Chapter 3 - Time Value of Money

Concept of Time Value of Money and other Relevant Values

In the literature of Finance and Mathematics, time value of money concept has been recognized.
The concept signifies that money has time value. That is, the value of money varies in terms of
time. According to this concept, a dollar received today is worth more than a dollar expected to
be received in the future. This is because of the fact that the sooner a dollar is received, the
uic!er it can be invested to earn a positive return. Therefore, it is true that one dollar in the
future is less valuable than one dollar of today. The relationship between one dollar in the future
and one dollar of today is !nown as the time value of money. This present value concept of time
value of money should be clearly understood by the investors as well as financial managers in
order to examine its impact on the value of an asset.
Future value or terminal value and present value are associated with present value of money. The
following paragraphs deal with these values.
FUTURE VALUE R TERM!"AL VALUE
Future value is the value of a cash flow or a series of cash flows at some time of a present
amount of money. That is, future value refers to the amount to which a cash flow or a series of
cash flows will grow over a given period of time. Therefore, the future value is dependent on
three things # i" present value# $ii" period and $iii" rate of interest. Thus, the future value at the
end of one year euals the present value multiplied by one plus interest rate. As for example, if
present value euals to T!. %&&, period is % year and rate of interest is %& percent# then future
value will be T!. %%&.
$RE%E"T VALUE
'resent value is the value today of a future cash flow or series of cash flows. That is, present
value is a future amount discounted to the present by some reuired rate. The present value is
dependent on three things( $i" future value, $ii" period and rate of interest. As for example, if
future value is T!.%%), period is one year and rate of interest is %) percent# then present value
will be T!. %&& only.
%*
+ince, cash flow is involved in both the future value and present value# it needs clarification.
,ash flow embraces both cash outflow and cash inflow. ,ash outflow is a payment or
disbursement of cash for expenses, investments and so on. -n the other hand, cash inflow is a
receipt of cash from an investment, an employer, a ban!er or from any other sources.
TL% A"& TEC'"!(UE% F T!ME VALUE F M"E)
Tools used in Time Value of Money
-ne of the most important tools in time value of money analysis is the cash flow time line. It is a
graphical representation used to show the timing of cash flows. +uch line is used helping us
visualizing when the cash flows associated with a particular situation. ,onstructing a cash flow
time line will help us to solve problems related to the time value of money. This is because of the
fact that it illustrates what happens in a particular situation, ma!ing it easier to set up the problem
for solution. To illustrate the time line concept, let us consider the following diagram.
& % . / 0
TIM1(
The above diagram shows that time & is today, time2% one period from today or the end of the
period2%# time2. is two periods from today or the end of period2. and so on. Thus the values on
the top of the tic! mar!s represent end of period values. -ften the periods are years, but other
time intervals li!e semi2annuals, uarters, months or even days are also used.
,ash flows are placed directly below the tic! mar!s and interest rates are shown directly above
the cash flows time line. 3n!nown cash flows which need to be found out in the analysis are
indicated by uestion mar!. As for example, consider the following time line.

