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**Time Value of Money
**

Learning Objectives

To elaborate the concept of time value of money and time line.

To explain the differences between simple interest and

compound interest.

To elucidate the future value of single amount.

To explain the effects of frequent compounding towards future

value amount.

To clarify the differences between effective and nominal interest

rate.

To explain the present value for an amount in the future

To illustrate the calculation of future value and present value for

both ordinary annuity and annuity due.

To calculate the value of uneven cash flows.

To discuss on perpetuity.

To elaborate on the application of time value of money concept

in loan amortization.

Generally, receiving $1 today is worth more

than $1 in the future. This is due to

opportunity costs.

The opportunity cost of receiving $1 in the

future is the interest we could have earned

if we had received the $1 sooner.

Today Future

If we can measure this opportunity

cost, we can:

Translate $1 today into its equivalent in the future

(compounding).

Translate $1 in the future into its equivalent today

(discounting).

?

Today

Future

Today

?

Future

Significance of the time value of money

Time value of money is important in understanding

financial management.

It should be considered for making financial

decisions.

It can be used to compare investment alternatives and

to solve problems involving loans, mortgages, leases,

savings, and annuities.

Simple Interest

Interest is earned only on principal.

Example: Compute simple interest on $100

invested at 6% per year for three years.

1

st

year interest is $6.00

2

nd

year interest is $6.00

3

rd

year interest is $6.00

Total interest earned: $18.00

Compound Interest

Compounding is when interest paid on an investment

during the first period is added to the principal; then,

during the second period, interest is earned on the

new sum (that includes the principal and interest

earned so far).

Is the amount a sum will grow to in a certain number

of years when compounded at a specific rate.

Compounding : process of determining the Future

Value (FV) of cash flow.

Compounded amount = Future Value (beginning

amount plus interest earned. )

Compound Interest

Example: Compute compound interest on

$100 invested at 6% for three years with

annual compounding.

1

st

year interest is $6.00 Principal now is $106.00

2

nd

year interest is $6.36 Principal now is $112.36

3

rd

year interest is $6.74 Principal now is $119.11

Total interest earned: $19.10

• Suppose you invest $100 for one year at 5% per year.

What is the future value in one year?

– Interest = 100(.05) = 5

– Value in one year = principal + interest = 100 + 5 = 105

– Future Value (FV) = 100(1 + .05) = 105

• Suppose you leave the money in for another year. How

much will you have two years from now?

– FV = 100(1.05)(1.05) = 100(1.05)

2

= 110.25

• FV = PV(1 + r)

t

– FV = future value

– PV = present value

– r = period interest rate, expressed as a decimal

– t = number of periods

• Future value interest factor = (1 + r)

t

Future Value

Future Value is the amount a sum will grow to in a certain number of

years when compounded at a specific rate.

Two ways to calculate Future Value (FV): by using Manual Formula or

Using Table.

Manual Formula Table

FV

n

= PV (1 + r)

n

FV

n

= PV (FVIF

i,n

)

n

Where :

FV

n

= the future of the investment at the end of “n” years

r = the annual interest (or discount) rate

n = number of years

PV = the present value, or original amount invested at the beginning of the

first year

FVIF=Futurevalueinterestfactororthecompoundsum$1

Future Value - single sums

If you deposit $100 in an account earning 6%, how

much would you have in the account after 1 year?

Mathematical Solution:

FV = PV (FVIF

i, n

)

FV = 100 (FVIF

.06, 1

) (use FVIF table, or)

FV = PV (1 + i)

n

FV = 100 (1.06)

1

= $106

0 1

PV = -100 FV = ???

Future Value - single sums

If you deposit $100 in an account earning 6%, how

much would you have in the account after 5 years?

Mathematical Solution:

FV = PV (FVIF

i, n

)

FV = 100 (FVIF

.06, 5

) (use FVIF table, or)

FV = PV (1 + i)

n

FV = 100 (1.06)

5

= $133.82

0 5

PV = -100 FV = ???

