Time Value of

Money
Chapter
9
 Present vs Future Value
Time value of money (TVM) calculations involve Present
value (what a cash flow would be worth to you today) &
Future value (what a cash flow will be worth in the future).
Intr
o
Congratulations!!!
You have won a cash prize! You
have two payment options:

A - Receive $10,000 now OR

B - Receive $10,000 in three

years.

Which option would you

In general, normally
most people would
choose to receive
the $10,000 now.
Rule
:All things being
equal, it is better to
have money now
rather than later
Intr
o
But, why is that? Aren’t they the
same?

A BD 20 A BD 20 after 3
Today years
Although the bill is the
same, you can do much
more with the money if
you have it now.
Over
interetime you can earn
on your
more
st money
Intr
o
If you receive the $10,000 today, you can increase the future
value of your money by investing and earning money over time.

However, if you chose Option B, whatever you receive is

actually the future value.
Can we calculate how
much exactly your
$10,000 would be
worth in the future?
Compounding and
Future Value
Intr
o
If you receive the $10,000 today, you can increase the future
value of your money by investing and earning money over time.

However, if you chose Option B, whatever you receive is

actually the future value.
Future
Value
Let’s assume you choose option A, you simply
deposited it in a saving account at an annual rate of
4.5%. How much would the $10,000 worth at the end
of the first year?
Future
Value
Let’s assume you choose option A, you simply
deposited it in a saving account at an annual rate of
4.5%. How much would the $10,000 worth at the end
of the first year?

10,000 + (10,000*4.5%) = $10,450

OR 10,000 (1 + 4.5%) =
$10,450
Future
Value
If you left your amount untouched one more
year, how
much would it worth?
10,450 + (10,450*4.5%) =
$10,920.25
10,450 ( 1+ 4.5%) =
$10,920.25
10,000 (1+ 4.5%) (1+4.5%) =
$10,920.25

Interest you
Interest you receive in year 1
receive in year 2
Future
Value
If you left your amount untouched one more
year, how
much would it worth?
Mathematically, It is possible to to rewrite the formula
(Short cut to use):

10,000 (1+4.5)^2 =
$10,920.25
Future
Value
General
Formula:

where:
FV = Future
Value PV = Remember, it is
Present Value i compounding of
Interest
= interest rate
Future
Value
Future
Value
Now, can you calculate how much the $10,000 worth
after 3 years?
Future
Value
Now, can you calculate how much the $10,000 worth
after 3 years?

10,000 (1+4.5%)^3 = $11,411.66

Future
Value
Using the financial
calculator to calculate
future values:
Use CMPD function: (solving
the previous problem)
n=3
PV =
10,000
FV = ?
I = 4.5%
Future
Value
Question: ( without the use of calculator)

You invest $4,000 for three years at 7 percent.

1. What is the value of your investment after one

year?
2. What is the value of your investment after two
years?
3. What is the value of your investment after three
years?
 Semi-annually = 2 times a year (every 6 months) nx i/
Future Quarterly = 4 times a year (every 3 months)
Monthly = 12 times year (every month)
nx i/
nx i/
Value
Question: Weekly = 52 times a year (every week) nx i/
Daily = 365 times a year (every day) nx i/
If you invest $19,500 today, how much will you have:

a. In 12 years at 11 percent?

b. In 18 years at 7 percent?

c. In 25 years at 8 percent?

d. In 10 years at 6 percent (compounded

Discounting and
Present Value
Present
Value
If you received $10,000 today, the present value
would be $10,000.

Present value: Is what your investment gives you

now if you were to spend it today.
Present
Value
Let’s assume, you are
planning to study MBA after
three years. The MBA course
would cost $10,000.
How much you should invest
today?

In other words, how much is

the $10,000 needed, worth
today?
Present
Value
To calculate the present value you must
subtract the (hypothetical) accumulated
interest from the
$10,000.

To achieve this, we can discount the future

payment amount ($10,000) by the interest
rate for the period.

