Time Value of Money

Time Value
of
Money

Concept Compounding Future Present Investment Annuity Perpetuity Effective

Value Value Period Annual
(FV) (PV) Rate
(EAR)

Continuous Ordinary Annuity

Compounding Annuity Due

1. The Time Value of Money

Why money has time value?

Money received today is worth more than the same sum received in the future, i.e. it
has a time value.
This occurs for three reasons:
(a) potential for earning interest (cost of finance)
(b) impact of inflation
(c) effect of risk.

Compounding

EXAMPLE 1
An investment of $100 is to be made today. What is the value of the investment after
two years if the interest rate is 10%?

Solution:

The formula for calculating the future value (FV) of a sum is:

FV = P (1 + r)n
FV = $100 (1 + 10%)2 = $121
Sometimes financial transactions take place on the basis that interest will be calculated
more frequently than once a year.

EXAMPLE 2
If you put $100 in a bank account earning 12% per annum, then your return after
one year is:
FV = $100 (1 + 12%) = $112

If the interest is compounded semi-annually, then your return after one year is: FV =
$100 (1 + 12%/2)2 = $112.36

If the interest is compounded quarterly, then

FV = $100 (1 + 12%/4)4 = $112.55

If the interest is compounded daily, then

FV = $100 (1 + 12%/365)365 = $112.75

Continuous compounding/ Future value

If the compounding frequency is taken to the limit we say that there is continuous
compounding. When the number of compounding periods approaches infinity the
future value is found by

FV = P ein

Where e is the value of the exponential function. This is set as 2.71828.

EXAMPLE 3
The future value of $100 deposited in a bank paying 12% nominal compounded
continuously after eight years is:

$100 2.718280.12x8 = $261.17

Present values

Present value (PV) is the cash equivalent now of a sum of money receivable or
payable at a stated future date, discounted at a specified rate of return.
Discounting starts with the future value, and converts a future value to a present value.
 EXAMPLE 4
If a company expects to earn a (compound) rate of return of 10% on investments,
how much would it need to invest now to have the following investments?
(a) $11,000 after 1 year
(b) $12,100 after 2 years
(c) $13,310 after 3 years

Solution:

The discounting formula to calculate the present value of a future sum of money at
the end of n time periods is:

1
PV FV
(1 r ) n

1
(a) PV1 $11,000 $10,000
(1 10%)
1
(b) PV2 $12,100 $10,000
(1 10%) 2
1
(c) PV3 $13,310 $10,000
(1 10%) 3

Determining the investment period

Rearranging the standard equation so that we can find n (the number of years of the
investment), we create the following equation:

FV PV (1 r ) n
FV
(1 r ) n
PV
FV
log n log(1 r )
PV
FV
log
PV
n
log(1 r )
1.5.2 EXAMPLE 5
How many years does it take for $10 to grow to $17.62 when the interest rate is
12%?

Solution:

log(17.62 10)
n 5 years
log(1 0.12)

Annuities

Quite often there is not just one payment at the end of a certain number of years. There
can be a series of identical payments made over a period of years. For example, $100
paid at the end of each of the next years is a 3-year annuity.
If payments occur at the end of each period, then we have an ordinary (or deferred)
annuity. Payments on mortgages, car loans, and student loans are examples of
ordinary annuities.
If the payments are made at the beginning of each period, then we have an annuity
due. Rental payments for an apartment, life insurance premiums, and lottery payoffs
are examples of annuities due.

EXAMPLE 6
Here are the time lines for a $100, 3-year, 5%, ordinary annuity and for the same
annuity on an annuity due basis. With the annuity due, each payment is shifted back
to the left by 1 year.
 (a) Future value of ordinary annuity
FVA3 = 100 + 100 (1 + 5%) + 100 (1 + 5%)2
= 315.25
(b) Future value of annuity due
FVAdue = 100 (1 + 5%) + 100 (1 + 5%)2 + 100 (1 + 5%)3
= 331.01

From the above calculation, we can find that:

FVAdue = FVAordinary (1 + r)

(c) Present value of ordinary annuity

100 100 100
PVA3 = 2
= 272.32
(1 5%) (1 5%) (1 5%) 3
(d) Present value of annuity due
100 100
PVAdue = 100 = 285.94
(1 5%) (1 5%) 2

Similarly, we can find that:

PVAdue = PVAordinary (1 + r)

1.7 Perpetuities

1.7.1 Some contracts run indefinitely and there is no end to a series of identical payments.
Perpetuities are rare in the private sector, but certain government securities do not have
an end date; that is, the amount paid when the bond was purchased by the lender will
never be repaid, only interest payments are made.
1.7.2 For example, the UK government has issued Consolidated Stocks or War Loans which
will never be redeemed.
1.7.3 The value of a perpetuity is simply the annual amount received divided by the interest
rate when the latter is expressed as a decimal.

Cash Flows
PV of perpetuity =
r
1.7.4 EXAMPLE 7
If $10 is to be received as an indefinite annual payment then the present value, at a
discount rate of 12%, is:

10
PV = = $83.33
12%

2. Annual Percentage Rate

Sometimes you are presented with a monthly or daily rate of interest and wish to know
what that is equivalent to in terms of annual percentage rate (APR) or effective annual
rate (EAR).

EXAMPLE 8
If m is the monthly interest or discount rate, then over 12 months:

(1 + m)12 = 1 + i, where i is the annual compound rate.

i = (1 + m)12 1

If a credit card company charges 1.5% per month, the APR is:
i = (1 + 0.015)12 1 = 19.56%

For daily rate: (1 + d)365 = 1 + i