THE TIME VALUE OF MONEY

1.0- DEFINITION OF COMPOUNDING How much will money put into a saving account today be worth in the future You put money in an account today (PV) for a promised rate of return (interest) for a number of periods (usually months or years). The interest received in reinvested at the end of each period (compounds)

1.1- EXAMPLE- COMPOUNDING Question: Assume that you plan to deposit $100 in a bank that pays a guaranteed 5% interest each year. How much would you have at the end of year 3? The Answer: First step: List all the important information 1234$100 as our beginning amount (PV) 5% interest each year paid by bank to us (I) Year 3 is our number of time period (N) How much will $100 invested today at 5% be worth in 3 years? FV ????

Second step: Apply the formula approach

FVN = PV (1+I)N
FV N PV I Future Value or ending amount Number of time periods Present Value, or beginning amount Interest rate earned per year

Third step: Fill up the amount in the equation

FVN = PV (1+I)N
FV3 = $100 (1 + 0.05) FV3 = $100 (1.05) FV3 = $ 115.7625 $115.76

Fourth step: Sketch the time line Time (years) Amount of beginning of period 0- PV 1 2 3

$100.00

$105.00

$110.25

$115.76

2.0- DEFINITION OF DISCOUNTING How much money do I have to put into a savings account today to have X amount at a certain time in the future We know the how much we need on a specific date in the future (FV) , so we should calculate how much we need to invest today (PV) at an interest rate.

2.1- EXAMPLE- DISCOUNTING Question: How much would an investor have to set aside today in order to have $20, 000 in 5 years from now if the current rate is 15%? The Answer: First step: List all the important information 1- $20, 000 as our ending amount (FV) 2- 15% interest each year paid by bank to us (I) 3- 5 year is our number of time period (N) 4- How much we need to spend today to get $20, 000 in coming 5 years at 15% interest rate. PV ????

Second step: Apply the formula approach

PV =

FVN (1+I)N

PV N FV I

Present Value, or beginning amount Number of time periods Future Value or ending amount Interest rate earned per year

Third step: Fill up the amount in the equation

PV =

FVN (1+I)N

PV = PV =

$20, 000 (1 + 0.15)5 $20, 000 (1.15)5

PV = $ 9,943.53

Fourth step: Sketch the time line Time (years) Amount of ending of period

5-FV

$9,943.53

$20,000

Perpetuities
What is perpetuities? Stretch of cash payment that continue forever An annuity with an extended life
1 100 PV = ? 2 100

100

Pmt = 100 I = 8% PV = ?

Perpetuities
PV of a perpetuity = PMT I Example:Pmt = 100
Int = 8% PV = ?

PVp = 100 0.8 =$ 1250

Exercise
Problem
What is the present value of perpetuity that pays $1500 per year if the interest rate is 4%?

Solution
PV p = PMT I PV p = 1500 0.04

Thank You