%4
& % . / 0 )
TIM1( %)5
,ash flows( 2%&&& 6
In the above diagram, the interest rates for each of the five periods is %)5# a single amount or
lump sum cash flows are made at time2&# and the time2) value is an un!nown inflow. 7ecause,
the initial T!. %&&& is a cash outflow or an investment, so it has a minus sign. 7ut, the period2)
amount is a cash inflow# so it does not have a minus sign. 8ote that no cash flows occur at times2
%, ., / and 0. Also note that we do not show Ta!a signs on time lines# this reduces clutter.
The cash flow time line is an essential tool for better understanding time value of money
concepts. The financial experts use cash flow time line to analyze the complex problems.
Techni*ues of Time Value of Money
The following two techniues are generally used in time value money # $i" compounding and $ii"
discounting. The following paragraphs deal with each of the techniues.
Compoundin+ Techni*ue
A Ta!a in hand today is worth more than a Ta!a to be received in the future. This is because of
the fact that if you had it now, you could invest it, earn interest and end up with more than one
Ta!a. The process of going from today9s values which are termed as present values $':", to
future values $F:" is called compounding. That is, the process of determining the value of a cash
flow sometime in the future, by applying compound interest rate is !nown as compounding. 7y
compound interest we mean interest earned on interest.
Compound !nterest vs, %imple !nterest
,ompound interest refers to the interest earned on both the initial principal and the interest
reinvested from prior periods, while simple interest refers to the interest earned only on the
original principal amount invested. ;et us clear these with examples. +uppose your principal
%<
amount is T!. %&&& and the rate of interest is %&5 and the period is / years. In the example,
compound interest comes to T!. //% $%&&=%%&=%.%"# whereas, simple interest comes to T!. /&&
$%&&=%&&=%&&" only at the end of / years.
8ow, the uestion arises how the F:s are determined. There are two approaches to determine
F:s# one is 1uation approach and the other is Tabular approach.
!n case of annual -sin+le. compoundin+#
>here, F:n ? Future value at period n
': ? 'resent value
I ? @ate of interest
n ? Time period
Under Ta/ular Approach#
F:n ? $% = i"
n
? ':$F: IF i,n"
>here, F:n ? Future value at period n
': ? 'resent value
IF ? Interest factor to be found out from
Future :alue Table
I ? @ate of interest
n ? Time period
Terms of !nterest and Future Values
Interest may be paid annually, semiannually, uarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is !nown as terms of interest.
Interest may be paid annually, semiannually, uarterly, monthly, even daily and even
continuously or infinitely and such mode of payment of interest is !nown as terms of interest.
+uch terms of interest have impact on the F:s. In the above 1uation and Tabular Approaches of
calculating F:s, we have assumed that interest is paid annually. 8ow, let us consider the
relationship between F:s and interest rates for different periods of compounding. F:s and terms
.&
Under E*uation Approach #
F:n ? ': $%=i"
n
of interest have direct relationship, implying that the number of times interest paid in a year $m"
is increased, the F: also increases. For different terms of interest, the formula for finding out
F:s under both the 1uation and Tabular Approaches need to be adAusted as follows #
a. !n case of Multiple Compoundin+
/. !n case of continuous or infinite compoundin+
Under Ta/ular Approach
F:n ? ': $e
i x n
"
>here, e is the value eual to ..*%4/
Future Value !nterest Factor for i and n -FV!F
i0 n
.
F:IFi,n refers to the future value of T!. % left on deposit for n periods at a rate of i percent per
period that is, the multiple by which an initial investment grows because of the interest earned. In
order to find out IF from Future :alue Table, time period $n" and rate of interest $i" should be
considered simultaneously. In the Table, the vertical column represent n# whereas, the horizontal
columns represent rates of interest.
$ro/lems and solutions
$ro/lem 1 2
Find out the future values $F:" in the following situations #
a" At the end of / years, how much is an initial deposit of Ta!a %,&&& worth, assuming a annually
compounded interest rate of $i" %&5 and $ii" %&&5.
.%
Under E*uation Approach
i
F:n ? 'v $% = 222222"
mn
m
Under Ta/ular Approach
i i
F:n ? $% = 222222"
mn
': $F:IF 2222222, mn"
m m
b" At the end of %& years, how much is an initial investment of Ta!a %,&&& worth, assuming an
interest rate of %&5 compounded # $i" annually# $ii" semiannually# $iii" uarterly, $iv"monthly and
$v" continuously 6
%olution #
a" In this problem, given ': ? T!. %,&&&# n ? /years and i ? %&5 percent# %&&5# reuired
finding out F:.
Under E*uation Approach Under Ta/ular Approach
F:n ? ':$%=i"
n
F:n ? ': $F:IFi,n"
>here, F:n ? Future value at n period# %,&&&$F:IF%&5,/"
': ? 'resent value %,&&& x %.//%&
i ? Interest rate and T!. %,//%.
n ? Time period
? %,&&&$% = .%&"
/
F:n ? ':$F:IFi,n"
? %,&&&$%.%&"
/
? %,&&&$F:IF%&&5,/"
? %,&&& x %.//% ? %,&&& x 4.&&&
? T!. %,//% ? T!. 4.&&&.
Again, %,&&&$% = %"
/
? %,&&& x 4
? 4,&&&.
b" In this problem, given ': ? T!. %,&&&# n ? %& years and i ? %&5# what is F:.
%olution #
Under E*uation Approach Under Ta/ular Approach
!n case of annual interest #
)<0 , . .
)<0 . . &&& , %
" %& . & % $ %&&&
" % $ "
%&
Tk
i PV FVn i
n

+
+
)<0 , . .
)<0 . . &&& , %
" %& 5, %& $ &&& , %
" , $ "
Tk
FVIF
n FVIFi PV FVn i

..
!n case of semiannual interest #
B)/ , . .
B)// . . %&&&
" &) . & % $ %&&&
"
.
%&
% $ %&&&
" % $ "
.&
%& .
Tk
m
i
PV FVn ii
mn

+
+
+

.B)/ .
" B)// . . $
" .& 5, ) $
" $ "
Tk
PV
FVIF PV
mn FVIF PV FVn ii
m
i

!n case of *uarterly interest #

B4) , . .
" B4)% . . $ %&&&
" &.) . % $ %&&&
"
0
%& .
% $ "
0&
%& . 0
TK
PV FVn iii

+
+
B4) , . .
B4)% . . %&&&
" 0& , $ %&&&
" , $ "
5 .) .
TK
x
FVIF
mn FVIF PV FVn iii
m
i

!n case of monthly interest #

.*&B .
" *&)< . . $ %&&&
" &&4// . % $ %&&&
"
%.
%& .
% $ "
%.&
%& %.
TK
PV FVn iv
x

