Topic 5

Time Value of Money

Learning Objectives
To elaborate the concept of time value of money and time line.
To explain the differences between simple interest and
compound interest.
To elucidate the future value of single amount.
To explain the effects of frequent compounding towards future
value amount.
To clarify the differences between effective and nominal interest
rate.
To explain the present value for an amount in the future
To illustrate the calculation of future value and present value for
both ordinary annuity and annuity due.
To calculate the value of uneven cash flows.
To discuss on perpetuity.
To elaborate on the application of time value of money concept
in loan amortization.


Generally, receiving $1 today is worth more
than $1 in the future. This is due to
opportunity costs.
The opportunity cost of receiving $1 in the
future is the interest we could have earned
if we had received the $1 sooner.
Today Future
If we can measure this opportunity
cost, we can:
Translate $1 today into its equivalent in the future
(compounding).




Translate $1 in the future into its equivalent today
(discounting).
?
Today
Future
Today
?
Future
Significance of the time value of money
Time value of money is important in understanding
financial management.
It should be considered for making financial
decisions.
It can be used to compare investment alternatives and
to solve problems involving loans, mortgages, leases,
savings, and annuities.

Simple Interest
Interest is earned only on principal.
Example: Compute simple interest on $100
invested at 6% per year for three years.
1
st
year interest is $6.00
2
nd
year interest is $6.00
3
rd
year interest is $6.00
Total interest earned: $18.00
Compound Interest
Compounding is when interest paid on an investment
during the first period is added to the principal; then,
during the second period, interest is earned on the
new sum (that includes the principal and interest
earned so far).
Is the amount a sum will grow to in a certain number
of years when compounded at a specific rate.
Compounding : process of determining the Future
Value (FV) of cash flow.
Compounded amount = Future Value (beginning
amount plus interest earned. )


Compound Interest
Example: Compute compound interest on
$100 invested at 6% for three years with
annual compounding.
1
st
year interest is $6.00 Principal now is $106.00
2
nd
year interest is $6.36 Principal now is $112.36
3
rd
year interest is $6.74 Principal now is $119.11
Total interest earned: $19.10
Suppose you invest $100 for one year at 5% per year.
What is the future value in one year?
Interest = 100(.05) = 5
Value in one year = principal + interest = 100 + 5 = 105
Future Value (FV) = 100(1 + .05) = 105

Suppose you leave the money in for another year. How
much will you have two years from now?
FV = 100(1.05)(1.05) = 100(1.05)
2
= 110.25
FV = PV(1 + r)
t

FV = future value
PV = present value
r = period interest rate, expressed as a decimal
t = number of periods
Future value interest factor = (1 + r)
t


Future Value
Future Value is the amount a sum will grow to in a certain number of
years when compounded at a specific rate.
Two ways to calculate Future Value (FV): by using Manual Formula or
Using Table.
Manual Formula Table
FV
n
= PV (1 + r)
n
FV
n
= PV (FVIF
i,n
)
n
Where :
FV
n
= the future of the investment at the end of n years
r = the annual interest (or discount) rate
n = number of years
PV = the present value, or original amount invested at the beginning of the
first year
FVIF=Futurevalueinterestfactororthecompoundsum$1
Future Value - single sums

If you deposit $100 in an account earning 6%, how
much would you have in the account after 1 year?
Mathematical Solution:
FV = PV (FVIF
i, n
)
FV = 100 (FVIF
.06, 1
) (use FVIF table, or)
FV = PV (1 + i)
n
FV = 100 (1.06)
1
= $106
0 1
PV = -100 FV = ???
Future Value - single sums

