Time Value

Of
Money
 Time preference for money is an individual’s
preference for possession of a given amount
of money now, rather than the same amount
at some future time.
Reasons:
◦ Risk
◦ Preference for consumption
◦ Investment opportunities
 Minimum rate of return which should be earn
on an investment

Required Rate Of Return= Risk Free Rate

+ Risk Premium
 Compounding:
It is the process of calculating future values
of cash flows.

 Discounting:
It is the process of calculating present values
of cash flows.
Future Value
 Compounding is the process of finding the

future values of cash flows by applying the

concept of compound interest.
FV = PV (1 + i)n

Future Value of Annuity

 Annuity is a fixed payment or receipt each
year for a specified number of years
FVn = P [((1 + i)n - 1) / i]
Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

0 1 2 3 4 5

10%
$10,000
FV5
 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10) 5

= $16,105.10
 Calculation based on Table I:

FV5 = $10,000 (FVIF10%, 5)

= $10,000 (1.611)
= $16,110
Present value is a future cash flow (inflow or
outflow) is the amount of current cash that is
of equivalent value of the decision maker.

 Discounting is the process of determining

present value of a series of future cash flows.

 The interest rate used for discounting cash

flows is also called the discount rate.
Present Value of Single Cash Flow:

PV = FV/(1 + r)n

Present Value of Annuity:

PVoa = Fn[(1 - (1 / (1 + i)n)) / i]

Assume that you need $1,000 in 2 years.
Let’s examine the process to determine how
much you need to deposit today at a
discount rate of 7% compounded annually.

0 1 2
7%

$1,000
PV0 PV1
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 =
FV2 / (1+i)2 = $873.44

0 1 2
7%

$1,000
PV0
 PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2

etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
PVIFi,n is found on Table II
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant
periods.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
 Annuity Due:
Due Payments or receipts
occur at the beginning of each period.
 Student Loan Payments
 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
Equal Cash Flows
Each 1 Period Apart
 (Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
 Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn

... + R(1+i)1 + R(1+i)0
 Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 =
= $1,145 + $1,070 + $1,000 FVA3
= $3,215
The future value of an ordinary
annuity can be viewed as
occurring at the end of the
last cash flow period, whereas
the future value of an annuity
due can be viewed as
occurring at the beginning of
the last cash flow period.
FVAn = R (FVIFAi%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215) =$3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867