The Time Value of Money

Time Value Topics

 Future value
 Present value
 Rates of return
 Amortization

2
The Time Value of Money

Compounding and
Discounting Single Sums
We know that 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).
Today Future

?
Translate $1 in the future into its equivalent
today (discounting
Today Future

?
 Time Lines of
The Cash Flows
Time lines show timing of
cash flows.

0 1 2 3
R%

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time
0 is today; Time 1 is the end of Period
1; or the beginning of Period 2.
7
Ordinary Annuity vs. Annuity Due

Ordinary Annuity
0 1 2 3
R%

PMT PMT PMT

Annuity Due
0 1 2 3
R%

PMT PMT PMT

8
Future Value
Time line for a $100 lump sum
due at the end of Year 2.

0 1 2 Year
R%

100

10
Time line for an ordinary
annuity of $100 for 3 years

0 1 2 3
R%

100 100 100

11
Time line for uneven CFs

0 1 2 3
R%

-50 100 75 50

12
 Compound Interest
 Interest is earned on previously earned interest
 $100 invested at 10% with annual compounding
 1st year interest is $10.00Principal is $110
 2nd year interest is $21.0 Principal is $121.0
 3rd year interest is $33.10Principal is $133.10
 Total interest earned: $33.10

13
 FV of an initial $100 after
3 years (R = 10%)

0 1 2 3
10%

100 FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.

14
After 1 year

FV1 = PV + RNT1 = PV + PV (R)

= PV(1 + R)
= $100(1.10)
= $110.00.

15
After 2 years

FV2 = FV1(1+R) = PV(1 + R)(1+R)

= PV(1+R)2
= $100(1.10)2
= $121.00.

16
After 3 years
FV3 = FV2(1+R)=PV(1 + R)2(1+R)
= PV(1+R)3
= $100(1.10)3
= $133.10

In general,
FVN = PV(1 + R)N.

17
Financial Calculator Solution
Financial calculators solve this
equation:

FVN + PV (1+R)N = 0.

There are 4 variables. If 3 are

known, the calculator will solve
for the 4th.

18
 Calculator Keys

 Texas Instruments BA-II Plus

 FV = future value
 PV = present value
 I/Y = period interest rate
 P/Y must equal 1 for the I/Y to be the period rate
 Interest is entered as a percent, not a decimal
 N = number of periods
 Remember to clear the registers (CLR TVM) after
each problem
 Other calculators are similar in format

19
 The setup to find FV

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

20
If the $100 is entered as a positive
Number, then

INPUTS 3 10 100 0
NN I/YR
I/YR PV
PV PMT
PMT FV
FV

OUTPUT -133.10

21
Quick Quiz – Part I
 What is the difference between simple
interest and compound interest?
 Suppose you have $500 to invest and you
believe that you can earn 8% per year over
the next 15 years.
 How much would you have at the end of 15 years
using compound interest?
 How much would you have using simple interest?

22
Present Value
 What’s the PV of $100 due in
3 years if R = 10%?
Finding PVs is discounting, and it’s
the reverse of compounding.

0 1 2 3
10%

PV = ? 100
24
Solve FVN = PV(1 + R )N for
PV

FVN N
PV =
(1+R) N
= FVn ( 1
1 +R
)
3
 1 
PV = $100 
 1.10 
= $100 0.7513  = $75.13.

25
 Financial Calculator Solution

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Either PV or FV must be negative. Here

PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
26
Present Values – Example 2
 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

27
 Present Values – Example 3
 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 = 10,000

28
 Present Value – Important Relationship I

 For a given interest rate – the longer the

time period, the lower the present value
 What is the present value of $500 to be
received in 5 years? 10 years? The discount
rate is 10%
 5 years: PV = 500 / (1.1)5 = 310.46
 10 years: PV = 500 / (1.1)10 = 192.77

29
 Present Value – Important Relationship II

 For a given time period – the higher the

interest rate, the smaller the present
value
 What is the present value of $500 received
in 5 years if the interest rate is 10%? 15%?
 Rate = 10%: PV = 500 / (1.1)5 = 310.46
 Rate = 15%; PV = 500 / (1.15)5 = 248.59

30
Quick Quiz – Part II
 What is the relationship between present
value and future value?
 Suppose you need $15,000 in 3 years. If you
can earn 6% annually, how much do you
need to invest today?
 If you could invest the money at 8%, would
you have to invest more or less than at 6%?
How much?

