Chapter 4 Time Value of Money (TVM)

Lecture objective: after finishing this lecture, you should be able to:

1. Understand the concept of present value, future value.

2. Understand the concept of compounding and discounting.
3. Deal with compounding at different frequencies (monthly/daily/quarterly compounding etc.)

1. Present Value vs. Future Value (denoted by PV and FV respectively)

These two concepts are usually used in a relative sense. Present and Future are time qualifiers.
To better understand these two concepts, it is useful to have a brief discussion of a timeline. You
can loosely think of the timeline as a line of time moving forward. The timeline can be a
conventional calendar timeline or an unconventional timeline. The timeline can be measured in
different units such as years/quarters/months/weeks/days etc. As we will see in the future, these
different units correspond to different compounding frequencies (i.e., the time interval used to
accrue interest on your money).

Once we have a timeline, it is fairly easy to define PV and FV. Simply put, present value refers to
value at some earlier point along the timeline whereas future value refers to value at some later
point along the timeline.

Example 1: An example of Present Value & Future Value:

A dollar invested 25 years ago can be a case of future value if we are interested in knowing the
value of such a dollar 50 years ago (because 50 years ago is earlier than 25 years ago).

On the other hand, a dollar invested 25 years ago can be a case of present value if we are
interested in knowing the value of such a dollar today. Similarly, a dollar invested tomorrow can
be a case of present value if we are interested in knowing the value of such a dollar one week
from today (because today is ahead of one week from today).

Comments: people are often confused about what to compute, PV or FV. It is helpful to notice
that depending on each specific problem, make sure you have a clear idea of the timeline. This
timeline may or may not be the calendar timeline. However, you can always find an earlier and a
later point along the timeline, and hence, value at the earlier point corresponds to present value
and value at the later point corresponds to future value.

Example 2: Another example of Present Value & Future Value:

You have $10,000 you want to invest for the next 40 years. You are offered an investment plan
that will pay you 8 percent per year for the next 20 years and 12 percent per year for the last 20
years. How much will you have at the end of the 40 years? Does it matter if the investment plan
pays you 12 percent per year for the first 20 years and 8 percent per year for the next 20 years?
Why or why not?

This example raises a very difficult question. And we have not covered all that is needed to
answer this question. But still, we can use it as an example to take another look at the timeline
and decide what are present value and future value.

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Obviously $10,000 today is present value and the value of such an investment at the end of the
next 40 years is future value.

But there is an interesting twist here: the 40-year period is divided into two 20-year periods. So, if
I were to pick the value of the mid-point of this timeline (i.e., year 20) and ask whether it is
present value or future value, what would you say?

It turns out that the value at the mid-point of this timeline serves as both present value and future
value simultaneously. It is future value for the present value of $10,000. It is the present value for
the future value of the investment at the end of the next 40 years.

2. Interest rate (denoted by r, sometimes by i)

It is often said that “a dollar today is not the same as a dollar tomorrow”. This is because money
can grow interest. Today’s one dollar can grow interest at the interest rate (technically, it will
grow interest at the rate that is applicable between today and tomorrow). The notion of time
value of money basically means that money can grow interest. There are many ways as to how
money grows interest and money grows interest at very different speeds. For instance, you can
put the money in the bank. Alternatively, you can purchase treasury securities. Or even more
aggressively, you can put money in the stock market. Of course, different investments have
different risks and hence you earn different interest and investment returns.

In many cases, interest rate is also mentioned as discount rate. This is especially true when we
want to determine the present value of a certain future value. Finding the PV of a known FV
involves discounting and hence, interest rate is interchangeably used as discount rate.

3. Time Period (denoted by T)

Time period is simply the length of time between the time points at which we talk about PV and
FV. It is very important to match the time period with the interest rate. We will get back to
this when we discuss compounding at different frequencies.

4. Compounding vs. Discounting ((1+r)T vs. 1/(1+r)T)

Having discussed the notion of PV/FV/r, we are ready to introduce the notion of compounding
and discounting. More formally, finding the future value of a certain present value is called
compounding. In comparison, finding the present value of a certain future value is called
discounting. In other words, if we know PV and we want to find FV, we do compounding; if we
know FV and we want to find PV, we do discounting.

Draw a simple timeline here. Go backwards vs. go forward to demonstrate the difference between
compounding & discounting. Recommend: add a graphical representation here.

