SHIVAM POPAT

What is Time Value?

We say that money has a time value because that money
can be invested with the expectation of earning a positive
rate of return
In other words, a dollar received today is worth more than
a dollar to be received tomorrow
That is because todays dollar can be invested so that we
have more than one dollar tomorrow
Time Value of Money
A dollar received
today is worth more
than a dollar received
in the future.
The sooner your
money can earn
interest, the faster
the interest can earn
interest.
Interest and Compound
Interest
Interest -- is the return you receive for investing your
money.
Compound interest -- is the interest that your
investment earns on the interest that your investment
previously earned.
The Terminology of Time Value
Present Value - An amount of money today, or the current
value of a future cash flow
Future Value - An amount of money at some future time
period
Period - A length of time (often a year, but can be a month,
week, day, hour, etc.)
Interest Rate - The compensation paid to a lender (or
saver) for the use of funds expressed as a percentage for a
period (normally expressed as an annual rate)
Abbreviations
PV - Present value
FV - Future value
Pmt - Per period payment amount
N - Either the total number of cash flows or
the number of a specific period
i - The interest rate per period
Timelines
A timeline is a graphical device used to clarify the
timing of the cash flows for an investment
Each tick represents one time period
0 1 2 3 4 5
PV FV
Today
Calculating the Future Value
Suppose that you have an extra $100 today that you wish
to invest for one year. If you can earn 10% per year on
your investment, how much will you have in one year?
0 1 2 3 4 5
-100 ?
( )
FV
1
100 1 010 110 = + = .
Calculating the Future Value (cont.)
Suppose that at the end of year 1 you decide to extend
the investment for a second year. How much will you
have accumulated at the end of year 2?
0 1 2 3 4 5
-110 ?
( )( )
( )
FV
or
FV
2
2
2
100 1 010 1 010 121
100 1 010 121
= + + =
= + =
. .
.
Generalizing the Future Value
Recognizing the pattern that is developing, we can
generalize the future value calculations as follows:
( )
FV PV i
N
N
= + 1
If you extended the investment for a third
year, you would have:
( )
FV
3
3
100 1 010 13310 = + = . .
Compound Interest
Note from the example that the future value is
increasing at an increasing rate
In other words, the amount of interest earned each
year is increasing
Year 1: $10
Year 2: $11
Year 3: $12.10
The reason for the increase is that each year you are
earning interest on the interest that was earned in
previous years in addition to the interest on the original
principle amount
Compound Interest Graphically
0
500
1000
1500
2000
2500
3000
3500
4000
4500
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
F
u
t
u
r
e

V
a
l
u
e
Years
5%
10%
15%
20%
3833.76
1636.65
672.75
265.33
The Magic of Compounding
On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly purchased
Manhattan from the Indians for $24 worth of beads and other
trinkets. Was this a good deal for the Indians?
This happened about 371 years ago, so if they could earn 5% per
year they would now (in 1997) have:
If they could have earned 10% per year, they would now have:
$54,562,898,811,973,500.00 = 24(1.10)
371
$1,743,577,261.65 = 24(1.05)
371
Thats about 54,563 Trillion dollars!
The Magic of Compounding (cont.)
The Wall Street Journal (17 Jan. 92) says that all of New York city
real estate is worth about $324 billion. Of this amount, Manhattan
is about 30%, which is $97.2 billion
At 10%, this is $54,562 trillion! Our U.S. GNP is only around $6
trillion per year. So this amount represents about 9,094 years
worth of the total economic output of the USA!
At 5% it seems the Indians got a bad deal, but if they earned 10%
per year, it was the Dutch that got the raw deal
Not only that, but it turns out that the Indians really had no claim
on Manhattan (then called Manahatta). They lived on Long
Island!
As a final insult, the British arrived in the 1660s and
unceremoniously tossed out the Dutch settlers.
The Rule of 72
Estimates how many years an investment will take to
double in value
Number of years to double =
72 / annual compound growth rate
Example -- 72 / 8 = 9 therefore, it will take 9 years
for an investment to double in value if it earns 8%
annually
Calculating the Present Value
So far, we have seen how to calculate the future
value of an investment
But we can turn this around to find the amount
that needs to be invested to achieve some desired
future value:
( )
PV
FV
i
N
N
=
+ 1
Present Value: An Example
Suppose that your five-year old daughter has just
announced her desire to attend college. After some
research, you determine that you will need about
$100,000 on her 18th birthday to pay for four years of
college. If you can earn 8% per year on your
investments, how much do you need to invest today to
achieve your goal?
( )
PV = =
100 000
108
769 79
13
,
.
$36, .
Annuities
An annuity is a series of nominally equal payments
equally spaced in time
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100 annuity
0 1 2 3 4 5
100 100 100 100 100
The Principle of Value Additivity
How do we find the value (PV or FV) of an annuity?
First, you must understand the principle of value
additivity:
The value of any stream of cash flows is equal to the sum
of the values of the components
In other words, if we can move the cash flows to the
same time period we can simply add them all together
to get the total value
Present Value of an Annuity
We can use the principle of value additivity to find the
present value of an annuity, by simply summing the
present values of each of the components:
( ) ( ) ( ) ( )
PV
Pmt
i
Pmt
i
Pmt
i
Pmt
i
A
t
t
t
N
N
N
=
+
=
+
+
+
+ +
+
=

