FIN 3000

Chapter 5
Time Value of Money

Liuren Wu
Overview

1. Using Time Lines

2. Compounding and Future Value
3. Discounting and Present Value
4. Making Interest Rates Comparable

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Learning Objectives
1. Construct cash flow timelines to organize your analysis of time
value of money problems and learn three techniques for solving
time value of money problems.

2. Understand compounding and calculate the future value of cash

flow using mathematical formulas, a financial calculator, and an
Excel worksheet.

3. Understand discounting and calculate the present value of cash

flows using mathematical formulas, a financial calculator, and an
excel spreadsheet.

4. Understand how interest rates are quoted and how to make them
comparable.

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Principles Used in this Chapter

 Principle 1: Money Has a Time Value.

 The concept of time value of money – a dollar received today,

other things being the same, is worth more than a dollar
received a year from now, underlies many financial decisions
faced in business.

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Using Timelines to Visualize Cashflows

 A timeline identifies the timing and amount of a stream of

cash flows along with the interest rate.

 A timeline is typically expressed in years, but it can also be

expressed in months, days, or any other unit of time.

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Time Line Example
i=10%
 Years 0 1 2 3 4

 Cash flow -$100 $30 $20 -$10 $50

 The 4-year timeline illustrates the following:
 The interest rate is 10%.
 A cash outflow of $100 occurs at the beginning of the first year
(at time 0), followed by cash inflows of $30 and $20 in years 1
and 2, a cash outflow of $10 in year 3 and cash inflow of $50 in
year 4.

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Checkpoint 5.1

Creating a Timeline

Suppose you lend a friend $10,000 today to help him

finance a new Jimmy John’s Sub Shop franchise and in
return he promises to give you $12,155 at the end of the
fourth year. How can one represent this as a timeline?
Note that the interest rate is 5%.

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Checkpoint 5.1: Check yourself

Draw a timeline for an investment of $40,000 today that

returns nothing in one year, $20,000 at the end of year 2,
nothing in year 3, and $40,000 at the end of year 4.

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Timeline
i=interest rate; not given

Time Period 0 1 2 3 4

Cash flow -$40,000 $0 $20,000 $0 $40,000

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Simple Interest and Compound Interest

 What is the difference between simple interest and

compound interest?
 Simple interest: Interest is earned only on the principal amount.
 Compound interest: Interest is earned on both the principal and
accumulated interest of prior periods.

 Example 5.1: Suppose that you deposit $500 in your savings

account that earns 5% annual interest. How much will you
have in your account after two years using (a) simple interest
and (b) compound interest?

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Example 5.1
 Simple Interest
 Interest earned = 5% of $500 = .05×500 = $25 per year
 Total interest earned = $25×2 = $50
 Balance in your savings account:
= Principal + accumulated interest
= $500 + $50 = $550

 Compound interest (assuming compounding once a year)

 Interest earned in Year 1 = 5% of $500 = $25
 Interest earned in Year 2 = 5% of ($500 + accumulated interest)
= 5% of ($500 + 25) = .05×525 = $26.25
 Balance in your savings account:
= Principal + interest earned = $500 + $25 + $26.25 = $551.25

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Present Value and Future Value
 Time value of money calculations involve Present value (what a cash
flow would be worth to you today) and Future value (what a cash flow
will be worth in the future).

 In example 5.1, Present value is $500 and Future value is $551.25 (if the
yearly compounding rate is 5%).

 The linkage between present value and future value is:

Future Value = Present Value x (1+Interest Rate per period)Number of periods

 For annual compounding (compounding once a year),

Future Value = Present Value x (1+Annual Interest Rate)Number of years

If nothing is said, assume annual compounding.

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Example:
 Example 5.1: The future value of $500 in 2 years with annual
compounding interest rate of 5% can be computed directly
from the formula:
FV2=PV(1+i)2 = 500(1+0.05)2=500(1.05)2=551.25.
 Continue example 5.1 where you deposit $500 in savings
account earning 5% annual interest. Show the amount of
interest earned for the first five years and the value of your
savings at the end of five years.
 You can do the calculation year by year
 or use the formula for future value: FVn= PV(1+i)n

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Year by year compounding
YEAR PV or Interest Earned FV or
Beginning (5%) Ending Value
Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $551.25
$26.25
3 $551.25 $551.25*.05 $578.81
=$27.56
4 $578.81 $578.81*.05=$28 $607.75
.94
5 $607.75 $607.75*.05=$30 $638.14
.39

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Use the Future Value Equation

 We will obtain the same answer using the future value

equation: FV = PV(1+i)n
= 500(1.05)5 = $638.14

 So the balance in savings account at the end of 5 years

will equal $638.14. The total interest earned on the
original principal amount of $500 will equal $138.14 (i.e.
$638.14- $500.00).