If you deposit $100 in an account earning 6%, how
much would you have in the account after 5 years?
Mathematical Solution:
FV = PV (FVIF
i, n
)
FV = 100 (FVIF
.06, 5
) (use FVIF table, or)
FV = PV (1 + i)
n
FV = 100 (1.06)
5
= $133.82
0 5
PV = -100 FV = ???
Compound Interest With Non-annual
Periods
Non-annual periods : not annual compounding but occur
semiannually, quarterly, monthly or daily
If semiannually compounding :
FV = PV (1 + i/2)
n x 2
or FV
n
= PV (FVIF
i/2
,
nx2
)
If quarterly compounding :
FV = PV (1 + i/4)
n x 4
or FV
n
= PV (FVIF
i/4,nx4
)
If monthly compounding :
FV = PV (1 + i/12)
n x 12
or FV
n
= PV (FVIF
i/12,nx12
)
If daily compounding :
FV = PV (1 + i/365)
n x 365
or FV
n
= PV (FVIF
i/365,nx365
)

Mathematical Solution:
FV = PV (FVIF
i, n
)
FV = 100 (FVIF
.015, 20
) (cant use FVIF table)
FV = PV (1 + i/m)
m x n
FV = 100 (1.015)
20
= $134.68
0 20
PV = -100 FV = 134.
68

Future Value - single sums
If you deposit $100 in an account earning 6% with
quarterly compounding, how much would you have in
the account after 5 years?
Mathematical Solution:
FV = PV (FVIF
i, n
)
FV = 100 (FVIF
.005, 60
) (cant use FVIF table)
FV = PV (1 + i/m)
m x n
FV = 100 (1.005)
60
= $134.89
0 60
PV = -100 FV = 134.
89

Future Value - single sums
If you deposit $100 in an account earning 6% with
monthly compounding, how much would you have in
the account after 5 years?
Present Value
Present value reflects the current value of a future payment or
receipt.
How much do I have to invest today to have some amount in the
future?
Finding Present Values(PVs)= discounting
Manual Formula Table
PV
n
= FV/ (1 + r)
n
PV
n
= FV (PVIF
i,n
)
n
Where :
FV
n
= the future of the investment at the end of n years
r = the annual interest (or discount) rate
n = number of years
PV= the present value, or original amount invested at the beginning of
the first year
PVIF=Present Value Interest Factor or the discount sum$1
Mathematical Solution:
PV = FV (PVIF
i, n
)
PV = 100 (PVIF
.06, 1
) (use PVIF table, or)
PV = FV / (1 + i)
n
PV = 100 / (1.06)
1
= $94.34
PV = ??? FV = 100
0 1
Present Value - single sums
If you receive $100 one year from now, what is the PV
of that $100 if your opportunity cost is 6%?
Mathematical Solution:
PV = FV (PVIF
i, n
)
PV = 100 (PVIF
.06, 5
) (use PVIF table, or)
PV = FV / (1 + i)
n
PV = 100 / (1.06)
5
= $74.73
Present Value - single sums
If you receive $100 five years from now, what is the
PV of that $100 if your opportunity cost is 6%?
0 5
PV = ??? FV = 100
Mathematical Solution:
PV = FV (PVIF
i, n
)
PV = 1000 (PVIF
.07, 15
) (use PVIF table, or)
PV = FV / (1 + i)
n
PV = 1000 / (1.07)
15
= $362.45
Present Value - single sums
What is the PV of $1,000 to be received 15 years from
now if your opportunity cost is 7%?
0 15
PV = -362.
45
FV = 1000
Suppose you need $10,000 in one year for the down
payment on a new car. If you can earn 7% annually, how
much do you need to invest today?
PV = 10,000 / (1.07)
1
= 9,345.79

You want to begin saving for your daughters college
education and you estimate that she will need $150,000 in
17 years. If you feel confident that you can earn 8% per
year, how much do you need to invest today?
PV = 150,000 / (1.08)
17
= 40,540.34

Your parents set up a trust fund for you 10 years ago that
is now worth $19,671.51. If the fund earned 7% per year,
how much did your parents invest?
PV = 19,671.51 / (1.07)
10
= 9,999.998 = 10,000

5C-20
Finding i
1. At what annual rate would the following have to be invested;
$500 to grow to RM1183.70 in 10 years.
FV
n
= PV (FVIF
i,n
)
1183.70 = 500 (FVIF
i,10
)
1183.70/500 = (FVIF
i,10
)
2.3674 = (FVIF
i,10
) refer to FVIF table
i = 9%
2. If you sold land for $11,439 that you bought 5 years ago for
$5,000, what is your annual rate of return?
FV = PV (FVIF
i, n
)
11,439 = 5,000 (FVIF
?, 5
)
11,439/ 5,000= (FVIF
?, 5
)
2.3866 = (FVIF
?, 5
)
i = .18

