COMM 101: The Time Value of Money

Money has the ability to earn more money over the passage of time. It can be deposited in a bank, lent to a
borrower, used to purchase a common or preferred share, and so on. In all cases, the investor or lender is
looking to get their money back, plus a return on the money. As such, $1 today is worth more than a $1 in the
future since $1 today can earn money starting today. This concept is referred to as the time value of money.

Math for Single Payments

Simple Interest
The return that an investor or lender earns is expressed as an interest rate. The interest can be either simple or
compound. In the case of simple interest, the interest rate is applied to the principal only (i.e. the original
amount invested or lent). It doesn’t matter how long the investment or loan is outstanding for, interest will only
be calculated based on the original amount, the simple interest rate, and the time the investment or loan is
outstanding.
The simple interest variables are as follows:
PV – The amount invested or loaned at the start of the time period, often called the principal amount of the
investment or the present value, expressed in dollars
r – The interest rate charged on an annual basis, expressed as a percentage
t – The time period the loan is outstanding for, expressed in years
For 7 months, t = 7/12; for 16 days, t = 16/365.
I – The interest charged or earned over the time period, expressed in dollars
I = PV*r*t

FV – The amount due by the end of the time period, called the future value (also called the accumulated value),
expressed in dollars. The future value is the principal plus interest.
FV = PV + I

By definition, FV = PV + I
Also by definition, I = PV*r*t

We can therefore see that FV = PV * (1 + r*t)

The formula for future value of a single payment is FV = PV * (1 + r*t)

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Example
Determine the future value of $2,500 invested at 12% simple interest for a) 18 months; b) 5 years and c) 30
days, assuming simple interest is paid.
Solution
a) We are given: PV = $2,500, r= 0.12, t=18/12
Therefore, we calculate the future value as:
FV = PV*(1 + r*t) = $2,500*(1+0.12 x 18/12) = $2,950
The future value after 18 months is $2,950.
b) We are given: t= 5
Therefore we calculate the future value as
FV = PV*(1 + r*t) = $2,500*(1 + 5*.12) = $4,000
c) We are given: t= 30/365
Therefore we calculate the future value as
FV = PV*(1 + r*t) = $2,500*(1 + .12*30/365) = $2,524.66

Calculating the number of days

Although other countries have different conventions for counting the number of days (the United States for
example often uses a 360 day year), in Canada you will be charged interest for
- the day the loan was made OR the day the loan was repaid but never both, and
- the exact number of days by reference to the calendar.
So calculating the number of days is relatively easy as long as you know the number of days in a month (30
days hath September…). Note that the calculation is easiest if we assume the borrower is not charged for the
day the loan is made, just the day the loan is repaid.
Example: Fred borrows $5,000 at 8% simple interest on March 15. He repays the loan on May 27. How much
interest will he be charged?
Solution
We are given: PV = $5,000 r = 0.08 t = the number of days from March 15 to May 27, expressed in years
Number of days in March: 31-15 = 16 (since Fred is not charged for the 15th – the day the loan was made)
Number of days in April: 30
Number of days in May: 27 (since Fred will be charged for the day the loan was repaid – the 27th)
Total number of days: 16+30+27=73

Therefore, we calculate the interest as:

I = PV *r*t = $5,000 * 0.08 * 73/365 = $80.00
Therefore Fred will be charged interest of $80.00.
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Concept Check
Lisa loans Bob $1,000 from April 10 to October 21. Bob pays her back the $1,000 borrowed plus $50 for
interest. What rate of simple interest did Lisa earn?
We are given: PV = $1,000; FV = $1,050; t = the number of days from April 10 to October 21, expressed
in years.
Number of days in April: 30-10=20
Number of days in May, June, July, August, and September: 31 + 30 + 31 + 31+30=153
Number of days in October: 21
Total number of days = 194
So FV = PV * (1 + r*t) or $1,050 = $1,000 * (1 + r * 194/365)
Hence r = 0.094
Therefore, Lisa earned a simple interest rate of 9.4%.

