Time Value

of Money
 Learning Goals

Discuss the role of time value in finance and the use

of computational aids to simplify its application.
Understand the concept of future value and its
calculation for a single amount; understand the
effects on future value and the true rate of interest
of compounding more frequently than annually.
Understand the concept of present value, its calculation
for a single amount, and the relationship of present
to future cash flow.

Copyright © 2001 Addison-Wesley 5-2

 Learning Goals

Find the future value and present value of an ordinary

annuity, the future value of an annuity due, and the
present value of a perpetuity.
Calculate the present value of a mixed stream
of cash flows, describe the procedures involved in:
 Determining deposits to accumulate to a future sum
 Loan amortization
 Finding interest or growth rates

Copyright © 2001 Addison-Wesley 5-3

 The Time Value of Money

Money NOW
is worth more than
money LATER!

2007 Pearson Education Asia

 Introduction

 The financial system

coordinates saving
and investment.
 Participants in the financial system make decisions
regarding the allocation of resources over time
and the handling of risk.
 Finance is the field that studies such
decision making.

THE BASIC TOOLS OF FINANCE 5

 The Role of Time Value in Finance

 Most financial decisions involve costs

and benefits that are spread out over time.
 Time value of money allows comparison
of cash flows from different periods.
 Question
 Would it be better for a company to invest $100,000 in a product
that would return a total of $200,000 in one year, or one that
would return $500,000 after two years?
 Answer
 It depends on the interest rate!

Copyright © 2001 Addison-Wesley 5-6

 Basic Concepts
 Future Value
 Compounding or growth over time
 Present Value
 Discounting to today’s value
 Single cash flows and series of cash flows can
be considered
 Time lines are used to illustrate these relationships

Copyright © 2001 Addison-Wesley 5-7

 Computational Aids

 Use the equations

 Use the financial tables
 Use financial calculators
 Use spreadsheets

Copyright © 2001 Addison-Wesley 5-8

Present Value: The Time Value of Money
 To compare a sums from different times, we use
the concept of present value.
 The present value of a future sum: the amount
that would be needed today to yield that future sum
at prevailing interest rates
 Related concept:
The future value of a sum: the amount the sum
will be worth at a given future date, when allowed
to earn interest at the prevailing rate

THE BASIC TOOLS OF FINANCE 9

 Computational Aids

Copyright © 2001 Addison-Wesley Figure 5.1 5-10

 Computational Aids

Copyright © 2001 Addison-Wesley Figure 5.2 5-11

 Computational Aids

Copyright © 2001 Addison-Wesley Figure 5.3 5-12

 Computational Aids

Copyright © 2001 Addison-Wesley Figure 5.4 5-13

 Simple Interest

 With simple interest, you don’t earn interest

on interest.
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125

Copyright © 2001 Addison-Wesley 5-14

 Compound Interest
 With compound interest, a depositor earns interest on
interest!
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

Copyright © 2001 Addison-Wesley 5-15

 Time Value Terms

PV0 = present value or beginning amount

k = interest rate
FVn = future value at end of “n” periods

n = number of compounding periods

A = an annuity (series of equal
payments or receipts)

Copyright © 2001 Addison-Wesley 5-16

 Four Basic Models

FVn = PV0(1+k)n = PV(FVIFk,n)

PV0 = FVn[1/(1+k)n] = FV(PVIFk,n)

FVAn = A (1+k)n - 1 = A(FVIFAk,n)

k

PVA0 = A 1 - [1/(1+k)n] = A(PVIFAk,n)

k
Copyright © 2001 Addison-Wesley 5-17
 Future Value Example

 Algebraically and Using FVIF Tables

 You deposit $2,000 today at 6% interest.
How much will you have in 5 years?

$2,000 x (1.06)5 = $2,000 x FVIF6%,5

$2,000 x 1.3382 = $2,676.40

Copyright © 2001 Addison-Wesley 5-18

 Future Value Example

 Using Microsoft® Excel

 You deposit $2,000 today at 6% interest.
How much will you have in 5 years?

