CHAPTER

3
Time Value of
Money

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CHAPTER 3 OUTLINE

3.1 Monetary Flow Diagrams

3.2 Interest Rates

3.3 Income Rate Mechanics

3.4 Time Value Equivalence and Compound Interest

Factors

3.5 Bonds

3.6 Stocks

3.7 Examples

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3.1 MONETARY FLOW DIAGRAMS

Monetary Flow

Inflow or outflow of cash at a particular point in time

• Capital expenditures and operating expenses are negative flows, i.e. funds
flowing out of a project or outflows

• Revenues are positive flows, i.e. funds flowing into the project or inflows

Monetary Flow Diagrams

Describes a project by its stream of inflows and outflows over time.

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3.1 MONETARY FLOW DIAGRAMS

+
MONETARY FLOW

PERIODS
0 1 2 3 4 5

1 2 3 4 5
TIME

-
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3.1 MONETARY FLOW DIAGRAMS

End-of-period convention

• Outflows and inflows occur at irregular intervals over time

• Outflows and inflows occurring over a particular period of time are represented by
net amounts at end of the periods over which they occur

0 1
2 3 4 5
TIME

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3.2 INTEREST RATES

Consider the following alternatives:

Receive either
• $100 today
• $100 in one year’s time:
The choice is evident…
$100 today is worth more than $100 in one year’s time
However, if the second choice is changed to:
Receive either
• $100 today
• $125 in one year’s time
The choice is not as evident… It depends on how the money is used...
• If money is invested and earns 10 %, the second alternative is preferable.
• If money is invested and earns 25 %, both alternatives are equally desirable, i.e.
the alternatives are EQUIVALENT.

Money is used by investing it, i.e., putting it to work. Its efficiency represents its TIME
VALUE, expressed as an interest rate.

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3.3 INTEREST RATE MECHANICS

Simple Interest
Using simple interest, the interest payment is due with the amount borrowed, which is
referred to as the principal.

Example 3.1
Borrow $100 over a two-year period subject to a simple interest rate of 10 % per year

In two years’ time, repay $100 + $100 (0.1) (2) = $120

Interest per period = (Principal) (Interest Rate)

P: Principal, amount borrowed

i: Interest rate per period in decimal
n: Number of periods

Amount owed after n periods = P 1  (i) (n)

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3.3 INTEREST RATE MECHANICS

Compound Interest
With compound interest, interest payments are due at the end of each
compounding period, the time at which the interest payment is calculated.
Example 3.2
Borrow $100 over a two-year period subject to a compound interest rate of 10 % per
year

In two years’ time, repay $100 + $100 (0.1) + $110 (0.1) = $121
Or
In one year’s time pay $10, and in two year’s time repay $110
Interest payment due at end of compounding period:
(Amount owed at beginning of period) (Interest rate per period)

P: Principal, amount borrowed

F: Amount owed after n periods (i.e. in the Future)
i: Interest rate per period in decimal
n: Number of periods

F  P 1  i n
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3.3 INTEREST RATE MECHANICS

Nominal Interest Rate
The nominal interest rate is the total interest rate paid per standard interval of time.
• By convention, the standard interval of time is one year. However, it can be set
to any other length of time.
• The compounding period does not necessarily match the standard interval.

For instance, “8 % compounded quarterly” means that at the end of every three-
month period, an interest payment equal to 2 % of the outstanding balance at the
beginning of the period is due. Thus, interest payments are due four times per year.

The 8 % interest is the “nominal interest rate”, denoted r.

The interest rate per compounding period, denoted i, is obtained by dividing the
nominal rate by the number of compounding periods per year (or other standard
interval), denoted m.
r: nominal interest rate
i: interest rate per compounding period
m: number of compounding periods per standard interval

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3.3 INTEREST RATE MECHANICS

Effective Interest Rate
The effective interest rate is the rate, which compounded once per standard interval,
yields the same terminal amount (F) as a particular nominal rate, compounded m
times per standard interval.

Thus, the effective interest rate per standard interval (EIR) is:

EIR= Total amount of interest paid over interval

Principal

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3.3 INTEREST RATE MECHANICS

Example 3.3- Savings Account
Given a nominal rate of 8 % compounded quarterly, 2 % of the amount contained in
the savings account at the beginning of a particular 3-month period is paid at the end
of that period, and this, 4 times per year.

