Chapter 3
Time Value of
Money
Instructor: Ajab Khan Burki
3-1
The Time Value of Money
3-2
The Interest Rate
Simple Interest
Compound Interest
Amortizing a Loan
The Interest Rate
Which would you prefer -- $10,000
today or $10,000 in 5 years?
years
Obviously, $10,000 today.
today
You already recognize that there is
TIME VALUE TO MONEY!!
MONEY
3-3
Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
3-4
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).
3-5
Simple Interest Formula
Formula
3-6
SI = P0(i)(n)
SI:
Simple Interest
P0 :
Deposit today (t=0)
i:
Interest Rate per Period
n:
Number of Time Periods
Simple Interest Example
Assume that you deposit $1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?
SI
3-7
= P0(i)(n)
= $1,000(.07)(2)
= $140
Simple Interest (FV)
What is the Future Value (FV)
FV of the
deposit?
FV
3-8
= P0 + SI
= $1,000 + $140
= $1,140
Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Simple Interest (PV)
What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
3-9
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
Why Compound Interest?
Future Value (U.S. Dollars)
Future Value of a Single $1,000 Deposit
3-10
20000
10% Simple
Interest
7% Compound
Interest
10% Compound
Interest
15000
10000
5000
0
1st Year 10th
Year
20th
Year
30th
Year
Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
years
7%
$1,000
FV2
3-11
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1
= $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
3-12
Future Value
Single Deposit (Formula)
FV1
= P0 (1+i)1 = $1,000 (1.07)
= $1,070
FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) =
$1,000(1.07)(1.07)
= P0 (1+i)2=
$1,000
2 = $1,144.90
$1,000(1.07)
$1,000
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
3-13
General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.
General Future Value Formula:
FVn = P0 (1+i)n
or
3-14
FVn = P0 (FVIFi,n) -- See Table I
Valuation Using Table I
FVIFi,n is found on Table I at the end
of the book or on the card insert.
3-15
Period
1
2
3
4
5
6%
1.060
1.124
1.191
1.262
1.338
7%
1.070
1.145
1.225
1.311
1.403
8%
1.080
1.166
1.260
1.360
1.469
Using Future Value Tables
FV2
= $1,000 (FVIF7%,2) = $1,000
(1.145) = $1,145 [Due to Rounding]
3-16
Period
1
2
3
4
5
6%
1.060
1.124
1.191
1.262
1.338
7%
1.070
1.145
1.225
1.311
1.403
8%
1.080
1.166
1.260
1.360
1.469
Story Problem Example
Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years
10%
$10,000
FV5
3-17
Story Problem Solution
Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
Calculation based on Table I:
FV5 = $10,000 (FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [Due to Rounding]
3-18
Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
7%
$1,000
PV0
3-19
PV1
Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2
= $1,000 / (1.07)2
= FV2 / (1+i)2
= $873.44
0
7%
$1,000
PV0
3-20
General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or
3-21
PV0 = FVn (PVIFi,n) -- See Table II
Valuation Using Table II
PVIFi,n is found on Table II at the end
of the book or on the card insert.
Period
1
2
3
4
5
3-22
6%
.943
.890
.840
.792
.747
7%
.935
.873
.816
.763
.713
8%
.926
.857
.794
.735
.681
Using Present Value Tables
PV2
= $1,000 (PVIF7%,2)= $1,000
(.873) = $873 [Due to Rounding]
3-23
Period
1
2
3
4
5
6%
.943
.890
.840
.792
.747
7%
.935
.873
.816
.763
.713
8%
.926
.857
.794
.735
.681
Story Problem Example
Julie Miller wants to know how large of a
deposit to make so that the money will grow
to $10,000 in 5 years at a discount rate of
10%.
10%
5
$10,000
PV0
3-24
Story Problem Solution
Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
3-25
Types of Annuities
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Annuity Due:
Due Payments or receipts
occur at the beginning of each period.
