TIME VALUE OF MONEY

VALUATION OF FUTURE CASH FLOWS

Financial Management
 LEARNING OBJECTIVES
• Differentiate between simple interest – compound
interest ; Being able to compute the amount of interest
that will be earned on an investment
• Understand the concept “the time value of money”;
Being able to compute the present and future values of
lump sum payment (single period case) as well as for
multiperiod case
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• Understand and being able to compute the nominal,

periodic and annual equivalent interest rates

• Compute the present and future values for annuities and

perpetuities – and its applications on mortgage
amortization schedule
• Know how to determine the payout figures for existing
loans
 TIME VALUE OF MONEY CONCEPT
EXAMPLE:

The Washington Post:

“On 12/02/1982, General
Motors Acceptance
Corporation (GMAC), - a Should we trade $500 NOW
Financial Management

branch of General Motors, for $10,000 IN 30 YEARS?

sold securities to the public
at $500 each. Holders will be
entitled to a single lump sum
payment of $10,000 in 2012
(30 years).
TIME VALUE OF MONEY CONCEPT
EXAMPLE:

GRANDMOM’S ANH : “It’s

WILL IN THE
dangerous keeping
INHERITANCE
EM: “Yes. But one lots of money. As
ANH $30,000 year from now long as you’ve
EM $30,000 when I graduate decided to go, I
from IU, I will need would transfer
$ to go study $11,500 to your
abroad. Will you bank account each
ANH : “I’ll keep it for give me back year in 3
you. I’ll give you $34,000 ?” consecutive years
back your $30,000 until you’re done
when you’re done with your degree
with school”
abroad”.
 TIME VALUE OF MONEY CONCEPT
EXAMPLE:

1
NOW YEAR
FUTURE
FV > $ 30,000 ?
PV = $ 30,000
= $ 30,000 + ?
Financial Management

= $ 30,000 + $ 30,000 *r
 TIME VALUE OF MONEY CONCEPT

WHY ?

• Opportunity cost
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2
• Uncertainty

• Inflation
3
 DRAWING A TIMELINE
❑ Why needs a timeline ?
•A timeline depicts the cash flows (cash in and cash out – both
positive and negative) on a horizontal line, with time zero at
the left and future periods shown moving from left to right

• Because money has a time value, the cash flow associated

with an investment must be measured at the same point in
Financial Management

time FV (Future value)

0 1 2 N-1

3 N

PV (Present value) The interval from 0 to 1, 1 to 2, (n-1) to

n, etc. are called periods. Periods can be
months, quarters, years, etc.
 SIMPLE INTEREST
❑ Interest is earned on principal only. There is no re-investing of
interest for the next period

FORMULA: SI = PV*r*n
in which:
Management
FinancialManagement

SI : Simple interest earned

PV: Principal, or original amount borrowed (lent) at time 0
r : Interest rate per time period (%)
Financial

n: Number of time periods (months, quarters, years,etc.)

 SIMPLE INTEREST
Beginning Simple
Period Ending Balance (FVn)
Balance Interest
1 PV PV*r FV1 = PV + PV*r = PV(1+r)
2 PV*(1+r) PV*r FV2 = PV*(1+r) + PV*r = PV*(1+2r)
3 PV*(1+2r) PV*r FV3 = PV*(1+3r)
… … … …
n PV*(1+(n-1)r) PV*r FVn = PV*(1+nr)

SI = FVn - PV = PV * (1+ n * r) - PV = PV * r * n
 SIMPLE INTEREST
What is the simple interest earned on $100 bank deposit at
6% p.a for 5 years ?
Financial Management
 COMPOUND INTEREST
❑ Interest is earned on principal and interest reinvested from
prior periods. It is interest-on-interest, or compounding effect,
that accounts for the dramatic difference between simple and
compound interest.
Management

