LECTURE NOTE OF CHAPTER 2 – FINANCIAL MANAGEMENT COURSE

CHAPTER 2: TIME VALUE OF MONEY

Time value analysis has many applications, including planning for retirement, valuing
stocks and bonds, setting up loan payment schedules, and making corporate decisions regarding
investing in new plant and equipment. In fact, of all financial concepts, time value of money is
the single most important
What we learn in the chapter:

- The meaning of interest and discount rate

- The concept of future and present values
- The meaning and implication of compounding and compounding frequency
- Future and present values of an annuity and the present value of perpetuity
- The application of present and future value concepts to special situation such as growth rates and
loan amortization
You need to understand basic time value concepts, but conceptual knowledge will do you
little good if you can’t do the required calculations. Therefore, this chapter is heavy on
calculations. However, when they start on this chapter, many students don’t know how to use the
time value functions in their calculator or computer. If you are in that situation, you will find
yourself simultaneously studying concepts and trying to learn to use your calculator, and then
practice frequently to master this chapter.

I. INTEREST
1. INTEREST:
Money can be thought of as having a time value. In other words, an amount of money
received today is worth more than the same dollar amount would be if it were received a year
from now. The primary reason is that the current dollar can be invested to earn interest and end
up more than the amount of money in the future.
Suppose, for example, that you have $100 today and invest this amount in some
alternative investments, such as bonds or stocks. Thus, you can earn additional amount of money
from this investment next year. One year later, you hold more than $100. That means $100 today
is worth more than that amount if you received a year from now.
Interest (I) is the amount paid by borrowers of assets to lenders.
The principal (P) is the amount of money borrowed or invested.
The rate of interest, interest rate (i) is the percentage on the principal that the borrower
pays the lender per time period.
𝐈𝐈
𝐢𝐢 = × 𝟏𝟏𝟏𝟏𝟏𝟏% (𝟐𝟐. 𝟏𝟏)
𝐏𝐏 × 𝐭𝐭
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Where: I: The Interest amount

P: The principal amount
t: The number of time periods
i: The rate of interest (interest rate)
2. SIMPLE INTEREST vs COMPOUDING INTEREST:
2.1 SIMPLE INTEREST:
Simple interest is the interest paid (in the case of borrowed money) or earned (in the
case of invested money) on the principal only. The amount of simple interest is equal to the
product of principal times the rate of return time the number of time periods:

𝐈𝐈 = 𝐏𝐏 × 𝐢𝐢 × 𝐭𝐭
Examples illustrate the above equation.
1. What is the simple interest on $100 at 10% per year? I = $100 x 0.1 x 1 = $10
2. If you deposits $1000 in saving account pay 6% interest compounded annually, the future
value of your account at the end of year 1:
FV1 = P0 + I0 = P0 + P0 x i = $1000 + $1000 x 6% = $1,060
Because of your interest earned on the principle only, the future value of your account at the end
of year 2 is:
FV2 = P0 + I1 = P0 + P0 x i x 2 = $1000 + $1000*6% x 2 = $1,120
If we use simple interest, the future value at the end of year n:
FVn = P0 + In = P0 + P0 x i x n
FVn = P0 (1 + (i x n)) (2.2)
Where: FV: The future value
P: The principal amount
n: The number of time periods
i: The rate of interest
2.2 COMPOUND INTEREST
Compound interest is interest that is paid not only on the principal but also on any
interest earned but not withdrawn during earlier periods.

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For example
If you deposits $1000 in a savings account paying 6% interest compounded annually, the future
value of your account at the end of the first year:
FV1 = P0 x (1 + i) = $1000 x (1 + 0.06) = $ 1,060

If you leave the $1000 plus the accumulated interest in the account for another year, at the end of
the second year, the future value is:
FV2 = FV1 x (1+i) = $1,060 x 1.06 = $1,123.60.
Other way : FV2 = FV1 x (1+i) = P 0 x (1+i)2 = $1000 x (1 + 0.06)2 = $1,123.60.

