Time Value of Money: Debashis Saha, Assistant Professor, F & B, Jahangirnagar University

Time value of Money
Debashis Saha, Assistant Professor, F

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& B, Jahangirnagar University
The time value of money (TVM) is an economic principle that
suggests present day money is worth less than money in the
future because of its earning power over time.

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Time value of Money
Money has time values……..???
The time value of money (TVM) is the concept that suggests present
day money is worth less than money in the future because of its earning
power over time. A taka today is more valuable than a taka a year hence
Risk -investment risk that investors undertake when putting

their money into investment assets.
Opportunity cost refers to the loss of investment opportunities and the
WHY
benefit associated with them due to the commitment of money to another

investment for a specific period of time.
Inflation is reducing the purchasing power of money because it
increases the prices of goods and services. Therefore, over time
the same amount of money can purchase fewer goods and
services.
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Debashis Saha,
Debashis Saha, BBM(India), MBA( Germany)
Assistant Professor, F
Formulas
Future Values
FVt = CF0 * (1+r)t OR FVt = PV *
Of A Single
(1+r)t
Amount
Present Values
PV = CFt / (1+r)t OR PV = FVt /
Of A Single
(1+r)t
Amount
Future Values FVAt = A * {[(1+r)t –1]/r}, FVIFAt=
Of An Annuity {[(1+r)t –1]/r},
Present Values
Of An Annuity
PVAt =A* {[1-(1+r)-t]/r}
PV of a Perpetuity P= A. PVIFAr,∝ , PVIFA= 1/r
Intra-year
Compounding 4
Variables
where
r = rate of return
t = time period
n = number of time periods
A = constant periodic flow
CF = Cash flow (the subscripts t and 0 mean at time t
and at time zero, respectively)
PV = present value (PVA = present value of an annuity)
FV = future value (FVA = future value of an annuity)
Debashis Saha, Assistant Professor, F & B,

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Jahangirnagar University
Overview
Time value of Money

I. Using Time Lines
II. Future Values Of A Single Amount
III. Present Values Of A Single Amount
IV. Future Values Of An Annuity
V. Present Values Of An Annuity
VI. Perpetuity
VII. Intra-year Compounding And Discounting
Debashis Saha, Assistant Professor, F & B,

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Jahangirnagar University
Using Time Lines
Using Time Lines
A timeline refers to a horizontal line on which time zero
appears at the leftmost end and future periods are marked
from left to right; can be used to depict investment cash
flows. Timeline identifies the timing and amount of a
stream of cash flows along with the interest rate.
A point in time A period in time

Cash flow occur in a point Cash flow occur in a period
i=10%
0 1 2 3 4
❑ Years 0 1 2 3 4
❑ Cash flow -$100 $30 $20 -$10 $50
Checkpoint
Creating a Timeline
Suppose you lend a friend $10,000 today to help him

finance a new Jimmy John’s Sub Shop franchise and in
return he promises to give you $12,155 at the end of the
fourth year. How can one represent this as a timeline? Note
that the interest rate is 5%.

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10
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Compounding
and Discounting
Time line showing compounding to find future value and
discounting to find present value

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Basic Patterns of Cash Flow
Single amount: A lump-sum amount either currently held or

expected at some future date. Examples include $1,000 today and
$650 to be received at the end of 10 years.
Annuity: A level periodic stream of cash flow. For our purposes, we’ll
work primarily with annual cash flows. Examples include either paying
out or receiving $800 at the end of each of the next 7 years.
Mixed stream: A stream of cash flow that is not an annuity; a stream

of unequal periodic cash flows that reflect no particular pattern.

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Future Values Of A
Single Amount
Future Values Of A Single Amount
Future value determines the amount that a sum of money
invested today will grow to in a given period of time
The process of finding a future value is called
“compounding”
FVt = CF0 * (1+r)t OR FVt = PV *
Formula =
(1+r)t
FV = $100 * (1+.1)5 = $161.05
How much money
will you have in 5
i = 10%
Years if you invest $100 ?
$100 today at a
10% rate of
0 1 2 3 4 5
return?
Solve
Jane Farber places $800 in a savings account paying 6% interest

compounded annually. She wants to know how much money will
be in the account at the end of 5 years.

