Chapter 3

Chapter 3
The Time Value of

Money
Time value of money (TVM) is a concept concerning the value of the money we have at different
points of time. As such, the promise or a Ringgit one-year from now is not equal to the value of a
Ringgit to be received today. For example, which would you prefer to receive; RM1000 today or
RM1000 in 3 years? Obviously, the choice will be RM1,000 today. The preferences over the choice of
when to receive the money lies the whole basis of time value of money that a Ringgit in the hand
today is worth more than a Ringgit to be received at some time in the future. A Ringgit received today
can be invested and it will grow with time. If the money is deposited into a saving account paying 10
percent interest, it will grow to RM1.10 a year from now.
The essential element here is time. Time is very important as it allows us the opportunity to postpone
consumption and invest it to earn interest. Thus, the basic principle suggests that the value of money
is not the same, and the acknowledgment of the real values is utmost important in financial decision.
The time value of money concepts provides the necessary framework for analysis of relative
attractiveness of alternative investment opportunities. Most financial decisions require current
investment outlay that provides return of future cash flows over number of years in future.
Thus, to evaluate the attractiveness of the investment will require the financial manager to recognize
the real money values, and evaluate whether the returns are higher than the cost of investment. All
cash flows must be weighted accordingly based on its amount, timing, and the rate of return from
investment required by the firm in order to increase the firm’s value. The most common measure of
value created by financial decision is the Net Present Value (NPV), defined as present value of
expected future cash flows less costs of investment.
1. A positive NPV signify an increase in wealth because the asset is worth more than it costs.
Therefore the company earns more than the fair rate of return.
2. A negative NPV decreases wealth as the asset costs more than its worth and earns less than
the fair rate of return.
3. Although it rarely happens, a zero NPV decision shows that the firm earns the “fair” rate of
return, and still an acceptable investment.
The fair rate of return mentioned normally refers to the discount rate or the price of using money.
There are several concepts of rate of return that need clarifications, namely required rate of return,
expected rate of return, realized rate of return and weighted average cost of capital (WACC).
1. Required Rate of Return. The required rate of return is the return that exactly reflects the
risk of the expected future cash flows. Represent the minimum return a person requires from
an investment before she/he is willing to commit in the investment. In essence, it reflects the
opportunity cost of the investment and normally dictates by the market conditions.
2. Expected Rate of Return. It is the return that investor expects to earn from investment. If it is
equal to the required rate of return, the investment has a zero NPV. If it is greater than the
required rate of return, the investment has a positive NPV. If it is less than the required rate of
return, the investment has a negative NPV.
Part II: Valuation of Future Cash Flows
CHAPTER THREE ♦ The Time Value of Money 26
3. Realized Rate of Return. It is the return actually earned on the investment during a given
time period. It can only be observed after the fact or the outcome of having made the
decisions to invest. The differences between the required (or the expected) rate of return and
realized rate of return exist because cash flows are risky. Therefore, the actual outcome
rarely equals the expected amount.
4. Weighted Average Cost of Capital. It is the average rate of return required by the suppliers
of capital for the firm’s capital project that compensates them for the proportional risk they
bear. Therefore, the WACC represent the minimum rate of return that must be earned by the
firm from the investment to satisfy the investors’ demand and to increase the firm’s wealth.
The WACC will be covered extensively in chapter 5.
BASICS OF TIME VALUE OF MONEY (TVM)
Before we discuss the details of TVM concepts and applications, revisions of the basics of TVM are
necessary especially concerning the types of interest, concepts of present value and future value,
time line, and notation that are frequently used in TVM applications.
Future Value versus Present Value
Future value is the value at some future time of a present amount of money, or a series of payments,
compounded at a given interest rate. It deals with the accumulation of money as it grows over time to
some date in future. The interest earned will accumulate in the account until the investment is
withdrawn.
Figure 3.1 Future Value Concept and Effects of Interest on FV
PV0
FVn
t0 t1 t2 t3 t4 t5 tn-1 tn Time
FV (RM)
FV20%,n
FV10%,n
FV0%,n
The amount of growth in the particular investment will depend on the compound rate of return, k,
earned on the investment and the period of time, n, and the funds tied up as shown in Figure 3.1. As
such, higher interest rate, longer period, and greater frequency of compounding per period will lead to
higher future value.
The future value by itself has little application in the financial decisions, but from this concept, the
present value (PV) concept is derived. The present value concept has a wide application in financial
decision-making, such as in capital budgeting. It lies on the same principle as that of future values,
except it is the reciprocal of it. At any given time, the present value of cash flows will depend on its
timing and the earnings' opportunities required rate of return of the investors.
Present value is the current value of a future amount of money, or a series of payments, evaluated at
a given interest rate. Figure 3.2; indicate the discounting process that concerned with discounting a
future value (FVn) in order to determine its present value (PV0).
Figure 3.2 Present Value Concept and Effects of Interest on PV
PV0
FVn
PV (RM)
PV0%
FVn
PV10%
PV20%
Discounting is a process to determine the present value (PV0) of a cash flow that will be received in
some future date. As discount rate, frequency of discounting and time increases, the present value
will decrease, and vice versa. Thus, it shows that the present value and future value concepts are
reciprocal to each other as it is the reverse of the compounding process in determining the future
value of present cash flows.
The present value concept is considered as the most powerful tool for financial manager in dealing
with investment decisions such as investment in fixed assets, portfolio management, banking, real
estates, and others. It focuses on the opportunity cost of capital employed in one particular investment
relative to another. Thus, it tries to allocate financial resources effectively to maximize the owners'
wealth.
Since money at any time has an alternative use, it creates the concept of opportunity cost that is the
forgone income in other alternatives' investment. This opportunity cost represents the rate of return
required by investors. Thus, it is appropriate to use the opportunity cost of funds as a discount rate, k,
to discount the amount receive in some future date to present value.
Using the TVM Tables
Factors presented in TVM tables are pre-calculated values of relevant interest factors for a given
interest and periods of discounting and compounding. The following symbols are relevant in
understanding and applications of the tables involved:
Where PV : Present value