Example 3: An Example of Compounding:

Suppose you deposit $100 in a bank that offers 6% annual interest. What is the value of this
deposit in one year? In two years? In three years?

This example certainly has its own timeline. More specifically, you deposit $100 today. And you
want to determine the value of such $100 in one year, in two years and in three years. In our
jargon, $100 deposit today is our Present value; Value of such $100 deposit in one/two/three
years is our Future value. 6% is our interest rate and notice here that 6% is the annual interest
rate. So implicitly it corresponds to the annual time period, i.e., a year.

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Let’s first consider what happens in one year. (Draw a timeline here!) $100 deposit today will
grow interest over the year at the rate of 6%. So, this amount will increase by 1+6%, i.e., a factor
of 1.06 and become $106 next year. In this single period case, $100 is the so-called principal
amount and $6 is the interest you earn on your principal.

Things become a little bit complicated when we consider what happens in 2 years. (Draw a
timeline here!) This is a good place to introduce the so-called simple interest versus compound
interest. The difference between simple interest and compound interest arises when you decide
what to do with the interest you have earned over the first year. If you continue to invest with
your principal amount of $100 along with the $6 interest you’ve earned during the first year for
the second year, the interest will certainly grow interest, and hence you earn compound interest.
On the other hand, if you pull out the $6 interest you’ve earned in the first year and continue to
invest only with your $100 principal, you will only earn simple interest. In other words, with
compound interest, you earn interest on both the principal and the previous interest you have
earned. With simple interest, you only earn interest on the principal.

To compute simple interest, you just need to compute the interest you earn in each period. In the
first year, you earn an interest of $6. You also earn $6 interest for the second year. So, the future
value with simple interest in 2 years is nothing but $100 principal plus first-year $6 interest plus
second-year $6 interest, which is $112 in total.

More generally, future value with simple interest can be computed as follows:

FV with Simple Interest = PV*(1+r*T) ------------------------------------------------ (0)

Now let’s consider compound interest. In the first year, $100 deposit will grow by a factor of 1.06
and becomes $106. In the second year, $106 will grow again by a factor of 1+6% and becomes
100*(1.06) *(1.06) = $112.36.

The additional $0.36 is the so-called interest on interest. More specifically, it is the interest
earned in the second year on the $6 first year interest ($6 x 6% = $0.36). Similarly, compounding
the interest annually, $100 will grow to 100(1.06)3 = $119.10 after three years.

In the future, unless otherwise specified, we will deal with compound interest because simple
interest is simple.

5. Future Value with Compound Interest: General Formula

Let’s assume annual interest rate is r (Remember: interest rate implicitly corresponds to the time
period, in this case, period is defined as a year); PV is the present value; FV is the future value.
Then after T years,

FV with Compound Interest = PV*(1+r) T ------------------------------------------

(1)

Comments:

1) This is one of the basic formulas in finance. It relates to four quantities: FV, PV, r, T.
Consequently, knowing any three quantities means the fourth variable can be solved.

2) Sometimes we need to manipulate the above formula to solve PV, or r, or T. More

specifically,

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 ------------------------------ (1’)

3) Compare equation (1) with Equation (0), you can see that the main difference is where T
appears. For future value with simple interest, T is multiplied by r whereas for future value
with compound interest, T is in the exponential.

4) Sometimes (1+r) T is labeled as the future value interest factor since multiplying the PV by
this factor, you can obtain the FV. It is often abbreviated as FVIF (r, T). The good thing about
this abbreviation is that it reminds us of the two main arguments: interest rate and time
period; Similarly, 1/(1+r) T is labeled as present value interest factor since multiplying the
FV by this factor, you obtain the PV. It can also be abbreviated as PVIF (r, T).

Example 4: Replicating the PVIF (r, T) and the FVIF (r, T) in Excel using Excel Data Table.

Please follow me in class. Please refer to textbook Appendices A1 and A2 as well.

Example 5: An example of finding the interest rate:

Assume the total cost of a college education will be $290,000 when your child enters college in
18 years. You presently have $35,000 to invest. What annual rate of interest must you earn on
your investment to cover the cost of your child’s college education?

This example asks for the annual rate of interest. Let’s sort out the known pieces of information
first. You presently have $35,000 to invest. And you need $290,000 in 18 years to cover the
college education of your child. So, $35,000 is our PV and $290,000 is our FV. Also, we know
that your money has 18 years to grow, i.e., T is 18 years in this case. Following the above
equation (1’), we have

(Excel function approach: = rate (19,0, -35000,290000) = 12.47%)

Example 6: An example of finding the number of periods:

At 9 percent interest, how long does it take to double your money? To quadruple it?

