BSNS108

Time Value of Money I

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Time Value of Money I
Dr. Helen Roberts (Finance)
Key Concepts/Skills
What is the...
future value of an investment made now?
present value of cash to be received in the future?
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interest rate?
timing of a cash flow/series of cash flows?
Interest Rate
Interest rate: an exchange rate between
present values & future values. Examples:
saving (earn) or loan (pay) rates at bank
a required return on an investment
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a required return on an investment
an actual realized return on an investment
cost of capital or discount rate in Project
Evaluation
Future Value (FV)
Invest $1000 for 1 year at 5% per year. What
is the FV of the investment in one year?
FV = Principal + Interest
Principal = $1,000
Interest = $1,000 x 0.05 = $50
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Interest = $1,000 x 0.05 = $50
So, FV = $1,000 + $50 = $1,050,
or
FV = $1,000 x (1 + 0.05)
= $1,000 x 1.05 = $1,050
Future Value (FV)
leave the money invested for a second
year. What is the FV after 2 years?
FV = [balance after 1 year] x 1.05
= [$1,000 x 1.05] x 1.05
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= [$1,000 x 1.05] x 1.05
= $1,000 x (1.05)
2
= $1,102.50
What if the interest rate = 7.5%?
FV: General Formula
FV = PV x (1 + r)
t
r = interest rate per period
t = number of periods
Future value interest factor = (1 + r)
t
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Future value interest factor = (1 + r)
multiplies PV to give FV,
assumes r is constant
Need the x
y
(or ^ ) key on your calculator
Compounding
In previous example, your FV was:
FV= $1,102.50 = $1,000 + $50 + $50 +$2.50
FV= Principal + simple interest for two years,
plus interest on the interest
Compound interest means you earn interest
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Compound interest means you earn interest
on both principal and on earned interest
FV of $100 invested @ 10% for 5 years?
FV = $
How much of this is simple interest?
Figure 4.1
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Future Value (FV)
Compounding implies that FV increases
as the number of periods increases.
KiwiSaver Example #1:
Newborn Baby opens KS account; deposits
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Newborn Baby opens KS account; deposits
$1,000 & gets $1,000 Kick-Start from IRD
Invests in ING Growth Fund; assume r=10%.
Make no other contributions
At age 18 this is worth FV=
Present Value (PV)
How much do I have to invest today to have a
quoted dollar amount in the future?
Rearrange FV = PV x (1 + r)
t
...to solve for PV = FV / (1 + r)
t
When we talk about discounting, we mean
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When we talk about discounting, we mean
finding the PV of some future amount.
When we talk about the value of something, we
usually mean the PV unless we specifically
indicate that we want the FV or value at some
other date.
Example (PV; 1-period)
You need $10,000 in one year to buy a car.
You can earn 7% per annum. How much do
you need to invest today to meet your goal?
PV = $10,000 / (1.07)
1
= $9,345.79
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PV = $10,000 / (1.07)
1
= $9,345.79
What is the PV if you can earn 12% p.a.?
PV= ...have a guess first!
Example (PV; t-period)
It is 2009. My 2-year old wants to go to Harvard
(a private U.S. university) starting 2025 (in 16
yrs). Estimated FV of costs is USD614,050.

