Time Value of Money

Part I
September 2020

1
 TVM Part I - Learning Objectives
 Describe the key concepts surrounding the time value of money:
o Compounding and Discounting
o Future and Present Value
o Simple and Compound interest
o Nominal and Effective rates of interest
o Patterns of Cash Flows

 Compute Future Value and examine its applications

2
 Intro to TVM
 Financial managers = investment decisions (max SH wealth)

 Financial/investment decisions = benefits vs cost

 Investment decisions = multiple CFS, not all in 1 period

 How do we compare these CFS from different periods to

make a decision NOW(time 0)?

3
 Consider the following
 You won the lottery of $1.5M. The NLCB offers you the following
choices:
(i) Take all NOW
(ii)Take all 1 year from now
(iii) Take all 3 years from now
(iv)Take the $1.5M staggered -$300k in yr 1; $500k in yr 2; $400k
in yr 3 and $300k in yr 4

Which option would you choose and why?

Why is the consideration of time necessary?
4
 Compounding & Discounting
Future Value & Present Value
 Let’s draw a timeline of option (iv) to explain these concepts
Compounding and discounting (FV &PV)
(NB CFs rec’d at EOY-assumption)

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 TIMELINE

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 Interest
 Simple interest – [P x R x T]
 Compound interest
 What is this?
 What do we mean by the term “interest on interest”?
 Nominal rate of interest
 Stated /contracted rate
 Effective rate of interest
 True rate

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 Effective Rate of interest (keff)
m
 Formula
 Example – If k= 12%, let’s complete the table.
m keff Effective
Rate
Annual

Semi-Annual

Quarterly

Monthly

Daily

Continuously ∞
 What can we deduce about keff from the table?
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 Key Concepts cont’d
 Discount rate / req’d ROR / COC - i / k / r
 CF patterns

Single Amount

Pattern Mixed

Stream Ordinary

Annuity
Due

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 Methods to derive FV/PV
 Equation

 Financial calculator

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 FV Computation & Applications
 Single amount CF

 Mixed stream of CF

 Annuity

 Manipulations - n, k & intra-year compounding

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 A. FV of Single Amount CF
Equation:

Q1 ICP: Chapter 4 P8 (a) pg 165 EMF Text

Meg inherited $12,000 and want to invest. By investing
today, how much will she have in 6 years at 7%?

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 A. FV of Single Amount CF
Solution to Q1 ICP using Formula/Equation

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 A. FV of Single Amount CF
Solution to Q1 ICP using Financial Calculator / App

Let’s watch the Screen Recording of this using the F/C App
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 B. FV of Mixed Stream of CFs
Q2 ICP: Chapter 4 P24 pg 168 EMFText

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 B. FV of Mixed Stream of CFs
Solution to Q2 ICP using Equation

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 B. FV of Mixed Stream of CFs
Solution to Q2 ICP using Financial Calculator / App

Let’s watch the Screen Recording of this using the F/C App
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 C. FV of Annuities
Equation
- FV of Ordinary Annuity

- FV of Annuity Due

Q3 ICP: Chapter 4 P26(a) pg 169 EMF Text

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 B. FV of Annuities
Solution to Q3 ICP using Equation

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 B. FV of Annuities
Solution to Q3 ICP using Financial Calculator / App

Let’s watch the Screen Recording of this using the F/C App
20
 B. FV of Annuities
Solution to Q3 ICP using Equation

21
 B. FV of Annuities
Solution to Q3 ICP using Financial Calculator / App

22 Let’s watch the Screen Recording of this using the F/C App
 D. FV Manipulation # 1 – Finding n
 Example- Q4
 How long will it take Xerox to double its investment of $1,000
if the company places it in an account earning 10%
compounded annually?

 What do we know?
 Equation, known variables
 Solve for n (the unknown variable)

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 D. FV Manipulation # 1 – Finding n
 Sol’n to Q4 using Equation
How long will it take Xerox to double its investment of $1,000 if the company
places it in an account earning 10% compounded annually?

24
 D. FV Manipulation # 1 – Finding n
 Sol’n to Q4 using Equation cont’d
How long will it take Xerox to double its investment of $1,000 if the company
places it in an account earning 10% compounded annually?

