The Time Value of Money

References:
Keown, 2005, Financial Management: Principles and
Applications, 10th ed., Prentice Hall
Ross, Westerfield, and Jordan, 2006, Fundamentals of
Corporate Finance, 7th ed., McGraw-Hill
Brigham & Houston, Fundamentals of Financial
Management, 8th ed.

Prepared By:
Liem Pei Fun, S.E., MCom.
 About me
 1998-2002 Bachelor of Economics (Majoring in
Finance), Petra Christian University
 2004-2005 Postgraduate Diploma in Finance,
The University of Melbourne
 2005-2006 Master of Commerce (Finance), The
University of Melbourne
 Pass CFA Exam Level I
 Bloomberg Global Product Certification – Equity
Level One
 Head of Finance Program, Faculty of Economics,
Petra Christian University
 OUTLINE
 Future Value Single Sum
 Present Value Single Sum
 Future Value Annuities
 Present Value Annuities
 Ordinary Annuity vs Annuity Due
 Perpetuities
 Practice Problems
The Time Value of Money

, Prentice Hall, Inc.

Compounding and
Discounting
Single Sums
 We know that receiving $1 today is
worth more than $1 in the future.
This is due to opportunity costs.
The opportunity cost of receiving
$1 in the future is the interest we
could have earned if we had
received the $1 sooner.
Today Future
 If we can measure this
opportunity cost, we can:
 Translate $1 today into its equivalent in the future (compounding).
(compounding).

 Translate $1 in the future into its equivalent today (discounting).

(discounting).

Today Future

Today Future

?
Future Value
 Future Value - single sums
If you deposit $100 in an account earning
6%, how much would you have in the
account after 1 year?
PV = -100 FV = 106

0 1
Mathematical Solution:
(Arithmetic Method)
FV = PV (1 + i)n
FV = 100 (1.06)1 = $106
 Calculator Keys
 Texas Instruments BA-II Plus
 FV = future value
 PV = present value
 I/Y = period interest rate
 P/Y must equal 1 for the I/Y to be the period rate
 Interest is entered as a percent, not a decimal

 N = number of periods
 Remember to clear the registers (CLR TVM)
after each problem
 Other calculators are similar in format
 Future Value - single sums
If you deposit $100 in an account earning
6%, how much would you have in the
account after 1 year?
PV = -100 FV = 106

0 1

Calculator Solution:
P/Y = 1 I/Y = 6
N=1 PV = -100
FV = $106
 Future Value - single sums
If you deposit $100 in an account earning
6%, how much would you have in the
account after 5 years?
PV = -100 FV = 133.82

0 5
Mathematical Solution:
(Arithmetic Method)
FV = PV (1 + i)n
FV = 100 (1.06)5 = $133.82
 Future Value - single sums
If you deposit $100 in an account earning
6%, how much would you have in the
account after 5 years?
PV = -100 FV = 133.82

0 5

Calculator Solution:
P/Y = 1 I/Y = 6
N=5 PV = -100
FV = $133.82
 Future Value - single sums
If you deposit $100 in an account earning
6% with quarterly compounding, how
much would you have in the account after
5 years?
PV = -100 FV = 134.68

0 20
Mathematical Solution:
(Arithmetic Method)
FV = PV (1 + i/m) m x n
FV = 100 (1.015)20 = $134.68
 Future Value - single sums
If you deposit $100 in an account earning
6% with quarterly compounding, how
much would you have in the account after
5 years?
PV = -100 FV = 134.68

0 20
Calculator Solution:
P/Y = 4 I/Y = 6
N = 20 PV = -100
FV = $134.68
 Future Value - single sums
If you deposit $100 in an account earning
6% with monthly compounding, how
much would you have in the account after
5 years?
PV = -100 FV = 134.89

0 60
Mathematical Solution:
(Arithmetic Method)
FV = PV (1 + i/m) m x n
FV = 100 (1.005)60 = $134.89
 Future Value - single sums
If you deposit $100 in an account earning
6% with monthly compounding, how
much would you have in the account after
5 years?
PV = -100 FV = 134.89

