Chapter 9

Time value of money

Dr.Heba Gazzaz

Relation to capital outlay decision:

Decision to buy new plant and equipment OR start producing a new product by the financial mangers →needs capital budgeting techniques to determine
whether the future return can cover the current expenses or not. Using the mathematical tools of the time value of money allow them to determine the value of
an asset or investment at any point in time and therefore, making capital allocation decisions

9.1 Money has a time value!

Example: I will offer you two options (no risk associate with these two options)

1000 Today ?

Or

1000 after one Year ?

Option 1 is better because of the interest:

# the $1000 today worth more than $1000 received in the future because you can invested and earn a return, so when you want to cash out your money after 1
year, you will receive the 1050

#the $1000 received in the future worth less than $1000 today because after 1 year you will discount the future value by the interest rate =$952.3 and the longer
you wait to receive your money →the less it is worth today.

Since the interest is the key element in the time value of money

I will introduce two kind of interest:

1- Simple interest (receive =lend/invest OR pay=borrow), doesn’t matter!

#the earing is based on the initial investment.
Ex: Invest 1000 for 4 year at a 10% interest rate per year?

1000*[1+ (%*n)] →1000*1.4=1400

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9.2 Future values –single amount (compounding techniques associated with future value)
2- Compound interest (receive =lend/invest OR pay=borrow), better to receive, why??

#the earning is based on the balance of the investment not only the initial investment, in other words: previous balance + % from the previous balance.

Ex1: Invest 1000 for 4 year at a 10% interest rate per year? What is the value at the end of the fourth year? What the worth of the 1000 after 4 year if it grows
by 10% ?

Using a generalized formula:

FV = 1000 ( 1.10 )4 = 1,464

Using the interest table as more efficient and quick way to calculate the future value –single amount (Table 9-1 OR Appendix A):

Where FVIF = the interest factor

Thus, the future value is the worth of today’s money after n number of years if it grows by a given interest rate

Ex 2: At the end of 3 years, how much is an initial deposit of $100 worth, assuming a compound annual interest rate of 10% ?

FV 3 = PV ( FVIFi , n ¿

FV 3 = PV ( FVIF10 , 3 ¿ (Use Table 1)

= 100(1.331) = $133.10
Ex 3: If $10,000 were invested for 10 years at 8%, what is the future value?

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9.3 present value-single amount (discounting techniques is associated with present value) discounting because the PV is normally less than FV.
Present value-single amount: it’s today value (current worth=right now) of cash flow to be received at some point in the future/the amount that you would
pay(invest)today(now-current) to receive accumulated cash flow in the future (sum payable in the future)

Ex1: you will receive $1464 after 4 at a discount rate of 10%, how much is this worth today?

It’s the exact opposite of the future value →restating the generalized formula of the future value:

Using the interest table as more efficient and quick way to calculate the present value –single amount (Table 9-2 OR Appendix B):

Pv = $1464 * .683 = $683

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Ex2: If $1,000 is to be received at the end of one year, $500 at the end of two years, and $100 at the end of three years. What is the aggregate present value
(PV) of their receipts assuming a discount rate 4% ?

Year 1 = 1,000(0.962) Table II 962.00

Year 2 = 500(0.925) Table II 462.00
Year 3 = 100(0.889) Table II 88.9
Total PV = 1,512.9 ≈ 1,513.00

9.4 Future value-annuity

Annuity: is a series of equal cash flow that either paid to you (semi-annual coupon from a bond/ by you (car payments)

1-annuity due: payment made at the beginning of the period (you pay the car rent in advance)

2-annuity ordinary: payment made at the end of the period (payment for the coupon(bond) holder at the end of the 6 months)

Term payment: refer to the amount of the cash flow in an annuity!

Future Value of an Annuity: future value of a series of equal payment: Calculated by compounding each individual payment into the future and then adding up
all of these payments=solve the future value individually for each payment and then sum them up.

Ex1: you will receive 1000 at the end of each year for 4 year. What’s the accumulated value at the end of the fourth period if money grows at 10%? What’s the
future worth of this annuity (equal payment)?

Using the interest table as more efficient and quick way

to calculate the future value –annuity (Table 9-3 OR Appendix C):

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Ex2: If a wealthy relative offered to set aside $2,500 a year for the next 20 years for you, how much would you have accumulated (future worth) in your
account after 20 years? If fund grows by 8% (interest rate)?

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Ex3: Christy Reed has been depositing $1,500 in her savings account every December since 2001 for her daughter’s education. Her account earns 6 percent
compounded annually. How much will she have in December 2010? (Assume that a deposit is made in December of 2010. Make sure to count the years
carefully.)

# accumulated/compounded vale=future value

FVA = A × FVIFA (6%, n = 10) use Appendix C or Table III

FVA = $1,500 × 13.181 = $19,771.50

9.5 Present value-annuity

Present Value of an Annuity (present value of a series of equal payment) : Calculated by discounting each individual payment back to the present and then
adding up all of these payments=solve the present value individually for each payment and then sum them up.

Ex1: you will receive 1000 at the end of each year for 4 years; at a discount rate of 10%. what is this cash flow currently worth??

Using the interest table as more efficient and quick way to calculate

the future value –annuity (Table 9-4 OR Appendix D):

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Ex2: General Mills will receive $27,500 per year for the next 10 years as a payment for a weapon they invented. If a 12 percent rate is applied, should they be
willing to sell out their future rights now for $160,000?

# what is this cash flow currently worth???

PVA = A × PVIFA (12%, 10 periods) use Appendix D or Table VI

PVA = $27,500 × 5.650 = $155,375

Yes, the present value of the annuity is worth less than $160,000.

Ex3: what is the present value of $500 received at the end of each year of the next 3 years where the discount rate is 4%??
…………………………………………………………………………………………………………………………………………………………………………
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9.5 Annuity equalling a Future value

Used to determine the size of annuity (equal amount) that will equal the future value

Ex1: assume you wish to accumulate $4,641 after 4 years at 10% interest rate, how much you must put aside at the end of each of the four periods?

# use the same table and appendix as in Future value –Annity (Table 9-3 and appendix C)

( n = 4 ,i = 10% )

Ex2: you need $10,000 after 3 periods with the interest rate of 8%, how much you must put aside at the end of each period to accumulate this amount?

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Ex3: You need to have $ 50,000 at the end of 10 years. To accumulate this sum, you have decided to save a certain amount at the end of each year and deposit
it in the bank for the next 10 years and deposit it in the bank. The bank pays 8% interest compounded annually for long-term deposits. How much will you have
to save each year?

FV ᴀ 10
A= use Table III
FVIF ᴀ 8 % ,10

50,000
= 14.487
=$ 3,452

9.5 Annuity equalling a Present value

In determining the size of an annuity (equal amount) equal to a given present value.

# use the same table and appendix as in Present value –Annity (Table 9-4 and appendix D)

EX1: what a four years annuity is equivalent of $1000 today with an interest rate of 10%??

1,000
PVIFA (n= 4 , i= 10% ) A = 3.170 = 315.46

9.6 Loan Amortization (continuing Annuity equalling a Present value)

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Ex2: your wealthy uncle presents you with $10,000 now to help to pay for your collage fee over the next 4 years and asked you to deposit this amount in the
bank so you earn a 6% interest. How much you can withdraw at the end of each year for the next 4 years??? You need to know the value of an annuity equal to
a given present value.

PVA
A = PVIFA PVIFA ( n= 4 , i= 6% )

10,000
A = 3.465 = 2,886

A Loan of $10,000 for 4 Years at interest rate of 6%

1 2 3 4

Annual Payment ---- Annuity ---- Annual Withdrawal

(1) –( 3) +( 2) =(4) Or ( 1) + ( 2 ) – ( 3 ) = ( 4 )

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Ex3: assume you borrowed money to buy a house (mortgage loan) of $80,000 and this loan need to be repaid over the next 20 years with interest rate of 8%?
How must you should pay annually to eventually liquidate the loan? In other words, what annuity paid over 20 years is the equivalent of an $80,000 present
value with an 8 percent interest rate? (Loan amortization)

#Amortization Table (payoff table) is a table that shows each loan payment over the life of the loan and the breakdown of the amount of interest and principal
paid to calculate the reaming balance after each payment has been made. This break down is really important because on business loan, only interest is tax
detectible

#Present value concept is used to determine the required payments for an instalment-type loan

n=20 , i= 8% Table VI

PVA Loan 80,000

A= PVIFA = PVIFA = 9.818 = 8,148 this is annual payment for the next 20 years.

1 2 3 4 5

(1 ) – ( 2 ) + ( 3 ) = ( 5 ) , ( 2)-( 3) = (4) OR ( 1) -( 4) = (5)

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EX3: Assume you borrow 22,000 at 12 % compound annual interest to be repaid over the next 6 years. What are the equal instalment payments are required at
the end of each year??

Period Beginning Annual Annual Principal Ending

Balance Interest Payment Payments Balance

9.7 Yield on investment –present value single amount/annuity

Determine the interest rate/yield that will associate with the future return of an investment, finding the interest rate from the interest table can be:

1-Direct: you will find the exact interest rate

2-Indirect: you will not find the exact interest rate→ interpolation to find a more precise interest rate.

Ex1: An investment producing $1,464 after 4 years having a present value of $1,000. What is the interest rate or yield on investment??

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Ex2: Yield (LO4) Franklin Templeton has just invested $8,760 for her son (age one). This money will be used for his son’s education 17 years from now. He
calculates that he will need $60,000 by the time the boy goes to school. What rate of return will Mr. Templeton need in order to achieve this goal?

#determining yield of investment (single amount)

Solution:
Alternative solution:
Use Table B Use Table A

OR

Ex3: An investment producing $1,490 per annum for the next 10 years having a present value (investment) of $10,000. what is the interest rate or yield on
investment??
PVA = A × PVIFA
PV A 10,000
PVIFA = A = 1,490
=¿ 6.711 we search in Table 4 and we will find i=8%

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Ex4: An investment producing $1,161 after 3 years having a present value of $1,000. What is the interest rate or yield on investment??

PV 1,000
PVIF =
FV
= 1,161
=¿ . 861

It’s between 5% and 6%, so we can use two ways:

1-

A. Take the difference between PV IF at 5% and PV IF at 6% → 0.864 - 0.840=0.024 → x

B. Take the difference between PV IF at 5% (lowest interest rate) and PV IF designated → 0.864 - 0.861= 0.003 → y
y 0.003
C. Lowest interest rate +[ ×(difference between the two interest rates)] → 5% +[ ×1%] = 5.125%
x 0.024

2-

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EX.5 Yield with interpolation (LO4) On January 1, 2008, Mr. Dow bought 100 shares of stock at $12 per share. On December 31, 2010, he sold the stock for
$18 per share. What is his annual rate of return? Interpolate to find the answer.

Solution:
Appendix B

(3 periods)

Return is between 14%-15% for 3 years

14% + (.008/.017) (1%)

14% + .471 (1%)
14.47%

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EX.6: An investment producing $2,211 per annum for 6 years having a present value of $10,000.What is the interest rate or yield on investment??

PV A 10,000
PVIFA = A = 2,211
=¿4.5228 ͌ 4.523

It’s between 8% and 9% , so we can use two ways:

1-

A. Take the difference between PV IF at 8% and PV IF at 9% → 4.623 - 4.486=0.137 → x

B. Take the difference between PV IF at 8% (lowest interest rate) and PV IF designated → 4.623 - 4.523=0.1 → y
y 0.1
C. Lowest interest rate +[ ×(difference between the two interest rates)] → 8% +[ ×1%] = 8.730 %
x 0.137

2-

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9-8 special considerations in time value of money

1) Compounding frequency: certain contractual agreements may require semiannual, quarterly, or monthly compounding periods, in such cases:

N = No. of years × No. of compounding periods during the year

I = Quoted annual interest / No. of compounding periods during the year

# semiannual → (n×2, I/2); quarterly→ (n×4, I/4); monthly→ (n×12, I/12)

Ex1: Determine the future value of a $1,000 investment after 5 years at 8% annual interest compounded semiannually??

Ex2: Determine the present value of 20 quarterly payments of $2,000 each to be received over the next 5 years, where i = 8% per annum??

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Ex3: Quarterly compounding (LO5) Beverly Hills started a paper route on January 1, 2004. Every three months, she deposits $300 in her bank account, which
earns 8 percent annually but is compounded quarterly. On December 31, 2007, she used the entire balance in her bank account to invest in an investment
at 12 percent annually. How much will she have on December 31, 2010?
#first step: I want to know the accumulated value of the annuity investment from 2004 to 2007??
#second step: I want to know the value she will have (future value) at the end of 2010(from 2007 to 2010)???
# percentage: i →8% quarterly: 8% /4=2% , n → 4 years× 4 =16
Percent –divide
Period –multiply

Appendix C
FVA = A × FVIFA (2%, 16 periods)
FVA = $300 × 18.639 = $5,591.70 after four years

Appendix A
FV = PV × FVIF (12%, 3 periods)
FV = $5,591.70 × 1.405
FV = $7,856.34 after three more years

Ex4: At the end of 3 years, how much is an initial deposit of $100 worth, assuming a quarterly compounded annual interest rate of 10%?

FV 3= PV (1+[i /m])mn Go to table 1, look at period (12) at 2% and 3% , add them together and take the average

= 100(1+[10 /4])
( 4 ) (3 )
OR FVIF of 2% at (n=12) = 1.2682
12
= 100(1+2.5 %) FVIF of 3% at (n=12) = 1.4258
FV 3 = $134.5 2.6940 → 2.6940 ÷ 2 = 1.34

FV 3 = 100(1.347) = $134.7
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1) The general formula for FV at the end of n years where interest is paid m times a year is:

- FV= PV (1+[i/m])mn

- If interest paid is 8% annually, then will be 4% semiannually, or 2% quarterly.

- If you deposit $100 in a saving account, 8% interest rate, the future value at the end of six month would be:

- FV 0.5= 100(1+[0.08 /2])( 2) (0.5 ) = 104 (half a year)

- FV 1= 100(1+[0.08 /2])( 2) (1) = 108.16 (a year)

- Note: 108.16 is higher than 108 because the one half a year or the 4% interest paid earned 0.16 extra / year.

- Suppose interest is paid quarterly, the FV of SR 100 at the end of one year which is stated 8% annually is:

FV = 100(1+[0.08 /4 ])( 4 )(1) = 100(1+0.02)4 = SR 108.24

2) The FV of SR 100 at the end of 3 years with quarterly compounding is:

FV 3= 100(1+[0.08 /4 ])( 4 )(3) or use Table I ( i =2% , n = 12 )

= 100(1+0.02)12 = 100(1.268) = SR 126.82

- With semiannual compounding is:

FV 3= 100(1+[0.08 /2])( 2) (3) or use Table I ( i = 4% , n = 6)

= 100(1+0.04)6 = 100(1.265) = SR 126.5

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- With annual compounding is:

FV 3= 100(1+[0.08 /1])( 1)(3) or use Table I ( i = 8% , n = 3)

= 100(1+0.08)3 = 100(1.260)

= SR 126.0

- Note: The more frequently interest is paid each year, the greater the future value.

3) The PV of SR100 to be received at the end of year 3, 8% discounted quarterly:

- PV = FV/ (1+[i /m])mn { i = 2% , n=12 } or use Table II

= 100 /(1+[0.08 /4 ])( 4 )(3) = 100(0.788) = SR 78.80

- If 8% is discounted annually: PV = 100 /(1+[0.08 ])(3) = 100(0.794) = SR 79.40

- Note: The fewer times a year interest is discounted, the greater the PV. The relation is just the opposite of that for the FV.

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2) Patterns of payments-deferred annuity:

#Situations involving a combination of single amounts and an annuity and annuity is paid sometime in the future

Ex1: Assuming a contract involving payments of different amounts each year for a three-year period and an annuity of $1,000 to be paid at the end of each year
from the fourth through the eighth year, what is the present value of the cash flows at 8% discount rate???

Step 1: Calculate present value –Single amount (A):

PV = FV × PVIF use Table 2

Step 2: Calculate present value -Annuity (B):

Present value of annuity from the 8th year to the beginning of 4th year:

PV A= A × PV IFA (n=5, i=8%)

PV=1000 × 3.993=$3,993

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Step 3: Discount the sum of annual payments back to present:

Present value from the end of the 3rd year to 0 (today):

PV =FV × PV IF (n=3, i=8%)

PV=3,993×0.794= $3,170

Step 4: sum the result of step 1 and step 3 ,

Thus, the total present value =

Alternative method:

1- determine the present value factor of an annuity for the total period → n=8, i=8% → PV IFA = 5.747

2- determine the present value factor of deferred annuity period → n=8-5=3 , i=8% → PV IFA = 2.577

3-take the difference between 1&2→5.747-2.577=3.170 , then , multiply it by the annuity 3.170 ×$1000 =$3,170 (present value of annuity)

4- Added to the present value of single amount (3 periods) →, $5,022 + $3,170= $8,192

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9-38. Deferred annuity (LO3) Rusty Steele will receive the following payments at the end of the next three years: $4,000, $7,000, and $9,000. Then from the
end of the fourth year through the end of the tenth year, he will receive an annuity of $10,000. At a discount rate of 10 percent, what is the present value
of all future benefits?

#First find the present value of the first three payments.

PV = FV × PVIF (Appendix B) i = 10%

1) $4,000 × .909 = $3,636

2) 7,000 × .826 = 5,782
3) 9,000 × .751 = 6,759
$16,177

Then find the present value of the deferred annuity. Appendix D will give a factor for a seven-period annuity (fourth year through the tenth year) at a
discount rate of 10 percent. The value of the annuity at the beginning of the fourth year is:

This value at the beginning of year four (end of year three) must now be discounted back for three years to get the present value of the deferred
annuity. Use Appendix B.
Take the PVIFA for 10 years at 10% and subtract the
OR PVIFA for 3 years at 10% to end up with the 7 years
deferred annuity.

Finally, find the total present value of all future payments. PVIFA = 6.145 (10 years at 10%)
PVIFA = 2.487 ( 3 years at 10%)
Present value of first three payments $16,177 PVIFA = 3.658 (years 4 through 10 years at 10%)
Present value of the deferred annuity 36,559
$52,736 $10,000 × 3.658 = $36,580

Present value of first three payments $16,177

Present value of the deferred annuity 36,580 21
$52,757