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Time Value of Money (TVOM) Tutorial

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TVOM Concept and Components
Introduction

John is an acquaintance of yours. He is a marketing
major and has made the dean's list every semester.
John decides to start up a small consulting company
during his senior year. He has approached you and
asked you to lend him $10,000, which he will pay
back after three years.
If you decide to keep the money, you can use it
to pay your bills, take a vacation, add to your
savings, etc.
If you decide to lend him the money, you will
have to go without the things that this $10,000
can buy.
After some careful consideration, you decide to lend
him the money. How much should you expect back
after three years? The same amount, or more or less
than $10,000? Why?
In this example, you should expect to get more than
$10,000 back from your acquaintance, John.
Why should you (as well as others) expect to get back
more than the amount that you lend i.e., $10,000?
Because if you do not lend the money, you can use it
to do other things. By lending, you are giving up
using it for the next three years, and hence you
require some returns to compensate for what you will
give up. This is a tradeoff between using money today
and saving for future use, and hence time has value.
The underlying basis of the Time Value of Money
(TVOM) is that time has value. That is, a dollar
today is worth more than a dollar tomorrow.
Objectives
Upon completing this section of the TVOM tutorial,
you will be able to:
Describe the concept of Time Value of Money
(TVOM).
Correctly label a time line.
Explain the difference between present value
and future value.
Explain the difference between compound and
simple interest rate.

Time Line
The time line is a very useful tool for an analysis of
the time value of money because it provides a visual
for setting up the problem. It is simply a straight line
that shows cash flow, its timing, and interest rate.

A time line consists of the following components:
Time period
Interest rate
Cash flow
Time period (t) can be any time interval such as year,
half a year, and month. Each period should have
equal time interval. Zero represents a starting point,
and a tick represents the end of one period. From the
example at the beginning of this section, there are
three years or annual periods and hence the time line
has three ticks. Each tick represents a period of one
year.

Interest rate (r) is the rate earned or paid on cash
flow per period. It is labeled above the time line.
If a 10% return per year is required, the time line
should be:

Cash flow (CF) is amount of money. It is
placed directly below a tick at time period that it
occurs. Cash flow can be known or unknown amount.
Cash outflow, an amount that you pay, cost to
you, or spending amount, has a negative sign.
Cash inflow, an amount that you receive or
savings amount, has a positive sign.
Cash flow, like interest rate, can be a known or an
unknown amount. For both, the unknown value that
you try to solve for (e.g., cash flow or interest rate) is
indicated by a question mark.
From our example, if John has also told you that he
will return $13,000 at the end of three years, and you
want to calculate the return on this investment, the
time line should be:

Remember: Time line can help you simplify a
complex problem.


An important note about cash flows: When a
problem has only one type of cash flow (i.e., either
inflows or outflows), the sign of cash flows can be
ignored.
For example, over the past three years, you deposited
$100, $200, and $300 in a bank account that earned
5%. How much do you have today? The signs of
$100, $200, and $300 can be ignored because they
are the same type of cash flows.
The timeline for this example is as follows:

Note: The unknown amount for this example will be
later known as future value (FV).
There are times, however when a problem
has both cash inflows and outflows. In this case, signs
of cash flows are very important. For example, three
years ago you deposited $100. Then, you withdrew
$50 one year after that. Last year, you deposited
$200. How much do you have today if you earn 5%?
In this case, signs of cash flows can not be ignored.
The signs of $100 and $200 must be the same, and
different from the sign of $50 because $100 and $200
are deposits while $50 is a withdrawal.
If the deposits are considered cash outflows and
therefore have a negative sign, the withdrawal must
be positive. The time line is as follows:

If the deposits are considered savings and hence have
a positive sign, the withdrawal must be negative. The
time line is as follows:

For this tutorial, the sign of cash flows will be ignored
for problems with only one type of cash flow.

Practice: Using the time line below, indicate the
values for A, B and C for each of the three problems.

