The Time Value of Money

‘A Pound today is more valuable than a Pound tomorrow’

Why?
 What is covered?

 The interest rates & Expected Inflation

 The future value of a lump sum
 The present value of a Lump sum
 The future value of an annuity
 The present value of an annuity
 The present value of uneven cash flows

The Time Value of Money 2

 Nominal vs. Real Interests
The Fisher hypothesis suggests that nominal rate of interest
comprises of real rate of interest and expected inflation rate. It
could be defined as:

R  1  r 1  E (i )   1

Where:
R = nominal rate of interest
r = real rate of interest
E(i) = expected inflation rate

The Time Value of Money 3

 Nominal vs. Real Interest
Example:
If the real rate of interest is 10% pa and expected inflation is
5%pa what should be the market rate of interest?

Solution:
Recall: R = [(1+r)(1+E(i))] – 1
R = (1.10)*(1.05) -1
R = 0.155
The nominal (or market) rate of interest should about be 15.5%

The Time Value of Money 4

 Simple vs. Compound Interests
Simple interest is paid (or received) on the principal amount.

Example:
Mr Booth borrows £100,000 from Ms Smith at 10% interest per
annum. Estimate the interest that Mr Booth should pay to Ms
Smith every year until the loan is repaid.

Solution:
Annual interest = Principal * interest rate
Annual interest = £100,000 * 0.10 = £10,000.
Ms Smith receives £10,000 from Mr Booth ever year.
The Time Value of Money 5
 Simple vs. Compound Interests
Compound Interest is paid on the principal as well as on the
interest earned but not withdrawn.
Example:
Today Miss Smith is depositing £100,000 in a bank that pays a rate
of interest of 10% per annum. She plans to withdraw the sum
(interest plus principal) in two years. How much she will receive?

Solution:
At the end of the first year Miss Smith earns £10,000 on interest. It
is reinvested and hence in year 2 total amount invested becomes
£110,000. Miss Smith earns 10% interest on £110,000. Hence, the
interest earned in year 2 is £11,000. Therefore, she receives
£121,000 at the end of year 2.
The Time Value of Money 6
 Future value of a lump sum
Consider the following:
If Mr Harris deposits £10,000 in a bank account that earns 10%
interest how much he will get in 5 years assuming that interest
earned are reinvested in the same account?

Define/summarise:
 Present value (P0) = £10,000
 Rate of interest (R) = 10% per annum
 Number of years (N) = 5 years
 Future value (FV) =?

The Time Value of Money 7

 Future value of a lump sum
Solution:
 Estimating future value is compounding.
 The future value of a lump sum is given by:
FVN  ( PV0 ) * (1  R ) N
Therefore:
FV = £10,000 * (1.10)5
FV = £10,000* (1.6105)
FV = £16,105.0
Mr Harrison will receive £16,105.0 in 5 years.

The Time Value of Money 8

 Future value of a lump sum
Additional Example:
 Mr Jackson is receiving 10% annual interest on his £20,000
savings. He is reinvesting the interest every year on the same
account. How much Mr Jackson will have in 10 years?

 Solution:
Recall: FVN  ( PV0 )(1  R) N
FV10 = £20,000 * (1.10)10
£20,000 * (2.5937) = £51,874

Note: 2.5937 is also available from table (FVA10%,10).

The Time Value of Money 9

 Present value of a lump sum
 Present value is the current worth of a future sum or cash-
flows. The process of estimating present value is known as
discounting. It is the reverse of compounding.

Recall: FV N  ( PV0 )(1  R ) N

Reorganise the equation to solve for PV0 we get:

FVN 1
PV0  or FVN *
1  R  1  R 
N N

 Consider that you wish to receive £16,105 in 5 years time to

buy a car. How much you need to deposit now in an account
that gives you 10% interest per annum?

The Time Value of Money 10

 Present value of a lump sum
Solution
FVN
Recall from previous page: PV0 
1  R 
N

We have FV, R and N and need to find the value of PV0.

£16,105 £16,105
PV0    £10, 000
1  0.10 
5
1.6105

1 1
Alternatively, the value of 1  R  N i.e.  0.6209
1  0.10 
5

can be found at present value table.

Then: PV = FV0 * (PVR,N) = £16,105 * 0.6209 = £10,000.

