What is Time value of Money?

“It is better to receive money sooner than

later. A dollar today is worth more than a
dollar in the future.”

-Principles of Managerial
finance; p.210
Time Value of Money

■ Future value
■ Present value
■ Annuities
■ Rates of return
■ Amortization
Today 1 year from now
Today 1 year from now
Investme
nt
 Time line
• Time line is a graphical representation used to show the
timing of cash flow.

0 1 2 3 4 5
Compound Interest Interest on Interest

$10 $1
=$110+ ($100*10%)+ ($10*10%)= $121

0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023

=$100+($100*10%)= $110
$100 Today = $110 in one year
 Most Valuable

0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023
Future value refers to the amount of money an investment will grow to
over some length of time at some given interest rate.
FV = PV0 × (1 + r)n

0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023
0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023
Solving for FV:
The step-by-step and formula methods
• After 1 year:
• FV1 = PV (1 + I) = $100 (1.10)
= $110.00
• After 2 years:
• FV2 = PV (1 + I)2 = $100 (1.10)2
=$121.00
• After 3 years:
• FV3 = PV (1 + I)3 = $100 (1.10)3
=$133.10
• After N years (general case):
• FVN = PV (1 + I)N
• If you invested $100 today in an account that pays 6%
interest, with interest compounded annually, how much will
be in the account at the end of five years if there are no
withdrawals?

0 1 2 3 4 5

100

Interest Earned
• If you invested $100 today in an account that pays 6%
interest, with interest compounded annually, how much will
be in the account at the end of five years if there are no
withdrawals?

0 1 2 3 4 5

100 106 112.36 119.10 126.25 133.82

6 6.36 6.74 7.15 7.58

Interest Earned
 0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023

Investment
0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023
0 1 2 3
10% 10% 10%
= $133.1
2021 2022 2023
• The value today of a future cash flow or series of cash flows.
● Discounting is the process of translating a future value or a set of future cash
flows into a present value.
● To compute present value of a single cash flow, we need:
●Future value of the cash flow (FV)
●Interest rate (r) and
●Time Period (n)
 TK 9,00,000
In 4 years

@ 10% in 4 years
Deposit
Tk 6,14,712
Problem
Paul Shorter has an opportunity to receive $3000, eight
years from now. If he can earn 6% on his investments in
the normal course of events, what is the most he
should pay now for this opportunity?
Solution
• Pv = Fv/(1+r)n

= 3000/(1.06)8
= $1,882
 Solving for Interest rate (r)

0 r=? 1 2 3 4 5

74.72 100
 Solving for Interest rate (r)
• FV = PV × (1+r)n
r= (FV/PV)1/n
-1
Solving for number of years (n)

n= ?
0 1 2

74.72 100
 Solving for number of years (n)
• n = ln(FV / PV) / ln(1 + r)
= ln (100/74.72) / ln (1+0.06)
= 5 years
Problem
Ray Noble purchased an investment four years ago for
$1,250.Now it is worth $1,520. What compound annual
rate of return has Ray earned on this investment?
 Solution
• r = ($1,520 /$1,250)(1/4) - 1 = 0.0501 = 5.01% per year
Time value of Money
⮚ Future value- Compounding Interest [ FVn = PV0 × (1 + r)n ]

⮚ Present Value – Discounting [PV0 = FVn / (1 + r)n ]

 Basic patterns of cash flow
• Single amount
• Annuity
• Mixed stream
 Basic patterns of cash flow
• Single amount
• Annuity
• Mixed stream

Fixed Deposit, Home lone Interest, Insurance premium

Annuity
• An annuity is a stream of equal periodic cash flows, over
a specified time period.
• Ordinary Annuity: Payments or receipts occur at the
end of each period.

