ch1 Notes Cfa

Reading: The Time Value of Money
Disclaimer: Certain materials contained within this text are the copyright property of CFA Institute. The
following is the source for these materials: “CFA® Program Curriculum Level I Volume 1, page no. 313
to 368”.
Learning Outcome (LOS) 1: Introduction

This chapter is based on the concept that money has time value.
Let us assume the following two options:
Option 1 Option 2
Receive $10,000 today. Receive $10,000 after one year.
You will prefer you receive $10,000 today. This is because by receiving the money early, you can simply
put the money in the bank and earn some interest. This incremental gain is time value of money.
If the interest rate would be zero, there will be no time value of money. Thus, interest plays an
important role in determining the time value of money.
In order to make the above two options comparable we use the concept of TVM.
Option 1 Let’s say ROI = 10% p.a. Option 2
Receive $10,000 today Receive $11,000 after one year
Now the above options are comparable. TVM is based on 2 techniques i.e. Compounding (Future Value
technique) and Discounting (Present Value technique).
s
Compounding Discounting
Process of calculating future Process of finding present

values (FV) of cash flows. value (PV) of cash flows.
Example: Suppose you have Example: Suppose you want
deposited $ 100 in a bank at to have $ 110 after one year.
a rate of interest of 10% p.a. Bank’s current rate of
for one year. The technique interest is 10% p.a. The
used to compute the technique used to compute
investment value after one the investment value as on
year is known as today is known as
compounding technique. discounting technique.
The Time Value of Money
The process of finding FV with the help of

PV is terms as COMPOUNDING
Present Value Future Value
(PV) (FV)
The process of finding PV with the help of

FV is terms as DISCOUNTING
LOS 2: Future Value
FV is the value of an investment at a specified date in the future based on a given rate of interest. FV
is the summation of PV and interest earned on investment.
Interest income earned on the investment are of two types: Simple Interest and Compound Interest.
Simple interest (SI): Calculated as a simple % of the original principal amount.

Formula for SI is:
SI = P0 * (r) * (t)
If we add principal to the interest i.e. P0+SI, we get the future value.
Compound interest (CI): When interest is calculated on total of previously earned interest and the
original principal, it is known as CI.
Annual Compounding Intra-year Compounding
Here compounding is done When compounding is done

only 1 time in a year. more than one time in a
year. Let’s say half yearly,
FVn =PV (1+r)t quarterly, monthly or daily
compounding. Here, ROI
FVIFn (Future value interest p.a. is divided by the no. of
factor at end of nth year) times compounding is to be
done during one year & no.
of years are multiplied with
no. of times compounding is
to be done in 1 year.
r
FVn =PV (1+ m) t *m
Page 2 of 18
LOS 3: Effective Rate of Interest (EIR)

EIR is the actual equivalent annual rate of interest when compounding is done more than once in a
year. The higher the no. of times compounding is done, the higher is EIR.
r m
EIR = (1+ m
) -1
LOS 4: Present Value (PV) of a single cash flow

PV of a single cash flow is determined by discounting the future value at the interest rate that the
money could earn over the period.
1
P0 = FVn x n
(1+r)
PVIF (Present value interest factor)
LOS 5: PV of multiple unequal cash flows

<<to be discussed in class>>
LOS 6: PV and FV of multiple equal cash flows (deferred annuity or ordinary annuity)
LOS 7: PV of equal cash flows up to perpetuity

The formula for calculation of:
PV of equal CF up to perpetuity =
LOS 8: PV of perpetual growing cash flows

The formula for calculation of:
PV of perpetual growing cash flows = ( )
LOS 9: Annuity
An annuity is a series of equal payments or receipts occurring over a specified no. of periods.
Ordinary/Deferred Annuity (if Q is silent): When cash flows occur at the end of each period.
Annuity due: When cash flows occur at the beginning of each period.
How to solve: Treat the cash flow stream as an ordinary annuity over N compounding periods, and
simply multiply the resulting PV or FV by (1+ periodic interest rate).
Therefore,
𝑃𝑉 = 𝑃𝑉 x (1+r)
𝐹𝑉 = 𝐹𝑉 x (1+r)
Page 3 of 18
LOS 10: Compute FV of unequal CFs.

