TIME VALUE OF MONEY

LEARNING GOALS
1. Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash
flow.
2. Understand the concepts of future value and present value, their calculation for single amounts, and the
relationship between them.
3. Find the future value and the present value of both an ordinary annuity and an annuity due, and find the
present value of a perpetuity.
4. Calculate both the future value and the present value of a mixed stream of cash flows.
5. Understand the effect that compounding interest more frequently than annually has on future value.
WHY THIS MATTERS TO YOU?
In your professional life
ACCOUNTING : You need to understand time-value-of-money calculations to account for certain transactions such
as loan amortization, lease payments, and bond interest rates.
INFORMATION SYSTEMS : You need to understand time-value-of-money calculations to design systems that
accurately measure and value the firms cash flows.
MANAGEMENT : You need to understand time-value-of-money calculations so that you can manage cash receipts
and disbursements in a way that will enable the firm to receive the greatest value from its cash flows.
MARKETING : You need to understand time value of money because funding for new programs and products must
be justified financially using time-value-of-money techniques.
OPERATIONS : You need to understand time value of money because the value of investments in new equipment,
in new processes, and in inventory will be affected by the time value of money.
In your personal life
Time-value-of-money techniques are widely used in personal financial planning. You can use them to calculate the
value of savings at given future dates and to estimate the amount you need now to accumulate a given amount at a
future date. You also can apply them to value lumpsum amounts or streams of periodic cash flows and to the
interest rate or amount of time needed to achieve a given financial goal.
THE ROLE OF TIME VALUE IN FINANCE
The time value of money refers to the observation that it is better to receive money sooner than later. Money that
you have in hand today can be invested to earn a positive rate of return, producing more money tomorrow. For that
reason, a peso today is worth more than a peso in the future. In business, managers constantly face trade-offs in
situations where actions that require outflows of cash today may produce inflows of cash later. Because the cash
that comes in the future is worth less than the cash that firms spend up front, managers need a set of tools to help
them compare cash inflows and outflows that occur at different times.
Computational Tools

Financial Calculators. This includes numerous preprogrammed financial routines to compute the PV and
FV.
Electronic Spreadsheets. The PV and FV is computed using the functions of spreadsheets

Basic Patters of Cash Flows

The cash flowboth inflows and outflowsof a firm can be described by its general pattern. It can be defined as a
single amount, an annuity, or a mixed stream.
1. Single amount: A lump-sum amount either currently held or expected at some future date. Examples
include $1,000 today and $650 to be received at the end of 10 years.
2. Annuity: A level periodic stream of cash flow. For our purposes, well work primarily with annual cash
flows. Examples include either paying out or receiving $800 at the end of each of the next 7 years.
3. Mixed stream: A stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that
reflect no particular pattern. Examples include the following two cash flow streams A and B. Note that
neither cash flow stream has equal, periodic cash flows and that A is a 6-year mixed stream and B is a 4year mixed stream.

SINGLE AMOUNTS
Future Value of a Single Amount
The most basic future value and present value concepts and computations concern single amounts, either present
or future amounts. Future value is the value at a given future date of an amount placed on deposit today and
earning interest at a specified rate. The future value depends on the rate of interest earned and the length of time
the money is left on deposit.

PV = Present Value
r = rate
n = number of periods
Present Value of a Single Amount
It is often useful to determine the value today of a future amount of money. Present value is the current peso value
of a future amountthe amount of money that would have to be invested today at a given interest rate over a
specified period to equal the future amount. Like future value, the present value depends largely on the interest rate
and the point in time at which the amount is to be received.
The Concept of Present Value
The process of finding present values is often referred to as discounting cash flows. It is concerned with
answering the following question: If I can earn r percent on my money, what is the most I would be willing to pay
now for an opportunity to receive FVn pesos n periods from today?

ANNUITIES
How much would you pay today, given that you can earn 7 percent on low-risk investments, to receive a
guaranteed $3,000 at the end of each of the next 20 years? How much will you have at the end of 5 years if your
employer withholds and invests $1,000 of your bonus at the end of each of the next 5 years, guaranteeing you a 9
percent annual rate of return? To answer these questions, you need to understand the application of the time value
of money to annuities.
An annuity is a stream of equal periodic cash flows, over a specified time period. These cash flows are usually
annual but can occur at other intervals, such as monthly rent or car payments. The cash flows in an annuity can be
inflows (the $3,000 received at the end of each of the next 20 years) or outflows (the
$1,000 invested at the end of each of the next 5 years).
Types of Annuities
There are two basic types of annuities. For an ordinary annuity, the cash flow occurs at the end of each period.
For an annuity due, the cash flow occurs at the beginning of each period.
Finding the Future Value of an Ordinary Annuity
One way to find the future value of an ordinary annuity is to calculate the future value of each of the individual cash
flows and then add up those figures. Shortcut?

