Chapter 4

Time Value of Money

 Future Values, Present values

 Interest rates
 Chapter Outline
• Time value associated with money
• Determining future value based on number
of periods over which funds are to be
compounded at given interest rate
• Present value based on current value of
funds to be received
• Tables for future and present values, their
need in computations, determination of yield
• Compounding or discounting occurring on a
less than annual basis
 Relationship to
the Capital Outlay Decision
• Determine whether future benefits are
sufficiently large to justify current outlays
• Mathematical tools help in making capital
allocation decisions
 Future Value – Single Amount
• Measuring value of an amount that is
allowed to grow at a given interest over a
period of time is necessary
– Assuming that the worth of $1,000 needs to be
calculated after 4 years at a 10% interest per
year, we have:
1st year……$1,000 X 1.10 = $1,100
2nd year…...$1,100 X 1.10 = $1,210
3rd year……$1,210 X 1.10 = $1,331
4th year……$1,331 X 1.10 = $1,464
 Future Value – Single Amount
(cont’d)
A generalized formula is:

Where
FV = Future value
PV = Present value
i = Interest rate
n = Number of periods;

In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of $1(FVIF)
 Future Value – Single Amount
(cont’d)
• In determining future value, the following can be used:

• Where = The interest factor

• If $10,000 were invested for 10 years at 8%, the future

value would be:
 Present Value – Single Amount
• A sum payable in the future is worth less
today than the stated amount
– The formula for the present value is derived from the original
formula for future value:

– The present value can be determined by solving for a mathematical

solution to the formula above, thus restating the formula as:
– Assuming
Present Value of $1(PVIF)
Relationship of Present
and Future Value
 Future Value – Annuity
• A series of consecutive payments or receipts
of equal amount
– The future value of each payment can be totaled
to find the future value of an annuity
– Assuming, A = $1,000, n = 4, and i = 10%
 Future Value
of an Annuity of $1(FVIFA)
Compounding Process for Annuity
 Present Value – Annuity
• Calculated by discounting each individual payment
back to the present and then all of these payments
are added up
– Assuming that A = $1,000, n = 4, i = 10%, we have:
 Presentation of
Time Value Relationship
• Requires various comparison which include:
– The relationship between present value and
future value
– The relationship between the present value of a
single amount and the present value of an
annuity
– Future value related to future value of annuity
Annuity Equaling a Future Value
– Assuming that at a 10% interest rate, after 4 years, an
$4,641 needs to accumulated:

– For n = 4, and i = 10%, is 4.641. This A equals

$1,000
Annuity Equaling a Present Value
– Determining what size annuity can be equated to a given
amount:

– Assuming n = 4, i = 6%:
Relationship of Present Value
to Annuity
Annuity Equaling a Present Value
(cont’d)
• Determining the necessary repayments on a loan:

• Assuming n 20, i = 8%,

Total payments ($4,074 for 20 years)……………..$81,480

Repayment of principal…………………………….– 40,000
Payments applied to interest……………………….$ .
Payoff Table for Loan
(amortization table)
Review
 Yield – Present Value
of a Single Amount
• To calculate the yield on an investment producing $1,464
after 4 years having a present value of $1,000:

• We see that for n = 4 and = 0.683, the interest rate or

yield is 10%
 Yield – Present Value
of a Single Amount (cont’d)
• Interpolation may also be used to find a more precise answer

• Difference between the value at the lowest interest rate and the
designated value

• The exact value can be determined thus:

Yield – Present Value of an Annuity
• To calculate the yield on an investment of $10,000,
producing $1,490 per annum for 10 years:

• Hence:
 Special Considerations
in Time Value Analysis
• Certain contractual agreements may require
semiannual, quarterly, or monthly
compounding periods
– In such cases, to determine n, multiply the
number of years by the number of compounding
periods during the year
– The factor for i is determined by dividing the
quoted annual interest rate by the number of
compounding periods
 Cases
• Case 1: Determine the future value of a $1,000 investment after 5 years
at 8% annual interest compounded semiannually
– Where, n = 5 X 2 = 10; i = 8% / 2 = 4%

• Case 2: Determine the present value of 20 quarterly payments of

$2,000 each to be received over the next 5 years, where i = 8% per
annum
– Where, n = 20; i = 20%