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INTRODUCTION

The scope of business decisions covers a considerable length of time. The values of cash flows related to

those decisions occurring over this wide time period are affected by the time value of money. Most

decisions focus on doing something today, investments, with returns flowing over future time periods. It

is important to understand that cash flows in different time periods are not comparable and must be

adjusted to a common time period, usually to the present, before comparison and analyses can be

performed. This adjustment reflects the opportunity cost of alternative investment and the adjustment

focus in most decisions is the current period, the present.

Here is a suggestion in helping solve each problem -- draw a picture of the cashflow for someone paying

out the present value today of those cashflows today. Since these are "time" problems, draw a horizontal

time line and sketch the in and out cashflows on the line. The present at time 0 is on the far left, and

future cash flows are distributed across time to the right, with payments (annuity) marked on the time

segments of the line. Most problems have three variables and ask you to solve for the fourth (PV, FV, C,

and r). Identify the unknown on the time line then write out the formula and solve using a calculator. The

cash outflow or purchase price should equal the discounted sum of the cash inflows.

Coupon (C)

Annuity or

Coupon (C)

Annuity or

Coupon (C)

Annuity or

Cash

Inflows

Time

Cash

or Present Value (PV)

Purchase Price of Security

Outflows

1

The cash flows discussed in the first part of this guide are assumed to hold their purchasing power across

time periods. Inflation, or the steady decline in purchasing power, is introduced in the last section. If the

purchasing power of money is declining in the future, then one should discount this cheaper value via a

higher required rate of return r and a lower present value.

LEARNING CHECKLIST

After you have worked enough problems, come back here and check off your ability to:

_____1. Calculate the future value of money invested at a given interest rate.

_____2. Be able to compare interest rates quoted over time such as calculating the annual effective

rate when a monthly interest rate is given.

_____3. Be able to calculate present value and future values (FV) and know how to distinguish

between a present value versus a future value problem.

Understand the difference between real and nominal cash flows and between real and nominal interest

rates.

2

OUTLINE: KEY CONCEPTS AND TERMS

I. FUTURE VALUES AND COMPOUND INTEREST

A. Cash flows occurring in different time periods are not comparable unless adjusted for time

value.

FV = $100 (1 + r ) t

B. The face value or future value is the amount to which an investment will grow after earning

interest. Future value = investment (1+r)t.

C. The expression, (1+r)t, refers to compound interest or interest earned on interest at the rate,

r, for t periods.

An investment of $100 for five years at 7 percent interest compounded annually would be

$100 (1.07)5 = $140.26, with the $40.26 representing the accumulated interest.

D. If the $100 investment above earned 7 percent simple interest, or annual interest on the

original investment, the sum of the original $100 plus accumulated simple interest would be

$100 .07 five years = $35.00. Note that with compound interest an additional $5.26 is

earned in the five year period. See Table 3.1 and Figure 3.1 for arithmetic and graphic

analyses, respectively.

RATES

A. The effective annual interest rate is the period rate annualized using compound interest. If

the three month period rate is 5 percent (or 20 percent APR with quarterly compounding),

then effective annual rate is 5 percent to the fourth power for there are four three-month

periods in a year. Thus, (1.05)4 -1 = .2155 or 21.55 percent. The exponent used is the number

of periods m (in this case three months) in one year.

B. The annual percentage rate (APR) is the period rate times the number of periods to

complete a year or the interest rate that is annualized using simple interest. In the case above

the three-month period rate of 5 percent times the number of three-month period in a year,

four, equals 20 percent. This is the APR. Put another way, 5 percent per three-month period

using simple interest will equal the amount, say $100, times 5 percent times four. This yields

an annualized amount of simple interest of $20.00 or 20 percent APR.

3

C. To convert an annual percentage rate (APR) to an effective annual rate (EAR), divide the

APR by the number of annual interest periods and annualize that period rate. In this example

it is 1.054 -1 = .2155 or 21.55 percent. See Table 3.3 which calculates the effective rates for

several compounding periods using a 6 percent APR.

70

Interest Rates

0%

60

5%

50

10%

FV o f $1

40

15%

30

20

10

0

12

15

18

21

24

27

30

0

Nu m ber o f Years

A. The value today of a future cash flow is called the

present value. The present value computation

solves for the original investment at a certain rate

Future Value after t periods

when one knows the future value. The present

value is the reciprocal of the future value PV = (1+ r) t

calculation. Present value (1+r)t = future value,

while the present value = 1/(1+r)t future value.

See Figure 3.3 for a graphical interpretation of this relationship.

B. The interest rate used to compute present values of future cash flows is called the discount

rate.

C. Present values are directly related to the future cash flows and inversely related to the

discount rate, r, and time, t. The higher the future cash flows, the higher the PV; the higher

the discount rate and longer the term, the lower the PV.

discount factor, which is the PV of a $1 Discount Factor = DF = PV of $1

future payment. Discount factors for

whole number discount rates and years,

DF = 1

( 1+ r )

t

4

are calculated and available for use in Tables 3.4.

