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Time Value of Money

Dan Parlagreco
Financial Management I and I I
University of Phoenix Online
Welcome to a brief introduction to the concept of the time value of
money.
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Overview
n Time Value: What and Why?
n How t o comput e
n Simple Examples
n Applicat ions
n Capit al Budget Process
n Conclusion
During this presentation, we will explore what the time value of money
is, how we compute it and how we use it in simple examples. We will
look beyond the simple to real life applications, where time value of
money concepts are typically used. One of the main areas of
application for time value of money is capital budgeting analysis, and
we will consider some of the aspects associated with project evaluation
as an illustration of the concepts we are considering. We will conclude
with a few observations about money and its value over time.
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Time Value: What and Why
n Whimpy Says
n I will gladly give you five dollars t omorrow
for a hamburger t oday.
n Banks pay int erest t o hold your money
n I nvest ors give f unds in ret urn f or f ut ure
ret urns
n Why do people do t his?
Popeye was one of my favorite cartoons as a kid. In the cartoon, a
rather portly character, Whimpy, often had the line I will gladly pay you
$5.00 tomorrow for a hamburger today. This was meant to be funny,
because at the time a hamburger could be had for about $0.50. It is
also an illustration as to why money has time value, Whimpy wanted his
hamburger now, and was willing to forgo the possibility of ten
hamburgers in the future to get it. (another part of the joke, however,
was that Whimpy would never pay, another reason why its better to
have money now then later).
More realistically, we know that banks are willing to pay us interest and
that investors are willing to risk their money in bonds and stocks in
return for the expectation of more money later. Why do it? The simple
answer is that investors will invest funds when the expectation of future
returns makes them indifferent between the funds they have now and
the funds they expect to receive in the future.
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Time Value: What and Why
n I nvest ment
n Propert y or anot her possession acquired for
fut ure financial ret urn or benefit .
n Risks involved
n Not get t ing ret urn promised
n Not get t ing your money back
n Get t ing an amount ot her t han promised
n I nvest ors invest t o get a ret urn, t he amount
of which is det ermined by t he degree of risk
So what is an investment, anyway?
The dictionary defines investment as property or another possession
acquired for future financial return or benefit, meaning that its
something you are not using now in the expectation that you will get to
use more in the future.
Investments do have risks, which increase the required return of
investors. Some of the risks are obvious, like not getting the return you
expected or not getting your money back. Not so obvious is the risk
that you might get a lot more or less than you expect. Variation in
returns is the financial definition of risk.
Investors invest to get a return, the amount of which is determined by
the degree of risk they are undertaking.
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Time Value: What and Why
n Risk and Ret urn are relat ed
n More risk = Great er average ret urn
n Less risk = Lower average ret urn
n Financial Risk vs. Everyday Risk
n Financial risk = variat ion in ret urns
n Everyday risk = risk of loss or anot her
disast er
This means risk and return are related. The higher the risk, the greater
the return you will need. A low risk investment, however, gives a near
certain return and therefore the investor need be compensated only a
little since his risk is low. This is why the banks pay 1% on a passbook
account, which is guaranteed by the government and which will almost
certainly pay the rate indicated. It is also why risky companies have to
pay 10% and more to get funds; investors know there is a chance they
will not get the amount promised and even a chance they might loose
their money.
Everyday risk and financial risk are different. Everyday risk refers
usually to a risk of a loss or injury. In other words, you risk your life,
your limb, your house, etc Financial risk means variation in returns. A
risky investment in a financial sense has a high variation in return which
leads to investors bidding the price to a level where the average
expected return is higher than if the return were certain, even if the
certain return were less than the average return expected.
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Time Value: What and Why
n Need a way t o comput e
n Time Value of Money
n Present Value
n Fut ure Value
n Annuit y Valuat ion
n Gradient Valuat ion
n I nput s
n Time (n)
n Rat e of Ret urn (k)
n I nit ial invest ment (AMT)
n Ret urns (PMT)
So how do we compute this? We use time value of money concepts.
Given the time in number of periods (n), rate of return expected (k), sum
involved (AMT) and return (PMT), you can solve for the following
amounts:
Present Value: the amount required to make an investor indifferent
between a sum today and another larger sum in the future.
Future Value: the amount required in the future to make the investor
indifferent between that sum and a smaller sum today.
Annuities are equal payments spread over time, and these can be
valued in relation to lump sums today (present value) or at some future
time (future value).
Gradients are equally increasing annuity payments, and are beyond the
scope of our present discussion.
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How t o comput e
n Present value
n The amount you would need t oday t o be
indifferent bet ween t he lump sum and t he
fut ure lump sum payment .
n
k
PMT
PV
) 1 ( +

To compute the present value of a future sum (PMT), just divide by the
quantity one plus the interest (or discount) rate and raise the rate to the
nth power where n is the number of periods.
A word on the math:
Raising a sum to a power is the same as multiplying it out n times (if n
is the power).
So (1+k)
3
is the same as (1+k)(1+k)(1+k)
Be sure that k and n are for comparable periods. If periods are months,
you need to use a monthly interest rate for k. So if an annual rate is
given, you would divide by 12 to make it into a monthly rate to match
the monthly periods in that case.
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Present Value: Simple Example
n Grandmas Will
n Uncle Sal get s $25,000 t oday
n Uncle Vit o get s $30,000 five years from
t oday
n Banks pay 5% on 5-year CDs
n Should Sal be mad or should Vit o rough
him up?
Lets look at an example.
Uncle Sal gets $25K now, so the present value of that is easily seen to
be $25,000.00
Uncle Vito gets $30,000 five years from now and banks pay 5% annual
interest.
Question is, who got the short end of Grandmas stick?
To answer this, we would compute the present value of Uncle Vitos
$30K to be received 5 years from now at a discount rate of 5%, since
Vito could put a sum in the bank today and get that amount back.
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Present Value: Simple Example
n PV of Sals t ake
n PV of Vit o's t ake
00 . 000 , 25 $
) 05 . 0 1 (
1
000 , 25
0

