Time Value of Money

Lecture 8-9

4-1
 Time Value of Money

Why is TIME such an important element

in your decision?

The worth or value of MONEY at different

points in time is “Time value of Money”

4-2
 Types of Interest

 Simple Interest
Interest paid (earned) on only the original
amount, or principal borrowed (lent).

• Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed
(lent).

4-3
 Simple Interest

We require:
Value:Simple Interest
PV: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

Two types of Values:

• Present Value
• Future Value
4-4
 Future Value (FV)
• FV is the value at some future time of a present
amount of money, or a series of payments,
evaluated at a given interest rate.
• The process of going from today’s value to future
values is called Compounding
FV = PV (1 + i)ⁿ
FV = Future Value
PV= Present Value
i= interest rate
n = No of years 4-5
 FV Example

• Assume that you deposit Rs.1,000 in an

account earning 7% simple interest for 2
years. What is the accumulated interest at the
end of the 2nd year?
FV = PV (1 + i)ⁿ

4-6
 Future Value
Single Deposit (Graphic)
Assume that you deposit Rs.1,000 at a
compound interest rate of 7% for 2 years.

0 1 2
7%

Rs.1,000
FV2

4-7
 Future Value
Single Deposit (Formula)
FV1 = PV(1+i)1 = Rs.1,000 (1.07)
= Rs.1,070
Compound Interest
You earned Rs.70 interest on your Rs.1,000
deposit over the first year.
This is the same amount of interest you would
earn under simple interest.

4-8
 Future Value
Single Deposit (Formula)
FV1 = PV(1+i)1 = Rs.1,000
(1.07)
= Rs.1,070
FV2 = FV1 (1+i)1

= PV (1+i)(1+i) = Rs.1,000(1.07)(1.07)
= PV(1+i)2 =
Rs.1,000(1.07)2 4-9
 General Future Value
Formula
FV1 = PV(1+i)1
FV2 = PV(1+i)2
etc.
General Future Value Formula:
FVn = PV(1+i)n
or FVn = PV(FVIFi,n)

4-10
 Valuation Using Table
FVIFi,n

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145
1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469 4-11
 Using Future Value Tables
FV2 = Rs.1,000 (FVIF7%,2)
= Rs.1,000 (1.145)
= Rs.1,145 [Due to
Rounding]
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469 4-12
 Problem Example
Julie Miller wants to know how large her deposit of
Rs.10,000 today will become at a compound annual
interest rate of 10% for 5 years.

0 1 2 3 4 5

10%
Rs.10,000
FV5

4-13
 Story Problem Solution
 Calculation based on general formula:
FVn = PV(1+i)n
FV5 =

• Calculation based on Table: FV5

= Rs.10,000 (FVIF10%, 5)

4-14
 Present Value (PV)
• PV is the current value of a future amount of
money, or a series of payments, evaluated at a
given interest rate
• The process of finding Present values is called
Discounting
PV = FV (1 + i)⁻ⁿ
FV = Future Value
PV= Present Value
i= interest rate
n = No of years 4-15
 Present Value (PV)
Assume that you need Rs. 1,000 in 2 years. Let’s
examine the process to determine how much you
need to deposit today at a discount rate of 7%
compounded annually.
PV = FV (1 + i)⁻ⁿ

4-16
 Present Value
Single Deposit (Formula)
PV = FV2 (1+i)⁻2 = Rs.1,000 (1.07)⁻2
PV = FV2 (1+i)⁻2 = Rs.873.44

0 1 2
7%

Rs.1,000
PV

4-17
 General Present Value
Formula
PV = FV1 (1+i)⁻1
PV = FV2 (1+i)⁻2
etc.
General Present Value Formula:
PV = FVn (1+i)⁻n
or PV = FVn (PVIFi,n)

4-18
 Valuation Using Table
PVIFi,n

Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873
.873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
4-19
 Problem Example
Julie Miller wants to know how large of a deposit
to make so that the money will grow to Rs.10,000
in 5 years at a discount rate of 10%.

0 1 2 3 4 5

10%
Rs.10,000
PV0
4-20
 Problem Solution
• Calculation based on general formula:
PV = FV (1+i)⁻n

• Calculation based on Table:

PV = Rs.10,000 (PVIF10%, 5)

4-21
 Types of Annuities

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
• Ordinary Annuity: Payments or receipts occur
at the end of each period.
• Annuity Due: Payments or receipts occur at the
beginning of each period.

4-22
 Examples of Annuities

• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings

4-23
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.100

Today
Equal Cash Flows
Each 1 Period Apart 4-24
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

Rs.100 Rs.100 Rs.100

Today Equal Cash Flows
Each 1 Period Apart 4-25
 Future Value Annuity - FVA
• Future Value annuity is the future value of the
series of equal payments for specified
equidistant periods
Ordinary Annuity Annuity Due

4-26
 Ordinary Annuity - FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+i) + R(1+i) +
n-1 n-2

... + R(1+i)1 + R(1+i)0

4-27
 Example of an
Ordinary Annuity - FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose a bank is offering 7% interest rate at an equal amount of
deposit of Rs. 1000 at the end of each year for the next 3 years. What
amount you will have at the end of 3 years if you deposit equal
payments of Rs. 1000 each.