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Compound Interest
Most transactions in business, whether they be loans or investments, utilize compound interest. This is the type
of investment where the investor earns (or borrower pays) interest on their principal plus interest on the
accumulated interest. For example, on a savings account where interest is compounded monthly, banks will
add the interest earned to your account balance at the end of each month. The next month’s interest is then
calculated based on your cumulative balance, which includes the interest you just earned. This is referred to as
interest that is compounded monthly. Note that the rate the bank publishes is not the monthly rate but rather an
annual rate that is referred to as the nominal rate. The monthly rate used for compounding is this nominal rate
divided by 12, the number of months in a year.
We start by looking at the value of a single payment at some other time. For example, we will be solving
questions such as “What is the future value of $1,000 invested at 10%, after 5 years” or “What is the present
value of $10,000 in 3 years, if the interest rate is 6%”.
Obviously it is important to know how often interest is being compounded – different instruments use different
compounding periods.
- Bond and mortgage rates are typically compounded semi-annually (twice per year).
- Personal loans are typically compounded monthly.
- Savings accounts and term deposits can be compounded monthly or even daily.
- Some promissory notes are compounded quarterly.
Definitions
The compound interest variables are as follows:
PV – The amount invested or lent, sometimes referred to as the principal or present value (of FV)
FV – The future or accumulated value (of PV)
m – The number of compounding periods per year
n – The term of the investment in total number of compounding periods n= m * number of years
jm – The nominal or yearly interest rate
i – The interest rate per compounding period i = jm / m
Using the above terminology, we can see that paying interest at j12 = 6% means interest will be 6%
compounded monthly and the rate that is used each month is 6%/12 = 0.5%. Whereas if the rate were j4 =
6%, it would mean 6% compounded quarterly and the rate used each quarter would be 6%/4 = 1.5%.
Example:
Nominal Rate(jm) Number of Compounding Periods Rate in each Period
Per Year (m) (i)
j2 = 10% 2 10% / 2 = 5%
Every 6 months
j6 = 15% 6 15% / 6 = 2.5%
Every 2 months
j12 =12% 12 12% / 12 = 1%
Every month
j4 = 8% 4 8% / 4 = 2%
Every quarter
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Concept Check
If a 6% rate is compounded on a monthly basis, what interest rate will be applied to the balance at the end of
every month?
The rate will be 6/12% or 0.5%.

Future Value of a Single Payment

If an investor starts with PV, by the end of the first compounding period, they will have
PV + PV*i, = PV*(1+i).
Then, at the end of the second compounding period, interest at the rate of i will be applied to this balance so
they will have
PV*(1+i) + i*PV*(1+i) = PV*(1+i)2.
At the end of the third period, interest will be applied to this balance at the rate of i to get
PV*(1+i)2 + i*PV*(1+i)2 = PV*(1+i)3.
Continuing for n periods we get the basic formula for the future value of a single payment
FV = PV * (1 + i)n
Definition
The formula for future value of a single payment is: FV = PV * (1 + i)n
Example:
What is the future value of $10,000 after 25 years if interest at 9% is compounded a) semi-annually; b)
quarterly; c) monthly; d) daily?
PV Nominal Rate m n i FV
$10,000 j2 = 9% 2 2 * 25 = 50 .045 10,000*(1+.045)50 = 90,326.36
j4 = 9% 4 4 * 25 = 100 .0225 10,000*(1+.0225)100 = 92,540.46
j12 = 9% 12 12 * 25 = 300 .0075 10,000*(1+.0075)300 = 94,084.15
j365 = 9% 365 365 * 25 = .00024658 10,000*(1+.00024658)9125 = $94,851.05
9125

We can see from the above example that the more often interest is compounded at the same nominal
interest rate, the higher the future value.
It should also be apparent that all 9% rates are not created equal — it very much depends on how often interest
is compounded. For this reason, investors and borrowers often translate interest rates to the effective annual
rate — this is the rate that equates to the nominal rate if interest were being compounded annually. It’s easy to
calculate and is denoted as j1.

Hence for 9% compounded semi-annually, j1 = (1+0.09/2)2 – 1 = 0.092025

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For 9% compounded quarterly, j1 = (1+0.09/4)4 – 1 = 0.093083

For 9% compounded monthly, j1 = (1+0.09/12)12 – 1 = 0.093807

For 9% compounded daily, j1 = (1+0.09/365)365 – 1 = 0.094162

This is another way of showing that the more often interest is compounded at the same nominal rate, the higher
will be the future value.

Compare the amounts in the above example to the future value if interest were calculated at 9% simple interest.
For simple interest,
FV = PV * (1+r*t) = 10000*(1+.09*25) = $32,500.
Clearly, an investor would prefer to earn compound interest!
Concept Check
Jim is trying to decide between two term deposits: at Queens Bank, they are offering 5.25% compounded semi-
annually but Kings Bank is offering 5% compounded daily. Jim intends to invest $10,000 for 5 years. Which
bank should he choose? What annual compound rate will Jim have earned?
To answer the question, you really don’t need to consider either the amount invested or the term of the
investment.
Queens Bank is offering 5.25% compounded semi-annually which equates to an annual compound rate of
j1 = (1 + .0525/2)2 – 1 = 5.319%
Kings Bank is offering 5% compounded daily which equates to an annual compound rate of
j1 = (1 + .05/365)365 – 1 = 5.127%
Therefore Queens Bank is the better choice at an annual rate of 5.319%.
This problem can also be solved another way, using the FV formula.
The FV for Queens Bank is 10,000*(1 + .0525/2)10 = 12,957.81 and the annual rate is found by solving
12,957.81 = 10,000 * (1+i)5 giving i = 5.319%.
The FV for Kings Bank is $10,000*(1 + .05/365)365*5 = 12,840.03 and the annual rate is found by solving
12,840.03 = 10,000 * (1+i)5 giving i = 5.127%.

