CHAPTER 6

Time Value of Money

 Understanding Time Value of
Money
 Role of time value in finance
 Understand the concept of future
value and present value
 Annuities and Amortization
6-1
 Why
Why TIME?
TIME?
Why is TIME such an important element
in your decision?

TIME allows you the opportunity to postpone

consumption and earn INTEREST/ PROFIT.

So that you can maximize your wealth.

6-2
 Introduction
 Time has a value
 If we owe, we would prefer to pay money later
 If we are owed, we would prefer to receive
money sooner
 The longer the term of a single-payment loan, the
higher the amount the borrower must repay

6-3
 Understanding Time Value of
Money
Time Value of Money is an important
concept in financial management. It is
one of the important tools used in
project appraisals to compare various
investment alternatives, and solve
problems involved in loans, mortgages,
leases, savings, and annuities.

6-4
 Understanding Time Value of Money
 The relationship between one dollar in the
future and one dollar of today is known as the
time value of money.
 This present value concept of time value of
money should be clearly understood by the
investors as well as financial managers in order
to examine its impact on the value of an asset.
 The time value of money refers to the
observation that it is better to receive
money sooner than later.
6-5
 Contd.
A key concept behind Time Value of Money
is that a single sum of money or a series of
equal, evenly spaced payments or receipts
promised in the future, can be converted to
an equivalent value today. Conversely, you
can determine the value to which a single
sum or a series of future payments will
grow to at some future date. The former is
called Present Value of Cash Flows and the
later is called Future Value of Cash Flows.
6-6
 Contd.
 A dollar received today is worth more than a
dollar expected to be received in the future.
This is because of the fact that the sooner a
dollar is received, the quicker it can be
invested to earn a positive return. Therefore,
it is true that one dollar in the future is less
valuable than one dollar of today.

6-7
 Significance of TVM
Most financial decisions involve costs &
benefits that are spread out over time.
Time value of money allows comparison
of cash flows from different periods.
The process of determining how much a sum
of money is worth today is called discounting.
It is done for most major business
transactions as well as project evaluation .
6-8
Why is the Time Value of Money Important?

The time value of money is a concept that is

essential to all parts of business. An investor does
not want to know just what an investment is worth
today­—it wants to know the total value of the
investment. What is the investment worth in total ?
Let's take a look at a couple of examples.
Suppose, you are one of the lucky people to win the
lottery. You are given two options on how to
receive the money
6-9
 Contd.
 Option 1: Take $5,000,000 right now.
 Option 2: Get paid $600,000 every year for
the next 10 years
In option 1, you get $5,000,000 and in option
2 you get $6,000,000. Option 2 may seem
like the better bet because you get an extra
$1,000,000, but the time value of money
theory says that since some of the money is
paid to you in the future, it is worth less.
6-10
 Contd.
By can calculate how much option 2 is
worth today through a process called
discounting. If option 2 turns out to be
worth less than $5,000,000 today, you
should choose option 1, or vice versa.

6-11
 Basic Concepts Of TVM
 Future Value- A future value is the
compounded value of a present value.
 Present Value- A present value is the
discounted value of one or more future cash
flows.
 The discount factor is the present value of a
dollar invested in the future.
 The compounding factor is the future value of
a dollar invested today
6-12
 Basic Concepts Of TVM
 Inflow- a cash receipt (Single cash flows &
series of cash flows can be considered)
 Outflow-a cash deposit, cost, or amount paid.
 Time lines - are used to illustrate these
relationships- an important tool used in TVM
analysis; it is graphical presentation used to
show the timing of cash flows