1. The bank lends you $20,000 and requires a 10%
return. To assist you in calculating the amount of
money you would pay back, you would label parts A,
B, and C of the time line as:
A. ____________________
B. ____________________
C. ____________________
2. Your brother borrows $100 and has also told you that
he will return $120 at the end of three years. To
assist you in calculating the return on this investment,
you would label parts A, B, and C of the time line as:
. ____________________
A. ____________________
B. ____________________
3. Based on a 10% return, your roommate determines
she will need $500 at the end of three years to pay
back a loan. To assist you in calculating the amount of
money originally borrowed by your roommate, you
would label parts A, B, and C of the timeline as:
. ____________________
A. ____________________
B. ____________________

Answers to Practice Problems:

1. If a bank lends you $20,000 and requires a 10%
return. To assist you in calculating the amount of
money you would pay back, you would label parts A,
B, and C of the time line as:
A. r = 10%
B. +$20,000
C. ?
2. Your brother borrows $100 and has also told you that
he will return $120 at the end of 2 years. To assist
you in calculating the return on this investment, you
would label parts A, B, and C of the time line as:
. r=?
A. -$100
B. +$120
3. Based on a 10% return, your roommate determines
she will need $500 at the end of three years to pay
back a loan. To assist you in calculating the amount of
money originally borrowed by your roommate, you
would label parts A, B, and C of the timeline as:
. r=10%
A. ?
B. +$500

Present v. Future Value
What is the difference between future value and
present value?
Present value (PV) is the current value of future
cash flow.
Future value (FV) is the value of cash flow after
a specified period.
A simple way to classify whether cash flows are
present value or future value is to remember that:
PV is the value at the beginning of a time period
that you are considering.
FV is the value at the end of the time period that
you are considering.

Recall the example from the beginning of this section:
John is an acquaintance of yours. He is a business major and has
made the dean's list every semester. John wants to start up a small
consulting company during his senior year. He has approached you
and asked you to lend him $10,000, which he will pay back after
three years.
For the three-year period that you consider lending,
$10,000 is the value at the beginning and hence
called PV, and the amount that you will get back from
John (i.e., $13,000) is the value at the end and hence
called FV.

Practice: Now try answering the following two
problems, and then check your answers on the next
screen. Be sure to draw a timeline to assist you in
finding the answer:
1. You lent $10,000 to John in 1997 and he returned
$13,000 to you in 2000, which amount should be
called PV and FV?
2. You lend John $10,000 in 2006, and get $13,000 back
three years after that, in 2009. Is $10,000 PV or FV?
Answers to Practice Problems:
1. You lent $10,000 to John in 1997 and he returned
$13,000 to you in 2000, which amount should be
called PV and FV?

Answer: Although both $10,000 and $13,000 are cash
flows that occurred in the past, $10,000 is still called
PV, and $13,000 is called FV. This is because $10,000
is the cash flow at the beginning, and $13,000 is the
cash flow at the end of the time period being
considered.


2. You lend John $10,000 in 2006, and get $13,000 back
three years after that, in 2009. Is $10,000 PV or FV?

Answer: Again, $10,000 is still called PV and $13,000
is called FV although $13,000 is cash flow in the
future. The same logic applies, $10,000 is value at
the beginning and $13,000 is value at the end.


Remember: Present value is not necessarily today's
value, and future value is not necessarily a value in
the future.

An emphasis here is that for any problem, especially a
complex one, there might be more than one time
period that you have to consider separately.
Therefore a time period that you are considering
might not be the same as the (entire) time period of
the problem.
For example, three years ago, you saved $1,000 that
you earned from your summer job in a bank account
with 5% interest rate. Now you're interested of using
the money. You want to split the money into four
equal amounts withdrawn in the next four years. How
much can you withdraw per year?

For this example, let's create the timeline:
There are 7 annual periods from the time you
placed your $1,000 in the bank to the last
withdrawal. Hence the time line should have
seven "ticks" after the zero.
The interest rate is 5%, so r=5%.
The cash outflow or the amount you contribute,
is -$1,000.
The cash inflow or the four withdrawal amounts
are unknown.

In order to solve for the four equal cash flows
(withdrawals), first you need to find out how much
you have today (X) or calculate FV of $1,000.
Today's value (X) of $1000 is called FV because:
You are considering the time period from t=0 to
t=3.
The value of $1000 is at the beginning of this
time period (rather than the time period of the
entire problem) and hence is called PV.
The X amount at t=3 is the value at the end of
the time period and hence called FV.
This is how it is depicted graphically:

After calculating X, you can solve for the four equal
withdraws (?). Now, X is called PV because you're
considering the time period from t=3 to t=7 and X is
at the beginning of the time period. Graphically,

As mentioned earlier, the same cash flow (X) can be
called either PV or FV for the same problem,
depending on whether it is at the beginning or at the
end of time period that you consider.