LOS 11: Interest rate

Interest rates can be considered in the following ways:
(a) Required rate of return
(b) Discount Rate
(c) Opportunity Cost- It is the value that investors forgo by choosing a particular course of action.
Interest rate (r) = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity
premium + Maturity premium
(a) Real risk-free interest rate: It is the single-period interest rate for completely risk-free security if
no inflation were expected. The sum of the real risk-free interest rate and the inflation premium
is the nominal risk-free interest rate.
(b) Inflation premium: It compensates investors for expected inflation and reflects the average
inflation rate expected over the maturity of the debt.
(c) Default risk premium: It compensates investors for the possibility that the borrower will fail to
make a promised payment at the contracted time and in the contracted amount.
(d) Liquidity premium: It compensates investors for the risk of loss relative to an investment’s fair
value if the investment needs to be converted to cash quickly.
(e) Maturity premium: It compensates investors for the increased sensitivity of the market value of
debt to a change in market interest rates as maturity is extended.
LOS 12: Continuous compounding

Continuous compounding calculates interest assuming constant compounding over an infinite number
of periods.
In case of continuous compounding, FV = PV x 𝑒 ∗

Where e is the mathematical constant approximated as 2.7183.
Even with substantial investment amounts, the difference in the total interest earned through
continuous compounding is not very high when compared to traditional compounding periods.
Page 4 of 18
Formula list
I. Future Value (FV) = PV * (1 + ) ∗
II. Effective Annual Rate (EAR) = (1 + ) - 1, where m = no. of times compounding

is done in a year
III. Present Value (PV) = P0 = FV x

( ) ∗
IV. PV of equal CF up to perpetuity =
V. PV of perpetual growing cash flows =

( )
VI. PV = PV x (1+r)
VII. FV = FV x (1+r)
VIII. In case of continuous compounding, FV = PV x e ∗
Page 5 of 18
Learning Outcome as per CFA Institute:

a. interpret interest rates as required rates of return, discount rates, or opportunity costs;
b. explain an interest rate as the sum of a real risk- free rate and premiums that compensate
investors for bearing distinct types of risk;
c. calculate and interpret the effective annual rate, given the stated annual interest rate and the
frequency of compounding;
d. solve time value of money problems for different frequencies of compounding;
e. calculate and interpret the future value (FV) and present value (PV) of a single sum of money, an
ordinary annuity, an annuity due, a perpetuity (PV only), and a series of unequal cash flows;
f. demonstrate the use of a time line in modeling and solving time value of money problems.
1. The nominal risk-free rate is best described as the sum of the real risk-free rate and a premium
for:
A. maturity.
B. Liquidity.
C. Expected inflation.
2. Which of the following risk premiums is most relevant in explaining the difference in yields
between 30-year bonds issued by the US Treasury and 30-year bonds issued by a small private
issuer?
A. Inflation
B. Maturity
C. Liquidity
3. Once an investor chooses a particular course of action, the value forgone from alternative actions
is best described as a(n):
A. sunk cost.
B. Required return.
C. Opportunity cost.
4. The minimum rate of return an investor must receive in order to accept an investment is best
described as the:
A. internal rate of return.
B. The required rate of return.
C. Expected return.
5. Assume the following:

The real risk-free rate of return is 3%.
The expected inflation premium is 5%.
The market-determined interest rate of security is 12%.
The sum of the default risk premium, liquidity premium, and maturity premium for the security is
closest to:
A. 10%.
B. 4%.
C. 8%.
6. The value in six years of $75,000 invested today at a stated annual interest rate of 7% compounded
quarterly is closest to:
Page 6 of 18
A. $112,555.
B. $113,330.
C. $113,733.
7. A bank quotes a stated annual interest rate of 4.00%. If that rate is equal to an effective annual
rate of 4.08%, then the bank is compounding interest:
A. daily.
B. Quarterly.
C. Semi-annually.
8. Given a €1,000,000 investment for four years with a stated annual rate of 3% compounded
continuously, the difference in its interest earnings compared with the same investment
compounded daily is closest to:
A. €1.
B. €6.
C. €455.
9. If the stated annual interest rate is 9%, and the frequency of compounding is daily, the effective
annual rate (EAR) is closest to:
A. 9.00%.
B. 9.86%.
C. 9.42%.
10. An investor deposits £2,000 into an account that pays 6% per annum compounded continuously.
The value of the account at the end of four years is closest to:
A. £2,854.
B. £2,525.
C. £2,542.
11. The stated annual interest rate is 12.75%. If the frequency of compounding is monthly, the
effective annual rate (EAR) is closest to:
A. 13.52%.
B. 12.75%.
C. 12.06%.
12. A saver deposits the following amounts in an account paying a stated annual rate of 4%,
compounded semi-annually:
Year End of Year Deposits ($)
1 4,000
2 8,000
3 7,000
4 10,000
At the end of Year 4, the value of the account is closest to:
A. $30,432
B. $30,447
C. $31,677
Page 7 of 18
13. A consultant starts a project today that will last for three years. Her compensation package
includes the following:
Year End of Year Payment
1 100,000
2 150,000
3 200,000
If she expects to invest these amounts at an annual interest rate of 3%, compounded annually
until her retirement 10 years from now, the value at the end of 10 years is closest to:
A. $618,994.
B. $566,466.
C. $460,590.
14. Given a discount rate of 4% a year compounded annually, the present value (PV), as of the end of
Year 5 (𝑃𝑉 ), of the cash flow $50,000 received at the end of Year 20 is closest to:
A. $22,819.
B. $27,763.
C. $28,873.
15. A client requires £100,000 one year from now. If the stated annual rate is 2.50% compounded
weekly, the deposit needed today is closest to:
A. £97,500.
B. £97,532.
C. £97,561.
16. An investment pays €300 annually for five years, with the first payment occurring today. The
present value (PV) of the investment discounted at a 4% annual rate is closest to:
A. €1,336.
B. €1,389.
C. €1,625.
17. At a 5% interest rate per year compounded annually, the present value (PV) of a 10-year ordinary
annuity with annual payments of $2,000 is $15,443.47. The PV of a 10-year annuity due with the
same interest rate and payments is closest to:
A. $14,708.
B. $16,216.
C. $17,443.
18. Grandparents are funding a newborn’s future university tuition costs, estimated at $50,000/year
for four years, with the first payment due as a lump sum in 18 years. Assuming a 6% effective
annual rate, the required deposit today is closest to:
A. $60,699.
B. $64,341.
C. $68,201.
Page 8 of 18
19. The present value (PV) of an investment with the following year-end cash flows (CF) and a 12%
required annual rate of return is closest to:
Year Cash Flow (€)
1 100,000
2 150,000
5 -10,000
A. €201,747.
B. €203,191.
C. €227,573.
20. A perpetual preferred stock makes its first quarterly dividend payment of $2.00 in five quarters. If
the required annual rate of return is 6% compounded quarterly, the stock’s present value is closest
to:
A. $31.
B. $126.
C. $133.
21. A sweepstakes winner may select either perpetuity of £2,000 a month beginning with the first
payment in one month or an immediate lump sum payment of £350,000. If the annual discount
