Chapter 4

The Time Value

of Money
What is Time Value of Money (TVM)

• All else equal, the sooner cash is received, the

more valuable it is. The logic is simple—the sooner a dollar is
received the more quickly it can be invested to earn a positive
return.
 Time Value of Money: The principles and
computations used to revalue cash payoffs at
different times so they are stated in dollars of the
same time period; used to convert dollars from one
time period to those of another time period.
 The percentage change in value of a certain amount
of money for a certain time period gap is known as
time value of money.
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Cash Flow Time Lines

• Cash flow timeline: An important tool used in time value of

money analysis; it is a graphical representation used to show
the timing of cash flows (cash outflow: a payment, or disbursement,
of cash for expenses, investments, and so forth; cash inflow: a receipt of
cash from an investment, an employer, or other sources)
o To illustrate the time line concept, consider the following
diagram:

 Here $100 is invested at Time 0, and we want to determine how

much this investment will be worth in three years if it earns 6
percent interest each year.

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Future Value (FV) and Present
Value (PV)
• Future Value (FV): The amount to which a cash flow or series of
cash flows will grow over a given period of time when compounded
at a given interest rate.
– Compounding: The process of determining the value of a cash flow or
series of cash flows at some time in the future when compound interest is
applied.
• Present Value (PV): The value today—that is, current value—of a
future cash flow or series of cash flows.
– In other words, The value of today that is obtained by discounting a
future cash flow or a series of cash flows by the opportunity cost of fund
as discount rate.
• Discounting: The process of determining the present value of a cash
flow or a series of cash flows received (paid) in the future; the reverse
of compounding.
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Simple and Compounded interest rate

• Simple interest rate: The interest rate that charged only on

the principal amount for a specific period is called simple
interest rate.
• Compounded interest rate: Interest earned on interest that is
reinvested. In other words, the interest rate that is charged
both on principal and interest amount period to period is called
compound interest rate.
 PV = Present value, or beginning amount
 r = Interest rate
 INT = Dollars of interest you earn during the year = (Beginning amount) * r
 FVn = Future value, or value of the account at the end of n periods
 n = Number of periods
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Future Value (FV)

Time Line Solution:

Equation (Numerical) Solution:

FVn = PV * ( 1 + r )n
FV3 = $100 * ( 1 + 0.06 )3 = $100 * 1.191016 = $119.10

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Future Value (FV) (Cont’d)

 Example # 1: page # 134

– Assume that you invest $2,500 today. How much

will this amount be worth in five years if the interest
rate is 4 percent? How would your answer change
if the interest rate is 6 percent? (Answers:
$3,041.63; $3,345.56)

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Present Value (PV)

• Present Value (PV): The value today—that is,

current value—of a future cash flow or series of cash
flows.
– In other words, The value of today that is
obtained by discounting a future cash flow or a
series of cash flows by the opportunity cost of fund
as discount rate.
Discounting: The process of determining the present
value of a cash flow or a series of cash flows received
(paid) in the future; the reverse of compounding.

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Present Value (PV) (Cont’d)

• Opportunity cost rate: The rate of return on the best

available alternative investment of equal risk.
– Suppose someone offered to sell you an investment
that promises to pay $119.10 in three years for $95
today. Should you buy this investment if your
opportunity cost is 6 percent?
• Answer: You should definitely buy it because, as we
discovered in the previous section, it would cost you
exactly $100 to produce the $119.10 in three years if
you earn a 6 percent return. On the other hand, if the
price is greater than $100, you should not buy it.
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Present Value (PV) (Cont’d)

Time Line Solution:

Equation (Numerical) Solution:

PV = FVn / ( 1 + r )n
PV = FV3 / ( 1 + r )3 = $119.10 / ( 1+0.06 )3 = $100.00

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Present Value (PV) (Cont’d)

