Chapter 2 Time Value of Money Edited (Student)

7/11/2022
TIME VALUE OF
MONEY
© Pearson Education Limited, 2015. 5-1
Investment?
Suppose a firm has an opportunity to spend

$10,000 today on some investment that will
produce $15,000 spread out over the next two
years as follows:
A B
Year Cash flow Year Cash flow
1 $6,000 1 $9,000
2 $9,000 2 $6,000
Is this a wise investment?

A or B?
The Concept of Time Value
$1 today is worth more than $1 in the future.
Money available at the present time is worth more than the

same amount in the future due to its potential earning
capacity.
Time value of money allows comparison of cash flows from

different periods.
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Key concepts and skills

Be able to compute the following:
• The future value of an investment made today
• The present value of cash to be received at some future
date
• The return (interest rate) on an investment
Be able to predict how long it will take for an

investment to reach a desired value
Be able to solve time value of money problems using:

• formulas
• a financial calculator
• a spreadsheet
4-4
Basic definitions
• Present value (PV)
– The current value of future cash flows discounted at the
appropriate discount rate.
– Value at t=0 on a time line
• Future value (FV)
– The amount an investment is worth after one or more
periods.
– ‘Later’ money on a time line
4-5
Future Value versus Present Value (cont.)
To make the right investment decision, managers

need to compare the cash flows at a single point in
time.
Figure 5.1 Time Line
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Basic definitions (cont.)

• Interest rate (r)
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
– Terminology depends on usage
4-7
Future values:
Effects of compounding
• Simple interest
–Interest earned only on the original
principal
• Compound interest
–Interest earned on principal and on
interest received
–‘Interest on interest’—interest
earned on reinvestment of previous
interest payments
4-8
14
Simple Interest
Interest paid (earned) is based on the original amount, or principal
borrowed (lent).
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125
You don’t earn interest on interest
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15
Compound Interest
Interest paid (earned) is based on any previous interest earned, as
well as on the principal borrowed (lent).
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5.51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
You earn interest on interest
10
Future values:
Effects of compounding
• Consider the previous example:
–FV w/simple interest
= 100 + 10 + 10 = 120
–FV w/compound interest
=100(1.10)2 = 121.00
–The extra 1.00 comes from the
interest of .10(10) = 1.00 earned on
the first interest payment.
4-11
11
Future Value versus Present Value
Suppose a firm has an opportunity to spend

$15,000 today on some investment that will
produce $17,000 spread out over the next five
years as follows:
Year Cash flow
1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000
Is this a wise investment?
12
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To make the right investment decision, managers

need to compare the cash flows at a single point in
time.
Figure 5.1 Time Line
13

When making investment decisions, managers usually
calculate present value.
Figure 5.2 Compounding and Discounting
14
Future Value of a Single Amount
• Future value is the value at a given future date of

an amount placed on deposit today and earning
interest at a specified rate. Found by applying
compound interest over a specified period of time.
• Compound interest is interest that is earned on a
given deposit and has become part of the principal
at the end of a specified period.
• Principal is the amount of money on which interest
is paid.
15
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Future Value of a Single Amount: The

Equation for Future Value
• We use the following notation for the various
inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial
calculators, I is typically used to represent this rate.)
– n = number of periods (typically years) that the money is
left on deposit
• The general equation for the future value at the
end of period n is
FVn = PV  (1 + r)n
16
Future Value of a Single Amount: The

Jane Farber places $800 in a savings account paying 6%
interest compounded annually. She wants to know how much
money will be in the account at the end of five years.
FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58
This analysis can be depicted on a time line as follows:
17
Figure 5.4
Future Value Relationship
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Present Value of a Single Amount
• Present value is the current dollar value of a

future amount—the amount of money that would
have to be invested today at a given interest rate
over a specified period to equal the future amount.
• It is based on the idea that a dollar today is worth
more than a dollar tomorrow.
• Discounting cash flows is the process of finding
present values; the inverse of compounding
interest.
• The discount rate is often also referred to as the
opportunity cost, the discount rate, the required
return, or the cost of capital.
19
Present Value of a Single Amount: The

