Time Value of Money

Lecture 03
 Some Key Concepts
Future Value (FV) The amount an investment is worth after one or more periods.
The process of accumulating interest on an investment over time to earn more
Compounding interest.
Interest earned on the reinvestment of previous interest payments.
Interest on Interest
Interest earned on both the initial principal and the interest reinvested from prior
Compound Interest periods.
Interest earned only on the original principal amount invested.
Simple Interest
The current value of future cash flows discounted at the appropriate discount
Present Value (PV) rate.
Calculate the present value of some future amount.
Discount
The rate used to calculate the present value of future cash flows.
Discount Rate

Discounted Cash Flow (DCF) Calculating the present value of a future cash flow to determine its value today.
Valuation
Refers to the fact that a dollar in hand today is worth more than a dollar promised
Time Value of Money at some time in the future.
Lecture 3: Time Value of Money 2
What is Time Value of Money??
• The time value of money (TVM) is the concept that a sum of money is
worth more now than the same sum will be at a future date due to its
earnings potential in the interim.
• The difference in the value of money today and tomorrow is referred
to as the time value of money.
• This is a core principle of finance.
• A sum of money in the hand has greater value than the same sum to
be paid in the future.
• The time value of money is also referred to as present discounted
value.
Lecture 3: Time Value of Money 3
Examples of Time Value of Money
• Saving Account
• Interest increases the amount with time
• Loan
• Payment amount
• Retirement Annuity
• Pays out constant amount per month
• Pays out an amount that increases with inflation per month
 Determinants of TVM
1. Risk and Uncertainty
•Future is always uncertain and risky. Outflow of cash is in our control as
payments to parties are made by us. There is no certainty for future cash
inflows. Cash inflows are dependent on our Creditor, Bank etc. As an
individual or firm is not certain about future cash receipts, it prefers
receiving cash now.
2. Inflation:
•In an inflationary economy, the money received today, has more
purchasing power than the money to be received in future. In other words,
a rupee today represents a greater real purchasing power than a rupee a
year after.
Lecture 3: Time Value of Money 5
 Determinants of TVM
3. Consumption:
•Individuals generally prefer current consumption to future consumption.
4. Investment opportunities:
•An investor can profitably employ a rupee received today, to give him a
higher value to be received tomorrow or after a certain period of time.
Thus, the fundamental principle behind the concept of time value of
money is that, a sum of money received today, is worth more than if the
same is received after a certain period of time.
•For example, if an individual is given an alternative either to receive
Rs.10,000 now or after one year, he will prefer Rs. 10,000 now. This is
because, today, he may be in a position to purchase more goods with this
money than what he is going to get for the same amount after one year.
Lecture 3: Time Value of Money 6
 The Time value of Money
• Compounding is the process of moving cash flows forward in time.
• Discounting is the process of moving cash flows back in time.
• Time value of money problems help us assess equivalency of differing cash
flow streams across time, including
• The value today (present value, or PV) of a single amount we will receive
in the future (future value, or FV)
• The value today (PV) of a stream of equally sized cash flows to be
received at uniform increments of time in the future (payments or
annuity, “A”)
• The value today (PV) of a stream of unequally sized and/or timed cash
flows in the future (CF)
Discounting
Time
Compounding
Lecture 3: Time Value of Money 7
 Different Interest Rates
The frequency with which interest is calculated is known as
compounding.
• Simple interest is the amount of principal times the stated rate of
interest for a single period with no compounding.
• If the period of time for which we are examining simple interest is
less than a year, the interest rate for a single period is known as a
periodic rate.
• If the instrument pays interest more than once a year, the interest rate
will generally be known as a stated annual interest rate or a quoted
interest rate.
• The expression of the rate will then typically be followed by an
indication of how often interest is calculated.
• For example: 12% compounded monthly

Lecture 3: Time Value of Money 8

Simple interest
• Simple interest is interest that is paid (earned) on only the original amount, or
principal, borrowed (lent).
• The formula for calculating simple interest is
SI = P0(i)(n)
• where SI = simple interest in dollars
• P0 = principal, or original amount borrowed (lent) at time period 0
• i = interest rate per time period
• n = number of time periods
For example, assume that you deposit $100 in a savings account paying 8 percent
simple interest and keep it there for 10 years.
At the end of 10 years, the amount of interest accumulated is determined as
follows: $80 = $100(0.08)(10)
Lecture 3: Time Value of Money 9
Simple Interest
• Future value (terminal value) The value at some future time of a present
amount of money, or a series of payments, evaluated at a given interest
rate.
• For any simple interest rate, the future value of an account at the end of n
periods is FVn = P0 + SI
= P0 + P0(i)(n)
FVn = P0[1 + (i)(n)]
• To solve for the future value (also known as the terminal value) of the
account at the end of 10 years (FV10), we add the interest earned on the
principal only to the original amount invested.
• Therefore FV10 = $100 + [$100(0.08)(10)] = $180
Lecture 3: Time Value of Money 10
Simple Interest
• Present value The current value of a future amount of money, or
a series of payments, evaluated at a given interest rate.
• Sometimes we need to proceed in the opposite direction. That is,
we know the future value of a deposit at i percent for n years,
but we don’t know the principal originally invested the account’s
present value (PV0 = P0).
PV0 = P0 = FVn / [1 + (i)(n)]

Lecture 3: Time Value of Money 11

 Compound Interest
• Interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent).
• Compound interest occurs when previously earned interest is added to
the principal amount invested or borrowed.
• It is commonly described as "interest earned on interest.“
• If you're borrowing money, you want interest compounded as
infrequently as possible; if you're investing, you want interest
compounded as often as possible.
• FVn, the future (compound) value of a deposit at the end of n periods, is
FVn = P0 (1 + i) ^ n

Lecture 3: Time Value of Money 12

Lecture 3: Time Value of Money 13
Examples
• In 1790 John Jacob Astor bought approximately an acre of land on the
east side of Manhattan Island for $58. Astor, who was considered a
shrewd investor, made many such purchases. How much would his
descendants have in 2009, if instead of buying the land, Astor had
invested the $58 at 5 percent compound annual interest?
Solution:
FV 219 = P0 × (1 + i) ^ 219
FV 219 = $58 x (1+0.05) ^ 219
FV 219 = $58 × 43,692.26
= $2,534,151.08

Lecture 3: Time Value of Money 14

 Future Value (FV)
Given a present value (PV), we can compound to return a future value (FV).

FV2 = $1,254.40
t=0 t=1 t=2 r = 12%
r = 12% t=0 t=1 t=2
PV0 = $1,000

Lecture 3: Time Value of Money 15

 Present Value (PV)
Given a future value (FV), we can discount it to return a
present value (PV).

FV3 = $25,000

r = 9% t = 0t = 1t = 2t = 3
t = 0t = 1t = 2t = 3 r = 9%
PV0 = $19,604.59

Lecture 3: Time Value of Money 16

 Problem 1
• Present Value and Multiple Cash Flows Mercer Shaved Ice Co.
has identified an investment project with the following cash
flows. If the discount rate is 10 percent, what is the present
value of these cash flows? What is the present value at 18
percent? At 24 percent?

Lecture 3: Time Value of Money 17

Problem 2

Lecture 3: Time Value of Money 18