Time Value of Money

(Chapter 4)
Overview
 The phrase “time value of money” refers to the fact that a dollar in hand today is worth
more than a dollar to be received at some time in the future. Why is that the case?
 Dollars that we have today (“present dollars”) can be invested and start earning a return
immediately. Dollars that we will not receive until some future date (“future dollars”) will
not start earning a return until we receive them. Therefore, present dollars and future
dollars are not equal in value because of the opportunity cost associated with the delay
in earning a return.
 Many of the financial management decisions that we make involve evaluating cash flows
where there is a mix of present dollars and future dollars. This type of analysis is Time
Value of Money (“TVM”) or Discounted Cash Flow (“DCF”) analysis.
 TVM/DCF provides a set of tools to allow us to convert future dollars to present dollars
(and vice versa) so that we can make a fair comparison of alternative courses of action.
The basic tools at our disposal are:
o Future value: Converting present dollars into future dollars through the use of
compounding.
 o Present value: Converting future dollars into present dollars through the use of
discounting.

 The first step in analyzing a TVM problem is to set up a cash flow time line:
0 1 2 3

PV=? -$100 -$100 -$100

End of period 1 & Cash flows: negative if an

beginning of period 2 outflow, positive if an inflow

 The time line allows us to organize the cash flows logically so that we can
input them into our calculator (Texas Instruments BA II Plus) properly and
get the correct answer.
CF (“cash flow”) keys: for NPV of a series
of unequal cash flows and for IRR
calculations.

Annuity keys: PV and FV of a single

payment and for PV and FV of a series
of equal cash flows.
Future Value
Future value is the amount of future dollars that an investment of an amount of
cash (PV) will grow to over some length of time (N) at some given rate of return
(I).
Example 1:
We will invest $1,000 today in an investment that will earn 10% per year for three
years. What will our investment be worth at the end of three years?
0 1 2 3

-$1000 FV= ?

1st yr = 1,000 x 1.10 = 1,100

2nd yr = 1,100 x 1.10 = 1,210
3rd yr = 1,210 x 1.1 = 1,331 or 1,000 x (1.10)3 =1,331
This result means that you are indifferent between receiving $1,000 now and receiving
$1,331 3 years from now, if your opportunity cost is 10%.
Interest on interest = 31 if only simple interest then FV= 1,300
Note that during years two and three in our example, we are earning interest on
our original $1,000 (the “principal”) as well as the reinvested interest. This
“interest on interest” is called compound interest. Most time value of money
calculations assume that interest is reinvested and that interest is earned on
interest. If we did not make that assumption, we would end up with a simple
interest calculation (i.e. interest earned only on the principal) and a very different
result.

Calculator key strokes:

N=3 PV = -1,000 I=10% CPT FV=1,331. Notice we input the initial amount (the PV)
as a negative number. This is because we are treating it as a $1,000 payment today for
some sort of investment that later gives us a cash payment of $1,331, which our calculator
returns as a positive number.

Formula:
FV =PV ¿ (formulae are provided in the text but once you are familiar with your
N

calculator you won’t really need them)

FV=1,000 X (1.10)3=1,331
Example 2:
Assume that we will invest $1,000 each year for three years, with the first $1,000
to be invested one year from now. If the annual rate of return is 10%, what will
the investment be worth at the end of three years?
0 1 2 3

-$1000 -$1000 -$1000

FV=?

Payment at end of year 1: 1,000x1.10x1.10 = 1,210=FV, end of year 3

Payment at end of year 2: 1,000x1.10 = 1,100=FV, end of year 3
Payment at end of year 3: 1,000 = 1,000=FV, end of year 3
Total = 3,310
This pattern of cash flows where the periodic payments are at the end of each
period is called an ordinary annuity.
Calculator key strokes:
N=3 PMT= -1,000 I=10 PV= 0 CPT FV=3,310
Example 3:
Based on the information in the previous example, assume the annual
investments are shifted to the beginning of each year, with the first investment
being made today. What will the investment be worth at the end of three years?
0 1 2 3

-$1000 -$1000 -$1000 FV=?