31
Finding the Time to Double

0 1 2 ?
20%

-1 2
FV = PV(1 + R)N

Continued on next slide

32
Time to Double (Continued)

$2= $1(1 + 0.20)N

(1.2)N = $2/$1 = 2
N LN(1.2) = LN(2)
N = LN(2)/LN(1.2)
N = 0.693/0.182 = 3.8.

33
 Time to Double– Example 2

 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 = .122462 =
12.25%

34
 Discount Rate – Example 3
 Suppose you have a 1-year old son and
you want to provide $75,000 in 17 years
towards his college education. You
currently have $5,000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?
 r = (75,000 / 5,000)1/17 – 1 = .172688 =
17.27%

35
Financial Calculator Solution

INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

36
 Finding the Interest Rate
or
Discount Rate

 Often we will want to know what the

implied interest rate is in an investment
 Rearrange the basic PV equation and
solve for r
 FV = PV(1 + R)N
 r = (FV / PV)1/N – 1

37
Finding the Interest Rate

0 1 2 3
?%

-1 FV = PV(1 + R)N 2
$2 = $1(1 + R)3
(2)(1/3) = (1 + R)
1.2599 = (1 + R)
I = 0.2599 = 25.99%.
38
Financial Calculator

INPUTS 3 -1 0 2
N I/YR PV PMT FV
OUTPUT 25.99

39
 Finding the Interest Rate- Example 2
 Suppose you have a 1-year old son and
you want to provide $75,000 in 17 years
towards his college education. You
currently have $5,000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?
 r = (75,000 / 5,000)1/17 – 1 = .172688 =
17.27%

40
Finding the Number of Periods
 Start with basic equation and solve for
N (remember your logs)
 FV = PV(1 + R)N
 N = ln(FV / PV) / ln(1 + R)
 You can use the financial keys on the
calculator as well; just remember the
sign convention.

41
Number of Periods – Example 1

 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?
 N= ln(20,000 / 15,000) / ln(1.1) = 3.02
years

42
 Number of Periods – Example 2

 Suppose you want to buy a new house. You

currently have $15,000 and you figure you need
to have a 10% down payment plus an additional
5% of the loan amount for closing costs. Assume
the type of house you want will cost about
$150,000 and you can earn 7.5% per year, how
long will it be before you have enough money
for the down payment and closing costs?

43
Number of Periods – Example 2 Continued

 How much do you need to have in the future?

 Down payment = .1(150,000) = 15,000

 Closing costs = .05(150,000 – 15,000) = 6,750

 Total needed = 15,000 + 6,750 = 21,750

 Compute the number of periods

 Using the formula
 N= ln(21,750 / 15,000) / ln(1.075) = 5.14 years

 Per a financial calculator:

 PV = -15,000, FV = 21,750, I/Y = 7.5, CPT N = 5.14 years

44
Quick Quiz – Part III
 What are some situations in which you might want to
know the implied interest rate?
 You are offered the following investments:
 You can invest $500 today and receive $600 in 5 years. The
investment is considered low risk.
 You can invest the $500 in a bank account paying 4%.
 What is the implied interest rate for the first choice and
which investment should you choose?

45
Spreadsheet Example
 Use the following formulas for TVM calculations
 FV(rate,nper,pmt,pv)
 PV(rate,nper,pmt,fv)
 RATE(nper,pmt,pv,fv)
 NPER(rate,pmt,pv,fv)
 The formula icon is very useful when you can’t
remember the exact formula
 Click on the Excel icon to open a spreadsheet
containing four different examples.

46
 The Time Value of
Money
Compounding and
Discounting
Cash Flow Streams

0 1 2 3 4
 Annuities
 Annuity: a sequence of equal
cash flows, occurring at the
end of each period.