FORMULA: CI = PV*(1+r)n - PV
FinancialManagement

in which:
CI: Compound interest earned
PV: Principal, or original amount borrowed (lent) at time
Financial

r : Interest rate per time period (%)

n: Number of time periods (months, quarters, years,etc.)
 COMPOUND INTEREST
Beginning Compound
Period Ending Balance (FVn)
Balance Interest
1 PV PV*r FV1 = PV + PV*r = PV(1+r)
2 PV*(1+r) PV*(1+r)*r FV2 = PV*(1+r)2
3 PV*(1+r)2 PV*(1+r)2*r FV3 = PV*(1+r)3
… … … …
n PV*(1+r)n-1 PV*(1+r)n-1*r FVn = PV*(1+r)n

CI = FVn - PV = PV * (1+ r)n – PV = PV * [(1+ r)n -1]

COMPOUND INTEREST
What is the compound interest earned on $100 bank
deposit at 6% p.a for 5 years ?
14
 CHECK YOUR UNDERSTANDING

Barney lends $100,000 to John, his cousin for a total of

10 years at 5% p.a.
a. How much does John have to pay after 10 years (if
using simple interest rate)?
b. How much does John have to pay after 10 years (if
using compounded interest rate)?
c. Assume that Barney lends $100,000 to John, using
simple interest rate, but wants to receive the payment
which is equal to that if using compounded interest.
What should the interest rate be?

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 TIME VALUE TERMINOLOGY
0 1 2 3 4

PV FV
Future value (FV) is the amount an investment is worth after
one or more periods at some given interest rate.
Financial Management

Present value (PV) is the current value of one or more future

cash flows from an investment.

The number of time periods between the present value and the
future value is represented by ‘N’.
The rate of interest for discounting or compounding is called ‘r’.
All time value questions involve four values: PV, FV, r and N.
Given three of them, it is always possible to calculate the fourth.
 FUTURE VALUE AND PRESENT VALUE
THE SINGLE CASH FLOW CASE
Financial Management
 FUTURE VALUE
SINGLE CASH FLOW CASE
Future value
interest factor
FVn = PV * (1 + r)n (FVIF)

A father set aside $5,000 for his

newborn child’s education. How much
will he have after 18 years, given the
Financial Management

interest rate of 5% per annum ?

• Use your calculator

• Refer to the table

 FUTURE VALUE (cont)
SINGLE CASH FLOW CASE
In 1626, Peter bought Manhattan Island
for $24. What is the value of the island
in 2011, given an interest rate of 8% per
annum ?
After 385 years (1626-2011), the value
of $24 would be:
$24 * (1+0.08)385 =
Financial Management

$177,156,500,000,000

Given today’s real estates value in New

York, Manhattan Island costs alot less!

Assuming the interest rate is only 4%

per year, the value of $24 would be:
$24 * (1+0.04) 385 = $86,755.544
 THE RELATIONSHIP BETWEEN INTEREST RATE AND
FUTURE VALUE

Future value of $1
Financial Management

Periods
 PRESENT VALUE
SINGLE CASH FLOW CASE

• Can be derived from the Future value formula

Present value
interest factor

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 PRESENT VALUE
FINDING THE PRESENT VALUE – THE SINGLE CASH FLOW CASE

EXAMPLE 1:

In 1995, Coca Cola needed $ 1 billion to launch its new

project and issued IOU (I Owe You) certificates onto the
market. Holder of this certificate will be entitled to a lump
sum of $1,000 in 25 years. How much would you buy this
IOU certificate by Coca Cola, assuming the market interest
rate is 8.53% per year ?
The price of this IOU is the current value of $1,000 in 25 years:

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 PRESENT VALUE
FINDING THE PRESENT VALUE – THE SINGLE CASH FLOW CASE

You want to begin saving for your daughter’s college

education and you estimate that she will need $150,000 in
17 years. If you feel confident that you can earn 8% per
year, how much do you need to invest today?

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 PRESENT VALUE
FINDING THE DISCOUNT RATE – THE SINGLE CASH FLOW CASE

EXAMPLE 3:

Suppose you are offered an investment that will allow you to

double your money in 6 years. You have $10,000 to invest.
What is the implied rate of interest?