This equation can be further generalized to calculate the future value at the end of period n for
any payment compounded at the interest rate i:

𝐅𝐅𝐅𝐅𝐅𝐅 = 𝐏𝐏𝐏𝐏 (𝟏𝟏 + 𝐢𝐢)𝐧𝐧 (2.3)

Where: FV: The future value
PV: The principal amount
n: The number of time periods
i: The rate of interest
In the case of compound interest, interest in each period is earned not only on the
principle but also on any interest accumulated during previous periods and not withdrawn. Thus,

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LECTURE NOTE OF CHAPTER 2 – FINANCIAL MANAGEMENT COURSE

if account paid compound interest instead of simple interest, the value of end of year 2 would
$1,123.6 instead of $1,120
3. COMPARING INTEREST RATES
The nominal interest rate (INOM) (or called quoted or stated rate or annual percentage
rate (APR)) is the rate that credit card companies, student loan officers, auto dealers and so
forth, tell you they are charging on loans.
If two banks offer loans with a stated rate of 8 % but one requires monthly payments and
the other quarterly payments, they are not charging the same “true” rate. The one requires
monthly payments is charging more than the one with quarterly payments. The reason is that you
get your money from the one with monthly payment sooner so you can get more money from
compounding money.
The effective annual rate (EFF), also called equivalent annual rate (EAR) is the actual
interest rate being earned.
If using annual compounding, the nominal rate is also its effective rate.
If compounding occurs more than once a year, the EFF% is higher than INOM

I 𝐌𝐌 (2.4)
𝐄𝐄𝐄𝐄𝐄𝐄 = �𝟏𝟏 + �
𝐌𝐌
EFF : Effective annual rate
I NOM: nominal interest rate
M: number of compounding periods per year
Example: The nominal rate is 10%, semiannual compounding. The effective anuual rate is:
0.1 2
EFF = (1 + ) – 1 = 10.25%
2

Thus, one investment promises pay 10% with semiannual compounding are indifferent
with the one that promises 10.25% with annual compounding.
4. SEMIANNUAL AND OTHER COMPOUNDING PERIODS:
Thus far, we assume that interest was compounded once a year, annually. This is called
annual compounding. What happen if interest was paid semiannually, quarterly, monthly rather
than annually? First, whenever payments occur more than once a year, you must follow two
steps:
1. Convert the stated interest rate into a “periodic rate” (IPER)
2. Convert the number of year into “number of periods”

Stated annual rate i

Periodic rate = =
Number of payments per year M
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Number of periods = (Number of years)x(Periods per year) = NxM

Example:
Investment $100 with 5% per year for 10 years and pay interest semiannually.
Periodic rate = 5%/2 = 2.5%
Number of periods = 10 x 2= 20

Periodic rate Number of periods FV of $100

Annual compounding 5% 10 $ 162.89
Semiannual compounding 5%/2 = 2.5% 10 x 2 = 20 $ 163.86
Quarterly compounding 5%/4 = 1.25% 10 x 4 = 40 $164.36
Monthly compounding 5%/12= 0.4167% 10 x 12 = 120 $164.70
Daily compounding 5%/365 = 10 x 365 =3,650 $164.87
0.0136%

II. THE TIME VALUE OF MONEY

To calculate easily the time value of money, we divide thr ee types of money:
- Single payment or “lump sums”
- Annuity (PMT): ordinal annuity, annuity due and perpetuity
- Mixed flows or Uneven Cash flows (CF)
Single payment, or “lump sums” is amount of money at specific time. .For example,
you receive $100 today ($100 is called a single payment or lump sums).
Annuity is a series of equal payments at fixed intervals for a specified number of
periods. For example, you pay the same tuition fee (13.000.000 VND) at the beginning of each
of the next 4 years. It is called 4-year annuity. You rent the house in 2 years. You pay the rent for
house owner each month in 2 years.
If the payment occurs at the end of each year, the annuity is an ordinary (or deferred)
annuity
If the payment occurs at the beginning of each year, the annuity is annuity due.
A perpetuity is simply an annuity with an extended life. That means perpetuity is an
annuity that promise to pay interest forever.

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Mixed flows or Uneven, or non-constant, cash flows involve payments that are unequal
in every period. For example: the sale of a product is different in each month. The money
received each month is called uneven cash flows
1. SINGLE PAYMENT or LUMP SUMS:
1.1 The future value of Single payment:
The future value of the money is the amount of money plus the interest from that amount
received in the future. The process going to the future value (FV) from the present value (PV) is
called compounding.
For example, you plan deposit $100 in the bank that guaranteed 5% compound interest
each year. How much you have at the end of year 3?
There are different methods to solve this problem.
STEP BY STEP APPROACH
The future value of $100 at the first year: $100 (1+0.05) = $105
The future value of $100 at the second year (compounding interest): $105(1+0.05) = 110.25
The future value of $100 at the third year: $110.25 (1+0.05) = $115.76

The step by step is useful so it is shown what happen to your money during the time but
this approach is time-consuming if a number of times are involved.
FORMULA APPROACH
The formulation to find the future value of money is shown below:

𝐅𝐅𝐅𝐅 = 𝐏𝐏𝐏𝐏(𝟏𝟏 + 𝐢𝐢)𝐍𝐍 (𝟐𝟐. 𝟓𝟓)

FV: Future value, or ending amount, of your account after N periods
PV: Present value, or beginning amount
i: interest rate
N: number of periods
With above Example, we can apply equation (2.5) to find the FV
FV = 100 (1+0.05)3 = 115.76
Equation (2.5) can be used with any calculator that has an exponential function, making it
easy to find FVs, no matter how many years are involved.