+
+
*&B , . .
" *&)< . . $ &&& , %
" , $ "
TK
mn FVIF PV FVn iv
m
i

!n case of Continuous Compoundin+

!nterest#
v) FVn = PV (e
i x n
)
= (2.7183)
.10 x 10
= Tk. 2,718.30
C"ote # In cases of F:IF value has not been provided in the Future :alue Table. +o, in these
cases F:IF has been calculated by using the alternative formula viz. F:IF ?
D % mn
m
i

,
_

+
$ro/lem - 3
Assume that it is now Eanuary %, .&&&. -n Eanuary %, .&&%, you will deposit T!. %&&& into a
+avings Account of Eanata 7an! that pays %. percent interest per annum.
./
Re*uired #
$a" If the ban! compounds interests annually how much will you have in your account on
Eanuary2%, .&&B6
$b" >hat would your Eanuary2%, .&&) balance be if the ban! used uarterly compound6
$c" +uppose you deposited T!. %&&& in payments of T!. .&& each on Eanuary %, .&&%, .&&.,
.&&/, .&&0 and .&&). Fow much would you have in account on Eanuary2%, .&&), based on %&
percent annual compounding6
%olution #
Under E*uation Approach Under Ta/ular Approach
$a" F:n ? ': $% = i"
n
F:n ? ': $F:IFi, n"
? %&&& $% = &.%."
)
? %&&& $F:IF
%.5
, )"
? %&&& x %.*B./ ? %&&& x %.*B*./
? T!. %*B. ? T!. %*B.
$b" Under E*uation Approach Under Ta/ular Approach
%B&) .
B&0** . % %&&&
" &/ . % $ %&&&
"
0
%. .
% $ %&&&
" % $
%B
0 . 0
Tk
m
i
PV FVn
mn

+
+
%B&) .
B&0* . % %&&&
" %B , $
" , $
5 /
Tk
FVIF PV
mn FVIF PV PVn
m
i

$c" Gou may solve this problem by finding the future value of an annuity of T!. .&& for 0 years
at
%& percent#
F:n ? 'MT $F:IFA
i
,n"
.0
T!. .&&$F:IFA
%&5,
)"
T!. .&& $B.%&)%"
T!. %,..%.
&iscountin+ Techni*ue
Hiscounting refers to the process of determining the present value of a cash flow or a series of
cash flows. It is the reverse of compounding. That is, the process of finding present values from
future values is called discounting. If you !now the F:s, you can discount the ':s. At the time
of discounting you would follow these steps.
CA%' FL4 T!ME L!"E
& )5 % . / 0 )
': ? 2%&& %.*.B/
In the above figure it is seen that T!. %&& would grow to T!. %.*.B/ in ) years at a ) percent
interest rates. Therefore, T!. %&& is the ': of T!. %.*.B/ due in ) years in the future when the
opportunity cost rate is ) percent.
&ETERM!"!"5 $Vs T'RU5' &!%CU"T!"5
;i!e determination of F:s, ':s can also be determined by 1uation Approach and Tabular
Approach.
Under E*uation Approach Under Ta/ular Approach
n
i
FVn
PV i
" % $
"
+

$In case single

$V -%in+le payment. 6
.)
interest payment"
mn
m
i
FVn
PV ii
" % $
"
+

$In case multiple interest payment in a year
li!es semiannually, uarterly, monthly and
daily."
iii" ': ?
eixn
FVn
" $
n i
e FVn

$In case
continuous or infinite compounding"
>here e is the value eual to ..*%4/.

" , $
" % $
%
n PVIF FVn
i
FVn
i
n

1
]
1

+
$V -Multiple payment. 6

" , $
" % $
%
mn
m
PVIF FVn
m
i
FVn
i
mn

1
1
1
]
1

+
$RE%E"T VALUE !"TERE%T FACTR -$V!F.
'resent value interest factor for i and n $':IFi,n" refers to the present value of T!. % due n
periods in the future discounted at i percent per period. In order to find out IF from 'resent :alue
Table, time period $n" and rate of interest $i" should be considered simultaneously. In the Table,
the vertical column represents n# whereas, the horizontal column represent rates of interest.
$R7LME% A"& %LUT!"%
$ro/lem - 3
Hetermine the 'resent :alues $':s" in the following cases #
a" Ta!a %,&&& at the end of ) years is worth how much today, assuming a discount rate of # $i" %&
'ercent and $ii" %&& percent#
b" >hat is the aggregate ':s of the following receipts, assuming a discount rate of %) percent #
i" Ta!a %,&&& at the end of % year#
ii" Ta!a %,)&& at the end of . years#
iii" Ta!a %,4&& at the end of / years#
iv" Ta!a .,.&& at the end of 0 years and
v" Ta!a .,)&& at the end of ) years 6
.B
%olution
a" $i" In case of %& percent discounting rate #
Under E*uation Approach Under Ta/ular Approach
n
i
FVn
PV
" % $ +