Period Beginning Balance Interest Paid Ending Balance

1 100.00 2.00 102.00
2 102.00 2.04 104.04
3 104.04 2.08 106.12
4 106.12 2.12 108.24

Total amount of interest earned during year:

108.24 - 100.00 = 8.24
Thus,
EIR = 8.24 = 0.0824 or 8.24 %
100.00

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3.3 INTEREST RATE MECHANICS

Example 3.3- Savings Account

In general,

m
 r 
EIR  1   1
 m
r: nominal interest rate
m: number of compounding periods per standard interval

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3.3 INTEREST RATE MECHANICS

Example 3.4

The effective annual rate associated with a nominal rate of 12% compounded…

Semi-annually, i.e. 6 % every 6 months is:

EIR  1  0.062  1  0.1236  12.36%

Quarterly, i.e. 3 % every 3 months is:

EIR  1  0.034  1  0.1255  12.55%

Monthly, i.e. 1 % every month is:

EIR  1  0.0112  1  0.1268  12.68%

Daily, i.e. 12/365 % every day is:
365
 0.12 
EIR  1    1  0.1275  12.75 %
 365 

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3.3 INTEREST RATE MECHANICS

Continuous Compounding
At the limit, when compounding occurs every instant of time, i.e., the compounding
period becomes infinitely short, compounding is said to be CONTINUOUS.
m
 r  r
When m  , the limit of 1   is e .
 m
Thus the effective interest rate in this case is: er  1
For instance, a nominal rate of 8 % compounded continuously is equivalent to
(e0.08  1)  0.0833  8.33%
compounded once per year (versus 8.24 % quarterly).

A nominal rate of 12 % compounded continuously is equivalent to

(e 0.12
 1)  0.1275  12.75%
compounded once per year (versus 12.75 % daily).

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3.3 INTEREST RATE MECHANICS

Example 3.5
A bank offers a nominal annual interest rate of 6 %, claiming that interest is paid
daily. However, the interest paid daily is not deposited in the main account, but in a
sub-account*, with the balance transferred to the main account every month. What
is the effective annual interest rate?

* No interest paid on sub-account balance

Solution

12
 0.06 
EIR  1    1  0.0617  6.17%
 12 

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3.3 INTEREST RATE MECHANICS

Example 3.6
What nominal interest rate, which compounded monthly, is equivalent to a nominal
annual rate of 12 % compounded semi-annually?

Solution

EIR  1  0.06   1  0.1236  12.36%

2

12
 r 
EIR  1    1  0.1236
 12 
12
 r  r
 1    1.1236  0.00976
 12  12
r  0.1171  11.71%

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3.3 INTEREST RATE MECHANICS

Example 3.7
Determine the effective annual interest rate associated with a nominal rate of 6 %
compounded monthly.

Solution

r: 6 %
i: 6 % / 12 = 0.5 %

EIR  1  0.005
12
 1  0.0617  6.17%

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3.3 INTEREST RATE MECHANICS

Example 3.8
Borrow $5000 at a nominal annual interest rate of 12 % compounded monthly, with
principal and interest to be remitted in two years’ time. What amount is owed?

i) Using monthly compounding periods

12%
i:  1% per month
12
n: 24 months

F  5000 (1  0.01) 24  $6348.50

1.2697

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3.3 INTEREST RATE MECHANICS

Example 3.8
ii) Using standard interval of one year
12
 0.12 
EIR  1    1  0.1268
 12 
n : 2 years
F  5000 (1  0.1268) 2  $6348.50
iii) Using periods of two years

24
 0.12 
EIR  1    1  0.2697
 12 
n : 1 period of 2 years
F  5000 (1  0.2697)  $6348.50

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3.3 INTEREST RATE MECHANICS

Example 3.9
Borrow $5000 at a nominal annual interest rate of 12 % compounded continuously,
with principal and interest to be remitted in two years’ time. What amount is owed?

i) Using the effective annual interest rate

EIR  e r  1  (2.7182) 0.12  1  0.1275

F  5000 (1  0.1275) 2  $6356.50
ii) Using direct relationship

F  P (1  i) n
 
F  P 1  e 1 r
 n
 P  e rn
F  5000 (2.7182) (.12)(2)  $6356.00

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Relationship between F and P

F  P (1  i) n

Equivalent Time Value of Money

F and P are equivalent because they have the same earning power, but not the same
purchasing power.

Equivalence is the concept used in Engineering Economic Analysis to

compare projects or determine their individual economic viability.

