Time Value of

Money

Financial Management Session 8

Application of Time Value Analyis

Used in many applications, including

planning for retirement
valuing stocks and bonds
setting up loan payment schedule
making corporate decisions regarding investing in new plants and equipment
Also the single most important concept of all financial concept
Time Lines
The first step is to set up a time line
Help you visualize what’s happening in a particular problem
PV represents $100 that is on hand today
FV is the value that will be in the account on a future date
Each tick mark corresponds to both the end of one period and the
beginning of the next one.
Time 0 is today, and it is the beginning of Period
Time Lines
Cash flows are shown directly below the tick marks
The relevant interest rate is shown just above the time line
Unknown cash flows, which you are trying to find, are indicated by
question marks.
Interest rate is 5%; a single cash outflow, $100, is invested at Time 0;
and the Time 3 value is an unknown inflow.
Interest rate is constant for all three years.
Future Value
A dollar in hand today is worth more than a dollar to be received in the future.
If you had it now, you could invest it, earn interest, and own more than a
dollar in the future.
Present Value: The value today of a future cash flow or series of cash flows.
Future Value: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.
The process of going to future value (FV) from present value (PV) is called
compounding.
Future Value
PV= Present value, or beginning amount. In our example, PV = $100.
FV( N)= Future value, or ending amount, of your account after N periods.
CF(N/t)= Cash flow. Cash flows can be positive or negative.
I= Interest rate earned per year
INT= Dollars of interest earned during the year = Beginning amount x I. In
our example, INT = $100(0.05 or 5%) =$5.
N= Number of periods involved in the analysis.In our example,N =3.
Formulas to calculate Future Value
Compound Interest: Occurs when interest is earned on prior
periods’ interest.

Simple Interest : Occurs when interest is not earned on interest.

FV= PV ( 1+ It)
FV= $100 ( 1+ 0.05*3)= $115
 Self- Test

Explain why this statement is true: A dollar in hand today is worth more
than a dollar to be received next year.
What is compounding? What’s the difference between simple interest and
compound interest? What would the future value of $100 be after 5
years at 10% compound interest? At 10% simple interest?
Suppose you currently have $2,000 and plan to purchase a 3-year
certificate of deposit (CD) that pays 4% interest compounded annually.
How much will you have when the CD matures? How would your answer
change if the interest rate were 5% or 6% or 20%?
Present Value
Finding a present value is the reverse of finding a future value.
Finding present values is called discounting.
Discounting : The process of finding the present value of a cash flow
or a series of cash flows; discounting is the reverse of compounding.
Present Value ( Example )

A broker offers to sell you a Treasury bond that will pay $115.76 three
years from now. Banks are currently offering a guaranteed 5% interest on
3-year certificates of deposit (CDs), and if you don’t buy the bond, you will
buy a CD.
The 5% rate paid on the CDs is defined as your opportunity cost,
Opportunity cost: the rate of return you could earn on an alternative
investment of similar risk.
What’s the most you should pay for the bond?
 Present Value ( Example )

FV = $115.76
Interest Rate = 5%
No of period (t/N)= 3

PV= 115.76 / ( 1+0.05)^3 = $100 ( fair Value of bond)

If you could buy the bond for less than $100, you should buy it rather
than invest in the CD.
Self- Test (2)

Suppose a U.S. government bond promises to pay $2,249.73 three years

from now. If the going interest rate on 3-year government bonds is 4%,
how much is the bond worth today?
How much is it worth today if the bond matured in 5 years rather than
3?
How much is it worth today if the interest rate on the 5-year bond was
6% rather than 4%?
Annuities
A series of equal payments at fixed intervals for a specified number of periods.
Ordinary (Deferred) Annuity : An annuity whose payments occur at the end of
each period.
Annuity Due : An annuity whose payments occur at the beginning of each
period.

Time lines for a $100, 3-year, 5% ordinary annuity and for an annuity due.
Future Value of Ordinary Annuities

You deposit $100 at the end of each year for 3 years and earn 5% per year.
How much will you have at the end of the third year?
The first payment earns interest for two periods, the second payment earns
interest for one period, and the third payment earns no interest at all
because it is made at the end of the annuity’s life.

*PMT= Payment Amount

Future Value of Ordinary Annuities

FVA (3)= ( 100) ( 1+ 0.05)^3 -1/0.05= $315.25

Future Value of Annuity Due

Each payment occurs one period earlier with an annuity due, all of the
payments earn interest for one additional period.
FV of an annuity due will be greater than that of a similar ordinary
annuity.
Present Value of Ordinary Annuity
PVA(N)= (The present value of an annuity of N periods.
Present Value of Ordinary Annuity
PVA(N)= (The present value of an annuity of N periods.
Self- Test 3

You just won the Florida lottery. To receive your winnings, you must
select ONE of the two following choices:
You can receive $1,000,000 a year at the end of each of the next 30
years.
You can receive a one-time payment of $15,000,000 today.
Assume that the current interest rate is 6%.
Which option is most valuable?
Option 1: 1,000,000 a year at the end of each of the next 30 years.
FV of Annuity = 1,000,000 , N= 30 years, I= 6%
Option 2: $15,000,000 today
Perpetuities
A stream of equal payments at fixed intervals expected to continue
forever.
Perpetuities (Example )

You buy preferred stock in a company that pays you a fixed dividend of
$2.50 each year the company is in business. If we assume that the
company will go on indefinitely, the preferred stock can be valued as a
perpetuity. "
If the discount rate on the preferred stock is 10%, what is the present
value of the perpetuity, the preferred stock ?
Perpetuities
A stream of equal payments at fixed intervals expected to continue
forever.
Uneven Cash Flows

Many financial decisions involve constant payments, many others

involve uneven, or non-constant, cash flows.
Uneven cash flow: A series of cash flows where the amount varies from
one period to the next.
Payment (PMT): This term designates equal cash flows coming at
regular intervals.
Cash Flow (CFt): This term designates a cash flow that’s not part of an
annuity.
Uneven Cash Flows

Two important classes of uneven cash flows:

(1) a stream that consists of a series of annuity payments plus an
additional final lump sum
(2) all other uneven streams
Bonds represent the best example of the first type, while stocks and
capital investments illustrate the second type.
Uneven Cash Flows (Example)
Present Value of Uneven Cash Flows (formula)

We can find the PV of either stream by discounting each cash flow and
then sum them to find the PV of the stream:
PV of Uneven Cash Flows (Example)

PV =100/ (1+ 0.12)+ 100/ ( 1+0.12)^2+100/( 0+1.12)^3+ 100/( 1+ 0.12)^4+

1100/(1+0.12)^5
=$927.90
PV of Uneven Cash Flow: Example
PV of Uneven Cash Flows (formula)
Future Value of Uneven Cash Flows
Self- Test