Time Value of Money

(화폐의 시간가치)

Spring 2023

Jin Q Jeon
Professor of Finance
Dongguk Business School
Dongguk University
Time Value of Money

l Concept
ü Money available at the present time is worth more than the identical sum in the future

Today 1 year later

Value 100 > 100
Maybe to Mr. Kim 100 = 110

l Why?
ü We prefer present consumption to future consumption (liquidity preference, 유동성선호현상)

ü Inflation occurs in most cases and, then, the value of currency decreases over time
ü The possibility of default in the future reduces the value of cash.

l Notation
ü PV (present value 현재가치) = 100
ü FV (future value 미래가치) = 110

ü N (number of periods 기간) = 1 (year)

ü r (interest rate (기간) 이자율) = 10%

ü PMTi = future payment in each period

Time Value of Money

l General Formula
ü For 1 period, FV = PV (1+r)

ü For 2 periods, FV2 = FV1 (1+r)=PV(1+r)(1+r)=PV(1+r)2 , Interest compounding (복리효과)

Today 1 year 2 year

100 100(1+0.1) 100(1+0.1)(1+0.1)
or 100(1+0.1)2
ü More generally, with N periods
!"!
FVN = PV (1+r)N Or PV =
($%&)!

Warming up…
1) You deposit $1100 in a bank today at an 8% interest rate per year. How much will you have after
50 years?

2) If someone offers you $5,000 to be paid 5 years from now, how much would you accept today if
the interest rate is 10%?
PV of A Cash Flow Stream

l PV of uneven future payments

r=10%

100 200 300

Ex) An investment will pay $100 at the end of each of the next 3years, $200 at the end of
year 4, $300 at the end of year 5, and $500 at the end of year 6. Find the present value
when the interest rate is 8%
PV of A Cash Flow Stream

l Perpetuity (영구연금)
ü When the same amount of money comes each year forever,
r=10%
∞

100 100 100 100

l Annuity (연금)
ü When the future payments (PMTi) are equal and are made at fixed intervals.

100 100 100

● In the class, we use PVIF (Present Value Interest Factor, 현가이자요소) and PVIFA (Present Value Interest
Factor of Annuity, 연금의 현가이자요소)

PVIF(%, N) or PVIFA(%, N) will be given on the exam, so that we can easily calculate PVs
Examples

ü What is the present values of a $100 perpetuity if the interest rate is 7%?

ü What present amount is equivalent to $100 received at the end of year 8, given an interest rate of
2%? Note, PVIF(2%, 8)=0.8535.

ü What present amount is equivalent to $100 received at the end of each year for 8 years, given an
interest rate of 2%? Note, PVIFA(2%, 8) = 7.3255
Rule of 72

ü Methods for estimating an investment's doubling time.

ü If you invest $100 at a rate of 9% per annum, how many years are required for the investment to
be worth $200?

Number of Years

ü Is it correct?

So, it is not precise but it works.

Ex, If the house price has doubled in 5 years, the annual return is
Difficulty in calculating

We use trial and error or Excel.

Compounding within Year (연간 k번 복리 가정)

Suppose you want to invest $1 in a bank. The interest rate for all banks is 12% a year.
However, Bank A pays the interest one time at the end of year, while Bank B pays every 6 months.
Likewise, Bank C, D and E pay every quarter, month and day, respectively.
Then the real interest rates that you can earn from each bank are

Bank Month

1 2 3 … 6 … Final Value on Month 12 Real Rate

A 1.012 =$1(1.012) 0.12

B $1(1+0.12/2) 1.1236 =$1(1+.06)2 0.1236

C $1(1+0.12/4) $1(1+0.12/4)2 1.1255 =$1(1+0.03)4 0.1255

D $1(1+0.12/12) $1(1+0.01)2 … 1.1268 =$1(1+0.01)12 0.1268

E 1.1052 =$1(1+0.1/365)365 0.1275

Compounding within Year (연간 k번 복리 가정)

l The nominal APR (Annual Percentage Rate, 연 이자율 또는 연간 표시이자율) is the simple-
interest rate (for a year), i.e, 12% in the example.
l Effective annual rate (EAR, 실효이자율) – the annual rate of interest actually being earned,
accounting for compounding.
l EAR for 12% of (APR) with semiannual compounding (K=number of payment a year)
EAR = ( 1 +APR /K )K – 1
= ( 1 + 0.12/2 )2 – 1 = 12.36%
l Should be indifferent between receiving 12.36% annual interest and receiving 12% interest,
compounded semiannually.

Ex, Find the present value of $100 to be received at the end of year 2 if the interest rate is 12%
compounded monthly.
Discount Rate (할인율)

l One of key fundamentals in finance : Discount future cash flows to get the (present)
value.

l Which rate to be used to calculate PV or FV?

ü It depends on your objective to calculate PV or FV.
ü Note the discount rate and interest have the same meaning.

l Here are some examples. All these rates serve as “discount rate”
ü Interest rate (이자율),
ü Opportunity cost (기회비용) : to compare the value of your choice to that of the next best choice
ü Financial cost (자금조달비용): to know whether your value is greater than the initial investment
after considering the cost associate with financing.
• Financing cost for stock: Cost of equity (which is RRR)
• Financing cost for debt : Yields to maturity (YTM)
• Combining these two, we call “Cost of Capital (자본비용)”.

l Discount factor
ü PVIF(r,n) : Present value interest factor (현가이자요소)

ü PVIFA(r,n) : Present value interest factor of annuity (원금의 현가이자요소)

Excel Functions

Use NPV(..) for an uneven cash

flow stream
Exercises
ü Jason Spector has shopped around for the best interest rates for his investment of $10,000
over the next year. He has found 1) 6.10% with annual compounding, 2) 5.9% with
semiannual compounding, 3) 5.85% with monthly compounding. Which investment offers
Jason the highest effective rate of return?

ü Wang just won the lottery, and she must choose among three award options: a lump sum
today of $61m, 10 end-of-year payments of $9.5m, or 30 end-of-year payments of 5.5m.
Which should she choose if she thinks she can earn 7% annually?
• PVIFA(7%,10)=7.0236, PVIFA(7%,30)=12.4090

ü David and Helen are saving to buy a boat at the end of 5 years. If the boat will cost
$20,000 (in year 5) and they can earn 10% a year on their savings, how much do they need
to deposit at the end of years 1 through 5.
• PVIFA(10%,5)=3.7908

ü Melissa Gould wants to begin saving in order to assure adequate funds for her son’s
college education. She estimates that her son will need $20,000 at the end of 18 years;
$25,000 at the end of 19 years; $30,000 at the end of 20 years; and $40,000 at the end of
21 years. How much will Melissa have to invest in a fund (starting one year from now
when her son is 1year old) and the last deposit will occur at the end of year 15) if the fund
earns 6% per year?
• PVIFA(6%,15)=9.7122, PVIF(6%,18)=0.3503, PVIF(6%,19)=0.3305, PVIF(6%,20)=0.3118, PVIF(6%,21)=0.2942