Practice Question: Your Uncle Lee plans to retire
next year on his 63rd birthday. He is curious how
much he can spend each year after retirement. Since
he was 25 years old, Uncle Lee has saved $30,000
per year in an account that earns 5% interest rate.
His life expectancy is 90.
1. Calculate the amount of savings that Uncle Lee will
have accumulated at age 63.
2. Calculate the value of all withdrawals that Uncle Lee
will make if he lives to 90.
Based on this information, the time line below can be
created:

In order to solve the above problems, should
you solve for PV or FV?
Let's consider the first problem, calculate savings
amount that Uncle Lee has accumulated until Age 63.
To calculate the savings amount at Age 63, you
should consider the time period between ages 25-63
as follows:


Because 63 is at the end of the time period, you need
to determine the FV to calculate savings amount of
30,000 annual deposits.

Now let's look at the second problem, calculate the
value at Age 63 of all withdrawals that Uncle Lee will
make.
To consider value at Age 63 of all withdrawals, you
should consider the time period between ages 63-90
as follows:


Because the value of withdrawals at Age 63 is at the
beginning of the time period, you need to determine
the PV of the "C" amount in order to calculate the
value of withdrawals.

Simple v. Compound
What is compound interest rate? How is it different
from simple interest rate?
For a simple interest rate, interest is earned on
the original principal only.
For a compound interest rate, interest is earned
on both the original principal and interests
reinvested from prior periods.
The difference is the amount of interest that is earned
on the reinvested interests.
For example, you invest $100 for 3 years in an
investment company that provides a fixed 10%
interest rate. What is your payback at the end of 3
years?

If the interest rate is a simple rate, the payback for:
The first year (X
1
) is $100 of original principal +
$10 of interest:
X
1
= $100 + (10% $100) = $110.
The payback for the second year (X
2
) is $100 of
the principal + $10 of interest from the first year
+ $10 of interest from the second year:
X
2
= $100 + (10% $100) + (10%
$100) = $120.
The payback for the third year (X
3
) is $100 of
the principal + $10 of interest from the first year
+ $10 of interest from the second year + $10 of
interest from the third year:
X
3
= $100 + (10% $100) + (10%
$100) + (10% $100) = $130.

If the interest rate is an annual compound rate (i.e.,
computed once a year), the payback for:
The first year (X
1
) is $100 of original principal +
$10 of interest:
X
1
= $100 + (10% $100) = $110
The payback for the second year (X
2
) is, $100 of
the principal + $10 of interest from the first year
+ $11 of interest from the second year:
X
2
= $100 + (10% $100) + (10%
$110) = $121
The payback for the third year (X
3
) is $100 of
the principal + $10 of interest from the first year
+ $11 of interest from the second year + $12.1
of interest from the third year:
X
3
= $100 + (10% $100) + (10%
$110) + (10% 121) = $133.1


Note that the payback for the first year is the same
for both simple and compound rate. However, the
paybacks after the first year are higher for the
compound rate than for the simple rate because
interest is computed on the prior year's principal,
not the original principal. The longer the time period
is, the larger the difference. TVOM assumes
compound interest rate.

Practice Question: Josh, your close friend,
borrowed $500 from you three years ago. He has
promised to return the money to you today with 6%
interest rate per year. If Josh returns $595 and some
change to you, is the interest rate a simple or
compound rate?

For a simple interest rate of 6%, the amount of
interest per year would be:
X
1
= $500 + (.06 $500) = $530
X
2
= $500 + (.06 $500) + (.06 $500) =
$560
X
3
= $500 + (.06 $500) + (.06 $500) +
(.06 $500) = $590
As such, you should get back $590.
For a compound interest rate of 6%, the amount of
interest per year would be:
X
1
= $500 + (.06 $500) = $530
X
2
= $500 + (.06 $500) + (.06 $530) =
561.80
X
3
= $500 + (.06 $500) + (.06 $530) +
(.06 $561.80) = $595.51
Since Josh returns $595.51, $500 of principal and
$95.51 of interest, the interest rate is a compound
rate. Under a compound rate, interest amount is
greater than under a simple rate because interest is
earned on the prior year's interest.