In essence, all you are doing is rearranging the

future value equation above so that you may
solve for P.
Present
Value
Hence,

The formula is as
following:

Remember, in present
values, we discount
future values
Present
Value
Present
Value
So, back to your MBA. How much should you invest
today?

Let’s assume, you are planning to study MBA after

three years. The MBA course would cost $10,000.
How much you should invest today if the interest rate is
4.5%?

PV = ?
FV = 10,000
i = 4.5%
Present
Value
So, back to your MBA. How much should you invest
today?

PV = ?
FV = 10,000
i = 4.5%
n=3

PV = (10,000)/ (1+0.045)^3 = $8,762.9

Present
Value
Using the financial
calculator to calculate
future values:
Use CMPD function: (solving
the previous problem)
n=
3 PV
=?
FV =
10,0
Present
Value
Say you could receive either $15,000 today or $18,000 in
four years. Which would you choose if interest rates are
currently 4%?
Present
Value
Question: What is the present value
of:
a. $7,900 in 10 years at 11
percent?
b. $16,600 in 5 years at 9
percent?
c. ME
GIVE $26,000 in I14
15000$ AND WILLyears at26000$
GIVE YOU 6 IN 14 YEARS (FYI INTEREST IS 6%)
percent?
Present
Value
Say you could receive either $15,000 today or $18,000 in
four years. Which would you choose if interest rates are
currently 4%? we should compare between Present
values:

$15,000
The present value of
$18,000 that you will
receive in four years?

today
PV = 18,000/
(1+0.04)^4 =
$15,386.48
Present
Value
a. What is the present value of $270,000 to be
received after 40 years with a 19 percent discount
rate?

b. Would the present value of the funds in part a be

enough to buy a $1,300 concert ticket?
Present
Value
Your aunt offers you a choice of $20,100
in 20 years or $870 today. If money is
discounted at 17 percent, which should
you choose?
Present
Value
How much would you have to invest today to
receive:
a. $15,000 in 8 years at 10 percent?
b. $20,000 in 12 years at 13 percent?
c. $6,000 each year for 10 years at 9
percent?
d. $50,000 each year for 50 years at 7
percent?
Present
Value
Your father offers you a choice of $105,000 in 12 years or
$47,000 today.
a.If money is discounted at 8 percent, which should
you choose?
b.If money is still discounted at 8 percent, but your
choice is between $105,000 in 9 years or $47,000 today,
which should you choose?
Interest Rate
 Given, the two
Interest formulas
we have learnt, can
Rates you
find the interest rates
if
you were
asked?
 We find interest rates,
ifwe know the present
Interest andfuture values of
the
the
investment, but we
Rates towish
know the return on
theinvestment we
have mad
e.
 Also known as:
- Rate of Return
Interest - Compound Rate of
Return
Rates - Rate
- i=k=r
Interest
Rates
 Questio Frankli
Interest n:
Templeton
has
n jus
t
invested $9,260 for his
Rates son (age one). This
be
moneyused
willfor his
education 18 years
son’s
now. He calculates
from
that
he will need $71,231 by
the time the boy goes
to school. What rate of
return will Mr.
Templeton need in
order to achieve this
Interest Your investment of $10,000
grew to $12,500 after 12
Rates years. What compound
rate of return (i) did you
earn on your money?
Investment
Period
 Given, the formulas
Investment we have learnt, can
you
Period find the investment
period required if
you were
asked?
 We shall use
the
following formula to
find
the period to
invest a amount to
specified
and
receive
Investment returns.

Period
Investment Question: How
Period many
years will it take
for $8,500 to
ln FVn / PV0  grow
to grow to
n
ln 1  k  $10,000
at 7% interest
ln $10,000 / $8,500 ln[1.17647 ] rate?
n 
ln 1  .07 ln[1.07]
0.1625
n 2.4 years
0.06766
Investment Question: At a
Period growth
(interest) rate of 15
percent
annually, how long will it
take
for a sum to double? To
triple? the year that is
Select
closest
to the correct
answer.
Investment The Rule of 72
Used to determine the
Period number of years needed
go double an investment

N = 72/interest rate
(*100)
Investment Example:
if you are able to
Period generate an annual
return of 9%, it will
take 8 years (=72/9) to
double the value of
investment.
APR vs EAR
APR vs. EAR
APR = The Annual Percentage Rate (APR) indicates the interest
rate paid or earned in one year without compounding. APR is
also known as the nominal or quoted (stated) interest rate.

