The Time Value of Money

The Time Value of Money
Lohithkumar B
What is Time Value?
We say that money has a time value because

that money can be invested with the
expectation of earning a positive rate of return
In other words, a dollar received today is
worth more than a dollar to be received
tomorrow
That is because todays dollar can be invested
so that we have more than one dollar
tomorrow
July 15, 2015
Lohithkumar B
Why TIME?
TIME allows one the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
NOT having the opportunity to earn
interest on money is called
OPPORTUNITY COST.
July 15, 2015
Lohithkumar B
The Time Value of Money

Which would you rather have -- $1,000
today or $1,000 in 5 years?
Obviously, $1,000 today.
today
Money received sooner rather than later
allows one to use the funds for investment
or consumption purposes. This concept is
referred to as the TIME VALUE OF MONEY!!
MONEY
July 15, 2015
Lohithkumar B
The Terminology of Time

Value
Present Value - An amount of money today,

or the current value of a future cash flow
Future Value - An amount of money at some
future time period
Period - A length of time (often a year, but
can be a month, week, day, hour, etc.)
Interest Rate - The compensation paid to a
lender (or saver) for the use of funds
expressed as a percentage for a period
(normally expressed as an annual rate)
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Lohithkumar B
Abbreviations
PV - Present value
FV - Future value
Pmt - Per period payment amount
N - Either the total number of cash flows
or
the number of a specific period
i - The interest rate per period
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Lohithkumar B
Timelines
A timeline is a graphical device used to clarify
the timing of the cash flows for an investment
Each tick represents one time period
PV
0
Today
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FV
1
3
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5
7
Calculating the Future Value
Suppose that you have an extra $100 today

that you wish to invest for one year. If you can
earn 10% per year on your investment, how
much will you have in one year?
-100
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Lohithkumar B
Single Sum - Future & Present

FV = (1+i) PV
Value FV = (1+i)PV FV = (1+i) PV
2
PV
Assume can invest PV at interest rate i to receive future

sum, FV
Similar reasoning leads to Present Value of a Future sum
FV1
FV2
FV3
today.
PV = FV1/(1+i)
PV = FV2/(1+i)2
PV = FV /(1+i)3
3
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Lohithkumar B
Calculating the Future Value

(cont.)
Suppose that at the end of year 1 you decide to

extend the investment for a second year. How much
will you have accumulated at the end of year 2?
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-110
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10
Generalizing the Future Value
Recognizing the pattern that is

developing, we can generalize the
future value calculations as follows:
If you extended the investment for a

third year, you would have:
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Lohithkumar B
11
Compound Interest
Note from the example that the future value is

increasing at an increasing rate
In other words, the amount of interest earned
each year is increasing
Year 1: $10
Year 2: $11
Year 3: $12.10
The reason for the increase is that each year

you are earning interest on the interest that
was earned in previous years in addition to the
interest on the original principle amount
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Lohithkumar B
12
Compound Interest
Graphically
4000
3833.76
3500
5%
3000
10%
15%
Future Value
2500
20%
2000
1636.65
1500
1000
672.75
500
265.33
0
0
10
11
12
13
14
15
16
17
18
19
20
Years
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13
The Magic of Compounding
On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly

purchased Manhattan from the Indians for $24 worth of beads
and other trinkets. Was this a good deal for the Indians?
This happened about 371 years ago, so if they could earn 5%
per year they would now (in 1997) have:
$1,743,577,261.65 = 24(1.05) 371
If they could have earned 10% per year, they would now
have:
$54,562,898,811,973,500.00 = 24(1.10) 371
Thats about 54,563 Trillion dollars!

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Lohithkumar B
14
The Magic of Compounding

(cont.)
The Wall Street Journal (17 Jan. 92) says that all of New York
city real estate is worth about $324 billion. Of this amount,
Manhattan is about 30%, which is $97.2 billion
At 10%, this is $54,562 trillion! Our U.S. GNP is only around
$6 trillion per year. So this amount represents about 9,094
years worth of the total economic output of the USA!
At 5% it seems the Indians got a bad deal, but if they earned
10% per year, it was the Dutch that got the raw deal
Not only that, but it turns out that the Indians really had no
claim on Manhattan (then called Manahatta). They lived on
Long Island!
As a final insult, the British arrived in the 1660s and
unceremoniously tossed out the Dutch settlers.
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Present Value
Discounting is the process of translating

a future value or a set of future cash
flows into a present value.
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Calculating the Present Value
So far, we have seen how to calculate

the future value of an investment
But we can turn this around to find the
amount that needs to be invested to
achieve some desired future value:
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17
Present Value: An Example
Suppose that your five-year old daughter has just

announced her desire to attend college. After
some research, you determine that you will need
about $100,000 on her 18th birthday to pay for
four years of college. If you can earn 8% per
year on your investments, how much do you need
to invest today to achieve your goal?
July 15, 2015
Lohithkumar B
18
Present Value Example
Joann needs to know how large of a deposit to

make today so that the money will grow to
$2,500 in 5 years. Assume todays deposit will
grow at a compound rate of 4% annually.
4%
PV0
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$2,500
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Present Value Solution
Calculation based on general formula:

PV0 = FVn / (1+i)n
PV0
= $2,500/(1.04)5
= $2,054.81
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Finding n or i when one

knows PV and FV
If one invests $2,000 today and has

accumulated $2,676.45 after exactly
five years, what rate of annual
compound interest was earned?
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Frequency of Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n:
Number of Years
m:
Compounding Periods per Year
i: Annual Interest Rate

FVn,m: FV at the end of Year n
PV0:
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PV of the Cash Flow today

Lohithkumar B
22
Frequency of Compounding
Example
Suppose you deposit $1,000 in an account

that pays 12% interest, compounded
quarterly. How much will be in the
account after eight years if there are no
withdrawals?
PV = $1,000
i = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
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Solution based on formula:

FV= PV (1 + i)n
= 1,000(1.03)32
= 2,575.10
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Annuities
Regular or ordinary annuity is a

finite set of sequential cash flows, all
with the same value A, which has a first
cash flow that occurs one period from
now.
An annuity due is a finite set of

sequential cash flows, all with the same
value A, which has a first cash flow that
is paid immediately.
immediately
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25
25
25
Annuities
An annuity is a series of nominally equal

payments equally spaced in time
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year,

$100 annuity
0
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100
100
100
100
100
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The Principle of Value

Additivity
How do we find the value (PV or FV) of an

annuity?
First, you must understand the principle of
value additivity:
The value of any stream of cash flows is equal to
the sum of the values of the components
In other words, if we can move the cash

flows to the same time period we can simply
add them all together to get the total value
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Present Value of an Annuity
We can use the principle of value additivity to find the

present value of an annuity, by simply summing the
present values of each of the components:
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(cont.)
Using the example, and assuming a discount rate

of 10% per year, we find that the present value is:
62.0
68.3
9
75.1
0
82.6
3
90.9
4
1
379.0
8
0
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100
100
100
100
100
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(cont.)
Actually, there is no need to take the

present value of each cash flow separately
We can use a closed-form of the PV A
equation instead:
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(cont.)
We can use this equation to find the present

value of our example annuity as follows:
This equation works for all regular

annuities, regardless of the number of
payments
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The Future Value of an

Annuity
We can also use the principle of value additivity

to find the future value of an annuity, by simply
summing the future values of each of the
components:
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The Future Value of an Annuity

(cont.)
Using the example, and assuming a discount rate

of 10% per year, we find that the future value is:
146.41
133.10
121.00
110.00
0
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100
100
100
100
100
Lohithkumar B
=
610.51
at year
5
33

(cont.)
Just as we did for the PVA equation, we

could instead use a closed-form of the
FVA equation:
This equation works for all regular

annuities, regardless of the number of
payments
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(cont.)
We can use this equation to find the

future value of the example annuity:
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Annuities Due
Thus far, the annuities that we have looked at

begin their payments at the end of period 1;
these are referred to as regular annuities
A annuity due is the same as a regular annuity,
except that its cash flows occur at the
beginning of the period rather than at the end
5-period Annuity Due

5-period Regular
Annuity
100
0
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100
100
100
100
100
100
100
100
100
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36

Due
We can find the present value of an annuity due

in the same way as we did for a regular annuity,
with one exception
Note from the timeline that, if we ignore the first
cash flow, the annuity due looks just like a fourperiod regular annuity
Therefore, we can value an annuity due with:
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Present Value of an Annuity Due

(cont.)
Therefore, the present value of our

example annuity due is:
Note that this is higher than the PV of

the, otherwise equivalent, regular
annuity
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Future Value of an Annuity

Due
To calculate the FV of an annuity due,

we can treat it as regular annuity, and
then take it one more period forward:
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Pmt
Pmt
Pmt
Pmt
Pmt
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39
Future Value of an Annuity Due

(cont.)
The future value of our example annuity is:
Note that this is higher than the future

value of the, otherwise equivalent,
regular annuity
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40
Deferred Annuities
A deferred annuity is the same as any

other annuity, except that its payments
do not begin until some later period
The timeline shows a five-period
deferred annuity
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100
100
100
100
100
Lohithkumar B
41
PV of a Deferred Annuity
We can find the present value of a deferred

annuity in the same way as any other annuity,
with an extra step required
Before we can do this however, there is an
important rule to understand:
When using the PVA equation, the resulting
PV is always one period before the first
payment occurs
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(cont.)
To find the PV of a deferred annuity, we

first find use the PVA equation, and then
discount that result back to period 0
Here we are using a 10% discount rate
PV2 = 379.08
PV0 = 313.29
0
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100
100
100
100
100
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(cont.)
Step 1:
Step 2:
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FV of a Deferred Annuity
The future value of a deferred annuity is

calculated in exactly the same way as
any other annuity
There are no extra steps at all
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Uneven Cash Flows
Very often an investment offers a

stream of cash flows which are not
either a lump sum or an annuity
We can find the present or future value
of such a stream by using the principle
of value additivity
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Uneven Cash Flows: An