Payment at beginning of year 1: 1,000 x1.10 x 1.10 x 1.10 = 1,331=FV at end of year 3
Payment at beginning of year 2: 1,000 x1.10 x 1.10 = 1,210=FV at end of year 3
Payment at beginning of year 3: 1,000 x 1.10 = 1,100=FV at end of year 3
Total = 3,641
When the periodic payments are shifted to the beginning of each period, we have
an annuity due.
Calculator key strokes:
2nd BGN 2nd SET 2ND QUIT CPT FV = 3,641
Notice that FV of annuity is equal to FV of ordinary annuity x (1+discount rate): 3,310 x
1.10=3,641
Present Value
Present value represents the value in present dollars of future cash flows
discounted at an appropriate rate of return (the “discount rate”). The appropriate
discount rate is the rate of return that the future cash flows could earn if they
could be invested today.
Example 4:
What is the present value of $1,000 to be received three years from now if the
discount rate is 10%?
0 1 2 3

PV=? $1000

Basic formula: PV =
FV N
(1+ I )
N
PV=1,000/(1.10)3 = 751.31

Calculator key strokes:

FV=1,000 N=3 I=10 PMT=0 CPT PV=-751.31: Receiving $751.31 now is the same
as receiving $1,000 3 years from now if 10% is your opportunity cost. Notice that the
calculator returns this amount as a negative number i.e. it is the amount we would pay now
in order to receive $1,000 in 3 years.
Example 5:
What is the present value of $1,000 to be received at the end of each year for
three years, discounted at 10% (i.e. an ordinary annuity)?
0 1 2 3

PV=? $1000 $1000 $1000

Payment at end of year 3: 1,000/(1.10)3 = 751.31=PV today

Payment at end of year 2: 1,000/(1.10)2 = 826.45=PV today
Payment at end of year 1: 1,000/(1.10) = 909.09=PV today
Total = 2,486.85=PV today
Calculator key strokes:
N=3 PMT = 1000 I=10 FV= 0 CPT PV = -2,486.85
Example 6:
Based on the information in the previous example, assume the annual
investment returns are shifted to the beginning of each year, with the first
payment being received today. What is the present value of this annuity due?
0 1 2 3

$1000 $1000 $1000

PV=?

Calculator key strokes: 2nd BGN 2nd SET 2nd QUIT CPT PV= -2,735.54
 Example 7:
Sometimes, as with a bond, we will have an annuity plus an additional final
payment. What is the present value of $100 to be received at the end of each
year for five years plus a final payment of $1,000, discounted at 8%?

0 1 2 3 4 5

PV=? $100 $100 $100 $100 $100+

$1,000
Calculator key strokes:
N=5 PMT = 100 I=8 FV= 1,000 CPT PV = -1,079.85. Note the payments and the FV
are all input as positive (the cash flows you receive from the bond) and that the PV is
negative (the price you must pay for the bond).
Example 8:
What is the present value of $1,000 per year received at the end of each year
into infinity if the discount rate is 10%?
This pattern of cash flows is called a perpetuity.
Formula:
PMT
PV of a perpetuity=
I

PV=1,000/0.10 = 10,000
 Example 9
Assume that the perpetual cash flows in the previous example do not start until
the end of year three (i.e. a delayed perpetuity).
0 1 2 3 4 5
∞
PV=? $0 $0 $1000 $1000 $1000

PV2=?
Formula:
PMT N 1
PV = ×
I ( 1+ I )N −1

First calculate the PV of the perpetuity. The first perpetual payment is at the end

of year 3 so the PV at the end of year two is: PV2= (1,000/0.10) =10,000. The

PV today of this amount is 10,000/(1.102)=8,264.46.