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

For instance,

P: 5000
i: 10% F3 = 5000 (1 + 0.1)3 = 6655
n: 3 years

Amount borrowed: 5000

3
| | | |
0 1 2

EQUIVALENT

Amount repaid: 6655

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

EQUIVALENT
Likewise, Amounts borrowed

2000 2000 2000

3
| | | |
0 1 2

F3  2000 (1.10)3  2000 (1.10) 2  2000 (1.10)1  7282

7282

Amount repaid

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Amount borrowed
And,
4973.70

1 2 3
| | | |
0

2000 2000 2000

Amounts repaid
EQUIVALENT

2000 2000 2000

P    4973.70
(1  0.1) (1  0.1) 2
(1  0.1) 3

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

BA II Plus
• Set FORMAT options: [2nd] [FORMAT]… (pp. 12-15, Guidebook)
• Set payments (P/Y) and compounding (C/Y) to 1 per period
[2nd] [P/Y] [1] [Enter] [2nd] [QUIT] (pp. 21-22, Guidebook)
• Clear all TVM registers: [2nd] [CLR TVM]

• Enter data: [3] [N] [10] [I/Y] [5000] [PV]

• Compute future value equivalent: [CPT] [FV] = -6655
• Clear PV and enter data: [0] [PV] [2000] [PMT]
• Set to beginning-of-period payments: [2nd] [BGN] [2nd] [SET] [2nd] [QUIT]
• Compute future value equivalent: [CPT] [FV] = -7282
• Set to end-of-period payments: [2nd] [BGN] [2nd] [SET] [2nd] [QUIT]
• Clear FV: [0] [FV]
• Compute present value equivalent: [CPT] [PV] = -4973.70

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

For the purpose of comparing alternative investment proposals, monetary values are
converted to present or future values with compound interest factors.

Notation

• Interest per period: i (decimal) represents time value of money

• Number of periods: n (any time interval may be used)
• Present worth or value: P
• Future worth or value: F
• Annuity: Stream of equal values over n periods
 Ordinary annuity – end-of-period payments: A
 Annuity due – beginning-of-period payments: A

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Interest rate per period: i (constant)

Number of periods: n
Present worth or value: P
Future worth or value: F
F
Ordinary annuity: A
Annuity due: A

P
A A

i
| | | | | | |
0 n

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Compound Amount Factor (CAF)

Used to determine the future value equivalent of a given present value (“appreciate”)

F=?

F  P (1  i)
P n

(F/P, i, n) : (1  i)
n

| | | | | |
0 1 2 3 … n

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Compound Amount Factor (CAF)

Example 3.10
What is the future value of a present day deposit of $2500 after 5 years, if time has a
value of 12% per year.

BA II Plus
F  2500 (1  0.12)5 P/Y and C/Y set to 1

 2500 (1.7623) [2nd] [CLR TVM]

 $4405.85 [2500] [PV]

[12] [I/Y]
[5] [N]
[CPT] [FV] = -4405.85

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Present Value (Worth) Factor (PVF)

Used to determine the present value equivalent of a given future value (referred to as
discounting; thus, the interest rate is referred to as the discount rate)

F
 1 
P=? PF  n
 (1  i) 
1
(P/F, i, n) :
(1  i)
n

| | | | | | This is the reciprocal of the

0 1 2 3 … n Compound Amount Factor

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Present Value (Worth) Factor (PVF)

Example 3.11
What amount deposited today will yield a future value of $5000, 4 years from now, if
time is valued at 8% per year?

BA II Plus
5000 5000 P/Y and C/Y set to 1
P   $3675.15
(1  0.08) 4
1.3605 [2nd] [CLR TVM]
[5000] [FV]
[8] [I/Y]
[4] [N]
[CPT] [PV] = -3675.15

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Series Compound Amount Factor (SCAF)

Used to determine the future value equivalent of a uniform series of end-of-period
payments (i.e. ordinary annuity).

n 1
A  (1  i) j  (1  i) n  1
j0 F=? FA  
 i 
A  (1  i) n  1
(F/A, i, n) :  
 i 

| | | | | |
0 1 2 3 … n

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Series Compound Amount Factor (SCAF)

Example 3.12
What is the future value equivalent of end-of-year payments of $500 over a period of
6 years, if time is valued at 10% per year.

 (1  0.10)6  1
F  500    500 (7.7156)  $3857.80
 0.10 
BA II Plus (Set to end-of-period payments)
P/Y and C/Y set to 1
[2nd] [CLR TVM] [6] [N] [10] [I/Y] [500] [PMT] [CPT] [FV] = -3857.80

Note: If payments were made at the beginning of each year, with the first today, then
F6 = 3857.80 (1.1) = $4243.58

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Series Present Value (Worth) Factor (SPVF)

Used to determine the present value equivalent of a uniform series of end-of-period
payments (i.e. ordinary annuity).

n 1
A 1  (1  i)  n 
j1 (1  i)
j
P=? PA  
 i 
A 1  (1  i)  n 
(P/A, i, n) :  
 i 

| | | | | | Also referred to as
0 1 2 3 … n “Cumulative Present Value Factor”
(CPVF)

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Series Present Value (Worth) Factor (SPVF)

Example 3.13

What lump-sum payment is required to retire an outstanding debt paid at $250 per
month, if interest is 12% compounded monthly, and 24 end-of-month payments
remain (today’s payment made).