The Pennsylvania State University 2006. All rights reserved.




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Time Value of Money (TVOM) Tutorial
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Different Types of TVOM
Introduction

Can you identify the type of TVOM for each scenario?
Josh and Sarah, both sophomores, want to travel
abroad during their senior year of college. They have
combined the money they saved from their summer
jobs, and will let it collect interest for the next two
years. How much money will Josh and Sarah have for
their trip?

Taisha and Darrell are planning to get married
following graduation this semester. They deposited
the extra money that they earned from their part
times jobs into a savings account over the past three
years. The first year they deposited $900, the second,
$1300 and the third, $1,200. How much money do
they have for their wedding?

Sections 2-A and 2-B cover the major types of TVOM,
which include:
1. lump sum
2. multiple cash flows
3. annuity
4. annuity due
5. perpetuity
6. growing perpetuity
7. growing annuity
Objectives
Upon completing sections 2-A and 2-B of the tutorial,
you will be able to:
Identify the seven types of TVOM.
Explain how they are different from one another.
Once you are able to distinguish one type of TVOM
from another, you will be able to simplify the problem
and choose the correct equation.

Lump Sum
The lump sum has the following characteristics:
There are 2 cash flows on the time line:
o Present value (PV) at the beginning of
the time line
o Future value (FV) at the end of the time
line
There is no cash flow in between PV and FV.

The equation for lump sum is:
FV = PV(1+r)
t

or

Where:
FV = future value of lump sum
PV = present value of lump sum
r = interest rate per period
t = number of compounding periods

For example, you earn $500 from your summer job
and want to save for European trip in the next three
years. How much will you have when you go for the
trip if you deposit the money in a savings account that
earns 10% interest? Using the time line for this
problem, complete the equation:

FV = PV(1+r)
t

FV = ?
PV = 500
r = .10
t = 3
FV = 500(1+.10)
3

Note: Interest is computed three times and
therefore t equals 3.

Multiple Cash Flows
For this type of TVOM, there are many cash flows over
the time line. Cash flows can be all the same or all
different. Cash flows are not necessarily consecutive.

To solve for the Future Value (FV) of multiple cash
flows, simply treat each cash flow as a lump sum and
then add them up:
FV = FV of C
1
+ FV of C
2
+ FV of C
3

FV = C
1
(1 + r)
2
+ C
2
(1 + r)
1
+ C
3
(1 + r)
0

Similarly, to solve for the Present Value (PV) of
multiple cash flows:
PV = PV of C
1
+ PV of C
2
+ PV of C
3


For example, over the next three years, you expect to
earn the following amounts of money: $100, $200
and $150. If you save these in a saving account that
earns 5%, how much will you have at the end of year
3? The time line is as follow:

For this example, calculate the value at the end of the
time line or FV of $100, $200 and $150. (Hint: Use
the lump sum equation, FV = PV(1+r)
t
, to solve for
each cash flow and then add them together.)
FV = FV of 100 + FV of 200 + FV of 150
FV =100(1 + 0.05)
2
+ 200(1 + 0.05)
1
+ 150
Note: The interest is computed twice for $100 and
therefore t for $100 is 2. The interest is computed
once for $200 and therefore t for $200 is 1. There is
no interest earned on the last $150.

Annuity
Annuity is a special case of multiple cash flows where:
The cash flows are equal for a fixed period of
time.
The cash flows are at the end of each period.
The equal amount of cash flows is called annuity
payment or payment (C).

You can solve an annuity problem the same way as
multiple cash flows, calculating the value of each cash
flow and sum all values. However, this can be quite
tedious especially when dealing with long series of
annuity payments. Fortunately, future and present
values of annuity payments can be calculated from
the following equations:
or
Where:
FVA = future value of annuity
PVA = present value of annuity
C = amount of equal payments
r = interest rate per period
t = number of payments (number of time
periods)

For example, you plan to save $200 per year for the
next five years for your new car's down payment.
How much will you have as the down payment if you
earn 10% interest rate on the savings? Using the time
line below, we can fill in the missing information of
the equation to solve for FVA:


FVA = ?
C = 200
r = .10
t = 5

In order to call a series of cash flows an annuity and
use the PVA and FVA equations, the following must be
true:
1. All payments must be equal and consecutive.
2. Payments last for a certain period.
3. The first payment starts one period from the
beginning of the time line (time period for PV).
4. The last payment is at the end of time line (time
period for FV).
A quick way to check whether a series of payments is
annuity is that the number of payments must be the
same as the number of time periods. In the previous
example, there are 5 payments (C) which are equal to
5 periods (years). Therefore, the problem can be
called annuity.
The series of payments displayed in the time line
below, however, cannot be called annuity because the
number of payments (C) is not the same as the
number of time periods (t). Thus the PVA and FVA
equations cannot be applied.

Note: There are three payments (c) and five time
periods (t).

Annuity Due
Annuity due is similar to annuity in that there is a
series of equal and consecutive payments that last for
a certain period, but the payments start at the
beginning of each time period and the last payment
stops one period before the end of the specified time
period.

To determine whether a series of payments are
classified as annuity due is the similar to the way you
would determine if they were an annuity: Check to
see if the number of payments is the same as the
number of time periods.

Let's Compare the Annuity and Annuity Due Time
lines:
Annuity Timeline:

Annuity Due Timeline:

Note that the annuity and annuity due time lines
are similar because:
Payments are equal and consecutive.
Payments last for a certain period of time.
The annuity due time line, however, is different from
the annuity time line, because:
The first payment starts right away.
The last payment stops one period before the
end of time line.
PV is the value at the same time period as the
first payment.
FV is the value one period after the last
payment.

As discussed, for both annuity and annuity due, there
is the same number of payments. But all payments of
annuity due earn one more period of interest, and
hence:
The future value of annuity due equals to future value
of annuity multiplied by (1+r).

The present value of annuity due equals to present
value of annuity multiplied by (1+r).
===
where
FVA(Due) = future value of annuity due
PVA(Due) = present value of annuity due
C = amount of equal payments
r = interest rate per period
t = number of payments (number of time
periods)

For example, you plan to save for your new car's
down payment that you will need five years from now.
Like in the annuity example, there will be five
deposits of $200 per year. However, you will start the
first deposit right away. How much will you have as
the down payment for your car if you earn 10%
interest rate on the saving? Using the time line below,
fill in the missing information to solve for FVA (due):


FVA(Due) = ?
C = 200
r = .10
t = 5

Perpetuity
Perpetuity is similar to annuity. The only difference
between annuity and perpetuity is the ending period.
For annuity, payments last for a certain period,
whereas for perpetuity, they continue indefinitely, as
represented by ().

The equation below is used to calculate present value
of perpetuity. It requires only the first payment and
interest rate.


where
PV() = present value of perpetuity.
C = the first payment
r = interest rate per period

For example, an insurance company has just launched
a security that will pay $150 indefinitely, starting the
first payment next year. How much should this
security be worth today if the appropriate return is
10%? Using the time line below, complete the PV()
equation.

The equation below is used to calculate present value
of perpetuity. It requires only the first payment and
interest rate.


PV() = ?
C = 150
r = .10


Growing Perpetuity
With a growing perpetuity, there is a series of
consecutive payments that continue indefinitely, and
each payment grows at a constant rate.

The equation below is used to calculate growing
perpetuity:


where
PVG() = present value of growing perpetuity.
C
1
= the first payment
r = interest rate per period, and
g = a constant growth rate.
Note that C
1
is the value of the first payment (not the
value of payment at t=0), and r must not be equal to
g.

For example, a company is expected to pay $2 of
dividend per share that will increase 5% forever. If
investors require 10% return on the company's
stocks, how much should investors pay for the stocks?
The cash flows are as follow:

The equation below is used to calculate growing
perpetuity:


where
PVG() = ?
C
1
= $2
r = .10
g = .05


Growing Annuity
A growing annuity is the same as annuity in that
payments for both end at a certain period. However,
payments of growing annuity increase at a constant
rate while payments of annuity are fixed.
Growing annuity is also similar to growing perpetuity;
payments of both increase at a constant rate. Unlike
growing perpetuity, payments of growing annuity end
at some point.

