The Time Value Of

Money
Chapter 3

© 2009 Cengage Learning/South-Western

 Time Value of Money

Financial managers compare the marginal benefits

and marginal cost of investment projects.

Projects usually have a long-term horizon: timing of

benefits and costs matters.

Time-value of money: A dollar received today is

worth more than a dollar received in the future.
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 Future Value
Future Value: The value of an investment made
today measured at a specific future date using
compound interest.

FVn = PV x (1+r)n

Interest rate
Future Value
Number of periods
depends on:
Compounding interval
3
 Future Value of $200
4 years, 7% interest

FV
FV44 == $262.16
$262.16
FV
FV33 == $245.01
$245.01

FV
FV22 == $228.98
$228.98

FV
FV11 == $214
$214

PV = $200

0 1 2 3 4
End of Year

Compound interest: Interest earned both on the

principal amount and on the interest earned in
4
previous periods.
 Compounding
Year 1: • Earns 7% interest on initial $200
FV1 = $214 • FV1 = $200+$14 = $214

• Earn $14 interest again on $200 principal

Year 2: • Earns $0.98 on previous year’s interest of
FV2 = $228.98 $14: $14 x 7% = $0.98
• FV2 = $214+$14+$0.98 = $228.98
• Earn $14 interest again on $200 principal
Year 3: • Earns $2.03 on previous years’ interest of
FV3 = $245.01 $28.98: $28.98 x 7% = $2.03
• FV3 = $228.98+$14+$2.03 = $245.01
• Earn $14 interest again on $200 principal
Year 4: • Earns $3.15 on previous years’ interest of
FV4 = $262.16 $45.01: $45.01 x 7% = $3.15
5 • FV4 = $245.01+$14+$3.15 = $262.16
 The Power of Compound Interest

41

20%
36

31

26

21

15%
16

11

10%
6
5%
1
0%
1 3 5 7 9 11 13 15 17 19 21 23 25

6 Periods
 Present Value
Present value: The value today of a cash flow to be
received at a specific date in the future, assuming
an opportunity to earn interest at a specified rate.

FVn  PV  1  r 
n

FVn
PV 
7
(1  r ) n
 Present Value of $200
4 Years, 7% Interest
Discounting

0 1 2 3 4
FV
FV11 == $200
$200 FV
FV22 == $200
$200 FV
FV33 == $200
$200 FV
FV44 == $200
$200
End of Year
PV
PV == $186.92
$186.92

PV
PV == $174.69
$174.69

PV
PV == $163.26
$163.26

PV
PV == $152.58
$152.58

Discounting: The process of calculating present

8
values.
 The Power of Discounting
Present Value of One Dollar ($)

1.00 0%

0.75

0.5
5%

0.25 10%
15%
20%
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods
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 Future Value of Cash Flow Streams

Mixed • A series of unequal cash flows

stream reflecting no particular pattern.

• A stream of equal periodic cash

Annuity
flows.

n
FV   CFt  1  r 
n t

t 1

1
0
 Future and Present Values
of An Ordinary Annuity
Compounding

Future
Future
Value
Value

$1,000 $1,000 $1,000 $1,000 $1,000

0 1 2 3 4 5
End of Year

Present
Present
Value
Value

1 Discounting
1
 Future Value of An Ordinary Annuity
5 Years, 5.5% Interest
$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000.00

$1,000 $1,000 $1,000 $1,000 $1,000

0 1 2 3 4 5
End of Year

(1  r )  1 n
FV  PMT   $5,581.08
r
Ordinary annuity: An annuity for which the payments occur
1
at the end of each period.
2
 Future Value of An Annuity Due
5 Years, 5.5% Interest
$1,306.96
$1,238.82
$1,174.24
$1,113.02
$1,055.00

$1,000 $1,000 $1,000 $1,000 $1,000

0 1 2 3 4 5
End of Year

(1  r ) n  1
FV  PMT   1  r   $5,888.04
r
Annuity due: An annuity for which the payments occur at
1 the beginning of each period.
3
 Present Value of Cash Flow Streams

• Mixed streams
• Annuities
• Perpetuities: cash flow streams that continue
forever

n
1
PV   CFt 
t 1 1  r  t

1
4
 Present Value of An Ordinary Annuity
5 Years, 5.5% Interest
0 1 2 3 4 5

$1,000 $1,000 $1,000 $1,000 $1,000

End of Year

$947.87
$898.45

$851.61

$807.22

$765.13

PMT  1 
PV   1  n 
 $4,270.28
r  (1  r ) 
1
5
 Present Value of An Annuity Due
5 Years, 5.5% Interest
0 1 2 3 4 5

$1,000 $1,000 $1,000 $1,000 $1,000

$1,000.00 End of Year

$947.87
$898.45

$851.61

$807.22

PMT  1 
PV   1  n 
 1  r   $4,505.15
r  (1  r ) 
1
6
 Future and Present Values of A Mixed Steam
5 Years, 4% Interest
Compounding
- $12,166.5
$3,509.6
FV
FV
$5,624.3
$6,413.8
$6,413.8
$4,326.4
$3,120.0

-$10,000 $3,000 $5,000 $4,000 $3,000 $2,000.0

0 1 2 3 4 5

$2,884.6 End of Year

$4,622.8
PV
PV
$3,556.0 $5,271.7
$5,271.7
$2,564.4
$1,643.9
1 Discounting
7
 Present Value of A Perpetuity

• For a constant stream of cash flows that

continues forever


1
PV  PMT  
t 1 (1  r )
t

1
 PMT 
r
PMT

r
1
8
 Present Value of A Growing Perpetuity

CF1
PV0  rg
rg
0 1 2 3 4

$1,000 $1,000(1+0.02)1 $1,000(1+0.02)2 $1,000(1+0.02)3 …

$1,000 $1,020 $1,040.4 $1,061.2

Growing Perpetuity
CF1 = $1,000 $1,000
PV0   $20,000
r = 7% per year 0.07  0.02
g = 2% per year

1
9
 Compounding More Frequently Than Annually

• m compounding periods
mn
 r
FVn  PV  1  
 m
• continuous compounding

FVn  PV  e  
r n

• The more frequent the compound period, the

larger the FV!
2
0
 Compounding More Frequently Than Annually

FV at end of 2 years of $125,000 at 5% interest

• Semiannual compounding:
2 2
 0.05 
FV2  $125,000  1    $137,976.61
 2 
• Quarterly compounding:
4 2
 0.05 
FV2  $125,000  1    $138,060.76
 4 
• Continuous compounding:
0.05 2
FV2  $125,000  e  $138,146.365
2
1
 Stated Versus Effective Annual Interest Rates

• The contractual annual rate of

Stated
interest charged by a lender or
annual rate
promised by a borrower.

• The annual rate of interest actually

Effective
paid or earned, reflecting the impact
annual rate
of compounding frequency.

m
 r 
EAR  1    1
 m
EARcontinuous compounding  e r  1
2
2
 Stated Versus Effective Annual Interest Rates

Annual • The stated annual rate calculated by

percentage multiplying the periodic rate by the
rate (APR) number of periods in one year.

• The annual rate of interest actually

Annual
paid or earned, reflecting the impact
percentage
of compounding frequency. The
yield (APY) same as the effective annual rate.

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3
 Additional Applications of Time Value

• Deposits needed to accumulate a future sum

• Loan amortization
• Implied interest or growth rates
• Number of compounding periods

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4
 The Time Value of Money

• Much of finance involves finding future and

present values.
• The time value of money is central to all
financial valuation techniques.

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