future Value

Example: What is the future value of a 3-year
$100 annuity due if the cash flows are invested
at 6% compounded annually?

FVANDn = PMT FVIFAi,n 1 i

$100 3.184(1.06) $337.50
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Annuities: Present Value

The present value of an annuity is the sum of
the present values of all individual cash flows.
0

PV
PV
PV
PV of Annuity

$100

$100

$100

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Annuities: Present Value Algebra

Present value of an ordinary annuity

1- 1+i -n
PVOrdinary = PMT

i
Annuity

PV = present value of the annuity

PMT = equal periodic cash flow
i = the (annually compounded) interest or discount rate
n = number of years

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Annuities: Present Value Algebra

Example: What is the present value of a three year,
$100 ordinary annuity, given a discount rate of 6%?

1- 1+i -n
PVOrdinary=PMT

i
Annuity

1 - 1.06 -3
100

.
06

$267.30
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Annuities: Present Value Algebra

Present value of an annuity due:
1- 1+i -n
PVAnnuity = PMT
1+i

i
Due

PV = present value of the annuity

PMT = equal periodic cash flow
i = the (annually compounded) interest or discount rate
n = number of years

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Annuities: Present Value

Algebra
Example: What is the present value of a three year,
$100 annuity due, given a discount rate of 6%?

1- 1+i -n
PVAnnuity= PMT
1+i

i
Due

1 1.06 3
100
1.06

.06

$283.34

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Annuities: Present Value Table

The present value of an ordinary annuity can be
calculated using Table, where present value of
an ordinary annuity interest factors (PVIFA) are
found.

PVAN0 = PMT(PVIFAi,n ), where:

PVIFAi,n

1- 1+i -n

=
i

PMT = cash flow

i = the (annually compounded) interest or discount rate
n = number of periods
PVAN = present value (ordinary annuity)
PVIFA = present value interest factor
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Annuities: Present Value Table

Example: What is the present value of a 3-year
$100 ordinary annuity if current interest rates
are 6% compounded annually?

PVAN0 = PMT(PVIFAi,n )
=$100 2.673 $267.30
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Annuities: Present Value Table

Calculated using Table, where PVIFAs are found.
Present value of ordinary annuity formula is
modified to account for one less period of
interest.

PVAND0 = PMT PVIFAi,n(1 i)

PVIFA

1- 1+i n

=
i

i,n
PMT = cash flow
i = the (annually compounded) interest or discount rate
n = number of periods
PVAND = present value (annuity due)
PVIFA = present value interest factor
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Annuities: Present Value Table

Example: What is the present value of a 3-year
$100 annuity due if current interest rates are
6% compounded annually?

PVAND0 = PMT PVIFAi,n(1 i)

$100 2.673 1.06 $283.34
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Other Uses of Annuity Formulas

Sinking Fund Problems: calculating the annuity
payment that must be received or invested each
year to produce a future value.
Ordinary Annuity

FVANn
PMT=
FVIFAi,n

Annuity Due

FVANn
PMT=
FVIFAi,n 1 i

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Other Uses of Annuity Formulas

Loan Amortization and Capital Recovery
Problems: calculating the payments necessary to
pay off, or amortize, a loan.

PVAN0
PMT=
PVIFAi,n

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Perpetuities
Financial instrument that pays an equal cash flow
per period into the indefinite future (i.e. to
infinity).
Example: dividend stream on common and
preferred stock
0

$60

$60

$60

$60

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Perpetuities
Present value of a perpetuity equals the sum of
the present values of each cash flow.
Equal to a simple function of the cash flow (PMT)
and interest rate (i).

PMT
PVPER 0
n
(1+i)
t 1

PMT
PVPER 0
i

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Perpetuities
Example: What is the present value of a $100
perpetuity, given a discount rate of 8%
compounded annually?

PMT $100
PVPER 0

$1,250.00
i
0.08

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More Frequent Compounding

Nominal Interest Rate: the annual percentage
interest rate, often referred to as the Annual
Percentage Rate (APR).
Example: 12% compounded semi-annually
12%

0
-$1,000

6%

0.5
$60.00

6%

1
$63.60

6%

1.5
$67.42

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More Frequent Compounding

Increased interest payment frequency requires
future and present value formulas to be
adjusted to account for the number of
compounding periods per year (m).
Future Value

inom
FVn PV0 1

Present Value
mn

PV0

FVn
inom
1+ m

mn

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More Frequent Compounding

Example: What is a $1,000 investment worth in
five years if it earns 8% interest, compounded
quarterly?

inom
FVn PV0 1

mn

0.08
$1,000 1

$1, 485.95

(4)(5)

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More Frequent Compounding

Example: How much do you have to invest today
in order to have $10,000 in 20 years, if you can
earn 10% interest, compounded monthly?

PV0

FVn

mn

inom
1+ m

$10,000

0.10
1+ 12

(12)(20)

$1,364.62

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Impact of Compounding Frequency

$1,000 Invested at Different
10% Nominal Rates for One Year

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Effective Annual Rate (EAR)

The annually compounded interest rate that is
identical to some nominal rate, compounded
m times per year.

ieff

inom
1+
m

ieff effective annual rate

inom nominal interest rate
m = compounding frequency per year

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Effective Annual Rate (EAR)

EAR provides a common basis for comparing
investment alternatives.

Example: Would you prefer an investment offering

6.12%, compounded quarterly or one offering 6.10%,
compounded monthly?

ieff

inom
1+
m

1
4

0.0612
1+
1

6.262%

ieff

inom
1+
m

0.061
1+

12

6.273%

12

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Major Points
The time value of money underlies the valuation of
almost all real & financial assets
Present value what something is worth today
Future value the dollar value of something in the future
Investors should be indifferent between:
Receiving a present value today
Receiving a future value tomorrow
A lump sum today or in the future
An annuity
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