</ . B.&
B%&) . %
%&&&
" %& . % $
%&&&
)
TK

': ? F:n $':IFi,n"

? %,&&& $':IF%&5,)"
? %,&&&$.B.&<"
? TI. B.&.<
$ii" In case of %&& percent discounting rate #
Under E*uation Approach Under Ta/ular Approach
n
i
FVn
PV
" % $ +

.) . /%
/.)
%&&&
" % % $
%&&&
)
TK

': ? F:n $':I Fi,n"

? %,&&& $':I F %&&5,)"
? %,&&&$.&/%.)<"
? TI. /%..)
/.Under E*uation Approach Under Ta/ular Approach
.*
i"
)* . 4B< .
" %) . % $
%&&&
" % $
%
TK
i
FVn
PV
n

+

ii"
.. . %%/0 .
/..) . %
%)&&
" %) . % $
%)&&
" % $
. .
TK
i
FVn
PV
+

iii"
)% . %%4/ .
).&< . %
%4&&
" %) . % $
%4&&
" % $
/ /
TK
i
FVn
PV
+

iv"
4B . %.)* .
*0<& . %
..&&
" %) . % $
..&&
" % $
0 0
TK
i
FVn
PV
+

v"
<. . %.0. .
&%%0 . .
.)&&
" %) . % $
.)&&
" % $
) )
TK
i
FVn
PV
+

i" ': ? F:n $':I Fi,n"

? %,&&& $':I F%)5,%"
? %,&&&$.4B<B"
? TI. 4B<.B&
ii" ': ? F:n $':I F%)5,."
? %,)&& $.*)B%"
? TI. %%/0.%)
iii" ': ? F:n $':I F%)5,/"
? %,4&& $.B)*)"
? TI. %%4/.)&
iv" ': ? F:n $':I F%)5,0"
? .,.&& $.)*%4"
? TI. %.)*.<B
v" ': ? F:n $':I F%)5,)"
? .,)&& $.0<*..
? TI. %.0/.&&
Fence, aggregate ': s ? T!. 4B<.)* = T!. %,%/0... = %,%4/.)% = T!. %,.)*.4B = %,.0..<.
? T!. ),B44.&4
Fence, aggregate ': s ? T!. 4B<.B& = T!. %,%/0.%) = %,%4/.)& = T!. %,.)*.<B = T!. %,.0/.&&
? T!. ),B44..%
$ro/lem - 8
Find the present values of the following amount due #
.4
a" Ta!a B,B&& due in %& years at a B percent discount rate, calculating annually#
b" Ta!a <,&&& due in 4 years at a %. percent discount rate, calculated semiannually#
c" Ta!a%.,&&& due in B years at a %4 percent discount rate, calculated uarterly and
d" Ta!a %),&&& due in / years at a %. percent discount rate, calculated monthly.
e" Ta!a %4,&&& due in ) years at a %) percent discount rate, calculated continuously.
%olution#
a"
)& . B4) , / .
*<&4 . %
B&& , B
" &B . % $
B&& , B
" % $
%&
TK
i
FVn
PV
n

+

b"
4. . /)0. .
)0&/) . .
<&&&
"
.
%. .
% $
<&&&
" % $
4 . .
TK
m
i
FVn
PV
mn

+

c"
0B . 0%*. .
4*B& . .
%.&&&
"
0
%4 .
% $
%.&&&
" % $
B . 0
TK
m
i
FVn
PV
mn

+

d"
B) . %&04/ .
0/&4 . %
%)&&&
"
%.
%. .
% $
%)&&&
" % $
/ . %.
TK
m
i
FVn
PV
mn

+

e" 8ot Applicable

a" ': ? F:n $':I Fi,n"
? B,B&& $':I FB5,%&"
? B,B&&$.))40"
? TI. /B4).00
b" ': ? F:n $':I
FiJm,mn"
? <,&&& $':I F
%.5J.
,
..4
"
? <,&&& $':IF B5, %B"
? TI. /)0..0&
c" ': ? F:n $':I
FiJm,mn"
? %.,&&& $':IF 0.)5,
.0"
?%.,&&& $./0**"
? TI. 0%*..0&
d" ': ? F:n $':I
FiJm,mn"
? %),&&& $':IF %5,
/B"
? %),&&& $.B<4<"
? TI. %&04/.)&
.<
F:n
e" ': ?
e
i x n
%4,&&&
? 222222222222
..*%4/
.%. x )
%4,&&&
? 222222222222
%.4..%
? T!. <,4*4.*%
C8ote K In the present :alue Table, ':IF for 0.)5 and .0 periods and %5 for /B periods are not
shown. Fence, in cases two cases ':IF has been found out by using the alternative formula
which goes as under #
mn
m
i
PVIF
" % $
%
+

