Time Value of Money

Time Value of Money
Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker
5-1
Chapter Organisation
5.1
5.2
5.3
5.4
5.5
Future value and compounding

Present value and discounting
More on present and future values
Present and future values of multiple cash flows
Valuing equal cash flows: annuities and
perpetuities
5.6 Comparing rates: the effect of compounding
periods
5.7 Loan types and loan amortisation
Summary and conclusions

5-2
Chapter Objectives
Understand how to determine the future value of an investment

made today.
Understand how to determine the present value of cash to be
received at a future date.
Understand how to find the return on an investment.
Understand how long it takes for an investment to reach a desired
value.
Understand how to determine the future and present value of
investments with multiple cash flows.
Understand how loan payments are calculated, and how to find the
interest rate on a loan.
Understand how loans are amortised or paid off.
Understand how interest rates are quoted (and misquoted).

5-3
The Interest Rate

Which would you prefer -- $10,000
today orObviously,
$10,000
in
5
years?
$10,000 today.
today
You already recognize that there is TIME VALUE TO MONEY!!
MONEY
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
Why TIME?
Why is TIME such an important element in
your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
Types of Interest
Simple Interest
Interest paid (earned) on only the original amount, or principal,
borrowed (lent).
Compound Interest
Interest paid (earned) on any previous interest earned, as well as
on the principal borrowed (lent).
Time Value Terminology

Future value (FV) is the amount an investment
is worth after one or more periods.
Present value (PV) is the amount that
corresponds to todays value of a promised
future sum.
The number of time periods between the
present value and the future value is
represented by t.
The rate of interest for discounting or
compounding is called r.

5-7
Time Value Terminology

Compounding is the process of accumulating
interest in an investment over time, to earn more
interest.
Interest on interest is earned on the reinvestment
of previous interest payments.
Discount rate is the interest rate that reduces a
given future value to an equivalent present value.

5-8
Simple Interest Formula
Formula
SI = P0(r)(t)
SI: Simple Interest

P0: Deposit today (t=0)
r: Interest Rate per Period
t: Number of Time Periods
.
Simple Interest Example

Assume that you deposit $100 in an
account earning 10% simple interest
for 5 years. What is the accumulated
interest at the end of the 5th year?
SI
= P0(r)(t )
= $100(.10)(5)
= $50
Simple Interest Example

What is the Future Value (FV)
FV of the
deposit?
FV
= P0 + SI
= $100 + $50
= $150
Future Value with compounding

You invest $100 in a savings account that earns 10
per cent interest per annum (compounded) for five
years.
After one year: $100 (1 + 0.10) = $110
After two years: $110 (1 + 0.10) = $121
After three years: $121 (1 + 0.10) = $133.10
After four years: $133.10 (1 + 0.10) =
$146.41
After five years: $146.41 (1 + 0.10) =
$161.05
.

5 - 12
Simple Vs Compound Interest
Future Values of $100 at 10%

5 - 14
Future Value with Compounding

The accumulated value of this investment at the
end of five years can be split into two
components:
original principal
$100.00
interest earned
$61.05
Using simple interest, the total interest earned
would only have been $50. The other $11.05 is
from compounding.

5 - 15
Future Value
In general, the future value, FV t, of $1 invested
today at r per cent for t periods is:
FVt $1 1 r
The expression (1 + r)t is the future value

interest factor (FVIF).
You can also refer to Future Value table for
calculating the future values.

5 - 16
ExampleFuture Value
What will $1000 amount to in five years time if interest is 6 per cent per annum, compounded
annually?
From the example, now assume interest is 6 per cent per annum, compounded monthly.
Always remember that t is the number of compounding periods, not 5the number of years.
FV $1 000 1 0.06
$1 000 1.3382
$1 338.22
FV $1 000 1 0.005
$1 000 1.3489
$1 348.90

60
5 - 17
Future Value of $1 for Different

Periods and Rates

5 - 18
Present Value
You need $1000 in five years time. If you can earn10
per cent per annum, how much do you need to invest
now?
Discount one year: $1000 (1 + 0.10) 1 =
$909.09
Discount two years: $909.09 (1 + 0.10) 1
=
$826.45
Discount three years:
$826.45 (1 + 0.10) 1
=
$751.32
Discount four years: $751.32 (1 + 0.10) 1
=
$683.02
Discount five years: $683.02 (1 + 0.10) 1
=
$620.93

5 - 19
Present Value
In general, the present value of $1 received in t
periods of time, earning r per cent interest is:
PV $1 1 r
$1
t
1 r
The expression (1 + r)t is the present value

interest factor (PVIF).
You can also refer to Present Value table for
calculating the present values.
.

5 - 20
ExamplePresent Value
Your rich uncle promises to give you $100,000 in
10 years time. If interest rates are 6 per cent per
annum, how much is that gift worth today?
PV $100 000 1 0.06
$100 000 0.5584
$55 840

10
5 - 21
Present Value of $1 for Different

Periods and Rates

5 - 22
Determining the Discount Rate

You currently have $100 available for investment
for a 21-year period. At what interest rate must
you invest this amount in order for it to be worth
$500 at maturity?
r can be solved in one of two ways:
Take the nth root of both sides of the equation
Use the future value tables to find a corresponding
value. In this example, you need to find the r for
which the FVIF after 21 years is 5 (500/100).

