Time Value of Money

The time value of money is money's potential to grow in value over time and this growth
is associated with the expected return form investment of money. Because of this
potential, money that's available in the present is considered more valuable than the same
amount in the future. For example, if you were given !"" today and invested it at an
annual rate of only !#, it could be worth !"! at the end of one year, which is more than
you'd have if you received !"" at that point. $fter all, you should receive some
compensation for foregoing spending. %f you invest ! dollar for one year at a &# annual
interest rate you can say that the future value of the dollar is !."& given a &# interest
rate and a one'year period. %t follows that the present value of the !."& you expect to
receive in one year is only !.
The time value of money can be used to calculate how much you need to invest now to
meet a certain future goal.
%nflation has the reverse effect on the time value of money. Because of the constant
decline in the purchasing power of money, an uninvested dollar is worth more in the
present than the same uninvested dollar will be in the future.
Time (alue of )oney *T()+ is an important concept in financial management. %t can be
used to compare investment alternatives and to solve problems involving loans,
mortgages, leases, savings, and annuities.
$ ,ey concept of T() is that a single sum of money or a series of e-ual, evenly'spaced
payments or receipts promised in the future can be converted to an e-uivalent value
today. .onversely, you can determine the value to which a single sum or a series of
future payments will grow to at some future date.
Calculations
/ou can calculate the fifth value if you are given any four of0 %nterest 1ate, 2umber of
3eriods, 3ayments, 3resent (alue, and Future (alue. 4ach of these factors is very briefly
defined in the right'hand column below. The left column has references to more detailed
explanations, formulas, and examples.
%nterest
Simple
Compou
nd
%nterest is a charge for borrowing money, usually stated as a percentage of the
amount borrowed over a specific period of time. Simple interest is computed
only on the original amount borrowed. %t is the return on that principal for one
time period. %n contrast, compound interest is calculated each period on the
original amount borrowed plus all unpaid interest accumulated to date.
.ompound interest is always assumed in T() problems.
2umber of
3eriods
3eriods are evenly'spaced intervals of time. They are intentionally not stated
in years since each interval must correspond to a compounding period for a
single amount or a payment period for an annuity.
3ayments

3ayments are a series of e-ual, evenly'spaced cash flows. %n T()
applications, payments must represent all outflows *negative amount+ or all
inflows *positive amount+.
3resent (alue Present Value is an amount today that is e-uivalent to a future payment, or
Single
Amount
Annuity
series of payments, that has been discounted by an appropriate interest rate.
The future amount can be a single sum that will be received at the end of the
last period, as a series of e-ually'spaced payments *an annuity+, or both. 5ince
money has time value, the present value of a promised future amount is worth
less the longer you have to wait to receive it.
Future (alue
Single
Amount
Annuity
Future Value is the amount of money that an investment with a fixed,
compounded interest rate will grow to by some future date. The investment
can be a single sum deposited at the beginning of the first period, a series of
e-ually'spaced payments *an annuity+, or both. 5ince money has time value,
we naturally expect the future value to be greater than the present value. The
difference between the two depends on the number of compounding periods
involved and the going interest rate.
6oan
$morti7a
tion
$ method for repaying a loan in e-ual installments. 3art of each payment goes
toward interest and any remainder is used to reduce the principal. $s the
balance of the loan is gradually reduced, a progressively larger portion of each
payment goes toward reducing principal.
.ash Flow
8iagram
$ cash flow diagram is a picture of a financial problem that shows all cash
inflows and outflows along a time line. %t can help you to visuali7e a problem
and to determine if it can be solved by T() methods.
Investing For a Single Period:
5uppose you invest !"" in a savings account that pays !" percent interest per year. 9ow
much will you have in one year: /ou will have !!". This !!" is e-ual to your original
principal of !"" plus !" in interest. ;e say that !!" is the future value of !""
invested for one year at !" percent, meaning that !"" today is worth !!" in one year,
given that the interest rate is !" percent.
%n general, if you invest for one period at an interest rate r, your investment will grow to
(1 + r) per dollar invested. %n our example, r is !" percent, so your investment grows to 1
+ .10 = 1.10 dollars per dollar invested. /ou invested !"" in this case, so you ended up
with $100 x 1.10 = $110.
Investing For More Than One Period:
.onsider your !"" investment that has now grown to !!". %f you ,eep that money in
the ban,, what will you have after two years, assuming the interest rate remains the
same:
/ou will earn $110 x .10 = $11 in interest after the second year, ma,ing a total of $100
+ $11 = $121. This !<! is the future value of !"" in two years at !" percent.