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PRESENT VALUE
FINDING THE NUMBER OF PERIODS – THE SINGLE CASH FLOW CASE
EXAMPLE 5:

Suppose you want to buy a new house. You

currently have $15,000, and you figure you need to
have a 10% down payment plus an additional 5% of
the loan amount for closing costs. Assume the type
of house you want will cost about $150,000 and
you can earn 7.5% per year, how long will it be
before you have enough money for the down
payment and closing costs?

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 PRESENT VALUE AND INTEREST RATE

No. of Present value of $100 at different interest rates

periods
(year) 5% 10% 15% 20%

1 $95.24 $90.91 $86.96 $83.33

2 $90.70 $82.64 $75.61 $69.44

3 $86.38 $75.13 $65.75 $57.87

4 $82.27 $68.30 $57.18 $48.23

5 $78.35 $62.09 $49.72 $40.19

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 PRESENT VALUE AND INTEREST RATE
PV of
$1

Periods
(year)
28
 FUTURE VALUE AND PRESENT VALUE
THE MULTIPLE CASH FLOWS CASE
Financial Management
 FUTURE VALUE
MULTIPLE CASH FLOWS CASE
• Compound all cash flows to last period and add them
together

0 1 2 3……(n-1) n

CF1 CF2 CF3 CFn-1 CFn

CFn *(1+r)n-n
CFn-1 * (1+r)n-(n-1)
CF3 * (1+r)n-3
CF2 *(1+r)n-2
CF1*(1+r)n-1

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 FUTURE VALUE
MULTIPLE CASH FLOWS CASE

EXAMPLE
Suppose you plan to deposit into a bank account $100 now;
$200 in a year; and $300 in 2 years. How much will you have
by the end of year 3, given the bank’s interest rate of 10% ?

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 PRESENT VALUE
MULTIPLE CASH FLOWS CASE
• Discount all cash flows back to present and add them
together

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 PRESENT VALUE
MUTIPLE CASH FLOWS CASE
EXAMPLE 1:
A car dealer offers you the following terms:
OPTION 1 OPTION 2

INSTALLMENTS

DOWN PAYMENT Down payment $9,000

$4,000 in 1 year
$15,500 $ 4,000 in 2 years
(Assuming the prevailing
market interest rate of
33
8%)
PRESENT VALUE
MUTIPLE CASH FLOWS CASE
GRANDMOM’S ANH : “It’s
WILL IN THE dangerous keeping
INHERITANCE lots of money. As
EM: “Yes. But one long as you’ve
ANH $30,000 year from now decided to go, I
EM $30,000 when I graduate would transfer
from IU, I will need $11,500 to your
$ to go study bank account each
abroad. Will you year in 3 consecutive
ANH : “I’ll keep it for give me back years until you’re
you. I’ll give you $34,000 ?” done with your
back your $30,000 degree abroad”.
when you’re done (Assuming an
with school” interest rate of 9.5%)
 FUTURE VALUE AND PRESENT VALUE
ANNUITY
Financial Management
 ANNUITY CONCEPT
• An annuity is a finite series of equal payments that occurs at regular
intervals
• Eg. Rent payment $1,000 each month for 12 months
• Eg. Insurance premium of $100 each month for 36 months

• Ordinary annuity: Payments occur at the end of each period (i.e.

first cash flow starts one period from today)
• Annuity due: Payments occur at the beginning of each period (i.e.
first cash flow starts now) FV
C (Annuity)

1 2 3 N-1 N

38
PV C (Annuity)
 FUTURE VALUE OF AN ANNUITY

Eg. Starting one year from today, deposit $500 into bank
account every year for 6 years. If r =6% pa., how much is in the
bank account after 6 years ?
500 500 500 500 500 500

0 1 2 3 4 5 6
Not compounded
Contract date Compounded 1 year
Compounded 2 years
Compounded 3 years
Compounded 4 years
Compounded 5 years

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 FUTURE VALUE OF AN ANNUITY

FV
C (Annuity)