Compound Interest With Non-annual

Periods

Non-annual periods : not annual compounding but occur

semiannually, quarterly, monthly or daily…

If semiannually compounding :

FV = PV (1 + i/2)

n x 2

or FV

n

= PV (FVIF

i/2

,

nx2

)

If quarterly compounding :

FV = PV (1 + i/4)

n x 4

or FV

n

= PV (FVIF

i/4,nx4

)

If monthly compounding :

FV = PV (1 + i/12)

n x 12

or FV

n

= PV (FVIF

i/12,nx12

)

If daily compounding :

FV = PV (1 + i/365)

n x 365

or FV

n

= PV (FVIF

i/365,nx365

)

Mathematical Solution:

FV = PV (FVIF

i, n

)

FV = 100 (FVIF

.015, 20

) (can’t use FVIF table)

FV = PV (1 + i/m)

m x n

FV = 100 (1.015)

20

= $134.68

0 20

PV = -100 FV = 134.

68

Future Value - single sums

If you deposit $100 in an account earning 6% with

quarterly compounding, how much would you have in

the account after 5 years?

Mathematical Solution:

FV = PV (FVIF

i, n

)

FV = 100 (FVIF

.005, 60

) (can’t use FVIF table)

FV = PV (1 + i/m)

m x n

FV = 100 (1.005)

60

= $134.89

0 60

PV = -100 FV = 134.

89

Future Value - single sums

If you deposit $100 in an account earning 6% with

monthly compounding, how much would you have in

the account after 5 years?

Present Value

Present value reflects the current value of a future payment or

receipt.

How much do I have to invest today to have some amount in the

future?

Finding Present Values(PVs)= discounting

Manual Formula Table

PV

n

= FV/ (1 + r)

n

PV

n

= FV (PVIF

i,n

)

n

Where :

FV

n

= the future of the investment at the end of “n” years

r = the annual interest (or discount) rate

n = number of years

PV= the present value, or original amount invested at the beginning of

the first year

PVIF=Present Value Interest Factor or the discount sum$1

Mathematical Solution:

PV = FV (PVIF

i, n

)

PV = 100 (PVIF

.06, 1

) (use PVIF table, or)

PV = FV / (1 + i)

n

PV = 100 / (1.06)

1

= $94.34

PV = ??? FV = 100

0 1

Present Value - single sums

If you receive $100 one year from now, what is the PV

of that $100 if your opportunity cost is 6%?

Mathematical Solution:

PV = FV (PVIF

i, n

)

PV = 100 (PVIF

.06, 5

) (use PVIF table, or)

PV = FV / (1 + i)

n

PV = 100 / (1.06)

5

= $74.73

Present Value - single sums

If you receive $100 five years from now, what is the

PV of that $100 if your opportunity cost is 6%?

0 5

PV = ??? FV = 100

Mathematical Solution:

PV = FV (PVIF

i, n

)

PV = 1000 (PVIF

.07, 15

) (use PVIF table, or)

PV = FV / (1 + i)

n

PV = 1000 / (1.07)

15

= $362.45

Present Value - single sums

What is the PV of $1,000 to be received 15 years from

now if your opportunity cost is 7%?

0 15

PV = -362.

45

FV = 1000

• Suppose you need $10,000 in one year for the down

payment on a new car. If you can earn 7% annually, how

much do you need to invest today?

– PV = 10,000 / (1.07)

1

= 9,345.79

• You want to begin saving for your daughter’s college

education and you estimate that she will need $150,000 in

17 years. If you feel confident that you can earn 8% per

year, how much do you need to invest today?

– PV = 150,000 / (1.08)

17

= 40,540.34

• Your parents set up a trust fund for you 10 years ago that

is now worth $19,671.51. If the fund earned 7% per year,

how much did your parents invest?

– PV = 19,671.51 / (1.07)

10

= 9,999.998 = 10,000

5C-20

Finding i

1. At what annual rate would the following have to be invested;

$500 to grow to RM1183.70 in 10 years.

FV

n

= PV (FVIF

i,n

)

1183.70 = 500 (FVIF

i,10

)

1183.70/500 = (FVIF

i,10

)

2.3674 = (FVIF

i,10

) refer to FVIF table

i = 9%

2. If you sold land for $11,439 that you bought 5 years ago for

$5,000, what is your annual rate of return?