6-13
 Time Value Terms
 PV0 = present value or beginning amount
 i = interest rate
 FVn =future value at end of “n” periods
 n = number of compounding periods
 A= an annuity (series of equal
payments or receipts)
PMT- Periodic
PVIF- Present value Interest Factor
FVIF- Future value Interest Factor
6-14
 Present and Future Values
 Future value is the value of a cash flow or a series of
cash flows at some time of a present amount of money.
That is, future value refers to the amount to which a cash
flow or a series of cash flows will grow over a given
period of time.
 FV: The amount to which a cash flow or series of cash
flows will grow over a given period of time when
compounded at a given interest rate.
 Therefore, the future value is dependent on three things :
i) present value; (ii) period and (iii) rate of interest.
 FV = PV (1+i)n , where, PV = Present Value, I = Interest
rate, n = no. of period
6-15
 Present and Future Values
 Present value is the value today of a future
cash flow or series of cash flows. That is,
present value is a future amount discounted to
the present by some required rate. The present
value is dependent on three things : (i) future
value, (ii) period and rate of interest.
 PV = FV
 (1+i)n

6-16
 Present and Future Values
 Basic time value of money relationships:
PV  FV  DF
PV  FV  DF
FV  PV  CF
FV  PV  CF
where
where PV =present
PV = present value;
value;
FV =future
FV = future value;
value;
DF =discount
DF = discount factor
factor R
= 1/(1= )t  R )t
1/(1
CF = compounding factor = (1  R
CF = compounding factor = (1  R )t ) t

R = interest rate per period; and

R = interest rate per period; and
t = time in periods
t = time in periods
6-17
Tools and Techniques of Time Value of Money
 It is a graphical representation used to show the
timing of cash flows. Such line is used helping
us visualizing when the cash flows associated
with a particular situation.
 Constructing a cash flow time line will help us
to solve problems related to the time value of
money.
 So, time line is A horizontal line on which time

 zero appears at the leftmost end and future

periods are marked from left to right; can be
used to depict investment cash flows. 6-18
 Tools and Techniques of Time Value of
Money

0 1 2 3
i%

CF0 CF1 CF2 CF3

 Time line shows the timing of cash flows. A time line
depicts the cash flows associated with a given investment. It
is a horizontal line on which time zero appears at the leftmost
end and future periods are marked from left to right.
 Tick marks occur at the end of periods, so Time 0 is today;
Time 1 is the end of the first period (year, month, etc.) or
the beginning of the second period. 6-19
 Techniques of Time Value of Money
 (i) compounding and (ii) discounting
 Compounding: The arithmetic process of
determining the final value of a cash flow or series of
cash flows when compound interest is applied.
 So, The process of going from today’s values, or
present values (PVs), to future values (FVs) is called
compounding.
 That is, the process of determining the value of a cash
flow sometime in the future, by applying compound
interest rate is known as compounding. By compound
interest we mean interest earned on interest

6-20
 Techniques of Time Value of Money
 Compound Interest vs. Simple Interest
 Compound interest refers to the interest earned
on both the initial principal and the interest
reinvested from prior periods, while simple
interest refers to the interest earned only on the
original principal amount invested.
 Suppose your principal amount is Tk. 1000 and the
rate of interest is 10% and the period is 3 years. In the
example, compound interest comes to Tk. 331
(100+110+121); whereas, simple interest comes to
Tk. 300 (100+100+100) only at the end of 3 years.
6-21
 Techniques of Time Value of Money
 Future value of a single amount: FV is the
value at a given future date of an amount
placed on deposit today and earning interest at
a specified rate. Found by applying compound
interest over a specified period of time.
 Future value of compound amount: Interest
that is earned on a given deposit and has
become part of the principal at the end of a
specified period.
 Principal: The amount of money on which
interest is paid. 6-22
 Terms of Interest and Future Values
 Interest may be paid annually, semiannually,
quarterly, monthly, even daily and even
continuously or infinitely and such mode of
payment of interest is known as terms of
interest.
 In case of Multiple Compounding
 a) Under Equation Approach
 i
 FVn = Pv (1 + ------)mn
 m 6-23
 Terms of Interest and Future Values
 Under Tabular Approach
i
 FVn = (1 + ------)mn
m
 b) In case of continuous or infinite compounding
  Under Tabular Approach
 FVn = PV (ei x n)
 Where, e is the value equal to 2.7183