PV 1 2 3 N-1 N

C (Annuity)

The future value of an annuity is

 (1 + r ) n − 1

FV = C 1 + (1 + r ) + (1 + r ) + .... + (1 + r )
2 n −1
 = C 
 r 
Note: This formula gives a value at the time
40 of the last Cash Flow
 FUTURE VALUE OF AN ANNUITY
ILLUSTRATION 1

 Eg. 1 : You plan to retire exactly 35 years from today with

savings of $2 million. If the interest rate is 9% p.a. how
much will you need to put aside each year to reach your
goal ?
 Assume that your first payment will occur one year from
now and that your final payment will occur in exactly 35
years C C C …… C 2 MI

0 1 2 3 …. 35

41
 FUTURE VALUE OF AN ANNUITY
ILLUSTRATION 2

 Eg. 2: Suppose you save $4,000 per year for 20

years and then retire. Given the interest rate of
10% per year, how much will you have at
retirement ?

42
 PRESENT VALUE OF AN ANNUITY

 E.g: Starting one year from today, to withdraw 500 each year in
6 years from a saving account earning 6% p.a. How much is your
initial investment ?
500 500 500 500 500 500
Contract date
0

Discounted 1 year1 2 3 4 5 6
Discounted 2 years

Discounted 3 years

Discounted 4 years

Discounted 5 years

Discounted 6 years
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 PRESENT VALUE OF AN ANNUITY

C (Annuity)

PV 1 2 3 N-1 N

C C C C
PV = + + + ... +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) n

Note: This formula gives a value one period

before the first CF happens

44
 PRESENT VALUE OF AN ANNUITY
ILLUSTRATION 1
 You will receive $500 at the end of each of the next five
years. The current interest rate is 9 per cent per annum.
What is the present value of this series of cash flows?

45
 PRESENT VALUE OF AN ANNUITY
ILLUSTRATION 2
 You borrow $7,500 to buy a car and agree to repay the
loan by way of equal monthly repayments over five years.
The current interest rate is 12 per cent per annum,
compounded monthly. What is the amount of each
monthly repayment?

46
 VALUE OF A GROWING ANNUITY

 PRESENT VALUE OF GROWING ANNUITY (g is the

growth rate)

 FUTURE VALUE OF GROWING ANNUITY (g is the

growth rate)

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PRESENT VALUE OF A GROWING ANNUITY
ILLUSTRATION 1
Eg 1: Mr. Booth decides to fund a scholarship for Chicago
students for the next 10 years of $300,000 in the first year,
and this amount will increase by 5% each year. How much
should he donate today, if the school can earn 10% p.a ?

0 1 2 3 4 …. 10

300,000 315,000 330,750

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 MEASURING VALUE FOR A
PERPETUITY
Financial Management
 PRESENT VALUE OF A PERPETUITY
An annuity with an infinite number of payments

C C C

PV 1 2 3 … … … ∞

50
 PRESENT VALUE OF A PERPETUITY
ILLUSTRATION 1
A landlord expects to lease his building forever. The estimated revenue
and operating cost of the building (cleaning, other services..) is given:
- Annual revenue : $10,000
- Annual cost : $2,000
- Tax cost: 35%
Assume that the income from the building is expected to last forever.
Calculate the present value of the estate, given the interest rate of 5% p.a.

51
 CONSTANT GROWTH PERPETUITY

0 1 2 3 4 ….

C C(1+g) C(1+g)2 C(1+g)3

52
 CONSTANT GROWTH PERPETUITY
ILLUSTRATION

Ex: Mr. Booth was originally planning to donate $10,000

for his former MBA’s program, starting one year from
today. But after careful consideration, he decides that the
scholarship he endows at school should keep pace with
inflation, which is expected to be 4% per year. How does
this change his donated amount? (r = 10%)

0 1 2 3 4 ….

