The Time Value of Money
Understanding the time value of money is crucial to effective financial management.
In fact, anyone who is involved with money should have some comprehension of the Time
Value of Money.
Watch this: Time Value of Money - Explained (Step by Step Beginner's Guide) (youtube.com)
https://youtu.be/_Kn5Q3DyZmY?si=NL6bn1-MSZUa_6nW
What Is the Time Value of Money (TVM)?
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 time
value of money 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 the
present discounted value.
KEY TAKEAWAYS
⚫ The time value of money means that a sum of money is worth more now than the same
sum of money in the future.
⚫ The principle of the time value of money means that it can grow only through investing so
a delayed investment is a lost opportunity.
⚫ The formula for computing the time value of money considers the amount of money, its
future value, the amount it can earn, and the time frame.
⚫ For savings accounts, the number of compounding periods is an important determinant as
well.
⚫ Inflation has a negative impact on the time value of money because your purchasing
power decreases as prices rise.
An understanding of interest is crucial to sound financial management.
I. Simple interest is interest earned or paid on the principal only. The amount of simple
interest is equal to the product of the principal times the rate per time period times the n
II. umber of time periods:
I = PV₀ x i x n Equation 1
Where:
I = the simple interest in dollars;
PV₀ = the principal amount at time 0, or the present value;
i = the interest rate per time period; and
n = the number of time periods. The following problems illustrate the use of Equation 1.
➢ What is the simple interest on $100 at 10 percent per annum for six months? Substituting
$100 for PV₀ , 10 percent (0.10) for i, and 6⁄12 (0.5) for n yields the following:
I = $100 x 0.10 x 0.5
= $5
➢ If Isaiah Williams bought a house and borrowed $30,000 at a 10 percent annual interest
rate, what would be his first month’s interest payment? Substituting $30,000 for PV₀ , 10
percent (0.10) for i, and 1⁄12 for n yields the following:
I = $30,000 x 0.10 x 1/12
= $250
➢ Mary Schiller receives $30 every three months from a bank account that pays a 6 percent
annual interest rate. How much is invested in the account? Because PV0 is the unknown
in this example, Equation 1 is rearranged:
III
PV₀ = i x n Equation 2
Substituting $30 for I, 0.06 for i, and 1/4 (0.25) for n yields the following:
$30
PV0 = 0.06 x 0.25
= $2,000
It also is useful to be able to calculate the amount of funds a person can expect to receive at
some point in the future. In financial mathematics, the terminal, or future, value of an
investment is called FVn and denotes the principal plus interest accumulated at the end of n
years. It is written as follows:
FVn = PV0 + I Equation 3
➢ Raymond Gomez borrows $1,000 for 9 months at a rate of 8 percent per annum. How
much will he have to repay at the end of the 9-month period? Combining Equations 1 and
3 to solve for FVn results in the following new equation:
FVn = PV0 + (PV0 i n) Equation 4
Substituting $1,000 for PV0, 0.08 for i, and 3⁄4 (9 months = 3⁄4 of 1 year) for n yields the
following: FV3⁄4 = $1,000 + (1,000 0.08 3⁄4) = $1,060 This problem can be illustrated
using the following timeline:
➢ Marie Como agrees to invest $1,000 in a venture that promises to pay 10 percent simple
interest each year for two years. How much money will she have at the end of the second
year? Using Equation 4 and assuming two 10 percent simple interest payments, the future
value of Marie’s investment at the end of two years is computed as follows:
FV2 = PV0 + (PV0 x i x 2)
= $1,000 + ($1,000 x 0.10 x 2)
= $1,200
This problem can be illustrated using the following timeline:
In general, in the case of simple interest, the future, or terminal, value (FVn) at the end of n
years is given by Equation 4.
III. Compound interest is interest paid not only on the principal but also on any interest
earned but not withdrawn during earlier periods. For example, if Jerry Jones deposits $1,000 in
a savings account paying 6 percent interest compounded annually, the future (compound)
value of his account at the end of one year (FV1) is calculated as follows:
FV1 = PV0(1 + i) Equation 5
= $1,000(1 + 0.06)
= $1,060
This problem can be illustrated using the following timeline:
If Jones leaves the $1,000 plus the accumulated interest in the account for another year, its
worth at the end of the second year is calculated as follows:
FV2 = FV1(1 + i) Equation 6
= $1,060(1 + 0.06)
= $1,123.60
This problem can be illustrated using the following timeline:
Recall that in the case of compound interest, interest in each period is earned not
only on the principal but also on any interest accumulated during previous periods and not
withdrawn. As shown in Figure 5.1, if Jones’s account paid simple interest instead of
compound interest, its value at the end of two years would be $1,120 instead of $1,123.60.
The $3.60 difference is the interest on the first year’s interest, 0.06 $60. If Jones makes no
withdrawals from the account for another year, it will total the follow ing at the end of the
third year:
FV3 = FV2(1 + i) Equation 7
= $1,123.60(1 + 0.06)
= $1,191.02
This problem can be illustrated using the following timeline:
Figure 5.1 illustrates that if the account paid only simple interest, it would be worth only
$1,180 at the end of three years. The $11.02 difference (i.e., $1191.02 – $1180) is the interest
on the first and second years’ interest, 0.06 ($60 + $123.60).
