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CH 5 Time Value of Money

This document provides an overview of key concepts related to the time value of money, including: 1) It discusses the role of time value in finance and introduces the concepts of future value and present value for evaluating cash flows that occur at different points in time. 2) It covers the calculation of future value and present value for single amounts, annuities, perpetuities, and mixed streams of cash flows. 3) It explains how compound interest, discounting, and the frequency of compounding impact the calculation of future and present value. Special applications like loan amortization and determining deposit amounts are also covered.

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Md. Arjit Isalm
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© © All Rights Reserved
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28 views

CH 5 Time Value of Money

This document provides an overview of key concepts related to the time value of money, including: 1) It discusses the role of time value in finance and introduces the concepts of future value and present value for evaluating cash flows that occur at different points in time. 2) It covers the calculation of future value and present value for single amounts, annuities, perpetuities, and mixed streams of cash flows. 3) It explains how compound interest, discounting, and the frequency of compounding impact the calculation of future and present value. Special applications like loan amortization and determining deposit amounts are also covered.

Uploaded by

Md. Arjit Isalm
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER FIVE

TIME VALUE OF
MONEY
Learning Goals

A. Discuss the role of time value in finance,


the use of computational tools, and the
basic patterns of cash flow.
B. Understand the concepts of future value
and present value, their calculation for
single amounts, and the relationship
between them.
C. 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.
Learning Goals

D. Calculate both the future value and the


present value of a mixed stream of cash flows.
E. Understand the effect that compounding
interest more frequently than annually has on
future value and on the effective
annual rate of interest.
F. Describe the procedures involved in
i. determining deposits needed to accumulate
a future sum,
ii. loan amortization,
iii. finding interest or growth rates, and
iv. finding an unknown number of periods
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 dollar today is
worth more than a dollar 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. This chapter we will introduce to those tools.
THE ROLE OF TIME VALUE IN FINANCE

FUTURE VALUE VERSUS PRESENT VALUE


THE ROLE OF TIME VALUE IN FINANCE
THE ROLE OF TIME VALUE IN FINANCE

A time line depicts the cash flows associated with a given


investment. It is a horizontal line on which time zero appears at
the leftmost end and future periods are marked from left to right.
A time line illustrating our hypothetical investment problem
appears in Figure 5.1. The cash flows occurring at time zero
(today) and at the end of each subsequent year are above the line;
the negative values represent cash outflows ($15,000 invested
today at time zero), and the positive values represent cash inflows
($3,000 inflow in 1 year, $5,000 inflow in 2 years, and so on).
THE ROLE OF TIME VALUE IN FINANCE

The future value technique uses compounding


to find the future value of each cash flow at the
end of the investment’s life and then sums
these values to find the investment’s future
value.

Alternatively, the present value technique uses


discounting to find the present value of each
cash flow at time zero and then sums these
values to find the investment’s value today.
THE ROLE OF TIME VALUE IN FINANCE

BASIC PATTERNS OF CASH FLOW


The cash flow—both inflows and outflows—of a firm can be
described as a single amount, an annuity, or a mixed
stream.

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.
Annuity: A level periodic stream of cash flow. For our
purposes, we’ll work primarily with annual cash flows.
Examples include either paying out or receiving $800 at
the end of each of the next 7 years.
Mixed stream: A stream of cash flow that is not an
annuity; a stream of unequal periodic cash flows that
reflect no particular pattern
THE ROLE OF TIME VALUE IN FINANCE

SINGLE AMOUNTS
FUTURE VALUE OF A SINGLE AMOUNT
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/ initial investment.
Compound Interest
Interest that is earned on a given deposit and has
become part of the principal at the end of a specified
period.
Principal
The amount of money on which interest is paid.
THE ROLE OF TIME VALUE IN FINANCE

The Equation for Future Value


𝑛
𝐹 𝑉 𝑛= 𝑃𝑉 × ( 1 +𝑟 )
THE ROLE OF TIME VALUE IN FINANCE
THE ROLE OF TIME VALUE IN FINANCE

PRESENT VALUE OF A SINGLE AMOUNT

Present value is the current dollar value of a future amount


—the 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, future value

Discounting Cash Flows


The process of finding present values; the inverse of
compounding interest.
THE ROLE OF TIME VALUE IN FINANCE

The Equation for Present Value


THE ROLE OF TIME VALUE IN FINANCE

Annuities
A stream of equal periodic cash flows over a
specified time period. These cash flows can be
inflows of returns earned on investments or
outflows of funds invested to earn future returns.
Ordinary Annuity
An annuity for which the cash flow occurs at the
end of each period.
Annuity Due /immediate annuity
An annuity for which the cash flow occurs at the
beginning of each period.
THE ROLE OF TIME VALUE IN FINANCE

FINDING THE FUTURE VALUE OF AN


ORDINARY ANNUITY
THE ROLE OF TIME VALUE IN FINANCE
THE ROLE OF TIME VALUE IN FINANCE

FINDING THE PRESENT VALUE OF AN


ORDINARY ANNUITY
[See example 5.8]
THE ROLE OF TIME VALUE IN FINANCE

FINDING THE FUTURE VALUE OF AN ANNUITY


DUE
[see example 5.9]
THE ROLE OF TIME VALUE IN FINANCE

FINDING THE PRESENT VALUE OF AN


ANNUITY DUE
THE ROLE OF TIME VALUE IN FINANCE

FINDING THE PRESENT VALUE OF A


PERPETUITY

A perpetuity is an annuity with an infinite life in


other words, an annuity that never stops
providing its holder with a cash flow at the end of
each year.
THE ROLE OF TIME VALUE IN FINANCE

Compounding Interest More Frequently


Than Annually

Semimanual Compounding
Compounding of interest over two periods within
the year
Quarterly Compounding
Compounding of interest over four periods within
the year.
THE ROLE OF TIME VALUE IN FINANCE

A GENERAL EQUATION FOR COMPOUNDING


MORE FREQUENTLY THAN ANNUALLY
THE ROLE OF TIME VALUE IN FINANCE

CONTINUOUS COMPOUNDING
Compounding of interest an infinite number of
times per year at intervals of microseconds.
THE ROLE OF TIME VALUE IN FINANCE

NOMINAL AND EFFECTIVE ANNUAL RATES OF


INTEREST
Nominal (stated) Annual Rate
Contractual annual rate of interest charged
by a lender or promised by a borrower
Effective (True) Annual Rate (EAR)
The annual rate of interest actually paid or
earned.
THE ROLE OF TIME VALUE IN FINANCE
THE ROLE OF TIME VALUE IN FINANCE

SPECIAL APPLICATIONS OF TIME VALUE


DETERMINING DEPOSITS NEEDED TO
ACCUMULATE A FUTURE SUM

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.
THE ROLE OF TIME VALUE IN FINANCE

Loan Amortization
The determination of the equal periodic loan
payments necessary to provide a lender with a
specified interest return and to repay the loan
principal over a specified period.
For example, say you borrow $6,000 at 10 percent
and agree to make equal annual end-of-year
payments over 4 years.
THE ROLE OF TIME VALUE IN FINANCE

FINDING INTEREST OR GROWTH RATES


CHAPTER CLOSED

THANK YOU
• Assignment:
Chapter-1: Quick Check-1.1-1.4,

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