1 1 1 1
1
1
1
2
2
Present Value of an Annuity (cont.)
Using the example, and assuming a discount rate of 10%
per year, we find that the present value is:
( ) ( ) ( ) ( ) ( )
PV
A
= + + + + =
100
110
100
110
100
110
100
110
100
110
379 08
1 2 3 4 5
. . . . .
.
0 1 2 3 4 5
100 100 100 100 100
62.09
68.30
75.13
82.64
90.91
379.08
Present Value of an Annuity (cont.)
Actually, there is no need to take the present value
of each cash flow separately
We can use a closed-form of the PV
A
equation
instead:
( )
( )
PV
Pmt
i
Pmt
i
i
A
t
t
t
N
N
=
+
=

+

(
(
( =

1
1
1
1
1
Present Value of an Annuity (cont.)
We can use this equation to find the present value
of our example annuity as follows:
( )
PV Pmt
A
=

(
(
(
=
1
1
110
010
379 08
5
.
.
.
v This equation works for all regular annuities,
regardless of the number of payments
The Future Value of an Annuity
We can also use the principle of value additivity to find
the future value of an annuity, by simply summing the
future values of each of the components:
( ) ( ) ( )
FV Pmt i Pmt i Pmt i Pmt
A t
N t
t
N
N N
N
= + = + + + + +

1 1 1
1
1
1
2
2
The Future Value of an Annuity (cont.)
Using the example, and assuming a discount rate of 10%
per year, we find that the future value is:
( ) ( ) ( ) ( )
FV
A
= + + + + = 100 110 100 110 100 110 100 110 100 61051
4 3 2 1
. . . . .
100 100 100 100 100
0 1 2 3 4 5
146.41
133.10
121.00
110.00
}
= 610.51
at year 5
The Future Value of an Annuity (cont.)
Just as we did for the PV
A
equation, we could
instead use a closed-form of the FV
A
equation:
( )
( )
FV Pmt i Pmt
i
i
A t
N t
t
N
N
= + =
+

(
(

1
1 1
1
v This equation works for all regular annuities,
regardless of the number of payments
The Future Value of an Annuity (cont.)
We can use this equation to find the future value of
the example annuity:
( )
FV
A
=

(
(
= 100
110 1
010
61051
5
.
.
.
Annuities Due
Thus far, the annuities that we have looked at begin
their payments at the end of period 1; these are referred
to as regular annuities
A annuity due is the same as a regular annuity, except
that its cash flows occur at the beginning of the period
rather than at the end
0 1 2 3 4 5
100 100 100 100 100
100 100 100 100 100 5-period Annuity Due
5-period Regular Annuity
Present Value of an Annuity Due
We can find the present value of an annuity due in the
same way as we did for a regular annuity, with one
exception
Note from the timeline that, if we ignore the first cash
flow, the annuity due looks just like a four-period
regular annuity
Therefore, we can value an annuity due with:
( )
( )
PV Pmt
i
i
Pmt
AD
N
=

+

(
(
(
(
+

1
1
1
1
Present Value of an Annuity Due (cont.)
Therefore, the present value of our example annuity
due is:
( )
( )
PV
AD
=

(
(
(
(
+ =

100
1
1
110
010
100 416 98
5 1
.
.
.
v Note that this is higher than the PV of the,
otherwise equivalent, regular annuity
Future Value of an Annuity Due
To calculate the FV of an annuity due, we can treat
it as regular annuity, and then take it one more
period forward:
( )
( )
FV Pmt
i
i
i
AD
N
=
+

