Time Value of Money

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Financial Management - 1.

unit 3

Time
Time Value
Value of
of
Money
Money
Financial Management - 1.2

Time value of money

 The concept of the time value of money is that money


received now is generally better than the same amount
of money received some time later.

 One dollar today is worth more than one dollar

tomorrow .
Financial Management - 1.3

Time value of money


Financial Management - 1.4

Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read Problem Thoroughly
2. Determine if it is a PV or FV Problem
3. Create a Time Line
4. Put Cash Flows and Arrows on Time Line
5. Determine if Solution involves a Single
CF, Annuity Stream(s), or Mixed Flow
6. Solve the Problem
Financial Management - 1.5

Types
Types of
of Interest
Interest
 Interest is the cost of using money (capital) over a
specified time period.
 Simple Interest
Interest paid (earned) on only the original amount, or
principal borrowed (lent).

 Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed (lent).
Financial Management - 1.6

Simple
Simple Interest
Interest Formula
Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
Financial Management - 1.7

Simple
Simple Interest
Interest Example
Example
 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?
 SI = P0(i)(n)
= $1,000(.07)(2)
= $140
Financial Management - 1.8

Simple
Simple Interest
Interest (FV)
(FV)
 What is the Future Value (FV)
FV of the
deposit?
FV = P0 + SI
= $1,000 + $140
= $1,140
 Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Financial Management - 1.9

Simple
Simple Interest
Interest (PV)
(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.
Financial Management - 1.10

Compound
Compound Interest
Interest

Assume that you deposit $1,000 at


a compound interest rate of 7% for
2 years.
years
0 1 2
7%
$1,000
FV2
Financial Management - 1.11

Contd…
Contd…

FV1 = P0 (1+i)1 = $1,000 (1.07)


= $1,070
You earned $70 interest on your
$1,000 deposit over the first year.
This is the same interest you would
earn under simple interest.
Financial Management - 1.12

Contd…
Contd…

FV1 = P0 (1+i)1 = $1,000 (1.07)


= $1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)(1.07)
$1,000
= P0 (1+i)2 = $1,000(1.07)
$1,000 2

= $1,144.90
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
Financial Management - 1.13

General
General Future
Future Value
Value Formula
Formula

FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:


FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
Financial Management - 1.14

Valuation
Valuation Using
Using Table
Table II
FVIFi,n is found on Table I at End
of Book or on the Card Insert.
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Financial Management - 1.15

Using
Using Future
Future Value
Value Tables
Tables
FV2 = $1,000 (FVIF7%,2) =
$1,000 (1.145) =
$1,145 [Due to Rounding]
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Financial Management - 1.16

Story
Story Problem
Problem Example
Example
Julie Miller wants to know how large her
$10,000 deposit will become at a
compound interest rate of 10% for 5 years.
years

0 1 2 3 4 5
10%
$10,000
FV5
Financial Management - 1.17

Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
 Calculation based on Table I:
FV5 = $10,000 (FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [Due to Rounding]
Financial Management - 1.18

Frequency
Frequency of
of Compounding
Compounding

General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per
Yeari: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
Financial Management - 1.19

Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+
1,000 [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
1,000 [.12/2])(2)(2)
= 1,262.48
Financial Management - 1.20

Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1+
1,000 [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+
1,000 [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+
1,000 [.12/365])(365)
(2)
= 1,271.20
Financial Management - 1.21
Effective
Effective Annual
Annual
Interest
Interest Rate
Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )m - 1
Financial Management - 1.22
BWs
BWs Effective
Effective
Annual
Annual Interest
Interest Rate
Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate is
6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
Financial Management - 1.23

Present
Present Value
Value (Single
(Single Deposit)
Deposit)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7%.
0 1 2
7%
$1,000
PV0 PV1
Financial Management - 1.24

Contd…
Contd…

PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 =


FV2 / (1+i)2 = $873.44

0 1 2
7%
$1,000
PV0
Financial Management - 1.25

General
General Present
Present Value
Value Formula
Formula

PV0 = FV1 / (1+i)1

PV0 = FV2 / (1+i)2


etc.

General Present Value Formula:


PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
Financial Management - 1.26

Valuation
Valuation Using
Using Table
Table IIII
PVIFi,n is found on Table II at End
of Book or on the Card Insert.
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Financial Management - 1.27

Using
Using Present
Present Value
Value Tables
Tables
PV2 = $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Financial Management - 1.28

Story
Story Problem
Problem Example
Example
Julie Miller 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
Financial Management - 1.29

Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
 Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
Financial Management - 1.30

Annuities
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Types of annuities
Ordinary Annuity:
Annuity Payments or receipts occur
at the end of each period.
AnnuityDue:
Due Payments or receipts occur at
the beginning of each period.
Financial Management - 1.31

Examples of Annuities

 Student Loan Payments


 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
Financial Management - 1.32

Parts
Parts of
of an
an Annuity
Annuity
(Ordinary Annuity) (Annuity Due) (Annuity Due)
End of Beginning of End of
Year 1 Year 1 Year 1

