Understanding the Time Value of Money

Congratulations!!! You have won a cash prize! You have two payment options: A - Receive
$10,000 now OR B - Receive $10,000 in three years. Which option would you choose?

What Is Time Value?

If you're like most people, you would choose to receive the $10,000 now. After all, three
years is a long time to wait. Why would any rational person defer payment into
the future when he or she could have the same amount of money now? For most of us,
taking the money in the present is just plain instinctive. So at the most basic level, the time
value of money demonstrates that, all things being equal, it is better to have money now
rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can do much more with the money if you have it
now because over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future
value of your money by investing and gaining interest over a period of time. For Option B,
you don't have time on your side, and the payment received in three years would be your
future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired
over the three years. The future value for Option B, on the other hand, would only be
$10,000. So how can you calculate exactly how much more Option A is worth, compared to
Option B? Let's take a look.
SEE: Internal Rate Of Return: An Inside Look

Future Value Basics

If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the
future value of your investment at the end of the first year is $10,450, which of course is
calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and
then adding the interest gained to the principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a one-year investment with a simple manipulation
of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450

Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450

Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable $10,000 (the
principal amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched
and you invested it at 4.5% for another year, how much would you have? To calculate this,
you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two
years, you would have $10,920:

Future value of investment at end of second year:

= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)
Think back to math class and the rule of exponents, which states that the multiplication of
like terms is equivalent to adding their exponents. In the above equation, the two like terms
are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be
represented as the following:

We can see that the exponent is equal to the number of years for which the money is
earning interest in an investment. So, the equation for calculating the three-year future
value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first year,
then the second year, then the third year, and so on. If you know how many years you would
like to hold a present amount of money in an investment, the future value of that amount is
calculated by the following equation:

SEE: Accelerating
Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because
present value is what your investment gives you now if you were to spend it today. If
$10,000 were to be received in a year, the present value of the amount would not be
$10,000 because you do not have it in your hand now, in the present. To find the present
value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is
the total future value of an amount that you invested today. In other words, to find the
present value of the future $10,000, we need to find out how much we would have to invest
today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must
subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can
discount the future payment amount ($10,000) by the interest rate for the period. In
essence, all you are doing is rearranging the future value equation above so that you may
solve for P. The above future value equation can be rewritten by replacing the P variable
with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be
received in three years is really the same as the future value of an investment. If today we
were at the two-year mark, we would discount the payment back one year. At the two-year
mark, the present value of the $10,000 to be received in one year is represented as the
following:
Present value of future payment of $10,000 at end of year two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered
the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of
$10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a
$10,000 payment expected in two years would be the following:
Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of
the investment every year counting back from the $10,000 investment at the third year. We
could put the equation more concisely and use the $10,000 as FV. So, here is how you can
calculate today's present value of the $10,000 expected from a three-year investment
earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest
rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and
then investing it for three years. The equations above illustrate that Option A is better not
only because it offers you money right now but because it offers you $1,237.03 ($10,000 $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from
Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 - $10,000)
greater than the future value of Option B.
SEE: Economics And The Time Value Of Money

Present Value of a Future Payment

Let's add a little spice to our investment knowledge. What if the payment in three years is
more than the amount you'd receive today? Say you could receive either $15,000 today or
$18,000 in four years. Which would you choose? The decision is now more difficult. If you
choose to receive $15,000 today and invest the entire amount, you may actually end up
with an amount of cash in four years that is less than $18,000. You could find the future
value of $15,000, but since we are always living in the present, let's find the present value of
$18,000 if interest rates are currently 4%. Remember that the equation for present value is
the following:

In the equation above, all we are doing is discounting the future value of an investment.
Using the numbers above, the present value of an $18,000 payment in four years would be
calculated as the following:
Present Value

From the above calculation we now know our choice is between receiving $15,000 or
$15,386.48 today. Of course we should choose to postpone payment for four years!

The Bottom Line

These calculations demonstrate that time literally is money - the value of the money you
have now is not the same as it will be in the future and vice versa. So, it is important to
know how to calculate the time value of money so that you can distinguish between the
worth of investments that offer you returns at different times.

Calculating the Present and

Future Value Of Annuities
At some point in your life, you may have had to make a series of fixed payments over a
period of time - such as rent or car payments - or have received a series of payments over a
period of time, such as bond coupons. These are called annuities. If you understand the time
value of money, you're ready to learn about annuities and how their present and future
values are calculated.
What Are Annuities?
Annuities are essentially a series of fixed payments required from you or paid to you at
a specified frequency over the course of a fixed time period. The most common payment

frequencies are yearly, semi-annually (twice a year), quarterly and monthly. There are two
basic types of annuities: ordinary annuities and annuities due.

