Chapter 5

Time Value of Money

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Time Value of Money
 As time goes on, the value of money
decreases. This is because of inflation
rate.
 Inflation is a general increase in the
prices of all goods & services.
 As a result the true value of money
decreases

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Time Value Topics
 Present value
 Present Value Single Cash flow (CF)
 Present value Mixed Cash flow(CF)
 Present Value Annuity CF
 Future Value
 Future value Single CF
 Future value Mixed CF
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Time Value Topics
 Present value Single CF
 John will receive 1,000 after 3 years,
how much will be the value of this
future CF today? Assume interest rates
in the market is 10%

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Time lines show timing of
cash flows.

0 1 2 3
r=10%

CF0 1,000

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Present Value Mixed CF
 Sara will receive the following cash
flows: 1,000 after 1 year, $500 after 2
years & $1,500 after 3 years. Calculate
the true value of her CFs today.
0 1 2 3
r=10%

CF0 1,000 500 1,500

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Present Value Mixed CF

$2.449.28 = 1126.97 + 413.22 + 909.09 =

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Present Value Annuity CF
 Sara will receive the following cash
flows: 1,000 after 1 year, $1,000 after 2
years & $1,000 after 3 years. Calculate
the true value of her CFs today.
0 1 2 3
r=10%

CF0 1,000 1,000 1,000

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 Future Value Single CF
 John deposits $100 in the bank today,
how much will he have after 3 years if
interest rate in the bank is 8%?

0 1 2 3
8%

100 FV = ?

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Future value Single CF

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 Future Value Mixed CF
 John will receive $1,000 today, $2,300 after 1
year & $500 after 2 years. If he decides to
deposit his money in the bank the minute he
receives them, calculate how much he will
have after 3 years if interest rate is 8%
0 1 2 3
8%

$1,000 $2,300 $500 12

Future Value Mixed CF

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The Effect of Compounding
 Is it better to collect $100 after one
year OR to collect $50 after 6 months
& the other $50 after one year?
 ANSWER??????????????????

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The Effect of Compounding
 The second option is better! Why?
 Because of the concept of compounding, as
long as I have my cash flows early I can
invest them or put them in the bank & they
will get interest. Then when I receive the 2nd
$50 after 1 year, I will have interest on
interest.
 Also 2nd option is better because of time
value of money.
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Examples
1) John puts $200,000 in a saving
account in a bank. If annual interest
rate is 6%, how much will he have in
his account after 5 years?

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Examples
2) Sara wants to invest her funds in a
bank & after 5 years withdraw a total
of $100,000. How much must she put
in the bank now, in order to withdraw
$100,000 after 5 years?

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Examples
3) Mark will invest in a project that will
generate a value of $5,000 annually for
5 years. Assuming that interest rates
are 10% every year, calculate the value
of his gains today.

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Assignment for next class
4) Assume Investment in Project “A”
produces the following cash flows,
calculate the present value of cash
flows.
Cash Flow (CF) Years
$1,000 1
$2,000 2
$5,000 3
$450 4

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Examples
4)

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Examples
5) Ahmed expects to receive $10,000
after 2 years from now, $5,000 after 3
years & $8,000 after 5 years from her
investment in a specific project. If she
deposits all her cash flows in the bank
the minute she receives them, how
much will she have after 8 years?
Assume annual interest rate is 6.5%.
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Examples
5)

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FV Annuity Formula
 The future value of an annuity with N
periods and an interest rate of I can be
found with the following formula:

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Ordinary Annuity vs. Annuity
Due

Ordinary Annuity
0 1 2 3
I%

CF CF CF
Annuity Due
0 1 2 3
I%

CF CF CF
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 Ordinary Annuity vs. Annuity
Due

• The Ordinary annuity is when cash flow is paid or received at the

end of the period.

• Annuity due is when cash flow is paid or received at the beginning

of the period or before the period begins.

• Annuity dues are always greater in value than ordinary annuities!

PV and FV of Annuity Due
vs. Ordinary Annuity
 PV of annuity due:
 = (PV of ordinary annuity) (1+I)
 = ($248.69) (1+ 0.10) = $273.56

 FV of annuity due:
 = (FV of ordinary annuity) (1+I)
 = ($331.00) (1+ 0.10) = $364.10
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