Chapter 3

Understanding and
Appreciating the
Time Value of
Money

3-1

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Compound Interest and

Future Values
Interest paid on interest (Compound
interest).
Reinvestment of interest paid on an
investments principal
Principal is the face value of the deposit or
debt instrument.

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How Compound Interest Works

Future value (FV) = Present Value (PV) x
Amount it has increased by the end of 1
year (1+i)
Future valuethe value of an investment at
some point in the future
Present valuethe current value in todays
dollars of a future sum of money

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How Compound Interest Works

Annual compoundingreinvesting interest
at end of each year for more than 1 year
FV = PV x Amount Present Value has
increased by the end of n years (1+i)n

is equal to the number of years during which

compounding occurs

3-4

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Figure 3.1 Compound Interest at 6

Percent Over Time

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Time Value of Money Calculator

http://www.zenwealth.com/BusinessFinanceOnline/TVM/
TVMCalcIntro.html

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Financial Calculator TVM

input keys

Note that some calculators (TI) have the CPT

key but others (HP) initiate calculation when
you press the key for which you want the
solution.
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Calculator Clues
Before solving problem:
1. Set to one payment per year
2. Set to display at least four decimal places
3. Set to end mode

Working a problem:
1. Positive and negative numbers
2. Enter zero for variables not in the problem
3. Enter interest rate as a %, 10 not 0.10

3-8

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Figure 3.3 The Power of Time in

Compounding

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Present Value
Whats a future amount worth in todays
dollars?
Inverse of compounding.
Discount rate is the interest rate used to
bring future money back to present.

3-10

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Present Value Example

Youre on vacation in Florida and you see an
advertisement stating that youll receive
$100 simply for taking a tour of a model
condominium.
You discover that the $100 is in the form of a
savings bond that will not pay you the $100
for 10 years.
What is the PV of the $100 to be received 10
years from today if your discount rate is 6%?
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Solution

-55.84

10

100

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Annuities
An annuity is a series of equal dollar
payments coming at the end of each time
period for a specific number of time period.

3-13

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Compound Annuities
A compound annuity involves depositing an equal
sum of money at the end of each year for a certain
number of years, allowing it to grow.
You want to know how much your savings will have
grown by some point in the future.
Sum up a number of future values.

3-14

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Table 3.4 Illustration of a 5-Year

$500 Annuity Compounded at 6%

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Compound Annuities Example

Youll need $10,000 for education in 8
years. How much must you put away at the
end of each year at 6% interest to have the
college money ready?

3-16

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Solution

-1010.36

10000

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Present Value of an Annuity

To compare the relative value of annuities,
you need to know the present value of
each.
Need to know what $500 received at the
end of the next 5 years is worth given
discount rate of 6%.

3-18

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Solution

-2106.18

500

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Table 3.6 Illustration of a 5-Year $500

Annuity Discounted Back to the Present at
6%

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Amortized Loans
Loans paid off in equal installments.
You borrow $16,000 at 8% interest to buy
a car and repay it in 4 equal payments at
the end of each of the next 4 years. What
are the annual payments?

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Solution

16000

-4830.73

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Figure 3.5 Loan Amortization Schedule

Involving a $16,000 Loan at 8% to Be
Repaid in 4 Years

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Perpetuities
A perpetuity is an annuity that continues to
pay forever.
Present value of a perpetuity = annual dollar
amount provided by the perpetuity divided
by the annual interest (or discount) rate.

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Example of a Perpetuity
A social security retirement payment is the
equivalent of a perpetuity.
A $2500 per month payment assuming a 4%
rate of return would have a Present Value of
$750,000.
2500/.003333=750,000
This would be part of your retirement nest egg.
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Retirement Income Needs

190,718

74,598

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How much do you need to save

each month for 30 years in
order to retire on $145,000 a
year for 20 years, i = 10%?
months before retirement years after retirement

Age
37

Age
67

...
PMT PMT

3-27

360
PMT

2013 Pearson Education, Inc. All rights reserved.

-145k

19

Age
87

...
-145k

20

-145k

-145k

How much must you have in your

account on the day you retire if
i = 10%?
years after retirement

Age
...
67

How much do you need

on this date?
2013 Pearson Education, Inc. All rights reserved.

20

-145k

-145k

...
-145k

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19

-145k

You need the present value of a

20- year 145k annuity--or
$1,234,467.

INPUTS

20

10

I/YR

OUTPUT

-145000 0
PV

PMT

FV

1,234,467

29
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How much do you need to save

each month for 30 years in order
to have the $1,234,467 in your
account?
months before retirement

Age
37

Age
67

...
PMT PMT

3-30

360
PMT

2013 Pearson Education, Inc. All rights reserved.

You need
$1,234,467
on this date.
...

You need a payment such that the

future value of a 360-period annuity
earning 10%/12 per period is
$1,234,467.

INPUTS

360

10/12

I/YR

PV

OUTPUT

1234467
PMT

FV

-546.11

It will take an investment of $546.11 per

month to fund your retirement.
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What if you have 40 years in which to

accumulate your next egg?

INPUTS

480

10/12

I/YR

PV

OUTPUT

1234467
PMT

FV

-195.20

Now it will only take an investment of

$195.20 per month to fund your
retirement starting at age 27.
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What if you have 45 years in which to

accumulate your nest egg?

INPUTS

540

10/12

I/YR

PV

OUTPUT

1234467
PMT

FV

-117.76

Now it will only take an investment of

$117.76 per month to fund your
retirement starting at age 22.
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Summary
The cornerstone of time value of money is
compound interest.
A higher interest rate (higher risk) or the
number of years that your money is
compounded for increases future values.
An annuity is a equal dollar periodic
payment of investment earnings or paying
off installment loans.

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