Time Value of Money

Section 1
Basic Ideas of Time Value
of Money Concept

2
 The Core Question of
Finance
Congratulations!!!
You have won a cash prize!
There are two optional payment
schedules:
A - receive $100,000 now
B - receive $100,000 in five years.
Which option would you choose?

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 Time Value of Money
Concept

In simple terms
the concept
implies that money today
is always better than
money tomorrow.

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 Why Time Value of Money
Exists?

 Risk and Uncertainty-future always involves some risk, especially in

respect to cash inflows of company as they are highly uncontrollable;

 Inflation-in an inflationary economy a dollar today has always more

purchasing power in compared to a dollar some point in future;

 Consumption Preference- individuals generally prefer current

consumption to a future one;

 Investment Opportunities-an investor can profitably use money received

today by investing it immediately;

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Allows investors to adjust cash
flows for the passage of time;

It’s an integral part of Capital

Budgeting Processes;

 Applied in present and future

value calculations;

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 Section 2
Interest Rates

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9
Formula
SI = P0(i)(n)

SI: Simple Interest

P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

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Simple Interest Example

Assume that you deposit $1,000 in an

account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?

SI = P0(i)(n)
= $1,000(.07)(2)
= $140
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 Compound Interest
 Yields higher return for
investors or deposit
holders;
 Cumbersome for
borrowers;
 Makes borrowers to be
more adhere to their
payment schedule,for
example.credit cards;
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 Compound Interest
Example
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2
years.
years
0 1 2
7%

$1,000
FV2

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 Compound Interest
Example
At the end of first year
P0 (1+i)1 = $1,000x (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
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 Compound Interest
Example(cont.)
At the end of first year = $1,000 (1.07)
= $1,070
At the end of second year = 1070 (1+i)1
1070x(1.07)
$1,144.90
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
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 Section 3
Present Value vs Future
Value

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Valuation Concepts

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 Future Value

The value at some future time of a present

amount of money, or a series of payments
evaluated at a given interest rate;

The interest earned on the initial principal

amount becomes a part of the principal at
the end of the compounding period;
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 Future Value Example
Problem
Suppose you invest $1000 for three years in a saving account that pays 10 %
interest per year. If you let your interest income be reinvested, your investment
will grow as follows:
First year : Principal at the beginning $1000
Interest for the year ($1,000 × 0.10) $100
Principal at the end $1,100
Second year : Principal at the beginning $1,100
Interest for the year ($1,100 × 0.10) $110
Principal at the end $1,210
Third year : Principal at the beginning $1,210
Interest for the year ($1210 × 0.10) $121
Principal at the end $1,331

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Formula
FV = P0(1+i)n

FV: Future Value

P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
In the previous example
FV=1000(1+0.1)3=1,331 20
 Double Your Money!
We will use
the“Rule-of-72”

Quick! How long

does it take to
double $5,000 at a
compound rate of
12% per year
(approx.)?
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 The “Rule-of-72”

Quick! How long does it take to

double $5,000 at a compound rate of
12% per year (approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
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 Present Value
Which one would you prefer assuming that
the rate is 8%?
a)$1000 today or,
b)$2000 10 years later?
To answer this question we have to
express $2000 in today’s money.
PV=FV/(1+i)n
$926=2000/(1+0.8)10
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 Types of Annuities

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
• Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period(coupon);
• Annuity Due:
Due Payments or receipts occur at
the beginning of each period(rent);

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 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
Equal Cash Flows
Each 1 Period Apart 25
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart 26
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$3,215 = FVA3
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
= $3,215 or R(FVIFAi,n)
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 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32 or R(PVIFAi,n) 28
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070
$1,145
$1,225

FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3

$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440 or R(FVIFAi,n)(1+i)
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 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
or R(PVIFA’,n-1+1)
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 Mixed Flows Example
Julie Miller will receive the set of cash
flows below. What is the Present Value at
a discount rate of 10%.
10%

0 1 2 3 4 5

10%
$600 $600 $400 $400 $100
PV0
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 How To Solve

1 2 3 4 5

10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow 32
 Effective Annual
Interest Rate

The actual rate of interest earned (paid)

after adjusting the nominal rate for
factors such as the number of
compounding periods per year.

(1 + [ i / m ] )m - 1
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 BW’s Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000 CD at
the bank. The interest rate is 6%
compounded quarterly for 1 year. What
is the Effective Annual Interest Rate
(EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!

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Amortizing a Loan Example
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774 35
Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
Thank You