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)
EAR
EAR
Question: What is the EAR on a quoted or stated rate of 13
percent that is compounded monthly?

EAR = [1+.13/12]^12 - 1
= 1.1380 – 1
= .1380 or 13.80%

Notice the difference between APR (13%) and EAR (13.80%)

EAR
EAR continues to be more significant as the period increase.

Banks frequently offer savings account that compound interest

every day, month, or quarter.

More frequent compounding will generate higher interest

income and lead to higher future values.

It is important to note if the bank is talking about EAR or APR.

EAR
Continuous EAR

When the time intervals between when interest is paid are

infinitely small, we can use the following mathematical formula
to compute the EAR.
EAR = (eAPR ) – 1

Where “e” is the number 2.71828

 Calculating FV using non annual
compounding periods

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?

In this case its very important to account for the monthly interest
and adjust the periods and interest.

n = 10 years x 12 months per year = 120

i = 10% per year / 12 times a year = 0.833%
 Calculating FV using non annual
compounding periods
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?
Using a Mathematical Using a Financial
Formula Calculator

FV = PV (1+i/12)m*12 N = 120
I/Y = .833%
= $50,000 (1+0.10/12)10*12 PV = -50,000
= $50,000 (2.7070) PMT = 0
FV= $135,352.07 FV = $135,352
 Calculating FV using non annual
compounding periods
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?

Notice the difference between annual and monthly compounding

If interest was compounded annually FV = $129687.12

However monthly compounding generated a higher return =
$135352.07
Example on Continuous
Compounding

Continuous compounding FV = PV x e(i x n)

 Continuous compounding FV = PV x e(ixn)

Example on Continuous
Compounding
Annuities and
Perpetuity
Annuities and
Perpetuity
Annuity: A finite series of equal and periodic cash flows.

Perpetuity: An infinite series of equal and periodic cash

flows.
Types of Annuity
Ordinary Annuity: Payments are made at the end of each
period

Annuity Due: Payments are made at the beginning of each

period
Future Value of Annuity
Future Value of
Annuity
At some point in your life, you may have had to make
a series of fixed payments over a period of time -
such as rent or car payments
Future Value of
Annuity
OR have received a series of payments over a
period of time, such as bond coupons.
These received or
paid fixed
amounts over a
calle
periodannuiti
of time are
d es
Future Value of
Annuity
Formal definition: Annuities are series of consecutive payments or
receipts of equal amounts.

There are two types of annuities:

Ordinary Annuity: Payments are required at the end of each

period. Annuity Due: Payments are required at the beginning

of each period.
Future Value of
Annuity
Being able to calculate the future value of annuity would help:

1. The inventor to recognize how much his periodic

investment would worth in the future.
2. The borrower to know the total cost of a loan based on the
required periodic payment he makes.
Future Value of
Annuity
Ordinary Annuity Example: Assume you know you are going to
receive $1000 every year for the coming five years. Also, you would
invest every received amount at interest 5%. How much you would
have at the end of the five-year period?
Future Value of
Annuity
Ordinary Annuity Example: Assume you know you are going to
receive $1000 every year for the coming five years. Also, you would
invest every received amount at interest 5%. How much you would
have at the end of the five-year period?
Future Value of
Annuity
However, the previous calculation can be found via the following
formula:

Where:

FVa = The future value of annuity , A = fixed periodic payment, i = interest rate,
n = period
Future Value of
Annuity
However, the previous calculation can be found via the following
formula:

=
=
$5525.63
Future Value of
Annuity
Using the financial
calculator to calculate
future values:
Use CMPD function: (solving
the previous problem)
n=5
PV =
0 FV
=? I
=5%
Present Value of Annuity
Present Value of
Annuity
If you would like to determine today's value of a future payment series,
you need to use the formula that calculates the present value of an
ordinary annuity. Meaning, the process is reversed. Hence, the
payments are discounted back to the present.
Let’s go back to our
example. You want to
know how much would
the five $1000 future
payments are worth today.
Present Value of
Annuity
Let’s go back to our example. You want to know how much
would the five $1000 future payments are worth today.
Present Value of
Annuity
Again, calculating and adding all these values will take a
considerable amount of time, especially if we expect many
future payments. As such, we can use a mathematical
shortcut for PV of an ordinary annuity.
Present Value of
Annuity
Again, calculating and adding all these values will take a
considerable amount of time, especially if we expect many
future payments. As such, we can use a mathematical
shortcut for PV of an ordinary annuity.

= $4329.48
Present Value of
Annuity
Using the financial
calculator to calculate
future values:
Use CMPD function: (solving
the previous problem)
n=5
PV =
? FV
=0
I
Present Value of
Annuity
Question: Your grandfather has offered you a choice of
one of the three following alternatives: $10,000 now;
$4,800 a year for eight years; or $56,000 at the end of
eight years. Assuming you could earn 9 percent
annually, which alternative should you choose? If you
could earn 10 percent annually, would you still choose
the same alternative?
Determining Annuity
Value
Determining the Annuity
Value
Based on the formulas presented is it possible to determine
the annuity value required?

For example: Imagine you want to take a trip around the

world in four years time. The trip would cost you $20,000.
How much you should save every year? Your bank offers
you a 4% interest rate.
Determining the Annuity
Value

A: Annuity
FVA: Future Value of Annuity
i: Interest rate
n: Periods
Determining the Annuity
Value
Annuity Equaling a Future value

Imagine you want to take a trip around the world

in four years time. The trip would cost you
$20,000. How much you should save every year?
Your bank offers you a 4% interest rate
Determining the Annuity
Value
Annuity Equaling a Future value

Imagine you want to take a trip around the world in four

years time. The trip would cost you $20,000. How much you
should save every year? Your bank offers you a 4% interest
rate

Meaning, you have to save $4709.8 every year at 4% for

the coming 4 years to be able to take the trip.
Determining the Annuity
Value
Annuity Equaling a Future value

Imagine you want to take a trip around the world in four

years time. The trip would cost you $20,000. How much you
should save every year? Your bank offers you a 4% interest
rate

PMT (A): ? = $4709.80

FVA: 20,000
i: 4%
n: 4
Determining the Annuity
Value Equaling a Present value
Annuity

Suppose your wealthy uncle present you with $10,000 now

to help you get through the next four years of college.If
you are able to earn 6% on deposited funds, what is the
value of the equal payments can you withdraw at the end
of each year for four years?
Determining the Annuity
Value

A: Annuity
PVA: Future Value of Annuity
i: Interest rate
n: Periods
Determining the Annuity
Value Equaling a Present value
Annuity

Suppose your wealthy uncle present you with $10,000 now

to help you get through the next four years of college.If
you are able to earn 6% on deposited funds, what is the
value of the equal payments can you withdraw at the end
of each year for four years?
Determining the Annuity
Value Equaling a Present value
Annuity

Suppose your wealthy uncle present you with $10,000 now

to help you get through the next four years of college.If
you are able to earn 6% on deposited funds, what is the
value of the equal payments can you withdraw at the end
of each year for four years?

PMT (A): ? = 2885.91

PVA: 10000
i: 6%
n: 4 years
Determining the Annuity
Value Equaling a Present value
Annuity

The table below shows the relationship of present value to

annuity.
Determining the Annuity
Value
Loan Amortization: The same process is used to indicate
necessary repayment on a loan.

Question: You plan to obtain a $6,000 loan from a furniture dealer

at 15% annual interest rate that you will pay off in annual
payments over four years. Determine the annual payments on
this loan and complete the amortization table.