FV : Future value
k : Interest rate per period; discount rate or compound rate
n : Number of period(s)
CFn : Cash flow in period n
ACFn : Annuity cash flows for n periods
FVIFk,n : Future Value Interest Factor at k,n
PVIFk,n : Present Value Interest Factor at k,n
FVIFAk,n : Future Value Interest Annuity Factor at k,n
PVIFAk,n : Present Value Interest Annuity Factor at k,n
The understanding of how the values in the mathematical tables are determined is very important to
promote understanding the time value of money concept and to simplify complex cash flows in
determining the TVM. The relationship between TVM formula approach and TVM tables approach
are:
Present value single payment PV0 = CFn / (1+k)n

= CFn (PVIFk,n)
Present value annuity PVA0 = CF1 /(1+k)1 + CF2 /(1+k)2 + ... + CFn /(1+k)n
= ACFn [1 – 1 / (1+k)n ] / k
= ACFn (PVIFAk,n)
Future value single payment FVn = CFn (1+k)n

= CFn (FVIFk,n)
Future value annuity FVAn = CF1 (1+k)1 + CF2 (1+k)2 + ... + CFn (1+k)n
= ACFn [(1+k)n – 1] / k
= ACFn (FVIFAk,n)
For our purpose, we are going to focus more on the latter approach of using TVM tables for
understanding and enable effective usage of financial calculator. The use of financial calculator will
solve problems when dealing with fractional rates that are not available in the TVM tables. Sample
calculations using financial calculator is shown on the right hand side of the calculations. The basic
guide for understanding the tables are shown in Table 3.1 and 3.2.
Table 3.1 Guide to Future Value Tables; k = 6%, n = 4
Year 0 1 2 3 4
Single CF FVIF6%,4 FVIF6%,3 FVIF6%,2 FVIF6%,1 FVIF6%,0
FVIF6%,4 FV4 is the focal of compounding.

+ FVIF6%,3 FVIF6%,3
+ FVIF6%,2 + FVIF6%,2 FVIF6%,2
+ FVIF6%,1 + FVIF6%,1 + FVIF6%,1 FVIF6%,1
+ FVIF6%,0 + FVIF6%,0 + FVIF6%,0 + FVIF6%,0 FVIF6%,0
Annuity CF = FVIFA6%,5 = FVIFA6%,4 = FVIFA6%,3 = FVIFA6%,2 = FVIFA6%,1
Note: FVIFA6%,5 = FVIF6%,0 + FVIF6%,1 + FVIF6%,2. + FVIF6%,3 + FVIF6%,4.
Table 3.2 Guide to Present Value Tables; k = 6%, n = 4
Year 0 1 2 3 4
Single CF PVIF6%,0 PVIF6%,1 PVIF6%,2 PVIF6%,3 PVIF6%,4
PV0 is the focal of discounting. PVIF6%,1

PVIF6%,1 + PVIF6%,2
PVIF6%,1 + PVIF6%,2 + PVIF6%,3
PVIF6%,0 PVIF6%,1 + PVIF6%,2 + PVIF6%,3 + PVIF6%,4
Annuity CF = PVIFA6%,0 = PVIFA6%,1 = PVIFA6%,2 = PVIFA6%,3 = PVIFA6%,4
Note: PVIFA6%,4 = PVIF6%,1 + PVIF6%,2 + PVIF6%,3 + PVIF6%,4.
Since the PV and FV are reciprocal to each other, therefore, future value interest factor (FVIF k,n) can
be transformed into a present value interest (PVIF k,n) and vice versa. For example let k=10, and n=5
as follows:
FVIF10,5 = 1 / PVIF 10%,5 2ND RESET ENTER;

= 1 / 0.6209 ‐1 PV; 10 I/Y; 5 N;
= 1.6105 CPT FV = 1.6105
PVIF 10,5 = 1 / FVIF 10%,5, 2ND REST ENTER

= 1 / 1.6105 ‐1 FV; 10 I/Y; 5 N;
= 0.6209 CPT PV = 0.6209
The above relationship however cannot be applied between FVIFA and PVIFA. To further illustrate
the reciprocal relationship, assume that you are given a choice either to receive RM1000 today or
RM1191 three years from now, and you could invest the money at 6% interest. Which one would you
choose? Let us compare the alternatives using the concepts presented:
PV FV
Period 0 1 2 3
Compounding 1,000 1,191
Discounting 1,000 1,191
FV3 = CF0 (FVIF6%,3) 2ND RESET ENTER;

= RM1,000(1.1910) ‐1000 PV; 6 I/Y; 3 N;
= RM1,191.00 CPT FV =1191.02
Thus, to prove the reciprocal relationship, let:
PV0 = CF3 (1 / FVIF6%,3)

= RM1,191(1 / 1.1910)
= RM1,191(0.839631)
= RM1,000
The PV0 is the same by using the pre-calculated factor for PVIF6%,3 as follows:
PV0 = CF3 (PVIF6%,3) 2ND RESET ENTER;

= RM1,191(0.8396) ‐1191.02 FV; 6 I/Y; 3 N;
= RM9,99.96 Due to rounding CPT PV =1000
Therefore, it is indifference whether to choose RM1,000 today or RM1,1910 in three years as the
actual value is the same at required rate of return of 6%.
Types of Interest
Simple interest: Interest paid (earned) on only the original amount, or principal borrowed (lent). To
illustrate, assume that you deposit RM1,000 in an account earning 10% simple interest for 2 years.
What is the accumulated interest at the end of year 2? Simple interest formula is defined as follows:
SI = CF0(k)(n) Where SI : Simple interest

CF0 : Deposit value today; n=0
k : Interest pate per period
n : Number of periods
Future value simple interest SI = CF0(k)(n)

= RM1,000(0.10)(2)
= RM200
Future value of deposit at end of year 2 FV2 = CF0 + SI

= RM1,000 + RM200
= RM1,200
The Present Value of the deposit is simply the RM1,000 that is the value today and the value at the
end of year two is RM1,200 that consists of RM1,000 of original principal plus RM200 on interest
earned over the period of two years.
Compound interest: Interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent). Assume the same example as above that you deposit RM1,000 at a
compound interest rate of 10% for 2 years.
Future value at end of year 1 FV1 = CF0 (1+k)1

= RM1,000(1+0.10)1
= RM1,100
It shows that you earned RM100 interest on your RM1,000 deposits over the first year. You would
earn this same interest under simple interest.
Future value of at end of year 2 FV2 = CF1 (1+k)1

