The Time Value of Money

The concept that an amount received is worth

more than an amount received in the future.
The reason in behind the time value of money
principle is that interest can be earned over a
period of time so that money received today
can earn interest and therefore accumulate
more value.
 Compounding: the arithmetic process of
determining the final value of a cash flow or a
series of cash flows when compound interest rate
is applied.
Discounting: the process of finding the present
value of a cash flow or a series of cash flows.
Interest means the money paid or earned for the use
of money. The rate of interest is used to express the
time value of money. Most financial decisions,
personal as well as business, involve the time value of
money.
Simple interest is the interest paid or earned on
only the original amount, or principal, borrowed
or lent.
 You have deposited Tk. 1000 in a savings
account paying 8% simple interest and the
deposit is for 10 years. At the end of 10 years,
the amount of interest accumulated is determined
as follows:
SI=Po(i)(n)
=Tk. 1000 (0.08) (10)
= Tk. 800
 Compound interest is interest paid or
earned on any previous interest earned, as
well as on the principle borrowed or lent.
0 1 2 3
i%

CF0 CF1 CF2 CF3

Show the timing of cash flows.

Tick marks occur at the end of periods, so
Time 0 is today; Time 1 is the end of the
first period (year, month, etc.) or the
beginning of the second period.
Future Value is the value at some future time of a
present amount of money, or a series of
payments, evaluated at a given interest rate. To
solve the future value or terminal value of the
amount at the end of a period, we add interest
earned on the principle only to the original
amount invested. So,
FV10= PV + SI
=PV+ PV (i) (n)
= PV [1+ (i)]n
 After 1 year:
FV1 = PV ( 1 + i ) = Tk.100 (1.10)
= Tk.110.00
After 2 years:
FV2 = PV ( 1 + i )2 =Tk.100(1.10)2
=Tk.121.00
After 3 years:
FV3 = PV ( 1 + i )3 =Tk.100(1.10)3
=Tk.133.10
After n years (general case):
FVn = PV ( 1 + i )n
Lets assume that if you invest Tk. 1000 today,
you will receive Tk. 3000 exactly in 8 years, what
is the rate of interest?
FVn = PV0 (FVIFi,n)
Tk. 3000= Tk. 1000 (FVIFi,n)
FVIFi,n = Tk. 3000/Tk. 1000=3
Reading across the 8-period row in Table I, we can
find the future value interest factor (FVIF) that
comes closest to our calculated value of 3. In the
table, that is 3.059 and it is in the 15% column.
Because 3.059 is slightly larger than 3, we
conclude that the interest rate is slightly less than
15%.
 For a more accurate answer, we simply
recognize that FVIF I, 8, can also be written
as (1+i)8. and solve directly for I as follows:
(1+i)8=3
(1+i)=31/8=30.125=1.1472
i=0.1472
Present value is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate. If future value
of an investment is known then present value can
be calculated as:
PV0= FVn / [1 + (i)]n
Example: If you want to receive Tk. 1800 after 10
years at 8% rate of interest, then what should be
your deposit?
PV0= FVn / [1 + (i)]n
= Tk. 1800 [1 + (0.08) (10) ]
= Tk. 1000
 How long would it take for an investment of Tk.
1000 to grow to Tk. 1900 if we invest it at a
compound annual interest rate of 10%?
FVn = PV (FVIF10%,n)
Tk. 1900= Tk. 1000 (FVIF10%,n)
FVIF10%,n= Tk. 1900/Tk. 1000=1.9
Reading down the 10% column in Table I , we find
the future value interest factor (FVIF) closest to
our calculated value of 1.9 is 1.949 and the
number corresponding to the 7-period row. We
can conclude that it will be less than 7 year.
 For greater accuracy , we can solve as
follows:
FVIF10%,n =(1+0.10)n
(1+0.10)n=1.9
n(ln 1.1)= ln 1.9
n=(ln 1.9)/ (ln 1.1)=6.73 years
 0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
 The rule of 72 is a shortcut to estimate the
number of years required to double your
money at a given annual rate of return.
1) How many years it will take an investment to
double at a given interest rate using
compounding interest.
2) How long it will take debt to double if no
payments are made.
3) The interest rate an investment must earn to
double within a specific time period.
4) How many times money (or debt) will double
in a specific time period.
 When 72 is divided by the interest rate, the
answer is the number of years it will take the
investment to double.