rate is 6% compounded monthly, the present value of the perpetuity is:
A. less than the lump sum.
B. Equal to the lump sum.
C. Greater than the lump sum.
22. For a lump sum investment of ¥250,000 invested at a stated annual rate of 3% compounded daily,
the number of months needed to grow the sum to ¥1,000,000 is closest to:
A. 555.
B. 563.
C. 576.
23. An investment of €500,000 today that grows to €800,000 after six years has a stated annual
interest rate closest to:
A. 7.5% compounded continuously.
B. 7.7% compounded daily.
C. 8.0% compounded semi-annually.
24. A sports car, purchased for £200,000, is financed for five years at an annual rate of 6%
compounded monthly. If the first payment is due in one month, the monthly payment is closest
to:
A. £3,847.
B. £3,867.
C. £3,957.
25. Given a stated annual interest rate of 6% compounded quarterly, the level amount that, deposited
quarterly, will grow to £25,000 at the end of 10 years is closest to:
A. £461.
B. £474.
C. £836.
Page 9 of 18
26. A borrower is considering three competing mortgage loan offers from her bank. The amount
borrowed on the mortgage is $1,000,000 with monthly compounding.
Particulars Stated Annual Interest Rate Year in Which
at Initiation of the Loan Rate First Adjusts
30-year fixed-rate 5.000% N/A
20-year fixed-rate 4.385% N/A
30-year adjustable-rate mortgage (ARM) 3.750% 3
The rate on the ARM resets at the end of Year 3. Assuming the ARM is permanently reset at 5.500%
(i.e., the remaining balance on loan is assumed to be repaid with a 5.500% stated annual interest),
which of the three loans will have the smallest monthly payment after the rate reset at the end of
Year 3?
A. 30-year fixed-rate loan
B. 20-year fixed-rate loan
C. 30-year ARM.
27. A client invests €20,000 in a four-year certificate of deposit (CD) that annually pays interest of
3.5%. The annual CD interest payments are automatically reinvested in a separate savings account
at a stated annual interest rate of 2% compounded monthly. At maturity, the value of the
combined asset is closest to:
A. €21,670.
B. €22,890.
C. €22,950.
Solutions
1. C is correct. The sum of the real risk-free interest rate and the inflation premium is the nominal
risk-free rate.
(LOS a and b)
2. C is correct. US Treasury bonds are highly liquid, whereas the bonds of small issuers trade
infrequently and the interest rate includes a liquidity premium. This liquidity premium reflects the
relatively high costs (including the impact on price) of selling a position.
(LOS a and b)
3. C is correct. An opportunity cost is a value that investors forgo by choosing a particular course of
action.
A is incorrect because a sunk cost is one that has already been incurred and therefore cannot be
changed.
B is incorrect because the required return is the minimum rate of return an investor must receive
in order to accept the investment.
(LOS a)
4. B is correct. The required rate of return is the minimum rate of return an investor must receive in
order to accept an investment.
Page 10 of 18
A is incorrect because the required rate of return is the minimum rate of return an investor must
receive in order to accept an investment. The internal rate of return is the discount rate that makes
net present value equal to zero
C is incorrect because the required rate of return is the minimum rate of return an investor must
receive in order to accept an investment. The expected return is based on the expected value of
a random variable and is not the minimum rate of return an investor must receive in order to
accept an investment (i.e., the expected return could also be negative).
(LOS a)
5. B is correct. The market-determined interest rate is equal to the real risk-free rate of return plus
an inflation premium plus risk premiums for default risk, liquidity, and maturity. In this case, 12 =
3 + 5 + X. Solving for X: X = 4.
(LOS b)
6. C is correct.
FV = PV x [1 + ]
.
or FV = 75,000 x [1 + ] = 113,733
Using BA II plus calculator