I can earn 6% p.a., how big is the lump sum I

need to deposit now in the U.S. to pay for this?
PV = USD614,050/ (1.06)
16
=USD127,076.40
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PV = USD614,050/ (1.06)
16
=USD127,076.40
Quiz: what about a state school then:
FV=USD171,564; PV=?
http://www.admissions.college.harvard.edu/financial_aid/cost.html : cost now (2009) = USD52,000. I assumed growth
at 7% per annum, and then paid for up front as simply 4 years times this future number..
PV Relationship I
What impact does timing t have on PV of a
future cash flow?
Given FV & interest rate r (both positive),
longer time period t implies lower PV
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longer time period t implies lower PV
e.g., What is the value today of a $500 gift to be received in
5 or 10 years (discount rate 10%)?:
In 5 years: PV = $500 / (1.10)
5
= $310.46
In 10 years: PV = $500 / (1.10)
10
= $192.77
PV Relationship II
What impact does interest rate r have on
the deposit I need to reach a fixed goal?
For a given (positive) FV & time period t,
higher interest rate r implies lower PV:
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higher interest rate r implies lower PV:
Goal of $500 in 5 years; two interest rates:
Rate = 10%: PV = $500 / (1.10)
5
= $310.46
Rate = 15%; PV = $500 / (1.15)
5
= $248.59
PV/FV Relation
FV = PV x (1+r)
t
PV = FV / (1 + r)
t
There are four parts to this equation
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There are four parts to this equation
PV, FV, r, and t
If we know any three, we can solve for
the fourth
Draw a time line!
Discount Rate (r)
Often we want to know the implied
interest rate for an investment
Take the FV equation:
FV = PV x (1 + r)
t
and rearrange to get
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FV = PV x (1 + r) and rearrange to get
r = (FV / PV)
1/t
1
Now need both the y
x
and the 1/x keys
Discount Rate (r) Example
An investment pays $1,200 in 5 years if
you deposit $1,000 today. What is the
implied rate of interest r per annum?
r = (FV / PV)
1/t
1
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= (1,200 / 1,000)
1/5
1
= .03714
= 3.714%
Check! Use FV=PV x (1+r)
t
to confirm
Solve for Number of Periods (t)
Start with basic equation and solve for t
FV = PV(1 + r)
t
[divide both sides by PV]: (FV/PV) = (1 + r)
t
[take log of both sides]: ln(FV/PV)= ln[(1 + r)
t
]
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[take log of both sides]: ln(FV/PV)= ln[(1 + r) ]
[recall property of logs: ln[y
a
]=a* ln(y)]
[so move t down]: ln(FV/PV)= t * ln(1 + r)
[now divide both sides by ln(1+r)]:
t = ln(FV / PV) / ln(1 + r)
Number of Periods (t) Example
You are willing to pay $20,000 for a car.
You have $15,000. You can earn 10% p.a.
How long until you can buy the car?
t = ln(FV / PV) / ln(1 + r)
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t = ln(FV / PV) / ln(1 + r)
= ln(20,000 / 15,000) / ln(1.10)
= 3.02 years (just over 3 yrs)
Now check it!
Summary of TVM I
t
r PV FV ) 1 ( + =
PV =
1

=
t
FV
ln
PV
FV

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t
r
FV
PV
) 1 ( +
=
1

=
t
PV
FV
r
) 1 ln( r
PV
t
+

=
Always draw a time line!
Always have a guess!
Always write down the formula!
Always check your answer! END
Worked Example (PV)
A relative set up a trust fund for you 10
years ago. It is now worth $19,671.51. If
the fund earned 7% per year, how much
did your relative invest?
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did your relative invest?
Draw a time line!
What do we know: FV, PV, r, t ?
PV = $19,671.51 / (1.07)
10
= $10,000
Worked Example (r)
An investment will double your money in 6
years. You have $10,000 to invest. What
is the implied interest or discount rate?
r = (FV / PV)
1/t
1
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= (20,000 / 10,000)
1/6
1
= .122462
= 12.25% p.a.
Check! Use FV=PV x (1+r)
t
to confirm
Worked Example (r)
US private college example again. Cost is
USD614,050 in 16 years. If I have only
USD50,000 to invest, what interest rate
p.a. will get me to my goal?
r = (FV / PV)
1/t
1
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r = (FV / PV) 1
= (614,050/50,000)
1/16
1
= 0.1697071
16.97%
What should you do now? Ch... !
Worked Example (t)...
You want to buy a $150,000 house some
time in the future. You need a 10% down
payment in cash plus 5% (of the loan) in
closing costs in cash. You have $15,000
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closing costs in cash. You have $15,000
in the bank, and you can earn 7.5% p.a.
interest. How long until you have enough
cash for the down payment and closing
costs?
...Example (t) Continued
How much do you need to have in the future?
Down payment = .10 x (150,000) = $15,000
Closing costs = .05 x (150,00015,000) = $6,750
Total needed = $15,000 + $6,750 = $21,750
Using the formula
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Using the formula
t = ln($21,750 / $15,000) / ln(1.075)
= 5.14 years (just over 5 years)
What should you do now? ...
Extra Problems (FV & PV)
Find the FV of a $2,000 deposit that earns
simple interest only at 12% p.a. for 3 years.
What is the FV if the interest is compounded for 3
years at 12% p.a.?
Find the PV of $10,000 to be received in 8 years
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Find the PV of $10,000 to be received in 8 years
time if the discount rate is 9% p.a.
What if the payment is in 12 years?
At 8% interest p.a. how long does it take to triple
your money?
Extra Problem
You have $10,000 to deposit. Which
option gives you the best return if the
money is left for 9 years:
a) 12% per year compounded monthly?
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a) 12% per year compounded monthly?
b) 12% compounded annually?