The Time Value

of Money

CHAPTER 8

1
Learning Objectives

 The “time value of money” and its

importance to business.
 The future value and present value of a
single amount.
 The future value and present value of an
annuity.
 The present value of a series of uneven
cash flows.

2
The Time Value of Money
 Money grows over time when it earns
interest.
 Therefore, money that is to be received at
some time in the future is worth less than
the same dollar amount to be received
today.
 Similarly, a debt of a given amount to be
paid in the future are less burdensome
than that debt to be paid now.

3
The Future Value of a Single Amount
 Suppose that you have $265 today and plan to
put it in a bank account that earns 8% per year.
 How much will you have after 1 year? 5? 15?
 After one year:
$265 + (.08 x $265) = $265 + $21.20 =
$286.20
 After two years
$286.20 + (.08 x $286.20) = $286.20 + $22.90
= $309.10

4
The Future Value of a Single Amount
 Suppose that you have $265 today and plan to
put it in a bank account that earns 8% per year.
 How much will you have after 1 year? 5? 15?
 After one year:
$265 (1.08)1 = $286.20
 After five years
$265 (1.08)5 = $389.37
 After fifteen years
$265 (1.08)15 =$840.62
 Equation:
FV = PV (1 + k)n
5
The Future Value of a Single Amount
Graphical Presentation

$1000
900 k = 8%
800
700
600
500
400
300
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 6
Year
The Future Value of a Single Amount
Graphical Presentation
Different Interest Rates

$1000
900 k = 8%
800
700
600 k = 4%
500
400
300
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 7
Year
The Future Value of a Single Amount
Graphical Presentation
Different Interest Rates

$1000
900 k = 8%
800
700
600
500 k = 4%

400
300 k = 0%
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 8
Year
Present Value of a Single Amount
 Value today of an amount to be received
or paid in the future.

PV = FVn x 1
(1 + k)n

9
 Present Value of a Single Amount
 Value today of an amount to be received
or paid in the future.

1
PV = FVn x
(1 + k)n

Example: Expect to receive $100 in one year. If you can

invest at 10% per year, what is it worth today?
0 1 2

$100
10
 Present Value of a Single Amount
 Value today of an amount to be received
or paid in the future.

PV = FVn x 1
(1 + k)n

Example: Expect to receive $100 in one year. If can invest

at 10%, what is it worth today?
0 1 2

PV = 100 = 90.90 $100

(1.10)
1

11
 Present Value of a Single Amount
 Value today of an amount to be received
or paid in the future.

PV = FVn x 1
(1 + k)n

Example: Expect to receive $100 in EIGHT years. If you

can invest at 10% per year, what is it worth
today?

12
 Present Value of a Single Amount
 Value today of an amount to be received
or paid in the future.

PV = FVn x 1
(1 + k)n

Example: Expect to receive $100 in EIGHT years. If can

invest at 10%, what is it worth today?
0 1 2 3 4 5 6 7 8

100 = 46.65 $100

PV =
(1+.10)8
13
Present Value of a Single Amount
Graphical Presentation

$100
90
80
70
60
50
40
30 k = 10%
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
14
Present Value of a Single Amount
Graphical Presentation

$100
90
80
70
60 k = 5%
50
40
30 k = 10%
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
15
Present Value of a Single Amount
Graphical Presentation

$100
k = 0%
90
80
70
60 k = 5%
50
40
30 k = 10%
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
16
 Financial Calculator Solution - PV

Previous Example: Expect to receive $100 in EIGHT

years. If can invest at 10% per year, what is it
worth today?
Using Formula:
100
PV =(1+.10)8= 46.65

17
 Financial Calculator Solution - PV

Previous Example: Expect to receive $100 in EIGHT

years. If can invest at 10%, what is it worth
today?
Using Formula:
100
PV =(1+.10)8= 46.65

Calculator:
Enter: - 46.65
N =8
I/YR = 10
FV = 100 N I/YR PV PMT FV

CPT PV = ? 8 10 ? 100 18
 Financial Calculator Solution - FV

Previous Example: You invest $265 at 10%. How much

is it worth after 5 years?

Using Formula:

FV = $265 (1.10)5 = $426.79

19
 Financial Calculator Solution - FV

Previous Example: You invest $265 at 10%. How much

is it worth after 5 years?