1  (1  0.01) 24 
P  250    250 (21.2434)  $5310.85
 0.01 
Note: If 24 beginning-of-month payments remain, with the first today, then P =
5310.85 (1.01) = $5363.96

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BA II Plus
• Using one month as time interval • Using one year as time interval

[2nd] [P/Y] [1] [ENTER] [2nd] [P/Y] [12] [ENTER]

[2nd] [QUIT] [2nd] [QUIT]
C/Y automatically set to 1 C/Y automatically set to 12
[2nd] [CLR TVM] [2nd] [CLR TVM]
[24] [N] [24] [N]
[1] [I/Y] [12] [I/Y]
[250] [PMT] [250] [PMT]
[CPT] [PV] = -5310.85 [CPT] [PV] = -5310.85

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Capital Recovery Factor (CRF)

Used to determine the future uniform series of end-of-period payments (i.e. ordinary
annuity) equivalent to a given present value.

 i 
P AP  n 
1  (1  i) 
A= ?  
i
(A/P, i, n) :  n 
1  (1  i) 

| | | | | | This is the reciprocal of the

Series Present Worth Factor
0 1 2 3 … n (“Mortgage payment” factor)

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Capital Recovery Factor (CRF)

Example 3.14
What monthly payment is associated with a $100 000 mortgage. The annual interest
rate is 12% compounded monthly and the mortgage is to be repaid over a 20-year
period.
 0.01 
A  100000   240 
 100 000 (0.0110109)  $1101.09
1  (1  0.01) 
BA II Plus (Set to end-of-period payments)
Using one month as time unit (P/Y and C/Y set to 1)
[2nd] [CLR TVM] [240] [N] [1] [I/Y] [100 000] [PV] [CPT] [PMT] = -1101.09

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Sinking Fund Factor (SFF)

Used to determine the uniform series of end-of-period payments (i.e. ordinary
annuity) equivalent to a given future value.

F  i 
AF  
 (1  i)  1
n

A= ?
 i 
(A/F, i, n) :  
 (1  i)  1
n

| | | | | | This is the reciprocal of the Series

0 1 2 3 … n Compound Amount Factor

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Sinking Fund Factor (SFF)

Example 3.15
What end-of-month deposit will accumulate to $10 000 over a period of 3 years? The
annual rate is 12% compounded monthly.

 0.01 
A  10 000    10 000 (0.023214)  $232.14
 (1  0.01)  1
36

BA II Plus (Set to end-of-period payments)

Using one month as time unit (P/Y and C/Y set to 1)
[2nd] [CLR TVM] [36] [N] [1] [I/Y] [10 000] [FV] [CPT] [PMT] = -232.14

Note: If payments were made at the beginning of each month, with the first today, then
A = 232.14 / (1.01) = $229.84

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Time Value Relationships

P/F or PVF

Present Worth Future Worth

F/P or CAF

Ordinary Annuity

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Compound Interest Tables

Compound interest tables are located in the appendices of any Engineering Economy
textbook.
Tables are presented in either of two formats:

• By interest rate
• By factor

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Series Compound Amount Factor [F/A,i,n]

Rate 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Periods
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051
6 6.1520 6.3081 6.4684 6.6330 [F/A, 8%, 6]
6.8019 6.9753 7.1533 7.3359 7.5233 7.7156
7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872
8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.2598 10.6366 11.0285 11.4359
9 9.3685 9.7546 10.1591 10.5828 11.0266 11.4913 11.9780 12.4876 13.0210 13.5795
10 10.4622 10.9497 11.4639 12.0061 12.5779 13.1808 13.8164 14.4866 15.1929 15.9374

To find a factor associated with an interest rate between those contained in the tables, use
linear interpolation between two adjacent values bracketing the desired rate.
To find a factor using the financial calculator, use a value of 1 for either PV, PMT or FV, in
combination with the appropriate values for N and I/Y.
Final Note: Because compound interest works in a discrete manner (i.e. interest accrues
once per period), fractional periods should not be used.

