Business Finance - Time Value of Money (TVM)
Course: BUS 302 - Corporate Finance
Class Topic: The Time Value of Money & Basic Valuation
1. Lecture Notes: Core TVM Concepts
1.1 What is TVM?
The idea that money today (Present Value, PV) is worth more than the same amount of money
in the future (Future Value, FV) – because money today can earn interest/investment returns.
• Class example: $100 today invested at 5% annual interest becomes $105 in 1 year – so $100
now > $100 in 1 year.
1.2 Key TVM Definitions
• Present Value (PV): Current worth of a future sum of money, discounted at a given interest
rate.
• Future Value (FV): Value of a current sum of money at a specific future date, compounded at a
given interest rate.
• Interest Rate (r): The “cost” of money – usually annual (e.g., 6% = 0.06 in calculations).
• Time Periods (n): Number of compounding periods (e.g., 5 years = 5 periods; 6 months = 0.5
periods if annual compounding).
• Annuity: Equal, regular cash flows over a set period (e.g., $200/month for 3 years). Two types:
◦ Ordinary Annuity: Cash flows at the end of each period (most common – e.g., loan payments).
◦ Annuity Due: Cash flows at the start of each period (e.g., rent payments).
1.3 Critical TVM Formulas
• Future Value of a Lump Sum: FV = PV × (1 + r)^n
◦ (1 + r)^n = Future Value Interest Factor (FVIF) – can use tables or calculators for this!
• Present Value of a Lump Sum: PV = FV / (1 + r)^n = FV × (1 + r)^(-n)
◦ (1 + r)^(-n) = Present Value Interest Factor (PVIF)
• Future Value of an Ordinary Annuity: FV_Annuity = PMT × [( (1 + r)^n - 1 ) / r ]
◦ PMT = periodic payment; [( (1 + r)^n - 1 ) / r ] = Future Value Annuity Factor (FVIFA)
• Present Value of an Ordinary Annuity: PV_Annuity = PMT × [ (1 - (1 + r)^(-n) ) / r ]
◦ [ (1 - (1 + r)^(-n) ) / r ] = Present Value Annuity Factor (PVIFA)
Note from class: Always double-check if r and n match (e.g., if interest is monthly, r = annual
rate / 12, n = years × 12).
2. Sample Problems (With Step-by-Step Solutions)
Problem 1: Future Value of a Lump Sum
You invest $5,000 today in a savings account that earns 4% annual interest, compounded
annually. How much will you have in 7 years?
Step 1: Identify variables
PV = $5,000; r = 4% = 0.04; n = 7 years
Step 2: Use the FV lump sum formula
FV = PV × (1 + r)^n
FV = 5,000 × (1 + 0.04)^7
Step 3: Calculate (1 + 0.04)^7
(1.04)^7 ≈ 1.31593 (use calculator or FVIF table for 4%, 7 periods)
Step 4: Solve for FV
FV = 5,000 × 1.31593 ≈ $6,579.65
Answer: You will have approximately $6,579.65 in 7 years.
Problem 2: Present Value of an Ordinary Annuity
A company offers you a retirement plan: $3,000 at the end of each year for the next 10 years. If
your required return is 6% annually, what is the present value of this annuity (how much is it
worth to you today)?
Step 1: Identify variables
PMT = $3,000; r = 6% = 0.06; n = 10 years
Step 2: Use the PV annuity formula
PV_Annuity = PMT × [ (1 - (1 + r)^(-n) ) / r ]
Step 3: Calculate the PVIFA
[ (1 - (1 + 0.06)^(-10) ) / 0.06 ] = [ (1 - 0.5584) / 0.06 ] ≈ (0.4416 / 0.06) ≈ 7.3601
Step 4: Solve for PV_Annuity
PV_Annuity = 3,000 × 7.3601 ≈ $22,080.30
Answer: The present value of the retirement plan is approximately $22,080.30.
Problem 3: Mixed TVM – Lump Sum + Annuity
You plan to save $1,500 at the end of each year for 5 years (annuity), and then invest the total
amount in a bond that earns 5% annual interest for another 3 years (lump sum). How much will
you have after 8 years total?
Step 1: Find FV of the 5-year annuity
PMT = $1,500; r = 5% = 0.05; n = 5
FV_Annuity = 1,500 × [ ( (1 + 0.05)^5 - 1 ) / 0.05 ]
FVIFA (5%, 5) ≈ 5.5256
FV_Annuity = 1,500 × 5.5256 = $8,288.40
Step 2: Find FV of the $8,288.40 lump sum over 3 years
PV = $8,288.40; r = 0.05; n = 3
FV = 8,288.40 × (1 + 0.05)^3 ≈ 8,288.40 × 1.1576 ≈ $9,594.66
Answer: You will have approximately $9,594.66 after 8 years.
3. Class Takeaways & Reminders
• Common Mistakes to Avoid: Mixing up annuity types (ordinary vs. due – for due, multiply
FV/PV by (1 + r)), using the wrong r/n (e.g., annual rate for monthly payments).
• Calculator Tip: Use the TVM solver on a financial calculator (N = n, I/Y = r, PV = -, PMT =, CPT
FV) – saves time on exams!
• Next Class: Bond valuation (how to apply TVM to bonds) – review annuity formulas
beforehand.
• Homework: Chapter 5, Problems 3, 8, 12, 15 (due Nov 19 – show all calculation steps!).
• Quick Note: Dr. said TVM is the “backbone of finance” – master this, and stock/bond valuation
will be easier!