0 60
Calculator Solution:
P/Y = 12 I/Y = 6
N = 60 PV = -100
FV = $134.89
 Future Value - continuous
compounding
What is the FV of $1,000 earning 8% with
continuous compounding, after 100 years?
PV = -1000 FV = $2.98m

0 100
Mathematical Solution:
(Arithmetic Method)
FV = PV (e in)
FV = 1000 (e .08x100) = 1000 (e 8)
FV = $2,980,957.99
Present Value
 Present Value - single sums
If you receive $100 one year from now,
what is the PV of that $100 if your
opportunity cost is 6%?
PV = -94.34 FV = 100

0 1
Mathematical Solution:
(Arithmetic Method)
PV = FV / (1 + i)n
PV = 100 / (1.06)1 = $94.34
 Present Value - single sums
If you receive $100 one year from now,
what is the PV of that $100 if your
opportunity cost is 6%?

PV = -94.34 FV = 100

0 1
Calculator Solution:
P/Y = 1 I/Y = 6
N=1 FV = 100
PV = -94.34
 Present Value - single sums
If you receive $100 five years from now,
what is the PV of that $100 if your
opportunity cost is 6%?

PV = -74.73 FV = 100

0 5
Mathematical Solution:
(Arithmetic Method)
PV = FV / (1 + i)n
PV = 100 / (1.06)5 = $74.73
 Present Value - single sums
If you receive $100 five years from now,
what is the PV of that $100 if your
opportunity cost is 6%?

PV = -74.73 FV = 100

0 5
Calculator Solution:
P/Y = 1 I/Y = 6
N=5 FV = 100
PV = -74.73
 Present Value - single sums
If you sold land for $11,933 that you
bought 5 years ago for $5,000, what is your
annual rate of return?

Mathematical Solution:
PV = FV / (1 + i)n
5,000 = 11,933 / (1+ i)5
.419 = ((1/ (1+i)5)
2.3866 = (1+i)5
(2.3866)1/5 = (1+i)
i = .19
 Present Value - single sums
If you sold land for $11,933 that you
bought 5 years ago for $5,000, what is your
annual rate of return?
PV = -5000 FV = 11,933

0 5

Calculator Solution:
P/Y = 1 N=5
PV = -5,000 FV = 11,933
I/Y = 19%
 Present Value - single sums
Suppose you placed $100 in an account
that pays 9.6% interest, compounded
monthly. How long will it take for your
account to grow to $500?
Mathematical Solution:
PV = FV / (1 + i)N
100 = 500 / (1+ .008)N
5 = (1.008)N
ln 5 = ln (1.008)N
ln 5 = N ln (1.008)
1.60944 = .007968 N
N = 202 months
 Present Value - single sums
Suppose you placed $100 in an account
that pays 9.6% interest, compounded
monthly. How long will it take for your
account to grow to $500?
PV = -100 FV = 500

0 ?
Calculator Solution:
 P/Y = 12 FV = 500
 I/Y = 9.6 PV = -100

 N = 202 months
 Compounding and
Discounting
Cash Flow Streams

0 1 2 3 4
 What is the difference between an
ordinary annuity and an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

 Ordinary Annuity
 a sequence of equal cash flows,
occurring at the end of each
period.

0 1 2 3 4
 Examples of Annuities:
 If you buy a bond, you will
receive equal semi-annual
coupon interest payments over
the life of the bond.
 If you borrow money to buy a

house or a car, you will pay a

stream of equal payments.
 Future Value - annuity
If you invest $1,000 each year at 8%, how
much would you have after 3 years?

0 1 2 3
 Future Value - annuity
If you invest $1,000 each year at 8%,
how much would you have after 3
years?
Mathematical Solution:
 (1  i ) n  1
FV  PMT  
 i 
 (1.08) 3  1
FV  1,000 
 0.08 
= $3,246.40
 Future Value - annuity
If you invest $1,000 each year at 8%, how
much would you have after 3 years?

1000 1000 1000

0 1 2 3

Calculator Solution:
P/Y = 1 I/Y = 8
PMT = -1,000 N = 3
FV = $3,246.40
 Present Value - annuity
What is the PV of $1,000 at the end of each
of the next 3 years, if the opportunity cost
is 8%?

