APPLYING TIME VALUE

CONCEPTS
CHAPTER 3
GROUP 2
• Cash accumulates when it is invested and earns interest because of the time value of money.
Over a long period of time, money can grow substantially because interest is earned both on
the deposited funds and on the interest that has already accumulated.
 IMPORTANCE OF THE TIME VALUE
OF MONEY
• The value of money is affected by the point in time it is received. Would you rather receive $1,000 five years
from now or one year from now?

• In general, the value of a given amount of money is greater the earlier it is received. A dollar today has more
value than a dollar received in one year. A dollar received in one year has more value than a dollar received in
five years.

• The time value of money is most commonly applied to two types of cash flows: a single dollar amount (also
referred to as a lump sum) and an annuity. An annuity is a stream of equal payments that are received or paid at
equal intervals in time.
 FUTURE VALUE OF A DOLLAR
AMOUNT
• When you deposit money in a bank savings account, your money grows because the bank pays interest on your
deposit. The interest is a reward to you for depositing your money in the account, is normally expressed as a
percentage of the deposit amount, and is paid either monthly, quarterly, or annually.

• To determine the future value of an amount of money you deposit today, you need to know:

 The amount of your deposit (or other investment) today

 The interest rate to be earned on your deposit

 The number of years the money will be invested

• If you make a bank deposit of $1,000 that earns 4% annually, the deposit will earn an annual interest of:

Interest rate times deposit

4% x $1,000 = $40

• Thus, your deposit will accumulate to be worth $1,040 by the end of one year. In the next year, the interest rate
of 4% will be applied not only to your original $1,000 deposit, but also to the interest that you earned in the
previous year. The process of earning interest on interest is called compounding.
• Assuming that the interest rate is 4% in the second year, it will be applied to your deposit balance of
$1,040, which results in interest of $41.60 (4% x $1,040). Thus, your balance by the end of the
second year will be $1,081.60.

• In the third year, a 4% interest rate would result in interest of $43.26 (4% of $1,081.60). Your deposit
balance will be $1,124.86 by the end of the third year.
 Future Value Interest Factor (FVIF)
USING THE • a factor multiplied by today’s savings to determine how

FUTURE the savings will accumulate over time. It is dependent on

the interest rate and the number of years the money is
VALUE invested

TABLE • Table C.1 in Appendix C shows the FVIF for various

interest rates (i) and time periods (n). Each column lists
an interest rate and each row lists a possible time period.
• Suppose you want to know how much money you will have in five years if you invest $5,000 now and earn an
annual return of 4%. The present value of money (PV) is the amount invested, or $5,000. The FVIF for an
interest rate of 4% and a time period of five years is 1.217 (look down the 4% column and across the row for
year 5). Thus, the future value (FV) of the $5,000 in five years will be:
 • the longer the time period in which your money is invested at a

IMPACT particular interest rate, the more your money will grow. This

OF A relationship is illustrated in the following example.

LONGER
PERIOD
 • the higher the interest rate at which your money is invested for a
IMPACT particular number of years, the more your money will grow. This
OF A relationship is illustrated in the following example.

HIGHER
INTERES
T RATE
 N = number of periods in which your deposit will be
USING A invested
FINANCIAL I = interest rate per period
CALCULATOR PV = present value (the initial amount deposited) FV =
TO COMPUTE future value of your initial deposit
FUTURE CPT = the compute function, which you press just before
VALUE the function you want the calculator to compute
• Repeat the previous problem in which you could earn an annual rate of 9% over twenty
years using the financial calculator instead of the future value table, and follow these
steps:
1. Press 20 and then press N (number of periods).
2. Press 9 and then press I (interest rate).
3. Press -5000 and then press PV (present value of the money you invest); the
negative sign is used to represent your deposit.
4. Press 0 and then press PMT (which means that there are no periodic payments
in this problem).
5. Press CPT (the compute function) and then press FV (future value).

Your calculator should display the computed future value, $28,022.

 • As a result of compounding, an amount of savings can grow

THE POWER OF substantially.

COMPOUNDING • Notice that your initial $1,000 deposit almost doubles in seven years
when considering the compounding effect (you earn interest on your
initial deposit and on any interest that has already accumulated). With
the assumed interest rate of 10%, it would take ten years for your
deposit to double if you only earned interest on the initial deposit and
not on the accumulated interest as well.
 • Just as compounding can expand your savings, it can also expand
THE FUTURE your debt. Notice how the debt would grow because you would pay

VALUE OF interest not only on your initial debt amount but also on the interest

DEBT that accumulates over time.

Example: Student Loan Debt

 • Some believe that avoiding the payment of debt for as long as
TWISTED possible is advantageous because it allows them to spend money on

LOGIC other purchases instead of paying off the debt.