The Time Value of Money 11
 Future value of an annuity
Future value of an ordinary annuity:
Mr Gregory is receiving £600 at the END of each year and investing
it at 10%. How much will he have at the end of year 4?

Solution: N 1

 Future value (FV) of an Annuity (A) = FVN  A 1  R  

T

T 0
 It could be simplified to:
 1  R  N  1  This could be
FV  A   found in FV table
 R 
 1  0.10 4  1 
FV  £600    £600* 4.6410  £2784.60
 0.10 
 Mr Gregory will have £2,784.60 at the end of year 4.
The Time Value of Money 12
 Present value of an annuity
Present value of an ordinary annuity:
 A financial instrument is offering you £6,000 per year at the end
of the year for 4 years. If you expect 10% pa return on your
investments what is the maximum price (present value) that you
are willing to pay?
 This could be estimated with:
N


1
PV 0 = A t
and summarised as:
T=1
(1+ R )
 1 1   1 1 
PV 0 = A  - N 
 £6,000  - 4 
 R R(1+ R )   0.10 0.10(1+0.10) 
PV 0  £6,000 * 3.1699 = £19,019.40
 Note: 3.1699 (PVAR,N) could be obtained from present value of
annuity factor table.
The Time Value of Money 13
 Present value of an annuity
Present value of an annuity in perpetuity:
 It can be estimated as:
C C C C
PV 0 = + 2
+ ... ... 
or simplified to:
(1+ R) (1+ R ) (1+ R ) R

 Consider that Mr. Holt receives £5,000 pa from consols. What is

the present value of his holdings if the market rate of interest is
5.0%pa?
PV0 = £5,000 / 0.05 = £100,000

 What should be the value if the rate of interest increases to 8%?

PV0 = £5,000 / 0.08 = £62,500
The Time Value of Money 14
 Present value of a growing perpetuity
 Consider that at the end of this year a landlord receives
£10,000 on rent. The rent is expected to increase by 5% pa
forever. What is the PV of his cash flows if the required rate of
return is 10%pa.

 The PV of a growing perpetuity could be estimated with:

C C* (1+ g) C* (1+ g )2 C* (1+ g )-1
PV = + + + ...+
(1+ R) (1+ R ) 2
(1+ R )3
(1+ R )

 Assuming the growth rate (g) remains constant then:

C £10, 000
PV =   £200, 000
(R - g) 0.10  0.05
The Time Value of Money 15
 Present value of uneven cash-flows
 Consider the following cash-flows:
 Year 1: £15,000
 Year 2: £10,000
 Year 3: £14,000
 The rate of interest is 10%
 1  R 
N
Ci
 PV of uneven cash-flows is given by: PV0  i
i 1

 Therefore:
£15, 000 £10, 000 £14, 000
PV0   
1.10  1.10  1.10 
1 2 3

PV0  £32, 419.23

The Time Value of Money 16

 Present value of uneven cash-flows
How to use present value table?
Reconsider the example above:

Year Cash-flow (£) Discount Factor at 10% Present Value (£)

[1/(1+R)N]
1 15,000 0.9091 13,636.36
2 10,000 0.8264 8,264.46
3 14,000 0.7513 10,518.41
Present value of cash-flows: 32,419.23

Could be obtained from

present value factor table

The Time Value of Money 17

 Present value of uneven cash-flows
An application:
 Today Miss Smart bought 300 ordinary shares of Lakes Plc at
the rate of £52 each. The expected dividends per share for the
next four years are £3.75, £3.00, £4.50 and £4.50 respectively.
The market price of these shares at the end of year four is
expected to be £85.00 each.
 Is this investment profitable if the required rate of return is
15%pa?
Continued…

The Time Value of Money 18

 Present value of uneven cash-flows
Solution:
Year Cash-flow per Discount Factor at 15% Present Value
share (£) [1/(1+R)N] (£)
1 3.75 0.8696 3.26
2 3.00 0.7561 2.27
3 4.50 0.6575 2.96
4 4.50+85.00 0.5718 51.17
Present value of cash-flows: 59.66

 The PV of expected cash-flows (£59.66) is higher than the

purchase price (£52.00). Hence it is a profitable investment.

The Time Value of Money 19