$nother way of loo,ing at it is that one year from now, you are effectively investing
!!" at !" percent for a year. This is a single'period problem, so you will end up with
!.!" for every dollar invested, or $110 x 1.1 = $121 total.
The process of leaving the initial investment plus any accumulated interest in a ban, for
more than one period is reinvesting the interest. This process is called compounding.
.ompounding the interest means earning interest on interest so we call the result
compound interest. ;ith simple interest, the interest is not reinvested, so interest is
earned each period is on the original principal only.
5olve the problems0
a. 5uppose you locate a two'year investment that pays != percent per year. %f you
invest ><?, how much will you have at the end of two years: 9ow much of this
is simple interest: 9ow much is compound interest:
b. 9ow many years a sum of money would ta,e to double itself if the interest rate
applied is !"# p.a compounded annually:
$ll of the standard calculations for time value money derive from the most basic
algebraic expression for the present value of a future sum. The same rate of interest r
used to get future value from a present value can be the discount rate can be used to
convert the future value into present value. For example,
$ sum of F( to be received in one year is F( @ 3( *! A r+
n
, where r is the rate of interest
and n is the number of interest periods *if interest is calculated -uarterly, there will be =
periods in a year and if annually, there is ! period in a year+.
$nd if we have the F(, the present value can be derived as 3( @
F(
B
*! A r+
n
, where *! A r+
is the discount factor and we get 3( by discounting the F(. $lso, 3( is the value at time
@ " and F( is the value at time @ n
The cumulative present value of future cash flows can be calculated by summing the
contributions of FV
t
, the value of cash flow at time@t
2ote that this series can be summed for a given value of n, or when n is C. This is a very
general formula, which leads to several important special cases given below.
Present value of an annuity (immediate) for n payment periods
%n this case the cash flow values remain the same throughout the n periods. The present
value of an annuity *3($+ formula has four variables, each of which can be solved for0
!. 3(*$+ is the value of the annuity at time@"
<. $ is the value of the individual payments in each compounding period
>. i e-uals the interest rate that would be compounded for each period of time
=. n is the number of payment periods.
To get the 3( of an annuity due, multiply the above e-uation by *! A i+.
Present value of a growing annuity
%n this case each cash flow grows by a factor of *!Ag+. 5imilar to the formula for an
annuity, the present value of a growing annuity *3(D$+ uses the same variables with the
addition of g as the rate of growth of the annuity *$ is the annuity payment in the first
period+. This is a calculation that is rarely provided for on financial calculators.
Were i ! g "
To get the 3( of a growing annuity due, multiply the above e-uation by *! A i+.
Were i # g "
Present value of a perpetuity
;hen n E C, the 3( of a perpetuity *a perpetual annuity+ formula becomes simple
division.
;hen this is an increasing perpetuity, this i becomes i !Ai@*!Ai+B*!Ag+ i@*i'g+B*!Ag+
so $Bi @ $ x *!Ag+B*i'g+ not *$B*i'g++
Present value of a growing perpetuity
;hen the perpetual annuity payment grows at a fixed rate *g+ the value is theoretically
determined according to the following formula. %n practice, there are few securities with
precisely these characteristics, and the application of this valuation approach is subFect to
various -ualifications and modifications. )ost importantly, it is rare to find a growing
perpetual annuity with fixed rates of growth and true perpetual cash flow generation.
8espite these -ualifications, the general approach may be used in valuations of real
estate, e-uities, and other assets.
This is the well ,nown Dordon Drowth model used for stoc, valuation.
Future value of a present sum
The future value *F(+ formula is similar and uses the same variables.
Future value of an annuity (immediate)
The future value of an annuity *F($+ formula has four variables, each of which can be
solved for0
!. FV*A+ is the value of the annuity at time @ n
<. A is the value of the individual payments in each compounding period
>. i is the interest rate that would be compounded for each period of time
=. n is the number of payment periods
To get the F( of an annuity due, multiply the above e-uation by *! A i+.
Future value of a growing annuity
The future value of a growing annuity *F($+ formula has five variables, each of which
can be solved for0
Were i ! g "
Were i # g "
!. FV*A+ is the value of the annuity at time @ n
<. A is the value of initial payment at time "
>. i is the interest rate that would be compounded for each period of time
=. g is the growing rate that would be compounded for each period of time
?. n is the number of payment periods
$erivations
Annuity derivation
The formula for the present value of a regular stream of future payments *an annuity+ is
derived from a sum of the formula for future value of a single future payment, as below,
where C is the payment amount and n the period.