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Present Value of a Single Payment
The future value of an amount is what an investment will be worth in the future if a certain rate is obtained. An
equally common question in the financial world is: what do I need to invest today in order to get a specific
amount in the future? Or in other words, we know where we want to end up; the question is how much we need
to start with.
For example, if I need $1,000,000 to retire and I believe the stock market will earn 12% per year, what should I
invest today to retire in 25 years?
In the equation FV = PV * (1 + i)n we need to solve for PV
FV = PV * (1 + i)n
PV = FV / (1 + i)n
The formula for present value of a single payment is therefore: PV = FV * (1 + i)-n
Example:
What is the present value of $25,000 in 10 years at a) j2 = 10%; b) j12 = 10%; and c) j365 = 10%.
a) P = 25000*(1+0.10/2)-2*10 = $9,422.24
b) P = 25000*(1+0.10/12)-12*10 = $9,235.17
c) P = 25000*(1+0.10/365)-365*10 = $9,198.25

From the above example, we can see that the more often interest is compounded at the same nominal
interest rate, the lower the present value. This makes intuitive sense since if we are ending up with the same
dollars, the same rate being compounded more frequently means we can start with less.
Concept Check:
What amount must be set aside today to have $500,000 in 25 years if a) one invests in the stock market at j 1 =
12% or b) one invests in government bonds at j2 = 8%. (Round answers to two decimal places.)
a) PV = 500,000(1+.12)-25 = 29,411.65
b) PV = 500,000(1+.08/2)-50 = $70,356.31

Using Present Value to Compare Alternatives

In business, present value is also useful when comparing alternatives. Given the time value of money, it is
sometimes difficult to compare two transactions if the timing is not identical. By stating the alternatives as a
present value, it means that both transactions are being brought back to the present day. Hence the difference
between the two alternatives is the difference as stated in today’s dollar terms, which is considered to be the
fairest way to compare.
Example:
You’re about to buy a farm in southwestern Ontario. The seller gives you the option of paying $300,000 cash or
$100,000 down plus $300,000 in 4 years. You believe you can earn money at j12 = 12%. Should you choose the
cash or payments option? What is the difference in terms of dollars today?

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Since the timing of payments is different, the fairest way to compare is by comparing the present values
and picking the lowest.
The present value of the cash option is obviously $300,000
The present value of the payments is $100,000 + $300,000 (1+.12/12)-4*12 = $286,078.12
Therefore the payments option is the better choice by $13,921.88 in today’s dollars.

Determining Rate or Time for a Single Payment

Sometimes investors or borrowers want to solve for the rate or the time. They might ask what rate is needed to
double my investment in 5 years, or how long will it take to triple my investment at a given rate? We use the
same formula but solve for either i or n.
FV = PV * (1 + i)n
Solving for i, i = (FV/PV)1/n – 1
Similarly, using logarithms to solve for n, n = (log (FV/PV))/(log(1+i))
Example:
At what monthly compounded rate will money double itself in 6 years? Express your answer as a nominal rate,
rounded to two decimal places.
Let the investment amount, PV, be x. Then we have FV = 2x. Since it is a monthly rate, we have n =
6*12 = 72
Therefore, using the formula i = (FV/PV)1/n – 1 = (2x/x)1/72 – 1 i = .009673533
Note that this is the rate per month. To arrive at the nominal rate, we must multiply by 12 to get the
nominal rate 11.61% compounded monthly.
At a nominal rate of 11.61% compounded monthly, money will double itself in 6 years.
Example:
How long will it take money to double at the rate j2 = 5%? Express your answer in years, rounded to two
decimal places.
Let the investment amount, PV, be x. Then we have FV = 2x
Since it is a semi-annual rate, we have i = .05/2 = .025
Therefore, using the formula: n = (log (FV/PV))/(log(1+i)); n = log(2)/log(1.025); n = 28.07
This is the number of semi-annual periods so to get the number of years we divide by 2 to get 14.04 years.

Concept check 1
How long will it take for $10,000 to accumulate to $100,000 at 3% compounded monthly? Express your answer
in years, rounded to 2 decimal places.
# months = log(100,000/10,000) / log (1+ .03/12) = 922.1849
# years = # months / 12 = 76.85
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Concept check 2
Betty Jo bought shares in her phone company for $25. The company does not pay any dividends. 12 years later
she sold them for $75. What annual compound rate of return did she achieve? Express your answer as a
percentage rounded to 2 decimal places.
Annual yield = ( (75/25)1/12 – 1) * 100% = 9.59%