4-28
 Valuation Using Table
FVAn = R (FVIFAi%,n)
FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 (3.215)=Rs.3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867 4-29
 Future Value Annuity Due
FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
. . .
i%
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn

... + R(1+i)2 + R(1+i)1 =
FVAn (1+i)
4-30
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose a bank is offering 7% interest rate at an equal amount of
deposit of Rs. 1000 at the beginning of each year for the next 3 years.
What amount you will have at the end of 3 years if you deposit equal
payments of Rs. 1000 each.

4-31
 Valuation Using Table
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = Rs.1,000 (FVIFA7%,3)(1.07) =
Rs.1,000 (3.215)(1.07)= Rs.3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
4-32
 Present Value Annuity - PVA
• Present Value annuity is the present value of
the series of equal payments for specified
equidistant periods
Ordinary Annuity Annuity Due

4-33
 Present Value Ordinary
Annuity - PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
4-34
 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000
Suppose you will need Rs. 10,000 after 3 years that will require equal
amount of deposit of Rs. 1000 at the end of each year for the next 3
years. What lump sum amount you should deposit today if the bank is
offering an interest rate of 7%?

4-35
 Valuation Using Table
PVAn = R (PVIFAi%,n)
PVA3 = Rs.1,000 (PVIFA7%,3)
= Rs.1,000 (2.624) =Rs.2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993 4-36
 Present Value Annuity Due
PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .

R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
4-37
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
Rs.1,000 Rs.1,000 Rs.1,000

Suppose you will need Rs. 10,000 after 3 years that will require equal
amount of deposit of Rs. 1000 at the beginning of each year for the
next 3 years. What lump sum amount you should deposit today if the
bank is offering an interest rate of 7%?

4-38
 Valuation Using Table
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = Rs.1,000 (PVIFA7%,3)(1.07)
= Rs.1,000 (2.624)(1.07) =
Period
Rs.2,808 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
4-39
 Uneven Cash Flows
• When we have UNEQUAL Payments over
UNEQUAL number of periods
• We cant use Annuity…
• Uneven Cash flow Stream…

4-40
 Uneven Cash Flows
Ali will receive the set of cash flows below.
What is the Present Value at a discount rate of
10%?
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

PV0

4-41
 How to Solve?
1. Solve a “piece-at-a-time” by
discounting each piece back to t=0.
0 1 2 3 4 5

i%
R R R R R

PV 4-42
 “Piece-At-A-Time”
PV of Uneven Cashflow Stream
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100
Rs.545.45
Rs.495.87
Rs.300.53
Rs.273.21
Rs. 62.09
Rs.1677.15 = PV of the Mixed Flow
4-43
 “Piece-At-A-Time”
FV of Uneven Cashflow Stream
0 1 2 3 4 5

10%
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

4-44
 Frequency of
Compounding
General Formula:
FVn = PV(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Yeari:
Annual Interest Rate

FVn,m: FV at the end of Year n

PV0 : PV of the Cash Flow today
4-45
 Frequency of
Compounding
Compounding Interest Year (i/m) No of Periods (nxm)

Annually

Semi-Annually

Quarterly

Monthly

Daily

4-46
 Impact of Frequency
Ali has Rs.1,000 to invest for 2 years at an annual
interest rate of 12%.
Annual FV =

Semi FV =

4-47
 Impact of Frequency
Qrtly FV

Monthly FV =

Daily FV =
4-48
 Impact of Frequency
Ali has to make equal payments of Rs.1,000 to for
3 years at an annual interest rate of 12% in order
to have some amount in future.
Annual FV =

Semi FV =

4-49
 Impact of Frequency
For Present Value:

4-50
 Impact of Frequency
Ali has to make equal payments of Rs.1,000 for 2
years at an annual interest rate of 12%. What
lump sum amount he should deposit today?
Annual PVA =

Semi PVA =

4-51
 Impact of Frequency
Qrtly PVA

Monthly PVA =

Daily PVA =
4-52
 Effective Annual Interest Rate
The actual rate of interest earned (paid) after
adjusting the nominal rate for factors such
as the number of compounding periods per
year.
Formula:

4-53
 Finding ‘i’ in Time Value of
Money Problems
• Suppose you deposit Rs. 1000 today that will become Rs. 1469
after 5 years. What interest rate you would earn on your
deposit?

4-54
 Finding ‘n’ in Time Value of
Money
• Suppose you deposit Rs. 100 and you will have Rs. 115 at an
interest rate of 5%. Hw much time it will take to earn Rs. 115?

4-55
 BW’s Effective
Annual Interest Rate
Basket Wonders (BW) has a Rs.1,000 CD at the
bank. The interest rate is 6% compounded
quarterly for 1 year. What is the Effective
Annual Interest Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1
= .0614 or 6.14%!
4-56
 Effective Annual Interest Rate

Suppose you borrow either through credit card which charges

12 % per month for a year or through bank loan with 12%
interest rate that is compounded quarterly. What should
you choose?

4-57
 Loan Amortization
• If a loan is to be repaid in equal periodic
payments, it is said to be amortized loan.

• It is an application of compounding interest

and annuity.

• Example: Car Loan, Mortgage Loan, Student

Loan
4-58
 Amortizing a Loan Example
Ali is borrowing Rs.10,000 at a compound annual
interest rate of 12%. Amortize the loan if annual
payments are made for 5 years.
Step 1: Payment
PV =

4-59
 Amortizing a Loan Example

End of Payment Interest Principal Ending

Year Balance
0 --- --- --- Rs10,000
1 Rs. 2,774 Rs.1,200 Rs.1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
Rs13,871 Rs3,871 Rs10,000
[Last Payment Slightly Higher Due to Rounding]
4-60