6/01/2014

The Time Value of Money

What Companies Do
Take the Money and Park?
Facing a huge projected 2009 budget deficit, Chicago Mayor Richard
Daley struck a deal to lease the citys 36,000 parking meters to an
investor group that included Morgan Stanley. Morgan Stanley and its
partners would pay Chicago $1.2 billion up front; in return, they
would collect revenue from parking meters for the next 75 years.
Was it an unbelievable deal for the city of Chicago or for Morgan
Stanley and its partners? To answer that question, you must know
how to compare an up-front payment with a long-term stream of
cash payments. This chapter will show you how to make that
comparison.

Time Value of Money

Financial managers compare the marginal benefits
and marginal cost of investment projects.
Projects usually have a long-term horizon: timing of
benefits and costs matters.

Time-value of money: A dollar received today is

worth more than a dollar received in the future.
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Future Value
Future Value: The value of an investment made
today measured at a specific future date using
compound interest.

FVn = PV x (1+r)n
Interest rate

Future Value
depends on:

Number of periods
Compounding interval
4

Future Value of $200

4 years, 7% interest
FV4 = $262.16
FV3 = $245.01
FV2 = $228.98
FV1 = $214
PV = $200
0

End of Year

Compound interest: Interest earned both on the

principal amount and on the interest earned in
previous periods.
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Compounding
Year 1:
FV1 = $214

Year 2:
FV2 = $228.98

Year 3:
FV3 = $245.01

Year 4:
FV4 = $262.16

Earns 7% interest on initial $200

FV1 = $200+$14 = $214
Earn $14 interest again on $200 principal
Earns $0.98 on previous years interest of
$14: $14 x 7% = $0.98
FV2 = $214+$14+$0.98 = $228.98
Earn $14 interest again on $200 principal
Earns $2.03 on previous years interest of
$28.98: $28.98 x 7% = $2.03
FV3 = $228.98+$14+$2.03 = $245.01
Earn $14 interest again on $200 principal
Earns $3.15 on previous years interest of
$45.01: $45.01 x 7% = $3.15
FV4 = $245.01+$14+$3.15 = $262.16 6

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The Power of Compound Interest

20%

15%

10%
5%
0%
Periods
7

Present Value
Present value: The value today of a cash flow to be
received at a specific date in the future, assuming
an opportunity to earn interest at a specified rate.

Present Value of $200

4 Years, 7% Interest
Discounting
0

1
FV1 = $200

PV = $186.92

FV2 = $200

FV3 = $200

FV4 = $200

End of Year

PV = $174.69

PV = $163.26

PV = $152.58

Discounting: The process of calculating present

values.
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The Power of Discounting

1.00

0%

0.75

0.5
5%
10%
0.25
15%
20%
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods
10

Future Value of Cash Flow Streams

Mixed
stream

A series of unequal cash flows

reflecting no particular pattern.

Annuity

A stream of equal periodic cash

flows.

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Future and Present Values

of An Ordinary Annuity
Compounding

Future
Value

$1,000
0

$1,000
2

$1,000
3

$1,000
4

$1,000
5

End of Year

Present
Value

Discounting

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Future Value of an Ordinary Annuity

5 Years, 5.5% Interest
$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000.00

$1,000

$1,000

$1,000

$1,000

$1,000
5

End of Year

Ordinary annuity: An annuity for which the payments occur

at the end of each period.
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Future Value of An Annuity Due

5 Years, 5.5% Interest
$1,306.96
$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000
0

$1,000
1

$1,000
2

$1,000
3

$1,000
4

End of Year

Annuity due: An annuity for which the payments occur at

the beginning of each period.
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Present Value of Cash Flow Streams

Mixed streams
Annuities
Perpetuities: cash flow streams that continue
forever

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Present Value of An Ordinary Annuity

5 Years, 5.5% Interest
0

$1,000

$1,000

$1,000

$1,000

5
$1,000

End of Year
$947.87
$898.45
$851.61
$807.22
$765.13

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Present Value of An Annuity Due

5 Years, 5.5% Interest
0

$1,000

$1,000

$1,000

$1,000

$1,000

End of Year

$1,000.00

$947.87
$898.45
$851.61
$807.22

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Future and Present Values of A Mixed

Stream
5 Years, 4% Interest
Compounding
- $12,166.5
$3,509.6
$5,624.3

FV
$6,413.8

$4,326.4
$3,120.0
-$10,000

0
$2,884.6

$3,000

$5,000

$4,000

$3,000

$2,000.0

End of Year

$4,622.8

PV
$5,271.7

$3,556.0
$2,564.4
$1,643.9

Discounting
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Present Value of A Perpetuity

For a constant stream of cash flows that
continues forever

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Present Value of A Growing Perpetuity

$1,000
$1,000

$1,000(1+0.02)1 $1,000(1+0.02)2
$1,020

$1,040.4

$1,000(1+0.02)3
$1,061.2

Growing Perpetuity
CF1 = $1,000
r = 7% per year
g = 2% per year
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Compounding More Frequently Than

Annually
m compounding periods

continuous compounding

The more frequent the compound period, the

larger the FV!
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Compounding More Frequently Than

Annually
FV at end of 2 years of $125,000 at 5% interest
Semiannual compounding:

Quarterly compounding:

Continuous compounding:
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Stated Versus Effective Annual

Interest Rates
Stated
annual rate

The contractual annual rate of

interest charged by a lender or
promised by a borrower.

Effective
annual rate

The annual rate of interest actually

paid or earned, reflecting the impact
of compounding frequency.

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Stated Versus Effective Annual

Interest Rates
Annual
percentage
rate (APR)

The stated annual rate calculated by

multiplying the periodic rate by the
number of periods in one year.

Annual
percentage
yield (APY)

The annual rate of interest actually

paid or earned, reflecting the impact
of compounding frequency. The
same as the effective annual rate.

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Additional Applications of Time Value

Deposits needed to accumulate a future sum
Loan amortization
Implied interest or growth rates
Number of compounding periods

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The Time Value of Money

Much of finance involves finding future and
present values.
The time value of money is central to all
financial valuation techniques.

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