FV = PV (FVIF

i, n

)

11,439 = 5,000 (FVIF

?, 5

)

11,439/ 5,000= (FVIF

?, 5

)

2.3866 = (FVIF

?, 5

)

i = .18

Finding n

1. How many years will the following investment takes? $100 to

grow to $672.75 if invested at 10% compounded annually

FV

n

= PV (FVIF

i,n

)

672.75 = 100 (FVIF

10%,n

)

672.75/100 = (FVIF

10%,n

)

6.7272 = (FVIF

10%,n

) refer to FVIF table

n = 20 years

2. Suppose you placed $100 in an account that pays 9% interest,

compounded annually. How long will it take for your account to

grow to $514?

FV = PV (1 + i)

n

514 = 100 (1+ .09)

N

514/100 = (FVIF

9%,n

)

5.14 = (FVIF

9%,n

) refer to FVIF table

n = 19 years

FV = PV (FVIF

i, n

)

11,933 = 5,000 (FVIF

?, 5

)

2.3866 = (FVIF

?, 5

) can’t find

FV = PV(1 + r)t

r = (FV / PV)1/t – 1

FV = PV (1 + i)

n

11,933 = 5,000 (1+ i)

5

11,933 / 5,000 = (1+i)

5

2.3866 = (1+i)

5

(2.3866)

1/5

= (1+i)

1.19 = 1+i i = .19

Finding i and n

If you sold land for $11,933 that you bought 5 years

ago for $5,000, what is your annual rate of return?

Finding i and n

Suppose you placed $100 in an account that pays 9.6%

interest, compounded monthly. How long will it take

for your account to grow to $500?

FV = PV (1 + i)

n

500 = 100 (1+ .008)

N

5 = (1.008)

N

ln 5 = ln (1.008)

N

ln 5 = N ln (1.008)

1.60944 = .007968 N

N = 202 months

– FV = PV(1 + r)

t

– t = ln(FV / PV) / ln(1 + r)

• You are looking at an investment that will pay $1,200 in 5

years if you invest $1,000 today. What is the implied rate

of interest?

– r = (1,200 / 1,000)

1/5

– 1 = .03714 = 3.714%

• Suppose you are offered an investment that will allow you

to double your money in 6 years. You have $10,000 to

invest. What is the implied rate of interest?

– r = (20,000 / 10,000)

1/6

– 1 = .1225 = 12.25%

• You want to purchase a new car, and you are willing to

pay $20,000. If you can invest at 10% per year and you

currently have $15,000, how long will it be before you

have enough money to pay cash for the car?

– t = ln(20,000 / 15,000) / ln(1 + 0.1) =3.02 years

5C-25

Hint for single sum problems:

In every single sum present value and future

value problem, there are four variables:

FV, PV, i and n.

When doing problems, you will be given three

variables and you will solve for the fourth

variable.

Keeping this in mind makes solving time value

problems much easier!

Handy Rule of Thumb

• Rule of 72 can estimate how long it takes to double a

sum of money

– Time to double money = 72 / (interest rate per year)

• If interest rate = 9% per year, it will take 8 years to

double the money

– Time to double money = 72 / 9% = 8 years

• If the time taken to double the money is 8 years, the

interest rate is 9% per year

– Interest rate per year = 72 / 8 years = 9%

5C-27

5C-28

5-29

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.

• Suppose you invest $500 in a mutual fund today

and $600 in one year. If the fund pays 9% annually, how

much will you have in two years?

– FV

2

= 500(1.09)

2

+ 600(1.09)

1

= 594.05 + 654.00

= 1,248.05

How much will you have in 5 years if you make no further

deposits?

– FV

5

= 500(1.09)

5

+ 600(1.09)

4

= 769.31 + 846.95 = 1,616.26

• Suppose you plan to deposit $100 into an account in one year

and $300 into the account in three years. How much will be

in the account in five years if the interest rate is 8%?

– FV

5

= 100 (1.08)

4

+ 300(1.08)

2

= 136.05 + 349.92

= 485.97

6C-30

5-31

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.