PMT (A): ? = $2101.59

PVA: $6000
i: 15%
n: 4 years
Determining the Annuity
Value
Loan Amortization: You plan to obtain a $6,000 loan from a
furniture dealer at 15% annual interest rate that you will
pay off in annual payments over four years. Determine the
annual payments on this loan and complete the
amortization table.

Principl
$2101.5 e But how
Interes much
9
t exactly?
Determining the Annuity
Value
Loan Amortization Table: Schedule for a $6,000 loan at 15% to
be repaid in 4 years:

Year Amount owed to the Annuity Interest Principal Outstanding

principal at the Payment Portion of Portion of Balance at the
beginning of the year Annuity Annuity end of the
year
Determining the Annuity
Value
Loan Amortization Table: Schedule for a $6,000 loan at 15% to
be repaid in 4 years:
Determining the Annuity
Value
Example: If your uncle borrows $51,000 from the
bank at 9 percent interest over the seven-year life
of the loan, what equal annual payments must be
made to discharge the loan, plus pay the bank its
required rate of interest (round to the nearest
dollar)? How much of his first payment will be
applied to interest? To principal? How much of his
second payment will be applied to each?
Loan Outstanding
Balance
Monthly Annuity
Some question will ask you to calculate the amount remaining on
a loan that has been somewhat paid already..

Question: Let’s assume you took out a $300,000, 30-year

mortgage with an annual interest rate of 8% and monthly
payments of $2,201.29. Because you have made 15 years worth
of payments (that’s 180 monthly payments) there are another
180 monthly payments left before your mortgage will be totally
paid off. How much do you still owe on your mortgage?
Monthly Annuity
Question: Let’s assume you took out a $300,000, 30-year
mortgage with an annual interest rate of 8% and monthly
payments of $2,201.29. Because you have made 15 years worth
of payments (that’s 180 monthly payments) there are another
180 monthly payments left before your mortgage will be totally
paid off. How much do you still owe on your mortgage?
Monthly Annuity
Monthly Annuity

PMT (A): $2101.59

i: 8% annual = 8%/12 = 0.67%
n: 15 years = 15 x 12 = 180 months
Monthly Annuity

Using a Financial
Calculator

N = 180
1/y =8/12
PMT = -2201.29
FV = 0

PV = $230,344.29
Perpetuity
Perpetuity
A perpetuity is an annuity that continues forever or has no
maturity. For example, a dividend stream on a share of preferred
stock. There are two basic types of perpetuities:

Level Perpetuity in which the payments are constant over time.

Growing Perpetuity in which cash flows grow at a constant rate

from period to period over time.
 Level
Perpetuity

PV: the present value of a level perpetuity

PMT: the constant dollar amount provided by the perpetuity
i: the interest (or discount) rate per period
Level Perpetuity
Question: What is the present value of stream of payments equal
to $90,000 paid annually and discounted back to the present at 9
percent?

PV: ? = $1,000,000
PMT: 90000 PV = 90000 / 0.09 = 1000000
i: 9% The present value of
FV:0 perpetuity is not affected
by time. Thus, the
perpetuity will be worth
$1,000,000 at 5 years and
Growing Perpetuity

PV: the present value of a level perpetuity

PMT: the constant dollar amount provided by the perpetuity
i: the interest (or discount) rate per period
g: growth rate
Growing Perpetuity
Question: What is the present value of a stream of payments
where the year 1 payment is $90,000 and the future payments
grow at a rate of 5% per year? The interest rate used to discount
the payments is 9%.

PV: ? = $2,250,000
PMT: 90000 PV = 90000 / (0.09-0.05) = 2250000
Comparing the present value of a level
i: 9% perpetuity with a growing perpetuity shows
g: 5% that adding a 5% growth rate has a dramatic
effect on the present value of cash flows. The
FV:0 present value increases from $1,000,000 to
$2,250,000.
Complex (Uneven)
Cashflow Streams
 Complex Cash Flows
In reality many cashflows are uneven. Instead, the cash flows may have
a mixed pattern of cash inflows and outflows, single and annuity cash
flows. This is also known as Deferred Annuity. Next Figure summarizes
the complex cash flow stream for Marriott
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the
end of years 1 through 5, a cash flow of negative $600 at the end
of year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the
end of years 1 through 5, a cash flow of negative $600 at the end
of year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?