6-24
Future Value Interest Factor for i and n
(FVIF i, n)
 FVIFi,n refers to the future value of Tk. 1 left
on deposit for n periods at a rate of i percent
per period that is, the multiple by which an
initial investment grows because of the interest
earned

6-25
 Problem – 1
 Find out the future values (FV) in the following
situations :
 a) At the end of 3 years, how much is an initial
deposit of Taka 1,000 worth, assuming a
quarterly compounded interest rate of (i) 10%
and (ii) 100%.
 b) At the end of 10 years, how much is an initial
investment of Taka 1,000 worth, assuming an
interest rate of 10% compounded : (i) annually;
(ii) semiannually; (iii) quarterly, (iv)monthly
and (v) continuously ? 6-26
 Problem – 2
 Assume that it is now January 1, 2014. On January 1,
2015, you will deposit Tk. 1000 into a Savings Account
of Janata Bank that pays 12 percent interest per annum.
 Required :
 (a) If the bank compounds interest annually how much
will you have in your account on January-1, 2020 ?
 (b) What would your January-1, 2019 balance be if the
bank used quarterly compound ?
 (c) Suppose you deposited Tk. 1000 in payments of Tk.
200 each on January 1, 2015, 2016, 2017, 2018 and
2019. How much would you have in account on January-
1, 2019, based on 10 percent annual compounding ?
6-27
 Discounting Technique
 The process of finding the present value of a cash
flow or series of cash is known as discounting.
 In case of Single interest payment:

 In case of Multiple interest payment

FVn
PVn 
i
(1  ) mn
m

 continuous or infinite compounding

FVn
PVn 
e ixn
where , e  2.7183
6-28
 Discounting Technique
 PROBLMES-3
 Taka 1,000 at the end of 5 years is worth how
much today, assuming a discount rate of : (i) 10
percent and (ii) 100 percent.
 PROBLMES-4(Solving for Period (n)& IR (i)
 Suppose, you can buy a security at a price of
Tk. 78.35 that will pay you Tk. 100 after
5years. In this case, PV, FV, and n are given;
we are to find out i, the interest rate you will
earn on your investment.
6-29
 FV & PV
 PROBLMES-5
 Suppose you know that the investment in
security will provide a return of 10% per year,
that it will cost Taka 204.90 and that you will
receive Tk. 300 at maturity. But, you do not
know when the security matures. So find out
the maturity period.

6-30
 FV & PV
 PROBLMES-6
 You have been awarded MBA degree from
Bangladesh Open University just one month ago. You
have applied for the post of Finance Manager in
BRAC. As part of the BRAC’s evaluation process,
you have been asked to appear at a test that covers
several financial analysis techniques. The first section
of the test addresses time value of money analysis.
See how would you do by answering the following
questions :
 a) What is the future value of an initial investment of
Taka 1,500 after 7 years if the investment earns 12%
annual interest ? 6-31
 FV & PV
 (Contd.)
 b) What is the present value of Taka 2,700 to be received
in 5 years if the interest rate is 15% ?
 c) If a company’s sales are growing at a rate of 20%
annually, approximately how will it take sales triple ?
 d) What annual interest will cause Taka 2,200 to grow to
Taka 7,700 in 5 years ?
 e) At what time periods Taka 3,000 will grow to Taka
9,000 if the rate of interest 15% p. a. ?
 f) Which amount is worth more at 14% : Taka 1,000 in
hand today Taka 2,000 due in 6 years ?

6-32
 Contd.
 What is the present value of Tk.8, 000 to be
paid at the end of three years if the correct
risk adjusted interest rate is 11%.

 = 8,000/(1.11)3
 = 8,000/1.36
 =Tk.5, 849
6-33
 Contd.
If you invest Tk.1000 today at 10%
in one year you will have

FV= PV x(1+i)n
1000x(1.1)1=Tk.1,100

6-34
 Future Value of a Single Amount:
Using FVIF Tables
If Mr. Fred places $100 in a savings account
paying 8% interest compounded annually,
how much will he have in the account at the
end of one year?

