TIME VALUE OF MONEY

Lecture 8th

Lecture 8th Outline

What is time value of money?

Compounding and discounting

Shortcuts: perpetuities and annuities

Working with inflation

Time value of money applications

2

What is time value of money? (I)

Most financial decisions involve costs and

benefits that are spread out over time
Time value of money allows comparison of cash
flows from different periods
Using TVM we can offer answers to questions
such as:
Would it be better for a company to invest
$100,000 in a product that would return a total of
$200,000 in one year, or one that would return
$500,000 after two years?
3

What is time value of money? (II)

TVM concept: A dollar today is worth more than

a dollar tomorrow
WHY?

Time
Risk

We lose the opportunity to invest the

amount of money we receive in the future at
the return of similar investments in the
market (as growth opportunities and risk)

Real interest rate

Inflation

Time value terminology

0

r
PV

r
FV

PV Present Value, that is, the value today.

FV Future Value, or the value at a future date.
t the number of time periods between PV and FV
r the discount rate (opportunity cost of capital)
All time value questions involve the four values above:
PV, FV, r, and t given three of them, it is always
possible to calculate the fourth
5

Future values

You deposit $100 today at 10% interest. How much

will you have in 1 year?
you are interested in finding the FV for one year of
the $100 today (=PV)
FV($100, 10%) = $100

(1.10) = $110

FV1 = PV x (1+r)
6

Future values

You deposit $100 today at 10% interest. How much

will you have in 5 years?
you are interested in finding the FV for five years of
the $100 today (=PV)
FV($100, 10%, 5y) = $100

(1.1)5 = $161.05

FV(t,r) PV (1 r) t
Future value factor (FVF)
7

Future values
What is the future value of $100 today in 5 years at
a 10% interest rate?

FV(5,10) = $100
= $100

FVF(5y, 10%)
1.6105 = $161.05
8

Simple interest vs. compound interest

Growth of $100
original amount at
10% per year
Darker shaded area
represents the
portion of the total
that results from
compounding of
interest.

The power of compounding

10

Simple vs. compound interest

You have just won a $1 million jackpot in the lottery.

You can buy a ten year certificate of deposit

which pays 6% compounded annually.

Alternatively, you can give the $1 million to your

brother-in-law, who promises to pay you 6%
simple interest annually over the ten year period.

Which alternative will provide you with more money

at the end of ten years?

11

Compounding more frequently than annually

Compounding more frequently than annually

results in a higher effective interest rate
because you are earning interest on interest
more frequently
As a result, the effective interest rate is greater
than then the nominal (annual) interest rate

The effective rate of interest will increase the

more frequently interest is compounded
12

Compounding more frequently than annually

What would be the difference in future value if you

deposit $100 for 5 years and earn 12% annual
interest
compounded
(a)
annually,
(b)
semiannually, (c) quarterly, and (d) monthly?
Annually

100 x (1 + 0.12/1)5x1 = $176.23

Semiannually

100 x (1 + 0.12/2)5x2 = $179.09

Quarterly

100 x (1 + 0.12/4)5x3 = $180.61

Monthly

100 x (1 + 0.12/12)5x3= $181.67

13

Nominal and effective rates

The nominal interest rate (sometimes denoted

APR from annual percentage rate) is the
stated or contractual rate of interest charged by
a lender or promised by a borrower
The effective annual rate (EAR) is the rate you
actually pay or earn
m

r
EAR 1 1
m
EAR > APR whenever compounding occurs more
than once per year
14

Nominal and effective rates

What is the EAR on your credit card if the

nominal rate is 18% p.a., compounded
monthly?
Answer:
EAR = (1 + 0.18/12)12 1 = 19.56%
What if compounded quarterly?
Answer:
EAR = (1+ 0.18/4)4 1 = 19.25%
15

Compounding periods, APRs and EARs

Compounding
period

Number of times
compounded

Effective annual
rate (%)

Year

10.000000

Quarter

10.381289

Month

12

10.471307

Week

52

10.506479

365

10.515578

8,760

10.517029

525,600
31,536,000

10.517091
10.517092

Day
Hour
Minute
Second

16

Continuous compounding

The number of compounding periods per year

approaches infinity
The FV equation becomes:

FV(t,r) = PV x ert
2.7183

What is the future value of a $100 deposit after 5

years if interest of 12% is compounded
continuously?
FV(5,12) = $100 x e0.12x5 = $182.22
17