ABOUT • They might not recognize how debt can accumulate over a long
period. Instead, they are more comfortable with long-term debt
LONG-TERM because there is much time before they must face the reality of paying
DEBT off the debt.
 PRESENT VALUE OF A DOLLAR
AMOUNT
 In many situations, you will want to know how much money you must deposit or invest today to accumulate a
specified amount of money at a future point in time. The process of obtaining present values is referred to as
discounting.
• To determine the present value of an amount of money expected in the future, you need to know:

• The future amount of money

• The interest rate to be earned on your deposit
• The number of years the money will be invested

 The present value can be calculated by using a present value interest factor (PVIF), which is a factor
multiplied by the future value to determine the present value of that amount.
 • the PVIF is lower as the number of years increases. This means
Using the that less money is needed to achieve a specific future value when

Present the money is invested for a greater number of years.

Value Table • Similarly, an inspection of any row reveals that less money is
needed to achieve a specific future value when the money is
invested at a higher rate of return.
• You would like to accumulate $50,000 in five years by making a single investment today. You believe you
can achieve a return from your investment of 7% annually. What is the dollar amount that you need to
invest today to achieve your goal?
• The PVIF in this example is 0.713. Using the present value table, the present value (PV) is:
 Using a Financial Calculator to Compute
Present Value
• Using a financial calculator, present values can be obtained quickly by inputting all known variables and solving
for the one unknown variable.
Loretta would have to invest $95,845.94 in order
for her to accumulate $500,00 in 20 years if she
earns an 8.61% return annually.
 FUTURE VALUE OF AN ANNUITY
• An alternative way to accumulate funds over time is through an ordinary annuity, which represents a stream of
equal payments (or investments) that occur at the end of each period.

• If the payment changes over time, the payment stream does not reflect an annuity.

• An alternative to an ordinary annuity is an annuity due, which is a series of equal cash flow payments that occur
at the beginning of each period.

• The best way to illustrate the future value of an ordinary annuity is through the use of timelines, which show the
payments received or paid over time.
 EXAMPLE
• You plan to invest $100 at the end of every year for the next three years. You expect to earn an annual interest
rate of 10% on the funds that you invest. Using a timeline, the cash flows from this annuity can be represented as
follows:

• You would like to know how much money will be in your investment account at the end of

the third year. This amount is the future value of the annuity.
• Using the future value in Table C.1 in Appendix C to obtain the future value interest factor for two years at 10%
(FVIF10%,2 = 1.21) and the future value interest factor for one year at 10% (FVIF10%,1 = 1.10), the future
value of your annuity can be determined as follows:
 • Computing the future value of an annuity by looking up each individual
single-sum future value interest factor (FVIF) is rather tedious.

• Future Value Interest Factor for an Annuity (FVIFA)

USING THE - A factor multiplied by the periodic savings level (annuity) to determine
FUTURE how the savings will accumulate over time.

VALUE (FVA = PMT x FVIFAi,n)

ANNUITY Where:

TABLE FVA = future value of an annuity

PMT = annuity payment

FVIFAi,n = Future Value Interest Factor for an annuity

 EXAMPLE
• Suppose that you consider working a side job as a tutor and expect that you could earn $10,000 at the end of every
year for the next twenty years. As soon as you receive the payments, you will invest them and hope to earn an
annual rate of return of 7%. How much will be in your account at the end of twenty years (assuming you do not
make any withdrawals)?

• Using the future value annuity table to determine the factor, look in the i = 7% column and the n = 20 periods row.
The table shows that this factor is 40.995. The next step is to determine the future value of your annuity:
 EXAMPLE #2
• Use the future value annuity table to determine the future value of five $172 payments,
received at the end of every year, and earning an interest rate of 14%.
Solution:
FVA= PMT x FVIFAi,n
= PMT x FVIFA14,5
= $ 172 x 6.610
FVA= $1,137
 USING A • Using a financial calculator to determine the future value of an annuity
is similar to using the calculator to determine the future value of a single
FINANCIAL dollar amount. As before, the known variables must be input to solve for

CALCULATOR the unknown variable. For problems involving annuities, the payment

TO COMPUTE (PMT) function must be used in addition to the other keys on the
financial calculator that were identified earlier. The PMT function
FVA represents the amount of payment per period.
 EXAMPLE
• You have $80 of each monthly paycheck invested in a retirement account. You expect to
earn 5% annually on this account. How much will be in the account in thirty years?

• This problem differs from the problems we have seen so far, in that the payments are
received on a monthly (not annual) basis. You would like to obtain the future value of the
annuity and consequently need the number of periods, the periodic interest rate, the
present value, and the payment.

• Given:

30 x 12 = 360 periods (N) PMT = 80

5/12 = 0.417% (I) present value = 0

 PRESENT VALUE OF AN ANNUITY

• Just as the future value of an annuity can be obtained by compounding the individual cash flows of the annuity
and then adding them up, the present value of an annuity can be obtained by discounting the individual cash
flows of the annuity and adding them up.

