Understanding The Time

Value Of Money
By Shauna Carther
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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 Returns With Continuous Compounding

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.

Time Value Of Money - Introduction To

The Time Value Of Money
In addition to being able to understand financial statements, it's important to be able to
estimate the value of an investment in the present and in the future.
The idea that money available at the present time is worth more than the same amount in
the future due to its potential earning capacity is called the time value of money. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. Thus, 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 now 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.
By receiving $10,000 today (Option A), you are poised to increase the future value of your
money by investing and gaining interest over a period of time. If you receive the money
three years down the line (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 choose 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.
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 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 of $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 is then 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 means 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:

Read more: Introduction To The Time Value Of Money - Complete Guide To Corporate What
You Should Know About The Time Value of Money
JUNE 17, 2014 BY ROBERT SCHMIDT7 COMMENTS

Being completely comfortable with the time value of money is critical when working in
the field of finance and commercial real estate. The time value of money is impossible to
ignore when dealing with loans, investment analysis, capital budgeting, and many other
financial decisions. Its a fundamental building block that the entire field of finance is
built upon. And yet, many finance and commercial real estate professionalsstill lack a
solid working knowledge of time value of money concepts and they consistently make
the same common mistakes. In this article we take a deep dive into the time value of
money, discuss the intuition behind the calculations, and well also clear up several
misconceptions along the way.

Why Money Has Time Value

First of all, why does money have time value? Time value of money is the economic
principal that a dollar received today has greater value than a dollar received in the
future. The intuition behind this concept is easy to see with a simple example. Suppose
you were given the choice between receiving $100,000 today or $100,000 in 100 years.
Which option would you rather take? Clearly the first option is more valuable for the
following reasons:
No Risk There is no risk of getting money back that you already have today.
Higher Purchasing Power Because of inflation, $100,000 can be exchanged for
more goods and services today than $100,000 in 100 years. Put another way, just think
back to what $100,000 could buy you 100 years ago. $100,000 in 1914 would be the
equivalent of roughly $2,300,000 today.
Opportunity cost a dollar received today can be invested now to earn interest,
resulting in a higher value in the future. In contrast, a dollar received in the future can
not begin earning interest until it is received. This lost opportunity to earn interest is the
opportunity cost.
For these reasons we can boil down time value of money into two fundamental
principals:
1. More is better than less.
2. Sooner is better than later.

With this fundamental intuition out of the way, lets jump right in to the two basic
techniques used in all time value of money calculations: compounding and discounting.

Compounding and Discounting: The Foundation For All Time Value of

Money Problems
All time value of money problems involve two fundamental techniques: compounding
and discounting. Compounding and discounting is a process used to compare dollars in
our pocket today versus dollars we have to wait to receive at some time in the future.
Before we dive into specific time value of money examples, lets first review these basic
building blocks.

Compounding is about moving money forwards in time. Its the process of determining
the future value of an investment made today and/or the future value of a series of equal
payments made over time (periodic payments).

Whats the
intuition behind compounding? Most people immediately understand the concept of
compound growth. If you invest $100,000 today and earn 10% annually, then your initial
investment will grow to some figure larger than the original amount invested. For
example, in the illustration above $100,000 is invested at time period 0 and grows at a
10% rate to $121,000 at time period 2. Well go over the details of this calculation later,
but for now just focus on the intuition. The initial investment compounds because
it earns interest on the principal amount invested, plus it also earns interest on the
interest.
Discounting is about moving money backwards in time. Its the process of determining
the present value of money to be received in the future (as a lump sum and/or as
periodic payments). Present value is determined by applying a discount rate
(opportunity cost) to the sums of money to be received in the future.

Whats the
intuition behind discounting? When solving for the future value of money set aside
today, we compound our investment at a particular rate of interest. When solving for the
present value of future cash flows, the problem is one of discounting, rather
than growing, and the required expected return acts as the discount rate. In other
words, discounting is merely the inverse of growing.

The 5 Components of All Time Value of Money Problems

So now that we have some basic intuition about compounding and discounting, lets
take a look at the 5 components of all time value of money problems. Why is it important
to understand this? Because in every single time value of money problem youll know
four out of these five variables and will be able to easily solve for the fifth unknown
variable. The 5 components of all time value of money problems are as follows:
Periods (n). The total number of compounding or discounting periods in the holding
period.
Rate (i). The periodic interest rate or discount rate used in the analysis, usually
expressed as an annual percentage.
Present Value (PV). Represents a single sum of money today.
Payment (PMT). Represents equal periodic payments received or paid each period.
When payments are received they are positive, when payments are made they are
negative.
Future Value (FV). A one-time single sum of money to be received or paid in the future.

