Chapter

Time Value of Money

The Role of Time Value in Finance

 Most financial decisions involve costs and benefits that are

spread out over time.
 Time value of money allows comparison of cash flows from
different periods.
 Question
 Would it be better for a company to invest $100,000 in a product
that would return a total of $200,000 in one year, or one that would
return $500,000 after two years?
 Answer
 It depends on the interest rate!
 Time Value of Money

 Money that the firm has in its

possession today is more valuable
than the money in the future because
the money it now has can be invested
and earn positive returns.
 Basic Concepts
 Future Value
 Compounding or growth over time
 Present Value
 Discounting to today’s value
 Single cash flows and series of cash flows can
be considered
 Time lines are used to illustrate these relationships
Computational Aids

Figure 5.2
 Simple Interest

 With simple interest, you don’t earn interest

on interest.
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125
 Simple Interest

 Example: you borrow $1000, and agree to

repay the loan by making a lump sum
payment in 1 year’s time at an interest rate of
12 % per annum.
Interest owed = 0.12 × $1000
= $120
Lump sum payment = $1000 + $120
= $1120
 Simple Interest

 Example: Rahat Bakers Ltd. Borrow Rs.100,000

and agrees to repay the loan by a lump sum
payment in 6 month’s time. The interest rate is 8
percent per annum (simple). Calculate the lump
sum payment.
 Future Sum
 Example: calculate Rahat’s repayment of a loan of
Rs.100,000 after 1 year if simple interest is used and the
interest rate is 8 % per annum.
FV = P0(1 + i*n)
= Rs.100,000 ( 1 + .08*1)
= Rs.108,000
 If the repayment is calculated after 6 months.
FV = P0(1 + i*n)
= Rs.100,000 ( 1 + .08*(6/12))
= Rs.104,000
 Present Value
 is the current value of a future amount of money,
or a series of payments, evaluated at a given
interest rate.
 Formula:
FV
PV =
(1 + i*n )
where PV = present value
FV = payment at future date
i = applicable interest rate
n = number of periods before payment
 Present Value

 Example: XYZ Ltd. Promises to pay Rs.500,000

in 60 days’ time. For a company with XYZ’s
credit standing the market interest rate for a loan
period of 60 days is 14.4 % per annum. How
much can XYZ borrow.

11
 Exercises

1. Albert deposit Rs.2000 in a bank fixed deposit

for 6 months at a simple interest rate of 13.25 %
per annum. How much interest will he earn?
How much he will in his account at the end of
six months?
2. Jane borrowed Rs.10,000 and repaid the loan
30 days later by a single payment of Rs.10,400.
what is the implied annual simple interest rate?

12
 Compound Interest

 With compound interest, a depositor earns interest

on interest!
Year 1: 5% of Rs100.00 = Rs5.00 + Rs100.00 =
Rs.105.00
Year 2: 5% of Rs105.00 = Rs5.25 + Rs105.00 =
Rs.110.25
 Time Value Terms

PV0 = present value or beginning amount

k or i = interest rate
FVn = future value at end of “n” periods

n = number of compounding periods

A = an annuity (series of equal
payments or receipts)
Four Basic Models

FVn = PV0(1+k)n = PV(FVIFk,n)

PV0 = FVn[1/(1+k)n] = FV(PVIFk,n)

FVAn = A (1+k)n - 1 = A(FVIFAk,n)

k

PVA0 = A 1 - [1/(1+k)n] = A(PVIFAk,n)

k
 Future Value Example

 Algebraically and Using FVIF Tables

 You deposit Rs.2,000 today at 6% interest.
How much will you have in 5 years?

Rs.2,000 x (1.06)5 = Rs.2,000 x FVIF6%,5

Rs.2,000 x 1.3382 = Rs.2,676.40
A Graphic View of Future Value

Figure 5.5
 Present Value
 Present value is the current dollar value of a future amount
of money.
 It is based on the idea that a dollar today is worth more
than a dollar tomorrow.
 It is the amount today that must be invested at a given rate
to reach a future amount.
 It is also known as discounting, the reverse
of compounding.
 The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return, and
the cost of capital.
 Present Value Example
 Algebraically and Using PVIF Tables
 How much must you deposit today in order to have
Rs.2,000 in 5 years if you can earn 6% interest
on your deposit?