Using calculator: N=2 I/Y=10 FV=10,000 PV=-8,264.46
 Example 10:
Assume that the perpetual cash flows in example 7 will grow at a constant rate of
3% per year (g).
0 1 2 3 4 5
∞
PV=? $1,000 $1,030 $1,061 $1,093 $1,126

Formula:
PMT 1
PV =
I−g
PV= 1,000/(0.10-0.03) = 14,285.71

Note in this example we are assuming that the first cash flow is $1,000 and that
the 3% growth starts in year two.
This concept of a “growing perpetuity” is important in the valuation of dividend
paying stocks.

Example 11:
Determine the present value of the following end of year cash inflows if the discount rate is
10%:
Year 1 $500
Year 2 $700
Year 3: $900
Year 4 $1,100
The pattern is called an “irregular” stream of cash flows.
0 1 2 3 4

PV= ? $500 $700 $900 $1,100

Calculator key strokes:

We can’t use the “annuity keys” on your calculator (the ones in row 3) because the cash
flows are irregular. We must use the “CF” keys in row 2.
CF CFo=0 C01=500 C02=700 C03=900 C04=1,100 NPV I=10
CPT NPV=2,460.56. Use the “down arrow” to move to next register and press “Enter”
when inputting values. Note that all cash flows are input as positive values and that, unlike
with the annuity keys, the NPV returned is also positive
Example 12:
Based on the information from the previous example, assume that after year four,
the cash flows will grow at a constant rate of 3% per year into infinity. What is the
PV of the cash flows?

0 1 2 3 4 5 6
∞
PV0=12,833 $500 $700 $900 $1,100 $1,133 $1,167

PV3=15,714.29
16,185.71
PV3=1,100/(0.10-0.03) = 15,714.29 This amount is the PV of the growing perpetuity at the
end of year 3.
Calculator key strokes:
CF CFo=0 C01=500 C02=700
C03=900+15,714.29=16,614.29 NPV I=10
CPT NPV=13,515.62

Investment Decision Making

 Net Present Value (NPV)
o NPV is the present value of the future cash flows, discounted at the opportunity cost
of capital/ required rate of return (see below), minus the initial investment.
o In order to enhance the value of the firm, the PV of all future cash flows must
exceed the initial cost of the investment (i.e. NPV must be >0).
o The opportunity cost of capital is the required return that is forgone by investing in
the project being analyzed instead of investing in a similar risk investment.
Example 13:
Assume a 15% required rate of return
Cash inflows (outflows)
Initial investment ($350,000)
Year 1 $85,000
Year 2 $100,000
Years 3 - 5 $125,000

0 1 2 3 4 5

$-350,000 $85,000 $100,000 $125,000 $125,000 $125,000

Determine the NPV of this investment:
CFO=-350,000 C01=85,000 C02=100,000 C03=125,000 F03=3 NPV I=15
ARROW DOWN CPT NPV=15,333.19

 Internal Rate of Return (IRR)

o The discount rate that equates the present value of a series of cash inflows with the
initial investment at t = 0 (i.e. the rate that makes NPV = 0).
o If the IRR is greater than the required rate of return (the "hurdle rate"), then we can
accept the investment.
 What is the IRR of the Example 13 cash flows?
IRR CPT IRR=16.71 is greater than 15% therefore NPV>0!
 What is the Net Future Value of the Example 13 cash flows?
2ND QUIT N=5 I=15 PV=-15,333.19 (NPV from earlier calculation)
PMT=0 CPT FV=30,840.52

Finding the Interest Rate, the Payment and the Number of Periods
All time value of money calculations use at least three of the five following variables: PV,
FV, I, N and PMT. If we have enough information we can solve for any of the missing
variables.
Example 14:
You just invested $3,000 in a security that will yield 8% per year. Assuming that your
annual returns are reinvested, how long will it take to double your investment?
PV=-3,000 FV=6,000 I=8 CPT N=9
Using logs: 1.08N = 2 N ln 1.08=ln 2 N=9.0065
Example 15:
You just sold a stock investment for $50 per share. You paid $35 per share for this
investment four years ago and did not receive any dividends during the period that you held
the stock. What was your compound annual rate of return on this investment?
PV=-35 FV=50 N=4 CPT I=9.32%
Example 16:
You need to borrow $10,000 and want to repay it in equal annual payments over five years.
The bank will charge an interest rate of 6%. What are the annual payments?
N=5 I=6 PV= 10,000 FV= 0 CPT PMT = -2,373.96