Microsoft® Excel Function

= FV(interest, periods, pmt, PV)
= FV(.06, 5, , 2000)

Copyright © 2001 Addison-Wesley 5-19

 A Graphic View of Future Value

Copyright © 2001 Addison-Wesley Figure 5.5 5-20

 Compounding More Frequently
Than Annually
 Compounding more frequently than once a year results
in a higher effective interest rate because you are
earning on interest on interest more frequently.
 As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
 Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.

Copyright © 2001 Addison-Wesley 5-21

 Compounding More Frequently
Than Annually
 For example, what would be the difference in future
value if I deposit $100 for 5 years and earn 12% annual
interest compounded (a) annually, (b) semiannually,
(c) quarterly, and (d) monthly?

Annually: 100 x (1 + .12)5 = $176.23

Semiannually: 100 x (1 + .06)10 = $179.09

Quarterly: 100 x (1 + .03)20 = $180.61

Monthly: 100 x (1 + .01)60 = $181.67

Copyright © 2001 Addison-Wesley 5-22

 Compounding More Frequently
Than Annually

Copyright © 2001 Addison-Wesley 5-23

 Continuous Compounding
 With continuous compounding the number
of compounding periods per year approaches infinity.
 Through the use of calculus, the equation thus becomes:

FVn (continuous compounding) = PV x (ekxn)

where “e” has a value of 2.7183

 Continuing with the previous example, find the future value of the
$100 deposit after 5 years if interest is compounded continuously.

FVn = 100 x (2.7183).12x5 = $182.22

Copyright © 2001 Addison-Wesley 5-24

 Nominal and Effective Rates
 The nominal interest rate is the stated or contractual
rate of interest charged by a lender or promised by
a borrower.
 The effective interest rate is the rate actually paid
or earned.
 In general, the effective rate is greater than the nominal
rate whenever compounding occurs more than once
per year.
EAR = (1 + k/m)m - 1

Copyright © 2001 Addison-Wesley 5-25

 Nominal and Effective Rates

 For example, what is the effective rate of interest

on your credit card if the nominal rate is 18% per
year, compounded monthly?

EAR = (1 + .18/12)12 - 1
EAR = 19.56%

Copyright © 2001 Addison-Wesley 5-26

 Present Value
 Present value is the current dollar value of a future amount
of money.
 It is based on the idea that a dollar today is worth more
than a dollar tomorrow.
 It is the amount today that must be invested at a given rate
to reach a future amount.
 It is also known as discounting, the reverse
of compounding.
 The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return, and
the cost of capital.

Copyright © 2001 Addison-Wesley 5-27

 Present Value Example

 Algebraically and Using PVIF Tables

 How much must you deposit today in order to have
$2,000 in 5 years if you can earn 6% interest
on your deposit?

$2,000 x [1/(1.06)5] = $2,000 x PVIF6%,5

$2,000 x 0.74758 = $1,494.52

Copyright © 2001 Addison-Wesley 5-28

 Present Value Example

 Using Microsoft® Excel

 How much must you deposit today in order
to have $2,000 in 5 years if you can earn
6% interest on your deposit?

Microsoft® Excel Function

=PV(interest, periods, pmt, FV)
=PV(.06, 5, , 2000)

Copyright © 2001 Addison-Wesley 5-29

A Graphic View of Present Value

Copyright © 2001 Addison-Wesley Figure 5.6 5-30

 Annuities
 Annuities are equally-spaced cash flows of equal size.

 Annuities can be either inflows or outflows.

 An ordinary (deferred) annuity has cash flows
that occur at the end of each period.
 An annuity due has cash flows that occur
at the beginning of each period.
 An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will
compound for an additional period.

Copyright © 2001 Addison-Wesley 5-31

 Annuities

Copyright © 2001 Addison-Wesley Table 5.1 5-32

 Future Value
of an Ordinary Annuity
 Using the FVIFA Tables
 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the end of each year at 5% interest for three years?