D
%olvin+ Time and !nterest Rates
In the determination of present values and future values, time factor and interest or discount
factor have been worth2mentioning. As for example, in determining future value, present value,
time factor and interest factor must exist. -n the other hand, in determining present value future
value, time factor and interest factor must exist. It is evident that in each of these cases, the
values of any three are given. The value of the fourth one can be found out. In such a context the
necessity of determining the value of either interest $i" or period $n" has arisen.
!n cases of Future Value -FV. and $resent Value -$V.
+uppose, you can buy a security at a price of T!. *4./) that will pay you T!. %&& after )years. In
this case, ':, F:, and n are given# we are to find out i, the interest rate you will earn on your
investment.
:alue of i is found out by applying the following formula #
F:
n
? ': $% = i"
n
? ': $F:IFi, n"
/&
Fence, T!. %&& ? T!. *4./) $% = i"
)
? $F:IFi, n"
%&&
or, $% =i"
)
? 2222222222 ? %..*B/ ? F:IFi, )
*4./)
or, $% ? i" ? $%..*B/"
%J)
? %.&)
or, i ? %.&)2% ? &.&) ? )5
%olvin+ for $eriod -n.
In cases of ':, F: and Annuities $ordinary and due", the period n can be found out if other
elements of Time :alue of Money viz.# ':, F:, Annuities and rate of interestJ discount $i" are
given. The following paragraphs deal with the determination of period n.
%olvin+ for period n in cases of FVs and $Vs
+uppose you !now that the investment in security will provide a return of %&5 per year, that it
will cost Ta!a .&0.<& and that you will receive T!. /&& at maturity. 7ut, you do not !now when
the security matures. In this case you !now ':, F: and i# but you are to !now n, the number of
periods. The solution is as under #
>e !now that F:
n
? ': $% = i"
n
? ': $F:IF
i, n
"
or, /&& ? .&0.<& $F:IF%&5, n"
/&&
or, F:IF%&5, n ? 22222222222 ? %.0B0%
.&0.<&
8ow, let us loo! across the %&5 column in Future :alue Table until we find F:IF ? %.0B0%.
This value is in @ow 0, which indicates that it ta!es 0 years for Ta!a .&0.<& to grow to Ta!a /&&
at %&5 interest rate.
Case %tudy #
/%
A father is planning a savings program to put his daughter through university. Fis daughter is
now %4 years old. Fe plans to enroll at the university in ) years. ,urrently, the cost per year for
everything K food, clothing, tuition fees, boo!s, conveyance and so forth is T!. %),&&&, but a )
percent inflation rate in these costs is forecasted. The daughter recently received T!. *,)&& from
her grand father9s estate# this money which is invested in a mutual fund paying 4 percent interest
compounded annually, will be used to help meet the cost of the daughter9s education. The rest of
the costs will be met by money the father will deposit in the savings account. Fe will B eual
deposits to the account in each year from now until his daughter starts university. These deposits
will begin today and will also earn 4 percent interest.
a" >hat will be the present value of the cost of ) years of education at the time the daughter
becomes .06
b" >hat will be the value of T!. *,)&& that the daughter received from her grand father when she
+tarts university at the age .06
c" If the father is planning to ma!e the first B deposits today, how large must each deposit be for
him to be able to put his daughter through university6
Annuity# Time Value of Money
Concept of Annuity
An annuity is a series of eual payments !nown as installments at fixed intervals for specified
number of periods. As foe instances T!. %&& paid as an installment at the end of the each of the
next five years is a five year annuity. The installment payments are symbolized as 'MT and they
can occur at either the beginning or the end of each year. If the installment payments occur at the
end of each period, as they typically do in business transactions, the annuity is !nown as
ordinaryJ deferred annuity. If installment payments are made at the beginning of each period, the
annuity is called an annuity due. +ince ordinary annuities are more common in Finance, when
the annuities are used in this boo!, you should assume that the installment payments occur at the
end of each period values otherwise mentioned. +uch annuities are closely related with ': and
F: which are examined in the following sub2sections.
Future Value of an rdinary Annuity
/.
Future value of an ordinary annuity depends on three things namely # $i" amount of 'MT# $ii"
rate of interest and $iii" period. The more the amount of 'MT, rate of interest and the period, the
higher will be the amount of F: of an annuity. ;et us ta!e an example. If you deposit Ta!a %&&
at the end of each of three years in a +avings AJ, that pays )5 interest per year# how much will
you have at the end of / years 6 To answer this uestion, we must find out F: of an ordinary
annuity $F:An". Fence, F:An represents the F: of an ordinary annuity over periods. 1ach
payment is compounded out to the end of period n and he sum of the compounded payments is
the F:An.
There are two approaches of determining F:An viz. $i" 1uation Approach and $ii" Tabular
Approach.
i" 3nder 1uation Approach ii" 3nder Tabular Approach