Finding n
1. How many years will the following investment takes? $100 to
grow to $672.75 if invested at 10% compounded annually
FV
n
= PV (FVIF
i,n
)
672.75 = 100 (FVIF
10%,n
)
672.75/100 = (FVIF
10%,n
)
6.7272 = (FVIF
10%,n
) refer to FVIF table
n = 20 years
2. Suppose you placed $100 in an account that pays 9% interest,
compounded annually. How long will it take for your account to
grow to $514?
FV = PV (1 + i)
n
514 = 100 (1+ .09)
N

514/100 = (FVIF
9%,n
)
5.14 = (FVIF
9%,n
) refer to FVIF table
n = 19 years

FV = PV (FVIF
i, n
)
11,933 = 5,000 (FVIF
?, 5
)
2.3866 = (FVIF
?, 5
) cant find
FV = PV(1 + r)t
r = (FV / PV)1/t 1
FV = PV (1 + i)
n
11,933 = 5,000 (1+ i)
5

11,933 / 5,000 = (1+i)
5

2.3866 = (1+i)
5

(2.3866)
1/5
= (1+i)
1.19 = 1+i i = .19
Finding i and n
If you sold land for $11,933 that you bought 5 years
ago for $5,000, what is your annual rate of return?
Finding i and n
Suppose you placed $100 in an account that pays 9.6%
interest, compounded monthly. How long will it take
for your account to grow to $500?
FV = PV (1 + i)
n
500 = 100 (1+ .008)
N

5 = (1.008)
N

ln 5 = ln (1.008)
N

ln 5 = N ln (1.008)
1.60944 = .007968 N
N = 202 months
FV = PV(1 + r)
t

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

You are looking at an investment that will pay $1,200 in 5
years if you invest $1,000 today. What is the implied rate
of interest?
r = (1,200 / 1,000)
1/5
1 = .03714 = 3.714%
Suppose you are offered an investment that will allow you
to double your money in 6 years. You have $10,000 to
invest. What is the implied rate of interest?
r = (20,000 / 10,000)
1/6
1 = .1225 = 12.25%

You want to purchase a new car, and you are willing to
pay $20,000. If you can invest at 10% per year and you
currently have $15,000, how long will it be before you
have enough money to pay cash for the car?

t = ln(20,000 / 15,000) / ln(1 + 0.1) =3.02 years

5C-25
Hint for single sum problems:
In every single sum present value and future
value problem, there are four variables:
FV, PV, i and n.
When doing problems, you will be given three
variables and you will solve for the fourth
variable.
Keeping this in mind makes solving time value
problems much easier!
Handy Rule of Thumb
Rule of 72 can estimate how long it takes to double a
sum of money
Time to double money = 72 / (interest rate per year)

If interest rate = 9% per year, it will take 8 years to
double the money
Time to double money = 72 / 9% = 8 years

If the time taken to double the money is 8 years, the
interest rate is 9% per year
Interest rate per year = 72 / 8 years = 9%

5C-27
5C-28
5-29
Future Value of a Mixed
Stream
If the firm expects to earn at least 8% on its investments, how
much will it accumulate by the end of year 5 if it immediately
invests these cash flows when they are received?
This situation is depicted on the following time line.
Suppose you invest $500 in a mutual fund today
and $600 in one year. If the fund pays 9% annually, how
much will you have in two years?

FV
2
= 500(1.09)
2
+ 600(1.09)
1

= 594.05 + 654.00
= 1,248.05
How much will you have in 5 years if you make no further
deposits?

FV
5
= 500(1.09)
5
+ 600(1.09)
4
= 769.31 + 846.95 = 1,616.26
Suppose you plan to deposit $100 into an account in one year
and $300 into the account in three years. How much will be
in the account in five years if the interest rate is 8%?