,
_

+
PV
78 . 505 , 23 $
) 05 . 1 (
1
000 , 30
5

,
_

+
PV
Here Grandmas favorite is revealed. As we see, Sal should be happy,
until Vito breaks his legs, that is
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How t o Comput e
n Fut ure Value
n The amount you would need at some t ime
in t he fut ure t o be indifferent bet ween a
different (smaller) amount t o be received
t oday and t hat fut ure amount .
n
k PV FV ) 1 ( +
Future value is the exact same computation as present value, but in
reverse. Al the same guidelines apply to this simple calculation.
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Fut ure Value: Simple Example
n Sal is promised a f ut ure payment of
$25,000 in ret urn f or his immediat e
invest ment of $12,500.
n Payment t o be made in five years
n Risk is high, so appropriat e rat e is 15%
n Should Sal do it ?
So if Sal is promised $25K in five years if he would just give Vito $12.5K
now, and Sal thinks a discount rate of 15% is appropriate, should he
take the deal or pass on it while he recuperates in the hospital?
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Fut ure Value: Simple Example
n Comput e Fut ure Value of $12,500 in
f ive years at a rat e of 15%
96 . 141 , 25 $
) 15 . 1 ( 500 , 12
5

+
FV
FV
Not being a fool, Sal computes that the future value of his $12.5K at
15% is just over $25,141.00, meaning he should pass up Vito on his
fine offer and opt for another investment.
The minimum payback that Sal would require to risk his money on Vito
is $25,141.96, meaning any proposed payback less than that would be
unacceptable to Sal.
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Series of Payment s: Annuit y
n An annuit y is a series of equal
payment s made over t ime
n Regular annuit y: paid at end of period
n Annuit y due: paid at beginning of period
n Annuit y payment s t hat are not equal
must be t reat ed dif f erent ly t han a
simple annuit y
Shifting gears a bit, we see that an annuity is a series of equal
payments. If the payment is made at the end of the period, its called a
regular annuity; if at the beginning its called an annuity due.
Annuity payments that are not equal must be treated as unequal cash
flows and each year must be handled separately.
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Annuit y Formulas
n Regular Annuit y
n Present Value
n Fut ure Value

,
_

1
]
1

1
]
1

n k n
k k k
PMT PVA
) 1 (
1 1
,

,
_

k
k
PMT FVA
n
n k
1 ) 1 (
,
The formulas here can be used to compute the present and future
values of any annuity given the periodic interest rate k, the number of
periods n, and the annuity payment amount PMT.
Note that if n is infinite, the annuity is called a perpetuity, and the
formula for the present value reduces to PMT/k (with k in periodic form
to match the frequency of receipt of PMT).
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Regular Annuit y: Simple Example
n Grandmas Will
n Sal get s his $25,000.00 immediat ely
n Vit o get s $500.00 a mont h for five years
n Banks pay 5% annual int erest on five year
CDs
n Again, should Sal or Vit o be upset ?
Lets look at another version of Grandmas Will and see if Sal or Vito is
the better man.
Sal gets his usual $25K, but Vito has now talked Grandma into giving
him $500 per month for five years.
The task is to value Vitos new inheritance at the same time Sal gets his,
which is now.
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Regular Annuit y: Simple Example
n Sals t ake is st ill $25,000.00
n Vit o has an annuit y f or f ive years.
n Five years = 12 x 5 or 60 mont hs
n Mont hly int erest is 0.05/ 12 or 0.004167

,
_

1
]
1

1
]
1

60 004167 . 0 , 60
) 004167 . 0 1 ( 004167 . 0
1
004167 .
1
500 PVA
Using the formula, we know that 5 years is 60 months and that 5%
equals a 0.004167 monthly interest rate (0.4167% expressed as a
decimal).
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Regular Annuit y: Simple
Example
n Vit os t ake is $26,495.00, or some $1,495.00
more t han Sals
n What if t he annuit y were an annuit y due
n Mult iply t he regular annuit y amount by (1+ k) t o
get t he annuit y due amount
n K is a periodic rat e
n Vit os t ake would be wort h $26,605 in t odays
dollars
Solving for the present value, we see Vito now is in the drivers seat,
getting some $1,495.00 more than Sal. Note that the sum of the
payments is still $30,000 like the first version of the will, but that smooth
talking Vito has tricked Grandma into giving him a lot more than the
$30K he would have got as a lump sum five years in the future.
If the annuity were an annuity due, Vito would be in even better shape.
The value of an annuity due is computed by taking the value of the
regular annuity and multiplying by (1+k).
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Applicat ions
n Comparison of amount s on a t ime
equalized basis
n Evaluat ion of Capit al proj ect s
n Company valuat ion models
n Ret irement Planning
n Savings and I nvest ment Management
Here are some common applications of these techniques, including
capital budgeting, valuation of companies for mergers, retirement
planning, amortization of loans, and savings and investment
management.
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Conclusion
n Time Value must be considered
n Not j ust a sales/ account ing issue
n Applicable t o business and everyday lif e
n Powerf ul t ool if underst ood
So we have seen why money has a time value, how to compute what
that value is, and have touched on how it might impact an everyday
situation. Clearly, the time value of money is a powerful concept for
those who understand it.