Book reference:

 Lawrence J. Gitman
 Charles P Jones

Learning objectives:
 To understand the meaning of the time value
of money and why the timing of the cash
flows is critical in finance
 To learn the techniques that will make cash
flows expected to be available at different
points in time equivalent to one another.
Would you prefer to
have $1 million now or
$1 million 10 years
from now?
Of course, we would all
prefer the money now!
This illustrates that there
is an inherent monetary
value attached to time.
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 Conceptually time value of
money means that the value
of money is different in
different time period.
 Time value is based on the
belief that a dollar today is
worth more than a dollar that
will be received at some
future date.
 financial managers and
investors want to earn positive
rates of return.
 A dollar received today is worth more than a
dollar received tomorrow
 This is because a dollar received today can be
invested to earn interest
 The amount of interest earned depends on the
rate of return that can be earned on the
investment

4
 Time Value of Money, or TVM, is a
concept that is used in all aspects of
finance including:
 Bond valuation
 Stock valuation
 Accept/reject decisions for project
management
 Financial analysis of firms
 And many others!

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 The following are simple rules that you should always use no
matter what type of TVM problem you are trying to solve:
1. Stop and think: Make sure you understand what the problem is
asking. You will get the wrong answer if you are answering
the wrong question.
2. Draw a representative timeline and label the cash flows and
time periods appropriately.
3. Write out the complete formula using symbols first and then
substitute the actual numbers to solve.
4. Check your answers using a calculator.
 While these may seem like trivial and time consuming tasks, they
will significantly increase your understanding of the material and
your accuracy rate.

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 Time lines show timing of cash flows.

0 1 2 3
i%

CF0 CF1 CF2 CF3

Time 0 is today; Time 1 is the end of

Period 1; or the beginning of Period 2.
 Time line: it is a graphical representation
used to show the timing of cash flows.

-20000 4000 5000 4000 2000 5000

0 1 2 3 4 5
 compounding: future value techniques uses
compounding to find the future value.
Compounding is the mathematical process of
computing the final value of one or more
payments when compound interest is involved.
 discounting: present value techniques uses
discounting to find the present value. It is a
mathematical process of reducing future values
to present values.
 0 1 2 3
10%

100 FV = ?
Finding FVs (moving to the right
on a time line) is called compounding.

10
 Finding PVs is discounting, and it’s the
reverse of compounding.

0 1 2 3
10%

PV = ? 100
11
 Single amount: a lump sum amount held or
expected at some future period.
 annuity: a series of equal payment for a
specified period.
 Future value: ( the amount to which one or
more payments will grow when compounded at a
stated rate for a stated period. i.e future value
is cash you will receive at a given future date)
 You can think of future value as the opposite
of present value
 Future value determines the amount that a
sum of money invested today will grow to in
a given period of time
 The process of finding a future value is
called “compounding” (hint: it gets larger)

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 0 1 2 3
10%

100 FV = ?

Finding FVs is compounding.

After 1 year:
FV1 = PV + INT1 = PV + PV(i)
= PV(1 + i)
= $100(1.10)
= $110.00.

After 2 years:
FV2 = PV(1 + i)2
= $100(1.10)2
= $121.00.
After 3 years:

FV3 = PV(1 + i)3

= $100(1.10)3
= $133.10.

In general,

FVn = PV(1 + k)n.

 FVn= PV (1+k)n [for single amount]
Or
= PV (FVIFk,n)
 Example: calculate the future value of $ 100
invested for 10 years at 6 percent interest per
year.
FV10= $100(1+0.6)10
= $100(1.791)
= $179.10
 the higher the interest rate, the higher the
future value,
 the longer the period of time, the higher the
future value.
 Present value: ( the value today of a future
payment or payments discounted at a stated
discount rate. i.e present value is just like
cash in hand today
 Present value calculations determine what the
value of a cash flow received in the future would
be worth today (time 0)
 The process of finding a present value is called
“discounting” (hint: it gets smaller)
 The interest rate used to discount cash flows is
generally called the discount rate

21
 How much would $100 received five years from
now be worth today if the current interest rate is
10%?
1. Draw a timeline

i=
? $100
10%
0 1 2 3 4 5
The arrow represents the flow of money and the
numbers under the timeline represent the time period.

Note that time period zero is today.

