Lecture 2

Time value of money

SSBM

prof PhD Dario Silić

 TVM- content

1. Simple Interest
2. Compound Interest
3. Future value, FV
4. Present value, PV
5. Mix CF
6. Perpetuity
7. Annuity
8. Inflation : nominal/real rates
9. Effective interest rate
 TVM Steps

1. Define problem
2. Determine weather PV (present value)
or FV (future value) is concerned
3. To draw time line divided in different intervals
4. To define CF’s on time line (up-arrows for positive CF, down-arrows
for negative CF)
5. Define if simple or mix CF is concerned
6. Solve problem with formula or excel
 Methods
• Formula

• Excel
Methods
Methods
 Future value
• Future value is a technic which mesure cash flows at the end
of project
• FV is a CF you get at the end of project
• Each CF is compounded until the end of project
• At the end of project you get the principal+interests
 Future value
Formula

FV = PV x (1+interest rate) n
 Future Value
using formula
• If you invest $100 in a cash deposit with 6%
interest rate with compounding, how much
you get at end of first year?

FV = PV x (1+interest rate) n

FV = 100 x (1 +6%)1

FV = $100 x 1.06

FV = $106
 Future value
• If you invest $800 in a bank deposit with 6%
interest rate with compounding, how much
you get at end of fifth year?
FV = $800 X (1 + 0.06)5

FV = $800 X (1.338)

FV = $1,070.4
Future value using Excel
 Future value of a deposit

deposit $1,000 with interest rate compounded

7% after 2 years.

0 1 2
7%
1.000 kn
FV
 Future value of a deposit

FV1 = P0 (1+i)1 = 1.000kn x (1.07)

= 1.070 $

Continuous compounding in a year

• You earned 70 $ of interests on
1.000 $ deposit after 1 year
• Same as simple interest rate
 FV of a deposit with continuous
compounding

FV1 = P0 (1+i)1 = 1.000 x (1.07)= 1.070 $

FV2 = FV1 x (1+i)1= P0 (1+i) x (1+i)

= 1.000 x (1.07) x (1.07)
= P0 (1+i)2= 1.000 x (1.07)2 = 1.144,90 $
If interests are not received ie. with
continuous
compounding you earned extra 4.90 $
(interests on unreceived interests) after 2
years
2 x FV1 = 1.070 + 1.070 = 1.140 $
 Case: X store company
CFO X store company wants to know how much will
earn on a deposit of 10.000 (in ‘000 eur) after 5 years
if no interests are received within 5 years
(compounded interest rate) with interest rate of 10%.
0 1 2 3 4 5
10%
10.000
FV5
 Case study: X store company

CFO X store company wants to know

how much will earn on a deposit of
10.000 (in ‘000 eur) after 5 years if no
interests are received within 5 years
(compounded interest rate) with interest
rate of 10%.
• FVn = PV x (1+i)n
• FV5 = 10,000 x (1+ 0.10)5= 16.105,10 eur
 FV with continuous compounding
7000
Interest Rates

6000 0%
5%
5000 10%
FV of $100

4000 15%

3000

2000

1000

Number of Years
 Manhattan Island Sale
In1626. Peter Minuit bought Manhattan Island for $24.
Was it a good deal or not (average int. rate is 8%)?

In order to answer to that question we have to determine the

value of $24 in 2012. using an interest rate of 8%.
 Manhattan Island Sale
In1626. Peter Minuit bought Manhattan Island for $24.
Was it a good deal or not (average int. rate is 8%)?

In order to answer to that question we have to determine the

value of $24 in 2019. using an interest rate of 8%.

FV= $24 x (1+ 8%)393

FV= 327.9 trillion
FV of mix or variable CF

Rate : 8%
FV of mix or variable CF
FV of mix or variable CF using Excel
 In which time we can double
profit???
Quickly! How long is it necessary to double initial
investment of 5.000 with a compounded interest rate of
12% per year (approximately or roughly)?

(Rule-of-72).
 In which time we can double
profit???
Quickly! How long is it necessary to double initial
investment of 5.000 with a compounded interest rate of
12% per year (approximately or roughly)?