= RM1,100 (1+ 0.10) 1
= RM1,210
With similar principal of RM1,000, you earned an extra RM10 (=1,210 – 1,200) in Year 2 with
compound over simple interest. The extra amount is the interest earned on the interest income from
year 1 that is RM10 (=100 x 0.10). It can be summarized in the following tables:
Interest earned on
Year Beg. Value (PV) (1 + k) End. Value (FV) Principal Interest
1 1,000 1.10 1,100 100(0.1) = 100 None
2 1,000 1.10 1,210 100(0.1) = 100 100(0.1) = 10
Totals 200 10
The RM1210 is the compound value; that is value after taking considerations that interest left in an
account itself earns interest in the following period. The whole process of calculating the future value
is known as "compounding."
The Time Line and Assumptions
It is advisable to prepare the time line that shows the amount and timing of relevant cash flows to view
the problems at hand objectively. This will help the understanding of the problems at hand and
develop able to develop better ways in problem solving. Helpful steps in solving TVM problems are:
1. Read the problem thoroughly

2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if solution involves a single cash flow, annuity stream(s), or mixed cash flows
5. Determine whether it is a present value or future value problem
6. Solve the problem
To illustrate, consider the following cash flows and its associated time line:
Year Notation Cash Flow (RM)

0 CF0 –5,000
1 CF1 2,000
2 CF2 3,000
3 CF3 3,500
End of Beginning of
Today Year 2 Year 3
PV FV
Period 0 1 2 3
Cash Flows 5,000 2,000 3,000 3,500
Unless otherwise stated, n=0 represents today, the decision point and cash flows occur at the end of
a time interval. Cash inflows are treated as positive amounts, while cash outflows are treated as
negative amounts. In addition, compounding or discounting frequency is the same as the cash flow
frequency.
MULTIPLE CASH FLOWS
In this section, we illustrate the use of TVM formulas and TVM tables in determining the present
values and future values of future cash flows of various sizes. Suppose that you expect to receive the
following cash flows and the required rate of return, k, is 10%. (Monetary values are given in RM)
Period 0 1 2 3
Cash Flows 5,000 2,000 3,000 3,500
What is the present value of the above cash flows? The PV of multiple cash flows equals to the
sum of the present values of the individual cash flows. Therefore the present value of the cash flows
is as follows and as depicted in Figure 3-3:
PV0 = CF0 (PVIF10%,0) + CF1 (PVIF10%,1) + CF2 (PVIF10%,2) + CF3 (PVIF10%,3)

= RM5,000(1.000) + RM2,000(0.9091) + RM3,000(0.8264) + RM3,500(0.7513)
= RM5,000 + RM1,818.20 + RM2,479.20 + RM2,629.55
= RM11,926.95
2ND RESET ENTER; CF;
2ND RESET ENTER;
CF0 5000 Enter ↓;
5000 STO 1;
C01 2000 Enter ↓ F01 1 Enter ↓;
‐2000 FV; 1 N; 10 I/Y; CPT PV; STO + 1;
C02 3000 Enter ↓ F02 1 Enter ↓;
‐3000 FV; 2 N; 10 I/Y; CPT PV; STO + 1;
C03 3500 Enter ↓ F03 1 Enter ↓;
‐3500 FV; 3 N; 10 I/Y; CPT PV; STO + 1;
NPV; I = 10 Enter ↓;
RCL 1 = 11,927.12
NPV = CPT = 11,927.12
Figure 3-3 Present Value Calculation for Multiple Cash Flows
Period 0 1 2 3
Cash Flows 5,000 2,000 3,000 3,500
PVIF10%,0 PVIF10%,1 PVIF10%,2 PVIF10%,3
Present value 5,000.00

Total present value 11,926.95
What is the future value at time period 3 (n=3) of the expected cash flows? The FV of multiple
cash flows at a common point in future is equals to the sum of the future values of the individual cash
flows at that point of time. Therefore, the future value calculation for the cash flows is as follows and
can be depicted in Figure 3.4:
FV3 = CF0 (FVIF10%,3) + CF1 (FVIF10%,2) + CF2 (FVIF10%,1) + CF3 (FVIF10%,0)

= RM5,000(1.3310) + RM2,000(1.2101) + RM3,000(1.1000) + RM3,500(1.000)
= RM6,655.00 + RM2,420.20 + RM3,300.00 + RM3,500.00
= RM15,875.20
2ND RESET ENTER;
3500 STO 1;
‐3000 PV; 1 N; 10 I/Y; CPT FV; STO + 1;
‐2000 PV; 2 N; 10 I/Y; CPT FV; STO + 1;
‐5000 PV; 3 N; 10 I/Y; CPT FV; STO + 1;
RCL 1 = 15875
Figure 3-4 Future value Calculation for Multiple Cash Flow
Period 0 1 2 3
Cash Flows 5,000 2,000 3,000 3,500
FVIF10%,3 FVIF10%,2 FVIF10%,1 FVIF10%,0
Future value 3,500.00

Total future value 15,875.20
What is the future value at time period 2 (n=2) of the expected cash flows? The FV at year 2 can
be computed by using combination of future value and present value. The following calculations using
TVM tables and Figure 3-5 illustrates this approach:
FV2 = CF0 (FVIF10%,2) + CF1 (FVIF10%,1) + CF2 (FVIF10%,0) + CF3 (PVIF10%,1)

= RM5,000(1.2101) + RM2,000(1.1000) + RM3,000(1.0000) + RM3,500(0.9091)
= RM6,050.50 + RM2,200.00 + RM3,000.00 + RM3,181.85
= 14,432.35
2ND RESET ENTER;
3000 STO 1;
‐3500 FV; 1 N; 10 I/Y; CPT PV; STO + 1;
‐2000 PV; 1 N; 10 I/Y; CPT FV; STO + 1;
‐5000 PV; 2 N; 10 I/Y; CPT FV; STO + 1;
RCL 1 = 14431.82
Figure 3-5 Future value Calculation for Multiple Cash Flow with Mixed Approach
Period 0 1 2 3
Cash Flows 5000 2000 3000 3500
FVIF10%,2 FVIF10%,1 FVIF10%,0 PVIF10%,1
Constant
Constant 3000.00
Present value 3181.85
Future value 2200.00
Future value 6050.50
Total future value 14432.35
Note that CF0 and CF1 are compounded to period 2, CF2 will remain constant as the money is
received at the focal point and CF3 is discounted to period 2.
ANNUITIES AND PERPETUITIES
An annuity is a series of identical cash flows that are expected to occur each period for a specified
number of periods. Thus, let assume that we have four cash flows, then CF1 equals CF2 equals CF3
equals CF4. Common examples of annuities are installment loans, car loans, mortgages, coupon
payment on corporate bonds, rental payment, student loan payment, car loan payments, insurance
premiums, mortgage payments, and retirement savings no name a few. The following sections
illustrate important aspects of annuity cash flows (ACF).
Future Value of an Annuity: The easiest example is the future value of your savings. Suppose you
save RM1000 per year for 4 years, beginning one year from today. The savings bank pays you 8%
interest per year. How much will you have at the end of 4 years? The time line and the future value of
your savings:
Period 0 1 2 3 4
Cash flow 1,000 1,000 1,000 1,000
FVA4 = CF1 FVIF8%,3 + CF2 FVIF8%,2 + CF3 FVIF8%,1 + CF4 FVIF8%,0