10,000 10,400 10,816

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 NOMINAL INTEREST RATE Vs. EFFECTIVE
ANNUAL INTEREST RATE (EAR)
Financial Management
INFLATION AND THE TIME VALUE OF MONEY

Consider $100 which can be invested at 10% when

inflation is 6%. How many $1 hamburgers can be
bought in 1 year if their price rises in line with
inflation ?

55
 INFLATION AND THE TIME VALUE OF MONEY
NOMINAL vs. REAL INTEREST RATE
 As inflation increases so does the minimum expected return. The
interest rates used so far includes an element due to inflation.
Removing inflation from the nominal rate creates the real rate of
return. They are linked by the following FISHER EFFECT equation:

(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate)

 Real rates: rates of return that have been adjusted for

inflation
 Nominal rates: rates of return that have not been adjusted
for inflation
 So if a company requires a 20% return on investment and
inflation is at 10% what is the real rate?
56
 INFLATION AND THE TIME VALUE OF MONEY
NOMINAL vs. REAL INTEREST RATE

(1 + Nominal rate) = (1 + Real rate) x (1 + inflation rate)

Rearranging:
Real rate = (1+ nominal rate)/(1+inflation rate) -1
Applied to previous example:
Real rate = (1+0.1)/(1+0.06) -1 = 3.8%

57
 ANNUAL PERCENTAGE RATE vs.
EFFECTIVE ANNUAL RATE
• Annual Percentage Rate (APR) – Interest rate that
is annualized using simple interest

• m: The number of times the interest is

compounded during the year

• Effective (equivalent) Annual Rate (EAR): interest

rate is actually earned per year

58
 ANNUAL PERCENTAGE RATE vs.
EFFECTIVE ANNUAL RATE
Effective (equivalent) Annual Rate (EAR) is the
annually compounded interest rate that is equivalent
to the stated rate on the loan

rnom = quoted rate/stated rate/ or APR

 COMPOUNDING FREQUENCY
ILLUSTRATION 1

What happens to the future value as the number of

compounding periods increases?
PV = 1,000; r_nominal = 10%; time = 2 years

60
 COMPOUNDING FREQUENCY
ILLUSTRATION 2
Below is the listed rate by the three banks:
ACB: 15%, compounded daily
Eximbank: 15.5%, compounded quarterly
Techcombank: 16%, compounded annually

If you have some money and want to deposit in

the bank, which bank you’re gonna choose?

61
 MATCHING CASH FLOWS WITH THE
FORMULAS
Financial Management
 PRINCIPLE 1 : CONSISTENCY

• When finding PV or FV of a single lump sum cash flow, the

time period does not have to be a whole number
• All that is required is a consistency between the interest
rate and the time period
• Ex: How much will you get if you invest $250,000 today at
the rate of 4% p.a. compounded once a year for a period of
18 months

0 ?

$ 250,000 18 months

64
 PRINCIPLE 2 :
PRESENT VALUE OF ORDINARY ANNUITY
 When finding the PV of an annuity/perpetuity, our
formulas give us the PV one period before the first cash
flow in the sequence
 Ex: How much do you have to put into the account earning
5% p.a (compound annually) right now to withdraw $100
per year for the next 10 years ?

0 1 2 3 4 …. 10

100 100 … … … 100

65
 PRINCIPLE 2 :
PRESENT VALUE OF ANNUITY DUE
How do we deal with a series of cash flows that begins
immediately? End of year 9,
beginning year 10

0 1 2 3 4 …. 9

100 100 100 … … … 100

66
 PRINCIPLE 3 :
FUTURE VALUE OF ORDINARY ANNUITY
• When finding the FV of an annuity, our formula gives us the
future value at the time of the last cash flow in the
sequence
• Eg: You decide to contribute $5,000 to your retirement
account each year for the next 30 years. The account earns
10% p.a. (compounding annually). What is the balance in
your account when you retire in 30 years from today ?

