Time Value of Money Ahmed Hassan

Time Value of
Money
Dr. Kamrul Hasan
Assistant Professor, AIUB
Boier Desh Publications

Foundation of Financial Management, 1/e
Chapter Outline
Introduction
Basic of Time Value of Money
Present value
Future Value
Concept of Interest
Concept of Annuity
Rule of 72
Rule of 69
Perpetuity and Growing perpetuity
EAR and APR
Summary and Conclusion
Time is more value than money. You can

get more money but cannot get more
time.
Jim Rohn

Time Value of
Money
The basic idea behind the concept of time value of
money is:
TK.1 received today is worth more than Tk.1 in the
future
OR
Tk.1 received in the future is worth less than Tk.1
today
Why?
because interest can be earned on the money
The connecting piece or link between present (today)
and future is the interest or discount rate

Time Value of Money

If you invest your 1 taka for 1 year at a 12% annual
interest rate. (12% interest rate & one-year period)

Then at the end of one year you will accumulate 1.12
taka, you can say that future value of 1 taka is 1.12.

So, present value of the 1.12 taka you expect to
receive in one year is only 1 taka.

A key concept of time value of money is that:
A single sum of money or a series of equal, evenly spaced
payment or receipts promised in the future can be converted

to an equivalent value today.
Time Value of Money

Time Value of Money (TVM) concept is used to
measure and evaluate many business and financial
transactions, including:
Investment analysis
Capital budgeting decisions
Stocks, bonds and other securities
Long-term Leases
Long-term capital assets
Accounts receivable
Accounts payable
Pensions and retirement plans
Mergers and acquisitions
Assets depreciation
Working capital management

Identify the Variables

There are five variables every time value of money has.
One should identify the variables. Those variable are:
Present Value (PV):
Any value that occurs at the beginning of the problem is a
Present Value. It is an amount today that is equivalent to a
future payment, or series of payments, that has been
discounted by an appropriate interest rate.
Future Value (FV):

Future Value is the amount of money that an investment with
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 equally spaced
payments (an annuity), or both.
Identify the Variables

Interest Rate (r):
Interest is a charge for borrowing money, usually stated as a percentage of the
amount borrowed over a specific period of time. Interest is two types: (1) Simple
interest & (2) Compound interest.
Annuity Payment (Pmt):

An annuity payment is a series of two or more equal payments that occur at
regular time intervals.
Number of Periods (t):

The number of periods is the total length of time that the
investment will be
held. Periods are evenly spaced intervals of time.

Present Value is Related

to.
PV
PV
PV
PV
is
is
is
is
positively related to FV
inversely related to the interest rate
inversely related to the number of periods
positively related to annuity payment

Two Concepts of Interest: Simple &

Compound
Simple interest refers to situation when interest is earned on a
principle only.
Compound interest refers the situation the interest is earned on the
original principle amount as well as any interest earned that
accumulated with the principal.
Compound and simple interest differs on one principle the simple
interest wont earn interest whereas compound interest does earn
interest on interest along with principal.
On the other hand, Continuous compound interest counts on
interest earned on principal daily and also counts the interest on
that interest earned principle compounded daily.
Continuous compounding happens when interest is charged against
principle and compound continuously, that is the interest is
continuously added to principle to be charged interest again.
Continuous compounding can be used to determine the future
value of a current amount when interest is compounded
continuously
Concepts of Interest
Here in the chart
you could see the
expected return
of 1 taka which
earns 12%
annually what
should be the
expected return
on various time
line at simple,
compound and
continuous
compound
interest rate.
Interest rate (12%)
Year 1
Year 10
Year 50
Simple
1.12
2.20
7.00
Compound
1.12
3.105
289.00
Continuous
compound
1.127
3.319
403.031

Calculating the Future Value Using Simple

Interest Rate
Problem 2.1
If you deposit 10,000 taka in a bank account that earns 12%
simple interest for 5 years then how much money would you
have after that period?
The equation for simple interest rate is quite straightforward.