• You are considering an investment that will pay you $1,000

in one year, $2,000 in two years and $3,000 in three years.

If you want to earn 10% on your money, how much would

you be willing to pay?

– PV = 1,000 / (1.10)

1

+ 2,000 / (1.10)

2

+3,000 / (1.10)

3

= 4,815.93

• Your broker calls you and tells you that he has this great

investment opportunity. If you invest $100 today, you will

receive $40 in one year and $75 in two years. If you

require a 15% return on investments of this risk, should

you take the investment?

– PV = 40 / (1.15)

1

+ 75 / (1.15)

2

= 91.49, reject this investment.

• You are offered the opportunity to put some money away

for retirement. You will receive five annual payments of

$25,000 each beginning in 40 years. How much would you

be willing to invest today if you desire an interest rate of

12%? PV = 25,000 / (1.12)

40

+ 25,000 / (1.12)

41

+25,000 / (1.12)

42

+

25,000 / (1.12)

43

+25,000 / (1.12)

44

= 1,084.71

6C-32

Compounding and Discounting

Cash Flow Streams

0 1 2 3 4

Two types of annuity: ordinary annuity and annuity due.

ordinary annuity: a sequence of equal cash flows, occurring

at the end of each period.

Annuity due: annuity payment occurs at the beginning of

the period rather than at the end of the period.

0 1 2 3 4

Annuities

Mathematical Solution:

FV = PMT (FVIFA

i, n

)

FV = 1,000 (FVIFA

.08, 3

) (use FVIFA table, or)

FV = PMT (1 + i)

n

- 1

i

FV = 1,000 (1.08)

3

- 1 = $3246.40

.08

Future Value - annuity

If you invest $1,000 each year at 8%, how much

would you have after 3 years?

Mathematical Solution:

PV = PMT (PVIFA

i, n

)

PV = 1,000 (PVIFA

.08, 3

) (use PVIFA table, or)

1

PV = PMT 1 - (1 + i)

n

i

1

PV = 1000 1 - (1.08 )

3

= $2,577.10

.08

Present Value - annuity

What is the PV of $1,000 at the end of each of the next

3 years, if the opportunity cost is 8%?

Perpetuities

Suppose you will receive a fixed

payment every period (month, year,

etc.) forever. This is an example of a

perpetuity.

You can think of a perpetuity as an

annuity that goes on forever.

PMT

i

PV =

So, the PV of a perpetuity is very

simple to find:

Present Value of a Perpetuity

What should you be willing to pay in

order to receive $10,000 annually

forever, if you require 8% per year

on the investment?

PMT $10,000

i .08

= $125,000

PV = =

Ordinary Annuity

vs.

Annuity Due

$1000 $1000 $1000

4 5 6 7 8

Earlier, we examined this

“ordinary” annuity:

Using an interest rate of 8%, we find

that:

The Future Value (at 3) is $3,246.40.

The Present Value (at 0) is $2,577.10.

0 1 2 3

1000 1000 1000

What about this annuity?

Same 3-year time line,

Same 3 $1000 cash flows, but

The cash flows occur at the beginning

of each year, rather than at the end

of each year.

This is an “annuity due.”

0 1 2 3

1000 1000 1000

Future Value - annuity due

If you invest $1,000 at the beginning of each of the

next 3 years at 8%, how much would you have at the

end of year 3?

Mathematical Solution: Simply compound the FV of the

ordinary annuity one more period:

FV = PMT (FVIFA

i, n

) (1 + i)

FV = 1,000 (FVIFA

.08, 3

) (1.08) (use FVIFA table, or)

FV = PMT (1 + i)

n

- 1

i

FV = 1,000 (1.08)

3

- 1 = $3,506.11

.08

(1 + i)

(1.08)

Present Value - annuity due

Mathematical Solution: Simply compound the FV of the

ordinary annuity one more period:

PV = PMT (PVIFA

i, n

) (1 + i)

PV = 1,000 (PVIFA

.08, 3

) (1.08) (use PVIFA table, or)

1

PV = PMT 1 - (1 + i)

n

i

1

PV = 1000 1 - (1.08 )

3

= $2,783.26

.08

(1 + i)

(1.08)

• Suppose you win the $10 million sweepstakes. The

money is paid in equal annual end-of-year installments of

$333,333.33 over 30 years. If the appropriate discount

rate is 5%, how much is the sweepstakes actually worth

today?