• Annuity Due: Payments or receipts occur at the

beginning of each period.
Examples of Annuities

• Student Loan Payments

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

Pension plan

2020 Dec 2021 Dec 2022 Dec 2023 Dec 2024 Dec 2025 Dec
 Annuity

Pension plan

Jan Dec Dec Dec

2020 2021 2022
 Parts of an Annuity

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

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

3-34
Each 1 Period Apart
 Ordinary Annuity

2020 Dec 2021 Dec 2022 Dec 2023 Dec 2024 Dec 2025 Dec
 Parts of an Annuity

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

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
3-36
 Annuity Due

Jan2020 Jan 2021 Jan 2022 Jan 2023 Jan 2024 Jan 2025 Dec
 Future value of an Ordinary Annuity
• Fran Abrams wishes to determine how much money she will
have at the end of 5 years if she chooses annuity A, the ordinary
annuity. She will deposit $1,000 annually, at the end of each of
the next 5 years, into a savings account paying 7% annual
interest.
 1310.80

1225.04

1144.90
1070
1000

5750.74

0 1 2 3 4 5

1000 1000 1000 1000 1000

FUTURE VALUE OF AN ORDINARY ANNUITY
Present value of an ordinary Annuity
• PVAn = PMT/(1+r)n
• Braden Company, a small producer of plastic toys, wants
to determine the most it should pay to purchase a
particular ordinary annuity. The annuity consists of cash
flows of $700 at the end of each year for 3 years. The firm
requires the annuity to provide a minimum return of 8%.
 648.15
600.14

555.68

1803.97

0 1 2 3

700 700 700

PRESENT VALUE OF AN ORDINARY ANNUITY
• Fran Abrams wishes to determine how much money she will have at the
end of 5 years if she chooses annuity B, the annuity Due. She will deposit
$1,000 annually, at the Beginning of each of the next 5 years, into a
savings account paying 7% annual interest.
Future value of Annuity due

0 1 2 3 4 5

1000 1000 1000 1000 1000

 1310.80

1225.04

1144.90
1070
1000

5750.74

0 1 2 3 4 5

1000 1000 1000 1000 1000

FUTURE VALUE OF AN ANNUITY DUE
• Fran Abrams wishes to determine how much money she
will have at the end of 5 years if she chooses annuity B,
the annuity Due. She will deposit $1,000 annually, at
the Beginning of each of the next 5 years, into a
savings account paying 7% annual interest.
Present value of Annuities due

0 1 2 3 4

100 100 100 100

 Present value of Annuties due

Braden Company, a small producer of plastic toys, wants to determine the

most it should pay to purchase a particular annuity due. The annuity consists
of cash flows of $700 at the beginning of each year for 3 years. The firm
requires the annuity to provide a minimum return of 8%.
 Present value of Annuties due

Braden Company, a small producer of plastic toys, wants to determine the

most it should pay to purchase a particular annuity due. The annuity consists
of cash flows of $700 at the beginning of each year for 3 years. The firm
requires the annuity to provide a minimum return of 8%.

$700
PRESENT VALUE OF AN ANNUITY DUE
 Mixed Flows Example
Julie Miller 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%
$600 $600 $400 $400 $100
PV0
3-53
 “Piece-At-A-Time”

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
3-54
 157.35

421.48

376.32
336
500

$1791.15

0 1 2 3 4 5
i=12%

100 300 300 300 500

 Present value of an uneven cash flow
stream
Frey Company, a shoe manufacturer, has been offered an
opportunity to receive the following mixed stream of cash
flows over the next 4 years:

End of year Cash Flow

1 $400
2 800
3 500
4 400

• If the firm must earn at least 9% on its investments, what is the

most it should pay for this opportunity?
 Solution
• PV = 400/(1.09) + 800/(1.09)2 + 500/(1.09)3 + 400/(1.09)4

Discounting [PV0 = FVn / (1 + r)n ]

0 1 2 3 4

400 800 500 400

366.97
673.34
386.09
283.37
1,709.77
perpetuity
• An annuity with an infinite life, providing continual annual cash flow.
In other words, it is an annuity that never stops providing its holder
with a cash flow at the end of each year (for example, the right to
receive $500 at the end of each year forever).
perpetuity
• Ross Clark wishes to endow a chair in finance at his alma mater. The
university indicated that it requires $200,000 per year to support the
chair, and the endowment would earn 10% per year. To determine the
amount Ross must give the university to fund the chair, we must
determine the present value of a $200,000 perpetuity discounted at
10%. Using Equation 5.7, we can determine that the present value of
a perpetuity paying $200,000 per year is $2 million when the interest
rate is 10%: PV = $200,000 , 0.10 = $2,000,000
• In other words, to generate $200,000 every year for an indefinite
period requires $2,000,000 today if Ross Clark’s alma mater can earn
10% on its investments.
 Compounding more frequently than
annually
• Semiannual compounding: Compounding of interest over
two period within the year.
• Quarterly Compounding: Compounding of interest over
four periods within the year.
A GENERAL EQUATION FOR COMPOUNDING
MORE FREQUENTLY THAN ANNUALLY

• FVn = Pv × (1+ r/m)m×n

• Where r = rate per period
• m = number of times per year interest is compounded.
• If the interest were compounded monthly, weekly, or daily,
m would equal 12, 52, or 365, respectively.

