Time Value of Money

Module 3, Lecture 1

Dr. Annette Poulsen

Sterne Professor of Banking and Finance
Josiah Meigs Distinguished Teaching Professor
Introduction
• In any business decision, decision makers consider:

• What are the expected future cash flows?

• What is the length of time until receiving cash

flows?

• What is the riskiness of the future cash flows?

• What else could be done with the capital?

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Time Value of Money (TVM)
• Time value of money refers to the idea that a dollar today
is not the same thing as a dollar expected tomorrow

• TVM is key to understanding financial decisions

• TVM is quantified through the use of Discounted Cash

Flow Analysis (DCF)

• DCF accounts for both the timing and the riskiness of

cash flows

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Time Value of Money
• Any decisions involving investing or financing where
cash flows occur at different points in time require an
understanding of the time value of money

• This will be one of the most crucial and enduring topics

covered in this course.

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Some definitions
Basic terms

• Rate of interest, r = return on the investment. Also called the

discount rate
• Present value, PVt=0 = the value today of an investment
• Future value, FVt = the value of an investment at the end of
time period t.
• Cash payments, Ct = payments made during the investment
period
• Time period, t (or n) = when a cash flow occurs. (We
assume all cash flows occur at the end of the period unless
otherwise stated).

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Some definitions (continued)
• The future value, FVt, is the value of an investment at the end of
time period t.

• PV0 is the value of an investment today (t=0).

• The rate of interest, r, is the rate of return on the investment. This

is also called the discount rate.

• The cash flow, Ct, is the net cash flow at the end of period t.

• (Note that there is some tendency to use “n” and “t”

interchangeably…. The same is true for “r” and “i” for interest rate)

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The Timeline
• A timeline helps in analyzing many finance
problems.

PV0 C1 C2 C3 C4 C5 C6 C7 C8

0 1 2 3 4 5 6 7 8

04/17/2025 Time Value of Money Part 1 7

Single period problem
• Suppose I put $100 in the bank today and earn 5% per year.
What is my account worth in one year?

• You can probably do this in your head but there is a formula:

• FV = PV * (1 + r)

• FV = 100 * (1 + .05)
• FV = 105
• The interest rate is called the discount rate or cost of capital
or market rate (or….)
• The rate reflects the riskiness of the investment and
compensation for giving up use of your money for a year

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Single period problem
• We can also determine the present value of a cash flow in
the future – rearrange the equation…

• Recall FV = PV * (1+r)  PV = FV/(1+r)

• PV = FV / (1 + r)

• If you need $20,000 for a car next year after graduation, put
away ?? now. You can earn 3% in your savings account.

• PV = 20,000 / (1 + .03) = 19,417.47

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Compound interest
• Compound interest is due (or paid) not only on the
principal but on prior interest also.

• The amount of interest due each period is the interest

rate times the principal amount at the beginning of each
period.

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Future value with compound interest
• For one period:
• FV1 = PV0(1 + r)

• For two periods:

• FV2 = PV1(1 + r) = [PV0 (1 + r)] (1 + r )
• FV2 = PV0(1 + r)2

• In general:
• FVt = PV0 (1 + r)t

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The power of compounding…
.

Starting balance = $10,000

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Types of interest rates
Compound annual return 1926 – 2018

Interest rates reflect the riskiness of the investment –

investors need compensation to bear risk

Data from Ibbotson SBBI Yearbook

Compound
Investment Risk Profile Annual Return
Small Stocks Medium to high 11.8%
Large Stock Medium 10.0%
Long-term Gov’t Bonds Low 5.5%
Treasury Bills Low 3.3%
Inflation 2.9%

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.
Ibbotson Stocks, Bonds, Bills, and Inflation 1926-2023
Example: Multi-period compounding
• You deposit $5,000 into an account which pays 10%
compounded annually.

• If you leave the money (plus all accumulated interest) in

the account for 5 years, what is the balance at the end of
the 5th year.

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Solution 1 – The long way

• FV1 = $5,000 ( 1 + .10) = $5,500

• FV2 = $5,500 ( 1 + .10) = $6,050

• FV3 = $6,050 ( 1 + .10) = $6,655

• FV4 = $6,655 ( 1 + .10) = $7,320

• FV5 = $7,320 ( 1 + .10) = $8,052

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Solution 2 – Arithmetic

• FVt = PV (1 + r)t

• t=5

• r = .10 or 10%

• FV5 = $5000 (1 + .10)5 = $8052.55

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Solution 3 – TI-BAII Plus
• Use the time value of money keys (N, I/Y, PV, PMT, FV).
• Set payments per period = 1
• Set to payments at end of period.
• Clear the calculator’s registers.

