Chapter 3

Principles of
Finance
The Time Value of
Money
 4- 2

Learning Objectives
Time Value of Money
 Calculate Future Value and
understand compounding.
 Calculate Present Value and
understand discounting.

Calculate interest rates

 Simple and Compound Interest Rate

Apply time value of money equation.

 4- 3

Money over time

Relationship of money and
time
Timeis money
or
Money is time

Money and time

Money can grow with time
• Education fund example
 4- 4

Time Value of Money (TVM)

Dollar in hand today is

worth more than a dollar
received in future

Compounding
 Computing Future Value

Discounting
 Computing Present Value
 4- 5

Simple Interest
or Simple Growth

Present Value (P.V.): Future Value (F.V.):

The value today of a Amount to which an
cash flow in the future. investment will grow
after earning interest.
Simple Interest:
Interest earned only on the original investment.

Compound Interest:
Interest earned on interest.
 4- 6

Simple Interest
or Simple Growth

Simple Interest - Interest earned only on

the original investment.
Mathematically:
Simple Interest = P r t
Where:
P= Principal
r = Interest rate
t = Time
 One time earning-payment
 Lump-sum payment
 4- 7

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Future Value
Interest Earned
Per Year = 100 X 0.06 X 5
= $ 30
= $130
 4- 8

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned
Value 100
 4- 9

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned 6
Value 100 106
 4- 10

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today Future Years
1 2 3 4 5
Interest Earned 6 6
Value 100 106 112
 4- 11

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today Future Years
1 2 3 4 5
Interest Earned 6 6 6
Value 100 106 112 118
 4- 12

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today Future Years
1 2 3 4 5
Interest Earned 6 6 6 6
Value 100 106 112 118 124
 4- 13

Simple Interest cont.

Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today Future Years
1 2 3 4 5
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130
Value at the end of Year 5 = $130
 4- 14

Compound Interest

 Interest earned on interest.

 Interest you earn in subsequent
period on the earned interest in
previous period.
 4- 15

Compound Interest cont.

Example:
Interest earned at a rate of 6% for five years on the
previous year’s balance.

Interest Earned Per Year =Prior Year Balance X .06

 4- 16

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous year’s balance.

Today Future Years

1 2 3 4 5
Interest Earned
Value 100
 4- 17

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous year’s balance.
Future Value = Deposit X (1+r)
Today Future Years
1 2 3 4 5
Interest Earned 6.00
Value 100 106.00
 4- 18

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous year’s balance.
Future Value = Deposit X (1+r) X (1+r)
Today Future Years
1 2 3 4 5
Interest Earned 6.00 6.36
Value 100 106.00 112.36
 4- 19

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous year’s balance.
Future Value = Deposit X (1+r) X (1+r) X (1+r)
Today Future Years
1 2 3 4 5
Interest Earned 6.00 6.36 6.74
Value 100 106.00 112.36 119.10
 4- 20

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous year’s balance.
Future Value = Deposit X (1+r) X (1+r) X (1+r) X (1+r)
Today Future Years
1 2 3 4 5
Interest Earned 6.00 6.36 6.74 7.15
Value 100 106.00 112.36 119.10 126.25
 4- 21

Compound Interest cont.

Example - Compound Interest
Interest earned at a rate of 6% for five years on the
previous year’s balance.
Future Value = Deposit X (1+r) X (1+r) X (1+r) X (1+r) X (1+r)
Today Future Years
1 2 3 4 5
Interest Earned 6.00 6.36 6.74 7.15 7.57
Value 100 106.00 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

 4- 22

Future Values

FV  PV  (1  r ) n

Where:

FV = Future Value
PV = Present Value
r = Interest Rate
n = Time Period
 4- 23

Future Values
FV  PV  (1  r ) n

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

FV  $100  (1  .06 )  $133 .82

5
 4- 24

Future Values with Compounding

7000 Interest Rates
6000 0%
5%
5000 10%
FV of $100

4000 15%

3000

2000

1000

0
10
12
14
16
18
20
22
24
26
28
30
0
2
4
6
8

Number of Years
 4- 25

Example: Island for Sale

Peter bought an Island in Dubai for $24 in 1636. Was
this a good deal?

To answer, determine $24 is worth in the year 2013,

compounded at 8%.

FV  $24  (1  .08) 377

 $95.712 trillion

FYI - The value of island is well below this figure.

 4- 26

Present Values
Present Value Discount Factor
Value today of a Present value of
future cash a $1 future
flow. payment.

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
 4- 27

Present Values
Present Value = PV

Future Value after t periods

PV = (1+r) t

Where:
r = Discount Rate
t = No. of years
 4- 28

Present Values

Discount Factor = DF = PV of $1

DF  1
(1 r ) t

Discount Factors can be used to compute

the present value of any cash flow.
 4- 29

Present Value
Present Value
Value today of a future cash flow.

Discount Rate
Interest rate used to compute
present values of future cash flows.
 4- 30

Present Values cont.

Present Value inverse of Future Value

FV  PV  (1  r ) n

PV  FV /(1  r ) n
 4- 31

Present Values cont.

Discount Factor = DF = PV of $1

DF  1
(1 r ) t

Discount Factors can be used to compute the present value

of any cash flow.
PVIF- Present Value Interest Factor
 4- 32

Example: Present Values

Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money, how much money should you set aside today
in order to make the payment when due in two years?

Future Value after t periods

PV = (1+ r) t

PV  3000
(1.08) 2  $2,572
 4- 33

Time Value of Money

(Applications)

The PV formula has many applications.

Given any variables in the equation, you
can solve for the remaining variable.

PV  FV  1
(1 r ) t
 4- 34

One Equation and Four Variables

 The PV formula has many applications. Given
any variables in the equation, you can solve for
the remaining variable.

FV  PV  (1  r )n
Interest rate/
Yield/
Discount rate/
PV  FV  (11r ) n
Growth rate
1/n Waiting time for a
 FV 
r   1 PV to mature to FV
 PV 

n

log FV
PV

log 1  r 
 4- 35

Time Value of Money

(Applications)

Saving for retirement/admission

Cost of loan

Discount rate

Growth rate

Rule of double
Doubling of Money 4- 36

(The Rule of 72)

The Rule of 72 estimates the number of years
required to double a sum of money at a given
rate of interest.

Example:
If the rate of interest is 9%, it
would take 72/9  8 years to
double a sum of money.
Doubling of Money 4- 37

(The Rule of 72) Cont.

Calculate the rate of interest needed to
double a sum of money by a certain number
of years.
Example:
To double a sum of money in 4 years, the
rate of return would have to be
approximately 18% (i.e. 72/4=18).
 4- 38

Time Value of Money

(Applications)
Q-Prestigious University is offering a new admission and
tuition payment plan for all alumni. On the birth of a child,
parents can guarantee admission to Prestigious University
if they pay the first year’s tuition $12,000. The university
will pay an annual rate of return of 4.5% on the deposited
tuition. The admission age is 18 years. What would parents
pay today if they just gave birth to a new baby and the
child will attend university in eighteen years?

PV = $12,000 × 1/(1.045)^18
= $12,000 × 1/(2.2085)
= $12,000 × 0.4528
PV = $5,433.60
 4- 39

Time Value of Money

Applications- Rate of discount
Future Bookstore sells books before they are published.
Today they offered the book Adventures in Finance for
$14.20, but the book will not be published for another two
years. The retail price when the book is published will be
$24.00. What is the discount rate Future Bookstore is
offering its customers for this book?

1/n
 FV 
r   1
 PV 

r = ($24/$14.20) ^1/2 – 1
= 1.30 – 1
= 30%
 4- 40

Time Value of Money

Applications- Triple my money
Ali believes that if he invests his graduation gifts of $5,000 in
his friends business he will be able to triple its value. The
expected return business will give is 12%. For how many years
will he have to keep the $5,000 worth of graduation gifts
invested?
PV = $5,000; FV = $15,000; I = 12%; n = ?

n

log FV
PV

log 1  r 

n = ln(3) / ln(1.12)

n = 9.89404 years (i.e., almost 10 years)

 4- 41

Time Value of Money

Applications –In how many years I will be rich

You as a student saved SR50,000. Your aim is to make this

sum SR10,00,000 by investing in a business. You expect the
business to pay you 20% per annum. In how many years your
will be able to earn this one million SR.

n 

log FV
PV

log1  r 
 4- 42

Time Value of Money

Applications – Calculating Number of years

You want to save $25,000 for a down

payment on a house. Bank A offers to pay
9.35% per year if you deposit $11,000
with them, while Bank B offers 8.25%
per year if you invest $10,000 with them.
How long will you have to wait to have
the down payment accumulated under
each option?
 4- 43
Additional Problems with Answers
Problem 5 (Answer)

Bank A

FV = $25,000, I = 9.35%, PV = -11,000;

n = 9.18 years

Bank B

FV = $25,000, I = 8.25%, PV = -10,000;

n = 11.558 years
 4- 44

Q&A
You have purchased a bond that will pay
$10,000 to your newborn child in 15 years. If
this bond is discounted at a rate of 3.875% per
year, what is today’s price for this bond?

a) $8,417
b) $8,500
c) $5,654
d) $10,000
 4- 45

Q&A
You can invest your money at a rate of 7% per
year. At this rate it will take you just over
________ years to double your money. Use the
Rule of 72 to determine your answer.

a) 4
b) 10
c) 5.5
d) There is not enough
information to answer this question.