The Key to Solving Any Time Value of Money Problem

Every single time value of money problem includes the above 5
components. Understanding this is critical because of one simple fact: if you can identify
any 4 of the 5 components then you can easily solve for the 5th. The key is to simply
learn to identify the 4 known variables in a time value of money problem. Lets revisit the
example above to illustrate how this works.
Suppose you invest $100,000 today at 10% compounded annually. What will this
investment be worth in 2 years?
First of all we know that our present value (PV) is $100,000 since this is what we are
investing today. Next the rate (i) is given to us as 10%. Third, the number of periods (n)
in this problem is 2 years. So that leaves 2 remaining variables out of the five: payment
(PMT) and future value (FV). Which one out of the two do we know? While it wasnt
explicitly given to us, we do know that the payment (PMT) in this problem is zero.
Whenever payment isnt explicitly given to us, its implied that there is no payment. So,
all that leaves us with is the future value (FV) component, which we can now easily
solve. For now dont worry about actually doing the calculations. Instead, just focus on
identifying the 4 known variables and the final 5th unknown.

The Time Value of Money Timeline

Time value of money problems can always be visualized using a simple horizontal or
vertical timeline. When youre first learning how to solve time value of money problems,
its often helpful to draw the 5 components of each problem out on a timeline so you can
visualize all of the moving pieces.

As shown above, the 5 components of all time value of money problems (PV, FV, PMT, i,
n) can be illustrated on a simple horizontal time line. Its also common to see a vertical
timeline as well:

When drawing out a timeline for a time value of money problem, simply fill in the 4
known components so you can clearly identify and solve for the unknown component.
Heres a timeline for the example compounding problem above showing the 4 known
components:

Consistency of Time Value of Money Components

Before we dive into specific time value of money example problems, lets quickly go over
one of the most common roadblocks people run into. One of the most common mistakes
when it comes to the time value of money is ignoring the frequency of the components.
Whenever you are solving any time value of money problem, make sure that the n
(number of periods), the i (interest rate), and the PMT (payment) components are all
expressed in the same frequency. For example, if you are using an annual interest rate,
then the number of periods should also be expressed annually. If youre using a monthly
interest rate, then the number of periods should be expressed as a monthly figure. In

other words, n should always be the total number of periods, i should be the interest rate
per period, and PMT should be the payment per period.
Note that most financial calculators have a Payment Per Year setting that attempts to
auto-correct the consistency of the n and i components. If youre just starting out with a
financial calculator its a good idea to ignore this functionality altogether. Instead you can
simply set the payments per year in the calculator to 1 (one) and then keep the n, i, and
PMT components consistent. This will greatly reduce the errors and frustration you
have with your financial calculator.

Cash Inflows vs Cash Outflows

In time value of money problems its also important to remember that negative and
positive signs have different meanings. One helpful way to think about about sign
changes is as inflows and outflows of money. A negative sign simply means money is
flowing out of your pocket. A positive sign means money is flowing into your pocket.

Financial Calculators and The Time Value of Money

The above 5 components of every time value of money problem are the same
regardless of how you decide to solve for the unknown. There are several popular
financial calculators available and all of them include the above 5 components as
buttons. Teaching you how to use a financial calculator is beyond the scope of this
article, but if youre just getting started we recommend either the Hewlett Packard 10BII
or the Texas Instruments BA II Plus. They both come with instruction manuals that
include helpful tutorials.
Additionally, all time value of money problems can also be solved in Excel. Below we
provide you a solutions worksheet containing sample time value of money problems and
answers. This will give you the exact formulas you can use in Excel to solve the most
common time value of money problems.

Time Value of Money Problems: The 6 Functions of a Dollar

With the above foundations out of the way, lets dive into some time value of money
practice problems. There are 3 fundamental types of compounding problems, and also

3 fundamental types of discounting problems. Together these make up whats

commonly referred to as the 6 functions of a dollar.
These fundamental time value of money problems come up over and over again in
finance and commercial real estate, so mastering them will go a long way towards
improving your skillset. As mentioned, we are providing you with a solutions worksheet
below containing answers to the following 6 time value of money problems. As you read
through the questions, focus on identifying the 4 known components, and if you are
already comfortable with a financial calculator, try solving them first before looking at the
answers.
3 Basic Types of Compounding Problems

Half of the 6 functions of a dollar are compounding problems. These time value of
money problems include finding the future value of a lump sum, the future value of a
series of payments, and the payment amount needed to achieve a future value. Lets
dive into each of these problems with specific time value of money examples.
Future value of a single sum
This type of problem compounds a single amount to a future value. Heres an example
of this type of time value of money problem: What will $100,000 invested today for 7
years grow to be worth if compounded annually at 5% per year?
To solve this problem simply identify the 4 known components and then use a calculator
to find the 5th unknown component. In this problem we know the present value

PV

is -

$100,000 because its whats invested today. Its negative because its leaving our
pocket when we put it into the investment. The number of periods
rate

is 7 years, and the

is 5%. The N and I components are both expressed annually, so they are

consistent. Knowing this we can simply plug those 4 components into the calculator and
solve for future value

FV ,

which is $140,710.