0 1 2 3 4
Ordinary Annuity vs. Annuity Due
Ordinary Annuity

0 1 2 3
R%

PMT PMT PMT

Annuity Due
0 1 2 3
R%

PMT PMT PMT

49
What’s the FV of a 3-year
ordinary annuity of $100 at 10%?

0 1 2 3
10%

100 100 100

110
121
FV = 331
50
 FV Annuity Formula
 The future value of an annuity
with n periods and an interest
rate of R can be found with the
following formula:
N 3
(1+ R) 1 (1+ .10 ) 1
FV A = C[ - ]  100[ - ]  $331
R R .10 .10

51
Financial Calculator Solution

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00

Have payments but no lump sum PV,

so enter 0 for present value.
52
What’s the PV of this ordinary annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV 53
 PV Annuity Formula
The present value of an annuity with n periods and an interest rate of i can
be found with the following formula:

1 1 C 1
PV = C[ - ]  [1  ]
R R(1 + R ) N R (1 + R ) N

100 1
PV = [1  ]  $248.69
.10 (1+ .10 )3

54
Financial Calculator Solution

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Have payments but no lump sum FV,

so enter 0 for future value.
55
Annuity – Sweepstakes Example

 Suppose you win the Publishers

Clearinghouse $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?
 30 N; 5 I/Y; 333,333.33 PMT; CPT PV =
5,124,150.29

56
 Buying a House

 You are ready to buy a house and you have $20,000

for a down payment and closing costs. Closing costs
are estimated to be 4% of the loan value. You have an
annual salary of $36,000 and the bank is willing to
allow your monthly mortgage payment to be equal to
28% of your monthly income. The interest rate on the
loan is 6% per year with monthly compounding (.5%
per month) for a 30-year fixed rate loan. How much
money will the bank loan you? How much can you
offer for the house?

57
Buying a House - Continued
 Bank loan
 Monthly income = 36,000 / 12 = 3,000
 Maximum payment = .28(3,000) = 840
 30*12 = 360 N
 .5 I/Y
 -840 PMT
 CPT PV = 140,105
 Total Price
 Closing costs = .04(140,105) = 5,604
 Down payment = 20,000 – 5,604 = 14,396
 Total Price = 140,105 + 14,396 = 154,501

58
 Annuities on the Spreadsheet - Example
 The present value and future value
formulas in a spreadsheet include a place
for annuity payments
 Click on the Excel icon to see an example

59
 Find the FV and PV if the
annuity were an annuity due.
(1 + R) N 1
FV A = C[ - ](1 + R)
R R

(1 + 10% )3 1
FV A = 100 [ - ](1 + 10% )  $364
10% 10%

0 1 2 3
10%

100 100 100

60
 PV and FV of Annuity Due
vs. Ordinary Annuity

 PV of annuity due:
 = (PV of ordinary annuity) (1+R)
 = (248.69) (1+ 0.10) = 273.56

 FV of annuity due:
 = (FV of ordinary annuity) (1+R)
 = (331.00) (1+ 0.10) = 364.1
61
PV of Annuity Due: Switch
from “End” to “Begin

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

62
FV of Annuity Due: Switch
from “End” to “Begin

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -364.1

63
 The Time Value of Money

0 1 2 3

Other Cash Flow Patterns

What is the PV of this
uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV 65
 Valuing “uneven” Cash Flows

First, set your calculator to 1 payment per year. Then, use

the cash flow menu:

CF0
0 CF3
600 I 12

CF1
200 F3
1 NPV 1,432.93

F1
1 CF4 800

CF2 400 F4
1
F2
1
 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.
 Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV    
(1  r ) (1  r ) (1  r )
2 3

C
PV 
r
 Present Value of a Perpetuity

 So, the PV of a perpetuity is

very simple to find:

PMT
PV =
R
What should you be willing to
pay in order to receive
$10,000 annually forever, if
you require 8% per year on
the investment?
PV = C $10,000
R .08

= $125,000
Nominal rate (RNOM)

 Stated in contracts, and quoted by banks

and brokers.
 Not used in calculations or shown on time
lines
 Periods per year (M) must be given.
 Examples:
 8%; Quarterly
 8%, Daily interest (365 days)

71
Periodic rate (IPER )
 RPER = RNOM/M, where M is number of compounding
periods per year. M = 4 for quarterly, 12 for monthly,
and 360 or 365 for daily compounding.
 Used in calculations, shown on time lines.
 Examples:
 8% quarterly: RPER = 8%/4 = 2%.

 8% daily (365): RPER = 8%/365 = 0.021918%.