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Present Values Of A
Single Amount
Present Values Of A Single Amount
Present value calculations determine what the value of a
cash flow received in the future would be worth today
(time 0)
The process of finding a present value is called
“discounting”
PV = CFt / (1+r)t OR PV = FVt /
Formula =
(1+r)t
PV = 100 / (1 + .1)5 = $62.09
How much would
$100 received five
years from now be i = 10%
worth today if the ? $100
current interest
rate 0 1 2 3 4 5
is 10%?
Pam Valenti wishes to find the present value of $1,700 that will
be received 8 years from now. Pam’s opportunity cost is 8%.

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Interest Rate
At what rate of interest should we invest our money today
to get a desired amount of money after a certain number of
years?
Simple interest: Interest is earned only on the principal amount , FV=PV(1+nr)
Compound interest: Interest is earned on both the principal and

accumulated interest of prior periods, FV=PV(1+r)^n
Jack and Sarah both open savings
accounts with a starting balance of
$1000.00 on the same day. Jack's bank
is paying him using compounded
interest, but Sarah's bank is paying her
using simple interest. Both Jack and
Sarah are receiving an interest rate of
8% annually. Who do you think will have
the larger balance in five years? 20 Debashis Saha, Assistant Professor, F
Impact of Interest Rates on PV
❑ If the interest rate (or discount rate) is higher (say 9%), the PV
will be lower.
❑ PV = 5000*(1/(1.09)10) = 5000*(0.4224) =$2,112.00
❑ If the interest rate (or discount rate) is lower (say 2%), the PV
will be higher.
❑ PV = 5000*(1/(1.02)10) = 5000*(0.8203)
= $4,101.50
❑ Note the slight variation in which the formula is written.

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Future Value Of An
Annuity
Future Value Of An Annuity
An annuity is a stream of constant cash flow occurring at
regular interval of times
Ordinary When the cash flows occur at the end of
annuity
Annuity each period

When the cash flows occur at the beginning
Annuity Due
of each period
FVAt = A * [(1+r)t –1]/r, FVIFAt= {[(1+r)t
Formula =
–1]/r},
Assume that Sally owns an
investment that will pay her FVA20 = $100 * {[(1+.15)20
$100 each year for 20 years. The –1]/.15
current interest rate is 15%. =$10,244.36
What is the FV of this annuity? 23 Debashis Saha, Assistant Professor, F
Ordinary Annuity
The future value of an annuity formula is used to calculate what the
value at a future date would be for a series of periodic payments.
The future value of an annuity formula assumes that
1. The rate does not change
2. The first payment is one period away
3. The periodic payment does not change
If the rate or periodic payment does change, then the sum of the future
value of each individual cash flow would need to be calculated to
determine the future value of the annuity. If the first cash flow, or
payment, is made immediately, the future value of annuity due
formula would be used. 24
Fran Abrams is choosing
which of two annuities to
receive. Both are 5-year,
$1,000 annuities; annuity A
is an ordinary annuity, and
annuity B is an annuity due.
To better understand the
difference between these
annuities, she has listed
their cash flows in Table.
Note that the amount of
each annuity totals $5,000.
The two annuities differ in
the timing of their cash
flows:
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Fran Abrams wishes to determine how much money she will have at
the end of 5 years if he chooses annuity A, the ordinary annuity. It
represents deposits of $1,000 annually, at the end of each of the
next 5 years, into a savings account paying 7% annual interest.
This situation is depicted on the following time line:

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FV of Annuity Due
The future value of annuity due formula is used to calculate the ending value of a series of
payments or cash flows where the first payment is received immediately. The first cash flow
received immediately is what distinguishes an annuity due from an ordinary annuity. An
annuity due is sometimes referred to as an immediate annuity.
The future value of annuity due formula calculates the value at a future date. The use of the
future value of annuity due formula in real situations is different than that of the present value
for an annuity due. For example, suppose that an individual or company wants to buy an
annuity from someone and the first payment is received today. To calculate the price to pay
for this particular situation would require use of the present value of annuity due formula.
However, if an individual is wanting to calculate what their balance would be after saving for 5
years in an interest bearing account and they choose to put the first cash flow into the
account today, the future value of annuity due27 would be used.
Fran Abrams wanted to choose between an ordinary annuity
and an annuity due, both offering similar terms except for the
timing of cash flows. We calculated the future value of the
ordinary annuity in the example on page 164. We now will
calculate the future value of the annuity due, using the cash
flows represented by annuity B