FVA = 100(FVIFA,5%,3) = $315.25

Year 1 $100 deposited at end of year = $100.00

Year 2 $100 x .05 = $5.00 + $100 + $100 = $205.00
Year 3 $205 x .05 = $10.25 + $205 + $100 = $315.25
Copyright © 2001 Addison-Wesley 5-33
 Future Value
of an Ordinary Annuity
 Using Microsoft® Excel
 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the end of each year at 5% interest for three years?

Microsoft® Excel Function

=FV(interest, periods, pmt, PV)
=FV(.06,5,100, )

Copyright © 2001 Addison-Wesley 5-34

 Future Value of an Annuity Due

 Using the FVIFA Tables

 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the beginning of each year at 5% interest for three years.

FVA = 100(FVIFA,5%,3)(1+k) = $330.96

FVA = 100(3.152)(1.05) = $330.96

Copyright © 2001 Addison-Wesley 5-35

 Future Value of an Annuity Due

 Using Microsoft® Excel

 An annuity is an equal annual series of cash flows.
 Example
• How much will your deposits grow to if you deposit $100
at the beginning of each year at 5% interest for three years.

Microsoft® Excel Function

=FV(interest, periods, pmt, PV)
=FV(.06, 5,100, )
=315.25*(1.05)

Copyright © 2001 Addison-Wesley 5-36

 Present Value
of an Ordinary Annuity
 Using PVIFA Tables
 An annuity is an equal annual series of cash flows.
 Example
• How much could you borrow if you could afford annual
payments of $2,000 (which includes both principal
and interest) at the end of each year for three years
at 10% interest?

PVA = 2,000(PVIFA,10%,3) = $4,973.70

Copyright © 2001 Addison-Wesley 5-37

 Present Value of an Ordinary
Annuity
 Using Microsoft® Excel
 An annuity is an equal annual series of cash flows.
 Example
• How much could you borrow if you could afford annual
payments of $2,000 (which includes both principal
and interest) at the end of each year for three years
at 10% interest?

Microsoft® Excel Function

=PV(interest, periods, pmt, FV)
=PV(.10, 3, 2000, )

Copyright © 2001 Addison-Wesley 5-38

Present Value of a Mixed Stream
 Using Microsoft® Excel
 A mixed stream of cash flows reflects no particular pattern
 Find the present value of the following mixed stream assuming
a required return of 9%.

Microsoft® Excel Function

=NPV(interest, cells containing CFs)
=NPV(.09,B3:B7)

Copyright © 2001 Addison-Wesley 5-39

 Present Value of a Perpetuity
 A perpetuity is a special kind of annuity.
 With a perpetuity, the periodic annuity or cash flow stream continues forever.

PV = Annuity/k

 For example, how much would I have to deposit today

in order to withdraw $1,000 each year forever if I can earn 8% on my
deposit?

PV = $1,000/.08 = $12,500

Copyright © 2001 Addison-Wesley 5-40

 Loan Amortization

Copyright © 2001 Addison-Wesley Table 5.7 5-41

 Determining Interest
or Growth Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund
in 1994 which grew as shown in the table below?

It is important to note
that although there are
7 years shown, there are
only 6 time periods
between the initial deposit
and the final value.

Copyright © 2001 Addison-Wesley 5-42

 Determining Interest
or Growth Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Thus, $1,000 is the present value,

$5,525 is the future value,
and 6 is the number of periods.

Copyright © 2001 Addison-Wesley 5-43

 Determining Interest
or Growth Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Copyright © 2001 Addison-Wesley 5-44

 Determining Interest or Growth
Rates
 At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
 For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Microsoft® Excel Function

=Rate(periods, pmt, PV, FV)
=Rate(6, ,1000, 5525)

Copyright © 2001 Addison-Wesley 5-45

 Using Microsoft Excel ®

 The Microsoft® Excel Spreadsheets used

in the this presentation can be downloaded
from the Introduction to Finance companion
web site: http://www.awl.com/gitman_madura

Copyright © 2001 Addison-Wesley 5-46

Chapter Introduction to Finance
5 Lawrence J. Gitman
Jeff Madura

End of Chapter