Week 4, The Time Value of Money The Basics

Using timelines to visualise cashflows

A timeline identifies the timing and amount of a stream of payments – both cash received and cash
spent – along with the interest rate earned.

A timeline is typically expressed in years, but it could also be expressed as months, days or any other
unit of time. For now, let us assume we are looking at cash flows that occur annually.

Time line example

A cash outflow of $100 occurs at the beginning of the first year (at time 0 or today), followed by cash inflows of
$30 and $20 in years 1 and 2, a cash outflow of $10 in year 3 and cash inflow of $50 in year 4.

Notations used in this chapter

FVn = the future value of the investment at the end of n periods.

i = the interest (or growth) rate per period.

PV0 = the present value, or original amount invested at the beginning of the first period.

n = Number of periods

Simple Interest

Simple interest is a specific form of interest calculation that is used in some circumstances,
particularly for short-term debt securities.

Simple interest for one period (e.g. a year) =

= Present Value (PV) × Annual interest rate (i)

For n periods, simple interest =

= Present Value (PV) × Annual interest rate (i) ×n

Recommended to always write the interest in a decimal rather than a percentage

If interest is not withdrawn, the future value resulting from an investment (e.g. loan) of PV for n
periods earning a simple interest rate of i per period is given by:

If we solve this for PV, we obtain the present value of a future sum FV in t periods’ time using a
simple interest rate of i per period:

This formula tells us how much we must invest (or lend) now to get FV in n periods’ time.

Example:
A company obtained a 2 years- $100 loan from a bank with a 10% p.a. simple interest rate, to be
paid at the end of each year and the lump sum borrowed returned at the end of the 2nd year.

1- The annual interest the company has to pay?

= Present Value (PV) × Annual interest rate (i)

100-0.10= $10

2- The total amount of funds the company paid by the end of the 2nd year (Maturity of the loan)?

$100 (1 + 0.10 x 2) = $120

Compound Interest

Compounding and future value

Time value of money calculations involve present value (what a cash flow would be worth to you
today) and future value (what a cash flow will be worth in the future).

This process of accumulating interest on an investment over multiple time periods is called
compounding. And, when interest is earned on both the initial principal and the reinvested interest
during prior periods, the result is called compound interest.
Example: Suppose that you deposited $100 in your savings account that earns 10% annual interest.
How much will you have in your account after two years?
FV2 = PV(1+i)n = 100(1.10)2 = $121

Applying compounding to things other than money

Example: A DVD rental firm is currently renting 8000 DVDs per year. How many DVDs will the firm be
renting in 10 years if the demand for DVD rentals is expected to increase by 7% per year?

Using equation 4-1a: FV = PV(1+i)n

FV = 8000(1.07)10
= 15 737.21 DVDs

Compound interest with shorter compounding periods-More frequent than annual compounding

Banks frequently offer savings accounts that compound interest every day, month or quarter.
More frequent compounding will generate higher interest income and lead to higher future values.

M: m indicates the frequency of compounding

DISCOUNTING AND PRESENT VALUE

What is the value today of cash flow to be received in the future?

The answer to this question requires computing the present value (PV), i.e. the value today of a
future cash flow, and the process of discounting or determining the present value of an expected
future cash flow.

Using an Excel spreadsheet

=FV(rate,nper,pmt,pv)
=FV(0.00833,120, 0,-50000)
=$135 352.07

The mechanics of discounting future cash flows

Discounting is actually the reverse of compounding.

To determine the present value of a known future cash flow, we simply take the FV equation(on
slide 10) and solve for PV:
Where i is discount rate or interest rate at which future payment is being brought back to present
from n periods

The rule of 72

This rule determines the number of years it will take to double the value of your investment.

n = 72/interest rate
Keep in mind that this is not a hard-and-fast rule, just an approximation—but it is a good
approximation.

The Rule of 72 can also be used to determine the annual interest rate required to double your
money from an investment given that the number of years required to do so is known.

MAKING INTEREST RATES COMPARABLE

It is difficult to determine exactly how much you are paying or earning on a loan. That is because the
loan might not be quoted as compounding annually, but rather as compounding quarterly or daily.

Annual percentage rate (APR)

The annual percentage rate (APR) indicates the interest rate paid or earned in one year without
compounding. APR is also known as the nominal or quoted (stated) interest rate.

Calculating the interest rate and converting it to an EAR

We cannot compare two loans based on APR if they do not have the same number of compounding
periods per year.

To make them comparable, we calculate their equivalent rate using an annual compounding period.
We do this by calculating the Effective Annual Rate (EAR)

General Rule
If the interest rate is NOT compounded annually, we should compute the EAR to determine the
actual interest earned on an investment or the actual interest paid on a loan.

To the extreme: continuous compounding

As m (number of compounding period) increases, so does the EAR. When the time intervals between
when interest is paid are infinitely small, we can use the following mathematical formula to compute
the EAR.

EAR = (e quoted rate ) – 1

Where e is the number 2.71828, with the corresponding calculator key generally appearing as ‘ex’.

PV= The value today of a future cash flow

Discounting= the reverse of compounding. This process Is used to determine the PV of a future cash
flow.