• Referring to our earlier example of an ordinary annuity with three $100 payments and an interest rate of 10%, we
can graphically illustrate the process as follows:
• Adding up the individual present values leads to the conclusion that the present value of this annuity is $248.60.
Therefore, three $100 payments received at the end of each of the next three years are worth $248.60 to you
today if you can invest your money at an interest rate of 10%.
 Present Value Interest Factor for an Annuity (PVIFA)

USING THE • A factor multiplied by a periodic savings level (annuity) to determine the

PRESENT present value of the annuity.

VALUE
ANNUITY • Table C.4 in Appendix C shows the present value interest factors for an

TABLE annuity (PVIFAi,n) for various interest rates (i) and time periods (n) in the
annuity. Each column in the table lists an interest rate, and each row lists a
time period.
 EXAMPLE
• You developed an app that you believe will generate $6,000 in income (after paying income taxes) for you at the
end of every year for the next ten years, and the app will become useless after that point. You will invest these
funds and expect to earn a 5% annual rate of return. A financial firm has offered to purchase your app from you
for $50,000. Are you better off keeping your app (in order to generate income over the next ten years), or selling
the app today in order to receive a large payment now?

• Using the present value annuity table to determine the factor, look in the i = 5% row and the n = 10 periods
column. The table shows that this factor is 7.722.
 USING A FINANCIAL CALCULATOR
TO COMPUTE PVA
Example: • A recent retiree, Dave Buzz, receives his $600 pension monthly. He will receive this
pension for twenty years. If Dave can invest his funds to earn an annual rate of return of
10%, he should be just as satisfied receiving this pension as receiving a lump-sum payment
today of what amount?

• Given:

20 x 12 = 240 months in twenty (N) PMT = 600

10/12 = 0.833% (I) FV = 0

The present value is $62,192. If Dave is offered a lump sum of $62,192 today, he should
accept it if he can invest his funds at an interest rate of 10%.
 USING TIME VALUE TO ESTIMATE
SAVINGS
• The key time value tools for building your financial plan are estimating the future value of annual
savings and determining the amount of annual savings necessary to achieve a specific amount of
savings in the future.
Estimating the • The future value of an annuity is especially useful when

Future Value determining how much money you will have saved by a future

from Savings point in time if you periodically save a specific amount of

money every year.
 EXAMPLE
Stephanie Spratt wants to know how much she will have in thirty years if she could save $5,000 per
year and earn 4% annual interest on her investment. The annuity in this example is $5,000. As you can see
in Table C.3 in Appendix C, the future value annuity factor based on a thirty-year period and a 4% interest
rate is 56.084. Thus, the future value is:

• PMT x FVIFA = FVA

• $5,000 x 56.084 = $280,420

If she is able to save an extra $1,000 per year, the value of her savings in thirty years would be
estimated as:

$6,000 x 56.084 = $336,504

 Estimating the • The future value of annuity tables are also useful for

Annual Savings determining how much money you need to save each year to

That Will achieve a specific amount of savings at a designated future

point in time.
Achieve a
FVA/FVIFA = PMT
Future Amount
 EXAMPLE
Stephanie now wants to know how much money she must save every year to achieve $600,000
in thirty years, based on a 6% annual rate of return on her savings. The future value is $600,000,
and the future value interest factor is 79.057. The unknown variable is the annuity.

PMT = FVA / FVIVA

= $600,000 / 79.057
= $7,589

Thus, Stephanie would need to save $7,589 per year in order to accumulate $600,000 of
savings in thirty years.
 She realizes she might not be able to earn 6% on her savings over time, so she re-estimates
how much she needs to save per year if she can only earn an annual rate of return of 4%.

PMT = FVA / FVIFA

= $600,000 /56.084
= $10,698
 How Time Value of Money Decisions Fit Within
Stephanie Spratt’s Financial Plan
ANALYSIS:
Expected Savings per Year = $5,000
Expected Annual Rate of Return = 6% (also try 4%)

Savings Accumulated over Assume Annual Return = Assume Annual Return =

6% (79.057) 4% (56.084)
5 years $28,185 $27,080
10 years 65,905 60,030
15 years 116,380 100,115
20 years 183,925 148,890
25 years 274,320 208,225
30 years 395,285 280,420
How Time Value Concepts Can Motivate
Saving
• Your money can grow substantially over time when you invest
periodically and when interest is earned on your savings over
time.

• The exercise of estimating the future value of an annuity might

encourage you to develop a savings plan because you see the
reward as a result of your willingness to save.

• Your estimates might convince you to save more money each

year, so that you can build your savings and wealth over time
and therefore have more money to spend in the future.