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Annuities

An annuity is a sequence of equal periodic payments, made at equal intervals of time, for a defined period
referred to as the term of the annuity. In business, there are several examples of an annuity – a consumer loan
whereby the same payment is made every month until a loan is paid off; a lease contract where again, a regular
payment is made every month, quarter or year, for the use of a particular asset (computer, phone, apartment); or
a savings plan whereby an individual contributes the same amount to an investment account until a particular
goal is reached, and so on.
Terms
A simple annuity is an annuity in which the payment interval and the interest compounding period are the
same.
In an ordinary annuity, payments are made at the end of the payment interval.
In an annuity due, payments are made at the beginning of the payment interval.
As with a single payment, investors, borrowers and lenders typically want to calculate what the payments will
accumulate to, or alternatively, what the present value of a specific stream of payments is.
Annuity Variables
The annuity variables are as follows:

FV = the future or accumulated value of an annuity

PV = the present or discounted value of an annuity
PMT = the periodic payment made every interval
n = the total number of compounding periods; note that for a simple annuity, n is also the number of
payments
i = the interest rate per compounding period

Future Value of a Simple Ordinary Annuity

Timeline
A simple ordinary annuity can be depicted on a timeline as follows. Draw a straight horizontal line with small
vertical marks evenly spaced; above each of the first 3 marks write 0, 1, 2, 3 and then nothing is labelled until
the last two which are labelled “n – 1” and “n”. Underneath each mark beginning at 1 and ending at n is “PMT”
(ignoring the marks that are not labelled). Underneath the final payment, insert “FV”
FV is the future value the stream of payments (PMTs) will accumulate to at the interest rate i, for n periods. It is
the total value of all payments at time n. Deriving the formula is straightforward.
The last payment, made at the end of the last period, will obviously accumulate to PMT (i.e. no interest).
The second last payment will accumulate to PMT*(1+i).
The third last payment will accumulate to PMT*(1+i)2.
And the first payment will accumulate to PMT*(1+i)n-1

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So, FV = PMT*(1 + (1+i) + (1+i)2 + … + (1+i)n-1)
The formula inside the brackets is a geometric progression of n terms whose first term is 1 and whose common
ratio is (1+i). (i.e. each term is increasing by (1+i)).
The sum of a geometric progression is given by:
Sum = t1*(rn – 1)/(r – 1)
where t1 is the first term, r is the common ratio and n is the number of terms.
Hence, substituting into the formula produces:
n
(1+i) −1
Sum = FV = PMT *
( 1+ i )−1
The formula for the future value of a simple ordinary annuity is:
n
(1+i) −1
FV = PMT *
i
Example:
On January 1, 2013 John starts investing $500 at the end of every quarter into a fund that returns j4 = 6%.
Assuming the first payment is made March 31 and the last on December 31, how much will he have
accumulated by December 31, 2019?
n
(1+i) −1
We are solving for FV in the formula FV = PMT * .
i
In this case, n is 28. Although it may look like he makes payments for 6 years (i.e. 2019 – 2013 = 6), he
actually makes them for 7 years. We know PMT = $500 and i = .06/4 = .015. Therefore,
FV = 500*(1.01528 – 1)/.015 = $17,240.74
John will have $17, 240.74 in his account on December 31, 2019.

Example:
Amy deposits $5,000 into a Registered Retirement Savings Plan (RRSP) every year starting at age 25 and
ending the year she turns 35. She then leaves the account alone to earn interest until she turns 65. Abigail
deposits $5,000 into an RRSP every year starting at age 36 and ending in the year she turns 65.
If money earns j1 = 10%, how much will each have in their RRSP at age 65?
For Amy, first we calculate the value of the annuity at the time of the last payment, and then we calculate
how much that balance will accumulate to by age 65. So to calculate Amy’s balance at age 35 we use the
annuity formula with n = 11, PMT = $5,000 and i = 10%. Her balance at age 35 will be:
FV = 5000*(1.1011 – 1)/.10 = $92,655.84
This amount will accumulate interest at 10% compounded annually for 30 years. Hence at age 65 Amy
will have: FV = 92,655.84*(1.1030) = $1,616,788.94

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For Abigail, her balance at age 65 is an annuity where n = 30, PMT = $5,000 and i = 10%. Hence at age
65 Abigail has: FV = 5000*(1.1030 – 1)/.10 = $822,470.11
Therefore Amy has $794,318.83 more than Abigail by age 65, despite the fact she made 19 fewer $5,000
payments.
Are you surprised by this example? Many people are. This is often referred to as the magic of compounding.
Because it is an exponential formula that gets steeper as the years go by, the earlier you start saving, the higher
the balance will be by age 65. In this case, even though Abigail makes 30 payments of $5,000 to Amy’s 11, by
starting at age 25, Amy will have significantly more by retirement at this interest rate. When Abigail starts her
savings, Amy already has close to $100,000 in her account. Whereas Abigail adds $5,000 to her account at age
36, the interest is adding almost double that to Amy’s at age 36. This is why Amy has so much more at 65. Note
that as the interest rate declines, so will the difference between the two. But even at a rate of 6%, Amy will still
have more (and don’t forget she’s made $95,000 less in payments).

