Time value of money

Money NOW
is worth more than
money LATER!
 Time Value of Money
 Money has a time value
because it can earn more
money over time (earning
power).
 Money has a time value
because its purchasing power
changes over time (inflation).
 Time value of money is
measured in terms of interest
rate.
 Interest is the cost of money—
a cost to the borrower and an
earning to the lender
 Uses of Time Value of Money
• Time Value of Money, or TVM, is a concept that is
used in all aspects of finance including:
– Bond valuation
– Stock valuation
– Accept/reject decisions for project management
– Financial analysis of firms
– And many others!

3
 Decision Dilemma—Take a Lump Sum or Annual
Installments
 A couple won a prize bond.

 They had to choose between a single lump sum

$104 million, or $198 million paid out over 25
years (or $7.92 million per year).

 The winning couple opted for the lump sum.

 Did they make the right choice? What basis do we

make such an economic comparison?
 Option A Option B
(Lump Sum) (Installment
Plan)
0 $104 M
1 $7.92 M
2 $7.92 M
3 $7.92 M

25 $7.92 M
NOT having the opportunity to earn
profit/interest on money is called
OPPORTUNITY COST.
 What Do We Need to Know?
To make such comparisons (the lottery
decision problem), we must be able to
compare the value of money at different point
in time.
To do this, we need to develop a method for
reducing a sequence of benefits and costs to a
single point in time. Then, we will make our
comparisons on that basis.
 Time lines
0 1 2 3
i%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Time 0 is today; Time 1 is the end of the first
period (year, month, etc.) or the beginning of
the second period.
 The Terminology of Time Value
• Present Value - An amount of money today, or the current
value of a future cash flow
• Future Value - An amount of money at some future time
period
• Period - A length of time (often a year, but can be a month,
week, day, hour, etc.)
• Interest Rate - The compensation paid to a lender (or saver)
for the use of funds expressed as a percentage for a period
(normally expressed as an annual rate)
 The Terminology of Time Value
• Annuity: A series of equal payments for a
specified number of years.
– Ordinary annuity payments occur at the end of
each period.
• Rate of return: The ratio of money gained or
lost (interest, profit/loss, gain/loss, or net
income/loss) on an investment relative to the
amount of money invested (asset, capital,
principal).
• Amortization: amortization is the process by
which your loan principal decreases over the
life of your loan.
 The interest rate or growth rate
in a time value problem is
designated by i
• i must be expressed as the interest rate per
period.
• For example if n is a number of years, i
must be the interest rate per year.
• If n is a number of months, i must be the
interest rate per month.
Methods of Calculating Interest
 Simple interest: the practice of charging an
interest rate only to an initial sum (principal
amount).
 Compound interest: the practice of charging
an interest rate to an initial sum and to any
previously accumulated interest that has not
been withdrawn.
 Simple Interest
Interest is earned only on principal.

Example: Compute simple interest on $100 invested

at 6% per year for three years.

1st year interest is $6.00

2nd year interest is $6.00
3rd year interest is $6.00
Total interest earned: $18.00

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 Compound Interest
Example: Compute compound interest on $100
invested at 6% for three years with annual
compounding.

1st year interest is $6.00--- Principal is $106.00

2nd year interest is $6.36--- Principal is $112.36
3rd year interest is $6.74--- Principal is $119.11

Total interest earned: $19.10

Keown, Martin, Petty - Chapter 5 14

 Compound Interest

• Compounding is when interest paid on an

investment during the first period is added to
the principal; then, during the second period,
interest is earned on the new sum (that
includes the principal and interest earned so
far).
• In simple interest calculation, interest is
earned only on principal.

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 Simple Interest Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 Simple Interest Example

• Assume that you deposit $1,000 in an account

earning 7% simple interest for 2 years. What
is the accumulated interest at the end of the
2nd year?

SI = P0(i)(n)
= $1,000(.07)(2)
= $140
A sum of money today is called a
present value.

• We designate it mathematically with a

subscript, as occurring in time period 0

• For example: PV0 = 1,000 refers to $1,000

today
A sum of money at a future time
is termed a future value

• We designate it mathematically with a

subscript showing that it occurs in time
period n.

• For example: FVn = 2,000 refers to $2,000

after n periods from now.
 Simple Interest (FV)

• What is the Future Value (FV)

FV of the deposit?

FV = P0 + SI
= $1,000 + $140
= $1,140
• Future Value is the value at some future time of a
present amount of money, or a series of
payments, evaluated at a given interest rate.
 Simple Interest (PV)

• What is the Present Value (PV)

PV of the previous
problem?
The Present Value is simply the
$1,000 you originally deposited. That
is the value today!
• Present Value is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate.
 The Magic of Compounding

• On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly purchased

Manhattan from the Indians for $24 worth of beads and other trinkets.
Was this a good deal for the Indians?
• This happened about 385 years ago, so if they could earn 5% per year
they would now (in 2011) have:

$3.45 Bn = 24(1.05)385
 If they could have earned 10% per year, they would now have:

$54,562,898,811,973,500.00 = 24(1.10) 371

That’s about 54,563 Trillion dollars!

The Magic of Compounding (cont.)

• The Wall Street Journal (17 Jan. 92) says that all of New York city real
estate is worth about $324 billion. Of this amount, Manhattan is
about 30%, which is $97.2 billion
• At 10%, this is $54,562 trillion! Our U.S. GNP is only around $6 trillion
per year. So this amount represents about 9,094 years worth of the
total economic output of the USA!
• At 5% it seems the Indians got a bad deal, but if they earned 10% per
year, it was the Dutch that got the raw deal
• Not only that, but it turns out that the Indians really had no claim on
Manhattan (then called Manahatta). They lived on Long Island!
• As a final insult, the British arrived in the 1660’s and unceremoniously
tossed out the Dutch settlers.
 Why Compound Interest?
Future Value of a Single $1,000 Deposit

20000
Future Value (U.S. Dollars)

10% Simple
15000 Interest
10000 7% Compound
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year