2nd CLR TVM
75,000 PV, 7/4 I/Y, 6x4 N
CPT FV → -113,733
(LOS d)
7. A is correct.
Effective interest rate (EIR) = [1 + ] –1
According to question
.
0.0408 = [1 + ] –1
.
or, [1 + ] = 1.0408
We have to find m using trial and error method

Options given in the question are:
A. m = 365 i.e., daily compounding
B. m = 4 i.e., quarterly compounding
C. m = 2 i.e., semi-annual compounding
Always try with options given in the middle, i.e., m = 4.
If m = 4,
.
[1 + ] = 1.0406 ≠ 1.0408
i.e., 1.0406 < 1.0408
Page 11 of 18
i.e., we should increase m
i.e., correct solution is m = 365
If m = 365,
.
[1 + ] = 1.0408
Hence, correct solution is m = 365 (daily)

(LOS c and d)
8. B is correct.
Daily compounding
FV = PV x [1 + ]
.
FV = 1,000,000 x [1 + ] = 1,127,491
Continuous compounding
FV = PV x e ∗
FV = 1,000,000 x e . ∗
[Note: How to solve e . ∗
: press 0.03 x 4 = 0.12, 2nd LN, 1.127497]
FV = 1,127,497
Difference between two is 1,127,497 – 1,127,491 = 6

(LOS c and d)
9. C is correct.
.
Effective interest rate (EIR) = [1 + ] – 1 = [1 + ] – 1 = 0.094162, rounded to 9.42%.
(LOS c)
10. C is correct.
FV = PV x e ∗
FV = 2,000 x e . ∗
[Note: How to solve e . ∗
: press 0.06 x 4 = 0.24, 2nd LN, 1.27124915]
FV = 2,542.50
(LOS d and LOS e)
11. A is correct.
.
Effective interest rate (EIR) = [1 + ] – 1 = [1 + ] – 1 = 0.13522, rounded to 13.52%.
(LOS c)
Page 12 of 18
12. B is correct.
Alternative I:
Year Cash Flow FVIF@4% FV
1 4,000 [1 +
.
] = 1.126 4,506
2 8,000 [1 +
.
] = 1.08243 8,659
3 7,000 [1 +
.
] = 1.0404 7,283
4 10,000 [1 +
.
] =1 10,000
Total 30,447
Alternative II:
CF 2nd CLR WORK
Display over calculator CF press 0 Enter ↓
C01 4,000 Enter ↓↓
C02 8,000 Enter ↓↓
C03 7,000 Enter ↓↓
C04 10,000 Enter
Press NPV → I → 4.04 (refer note 1) Enter ↓
NPV CPT → 25,986.14
Now FV of 25,986.14 after 4 years = 25,986.14 x (1.0404)4 = 30,447
Note 1: The interest rate given in the question is compounded semi-annually and the cash flows
are annual. The stated rate cannot be applied to the cash flows directly; hence we will convert the
stated rate of 4% p.a. (compounded semi-annual) to effective rate (annual) and apply the same to
given annual cash flows.
In this question, the stated rate is 4% p.a. compounded semi-annually, which translates into EIR
0.04 2
of (1+ ) -1 = 0.0404, or, EIR = 4.04% p.a.
2
(LOS e and f)
13. B is correct.
Alternative I:
1 100,000 [1+0.03]9= 1.30477 130,477
2 150,000 [1+0.03] = 1.26677 190,015
3 200,000 [1+0.03] = 1.22987 245,974
Total 566,467
Alternative II:
CF 2nd CLR WORK
C01 100,000 Enter ↓↓
C02 150,000 Enter ↓↓
C03 200,000 Enter
Page 13 of 18
Press NPV → I → 3 Enter ↓

NPV CPT → 421,505
Now FV of 421,505 after 10 years = 421,505 x (1.03)10 = 566,467

(LOS e)
14. B is correct.
2nd CLR TVM
50,000 FV, 4 I/Y, 15 N
CPT PV → -27,763
(LOS e and f)
15. B is correct.
FV = PV x 1 +
It is given in the question that it’s a weekly compounding
.
100,000 = PV x [1 + ]
or, PV = 97,532

2nd CLR TVM
100,000 FV, 2.50/52 I/Y, 1x52 N
CPT PV → -97,532
(LOS d)
16. B is correct.
2nd CLR TVM
300 PMT, 4 I/Y, 5 N
CPT PV → -1,335
PV of $1,335 is of an ordinary annuity; however, in our case, it is an annuity due.
PV of Annuity due = PV of ordinary annuity x (1+r) = 1,335 X (1.04) = 1,389