25
 D. FV Manipulation # 1 – Finding n
 Sol’n to Q4 using Financial Calculator / App
How long will it take Xerox to double its investment of $1,000 if the company
places it in an account earning 10% compounded annually?

26
 D. FV Manipulation # 1 – Finding n
 Sol’n to Q4 using Financial Calculator / App cont’d
How long will it take Xerox to double its investment of $1,000 if the company
places it in an account earning 10% compounded annually?

Let’s watch the Screen Recording of this using the F/C App
27
 FV Manipulation # 2 - Finding k
 Example-
 Pete received $ 7,000 on his 18th birthday. He plans on buying a
foreign used vehicle on his 24th birthday, but figures he’ll need
at least $10,500 for the down-payment. What is the minimum
annual compound rate of interest Pete’s deposit will need to
earn?

 What do we know?
 Equation, timeline, known variables
 Solve for k (the unknown variable)

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 FV Manipulation # 2 - Finding k
 Sol’n to Q5 using Equation
Pete received $ 7,000 on his 18th birthday. He plans on buying a foreign used vehicle on
his 24th birthday, but figures he’ll need at least $10,500 for the down-payment. What is
the minimum annual compound rate of interest Pete’s deposit will need to earn?

29
 FV Manipulation # 2 - Finding k
 Sol’n to Q5 using Equation cont’d
Pete received $ 7,000 on his 18th birthday. He plans on buying a foreign used vehicle on
his 24th birthday, but figures he’ll need at least $10,500 for the down-payment. What is
the minimum annual compound rate of interest Pete’s deposit will need to earn?

30
 FV Manipulation # 2 - Finding k
 Sol’n to Q5 using Financial Calculator / App
Pete received $ 7,000 on his 18th birthday. He plans on buying a foreign used vehicle on
his 24th birthday, but figures he’ll need at least $10,500 for the down-payment. What is
the minimum annual compound rate of interest Pete’s deposit will need to earn?

Let’s watch the Screen Recording of this using the F/C App
31
 FV Manipulation # 3 – Intra-yr Compounding

 “k ÷ m’ and “ n x m”
 Q6 ICP : Chapter 4 P8(d) pg 165 EMF Text
Meg inherited $12,000 and wants to invest. By investing today,
how much will she have in 25 years at 10 percent, compounded
semi-annually?

 What do we know?
 Equation
 Solve for FV

32
 FV Manipulation # 3 – Intra-yr Compounding

 Sol’n to Q6 using Equation

Meg inherited $12,000 and wants to invest. By investing today, how much will she have
in 25 years at 10 percent, compounded semi-annually?

FV = $
33
 FV Manipulation # 3 – Intra-yr Compounding

 Sol’n to Q6 using Financial Calculator / App

Meg inherited $12,000 and wants to invest. By investing today, how much will she have
in 25 years at 10 percent, compounded semi-annually?

Let’s watch the Screen Recording of this using the F/C App
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 Time Value of Money
Part II
September 2020

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 TVM Part II - Learning Objectives

 Compute Present Value and examine its applications

 Examine special applications of time value to compute:

o Perpetuity
o Deposit required to accumulate a future sum
o Preparation of a loan amortization schedule
o Interest or growth rates

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 PV Computation & Applications
 Single amount CF

 Mixed stream of CF

 Annuity

 Manipulations – k and n

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 A. PV of Single Amount CF
Equation

Q7: Meg wants to invest today but is unsure of how much to invest
given that she needs $18,009 in 6 yrs time. Using a discount rate of
7%, how much does she need to invest today?

What do we know?

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 A. PV of Single Amount CF
Sol’n to Q7 using Equation
Meg wants to invest today but is unsure of how much to invest given that
she needs $18,009 in 6 yrs time. Using a discount rate of 7%, how much
does she need to invest today?

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 A. PV of Single Amount CF
Sol’n to Q7 using Financial Calculator / App
Meg wants to invest today but is unsure of how much to invest given
that she needs $18,009 in 6 yrs time. Using a discount rate of 7%,
how much does she need to invest today?