Using Formula:

FV = $265 (1.10)5 = $426.79

Calculator:
Enter: 426.79
N = 5
I/YR = 10
N I/YR PV PMT FV
PV = -265
CPT FV = ? 5 10 -265 ? 20
Annuities
 An annuity is a series of equal cash
payments spaced evenly over time.
 For example, you pay your landlord an
annuity since your rent is the same
amount, paid on the same day of the
month for the entire year.

21
Annuities
 An annuity is a series of equal cash flows
spaced evenly over time.
 For example, you pay your landlord an
annuity since your rent is the same
amount, paid on the same day of the
month for the entire year.
Jan Feb Mar Dec

$500 $500 $500 $500 $500

22
Future Value of an Annuity

0 1 2 3

$0 $100 $100 $100

You deposit $100 each year (end of year) into a savings

account.

How much would this account have in it at the end of 3

years if interest were earned at a rate of 8% annually?
23
Future Value of an Annuity

0 1 2 3

$0 $100 $100 $100

$100(1.08)
$108
$100(1.08)2
$116.64
$324.64
You deposit $100 each year (end of year) into a
savings account.

How much would this account have in it at the end of 3

years if interest were earned at a rate of 8% annually?
24
Future Value of an Annuity

0 1 2 3

$0 $100 $100 $100

$100(1.08)
$108
$100(1.08)2
$116.64
$324.64
How much would this account have in it at the end of 3
years if interest were earned at a rate of 8% annually?
n 3
(1+k) - 1 = 100( (1+.08) - 1 )
FVA = PMT( k
) .08
= 100(3.2464) = 324.64
25
Future Value of an Annuity
Calculator Solution
0 1 2 3

$0 $100 $100 $100

Enter:
N =3
I/YR = 8
PMT = -100
CPT FV = ? N I/YR PV PMT FV

3 8 -100 ?

26
Future Value of an Annuity
Calculator Solution
0 1 2 3

$0 $100 $100 $100

Enter:
N =3 324.64
I/YR = 8
PMT = -100
CPT FV = ? N I/YR PV PMT FV

3 8 -100 ?

27
 Present Value of an Annuity
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$0 $100 $100 $100

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 Present Value of an Annuity
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$0 $100 $100 $100

$92.60 $100/(1.08)
$100 / (1.08)2
$85.73
$100 / (1.08)3
$79.38
$257.71

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 Present Value of an Annuity
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$0 $100 $100 $100

$92.60 $100/(1.08)
$100 / (1.08)2
$85.73
$100 / (1.08)3
$79.38
$257.71 1
1 - (1+k)n
PVA = PMT( k
)
1
1-
PVA = 100( (1.08)3
.08
)
= 100(2.5771) = 257.71 30
Present Value of an Annuity
Calculator Solution
0 1 2 3

$0 $100 $100 $100

PV=?

Enter:
N =3
I/YR = 8
PMT = 100
CPT PV = ? N I/YR PV PMT FV

3 8 ? 100

31
Present Value of an Annuity
Calculator Solution
0 1 2 3

$0 $100 $100 $100

PV=?

Enter:
N =3
-257.71
I/YR = 8
PMT = 100
CPT PV = ? N I/YR PV PMT FV

3 8 ? 100

32
Annuities
 An annuity is a series of equal cash
payments spaced evenly over time.

 Ordinary Annuity: The cash payments

occur at the END of each time period.

 Annuity Due: The cash payments occur at

the BEGINNING of each time period.

33
Future Value of an Annuity Due

0 1 2 3

$100 $100 $100 FVA=?

You deposit $100 each year (beginning of year) into a

savings account.

How much would this account have in it at the end of 3

years if interest were earned at a rate of 8% annually?
34
Future Value of an Annuity Due

0 1 2 3

$100 $100 $100

$100(1.08)
$108
$100(1.08) 2
$100(1.08)3 $116.64
$125.97
$350.61
You deposit $100 each year (beginning of year) into a
savings account.
How much would this account have in it at the end of 3
years if interest were earned at a rate of 8% annually?
35
 Future Value of an Annuity Due
0 1 2 3

$100 $100 $100

$100(1.08)
$108
$100(1.08)
2

$100(1.08)3 $116.64
$125.97
$350.61
How much would this account have in it at the end of 3
years if interest were earned at a rate of 8% annually?
3
n = 100( (1+.08) - 1)(1.08)
(1+k) - 1 .08
FVA = PMT( k ) (1+k)
=100(3.2464)(1.08)=350.61
36
 Present Value of an Annuity Due
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$100 $100 $100

PV=?