Future value of a series of payments

This type of problem compounds an annuity to a future value. Heres an example of this
type of time value of money problem: If you deposit $12,000 at the end of each year for
10 years earning 8% annually, how much money will be in the account at the end of
year 10?

To solve this problem, lets first identify the 4 known components. We know that the
payment amount

PMT

is -$12,000 because thats what we are depositing at the end of

each year. We also know that the interest rate

periods

is 8% and the total number of

is 10 years. What about the present value? Well, because we arent starting

with anything, our present value is simply $0. Again, in this problem the total number of
compounding periods is expressed annually and so is the interest rate, so the n and i
components are consistent. Now we can easily solve for the future value FV , which is the
5th remaining component.
Payments needed to achieve a future value
This type of problem compounds a series of equal payments into a future value and is
also known as a sinking fund payment. Heres an example of this type of time value of
money problem: At a 7% interest rate, how much needs to be deposited at the end of
each month over the next 10 years to grow to be exactly $50,000?
Lets start by identifying the 4 known variables. We know that the rate

is 7% and

it is implied to be an annual rate. Next, we are given the total number of periods
is 10 years, and finally the future value

FV

N which

we are trying to achieve is $50,000. A quick

check ensures that the rate and the number of periods are both expressed in years, but
what about the payment frequency? The payment frequency in this problem is
expressed monthly, so we are going to have to do some conversion in order to set this
problem up correctly. Lets convert everything to a monthly frequency so we are
consistent with our payments.
To do this we can simply divide the 7% interest rate by 12 month to get .58% per month.
Next we can multiply our 10 year analysis period by 12, since there are 12 months in
each year, to get 120 total months. Now our
our

FV

is 120 months,

is $0 and we can solve for a monthly payment

PMT

is .58% per month,

amount. Now we can simply

plug these 4 known components in and solve for the payment

PMT needed.

3 Basic Types of Discounting Problems

The other half of the 6 functions of a dollar involve discounting. These time value of
money problems involve finding the present value of a lump sum, the present value of a
series of payments, and the payment amount needed to amortize a present value such
as a loan. Lets dive into these discounting problems with some specific time value of
money examples.

Present value of a single sum

This type of problem discounts a single future amount to a present value. Heres an
example of this type of time value of money problem: A U.S. savings bond will be worth
$10,000 in 10 years. What should you pay for it today in order to earn 6.5% annually?
To solve this time value of money problem lets take a look at the 4 variables that we
know. We are given the future value
years, and the rate

FV

of $10,000, the number of periods

is 10

is 6.5% per year. Both the rate and the number of periods are

consistent, so we can now solve for the unknown present value

PV .

Present value of a series of payments

This type of problem discounts an annuity (or series of equal payments) to a present
value. Heres an example of this type of time value of money problem: An insurance
company is offering an annuity that pays $2500 per month for the next 20 years. How
much should you pay for the annuity in order to earn 8% per year?
In this time value of money problem we know that the payment
the total number of periods

is 20 years, and the rate

PMT

is $2500 per month,

is 8% per year. The rate and

the total number of periods is consistent as annual figures at first glance, however we
also have monthly payments. So, we have to convert our annual number of periods (20
years) to 240 months, and also convert our annual rate of 8% to a monthly rate of .667.
Now we can now easily solve for the present value

PV .

Amount needed to amortize a present value

This type of problem determines a series of equal payments necessary to amortize a
present value. Heres an example of this type of time value of money problem: What are
the monthly payments on a 30 year loan of $300,000 at a annual rate of 4.5%
compounded monthly?
In this problem we are given the total number of periods
value

PV

of $300,000, an annual interest rate

of 30 years, a present

of 4.5% compounded monthly, and

because this is a loan amortized over 30 years, it is implied that the future value

FV

is

$0. After a quick check it appears that the number of periods and the rate are actually
expressed in different compounding periods, which of course presents a conflict. To
resolve this lets adjust the n and i components so they are both expressed monthly.
Using the formulas above we can convert the total number of compounding periods to

30 x 12, or 360 months and the rate to 4.5% / 12, or 0.375% per month. Now we have
our 4 known components and can easily solve for the present value.

Time Value of Money Solutions Worksheet

As mentioned above, there are many ways to solve a time value of money problem,
including financial calculators, regular calculators, software, and spreadsheets. While
going over calculator keystrokes is outside of the scope of this article, we did put
together an Excel worksheet with solutions to the above 6 problems. Feel free to
download it for free here:

Time Value of Money Solutions Worksheet

Name*

First

Last

Email*

Dow nload Now

Conclusion
Time value of money concepts are at the core of valuation and other finance and
commercial real estate topics. This article provides a solid foundation for understanding
time value of money at an intuitive level and it also gives you the tools needed to solve
any time value of money problem. The time value of money is required as a basic
building block in finance and mastering these concepts will pay dividends for years to
come.

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