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Special Considerations

• Continuous Compounding

Effective interest rate is (e r  1)

 replace (1  i) n
by e rn

• Infinite time period

P/F 0 P/A
1
F/A 
i
F/P  A/P i A/F 0

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Example 3.16
What amount must be placed in a trust fund to provide an annual scholarship of $10
000 for perpetuity. The fund pays an annual rate of 10% compounded quarterly.

4
 0.1 
EIR  1    1  0.1038  10.38%
 4 

10 000
P= = $96 339.11
0.1038

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

• Time has no value, i.e. no interest is charged nor paid.

F/P = 1 P/A = n F/A = n

P/F = 1 A/P = 1/n A/F = 1/n

Example 3.17

Borrow $5000 to be repaid in end-of-year installments over a 5 year period. If no

interest is charged, what is the annual payment?

A = 5000 (A/P,0%,5)
= 5000 (1/5) = $1000

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

• Interest changes over time

 Cannot use A/P, P/A and F/A factors that are applicable when i is constant
 Must compose P/F and F/P factors.

For instance,

F3 / P0 , i1, i 2 , i3 ,3 : (1  i1 ) (1  i 2 ) (1  i3 )

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Example 3.18

F=?

$5000

i=5%
| | i=10% | i=15%| i=5% |
0 1 2 3 4

F4 = 5000 (1.05) (1.1) (1.15) (1.05) = $6973.31

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Example 3.19

$5000
P=? $3000

i=5%
| | i=10% | i=15%| i=5% |
0 1 2 4

$3000

P = [ (((5000 / 1.05) - 3000) / 1.15) + 3000 ] / (1.1) (1.05) = $3923.89

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

• Annual payments increase/decrease over time

Compound interest factors may be derived for situations when an annuity is replaced by:

i) End-of-period payments increasing/decreasing by a constant

amount per period

ii) End-of-period payments increasing/decreasing at a constant

compound rate per period

Note: The BA II Plus does not have any functions for these factors.

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

i) Uniform Gradient Series Factor

The end-of-period payments increase or decrease by a constant amount G per period.

• By convention, no payment at time 0

(n-1) G
• Payment at time 1 is (0)G, i.e. zero (n-2) G
(n-3) G

3G
2G
G
| | | | | | | | |
0 1 2 3 4 … n-2 n-1 n

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

This factor determines the annuity that is equivalent to the gradient series.

 1  n 
A  G    
 i  (1  i)  1
n
(n-1) G
 1  n  (n-2) G
(A/G, i, n) :    
  (1  i)  1 (n-3) G
n
i

3G
A= ?

2G
| | |G | | | | | |
0 1 2 3 4 … n-2 n-1 n
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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Example 3.20

Operating costs for a piece of equipment were $1500 over its first year of use, and are
expected to increase by $200 per year over a life of 10 years. Determine the
equivalent annual costs using an interest rate of 8%.

Divide series of operating costs into 2 parts:

3300
1600 1800
…
800
1500 400 600
0 200
1500

| | | | | | | | | | |
0 1 2 3 4 5 6 7 8 9 10
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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

i) $1500 per year over 10 year life – call this A’

ii) Gradient series with G=$200 – call this A”

 1  10 
A"  200   
  (1  0.08)  1
0.08 10

 200 (3.8713)  774

Therefore, the overall annuity is : 1500 + 774 = $2274

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

ii) Geometric Series Present Value Factor

The end-of-period payments increase or decrease at a constant compound rate g per

period.

• By convention, no payment at time 0

C(1+g)n-1
• Payment at time 1 is C (1+g)0, i.e. C
C(1+g)n-2
PV=?
C(1+g)n-3

C(1+g)3
C(1+g)2
C C(1+g)
| | | | | | | | |
0 1 2 3 4 … n-2 n-1 n
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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

This factor determines the present value equivalent of the gradient series.

 1  g  
n
 
P  C 1  / (i  g)
For g  i:
n 

 1  i   
  
P / C,i,g, n 
 n 
PC  

For g = i:
(1

g

)
( P / C,i ,g , n )

For n = : P = C [1 / (i - g)] for i > g

(P/C,i,g,)

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Example 3.21
Operating costs for a piece of equipment were $1500 over its first year of use, and
are expected to increase at a compound rate of 10% per year over a life of 6 years.
Determine the equivalent annual costs using an interest rate of 12%.

First, find the present worth equivalent of the stream of operating costs:

 (1  0.10) 
6
 
P  1500 1  / (0.12  0.10)
6

 (1  0.12)  
P  1500 (5.1236)  7685.40
Second, convert the present worth to an annuity:

A  7685.40 (A / P,12%,6)
 7685.40 (0.24323)  $1869.29

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3.4 TIME VALUE EQUIVALENCE & COMPOUND INTEREST FACTORS

Special Note
The factors covered here are those for DISCRETE monetary flows with either discrete
or continuous compounding.

