Chapter 9

The Time Value

of Money
Chapter 9 - Outline
Time Value of Money
Perpetuity
Future Value and Present Value
Effective Annual Rate (EAR)
Annuity
Time Value of Money
The basic idea behind the concept of time value of
money is:
– $1 received today is worth more than $1 in the future
OR
– $1 received in the future is worth less than $1 today

Why?
– because interest can be earned on the money

The connecting piece or link between present (today) and

future is the interest rate
2 Questions to Ask in Time Value
of Money Problems
Future Value or Present Value?
Future Value: Present (Now)  Future
Present Value: Future  Present (Now)

Single amount or Annuity?

Single amount: one-time (or lump) sum
Annuity: same amount per year for a number of years
Perpetuity: Constant Payment Forever

 PV = PMT/i
 This is the present value of
receiving a constant payment
forever.
 Valuing perpetuities
C
PV =
r

EXAMPLE:
• Suppose you wish to endow a chair at your old
university. The aim is to provide $100,000
forever and the interest rate is 10%.

$100,000
PV = = $1,000,000
.10
A donation of $1,000,000 will provide an annual
income of .10 x $1,000,000 = $100,000 forever.
Future Value and Present Value
Future Value (FV) is what money today will be worth at
some point in the future
FV = PV x FVIF
FVIF is the future value interest factor

Present Value (PV) is what money at some point in the

future is worth today
PV = FV x PVIF
PVIF is the present value interest factor
Future Value of a Lump Sum

 FV = PV * (1+i)n
 Why is this formula correct?
 This is the amount that will be
accumulated by investing a
given amount today for n
periods at a given interest rate.
 Simple & compound interest
Simple interest rates) are calculated by multiplying the rate per
period by the number of periods. Compound interest rates
recognize the opportunity to earn interest on interest.

i ii iii iv v
Periods Interest Value Annually
per per APR after compounded
year period (i x ii) one year interest rate

1 6% 6% 1.06 6.000%

2 3 6 1.032 = 1.0609 6.090

4 1.5 6 1.0154 = 1.06136 6.136

12 .5 6 1.00512 = 1.06168 6.168

52 .1154 6 1.00115452 = 1.06180 6.180

365 .0164 6 1.000164365 = 1.06183 6.183

Effective Annual Rate (EAR) or Yield
(EAY)

EAR or EAY = (1+inom/m)m-1

This is used to calculate the compounded yearly rate. It
considers interest being earned on interest.
Adjusting for Non-Annual Compounding
Interest is often compounded quarterly, monthly, or
semiannually in the real world
Since the time value of money tables and calculators
often assume annual compounding, an adjustment
must be made in those cases:
– the number of years is multiplied by the number of
compounding periods
– the annual interest rate is divided by the number of
compounding periods
FV With Compounding Intervals
FV of lump sum for various compounding intervals:
FV = PV * (1+i/m)n*m
where m=number of compounding periods per year
At an extreme there could be continuous
compounding, then FV can be calculated as follows:
FV = PV (ein) where e=2.7183...
PV of a Lump Sum
PV=FV/(1+i)n
This is the value today of a future lump sum to be
received in the future after n periods of time at a given
discount rate.
 Present values
example: saving for a new computer
Suppose: - you need $3000 next year to buy a computer
- the interest rate = 8% per year
How much do you need to set aside now?

3000
PV of $3000 = = 3000 x .926 = $2777.77
1.08
1- year
discount
factor

By end of 1 year $2777.77 grows to $2777.77 x 1.08 = $3000

Suppose you can postpone purchase until Year 2.

3000
PV = = 3000 x .857 = $2572.02
1.082
2-year
discount
factor
PV With Compounding Intervals
PV of a lump sum for various compounding intervals
is calculated as:
PV=FV/(1+i/m)n*m
where m=number of compounding periods per year
At an extreme there could be continuous discounting,
then PV=FV/(ein) where e=2.7183...
PV of an Annuity
PV=A/(1+i)n = A*{(1/i) - (1/i) [1/(1+i)n]}
This is the value today of a series of equal payments to
be received at the end of each period for n periods at a
given interest rate.
An annuity is equal to the difference between
two perpetuities
Asset Year of payment PV

1 2 . . t t+1 . .

Perpetuity (first C
payment year 1) r

Perpetuity (first C 1
payment year
t + 1)
( ) r (1+r) t

Annuity from year C C 1

1 to year t r
-
( ) r (1+r) t
 Using the annuity formula
Example: valuing an 'easy payment' scheme
Suppose:
 a car purchase involves 3 annual payments of $4000
 the interest rate is 10% a year

1 1
PV = $4000 x -
.10 .10(1.10)3

= $4000 x 2.487 = $9947.41

ANNUITY TABLE

Number Interest Rate

of years 5% 8% 10%

1 .952 .926 .909

2 1.859 1.783 1.736
3 2.723 2.577 2.487
5 4.329 3.993 3.791
10 7.722 6.710 6.145
FV of an Annuity
FV=A* (1+i)n = A*{[(1+i)n -1]/i}
This is the accumulated value of equal payments for n
years at a given interest rate.
Annuity Due
Annuity due: Payments received at the beginning of
each period.
Will be worth more (higher PV) since it gets payments
sooner.
Will have higher FV since it has one extra period to
earn interest.
Calculations are the same as before except now we
multiply by (1+i).
 Solving for Annuity Payments (Present
Value)

 Recall that
 PV=A*{(1/i) - (1/i) [1/(1+i)n]}, then

 A=PV/{(1/i) - (1/i) [1/(1+i)n]}

 A is the payment necessary for n years at given interest

rate to amortize a present (loan) amount.
 Solving for Annuity Payments (Future
Value)

 Recall that
 FV=A*{[(1+i)n-1]/i}, then
 A=FV/{[(1+i)n-1]/i}

 A is the amount needed to be invested each period at a given

interest rate to accumulate a desired future amount at the end of n
years.
Solving for Rate of Return (i)
For Lump Sum Case:

Since PV=FV/(1+i)n, then

(1+i)n=FV/PV, and it follows that
(1+i) = (FV/PV)1/n, and therefore
i= (FV/PV)1/n-1
Solving for Rate of Return (i)
Annuities:

In the annuity case, you could also solve for i using
annuity relationship once you know the annuity.
You do not need a cash flow register.
 Solving for Rate of Return (r) with
uneven cash flows

0 = C0 + C1 + C2 + . . .
(1 + r)1 (1 + r)2
•Spreadsheets (use financial function =IRR)
•Financial calculators (IRR using cash flow register)
•Manual (Trial and error until PV of all cash flows equal
zero)
Solving for
Number of Periods (n)

Since PV=FV/(1+i)n, then

(1+i)n=FV/PV, and it follows that
nLN(1+i)=LN(FV/PV), and therefore
n=LN(FV/PV)/LN(1+i)
 Net Present Value in the General
discounted cash flow formula

C1 C2
NPV = C0 + + + . . .
(1 + r)1 (1 + r)2

Note: It is today’s cost of capital that matters

Example
If C0 = -500, C1 = +400, C2 = +400
r1 = r2 = .12

400 400
NPV = -500 + +
1.12 (1.12)2

= -500 + 400 (.893) + 400 (.794)

= -500 + 357.20 + 318.80 = +176

 Growing perpetuities

PV = C
(r - g)

EXAMPLE:
Next year’s cash flow = $100
Constant expected growth rate = 10%, cost of capital = 15%
next year’s cash flow
cost of capital - growth rate
PV = 100 = 2000
.15 - .10