Time Value of Money

Chapter 4
Besley and Brigham
 Time Value of Money
• A basic financial principle states that, all else equal, the
sooner cash is received, the more valuable it is. The logic is
simple—the sooner a dollar is received, the more quickly it
can be invested to earn a positive return.
• So does this mean that receiving $700 today is better than
receiving $935 in three years? Not necessarily, because the
$935 payoff in three years is much greater than the $700
payoff today.
• To determine which payoff is more valuable, the dollar payoffs
of each option must be compared at the same point in time.
• For example, we can restate (revalue) the
future payoff of $935 in terms of current
(today’s) dollars and then compare the result
to the $700 payoff today. The concept used to
revalue payoffs from different time periods is
termed the time value of money (TVM).
• To make sound financial decisions, you must understand
fundamental TVM concepts.
• TVM concept states that dollars from different time
periods must be translated into the same time value—
that is, all dollars must be valued at the same time
period—before they can be compared.
• We restate, or translate, dollars to the same time period
by computing either the future value of current dollars
or the present value of future dollars.
• To “move” a value from one period to another, we use
TVM techniques to adjust the interest, or return, that
the amount has the opportunity to earn over the period
of time for which it can be invested.
 TVM
• Time value of money (TVM) The principles and
computations used to revalue cash payoffs from different
times so they are stated in dollars of the same time period.
 Cash Flow Time Line

A graphical representation used to show the timing of cash

flows.

On the timeline, we place the time above the line so that Time
0 is today, Time 1 is on period from today—perhaps one year,
one month, or some other time period—and so forth.
 Cash Flow Time Line
• PV: Present value, or beginning amount, that can be invested.
PV also represents the current value of some future amount.
In our example, the PV of Option A is $700 because this is the
amount that will be paid today. At this point, we do not know
the PV of Option B.
• FV: Future value, which is the value to which an amount
invested today will grow at the end of n periods (years, in this
case), after accounting for interest that will be earned during
the investment period. In our example, the FV of Option B in
Year 3 is $935. At this point, we do not know the FV of Option
A in Year 3.
 Cash Flow Time Line

• r Rate of return, or interest rate, that is paid each period. The

interest earned is based on the balance in the account at the
beginning of each period, and we assume that it is paid at the
end of the period. In our example, we assume that all investors
can earn a 10 percent rate of return each year. Thus, r 10% or,
expressed as a decimal, r 0.10.
• n Number of periods interest is earned. In our example, n 3
years (interest payments).
 Cash Flow Pattern
• The types of cash flow patterns that we normally see in business include:

– Lump-sum amount—A single payment (received or made) that occurs

either today or at some date in the future. The cash flows given in the
earlier examples and shown in the previous cash flow timeline are
lump-sum amounts.
– Annuity—Multiple payments of the same amount over equal time
periods. For example, an investment of $400 in each of the next three
years represents an annuity.
• If the payment is made at the end of the period, the annuity is
referred to as an ordinary annuity because this is the way most
payments are made between businesses.
• On the other hand, if the payment is made at the beginning of the
period, the annuity is referred to as an annuity due, because in such
situations a business has paid for, and is due to receive, certain
products or services.
 Cash Flow Pattern
• Uneven cash flows—Multiple payments of
different amounts over a period of time. For
example, investments of $400 this year, $300
next year, and $250 the following year
represent an uneven cash flow stream.
 Future Value
• Future value (FV) The amount to which a cash
flow or series of cash flows will grow over a
given period of time when compounded at a
given interest rate.
 Future value
• To compute the future value of an amount invested today (a
current amount), we “push forward” the current amount by
adding interest for each period in which the money can earn
interest in the future. This process is called compounding.
• Following is a cash flow timeline that shows how we “push
forward” the current $700 payment from Option A in our
example by adding annual interest (at a 10 percent rate) to
determine its value at the end of Year 3
 FV of a Lump-Sum Amount FVn

• The cash flow timeline solution shows that we can

compute the future value of a $700 investment that is
made today by multiplying the value of the investment at
the beginning of each of the three years by (1+r)=(1.10).
• As a result, in our example, we would get the same
ending balance of $931.70 if we multiplied the initial
$700 investment by (1.10)*(1.10)*(1.10) =(1.10)3
FV3= $700(1.10)3 =$931.7
• When this concept is generalized, the future value of an
amount invested today can be computed.
 FV of a Lump-Sum Amount—Equation
Solution