E. Cash flows occurring at different time periods are not comparable for financial decision

making. The cash flows must be time adjusted, at an appropriate discount rate, usually to the

"present" for comparison, summation, or other analysis.

F. Finding the interest rate:

1. In the expression, PV = FV(1+r)t, when the PV, FV, and t are known, (1+r) may be

solved arithmetically.

interest rate, growth rate, and internal rate of return,

PV = FV (1+r)

1

t

depending on the situation.

C1 C2

PV = (1+r)1

+ (1+r)2

+....

A. A future stream of cash flows associated with an investment may be compared or summed if

adjusted to a common time period, usually the present.

B. The multiple cash flows may be the same amount and be equally spaced over the term (called

an annuity), may be an annuity with cash flows assumed to be received forever (called a

perpetuity), or the future cash flow stream may be unequal

C. The key point is that when discounted to the present, all future cash flows are standardized

for comparison, for summing, and other analysis, such as net present value studied later.

called a perpetuity.

PV = Cr

2. The PV of a perpetuity is equal to the periodic cash flow divided by the

appropriate discount rate, or PV (perpetuity) = cash payments/r.

1. An annuity is an equally spaced level stream of cash flows, such as $50 per year for ten

years.

2. The present value of an annuity is the discounting of a series of equal cash flows.

Arithmetically, the PV of a n period annuity is, where C represents the same annuity

cash flow per period and r is the appropriate discount rate.

PV = C t =1 (1+1r ) t

n

5

The quantity in the formula below is called the annuity factor.

n

PVAF = 1

t

t=1 (1+r )

Alternatively, the present value of an annuity is the difference between the PV of the cash

flows in perpetuity less the PV of the cash flows beyond the relevant annuity period.

Omitting the derivation this leads to the following formula.

PV = C "# 1r r (1+r

1

) %

t

$

The bracketed quantity in the formula is again the annuity factor PVAF.

1 $

)t %

4. A loan amortization problem uses the same expression above, solving for C, now the

monthly or quarterly payments. The adjustment of annual to more frequent compounding

or payments is to multiply the annual t by the number of payments per year and divide

the r by the same number.

1. The future value sum of a series of consecutive, equal payments is called the future

value of an annuity or:

t

FV = [CPVAF ] (1+r)

6

2. The present value sum of a series of consecutive, equal payments is called the present

value of an annuity, calculated by dividing the future value of annuity, above, by (1 +r)t

3. With an ordinary annuity the cash flows (PMT or payments key in a financial calculator)

are assumed to flow at the end of the period. An annuity due assumes the cash flows

occur at the beginning of the period. (See the BGN or DUE key on your financial

calculator).

A. Inflation is an overall general rise in the price level for goods and services.

B. In the time value of money analysis above, interest rates were assumed to be "real" rates, and

the cash flows over the time line were assumed to have the same purchasing power. With

inflation the purchasing power of cash flows over a time line declines at the rate of inflation.

1. One measure of inflation is the Consumer Price Index (CPI). The annualized percentage

increases in the CPI are a measure of the rate of inflation.

2. Consumers and investors are concerned about the real value of $1 or the purchasing

power of the dollar or investment return in a period of time.

1+inflation rate

1. Actual dollar prices or interest rates are called nominal dollars or interest rates. Bonds,

loans, and most financial contracts are quoted in nominal interest rates.

2. Nominal rates, adjusted for inflation in a period, are real interest rates, or the rate at

which the purchasing power of an investment increases.

4. The approximate real rate is the nominal rate minus the inflation rate.

1. Investors and lenders include expected inflation rates in nominal rates to compensate for

the loss of purchasing power.

2. Nominal rates include expected real rates of return plus expected inflation rates.

F. Valuing Real Cash Payments

1. Since nominal rates include real rates plus expected inflation, discounting nominal future

cash flows by nominal rates will give the same answer as discounting real, expected

inflation adjusted cash flows by the real interest rate.

7

2. Current dollar cash flows must be discounted by the nominal interest rate; real cash flows

must be discounted by the real interest rate.

choice of vocation, or any long-term financial planning. Even a low rate of inflation can

have a major negative effect on people who will receive relatively fixed nominal income

or returns.

2. The actual purchasing power rate of return (real rate) on an investment is the nominal

expected rate of return, 1+r, divided by 1 + the expected inflation rate. With high

inflation, the realized real rate may be negative.

H. Real or Nominal?

1. Most financial analyses in our text will assume nominal rates and will discount nominal

cash flows. When one set of cash flows are presented in real term, such as the social

security cash flows, then nominal cash flows and rates must be adjusted to compare,

contrast, and mix the cash flows. As noted above, do not mix nominal and real or you

will have-garbage!