As before, in this equation r represents the interest rate, and n represents the number of payments in the annuity
(or equivalently, the number of years over which the annuity is spread).
Finding the Present Value of an Ordinary Annuity
Quite often in finance, there is a need to find the present value of a stream of cash flows to be received in future
periods. An annuity is, of course, a stream of equal periodic cash flows. The method for finding the present value of
an ordinary annuity is similar to the method just discussed. One approach would be to calculate the present value
of each cash flow in the annuity and then add up those present values. Shortcut?

Finding the Future Value of an Annuity Due

Remember that the cash flows of an annuity due occur at the start of the period. In other words, if we are dealing
with annual payments, each payment in an annuity due comes one year earlier than it would in an ordinary annuity.
This in turn means that each payment can earn an extra years worth of interest, which is why the future value of an
annuity due exceeds the future value of an otherwise identical ordinary annuity. Shortcut?

Finding the Present Value of an Annuity Due

We can also find the present value of an annuity due. This calculation can be easily performed by adjusting the
ordinary annuity calculation. Because the cash flows of an annuity due occur at the beginning rather than the end of
the period, to find their present value, each annuity due cash flow is discounted back one less year than for an
ordinary annuity. Shortcut?

Finding the Present Value of a Perpetuity

A perpetuity is an annuity with an infinite lifein other words, 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). It is
sometimes necessary to find the present value of a perpetuity. Fortunately, the calculation for the present value of a
perpetuity is one of the easiest in all of finance. If a perpetuity pays an annual cash flow of CF, starting one year
from now, the present value of the cash flow stream is

EXAMPLE
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 5.14, 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 Clarks
alma mater can earn 10% on its investments. If the university earns 10% interest annually on the $2,000,000, it can
withdraw $200,000 per year indefinitely.
MIXED STREAMS
Two basic types of cash flow streams are possible, the annuity and the mixed stream. Whereas an annuity is a
pattern of equal periodic cash flows, a mixed stream is a stream of unequal periodic cash flows that reflect no
particular pattern. Financial managers frequently need to evaluate opportunities that are expected to provide mixed
streams of cash flows. Here we consider both the future value and the present value of mixed streams.
Future Value of a Mixed Streams
Determining the future value of a mixed stream of cash flows is straightforward.
We determine the future value of each cash flow at the specified future date and
then add all the individual future values to find the total future value.
EXAMPLE:

Shrell Industries, a cabinet manufacturer, expects to receive the following mixed

stream of cash flows over the next 5 years from one of its small customers.
End of year
1
2
3
4
5

Cash flow
$11,500
14,000
12,900
16,000
18,000

If Shrell expects to earn 8% on its investments, how much will it accumulate by the end of year 5 if it immediately
invests these cash flows when they are received? This situation is depicted on the following time line:

Present Value of a Mixed Streams

Finding the present value of a mixed stream of cash flows is similar to finding the
future value of a mixed stream. We determine the present value of each future
amount and then add all the individual present values together to find the total
present value.
EXAMPLE
Frey Company, a shoe manufacturer, has been offered an opportunity to receive the following mixed stream of cash
flows over the next 5 years:
End of year
1
2
3
4
5

Cash flow
$400
800
500
400
300

If the firm must earn at least 9% on its investments, what is the most it should
pay for this opportunity? This situation is depicted on the following time line:

COMPOUNDING INTEREST MORE FREQUENTLY THAN ANNUALLY

Semiannual Compounding
Semiannual compounding of interest involves two compounding periods within the year. Instead of the stated
interest rate being paid once a year, one-half of the stated interest rate is paid twice a year.

Quarterly Compounding
Quarterly compounding of interest involves four compounding periods within the year. One-fourth of the stated
interest rate is paid four times a year.

A General Equation for Compounding More Frequently than Annually

If m equals the number of times per year
interest is compounded

Continuous Compounding
In the extreme case, interest can be compounded continuously. Continuous compounding

involves compounding over every nanosecondthe smallest time

period imaginable. In this case, m in Equation 5.15 would approach infinity.
Through the use of calculus, we know that as m approaches infinity, Equation
5.15 converges to

where e is the exponential function,3 which has a value of approximately 2.7183. (3. Most calculators have the
exponential function, typically noted by , built into them. The use of this key is especially
helpful in calculating future value when interest is compounded continuously.)