FV using simple interest rate =
Principal + Principal*interest rate*time or P+P*r*t

So, you get 10,000 + 10,000 * 0.12 * 5 = 10,000 + 6,000 =
16,000 tk
Simple formula of Calculating Future Value

Future Value (FV)= Present Value (PV) + [Present Value (PV) * Interest
Rate (r)] for 1 year.
However, if the investment is for two years then,
FV= PV + [PV*r] + {[PV + (PV*r)]*r}
Or, FV= PV(1+r+r+1) , [1+2.1.r+r = (1+r)]
Or, FV = PV (1+r) for two years.
So the generalized equation for the future value formula will be:
Future Value = Present Value * (1+interest rate)time
Or, FV = PV (1 + r)t
So if we try to solve the problem 2.1 using compound interest rate
then the expected return would be:
FV = 10,000 (1+0.12)5 = 17,623.42 taka
You could see the difference of 1623.42 taka due to earning interest on
interest. The number looks astronomical once you use a longer time
period like the graph has shown.
Calculating Future Value Using Compound

Interest

Monthly Compounded

Continuously Compounding

Continuously Compounding
Formula,
FV = PV(1+r1)(1+r2)(1+r3)
Where,
Here,
FV = Future Value
FV = ?
PV = Present Value
PV =
r1 = Year-1 interest rate
r1=
r2= Year-2 interest rate
r2=
r3= Year-3 interest rate
r3=
100,000
0.12
0.18
0.08

Calculating Present Value Using Compound

Interest
If, FV = PV (1+r)t then we can rewrite,

PV= FV/(1+r)t
The process by which
PV= 2000000/(1+0.12)5
future cash flows are
PV= 1,134,854 taka

Here, we can see that 1,134,854
adjusted to reflect
these factors is
taka is equivalent to 20 lac after 5
called discounting.
years if you are earning 12% interest
It is used to calculate
annually.
PV.
Calculating Present Value Using Compound

Interest

Finding the Interest Rate

Interest rate and the number of periods must always agree
as to the length of a time period.
Example: semi-annually (2), quarterly (4), weekly (52), or
even daily (365) then you need to adjust accordingly.
Interest rate problem could be solved by using basic TVM
formula.
Here, FV = PV (1+r)t
Or, (1+r)t = FV/PV
Or, (1+r)t/t = (FV/PV)(1/t)
So, r = (FV/PV)(1/t) -1
Finding the Interest Rate
Solution: r = (FV/PV)(1/t) -1
Since, you know the interest rate of first bank, all you need to find the rate
for the other two banks.
For the 2nd bank that doubles your money in 5 years the interest rate will
be:
r = (20000/10000)(1/5)-1
= 1.1486-1
= 14.86%
If you want to triple your money in 8 years the interest rate will be:
r = (30000/10000)(1/8)-1
= 1.1472-1
= 14.72%
So, it is better to put money in the second bank, bcz second bank double
your money after 5 years & you are earning the highest interest rate of
14.86% among the three banks.
Finding the Time Periods

To find the time periods we use the basic FV formula to
derive the equation for t.
Here, FV = PV (1+r)t
Or, (1+r)t = FV/PV
ln (1+r)t = ln (FV/PV)
t.ln (1+r)t = ln (FV/PV)
So, t = ln (FV/PV)/ln (1+r)
Problem- 2.8
If you want to Invest 5000 taka today at an annual interest rate of 11%,
how long do you have to wait to receive 20,000 taka?
Solution:
Here, t = ln (FV/PV)/ ln (1+r)
Or, t = ln (20,000/5,000)/ ln(1+0.11)
Or, t = 1,38629/ 0.10436
Or, t = 13.283 years.
So, you have to wait 13.283 years.
years
The Intuitive Basis for Present Value

There are three reason why a cash flow in the future is worth
less than a similar cash flow today. Those reasons are:
1. Individual prefer present consumption to future consumption.
2. Monetary Inflation
3. A promised cash flow might not be delivered for a number of
reasons:
The promised might default on payment
The promisee might not be around to receive payment
Some other contingency might intervene to prevent or reduce the promised
payment
Or any uncertainty (risk) associated with cash flow in the future reduces the
value of the cash flow.
Double Your Money!!!
We will use the Rule-of-72

Years to Double = 72 / i
72/12% = 6 Years (Approx)

Double Your Money!!!