There also exist factors for CONTINUOUS monetary flows with continuous
compounding.

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3.5 BONDS
Bond Certificate
• States the terms of the bond
Maturity Date
• Final repayment date
Term
• The time remaining until the repayment date

Coupon
• Promised interest payments

Face Value
• Notional amount used to compute the interest payments

Coupon Rate
• Determines the amount of each coupon payment, expressed as an APR
Coupon Payment
Coupon Rate  Face Value
CPN 
Number of Coupon Payments per Year
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3.5 BONDS
Coupon Bond
• Pay face value at maturity
• Pay regular coupon interest payments

Yield to Maturity
• The discount rate that sets the present value of the promised bond payments equal
to the current market price of the bond.

1  1  FV
P  CPN  1  N 

y  (1  y)  (1  y) N

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3.5 BONDS
Example 3.22
Consider the following semi-annual bond:
• $1000 par value
• 7 years until maturity
• 9% coupon rate
• Price is $1,080.55
What is the bond’s yield to maturity?

BA II Plus (Set to end-of-period payments)

Using six months as time unit (P/Y set to 1)
[2nd] [CLR TVM] [14] [N] [1080.55] [+/-] [PV] [45] [PMT] [1000] [FV] [CPT] [I/Y] = 3.74997

YTM = 3.74997 * 2 = 7.49995 = 7.50%

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3.5 BONDS
Discount
• Bond is selling at a discount if the price is less than the face value
• Coupon Rate > Yield to Maturity
• If a coupon bond trades at a discount, an investor will earn a return both from
receiving the coupons and from receiving a face value that exceeds the price
paid for the bond
Par
• A bond is selling at par if the price is equal to the face value
• Coupon Rate = Yield to Maturity

Premium
• A bond is selling at a premium if the price is greater than the face value
• Coupon Rate < Yield to Maturity
• If a coupon bond trades at a premium it will earn a return from receiving the
coupons but this return will be diminished by receiving a face value less than the
price paid for the bond

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3.6 STOCKS
A One-Year Investor

 Div1  P1 
P0   
 1  rE 

Since the cash flows are risky, we must discount them at the equity cost of capital.
• If the current stock price were less than this amount, expect investors to rush in
and buy it, driving up the stock’s price.
• If the stock price exceeded this amount, selling it would cause the stock price to
quickly fall.

Div1  P1 Div1 P1  P0
rE   1  
P0 P0 P0
Dividend Yield Capital Gain Rate

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3.6 STOCKS
A Multi-Year Investor

Div1 Div2 DivN PN

P0     
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N
• The price of any stock is equal to the present value of the expected future
dividends it will pay
• This is known as the Dividend-Discount Model

Constant Dividend Growth

Div1 Div1
P0  rE   g
rE  g P0
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3.6 STOCKS
Changing Growth Rates
• We cannot use the constant dividend growth model to value a stock if the growth
rate is not constant.
• Although we cannot use the constant dividend growth model directly when
growth is not constant, we can use the general form of the model to value a firm
by applying the constant growth model to calculate the future share price of the
stock once the expected growth rate stabilizes

Limitations of the Dividend-Discount Model

• There is a tremendous amount of uncertainty associated with forecasting a firm’s
dividend growth rate and future dividends.
• Small changes in the assumed dividend growth rate can lead to large changes in
the estimated stock price.

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3.6 STOCKS
Share Repurchases and the Total Payout Model
• When the firm uses excess cash to buy back its own stock
• The more cash the firm uses to repurchase shares, the less it has available to
pay dividends.
• By repurchasing, the firm decreases the number of shares outstanding, which
increases its earnings per share and dividends per share.
• Values all of the firm’s equity, rather than a single share. You discount total
dividends and share repurchases and use the growth rate of earnings (rather
than earnings per share) when forecasting the growth of the firm’s total payouts.

PV (Future Total Dividends and Repurchases)

PV0 
Shares Outstanding 0
Discounted Free Cash Flow Model
• Determines the value of the firm to all investors, including both equity and debt
holders
• The enterprise value can be interpreted as the net cost of acquiring the firm’s
equity, taking its cash, paying off all debt, and owning the unlevered business.