Let’s watch the Screen Recording of this using the F/C App
40
 B. PV of Mixed Stream of CFs
Equation
Q8 ICP: Chapter 4 P24(a) pg 168 EMF Text

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 B. PV of Mixed Stream of CFs
Sol’n to Q8 ICP using Equation

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 B. PV of Mixed Stream of CFs
Sol’n to Q8 ICP using Financial Calculator / App

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 B. PV of Mixed Stream of CFs
Sol’n to Q8 ICP using Financial Calculator / App cont’d

44 Let’s watch the Screen Recording of this using the F/C App
 B. PV of Mixed Stream of CFs
Note that Q2 & Q8 are similar except for requirement FV vs PV.
But we can use our Financial Calculator / App to solve for FV of a Mixed Stream

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 B. PV of Mixed Stream of CFs
Let’s see how:

0 1 2 3 4 5

46 Let’s watch the Screen Recording of this using the F/C App
 C. PV of Annuities
Equations
- PV of Ordinary Annuity

- PV of Annuity Due

- Q9 ICP Chapter 4 P26(c) pg 169 EMF Text

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 C. PV of Annuities
Sol’n to Q9 ICP using Equation

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 C. PV of Annuities
Sol’n to Q9 ICP using Financial Calculator / App

Let’s watch the Screen Recording of this using the F/C App
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 C. PV of Annuities
Sol’n to Q9 ICP using Equation

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 C. PV of Annuities
Solution to Q9 ICP using Financial Calculator / App

51 Let’s watch the Screen Recording of this using the F/C App
 D. PV Manipulation # 1 - Finding k
 Example- Q10
 Determine at what rate of return would Pete be indifferent
between $13,000 today and $20,000 in five years.

 What do we know?
 Equation, known variables
 Solve for k (the unknown variable)

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 D. PV Manipulation # 1 - Finding k
 Sol’n to Q10 using Equation
 Determine at what rate of return would Pete be indifferent
between $13,000 today and $20,000 in five years.

53
 D. PV Manipulation # 1 - Finding k
 Sol’n to Q10 using Equation cont’d
 Determine at what rate of return would Pete be indifferent
between $13,000 today and $20,000 in five years.

54
 D. PV Manipulation # 1 - Finding k
 Sol’n to Q10 using Financial Calculator / App
 Determine at what rate of return would Pete be indifferent
between $13,000 today and $20,000 in five years.

Let’s watch the Screen Recording of this using the F/C App

55
 PV Manipulation # 2 - Finding n
 Example- Q11
 Determine how long it would take Xerox to be indifferent
between $4,000 today and $4,800 in the future, assuming
Xerox can earn 6% on investments today.

 What do we know?
 Equation, known variables
 Solve for n (the unknown variable)

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 PV Manipulation # 2 - Finding n
 Sol’n to Q11 using Equation
Determine how long it would take Xerox to be indifferent between $4,000
today and $4,800 in the future, assuming Xerox can earn 6% on investments
today.

57
 PV Manipulation # 2 - Finding n
 Sol’n to Q11 using Financial Calculator / Ap
Determine how long it would take Xerox to be indifferent between $4,000
today and $4,800 in the future, assuming Xerox can earn 6% on investments
today.

Let’s watch the Screen Recording of this using the F/C App

58
 Special Applications of TVM
 Perpetuity

 Deposit to accumulate a future sum

 Equal loan payments (loan amortization schedule)

 Interest or growth rates

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 Application # 1 - Perpetuity
 An annuity with indefinite life i.e. continual annual CF
 PV calculation
 PV(of a perpetuity) PV = CF ÷ r

 Q12 ICP – Chapter 4 P25(a) pgs 168 - 169 EMF Text

Having acquired a great deal of wealth through hard work, Lizzie wanted
to give back to society. She decided that the best way is the creation of
an endowment at her alumni to assist three needy students per year. The
value is $600 per student for books. The endowment will be created via
a single payment to the university. The university expects to earn 6% per
year on these funds.
Required: What is the initial single payment Lizzie is required to make
to the university to fund the endowment?

 Solution:
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 Application #2 -
Deposit to accumulate a future sum
 Answer the question: How much to deposit annually to
achieve a future sum?
 Equation

OR Payment FV of Interest Factor of an Annuity

 This equation is a manipulation of the formula for FV of

ordinary annuity.
 Let’s attempt Q13 ICP from the EMFText pg 146-147

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 Application # 2 cont’d
Q13 ICP & Sol’n using Equation
Take for example Narendra may need a car in five years time to go work in Penal. He knows
that his dream car will cost him $20,000 and that Republic Bank is currently offering 8%
annual interest on all deposits. In light of this, Narendra would like to know how much he
should deposit each year to accumulate the $20,000 in five years time.