72
The Impact of Compounding
 Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated R% constant?
 Why?

73
The Impact of Compounding (Answer)

 LARGER!
 If compounding is more frequent than
once a year--for example, semiannually,
quarterly, or daily--interest is earned on
interest more often.

74
FV Formula with Different
Compounding Periods

MN
 RNOM 
FVN = PV 1 +
 M 

75
$100 at a 12% nominal rate with
semiannual compounding for 5 years

MN
 RNOM 
FVN = PV 1 +
 M 
2x5
 0.12 
FV5S = $100 1 + 
 2 
= $100(1.06)10 = $179.08
76
 FV of $100 at a 12% nominal rate for
5 years with different compounding

FV(Annual)= $100(1.12)5 = $176.23.

FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.

77
Effective Annual Rate (EAR =
EAR%)
 The EAR is the annual rate which
causes PV to grow to the same FV as
under multi-period compounding.

78
Effective Annual Rate Example
 Example: Invest $1 for one year at 12%,
semiannual:
FV = PV(1 + RNOM/M)M
FV = $1 (1.06)2 = 1.1236.
 EAR% = 12.36%, because $1 invested for
one year at 12% semiannual compounding
would grow to the same value as $1 invested
for one year at 12.36% annual compounding.

79
Comparing Rates
 An investment with monthly payments
is different from one with quarterly
payments. Must put on EAR% basis to
compare rates of return. Use EAR%
only for comparisons.
 Banks say “interest paid daily.” Same
as compounded daily.

80
Decisions, Decisions
 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?

81
 EAR (or EAR%) for a Nominal
Rate of of 12%

EARAnnual = 12%.

EARQ = (1 + 0.12/4)4 - 1 = 12.55%.

EARM = (1 + 0.12/12)12 - 1 = 12.68%.

EARD(365) = (1 + 0.12/365)365 - 1 = 12.75%.

82
Can the effective rate ever be
equal to the nominal rate?
 Yes, but only if annual compounding is
used, i.e., if M = 1.
 If M > 1, EAR% will always be greater
than the nominal rate.

83
 When is each rate used?

RNOM: Written into contracts, quoted

by banks and brokers. Not
used in calculations or shown
on time lines.

84
When is each rate used? (Continued)

RPER: Used in calculations, shown on

time lines.
If RNOM has annual compounding,
then RPER = RNOM/1 = RNOM.

85
When is each rate used? (Continued)

 EAR (or EAR%): Used to compare

returns on investments with different
payments per year.
 Used for calculations if and only if
dealing with annuities where payments
don’t match interest compounding
periods.

86
 Amortization Loans

 Amortized Loan: a loan that is

repaid in equal payments over
its life.
 Each periodic payment includes
not only interest but also a
portion of principal.

87
Amortization
 Construct an amortization schedule for
a $1,000, 10% annual rate loan with 3
equal payments.

88
 Step 1: Find the required
payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
89
Step 2: Find interest charge
for Year 1.

INTt = Beg balt (R)

INT1 = $1,000(0.10) = $100.

90
Step 3: Find repayment of
principal in Year 1.

Repmt = PMT - INT

= $402.11 - $100
= $302.11.

91
Step 4: Find ending balance
after Year 1.

End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.

92
Amortization Table
BEG PRIN END
YEAR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366

3 366 402 37 366 0

TOT 1,206.34 206.34 1,000

93
Interest declines because
outstanding balance declines.
$450
$400
$350
$300
$250 Interest
$200 Principal
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3

94
 Amortization

 Amortization tables are widely

used--for home mortgages, auto
loans, business loans, retirement
plans, and more. They are very
important!
 Financial calculators (and
spreadsheets) are great for setting
up amortization tables.
95
Amortized Loan with Fixed Principal Payment
- Example

 Consider a $50,000, 10 year loan at 8%

interest. The loan agreement requires the firm
to pay $5,000 in principal each year plus
interest for that year.
 Click on the Excel icon to see the amortization
table

96
Amortized Loan with Fixed Payment -
Example

 Each payment covers the interest expense plus reduces

principal
 Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is $5,000.
 What is the annual payment?
 4N
 8 I/Y
 5,000 PV
 CPT PMT = -1,509.60
 Click on the Excel icon to see the amortization table

97
Fractional Time Periods
 On January 1 you deposit $100 in an
account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
 How much will you have on October 1,
or after 9 months (273 days)? (Days
given.)