• Equation 4.1 shows that the future value (FV) of an amount

invested today (PV) is based on the multiple by which the
initial investment will increase in the future, (1 + r)n
• As you can see, this multiple depends on both the interest
rate (r) and the length of time (n) interest is earned—that is,
(1 + r)n .it is greater when r is greater.
 FV of a Lump-Sum Amount—Equation
Solution
• The equation solution to our current situation
was shown in the previous section with the
application of Equation 4.1—that is,
• FV =700(1.10)3 = 931.701
 FV of an Ordinary
Annuity—FVA
• Suppose Alice decides to deposit $400 each year for three
years in a savings account that pays 5 percent interest per
year. If Alice makes the first deposit. one year from today, how
much will be in the account when she makes the final
deposit? Because the first deposit is at the end of the year
(one year from today), the series of deposits represents an
ordinary annuity.
• One way to determine the future value of this annuity, which
we designate FVAn, is to compute the future value of each
individual payment using Equation 4.1 and then sum the
results. Using this approach, we find that FVA3 = $1,261.
 FVAn—Equation Solution
The timeline solution shows that we can
compute the future value of this $400 ordinary
annuity as follows:
• FVA3 = 400(1.05)2+ 400(1.05)1 + 400(1.05)0
=1,261.00
 
Equation of ordinary annuity
 FV of an Annuity Due—FVA(DUE)n

• Now suppose Alice’s twin brother, Alvin, thinks that his sister’s savings
plan is a good idea, so he decides to copy her by also depositing $400 each
year for three years in a savings account that pays 5 percent interest per
year. However, Alvin plans to make his first deposit today rather than one
year from today, which means that his series of deposits represents an
annuity due. Using
• Equation 4.1 to solve for the future value of the individual payments for
this annuity, which we designate FVA(DUE)n, we find
 FV of an Uneven Cash Flow
Stream—FVCFn
• When all cash flows in a series are non-
constant, represents an uneven cash flow
stream.
• The future value of an uneven cash flow
stream is called the terminal value
• It is found by compounding each payment to
the end of the stream and then summing the
future values.
• For example, suppose that rather than depositing $400 each year in her
bank account Alice managed to deposit $400 at the end of the first year,
$300 at the end of the second year, and $250 at the end of the third year. If
the account earns 5 percent interest each year, the future value of this
uneven cash flow stream is
FVCF —Equation Solution.
n
 PRESENT VALUE (PV)

• To compute the present value of a future amount, we “bring

back” the future amount by taking interest out for each future
period that the money has the opportunity to earn interest—
that is, we “de-interest” the future amount. This process,
which is called discounting, is essentially the opposite of
determining the future value of a current amount.
PV of a Lump-Sum Amount—PV
• The timeline solution shows that we can compute the present value of the
$935 payment in three years by dividing the value of the investment at the
end of each of the three years by (1 r) (1.10). As a result, in our example,
we would get the same present value of $702.48 if we divided the $935 to
be received in three years by (1.10)3, which discounts the $935 by the 10
percent interest that it will earn over the next three years. That is,
 PV of an Ordinary Annuity—PVAn
• Suppose that Alice, who we introduced earlier, has decided that she wants
to pay herself—that is, take out of savings—$400 each year for the next
three years rather than deposit these amounts in her savings account. If she
can invest a lump-sum amount in a savings account that pays 5 percent per
year, how much money does she need to deposit today to accomplish her
goal? Alice would make the first $400 withdrawal from the savings
account at the end of this year, which means that the series of cash flows
represents an ordinary annuity.
 PV of an Annuity Due—PVA(DUE)n
• Suppose that Alice’s twin brother, Alvin, again wants to copy
his sister. However, Alvin plans to make the first $400
withdrawal from his savings account today rather than one
year from today. The series of deposits now represents an
annuity due.
 Perpetuities
• perpetuities Streams of equal payments that are expected to continue
forever
• Suppose an investment promises to pay $100
per year in perpetuity. What is this investment
worth if the opportunity cost rate, or discount
rate, is 5 percent? The answer is $2,000:
 SOLVING FOR INTEREST RATES
(r) OR TIME (n)

• Suppose you can buy a security at a price of

$78.35 that will pay you $100 after five years.
What annual rate of return will you earn if you
purchase the security?
• Here you know PV, FV, and n, but you do not
know r, the interest rate that you will earn on
your investment
 SOLVING FOR n
• Suppose you know that a security will provide
a return of 10 percent per year, it will cost
$68.30, and you want to keep the investment
until it grows to a value of $100. How long
will it take the investment to grow to $100?
 ANNUAL PERCENTAGE RATE (APR) AND
EFFECTIVE ANNUAL RATE (EAR)

• simple (quoted) interest rate (rSIMPLE) The rate, quoted by borrowers

and lenders, that is used to determine the rate earned per compounding
period (periodic rate, rPER).

• annual percentage rate (APR) Another name for the

simple interest rate, rSIMPLE; does not consider the
effect of interest compounding.
• Effective (equivalent) annual rate (rEAR)
The annual rate of interest actually being
earned, as opposed to the quoted rate;
considers the compounding of interest