= RM1,000(1.2597) + RM1,000(1.1664) + RM1,000(1.0800) + RM1,000(1.0000)
= RM1,259.70 + RM1,166.40 + RM1,080.00 +RM1,000
= 4,506.10
2ND RESET ENTER;
Alternatively = ACF (FVIFA8%,4)
‐1000 PMT; 8 I/Y; 4 N;
= 1,000 (4.5061)
CPT FV = 4506.11
= 4,506.10
Present Value of an Annuity: To illustrate, let assume that you are going to make a bank loan that
requires payments of RM10,00 per year for the next 4 years with the first payment begin one year
from today. The stated interest is 8%. The time line for these particular cash flows is similar to the
previous example. The present value of your bank loan:
PVA4 = CF1 PVIF8%,1 + CF2 PVIF8%,2 + CF3 PVIF8%,3 + CF4 PVIF8%,4

= RM1,000 (0.9259) + RM1,000 (0.8573) + RM1,000 (0.7938) + RM1,000 (0.7350)
= RM925.90 + RM857.30 + RM793.80 + RM735.00
= RM3,312.00
2ND REST ENTER;
Alternatively = ACF (PVIFA8%,4) ‐1000 PMT; 8 I/Y; 4 N;
= RM1,000 (3.3121) CPT PV = 3312.13
= RM3,312.10 Due to rounding
Both of the above problems deal with the assumptions that the compounding or discounting frequency
is the same as the cash flow frequency. What if the compounding or discounting frequency is not the
same as the cash flow frequency? For example, what is the present value of the cash flows if the
interest is 8% and discounted semi-annually. Can we solve this problem under annuity approach? The
answer is NO. Each cash flow must be treated as single cash flow and calculated based on multiple
cash flows with k at 4% (=8% / 2), at n periods accordingly:
Period 0 1 2 3 4
Semi-annually 0 1 2 3 4 5 6 7 8
Cash flow 1,000 1,000 1,000 1,000
PVA4 = CF2 (PVIF4%,2) + CF4 (PVIF4%,4) + CF6 (PVIF4%,6) + CF8 (PVIF4%,8)

= RM1,000(0.9246) + RM1,000(0.8548) + RM1,000(0.7903) + RM1,000(0.7307)
= RM924.60 + RM854.80 + RM790.30 + RM730.70
= RM3,300.40 2ND RESET ENTER;
‐1000 FV; 2 N; 4 I/Y; CPT PV; STO 1;
‐1000 FV; 4 N; 4 I/Y; CPT PV; STO + 1;
‐1000 FV; 6 N; 4 I/Y; CPT FV; STO + 1;
‐1000 FV; 8 N; 4 I/Y; CPT FV; STO + 1;
RCL 1 = 3,300.37
As shown the value is lower due to increasing number of discounting from 4 periods to 8 periods even
at lower discount rate. On the other hand, the future value of cash flows with more than one frequency
of compounding is higher. Therefore, proper analysis of relevant cash flows is necessary to ensure
that the accept-reject decisions are on a sound basis to enhance the firm’s wealth.
Types of Annuities
In the previous section, we demonstrate problems dealing with ordinary annuity that are normally
used in practice dealing with series of payments. However, differentiation between types of annuities
must be made since the nature of the cash flows involved requires different approach in solving the
TVM problems. There are ordinary annuities, annuity due, and deferred annuity. To illustrate the
differences, let assume that you are going to receive RM100 each for 3 years. What is the present
value and future value of the cash flows at 10% under each type of the annuity?
Ordinary annuity: Is an annuity with end-of-period cash flows that is beginning one period from
today. Payments or receipts occur at the end of each period and represent the most common type of
annuity. The approach in solving the TVM problems is similar to the annuity problems demonstrated
earlier. Therefore, the time line and the present and future values of the cash flows:
Period 0 1 2 3
Cash flows 100 100 100
PVA0 = ACF (PVIFA10%,3) 2ND REST ENTER;

= RM100 (2.4868) ‐100 PMT; 10 I/Y; 3 N;
= RM248.68 CPT PV = 248.69
FVA3 = ACF (FVIFA1010%,3) 2ND RESET ENTER;

= RM100 (3.3101) ‐100 PMT; 10 I/Y; 3 N;
= RM331.01 CPT FV = 331.00
Annuity Due: Contrary to ordinary annuity, cash flows for annuity due are beginning-of-period cash
flows. Payments or receipts occur at the beginning of each period and this format of cash flows being
practice widely in rental and leases. Using the same cash flows as before with adjustment of point of
time the cash flows occur:
Period 0 1 2 3
To make it comparative with ordinary annuity, we are going to calculate present value and future
value at year 3 of the annuity cash flows. The present value of annuity due (PVAD):
PVADn = CF0 PVIF10%,0 + CF1 PVIF10%,1 +.CF2 PVIF10%,2 2ND RESET ENTER; CF

= RM100 (1.000) + RM100 (0.9091) + RM100 (0.8264) CF0 100 Enter ↓;
= RM100.00 + 90.91 + 82.64 C01 100 Enter ↓ F01 2 Enter ↓;
= RM273.55 NPV; I = 10 Enter ↓;
NPV = CPT = 273.55
Alternatively = RM100(PVIF10%,0) + RM100(PVIFA10%,2)
= RM100(1.0000) + RM100(1.7355)
= RM273.55 2ND RESET ENTER;
100 STO 1
Or = RM100(PVIFA10%,2+ 1) ‐100 PMT; 10 I/Y; 2 N;
= RM100(1.7355 + 1) CPT PV = 173.55
= RM273.55 STO +1; RCL 1 = 273.55
Note that the later calculation use +1 as a factor in addition to PVIFA10%,2. This in actual sense
represent the present value interest factor for CF0 that is PVIF10%,0 equals one. This is because cash
flow at point of time is not compounded or discounted and the value with remains constant. This is
unique to the annuity due problem and must not make it a rule, but proper analysis of cash flows
required. Consequently, the future value of annuity due (FVAD):
FVAD3 = CF0 FVIF10%,3 + CF1 FVIF10%,2 + CF2 FVIF10%,1

= RM100 (1.3310) + RM100 (1.2100) + RM100 (1.1000)
= RM133.10 + RM121.00 + RM110.00
= RM364.10
Alternatively = 100 (FVIFA10%,3)(FVIF10%,1) 2ND RESET ENTER;

= RM100(3.3100)(1.1000) ‐100 PMT; 10 I/Y; 3 N;
= RM364.10 CPT FV = 331.00
2ND RESET ENTER;
Or = RM100(FVIFA10%,4 – 1) ‐331.00 PV; 10 I/Y; 1 N;
= RM100(4.6410 – 1) CPT FV = 364.10
= RM364.10
In contrast to present value, future value of annuity due uses a factor of "–1". This is a factor for
FVIF10%,0 for the cash flow in year 3 in the time line. Notice that there is no cash flow occurs in year 3
and thus the factor should be deducted from FVIFA10%,4 used to calculate the future value. This
approach is relevant as the FVIFA10%,4 is the sum of FVIF10%,0 plus FVIF10%,1 plus FVIF10%,2 plus
FVIF10%,3.
Cooperatively, the present value and future value of annuity due is greater than that of ordinary
annuity. This is because annuity due involves in less discounting process in determining the present
value and receive the cash flows earlier, and similarly more compounding process involved in
determining the future value compared to ordinary annuity. Again, timing of the cash flows plays a
major role in determining the value of the cash flows involved, whether it is present value or future
value.
Deferred Annuity: Represent an annuity that begins more than one period from today. The first cash
flow in a deferred annuity is expected to occur later than t=1. The present value of the deferred
annuity can be computed as the difference in the present values of two annuities. To illustrate,
assume the first cash flows expected to occur 3 years from today. There are 3 cash flows in this
annuity, with each cash flow being RM100 as follows.
Period 0 1 2 3 4 5
At an interest rate of 10% per year, the present value of deferred annuity (PVDA) and future value of
the deferred annuity (FVDA) under the valuation or TVM approach:
PVDA0 = RM100(PVIFA10%,5 – PVIFA10%,2)
CF0 0 Enter ↓;
= 100(3.7908 – 1.7355)
C01 0 Enter ↓ F01 2 Enter ↓;
= RM205.53
NPV; I = 10 Enter ↓;
NPV = CPT = 205.52
Alternatively = RM100(PVIFA10%,3)(PVIF10%,2)
= 100(2.4869)(0.8264)
2ND RESET ENTER;
= 205.52 ‐100 FV; 3 N; 10 I/Y; CPT PV; STO 1;
‐100 FV; 4 N; 10 I/Y; CPT PV; STO + 1;
‐100 FV; 5 N; 10 I/Y; CPT PV; STO + 1;
RCL 1 = 205.52
The first approach assume that the deferred annuity consist of a 5-year ordinary annuity, and later
deduct the 2-year ordinary annuity as there is no cash flow occurred in the two periods. Alternatively
the second approach only recognizes a 3-period of ordinary annuity determine the present value at
n=2. Thus, the actual value of “100(PVIFA10%,3)” is the present value at n=2 and the value be
discounted to PV0 the factor of PVIF10%,2. The future value of the deferred annuity will follow the
normal ordinary annuity approach as follows:
FVDA5 = RM100 (FVIFA10%,3) 2ND RESET ENTER;

= RM100(3.3100) ‐100 PMT; 10 I/Y; 3 N;
= RM331.00 CPT FV = 331.00
Perpetuity Cash Flows
Perpetuity is an annuity with an infinite number of cash flows. The present value of cash flows
occurring in the distant future is very close to zero. At 10% interest, the present value of RM100 cash
flow occurring 20 years from today is RM14.86. The present value of RM100 cash flow occurring 50
years from today is less than RM1 and 100 years from today is less than one cent. To illustrate the
present value of perpetuity (PVP), consider the investment that provides return of RM10,000 per year
indefinitely. If you have a required rate of return is 10%, the present value of perpetuity or how much
the investment is worth equals:
PVP0 = Perpetual CF / k
= RM10,000 / 0.10
= RM100,000
Therefore, the investment is worth RM100,000 at present and that is the maximum value that an
investor would pay for the investment if the required rate of return were 10%. The value of the
investment will change in opposite direction with the change in the required rate of return.
Mixed Cash Flows
To solve the TVM problems under mixed cash flows requires creativity and overall understanding of
the TVM concepts. To illustrate, assume that you will receive the set of cash flows below. What is the
present value at a discount rate of 10%? The easiest way to solve the problem by “piece-at-a-
time” approach and discounting each cash flow back to PV individually as follows:
Period 0 1 2 3 4 5
Cash flows 400 400 200 200 100
400 PVIF10%,1 363.64

400 PVIF10%,2 330.56
200 PVIF10%,3 150.26
200 PVIF10%,4 136.60
100 PVIF10%,5 62.09
This approach is suitable only if the number of cash flows involved is not significant as our example as
it deals only with five cash flows or less. When significant cash flows involves, a “group-at-a-time”
approach is appropriate as it breaks the problem into streams of annuity group and single cash flow
group. Then each group will be discounted back to PV as follows:
Period 0 1 2 3 4 5
Cash flow 400 400 200 200 100
400 PVIFA10%,2 694.20

200(PVIFA10%,4 – PVIFA10%,2) 286.88
100 PVIF10%,5 62.09
CF0 0 Enter ↓;
NPV; I = 10 Enter ↓; NPV = CPT = 1043.17
As shown, total present values are the same under different approaches. Thus, dealing with TVM
problems require overall understanding of the concepts as you will get the same answer regardless of
the approach as long as the conceptual basis is correct.
More Frequent Compounding
Interest can be compounded or discounted more than once per year and as earlier mentioned one
should be alert in developing the TVM analysis especially when the compounding frequency is not the
same as the frequency of the cash flows. Interest in the market typically stated in term of the annual
percentage rate (APR) or the annual percentage yield (APY).
The APR is a nominal rate used widely in practice and defined as the periodic rate times the number
of periods per year. For example, credit card is charging 1.5% per month interest on the unpaid
balance, then the APR is 18% that is:
APR = (m)(k) Where m : Compounding periods per year

= (12)(0.015)
= 18.00%
However, 18% does not represent the true or effective annual rate charged by the bank. This is
because it does not take into accounts the effect of compound interest. This concept is discussed
earlier at the beginning of the chapter. Therefore, it is necessary to determine the APY as it represent
the “true” annually compounded interest rate or effective annual interest rate (EAR).
APY = [1 + (APR / m)] m – 1 m = 12 as there are 12 months per year

= [1+ (0.18 / 12)] 12 – 1
= 19.56%
Therefore, the effective rate is higher than the nominal rate in cases whereby the frequency of
compounding is not the same as the frequency of the cash flows. The recognition of the differential in
the given interest rates are important as in practice most installment loans are compounded more
than once a year, mostly monthly and some even daily basis.
For example, suppose that you borrow RM10000 from the bank and promise to repay the loan in 18
equal monthly installments of RM650 each, with the first payment to be made one month from today.
What is the APR? What is the APY?
PVA0 = ACFn (PVIFAk,n) 2ND RESET ENTER;

RM10,000 = RM650 (PVIFAk,18) ‐10000 PV; ‐650 PMT; 18 N;
CPT I/Y = 1.71
PVIFAk,20 = RM10,000 / 650
= RM15.3846
Looking at PVIFA table, row 18, 15.3846 is between 1% (=16.3983) and 2% (=14.9920.). By
interpolation, the actual monthly rate is, k:
Interest PVIFAk,20
1% 16.3983
k 15.3846 1.0137
2% 14.9920 1.4063
k = 1% + (1.0137 / 1.4063)(2 – 1)
= 1.7208%
Therefore, APR is 20.65% (=1.7208% x 12), and the APY equals to 22.72% as follows:
APY = [1 + (APR / m)] m – 1

= [1+ (0.2065 / 12)] 12 – 1
= 22.72%
The impact of frequency of compounding on present value and future value are also significant and
worth looking at in details. To illustrate, consider RM1,000 is deposited today in a saving account and
let it grow for 2 years. At the same time, you are going to receive RM1000 at the end of year 2. What
are the values of the respective cash flows under different compounding and discounting frequencies?
Table 3-4 shows the effects of multiple compounding and discounting per period on the future value
and present value respectively.
Table 3-4 Future Values and Present Values for Various Frequencies
Frequency K/m nxm

Annually 12% / 1 = 12% 2x 1 = 2
Semi-annually 12% / 2 = 6% 2x 2 = 4
Quarterly 12% / 4 = 3% 2x 4 = 8
Monthly 12% / 12 = 1% 2 x 12 = 24
Daily 12% / 360 = 0.0333% 2 x 360 = 720
Values Compounding (FV) Discounting (PV)

Annually RM1,000(FVIF12%,2) RM1,000(PVIF12%,2)
RM1,254.50 RM797.20
Semi-annually RM1,000(FVIF6%,4) RM1,000(PVIF6%,4)
RM1,262.50 RM792.10
Quarterly RM1,000(FVIF3%,8) RM1,000(PVIF3%,8)
RM1,266.80 RM789.40
Monthly RM1,000(FVIF1%,24) RM1,000(PVIF1%,24)
RM1,269.70 RM878.70
Daily RM1,000(FVIF0.0333%,720) RM1,000(PVIF 0.0333%,720)
RM1,270.89 RM786.85
With higher frequencies, the present value of future cash flows will decrease, but the future value will
increase. Which mode of compounding is better for you? The answer is it depends. If you are a
borrower, lesser frequencies are better as compound interest payment will be lower. However,
Investors prefer higher frequencies because interests earned on investment are compounded more
often which results in higher return.
APPLICATIONS OF TVM
This section will illustrate some common applications and TVM problems that you may encounter that
require cash flow analysis in financial decision-making. To simplify the calculations, the TVM tables
will be used through out the illustrations except where interest rate is not listed in TVM tables.
Double Your Money
Do you know how long does it takes for your money in your savings account to double? To determine
the approximate time in years for your money to double at certain compound rate, “Rule-of-72” can be
used. For example for RM1,000, at 10% annual compound rate your money will double in
approximately 7.2 years (=72 / 10). The actual time is calculated as follows:
PV0 = CFn(PVIF10%,n)
RM1,000 = RM2,000(PVIF10%,n)
PVIF10%,n = RM1,000 / RM2,000
= 0.5
Looking at PVIF table, under 10%, 0.5 is between period 7 (=0.5132) and period 8 (=0.4665). By
interpolation, the actual time is 7.28 years:
Period PVIF10%,n 2ND RESET ENTER;

7 0.5132 ‐1000 PV; 2000 FV; 10 I/Y;
n 0.5000 0.0132 CPT N = 7.27
8 0.4665 0.0467
n = 7 + (0.0132 / 0.0467)(8 – 7)
= 7.28
Present Value of Your Bank Loan
To illustrate, consider that Anisah agrees to repay her loan in 1½ years with monthly installments of
RM1219.64 each. If the interest rate on the loan is 12%, what is the present value of her loan
payments, or how much money is being borrowed? In this case, RM1219.64 is the annuity cash flows,
k=1% and n=18 periods. Utilizing the present value annuity formula, the principal value of the loan is
RM20,000 as follows:
PVA0 = ACFn [1 – 1 / (1+k)n ] / k 2ND RESET ENTER;

= ACF PVIFA1%,18) ‐1219.64 PMT; 1 I/Y; 18 N:
= RM1,219.64 [16.3983) CPT PV = 20000
= RM20,000.00
Saving for Retirement
Assume that you wish to retire 20 years from today with RM1000000 in the bank. If the bank pays
10% interest per year, how much should you save each year to reach your goal? This problem deals
with determining the annuity payments or cash flows at future value equals RM1000000, k=10% and
n=20 years. The annuity payments:
FVAn = ACFn (FVIFAk,n) 2ND RESET ENTER;

RM1,000,000 = ACFn (FVIFA10%,20) ‐1000000 FV; 10 I/Y; 20 N:
= ACFn (57.2691) CPT PMT = 17459.62
ACFn = RM1,000,000 / 57.2691

= 17,461.42
Therefore, you need to deposit RM17,461.42 every year to ensure that your goal to be a millionaire
will become a reality in 20 years.
Installment Payments on a Loan
The application of installment payment is of great importance in financial decision as the company
usually deals with term loans and leases. To illustrate, consider the Silvering Company borrows
RM10,000 to be repaid in five equal annual installments, beginning one year from today. What are the
annual payment or annuity cash flows (ACFn) on this loan if the bank charges the company 12%
interest per year? Annual payments with the present value of loan of RM10,000 at k=12% for n=5
periods:
PVA0 = ACFn (PVIFAk,n)

RM10,000 = ACFn (PVIFA12%,5) 2ND RESET ENTER;
= ACFn (3.6048) ‐10000 PV; 12 I/Y; 5 N:
CPT PMT = 2774.10
ACFn = RM10,000 / 3.6048
= RM2,774.08
Therefore, Silvering will pay RM2,774.08 yearly for 5 years to fully repay or amortized the loan at
interest rate of 12%. The actual yearly payment however is normally rounded to the nearest Ringgit of
RM2,774 in our case.
For the above example, what if the first payment starts today? Note that the installment payments
represent annuity due that require the following adjustment:
PVA0 = ACFn (PVIFAk,n-1 + 1)

RM10,000 = ACFn (PVIFA12%,4 + 1)
= ACFn (3.0373 + 1)
ACFn = RM10,000 / 4.0373

= RM2,476.90
As shown, the installment payments are lower as it is paid at the beginning of the period as compared
to ordinary annuity. Both calculation methods can be used with minor differences due to rounding
error.
Loan Amortization Schedule
The preparation of loan amortization schedule is important as it shows how a loan is paid off over
time. It breaks down each payment into the interest component and the principal component that
represent the raw data for preparation of the firm’s income statement and balance sheet. In essence,
it states the amount of outstanding debt of the firm and the amount of interest expenses available to
create tax shield as interest expenses reduce taxable income of the firm.
To illustrate, consider the Silvering Company in the previous example of 5-year loan of RM10000 at
12% loan with RM2,774 annual loan payments that starts one year from today. A complete
amortization schedule is presented in Table 3-3 by using the following steps in preparation:
1. Calculate the installment payment per period or annuity payments; B

2. Determine the interest in period n; C= (Beginning balance)(k%)
3. Compute principal payment in period n; D= (Annual payment – Interest expenses)
4. Determine ending balance in period n; E= (Beginning balance – Principal payment)
5. Start again at Step 2 and repeat.
Table 3-3 Amortization Schedule for RM10,000, 5-year Term Loan at 12%
In RM Year 1 2 3 4 5
A = E t–1 Beg. Balance 10,000.00 8,426.00 6,663.12 4,688.69 2,477.34
a
B= Installment payment 2,774.00 2,774.00 2,774.00 2,774.00 2,774.62
C = A(k%) Interest expenses 1,200.00 1,011.12 799.57 562.64 297.28
D=B–C Principal payment 1,574.00 1,762.88 1,974.43 2,211.36 2,477.34
E=A–D End. Balance 8,426.00 6,663.12 4,688.69 2,477.34 0.00
As shown in Table 3-3, the last payment is different from the annual payments of year 1 through 4.
The adjustment is required to accommodate the rounding of Ringgit to the nearest figure in the
annuity payments. To ensure the ending balance at end of loan period equals zero, the adjustment for
final payment is as follows:
‘a
Final payment in year 5 = Beginning Balancen (1 + k)
= RM2,477.34 (1 + 0.12)
= RM2,774.62
The final payment of RM2,774.62 represents the payment of the loan principal of RM2,477.34 and
interest on the outstanding balance of RM297.28. Yearly interest expenses are an income statement
item that will reduce taxable income and hence creates tax shield, and the ending balance for the
period represent balance sheet item that states the outstanding debt.
Installment Payments on a Hire Purchase
The payments on hire purchase present a special type of loan payments. Unlike under normal loans
that are based on declining balance in determining the interest charges, the flat rate interest charged
on hire purchase is based on add-on interest’s format. The term add-on means that interest is
calculated and added on the funds received to determine the face amount of the note. For example,
suppose you plan to purchase a brand new car at RM60,000 with 10% down payment of RM6,000.
The interest on the loan is 4% and is to be repaid in 7 years of monthly installment. The monthly
payments:
Cost of the car RM60,000.00

Less: Down payment 6,000.00
Amount borrowed RM54,000.00
Interest for 7 years 15,120.00 RM54,000 (0.04)(7 years)
Face amount of loan RM69,120.00
Divided by Number of months 84 12 months (6 years)
Monthly payments RM 822.86
The approximate effective annual interest rate (EAR) on the loan is approximately 8.00% as follows:
EAR = (Average Annual Interest) / (Loan Amount / 2)

= [(RM54,000)(0.04)] / (RM54,000 / 2)
= 8.00%
The main point to note here is that the interest is paid on the original amount of the loan, not on the
amount actually outstanding at the end of the period as was the case in amortized loans; which will be
presented in time value of money. This causes the effective interest rate to be almost double the
stated rate.
Solving for an Unknown Interest Rate Certificate of Deposit
To illustrate, consider the First Segamat Bank offers a Certificate of Deposit (CD) that pays you
RM10,000 in 2 years. It is sold on discount for RM8,000. If you hold the CD to maturity, what annual
interest rate is the bank paying on this CD?
This problem gives you the option either to use presents value format or future value format. This is
because the only unknown variable is k, whereas PV=RM8,000, FV=RM10000 and n=2. The interest
rate earned on the CD:
PV0 2ND RESET ENTER;
= FV2(PVIFk,2)
‐8000 PV; 10000 FV; 2 N;
RM8,000 = RM10,000 (PVIFk,2)
CPT I/Y = 11.80
PVIFk,2 = 8,000 / RM10,000
= 0.80
Looking at PVIF table, row 2, 0.80 is between 10% (=0.8264) and 12% (=0.7972). Therefore, by using
interpolation, the actual interest earned equals 11.81% as follows:
Interest PVIFk,2
10% 0.8264
‘k 0.8000 0.0264
12% 0.7972 0.0292
k = 10% + (0.0264 / 0.0292)(12 – 10)