 Example # 2: page # 136

– Assume you have the opportunity to purchase an

investment that promises to pay you $3,041.63 in
five years and your opportunity cost is 4 percent.
How much should you be willing to pay for this
investment today? How would your answer
change if your opportunity cost is 6 percent?
(Answers: $2,500; $2,272.88)

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FV and PV Calculation

Problem 4-1 (Brigham: Page-167)

If you invest $500 today in an account that pays 6
percent interest compounded annually, how much will
be in your account after two years? What if
compounded semiannually / quarterly / monthly /
weekly / daily? FVn = PV * ( 1 + r/m )m*n (i.e., m = number
of compounding periods per year)

Problem 4-2 (Brigham: Page-167)

 What is the present value of an investment that promises
to pay you $1,000 in five years if you can earn 6 percent
interest compounded annually?
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SOLVING for INTEREST RATES
(r) and TIME (n)
Solving for r:
 Suppose you just called the East Key State Bank and
found that the balance in your savings account is
$1,269.50. If you deposited $800 six years ago, what rate
of return have you earned on the savings account?
(Answer: 8.0%)

Solving for n:
 Assume you can invest $1,000 today at 7 percent interest.
If you plan to sell the investment when its value reaches
$1,500, for how long will your money have to be invested?
(Answer: 6 years)
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Rule of 70

 The rule of 70 is a means of estimating the number

of years it takes for a certain variable to double. This
rule is commonly used with an annual compound
interest rate to quickly determine how long it would
take to double your money.
r*n = 70
 Problem 4-4 (Brigham: Page-167): To the closest
year, how long will it take a $200 investment to
double if it earns 7 percent interest? How long will it
take if the investment earns 18 percent?
Source: www.investopedia.com
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Annuity Payments

 Annuity: A series of payments of an equal amount

at fixed, equal intervals for a specified number of
periods.
 Ordinary (deferred) annuity: An annuity with
payments that occur at the end of each period.
 Annuity due: An annuity with payments that
occur at the beginning of each period.
Note: If nothing is mentioned in a math then
ALWAYS consider Ordinary (deferred) annuity.

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Cash Flow Time Line

• Ordinary Annuity:

• Annuity Due:

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Future value of an annuity, FVA

• Future Value of an Ordinary Annuity:

• Future Value of an Annuity Due, FVA(DUE):

• Example (Brigham: Page-146): Suppose you want to start your own

business in 10 years, and you plan to save funds to invest in the business.
You have determined that you can save $5,000 per year for 10 years at 7
percent interest. If the first $5,000 deposit isn’t made until one year from
today, how much money will you have in 10 years when you start your
business? How much would you have if you deposit the first $5,000 today?
(Answers: $69,082; $73,918)
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FVA – Example

• Everything else equal, which annuity has

the greater future value: an ordinary
annuity or an annuity due? Why?
– Answer: The annuity due has a greater
value. Depositing the payment at the
beginning of the year instead of at the end,
allows the annuity to have an added year of
compounding.

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Present value of an annuity, PVA

• Present Value of an Ordinary Annuity:

• Present Value of an Annuity Due, PVA(DUE)

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PVA - Example

Example (Brigham: Page-149):

• Suppose you are considering an investment that
pays $5,000 per year for 10 years and your
opportunity cost is 7 percent interest. If you don’t
receive the first $5,000 payment until one year from
today, what is the most you should be willing to pay
for the investment? How much would you be willing
to pay if you receive the first $5,000 payment today?
(Answers: $35,118; $37,576)

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Perpetuities

• Perpetuity: A stream of equal payments expected to

continue forever.
• Most annuities call for payments to be made over
some finite period of time—for example, $100 per
year for three years. However, some annuities go on
indefinitely, or perpetually. [PVP = PMT / r]
• Example (Brigham: Page-152): What is the present value of
a $3,500 annuity that will be paid forever beginning in one
year if the interest rate is 7 percent? What is the value of this
perpetuity if the interest rate increases to 10 percent?
(Answers: $50,000; $35,000)
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Uneven Cash Flow Streams

• Uneven cash flow stream -- A series of cash

flows in which the amount varies (unequal /
nonconstant) from one period to the next.
– Payment (PMT) -- This term designates constant
cash flows— that is, the amount of an annuity
payment.
– Cash flow (CF) -- This term designates cash
flows in general, including uneven cash flows.