0 1 2 3 4 5
i=12%

$5000 6% 6% 6% 6% 6% 6% 6% 6% 6% 6%
• Fred Moreno has decided to invest $100 in a savings
account paying 8% interest compounded semiannually. If
he leaves his money in the account for 24 months (2
years) what he will end up with after 2 years?

Using the equation = 100 × ( 1+ 0.08/2)2×2

= 116.99
Annuity (Multiple compounding)

0 1 2 3 4 5
i=12%

6% 6% 6% 6% 6% 6% 6% 6% 6% 6%
$500 $500 $500 $500 $500 $500 $500 $500 $500 $500
 Nominal and Effective Annual Rates of
Interest
• The nominal (stated) annual rate is the contractual annual rate of interest charged by a
lender or promised by a borrower.
• The effective (true) annual rate (EAR) is the annual rate of interest actually paid or
earned.
• In general, the effective rate > nominal rate whenever compounding occurs more than once
per year

© 2012 Pearson Prentice Hall. All rights reserved. 5-64

 Personal Finance Example

Fred Moreno wishes to find the effective annual rate associated with an 8%
nominal annual rate (r = 0.08) when interest is compounded (1) annually (m = 1);
(2) semiannually (m = 2); and (3) quarterly (m = 4).

© 2012 Pearson Prentice Hall. All rights reserved. 5-65

 Special Applications of Time Value: Deposits
Needed to Accumulate a Future Sum

The following equation calculates the annual cash payment (CF) that we’d have to save to
achieve a future value (FVn):

Suppose you want to buy a house 5 years from now, and you estimate that an initial down
payment of $30,000 will be required at that time. To accumulate the $30,000, you will wish to
make equal annual end-of-year deposits into an account paying annual interest of 6 percent.

© 2012 Pearson Prentice Hall. All rights reserved. 5-66

Loan amortization
• Amortization tables are widely used for
home mortgages, auto loans,
business loans, retirement plans, etc.
 46

Step 1: Find the required

payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

PMT= Principle + Interest

 51

Loan Amortization

Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at

the end of each of the next 3 years. When the annual interest rate will be 10%, payment
will be made semi-annually.
 47

Amortization Table
BEG PRIN END
YEAR BALANCE PMT INT PMT BAL
(Pmt-Int) (Beg-Prin)
1

TOTAL
 47

Amortization Table
Year Beg Balance PMT INT Prin PMT End
balance
1. (1) $25000 $4925.44 1250 3675.44 21324.56
1. (2) 21324.56 4925.44 1066.23 3859.21 17465.35
2. (1) 17465.35 4925.44 $873.27 $4,052.17 $13,413.19
2.(2) $13,413.19 4925.44 $670.66 $4,254.78 $9,158.41
3.(1) $9,158.41 4925.44 $457.92 $4,467.52 $4,690.89
3.(2) $4,690.89 4925.44 $234.54 $4,690.89 0
Total 29552.64 4552.62 25000
PMT Calculation

=$4925.44
 49

Find interest charge for Year 1

INTt = Beg balt (r)

INT1 = $25,000(10%/2) =
$1250
 50

Find repayment of principal in Year 1

• Principle payment = PMT - INT

• = $4925.44 - $1250
• = $3675.44
 51

Find ending balance after Year 1

End balance = Beg balance – Principle payment

= $25000 - $3675.44 = $21324.56
 47

Year Beg Balance PMT INT Prin End

Payment Balance
1 (1)
1 (2)
1 (3)
1 (4)
2 (1)
2 (2)
2 (3)
2 (4)
3 (1)
3 (2)
3 (3)
3 (4)
Total