Time Value of Money
1
Outline
Understand what is meant by "the time value of money."
Understand the relationship between present and future
value.
Describe how the interest rate can be used to adjust the
value of cash flows – both forward and backward – to a
single point in time.
Calculate both the future and present value of:
an amount invested today (lump sum);
a stream of equal cash flows (an annuity)
a stream of uneven cash flows.
2
Time Value of Money
Which would you prefer -- $10,000 today or
$10,000 in 5 years?
years
Obviously, $10,000 today.
today
You already recognize that there is
TIME VALUE TO MONEY!!
MONEY
3
Time Value of Money
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
Interest Example (FV)
Assume that you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest
at the end of the 2nd year?
FV = PV ( 1+i) n
FV = 1,000 ( 1.07) 2 = $1,144.9
How much interest did you earn?
Time lines show timing of
cash flows.
0 1 2 3
I%
CF0 CF1 CF2 CF3
Tick marks at ends of periods, so Time 0 is
today; Time 1 is the end of Period 1; or the
beginning of Period 2.
6
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2
years.
years
0 1 2
7%
$1,000
FV2
Interest Example (PV)
What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
PV of a Lump Sum (Example)
Ayfer Yılmaz wants to know how large of a
deposit to make so that the money will grow to
$10,000 in 5 years at a discount rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
PV of a Lump Sum (Solution)
Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Annuities
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of periods, consecutively.
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Example of an Ordinary Annuity
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA0 PVA0 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
Formulas for PV and FV of
Annuities
13
Uneven Cash Flows Example
Ayfer Yılmaz will receive the set of cash
flows below. What is the Present Value at
a discount rate of 10%.
10%
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
Uneven Cash Flows Example
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
What is the FV of this CF stream at t=5?
PV of a Perpeuity
Stream of Cash Flows that Never Terminates
0 1 2 3 4
10%
$600 $600 $600 $600 $600
PV = CF / i
PV = 600/0.10 = $6,000
Steps for Solving TVM Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF,
annuity stream(s), or mixed flow
6. Solve the problem
The Impact of Compounding
Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated i% constant?
Why?
18
The Impact of Compounding
(Answer)
LARGER!
If compounding is more frequent than
once a year--for example, semiannually,
quarterly, or daily--interest is earned on
interest more often.
19
$100 at a 12% nominal rate with
semiannual compounding for 5 years
m*n
INOM
FVN = PV 1 +
n
2x5
0.12
FV5 = $100 1 +
2
= $100(1.06)10 = $179.08
20
FV of $100 at a 12% nominal rate for
5 years with different compounding
FV(Ann.) = $100(1.12)5 = $176.23
FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19
21
Effective Annual Rate (EAR)
The EAR is the annual rate that the
investor effectively earns in a year.
n
İAPR
EAR = 1 +
n
22
Effective Annual Rate Example
Example: Invest $1 for one year at 12%,
semiannual:
FV = PV(1 + Iapr/N)N
FV = $1 (1.06)2 = $1.1236.
EAR% = 12.36%, because $1 invested for
one year at 12% semiannual compounding.
23
EAR for a Nominal Rate of
12% (APR)
EARAnnual = 12%.
EARS = 2 p/yr = 12.36%.
EARQ = 4 p/yr = 12.55
EARM = 12 p/yr = 12.68%.
EARD(365) = 365 p/yr = 12.75%. 24
