FIN 300 – FINANCIAL MANAGEMENT JEAN Y.

ELIA
Chapter 6 - Time Value of Money
I – INTRODUCTION
It is essential for financial managers to have a clear understanding of the time value of money
and its impact on stock prices. The principles of time value analysis have many applications,
ranging from setting up schedules for paying off loans to decisions about whether to acquire
new equipment. In fact, of all the concepts used in finance, none is more important than the time
value of money, also called discounted cash flow (DCF) analysis.
Financial decisions often involve situations in which someone pays money at one point in time
and receives money at some later time. Dollars paid or received at two different points in
time are different, and this difference is recognized and accounted for by time value of money
(TVM) analysis.

II - TIME LINES
Time Line - An important tool used in time value of money analysis; it is a graphical
representation used to show the timing of cash flows.

Outflow - A cash deposit, cost, or amount paid. It has a minus sign.

Inflow - A cash receipt.

III - FUTURE VALUE

Compounding is the process of determining the future value (FV) of a cash flow or a series of
cash flows. The compounded amount, or future value, is equal to the beginning amount plus the
interest earned.
Future Value (FV) The amount to which a cash flow or series of cash flows will grow over a
given period of time when compounded at a given interest rate.
Future value: FVn = PV (1 + i) n ---------------(1)
Example: $1,000 compounded for 2 years at 4 percent:
FV2 = $1,000(1.04)2 = $1,081.6

Find the future value of $100 after five years at 5 percent.

= $127.63
IV - PRESENT VALUE
Opportunity Cost Rate - The rate of return on the best available alternative investment of equal
risk.
Example: Suppose you have some extra cash, and you have a chance to buy a low-risk security
that will pay $127.63 at the end of five years. Your local bank is currently offering 5 percent
interest on five-year certificates of deposit (CDs), and you regard the security as being exactly as
safe as a CD. The 5 percent rate is defined as your opportunity cost rate, or the rate of return you
could earn on an alternative investment of similar risk.

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money
Present Value (PV) - The value today of a future cash flow or series of cash flows.
Example: From the future value example presented in the previous section, we saw that an
initial amount of $100 invested at 5 percent per year would be worth $127.63 at the end of five
years. As we will see in a moment, you should be indifferent between $100 today and $127.63 at
the end of five years.
The $100 is defined as the present value, or PV, of $127.63 due in five years when the
opportunity cost rate is 5 percent.
If the price of the security were less than $100, you should buy it, because its price would then
be less than the $100 you would have to spend on a similar-risk alternative to end up with
$127.63 after five years. Conversely, if the security cost more than $100, you should not buy it,
because you would have to invest only $100 in a similar risk alternative to end up with $127.63
after five years.
If the price were exactly $100, then you should be indifferent — you could either buy the
security or turn it down. Therefore, $100 is defined as the security’s fair, or equilibrium, value.
Fair (Equilibrium) Value - The price at which investors are indifferent between buying or
selling a security.
Discounting - The process of finding the present value of a cash flow or a series of cash flows;
discounting is the reverse of compounding.
Future Value => FVn = PV (1 + i) n
FV n
Present Value = ---------------(2)
(1+i) n
or Present Value = FVn (1 + i) -n

V - SOLVING FOR INTEREST RATE AND TIME

There are four variables in the equations (1 and 2) — PV, FV, i, and n — and if you know the
values of any three, you can find the value of the fourth.

Starter Problems

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money
VI - FUTURE VALUE OF AN ANNUITY
Annuity - A series of payments of an equal amount at fixed intervals for a specified number of
periods.
FVAn - The future value of an annuity over n periods.
Ordinary (Deferred) Annuity - An annuity whose payments occur at the end of each period.
n
(1+i) −1
FVAn = a [ ]
i
Annuity Due - An annuity whose payments occur at the beginning of each period.
n
(1+i) −1
FVAn = a [ ] (1+i)
i

Starter Problems

VII - PRESENT VALUE OF AN ANNUITY

PVAn - The present value of an annuity of n periods.
Ordinary (Deferred) Annuity
−n
1−( 1+i )
PVAn = a [ ]
i
Annuity Due
1−( 1+i )−n
PVAn = a [ ] (1+i)
i

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money
VIII - PERPETUITIES
Perpetuity - A stream of equal payments expected to continue forever.
Payment PYMT
PV(Perpetuity) =
Interest rate
= i
Consol - A perpetual bond issued by the British government to consolidate past debts; in general,
any perpetual bond.
Example: preferred stocks

Extra Problems

Robert Blanding’s employer offers

its workers an optional two-month
unpaid vacation after 7 years of
service to the firm. Robert, who
just started working for the firm,
plans to spend his vacation touring
Europe at an estimated cost of
$24,000. To finance his trip,
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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money

Robert plans to make an annual

deposit of
$2,500 into a savings account at
the end of each of the next seven
years (the first deposit will occur
one
year from today). The account
pays 8% annual interest.
Robert Blanding’s employer offers
its workers an optional two-month
unpaid vacation after 7 years of
service to the firm. Robert, who
just started working for the firm,
plans to spend his vacation touring
Europe at an estimated cost of
$24,000. To finance his trip,

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money

Robert plans to make an annual

deposit of
$2,500 into a savings account at
the end of each of the next seven
years (the first deposit will occur
one
year from today). The account
pays 8% annual interest.
Problem # 1:

Problem # 2:

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FIN 300 – FINANCIAL MANAGEMENT JEAN Y. ELIA
Chapter 6 - Time Value of Money
Problem # 3:

Problem # 4:

Problem # 5:
What is the present value of a 4-year annuity, if the annual interest is 5%, and the annual
payment is $1,000?

Problem # 6:
An investment of $3000 per quarter for 6 years at annual interest rate of 8%, compounded
quarterly, will accumulate by the end of year 6 to…?

Problem # 7:
You make equal $400 monthly payments on a loan. The interest rate equals 15%, compounded
monthly. The loan is for 12 years. What is the amount of the loan?

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