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Besides this methods are mentioned above, we use the Excel to calculate the future value. It is
shown in the table below:

Graphic View of the Compounding Process

Future value for $1 at interest rate I for n period

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1.2 The present value of Single payment:

The process to find the present value is called discounting, the reserve of compounding.
If you know the PV, you can compound to find FV and if you know the FV, you can discount to
find PV. Present value of the money is calculated from the equation (2.5)
𝐅𝐅𝐅𝐅 = 𝐏𝐏𝐏𝐏 (𝟏𝟏 + 𝐢𝐢)𝐍𝐍
𝐅𝐅𝐅𝐅 (2.6)
𝐏𝐏𝐏𝐏 =
(𝟏𝟏 + 𝐢𝐢)𝐍𝐍
FV: Future value, or ending amount, of your account after N periods
PV: Present value, or beginning amount
i: interest rate
N: number of periods
Example: A broker offers to sell you a Treasury bond that three years from now will pay
$115.76, guaranteed 5 percent interest on three-year certificates of deposit. Given these
conditions, what’s the most you should pay for the bond?
We answer this question using the different methods we discussed in the last section—
step-by-step, formula, calculator, and spreadsheet. Table below summarizes our results. The top
section of Table calculates the PV using the step-by-step approach.

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To find present values, we work backward, or from right to left, dividing the future value
and each subsequent amount by (1+ I). This procedure shows exactly what’s happening, and that
can be quite useful when you are working complex problems. However, it’s inefficient,
especially if you are dealing with a number of years.
With the formula approach we use Equation 2-6, simply dividing the future value by (1+
N
I) . This is more efficient than the step-by-step approach, and it gives the same result.
The fundamental goal of financial management is to maximize the firm’s value, and the
value of a business (or any asset, including stocks and bonds) is the present value of its expected
future cash flows. Because present value lies at the heart of the valuation process, we will have
much more to say about it in the remainder of this chapter and throughout the book.

Graphic view of discounting process

Present value of $1 at interest rate i for n periods

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2. ANNUITIES:
Thus far we have dealt with single payments, or “lump sums.” However, many assets provide
a series of cash inflows over time, and mortgage loans require a series of payments. If the
payments are equal and are made at fixed intervals, then the series is an annuity. Annuities have
two properties, constant payment and fixed number of periods. If these conditions don’t
hold, we don’t have an annuity.
If the payment occurs at the end of each year, the annuity is an ordinary (or deferred)
annuity
If the payment occurs at the beginning of each year, the annuity is annuity due.
Here are the time lines for a $100, three-year, 5 percent, ordinary annuity and for the same
annuity on an annuity due basis. With the annuity due, each payment is shifted back to the left by
one year. A $100 deposit will be made each year, so we show the payments with minus signs:

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Ordinary annuities are more common in finance, so when we use the term “annuity” in
this book, assume that the payments occur at the ends of the periods unless otherwise noted.
2.1 ORDINARY ANNUITY
2.1.1 Future value of an Ordinary Annuity:
The future value of an ordinary annuity (FVA) can be found by different methods above.
For example, you deposit $100 at the end of each year for 3 years and earn 5% per year.
How much will you have at the end of the third year?
Step-by-step:

Formula approach:
FVAN = PMT (1+I)N-1 + PMT (1+I)N-2+ PMT (1+I)N-3
= $100 (1.05)2 + $100 (1.05) + $100 (1.05)0
= $315.25
We can generalize this equation:

(2.7)

Where: FVA: The future value of ordinary annuity

PMT: payment amount
I: Interest rate
N: Number of periods

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Using excel :

2.1.2 Present value of Ordinary Annuity:

The present value of an annuity, PVA, can be found using the step-by-step, formula,
calculator, or spreadsheet methods. To find the FV of the annuity, we compounded the deposits.
To find the PV, we discount them, dividing each payment by (1+I). The step-by-step procedure
is diagrammed:

Formula approach:

(2.8)

Where: PVA: The present value of annuity

PMT: payment amount
I: Interest rate
N: Number of periods

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2.2 ANNUITY DUE:

2.2.1 Future value of an Annuity Due:
Each payment occurs one period earlier with an annuity due, all of the payments earn
interest for one additional period. Future value of an annuity due will be greater than that of a
similar ordinary annuity. If you went through the step-by-step procedure, you would see that our
illustrative annuity due has an FV of $331.01 versus $315.25 for the ordinary annuity.
With the formula approach, we first use Equation 2-8, but since each payment occurs one
period earlier, we multiply the Equation 2-8 result by (1+i):

FVA Due = FVA (1+i) (2.9)

Where: FVA due (FVAD): The future value of annuity due
FVA: The future value of ordinary anuuity
i: Interest rate
If the deposit happens at the beginning of the year, the future value is FVA due = $315.25
(1.05) = $331.01
2.2.2 Present value of an Annuity Due:
With the same logic, the annuity appears one period earlier so the present value of
annuity due is:
PVA Due = PVA (1+i) (2.10)
Where: PVA due (PVAD): The present value of annuity due
PVA: The present value of ordinary anuuity
i: Interest rate
The present value of an annuity due: PVA Due = 272.32 (1.05) = 285.93
2.3 . PERPETUITIES:
In the last section we dealt with annuities whose payments continue for a specific number
of periods—for example, $100 per year for 10 years. However, some securities promise to make
payments forever. For example, in 1749 the British government issued some bonds whose
proceeds were used to pay off other British bonds, and since this action consolidated the
government’s debt, the new bonds were called consols. Because consols promise to pay interest
forever, they are “perpetuities.”

A perpetuity is simply an annuity that promise to pay interest forever. Because the
payments go on forever, we can apply the step-by-step approach. However, it’s easy to find the
PV of a perpetuity with a formula found by solving

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LECTURE NOTE OF CHAPTER 2 – FINANCIAL MANAGEMENT COURSE

𝐏𝐏𝐏𝐏𝐏𝐏 (2.11)
𝐏𝐏𝐏𝐏 𝐨𝐨𝐨𝐨 𝐚𝐚 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 =
𝐢𝐢
Where: PV: The present value of perpetuity
PMT: payment amount
i: Interest rate
Example:
1. What is the present value of $100 annuity with a 25-year, 50-year and infinite at 10% interest
rate?
Present value of 25-Year Annuity: $907,70
Present value of 50-Year Annuity: $991,48
Present value of infinite Annuity: $1000,00
3. UNEVEN CASH FLOWS or MIXED FLOWS:
The definition of an annuity includes the words constant payment—in other words,
annuities involve payments that are equal in every period. Although many financial decisions do
involve constant payments, many others involve non-constant, or uneven, cash flows. Uneven,
or non-constant, cash flows involve payments that are unequal in every period. The dividend of
common stock and investment in capital equipment are examples of uneven cash flows.
Note:

- The term payment (PMT) is used for annuity with their equal payment in each period
- The term Cash Flow (CFt) is denoted uneven cash flows, where t designates the period in
which cash flow occurs
Two types of uneven cash flows:
- A stream that consists of a series annuity payments plus an additional final lump sum.
For example, if you buy a 10-year bond $1000 with coupon rate 10%, you will receive a $100
each year and at the tenth year, you also get single payment, or “lump sum” $1000. The rate of
interest of the bond 12%.

- All other uneven streams such as stock or capital investment.

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3.1 Present value of cash flows:

The values of all financial assets—stocks, bonds, or business capital investments— are
found as the present values of their expected future cash flows. Therefore, we need to calculate
present values very often, far more often than future values.
The step-by step procedure is straightforward, but if we have a large number of cash
flows, it is time-consuming.

Formulation approach:
We discount each cash flow and then sum them to find the PV of the stream:

(2.8)

$100 $300 $300 $300 $500

𝑃𝑃𝑃𝑃 = 1
+ 2
+ 3
+ 4
+ = $1,016.35
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)5
3.2 Future Value of an Uneven Cash Flow Stream:
We find the future value of uneven cash flow streams by compounding rather than
discounting. However, we calculate present values of an uneven cash flow more often than future
value. The reason is that the values of all financial assets – stocks, bonds and business capital
investments are found as the present values of their expected future cash flows.

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4. AMORTIZED LOANS:
An important application of compound interest involves loans that are paid off in
installments over time. Included are automobile loans, home mortgage loans, student loans, and
many business loans.

Amortized loan is a loan that is to be repaid in equal amounts on a monthly, quarterly, or

annual basis. For example: A homeowner borrows $100,000 on a mortgage loan, and the loan is
to be repaid in five equal payments at the end of each of the next five years. The lender charges 6
percent on the balance at the beginning of each year.
Our first task is to determine the payment the homeowner must make each year. The payments
must be such that the sum of their PVs equals $100,000:

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