0 1 2 3 4 …. 30

5,000 5,000 5,000… … 5,000

67
 PRINCIPLE 3 :
FUTURE VALUE OF ANNUITY DUE
What if you plan to make the first contribution today?

0 1 2 3 4 …. 29

5,000 5,000 5,000… … 5,000

68
 PRACTICAL EXAMPLE 1

Eg.1 : You will receive (and deposit) $75 per year for four
years, then $200 at the end of the 6th year. If your account
earns 8% compounded annually, what will the future value be
at end of year 6 ?
0 1 2 3 4 5 6

$75 $75 $75 $75 $200

69
 PRACTICAL EXAMPLE 2

Ex 2: Due Annuity
do again

• RadioShack is selling TVs on the following terms:

• No payments until end of month 13 (beg of month 14)
after purchase
• At end of month 13 (beg of month 14) make 12
monthly payments of $75 each
Your interest rate is 6% p.a.
While BestBuy is selling the same TV for $750 cash

70
 PRACTICAL EXAMPLE 3

Ex 3: Unequal payments
• Consider a project that returns $2,000 in each of the 3rd
and 4th year, and $5,000 in the 5th and 6th year. At an
opportunity cost of 6% p.a., what is this project worth ?
0 1 2 3 4 5 6

$2,000 $2,000 $5,000 $5,000

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 MEASURING VALUE
MORTGAGE AND LOAN REPAYMENTS
Financial Management
 AMORTIZING A LOAN
 Determine payments required for an installment – loan
type (annuities)
 Loan is repaid in equal periodic payments – including both
interest and principal
 Thus, payment amount is set such that the present value
of all payments equals the loan amount
 Eg. Mortgage loans, auto loans, consumer loans, business
loans,…

73
 COMPUTING LOAN PAYMENTS

 Payment amount is set such that the present value

of all payments equals the loan amount

Loan
amount

74
 COMPUTING LOAN PAYMENTS
ILLUSTRATION
Ex: Suppose you enter a fixed-rate mortgage loan of $22,000
at 12% p.a. compounded annually
The loan is repaid every year over 6 years

75
 COMPUTING PAYOUT FIGURE
ILLUSTRATION
The payout figure is the present value of all remaining repayments
Ex: 30 year $100,000 fixed rate mortgage at 12% p.a. with monthly
repayments

76
 COMPUTING PAYOUT FIGURE
ILLUSTRATION (cont)
• If you make an extra payment, this reduces the outstanding
principal balance
• Consider a payment of $50,000 after 10 years, then the
repayments will be reduced:

77
 MORTGAGE PRACTICAL EXAMPLES
Financial Management

BANK LOANS

REFINANCING

CHOOSING A MORTGAGE LOAN

 BANK LOANS

Suppose you buy a new car on the following terms:

• $20,000 cash price less $2,000 down payment : $18,000
borrowed
• Loan term 3 years, monthly payment of $C
• Nominal interest rate 12% p.a. compounded monthly

❖ What is the monthly payment amount?

❖ How much of the first payment is interest and how much is
principal?
❖ After 1 year, how much do you still owe?
79
 REFINANCING

• Your current mortgage calls for monthly payments

of $1477.98 at a quoted rate of 7.5% p.a with 15
years remaining
• ANZ bank offers a 7% mortgage
• If transaction costs are $3,000 (fees, stamp duty,
etc…), should you refinance your mortgage?

82
 CHOOSING A MORTGAGE

• City Bank:
• Rate: 6.57% p.a. compounded monthly
• Monthly fee: $8
• Upfront cost: $550

• ACB loan:
• Rate 6.45% p.a. compounded monthly
• No monthly fee
• Upfront cost: $820

85
Assume you need $100,000 over a 25 year term
 CHOOSING A MORTGAGE (cont)

• How do you compare loans ?

1. Set the initial cash flow equal by assuming you

borrow the upfront fee
2. Compute the monthly payment for each loan
adding in any fees
3. Compare the monthly cost of each loan

86
 EXTENSION PROBLEM

Suppose City Bank offers you a deal: no up-front

costs, and only $4 per month in fees
Is the ACB loan still a better deal ?
(everything else remains the same)

89