Chapter Two-Time Value of Given: FV=P10,000; r=8%; t=6yrs
Money PV = P10,000/(1 +0.08)6
PV = P10,000(.630170)
Time Value of Money and Interest
Rates PV = P6,301.70
The time value of money is based on Future Value of a Lump Sum
the notion that a dollar received today
The future value of a lump sum equation
is worth more than a dollar received
translates a cash flow received at the
at some future date
beginning of an investment period to a
Simple interest: interest earned on an
terminal (future) value at the end of an
investment is not reinvested
investment horizon (e.g., 5 years, 6
Compound interest: interest earned
years, 10 years, etc.)
on an investment is reinvested, most
common The future value (FV) of a lump sum
received at the beginning of the investment
Present Value of a Lump Sum
horizon
The present value function converts
FVt = PV (1 + r)t
cash flows received over a future
investment horizon into an equivalent Example
(present) value as if they were
You plan to invest today P10,000 in
received at the beginning of the
exchange for a fixed payment at the end of
current investment horizon.
six years. If the appropriate annual interest
Discount future payments using current rate on the investment is 8 percent
interest rates to find the present value (PV) compounded annually, the future value of
this investment is computed as follows:
PV = FVt
FV = PV(1+r)t
(1 + r)t
Given: FV=P10,000; r=8%; t=6yrs
PV = present value of cash flow
FVt = future value of cash flow (lump FV = P10,000(1+0.08)6
sum) received in t periods FV = P10,000(1.586874)
r = interest rate earned per period on
investment FV = P15,868.74
t = number of compounding periods Present Value of an Annuity
in investment horizon
The present value of an annuity equation
Example converts finite series of constant (or equal)
You have been offered a security cash flow received on the last day of equal
investment such as a bond that will pay you intervals throughout the investment horizon
P10,000 at the end of six years in exchange into an equivalent (present) value as if they
for a fixed payment today. If the appropriate were received at the beginning of the
annual interest rate on the investment is 8 investment horizon.
percent compounded annually, the present The present value of a finite series of equal
value of this investment computed as cash flows received on the last day of equal
follows: intervals throughout the investment horizon
PV = FVt/(1+r)t
the future value of this investment in six
years is computed as follows:
FV = PMT X [(1+r)t-1/r]
Given: PMT=P10,000; r=8%; t=6yrs
PV = PMT X [1-(1+R)-n]/R
FV = P10,000[(1+0.08)6-1/0.08]
PMT = periodic annuity payment
FV = P10,000(7.335929)
Example
FV = P73,359.29
You have been offered a bond that will pay
you P10,000 on the last day of every year Financial Calculators
for the next six years in exchange for a
fixed payment today. If the appropriate Setting up a financial calculator
annual interest rate on the investment is 8 Number of digits shown after decimal
percent, the present value of this point
investment is computed as follows: Number of compounding periods per
year
PV = PMT X [1-(1+r)-n]/r Key inputs/outputs (solve for one of
Given: PMT=P10,000; r=8%; t=6yrs five)
PV = P10,000[1-(1+0.08)-6]/0.08 N = number of compounding periods
PV = P10,000(4.622880) I/Y = annual interest rate
PV = P46,228.80 PV = present value (i.e., current price)
Future Value of an Annuity PMT = a constant payment every period
The future value of an annuity equation FV = future value (i.e., future price)
converts a series of equal cash flows
received at equal intervals throughout the
investment horizon into an equivalent future Present Value of Ordinary Annuity End
amount at the end of the investment of the Period
horizon. The equation used to calculate this
value is represented as follows:
The future value of a series of equal cash
flows received at equal intervals throughout
the investment horizon
Example
You plan to invest P10,000 on the last day
of every year for the next six years. If the
interest rate on the investment is 8 percent,
Present Value of Annuity Due
Beginning of the Period
Future Value of Ordinary Annuity
Future Value of Annuity Due