FV - The case of a stream of cash flows

FV of a set of cash flows is the sum of FVs for the

individual cash flows
0

100

300

300

-50

10%

133.10
363.00

330.00
FV = 776.10

Numerical Solution:
FV C1 (1 r) t-1 C 2 (1 r) t-2 ... C t-1 (1 r) 1 C t-1 (1 r) 0
t

C i (1 r) t-i
i 1

FV 100 (1 0.1)3 300 (1 0.1)2 300 (1 0.1)1 (-50) 776.10

Future Value of an Annuity

Annuity: A series of payments of equal

amounts at fixed intervals for a specified
number of periods.
Ordinary (deferred) Annuity: An annuity
whose payments occur at the end of each
period.
Annuity Due: An annuity whose payments
occur at the beginning of each period.

Ordinary Annuity Versus

Annuity Due
Ordinary Annuity

r%

1
C

Annuity Due
0
r%

2
C
2

3
C
3

FV - The case of a stream of constant cash flows

FV of a set of cash flows is the sum of FVs for the
individual cash flows
0

10%

100

100

100
110
121

FV

= 331

Numerical Solution:
t
t

(1

r)

1
(1

r)
1
t 1

t
FV C (1 r) C

C
r
r
i1

FV ANNUITY FACTOR

(1.10)3 1
FV $100

0.10
$100(3.310) $331.00

Calculating FV of an annuity

Assume you deposit $2,000 per year in a

savings account at 4% p.a., compounded
annually for 5 years. The first payment is
made one year from now. How much money
will you have in the account after 5 years?

24

Calculating FV of an annuity

(1.04)5
1
FV(5,000; 5y,4%) 2,000

0.04
0.04

2,000 5.4163 $10,832.6

25

Finding the payment in an annuity calculation

You would like to have $3,000 in your savings

account 12 months from now. If the account pays
9% annual interest compounded monthly, how
much should you deposit at the end of each month
to reach your goal?
(1.0075)12
1
3,000 C

0.0075
0.0075

C 3,000 12.5075 239.85

26

Future value applications in Finance

Future Value Finance Program - involves making

projections about the future worth of an asset and
adjusting the financing arrangement accordingly
(ex. new loan for a second mortgage)

Future retirement planning involves making

projection about the stream of payments that
should be made during the working life (retirement
fund accumulation) in order to get a monthly
pension of a certain level starting at a certain age.
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Present values

The process of obtaining the PV is the inverse of

the one which gives the FV
Suppose you need $20,000 in three years to pay
your college tuition. If you can earn 8% each year
on your money in a bank deposit, how much do
you need to deposit today?

PV = $20,000

1/(1.08)3 = $15,876.64

1
PV(t,r) FV
t
1 r

Present value factor (PVF)

28

Present values
What is the present value of $1000 to be received in
3 years at a 15% interest rate?

PV(3,15) = $1,000
= $1,000

PVF(3y, 15%)
0.6575 = $657.5
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The power of discounting

30

Finding the rate

Suppose you deposit $5,000 today in an account

paying r% p.a. If you will get $10,000 in 10
years, what rate of return are you being
offered?
Answer:

FV = $10,000; PV = $5,000; t = 10 years

$5,000 = $10,000 / (1+r)10 r = 7.18%

31

PV - The case of a stream of cash flows

PV of a set of cash flows is the sum of PVs for the

individual cash flows
1

100

300

300

-50

10%

90.91
247.93
225.39
-34.15
530.08 = PV

Numerical Solution:
1
1
1
PV C1
C2
... C t
1
2
(1 r)
(1 r)
(1 r) t
1
Ci
i
(1

r)
i 1
t

PV 100 0.9090 300 0.8264 300 0.7513 50 0.6830 530.08

PV - The case of a stream of constant cash flows

10%

90.91
82.64
75.13

248.69 = PV

100

100

100

Numerical Solution:
1
PV C
C
i
(1 r)
i 1
t

1 r
r

1
1
C
t
r r 1 r
PV ANNUITY FACTOR

PV 100 2.4869 248.69

Calculating PV of an annuity

Suppose you need $5,000 each year for the

next three years to make your tuition
payments. You need the first $5,000 in one
year. You can place money in a savings
account yielding 5% compounded annually.
How much do you need to have in the
account today?