Equation for Present Value
The present value, PV, of some future amount, FVn, to
be received n periods from now, assuming an interest
rate (or opportunity cost) of r, is calculated as
follows:
20
Present Value of a Single Amount: The

Pam Valenti wishes to find the present value of
$1,700 that will be received 8 years from now.
Pam’s opportunity cost is 8%.
PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
This analysis can be depicted on a time line as

follows:
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Figure 5.5
Present Value Relationship
22
Future Value of a Mixed Stream
Shrell Industries, a cabinet manufacturer, expects to

receive the following mixed stream of cash flows over
the next 5 years from one of its small customers.
23
Future Value of a Mixed Stream
If the firm expects to earn at least 8% on its

investments, how much will it accumulate by the end
of year 5 if it immediately invests these cash flows
when they are received?
This situation is depicted on the following time line.
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Present Value of a Mixed Stream
Frey Company, a shoe manufacturer, has been

offered an opportunity to receive the following mixed
stream of cash flows over the next 5 years.
25
Present Value of a Mixed Stream
If the firm must earn at least 9% on its investments,

what is the most it should pay for this opportunity?
This situation is depicted on the following time line.
26
Multiple Cash Flows – FV
• You think you will be able to deposit $4,000 at the

end of each year of the next three years in a bank
account paying 8 percent interest.
• You currently have $7,000 in the account.
– How much will you have in three years?
– How much will you have in four years?
27
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Multiple Cash Flows – FV (Cont’d)

▪ Find the value at year 3 of each cash flow and add them together.
▪ Today (year 0): FV = 7000(1.08)3 = 8,817.98
▪ Year 1: FV = 4,000(1.08)2 = 4,665.60
▪ Year 2: FV = 4,000(1.08) = 4,320
▪ Year 3: value = 4,000
▪ Total value in 3 years = 8,817.98 + 4,665.60 + 4,320 + 4,000 =
21,803.58
▪ Value at year 4 = 21,803.58(1.08) = 23,547.87
28
Annuities
An annuity is a stream of equal periodic cash flows,

over a specified time period. These cash flows can be
inflows of returns earned on investments or outflows
of funds invested to earn future returns.
– An ordinary annuity is an annuity for which the cash flow

occurs at the end of each period
– An annuity due is an annuity for which the cash flow

occurs at the beginning of each period.
29
Personal Finance Example
Fran Abrams is choosing which of two annuities to

receive. Both are 5-year $1,000 annuities; annuity A is
an ordinary annuity, and annuity B is an annuity due.
Fran has listed the cash flows for both annuities as
shown in Table 5.1 on the following slide.
Note that the amount of both annuities total $5,000.
30
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Table 5.1 Comparison of Ordinary Annuity and

Annuity Due Cash Flows ($1,000, 5 Years,
7%/year)
31
Finding the Future Value of an Ordinary

Annuity
• You can calculate the future value of an ordinary
annuity that pays an annual cash flow equal to CF
(PMT) by using the following equation:
• As before, in this equation r represents the interest

rate and n represents the number of payments in
the annuity (or equivalently, the number of years
over which the annuity is spread).
32
Fran Abrams wishes to determine how much money she

will have at the end of 5 years if he chooses annuity A, the
ordinary annuity and it earns 7% annually. Annuity A is
depicted graphically below:
This analysis can be depicted on a time line as follows:
33
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Finding the Present Value of an Ordinary

Annuity
• You can calculate the present value of an ordinary
by using the following equation:

34
Finding the Present Value of an Ordinary

Annuity (cont.)
Braden Company, a small producer of plastic toys, wants
to determine the most it should pay to purchase a
particular annuity. The annuity consists of cash flows of
$700 at the end of each year for 5 years. The firm requires
the annuity to provide a minimum return of 8%.
This situation can be depicted on a time line as follows:
35
Fran Abrams now wishes to choose between an ordinary annuity

and an annuity due, both offering similar terms except the
timing of cash flows. We have already calculated the value of the
ordinary annuity, but need to calculate the value of an annuity
due. (7%)
36
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Personal Finance Example (cont.)
Future value of ordinary Future value of annuity

annuity due
$5,705.74 $6,153.29
The future value of an annuity due is always higher

than the future value of an ordinary annuity.
37
Finding the Future Value of an Annuity

Due
• You can calculate the present value of an annuity
due that pays an annual cash flow equal to CF by
using the following equation:

38
Finding the Present Value of an Annuity

Due
• You can calculate the present value of an ordinary
by using the following equation:

39
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Perpetuities
A perpetuity is a stream that continues forever or

has no maturity. For example, a dividend stream on a
share of preferred stock. There are two basic types of
perpetuities:
– Level perpetuity in which the payments are constant over
time.
– Growing perpetuity in which cash flows grow at a
constant rate from period to period over time.
40
Calculating the Present Value of a Level

Perpetuity
CF
PV =
r
PV = the present value of a level perpetuity
CF = the constant dollar amount provided by the
perpetuity
r = the interest (or discount) rate per period
41
Calculating the Present Value of a

Growing Perpetuity
In growing perpetuities, the periodic cash flows grow
at a constant rate each period.
CFperiod 1
PV =
r −g
42
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Compounding Interest More Frequently

Than Annually
• Compounding more frequently than once a year
results in a higher effective interest rate because
you are earning on interest on interest more
frequently.
• As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
• Furthermore, the effective rate of interest will
increase the more frequently interest is
compounded.
43
Compounding Interest More Frequently

Than Annually (cont.)
A general equation for compounding more frequently
than annually
If Fred Moreno places $100 in a savings account

paying 8% interest annually, how much will he have
at the end of 2 year assuming (1) semiannual
compounding and (2) quarterly compounding.
44
Nominal and Effective Annual Rates of

Interest
• The nominal (stated) annual rate is the
contractual annual rate of interest charged by a
lender or promised by a borrower.
• The effective (true) annual rate (EAR) is the
annual rate of interest actually paid or earned.
• In general, the effective rate > nominal rate
whenever compounding occurs more than once per
year
• m: compounding frequency
45
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Fred Moreno wishes to find the effective annual rate

associated with an 8% nominal annual rate (r = 0.08)
when interest is compounded (1) annually; (2)
semiannually; and (3) quarterly.
46
32
Present Value of Deferred Annuity

$1,000 2,000 3,000 1,000 1,000 1,000 1,000 1,000
0 1 2 3 4 5 6 7 8
You expect to receive $1,000 in the first year, $2,000 in the second
year and 3,000 in the third year. Then, you receive an annuity of
$1,000 paid at end of each year from fourth through eighth year. How
much should you invest now if you require a 8% rate of return?
47
32
Present Value of Deferred Annuity

$20,000 20,00020,00020,00020,000
0 1 2 3 4 5 6 7 8
You expect to receive $20,000 per year at the end of year 4, 5, 6, 7

and 8 from an investment. How much should you invest now if you
require a 20% rate of return?
48
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33
Future Value of Deferred Annuity

$20,000 20,000 20,000 20,000 20,000
0 1 2 3 4 5 6 7 8
You expect to receive $20,000 per year at the end of year 2, 3, 4,

5 and 6 from an investment. How much would you receive at the
end of Year 8 if the discount rate is 20%?
49
1. Deposits to Accumulate a Future 40
Sum
Suppose you want to buy a house 5 years from now and you
estimate that the down payment needed will be $30,000. How
much would you need to deposit at the end of each year for
the next 5 years to accumulate $30,000, if you can earn 6% on
your deposits?
50
2. Loan 41
Amortization
You borrow $6,000 at 10 percent and agree to make equal

annual end- of-year payments over 4 years. To find the size of
the payments, the lender determines the amount of a 4-year
annuity discounted at 10 percent that has a present value of
$6,000.
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Loan Amortization Schedule