+
%
&
" % $
n
t
t
i PMT FVAn
" , $
D
% " % $
C
n FVIFAi PMT
i
i
PMT FVAn
n

E9planation of FV!FAi0n #
The summation term in the brac!ets in the formula under Tabular Approach is called the Future
:alue Annuity Interest Factor for an annuity of n payments compounded at % percent of interest.
In order to find out this interest factor, both n and I should be considered simultaneously in the
Future :alue Annuity Table.
$R7LEM A"& %LUT!"
$ro/lem - 2
Find out the Future :alues of the following ordinary annuities #
$i" Ta!a 0,&&& per year for %& years at %. percent#
$ii" Ta!a .,&&& per year for ) years at %& percent#
$iii" Ta!a %,&&& per year for B years at & percent.
%olution
$i" F:An ? 'MT $F:IFAi,n" $ii" F:An ? 'MT $F:IFAi,n"
//
? 0,&&& $F:IFA%.5, %&" ? .,&&& $F:IFA%&5, )"
? 0,&&& $%*.)0<" ? .,&&& $B.%&)%"
? T!. *&,%<B ? T!. %,..%&..&
$iii" F:An ? 'MT $F:IFAi,n"
? %,&&& $F:IFA&5, B"
? %,&&& $B"
? T!. B,&&&.
Future Value of an Annuity &ue
;i!e future value of an ordinary annuity, future value of an annuity due also depends on the #
$i" amount of payments# $ii" rate of interest and $iii" number of periods. The more the amount of
'MT, rate of interest and the number of periods# the higher will be future value of annuity due.
Fad there been T!. %&& payments in the previous example being made at the beginning of each
year, the annuity would have been !nown as an annuity due.
Future value of an annuity due F:A $H31" can also be found out in two approaches viz. ( $i"
1uation Approach and $ii" Tabular Approach.
Under E*uation Approach
1
]
1

'
+
" % $
% " % $
" $ i
i
i
PMT DUE FVA
n
Under Ta/ular Approach
{ } [ ] " % $ " $
,
i FVIFA PMT DUE FVA
n i
+
Future value interest factor annuity $H31" for n periods at I interest percent can be found from
the Future :alue Annuity Table, considering n periods and I interest rates.
$R7LEM A"& %LUT!"
$ro/lem 1 3
/0
Find out the future value of the following annuities due 2
$a" T!. /,&&& per year for 4 years at 45#
$b" T!. ),&&& per year for %& years at %.5 and
$c" T!. .,&&& per year for * years at &5.
%olution
$a" F:A $H31" ? 'MT C$F:IFAi, n" $% = i"D $b" F:A $H31" ? 'MT C$F:IFAi, n" $% = i"D
? /,&&& C$F:IFA45, 4" $% = .&4"D ? ),&&& C$F:IFA
%.5
, %&" $% = .%."D
? /,&&& C$%&.B/*" $%.&4"D ? ),&&& C$%*.)0<" $%.%."D
? T!. /0,0B/.44 ? T!. <4,.*0.0&
$c" F:A $H31" ? 'MT C$F:IFAi, n" $% = i"D
? .,&&& C$F:IFA&5, *"D
? .,&&& $*" $%"
? T!. %0,&&&
$resent Value of an rdinary Annuity
'resent value of an ordinary annuity refers to the value today of a future ordinary annuity.
+uppose you are offered the following alternatives # $i" a three year annuity with payments of T!.
%&& at the end of each of the / years and $ii" a lump2sum payment today. 8ow, the uestion is (
Fow large must the lump2sum payment today be to ma!e it euivalent to the annuity 6 To
answer this uestion, we must find out the present value of an ordinary annuity $':An". 1ach of
the payment is to be discounted and the sum of the discounted payments is the ':An.
There are two approaches of finding out ':An viz.( $i" 1uation Approach and $ii" Tabular
Approach.
/)
Under E*uation Approach Under Ta/ular Approach
1
]
1

