Appendix 4A

The Time Value of Money

 Answers to Concepts in Review

4A.1. Time value of money refers to the fact that, with the opportunity to earn interest on funds, the value
of money depends on the point in time when the money received. Thus, the sooner one receives
money the better—the more valuable is that money.

Because money has time value, people who are willing to invest their money should be able to
earn a positive return. For example, an investor expecting to receive a $100 interest payment for
two different securities doesn’t necessarily value them equally. If the first investment pays the
interest at the end of one year, but the second investment pays the interest at the end of two years,
the first investment will be more valuable. The $100 can be reinvested to earn interest for an entire
year.

At the end of year 2, the first investment has returned $100  interest; the second has returned
$100 to the investor. The $100 reinvestment has earned a positive return; the other $100 has not
had a chance to accumulate interest.

4A.2. a. Interest is the income you receive from placing available funds in a savings account, CD,
bond, or by making a loan. It is in effect the “rent” paid on your money by those who obtain
use of it.

b. Simple interest is interest paid (earned) only on the initial balance for the actual amount of
time it is invested. With simple interest, the stated interest rate is always equal to the true rate
of interest (or return).

c. Compound interest is interest paid not only on the initial deposit but also on interest
accumulated from one period to the next. This is the method savings institutions generally
employ. When interest is compounded annually, the simple, compound, and true rates of
interest are the same.

d. The true rate of interest (or return) takes the concept of compounding into account. When
interest is compounded annually, the stated and true interest rates are equal. For more frequent
compounding, the “true” rate of interest would be higher than the stated rate. Hence, an APR
of 15% on a credit card that is compounded daily has a true interest rate of 16.18%.

4A.3. The true rate of interest rises as interest is compounded more frequently than annually. The true
and stated rates are the same when interest is compounded annually. Continuous compounding
occurs when interest is compounded over the smallest possible time period.

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2 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

4A.4. The future value of a cash flow represents the amount to which a current deposit will grow over a
given time period if it is placed in an account paying compound interest. Present value is
concerned with finding the current value of a future sum, given that the investor earns a stated
return—the discount rate (or opportunity cost)—on similar investments. The discount rate is the
rate at which future sums are discounted to find their present values. The present value concept is
the inverse of the future value concept.

4A.5. An annuity is a stream of equal cash flows that occur in equal intervals over time. These cash
flows can be paid out or received. An ordinary annuity has cash flows that occur at the end of each
period. To simplify the calculation of the future value of an annuity, one can use the PMT key on
financial calculators to enter the level cash flows or enter them as PMT in a spreadsheet =FV
formula. .

4A.6 A mixed stream of returns is a series of returns that exhibits no pattern. To find the present value
of a mixed stream, calculate the present value of each component of the mixed stream. The
summation of the present value of individual components gives us the present value of the entire
mixed stream. Better financial calculators allow for the calculation of the present value of mixed
streams, although the methods of entering data differ. The =NPV formula for spreadsheets also
calculates the PV of mixed streams. It is useful to know that the future value of a mixed stream is
just the future value of the present value held for the same number of years compounded at the
discount rate.

©2017 Pearson Education, Inc.