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Comparison of an Annuity Due
with an Ordinary Annuity Future Value
The future value of an annuity due is always greater than the

future value of an otherwise identical ordinary annuity. We can
see this by comparing the future values at the end of year 5 of
Fran Abrams’s two annuities:
Ordinary annuity=$5,750.74 Annuity due=$6,153.29
Because the cash flow of the annuity due occurs at the

beginning of the period rather than at the end, its future value is
greater. In the example, Fran would earn about $400 more with
the annuity due.

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Knowing what lies in store for You
Suppose you have decided to deposits Tk 30,000 per year in

your Public Provident Fund Account for 30 years . What will
be the accumulated amount in your Public provident Account
at the end of 30 years if the interest rate is 11 percent?
FVAt = A * [(1+r)t –1]/r=30,000*(1.11^30-1)/.11 = 5,970,600

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How much should you save annually

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Present Value Of An
Annuity
Present Value Of An Annuity
The present value of an annuity is the current value of future payments from an annuity,
given a specified rate of return or discount rate. The annuity's future cash flows are
discounted at the discount rate. Thus, the higher the discount rate, the lower the
present value of the annuity.
PVAt =A* [1-(1/1+r)t]/r, PVIFAr,n =
Formula =
[1-(1/1+r)t]/r
Assume that Sally owns an investment that will pay her $100 each
year for 20 years. The current interest rate is 15%. What is the
PV of this annuity?
PVAt =$100 * {1-(1/1+.15)20]/.15}=$625.93

The present value of ordinary
annuity
The present value of ordinary annuity formula determines the value of a series of future
periodic payments at a given time. The present value of annuity formula relies on the concept
of time value of money, in that one dollar present day is worth more than that same dollar at a
future date.
The formula shown has assumptions, in that it must be an ordinary annuity. These assumptions
are that
1) The periodic payment does not change PV=
2) The rate does not change
3) The first payment is one period away
If the payment and/or rate changes, the calculation of the present value would need to be adjusted depending on the specifics.
If the payment increases at a specific rate, the present value of a growing annuity formula would be used.
If the first payment is not one period away, as the 3rd assumption requires, the present value of annuity due or present value of
deferred annuity may be used. An annuity due is an annuity that's initial payment is at the beginning of the annuity as opposed
to one period away. A deferred annuity pays the initial payment Debashis Saha, Assistant Professor, F
34 at a later time.
Present Value of Annuity Due
The formula for the present value of an annuity due, sometimes

referred to as an immediate annuity, is used to calculate a series
of periodic payments, or cash flows, that start immediately.
Formula:
PV=

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How Much Can You Borrow For A Car
After reviewing your budget, you have determined that you

can afford to pay Tk 12,000 per month for 3 years toward a
new car. You call afinance company and learn that the going
rate of interest on car finance is 1.5 % per month for 36
months. How much you can borrow ?
PVIFA = [1-(1/1+r)t]/r = * [1-(1/1+.015)36]/.015=27.70
PV= 12000*27.70= 332,400

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Perpetuity
Perpetuity
A series of level/even/equal sized cash flows that occur at
the end of each period for an infinite time period
PV of a Perpetuity P= A.
∝ PVIFAr,∝ , PVIFAr,∝= 1/r
Growing
Perpetuity PV=C/(r-g)
An insurance company has just launched a security that will
pay $150 indefinitely, starting the first payment next year.
How much should this security be worth today if the
appropriate return is 10%? Using the time line below,
complete the PV(∞) equation.

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Mixed Stream
Future Value of a Mixed Stream
A mixed stream is a stream of unequal periodic cash flows that

reflect no particular pattern.
Financial managers frequently need to evaluate opportunities

that are expected to provide mixed streams of cash flows. Here
we consider both the future value and the present value of
mixed streams.