37
 Present Value of an Annuity Due
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$100 $100 $100

$92.60 $100/(1.08)
$100 / (1.08)2
$85.73
$278.33

38
 Present Value of an Annuity Due
•How much would the following cash flows be worth to
you today if you could earn 8% on your deposits?
0 1 2 3

$100 $100 $100

$92.60 $100/(1.08)
$100 / (1.08)2
$85.73
$278.33
1
1- (1+k)n
PVA = PMT( k
)(1+k)
1
1-
PVA = 100( (1.08)3
.08
)(1.08)
= 100(2.5771)(1.08) = 278.33 39
Amortized Loans
 A loan that is paid off in equal amounts
that include principal as well as interest..

 Solving for loan payments.

40
Amortized Loans
 You borrow $5,000 from your parents to purchase
a used car. You agree to make payments at the
end of each year for the next 5 years. If the
interest rate on this loan is 6%, how much is your
annual payment?
0 1 2 3 4 5

$5,000 $? $? $? $? $?

N I/YR PV PMT FV
41
Amortized Loans
 You borrow $5,000 from your parents to purchase
a used car. You agree to make payments at the
end of each year for the next 5 years. If the
interest rate on this loan is 6%, how much is your
annual payment?
0 1 2 3 4 5

$5,000 $? $? $? $? $?

ENTER:
N =5 –1,186.98
I/YR = 6
PV = 5,000
CPT PMT = ? N I/YR PV PMT FV
42
5 6 5,000 ?
Amortized Loans
 You borrow $20,000 from the bank to help pay for
a new car. You agree to make payments at the
end of each month for the next 4 years. If the
interest rate on this loan is 9%, how much is your
monthly payment?
1
1- (1+k)n
PVA = PMT( )
k
__1___
1-
(1.0075)48
$20,000 = PMT( .0075
)
$20,000 = PMT(40.184782)
PMT = $497.70 43
Amortized Loans
 You borrow $20,000 from the bank to help pay for
a new car. You agree to make payments at the
end of each month for the next 4 years. If the
interest rate on this loan is 9%, how much is your
monthly payment?
0 1 2 3 4 5

$20,000 $? $? $? $? $?

ENTER:
N = 48 –497.70
I/YR = .75
PV = 20,000
CPT PMT = ? N I/YR PV PMT FV
44
48 .75 20,000 ?
Perpetuities

 A perpetuity is a series of equal payments

at equal time intervals (an annuity) that
will be received into infinity.

PVP = PMT
k

45
Perpetuities

 A perpetuity is a series of equal payments

at equal time intervals (an annuity) that
will be received into infinity.
 Example: A share of preferred stock pays
a constant dividend of $5 per year. What is
the present value if k = 8%?
PVP = PMT
k

46
Perpetuities

 A perpetuity is a series of equal payments

at equal time intervals (an annuity) that will
be received into infinity.
 Example: A share of preferred stock pays a
constant dividend of $5 per year. What is
the present value if k = 8%?

PVP = PMT
k
If k = 8%: PVP = $5/.08 = $62.50
47
Solving for k

Example: A $200 investment has grown to $230 over

two years. What is the ANNUAL return on
this investment?

0 1 2

$200 $230

FV = PV(1+ k)n

48
Solving for k

Example: A $200 investment has grown to $230 over

two years. What is the ANNUAL return on
this investment?

0 1 2

$200 $230
230 = 200(1+ k)2
FV = PV(1+ k)n 1.15 = (1+ k)2
1.15 = (1+ k)2
1.0724 = 1+ k
k = .0724 = 7.24% 49
 Solving for k - Calculator Solution

Example: A $200 investment has grown to $230 over

two years. What is the ANNUAL return on
this investment?

Enter the known values of N, I/YR, PV, FV, PMT.

Solve for the unknown parameter.

7.24
or FVn = PV(1+ i)n
N I/YR PV PMT FV

2 ? -200 230 50
Compounding more than Once per Year

 $500 invested at 9% annual interest for 2

years. Compute FV.
Compounding
Frequency
$500(1.09)2 = $594.05 Annual
$500(1.045)4 = $596.26 Semi-annual
$500(1.0225)8 = $597.42 Quarterly
$500(1.0075)24 = $598.21 Monthly
$500(1.000246575)730 = $598.60 Daily
51
Continuous Compounding

 Compounding frequency is infinitely large.

 Compounding period is infinitely small.

kn
FV = PV x e
Example: $500 invested at 9% annual
interest for 2 years with continuous
compounding.

FV = $500 x e.09 x 2 = $598.61

52