Reading 6: The Time Value of Money
Reading 6: The Time Value of Money
Reading 6: The Time Value of Money
Money
Learning Outcome Statements
• Covered
• 6a, 6b, 6c, 6d, 6e, 6f
• Not Covered
• None
Interest Rates
Interest rates can be thought of in three ways:
• The minimum rate of return that you require
to accept a payment at a later date.
• The discount rate that must be applied to a
future cash flow in order to determine its
present value.
• The opportunity cost of spending the money
today as opposed to saving it for a certain
period and earning a return on it.
Composition of Interest Rates
r = Real risk-free interest rate
Nominal risk-free rate
+ Inflation premium
+ Default risk premium
+ Liquidity premium
+ Maturity premium
(+ Premia for other risks)
These are cash flow buttons; the sign on PV, PMT, and FV
determines whether it is a cash inflow (positive) or a cash
outflow (negative)
The Future Value of a Single Cash Flow
If you invested $100 in an account paying 6%,
what would be the future value of your money in
one year, and in two years?
The Present Value of a Single Cash Flow
Calculating the present value involves
determining the value in today’s terms of a cash
flow or cash flow stream that will be received in
the future.
The Present Value of a Single Cash Flow
An investment promises to pay you $1,200 at
the end of 15 years. What is the most you would
be willing to pay for it today if your minimum
acceptable rate of return is 8%?
1,200
𝑃𝑉 = 15
= $ 378.29
( 1.08 )
FV and PV of a Series of Cash Flows
An annuity is a finite set of level sequential cash
flows.
An ordinary annuity is an annuity where the
cash flows occur at the end of each
compounding period.
An annuity due is an annuity where the periodic
cash flows occur at the beginning of every
period.
PV of an Annuity
What is the present value of a 10-year, $10,000 ordinary annuity
if the discount rate is 4%? What if this were an annuity due?
0 1 2 3
0 1 2 3
x 1.101 330
x 1.102 605
1,035
The Frequency of Compounding
The stated annual interest rate rs is the rate per
year.
If N is the number of compounding periods, then
the periodic interest rate is rs /N, and
Solve:
(1 + r/365)365 – 1 = 4.85%
(1 + r/365)365 = 1.0485
1 + r/365 = 1.04851/365 = 1.000130
r/365 = 0.000130
r = 0.04736 = 4.736%
Compounding and Future Values
Calculate the returns realized on an investment of $100
for one year at a stated annual interest rate of 8%
assuming different compounding frequencies.
Practice Question
What is the future value of $1,000 invested for five years at 6%
(nominal, annual) compounded quarterly?
Practice Question
What
is the future value of $1,000 invested for five years at 6%
(nominal, annual) compounded quarterly?
n = 20 (= 5 × 4)
i = 1.5% (= 6% ÷ 4)
PV = -1,000
PMT = 0
Solve for FV = 1,346.86
Alternatively,
n = 18
i = 5%
PV = 0
FV = 100,000
Solve for PMT = –3,385.35
i = 4.5
PV = 0
PMT = 2,000
FV = –50,000 (note the sign)
Solve for n = 17
n = 20
PV = 0
PMT = 5,000
FV = –150,000 (note the sign)
Solve for i = 4.0715