5 - 23
Future Value of Multiple Cash Flows

You deposit $1 000 now, $1 500 in one more
year, $2 000 in two years and $2 500 in three
years in an account paying 10 per cent interest
per annum. How much do you have in the
account at the end of the third year?
You can solve by either:
compounding the accumulated balance
forward one year at a time
calculating the future value of each cash
flow first, and then totaling them.

5 - 24
Solutions
Solution 1
End of year 1:
End of year 2:
End of year 3:
($1 000 1.10) + $1 500 =

($2 600 1.10) + $2 000 =
($4 860 1.10) + $2 500 =
$2 600
$4 860
$7 846
Solution 2
$1 000 (1.10)3
$1 500 (1.10)2
$2 000 (1.10)1
$2 500 1.00
Total
=
=
=
=
=
$1 331
$1 815
$2 200
$2 500
$7 846

5 - 25
Solutions on Time Lines

Future value calculated by compounding forward one period at a
time
0
3
Time
(years)
$0
$1100
1000
1500
$1000
x 1.1
$2860
x 1.1
$2600
2000
$4860
$5346
x 1.1
2500
$7846
Future value calculated by compounding each cash flow

separately
0
3
Time
(years)
$1000
$1500
$2000
x 1.1
x 1.1
x 1.1
2200
1815
1331
Total future value
$2500
$7846

5 - 26
Present Value of Multiple Cash Flows

You will deposit $1 500 in one years time from
now, $2 000 in two years time and $2 500 in
three years time, in an account paying 10 per
cent interest per annum. What is the present
value of these cash flows?
You can solve by either:
discounting back one year at a time
calculating the present value of each cash
flow first, and then totaling them.

5 - 28
Solutions
Solution 1
End of year 2:
End of year 1:
Present value:
($2500 1.101) + $2000=

($4273 1.101) + $1500=
($5385 1.101) + $1000=
$4273
$5385
$5895
Solution 2
$2500 (1.10) 3
$2000 (1.10) 2
$1500 (1.10) 1
$1000 (1.0)
Total
=
=
=
=
=
$1878
$1653
$1364
$1000
$5895

5 - 29
Annuities
An ordinary annuity is a series of equal cash
flows that occur at the end of each period for
some fixed number of periods.
Examples include consumer loans and home
mortgages.

5 - 30
Future Value of an Annuity
1 r 1
FVA C
t
C = equal cash flow
The compounding term is called the future

value interest factor for annuities (FVIFA).
You can also refer to Future Value Annuity
table for calculating the future value of annuity.

5 - 31
ExampleFuture Value of an
Annuity
What is the future value of $1 000 deposited at
the end of every year for 20 years if the interest
rate is 6 per cent per annum?
(1.06)
FVA $1 000
20
0.06
$1 000 36.7856
$36 785.60
.

5 - 32
Present Value of an Annuity
1 1/ 1 r t
PVA C
C = equal cash flow

The discounting term is called the present
value interest factor for annuities (PVIFA).
You can also refer to Present Value Annuity
table for calculating the present value of
annuity
.

5 - 33
Example 1
You will receive $1 000 at the end of each of
the next ten years. The current interest
rate is 6 per cent per annum. What is the
present value of this series of cash flows?
1 1/ 1.06 10
PVA $1 000
0.06
$1 000 7.3601
$7 360.10

5 - 34
Example 2
You borrow $10 000 to buy a car and
agree to repay the loan by way of equal
monthly repayments over four years. The
current interest rate is 12 per cent per
annum, compounded monthly. What is the
amount of each monthly repayment?
1 1/ 1.01 48
$10 000 C
0.01
C $10 000 37.97

$263.33

5 - 35
Perpetuities
The future value of a perpetuity cannot be calculated, as the cash flows are infinite.
The present value of a perpetuity is calculated as follows:
where C is cash flow

and r is rate.
C
PV
r

5 - 36
Comparing Rates
The quoted or stated interest rate is the
interest rate expressed in terms of the
interest payment made each year.
The effective annual interest rate (EAR) is
the interest rate expressed as if it was
compounded once per year.
When interest is compounded more
frequently than annually, the EAR will be
greater than the quoted interest rate.
.

5 - 37
Calculation of EAR
Quoted Rate
EAR 1
m = number of times the interest is compounded

5 - 38
Comparing EARS
Consider the following interest rates quoted by three banks:
Bank A: 8.3%, compounded daily
Bank B: 8.4%, compounded quarterly
Bank C: 8.5%, compounded annually

5 - 39
Comparing EARS
EAR Bank A
0.083
1
365
0.084
EAR Bank B 1
4
EAR Bank C
365
1 8.65%
1 8.67%
0.085
1
1 8.50%

5 - 40
Comparing EARS
Which is the best rate? For a saver, Bank B
offers the best (highest) interest rate. For a
borrower, Banks A and C offer the best (lowest)
interest rates.
The highest quoted interest rate is not
necessarily the best.
Compounding during the year can lead to a
significant difference between the quoted
interest rate and the EAR, especially for higher
rates.
.