Enterprise Value  Market Value of Equity  Debt  Cash

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3.7 EXAMPLES
Example 3.23
A loan of $2000 is to be reimbursed with end-of-year payments of $500 over a 5 year
period. Payments are to start 12 months after the money is borrowed. What annual
compound interest rate is charged?

$2000

| | | | | |
0 1 2 3 4 5

$500

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3.7 EXAMPLES
Solution
• Amount borrowed is equivalent to an annuity of $500 over a 5-year period
BA II Plus

2000  500 (P / A, i,5) [2nd] [CLR TVM]

2000 [5] [N]
(P / A, i,5)  4
500 [2000] [PV]
[500] [+/-] [PMT]
• Using the series present value factor:
[CPT] [I/Y] = 7.93
n 5
For i  7%  4.1002  4.1002  4.000 
i  7%    (1%)  7.9%
For i  8%  3.9927  4.1002  3.9927 

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3.7 EXAMPLES
Example 3.24
If payments are made every 2 years over a 10-year period, what annual compound
interest rate is charged?

$2000

|| | || | || | || | || | ||
0 2 4 6 8 10

$500

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3.7 EXAMPLES

Same reasoning as previous example…

2000 = 500 (P/F,i,2) + 500 (P/F,i,4) + 500 (P/F,i,6) +

500 (P/F,i,8) + 500 (P/F,i,10)

Now solve by trial and error,

i = 3.9%

Alternate Solution

Result of 7.9% in first example is still valid, but it’s the compound rate per 2-year
period, i.e. the effective rate for a period of two years.

EIR = (1 + i)2 - 1 = 0.079

(1 + i)2 = 1.079
(1 + i) = (1.079)0.5 = 1.0387
 i = 3.9%

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3.7 EXAMPLES
Example 3.25

Ad indicates 6-month loan. Therefore, assume

26 payments.

The interest rate charged per week (i) is found by

solving:
1000 = 55 (P/A,i,26)

Use financial calculator with:

PV=-1000, PMT=55 and N=26

Compute I/Y: 2.85%

 Nominal Rate: 2.85 (52) = 148%

Effective Rate: (1 + 0.0285)52 - 1 = 331%

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3.7 EXAMPLES
Example 3.26
What payment is to be deposited annually into an account yielding an annual interest
rate of 10%, with the first deposit today and 25 deposits thereafter, eventually
accumulating to $100 000 on the day of the last deposit. $100 000
(A/F)

| | | | | | | | |
0 1 2 3 4 ... 23 24 25
0 1 2 3 4 5 ... 24 25 26

BA II Plus
A = 100 000 (A/F,10%,26)
= $915.90 [2nd] [CLR TVM]
[26] [N] [10] [I/Y] [100 000] [FV]
[CPT] [PMT] = -915.90
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3.7 EXAMPLES
Alternate Solution

Isolate the first payment (at t=0) from the 25 others

First payment 25 other payments

100 000  A (F/P, 10%, 25)  A (F/A,10%, 25)

    
10.8347 98.3471
100 000  109.1818 A
A  $915.90

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3.7 EXAMPLES
Example 3.27
Walter started depositing annual amounts of $1200 fifteen years ago, when interest
rates were 5% per annum. Five years later, interest rates increased to 6%, and four
years ago, interest rates increased to 7%. What amount has accumulated in his
account, including today’s deposit?

?
1 2 3

1 2 3 4 5 6 1 2 3 4 5 6 1 2 3 4
$1200

| | | | | | | | | | | | | | | |
-15 -10 -5 0

i=5% i=6% i=7%

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3.7 EXAMPLES

Future value of first 6 deposits at time 0

1  1200 (F/A,5%,6) (F/P,6%,6) (F/P,7%,4)

  
6.802 1.419 1.317
 15 185
Future value of next 6 deposits at time 0

2  1200 ( F / A,6%,6) ( F / P,4,7%)

       
6.975 1.311 $31 486
 10 973
Future value of last 4 deposits at time 0

3  1200 (F / A,7%,4)

4.440
 5328
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3.7 EXAMPLES
BA II Plus
We first move the first six deposits to time -10 (i.e. convert A into F).

[CLR TVM] [6] [N] 5 [I/Y] [1200] [PMT] [CPT] [FV] = -8162.30

FV = 8162.30

1
1 2 3 4 5 6

| | | | | | | | | | | | | | | |
-15 -10 -5 0

i=5%
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3.7 EXAMPLES

Next we find the combined future value of 8162.30 (becomes a PV with respect to the
new time frame) and the following six deposits at time -4.