A general rule estimating how long it will take for an
investment to double, assuming continuously
compounding interest.
Can calculates this by dividing 69 by the rate of
return .
Rule of 69 is not exact
But provides a quick look at the effects of
compounding on an investment
Rule of 69 is similar to the Rule of 72
But Rule of 72 is more useful for non-continuously
compounding interest
PV dealing with multiple, uneven cash

flows
The key to finding the PV of multiple, uneven cash flows are
to compound each cash flow separately for the appropriate

number of time periods and earned interest rate.
Problem- 2.9
What is the present value of receiving 50,000 taka in one year, 75,000
taka in two years, and 10,000 taka in three years if the interest rate is
13.5%?
Solution:
PV of 50,000 taka is 50,000/ (1+ 0.135) = 44,052.86 taka
PV of 75,000 taka is 75,000/ (1+ 0.135)= 58,219.64 taka
PV of 100,000 taka is 100,000/ (1+0.135)= 68,393.11 taka
So, the PV of the series of cash flows is simply their combined PV:
Total PV = 44,052.86 + 58,219.64 + 63,393.11 = 1,70,665.62
taka.

Types of Annuities
An annuity is a series of equal payments (inflows or
outflows) for a certain number of time periods.
There are two types of annuities, those are:
Ordinary Annuity: Payments or receipts occur at the end of
each period, it is also called deferred annuity. Example:
Bond that pays interest on the last day of the month.
Annuity Due:
Due Payments or receipts occur at the beginning
of each period. Example: A mortgage payment or house
rent which is usually due on the first day of the month.

Parts of an Annuity
(Ordinary
Annuity)
End of
Period 1
End of
Period 2
1
$1000
Today
End of
Period
3
$1000
Equal Cash Flows

Each 1 Period Apart

PV of an Ordinary Annuity
To determine todays value of a series of future
payments, need to use the formula of present value
of an ordinary annuity.
PV of ordinary annuity calculates the present value of
coupon payments that will receive in the future.
Simple logic of PV of an ordinary annuity is receiving a
series of payment of 1,000 taka at a different time
period is less today than receiving a lump sum cash
flow of 5,000 tk today.
PV of an Ordinary Annuity
Assume that interest rate is 14% and the PV of an
annuity that pays 1,000 tk per year for five year.

Lets find the value of this ordinary annuity using
formula:
PVordinary annuity = Payment*[1-(1+r/n)-t*n r/n]
PVordinary annuity = 1000[1-(1+0.14)-5 0.14]
PVordinary annuity = 3433.08 taka
Here,
PV ordinary annuity of
Year 1: 1000(1+0.14)-1 = 877.19

Year 2: 1000(1+0.14)-2 = 769.46
Year 3: 1000(1+0.14)-3 = 674.97
Year 4: 1000(1+0.14)-4 = 592.08
Year 5: 1000(1+0.14)-5 = 519.36
3433.08

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1
Beginning of
Period 2
$1000
Today
$1000
Beginning of
Period 3
2
$1000
Equal Cash Flows

Each 1 Period Apart
PV of an Annuity Due
Assume that interest rate is 14% and the PV of an annuity
that pays 1,000 tk per year for five year.
Formula.
PV
PV
annuity due
annuity due
= Payment*[1-(1+r/n)-t*n * (1+r/n) r/n]
= 1000[1-(1+0.14)-5 * (1+0.14) 0.14] = 3913.71 Taka
Here,
PV annuity due
PV annuity due of
PV annuity due of
PV annuity due of
PV annuity due of
of Year 0: 1000(1+0.14)-o = 1,000

Year 1: 1000(1+0.14)-1 = 877.19
Year 2: 1000(1+0.14)-2 = 769.46
Year 3: 1000(1+0.14)-3 = 674.97
Year 4: 1000(1+0.14)-4 = 592.08
3913.71

FV of an Ordinary Annuity
FV of an ordinary annuity measures how much you would have in
the future given a specified rate of return.
Assume that interest rate is 14% and the FV of an annuity
that pays 1,000 tk per year for five year.
Formula, FV
FV
ordinary annuity =
ordinary annuity =
Pmt*{(1+r/n)t*n-1} r/n]
1000*{(1+0.14)4-1} 0.14] = 6610.10 taka.
Here,
FV ordinary annuity of
Year 0: 1000(1+0.14)0 = 1,000.00

Year 2: 1000(1+0.14)1= 1140.00
Year 3: 1000(1+0.14)2 = 1299.60
Year 4: 1000(1+0.14)3 = 1481.54
Year 5: 1000(1+0.14)4 = 1688.96
6610.10

FV of an Annuity Due
Assume that interest rate is 14% and the FV of an annuity that
pays 1,000 tk per year for five year.
Formula.
FV annuity due = Pmt*{(1+r/n)t*n-1}*(1+r/n)} r/n
FV annuity due = 1000*{(1+0.14)5-1}*(1+0.14)} 0.14 = 7,535 taka
Here,
FV
of Year 1: 1000(1+0.14)1 = 1,140