5 - 41
Annual Percentage Rate (APR)

The interest rate charged per period
multiplied by the number of periods
per year.
APR
EAR 1
m = number of times the interest is compounded
Types of Loans
An interest-only loan requires the borrower to
only pay interest each period, and to repay
the entire principal at some point in the
future.
An amortised loan requires the borrower to
repay parts of both the principal and interest
over time.

5 - 43
Amortisation of a Loan

5 - 44
Quick Quiz Part I

What is the difference between simple interest and
compound interest?
Suppose you have $500 to invest and you believe that
you can earn 8% per year over the next 15 years.
How much would you have at the end of 15 years
using compound interest?
How much would you have using simple interest?

5 - 45
Quick Quiz Part II

What is the relationship between present
value and future value?
Suppose you need $15 000 in 3 years. If you
can earn 6% annually, how much do you
need to invest today?
If you could invest the money at 8%, would
you have to invest more or less than at 6%?
How much?

5 - 46
Quick Quiz Part III

What are some situations in which you might
want to know the implied interest rate?
You are offered the following investments:
You can invest $500 today and receive
$600 in 5 years. The investment is low
risk.
You can invest the $500 in a bank account
paying 4%.
What is the implied interest rate for the
first choice, and which investment should
you choose?
.

5 - 47
Quick Quiz Part IV

When might you want to compute the
number of periods?
Suppose you want to buy some new
furniture for your family room. You currently
have $500, and the furniture you want costs
$600. If you can earn 6%, how long will you
have to wait if you dont add any additional
money?

5 - 48
Comprehensive Problem
You have $10 000 to invest for five years.
How much additional interest will you earn if
the investment provides a 5% annual return,
when compared to a 4.5% annual return?
How long will it take your $10 000 to double
in value if it earns 5% annually?
What annual rate has been earned if $1 000
grows into $ 4 000 in 20 years?

5 - 49
Summary and Conclusions

For a given rate of return, the value at some point in the future of an investment
made today can be determined by calculating the future value of that investment.
The current worth of a future cash flow or series of cash flows can be determined for
a given rate of return by calculating the present value of the cash flow(s) involved.
It is possible to find any one of the four components
(PV, FV, r, t) given the other three.
A series of constant cash flows that arrive or are paid at the end of each period is
called an ordinary annuity.
For financial decisions, it is important that any rates are converted to effective rates
before being compared.

5 - 50

Time Value of Money

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Time Value of Money

Copyright 2011 McGraw-Hill Australia Pty Ltd

Future value and compounding

Copyright 2011 McGraw-Hill Australia Pty Ltd

Understand how to determine the future value of an investment

Copyright 2011 McGraw-Hill Australia Pty Ltd

The Interest Rate

Time Value Terminology

Copyright 2011 McGraw-Hill Australia Pty Ltd

Time Value Terminology

Copyright 2011 McGraw-Hill Australia Pty Ltd

Simple Interest Formula

SI: Simple Interest

Simple Interest Example

Simple Interest Example

Future Value with compounding

Copyright 2011 McGraw-Hill Australia Pty Ltd

Simple Vs Compound Interest

Future Values of $100 at 10%

Copyright 2011 McGraw-Hill Australia Pty Ltd

Future Value with Compounding

Copyright 2011 McGraw-Hill Australia Pty Ltd

The expression (1 + r)t is the future value

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

Future Value of $1 for Different

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

The expression (1 + r)t is the present value

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

Present Value of $1 for Different

Copyright 2011 McGraw-Hill Australia Pty Ltd

Determining the Discount Rate

Copyright 2011 McGraw-Hill Australia Pty Ltd

Future Value of Multiple Cash Flows

Copyright 2011 McGraw-Hill Australia Pty Ltd

($1 000 1.10) + $1 500 =

Copyright 2011 McGraw-Hill Australia Pty Ltd

Solutions on Time Lines

Future value calculated by compounding each cash flow

Total future value

Copyright 2011 McGraw-Hill Australia Pty Ltd

Present Value of Multiple Cash Flows

Copyright 2011 McGraw-Hill Australia Pty Ltd

($2500 1.101) + $2000=

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

Future Value of an Annuity

C = equal cash flow

The compounding term is called the future

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

Present Value of an Annuity

C = equal cash flow

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

C $10 000 37.97

Copyright 2011 McGraw-Hill Australia Pty Ltd

where C is cash flow

Copyright 2011 McGraw-Hill Australia Pty Ltd

Copyright 2011 McGraw-Hill Australia Pty Ltd

m = number of times the interest is compounded

Copyright 2011 McGraw-Hill Australia Pty Ltd