Example (1)
Assume that an investment offers the following

cash flows. If your required return is 7%, what
is the maximum price that you would pay for
this investment?
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100
200
300
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Uneven Cash Flows: An

Example (2)
Suppose that you were to deposit the following

amounts in an account paying 5% per year.
What would the balance of the account be at
the end of the third year?
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300
500
700
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Non-annual Compounding
So far we have assumed that the time period

is equal to a year
However, there is no reason that a time period
cant be any other length of time
We could assume that interest is earned semiannually, quarterly, monthly, daily, or any
other length of time
The only change that must be made is to make
sure that the rate of interest is adjusted to the
period length
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(cont.)
Suppose that you have $1,000 available for

investment. After investigating the local banks, you
have compiled the following table for comparison.
In which bank should you deposit your funds?
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50
(cont.)
To solve this problem, you need to determine

which bank will pay you the most interest
In other words, at which bank will you have the
highest future value?
To find out, lets change our basic FV equation
slightly:
In this version of the equation m is the number of

compounding periods per year
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(cont.)
We can find the FV for each bank as follows:
First National Bank:

Second National Bank:
Third National Bank:
Obviously, you should choose the Third National Bank

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Perpetuities
Perpetuity is a series of constant payments, A, each
period forever.
0
PV1
PV2
PV3
PV4
=
=
=
=
A/(1+r)
A/(1+r)2
A/(1+r)3
A/(1+r)4
etc.
etc.
PVperpetuity = [A/(1+i)t] = A [1/(1+i)t] =

A/i
Intuition:
Present Value of a perpetuity is the amount that must invested toda
interest rate i to yield a payment of A each year without affecting th
of the initial investment.
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53
Perpetuities
A perpetuity is an annuity that has no

definite end, or a stream of cash payments
that continues forever.
A perpetuity is an annuity in which the
periodic payments begin on a fixed date
and continue indefinitely.
Fixed coupon payments on permanently
invested (irredeemable) sums of money
are prime examples of perpetuities.
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Methods of Calculating
Interest
Simple interest: the practice of charging

an interest rate only to an initial sum
(principal amount).
Compound interest: the practice of
charging an interest rate to an initial
sum and to any previously accumulated
interest that has not been withdrawn.
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Simple Interest Formula

F P (iP) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N
F $1, 000 (0.08)($1, 000)(3)
$1, 240
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Compound Interest
Compound interest: the practice of

charging an interest rate to an initial
sum and to any previously accumulated
interest that has not been withdrawn.
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Compound Interest Formula
n 0: P
n 1: F1 P (1 i )
n 2 : F2 F1 (1 i ) P (1 i )
M
n N : F P (1 i )
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Compound Interest
$1,259.71
2
3
$1,000
July 15, 2015
F $1, 000(1 0.08)3

$1, 259.71
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Amortized loan
Installment loan in which the monthly

payments are applied first toward reducing
the interest balance, and any remaining sum
towards the principal balance. As the loan is
paid off, a progressively larger portion of the
payments goes toward principal and a
progressively smaller portion towards the
interest. Also called amortizing loan.
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Continuous Compounding
There is no reason why we need to stop increasing

the compounding frequency at daily
We could compound every hour, minute, or second
We can also compound every instant (i.e.,
continuously):
Here, F is the future value, P is the present

value, r is the annual rate of interest, t is the
total number of years, and e is a constant
equal to about 2.718
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61
(cont.)
Suppose that the Fourth National Bank is offering to

pay 10% per year compounded continuously. What is
the future value of your $1,000 investment?
This is even better than daily compounding

The basic rule of compounding is: The more
frequently interest is compounded, the higher
the future value
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(cont.)
Suppose that the Fourth National Bank is offering to

pay 10% per year compounded continuously. If you
plan to leave the money in the account for 5 years,
what is the future value of your $1,000 investment?
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Congratulations!
You obviously understand this material.

Now try the next problem.
The Interactive Exercises are found in

book.
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64
Comparing PV to FV
Remember, both quantities must be

present value amounts or both
quantities must be future value
amounts in order to be compared.
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65
How to solve a time value of money

problem.
The value four years from today is a

future value amount.
The expected cash flows of $100 per
year for four years refers to an annuity
of $100.
Since it is a future value problem and
there is an annuity, you need to solve
for a FUTURE VALUE OF AN ANNUITY.
July 15, 2015
Lohithkumar B
66

The Time Value of Money

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The Time Value of Money

What is Time Value?

We say that money has a time value because

July 15, 2015

July 15, 2015