3-26
Examples of Annuities
3-27
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
Parts of an Annuity
(Ordinary Annuity)
End of
Period 1
Today
3-28
End of
Period 2
End of
Period 3
$100
$100
$100
Equal Cash Flows
Each 1 Period Apart
Parts of an Annuity
(Annuity Due)
Beginning of
Period 1
$100
$100
$100
Today
3-29
Beginning of
Period 2
Beginning of
Period 3
Equal Cash Flows
Each 1 Period Apart
Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
. . .
i%
R
R = Periodic
Cash Flow
FVAn = R(1+i) + R(1+i)
... + R(1+i)1 + R(1+i)0
n-1
3-30
n-2
FVAn
n+1
Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
$1,000
$1,000
7%
$1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
= $3,215
3-31
$3,215 = FVA3
Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
3-32
Valuation Using Table III
FVAn = R (FVIFAi%,n)
FVA3
=
$1,000 (FVIFA7%,3)
= $1,000 (3.215) =
$3,215
3-33
Period
1
2
3
4
5
6%
1.000
2.060
3.184
4.375
5.637
7%
1.000
2.070
3.215
4.440
5.751
8%
1.000
2.080
3.246
4.506
5.867
Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
i%
R
. . .
FVADn = R(1+i)n + R(1+i)n-1 +
... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
3-34
n-1
FVADn
Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
$1,000
$1,000
$1,070
7%
$1,000
$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$3,440 = FVAD3
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440
3-35
Valuation Using Table III
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
(3.215)(1.07) = $3,440
3-36
Period
1
2
3
4
5
6%
1.000
2.060
3.184
4.375
5.637
7%
1.000
2.070
3.215
4.440
5.751
= $1,000
8%
1.000
2.080
3.246
4.506
5.867
Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
n+1
. . .
i%
R
R
R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
3-37
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
$1,000
$1,000
7%
$ 934.58
$ 873.44
$ 816.30
$1,000
$2,624.32 = PVA3
PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 + $1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
3-38
Hint on Annuity Valuation
The present value of an ordinary
annuity can be viewed as
occurring at the beginning of the
first cash flow period, whereas
the present value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.
3-39
Valuation Using Table IV
PVAn = R (PVIFAi%,n)
PVA3
=
$1,000 (PVIFA7%,3)
= $1,000 (2.624) =
$2,624
3-40
Period
1
2
3
4
5
6%
0.943
1.833
2.673
3.465
4.212
7%
0.935
1.808
2.624
3.387
4.100
8%
0.926
1.783
2.577
3.312
3.993
Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
PVADn
. . .
i%
R
n-1
R: Periodic
Cash Flow
PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1
= PVAn (1+i)
3-41
Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
$1,000
$1,000
7%
$1,000.00
$ 934.58
$ 873.44
$2,808.02 = PVADn
PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +
$1,000/(1.07)2 = $2,808.02
3-42
Valuation Using Table IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07) = $1,000
(2.624)(1.07) = $2,808
3-43
Period
1
2
3
4
5
6%
0.943
1.833
2.673
3.465
4.212
7%
0.935
1.808
2.624
3.387
4.100
8%
0.926
1.783
2.577
3.312
3.993
Mixed Flows Example
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%?
10%
PV0
3-44
10%
$600
$600 $400 $400 $100
How to Solve?
1. Solve a piece-at-a-time
piece-at-a-time by
discounting each piece back to t=0.
2. Solve a group-at-a-time
group-at-a-time by first
breaking problem into groups
of annuity streams and any single
cash flow group. Then discount
each group back to t=0.
3-45
Piece-At-A-Time
0
10%
$600
$600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
3-46
$1677.15 = PV0 of the Mixed Flow
Group-At-A-Time (#1)
0
10%
$600
$600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) =
$600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) =
$100 (0.621) =
$62.10
3-47
Group-At-A-Time (#2)
0
$1,268.00
Plus
$347.20
Plus
$62.10
3-48
$400
$400
$400
$200
$200
4
$400
PV0 equals
$1677.30.
3
5
$100