• Suppose you begin saving for your retirement by

depositing $2,000 per year in a savings account. If the

interest rate is 7.5%, how much will you have in 40

years?

6C-45

29 . 150 . 124 , 5

0.05

) 05 . 0 (1

1

1

333,333.33

r

r) (1

1

1

C PV

30 t

=

(

(

(

(

¸

(

¸

+

÷

=

(

(

(

(

¸

(

¸

+

÷

=

454,513.04

0.075

1 0.075) (1

2,000

r

1 r) (1

C FV

40 t

=

(

¸

(

¸

÷ +

=

(

¸

(

¸

÷ +

=

• Suppose you borrow $2,000 at 5%, and you are going to

make annual payments of $734.42. How long will you take

to pay off the loan?

To pay your children’s education, you wish to have

accumulated RM25,000 at the end of 15 years. To do this,

you plan to deposit an equal amount into the bank at the

end of each year. If the bank is willing to pay 7%

compounded annually, how much must you deposit each

year to obtain your goal?

FVn = PMT (FVIFA7%,15)

RM25,000 = PMT (FVIFA7%,15)

RM25,000 = PMT(25.129)

Thus, PMT = RM994.87

6C-46

3 t 2,000

0.05

0.05) (1

1

1

734.42

r

r) (1

1

1

C PV

t t

= ¬ =

(

(

(

(

¸

(

¸

+

÷

=

(

(

(

(

¸

(

¸

+

÷

=

Annual Percentage Rate (APR)

• This is the annual rate that is quoted by law.

• By definition, APR = period rate times the number of periods

per year.

– Period rate = APR / number of periods per year

• . What is the APR if the monthly rate is 0.5%?

– 0.5(12) = 6%

• What is the APR if the semiannual rate is 0.5%?

– 0.5(2) = 1%

• What is the monthly rate if the APR is 12% with monthly

compounding?

– 12 / 12 = 1%

6C-48

Effective Annual Rate (EAR)

Which is the better loan:

8% compounded annually, or

7.85% compounded quarterly?

We can’t compare these nominal (quoted)

interest rates, because they don’t include the

same number of compounding periods per

year!

We need to calculate the EAR (or Annual

Percentage Yield (APY)

Effective Annual Rate(EAR)

Find the APY for the quarterly loan:

The quarterly loan is more expensive than

the 8% loan with annual compounding!

EAR= ( 1 + )

m

- 1

quoted rate

m

EAR = ( 1 + )

4

- 1

EAR = .0808, or 8.08%

.0785

4

Making Decisions using EAR

• You are looking at two savings accounts. One pays

5.25%, with daily compounding. The other pays 5.3%

with semiannual compounding. Which account should

you use?

– First account:

• EAR = (1 + .0525/365)

365

– 1 = 5.39%

– Second account:

• EAR = (1 + .053/2)

2

– 1 = 5.37%

• Which account should you choose and why?

Amortized Loans

Loans paid off in equal installments over time are

called amortized loans.

Example: Home mortgages, auto loans.

Reducing the balance of a loan via annuity payments

is called amortizing.

The periodic payment is fixed. However, different

amounts of each payment are applied towards the

principal and interest.

With each payment, you owe less towards principal.

As a result, amount that goes toward interest

declines with every payment (as seen in Figure 5-4).

If you want to finance a new machinery with a purchase price of

$6,000 at an interest rate of 15% over 4 years, what will your

annual payments be?

Finding Payment: Payment amount can be found by solving for

PMT using PV of annuity formula.

PV of Annuity = PMT {1 – (1 + r)

–4

}/r

6,000 = PMT {1 – (1 + .15)

–4

}/.15

6,000 = PMT (2.855)

PMT = 6,000/2.855 = $2,101.58

PVIFA = 6,000=PMT (PVIFA15%,4)

6,000=PMT(2.855)

PMT = 6,000/2.855 = $2,101.58

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