$100 x (1.08)1 = $100 x FVIF8%,1

$100 x 1.08 = $108

6-35
 example
You just invested $2,000 in a three-year bank
certificate of deposit (CD) with a 9 percent interest
rate.
How much will you receive at maturity?
Solution: Solve for the future value:
We know, FV= PVx(1+i)n
Putting the values , we get FV=
FV  $2, 000  1.093
 $2, 000  1.2950
 $2, 590
6-36
 Lecture# 02
Annuity
 A series of payments of an equal
amount at fixed intervals for a
specified number of periods.
 An annuity is a series of payments at equal
time intervals.
 So, An annuity is a series of equal
payments known as installments at fixed
intervals for specified number of periods.
6-37
 Lecture# 02
Annuity
 A stream of equal periodic cash flows
over a specified time period. These cash
flows can be inflows of returns earned on
investments or outflows of funds invested
to earn future returns.

6-38
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings

6-39
 Types of Annuities
Annuities are equally-spaced cash flows of equal
size. Annuities can be either inflows or outflows.
Annuity may be two types:
An ordinary (deferred) annuity has cash flows
that occur at the end of each period.
An annuity due has cash flows that occur at the
beginning of each period.
An annuity due will always be greater than an
otherwise equivalent ordinary annuity because
interest will compound for an additional period.
6-40
 Types of Annuities
 Future Value of an Ordinary Annuity :
 One way to find the future value of an ordinary annuity is to calculate
the future value of each of the individual cash flows and then add up
those figures.
 FVAn =
n
FVAn  PMT  (1  i ) n t
t 0

in this equation r represents the interest rate, and

n represents the number of payments in the
annuity (or equivalently, the number of years
over which the annuity is spread).
6-41
 Future value of an annuity:
In determining the future value of a series of
consecutive, equal payments, for example,
you will receive Tk. 1,000 at the end of each
period for four periods. What is the
accumulated value at the end of the fourth
period if money grows a 10%?
 (1  i ) n  1
FV An  PMT  
 i 
= 1,000 x 4.6410 = 4641

6-42
 Types of Annuities
 FINDING THE PRESENT VALUE OF AN ORDINARY
ANNUITY
 Quite often in finance, there is a need to find the
present value of a stream of cash flows to be
received in future periods. An annuity is, of
course, a stream of equal periodic cash flows.

6-43
  (1  i ) n  1 
FVA ( DUE )  PMT    (1  i ) 
 i  

Types of Annuities
 FINDING THE FUTURE VALUE OF AN ANNUITY DUE
 Like future value of an ordinary annuity, future value of an
annuity due also depends on the :  
 (i) amount of payments; (ii) rate of interest and (iii) number of
periods. The more the amount of PMT, rate of interest and the
number of periods; the higher will be future value of annuity due.

6-44
  (1  i ) n  1 
FVA ( DUE )  PMT    (1  i ) 
 i  

Types of Annuities
 FINDING THE PRESENT VALUE OF AN ANNUITY
DUE
 Like the present value of an ordinary annuity; present
value of an annuity due can be found out on the basis of
the amount of payment, n periods and present discount
rate. The more the amount of PMT, n periods and i
percent of discount; the higher will be the annuity due
and vice-versa.

6-45
 Ordinary Annuities
and Annuities Due
You have just won the lottery! You will
receive $1 million in ten installments of
$100,000 each. You think you can invest the
$1 million at an 8 percent interest rate.

What is the present value of the $1 million if

the first $100,000 payment occurs one year
from today? What is the present value if the
first payment occurs today?

6-46
 Contd.
Solution:
These questions treat the cash flows as an ordinary annuity
and an annuity due, respectively:

PV of ordinary annuity  $100,000  6.7100  $671,000

PV of annuity due  $100,000  ($100,000  6.2468)  $724,680

6-47
 Discrete Versus
Continuous Intervals
 Discrete compounding means we can count
the number of compounding periods per year
 E.g., once a year, twice a year, quarterly, monthly,
or daily

 Continuous compounding results when there

is an infinite number of compounding periods

6-48
 Discrete Versus
Continuous Intervals (cont’d)
Example

Your bank pays you 3 percent per year on your

savings account. You just deposited $100.00 in your
savings account.

What is the future value of the $100.00 in one year if

interest is compounded quarterly? If interest is
compounded continuously?

6-49
 continuous compounding : Compounding of
interest an infinite number of times per year at
intervals of microseconds.

 where e is the exponential function, which has a

value of approximately 2.7183.

6-50
 Example of continuous
 To find the value at the end of 2 years ( ) of Fred
Moreno’s $100 deposit in an account paying 8%
annual interest compounded continuously, we can
substitute into the following Equation:

6-51
 Discrete Versus
Continuous Intervals (cont’d)
Example (cont’d)
Solution: For quarterly
compounding:

FV  PV (1  R / m ) mt
 $100.00(1  0.03 / 4) 4
 $103.03

For continuous compounding:

FV  PVe Rt
 $100.00  e 0.03
 $103.05
6-52
 Perpetuity
Perpetuity- perpetuity is a stream of cash
flows that goes on forever.
 So, perpetuity is An annuity with an
infinite life, providing continual annual
cash flow.
PV of a perpetuity = CF/r

6-53
 Nominal Versus
Effective Yields
 The stated rate of interest is the simple rate or
nominal rate
e.g. example 3.00%
 The interest rate that relates present and future
values is the effective rate
 $3.03/$100 = 3.03% for quarterly
compounding
 $3.05/$100 = 3.05% for continuous
compounding
6-54
 Nominal Versus
Effective Yields
 Nominal (Quoted, or Stated) Interest Rate
 The contracted, or quoted, or stated, interest
rate. So, nominal (stated) annual rate is the
contractual annual rate of interest charged by a
lender or promised by a borrower.
 Effective (Equivalent) Annual Rate (EFF%
or EAR): The annual rate of interest actually
being earned, as opposed to the quoted rate.
Also called the “equivalent annual rate.”
6-55
 Nominal Versus
Effective Yields
So, the effective (true) annual rate (EAR) is
The annual rate of interest actually paid or
earned.

6-56
 Nominal Versus Effective Yields: Examples:
 Fred Moreno wishes to find the effective annual rate
associated with an 8% nominal annual rate (r = 0.08)
when interest is compounded (1) annually(m = 1) ;
(2) semiannually(m = 2) ; and (3) quarterly(m = 4)

6-57
 Self Test
ST: 1
You just bought a new computer for $3,000. The
payment terms are 2 years same as cash. If you
can earn 8% on your money, how much money
should you set aside today in order to make the
payment when due in two years?
 Solution:
PV  3000
(1.08 ) 2
 $2,572

6-58
Classifications of interest rates
 Nominal rate (iNOM) – also called the quoted or
state rate. An annual rate that ignores compounding
effects. Contractual annual rate of interest charged
by a lender or promised by a borrower
 iNOMis stated in contracts. Periods must also be
given, e.g. 8% Quarterly or 8% Daily interest.
 Periodic rate (iPER) – amount of interest charged
each period, e.g. monthly or quarterly.
 iPER= iNOM / m, where m is the number of
compounding periods per year. m = 4 for quarterly
and m = 12 for monthly compounding.
6-59
Classifications of interest rates
 Effective (true) annual rate (EAR): The
annual rate of interest actually paid or earned.

Annual percentage rate (APR) : The nominal annual

rate of interest, found by multiplying the periodic rate by
the number of periods in one year, that must be
disclosed to consumers on credit cards and loans as a
result of “truth-in lending laws.”
6-60
 Classifications of interest rates
 Annual percentage yield (APY): The effective annual
rate of interest that must be disclosed to consumers by
banks on their savings products as a result of “truth-in-
savings laws.”

6-61
 Amortized Loan.
 The term loan amortization refers to the
determination of equal periodic loan payments.
 These payments provide a lender with a
specified interest return and repay the loan
principal over a specified period.
 The loan amortization process involves finding
the future payments, over the term of the loan,
whose present value at the loan interest rate
equals the amount of initial principal borrowed.
6-62
 Amortized Loan.
 The determination of the equal periodic loan
payments necessary to provide a lender with a
specified interest return and to repay the loan
principal over a specified period.
 If a loan is to be paid in equal periodic amounts
(weekly, monthly, quarterly, or annually), it is
said to be an amortized loan. A simple way of
amortizing a loan is to have the borrower pay
the interest each period plus some fixed amount
of principal.
6-63
 Amortized Loan Schedule
 A schedule of equal payments to repay a
loan. It shows the allocation of each loan
payment to interest and principal.
 So, Amortization Schedule is a table
showing precisely how a loan will be
repaid. It gives the required payment on
each payment date and a breakdown of the
payment, showing how much is interest
and how much is repayment of principal.
6-64
 Amortizing
Amortizing aa Loan
Loan Example
Example
Julie Miller is borrowing $10,000 at a compound
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
6-65
 Usefulness of Amortization
1. Determine Interest Expense --
Interest expenses may reduce
taxable income of the firm.
2. Calculate Debt Outstanding -- The
quantity of outstanding debt may be
used in financing the day-to-day
activities of the firm.

6-66
 When is each rate used?
 iNOM written into contracts, quoted by banks
and brokers. Not used in calculations or
shown on time lines.
 iPER Used in calculations and shown on time
lines. If m = 1, iNOM = iPER = EAR.
 EAR Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.

6-67
What is the FV of $100 after 3 years under
10% semiannual compounding? Quarterly
compounding?
iNOM mn
FVn  PV ( 1  )
m

0.10 23
FV3S  $100 ( 1  )
2
6
FV3S  $100 (1.05)  $134.01
12
FV3Q  $100 (1.025)  $134.49
6-68
 Loan amortization
 Amortization tables are widely used for home
mortgages, auto loans, business loans,
retirement plans, etc.
 Financial calculators and spreadsheets are
great for setting up amortization tables.

 EXAMPLE: Construct an amortization

schedule for a $1,000, 10% annual rate loan
with 3 equal payments.
6-69
 Amortizing
Amortizing aa Loan
Loan Example
Example
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]

6-70
 Starter Problem
6.1 : If you deposit $10,000 in a bank account
that pays 10 percent interest annually, how
much money will be in your account after 5 years?

6.2 : What is the present value of a security that

promises to pay you $5,000 in 20 years?
Assume that you can earn 7 percent if you were to
invest in other securities of equal risk.

6.3 : If you deposit money today into an account that

pays 6.5 percent interest, how long will it take for
you to double your money?

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 Contd.
6.4 John Roberts has $42,180.53 in a brokerage account, and
he plans to contribute an additional $5,000 to the account
at the end of every year. The brokerage account has an
expected annual return of 12 percent. If John’s goal is to
accumulate $250,000 in the ac-count, how many years will
it take for John to reach his goal?

6.5 Your parents are planning to retire in 18 years.

They currently have $250,000, and they would like
to have $1,000,000 when they retire. What annual
rate of interest would they have to earn on their
$250,000 in order to reach their goal, assuming
they save no more money?
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 Review Questions
 Discuss the importance of Time Value of
Money (TVM) in Finance
 What are tools used in TVM?

 Differentiate between: i) Annuities and

Amortization ii) Present anf Future value
iii) Niminal and Effective rate
iv) Annuity and Perpetuity
v) Annuity Due and Ordinary Annuity.
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