Concept Check
In the above example, assume Amy continues making $5,000 payments until she turns 65. Using the same 10%
rate, how much more will Amy have in her investment account at age 65 than Abigail?
Amy will now have the future value of an annuity where PMT = $5,000, i = .10 and n = 41. So at age 65,
Amy will have: FV = $5,000*(1.141 – 1)/.10 = $2,439,259.06
This is $1,616,788.95 more than Abigail.

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Solving for Other Variables in the Future Value Formula
Note that the formula for the FV of a simple ordinary annuity can also be used to solve for the other variables,
proving useful in retirement planning. Consider the following.
Example:
Bill wants to have $500,000 in his retirement account when he retires on December 31, 2025. He intends to
make two equal payments a year, on June 30 and December 31, and will make his first payment on June 30,
2004. He is confident the account will earn interest at j2 = 8%. What must be the amount of his payments?
In this case, we know FV = $500,000, i = .04 (.08/2) and n = 44. Therefore to find the payment we solve:
500,000 = PMT * (1.0444 – 1)/.04
PMT = 500000/((1.0444 – 1)/.04) = $4,332.27
Therefore Bill must make payments of $4,332.27 every 6 months to meet his retirement goal.
Example:
Now assume Bill can afford to make payments of $10,000. How many payments of $10,000 will he need to
make in order to have at least $500,000 in his account? Use the same interest rate and assume Bill will only
make payments of $10,000, i.e. no partial payments.
In this case, we know FV = $500,000, PMT = $10,000 and i = .04. In the annuity formula, we’re trying to
find n.
500,000 = 10,000 * (1.04n – 1)/.04
n = log ($500,000*.04/$10,000 +1) / log (1.04) = 28.01
Since we need to have at least $500,000 in his account, we will need to round up to 29 – 28 payments will
fall just short of $500,000.
Example
Lastly, again assume Bill wants to have $500,000 in his retirement account. He intends to make two equal payments a
year, on June 30 and December 31. Assume Bill can only afford to make payments of $3,000. He will start on June 30,
2004 and end on December 31, 2025. What rate will he have to earn in order to reach his $500,000 goal? Express your
answer as a nominal rate.

We’re given FV = $500,000, PMT = $10,000 and n = 44. In the annuity formula, we’re trying to find i.
To solve for i, we will need to use either a financial calculator or spreadsheet software such as Microsoft Excel. In
Excel, we use the RATE function. In Excel, enter ‘=RATE (nper, pmt, pv, fv)’
Excel refers to the number of compounding periods as nper. We enter 44. The periodic payment, pmt, is 3,000. The
payment value needs to be entered as a negative number. The present value, pv, is 0. The future value, fv, is
$500,000. Therefore on a spreadsheet, we enter ‘=RATE(44, -3000, 0, 500000)’
When we hit Enter, Excel calculates the interest rate i as 5.35411%. Note that this is the rate per period, or in our
case, per six month period.
Thus, the nominal semi-annual rate will be twice this amount, or 10.71% (i.e. 10.71%, compounded semi-
annually).

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Note that for this function Excel assumes payments are made at the END of each period. If you want the calculation done
for payments at the BEGINNING of each period, then you must add a 1 at the end of the bracketed terms. Hence for this
problem, if we entered ‘=RATE(44,-3000,0,500000,1)’, Excel would perform the same calculation assuming payments
are being made at the beginning of each period.

Concept Check
A. Rhonda is saving to buy a house. She believes she will need a down payment of at least $50,000 to buy the
house she wants. She believes interest rates will remain steady at 6 compounded monthly. She would like to buy
the house at the end of 3 years. What monthly payment does Rhonda need to make?
This is an annuity problem where the FV is $50,000, i = .06/12 and n = 3*12. We are solving for PMT.
$50,000 = PMT * ((1+.06/12)3*12 – 1)/(.06/12) PMT = $1,271.10
To meet her down payment, Rhonda must put away monthly savings of $1,271.10.
B. Rhonda believes she can actually afford to save $1,000 every month. Assuming the same interest rate, how
many months will it take Rhonda to accumulate at least $50,000 in her account.
This is an annuity problem where the FV is $50,000, i = .06/12 and PMT = $1,000. We are solving for n.
$50,000 = $1,000* ((1+.06/12)n – 1)/(.06/12) n = log ($50,000*(.06/12)/$1,000 +1) / log (1 + .06/12) = 44.74
It will take Rhonda 45 months to accumulate at least $50,000, or 3.75 years.
C. Rhonda’s mother is an experienced investor. The mother thinks she can find investments that will enable
Rhonda to have her down payment in only 2 years. Assuming the same monthly payment of $1,000, what
monthly compound rate will Rhonda’s mother have to earn to accumulate $50,000 in just 24 months? Express
your answer as a nominal rate, rounded to two decimal places.
Solving for all 3 options. This is an annuity problem where the FV is $50,000, n - 24 and PMT = $1,000.
We are solving for i.
$50,000 = $1,000 * ((1+i)24 – 1)/(i) In excel we enter RATE (24, -1000, 0, 50000); The answer per period is
5.87912%. To get the nominal rate we multiply by 12.
Therefore Rhonda’s mother must earn 70.55% compounded monthly.