36

Calculating PV of an annuity

1
PV(5,000; 3y,5%) 5,000

3
0.05
0.05(1.05)

5,000 2.7232 $13,616

37

Finding the annuity period

Suppose you owe $2,000 (=PV) on a VISA card,

and the interest rate is 2% per month. If you
make monthly payments of $50, how long will it
take you to pay off the debt?
1
1

2,000 50

t
0.02 0.02 1.02
5.0 1.02 t
t 81.27 months 6.78 years

38

PV formula for perpetuities - a shortcut

Perpetuity = a stream of cash flows which

will be paid or cashed for a very long period
of time (or forever)
Cash flow C
PV(perpetuity)

r
r
Example: Suppose you receive $1,000 per year
forever. Your discount rate is 6%. What is the
value today of this set of cash flows?
$1,000
PV(perpetu ity)
$16,666.66
0.06
39

Growing perpetuities

Imagine an apartment building where cash flows to

the landlord net of expenses will be $100,000 next
year. These cash flows are expected to rise at 5%
p.a. and the discount rate is 10%.
If this continues indefinitely growing perpetuity

C
PV(growing perpetuity )
r-g
100,000
PV(growing perpetuity )
2,000,000
0.1- 0.05
40

Few points concerning growing perpetuities

1. The numerator (C) is the first cash flow expected
to be cashed, the following cash flows will grow
yearly at constant rate.
2. The discount rate (r) is greater than the growth
rate (g) for the formula to work (its a correct

assumption as we consider a very long period of

time)

3. Timing assumption formula assumes cash

flows are received and disbursed at regular and

discrete points in time

41

Present value applications in Finance (I)

Assets and business valuation - involves making

projections about the future cash flow that assets or the
business will generate and discount them with the
opportunity cost of capital in order to estimate their
current value.
Investment valuation - involves making projections
about the future cash flow that investment will generate
and estimate the NPV of the investment.
Securities valuation (e.g stocks, bonds) - involves
making projections about the dividends/coupons that
will be paid to investors and discount them with the
opportunity cost of capital in order to estimate their
market value.
42

Present value applications in Finance (II)

Valuation of the financing offers (e.g. leasing) - involves

comparative analysis of the financing offers available on
the market by considering the present value of the
payments that should be made in each case.

Loan amortization schedule calculator - determine how

the principal and interest are decreasing over time for
each payment that is made against the loan. Loan
amount, interest rate and maturity period are the key
terms employed in this calculator that determine the
annuity of the loan, by using the present value formula.
43

A word on inflation

Rate of inflation = rate at which prices as a

whole are increasing
Nominal interest rate = rate at which money
invested grows
Real interest rate = rate at which the
purchasing power of an investment increases

44

Nominal and real interest rates

1 nominal interest rate
1 real interest rate
1 inflation rate
APPROXIMATION FORMULA
Real interest rate = Nominal interest rate Inflation rate

45

Nominal and real interest rates

Suppose you invest your funds at an interest

rate of 8%. What will be your real rate of
interest if the inflation rate is zero?
1.08
Real interest rate
1 8%
1.0

What if inflation rate is 5%?

1.08
Real interest rate
1 2.85%
1.05

46

Inflation and cash flows

CONSISTENCY is the rule for handling

inflation

Use nominal rates to discount nominal cash

flows
Use real interest rates to discount real cash
flows

You will get the same results, whether you

use nominal or real figures
47

Inflation and cash flows - example

Shields Electric forecasts the following nominal

cash flows on a project:
Date
Cash flow

-$1,000

$600

$650

If the nominal discount rate is 14%, and the

inflation rate is forecast to be 5%, what is the
NPV of the project?

Remember!

1 nominal interest rate

1 real interest rate
1 inflation rate
48

Inflation and cash flows - example

Using nominal cash flows and discount rate

600
650
NPV 1,000

$26.47
2
1.14 (1.14)

Using real cash flows and discount rate

Date
Real cash flow

0
-$1,000

$571.43 $589.57
600

1.05

650

2
1.05

571.43
589.57
NPV 1,000

$26.47
2
1.08571 (1.08571)
49

Suggested quizzes and problems

Brealey&Myres&Marcus,
Principles
Corpotrate Finance, Chapter 3

of

Quizzes/p. 51 1-15
Questions & problems/p. 52 1-10; 12; 16-17;
26; 29

50