The Time Value of Money

Critical Thinking

5.1 Explain the phrase ‘a dollar today is worth more than a dollar tomorrow’: A dollar is
worth more today than one year from now, due to its potential earning capacity. If you
have the money in your hand today, you have the opportunity to invest it and earn
interest or you can purchase goods and services for your immediate consumption.
Given that people have a positive preference for consumption, time value of money
holds true.

5.3 Differentiate between future value from present value: “Present value” is also known
as “present discounted value” or “discounted value.” It is defined as the value on a given
date of a payment or series of payments made at other times. However, “Future value”
is defined as “the value of an asset at a specific date.” In other words, “future value” is
the value of an asset or cash at a specified date in the future that is equivalent in value
to a specified sum today.

5.5 Differentiate between compounding and discounting: The process of converting an

amount given at the present time into a future value is called compounding. It is the
process of earning interest over time. Discounting is the process of converting future
cash flows to what its present value is. In other words, present value is the current value
of the future cash flows that are discounted at an appropriate interest rate.

Questions and Problems

5.3 Future Value: Your aunt is planning to invest in a bank deposit that will pay 7.5
percent interest semiannually. If she has $5,000 to invest, how much will she have at
the end of four years?

Amount invested today = PV = $5,000

Return expected from return = I = 7.5%
Duration of investment = n =4 years
Frequency of compounding = m = 2 years
Value of investment after four years = Fv4
FV4 = PV (1 + I / m ) mn = $5000 x (1 + 0.075 / 2 ) 2x4 = $5000 x (1.0375) 8 =
$6712.35
5.9 Present Value: Roy Gross is considering an investment that pays 7.6 per cent. How
much will he have to invest today so that the investment will be worth $25,000 in 6
years?
Value of investment after 6 years = FV5= $25,000

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 Return expected from investment = I = 7.6%
Duration of investment = n = 6 years
Amount to be invested today = PV

PV = FVn / (1+i)n = $25 000 / (1.076)6 = $16,108.92

5.12 Present Value: Tracy Chapman is saving to buy a house in five years time. She
plans to put down 20 percent down at that time, and she believes that she will need
$35,000 for the down payment. If Tracy can invest in a fund that pays 9.25 percent
annually, how much will she need to invest today?

Amount needed for down payment after 5 years = FV5 = $35,000

Return expected from investment = I = 9.25%
Duration of investment = n = 5 years
Amount to be invested today = PV

PV = FVn / (1+i) n = $35000 / (1.0925)5 = $22,488.52

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