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Power of Time
Figure 5.1 Future Value and Compound Interest Illustrated

Future value of original investment increases with time, unless interest rate is
zero.

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Power of Interest Rate
Figure 5.1 Future Value and Compound Interest Illustrated

An increase in interest rate leads to an increase in future value.

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Checkpoint 5.2

Calculating the Future Value of a Cash Flow

You are put in charge of managing your firm’s working

capital. Your firm has $100,000 in extra cash on hand and
decides to put it in a savings account paying 7% interest
compounded annually. How much will you have in your
account in 10 years?

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Checkpoint 5.2

 Draw the time line

 It is a simple future value problem. Use the future value equation:

FV10=PV(1+i)10=100000(1.07)10=196,715

 Check for yourself: What’s future value in 20 years? What if the

annual return (interest rate) on the cash is 12%?
386,968; 964,629.

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FV Applications in Other Areas

 Example 5.2 A DVD rental firm is currently renting 8,000

DVDs per year. How many DVDs will the firm be renting in 10
years if the demand for DVD rentals is expected to increase
by 7% per year?

 Example 5.3 Your annual tuition at a State University is

currently $20,000. If the tuition increases by 6% annually,
what will be the annual cost of attending the State University
in 25 years?

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FV Applications in Other Areas

 Answers:
 Example 5.2: FV = 8000(1.07)10 = $15,737.21
 Example5.3: FV =$20,000 (1.06)25= $85,837.41 per year

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Compound Interest with Shorter (Other)
Compounding Periods

 Banks frequently offer savings account that compound interest

every day, month, or quarter.
 More frequent compounding will generate higher interest income
for the savers if the annual interest rate is the same.
 Example 5.4 You invest $500 for seven years to earn an annual
interest rate of 8%, and the investment is compounded semi-
annually. What will be the future value of this investment?
 Use the more general formula:
FV=PV(1+rate per period)Number of periods
 Rate per half year period is 8%/2=4%.
 Number of half-year periods in 7 years is 7x2=14 half years.
 FV=500x(1+0.04)14=865.84

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Compound Interest with Shorter
Compounding Periods

 Another way to write the future value equation, in terms of

annual rates and years:

 Example 5.4 again:

FV = PV(1+i/2)m*2 = 500(1+.08/2)7*2 = 500x(1.04)14=865.84.

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Given the same rate and time period, the more frequent the
compounding, the higher the future value.

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Checkpoint 5.3

Calculating Future Values Using Non-Annual Compounding Periods

You have been put in charge of managing your firm’s cash position and
noticed that the Plaza National Bank of Portland, Oregon, has recently
decided to begin paying interest compounded semi-annually instead of
annually. If you deposit $1,000 with Plaza National Bank at an interest rate of
12%, what will your account balance be in five years?

If you deposit $50,000 in an account that pays an annual interest rate of 10%
compounded monthly, what will your account balance be in 10 years?

Verify the answers: [1]$1790.85; [2]$135,352.07

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Discounting and Present Value

 What is value today of cash flow to be received in the future?

 The answer to this question requires computing the present
value, i.e., the value today of a future cash flow, and the process
of discounting, determining the present value of an expected
future cash flow.
 Since we know how to compound to get future value:
FVn=PV(1+i)n
 We can get PV from FV:
PV=FVn/(1+i)n
 Compound (multiply) to get future value; discount (divide) to
get present value.
 Present value is smaller than future value with positive rate.
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Example

 Example 5.5 How much will $5,000 to be received in 10 years

be worth today if the interest rate is 7%?

 PV = FV /(1+i)n =5000 /(1.07)10= $2,541.50

 To calculate present value, the interest rate is often referred

to as the “discount rate.”

 The textbook version of the PV formula (for annual

compounding):

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Impact of Interest Rates on PV

 If the interest rate (or discount rate) is higher (say 9%), the PV
will be lower.
 PV = 5000*(1/(1.09)10) = 5000*(0.4224)
=$2,112.00

 If the interest rate (or discount rate) is lower (say 2%), the PV
will be higher.
 PV = 5000*(1/(1.02)10) = 5000*(0.8203)
= $4,101.50

 Note the slight variation in which the formula is written.

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Checkpoint 5.4

Solving for the Present Value of a Future Cash Flow

Your firm has just sold a piece of property for $500,000, but under
the sales agreement, it won’t receive the $500,000 until ten years
from today. What is the present value of $500,000 to be received ten
years from today if the discount rate is 6% annually?
 Verify the answer: $279,197.39

What is the present value of $100,000 to be received at the end of 25

years given a 5% discount rate?
 Verify the answer: $29,530.28

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Solving for the Number of Periods

 Key Question: How long will it take to accumulate a specific

amount in the future?

