Chapter 4

Time Value of Money

Slide 4-1

Learning Goals
1. Discuss the role of time value in finance, the use of computational aids, and the basic patterns of cash flow. 2. Understand the concept of future value, their calculation for a single amount, and the relationship of present to future cash flow. 3. Find the future value and present value of both an ordinary annuity and an annuity due, and the present value of a perpetuity.

Slide 4-2

Learning Goals
4. Calculate the present value of a mixed stream of cash flows. 5. Understand the effect that compounding more frequently than annually has on future value and the effective annual interest rate. 6. Describe the procedures involved in (1) determining deposits to accumulate to a future sum, (2) loan amortization, (3) finding interest or growth rates, and (4) finding an unknown number of periods.

Slide 4-3

The Role of Time Value in Finance
• Most financial decisions involve costs & benefits that are spread out over time. • Time value of money allows comparison of cash flows from different periods. Question? Would it be better for a company to invest \$100,000 in a product that would return a total of \$200,000 after one year, or one that would return \$220,000 after two years?

Slide 4-4

The Role of Time Value in Finance • Most financial decisions involve costs & benefits that are spread out over time. Slide 4-5 . Inc. • Time value of money allows comparison of cash flows from different periods. Answer! It depends on the interest rate! Copyright © 2003 Pearson Education.

Inc.Basic Concepts • Future Value: compounding or growth over time • Present Value: discounting to today’s value • Single cash flows & series of cash flows can be considered • Time lines are used to illustrate these relationships Copyright © 2003 Pearson Education. Slide 4-6 .

Inc.Computational Aids • Use the Equations • Use the Financial Tables • Use Financial Calculators • Use Spreadsheets Copyright © 2003 Pearson Education. Slide 4-7 .

Slide 4-12 .Basic Patterns of Cash Flow • The cash inflows and outflows of a firm can be described by its general pattern. or a mixed stream: Copyright © 2003 Pearson Education. an annuity. • The three basic patterns include a single amount. Inc.

you don’t earn interest on interest. \$5 + \$100 = \$105 \$5 + \$105 = \$110 \$5 + \$110 = \$115 \$5 + \$115 = \$120 \$5 + \$120 = \$125 Slide 4-13 . Inc.Simple Interest With simple interest. • Year 1: 5% of \$100 = • Year 2: 5% of \$100 = • Year 3: 5% of \$100 = • Year 4: 5% of \$100 = • Year 5: 5% of \$100 = Copyright © 2003 Pearson Education.

a depositor earns interest on interest! • Year 1: 5% of \$100.63 Copyright © 2003 Pearson Education.55 = \$6.76 • Year 4: 5% of \$115.51+ \$110. Inc.00 = \$110. Slide 4-14 .25 + \$105.25 = \$5 .00 = \$5.00 + \$100.08 + \$121.25 = \$115.55 = \$127.00 = \$5.55 • Year 5: 5% of \$121.00 • Year 2: 5% of \$105.79 + \$115.25 • Year 3: 5% of \$110.00 = \$105.Compound Interest With compound interest.76 = \$121.76 = \$5.

Inc. • FVn = • n • A = = Slide 4-15 .Time Value Terms • PV0 = • k = present value or beginning amount interest rate future value at end of “n” periods number of compounding periods an annuity (series of equal payments or receipts) Copyright © 2003 Pearson Education.

Inc.[1/(1+k)n] = k Copyright © 2003 Pearson Education.n) • FVAn = A(PVIFAk. = = = PV(FVIFk.1 k • PVA0 = A 1 .n) FV(PVIFk.Four Basic Models • FVn • PV0 = = PV0(1+k)n FVn[1/(1+k)n] A (1+k)n .n) A(FVIFAk.n) Slide 4-16 .

Inc.40 Copyright © 2003 Pearson Education.3382 = \$2.676.000 x FVIF6%. How much will you have in 5 years? \$2.000 x 1.000 x (1. Slide 4-17 .06)5 = \$2.5 \$2.Future Value Example Algebraically and Using FVIF Tables You deposit \$2.000 today at 6% interest.

Inc.06.00% 5 \$2. .676 Excel Function =FV (interest. periods.Future Value Example Using Excel You deposit \$2.000 today at 6% interest. Slide 4-18 . How much will you have in 5 years? PV k n FV? \$ 2. pmt. 5. PV) =FV (.000 6. 2000) Copyright © 2003 Pearson Education.