Lastly, note that to use the annuity formula, it is critical that the interest rate remains the same throughout the
term. If the interest rate changes during the term, the math must be adjusted accordingly.
Example:
Jane deposits $2,500 at the end of every year for 15 years into an account that earns j1 = 7% for the first 6 years
and j1 = 5% thereafter. What is the value of the account two years after her last deposit? Round to two decimal
places.
In this case, we have two rates and therefore must use two annuities. The first annuity has n = 6, i = .07
and PMT - $2,500. The second annuity has n = 9 (15 – 6), i = .05 and PMT = $2,500.
The FV formula will give us the value of the first annuity after the 6th payment. It is:
$2,500*(1.076 – 1)/.07 = $17,883.23.

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This will then accumulate interest for the next 11 years at 5%. Hence it will accumulate to:
$17,883.23*1.0511 = $30,586.39
The FV formula will give us the value of the second annuity after the 15th payment. It is:
2500*(1.059 – 1)/.05) = $27,566.41. This will then accumulate interest for the next 2 years at 5%. Hence it
will accumulate to: $27,566.41*1.052 = $30,391.97. Therefore, two years after her last payment, Jane will
have the sum of the two annuities or $60,978.36.

Present Value of a Simple Ordinary Annuity

The present value of a simple ordinary annuity is the present value at the beginning of the term (i.e. time zero)
of all the payments due over the term. Once again, the payments are made at the end of each period. The
annuity can be depicted on a timeline as follows:
Insert again a straight line with marks evenly spaced; above each of the first 3 marks is 0, 1, 2, 3 and then
nothing is labelled until the last two labelled “n – 1” and “n”. Underneath each mark beginning at 1 and
ending at n is “PMT” (ignoring the marks that are not labelled). Underneath time 0 on the same level as the
“FV” from above, insert “PV”
If the payment amount is PMT, the PV of all payments must be:
PV = PMT*(1+i)-1 + PMT*(1+i)-2 + …. + PMT*(1+i)-n
Again, this is a geometric progression of n terms with first term being PMT*(1+i)-1 and common ratio is (1+i)-1
The sum is therefore PV = t1*(1-rn)/(1-r) = PMT(1+i)-1 * (1-(1+i)-n)/(1-(1+i)-1)
−n
1−( 1+i )
Which reduces to PV = PMT *
i
We can also note that PV = FV * (1+i)-n which will give us the same answer.
−n
1−( 1+i )
The formula for the present value of a simple ordinary annuity is: PV = PMT *
i
Note that in business, the present value of an annuity has many useful applications. When a borrower borrows,
the present value of all payments must equal the initial amount of the loan. Insurance companies sell annuities,
i.e. they will sell a stream of equal payments to their customers. The cost of the annuity is the present value of
the payments. If we are trying to decide whether we should pay cash or lease an asset, we can compare the
present value of each alternative to see which is more expensive.
Example:
On January 1, 2010 Sally buys an annuity that will pay $1,000 a month for 20 years, with the first payment due
to arrive on January 31, 2010. If the interest rate is j12 = 6%, how much does she pay? Round to two decimal
places.
The cost of the annuity is the present value of the payments. In the PV annuity formula we have PMT =
$1,000, n = 20*12 and i = .005 (.06/12)
PV = 1000 * (1 – (1.005-240))/.005 = $139,580.77
Hence the annuity will cost Sally $139,580.77.
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Concept Check
Raymond is 65 years old. He wants to buy an annuity that will pay him $4,000 per month for the next 20 years.
An annuity salesman tells him that the current interest rate is 6%, compounded monthly. How much will
Raymond have to pay for the annuity?
The cost of the annuity is the present value of the payments. In the PV annuity formula, we have PMT =
$4,000, n = 20*12 and i = .06/12. Therefore:
PV = 4,000 * ((1 – (1+.06/12)-20*12 / (.06/12))
PV = 558,323.09
To receive an annuity of $4,000 per month for 20 years, Raymond will have to pay $558,323.09.

Example:
Rachel buys a computer from a local store for $250 down and $50 per month for the next 3 years. The interest
rate is 12% compounded monthly.
a) What is the equivalent cash value? Round to two decimal places.
The equivalent cash value is the present value of the payments owing. The present value of the cash is
obviously the cash amount. We use the PV annuity formula to get the present value of the payments, with
PMT = $50, n = 36 and i = .01 (.12/12). So the total PV becomes:
PV = 250 + 50*(1-1.01-36)/.01 = $1,755.38
An equivalent cash value to Rachel’s payment terms is $1,755.38.
Example:
If Rachel misses the first 6 payments, how much must she pay at the time the 7th payment is due to bring the
contract up to date?
This is not a present value problem. Since Rachel is paying interest on her purchase, when she misses a
payment, she must pay interest on it. So if she misses 6 payments she must pay interest on the payments
missed. Hence at the time of the 7th payment, the amount she owes is the future value of all the missed
payments.
The FV formula gives us the future value of payments assuming we make a payment on the last date
(with no interest on the final payment). Hence we can use the FV formula with PMT = $50, i = .01 and n =
7. Therefore the amount Rachel must pay is:
FV = $50*(1.017 – 1)/.01 = $360.68
To bring the contract up to date at the time the seventh payment is due, Rachel must pay $360.68.
Example:
If Rachel misses the first 6 payments, how much must she pay at the time the 7th payment is due to repay the
debt in full?
This is a combination future value/present value problem. The future value was calculated in the
previous example. In addition to that amount, Rachel must pay the present value of the remaining
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payments. We use the PV formula with PMT = $50, i = .01 and n = 29. The PV of the remaining payments
is:
PV = 50*(1-1.01-29)/.01 = $1,253.29
Therefore, to repay the debt in full, Rachel must pay the sum total of $1,613.97

Concept Check
In the earlier example, Rachel bought a computer from a local store for $250 down and $50 per month for the
next 3 years, at an interest rate of 12% compounded monthly. Rachel sees the same computer selling online for
$1,000. Assuming the same interest rate, how much cheaper is this? Round your answer to two decimal places.
The present value of the online purchase is $1,000. In the example we calculated the present value of the
store computer at $1,755.38. Thus, the online option is $755.38 cheaper.

Solving for Other Variables in the Present Value Formula

Just like with the FV formula, given three of the variables, we can solve for the other. Typically this is most
useful in assessing loan or lease situations.
Example:
John is looking to buy a car that costs $15,000. He can afford to make a down payment of $2,000. He knows the
bank is charging an interest rate of j12 = 9% on car loans and they expect the loan to be repaid over 4 years.
What will be the amount of his monthly car loan payment?
In this case, we use the PV formula with PV = $13,000, i = .09/12 = .0075 and n = 48. We need to find
PMT.
13,000 = PMT * (1 – (1.0075-48))/.0075 or PMT = $323.51
John’s monthly payment will be $323.51
Example:
If John can afford monthly payments of $500, how quickly could he pay off the loan, assuming the same
interest rate?
In this case, we have PV = $13,000, i = .0075 and PMT = $500. We need to solve for n.
13,000 = 500 * (1 – (1.0075-n))/.0075 or n = -log (1 - 13,000*.0075/500) / log (1.0075) = 29.03
Hence, John can pay off the loan in 29 months if he adds a little to his final monthly payment or he can
pay off the loan in 30 months by making 29 payments of $500 followed by one smaller payment in the 30th
month.
Example
Assume the bank tells John that they would lend him the $13,000 on a 48 month term but the monthly payment
will be $375. What interest rate is the bank charging? State your answer as a nominal percentage, rounded to
two decimal places.

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In this case, we have PV = $13,000, n = 48 and PMT = $375. We need to solve for i.
13,000 = 375 * (1 – (1 + i)-48)) / i
As before, we solve this using a financial calculator or the RATE function in Excel. Using Excel and
entering 48 for nper, -375 for PMT, 13000 for PV and 0 for FV, we get i = 1.41523%. As a nominal rate
the bank is charging 12 x i = 16.98%, compounded monthly

Concept Check
In the example above where John was paying $500 per month on a $13,000 loan, paying an interest rate of j12 =
9%, what would be the size of his final payment if he paid off the car loan with his 29th payment. Round your
answer to two decimal places.
The PV of the payments must equal the amount of the loan. We know we have 28 payments of $500 and a
29th larger payment represented by X. Thus: 13,000 = 500 * (1 – (1.0075-28))/.0075 + X*1.0075-29
and X = $514.97
To pay off the loan, John’s 29th payment will be $514.97.

Concept Check
A. Jingyi has decided to buy a car. Her bank is charging 6% compounded monthly for car loans. The car costs
$20,000 and Jingyi has no money for a down payment. The loan must be repaid over 5 years. What will Jingyi’s
monthly payment be?
The loan is an annuity where the PV is $20,000, i = .06/12 and n = 5*12 months. Therefore the PMT must
be: $20,000 = PMT*((1- (1+.06/12)-5*12 / (.06/12)) and PMT = $386.66
Jingyi will need to make monthly payments of $386.66.
B. If Jingyi can afford monthly payments of no more than $400, how long will it take her to pay off the $20,000
loan at the same interest rate? State your answer in months.
The loan is an annuity where the PV is $20,000, i = .06/12 and PMT = $400. We are solving for n in the
equation: $20,000 = $400*((1- (1+.06/12)-n / (.06/12)) and n = -log (1 – 20,000*.06/12/400) / log (1+.06/12)
or n = 57.68
The answer must be rounded up since Jingyi can afford to pay no more than $400. Hence it will take
Jingyi 58 months to pay off the $20,000 loan.
C. The bank tells Jingyi that her monthly payment will be $425 and that the $20,000 loan must be paid off in 5
years. What interest rate, compounded monthly are they charging? State your answer as a nominal rate.
The loan is an annuity where the PV is $20,000, PMT = $425 and n = 5*12. We are solving for i in the
equation: $20,000 = $425*((1- (1+i)-5*12 / (i)) In excel we use the RATE function as RATE (60, -425, 20000,
0). This gives us the rate per period of 0.83383%.
To get the nominal rate, we multiply by 12 so the bank is charging 10.0% compounded monthly.

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Simple Annuity Due
It is also common for annuities to have the payments made at the beginning of the payment interval rather than
at the end of the payment interval. Many loans and leases require this payment pattern.
A simple annuity due is an annuity where the payment interval and the compounding period are the same, and
the identical payments are made at the beginning of the payment interval. Hence the term of the annuity starts
with the first payment, and ends one interval after the final payment.
It can be depicted on a timeline as follows.
Insert straight line with marks evenly spaced; above each of the first 4 marks is 0, 1, 2, 3 and then nothing is
labelled until the last two labelled “n – 1” and “n”. Underneath each mark beginning at 0 and ending at “n –
1” is “PMT” (ignoring the marks that are not labelled). There is no PMT underneath n this time. Underneath
“n” insert “FV” and underneath 0 on the same level, insert “PV”.
In comparing annuities due to ordinary annuities, it is easy to see that an annuity due is identical to an ordinary
annuity except that each payment on a time diagram has been shifted one interval to the left. Since each
payment is accumulating interest for one period longer, it should be easy to see that the future value for an
annuity due is just the future value for an ordinary annuity times (1+i).
n
(1+i) −1
The formula becomes FV = PMT * ∗(1+i)
i
n+1
(1+i) −1
Note that this can also be written as FV = PMT * −PMT
i
The formula for the future value of a simple annuity due is
n
(1+i) −1
FV = PMT * ∗(1+i)
i
This makes sense when we look at the timeline; i.e. if we add one payment to the ordinary annuity, we get an
annuity due with one extra payment at the end – so the future value for the simple annuity due must deduct the
one extra payment.
For the present value of an annuity due, we also can multiply the present value of an ordinary annuity by (1+i).
−n
1−( 1+i )
The formula becomes PV = PMT * ∗(1+ i)
i
−(n−1)
1−( 1+i )
Similarly we can also write this as PV = PMT * + PMT
i
Again, this makes sense when we look at the time diagram since if we discount an ordinary annuity with n-1
terms, we only need to add the first payment to get the present value for a simple annuity due.

The formula for the present value of a simple annuity due is

−n
1−( 1+i )
PV = PMT * ∗( 1+i )
i

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Example:
1. Bobby Jo deposits $500 into a savings account on the first day of every month starting January 1, 2010. If the
account pays j12 = 3% and the last payment is made December 1, 2013, how much will she have accumulated by
January 1, 2014?
This is an annuity due where the PMT = $500, i = .0025 (.03/12) and n = 48
FV = 500*((1.002548 - )/.0025)*(1.0025) = $25,529.27
Bobby Jo will have $25,529.27 in her account on January 1, 2014.

Concept Check
Joe rents an apartment for $1,200 per month, payable on the first of every month. If money is worth j12 = 5%,
what would be an equivalent yearly amount paid in advance?
In this case, the annuity due has PMT = $1,200, i = .05/12 and n = 12. The PV is the equivalent yearly
amount, assuming it too is paid in advance. PV = $1,200*((1-(1+.05/12)-12)/(.05/12))*(1+.05/12) =
$14,075.87
The equivalent yearly rent paid in advance is $14,075.87.
Concept Check 2
a) Sarah wants to accumulate $75,000 in 4 years. She intends to deposit the same amount into an investment account
every quarter starting today. The account earns interest at a rate of j 4 = 4%. How much should she deposit every quarter?

In this annuity due, we have FV = 75,000; i = .04/4 and n = 4*4. We are solving for PMT. $75,000 =
PMT*((1+.04/4)4*4-1)/(.04/4))*(1+.04/4) and PMT = 4,302.82
To reach her goal, at the beginning of every quarter, Sarah needs to deposit $4,302.82

b) How much would Sarah have to deposit to reach her goal if she made her deposit at the end of every quarter?
Round your answer to two decimal places.
This is a simple ordinary annuity with the same FV, i and n. $75,000 = PMT*((1+.04/4)4*4-1)/(.04/4)) and
PMT = 4,345.85 (rounded up)
If Sarah makes her deposit at the end of every quarter she will have to deposit $4,345.85.
Note that the amount has to be higher since there is one quarter’s less interest being earned by every one
of the 20 payments.

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