A growing annuity problem can be treated as multiple
cash flows because all cash flows are not equal.
However, it is very tedious to calculate present values
of many cash flows separately.
Fortunately, the following equation can be used to
calculate present value of growing annuity.

where:
PVGA = present value of growing annuity
C
1
= the first payment,
r = interest rate per period, and
g = a constant growth rate.
Note: The PVGA equation requires the first payment
or C
1
for the present value at time 0.

For example, an investment company just issued a
security which will provide 10 payments, starting next
year for $100 and increasing 5% per year after that.
How much is this security worth if the appropriate
required return is 10%? The cash flows for the next
ten years are as follows:


where:
PVGA = present value of growing annuity
C
1
= $100
r = .10
g = .05

Practice
To solve each problem follow these steps:
1. Create a time line
2. Identify type of cash flows and
3. Identify the appropriate equation needed to solve a
problem.
Note: The solution to each problem is given.
Practice Question 1:
Tyler won a lottery. The commission asked him to
choose between $10,000 today and $20,000 three
years from today. Which option should Tyler take if
his investment opportunity is 10% annually
compounding?
Solution:
$10,000 is today's value while $20,000 is the value
three years from today. In order to choose between
these two options, you need to convert $20,000 to be
today's value so that it can be compared to $10,000.
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: Since
$20,000 is only one cash flow amount on the time
line, the type of cash flow is lump sum.
Step 3- Select the appropriate equation: We can
also see that the present value of $20,000 is needed.
The equation for the problem is present value of lump
sum:

Step 4- Enter the variables in the equation and
solve: FV = $20,000 (value at the end); r = 10%
(investment opportunity); t = 3 (compounding
periods)

Practice Question 2:
Rhon started his small business five years ago. His
business generated $300, $500, $200, $400 and -
$200 of cash flows over the past five years. How
much money has Rhon accumulated from his business
as of today? Assume that he has earned 8% annually
compounding and never spent the money.
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The cash
flows are not the same and hence the series of cash
flows is multiple cash flows.
Step 3- Select the appropriate equation: The
value at the end of time period or future value is
needed. To calculate future value of multiple cash
flows, simply calculate future value of each lump sum
and add all of them together. The future value of
lump sum equation is FV = PV(1+r)
t
, so multiple cash
flows can be represented as:
FV = C
1
(1 + r)
4
+ C
2
(1 + r)
3
+ C
3
(1 + r)
2
+
C
4
(1 + r)
1
+ C
5
(1 + r)
0

Step 4- Enter the variables in the equation and
solve:
C
1
= 300, C
2
= 500, C
3
= 200, C
4
= 400, C
5
= -200,
plus r = 8% (interest rate); t and PV vary for each
cash flow.
FV = 300 (1.08)
4
+ 500 (1.08)
3
+ 200 (1.08)
2
+
400 (1.08)
1
+ (-200)

Practice Question 3:
Nikki just had a new born son. She wants to set aside
some money for her son's college expenses in 16
years. If the tuition's total cost is $100,000 when he
turns 16, how much does she have to save per year?
Assume she earns 5% annually compounding.
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The series
of equal annual payments is annuity.
Step 3- Select the appropriate
equation: $100,000 is cash flow at the end of time
period or future value. Therefore, the equation
needed for the problem is future value of annuity.

Step 4- Enter the variables in the equation and
solve: FV = 100,000 (tuition cost); r = 5% (interest
earned); t = 16 (number of payments)

Practice Question 4:
Yoma bought a $30,000 car for his wife. If he finances
the car with a bank that charges 6% monthly
compounding, how much does Yoma have to pay per
month over the next 5 years, starting the first
payment now?
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The series
of equal payments with the first payment starts right
away is annuity due.
Step 3- Select the appropriate equation: $30,000
is the value at the beginning of the time period or
present value. The equation for the problem is
present value of annuity due.

Step 4- Enter the variables in the equation and
solve: PV = $30,000 (car cost); r =
6%
/
12
(financing
cost); t = 60 (number of payments)

Practice Question 5:
PA State issues a security that pays $100 per year
indefinitely. If the appropriate required return for this
security is 10%, what should be the price of the
security?
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The series
of equal amount of payments that continue
indefinitely is perpetuity.
Step 3- Select the appropriate equation: The
price of security is present value. The equation for the
problem is present value perpetuity.

