Time Value of Money
Time value of money is based on the belief
that a dollar today is worth more than a
dollar that will be received at some future
date because the money it now can be
invested & earn positive return.
Time 0 is today; Time 1 is one period from today
Interest rate
0 5% 1
Time
Cash Flows
-100
Outflow
105
Inflow
Compounding
The process of determining the value of a cash
flow or series of cash flows some time in the
future when compound interest is applied.
The amount to which a cash flow or series of cash
flows will grow over a given period of time when
compounded at a given interest rate
Interest earned on interest
FVn PV(1 i)
Time
0 5%
5.00
5.25
5.51
5.79
6.08
Total Value 105.00
110.25
-100
Interest
115.76 121.55 127.63
FVn = PV(1 + i)n = PV(FVIFi,n)
Period (n)
1
2
3
4
5
6
4%
1.0400
1.0816
1.1249
1.1699
1.2167
1.2653
5%
6%
1.0500
1.1025
1.1576
1.2155
1.2763
1.3401
1.0600
1.1236
1.1910
1.2625
1.3382
1.4185
For $100 at i = 5% and n = 5 periods
FVn = PV(1 + i)n = PV(FVIFi,n)
Period (n)
1
2
3
4
5
6
4%
1.0400
1.0816
1.1249
1.1699
1.2167
1.2653
5%
6%
1.0500
1.1025
1.1576
1.2155
1.2763
1.3401
1.0600
1.1236
1.1910
1.2625
1.3382
1.4185
For $100 at i = 5% and n = 5 periods
$100 (1.2763) = $127.63
Five keys for variable input
N = the number of periods
I = interest rate per period
may be I, INT, or I/Y
PV = present value
PMT = annuity payment
FV = future value
Find the future value of $100 at 5%
interest per year for five years
1. Numerical Solution:
Time
5%
Cash
-100
Flows
5.00
5.25
5.51
4
5.79
5
6.08
Total Value 105.00 110.25 115.76 121.55 127.63
FV5 = $100(1.05)5 = $100(1.2763) = $127.63
2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PV = -100 PMT = 0 FV = ?
Output: = 127.63
Relationship among Future Value, Growth
or Interest Rates, and Time
Future Value of $1
i= 15%
i= 10%
i= 5%
2
1
0
i= 0%
8
10
Periods
The present value is the value today of a
future cash flow or series of cash flows
The process of finding the present value is
discounting, and is the reverse of
compounding
Opportunity
cost becomes a factor in
discounting
Start with future value:
FVn = PV(1 + i)n
FVn
1
PV
FVn
n
n
(1 i)
1 i
Find the present value of $127.63 in five
years when the opportunity cost rate is 5%
1. Numerical Solution:
0
5% 1
PV = ? 1.05
1.05
1.05
-100.00 105.00
110.25
115.76
4
1.05
5
127.63
121.55
$127.63 $127.63
PV
$127.63(0.7835) $100
5
1.2763
1.05
Find the present value of $127.63 in five
years when the opportunity cost rate is 5%
2. Financial Calculator Solution:
Inputs: N = 5 I = 5 PMT = 0 FV = 127.63 PV = ?
Output: = -100
Relationship among Present Value, Interest
Rates,
Present
Value and
of $1 Time
i= 0%
0.8
0.6
i= 5%
0.4
i= 10%
0.2
0
i= 15%
10
12
14
16
18
Periods
20
An annuity is a series of payments of an
equal amount at fixed intervals for a
specified number of periods
Ordinary (deferred) annuity has
payments at the end of each period
Annuity due has payments at the
beginning of each period
FVAn is the future value of an annuity
over n periods
The future value of an annuity is the
amount received over time plus the interest
earned on the payments from the time
received until the future date being valued
The future value of each payment can be
calculated separately and then the total
summed
If you deposit $100 at the end of each year
for three years in a savings account that
pays 5% interest per year, how much will
you have at the end of three years?
5%
100
100
3
100.00 = 100 (1.05)0
105.00 = 100 (1.05)1
110.25 = 100 (1.05)2
315.25
FVA n PMT(1 i) 0 PMT(1 i)1 PMT(1 i)n -1 PMT
PMT
t 1
1 i
n -1
t 0
1 i t
1 i n 1
PMT
nt
1.05 3 1
FVA 3 $100
$100(3.1525) $315.25
0.05
If the three $100 payments had been made
at the beginning of each year, the annuity
would have been an annuity due.