Slide 4-19 . Inc.Future Value Example A Graphic View of Future Value Copyright © 2003 Pearson Education.

Copyright © 2003 Pearson Education. the effective rate of interest will increase the more frequently interest is compounded. • Furthermore. Inc. the effective interest rate is greater than the nominal (annual) interest rate.Compounding More Frequently than Annually • Compounding more frequently than once a year results in a higher effective interest rate because you are earning on interest on interest more frequently. Slide 4-20 . • As a result.

an (d) monthly? Annually: Semiannually: Quarterly: Monthly: Copyright © 2003 Pearson Education.61 \$181.09 \$180. (b) semiannually. (c) quarterly. Inc.03)20 = 100 x (1 + .23 \$179. what would be the difference in future value if I deposit \$100 for 5 years and earn 12% annual interest compounded (a) annually.06)10 = 100 x (1 + .67 Slide 4-21 . 100 x (1 + .Compounding More Frequently than Annually • For example.01)60 = \$176.12)5 = 100 x (1 + .

Inc.00 0.06 10 \$179.08 \$ 100.03 20 \$180.01 60 \$181.00 0.00 0.67 Copyright © 2003 Pearson Education.00 12.0% 5 \$176.61 Monthly \$ 100.23 Sem iAnnually Quarterly \$ 100.Compounding More Frequently than Annually On Excel Annually PV k n FV \$ 100. Slide 4-22 .

• Through the use of calculus. • Continuing with the previous example.7183. Slide 4-23 . Inc. find the Future value of the \$100 deposit after 5 years if interest is compounded continuously.Continuous Compounding • With continuous compounding the number of compounding periods per year approaches infinity. the equation thus becomes: FVn (continuous compounding) = PV x (ekxn) where “e” has a value of 2. Copyright © 2003 Pearson Education.

the equation thus becomes: FVn (continuous compounding) = PV x (ekxn) where “e” has a value of 2.7183. Inc.Continuous Compounding • With continuous compounding the number of compounding periods per year approaches infinity. Slide 4-24 .7183). • Through the use of calculus. FVn = 100 x (2.22 Copyright © 2003 Pearson Education.12x5 = \$182.

• In general. Inc. • The effective interest rate is the rate actually paid or earned.Nominal & Effective Rates • The nominal interest rate is the stated or contractual rate of interest charged by a lender or promised by a borrower. Slide 4-25 . the effective rate > nominal rate whenever compounding occurs more than once per year EAR = (1 + k/m) m -1 Copyright © 2003 Pearson Education.

what is the effective rate of interest on your credit card if the nominal rate is 18% per year. Slide 4-26 . Inc.56% Copyright © 2003 Pearson Education.18/12) 12 -1 EAR = 19. compounded monthly? EAR = (1 + .Nominal & Effective Rates • For example.

• The discount rate is often also referred to as the opportunity cost. Copyright © 2003 Pearson Education. • It is the amount today that must be invested at a given rate to reach a future amount. the required return. • Calculating present value is also known as discounting. • It is based on the idea that a dollar today is worth more than a dollar tomorrow. the discount rate. and the cost of capital. Inc. Slide 4-27 .Present Value • Present value is the current dollar value of a future amount of money.

Inc.06)5] = \$2.000 x PVIF6%.000 x 0.000 x [1/(1.74758 = \$1.000 in 5 years if you can earn 6% interest on your deposit? \$2.Present Value Example Algebraically and Using PVIF Tables How much must you deposit today in order to have \$2. Slide 4-28 .494.5 \$2.52 Copyright © 2003 Pearson Education.

000 6. FV) =PV (. Slide 4-29 . 5.495 Excel Function =PV (interest. pmt.000 in 5 years if you can earn 6% interest on your deposit? FV k n PV? \$ 2. 2000) Copyright © 2003 Pearson Education. Inc.Present Value Example Using Excel How much must you deposit today in order to have \$2.06. periods.00% 5 \$1. .

Inc. Slide 4-30 .Present Value Example A Graphic View of Present Value Copyright © 2003 Pearson Education.

Copyright © 2003 Pearson Education. • An ordinary (deferred) annuity has cash flows that occur at the end of each period.• Annuities are equally-spaced cash flows of equal size. • An annuity due has cash flows that occur at the beginning of each period. • Annuities can be either inflows or outflows. Inc. Annuities Slide 4-31 . • An annuity due will always be greater than an otherwise equivalent ordinary annuity because interest will compound for an additional period.

