Time Value of Money

Value of Money = f(Time)

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Chapter outline
 The concept of TVM
 Interest
rate (Meaning, Components, Simple
vs Compound)
 Time lines (why important?)
 Present value, Future value
 Annuities (ordinary vs annuity due)
 Nominal/Quoted vs Effective Interest rates
 Amortization Schedule

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Time Value of Money
Define
Indicates the purchasing power of money changes during time
being or the money in your hand now is not equal to the
money will be in future
Why matters
- Inflation/Deflation
- Uncertainty/Risk
- Opportunity costs
Applications
 planning for retirement,
 valuing stocks and bonds,
 setting up loan payment schedules, and making corporate
decisions regarding investing in new plant and equipment
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Interest Rate

An interest rate is the percentage of principal

charged by the lender for the use of its
money/fund
Components:
- Inflation
- Opportunity cost
- Risk

Example: If you deposit $100 at 10% interest rate for 5 years, how
much you will receive if you follow, simple interest rate and if you
follow compound interest rate
Simple vs Compound Interest Rate
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Time lines

0 1 2 3
i%

CF0 CF1 CF2 CF3

 Show the timing of cash flows.

 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.
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 Drawing time lines:
$100 lump sum due in 2 years;
3-year $100 ordinary annuity

$100 lump sum due in 2 years

0 1 2
i%

100
3 year $100 ordinary annuity
0 1 2 3
i%

100 100 100

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 Drawing time lines:
Uneven cash flow stream; CF0 = -$50,
CF1 = $100, CF2 = $75, and CF3 = $50

Uneven cash flow stream

0 1 2 3
i%

-50 100 75 50

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 Future value calculation

Example: If you deposit $1000 for 5 years at 10 interest rate, how

much will you receive after 5 years? (if there is one cash inflow and
one cash outflow)

Example: if you deposit $300 at the end year 1, $200 at the end of
year 2, $0 at the end year 3, $500 at the end of year 4, how much you
will receive after 5 years? (If there is more than one cash outflow
and one cash inflow)

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What is the future value (FV) of an initial
$100 after 3 years, if i/YR = 10%?

 Finding the FV of a cash flow or series of

cash flows when compound interest is
applied is called compounding.
 FV can be solved by using the arithmetic,
financial calculator, and spreadsheet
methods.
0 1 2 3
10%

100 FV = ?
6-9
Solving for FV: The arithmetic method

 After 1 year:
FV1 = PV ( 1 + i ) = $100 (1.10)
= $110.00
 After 2 years:
FV2 = PV ( 1 + i )2 = $100 (1.10)2
=$121.00
 After 3 years:
FV3 = PV ( 1 + i )3 = $100 (1.10)3
=$133.10
 After n years (general case):
FVn = PV ( 1 + i )n

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Future Values of $100 at 10%

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Future Value of $1 for Different Periods and Rates

5-12

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FV (some examples)
If Cash inflow and outflow one time:
- If you deposit $1000 for 10 years at 12% interest rate, how much will
you receive after 10 years? Calculate and show time lines.
- If your grand father deposited $5000 before 30 years at 10% interest
rate at a commercial bank, how much would you receive today. Show
calculations and time lines.

If there is more than one cash outflow and one cash

inflow:
- If you deposit $1000 now, $5000 after 1 year, $6000 after 2 year, and
$4000 after 3 years, how much will you receive after 4 years at 10%
interest rate. Show calculations and time lines.
- If your forefathers deposited $10000 before 50 years at 6% interest
rate, and more $10000 before 30 years at 8% interest rate. How much
in total you would receive today. Show calculations and time lines of
each scenario.
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 Present Value of a Lump Sum

You need $1000 in five years time. If you can earn 10 per cent per
annum, how much do you need to invest now?

Discount one year: $1000 (1 + 0.10) –1 = $909.09

Discount two years: $909.09 (1 + 0.10) –1 = $826.45
Discount three years: $826.45 (1 + 0.10) –1 = $751.32
Discount four years: $751.32 (1 + 0.10) –1 = $683.02
Discount five years: $683.02 (1 + 0.10) –1 = $620.93

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What is the present value (PV) of $100 due in 3
years, if i/YR = 10%?

 Finding the PV of a cash flow or series of cash

flows when compound interest is applied is called
discounting (the reverse of compounding).
 The PV shows the value of cash flows in terms of
today’s purchasing power.

0 1 2 3
10%

PV = ? 100
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PV calculation
If there is one cash outflow and one cash inflow
-If you would like to receive $500 after 5 years, how much you need to
deposit today at 10% interest/discount rate?
- Your rich uncle promises to give you $100 000 in 10 years time. If interest
rates are 6 per cent per annum, how much is that gift worth today?