Each payment would shift to the left one
year and each payment would earn interest
for an additional year (period).
$100 at the start of each year
0
100
5%
100
100
105.00
= 100 (1.05)1
110.25
= 100 (1.05)2
115.7625 = 100 (1.05)3
331.0125
Numerical solution:
1 i
FVA(DUE) n PMT
t 1
PMT 1 i 1 i
t 1
1 i n 1
PMT
1 i
i
n -t
Numerical solution:
1.05 3 1
FVA(DUE) n $100
1.05
0.05
$100 3.1525 1.05
$331.0125
If you were offered a three-year annuity
with payments of $100 at the end of each
year
Or a lump sum payment today that you
could put in a savings account paying 5%
interest per year
How large must the lump sum payment
be to make it equivalent to the annuity?
0
100
95.238
1
1.05
100
90.703
2
1.05
100
86.384
3
1.05
272.325
5%
100
100
100
Numerical solution:
PVA n PMT
1 i
PMT
PMT
1 i
t 1
1 i
PMT
1 i
PVA n PMT
1 i
PMT
1 i
PMT
PMT
n
1 i
n
1
1 i n
PMT
t
t 1 1 i
i
1
1
1.05
$100(2.7232) $272.32
$100
0.05
Payments at the beginning of each year
Payments all come one year sooner
Each payment would be discounted for
one less year
Present value of annuity due will exceed
the value of the ordinary annuity by one
years interest on the present value of the
ordinary annuity
0
100
1.05
100
1.05
1.05
1
1.05
1
100
1.05
1.05
100
1.05
100
1.05
1.05
100
5%
100.000 100
95.238
90.703
285.941
2
100
Numerical solution:
PVA(DUE) n PMT
n -1
PMT
t 0 1 i
t 1
1 i
1 i n
PMT
1 i
i
1 i
PV(DUE) 3 $100
1 1.05 3
0.05
1.05
$100 [(2.72325)(1.05)]
$100 (2.85941)
$285.941
Perpetuity - a stream of equal payments
expected to continue forever
Consol - a perpetual bond issued by the
British government to consolidate past
debts; in general, and perpetual bond
Payment
PMT
PVP
Interest Rate
i
Uneven cash flow stream is a series of cash
flows in which the amount varies from one
period to the next
Payment (PMT) designates constant cash
flows
Cash Flow (CF) designates cash flows in
general, including uneven cash flows
PV of uneven cash flow stream is the sum of
the PVs of the individual cash flows of the
stream
PV CF1
1 i
t 1
CFt
CF2
1 i
1 i
CFn
1 i
Terminal value is the future value of an
uneven cash flow stream
FVn CF1 1 i n -1 CF2 1 i n - 2 CFn 1 i 0
t 1
CFt 1 i n - t
Loans that are repaid in equal payments
over its life
Borrow $15,000 to repay in three equal
payments at the end of the next three
years, with 8% interest due on the
outstanding loan balance at the beginning
of each year
8%
15,000
PMT
PMT
PVA 3
$15,000
PMT
1 i
PMT
1 i
PMT
t 1
1 i t
t 1
PMT
1.08
3
PMT
PMT
1 i 3
Numerical Solution:
PMT
$15,000
PMT
t
t 1 1.08
1
PMT
t 1 1.08
3
$15,000 PMT 2.5771
$15,000
PMT
$5,820.50
2.5771
1
11.08 3
0.08
Year
1
2
3
Beginning
Amount
(1)
Repayment Remainin
of Principalb g Balance
(1)-(4)=(5)
(2)-(3)=(4)
Amortization Schedule shows how a loan
will
be repaid
with a$breakdown
of
interest
$ 15,000.00
$
5,820.50
1,200.00
$
4,620.50
$ 10,379.50
10,379.50
5,820.50
830.36
4,990.14
5,389.36
and 5,389.36
principle 5,820.50
on each payment
date
431.15
5,389.35
0.01
Payment
(2)
Interesta
(3)
Interest is calculated by multiplying the loan balance at the
beginning of the year by the interest rate. Therefore, interest in Year
1 is $15,000(0.08) = $1,200; in Year 2, it is
$10,379.50(0.08)=$830.36; and in Year 3, it is $5,389.36(0.08) =
$431.15 (rounded).
a
Repayment of principal is equal to the payment of $5,820.50 minus
the interest charge for each year.
b
The $0.01 remaining balance at the end of Year 3 results from
rounding differences.
c