$ single payment . at future time m has the following future value at future time n0
5umming over all payments from time ! to time n, then reversing the order of terms and
substituting k @ n G m0
2ote that this is a geometric series, with the initial value being a @ C, the multiplicative
factor being ! A i, with n terms. $pplying the formula for geometric series, we get
The present value of the annuity *3($+ is obtained by simply dividing by *! A i+
n
0
$nother simple and intuitive way to derive the future value of an annuity is to consider an
endowment, whose interest is paid as the annuity, and whose principal remains constant.
The principal of this hypothetical endowment can be computed as that whose interest
e-uals the annuity payment amount0
3rincipal @ CBi A goal
2ote that no money enters or leaves the combined system of endowment principal A
accumulated annuity payments, and thus the future value of this system can be computed
simply via the future value formula0
FV @ PV*! A i+
n
%nitially, before any payments, the present value of the system is Fust the endowment
principal *PV @ C B i+. $t the end, the future value is the endowment principal *which is
the same+ plus the future value of the total annuity payments *FV @ C B i A FVA+.
3lugging this bac, into the e-uation0
Perpetuity derivation
;ithout showing the formal derivation here, the perpetuity formula is derived from the
annuity formula. 5pecifically, the term0
can be seen to approach the value of ! as n grows larger. $t infinity, it is e-ual to !,
leaving as the only term remaining.
%&amples
%&ample '" Present value
Hne hundred euros to be paid ! year from now, where the expected rate of return is ?#
per year, is worth in today's money0
5o the present value of I!"" one year from now at ?# is IJ?.<>.
%&ample (" Present value of an annuity ) solving for te payment amount
.onsider a !" year mortgage where the principal amount P is <"",""" and the annual
interest rate is &#.
The number of monthly payments is
and the monthly interest rate is

The annuity formula for *ABP+ calculates the monthly payment0
%&ample *" Solving for te period needed to dou+le money
.onsider a deposit of !"" placed at !"# *annual+. 9ow many years are needed for the
value of the deposit to double to <"":
Ksing the algrebraic identity that if0
Then
The present value formula can be rearranged such that0
*years+
This same method can be used to determine the length of time needed to increase a
deposit to any particular sum, as long as the interest rate is ,nown. For the period of time
needed to double an investment, the Rule of ! is a useful shortcut that gives a
reasonable approximation of the period needed.
%&ample ," Wat return is needed to dou+le money-
5imilarly, the present value formula can be rearranged to determine what rate of return is
needed to accumulate a given amount from an investment. For example, !"" is invested
today and <"" return is expected in five yearsL what rate of return *interest rate+ does
this represent:
The present value formula restated in terms of the interest rate is0
see also Rule of !
%&ample ." Calculate te value of a regular savings deposit in te future/
To calculate the future value of a stream of savings deposit in the future re-uires two
steps, or, alternatively, combining the two steps into one large formula. First, calculate
the present value of a stream of deposits of !,""" every year for <" years earning M#
interest0
This does not sound li,e very much, but remember ' this is future mne! discounted bac,
to its value t"a!L it is understandably lower. To calculate the future value *at the end of
the twenty'year period+0
These steps can be combined into a single formula0
%&ample 0" Price1earnings (P1%) ratio
%t is often mentioned that perpetuities, or securities with an indefinitely long maturity, are
rare or unrealistic, and particularly those with a growing payment. %n fact, many types of
assets have characteristics that are similar to perpetuities. 4xamples might include
income'oriented real estate, preferred shares, and even most forms of publicly'traded
stoc,s. Fre-uently, the terminology may be slightly different, but are based on the
fundamentals of time value of money calculations. The application of this methodology is
subFect to various -ualifications or modifications, such as the Dordon growth model.
For example, stoc,s are commonly noted as trading at a certain 3B4 ratio. The 3B4 ratio is
easily recogni7ed as a variation on the perpetuity or growing perpetuity formulae ' save
that the 3B4 ratio is usually cited as the inverse of the NrateN in the perpetuity formula.
%f we substitute for the time being0 the price of the stoc, for the present valueL the
earnings per share of the stoc, for the cash annuityL and, the discount rate of the stoc,
for the interest rate, we can see that0
$nd in fact, the 3B4 ratio is analogous to the inverse of the interest rate *or discount rate+.