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 Application # 2 cont’d
Q13 ICP & Sol’n using Financial Calculator / App
Take for example Narendra may need a car in five years time to go work in Penal. He knows
that his dream car will cost him $20,000 and that Republic Bank is currently offering 8%
annual interest on all deposits. In light of this, Narendra would like to know how much he
should deposit each year to accumulate the $20,000 in five years time.

Let’s watch the Screen Recording of this using the F/C App

Therefore, for Narendra to purchase his dream car in five years time, he must deposit
__________ yearly into the Republic Bank account earning a rate of interest of 8% so
that these annual deposits will accumulate to $20,000 in five years time.
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 Application # 3 – Loan Amortization
 Equal periodic loan payments
 Principal repayment + interest payments are depicted on a
Loan Amortization Schedule
 Equation -

 This equation is a manipulation of the formula for PV of

annuity
 Q14 ICP: Chapter 4 P30 pg 170 EMFText

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 Application # 3 cont’d
Q14 ICP:
Larry wanted to purchase a car and went to his local bank.
He borrowed $15,000 at a 14 percent annual rate of interest
to be repaid over a 3-year period. The loan is amortized into
three equal, annual, end-of-year payments.
Required:
a. What is Larry’s annual, end-of-year loan payment?
b. Prepare an amortization schedule for the loan. Be sure to
include the interest and principal breakdown of each of the
three loan payments.

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 Application # 3 cont’d
Sol’n to Q14 ICP using Equation

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 Application # 3 cont’d
Sol’n to Q14 ICP using Equation cont’d
Part (b) Template
End of Loan Beginning-of- Interest Principal End-of-Year
Year Payment Year Principal Payment Payment Principal

(1) (2) (3) = (2) x Rate (4) = (1) – (3) (5) = (2) – (4)

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 Application # 3 cont’d
SOLUTION to Problem 30:
Part (b)
End of Loan Beginning-of- Interest Principal End-of-Year
Year Payment Year Principal Payment Payment Principal
(1) (2) (3) = (2) x Rate (4) = (1) – (3) (5) = (2) – (4)

1 $6,460.97 $15,000.00 $2,100.00 $4,360.97 $10,639.03

2 6,460.97 10,639.03 1,489.46 4,971.51 5,667.52

3 6,460.97 5,667.52 793.45 5,667.52 0

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 Application # 3 cont’d
Sol’n to Q14 ICP using Financial Calculator / App

69
 Application # 3 cont’d
Sol’n to Q14 ICP using Financial Calculator / App cont’d

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Let’s watch the Screen Recording of this using the F/C App
 Application # 3 cont’d
Sol’n to Q14 ICP using Financial Calculator / App cont’d

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 Application # 4 –
Interest or Growth Rates
A. Stream of CF
 Equation:

 Q15 ICP: Chapter 4 P20(a) pg 167-168 EMF Text

Sue purchased 1,000 shares of M & N Company stock for $10 per
share on January 1, 2010.Determine the value of her annual rate
of return if she sells the stock on December 31, 2011 for $12.25
per share.

Sol’n to Q15 using Equation:

72
 Application # 4 –
Interest or Growth Rates
Sol’n to Q15 ICP using Financial Calculator / App
Sue purchased 1,000 shares of M & N Company stock for $10 per share on January 1,
2010.Determine the value of her annual rate of return if she sells the stock on December
31, 2011 for $12.25 per share.

73 Let’s watch the Screen Recording of this using the F/C App
Reviewing Questions on
TVM

KRM
September 2020
Question 1
Question 2
Question 3
Question 3
Question 3
Question 4
Question 4
Question 5
Question 5
Question 5
Question 5
Question 5
Question 5
 Question 6

c. What equal annual deposit must you make each year to provide the fund calculated in part (a) if
you earn only 7% per year during the 20 years preceding retirement?
Question 6
Question 6
 Question 6

c. What equal annual deposit must you make each year to provide the fund calculated in part (a) if
you earn only 7% per year during the 20 years preceding retirement?