(
(
+
1 1
1
0 1 2 3 4 5
Pmt Pmt Pmt Pmt Pmt
Future Value of an Annuity Due (cont.)
The future value of our example annuity is:
( )
( )
FV
AD
=

(
(
= 100
110 1
010
110 67156
5
.
.
. .
v Note that this is higher than the future value
of the, otherwise equivalent, regular annuity
Deferred Annuities
A deferred annuity is the same as any other annuity,
except that its payments do not begin until some
later period
The timeline shows a five-period deferred annuity
0 1 2 3 4 5
100 100 100 100 100
6 7
PV of a Deferred Annuity
We can find the present value of a deferred annuity in
the same way as any other annuity, with an extra step
required
Before we can do this however, there is an important
rule to understand:
When using the PV
A
equation, the resulting PV is
always one period before the first payment occurs
PV of a Deferred Annuity (cont.)
To find the PV of a deferred annuity, we first find
use the PV
A
equation, and then discount that result
back to period 0
Here we are using a 10% discount rate
0 1 2 3 4 5
0 0 100 100 100 100 100
6 7
PV
2
= 379.08
PV
0
= 313.29
PV of a Deferred Annuity (cont.)
( )
PV
2
5
100
1
1
110
010
379 08 =

(
(
(
(
=
.
.
.
( )
PV
0
2
379 08
110
31329 = =
.
.
.
Step 1:
Step 2:
FV of a Deferred Annuity
The future value of a deferred annuity is calculated in
exactly the same way as any other annuity
There are no extra steps at all
Uneven Cash Flows
Very often an investment offers a stream of cash flows
which are not either a lump sum or an annuity
We can find the present or future value of such a
stream by using the principle of value additivity
Uneven Cash Flows: An Example (1)
Assume that an investment offers the following cash
flows. If your required return is 7%, what is the
maximum price that you would pay for this investment?
0 1 2 3 4 5
100 200 300
( ) ( ) ( )
PV = + + =
100
107
200
107
300
107
51304
1 2 3
. . .
.
Uneven Cash Flows: An Example (2)
Suppose that you were to deposit the following amounts
in an account paying 5% per year. What would the
balance of the account be at the end of the third year?
0 1 2 3 4 5
300 500 700
( ) ( )
FV= + + = 300 105 500 105 700 155575
2 1
. . , .
Non-annual Compounding
So far we have assumed that the time period is equal to a
year
However, there is no reason that a time period cant be any
other length of time
We could assume that interest is earned semi-annually,
quarterly, monthly, daily, or any other length of time
The only change that must be made is to make sure that the
rate of interest is adjusted to the period length
Non-annual Compounding (cont.)
Suppose that you have $1,000 available for investment.
After investigating the local banks, you have compiled
the following table for comparison. In which bank
should you deposit your funds?
Bank Interest Rate Compounding
First National 10% Annual
Second National 10% Monthly
Third National 10% Daily
Non-annual Compounding (cont.)
To solve this problem, you need to determine which
bank will pay you the most interest
In other words, at which bank will you have the highest
future value?
To find out, lets change our basic FV equation slightly:
FV PV
i
m
Nm
= +
|
\

|
.
|
1
In this version of the equation m is the number of
compounding periods per year
Non-annual Compounding (cont.)
We can find the FV for each bank as follows:
( )
FV = = 1 000 110 1100
1
, . ,
FV = +
|
\

|
.
|
= 1 000 1
010
12
1104 71
12
,
.
, .
FV = +
|
\

|
.
|
= 1 000 1
010
365
110516
365
,
.
, .
First National Bank:
Second National Bank:
Third National Bank:
Obviously, you should choose the Third National Bank
Continuous Compounding
There is no reason why we need to stop increasing the
compounding frequency at daily
We could compound every hour, minute, or second
We can also compound every instant (i.e.,
continuously):
F Pe
rt
=
v Here, F is the future value, P is the present value, r is
the annual rate of interest, t is the total number of
years, and e is a constant equal to about 2.718
Continuous Compounding (cont.)
Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. What is
the future value of your $1,000 investment?
( )
F e = = 1 000 110517
0 10 1
, , .
.
v This is even better than daily compounding
v The basic rule of compounding is: The more frequently
interest is compounded, the higher the future value
Continuous Compounding (cont.)
Suppose that the Fourth National Bank is offering to
pay 10% per year compounded continuously. If you
plan to leave the money in the account for 5 years, what
is the future value of your $1,000 investment?
( )
F e = = 1 000 1 648 72
0 10 5
, , .
.