FINANCIAL MANAGEMENT, SPRING 2023

TOPIC 4 – Time Value of

Money Concept
4.1 Introduction of Time Value of Money
4.2 Timeline
4.3 Future value: Compounding
4.4 Present value: Discounting
 4.1 Introduction of
Time Value of Money
q If you give me a choice of taking VND 1million today versus VND 1million in
one year, I will take VND 1million today for the following reasons:
q First, I want to buy an Iphone4 for VND 1million today. That suggests that I (as
an individual) prefer present consumption over the future one. In order for me
to give up this consumption, you have to offer me more in the future.
q Second, there is inflation so that the value of VND 1 million decreases in the
future. In order word, the purchasing power of this VND 1million will be less in
one year.
q Third, there is possibility that you will not be able to keep your word. There is
always risks (uncertainty) associated with the cash flow.
q All else equal, the value of cash flow in the future will decrease because:
q Preference for current consumption increases
q Expected inflation increases.
q The uncertainty of cash flow increases.
One dollar tomorrow is worth less than one dollar today. As the time
passes, value of money changes as such money has time value, we name
it Time Value of Money.
4-2
Introduction
q How to factor the three elements of TVM?
q A discount rate does it all:
q A discount rate is a rate at which present value (value of cash flow at
the present) and future value (value of cash flow in the future) are
traded off. Make your choice!
q As preference for current consumption is greater, the discount rate will be
higher.
q As the expected inflation is higher, the discount rate will be higher.
q As level of uncertainty is higher, the discount rate will be higher.
q A discount rate is also an opportunity cost since it captures the return
that an individual would have made on the next best opportunity.
q Future value and present value can be converted into one another
using discounting and compounding process.
q Discounting converts future cash flows in to present cash flows.
q Compounding converts present cash flows in to future cash flows.

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TVM Rule
It is only possible to compare or combine values at the same
point in time
q Money has time value, as such values at different
point in time cannot be compared and aggregated.
q Implication: in order to compare or aggregate values
happening at different point in time, we first convert
cash flows to the same point in time.
q How: to do discounting and/ or compounding. The
point in time can be either today (present value) or in
the future (future value)

4-4
4.2 Timeline
0 1 2 3
i%

CF0 CF1 CF2 CF3

q Time line is the best way to present and visualize cash flows. In that
timeline, you list out how much you get, (CFs), when you get each
(period 1, 2, 3, etc.), and discount rate (i%)
q Tick marks occur at the end of periods, so “Time 0” is today; Time 1 is
the end of the first period (year, month, etc.) or the beginning of the
second period.

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Drawing timeline
$100 lump sum due in 2 years
0 1 2
i%

100
3 year $100 ordinary annuity (same amount of
money pay at the end of each period)
0 1 2 3
i%

100 100 100

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Drawing timeline
Uneven cash flow stream; CF0 = -$50,
CF1 = $100, CF2 = $75, and CF3 = $50
0 1 2 3
i%

-50 100 75 50

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4.3 Future value: Compounding

q The value of a sum of money in the future

q Example:
q If you deposits VND 100million in the bank at a rate of 10%
interest rate per year, what will be the value of your
deposit at the end of the year (FUTURE VALUE)?

0 10%
1

100 ?

q At the end of the year, you will receive an interest payment

and the amount deposited.

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 Example
¨ The interest you will earn (interest is always earned on the principal)
= 100m x 10% = 10m
¨ Adding the interest to the principal gives you the future value of:
= 100m + 10m = 110m
= 100m + 100m x 0.1
= 100m (1+0.1)
= 110m
¤ Generalize:
Future value = Principal + Interest
= Principal + Principal x Interest Rate
= Principal x (1+i)
PV: Present cash flow.
Or
I: Interest rate per period
FV: future value

FV = PV x (1+i) (1)

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Simple Interest vs. Compounding Interest

q Now, you deposit VND 100m for 2 years with an interest

rate of 10% per year (per annum or p.a). Assume that the
deposit is on simple interest term, (interest is paid once at
the end year 2) what will be value at the end of year 2?
0 10% 1 2

100 ?

q Simple interest per 1 year = 10% * 100m = 10m

q Total interest for 2 years = 2 x 10m = 20m
q Future value = 100m + 20m = 120m
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Simple Interest vs. Compounding Interest
q Suppose that bank pays you interest once a year, calculate the value of
your deposit at the end of year 2?
q End of 1st year: Principal + Interest = 100m x (1+10%) = 110m
q End of 2nd year:
q Principal + Interest = 110m x (1+10%)
q = 100m x (1+10%) x (1+10%) = 100m (1+10%)2 =
121m
q Note: The principal VND100m earns VND 10m each year. The VND 10m of the
1st year will earn 10m x 10% = 1m. You earn interest on interest in the 2nd year.

q Generalize:
q Compound interest: interest earned on previous interest
q The process of finding future value is compounding the cash flow.
q Future value using compound interest (used this interest rate from now on
unless specified)
PV: Present cash flow.
I: Interest rate per period
FV = PV (1+i)n (2) FV: future value
n: number of periods 4-11
 Lecture Questions & Exercises

Question 1: What is compound interest?

Question 2: Calculate the value of your account at the end of

year 3 if you deposit VN 100m now, earning an interest rate of
7% p.a. Interest is compounded yearly?

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Answer

0 1 2 3
7%

100 ?

FV = PV x (1+i)3
FV = 100m x (1+7%)3
= 122.05m

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Frequency of Compounding
q Example: If you deposits VND 100million in the bank at a rate
of 10% interest rate p.a, what will be the value of your deposit
at the end of the year, assuming that interest is compounded
every 6 months?
q What is the interest you will receive in the first 6 months?
q Obviously, you will receive only half of the annual interest rate.
q i = 10% / 2 = 5% per period (of 6 months)
q How many periods in which your money will be compounded.
q n = 1 x 2 = 2 periods (two 6 months)
q What is the value at the end of the year?
q FV = PV x (1+i) = 100m x (1+5%)2 = 110.25m
q Compare this answer to the answer in previous example:
obviously, you will receive higher value at the end of the year
if the interest is compounded twice a year than if it is
compounded once a year.
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Frequency of Compounding
For example, interest could compound:
To calculate r in the FV
formulas:
Semi-annually Twice a year
Divide the annual interest
Quarterly 4 times a year rate by number of periods
per year
Monthly 12 times a year
To calculate n in the PV
Fortnightly 26 times a year and FV formulas:

Weekly 52 times a year Multiply the number of

years by the number of
Daily 365 times a year periods per year
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 Exercises
¨ What is the future value of $100 deposit in year 5, with the interest rate
of 10% and compounded yearly, semi-annually, quarterly, and monthly
FV = PV (1+i)n
No. of m n i FV
Year (no. of period (no. of (periodic
per year) periods) interest rate)

Yearly 5 1 5 10% =100x(1+10%)5=$161.05

Semi-annually 5 2 10 5% = 100x(1+ 5%)10 =$162.89

Quarterly 5 4 20 2.5% = 100x(1+2.5%)20=$163.86

Monthly 5 12 60 1.25% = 100x(1+1.25%)60=$164.53

Number of periods = Number of year x number of period per year

Periodic interest = Annual interest rate / number of period per year
4-16
Effective Annual Rate
q In the above exercise, the stated annual rate (nominal
interest rate) is 10%; however, the future values of the VND
100m are different when the interest rate is compounded
differently. Specifically:
q More frequently the interest is compounded, the higher future value
is.
q Obviously, you will choose to deposit VND 100m in a bank that pays a
monthly compounded interest rate.
q Effective Annual Rate (EAR) is the annual rate of interest
actually being earned, taking into account compounding
effect. It is said to be “true” interest rate.
APR: Stated annual rate
EAR = (1+ APR/m)m -1 (3)
m: number of period per year.
EAR: Effective annual rate
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Effective Annual Rate
q Effective annual rate for an annual interest rate of 10%:
q Compounded yearly
EAR = (1+ 10%/1)1 = 10%
q Compounded semi-annually
EAR = (1+10%/2)2 = 10.25%
q Compounded quarterly
EAR = (1+10%/2)2 = 10.38%
q Compounded monthly
EAR = (1+10%/2)2 = 10.47%
q All else equal, you will deposit your money into a bank
paying interest monthly rather than into a bank paying
interest once a year because of higher EAR.
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Continuously Compounding
q In theory, compounding periods could become infinitely
small, and the number of compounding periods infinitely
large
q This is called continuous compounding
q Although interest can’t literally be calculated in this way,
many financial valuations involving growth in value other
than from interest (e.g. share price changes) are based on
the concept of continuous compounding
FV = the future value
C = the present cash flow
APR ´Y
FV = C ´ e (4) e = the base for natural logarithms (≈ 2.72)
APR = The Annual Percentage Rate
Y = the number of years
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4.4 Present value: Discounting
q Today is your 20th birthday and you want to buy a
new laptop when you are 22. You expect that the
new laptop would cost you $1,000 at that time. If
BIDV offers you a saving interest rate of 5% per
year, how much now would you need to put away
in order to have that money 2 years later?
q Timeline
0 5% 1 2

? $1,000
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Present Value
q This question can be solved through a discounting
process.
q How much would you have in your account at the end
of year 1 in order to have a balance of $1,000 at the
end of year 2?
q Given that amount of money in the account at the end
of year 1, how much would you deposit into the bank
today? 0 5% 1 2

$1,000
Step 1
P1
Step 2
P0 4-21
Discounting
q Step 1: At the end of year 1, we need P1 dollar in the
bank at the interest rate of 5% to have $1,000 at the
end of the year 2.
1,000 = P1 x (1+ 5%)
P1 = 1,000/(1+5%) = $952.38
q Step 2: do similar task to find the P0
952.38 = P0 x (1+5%)
P0 = 952.38/(1+5%) =$907.03

Solution: You need to put away $907.03 into a bank pay 5% per
year for two years in order to have $1,000.

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Present Value & Discounting
q The $952.38 is PRESENT VALUE of $1,000 (future
value) in year 1 based on the 5% interest rate per
annum.
q The $907.03 is PRESENT VALUE of
q $1,000 at current time (t=0) or now ($1,000 is FV in year 2)
q $952.38 at current time (t=0) or now ($952.38 is FV in year
1)
q The two steps (or two processes) we applied above are
both named DISCOUNTING. That 5% is DISCOUNT
RATE
q Finding present value of cash flow is the reverse of
finding a future value. From equation (2), we find PV:
PV: Present value of cash flow.
PV = FV/(1+i)n (5) I: Interest rate per period
FV: future value of cash flow
n: number of periods 4-23
Exercise
What is the present value (PV) of $100 due in 3
years, if interest is 10%, compounded annually?

0 1 2 3
10%

PV = ? 100

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Solving for Present Value
q Solve the general FV equation for PV:
PV = FVn / ( 1 + i )n = $100 / ( 1.10 )3 = $75.13
0 10% 1 2 3

PV = ? 100
PV2

PV1

PV0

q Step by step:
¤ Solving for PV2 – value of $100 in year 2: PV2 = 100/(1+10%) = $90.91
¤ Solving for PV1 – value of $90.91 in year 1: PV1 = 90.91/(1+10%) = $82.64
¤ Solving for PV0 – value of $82.64 now: PV0 = 82.64/1.1 = $75.13
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Solving for Discount Rate
q An investment will cost you $1,000 and will return $3,000
in three years. What is the annual rate of return?
0 10% 1 2 3

-$1,000 $3,000

q A negative cash flow indicates cash outflow and a positive cash

flow indicates cash inflow.
q PV0 = $1,000 and FV3 = $3,000
q Applying formula (2) and rearrange it to derive discount rate.
FV = PV (1+i)n so i = (FV/PV)1/n – 1
So: i = (3,000/1,000)1/3 – 1 = 44.22%

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 Solving for number of periods
q You deposit $1,000 into a bank which pays you an
annual interest rate of 10%, compounded semi-
annually. How many years for your deposit to
double?
0 5% 1 ?

-$1,000 $2,000
q Since annual rate is 10%, the money is compounded twice
a year, so for each period (i.e. 6 month) the interest rate
is halved, or 10%/2 = 5%
q In other word, you receive 5% interest every 6 month and
have chance to compound it for the remaining periods.
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Solving for number of periods
q Form an equation, using formula FV = PV (1+i)n
q Rearrange the formula and derive n

FV/PV = (1+i)n
n = ln(FV/PV)/ln(1+i)
q Plug the numbers and report answer:

n = ln(2,000/1,00)/ln(1+5%)
n = 14.21 periods
Solution: It takes approximately 7.11 years (14.21/2)
for the money to double.

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