Hf course, stoc,s may have increasing earnings. The formulation above does not allow
for growth in earnings, but to incorporate growth, the formula can be restated as follows0
%f we wish to determine the implied rate of growth *if we are given the discount rate+, we
may solve for g0
Time value of money formulas wit continuous compounding
1ates are sometimes converted into the continuous compound interest rate e-uivalent
because the continuous e-uivalent is more convenient *for example, more easily
differentiated+. 4ach of the formulO above may be restated in their continuous
e-uivalents. For example, the present value at time " of a future payment at time t can be
restated in the following way, where e is the base of the natural logarithm and r is the
continuously compounded rate0
5ee below for formulaic e-uivalents of the time value of money formulO with continuous
compounding.
Present value of an annuity
Present value of a perpetuity
Present value of a growing annuity
Present value of a growing perpetuity
Present value of an annuity wit continuous payments
2ption Time value
%n finance, the value of an option consists of two components, its intrinsic value and its
time value. Time value is simply the difference between option value and intrinsic value.
Time value is also ,nown as theta, extrinsic value, or instrumental value.
3ntrinsic value
Hption (alue
3ntrinsic value is the greater of 7ero and the difference between the exercise price of the
option *stri,e price, 4+ and the current value of the underlying instrument *spot price, S+L
see formulae below. %f the option does not have positive monetary value, it is referred to
as out'the'money. %f an option is out'the'money at expiration, its holder will simply
Nabandon the optionN and it will expire worthless. Because the option owner will never
choose to lose money by exercising, an option will never have a value less than 7ero.
For a call option0 value @ )ax P *5 Q R+, " S
For a put option0 value @ )ax P *R Q 5+, " S
$s seen on the graph, the call option's intrinsic value begins when the underlying asset's
spot price exceeds the option's stri,e price.
2ption value
2ption value *i.e. price+ is found via a formula such as Blac,'5choles or using a
numerical method such as the Binomial model. This price will reflect the Nli,elihoodN of
the option finishing Nin'the'moneyN. For an out'the'money option, the further in the
future the expiration date ' i.e. the longer the time to exercise ' the higher the chance of
this occurring, and thus the higher the option priceL for an in'the'money option the
chance in the money "ecreasesL however the fact that the option cannot have negative
value also wor,s in the owner's favor. The sensitivity of the option value to the amount of
time to expiry is ,nown as the option's NthetaNL see The Dree,s. The option value will
never be lower than its intrinsic value.
$s seen on the graph, the full call option value *intrinsic and time value+ is the red line.
Time value
Time value is, as above, the difference between option value and intrinsic value, i.e.
Time (alue @ Hption (alue ' %ntrinsic (alue.
)ore specifically, an option's time value captures the possibility, however remote, that
the option may increase in value due to volatility in the underlying asset. 2umerically,
this value depends on the time until the expiration date and the volatility of the
underlying instrument's price. The time value of an option is always positive and declines
exponentially with time, reaching 7ero at the expiration date. $t expiration, where the
option value is simply its intrinsic value, time value is 7ero. 3rior to expiration, the
change in time value with time is non'linear, being a function of the option price.
$iscounting
$iscounting is a financial mechanism in which a debtor obtains the right to delay
payments to a creditor, for a defined period of time, in exchange for a charge or fee.
4ssentially, the party that owes money in the present purchases the right to delay the
payment until some future date. The discount, or carge, is simply the difference
between the original amount owed in the present and the amount that has to be paid in the
future to settle the debt.
The discount is usually associated with a "iscunt rate, which is also called the "iscunt
!iel". The discount yield is simply the proportional share of the initial amount owed
*initial liability+ that must be paid to delay payment for ! year.
8iscount /ield @ N.hargeN to 8elay 3ayment for ! year B 8ebt 6iability
%t is also the rate at which the amount owed must rise to delay payment for ! year.
5ince a person can earn a return on money invested over some period of time, most
economic and financial models assume the N8iscount /ieldN is the same as the 1ate of
1eturn the person could receive by investing this money elsewhere *in assets of similar
ris,+ over the given period of time covered by the delay in payment. The .oncept is
associated with the Hpportunity .ost of not having use of the money for the period of
time covered by the delay in payment. The relationship between the N8iscount /ieldN and
the 1ate of 1eturn on other financial assets is usually discussed in such economic and
financial theories involving the inter'relation between various )ar,et 3rices, and the
achievement of 3areto Hptimality through the operations in the .apitalistic 3rice
)echanism, as well as in the discussion of the N4fficient *Financial+ )ar,et 9ypothesisN.
