The Time Value of Money

 The time value of money is the value of money figuring in

a given amount of interest earned over a given amount of
time.
 the value of money you have now is greater than a reliable
promise to receive the same amount of money at a future
date.
TIME VALUE OF MONEY
 The idea that money available at the present
time is worth more than the same amount in
the future due to its potential earning
capacity.
 Time Line:
The graphical representation used to show
the timings of cash flow

August, 2000 UT Department of Finance

The Time Value of Money
Which would you rather have -- $1,000 today or
$1,000 in 5 years?

Obviously, $1,000 today.

Money received sooner rather than later allows

one to use the funds for investment or
consumption purposes. This concept is referred
to as the TIME VALUE OF MONEY!!
TVM TERMNOLOGIES
 Interest
 Time period
 Future Value
 Present Value
 Frequency of Compounding
 Annuities
 Multiple Cash Flows
Interest
 Profit on investment
 the cost of borrowing money, usually expressed as a
percentage per year
 Cost of using funds
Borrowing case:
Interest = increase between principle amount borrowed and
the final amount owed
I = total amount to be Paid – principle amount borrowed
Investment case:
Interest = increase between original amount invested and final
amount accrued
I = total amount accrued – principle amount invested
 Example:
 investment case:
if a person deposit 100,000 on May 1 and withdraw
106000 after a year, interest?
Interest = 106000 – 100000
interest = 6000 (gain/ profit of investor)
 Borrowing case:
if a person borrow 100,000 on May 1 and pay 106000 after
a year, interest?
Interest = 106000 – 100000
Interest = 6000 (cost of using funds)

August, 2000 UT Department of Finance

 Interest (cont..)
 Interest Rate:
When the interest (Gain/cost) is expressed in percentage is
know as interest rate
 Formula:
Interest rate = interest accrued/paid x 100%
principle amount

(practice example from book page no 11, 12, 13)

August, 2000 UT Department of Finance

 Types of interest:
When we are concerning more then one interest
period, interest is sub divide in to
 Simple interest
 Compound interest
Simple interest:
Interest calculation on principle amount, for the
given interest period
Formula:
Interest = (principal)(no of periods)(interest rate)
(example 1.7 from book)
 Compound interest:

When interest is paid on not only the principal amount

invested, but also on any previous interest earned, this is
called compound interest.
 Formula:
Interest = ( principal + all accrued interest)(interest rate)
and to find out the lump sum amount
final amount = principal (1+i)n
I = interest
n = no of period
Future value:
 The amount to which a cash flows or series
of cash flows will grow over a given time
period when compounded at a given
interest.
COMPOUNDING:
 Compounding refers to the growth of a dollar
amount through time via reinvestment of interest
earned.
It is also the process of determining the future
value of an investment
Future Value
(Formula)
FV1 = PV (1+i)n = $2,000 (1.06)2
= $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
i = rate of interest per compounding period
n = number of compounding periods

Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =

August, 2000 UT Department of Finance

Future Value
(Graphic)
If you invested $2,000 today in an account that
pays 6% interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?
0 1 2
6%
$2,000
FV
August, 2000 UT Department of Finance
Future Value Example
John wants to know how large his $5,000 deposit will
become at an annual compound interest rate of 8% at
the end of 5 years.

0 1 2 3 4 5
8%
$5,000
FV5
August, 2000 UT Department of Finance
Future Value Solution
 Calculation based on general
formula: FVn = PV (1+i)n
FV5 = $5,000 (1+ 0.08)5
= $7,346.64
PRESENT VALUE

 The value today of a future cash flow or

series of cash flows.

DISCOUNTING:
 Discounting is the process of determining the
value today of an amount to be received in the
future.

August, 2000 UT Department of Finance

Present Value

 Since FV = PV(1 + i)n.

PV = FV / (1+i)n.

 Discounting is the process of translating a

future value or a set of future cash flows
into a present value.
August, 2000 UT Department of Finance
Present Value
(Graphic)
Assume that you need to have exactly $4,000 saved
10 years from now. How much must you deposit
today in an account that pays 6% interest,
compounded annually, so that you reach your goal of
$4,000?
0 5 10
6%
$4,000
PV0
August, 2000 UT Department of Finance
Present Value Example
Joann needs to know how large of a deposit to
make today so that the money will grow to $2,500
in 5 years. Assume today’s deposit will grow at a
compound rate of 4% annually.

0 1 2 3 4 5
4%
$2,500
PV0
August, 2000 UT Department of Finance
Present Value Solution
 Calculation based on general
formula: PV0 = FVn / (1+i)n
PV0 = $2,500/(1.04)5
= $2,054.81

 Calculator keystrokes: 1.04 2nd yx 5 =

2nd 1/x X 2500 =
August, 2000 UT Department of Finance
Finding “n” or “i” when one
knows PV and FV

 If one invests $2,000 today and has accumulated $2,676.45

after exactly five years, what rate of annual compound
interest was earned?

 Suppose you invest $78.35 at an interest rate of 5% per

year. How long will it take your investment to grow to
$100?

August, 2000 UT Department of Finance

Frequency of compounding:
(Semi- annually, quarterly, monthly)

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

 Suppose you deposit $1,000 in an account that pays 12%

interest, compounded quarterly. How much will be in the
account after eight years if there are no withdrawals?
PV = $1,000
i = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
FV= PV (1 + i)n
= 1,000(1.03)32

= 2,575.10

August, 2000 UT Department of Finance

 MONTHLY:
EXAMPLE
Suppose you invest $1000 at 9% interest, compounded
monthly. Find the amount you have after 18 months.
FV=1000(1+0.09/12)18
FV= 1143.96
SEMIANNUALLY:
 Suppose you invest $4000 at 7% interest, compounded
semiannually. Find the amount you have after 5 years.
 FV=4000(1+0.07/2)5(2)
 FV= 5642.39

August, 2000 UT Department of Finance
Annuities
An Annuity represents a series of equal
payments (or receipts) occurring over
a specified number of equidistant
periods.
 Examples of Annuities Include:
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
August, 2000 UT Department of Finance
 Types of annuity
1. Ordinary Annuity
Payment made at the end of the year
 FVA= PMT(1+i)n-1 + PMT(1+i)n-2 …..
 PVA= PMT/(1+i)1 + PMT/(1+i)2 ….
2. Annuity Due
Payment made at the beginning of the year
 FVA= PMT(1+i)5 + PMT(1+i)4 …..
 PVA= PMT/(1+i)0 + PMT/(1+i)1 ….
 (In annuity due formula I assume 5 years payments)
Types of annuity:
 Ordinary annuity
The annuity whose payment occurs at the end of
period
e.g: mortgage payments, car installments etc
As the payments are made at the end of the year so
the formula is
FVA = PMT(1+i)n-1 PMT(1+i)n-2 +….
PVA = PMT + PMT +…..
(1+i)1 (1+ i)2

August, 2000 UT Department of Finance

Example: ordinary annuity (cont..)
 If you deposit $100 at the end of each year in the
saving account @ 5% interest, how much you get
at the end of the year?

 If one saves $1,000 a year at the end of every year

for three years in an account earning 7% interest,
compounded annually, how much will one have at
the end of the third year?
Example of an Ordinary
Annuity -- FVA
End of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145

$3,215 = FVA3
PV OF ORDINARY ANNUITY
 WHAT amount today deposited in the bank
paying 3% interest annually allow you to
withdraw $7500 at the end of each year?
 Solve?????
 If one agrees to repay a loan by paying $1,000 a
year at the end of every year for three years and
the discount rate is 7%, how much could one
borrow today?
PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 +
$1,000/(1.07)3 = $2,624.32
 Example of anOrdinary
Annuity -- PVA
End of Year
0 1 2 3
7%

$1,000 $1,000 $1,000

$934.58
$873.44
$816.30

$2,624.32 = PVA3
 Annuity due: (payment at the beginning of the year)
 An annuity whose payment or receipts is to
be made immediately, rather than at the end
of the period.
Many lease agreements have annuity due
payment
 Rent is an example of annuity due. You are
usually required to pay rent when you first
move in at the beginning of the month, and
then on the first of each
(Annuity due cont…)
When you are receiving or paying cash flows for an
annuity due, your cash flow schedule would
appear as follows:

Since each payment in the series is made one period

sooner, we need to discount the formula one period

back .
Future value of annuity due

 FVA= PMT(1+i)5 + PMT(1+i)4 ……

 PMT stands for equal payments, in future
Value calculation of Annuity the Present
value is written as PMT

August, 2000 UT Department of Finance

 Annuity due
Example:

What is the future value of 5 years annuity that promises to

pay you $1000 at the beginning of each year? The rate of
interest is 5%.
Present value of Annuity due:

 PVA= PMT(1+i)0 + PMT(1+i)1 …..

Question:
What is the value of an annuity of $7500
received at the beginning of next three
years that earns 3% interest annually?
Solve:
Example:
calculating the present value of your rent payments as
specified in a lease you sign with your landlord, reassume
the last example that you make your first rent payment at
the beginning of the year.
Solution
Multiple cash flows:

The series of cash flows in which the amount varies

from time to time
Explanation:
The difference between annuity and multiple cash
flow is that annuity include constant/equal
payments/cashf lows however multiple cash flow
include uneven cash flows
 Annuity : FV & PV changed into PMT
 Multiple Cash flows: FV & PV changed in to CF
Multiple cash flows cont…
FORMULA:
Same as ANNUITY
If the cash flow occurs at the end of the period
PV= CF1 + CF2 +…..
(1+i)1 (1+ i)2
FV= CF1(1+i)n-1 + CF2(1+i)n-2
If the cash flows occurs at the beginning of the year
FV= CF1(1+i)5 + CF2(1+i)4 …..
PV= CF1/(1+i)0 + CF2/(1+i)1 ….
August, 2000 UT Department of Finance
Multiple Cash Flows Example
Suppose an investment promises a cash flow of $500 in one
year, $600 at the end of two years and $10,700 at the end of
the third year. If the discount rate is 5%, what is the value of
this investment today?

0 1 2 3
5%
$500 $600 $10,700
PV0
August, 2000 UT Department of Finance
Multiple Cash Flow Solution

0 1 2 3
5%
$500 $600 $10,700
$476.19
$544.22
$9,243.06

$10,263.47 = PV0 of the Multiple

Cash Flows
August, 2000 UT Department of Finance
Problem #2
 What is the value of $100 per year for four
years, with the first cash flow one year from
today, if one is earning 5% interest,
compounded annually? Find the value of
these cash flows four years from today.

August, 2000 UT Department of Finance

Possible Answers - Problem 2
 $400
 $431.01
 $452.56

Need a
Hint?