0 1 2 3
 Present Value - annuity
What is the PV of $1,000 at the end of
each of the next 3 years, if the
opportunity cost is 8%?
Mathematical Solution:
 1 
 1  
(1  i ) n
PV  PMT  
 i 

 

 1 
1  
(1.08) 3
PV  1,000  
 0.08 

 

PV  $2,577.10
 Present Value - annuity
What is the PV of $1,000 at the end of each
of the next 3 years, if the opportunity cost
is 8%?
1000 1000 1000

0 1 2 3

Calculator Solution:
P/Y = 1 I/Y = 8
PMT = -1,000 N = 3
PV = $2,577.10
 Ordinary Annuity
vs.
Annuity Due

$1000 $1000 $1000

4 5 6 7 8
 Begin Mode vs. End Mode

1000 1000 1000

4 5 6 7 8
 Begin Mode vs. End Mode

1000 1000 1000

year year year
4 5 5 6 6 7 7 8
 Begin Mode vs. End Mode

1000 1000 1000

year year year
4 5 5 6 6 7 7 8

PV
in
END
Mode
 Begin Mode vs. End Mode

1000 1000 1000

year year year
4 5 5 6 6 7 7 8

PV FV
in in
END END
Mode Mode
 Begin Mode vs. End Mode

1000 1000 1000

year year year

4 5 6 6 7 7 8 8
 Begin Mode vs. End Mode

1000 1000 1000

year year year

4 5 6 6 7 7 8 8

PV
in
BEGIN
Mode
 Begin Mode vs. End Mode

1000 1000 1000

year year year

4 5 6 6 7 7 8 8

PV FV
in in
BEGIN BEGIN
Mode Mode
 Earlier, we examined this
“ordinary” annuity:
1000 1000 1000

0 1 2 3
Using an interest rate of 8%,
we find that:
 The Future Value (at 3) is

$3,246.40.
 The Present Value (at 0) is

$2,577.10.
 What about this annuity?

1000 1000 1000

0 1 2 3
 Same 3-year time line,
 Same 3 $1000 cash flows, but

 The cash flows occur at the

beginning of each year, rather

than at the end of each year.
 This is an “annuity due.”
 Future Value - annuity due
If you invest $1,000 at the beginning of
each of the next 3 years at 8%, how much
would you have at the end of year 3?

0 1 2 3
 Future Value - annuity due
If you invest $1,000 at the beginning
of each of the next 3 years at 8%, how
much would you have at the end of
year 3?
Mathematical Solution: Simply compound the FV of
the ordinary annuity one more period:
FV = PMT (FVIFA i, n ) (1 + i)
FV = 1,000 (FVIFA .08, 3 ) (1.08) use FVIFA table or
 (1  i ) n  1
FV  PMT   (1  i )
 i 
 (1.08) 3  1
FV  1,000  (1.08)
 0.08 

= $3,506.11
 Present Value - annuity due
What is the PV of $1,000 at the beginning
of each of the next 3 years, if your
opportunity cost is 8%?

0 1 2 3
 Present Value - annuity due
Mathematical Solution: Simply compound the FV of
the ordinary annuity one more period:
PV = PMT (PVIFA i, n ) (1 + i)
PV = 1,000 (PVIFA .08, 3 ) (1.08) use PVIFA table or
 1 
 1  
(1  i ) n
PV  PMT   (1  i )
 i 

 

 1 
1  
(1.08) 3
PV  1,000   (1.08)
 0.08 

 

= $2,783.26
 Other Cash Flow Patterns

0 1 2 3
 Perpetuities
 Suppose you will receive a
fixed payment every period
(month, year, etc.) forever.
This is an example of a
perpetuity.
 You can think of a perpetuity

as an annuity that goes on

forever.
 Present Value of a
Perpetuity
 When we find the PV of an
annuity, we think of the
following relationship:

PV = PMT (PVIFA i, n )
Mathematically,
1
n
(PVIFA i, n ) = 1- (1 + i)
i

We said that a perpetuity is an

annuity where n = infinity.
What happens to this formula
when n gets very, very large?
When n gets very large,

1 this becomes zero.

n
1- (1 + i)
i

So we’re left with PVIFA =

1
i
 Present Value of a Perpetuity

 So, the PV of a perpetuity is

very simple to find:

PMT
PV =
i
What should you be willing to pay
in order to receive $10,000
annually forever, if you require
8% per year on the investment?

