The Time Value of Money

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 5

What is Time Value?

 We say that money has a time value because that

money can be invested with the expectation of
earning a positive rate of return
 In other words, “a dollar received today is worth
more than a dollar to be received tomorrow”
 That is because today’s dollar can be invested so that
we have more than one dollar tomorrow
The Terminology of Time Value

 Present Value - An amount of money today, or the

current value of a future cash flow
 Future Value - An amount of money at some future
time period
 Period - A length of time (often a year, but can be a
month, week, day, hour, etc.)
 Interest Rate - The compensation paid to a lender (or
saver) for the use of funds expressed as a percentage
for a period (normally expressed as an annual rate)
Abbreviations

 PV - Present value
 FV - Future value
 Pmt - Per period payment amount
 N - Either the total number of cash flows or
the number of a specific period
 i - The interest rate per period
Timelines

 A timeline is a graphical device used to clarify the

timing of the cash flows for an investment
 Each tick represents one time period

PV FV

0 1 2 3 4 5
Today
Calculating the Future Value

 Suppose that you have an extra $100 today that you

wish to invest for one year. If you can earn 10% per
year on your investment, how much will you have in
one year?

-100 ?

0 1 2 3 4 5
Calculating the Future Value (cont.)

 Suppose that at the end of year 1 you decide to

extend the investment for a second year. How much
will you have accumulated at the end of year 2?

-110 ?

0 1 2 3 4 5
Generalizing the Future Value

 Recognizing the pattern that is developing,

we can generalize the future value
calculations as follows:

 If you extended the investment for a third

year, you would have:
Compound Interest

 Note from the example that the future value is

increasing at an increasing rate
 In other words, the amount of interest earned each
year is increasing
• Year 1: $10
• Year 2: $11
• Year 3: $12.10
 The reason for the increase is that each year you are
earning interest on the interest that was earned in
previous years in addition to the interest on the
original principle amount
 Compound Interest Graphically
4000
3833.76

3500
5%
3000
10%

15%
2500
Future Value

20%
2000
1636.65
1500

1000
672.75

500
265.33

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years

1
The Magic of Compounding

 On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly

purchased Manhattan from the Indians for $24 worth of beads
and other trinkets. Was this a good deal for the Indians?
 This happened about 371 years ago, so if they could earn 5% per
year they would now (in 1997) have:

$1,743,577,261.65 = 24(1.05) 371

 If they could have earned 10% per year, they would now have:

$54,562,898,811,973,500.00 = 24(1.10) 371

That’s about 54,563 Trillion dollars!

1
The Magic of Compounding (cont.)

 The Wall Street Journal (17 Jan. 92) says that all of New York city
real estate is worth about $324 billion. Of this amount,
Manhattan is about 30%, which is $97.2 billion
 At 10%, this is $54,562 trillion! Our U.S. GNP is only around $6
trillion per year. So this amount represents about 9,094 years
worth of the total economic output of the USA!
 At 5% it seems the Indians got a bad deal, but if they earned 10%
per year, it was the Dutch that got the raw deal
 Not only that, but it turns out that the Indians really had no
claim on Manhattan (then called Manahatta). They lived on
Long Island!
 As a final insult, the British arrived in the 1660’s and
unceremoniously tossed out the Dutch settlers.

1
Calculating the Present Value

 So far, we have seen how to calculate the

future value of an investment
 But we can turn this around to find the
amount that needs to be invested to achieve
some desired future value:

1
Present Value: An Example

 Suppose that your five-year old daughter has just

announced her desire to attend college. After some
research, you determine that you will need about
$100,000 on her 18th birthday to pay for four years of
college. If you can earn 8% per year on your
investments, how much do you need to invest today
to achieve your goal?

1
Annuities

 An annuity is a series of nominally equal payments

equally spaced in time
 Annuities are very common:
• Rent
• Mortgage payments
• Car payment
• Pension income
 The timeline shows an example of a 5-year, $100
annuity
100 100 100 100 100

0 1 2 3 4 5
1
The Principle of Value Additivity

 How do we find the value (PV or FV) of an

annuity?
 First, you must understand the principle of
value additivity:
• The value of any stream of cash flows is equal to
the sum of the values of the components
 In other words, if we can move the cash flows
to the same time period we can simply add
them all together to get the total value

1
Present Value of an Annuity

 We can use the principle of value additivity to find

the present value of an annuity, by simply summing
the present values of each of the components:

1
 Present Value of an Annuity (cont.)

 Using the example, and assuming a discount rate of

10% per year, we find that the present value is:

62.0
68.3
9
75.1
0
82.6
3
90.9
4
1
379.08
100 100 100 100 100

0 1 2 3 4 5

1
Present Value of an Annuity (cont.)

 Actually, there is no need to take the present

value of each cash flow separately
 We can use a closed-form of the PVA equation
instead:

1
Present Value of an Annuity (cont.)

 We can use this equation to find the present

value of our example annuity as follows:

 This equation works for all regular annuities,

regardless of the number of payments

2
The Future Value of an Annuity

 We can also use the principle of value additivity to

find the future value of an annuity, by simply
summing the future values of each of the components:

2
The Future Value of an Annuity (cont.)

 Using the example, and assuming a discount rate of

10% per year, we find that the future value is:

}
146.41
133.10
121.00 = 610.51
110.00
at year 5
100 100 100 100 100

0 1 2 3 4 5

2
The Future Value of an Annuity (cont.)

 Just as we did for the PVA equation, we could

instead use a closed-form of the FVA equation:

 This equation works for all regular annuities,

regardless of the number of payments

2
The Future Value of an Annuity (cont.)

 We can use this equation to find the future

value of the example annuity:

2
 Annuities Due

 Thus far, the annuities that we have looked at begin

their payments at the end of period 1; these are
referred to as regular annuities
 A annuity due is the same as a regular annuity,
except that its cash flows occur at the beginning of
the period rather than at the end

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5

2
Present Value of an Annuity Due

 We can find the present value of an annuity due in the

same way as we did for a regular annuity, with one
exception
 Note from the timeline that, if we ignore the first cash
flow, the annuity due looks just like a four-period
regular annuity
 Therefore, we can value an annuity due with:

2
Present Value of an Annuity Due (cont.)

 Therefore, the present value of our example

annuity due is:

 Note that this is higher than the PV of the,

otherwise equivalent, regular annuity

2
Future Value of an Annuity Due

 To calculate the FV of an annuity due, we can

treat it as regular annuity, and then take it
one more period forward:

Pmt Pmt Pmt Pmt Pmt

0 1 2 3 4 5
2
Future Value of an Annuity Due (cont.)

 The future value of our example annuity is:

 Note that this is higher than the future value

of the, otherwise equivalent, regular annuity

2
Deferred Annuities

 A deferred annuity is the same as any other

annuity, except that its payments do not begin
until some later period
 The timeline shows a five-period deferred
annuity

100 100 100 100 100

0 1 2 3 4 5 6 7

3
PV of a Deferred Annuity

 We can find the present value of a deferred annuity

in the same way as any other annuity, with an extra
step required
 Before we can do this however, there is an important
rule to understand:
When using the PVA equation, the resulting PV is
always one period before the first payment occurs

3
PV of a Deferred Annuity (cont.)

 To find the PV of a deferred annuity, we first

find use the PVA equation, and then discount
that result back to period 0
 Here we are using a 10% discount rate

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7

3
PV of a Deferred Annuity (cont.)

Step 1:

Step 2:

3
FV of a Deferred Annuity

 The future value of a deferred annuity is

calculated in exactly the same way as any
other annuity
 There are no extra steps at all

3
Uneven Cash Flows

 Very often an investment offers a stream of

cash flows which are not either a lump sum
or an annuity
 We can find the present or future value of
such a stream by using the principle of value
additivity

3
Uneven Cash Flows: An Example (1)

 Assume that an investment offers the following cash

flows. If your required return is 7%, what is the
maximum price that you would pay for this
investment?
100 200 300

0 1 2 3 4 5

3
Uneven Cash Flows: An Example (2)

 Suppose that you were to deposit the following

amounts in an account paying 5% per year. What
would the balance of the account be at the end of the
third year?
300 500 700

0 1 2 3 4 5

3
Non-annual Compounding

 So far we have assumed that the time period is equal

to a year
 However, there is no reason that a time period can’t
be any other length of time
 We could assume that interest is earned semi-
annually, quarterly, monthly, daily, or any other
length of time
 The only change that must be made is to make sure
that the rate of interest is adjusted to the period
length

3
Non-annual Compounding (cont.)

 Suppose that you have $1,000 available for

investment. After investigating the local banks, you
have compiled the following table for comparison. In
which bank should you deposit your funds?

3
Non-annual Compounding (cont.)

 To solve this problem, you need to determine which

bank will pay you the most interest
 In other words, at which bank will you have the
highest future value?
 To find out, let’s change our basic FV equation
slightly:

In this version of the equation ‘m’ is the number of

compounding periods per year

4
Non-annual Compounding (cont.)

 We can find the FV for each bank as follows:

First National Bank:

Second National Bank:

Third National Bank:

Obviously, you should choose the Third National Bank

4
Continuous Compounding

 There is no reason why we need to stop increasing

the compounding frequency at daily
 We could compound every hour, minute, or second
 We can also compound every instant (i.e.,
continuously):

 Here, F is the future value, P is the present value, r is

the annual rate of interest, t is the total number of
years, and e is a constant equal to about 2.718

4
Continuous Compounding (cont.)

 Suppose that the Fourth National Bank is offering to

pay 10% per year compounded continuously. What
is the future value of your $1,000 investment?

 This is even better than daily compounding

 The basic rule of compounding is: The more frequently
interest is compounded, the higher the future value

4
Continuous Compounding (cont.)

 Suppose that the Fourth National Bank is offering to

pay 10% per year compounded continuously. If you
plan to leave the money in the account for 5 years,
what is the future value of your $1,000 investment?