• N=5

• I/Y = 10

• PV = -5000

• PMT = 0; Solve for: FV = 8052.55

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Solving on TI-BAII Plus
• 5 N

• 10 I/Y

• 5000 +/- PV (I.e., enter as negative value.)

• 0 PMT

• CPT FV

• Answer FV = $8052.55

• Note the signs!

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Solution 4 – Excel
• Excel is similar to the financial calculator The function for
finding future value is:

=FV(rate, nper, pmt, pv, type)

• Rate = interest rate per period in percent terms (10% or .10)

• Nper = number of periods

• Pmt = payment made each period

• PV = present value

• Type = 0 if regular annuity, 1 if annuity due (payment at

beginning of period). 0 is the default

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Solving in Excel
• Rate = .10

• Nper = 5

• Pmt = 0

• PV = -5000

• =FV (.10, 5, 0, -5000)  $8052.55

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Another example
• Suppose I put $5000 in a mutual fund that is expected to earn
15% per year. How long before my investment doubles?

• On the calculator:

N=??, I=15, PV = 5000, PMT = 0, FV = -10000

CPT N  N=4.96

• In Excel =nper(rate, pmt, pv, fv):

• =NPER(.15,0,5000,-10000)
• 4.96

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Present value
• Present value calculations find the amount at time zero, or PV 0,
that is equivalent to some future amount FV t.

• The present value of a future amount received in t years

discounted at interest rate r is:

• PV0 = FVt / (1 + r)t

• Or, PV0 = Ct / (1 + r)t

• Notice that we have simply rearranged the terms of the FV

equation from the last lecture

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Example: Present value
• In 10 years, you will need $10,000.

• If you can earn 12% on any money invested during this

ten-year period, how much would you have to deposit
today to meet your investment goal?

• As before, we can do the arithmetic, use the financial

calculator or excel to solve this problem

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Solution 1: Arithmetic

• PV0 = FVt / (1 + r)t

• PV0 = $10,000 / (1 + .12)10

• PV0 = $10,000 / 3.1058 = $3,219.78

• Thus, if we put $3,219.78 in an account that earns 12%

interest, it will be worth $10,000 in 10 years.

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Solution 2: Calculator
• Make sure the calculator’s registers are clear, payments
per year equal 1 and payments are at end of period.

• N = 10, I = 12, PMT = 0, FV = $10000

• Solve for: PV = -$3219.73

• (Keystrokes: 10 N, 12 I, 0 PMT, 10000 FV, CPT PV )

• Note that PV and FV have opposite signs.

• Note that the interest rate is entered as 12

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Solution 3: Excel
• The function name is PV

• The form is =PV(rate, nper, pmt, fv, type)

• The solution:

• =PV(.12, 10, 0, 10000) -$3219.73

• Again, note that PV and FV have opposite signs.

• Note that the interest rate is entered as .12

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Example Present Value
• Suppose a friend wants to borrow $1,000 today. He
promises to pay you back $1,050 next year. If you want
a 10% return on your investment, what should you do?

• I.e., would you lend $1000 today to receive $1050 a year

from now if you want a 10% rate of return

• PV of investment = $1050 / 1.10 = $954

• No … the most you would be willing to lend today is $954

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Example Future Value
• Suppose that a friend wants you to help fund her investment. She
wants to own and operate a Zaxby’s franchise and seeks $100,000
from you today. Based on your analysis, you decide you want a 12%
annual return and will seek to end your investment in 10 years. What
will be the required payment to you in 10 years to earn a 12% return?

• I.e., find the future value such that you earn a 12% return over 10
years:

• FV = $100,000 * 1.12^10 = 310,585

• N=10, I=12, PV=100000, PMT=0  FV = -310,585

• Again, note the opposite signs on PV and FV

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Things to think about
• As r increases, the PV of an amount in the future
decreases.

• As t increases, the PV of an amount in the future

decreases.

• As r increases, the future value of the cash flow increases.

• As t increases, the future value of the cash flow increases.

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