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 PV= FVn /(1+k)n
= FVn (PVIFk,n) where PVIF = 1/(1+k)n

Example: find the present value of $1700 that

will be received 8 years from now.
Opportunity cost is 8%.
PV=$1700/(1+.08)8
= $ 918.42
 the higher the discount rate, the lower the
present value
 the longer the period of time, the lower the
present value.
 Annuity is a series of payments of an equal
payments at fixed intervals for a specified
number of periods.
 two types of annuity
 annuity due [ where cash flow occurs at the
beginning of each period. i.e annuity whose
first payment is immediate rather than one
period from now ]
 ordinary (deferred) annuity [ where cash
flows occurs at the end of each period. i.e
first payment is to be received one period
from now ]
 Annuity: a sequence of equal cash flows,
occurring at the end of each period. This is
known as an ordinary annuity.

0 1 2 3 4
PV 26 FV
 If you buy a bond, you will receive equal
semi-annual coupon interest payments over
the life of the bond.
 If you borrow money to buy a house or a car,
you will re-pay the loan with a stream of
equal payments.

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 A sequence of periodic cash flows occurring
at the beginning of each period.

0 1 2 3 4
PV FV
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 Monthly Rent payments: due at the beginning
of each month.
 Car lease payments.
 Cable & Satellite TV and most internet
service bills.

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Ordinary Annuity
0 1 2 3
I%

$100=PMT $100 $100

Annuity Due
0 1 2 3
I%

$100=PMT $100 $100

30
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
 FVAn= C(1+k)n-1+C(1+k)n-2+….+C(1+k)1 +C(1+k)0
= C (FVIFAk,n)
= C{ (1+k)n-1/K} [ordinary annuity]

 FVAn= C{(1+k)n-1/k}(1+k) [annuity due]

 Ordinary annuity
0 1 2 3

1000 1000 1000 1000

+
1000(1+k)1
+
1000(1+k)2
0 1 2 3 annuity due

1000 1000 1000

1000(1+k)1
1000(1+k)2
1000(1+k)3
 Assume that Sally owns an investment that will
pay her $100 each year for 20 years. The
current interest rate is 15%. What is the FV of
this annuity?
1. Draw a timeline

$100 $100 $100 $100 $100

0 1 2 3 …………………… 19 20
…….
?
i= 35
 PVAn= C/(1+k)+C/(1+k)2+….+C/(1+k)n-1
+C/(1+k)n
= C (PVIFAk,n)
= C{ 1-(1+k)-n/k} [ordinary annuity]

 PVAn= C{ 1-(1+k)-n/k}(1+k) [annuity due]

 Assume that Sally owns an investment that will
pay her $100 each year for 20 years. The
current interest rate is 15%. What is the PV of
this annuity?
1. Draw a timeline

$100 $100 $100 $100 $100

0 1 2 3 …………………… 19 20
…….
?
i = 15%
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 perpetuity is a series of equal payments that
is expected to continue forever.
 PVAn = C/k
 effective annual interest rate is that rate
that is actually paid or earned, taking the
total compounding effect into account

 nominal or stated interest rate is a

contractual annual rate of interest charged
by a lender or promised by a borrower.
How do we find EFF% for a nominal
rate of 10%, compounded
semiannually?


EFF = 1 +
iNom
m – 1
m

=1 + 0.10  – 1.0

2
2
= (1.05)2 – 1.0
= 0.1025 = 10.25%.
 loan amortization problem:
 refers to this question is that what equal
payment is required to exactly recover a present
value
 PVAn= C (PVIFAk,n)
 C= PVAn/ (PVIFAk,n)
 it is schedule showing the repayment details for a
loan, including the amount of each payment
apportioned to interest and to principal.
 interest and principal repayment varies because
interest paid only on the outstanding balance of the
loan for that year.
 the amount of interest paid each year declines, the
amount of principal repayment increases each year.
 the beginning balance for the loan is the amount
borrowed. This amount decreases each year as a
result of principal repayment until the ending
balance in the final year of the payment schedule is
zero. Obviously the borrowed amount decreases, as
the loan is repaid.
 Step 1:Find the required annual
payments.
0 1 2 3
10%

-1,000 PMT PMT PMT

Step 2: Find the interest paid in
Year 1.
INTt = Beg balt (i)
INT1 = $1,000(0.10) = $100.

Step 3:Find repayment of

principal in Year 1.
Repmt = PMT – INT
= $402.11 – $100
= $302.11.
Step 4: Find ending balance after
Year 1.
End bal = Beg bal – Repmt
= $1,000 – $302.11 = $697.89.

Repeat steps 2-4 for Years 2 and 3

to complete the amortization table.
 BEG PRIN END
YR 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

Interest declines. Tax implications.

 Refers to this question: what equal payment
is required to provide a future sum.
 a firm borrow money and then be required
to make sinking jund payments each period
so as to have enough money accumulated at
the designated period to pay back the loan
 FVAn = C (FVIFAk,n)
 C = FVAn / (FVIFAk,n)