FV
5
= 100 (1.08)
4
+ 300(1.08)
2

= 136.05 + 349.92
= 485.97

6C-30
5-31
Present Value of a Mixed
Stream
If the firm must earn at least 9% on its investments, what
is the most it should pay for this opportunity?
This situation is depicted on the following time line.
You are considering an investment that will pay you $1,000
in one year, $2,000 in two years and $3,000 in three years.
If you want to earn 10% on your money, how much would
you be willing to pay?

PV = 1,000 / (1.10)
1
+ 2,000 / (1.10)
2
+3,000 / (1.10)
3
= 4,815.93
Your broker calls you and tells you that he has this great
investment opportunity. If you invest $100 today, you will
receive $40 in one year and $75 in two years. If you
require a 15% return on investments of this risk, should
you take the investment?

PV = 40 / (1.15)
1
+ 75 / (1.15)
2
= 91.49, reject this investment.
You are offered the opportunity to put some money away
for retirement. You will receive five annual payments of
$25,000 each beginning in 40 years. How much would you
be willing to invest today if you desire an interest rate of
12%? PV = 25,000 / (1.12)
40
+ 25,000 / (1.12)
41
+25,000 / (1.12)
42
+
25,000 / (1.12)
43
+25,000 / (1.12)
44
= 1,084.71



6C-32
Compounding and Discounting
Cash Flow Streams
0 1 2 3 4
Two types of annuity: ordinary annuity and annuity due.
ordinary annuity: a sequence of equal cash flows, occurring
at the end of each period.
Annuity due: annuity payment occurs at the beginning of
the period rather than at the end of the period.


0 1 2 3 4
Annuities
Mathematical Solution:
FV = PMT (FVIFA
i, n
)
FV = 1,000 (FVIFA
.08, 3
) (use FVIFA table, or)

FV = PMT (1 + i)
n
- 1
i
FV = 1,000 (1.08)
3
- 1 = $3246.40
.08
Future Value - annuity
If you invest $1,000 each year at 8%, how much
would you have after 3 years?
Mathematical Solution:
PV = PMT (PVIFA
i, n
)
PV = 1,000 (PVIFA
.08, 3
) (use PVIFA table, or)

1
PV = PMT 1 - (1 + i)
n

i
1
PV = 1000 1 - (1.08 )
3
= $2,577.10
.08
Present Value - annuity
What is the PV of $1,000 at the end of each of the next
3 years, if the opportunity cost is 8%?
Perpetuities
Suppose you will receive a fixed
payment every period (month, year,
etc.) forever. This is an example of a
perpetuity.
You can think of a perpetuity as an
annuity that goes on forever.
PMT
i
PV =
So, the PV of a perpetuity is very
simple to find:
Present Value of a Perpetuity
What should you be willing to pay in
order to receive $10,000 annually
forever, if you require 8% per year
on the investment?
PMT $10,000
i .08

= $125,000
PV = =
Ordinary Annuity
vs.
Annuity Due
$1000 $1000 $1000
4 5 6 7 8
Earlier, we examined this
ordinary annuity:
Using an interest rate of 8%, we find
that:
The Future Value (at 3) is $3,246.40.
The Present Value (at 0) is $2,577.10.
0 1 2 3
1000 1000 1000
What about this annuity?
Same 3-year time line,
Same 3 $1000 cash flows, but
The cash flows occur at the beginning
of each year, rather than at the end
of each year.
This is an annuity due.
0 1 2 3
1000 1000 1000
Future Value - annuity due
If you invest $1,000 at the beginning of each of the
next 3 years at 8%, how much would you have at the
end of year 3?
Mathematical Solution: Simply compound the FV of the
ordinary annuity one more period:
FV = PMT (FVIFA
i, n
) (1 + i)
FV = 1,000 (FVIFA
.08, 3
) (1.08) (use FVIFA table, or)

FV = PMT (1 + i)
n
- 1
i
FV = 1,000 (1.08)
3
- 1 = $3,506.11
.08
(1 + i)
(1.08)
Present Value - annuity due
Mathematical Solution: Simply compound the FV of the
ordinary annuity one more period:
PV = PMT (PVIFA
i, n
) (1 + i)
PV = 1,000 (PVIFA
.08, 3
) (1.08) (use PVIFA table, or)

1
PV = PMT 1 - (1 + i)
n

i
1
PV = 1000 1 - (1.08 )
3
= $2,783.26
.08
(1 + i)
(1.08)
Suppose you win the $10 million sweepstakes. The
money is paid in equal annual end-of-year installments of
$333,333.33 over 30 years. If the appropriate discount
rate is 5%, how much is the sweepstakes actually worth
today?