($6,000 Principal, 10% Interest, 4-Year 42
Repayment Period)
52
3. Monthly Housing Loan 43
Payment
If you borrow $100,000 at 7% fixed interest for 30 years in order

to buy a house, what will be your monthly housing loan
payment?
53
4. Growth
Year Cash Flow
44
2016 $1,520
Rates 2015
2014
$1,440
$1,370
2013 $1,300
2012 $1,250
You wish to find the growth rates reflected in the stream of cash
flows that you received from a real estate investment over the
period from 2012 through 2016 as shown above.
54
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5. Interest 45
Rate
You can borrow $2,000 to be repaid in equal annual end-of-

year amounts of $514.14 for the next 5 years. Find the
interest rate on this loan.
55
6. Finding an Unknown Number of 46
Periods
You wish to determine the number of years it will take for your
initial $1,000 deposit, earning 8% annual interest, to grow to
equal $2,500. Simply stated, at an 8% annual rate of interest,
how many years, n, will it take for your $1,000 to grow to
$2,500?
56
7. Retirement 47
Fund
After graduation, you plan to invest $400 per month in the stock
market. If you earn 12% per year on your stocks, how much will you
have accumulated when you retire in 30 years’ time?
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8. Retirement Fund for Specific 48
Purpose
Upon retirement, your goal is to spend 5 years traveling around
the world. To travel in style will require $250,000 per year at
the beginning of each year. If you plan to retire in 30 years,
what are the equal monthly payments necessary to achieve this
goal? The funds in your retirement account will compound at
10% annually.
58
20

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7/11/2022

© Pearson Education Limited, 2015. 5-1

Suppose a firm has an opportunity to spend

Is this a wise investment?

© Pearson Education Limited, 2015. 5-2

The Concept of Time Value

$1 today is worth more than $1 in the future.

Money available at the present time is worth more than the

Time value of money allows comparison of cash flows from

© Pearson Education Limited, 2015. 5-3

Key concepts and skills

Be able to predict how long it will take for an

Be able to solve time value of money problems using:

Future Value versus Present Value (cont.)

To make the right investment decision, managers

Figure 5.1 Time Line

© Pearson Education Limited, 2015. 5-6

Basic definitions (cont.)

© Pearson Education Limited, 2015. 5-9

Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25

Year 3: 5% of $110.25 = $5.51+ $110.25 = $115.76

Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55

Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

You earn interest on interest

© Pearson Education Limited, 2015. 5-10

Future Value versus Present Value

Suppose a firm has an opportunity to spend

Is this a wise investment?

© Pearson Education Limited, 2015. 5-12

Future Value versus Present Value (cont.)

To make the right investment decision, managers

Figure 5.1 Time Line

© Pearson Education Limited, 2015. 5-13

Future Value versus Present Value (cont.)

Figure 5.2 Compounding and Discounting

© Pearson Education Limited, 2015. 5-14

Future Value of a Single Amount

• Future value is the value at a given future date of

© Pearson Education Limited, 2015. 5-15

Future Value of a Single Amount: The

© Pearson Education Limited, 2015. 5-16

Future Value of a Single Amount: The

FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58

This analysis can be depicted on a time line as follows:

© Pearson Education Limited, 2015. 5-17

© Pearson Education Limited, 2015. 5-18

Present Value of a Single Amount

• Present value is the current dollar value of a

© Pearson Education Limited, 2015. 5-19

Present Value of a Single Amount: The

© Pearson Education Limited, 2015. 5-20

Present Value of a Single Amount: The

PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46

This analysis can be depicted on a time line as

© Pearson Education Limited, 2015. 5-21

© Pearson Education Limited, 2015. 5-22

Future Value of a Mixed Stream

Shrell Industries, a cabinet manufacturer, expects to

© Pearson Education Limited, 2015. 5-23

Future Value of a Mixed Stream

If the firm expects to earn at least 8% on its

© Pearson Education Limited, 2015. 5-24

Present Value of a Mixed Stream