Roughly. Years= 72 / i%
72 / 12% = 6 years
[real value 6.12 years]
 Present value
• PV, present value is a present value of a CF from
future
• $ is more worth today than tomorrow
• PV is an amount you invest today to get the FV
• Method to calculate the present value is called
Discounting

• Discount rate is known as opportunity

cost of capital (discount rate, required
return or cost of capital).
 Present value principles

Present value Discount factor

Value of Future CF Present value of 1 $
today

Discount rate
Interest rate used to
calculate PV
 Present value
Formula

PV = FV / (1+interest rate) n

Future value after t period

PV =
(1 + r) t

PV  FV  1
(1 r ) t
 Present value using
Formula
• You can get $300 at end of 1st year. If you can
get 6% on investment, how much you have to
invest today to get such amount?
PV = FV* [1/(1+interest rate)n]

$300 x [1/(1.06)1] = $300 x 0.9434

= $283.02
 Present value using
formula
• You want to calculate the PV from $1,700 that
you would get after 8 years from today.
Opportunity cost of capital is 8%.
PV = $1,700/(1 + 0.08)8

PV = $1,700/1.851 = $918.42
Present value using Excel
Present value with chart
 Case – present value (PV)
mix CF
Car seller offers you to buy a car with two possibilities :
1. In cash for 15.500 EUR
2. In three annuities
 8.000 EUR today and
 Two times 4.000 EUR at end of each year in next
two years
If the cost of money is 8%, what would you prefere?
 Case – present value (PV)
mix CF
Car seller offers you to buy a car with two possibilities :
1. In cash for 15.500 EUR
2. In three annuities
 8.000 EUR today and
 Two times 4.000 EUR at end of each year in next two years
If the cost of money is 8%, what would you prefere?

Immediate payment 8,000.00

PV1  4 , 000
(1.08 )1
 3,703.70
PV2  4 , 000
(1.08 ) 2
 3,429.36
Total PV  $15,133.06
 PV in Excel

Finding the present value of multiple cash flows by using a spreadsheet

Time until CF Cash flow Present value Formula in Column C

0 8000 $8.000,00 =PV($B$11,A4,0,-B4)
1 4000 $3.703,70 =PV($B$11,A5,0,-B5)
2 4000 $3.429,36 =PV($B$11,A6,0,-B6)

SUM: $15.133,06 =SUM(C4:C6)

Discount rate: 0,08

 PV of multiple cash flows

PV  C1
( 1 r ) 1  C2
( 1 r ) 2 ....
 Perpetuities & Annuities

Perpetuity
Constant CF which never mature, infinite CF.
Annuity
Constant CF which mature, final date defined
 Perpetuities & Annuities

Present value (PV) perpetuities : formula

PV  C
r

C = CF which never mature

r = interest rate
 Perpetuities & Annuities

Case – perpetuity
How much money you have to put on side in
order to get a yearly CF of 100.000 EUR with
10% interest rate?

PV  100, 000
.10
10%
 €1,000,000
 Annuities

 Annuity : constant CF which have a limited

duration.

1. Ordinary annuity :
annuity paid at end of each period.

2. Annuity due :
annuity paid at beggining of each period.
 Perpetuities & Annuities

Present value (PV) annuities: formula

PV  C  1
r  1
r ( 1 r ) t 
C = constant CF
r = interest rate
t = number of years
 Perpetuities & Annuities

Case: annuity
You buy a car. You have to pay it in three same
yearly annuities of 4.000 EUR. If interest rate
is 10% what is the price to be paid for your
car?
What is the present value (PV)?
 Perpetuities & Annuities
Case: anuitet (annuity)
You buy a car. You have to pay it in three same
yearly annuities of 4.000 EUR. If interest rate
is 10% what is the price to be paid for your
car?
What is the present value (PV)?

PV  4,000  1
.10  1
.10 (1.10 )3

PV  €9,947.41
Examples of yearly annuities

• Student loan
• Car loan
• Consumption loan
• Insurance premiums
• Mortgage loans
 Perpetuities & Annuities

Case: Future value (FV) of yearly payments

In next 20 years you plan to save a yearly
amount of 4.000 EUR and retire. If interest
rate is 10% what is the future value of your
retire saving?
 Perpetuities & Annuities

Case: Future value (FV) of yearly payments

In next 20 years you plan to save a yearly
amount of 4.000 EUR and retire. If interest
rate is 10% what is the future value of your
retire saving?