Rs.2,000 x [1/(1.06)5] = Rs.2,000 x PVIF6%,5

Rs.2,000 x 0.74758 = Rs.1,494.52
A Graphic View of Present Value

Figure 5.6
 Exercises
 John is investing Rs.5,000 into eight year
certificate of deposit (CD) that pays 6 percent
annual interest with annual compounding. How
much will he has when the CD matures?
 Hadi’s grandmother died and provided in her
will that Hadi will receive Rs.100,000 from a
trust when Hadi turns twenty-one years of age,
ten years from now. If the appropriate discount
rate is 8 percent, what is the present value of
this Rs.100,000 to Hadi?
 Compounding More Frequently
Than Annually
 Compounding more frequently than once a year results
in a higher effective interest rate because you are
earning on interest on interest more frequently.
 As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
 Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.
 Compounding More Frequently
Than Annually
 For example, what would be the difference in future
value if I deposit $100 for 5 years and earn 12% annual
interest compounded (a) annually, (b) semiannually,
(c) quarterly, and (d) monthly?

Annually: 100 x (1 + .12)5 = $176.23

Semiannually: 100 x (1 + .06)10 = $179.09

Quarterly: 100 x (1 + .03)20 = $180.61

Monthly: 100 x (1 + .01)60 = $181.67

 Exercises

 How much money would john have at maturity if

he puts his Rs. 5000 into an eight year CD that
pays 6 percent annual interest compounding
monthly?
 Philip invest Rs.17,200 at an interest rate of 2.5
percent per quarter. How much is the investment
worth after 2 years?
 Continuous Compounding
 With continuous compounding the number
of compounding periods per year approaches infinity.
 Through the use of calculus, the equation thus becomes:

FVn (continuous compounding) = PV x (ekxn)

where “e” has a value of 2.7183

 Continuing with the previous example, find the future value of the
Rs.100 deposit after 5 years if interest is compounded continuously.

FVn = 100 x (2.7183).12x5 = Rs.182.22

 Nominal and Effective Rates
 The nominal interest rate is the stated or contractual
rate of interest charged by a lender or promised by
a borrower.
 The effective interest rate is the rate actually paid
or earned.
 In general, the effective rate is greater than the nominal
rate whenever compounding occurs more than once
per year.
EAR = (1 + k/m)m - 1
 Nominal and Effective Rates

 For example, what is the effective rate of interest

on your credit card if the nominal rate is 18% per
year, compounded monthly?

EAR = (1 + .18/12)12 - 1
EAR = 19.56%
 Annuities
 Annuities are equally-spaced cash flows of equal size.

 Annuities can be either inflows or outflows.

 An ordinary (deferred) annuity has cash flows
that occur at the end of each period.
 An annuity due has cash flows that occur
at the beginning of each period.
 An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will
compound for an additional period.
Annuities

Table 5.1
 Future Value
of an Ordinary Annuity
 Using the FVIFA Tables
 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the end of each year at 5% interest for three years?

FVA = 100(FVIFA,5%,3) = $315.25

Year 1 $100 deposited at end of year = $100.00

Year 2 $100 x .05 = $5.00 + $100 + $100 = $205.00
Year 3 $205 x .05 = $10.25 + $205 + $100 = $315.25
Future Value of an Annuity Due

 Using the FVIFA Tables

 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the beginning of each year at 5% interest for three years.

FVA = 100(FVIFA,5%,3)(1+k) = $330.96

FVA = 100(3.152)(1.05) = $330.96

 Present Value
of an Ordinary Annuity
 Using PVIFA Tables
 An annuity is an equal annual series of cash flows.
 Example
• How much could you borrow if you could afford annual
payments of $2,000 (which includes both principal
and interest) at the end of each year for three years
at 10% interest?

PVA = 2,000(PVIFA,10%,3) = $4,973.70

 Present Value of a Perpetuity
 A perpetuity is a special kind of annuity.
 With a perpetuity, the periodic annuity or cash flow stream continues forever.

PV = Annuity/k

 For example, how much would I have to deposit today

in order to withdraw $1,000 each year forever if I can earn 8% on my
deposit?

PV = $1,000/.08 = $12,500
Loan Amortization

Table 5.7
 Determining Interest
or Growth Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund
in 1994 which grew as shown in the table below?

It is important to note
that although there are
7 years shown, there are
only 6 time periods
between the initial deposit
and the final value.
 Determining Interest
or Growth Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Thus, $1,000 is the present value,

$5,525 is the future value,
and 6 is the number of periods.
 Quiz # 2
 What will $247,000 grow to be in 9 years if it is invested today in an account
with an annual interest rate of 11%?
 If you wish to accumulate $197,000 in 5 years, how much must you deposit
today in an account that pays a quoted annual interest rate of 13% with semi-
annual compounding of interest?
 An investor can make an investment in a real estate development and receive
an expected cash return of $45,000 after six years. Based on a careful study of
other investment alternatives, she believes that an 18 percent annual return
compounded quarterly is a reasonable return to earn on this investment. How
much should she pay for it today?
 What will $153,000 grow to be in 13 years if it is invested today in an account
with a quoted annual interest rate of 10% with monthly compounding of
interest?
 Quiz # 1

1. Briefly explain Investment decision

and Financing decision.
2. Differentiate between money market
and capital markets.