A general formula for computing future values can be developed by combining
Equations 5,and 6.Substituting Equation 5 into Equation 6 yields the following equation:
FV2= PV0(1 + i) (1 + i) Equation 8
or
FV2= PV0(1 + i)2 Equation 8
This equation can be further generalized to calculate the future value at the end of
period n for any payment compounded at interest rate i:
FVn= PV0(1 + i)n Equation 9
Although Equation 9 is useful for solving future value problems involving
one,two,three, or even four years into the future, it is rather tedious to use this equation for
problems involving longer time periods.For example, solving for 20 years into the future
would require calculating (1 + i)20. Future value interest factors(FVIFs) are commonly used to
simplify such computations. Because each future value interest factor is defined as
FVIFin= (1 + i)n Equation 10
The FVIF may be thought of as the value that $1 today grows to in n periods at a
periodic interest rate of i. Equation 9 may be rewritten as follows:
FVn= PV0(FVIFin) Equation 11
where i= the nominal interest rate per period and n= the number of periods.
Table I at the end of the book provides a listing of future value interest factors for
various interest rates covering up to 60 periods (years or other time periods)
To better understand Table I, it is helpful to think of each factor as the result of
investing or lending $1 for a given number of periods, n,at interest rate i.The solution for any
amount other than $1 is the product of that principal amount times the factor for a $1
principal amount.
A portion of Table I is reproduced as Table 5.1. Table 5.1 can be used to determine
the value of $1,000 compounded at 6 percent for 20 years:
Solving for the Interest Rate In some compound value problems, the present value
(PV0) and future value (FVn) are given and the objective is to determine the interest rate (i)
that solves Equation 9. For example, the future value interest factor for an investment
requiring an initial outlay of $1,000 and promising a $1,629 return after 10 years is as follows:
Reading across the 10-year row in Table 5.1, 1.629 is found in the 5 percent column.
Thus, the investment yields a 5 percent compound rate of return.
Annuities
An annuity is the payment or receipt of equal cash flows per period for a specified
amount of time. An ordinary annuity is one in which the payments or receipts occur at the end
of each period, as shown in Figure 5.4. An annuity due is one in which payments or receipts
occur at the beginning of each period, as shown in Figure 5.5. Most lease payments, such as
apartment rentals, and life insurance premiums are annuities due.
Future Value of an Ordinary Annuity A future value of an ordinary annuity (FVANn)
problem asks the question:If PMT dollars are deposited in an account at the end of each year
for n years and if the deposits earn interest rate I compounded annually,what will be the value
of the account at the end of n years?
To illustrate,suppose Ms.Jefferson receives a 3-year ordinary annuity of$1,000 per
year and deposits the money in a savings account at the end of each year.The account earns
interest at a rate of 6 percent compounded annually. How much will her account be worth at
the end of the 3-year period? Figure 5.6 illustrates this concept. The problem involves the
calculation of future values.The last deposit,PMT3,made at the end of year 3,will earn no
interest.Thus,its future value is as follows:
The second deposit,PMT2,made at the end of year 2,will be in the account for one full year
before the end of the 3-year period,and it will earn interest.Thus,its future value is as follows:
The first deposit,PMT1,made at the end of year 1,will be in the account earning interest for
two full years before the end of the 3-year period.Therefore its future value is the following:
The sum of the three figures is the future value ofthe annuity:
Table 5.8 on page 168 summarizes the equations used to compute the future and present
values of the various cash flow streams.
➢ Sinking fund problems determine the annuity amount that must be invested each year to
produce a future value.
➢ Capital recovery problems determine the annuity amount necessary to recover some initial
investment.
➢ The more frequently compounding occurs during a given period, the higher the effective interest
rate on an investment. More frequent compounding results in higher future values and lower
present values than less frequent compounding at the same interest rate.
➢ The appropriate compounding or discount rate to use in a particular problem depends upon the
general level of interest rates in the economy, the time frame used for analysis, and the risk of
the investment being considered.
Self-Test Problems
ST1. Calculate the value in five years of $1,000 deposited in a
savings account today if the account pays interest at a rate of: a.
8 percent per year, compounded annually b. 8 percent per year,
compounded quarterly
ST2. A business is considering purchasing a machine that is
projected to yield cash savings of $1,000 per year over a 10-year
period. Using a 12 percent discount rate, calculate the present
value of the savings. (Assume that the cash savings occur at the
end of each year.)
ST3. Simpson Peripherals earned $0.90 per share in 2000 and
$1.52 in 2005. Calculate the annual growth rate in earnings per
share over this period.
ST4. You own a small business that is for sale. You have been
offered $2,000 per year for five years, with the first receipt at the
end of four years. Calculate the present value of this offer, using
a 14 percent discount rate.
ST5. Yolanda Williams is 35 years old today and is beginning to
plan for her retirement. She wants to set aside an equal amount
at the end of each of the next 25 years so that she can retire at
age 60. She expects to live to an age of 80 and wants to be able
to withdraw $50,000 per year from the account on her 61st
through 80th birthdays. The account is expected to earn 10 percent per year for the entire period of
time. Determine the size of the annual deposits that she must make.