Step 4- Enter the variables in the equation and
solve: C = 100 (equal amount of cash flows);
r = 10% (required return)

Practice Question 6:
Nicole wants to buy a stock of a company. Several
analysts expect that the company will pay $2 dividend
next year, and increase 5% per year after that. If
Nicole requires 10% return, how much should she pay
for the stock? Assume that dividend will continue
forever.
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The
amount of dividends increases at a constant rate of
5% and continue indefinitely. This type of cash flows
is called growing perpetuity.
Step 3- Select the appropriate equation: The
price of security is present value. The equation for the
problem is present value growing perpetuity.

Step 4- Enter the variables in the equation and
solve: C
1
= 2 (next year's dividend amount);
r = 10% (required return); g = 5% (constant growth
rate)

Practice Question 7:
Roman works as a sports agent. He is negotiating a
10-year contract for one of his clients, a NBA rookie.
The first annual pay will be $1 million and every pay
will increase at 5% per year. His client wants a lump
sum payment today instead of installments. What is
the minimum lump sum amount that Roman should
ask for his client if his client's investment opportunity
is 10% annually compounding?
Solution:
Step 1- Create a Timeline:

Step 2- Identify the type of cash flow: The series
of cash flows is growing annuity because the cash
flows increase at a constant rate, and last for a
certain period (i.e., 10 years).
Step 3- Select the appropriate equation: Since
the rookie wants a lump sum payment today, present
value is needed. The equation for the problem is
present value growing annuity.

Step 4- Enter the variables in the equation and
solve: C
1
= $1 million (the first annual pay); r = 10%
(investment opportunity); g = 5% (growth rate or
rate of pay increase); t = 10 (number of pays)


The Pennsylvania State University 2006. All rights reserved.



Skip to content.The ALT text used on graphical equations is similar to,
but not exactly like Math Speak; a few conventions are borrowed.
Exponents are read as supe followed by the exponent then base to
signify terms representing the exponent have ended. Subscrpts are
read as sub followed be the subscript, then base. Parenthesis are
read in line as they occur: left parens opens the parenthetical and
right parens closes it. Square brackets are read as left bracket then
right bracket. Fractions are always read as numerator followed by
denominator. One half would be numerator one denominator two.
Time Value of Money (TVOM) Tutorial
(Print-friendly version. Return to Tutorial)


Frequency of Compounding
Introduction

Your grandmother sends you $100 for your birthday,
and you decide to invest it.
You visit three different borrowers and each offers
you the same interest rate. You discover, however,
that one borrower computes interest monthly, the
other semiannually and the third annually.
Which borrower should you pick? Which one will result
in more money for you?

As mentioned earlier, TVOM assumes a compound
interest rate. This section highlights:
The effects of frequency of compounding
Differences between quoted rate, EAR and APR
Objectives
Upon completing this section you will be able to:
Calculate the amount of interest earned from
borrowers with annual, semi annual and monthly
compounding.
Calculate periodic rate.
Define quoted rate.
Calculate EAR.
Define APR.

Frequency of Compounding
Frequency of compounding concerns the number of
times that interest is computed per year. It can best
be explained through an example.
Assume Maria wants to invest $100 that she received
from her grandmother for her birthday. She finds
three borrowers that will pay her the same 12%
interest rate. However, the interest for each borrower
will be computed (and credited to Maria's account)
differently as follows:
Borrower#1 computes interest once a year
(called annual compounding).
Borrower#2 computes interest twice a year
(called semiannual compounding).
Borrower#3 computes interest twelve times a
year (called monthly compounding).
What is the amount of interest that Maria earns from
each borrower for one year?
To answer this question, you need to calculate future
value at the end of one year for each borrower and
compare it with the investment of $100.

First, let's look at the time line and interest
computation for Borrower#1 (annual compounding):

From Section 1 of this tutorial, you know the formula
for calculating a compound interest rate for the first
year, X
1
, is:
X
1
= X
1
+(X
1
r)
Using this same equation, but substituting FV
1
for X
1
:
FV
1
= 100+(100.12) = 100(1.12) = $112
Since this timeline has only two values, PV and FV,
you should also recognize it as a lump sum case. Thus
you could also use the lump sum formula from
Section 2-A to solve for FV
1
, which will give you the
same answer as above:
FV
1
= PV(1r)
t

FV
1
= 100(1.12)
1
= $112
Given the investment of $100, we can determine the
amount of interest for the year by subtracting the FV
from the PV:
$112-100 = $12
That is, Maria will earn a 12% return.