98
Convert interest to daily rate

RPER = 11.33463%/365
= 0.031054% per day.
0 1 2 273
0.031054%

-100 FV=?

99
Find FV

FV273 = $1001.00031054 
273

= $1001.08846 = $108.85.

100
Calculator Solution

RPER = RNOM/M
= 11.33463/365
= 0.031054% per day.

INPUTS 273 -100 0

N I/YR PV PMT FV
OUTPUT 108.85
101
Non-matching rates and periods
 What’s the value at the end of Year 3 of
the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?

102
Time line for non-matching rates and
periods

0 1 2 3 4 5 6 6-mos.
5% periods

100 100 100

103
Non-matching rates and periods
 Payments occur annually, but
compounding occurs each 6 months.
 So we can’t use normal annuity
valuation techniques.

104
1st Method: Compound Each CF

0 1 2 3 4 5 6
5%

100 100 100.00

110.25
121.55
331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100

= $331.80. 105
2nd Method: Treat as an
annuity, use financial calculator

Find the EAR for the quoted rate:

EAR = ( 0.10
1+ 2 ) - 1 = 10.25%.
2

106
 Use EAR = 10.25% as the
annual rate in calculator.

INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT
331.80

107
What’s the PV of this stream?

0 1 2 3
5%

100 100 100

90.70
82.27
74.62
247.59 108
Comparing Investments
 You are offered a note which pays
$1,000 in 15 months (or 456 days) for
$850. You have $850 in a bank which
pays a 6.76649% nominal rate, with
365 daily compounding, which is a daily
rate of 0.018538% and an EAR of
7.0%. You plan to leave the money in
the bank if you don’t buy the note. The
note is riskless.
 Should you buy it?
109
Daily time line

RPER = 0.018538% per day.

0 365 456 days

-850 1,000

110
Three solution methods
 1. Greatest future wealth: FV
 2. Greatest wealth today: PV
 3. Highest rate of return: Highest
EAR%

111
1. Greatest Future Wealth

Find FV of $850 left in bank for

15 months and compare with
note’s FV = $1,000.

FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.
112
Calculator Solution to FV

RPER = RNOM/M
= 6.76649%/365
= 0.018538% per day.

INPUTS 456 -850 0

N I/YR PV PMT FV
OUTPUT 924.97
113
2. Greatest Present Wealth

Find PV of note, and compare

with its $850 cost:
PV = $1,000/(1.00018538)456
= $918.95.

114
Financial Calculator Solution

6.76649/365 =
INPUTS 456 .018538 0 1000
N I/YR PV PMT FV

OUTPUT -918.95

PV of note is greater than its $850

cost, so buy the note. Raises your
wealth.
115
3. Rate of Return
Find the EAR% on note and compare
with 7.0% bank pays, which is your
opportunity cost of capital:
FVN = PV(1 + R)N
$1,000 = $850(1 + R)456
Now we must solve for R.

116
Calculator Solution

INPUTS 456 -850 0 1000

N I/YR PV PMT FV
OUTPUT 0.035646%
per day
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EAR% = (1.00035646)365 - 1
= 13.89%.
117
Using interest conversion

P/YR = 365
NOM% = 0.035646(365) = 13.01
EAR% = 13.89
Since 13.89% > 7.0% opportunity cost,
buy the note.

118
 Growing Perpetuities

 The cash flows of a growing

perpetuity grow at a constant rate
forever.
 The present value of a growing
perpetuity is:
PMT
PV =
R-g
119
Present Value of Growing Annuity
 Cash flows in business are very likely to grow
over time, due either to real growth or
inflation.
 The present value of a growing annuity is for
a finite number of growing cash flows:

N
C (1 + g )
PV = [1  ]
Rg (1 + R ) N

120
Present Value of Growing Annuity-
Example
 Ruben Ramirez, a first year MBA student at CSUF, is
going to be offered a job at $100,000 a year after his
graduation. He anticipates his salary increasing by
6% a year until his retirement in 30 years. Given an
interest rate of 10 percent, what is the present value
of his lifetime salary?

100,000 (1+ 6% )30

PV = [1  ]  $1,677,122
10%  6% (1+10 )30

121