The Time Value Of

Money
Chapter 3

2009 Cengage Learning/SouthWestern

Time Value of Money

Financial managers compare the marginal
benefits and marginal cost of investment
projects.
Projects usually have a long-term horizon:
timing of benefits and costs matters.
Time-value of money: A dollar received today
is worth more than a dollar received in the
future.
2

Future Value
Future Value: The value of an investment
made today measured at a specific future
date using compound interest.

FVn = PV x (1+r)n

Future
Value
depends
on:

Interest rate
Number of periods
Compounding interval

Future Value of $200

4 years, 7% interest
FV
FV44 == $262.16
$262.16
FV
FV33 == $245.01
$245.01
FV
FV22 == $228.98
$228.98
FV
FV11 == $214
$214
PV = $200
0

End of Year

Compound interest: Interest earned both

on the principal amount and on the interest
earned in previous periods.

Compounding
Year 1:
FV1 = $214

Year 2:
FV2 = $228.98

Year 3:
FV3 = $245.01

Year 4:
5

FV4 = $262.16

Earns 7% interest on initial $200

FV1 = $200+$14 = $214
Earn $14 interest again on $200
principal
Earns $0.98 on previous years
interest of $14: $14 x 7% = $0.98
FV2 = $214+$14+$0.98 = $228.98
Earn $14 interest again on $200
principal
Earns $2.03 on previous years
interest of $28.98: $28.98 x 7% =
$2.03
Earn $14 interest again on $200
FV3 = $228.98+$14+$2.03 =
principal
$245.01
Earns $3.15 on previous years
interest of $45.01: $45.01 x 7% =

The Power of Compound Interest

41

20%
36

31

26

21

15%

16

11

10%
6

5%
0%

1
1

11

13

Periods

15

17

19

21

23

25

Present Value
Present value: The value today of a cash flow
to be received at a specific date in the future,
assuming an opportunity to earn interest at a
specified rate.

FVn PV 1 r

PV
7

FVn
(1 r )

Present Value of $200

4 Years, 7% Interest
Discounting
0

1
FV
FV11 == $200
$200

PV
PV == $186.92
$186.92

2
FV
FV22 == $200
$200

3
FV
FV33 == $200
$200

4
FV
FV44 == $200
$200

End of Year

PV
PV == $174.69
$174.69
PV
PV == $163.26
$163.26
PV
PV == $152.58
$152.58

Discounting: The process of calculating

present values.

Present Value of One Dollar ($)

The Power of Discounting

1.00

0%

0.75
0.5
5%
0.25

10%
15%
20%
0 2 4 6 8 10 12 14 16 18 20 22 24
Periods

Future Value of Cash Flow Streams

Mixed
stream

A series of unequal cash flows

reflecting no particular pattern.

Annuity

A stream of equal periodic cash

flows.
n

FV CFt 1 r
t 1

10

n t

Future and Present Values

of An Ordinary Annuity
Compounding
Future
Future
Value
Value

$1,000

$1,000

$1,000

End of Year

Present
Present
Value
Value
11

Discounting

$1,000
4

$1,000
5

Future Value of An Ordinary

Annuity
5 Years, 5.5% Interest

$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000.00

$1,000

$1,000

$1,000

$1,000
4

$1,000
5

End of Year

(1 r ) 1
FV PMT
$5,581.08
r
n

12

Ordinary annuity: An annuity for which the

payments occur at the end of each period.

Future Value of An Annuity Due

5 Years, 5.5% Interest
$1,306.96
$1,238.82
$1,174.24
$1,113.02
$1,055.00
$1,000
0

$1,000
1

$1,000
2

$1,000

$1,000

End of Year

(1 r ) n 1
FV PMT
1 r $5,888.04
r
13

Annuity due: An annuity for which the payments

occur at the beginning of each period.

Present Value of Cash Flow

Streams
Mixed streams
Annuities
Perpetuities: cash flow streams that
continue forever
n

1
PV CFt
t
1 r
t 1
14

Present Value of An Ordinary

Annuity
0
1
2
3
5 Years,
5.5%
Interest
$1,000

$1,000

$1,000

4
$1,000

5
$1,000

End of Year
$947.87
$898.45
$851.61
$807.22
$765.13

PMT
1
PV
1
$4,270.28
n
r
(1 r )

15

Present Value of An Annuity Due

5 Years, 5.5% Interest
0
$1,000
$1,000.00

1
$1,000

2
$1,000

3
$1,000

$1,000

End of Year

$947.87
$898.45
$851.61
$807.22

PMT
1
PV
1
1 r $4,505.15
n
r
(1 r )

16

Future and Present Values of A Mixed

Steam
5 Years, 4% Interest

Compounding
- $12,166.5
$3,509.6
$5,624.3
$4,326.4

FV
FV
$6,413.8
$6,413.8

$3,120.0
-$10,000

0
$2,884.6

$3,000

$5,000

$4,000

$3,000

$2,000.0

End of Year

$4,622.8

PV
PV
$5,271.7
$5,271.7

$3,556.0
$2,564.4
$1,643.9
17

Discounting

Present Value of A Perpetuity

For a constant stream of cash flows that
continues forever

1
PV PMT
t
t 1 (1 r )
1
PMT
r
PMT

r
18

Present Value of A Growing

Perpetuity
CF1
PV0
rg
0

1
$1,000
$1,000

Growing
Perpetuity
CF1 = $1,000
r = 7% per year
19

g = 2% per year

rg
3

$1,000(1+0.02)1 $1,000(1+0.02)2
$1,020

$1,040.4

4
$1,000(1+0.02)3
$1,061.2

$1,000
PV0
$20,000
0.07 0.02

Compounding More Frequently Than

Annually
m compounding periods

r
FVn PV 1
m

mn

continuous compounding

FVn PV e

r n

The more frequent the compound period,

the larger the FV!
20

Compounding More Frequently Than

Annually
FV at end of 2 years of $125,000 at 5% interest
Semiannual compounding:

0.05
FV2 $125,000 1

Quarterly compounding:

0.05
FV2 $125,000 1

2 2

$137,976.61
4 2

$138,060.76

Continuous compounding:

FV2 $125,000 e
21

0.05 2

$138,146.365

Stated Versus Effective Annual Interest

Rates
Stated
annual
rate
Effective
annual
rate

The contractual annual rate of

interest charged by a lender or
promised by a borrower.
The annual rate of interest actually
paid or earned, reflecting the
impact of compounding frequency.

r
EAR 1 1
m

EARcontinuous compounding e r 1
22

Stated Versus Effective Annual Interest

Rates
Annual
percentag
e rate
(APR)
Annual
percentag
e yield
(APY)

23

The stated annual rate calculated

by multiplying the periodic rate by
the number of periods in one year.
The annual rate of interest actually paid or
earned, reflecting the impact of compounding
frequency. The same as the effective annual
rate.

Additional Applications of Time

Value
Deposits needed to accumulate a future
sum
Loan amortization
Implied interest or growth rates
Number of compounding periods

24

The Time Value of Money

Much of finance involves finding future
and present values.
The time value of money is central to all
financial valuation techniques.

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