PV = PMT = $10,000
i .08
= $125,000
 Uneven Cash Flows

-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4
 Is this an annuity?
 How do we find the PV of a cash flow

stream when all of the cash flows are

different? (Use a 10% discount rate).
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

 Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

 Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

 Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

 Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
 Uneven Cash Flows
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

 Sorry! There’s no quickie for this

one. We have to discount each
cash flow back separately.
-10,000 2,000 4,000 6,000 7,000

0 1 2 3 4

period CF PV (CF)
0 -10,000 -10,000.00
1 2,000 1,818.18
2 4,000 3,305.79
3 6,000 4,507.89
4 7,000 4,781.09
PV of Cash Flow Stream: $ 4,412.95
 Annual Percentage Yield
(APY)
Which is the better loan:
 8% compounded annually, or

 7.85% compounded quarterly?

 We can’t compare these nominal (quoted)

interest rates, because they don’t include

the same number of compounding periods
per year!
We need to calculate the APY.
Annual Percentage Yield
(APY)
Annual Percentage Yield
(APY)
APY = (1+ quoted rate
m
) m
- 1
 Annual Percentage Yield
(APY)
APY = (1+ quoted rate
m
) m
- 1
 Find the APY for the quarterly loan:
 Annual Percentage Yield
(APY)
APY = (1+ quoted rate
m
) m
- 1
 Find the APY for the quarterly loan:

APY = ( 1+
.0785
4
) 4
- 1
 Annual Percentage Yield
(APY)
APY = (1+ quoted rate
m
) m
- 1
 Find the APY for the quarterly loan:

APY = ( 1+
.0785
4
) 4
- 1

APY = .0808, or 8.08%

 Annual Percentage Yield
(APY)
APY = (1+ quoted rate
m
) m
- 1
 Find the APY for the quarterly loan:

APY = ( 1+
.0785
4
4
)
- 1
APY = .0808, or 8.08%
 The quarterly loan is more expensive
than the 8% loan with annual
compounding!
 Spreadsheet Example
 Use the following formulas for TVM
calculations
 FV(rate,nper,pmt,pv)
 PV(rate,nper,pmt,fv)
 RATE(nper,pmt,pv,fv)
 NPER(rate,pmt,pv,fv)
 The formula icon is very useful when you
can’t remember the exact formula
 Click on the Excel icon to open a spreadsheet
containing four different examples.
Practice Problems

, Prentice Hall, Inc.

 Example
 Cash flows from an investment are
expected to be $40,000 per year at
the end of years 4, 5, 6, 7, and 8. If
you require a 20% rate of return,
what is the PV of these cash flows?
 Example
 Cash flows from an investment are
expected to be $40,000 per year at
the end of years 4, 5, 6, 7, and 8. If
you require a 20% rate of return,
what is the PV of these cash flows?

$0 0 0 0 40 40 40 40 40

0 1 2 3 4 5 6 7 8
 Retirement Example

 If you invest $400 at the end of each

month for the next 30 years at 12%,
how much would you have at the end
of year 30?
 House Payment Example
If you borrow $100,000 at 7%
fixed interest for 30 years in
order to buy a house, what
will be your monthly house
payment?
 Example
 Baim ingin menabung untuk biaya wisata
keluar negeri. Bajuri ingin keluar negeri pada
akhir tahun 2012. Ia ingin memulai tabungan
ini pada awal tahun 2008. Biaya yang
diperlukan untuk keluar negeri adalah Rp.
150.000.000,-.
 Berapakah yang harus ditabung oleh Baim bila ia
ingin menabung sekali saja pada awal tahun
2008 bila suku bunga adalah 15 % ?
 Berapakah yang harus ditabung Baim bila ia ingin
menabung setiap awal tahun mulai tahun 2008
hingga tahun 2012, asumsi suku bunga 15 % ?