EXAMPLE:
We know our interest rate is 10% on our
investment.

TO FIGURE THIS:
72 10 = 7.2 YEARS TO DOUBLE
 Compound Interest is 8%
How long will it take for the investment to
double?

72 divided by 8% = 9 years
At the end of nine years, the initial savings of $100 will have increased to
$200 which is double the amount of initial savings
 If a person would like his/her investment to
double in 4 years, you would calculate it like
this
72 4 = 18% interest rate is required on the
investment

ANOTHER EXAMPLE:
Would like investment to double in 6 years
Need 12% interest rate for investment to double in 6 years
 For example, if a person earns 6% on a
$50,000 investment it will take 12 years to
double (72/6=12).
YEARS INVESTMENT
1 $50,000
12 $100,000
24 $200,000
36 $400,000
48 $800,000
60 $1,600,000
The Rule of 72
Is only an approximation
The interest rate must remain constant
The equation does not allow for
additional payments to be made to the
original amount
Interest earned is reinvested
Tax deductions are not included within
the equation
 Annuity is a series of equal payments or
receipts occurring over a specified number
of periods.
Ordinary Annuity: In an ordinary annuity,
payments or receipts occur at the end of each
period.
FVAn = PMT (FVIFAi,n), where PMT= Periodic
Receipt
PVAn= PMT(PVIFAi,n)
 Annuity Due: In an annuity due, payments or
receipts occur at the beginning of each
period.

FVADn=PMT(FVIFAi,n)(1+i)
PVADn=PMT(PVIFAi,n-1+1)
= (1+i)( PMT )(PVIFAi,n)
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

 LARGER, as the more frequently compounding
occurs, interest is earned on interest more often.
0 1 2 3
10%

100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
 Nominal rate (iNOM) also called the quoted
or state rate. An annual rate that ignores
compounding effects.
iNOM is stated in contracts. Periods must also be
given, e.g. 8% Quarterly or 8% Daily interest.
Periodic rate (iPER) amount of interest
charged each period, e.g. monthly or
quarterly.
iPER = iNOM / m, where m is the number of
compounding periods per year. m = 4 for
quarterly and m = 12 for monthly compounding.
The effective annual interest rate is the actual rate
of interest earned or paid after adjusting the
nominal rate for factors such as the number of
compounding periods per year.
Effective annual interest rate= (1+ [i/m])m-1
Where, m= No. of times compounded
Example: If a savings plan offered a nominal interest
rate of 8% compounded quarterly on a one-year
investment, the effective annual interest rate would
be:
(1 + [0.08/4])4-1=(1+0.2)4-1=0.08243
 An investment with monthly payments is different
from one with quarterly payments. Must put each
return on an EAR% basis to compare rates of
return. Must use EAR% for comparisons. See
following values of EAR% rates at various
compounding levels.

EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
 iNOM written into contracts, quoted by
banks and brokers. Not used in
calculations or shown on time lines.
iPER Used in calculations and shown on
time lines. If m = 1, iNOM = iPER =
EAR.
EAR Used to compare returns on
investments with different payments
per year. Used in calculations when
annuity payments dont match
compounding periods.
 iNO M mn
FVn PV ( 1 )
m