Ordinary Annuity: Payments are required at the end of each period. For example,
straight bonds usually pay coupon payments at the end of every six months until the
bond's maturity date.

Annuity Due: Payments are required at the beginning of each period. Rentis
an example of annuity due. You are usually required to pay rent when you first move
in at the beginning of the month, and then on the first of each month thereafter.

Since the present and future value calculations for ordinary annuities and annuities due are
slightly different, we will first discuss the present and future value calculation for ordinary
annuities.
Calculating the Future Value of an Ordinary Annuity
If you know how much you can invest per period for a certain time period, the future value
of an ordinary annuity formula is useful for finding out how much you would have in the
future by investing at your given interest rate. If you are making payments on a loan, the
future value is useful in determining the total cost of the loan.

Let's now run through Example 1. Consider the following annuity cash flow schedule:

To calculate the future value of the annuity, we have to calculate the future value of each
cash flow. Let's assume that you are receiving $1,000 every year for the next five years, and
you invested each payment at 5%. The following diagram shows how much you would have
at the end of the five-year period:

Since we have to add the future value of each payment, you may have noticed that if you
have an ordinary annuity with many cash flows, it would take a long time to calculate all the
future values and then add them together. Fortunately, mathematics provides a formula that
serves as a shortcut for finding the accumulated value of all cash flows received from an
ordinary annuity:

C = Cash flow per periodi = interest raten = number of payments

Using the above formula for Example 1 above, this is the result:

= $1000*[5.53]= $5525.63

Note that the 1 cent difference between $5,525.64 and $5,525.63 is due to a rounding error
in the first calculation. Each value of the first calculation must be rounded to the nearest
penny - the more you have to round numbers in a calculation, the more likely rounding
errors will occur. So, the above formula not only provides a shortcut to finding FV of an
ordinary annuity but also gives a more accurate result.
Calculating the Present Value of an Ordinary Annuity
If you would like to determine today's value of a future payment series, you need to use the
formula that calculates the present value of an ordinary annuity. This is the formula you
would use as part of abond pricing calculation. The PV of an ordinary annuity calculates the
present value of the couponpayments that you will receive in the future.
For Example 2, we'll use the same annuity cash flow schedule as we did in Example 1. To
obtain the total discounted value, we need to take the present value of each future payment
and, as we did in Example 1, add the cash flows together.

Again, calculating and adding all these values will take a considerable amount of time,
especially if we expect many future payments. As such, we can use a
mathematical shortcut for PV of an ordinary annuity.

C = Cash flow per periodic = interest rate = number of payments

The formula provides us with the PV in a few easy steps. Here is the calculation of the
annuity represented in the diagram for Example 2:

= $1000*[4.33]= $4329.48
Calculating the Future Value of an Annuity Due
When you are receiving or paying cash flows for an annuity due, your cash flow schedule
would appear as follows:

Since each payment in the series is made one period sooner, we need to discount the
formula one period back. A slight modification to the FV-of-an-ordinary-annuity formula
accounts for payments occurring at the beginning of each period. In Example 3, let's
illustrate why this modification is needed when each $1,000 payment is made at the
beginning of the period rather than at the end (interest rate is still 5%):

Notice that when payments are made at the beginning of the period, each amount is held
longer at the end of the period. For example, if the $1,000 was invested on January 1 rather
than December 31 each year, the last payment before we value our investment at the end
of five years (on December 31) would have been made a year prior (January 1) rather than
the same day on which it is valued. The future value of annuity formula would then read:

Therefore,

= $1000*5.53*1.05= $5801.91
Calculating the Present Value of an Annuity Due
For the present value of an annuity due formula, we need to discount the formula one period
forward as the payments are held for a lesser amount of time. When calculating the present
value, we assume that the first payment was made today.
We could use this formula for calculating the present value of your future rent payments as
specified in a lease you sign with your landlord. Let's say for Example 4 that you make your
first rent payment at the beginning of the month and are evaluating the present value of
your five-month lease on that same day. Your present value calculation would work as
follows:

Of course, we can use a formula shortcut to calculate the present value of an annuity due:

Therefore,

= $1000*4.33*1.05= $4545.95
Recall that the present value of an ordinary annuity returned a value of $4,329.48. The
present value of an ordinary annuity is less than that of an annuity due because the further
back we discount a future payment, the lower its present value: each payment or cash flow
in an ordinary annuity occurs one period further into the future.
Conclusion
Now you can see how annuity affects how you calculate the present and future value of any
amount of money. Remember that the payment frequencies, or number of payments, and
the time at which these payments are made (whether at the beginning or end of each
payment period) are all variables you need to account for in your calculations.