 It is easier to solve for “n” using the financial calculator or

Excel rather than mathematical formula:

 FV=PV(1+i)n
 (FV/PV)=(1+i)n  Move PV to the left.
 ln(FV/PV)=n ln(1+i)  Take natural logs (ln) on both sides
 n=[ln(FV/PV)]/[ln(1+i)]  Move ln(1+i) to the left, switch sides.

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Example

 Example 5.6 How many years will it take for an investment of

$7,500 to grow to $23,000 if it is invested at 8% annually?

 N=ln(FV/PV)/ln(1+i)

=[ln(2300/7500)]/[ln(1.08)] =1.12/0.077

=14.56

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Checkpoint 5.5

Solving for the Number of Periods, n

Let’s assume that the Toyota Corporation has guaranteed that the
price of a new Prius will always be $20,000, and you’d like to buy one
but currently have only $7,752. How many years will it take for your
initial investment of $7,752 to grow to $20,000 if it is invested so that it
earns 9% compounded annually?

How many years will it take for $10,000 to grow to $200,000 given a
15% compound growth rate?

 Verify the answers: 11years; 21.43 years.

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Rule of 72

 Rule of 72 is an approximate formula to determine the

number of years it will take to double the value of your
investment.

 Rule of 72: N = 72/interest rate in percentage

 Example 5.7 Using Rule of 72, determine how long it will

take to double your investment of $10,000 if you are able to
generate an annual return of 9%.
 Exact N=ln(2)/ln(1.09)=0.693/0.086=8.04
 Approximate N=72/9=8.

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Solving for Rate of Interest

 Key Question: What rate of interest will allow your

investment to grow to a desired future value?

 FV=PV(1+i)n

 (FV/PV)=(1+i)n  Move PV to the left

 (FV/PV)(1/n)=1+i  Take (1/n) root on both sides

 i=(FV/P)(1/n)-1.  Move 1 to the left, switch sides.

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Example

 Example 5.8 At what rate of interest must your savings of

$10,000 be compounded annually for it to grow to $22,000 in
8 years?

 i=(FV/PV)(1/n)-1 = (22000/10000)(1/8)-1 =0.1036=10.36%.

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Checkpoint 5.6

Solving for the Interest Rate, i

Let’s go back to that Prius example in Checkpoint 5.5. Recall that
the Prius always costs $20,000. In 10 years, you’d really like to have
$20,000 to buy a new Prius, but you only have $11,167 now. At what
rate must your $11,167 be compounded annually for it to grow to
$20,000 in 10 years?

At what rate will $50,000 have to grow to reach $1,000,000 in 30

years?

Verify the answers: 6%; 10.5%.

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Making Interest Rates Comparable

 The annual percentage rate (APR) indicates the amount of

interest paid or earned in one year without compounding.
APR is also known as the nominal or stated interest rate. This
is the rate required by law.

 We cannot compare two loans based on APR if they do not

have the same compounding period.

 To make them comparable, we calculate their equivalent rate

using an annual compounding period. We do this by
calculating the effective annual rate (EAR) .

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Linking APR to EAR

 APR is the quoted annual rate with a pre-specified

compounding frequency. [Let m be the number of
compounding periods per year for this APR.]

 EAR is the effective annual rate at an annual compounding

frequency. [One compounding per year]

 The two should generate the same amount of money in one

year:

 (1+APR/m)m=(1+EAR)  EAR=(1+APR/m)m-1.

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Example

 Example 5.9 Calculate the EAR for a loan that has a 5.45%
quoted annual interest rate compounded monthly.

 Monthly compounding implies 12 compounding per year.

m=12.

 EAR = (1+APR/m)m - 1 = (1+.0545/12)12 - 1

= 1.0558 – 1= .05588 or 5.59%

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Checkpoint 5.7

Calculating an EAR or Effective Annual Rate

Assume that you just received your first credit card statement and
the APR, or annual percentage rate listed on the statement, is 21.7%.
When you look closer you notice that the interest is compounded daily.
What is the EAR, or effective annual rate, on your credit card?

What is the EAR on a quoted or stated rate of 13% that is

compounded monthly?

Verify the answers: 24.23%; 13.80%.

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Continuous Compounding

 When the time intervals between when interest is paid are

infinitely small, we call it continuous compounding. In this
case, future value and present value is linked as:
 FV=PV er t
 r is the continuous compounding rate, t is number of years.
 E is the “natural number” 2.71828

 Continuous compounding rate is linked to EAR as

 EAR= er - 1, again obtained by matching the one-year future
value from the two compounding frequencies.

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Example

 Example 5.10 What is the EAR on your credit card with

continuous compounding if the APR is 18%?

 EAR = e.18 - 1

= 1.1972 – 1

= .1972 or 19.72%

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