00 \$205.05 = \$10.25 + \$205 + \$100 = .3) = \$315.00 + \$100 + \$100 Copyright © 2003 Pearson Education.25 Slide 4-33 Year 3 \$205 x .Future Value of an Ordinary Annuity Using the FVIFA Tables • Annuity = Equal Annual Series of Cash Flows • Example: How much will your deposits grow to if you deposit \$100 at the end of each year at 5% interest for three years. Inc.05 = \$5. FVA = 100(FVIFA.5%.25 Year 1 \$100 deposited at end of year Year 2 \$100 x . = = \$100.00 \$315.

Inc. PMT k n FV? \$ 100 5.0% 3 \$ 315. PV) =FV (. pmt.100.25 Excel Function =FV (interest. periods. 5.06.Future Value of an Ordinary Annuity Using Excel • Annuity = Equal Annual Series of Cash Flows • Example: How much will your deposits grow to if you deposit \$100 at the end of each year at 5% interest for three years. . ) Slide 4-34 Copyright © 2003 Pearson Education.

FVA = 100(FVIFA.96 FVA = 100(3.5%. Inc. Slide 4-35 .Future Value of an Annuity Due Using the FVIFA Tables • Annuity = Equal Annual Series of Cash Flows • Example: How much will your deposits grow to if you deposit \$100 at the beginning of each year at 5% interest for three years.152)(1.3)(1+k) = \$330.05) = \$330.96 Copyright © 2003 Pearson Education.

Excel Function =FV (interest. PMT \$ 100.25 FVA? \$ 331. Inc.100.25*(1.Future Value of an Annuity Due Using Excel • Annuity = Equal Annual Series of Cash Flows • Example: How much will your deposits grow to if you deposit \$100 at the beginning of each year at 5% interest for three years.00% n 3 FV \$315. pmt. periods. ) =315.05) Slide 4-36 .06.01 Copyright © 2003 Pearson Education. PV) =FV (. 5.00 k 5.

70 Copyright © 2003 Pearson Education. Inc. Slide 4-37 .10%.Present Value of an Ordinary Annuity Using PVIFA Tables • Annuity = Equal Annual Series of Cash Flows • Example: How much could you borrow if you could afford annual payments of \$2.000 (which includes both principal and interest) at the end of each year for three years at 10% interest? PVA = 2.3) = \$4.973.000(PVIFA.

0% 3 \$4. periods.10.000 (which includes both principal and interest) at the end of each year for three years at 10% interest? PMT I n PV? \$ 2.000 10. Inc. .973. pmt. 3.Present Value of an Ordinary Annuity Using Excel • Annuity = Equal Annual Series of Cash Flows • Example: How much could you borrow if you could afford annual payments of \$2. 2000. ) Slide 4-38 Copyright © 2003 Pearson Education. FV) =PV (.70 Excel Function =PV (interest.

80 \$ 673.Present Value of a Mixed Stream Using Tables • A mixed stream of cash flows reflects no particular pattern • Find the present value of the following mixed stream assuming a required return of 9%.842 0.60 Slide 4-39 400 800 500 400 300 . Inc.917 0. Year Cash Flow 1 2 3 4 5 Copyright © 2003 Pearson Education.904.00 \$ 283.00 \$1.20 \$ 195.N 0. PVIF9%.60 \$ 386.772 0.708 0.650 PV PV \$ 366.

09. .904. cells containing CFs) =NPV (.B3:B7) Slide 4-40 Copyright © 2003 Pearson Education.76 Excel Function =NPV (interest. Inc.Present Value of a Mixed Stream Using EXCEL • A mixed stream of cash flows reflects no particular pattern • Find the present value of the following mixed stream assuming a required return of 9%. Year Cash Flow 1 2 3 4 5 NPV 400 800 500 400 300 \$1.

Inc.Present Value of a Perpetuity • A perpetuity is a special kind of annuity. the periodic annuity or cash flow stream continues forever. PV = Annuity/k • For example.500 Copyright © 2003 Pearson Education. how much would I have to deposit today in order to withdraw \$1. • With a perpetuity.000 each year forever if I can earn 8% on my deposit? PV = \$1.08 = \$12. Slide 4-41 .000/.