Unit 3 Live Session -Time Value of

Money( Practice Questions)

Using Financial Calculator

Ranjeeta Garg
 The Value of Time
 You are given two choices:
 Choice 1: Receive $1000 now
 Choice 2: Receive $1000 on the same date next
year
 Which one will you choose? Why?
The Value of Time
 Choice 1, because $1000 received now can be reinvested
to grow greater than $1000 by the same date next year

 Moral: A $ today is more valuable than a $ tomorrow

The Value of Time
 If you had chosen choice 2, would you still
receive $1000?
The Value of Time
 On the face it, yes. But effectively no
 Why?
 Because inflation would have eroded
some of the value away so that effectively
your receipt would be worth less than a
$1000
Key Variables in TVM problems
• Present Value: is the current dollar value of a future
amount of money.(PV)
• It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
• It is the amount today that must be invested at a given rate to reach
a future amount.
• Calculating present value is also known as discounting.

 Future Value: is the future dollar value of current amount

of money(FV)
◦ It is the amount you end up with at a future date if you invest today
◦ Calculating future value is called compounding or growth over time
Discount and Growth Rates
 For computing the present or future values, we
need an interest rate(r or i)
 If we are computing the present value, we call
this interest rate, the discount rate
 If we are computing the future value, we call
this interest rate, the growth rate

 N – No. of Time Periods

 Cash Flow
• The three basic patterns include:

• A single amount: A single lump sum amount at a point in time.

For example, $10,000 invested in a project today.

• An annuity: A series of equally spaced cash flows of equal

amounts. For example, rent of $5,000 payable at equal
intervals of time, say, each month

• A mixed stream: An uneven stream of cash flow

Time Value Terms
 PV = present value or beginning amount

 r = interest rate (I/Y on the calculator)

 FVn = future value at end of “n” periods

 N = number of time periods

 PMT = Payment amount in an annuity

Calculation Methods

• Use the Equations (Formulas)

• Use the TVM Tables

• Use Financial Calculators (Our Focus in this session)

Using Financial Calculator for the
patterns of cash flows outlined earlier
Consistency of Time Value of
Money Components
 One of the most common mistakes when it comes to
the time value of money is ignoring the frequency of
the components. Whenever you are solving any time
value of money problem, make sure that the n
(number of time periods), the i (interest rate), and the
PMT (payment) components are expressed in the
same frequency. For example, if you are using an
annual interest rate, then the number of periods
should also be expressed annually. If you’re using a
monthly interest rate, then the number of periods
should be expressed as a monthly figure. In other
words, n should always be the total number of
periods, i should be the interest rate per period, and
PMT should be the payment per period.
 Note that most financial calculators have a
“Payment Per Year” setting that attempts to
auto-correct the consistency of the n and i
components. If you’re just starting out with a
financial calculator it’s a good idea to ignore
this functionality altogether. Instead you can
simply set the payments per year in the
calculator to 1 (one) and then keep the n, i,
and PMT components consistent. This will
greatly reduce the errors and frustration you
have with your financial calculator.
Cash Inflows vs Cash Outflows

 In time value of money problems it’s also

important to remember that negative and
positive signs have different meanings.
One helpful way to think about sign
changes is as inflows and outflows of
money. A negative sign simply means
money is flowing out of your pocket. A
positive sign means money is flowing into
your pocket.
Setting up the Calculator for use and general
tips
 Set payments per year (P/Y) to 1
 Set the display to 4 places after the decimal
 After each TVM calculation, clear all calculator memory
 You cannot have the same sign for PV and FV
◦ For example, if you invest $100 today (PV) and receive $110 after a year
(FV), both cannot be entered as a negative number or both cannot be
entered as a positive number.
◦ General Rule: All outgoing amounts should be entered as negative. All
incoming amounts should entered as positive
◦ In our example above, since you invest $100 today, it represents an
outgoing amount and should be entered in the calculator as a negative
number.
◦ $110 in the above example is an incoming amount and should be entered
in the calculator as a positive number
◦ Remember that the negative sign does not mean negative dollars. That is
not possible. The sign just tells us whether we are receiving or paying an
amount
Cash Flow Pattern 1: Single Amount
 Example 1.1
 Assume it is now December 31, 2014, and you
will need $1,000 on December 31, 2019. Your
bank compounds interest at an 8 percent annual
rate.
◦ How much must you deposit on December 31, 2015,
to have a balance of $1,000 on December 31 2019?
 Cash Flow Pattern 1: Single Amount
 Example 1.1
 Given:
 Type of Cash Flow: Single Amount
 +1,000 FV
 8% I/Y
 4N
 PV = ?
 CPT PV = -735.0298
 You should deposit (outgoing) $735.0298 today to receive
(incoming) $1000 4 years later
Cash Flow Pattern 1: Single Amount
 Example 1.2
 Assume that you purchase a 6-year, 8 percent
savings certificate for $1,000. If interest is
compounded annually, what will be the value of
the certificate when it matures?
Cash Flow Pattern 1: Single Amount
 Example 1.2
 -1,000 PV
 8 I/Y
 6N
 FV = ?
 CPT FV = +1,586.8743
Cash Flow Pattern 1I: Annuity
 Reminder: An annuity is a series of equal
cash flows (payments) repeated at
equidistant times
 There are two types of annuities:
 Ordinary Annuity: where cash flows occur
at the end of a time period
 Annuity Due: where cash flows occur at
the beginning of a time period
 The payments are indicated as PMT on
the calculator
Cash Flow Pattern 1I: Annuity
 Example 2.1
 You decide to begin saving towards the
purchase of a new car in five years. If you put
$1,000 at the end of each of the next 5 years in
a savings account paying 6 percent compounded
annually, how much will you accumulate after 5
years
Cash Flow Pattern 1I: Annuity
 Example 2.1
 Type of cash Flow: Ordinary annuity (same payment repeated at the
end of each year for 5 years)
 Visual Timeline:

 5N
 -1,000 PMT (negative sign indicates an outgoing payment)
 6% I/Y
 FV = ?
 CPT FV = +5,637.0929
 In simple English, an yearly deposit of $1000 for 5 years @6% will
help you accumulate $5,637.09 by the end of year 5
Cash Flow Pattern 1I: Annuity
 Example 2.2
 Refer to Example 2.1. What would be the
ending amount if the payments were made at
the beginning of each year?
Cash Flow Pattern 1I: Annuity
 Example 2.2
 Type of cash flow: Annuity Due (payments at the beginning of year)
 Visual timeline:

 Steps for computation:

 Step 1: Compute the FV assuming it to be an ordinary annuity. We know
that this would be $5,639.0929
 Step 2: Multiply the FV computed in step 1 by (1+r)
 Therefore, FV of an annuity due = 5,639.0929 (1+0.06) = $5,975.3185
Bond Pricing: An application of TVM
 A Bond pays constant coupon interest for its
life: This is an annuity
 A Bond pays back the face value at maturity:
This is a single amount
 Therefore;
 A Bond’s price is the sum of PVs of both above
 Current Bond Price = PV of annuity + PV of
single sum
 If you wish to compute manually, use the
formula
 Tonight, we are using only the calculator
Cash Flow Pattern 1I: Annuity +
Single Amount
 Example 2.3
 Government of T&T bonds pay semiannual
interest of $90. They mature in 20 years and
have a par value of $1000. The market rate of
interest is 6%. What is the market price for the
Government bonds?
 Important: When bonds make semi-annual
payments, all interest rates are divided by 2 and
time is multiplied by 2.
Cash Flow Pattern 1I: Annuity +
Single Amount
 A few pointers to note:
 A bond’s face value is $1,000 by default (unless
otherwise stated)
 There are 2 types of interest rates: coupon rate
and market rate (discount rate/required
return/yield to maturity)
 Coupon rate helps us find the coupon payment
and the market rate is used for discounting.
 Coupon rate is applied to a bond's face value
and remains constant whereas the market rate
can change with time.
 Cash Flow Pattern 1I: Annuity +
Single Amount
 In Example 2.3:
 +90 PMT per six months (already pre-computed)
 20 x 2 = 40 semi-annual periods
 Market rate = 6 / 2 = 3% I/Y per six months
 +1,000 FV (Bond’s face value to be received at
maturity)
 PV = Bond’s price today
 CPT PV = - 2,386.8863
Cash Flow Pattern 1I: Annuity + Single Amount
 Example 2.4
 XYZ Inc. issued 20-year bonds, 5 years ago at a coupon rate
of 10 percent. The bonds make semiannual payments. If these
bonds currently sell for 105 percent of par value, what is the
Yield to Maturity?
 Remaining life of the bond = 20 – 5 = 15 years
 Therefore;
 15 x 2 = 30 N (semi-annual periods)
 Coupon rate = 10 / 2 = 5% per six months
 5% of 1,000 = +50 PMT per 6 months
 Bond’s current price = 105% of 1,000 = -1,050 PV
 Bond’s face value = +1,000 FV
 YTM = I/Y = ?
 CPT I/Y = 4.6863% per 6 months
 Therefore annual YTM = 4.6863 x 2 = 9.3726% p.a.
Cash Flow Pattern 1I: Annuity
 Example 2.5
 You have applied for a mortgage of $60,000 to
finance the purchase of a new home. The bank
will require you to make annual payments of
$7,047.55 at the end of each of the next 20
years. Determine the interest rate in effect on
this mortgage.
Cash Flow Pattern 1I: Annuity
 Example 2.5
 Visual Timeline:

 +60,000 PV (Take a loan and receive $60,000 today:

Positive sign)
 -7,047.55 PMT (negative sign for repayments)
 20 N
 I/Y = ?
 CPT I/Y = 9.9999% or 10% p.a. rounded off
Cash Flow Pattern 1I: Annuity
 Example 2.6: Loan Amortization
 Amortization: Repayment of loan through
equal installments over time
 Each repayment is comprised of two parts:
◦ Interest payment
◦ Principal repayment
◦ An amortization schedule is prepared
 Example 2.5 refers to a 20-year mortgage of
$60,000. This is an amortized loan. How
much principal will be repaid in the second
year?
 Cash Flow Pattern 1I: Annuity
 Example 2.6
 Steps:
 Step 1: Compute PMT
◦ PV = 60,000, N = 20, I/Y = 10%
◦ Therefore, PMT = -7,047.57
 Step 2
◦ Press 2nd, followed by AMORT
◦ On the display, you see P1 = some value
◦ Press 1, followed by ENTER
◦ Use scrolling keys to scroll down (in the top row of calculator)
◦ On the display, you see P2 = some value
◦ Press 1, followed by ENTER
◦ Keep scrolling down to read the values for BAL, PRN and INT
 Step 3:
 Repeat step 2 by setting P1 and P2 equal to 2
Cash Flow Pattern 1I: Annuity
 Example 2.6
 Amortization Schedule for first two years:

 The amounts vary slightly due to rounding off

issues
 The question asked how much principal was repaid
in the 2nd year?
 $1,152.3
Cash Flow Pattern 3: Mixed Stream
 Reminder: A mixed stream of cash flows is
made up of uneven cash flows over time
 To compute the PV of a mixed stream on a
calculator, we have to use a combination of
following:
◦ CF
◦ I/Y
◦ NPV
Cash Flow Pattern 3: Mixed Stream
 Example 3.1
 Find the present value of the following mixed
stream assuming a required return of 15%.

Year Cash Flow

1 $50,000
2 40,000
3 30,000
4 20,000
5 10,000
 Cash Flow Pattern 3: Mixed Stream
 Example 3.1
 Steps:
 Press CF (2nd row, 2nd column)
 Press 0 followed ENTER (1st row, 2nd column)
 Use scrolling keys in the 1st row to scroll down
 The display says C01
 Type the 1st cash flow and press ENTER
 Scroll down till you see C02, type the 2nd cash flow
and press ENTER
 Continue till all cash flows are entered
Cash Flow Pattern 3: Mixed Stream
 Press NPV (2nd row, 3rd column)
 The display changed to I =
 Type the interest rate and press ENTER
 Scroll till you see NPV on display
 Press CPT to compute NPV
 This is the PV of the mixed stream =
109,856.3268
 Cash Flow Pattern 3: Mixed Stream
 Example 3.1
 An alternative method is to compute the PV of each
year’s cash flow individually and then add all PVs
to arrive at the final answer.
 For example, the PV of 1st year’s cash flow can be
found as follows:
 50,000 FV, 1 N, 15 I/Y, CPT PV = 43,478.2609
 Likewise, the PV for the last year’s cash flow will
be:
 10,000 FV, 5 N, 15 I/Y, CPT PV = 4,971.7674
 All PVs for all year’s can be found similarly and
added up to give the final answer.
 You can choose the method of your liking.
Compounding more than once in a year
 So far, all interest rates that we have used have assumed that there
will be one compounding in a year.
 What if there are more than 1 compounding in a year?
 For example, if you receive 10% per annum compounded once a
year on a $100 deposit, you end up with $110 after a year. What if
the interest was paid to you twice a year? (semi-annual
compounding)
 Well, you would receive 5% after 6 months and the next 5% after
another 6 months
 This means that I/Y has become 10 / 2 = 5% and N has become 1
x 2 = 2 periods of 6 months each
 General rule:
 When the number of compounding are more than one in a year,
divide the interest rate by no. of compounding and multiply the
time by number of compounding
Compounding more than once in a year
 Let us set time, N = 5 years
 Interest rate = 8% p.a.
 Then;
 With one compounding per year, N = 5, I/Y = 8
 With 2 compounding per year, N = 10, I/Y = 4
 With quarterly compounding per year, N = 20, I/Y = 2%
 With monthly compounding per year, N = 60, I/Y = 8 /
12 = 0.667%
 And so on….
 In such a case, we have:
◦ Nominal rate: The rate that is stated = 8% p.a. in this case
◦ Effective Annual Rate (EAR) = The rate that is actually earned or
paid
◦ General Rules:
 For more than one compounding in a year, EAR > Nominal rate
 For one compounding in a year, EAR = Nominal rate
Effective Annual Rate (EAR)
 What is the effective annual percentage rate (EAR) of
12 percent compounded monthly?
 Nominal Rate = 12%
 No. of compounding per year = 12
 On the calculator;
 Press 2nd, followed by ICONV
 The display shows NOM = -----
 Type 12, followed by ENTER
 Scroll down till C/Y is on display
 Type 12, followed by ENTER
 Scroll down till EFF is on display
 Press CPT and read the answer
 EAR = 12.68%
Compounding more than once in a year
 If you would like to accumulate $7,500 over the next 5
years, how much must you deposit each six months,
starting six months from now, given a 6 percent interest
rate and semiannual compounding?
 Compounding frequency = 2 times a year
 Therefore, interest rate is halved and time is doubled
 +7,500 FV
 5 x 2 = 10 N (semi-annual periods)
 6 / 2 = 3% I/Y (per semi-annual period)
 PMT = ?
 CPT PMT = -654.2288