8

COMPLETION QUESTIONS

1. The amount to which an investment will grow after earning interest is a ____________

____________. (2 words)

2. When interest is earned only on the original investment it is called ____________ interest. (one

word)

3. When interest is earned on interest as well as on the original investment it is called

_____________. (one word)

4. The (higher/lower) the interest rate the higher will be the future value.

5. The periodic interest rate (r/m) that is annualized using compound interest is known as the

_____________ annual interest rate. (one word)

6. The periodic interest rate (r/m) that is annualized using simple interest is the ____________

____________ rate. (2 words)

7. The shorter the compounding period, the (higher/lower) will be the effective annual rate.

8. The value today of a future cash flow is called the ____________ ____________. (2 words)

9. The ____________ ____________ is the interest rate used to compute present values of future cash

flows of the same value. (2 words)

10. The present value of a $1 future payment is called the ____________ factor. It is always

(less/more) than 1.0 for any positive interest rate.

11. The higher the discount rate, the (higher/lower) the present value of $1.

12. A stream of constant, or level, cash payments that never ends is called a ____________.

13. The present value of an infinite stream of level payments (is/is not) infinite.

14. An annuity is a stream of cash flows that are ____________ and spaced ____________. (both

words start with e)

15. The present value of a $1 annuity is called the ____________ factor. (one word)

16. The perpetuity and the annuity formulas assume that the first payment occurs at the

(beginning/end) of the initial period.

17. When a loan is repaid by a stream of level payments over its life, the loan is being ____________.

(one word starts with a).

18. The amount of principal repayment from a typical home mortgage gradually (decreases/increases)

over the life of the loan.

19. The expected rate of return that is given up by investing in a project is called the ____________

cost of capital. (one word)

20. Subtracting the initial investment from the present value of cash flows yields the ____________

____________ ____________. (three words)

21. A risky cash flow in the future is worth (less/more) today than the same amount of a more certain

cash flow.

9

PROBLEMS

1. Calculate the present value of $10 for the following combinations of discount rates and time

periods:

r = 5 percent, t = 5 years

r = 5 percent, t = 10 years

r = 20 percent, t = 5 years

r = 20 percent, t = 10 years

2. Compute the future value of $10 cash flow for the same combinations of rates and periods as in

problem 1.

3. Recently, the city of London was looking for a site on which to build a new airport. One location

would have involved demolishing the 12th-century Church of St. Michael's. Suppose this edifice

had been built for the equivalent of $240 and had increased 5 percent per year in value. What

would be the worth today, 900 years later?

4. In 10 years, how much would a deposit of $100 grow to in a bank that pays compound interest at

a 5 percent rate? How much of the ending balance would be interest earned on the interest paid?

5. Marlene and Jeff have a target of $100,000 in 20 years for their daughter Ariana's college

education fund. How much do they need to deposit in a bank account today if they could earn 5

percent per annum?

6. Complete the following table by calculating present value, future value, periods, or interest rate

for the missing cell on each line:

Question 6: Present Value Future Value Periods Interest Rate

APR and EAR

a $500 7 years 4%

b $150 $201.59 3%

c $320 $349.67 3 years

d $2430 3 years 5%

7. What is the equivalent annual rate of interest of 8 percent compounded a) monthly as compared to

b) semi-annual compounding? (Put your final answer as a percentage to decimal places)

8. Matthew's father agreed to give him an annual allowance of $1000 until he reaches his 18th

birthday, 10 years from today. His older brother negotiated payments of $1200 until his 18th

birthday which is 7 years from today. If both boys plan to save their money at a bank which pays

6 percent per annum, who has the best deal?

9. If you deposited $100 six years ago and your passbook savings account shows a balance of $200,

what annual percentage rate has the bank been paying?

10. Using an interest rate of 8 percent, what would be the present value of cash flows of $500 in one

year, $600 in two years, and $700 in three years?

11. Calculate the present value of the following annuities using a 7 percent discount rate:

10

a) Five years of $100 per year with the first payment coming one year from today.

12. What would be the monthly payment on a $10,000 auto loan to be repaid over the next 60 months

if the monthly interest rate was one percent, and the annual rate was 12% APR? (Hint: Solve for

C.)

13. What would be the opportunity cost of capital for a property that is valued at $100,000 if it offers

a return of $10,000 forever?

14. Using your bond formula, what is the price of a $1000 bond with a 3.% coupon rate,

semi annual coupons, and four years to maturity if it has a yield to maturity of 8% APR.

Make sure you first draw your time line and then write the formula, before solving.

15. What is the Effective Annual discount Rate of the above bond? (write in % form 2

decimal places)

16. A stock pays a constant dividend of $3.10 at the end of each year indefinitely. Calculate

the market value of P0 if the required market rate of return on this equity is 5% APR.?

(First write down the perpetuity formula, and draw your time line of payments ).

17. A corporation will pay a Dividend at time zero (Div0 = $4.12) and future Dividends are

expected to have constant growth of 3% per year. If equity cost of capital is r = 5%, then

the estimated fair share price is now just prior to the dividend payment? (First draw your

time line, write down your 'perpetuity due' formula and put your answer to the nearest

cent)

11

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