n
t
t
i
PMT PVAn
%
" % $
%
':An ? 'MT $':IFAi,n"
':IFA refers to the summation term in the brac!et in this 1uation is called the 'resent :alue
Interest Factor Annuity. It is the present value interest factor for an annuity of n periods,
discounted at I interest percent. In order to find out this interest factor, 'resent :alue Annuity
Table should be consulted considering n periods and discounted I interest factor. The present
value of an annuity depends on # $i" amount od 'MT# $ii" n periods and $iii" rate of discount i.
The more the amount of 'MT, n periods and rate of discount, the higher will be the amount of
annuity and vice2versa.
$R7LEM A"& %LUT!"
$ro/lem - 3
Find out the present values of the following ordinary annuities #
a" Ta!a .,)&& for %& years at %. percent#
b" Ta!a 0,)&& for %. years at %& percent and
c" Ta!a B,&&& for 4 years at & percent.
%olution
a" ':An ? 'MT $':IFAi,n" b" ':An ? 'MT $':IFAi,n"
? T!. .,)&& $':IFA%.5, %&" ? T!. 0,)&& $':IFA%&5,
%."
? T!. .,)&& $).B)&." ? T!. 0,)&& $B.4%/*"
? T!. %0,%.).)& ? T!. /&,BB%.B)
c" ':An ? 'MT $':IFAi,n"
? T!. 'MT $':IFA&5, 4"
? T!. B,&&& $4"
? T!. 04,&&&
$resent Value of an Annuity &ue
In the previous example cited in /././, had the three T!. %&& payments been made at the
beginning of each of the three years# the annuity would have been an annuity due. ;i!e the
present value of an ordinary annuity# present value of an annuity due can be found out on the
/B
basis of the amount of payment, n periods and present discount rate. Fe more the amount of
'MT, n periods and i percent of discount# the higher will be the annuity due and vice2versa.
'resent value of an annuity due can also be measured by two approaches viz. ( $i" 1uation
Approach and $ii" Tabular Approach.
The present interest factor for an annuity due K ':IFAn $H31"I, n is eual to ':IFAi, n L $% =
i". +uch interest factor would be found out from the 'resent :alue Annuity Table, considering n
periods and I rate of discount.
$R7LEM A"& %LUT!"
$ro/lem - 8
Find the present value of the following annuities# if the 'MT occur at the beginning of the year
i.e. annuities due #
a" Ta!a *,)&& for < years at %0 percent#
b" Ta!a %&,&&& for ) years at < percent and
c" Ta!a B,B&& for * years at & percent.
%olution
':A $H31" ? 'MT $':IFAi, n" x $% =i"
? T!. *,)&& $':IFA%05, <" x $% = &.%0"
? T!. *,)&& $0.<0B0" x $%.%0"
? T!. 0..<%.*.
b" ':A $H31" ? 'MT $':IFAi, n" x $% =i"
? T!. %&,&&& $':IFA<5, )" x $% = &.&<"
/*
-i. E*uation Approach
1
1
1
1
]
1

'