0 1 2 3

$100 $100 $100

Today Equal Cash Flows


Each 1 Year Apart
Financial Management - 1.33
Future
Future value
value of
of Ordinary
Ordinary
Annuity
Annuity --
-- FVA
FVA
End of Year
0 1 2 n n+1
i% . . .
R R R
R: Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn


... + R(1+i)1 + R(1+i)0
Financial Management - 1.34

Example
Example of
of an
an Ordinary
Ordinary Annuity
Annuity --
--
FVA
FVA

End of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0
$3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
Financial Management - 1.35

Valuation
Valuation Using
Using Table
Table III
III
FVAn = R (FVIFAi%,n) FVA3 =
$1,000 (FVIFA7%,3) = $1,000
(3.215) = $3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Financial Management - 1.36
Future
Future value
value of
of Annuity
Annuity
Due
Due --
-- FVAD
FVAD
Beginning of Year
0 1 2 n n+1
i% . . .
R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn


... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
Financial Management - 1.37
Example
Example of
of an
an
Annuity
Annuity Due
Due --
-- FVAD
FVAD
Beginning of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070
$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$1,000(1.07)2 + $1,000(1.07)1 FVAD3 = $3,440
= $1,225 + $1,145 + $1,070
= $3,440
Financial Management - 1.38

Valuation
Valuation Using
Using Table
Table III
III
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07) =
$1,000 (3.215)(1.07) = $3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Financial Management - 1.39
Present
Present value
value of
of Ordinary
Ordinary
Annuity
Annuity --
-- PVA
PVA
End of Year
0 1 2 n n+1
i% . . .
R R R

R: Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
Financial Management - 1.40

Example
Example of
of an
an Ordinary
Ordinary Annuity
Annuity --
-- PVA
PVA

End of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
Financial Management - 1.41

Valuation
Valuation Using
Using Table
Table IV
IV
PVAn = R (PVIFAi%,n) PVA3 =
$1,000 (PVIFA7%,3) = $1,000
(2.624) = $2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Financial Management - 1.42

Present
Present value
value of
of Annuity
Annuity Due
Due --
-- PVAD
PVAD

Beginning of Year
0 1 2 n n+1
i% . . .
R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1


= PVAn (1+i)
Financial Management - 1.43
Example
Example of
of an
an
Annuity
Annuity Due
Due --
-- PVAD
PVAD
Beginning of Year
0 1 2 3 4
7%
$1,000.00 $1,000 $1,000
$ 934.58
$ 873.44
PVADn=$2,808.02

PVADn = $1,000/(1.07)2 + $1,000/(1.07)1 +


$1,000/(1.07)0 = $2,808.02
Financial Management - 1.44

Valuation
Valuation Using
Using Table
Table IV
IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Financial Management - 1.45

Mixed
Mixed Flows
Flows Example
Example
Julie Miller 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
Financial Management - 1.46

How
How to
to Solve?
Solve?

1. Solve a “piece-at-a-time”
piece-at-a-time by
discounting each piece back to
t=0.
2. Solve a “group-at-a-time”
group-at-a-time by first
breaking problem into annuity
group streams and single cash
flow groups. Then discount
each group back to t=0.
Financial Management - 1.47

““Piece-At-A-Time”
Piece-At-A-Time”

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
Financial Management - 1.48

““Group-At-A-Time”
Group-At-A-Time” (#1)
(#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) = $600(1.736) = $1,041.60
$400(PVIFA10%,4) = $400(1.434) = $573.57
$100 (PVIF10%,5) =$100 (0.621) = $62.10
Financial Management - 1.49

““Group-At-A-Time”
Group-At-A-Time” (#2)
(#2)
0 1 2 3 4

$400 $400 $400 $400


$1,268.00
0 1 2 PV0 equals
Plus
$200 $200 $1677.30.
$347.20
0 1 2 3 4 5
Plus
$100
$62.10
Financial Management - 1.50

Amortization
 Amortization is an accounting technique used to periodically
lower the book value of a loan or an intangible asset over a
set period of time.
 Concerning a loan, amortization focuses on spreading out
loan payments over time.
 It helps us to know what portion of periodic loan payment is
covered from interest and how much is from principal.
 An amortization schedule is used to reduce the current
balance on a loan—for example, a mortgage or a car loan—
through installment payments.
Financial Management - 1.51

Contd…
Contd…
Steps
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Prepare Amortization schedule
Financial Management - 1.52

Amortizing
Amortizing aa Loan
Loan Example
Example
Julie Miller is borrowing $10,000 at an annual
interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Financial Management - 1.53

Amortizing
Amortizing schedule
schedule
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]


Financial Management - 1.54

Usefulness of Amortization

1. Interest Expense -- Interest


expenses may reduce
taxable income of the firm.
2. Debt Outstanding -- The
quantity of outstanding
debt may be used in day-
to-day activities of the firm.

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