Chapter 5—Time Value Of Money Part I

➢ Present Value is what a cash flow would be worth to you today

Answers the question “You want to have $10,000 in your savings account in
6 years, what amount should you deposit now if the account pays interest of
5% per year?”
➢ Future Value is what a cash flow will be worth in the future
Answers the question “If I deposit $1,000 in an account earning 5% per
year for 6 years, what amount will be in the account at the end?”
Compound Interest
• Interest earned on interest
• Interest earned at a rate of 6% for five years on a principal balance of
$100

Today Future Years

1 2 3 4 5
Interest Earned 6 6.36 6.74 7.15 7.57
Value 100 106 112.36 119.10 126.25 133.82

Simple Interest
• Interest earned only on the original investment
• Example — Simple Interest
Interest earned at a rate of 6% for five years on a principal balance of
$100
Today Future Years
1 2 3 4 5 6
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130
 FUTURE VALUE AND COMPOUND INTEREST
t
FV = PV × (1 + r)

EXAMPLE: Peter Minuit bought Manhattan Island for $24 in 1626. Was
this a good deal?
To answer, determine what $24 is worth in the year 2016,
compounded at 8%
FV = $24 × (1 + .08)390 = $260 trillion

PRESENT VALUE
Future value after t periods
PV =
(1 + r)t
Discounted Cash Flow (DCF)
• Method of calculating present value by discounting future cash flows
Discount Factor = DF = PV of $1
1
DF =
(1 + r)t
USING TIMELINES TO VISUALIZE CASH FLOWS
A timeline identifies the timing and amount of a stream of payments – both
cash received and cash spent - along with the interest rate earned.
A timeline is typically expressed in years, but it could also be expressed as
months, days or any other unit of time.
Always start by drawing a timeline of your problem. Just do. Trying to solve
things in your head or immediately plugging numbers in a formula can make
easy things complicated…
Example
You are able to put $1,200 in the bank now, and another $1,400 in 1 year. If you
earn an 8% rate of interest, how much will you be able to spend on a computer in 2
years?

FV1 = 1,400 × (1.08) = 1,512.00

FV2 = 1,200 × (1.08)2 = 1,399.68
__________________________________________________________________
______________
Total FV = $2,911.68

PRESENT VALUE OF MULTIPLE CASH FLOWS

C1 C2
PV = (1 + r) 1
+ (1 + r)2
+…

Example
Your auto dealer gives you the choice to pay $15,500 cash now, or make three
payments: $8,000 now and $4,000 at the end of the following two years. If your
cost of money is 8%, which do you prefer?
Immediate payment 8,000.00
4,000
PV1 = = 3,703.70
(1 + .08)1
4,000
PV2 = = 3,429.36
(1 +. 08)2
_____________________________________
Total PV = $15,133.06
FINANCIAL CALCULATOR

Annual Percentage Rate

The annual percentage rate (APR) indicates the interest rate paid or earned in one
year without compounding.
APR is also known as the nominal or quoted (stated) interest rate.
We cannot compare two loans (or two savings accounts) based on APR if they do
not have the same compounding period.
To make them comparable, we calculate their equivalent rate using an annual
compounding period. We do this by calculating the effective annual rate (EAR)

APR = MR × 12
Practice Problems:
1. Old Time Savings Bank pays 4% interest on its savings accounts. If you
deposit $1,300 in the bank and leave it there, how much interest will you
earn in the first year, the second year, and the 10th year?
2. After examining the various personal loan rates available to you, you find
that you can borrow funds from a bank at 12 percent compounded monthly,
11.5 percent continuously compounded, and 12.5 percent compounded
annually. Which alternative is the most attractive?
3. To what amount will $5000 invested for 10 years at 10 percent compounded
annually accumulate to?
4. If you deposit $10,000 today into an account earning an 11 percent annual
rate of return, in the third year how much interest will you have earned?
5. Jack plans on buying a Rolls-Royce phantom that costs $330,000. He
currently has $45,530 that he may invest. A mutual fund pays 4.5 percent
annual interest in which he’ll place the money. How long will it take for
Jack to buy his desired car?
6. If you were offered $1,079.50 ten years from now for an investment of $500
today, what annual rate of return would you earn if you take the offer?
7. Pirolo and Marisa both deposit $10,000 in their savings accounts today.
Both savings accounts have an APR of 10%, but Pirolo’s account
compounds annually while Marisa’s account compounds continuously. 5
years from now, the difference between the amounts in their accounts is...
(round to closest)
8. Your wealthy uncle established a bank account with $10,000 for you when
you were born. For the first 12 years of your life, the interest rate earned on
the account was 6%. Since then, rates have been only 3%. Now you are 23
years old and ready to cash in. How much is in your account?