" % $
" % $
%
%
" $ i
i
i
PMT DUE PVAn
n
-ii. Ta/ular Approach
':An $H31" ? 'MT C$':IFAi, n" $% = i"D
? T!. %&,&&& $/.44<*" x $%.&<"
? T!. 0.,/<*.*/
c" ':A $H31" ? 'MT $':IFAi, n" x $% =i"
? T!. B,B&& $':IFA&5, *" x $% = &"
? T!. B,B&&$*" x $%"
? T!. 0B,.&&
&etermination of $ayments -$MT.
In this sub2section, we shall examine how payments $'MT" are determined in cases of both types
of annuities viz. ordinary annuity and annuity due# where the values of annuities, rate of interest i
and period n are given.
a" Hetermination of 'MT in case of -rdinary annuity
+uppose you have borrowed Ta!a %4,&&& from a ban! with %.5 interest for a period of %) years.
>hat is the annual interest payment if the payments are to be made at the end of each year 6
This is a case of ordinary annuity. +o, ':An ? 'MT $':IFAi, n"
%4,&&& ? 'MT $':IFA%.5, %)"
%4,&&& ? 'MT $B.4%&<"
%4,&&&
? 'MT
B.4%&<
'MT ? Ta!a .B0..4.
b" Hetermination of 'MT in case of Annuity Hue
+uppose you have borrowed house building loan of Ta!a %& lacs from F7F, with %&5 interest
for a period of .& years. >hat is the annual interest payment if the payments are to be made at
the beginning of each year6
This is a case of annuity due. +o, ':An $H31" ? 'MT $':IFAi, n" $% = i"
%&,&&,&&& ? 'MT $':IFA%&5, .&" $% = &.%&"
%&,&&,&&& ? %.%& 'MT $4.)%/B"
/4
%&,&&,&&& %&,&&,&&&
'MT ? ? ? T!. %,&B,*4&.)*
%.%& x 4.)%/B <./B)
%olvin+ Time and !nterest Rates
In the determination of annuities, time factor and interest or discount factor have been worth2
mentioning. >hile determining annuities, either ordinary or due# payment, time factor and
interest factor must exist. It is evident that in each of these cases, the values of any three are
given. The value of the fourth one can be found out. In such a context the necessity of
determining the value of either interest $i" or period $n" has arisen.
!n case of Annuities -rdinary and &ue.
In the previous problems the F:s and ':s of ordinary annuity due as well as annuity have been
found out where 'MT, i and n are given. 7ut, here we are interested to determine i where F:s or
':s, 'MT and n are given. For the purpose of determining i, the same formula given under
Tabulation Approach while calculating F:s and ':s in cases of ordinary annuity and annuity
due need to be followed. The following problem deals with the calculation of i.
$R7LEM A"& %LUT!"
$ro/lem - :
Find out the interest rate $i" in the following cases #
a" Gou borrow Ta!a <,&&& and promise to ma!e eual payments of Ta!a .,B40.4& at the end of
each year for ) years#
b" Gou borrow Ta!a %/,.)& and promise to ma!e eual payments of Ta!a .,B0&.&* at the
7eginning of each year for %& years.
%olution
/<
This problem relates to ordinary annuity# since payments are made at the end of the year. +o, the
formula for ordinary annuity will be followed which is given as #
':An ? 'MT $':IFAi, n"
or, <,&&& ? .,B40.4& $':IFAi, )"
<,&&&
Fence, ':IFA ? 2222222222222 ? /./)..
.B40.4&
In 'resent :alue Annuity Table, let us loo! across the period $n" ) row until we find ':IFA ?
/./)... This value lies in the %)5 columns# so the interest rate at which a five year .,B40.4&
annuity has a ': of Ta!a<,&&& is %) percent.
b" This problem relates to annuity due# since payments are made at the beginning of the year. +o,
the formula for annuity due will be applied which is as under #
':An $H31" ? 'MT C$':IFAi, n" $% = i"
or, %/,.)& ? .,B0&.&* C$':IFAi, %&" $% = i"D
%/,.)&
Fence, ':IFA
i, %&
? 222222222222 ? ).&%44 $% =i"
.,B0&.&*
In the 'resent :alue Annuity Table, let us loo! across the period $n" %& row until we find ':IFA
? ).&%44. This value lies in %)5 column# so the interest rate at which a ten2year .,B0&.&* annuity
has a ': of Ta!a %/,.)& is %) K &.%) percent i.e. %0.4)5.
/. %olvin+ for period n in cases of Annuities0 rdinary and &ue
In case of either ordinary annuity or annuity, period n can be found out if values of ordinary
annuity or annuity due, pmt and i are given. The following examples will clear the matter.
0&
E;AM$LE%
a" +uppose you borrow Ta!a %),&&& and promise to ma!e eual installment payments of Ta!a
.,B&0.B. at the end each of the reuisite years at %& percent.. In this case, you !now the value of
ordinary annuity, 'MT and i# you are to determine period n. The solution goes as follows(
':An ? 'MT $':IFAi, n"
or, %),&&& ? .,B&0.B. $':IFA%&5, n"
%),&&&
':IFA%&5, n ? 222222222222 ? ).*)<
.,B&0.B.
In 'resent :alue Annuity Table, let us loo! across the %&5 column until we find ':IFA ?
).*)<. This value lies in @ow <, which indicates that it ta!es < years for Ta!a .,B&0.B. to grow to
Ta!a %),&&& at %&5 interest rate.
b" +uppose you borrow Ta!a%&, &&& and promise to ma!e eual installment payments of Ta!a
.,&)0.&B at the beginning of each of the reuisite years of %& percent. In this case, you !now the
value of annuity due, 'MT and i# you are to find out period n. The solution goes as under #
':An $H31" ? 'MT $':IFAi, n" $% = i"
or, %&,&&& ? .,&)0.&B $':IFA%&5, n" $% = &.%."
%&,&&&
or, ':IFAn%&5, n ? 2222222222222 $% = &.%&"
.,&)0.&B
? 0.4B40 $% = &.%&" ? )./)).
In the 'resent :alue Annuity Table, let us loo! across the %&5 column until we find ':IFA ?
)./)).. This value lies around @ow *, which indicates that it ta!es around * years for Ta!a
.,&)0.&B to grow to Ta!a %&,&&& at %&5 interest rate.
Revie< pro/lems
0%
$ro/lem - 2
Find the present value of Ta!a ),&&& due in the future in case of annuity due and ordinary
annuity under the following conditions #
a" %) percent interest rate, compounded annually, discounted bac! %& years#
b" %) percent interest rate, semiannually compounding, discounted bac! %& years#
c" %) percent interest rate, uarterly compounding, discounted bac! %& years#
d" %) percent interest rate, monthly compounding discounted bac! ) years#
e" %) percent interest rate, daily compounding discounted bac! B years#
f" %) percent interest rate, continuously compounding discounted bac! * years.
$ro/lem - 3
To help you reaching your T!. %&,&&& goal, your mother offers to give you T!. 0,&&& on Eanuary
%, .&&%. Gou will get a part time Aob and ma!e B additional payments of eual amount each of B
months thereafter. If all these money is deposited in ban! that pays %. percent, compounded
semiannually, how large must be each of the B payments 6
$ro/lem - 3
Find the future value of Ta!a %),&&& in case of annuity due and ordinary annuity under the
following conditions(
a" %. percent interest rate, compounded annually, discounted bac! %& years#
b" %. percent interest rate, continuously compounding discounted bac! * years." %. percent
interest rate, semiannually compounding, discounted bac! %& years#
c" %. percent interest rate, uarterly compounding, discounted bac! %& years#
d" %. percent interest rate, monthly compounding discounted bac! ) years#
0.