• [+/-] [PV] (changes the negative value to positive and enters it as PV)
• N=6 and PMT=1200 remain unchanged from the previous calculation.
• [6] [I/Y] [CPT] [FV] = -19 948.75
FV = 19 948.75
8162.30

2
1 2 3 4 5 6

| | | | | | | | | | | | | | | |
-15 -10 -5 0

i=6%
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3.7 EXAMPLES

Finally, we must find the combined future value of 19 948.75 (becomes a PV with
respect to the new time frame) and the last four deposits at time 0.

• [+/-] [PV]
• PMT=1200 remains unchanged from the previous calculation.
• [7] [I/Y] [4] [N] [CPT] [FV] = -31 476.68 FV = $31 476.68
19 948.75

Notice that in all calculations, we used the convention that

the deposits (or their equivalent) were positive. Special
attention must be given to the signs.
3
Notice how we did not have to reset FV to 0 for the last 1 2 3 4
two calculations. [CPT] [FV] does it automatically.

| | | | | | | | | | | | | | | |
-15 -10 -5 0

i=7%
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3.7 EXAMPLES
Example 3.28
A bond with a face value of $1500 is purchased for $1300. The bond has an 8%
coupon rate, payable quarterly. If the bond matures in 10 years, what will be it’s yield
to maturity?
$1500 BA II Plus
Interest payments: 2% of $1500, [2nd] [CLR TVM]
i.e. $30, every 3 months [40] [N]
$30
[1300] [+/-] [PV]
[30] [PMT]
1 2… 8 9 10
[1500] [FV]
[CPT] [I/Y] = 2.53
1300

Equivalence relationship: 1300 = 30 (P/A,i,40) + 1500 (P/F,i,40)

Solving for i by trial an error, i =2.54%

Thus, the yield to maturity is 4 (2.53) = 10.1%

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3.7 EXAMPLES

If the bond is to be sold after 5 years, what minimum price would guarantee the same yield?

If the yield to maturity (2.53% per quarter) is to be

maintained, the minimum selling price is the present value
equivalent at 2.53% per quarter of all future receipts that are BA II Plus
forfeited when the bond is sold
[2nd] [CLR TVM]
P = 30 (P/A, 2.53%,20) + [20] [N]
1500 (P/F,2.53%,20) [2.53] [I/Y]
= $1376.40
[30] [PMT]
[1500] [FV]
[CPT] [PV] = -1376.42

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3.7 EXAMPLES
Example 3.29
A $150 000 home is purchased with a down-payment of $30 000. The balance is
financed through a 25-year mortgage with monthly payments at a nominal annual rate
of 12 percent compounded monthly. The house is kept for 5 years and then sold.
What mortgage balance remains to be paid at the time of the sale?

Monthly mortgage payments: BA II Plus

A = 120 000 (A/P,1%,300) = $1263.84

[2nd] [CLR TVM]
0.010532 [300] [N]
[1] [I/Y]
[120 000] [PV]
[CPT] [PMT] = -1263.87

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3.7 EXAMPLES

At the time of the sale, there are 240 month-end payments remaining to be made.
Their present value equivalent is:

P = 1263.84 (P/A,1%,240)
90.8194
= $114 781 BA II Plus
[2ND] [CLR TVM]
[240] [N]
A lump sum amount of $114 781 is required to retire the [1] [I/Y]
mortgage, an amount about $5200 less than the [1263.87] [PMT]
amount owed originally!
[CPT] [PV] = -114 784

A total of $75 832 (60 times $1263.87) was paid over the 5-year period! Most of this
amount represents interest.

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3.7 EXAMPLES

These comments give a distorted picture of the situation because the monetary values
are not equivalent. The following gives a better picture of reality.

• Present value equivalent (at time of purchase) of 60 payments:

1263.84 (P/A,1%,60) = 56 816
44.9550

• Present value equivalent (at time of purchase) of amount owed:

114 781 (P/F,1%,60) = 63 181
0.5504

• Proportion of original debt paid up: Total: $120 000

56 816 = 47%
120 000

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3.7 EXAMPLES
Example 3.30
The improvement of a production process requires the investment of $50 000. If
implemented, the improvement would generate an annual saving of $7300 over an 8-
year period. Given that the discount rate is 10%, is this investment justified?

• Total Savings: 7300 (8) = $58 400

• Ignoring the time value of money, the investment is justified because the total
savings are greater than the required investment of $50 000.

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3.7 EXAMPLES

• However, if the time value of money is considered, the situation changes…

The present worth of the annual savings, assuming end-of-year amounts is:
7300 (P/A,10%,8) = $38 954
5.3349

Because the present worth of savings is lower than the required investment, there
is no economic justification to the improvement project.

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