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Finance
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DECEMBER 22, 2015

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TEACHING NOTE

TIME VALUE OF MONEY

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This reading covers the basic economics and mathematics of the time value of money. It may be used as a
standalone introduction to the topic for students who have never seen it and/or as a reference for
students beginning to apply the concepts to real-world problems as well as in combination with other
tools, such as Excel worksheets. The reading is a comprehensive guide to compounding and discounting,
but it does not treat the problem of risk or consider how risk premia are estimated for inclusion in
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discount rates.1 All sections include sample calculations. The reading concludes with more complicated
calculations drawn from real-world examples and a brief discussion of how the formulas developed in
the reading relate to pre-programmed Excel functions.

I. Content Overview
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Section 2.1 begins with the simple problem of relating present value (PV) to future value (FV) for a single
cash flow over a single period:

This fundamental relationship is then extended, one step at a time, in each subsequent section.
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Accordingly, Section 2.2 considers a single cash flow compounded or discounted over multiple periods.
Section 2.3 extends the PV/FV relationship to multiple cash flows over multiple periods. By the end of
Section 2.3 we have the generalized discounted cash flow formula that is ubiquitous in finance and
economics:
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1
For the latter topic, see Core Reading: Risk and Return (HBP No. 5220).

This teaching note was prepared by former HBS professor Timothy A. Luehrman with the assistance of writer Barbara Wall Lobosco, HBS MBA 1995,
for the sole purpose of aiding classroom instructors in the use of Core Reading: Time Value of Money (HBP No. 8299). It provides analysis and questions
that are intended to present alternative approaches to deepening students’ comprehension of business issues and energizing classroom discussion.
HBP Core Readings are developed solely as the basis for class discussion. HBP Core Readings are not intended to serve as endorsements, sources of
primary data, or illustrations of effective or ineffective management.

Copyright © 2015 Harvard Business School Publishing Corporation. All rights reserved.

Harvard Business Publishing is an affiliate of Harvard Business School.

This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
 Section 2.4 considers different compounding/discounting frequencies (annual, semiannual, monthly, etc.)

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for two basic purposes. First, it shows how to compute effective annual rates when the

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compounding/discounting frequency is less than one year (e.g., if you receive half the annual interest
rate every six months, what is the effective annual rate?). Second, the section shows how to convert an
annual rate into an equivalent semiannual (or quarterly, monthly, etc.) rate, i.e., holding the effective
annual rate constant. Continuous compounding/discounting is also covered in this section.

Section 2.5 (Perpetuities and Annuities) contains applications—real-world problems in which time value

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calculations are essential to arrive at solutions. To facilitate these calculations and to illustrate how they
are often performed in the real world, the section first derives formulas for the present values of
perpetuities and annuities. Then the example of a home mortgage is presented as an application of the
annuity formula. Following that is a more complex problem involving a proposed employee buyout
offer. This, too, involves an annuity, but the annuity is deferred, which requires an additional discounting
calculation. Finally, an additional wrinkle is added: the growing perpetuity. After this formula is
presented, it is applied in a last example involving consumer credit card debt.

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Section 3 (Supplemental Reading) is devoted entirely to showing students how to perform the same
compounding/discounting calculations using Excel. One way to do this, of course, is to program the
equations developed in the reading, simply by typing them as cell formulas in Excel. The other is to use
Excel’s functions, the most germane of which are functions for future values, present values, and
annuities. Section 3 includes both a discussion of these as well as a “map” that relates the variables and
formulas in the reading to the particular functions, notation, and syntax used by Excel. This section
presents worked examples, including some drawn from earlier parts of the reading, to show how Excel’s
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functions give the same answers as those calculated previously in the reading.

Section 6 (Practice Questions) is an interactive self-study tool. Students can use the interactive to test their
comprehension of the concepts covered in the reading without any impact on their course grade. The tool
provides students with the flexibility to refresh and retake the questions as needed until they reach their
desired level of proficiency.
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II. Syllabus Placement and Audience

The reading’s main mission is to introduce beginning students to time value calculations and to offer
more experienced students a refresher and a handy reference. As such, it may be used in many settings,
most obviously in an introductory finance course. Because it assumes no prior knowledge of finance, the
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reading may be inserted very early in the course; indeed, it could even be a pre-matriculation assignment
that students are expected to complete before the formal start of an introductory course. Nearly all of the
Core Readings in Finance presume students are familiar with the concept of time value and with basic
compounding/discounting calculations. Further, none of the other Core Readings repeats this material—
this reading is the sole source for it in the series.
If used as a reference or guide for more experienced students, the reading may be assigned as a
supplement in more specialized courses and students may refer to it as needed on a self-directed basis.
Courses in which this reading may be a helpful supplement include, for example, first courses in
Investment Management, Securities Analysis, Personal Finance, Public Finance, Corporate Finance,
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Project Finance, and Capital Budgeting, to name a few. Whether such courses involve primarily lectures
and problem sets, case studies, or some combination, Core Reading: Time Value of Money summarizes and
explains calculations that will be critical in all of these specialized applications.

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This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
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III. Interactive Illustrations

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The reading contains eight web-based interactive illustrations intended to illustrate key ideas and deepen
students’ understanding by giving them a visual representation or application of the ideas presented. In
most cases, students are invited to change key parameters and observe, visually, the consequences.

Interactive Illustration 1: Time Value of $100 Cash (Section 2.2)

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This illustration shows the value of $100 compounded or discounted over 1-, 2-, and 3-year periods.
Students compare PVs and FVs discounted/compounded over longer or shorter periods. They can
change the interest/discount rate and observe changes in future/present values while formulas (also
shown) and bar graphs are updated accordingly.