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Future Value of a Mixed Stream
Shrell Industries, a cabinet manufacturer, expects to receive the

following mixed stream of cash flows over the next 5 years from
one of its small customers.
If Shrell expects to earn 8% on its investments, how much will it

accumulate by the end of year 5 if it immediately invests these
cash flows when they are received?
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Frey Company, a shoe manufacturer, has been offered an
opportunity to receive the following mixed stream of cash flows
over the next 5 years:
If the firm must earn at least 9% on its investments, what is the

most it should pay for this opportunity? This situation is depicted
on the following time line:
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Present Value of a Mixed Stream
Finding the present value of a mixed stream of cash flows is

similar to finding the future value of a mixed stream. We
determine the present value of each future amount and then
add all the individual present values together to find the total
present value.

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Example
Frey Company, a shoe manufacturer, has been offered an

opportunity to receive the following mixed stream of cash flows
over the next 5 years:
If the firm must earn at least 9% on its investments, what is the

most it should pay for this opportunity?
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Intra-year
Compounding And
Discounting
Intra-year Compounding And
Discounting
Banks frequently offer savings account that compound

interest every day, month, or quarter.
More frequent compounding will generate higher interest
income for the savers if the annual interest rate is the
same

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You deposit Tk 5,000 in a bank for 6 years. If the interest is
12% and the frequency of compounding is 4 times a year,
what will be your deposits after 6 years.
5000(1+ .12/4)^(4*6) = 10,164

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Nominal and Effective Annual Rates
of Interest
Nominal (stated) annual rate :Contractual annual rate of interest

charged by a lender or promised by a borrower.
Effective (true) annual rate (EAR): The annual rate of interest

actually paid or earned.
The effective annual rate reflects the impact of compounding

frequency, whereas the nominal annual rate does not.
we can calculate the effective annual rate, EAR, by substituting

values for the nominal annual rate, i, and the compounding
frequency, m,

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Fred Moreno wishes to find the effective annual rate associated
with an 8% nominal annual rate (i=0.08) when interest is
compounded (1) annually (m=1); (2) semiannually (m=2); and (3)
quarterly (m=4).

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Loan Amortization
The term loan amortization refers to the computation of equal

periodic loan payments. These payments provide a lender with a
specified interest return and repay the loan principal over a
specified period.
The loan amortization process involves finding the future

payments, over the term of the loan, whose present value at the
loan interest rate equals the amount of initial principal
borrowed. Lenders use a loan amortization schedule to
determine these payment amounts and the allocation of each
payment to interest and principal.

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53
you want to determine the equal annual end-of-year payments
necessary to amortize fully a $6,000, 10% loan over 4 years.

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1 2

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Assignment:
Period of Loans Amortization
You want to borrow TK 1,080,000 to buy a flat. You approach

a housing finance company which charges 12.5 percent
interest. You can pay Tk 180000 per year toward loan
amortisation. What should be the maturity period of the
loan?

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Assignment
Mahesh deposits Tk 200000 in a bank account which pays

10% INTEREST. How much can he withdraw annually for a
period of 15 years.
You want to take a world tour which costs Tk 1,000,000 the

cost is expected to remain unchanged in nominal terms. You
are willing to save annually Tk 80,000 to fulfill your desire.
How long will you have to wait if your savings earn a return of
14 % per annum?
Shyam borrows Tk 80,000 for a musical system at a monthly

interest of 1.25% equal monthly installment, Payable at the
end of each month. Prepare the loan amortisation schedule
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Determinants of Intrinsic Value:
The Present Value Equation
Net operating Required investments

−
profit after taxes in operating capital
Free cash flow

=
(FCF)
FCF1 FCF2 FCF∞

Value = 1
+ 2
+ ...
+ (1 + WACC) (1 + WACC) (1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates Cost of debt Firm’s debt/equity mix
Market risk aversion Cost of 58

equity Debashis Saha, Assistant Professor, F
Firm’s business risk

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Time value of Money

Debashis Saha, Assistant Professor, F

Debashis Saha, Assistant Professor, F

Risk -investment risk that investors undertake when putting

benefit associated with them due to the commitment of money to another

PV of a Perpetuity P= A. PVIFAr,∝ , PVIFA= 1/r

Debashis Saha, Assistant Professor, F & B,