FV annuity due of Year 2: 1000(1+0.14)2 = 1299
FV annuity due of Year 3: 1000(1+0.14)3 = 1481.54
annuity due
7535 taka

PV of a Growing Annuity
The PV of growing annuity formula calculates the present
day value of a series of future periodic payments that grow at
a proportionate rate.
It may sometime referred to as an increasing annuity.
Example of an growing annuity would be an individual who
receive Tk. 100 the first year and successive payments
increase by 10% per year for a total three years.
[ Tk.100>Tk.110>Tk.121]
Formula of PV of a growing annuity = P(r-g)*[1-{(1+g)
(1+r)}t ]
Here, P = first payment, r = interest payment, g = growth
rate, and t = number of year.

PV of a Growing Annuity
Problem -2.16
Suppose you have just won the first prize in a lottery. The lottery
offers you two possibilities for receiving your prize. The first
possibility is to receive a payment of 10,000 taka at the end of the
year, and then, for the next 15 years this payment will be repeated,
but it will grow at a rate of 5%. The interest rate is 12% during the
entire period. The second possibility is to receive 100,000 tk right
now. Which one out of the two possibilities would you take?
Here,
P = 10,000; r = 0.12; g = 0.05; t = 16
PV of a growing annuity = P(r-g)*[1-{(1+g) (1+r)}t ]
= 10,000(0.12-0.05)*[1-{(1+0.05)
(1+0.12)}16 ]
= Tk. 91,989.41
Tk. 91,989.41 < Tk. 100,000 therefore, you would prefer to be paid out
right now.
FV of Growing Annuity
The formula of future value of growing annuity is used to calculate the
future amount of a series of cash flows, or payments, that grow at a
proportionate rate.
Fv of a growing annuity = P*[{(1+r)t (1+g)t} (r-g)]
Problem 2.17
If an employee saves 20000 tk per year which increases by 5% every
year and earns 12% annual interest then after 10 years , how much
would she have?
FV of this growing annuity =

20000*[{(1+0.12)10 (1+0.05)10} (0.12-0.05)]
= 431,295.35 taka.

Perpetuities
Perpetuity is a type of annuity that receives an infinite amount of periodic
payment.
Perpetuity is a constant cash flow at a regular intervals forever.
Formula of PV of Perpetuity = c/r
Here, c = coupon payment & r = interest rate.
Assume that you have a 12% coupon console bond. The value
of this bond, if the interest rate is 9% is as follows:
Value of Console Bond = 120/0.09 = 1,333.33 taka.
The value of a console will be equal to its face value only if the coupon
rate is equal to the interest rate.

Growing Perpetuity
A growing perpetuity is the same as a regular perpetuity (C/r), but just like
the cash flow is growing ( or declining) each year.
PV of growing perpetuity = c/(r-g)
Where, C= Initial cash flow or coupon payment, r= Interest rate, g= Growth
rate.
Problem 2.18
When would you be willing to pay for financial instrument, which promises
you to pay cash payment of 25,000 tk at the end of the each year, which
will increase every year by 5%, forever. The annual interest rate is fixed at
12%
What would you be willing to pay if the financial instrument paid out its first
25,000 tk right now, and everything else being same?
Solution
PV of Growing Annuity = 25,000 / (0.12 0.05) = 357,142.85
taka.
PV = [(25000 * 1.05) / (0.12 0.05)] + 25,000 = 400,000 taka.
EAR & APR

Effective Annual Interest Rate
The actual rate of interest earned (paid) after adjusting the nominal rate
for factors such as the number of compounding periods per year.
EAR (%) = (1+rnomibal /n)n 1
Here, n is number of compounding in a year.
EAR for continuous compounding = er - 1
Annual Percentage Rate

APR is defined as the period rate the number of periods per year.
Periodic Rate = rnominal / n
rnominal = Periodic Rate n = APR.
See Problem 2.19, Page 45

Summary and Conclusions

The financial manager uses
the time value of money

approach to value cash flows
that occur at different points
in time
A dollar invested today at
compound interest will grow a

larger value in future. That
future value, discounted at
compound interest, is equated
to a present value today
Cash values may be single
amounts, or a series of equal

amounts (annuity)

Time Value of Money Ahmed Hassan

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Time Value of

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Time is more value than money. You can

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and future is the interest or discount rate