The person delaying the payment of the current 6iability is essentially compensating the
person to whom heBshe owes money for the lost revenue that could be earned from an
investment during the time period covered by the delay in payment. $ccordingly, it is the
relevant N8iscount /ieldN that determines the N8iscountN, and not the other way around.
$s indicated, the 1ate of 1eturn is usually calculated in accordance to an annual return
on investment. 5ince an investor earns a return on the original principle amount of the
investment as well as on any prior period %nvestment income, investment earnings are
NcompoundedN as time advances. Therefore, considering the fact that the N8iscountN must
match the benefits obtained from a similar %nvestment $sset, the N8iscount /ieldN must
be used within the same compounding mechanism to negotiate an increase in the si7e of
the N8iscountN whenever the time period the payment is delayed is extended. The
T8iscount 1ateU is the rate at which the T8iscountU must grow as the delay in payment is
extended. This fact is directly tied into the NTime (alue of )oneyN and its calculations.
The NTime (alue of )oneyN indicates there is a difference between the NFuture (alueN of
a payment and the N3resent (alueN of the same payment. The 1ate of 1eturn on
investment should be the dominant factor in evaluating the mar,et's assessment of the
difference between the NFuture (alueN and the N3resent (alueN of a paymentL and it is the
)ar,et's assessment that counts the most. Therefore, the N8iscount /ieldN, which is
predetermined by a related 1eturn on %nvestment that is found in the financial mar,ets, is
what is used within the NTime (alue of )oneyN calculations to determine the N8iscountN
re-uired to delay payment of a financial liability for a given period of time.
5AS3C CA6C76AT328
%f we consider the value of the original payment presently due to be 3, and the debtor
wants to delay the payment for t years, then an r# )ar,et 1ate of 1eturn on a similar
%nvestment $ssets means the NFuture (alueN of 3 is 3 V *! A r#+
t
, and the N8iscountN
would be calculated as
8iscount @ 3 V *!Ar#+
t
' 3
where r# is also the N8iscount /ieldN.
%f F is a payment that will be made t years in the future, then the N3resent (alueN of this
3ayment, also called the N8iscounted (alueN of the payment, is
3 @ F B *!Ar#+
t

%&ample
To calculate the present value of a single cash flow, it is divided by one plus the interest
rate for each period of time that will pass. This is expressed mathematically as raising the
divisor to the power of the number of units of time.
.onsider the tas, to find the present value PV of !"" that will be received in five years.
Hr e-uivalently, which amount of money today will grow to !"" in five years when
subFect to a constant discount rate:
$ssuming a !<# per year interest rate it follows
$iscount rate
The discount rate which is used in financial calculations is usually chosen to be e-ual to
the .ost of .apital. The .ost of .apital, in a financial mar,et e-uilibrium, will be the
same as the )ar,et 1ate of 1eturn on the financial asset mixture the firm uses to finance
capital investment. 5ome adFustment may be made to the discount rate to ta,e account of
ris,s associated with uncertain cash flows, with other developments.
The discount rates typically applied to different types of companies show significant
differences0
5tartups see,ing money0 ?" Q !"" #
4arly 5tartups0 =" Q &" #
6ate 5tartups0 >" Q ?"#
)ature .ompanies0 !" Q <?#
1eason for high discount rates for startups0
1educed mar,etability of ownerships because stoc,s are not traded publicly.
6imited number of investors willing to invest.
5tartups face high ris,s.
Hver optimistic forecasts by enthusiastic founders.
Hne method that loo,s into a correct discount rate is the capital asset pricing model. This
model ta,es in account three variables that ma,e up the discount rate0
!. 9is: Free 9ate0 The percentage of return generated by investing in ris, free
securities such as government bonds.
<. 5eta0 The measurement of how a companys stoc, price reacts to a change in the
mar,et. $ beta higher than ! means that a change in share price is exaggerated
compared to the rest of shares in the same mar,et. $ beta less than ! means that
the share is stable and not very responsive to changes in the mar,et. 6ess than "
means that a share is moving in the opposite of the mar,et change.
>. %;uity Mar:et 9is: Premium0 The return on investment that investors re-uire
above the ris, free rate.
$iscount rate@ ris, free rate A betaV*e-uity mar,et ris, premium+
$iscount factor
The discount factor, 3*T+, is the number which a future cash flow, to be received at time
T, must be multiplied by in order to obtain the current present value. Thus, a fixed
annually compounded discount rate is
For fixed continuously compounded discount rate we have