Effective Annual Rates and Compounding

Terminology
 Nominal or Quoted Rate (INOM): the rate quoted by the bank, broker, etc. Also called
the Annual Percentage Rate (“APR”). It does not reflect the impact of any
compounding and is not used in calculations unless compounding occurs only
once per year.
 Periodic Rate (IPER): the rate charged or earned each “period” e.g. each year, quarter,
month, etc. The periodic rate is equal to the nominal rate divided by the number of
compounding periods (“M”) per year:
IPER = INOM/M
o In most cases the periodic rate is the rate used in calculations and shown on
a cash flow time line.
 Effective Annual Rate (“EAR” or “EFF”): the annual rate that takes into account any
compounding. EAR allows us the compare APRs that have different compounding
periods. The formula is:
 [ ]
M

EAR= 1 +
I NOM
−1
M
Where :
m=The number of compounding periods per year .
 The EAR adjusts the APR for the number of compounding periods per year and
expresses the interest rate as if it were compounded once per year. Another way
to think about the EAR is that it is the rate that converts a present value into a future
value over a one year period.

 If there is only one compounding period per year, the APR and the EAR are the same.
As the number of compounding periods increase however, the EAR starts to rise
relative to the nominal rate. For example, here are the EARs at different compounding
intervals for a quoted rate of 8%:

Compounding interval Effective annual rate

Annual 8.0000%
Semi-annual (2 times per year) 8.1600%
Quarterly 8.2432%
Monthly 8.3000%
Daily 8.3278%
 Example 17
What is the EAR of 12% compounded monthly?
EAR = (1+(0.12/12)^12 = 12.6825%
Calculator: 2nd ICONV 12 ENTER NOM=12 ARROW DOWN TWICE 12
ENTER ARROW UP CPT EFF=12.6825

Loan Amortization
 Loans that are repaid in fixed payments are called amortized loans. The payments are
usually blended: they contain both interest and principal. The early payments contain
mostly interest and a small amount of principal. As the principal is repaid, the interest
portion of the payment decreases and the amount of the payment applied to the loan
principal increases.
 The Texas Instruments BA II Plus (and many other financial calculators) contain a loan
amortization function that allows us to compute the loan payment as well as the
following:
o The balance of the loan after any payment.
o The interest and principal amounts of any payment.
o The amount of principal and interest paid over a range of payments.
 If the interest compounding interval corresponds to the payment interval (e.g. monthly
compounding and monthly payments), the calculations are fairly straightforward.
Adjustments must be made to the calculation if the compounding intervals are different
than the payment intervals. We will not cover those adjustments in this course.

Example 18:
(a) Determine the monthly payment for a $200,000 loan with quoted annual rate of 6%
and a 25-year amortization term.
PV=200,000 FV=0 N=25 x 12 =300 I/Y=6.00/12=0.50 CPT PMT=-1,288.60

(b) What will the balance of this loan be after the first year of payments?
2nd AMORTP1=1 ENTER P2=12 ENTER ARROW DOWN BAL=196,439.92

(c) How much of the 15th payment will be applied to the principal of the loan?
ARROW UP TWICE P1=15 ENTER P2=15 ENTER ARROW DOWN TWICE
PRN=-309.47

(d) What amounts of principal and interest will be paid during the third year of payments?
ARROW UP THREE TIMES P1=25 ENTER P2=36 ENTER ARROW DOWN TWICE
PRN=-4,012.78 ARROW DOWN INT=-11,450.46