(LOS e and f)
17. B is correct.
The PV of a 10-year annuity due is simply the PV of the ordinary annuity multiplied by 1.05:
PV = $15,443.47 × 1.05
PV = $16,215.64.
(LOS e and f)
Page 14 of 18
18. B is correct.
2nd CLR TVM
50,000 PMT, 6 I/Y, 4 N
CPT PV → -173,255
This PV of $173,255 is at the end of year 17.
,
PV at time 0 = = = 64,341
( ) ( . )
(LOS e and f)
19. B is correct.
Year Cash Flow PVF@12% PV
1 100,000 0.8928 89,285
2 150,000 0.79719 119,579
5 (10,000) 0.5674 (5,674)
Total 203,190

CF 2nd CLR WORK
C01 100,000 Enter ↓↓
C02 150,000 Enter ↓↓
C03 0 Enter ↓↓
C04 0 Enter ↓↓
C05 -10,000 Enter [Note: cash flow in year 5 is negative 10,000 use +/- sign in calculator]
Press NPV → I → 12 Enter ↓
NPV CPT → 203,190
(LOS e and f)
20. B is correct.
A perpetual preferred stock will make perpetual payment of $2 every quarter starting from 5 th
quarter.
PV at the end of 4th quarter = ( )

= . = .
= 133.33
( )
.
𝑃𝑉 = = . = 125.62
( ) ( )
(LOS e)
21. C is correct.
PV of equal CF till infinity = ( )
= . = 400,000
( )
Note: Discount rate should match CF frequency. CFs given in the question are monthly; hence, the
discount rate should also be monthly.
Page 15 of 18
(LOS e)
22. A is correct.
FV = PV x 1 +
.
1,000,000 = 250,000 x 1 +

2nd CLR TVM
-1,000,000 FV, 250,000 PV, 3/365 I/Y
CPT N → 16867.27 days
, .
Time in years = = 46.21 years
Time in months = 46.21 X 12 = 555 months

(LOS e)
23. C is correct.
Investment of €500,000 today grows to €800,000 in 6 year
To be solved using trial and error

Option A: 7.5% compounding continuous
FV = PV x e ∗
or, FV = 500,000 x e .
= 784,156
Option B: 7.7% compounding daily

FV = PV x [1 + ]
.
or, FV = 500,000 x [1 + ] = 793,583
Option C: 8% compounding semi-annually

FV = PV x [1 + ]
.
or, FV = 500,000 x [1 + ] = 800,516
(LOS e)
24. B is correct.
2nd CLR TVM
200,000 PV, 6/12 I/Y, 5*12 N
CPT PMT → -3,867
(LOS e and f)
Page 16 of 18
25. A is correct.
2nd CLR TVM
25,000 FV, 6/4 I/Y, 10*4 N
CPT PMT → -461
(LOS e and f)
26. A is correct.
Option A: 30-year fixed-rate loan
2nd CLR TVM
1,000,000 PV, 5/12 I/Y, 30x12 N
CPT PMT → -5,368
Monthly instalment in option A = 5,368
Option B: 20-year fixed-rate loan

2nd CLR TVM
1,000,000 PV, 4.385/12 I/Y, 20x12 N
CPT PMT → -6,264
Monthly instalment in option B = 6,264
Option C: 30-year adjustable-rate mortgage

2nd CLR TVM
1,000,000 PV, 3.750/12 I/Y, 30x12 N
CPT PMT → -4,631
Monthly instalment in option C = 4,631
However, the rate of loan changes at the end of year 3.
Loan value outstanding at the end of year 3

2nd CLR TVM
4,631 PMT, 3.750/12 I/Y, 27x12 N
CPT PV → -942,705
Loan outstanding at the end of year 3 = 942,705
Now interest rate changes to 5.5%, revised instalment would be:

2nd CLR TVM
942,705 PV, 5.5/12 I/Y, 27x12 N
CPT PMT → -5,591
Revised monthly instalment in option C = 5,591
Conclusion:
Monthly instalment in option A = 5,368
Monthly instalment in option B = 6,264
Revised monthly instalment in option C = 5,591
Post rate change, 30-year fixed-rate loan has the smallest EMI. (LOS d, e and f).
Page 17 of 18
27. B is correct.
Alternative I
Future value of the received cash flow would be:
1 700 [1 +
.
] = 1.06178 743
2 700 [1 +
.
] = 1.0408 728
3 700 [1 +
.
] = 1.02018 714
4 700 + 20,000 [1 +
.
] =1 20,700
Total 22,890
Alternative II
CF 2nd CLR WORK
C01 700 Enter ↓↓
C02 700 Enter ↓↓
C03 700 Enter ↓↓
C04 20,700 Enter
Press NPV → I → 2.0184356 (refer note 1) Enter ↓
NPV CPT → 21,127
Now FV of 21,127 after 4 years = 21,127 x (1.020184356)4 = 22,890
Note 1: The interest rate given in the question is compounded monthly and the cash flows are
annual. The stated rate cannot be applied to the cash flows directly; hence we will convert the
stated rate of 2% p.a. (compounded monthly) to effective rate (annual) and apply the same to
given annual cash flows.
In this question, the stated rate is 2% p.a. compounded monthly, which translates into EIR of
0.02 12
(1+ 12
) -1 = 0.020184356, or, EIR = 2.0184356% p.a.
(LOS e and f)
Page 18 of 18

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Reading: The Time Value of Money

Learning Outcome (LOS) 1: Introduction

Let us assume the following two options:

Receive $10,000 today. Receive $10,000 after one year.

Option 1 Let’s say ROI = 10% p.a. Option 2

Receive $10,000 today Receive $11,000 after one year

Process of calculating future Process of finding present

The process of finding FV with the help of

Present Value Future Value

The process of finding PV with the help of

Simple interest (SI): Calculated as a simple % of the original principal amount.

Annual Compounding Intra-year Compounding

Here compounding is done When compounding is done

LOS 3: Effective Rate of Interest (EIR)

LOS 4: Present Value (PV) of a single cash flow

PVIF (Present value interest factor)

LOS 5: PV of multiple unequal cash flows

LOS 7: PV of equal cash flows up to perpetuity

LOS 8: PV of perpetual growing cash flows

LOS 10: Compute FV of unequal CFs.

LOS 11: Interest rate

LOS 12: Continuous compounding

In case of continuous compounding, FV = PV x 𝑒 ∗

I. Future Value (FV) = PV * (1 + ) ∗

II. Effective Annual Rate (EAR) = (1 + ) - 1, where m = no. of times compounding

III. Present Value (PV) = P0 = FV x

IV. PV of equal CF up to perpetuity =

V. PV of perpetual growing cash flows =

VIII. In case of continuous compounding, FV = PV x e ∗

Learning Outcome as per CFA Institute:

5. Assume the following:

Using BA II plus calculator

We have to find m using trial and error method

Always try with options given in the middle, i.e., m = 4.

i.e., 1.0406 < 1.0408

i.e., we should increase m

i.e., correct solution is m = 365

Hence, correct solution is m = 365 (daily)

Difference between two is 1,127,497 – 1,127,491 = 6

Now FV of 25,986.14 after 4 years = 25,986.14 x (1.0404)4 = 30,447

Press NPV → I → 3 Enter ↓

Now FV of 421,505 after 10 years = 421,505 x (1.03)10 = 566,467

It is given in the question that it’s a weekly compounding

Using BA II plus calculator

PV of $1,335 is of an ordinary annuity; however, in our case, it is an annuity due.

PV of Annuity due = PV of ordinary annuity x (1+r) = 1,335 X (1.04) = 1,389

This PV of $173,255 is at the end of year 17.

Using BA II plus calculator

PV at the end of 4th quarter = ( )

Using BA II plus calculator

Time in months = 46.21 X 12 = 555 months

Investment of €500,000 today grows to €800,000 in 6 year

To be solved using trial and error

Option B: 7.7% compounding daily

Option C: 8% compounding semi-annually

Option B: 20-year fixed-rate loan

Option C: 30-year adjustable-rate mortgage

Loan value outstanding at the end of year 3

Now interest rate changes to 5.5%, revised instalment would be: