Chapter 5

CHAPTER 4

Time Value of
Money

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All rights reserved.
 Learning Goals

LG1 Discuss the role of time value in finance, the use of

computational tools, and the basic patterns of cash
flow.

LG2 Understand the concepts of future value and present

value, their calculation for single amounts, and the
relationship between them.

LG3 Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.

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 The Role of Time Value in
Finance
• Most financial decisions involve costs & benefits that are
spread out over time.
• Time value of money allows comparison of cash flows
from different periods.
• Question: Your father has offered to give you some
money and asks that you choose one of the following two
alternatives:
– $1,000 today, or
– $1,100 one year from now.
• What do you do?

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 The Role of Time Value in
Finance (cont.)
• The answer depends on what rate of interest you could
earn on any money you receive today.
• For example, if you could deposit the $1,000 today at
12% per year, you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited
funds, you would be better off if you chose the $1,100 in
one year.

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 Future Value versus Present
Value
• Suppose a firm has an opportunity to spend $15,000 today on some
investment that will produce $17,000 spread out over the next five
years as follows:
Year Cash flow
1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000

• Is this a wise investment?

• To make the right investment decision, managers need to compare
the cash flows at a single point in time.
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 Figure 5.1
Time Line

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 Figure 5.2
Compounding and Discounting

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 Basic Patterns of Cash Flow

• The cash inflows and outflows of a firm can be described by its

general pattern.
• The three basic patterns include a single amount, an annuity, or a
mixed stream:

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 Future Value of a Single
Amount
• Future value is the value at a given future date of an
amount placed on deposit today and earning interest at a
specified rate. Found by applying compound interest over
a specified period of time.
• Compound interest is interest that is earned on a given
deposit and has become part of the principal at the end of
a specified period.
• Principal is the amount of money on which interest is
paid.

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 Personal Finance Example

If Fred Moreno places $100 in a savings account paying 8%

interest compounded annually, how much will he have at the
end of 1 year?
Future value at end of year 1 = $100  (1 + 0.08) = $108
If Fred were to leave this money in the account for another
year, how much would he have at the end of the second year?
Future value at end of year 2 = $100  (1 + 0.08)  (1 + 0.08)
= $116.64

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 Recitation

If Restituto places $278 in a savings account paying

6% interest compounded annually, Compute the
following
Interest for year 1
= $ 278 x 6%= $ 16.68
Future value of Investment at end of year 2
= $ 278 x (1 + 0.06)^2= $ 312.36

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 RECITATION

If IsCool Moreno places $150 in a savings account paying 12%

interest compounded annually, Compute the following:

Future value of Investment at end of year 1

= $150  (1 + 0.12) = $168
Future value of Investment at end of year 10

= $150  (1 + 0.12)^10 = $465.88

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 Future Value of a Single Amount:
The Equation for Future Value
• We use the following notation for the various inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial calculators, I is typically
used to represent this rate.)
– n = number of periods (typically years) that the money is left on deposit
• The general equation for the future value at the end of period n is
FVn = PV  (1 + r)n

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 Future Value of a Single Amount:
The Equation for Future Value
Jane Farber places $800 in a savings account paying 6% interest
compounded annually. She wants to know how much money will be in
the account at the end of five years.
FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58
This analysis can be depicted on a time line as follows:

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 Figure 5.4
Future Value Relationship

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 Present Value of a Single
Amount
• Present value is the current dollar value of a future amount—the
amount of money that would have to be invested today at a given
interest rate over a specified period to equal the future amount.
• It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
• Discounting cash flows is the process of finding present values;
the inverse of compounding interest.
• The discount rate is often also referred to as the opportunity cost,
the discount rate, the required return, or the cost of capital.

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 Personal Finance Example

Paul Shorter has an opportunity to receive $300 one year

from now. If he can earn 6% on his investments, what is the
most he should pay now for this opportunity?

PV  (1 + 0.06) = $300

PV = $300/(1 + 0.06) = $283.02

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 Present Value of a Single Amount:
The Equation for Present Value

The present value, PV, of some future amount, FVn,

to be received n periods from now, assuming an
interest rate (or opportunity cost) of r, is calculated
as follows:

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 Present Value of a Single Amount:
The Equation for Future Value
Pam Valenti wishes to find the present value of $1,700 that will be
received 8 years from now. Pam’s opportunity cost is 8%.

PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46

This analysis can be depicted on a time line as follows:

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 Figure 5.5
Present Value Relationship

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 Annuities

An annuity is a stream of equal periodic cash flows, over a

specified time period. These cash flows can be inflows of
returns earned on investments or outflows of funds invested
to earn future returns.
– An ordinary (deferred) annuity is an annuity for which the
cash flow occurs at the end of each period
– An annuity due is an annuity for which the cash flow occurs at
the beginning of each period.
– An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound for
an additional period.

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 Personal Finance Example

Fran Abrams is choosing which of two annuities to receive.

Both are 5-year $1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due. Fran has listed the
cash flows for both annuities as shown in Table 5.1 on the
following slide.

Note that the amount of both annuities total $5,000.

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 Table 5.1 Comparison of Ordinary Annuity and
Annuity Due Cash Flows ($1,000, 5 Years)

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 Finding the Future Value of an
Ordinary Annuity
• You can calculate the future value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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 Personal Finance Example

Fran Abrams wishes to determine how much money she will have at the end
of 5 years if he chooses annuity A, the ordinary annuity and it earns 7%
annually. Annuity A is depicted graphically below:

This analysis can be depicted on a time line as follows:

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 Finding the Present Value of an
Ordinary Annuity
• You can calculate the present value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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 Finding the Present Value of an
Ordinary Annuity (cont.)
Braden Company, a small producer of plastic toys, wants to determine the
most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is
8%.

This analysis can be depicted on a time line as follows:

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 Table 5.2 Long Method for Finding the
Present Value of an Ordinary Annuity

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 Finding the Future Value of an
Annuity Due
• You can calculate the present value of an annuity due that
pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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 Finding the Present Value of an
Annuity Due
• You can calculate the present value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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 Finding the Present Value of a
Perpetuity
• A perpetuity is an annuity with an infinite life, providing
continual annual cash flow.
• If a perpetuity pays an annual cash flow of CF, starting
one year from now, the present value of the cash flow
stream is

PV = CF ÷ r

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 Personal Finance Example

Ross Clark wishes to endow a chair in finance at his alma

mater. The university indicated that it requires $200,000 per
year to support the chair, and the endowment would earn
10% per year. To determine the amount Ross must give the
university to fund the chair, we must determine the present
value of a $200,000 perpetuity discounted at 10%.

PV = $200,000 ÷ 0.10 = $2,000,000

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