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Interactive Illustration 2: Calculating the Present Value of Multiple Cash Flows (Section 2.3)
This is an animation of present value calculations involving multiple (equal) cash flows and multiple
periods, summed to give a final result. By watching the animation, students see all the pieces of a multi-
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step computation performed in a logical order. Students can choose the discount rate and the speed at
which the animation plays. After running the interactive at least once, students can also see how the
values change without running the animation.
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8300 | Teaching Note: TIME VALUE OF MONEY 3

This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
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Interactive Illustration 3: Present or Future Value of Multiple Cash Flows (Section 2.3)
This is similar to the previous illustration, involving multiple cash flows and multiple periods, except
now students choose whether to compute present values (discounting) or future values (compounding)
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and observe the results using different selected discount/interest rates. They can toggle back and forth
between PV and FV, holding the rate constant, as another way to appreciate the differences in process
and result between discounting and compounding.
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Interactive Illustration 4: Time Value of $100 With Compounding Frequencies (Section 2.4)
This is the same as Interactive Illustration 1, discussed above, except students can also choose the
compounding/discounting frequency (annual, semiannual, or continuous). As students make their
selections, the formulas, values, and bar graph are updated.

8300 | Teaching Note: TIME VALUE OF MONEY 4

This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
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Interactive Illustration 5: Effect of Compounding Frequency (Section 2.4)
This is an alternative visual representation of the effect of compounding frequency on future values.
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Students select an interest rate together with any of various compounding intervals to apply to $100 over
one year. Illustration 5 shows the resulting future value(s) graphically for comparison. In the process, it
also serves as a visual representation of how compounding frequency influences the effective annual rate
of return.
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Interactive Illustration 6: Mortgage as an Annuity (Section 2.5)

This is a very rich illustration of a conventional home mortgage. Students select an annual interest rate
and the term of the mortgage loan. Illustration 6 shows how these variables (converted to monthly bases)
enter the annuity formula and determine the associated monthly mortgage payment. A graph shows the
split, for each month over the life of the mortgage, between interest and principal. Finally, students can

8300 | Teaching Note: TIME VALUE OF MONEY 5

This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
 move a slider to see what happens when the borrower elects to pay more than the minimum each month,

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and the graph is updated to show the new splits between interest and principal and the shortened life of

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the loan.

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Interactive Illustration 7: Present Value of Perpetuity and Annuities by Term (Section 2.5)
The final illustration gives a visual comparison of a perpetuity paying $1,000 per year to annuities of
various terms but with the same $1,000 annual payment. Students select a discount rate and then observe
how closely the present value of an n-year annuity approximates the present value of the perpetuity. A
slider for the discount rate lets students watch the changing relationship between annuities and a
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perpetuity as interest rates change.

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8300 | Teaching Note: TIME VALUE OF MONEY 6

This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
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IV. Related Materials

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The materials listed below offer students additional practice in the application of concepts in the reading
and the performance of discounting/compounding calculations. Product numbers correspond to the
Harvard Business Publishing online catalog. A few additional remarks may be helpful:

• Most of the cases and exercises involve considerably more practice with discounting than
compounding; this is due to their orientation toward valuation problems in a corporate or personal

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finance setting and the prominence of present value considerations. The exception is the case by
Conroy and Harris.

• “Type” designations are those that appear in the HBP catalog. Instructors should be aware,
however, that most of the items designated “Case” are simple situations and very similar to those
designated “Exercises.” Either may be used as, or in place of, traditional problem sets. The
exceptions are the Lockheed TriStar case by Edelman and the two cases by Luehrman and
Luehrman and Abelli. These three involve somewhat richer corporate settings and are closer to

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traditional case studies.

• Finally, the online course is obviously quite different from cases and exercises. It offers a body of
material related to, but more extensive than, the time value of money and does so in the context of a
broader introduction to finance.
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V. Discussion Questions
1. How would you explain the time value of money to someone who has no experience in finance
and has never taken a finance course? Can you explain it without using a numerical example?

2. What is the clearest, most succinct example of discounting you have encountered in everyday life?
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3. What is the clearest, most succinct example of compounding you have encountered in everyday
life?

4. Make a list of the personal finance decisions you expect to encounter over the next five to ten
years. Which of these involve discounting or compounding calculations, either for the purpose of
making a decision or for financial planning?
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VI. Related Materials

Author(s) Title Product Number Product Type

Cleary, Foerster Time Value of Money: The Buy vs Rent Decision W14403 Case
Conroy, Harris Interest Rates, Market Pricing, and Compounding UV0779 Case
Edelson Investment Analysis and Lockheed Tri Star 291031 Case
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Edelson Valuation and Discounted Cash Flows 291028 Exercises

Frey Discounted Cash Flow Exercises UV0566 Exercises
Gompers Digital Everywhere, Inc. 298099 Case
Developing Financial Insights: Using a Future
Haskins Value (FV) and a Present Value (PV) Approach UV5137 Case

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This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.
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Kester Valuing Capital Investment Projects 298092 Exercises
Kester Fixed Income Valuation 298080 Exercises

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Luehrman Finance Online Course 6000 Online course
Luehrman, Abelli New Heritage Doll Company (Brief Case) 4212 Case
Luehrman Stryker Corp.: In-sourcing PCBs 207121 Case
Odegaard Replacing El Poderoso 909E25 Case

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Capital Budgeting: Discounted Cash Flow
Piper Analysis 298068 Exercises
Pulvino Bond Math 201101 Case
Ruback Tree Values 201031 Case
Stafford Ocean Carriers 202027 Case

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This Teaching Note is authorized for use only by John Michael Delos Reyes, De La Salle University - Phillipines until Sep 2021. Copying or posting is an infringement of copyright.
[email protected] or 617.783.7860.