6-16
Solving for PV: The arithmetic method

 Solve the general FV equation for PV:

PV = FVn / ( 1 + i )n

PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

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Present Value of $1 for Different Periods and
Rates

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What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV

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Solving for PV:
Uneven cash flow stream
 Inputcash flows in the
calculator’s “CFLO” register:
 CF0 = 0
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = -50

 Enter I/YR = 10, press NPV button

to get NPV = $530.09. (Here NPV
= PV.)

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Exercises (PV and FV): Single vs Multiple
Cashflows
 If you deposit $10000 for 5 years at 10% interest rate,
how much will you receive after 5 years?
 If you would like to receive $20000 after 5 years, how
much do you need to deposit today if the interest rate
is 10%?
 If you deposit $3000 at year 1, 3500 at year 2, $0 at
year 4 and $4000 at year 5, how much will you receive
after 5 years if the interest rate is 10%? Show time
lines.
 If you would like to receive $3000 at year 1, 3500 at
year 2, $0 at year 4 and $4000 at year 5, how much do
you need to deposit today if the interest rate is 10%?
Show time lines.
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 Time Project A Project B Project C Project D

1
2
3
4
5

1. If you would like to receive cash inflow from project A, B,

C and D as the table mentioned, how much you need to
deposit today at 10% interest rate?
2. Show times lines of each project
3. Interpret your result
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Discussion: Annuity
Annuity define: Series of equal payment or receipt/cash
inflow or outflow for number of periods (periods can be
day, month, quarter, year, etc)

Examples: EMI, home loan, automobile loan, Internet bill,

house rent, etc

i = 1, 2, …………………….n

Types:
1. Ordinary annuity
2. Annuity due

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What is the difference between an ordinary
annuity and an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

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Future Value Annuity


6-25
Present Value Annuity


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If you receive $20,000 loan from a commercial bank at 10%
interest rate for 15 years. How much you need to pay per
installment?

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 Perpetuities

 A perpetuity is an annuity in which the cash flows continue

forever.
 The future value of a perpetuity cannot be calculated as the cash
flows are infinite.

 The present value of a perpetuity is calculated as follows:

PV= C
r
 Perpetuity with growth rate
PV = C/r – g, where g is the growth rate

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 Comparing Rates

 The nominal interest rate (NIR) is the interest rate

expressed in terms of the interest payment made each
period.

 The effective annual interest rate (EAR) is the interest rate

expressed as if it was compounded once per year.

 When interest is compounded more frequently than

annually, the EAR will be greater than the NIR.

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 Calculation of EAR

 
NIR
EAR=1+  −1
m

 m
m = number of times the interest is compounded

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 Comparing EARS

 Consider the following interest rates quoted by three

banks:

 Bank A: 8.3%, compounded daily

 Bank B: 8.4%, compounded quarterly

 Bank C: 8.5%, compounded annually

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Relationship between EIR and m is

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Why is it important to consider
effective rates of return instead of
NIR or quoted interest rate?

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Can the effective rate ever be
equal to the nominal rate?

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 Types of Loans
 A pure discount loan is a loan where the borrower
receives money today and repays a single lump sum
in the future.

 An interest-only loan requires the borrower to only

pay interest each period and to repay the entire
principal at some point in the future.

 An amortized loan requires the borrower to repay

parts of both the principal and interest over time.

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 Loan amortization
 Amortized Loan - A loan that is repaid in equal
payments over its life.
 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.

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You took loan $10000 loan from a commercial bank at 10% interest
rate for 5 years. Construct an amortization schedule based on the
agreement. Based on your calculation, show the relationship between
principal payment and interest payment in the schedule.

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Step - 1

 Find how much do you need to pay equally in each

installment

You need to follow annuity formula

here

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Step 2:
Find the interest paid in Year
1 The borrower will owe interest upon the initial balance

at the end of the first year. Interest to be paid in the
first year can be found by multiplying the beginning
balance by the interest rate.

INTt = Beg balalancet (i)

INT1 = $1,000 (0.10) = $100

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 Step 3:
Find the principal repaid in Year 1

 If a payment of $402.11 was made at the end of the

first year and $100 was paid toward interest, the
remaining value must represent the amount of principal
repaid.

PRIN = PMT – INT

= $402.11 - $100 = $302.11

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Step 4:
Find the ending balance after
Year 1
 To find the balance at the end of the period, subtract
the amount paid toward principal from the beginning
balance.

END Balance= BEG Balance – PRIN

= $1,000 - $302.11
= $697.89

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 Constructing an amortization table:
Repeat steps 1 – 4 until end of loan

Year BEG BAL PMT (2) INT (3) PRIN END

(1) (4) BAL (6)
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOTAL 1,206.34 206.34 1,000 -

 Interest paid declines with each payment as

the balance declines. What are the tax
implications of this?
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Illustrating an amortized
payment:
Where does
$
the money go?
402.11
Interest

302.11

Principal Payments

0 1 2 3
 Constant payments.
 Declining interest payments.
 Declining balance.
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Example

 Construct Loan Amortization Schedule, $100,000 at 6%

for 5 Years

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Questions & Answers

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