0.10 23
FV3S $100 ( 1 )
2
6
FV3S $100 (1.05) $134.01
FV3Q $100 (1.025)12 $134.49
 An important use of present value concept is in determining
the payments required for an installment-type loan. A table is
prepared by showing the repayment schedule of interest and
principal necessary to pay off a loan by maturity is known as
Loan Amortization Schedule.
Suppose you borrow Tk. 22,000 at 12% compounded annual
interest to be repaid over the next six years by equal
installment payments required at the end of each year.
Annual payments will be,
Tk. 22,000= PMT(PVIFA 12%, 6)
Tk. 22,000= PMT (4.111)
R= Tk. 22,000/ 4.1111=Tk. 5,351
End of (1)Install (2) (3) (4)
year ment Annual Principal Principal
Payme Interest Payment amount
nt (4)t-1 X (1)- (2) owing at
0.12 the end of
year (4)t-1
- (3)
0 - Tk. 22,000
1 Tk. 5,351 Tk. 2,640 Tk. 2,711 1,9289
2 5,351 2,315 3,036 1,6253
3 5,351 1,951 3,400 1,2853
4 5,351 1,542 3,809 9,044
5 5,351 1,085 4,266 4,778
6 5,351 573 4,778 0
Tk.32,106 Tk. 10,106 Tk. 22,000
 The quantitative processes underlying the time value of money
and its associated calculations are central to the investment
process.
Using the time value of money concepts, we can
Determine the value of a series of future cash flows today
(present value)
Determine the value of a series of cash flows in the future
(future value)
Determine the value of a regular series of cash flows,
known as an annuity, that is equivalent to a specific value
today or in the future (annuitizing)
Valuation, a key function in the investment process, is often
performed using the time value of money calculation known as
present value.

35
 Assume that you are nearing graduation and
that you have applied for a job with a local
bank. As part of the bank's evaluation
process, you have been asked to take an
examination which covers several financial
analysis techniques. The first section of the
test addresses discounted cash flow analysis.
See how you would do by answering the
following questions.
 Draw time lines for (a) a $100 lump sum cash
flow at the end of year 2, (b) an ordinary
annuity of $100 per year for 3 years, and (c)
an uneven cash flow stream of -$50, $100,
$75, and $50 at the end of years 0 through 3.
What is the future value of an initial $100
after 3 years if it is invested in an account
paying 10 percent annual interest?
What is the present value of $100 to be
received in 3 years if the appropriate interest
rate is 10 percent?
 We sometimes need to find how long it will
take a sum of money (or anything else) to
grow to some specified amount. For
example, if a company's sales are growing at
a rate of 20 percent per year, how long will it
take sales to double?
If you want an investment to double in three
years, what interest rate must it earn?
What is the difference between an ordinary
annuity and an annuity due? What type of
annuity is shown below? How would you
change it to the other type of annuity?
 What is the future value of a 3-year ordinary
annuity of $100 if the appropriate interest
rate is 10 percent?
What is the present value of the annuity?
What would the future and present values be
if the annuity were an annuity due?
What is the present value of the following
uneven cash flow stream? The appropriate
interest rate is 10 percent, compounded
annually.
0 1 2 3 4 years
| | | | |
0 100 300 300 -50
 Define (a) the stated, or quoted, or nominal
rate, (iNom), and (b) the periodic rate (iPer).
Will the future value be larger or smaller if we
compound an initial amount more often than
annually, for example, every 6 months, or
semiannually, holding the stated interest rate
constant? Why?
What is the future value of $100 after 5 years
under 12 percent annual compounding?
Semiannual compounding? Quarterly
compounding? Monthly compounding? Daily
compounding
 What is the effective annual rate (EAR)? What
is the ear for a nominal rate of 12 percent,
compounded semiannually? Compounded
quarterly? Compounded monthly?
Compounded daily?
Will the effective annual rate ever be equal to
the nominal (quoted) rate?
Construct an amortization schedule for a
$1,000, 10 percent annual rate loan with 3
equal installments.
What is the annual interest expense for the
borrower, and the annual interest income for
the lender, during year 2?
 Suppose on January 1 you deposit $100 in an
account that pays a nominal, or quoted,
interest rate of 11.33463 percent, with
interest added (compounded) daily. How
much will you have in your account on
October 1, or after 9 months?
What is the value at the end of year 3 of the
following cash flow stream if the quoted
interest rate is 10 percent, compounded
semiannually?
What is the PV of the same stream?
 Suppose someone offered to sell you a note calling for the
payment of $1,000 15 months from today. They offer to sell
it to you for $850. You have $850 in a bank time deposit
which pays a 6.76649 percent nominal rate with daily
compounding, which is a 7 percent effective annual interest
rate, and you plan to leave the money in the bank unless you
buy the note. The note is not risky--you are sure it will be
paid on schedule. Should you buy the note? Check the
decision in three ways: (1) by comparing your future value if
you buy the note versus leaving your money in the bank, (2)
by comparing the PV of the note with your current bank
account, and (3) by comparing the ear on the note versus that
of the bank account.