Suppose you begin saving for your retirement by
depositing $2,000 per year in a savings account. If the
interest rate is 7.5%, how much will you have in 40
years?


6C-45
29 . 150 . 124 , 5
0.05
) 05 . 0 (1
1
1
333,333.33
r
r) (1
1
1
C PV
30 t
=
(
(
(
(

=
(
(
(
(

=
454,513.04
0.075
1 0.075) (1
2,000
r
1 r) (1
C FV
40 t
=
(

+
=
(

+
=
Suppose you borrow $2,000 at 5%, and you are going to
make annual payments of $734.42. How long will you take
to pay off the loan?



To pay your childrens education, you wish to have
accumulated RM25,000 at the end of 15 years. To do this,
you plan to deposit an equal amount into the bank at the
end of each year. If the bank is willing to pay 7%
compounded annually, how much must you deposit each
year to obtain your goal?
FVn = PMT (FVIFA7%,15)
RM25,000 = PMT (FVIFA7%,15)
RM25,000 = PMT(25.129)
Thus, PMT = RM994.87

6C-46
3 t 2,000
0.05
0.05) (1
1
1
734.42
r
r) (1
1
1
C PV
t t
= =
(
(
(
(

=
(
(
(
(

=
Annual Percentage Rate (APR)
This is the annual rate that is quoted by law.

By definition, APR = period rate times the number of periods
per year.

Period rate = APR / number of periods per year

. What is the APR if the monthly rate is 0.5%?
0.5(12) = 6%

What is the APR if the semiannual rate is 0.5%?
0.5(2) = 1%

What is the monthly rate if the APR is 12% with monthly
compounding?
12 / 12 = 1%

6C-48
Effective Annual Rate (EAR)
Which is the better loan:
8% compounded annually, or
7.85% compounded quarterly?
We cant compare these nominal (quoted)
interest rates, because they dont include the
same number of compounding periods per
year!
We need to calculate the EAR (or Annual
Percentage Yield (APY)
Effective Annual Rate(EAR)
Find the APY for the quarterly loan:





The quarterly loan is more expensive than
the 8% loan with annual compounding!
EAR= ( 1 + )
m
- 1
quoted rate
m
EAR = ( 1 + )
4
- 1

EAR = .0808, or 8.08%
.0785
4
Making Decisions using EAR
You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays 5.3%
with semiannual compounding. Which account should
you use?

First account:
EAR = (1 + .0525/365)
365
1 = 5.39%

Second account:
EAR = (1 + .053/2)
2
1 = 5.37%

Which account should you choose and why?
Amortized Loans
Loans paid off in equal installments over time are
called amortized loans.
Example: Home mortgages, auto loans.
Reducing the balance of a loan via annuity payments
is called amortizing.
The periodic payment is fixed. However, different
amounts of each payment are applied towards the
principal and interest.
With each payment, you owe less towards principal.
As a result, amount that goes toward interest
declines with every payment (as seen in Figure 5-4).




If you want to finance a new machinery with a purchase price of
$6,000 at an interest rate of 15% over 4 years, what will your
annual payments be?
Finding Payment: Payment amount can be found by solving for
PMT using PV of annuity formula.
PV of Annuity = PMT {1 (1 + r)
4
}/r
6,000 = PMT {1 (1 + .15)
4
}/.15
6,000 = PMT (2.855)
PMT = 6,000/2.855 = $2,101.58
PVIFA = 6,000=PMT (PVIFA15%,4)
6,000=PMT(2.855)
PMT = 6,000/2.855 = $2,101.58