Time Value of

Money
Definition

• The idea that money “now” or in the present,

is more desirable that the same amount of
money in the future because it can be invested
and earn interest as time goes by.
Terms and
concepts
• Interest
• Principal
• Rate
• Time
Interest
• The price or rental fee charged by a lender to a borrower for the use of money.
Calculating interest is also known as the simple interest formula.
• Denoted by “I”
• Computed as
I = PRT whereas P = Principal, R = Rate, T = Time
• For example:
What is the amount of interest for a loan of $8,000 at 9% interest for 1 year?
I = PRT I=8000 x .09 x 1 I = $720
Principal
• A sum of money, either invested or borrowed, on which
interest is calculated.
• Denoted by “P”
• Calculated as
Principal = Interest / (Rate x Time) P = I/(R )(T)
• For example
Allied Bank loaned Checkpoint Industries money at 8%
interest for 90 days. If the amount of interest was $4,000,
use the ordinary interest method to find the amount of
principal borrowed.
P=I/RT P=4000/.08(90/360) P=$200,000
Rate
• The percent that is charged or earned for the use of money per year.
• Denoted by “R”
• Calculated as
Rate=Interest/ (Principal x Time) R=I/PT
• For example
Using the ordinary interest method, what is the rate of interest on a loan of $5,000 for 125
days if the amount of interest is $166?
R=I/PT R=166/5000 x (125/360) R=166/1.73611 R=9.56%
Time
• Length of time, expressed in days, months, or years, of an investment or loan
• Denoted by “T”
• Calculated as
T=I/PR
• Ordinary interest uses the banker’s rule, where 360 days was used as the time factor denominator;
Exact interest method uses 365 days
• For example
What would be the time period of a loan for $7,600 at 11% ordinary interest if the amount of interest is
$290?
T=290/(7600*.11) T=290/836 T=.3468899 years x 360
T=124.8 or 125 days for ordinary interest
T=.3468899 years x 365 = 126.615 or 127 days for exact interest
 Time line
• An important tool used in time value analysis; it is a graphical
representation used to show the timing of cash flows.

Period
0 1 2 3 4

PV= $100 FV= ?

Future Value
• 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
• Calculated as

Compounding
• The arithmetic process of determining the final value of cash flow or
series of cash flows when compound interest is applied

• For example
Using a 3-year time line, assume that you plan to deposit $100 in a bank that
pays a guaranteed 5% interest each year. How much would you have at the
end of year 3?
Future Value
PV = $100
FVn= ending amount of your account after N periods given an interest
earned
R=5% annually
N= 3 number of periods

5%

$105 $110.25 $115.76

Future Value
PV = $100
FVn= ending amount of your account
after N periods given an interest earned
I=5% annually
N= 3 number of periods
Exercise 1: Future
Value
• It is now January 1, 2020. Today you will deposit
$1,000 into a savings account that pays 8%
annually.
• If the bank compounds interest annually, how
much will you have in your account on January
1, 2023?

• What will your January 1, 2023 balance be if

the bank uses quarterly compounding?
Present Values
• The value today of a future cash flow or series of cash flows.
• Calculated as

Discounting
• The process of finding the present value of a cash flow or a series of cash flows;
discounting is the reverse of compounding
Present Values

FVn=$115.76
I=5% annually
N= 3 number of periods
Exercise 2: Present Value
• It is now January 1, 2020; and you will
need $1,000 on January 1, 2023, in 3
years. Your bank compounds interest
at an 8% annual rate.
• How much must you deposit
today to have a balance of $1,000
on January 1, 2016?
• The present value of $500 due in 1
year at a discount rate of 6%.
• The present value of $500 due in 2
years at a discount rate of 6%.
Nominal &
Effective Rate
• Annual or nominal rate is the advertised or
stated interest rate of an investment or
loan. The rate used to calculate the
compound interest.

• Annual percentage yield (APY) or effective

rate is the real or true rate of return on an
investment. It is the total compound
interest earned in 1 year divided by the
principal. The more compounding periods
per year, the higher the APY.
 • For example
Calculate using a new table factor the compound
amount of $10,000 invested at 6% compounded
monthly for 3 years.
Nominal rate=6%
Nominal Interest rate per period= .06/12 = .005

Rate
Compounding periods= 3*12 = 36
New table factor= = 1.19668
Compound amount= 10,000 x 1.19668 =
$11,966.80
Exercise 3: • Stan Gray invests $3,500 at 8% interest
compounded quarterly for 7 years.

Nominal Calculate a new table factor and find the

compound amount of Stan’s investment.

Rate
APY or Effective Rate
Calculate as:
APY = Total compound interest earned in 1 year / Principal

For example:
What is the compound amount, compound interest, and annual percentage yield of $4,000 invested
for 1 year at 8% compounded semiannually?
Table factor = .08/2 = .04 Compound periods= 1*2 = 2
New factor=
Compound amount = 4,000 x 1.0816 = $4,326.40
Compound interest= 4326.40-4000 = 326.40
APY= 326.40/4000 = 8.16%
 • Jill Quinn invested $7,000 in a
certificate of deposit for 1 year at
Exercise 4 6% interest compounded quarterly.
What is the compound amount,
APY or compound interest, and annual
Effective percentage yield of Jill’s
investment? Round the APY to the
Rate nearest hundredth of a percent.
End of Discussion