Next, let's look at the time line and interest
computation for Borrower#2 (semiannual
compounding):

Because Borrower#2's interest rate is stated for the
entire year, the interest per half a year equals to 12%
divided by 2, which equals 6%. Thus, you can
calculate the compound interest of the future value
after the first six months (FV
1
) and the future value at
the end of the year (FV
2
):
FV
1
= 100+(100.06) = $106
FV
2
= 106+(106.06) = $112.36
Alternatively, using the future value of lump sum
equation, you get the same answer for future value at
the end of the year:
FV
2
= 100(1.06)
2
= $112.36
Given the investment of $100, we can determine the
amount of interest for the year by subtracting the FV
from the PV:
$112.36-100 = $12.36
That is, Maria will earn a 12.36% return.

The time line and interest computation for
Borrower#3 (monthly compounding) is:

Because interest rate is stated for the entire year,
interest per month equals to 12% divided by 12 or
1%. Calculating for compound interest, the future
values at the end of each month are:
FV
1
= 100+(1001%) = $101
FV
2
= 101+(1011%) = $102.01
FV
3
= 102.01+(102.011%) = $103.03
FV
4
= $103.03+($103.031%) = $104.06

FV
11
= 110.46+(110.461%) = $111.57
FV
12
= 111.57+(111.571%) = $112.68
Alternatively, using the future value of lump sum
equation, the future value at the end of the year is:
FV
12
= 100(1.01)
12
= $112.68
Given the investment of $100, we can determine the
amount of interest for the year by subtracting the FV
from the PV:
$112.68-100 = $12.68
That is, Maria will earn a 12.68% return.

In sum, interest amount and return that Maria earns
from each borrower are:
Borrower#1 Borrower#2 Borrower#3
Compounding Annual Semiannual Monthly
Amount $12.00 $12.36 $12.68
Return 12% 12.36% 12.68%
Although each borrower pays the same interest rate
of 12%, Maria will earn different amount of interest
and hence return because of different frequency of
compounding. The interest amount and return are
lowest for Borrower#1 and highest for Borrower#3.
This shows that the higher the frequency of
compounding, the higher the future value and hence
the return.

Quoted Rate, EAR, and APR
The 12% interest rate quoted by each borrower in the
example is called quoted rate, stated rate or nominal
rate. The words 'rate' or 'interest rate' often means
quoted rate.
The interest rate earned per period is called periodic
rate, and can be calculated using this formula:

where m = frequency of compounding.
From our example, the periodic rates are as follows:
For Borrower#1, the quoted rate of 12% is
divided by 1 (compounded annually) giving a
periodic rate of 12%.
For Borrower#2, the quoted rate of 12% is
divided by 2 (compounded semiannually or
every six months), giving the periodic rate of
6%.
For Borrower#3, the quoted rate of 12% is
divided by 12 (compounded monthly), giving the
periodic rate of 1%.

The 12%, 12.36% and 12.68% return from each
borrower are called effective annual rate
(EAR). EAR is interest rate expressed as if it were
compounded annually. That is, Maria will earn the
same interest from either 12% semiannual
compounding or 12.36% annual compounding.
Similarly, the interest for Maria is the same for either
12% monthly compounding or 12.68% annual
compounding.
The equation for converting from quoted rate
to EAR is:

For example, 12.36%EAR of 12% semiannual
compounding can be obtained from the equation as
follows:


What is APR? APR stands for annual percentage
rate. By law, lenders are required to disclose APR,
which is interest rate charged per period multiplied by
the number of periods per year.
In most types of loans such as auto loan and credit
card, APR is the same as quoted rate. For example, if
a bank charges 0.5% per month on a car loan, the
bank must report 6% APR on the loan. The 6% rate is
quoted rate, and 0.5% is periodic rate or interest rate
charged per month.
However, in case of mortgage loan, APR is not the
same as quoted rate because APR for mortgage loan
is calculated by including not only interest but also
some other fees such as discount points and loan-
processing fees charged by lenders. APR is not used
to calculate mortgage payments (quoted rate is), but
is used to provide an estimate of the borrowing cost.



The Pennsylvania State University 2006. All rights reserved.