= 11.81%
Solving for an Unknown Interest Rate on a Loan
Assume that you intend to borrow RM10,000 from a bank, and agree to repay the loan in six equal
annual installments of RM2,100 each. The first payment will be made today. What interest rate is the
bank charged?
This problem is quite similar to the previous Certificate of Deposit problem, where PVA=RM10,000,
ACF=RM2,100, n=6, and k is the unknown variable. Using the TVM tables:
PVA0 = ACFn (PVIFAk,n) 2ND RESET ENTER;

RM10,000 = RM2,100 (PVIFAk,6) ‐10000 PV; 2100 PMT; 6 N;
PVIFAk,6 = RM10,000 / RM2,100 CPT I/Y = 7.03
= 4.7619
Looking at PVIFA table, row 6, 4.7619 is between 7% (=4.7665) and 8% (=4.6228). The actual
interest charged on the loan is 7.03% by interpolation as follows:
Interest PVIFAk,6
7% 4.7665
‘k 4.7619 0.0046
8% 4.6228 0.1437
k = 7% + (0.0046 / 0.1437)(8 – 7)
= 7.03%
The comprehension of the materials presented is crucial to enhance the understanding of other
materials especially when dealing with capital budgeting decisions. This is because the TVM
represent the framework in the financial decisions.
A word of advice is that do not try to memorize the ways and means of the calculation, but understand
the concept to appreciate the calculations. Later you may find out that TVM calculations are based
entirely on logic and the applications of the TVM is very close at home.

Chapter 3

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Chapter 3

The Time Value of

BASICS OF TIME VALUE OF MONEY (TVM)

Future Value versus Present Value

Figure 3.1 Future Value Concept and Effects of Interest on FV

Figure 3.2 Present Value Concept and Effects of Interest on PV

Using the TVM Tables

Where PV : Present value

Present value single payment PV0 = CFn / (1+k)n

Future value single payment FVn = CFn (1+k)n

Table 3.1 Guide to Future Value Tables; k = 6%, n = 4

Single CF FVIF6%,4 FVIF6%,3 FVIF6%,2 FVIF6%,1 FVIF6%,0

FVIF6%,4 FV4 is the focal of compounding.

Note: FVIFA6%,5 = FVIF6%,0 + FVIF6%,1 + FVIF6%,2. + FVIF6%,3 + FVIF6%,4.

Table 3.2 Guide to Present Value Tables; k = 6%, n = 4

Single CF PVIF6%,0 PVIF6%,1 PVIF6%,2 PVIF6%,3 PVIF6%,4

PV0 is the focal of discounting. PVIF6%,1

Note: PVIFA6%,4 = PVIF6%,1 + PVIF6%,2 + PVIF6%,3 + PVIF6%,4.

FVIF10,5 = 1 / PVIF 10%,5 2ND RESET ENTER;

PVIF 10,5 = 1 / FVIF 10%,5, 2ND REST ENTER

FV3 = CF0 (FVIF6%,3) 2ND RESET ENTER;

Thus, to prove the reciprocal relationship, let:

PV0 = CF3 (1 / FVIF6%,3)

PV0 = CF3 (PVIF6%,3) 2ND RESET ENTER;

SI = CF0(k)(n) Where SI : Simple interest

Future value simple interest SI = CF0(k)(n)

Future value of deposit at end of year 2 FV2 = CF0 + SI

Future value at end of year 1 FV1 = CF0 (1+k)1

Future value of at end of year 2 FV2 = CF1 (1+k)1

The Time Line and Assumptions

1. Read the problem thoroughly

Year Notation Cash Flow (RM)

MULTIPLE CASH FLOWS

PV0 = CF0 (PVIF10%,0) + CF1 (PVIF10%,1) + CF2 (PVIF10%,2) + CF3 (PVIF10%,3)

Figure 3-3 Present Value Calculation for Multiple Cash Flows

Present value 5,000.00

FV3 = CF0 (FVIF10%,3) + CF1 (FVIF10%,2) + CF2 (FVIF10%,1) + CF3 (FVIF10%,0)

Figure 3-4 Future value Calculation for Multiple Cash Flow

Future value 3,500.00

FV2 = CF0 (FVIF10%,2) + CF1 (FVIF10%,1) + CF2 (FVIF10%,0) + CF3 (PVIF10%,1)

ANNUITIES AND PERPETUITIES

FVA4 = CF1 FVIF8%,3 + CF2 FVIF8%,2 + CF3 FVIF8%,1 + CF4 FVIF8%,0

PVA4 = CF1 PVIF8%,1 + CF2 PVIF8%,2 + CF3 PVIF8%,3 + CF4 PVIF8%,4

PVA4 = CF2 (PVIF4%,2) + CF4 (PVIF4%,4) + CF6 (PVIF4%,6) + CF8 (PVIF4%,8)

PVA0 = ACF (PVIFA10%,3) 2ND REST ENTER;

FVA3 = ACF (FVIFA1010%,3) 2ND RESET ENTER;

PVADn = CF0 PVIF10%,0 + CF1 PVIF10%,1 +.CF2 PVIF10%,2 2ND RESET ENTER; CF

FVAD3 = CF0 FVIF10%,3 + CF1 FVIF10%,2 + CF2 FVIF10%,1

Alternatively = 100 (FVIFA10%,3)(FVIF10%,1) 2ND RESET ENTER;

FVDA5 = RM100 (FVIFA10%,3) 2ND RESET ENTER;

Perpetuity Cash Flows

Mixed Cash Flows

400 PVIF10%,1 363.64

400 PVIFA10%,2 694.20

More Frequent Compounding

APR = (m)(k) Where m : Compounding periods per year

APY = [1 + (APR / m)] m – 1 m = 12 as there are 12 months per year

PVA0 = ACFn (PVIFAk,n) 2ND RESET ENTER;

APY = [1 + (APR / m)] m – 1

Frequency K/m nxm

Values Compounding (FV) Discounting (PV)

Double Your Money

Period PVIF10%,n 2ND RESET ENTER;

Present Value of Your Bank Loan

Chapter 3