FV  4 ,000 1
.10  1
.10 ( 1  .10 ) 20   (1.10) 20

FV  $229,100
 Inflation
Inflation is a rate of prices increase.

Nominal interest rate is the interest rate of

money increase.

Real interest rate is a rate of purchasing power

increase.
 Inflation

1+ nominal interest rate

1  real interest rate = 1+inflation rate

approximation formula
Real int. rate  nominal int. rate - inflation rate
 Inflation Savings

Case: Bond
If a yield on public bonds is 5,0% and inflation
2.2%, what is the real interest rate?

1+.050
1  real interestrate = 1+.022

1  real interestrate = 1.027

real interestrate = .027 or 2.7%

Approximation = .050 - .022 = .028or 2.8%

 Compounding

General formula:
FVn = PV0(1 + [i/m])mn

n: nb of years
m: nb of periods in a year
i: yearly interest rate
FVn,m: Future value(FV) at end of year n
PV0: Present value (PV) of CF
 Compounding

VIP company has 1.000 $ to invest in 2 years with

12% yearly interest rate.

Annual FV2 = 1.000(1+ [.12/1])(1)(2)

= 1,254.40 $
Semi-annual FV2 =1,000(1+[.12/2])(2)(2)
= 1,262.48 $
 Compounding
Qrtly FV2= 1,000(1+ [.12/4])(4)(2)
= 1,266.77 $
Monthly FV2= 1,000(1+ [.12/12])(12)(2)
= 1,269.73 $
Daily FV2 = 1,000(1+[.12/365])(365)(2)
= 1,271.20 $
Compounding using Excel
 Effective interest rate
Effective annual interest rate -EAR is a
yearly compounded interest rate
It is a real earned interest after a nominal
rate adjustment for factors such as
period, compounding, etc.

Annual percentage interest rate -

APR is a simple annual interest rate
Effective annual interest rate

(1 + [ i / m ] )m - 1
 Effective annual interest rate
Case:
If a monthly rate is 1%, what is the effective
annual rate – EAR ?
What is the annual percentage rate – APR ?
 Effective annual interest rate
Case:
If a monthly rate is 1%, what is the effective
annual rate – EAR ?
What is the annual percentage rate – APR ?

EAR = (1 + .01)12 - 1 = r
EAR = (1 + .01)12 - 1 = .1268 or 12.68%

APR = .01 x 12 = .12 or 12.00%

 Loan amortization- steps
1. Calculate annuity (pmt).
2. Calculate interests (loan balance na t-1) x (i% / m)
3. Deduct from annuity yearly interests and
obtain a loan principal in period t
4. Calculate the remaining debt principal balance t.
(Balance - principal payment in 3)
5. Restart from point 2 and continue the steps
 Case: debt amortization
Crosco company is taking a loan of 6.000 (in ’000 $)
with 10% yearly interest rate.
Amortize debt over 4 years.
First step: Payment, annuity
PV0 = A (PVIFA 10%,4)
6,000 = A (1/(1+10%)1+ 1/(1+10%)2+ 1/(1+10%)3+ 1/(1+10%)4)
6,000 = A (3.171)
A = 6,000 / 3.171 = $1,892
 Case Crosco company

Interests (2) = Principal (3) = Ending Balance

Year Annuity (1)
(4) x i (1) – (2) (4)
0 --- --- --- 6.000
1 1.892,8 600,0 1.292,8 4.707,2
2 1.892,8 470,7 1.422,1 3.285,1
3 1.892,8 328,5 1.564,3 1.720,8
4 1.892,8 172,1 1.720,7 0,0

Total 7.571,3 1.571,3 6.000,0

Loan amortization
 Calculation of period
• Calculate the number of periods from the
future and present values of CF.

Calculate the number of periods from initial

$1,000 deposit, with 8% interest rate, in order
to get $2,500. With 8% interest rate, how
many years, n, will be needed that the initial
amount of $1,000 (PVn) become $2,500 (FVn)
?
Calculation of number
of periods using Excel
SSBM

MBA
prof PhD Dario Silić