PV of Year 1 to Year 5:
PMT: 300
i: 10%
n: 5
FV: 0
PV: ? = 1137.24
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the end
of years 1 through 5, a cash flow of negative $600 at the end of
year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?

PV of Year 1 to Year 5:
PMT: 300
i: 10%
n: 5
FV: 0
PV: ? = 1137.24
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the end
of years 1 through 5, a cash flow of negative $600 at the end of
year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?

PV of Year 6
PMT: 0
i: 10%
n: 6
FV: -600
PV: ? = 338.68 Don’t forget that this cash flow is negative
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the end
of years 1 through 5, a cash flow of negative $600 at the end of
year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?

PV of Year 7 PV of Year 8 PV of Year 9 PV of Year 9

PMT: 0 PMT: 0 PMT: 0 PMT: 0
i: 10% i: 10% i: 10% i: 10%
n: 6 n: 8 n: 8 n: 8
FV: -800 FV: -800 FV: -800 FV: -800
PV: ? = 410.53 PV: ? = 373.20 PV: ? = 339.28 PV: ? = 308.43
 Complex Cash
Flows
Question: What is the present value of cash flows of $300 at the end
of years 1 through 5, a cash flow of negative $600 at the end of
year 6, and cash flows of $800 at the end of years 7-10 if the
appropriate discount rate is 10%?
Now we can add up all the PV payments

PV of this complex cashflow = 1137.24 + -338.68 + 410.53 +

373.20 + 339.28 + 308.43

= $2230
Patterns of Payments with a Deferred
AnnuityAn investment will pay $1000 in year 1, $2000 in year 2,
Question:
$3000 in year 3 and an amount of $1,000 that will be paid at the end of
each year from the fourth to the eighth year. With a discount rate of
8%. What is the present value of the cash flow?
1.
$1,000
Present Value =
$5,022
We have
2. to
$2,000
3. calculate
$3,000 Five-year
annuity
the PV of
4.
$1,000 the
5.
$1,000
annuities.
Patterns of Payments with a Deferred
Annuity
Question: An investment will pay $1000 in year 1, $2000 in year 2,
$3000 in year 3 and an amount of $1,000 that will be paid at the end of
each year from the fourth to the eighth year. With a discount rate of
8%. What is the present value of the cash flow?
Solving for the five-year annuity,
1. n=5, i = 8%, FV=0, PMT = 1000.
$1,000 Present Value =
$5,022 PV = $3,993.
2. Note that the present
$2,000 value is
calculated at year three, because
3. the annuity payment is at
first
$3,000 Five-year year 4.
4. annuity So, we have to take the PV to time
$1,000 =0,
i = 8%, FV = 3,993, PMT
5. =0,=n= 3
PV
$1,000 $3,170
Total PV = $5,022 + 3,170 =
Annuity Due
Annuities
Due due: Fixed payments or receipts that come at the beginning
Annuities
of each period. As it shown below:
Annuities Due: Present
Value
Assume you receive 5 due annuities.
Annuities Due: Present
Value
The following formula can be used to calculate present
value
of annuities due.

Where C = A = PMT = Annuity

payments.
Annuities Due: Future
Value
For the same example, let’s assume you would like to calculate the
future value of annuities.
Annuities Due: Present
Value
The following formula can be used to calculate future value
of annuities due.

Where C = A = PMT = Annuity

payments.
Annuities
Due
Using the financial
calculator to calculate
annuities :
Use CMPD function, make sure
you choose the beginning of year
settings.
Annuities
Due an investment pays you 100BD at the beginning of
Assume
each year. If the interest rate is 3% and this investment lasts
7 years what is
a. The present value of the investment?
b. The future value of the investment?

a. Set: Beginning b. Set: Beginning

PMT: 100 PMT: 100
i: 3% i: 3%
n: 7 n: 7
PV: ? = $641.72 FV: ? = $789.23
End of Chapter 4&5