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Present and Future Value of an
Uneven Cash Flow Stream
• PV – Uneven CF:

• FV – Uneven CF:
– Step 1:

– Step 2: FVn = PV * ( 1 + r )n

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Present and Future Value of an
Uneven Cash Flow Stream (Cont’d)
• Terminal value -- The future value of a cash flow stream.
• Example (Brigham: Page-155):
– Consider the following uneven cash flow stream:
$1,000 at the end of Year 1, $5,000 at the end of Year
2, $800 at the end of Year 3, and $2,000 at the end of
Year 4. If your opportunity cost is 10 percent, what is
the most you should pay for an investment with these
payoffs? If you were to invest each cash flow when you
receive it, how much would your investment be worth
at the end of four years? (Answers: $7,008.40;
$10,261)
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Semiannual and Other Compounding
Periods

• Annual compounding -- The process of

determining the future (or present) value of a
cash flow or series of cash flows when interest
is paid once per year.
• Semiannual compounding -- The process of
determining the future (or present) value of a
cash flow or series of cash flows when interest
is paid twice per year.

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Semiannual and Other Compounding
Periods (Cont’d)

FVn = PV * ( 1 + r/m )m*n

Here, m = number of compounding periods per year
• Example (Brigham: Page-157):
– Suppose you have $1,000 that you want to invest today.
How much would you have in 10 years if you put your
money in a savings account that pays 10 percent
compounded annually? How much would you have if the
bank pays 10 percent compounded quarterly? (Answers:
$2,593.74; $2,685.06). How much would you have if the
bank pays 10 percent compounded semiannually?

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Comparisons of Different
Interest Rates
• The effective annual return is higher with
semiannual compounding than with annual
compounding.
• Everything else equal, the greater the number
of compounding periods per year, the greater
the effective rate of return on an investment.

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Comparisons of Different
Interest Rates (Cont’d)
• Simple (quoted) interest rate (rSIMPLE) -- The rate
quoted by borrowers and lenders that is used to
determine the rate earned per compounding period
(periodic rate, rPER).
• Annual percentage rate (APR) -- Another name for
the simple interest rate, rSIMPLE; does not consider the
effect of interest compounding.
• Effective (equivalent) annual rate (rEAR): The annual
rate of interest actually being earned, as opposed to
the quoted rate, considering the compounding of
interest.
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Comparisons of Different
Interest Rates (Cont’d)

• Here m is the number of compounding periods (interest payments) per year

• Example (Brigham: Page-160):

– Suppose you are considering depositing $400 in
one of two banks. Bank A offers to pay 12 percent
interest compounded monthly, whereas Bank B
offers to pay 12.5 percent compounded annually.
Which bank offers the better effective rate?
(Answer: rEAR at Bank A = 12.7%; rEAR at Bank B = 12.5%).
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Amortized Loans (Cont’d)

• Amortized loan -- A loan that requires equal

payments over its life; the payments include
both interest and repayment of the debt.
• Amortization schedule -- A schedule
showing precisely how a loan will be repaid. It
gives the required payment on each payment
date and a breakdown of the payment,
showing how much is interest and how much
is repayment of principal.
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Amortized Loans

• Suppose a firm borrows $15,000, and the loan is to be repaid

in three equal payments at the end of each of the next three
years. The lender will charge 8 percent interest on the loan
balance that is outstanding at the beginning of each year.
• Step 1: Find out Payment (PMT) by using PVA (ordinary)
formula. Here PMT = $5820.50
• Step 2: Prepare loan Amortization schedule

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