This example deserves a little bit of explanation. At first sight, we don’t see any specific numbers
indicating PV or FV. The only thing we know seems to be the interest rate. And we need to find
out how long it takes to double our money. So, how should we start?

We can start from any amount of PV. Let’s denote this by PV (pretending as if this were some
exact number). Consequently, our FV is going to be expressed in terms of this arbitrary PV.
Obviously, if we want to double our money, FV = 2 x PV; if we want to quadruple our money,
FV = 4 x PV. Now, we can proceed to find how long it takes before our money reaches 2PV or
4PV.

Following equation (1’), we have:

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Comment:

1) Now it should become clear that sometimes we don’t need specific numbers for PV and FV.
We can still work it out as long as we know the ratio between PV and FV in this case. After
all, if you look at the formula for computing T, all that matters is just the ratio between FV
and PV.

2) There is actually a nice thing about doubling your money. The Rule of 72 argues that as a
rule of thumb, it takes about 72/r to double your money at the rate of r percent. Alternatively,
you must earn an interest rate of 72/T percent to double your money in T years. Going back
to the example, 72/9 = 8 (years), which is very close to the actual answer we get (8.04 years).
So, this Rule of 72 turns out to be a good approximation. A caveat is that this rule of 72 only
helps when we try to double our money.

6. Compounding at other frequencies:

Let’s now extend the above annual compounding to compounding at other frequencies. Often in
finance we have compounding at frequencies other than yearly. For instance, credit card users pay
off their credit card bills each month. Mortgage borrowers also pay off their mortgages monthly.
Most corporate bonds in the US pay semi-annual coupons. This said, we need to find a way to
deal with compounding at frequencies other than a year. Here is the way to deal with it:

Assume r is the annual interest rate and T is the number of years. If the compounding is
quarterly, then the rate of interest will be r/4 per quarter. But there will be 4T periods for
compounding. Not surprisingly, the formula (1) becomes:

FV = PV(1+r/4)4T

For monthly compounding, the rate of interest is r/12 and number of periods 12T, and the formula
becomes FV = PV(1+r/12)12T. More generally,

If we carry out the compounding k times a year, then we can write formula (1) as

-------------------------------------------------------
(2)

Comments:

1) What exactly is compounding at other frequencies? Remember compounding means the

process of accumulating interest in an investment over time to earn more interest. So, it really
boils down to what frequencies interests are earned. In this sense, annual compounding
simply means that interests are earned annually and reinvested. Similarly, quarterly/daily
compounding means that interests are earned quarterly/daily and reinvested for the next
quarter/day.

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2) Notice k = the number of compounding times in a year. So, we have

Compounding Freq. k
Annual k=1
Quarterly k=4
Monthly k=12
Weekly k=52
Daily k=365

Think: if we live in a bizarre world where money compounds every 13 months, what is the k?

3) It is very important to match the interest rate with the compounding period. To do this, we
need to adjust two things:

 The interest rate we now use should now be the so-called period rate. For monthly
compounding, the period rate is monthly rate, which is given by annual rate divided by 12.
For daily compounding, the period rate is the daily rate given by r/365.

 the number of periods. For monthly compounding, the period is a month; for daily
compounding, the period is a day. Consequently, we should use the number of periods
instead of the number of years.

Once we adjust for the r and T, equation (1’) on Page 3 is now revised to the following:

----------------------------- (2’)

Example 7: An example of the power of compounding

Please refer to textbook example 4.3 on Page 102.

Example 8: An example of compounding at other frequencies:

Harry DeAngelo is investing $5000 at a stated annual interest rate of 12 percent per year,
compounding quarterly, for five years. What is his wealth at the end of five years?

In this particular example, we are dealing with quarterly compounding, and we need to find the
FV. Notice first that, annual interest rate is 12%, so period rate is given by quarterly rate, which
is 12%/4 = 3%; the number of periods (i.e., the number of quarters) is given by number of years
(five years in this case) multiplied by number of quarters in a year, which is 4 if you live in earth,
and hence, 20 total number of periods.

So, FV = $5000 * (1+12%/4)5 * 4 = $5000 * 1.8061 = $9030.50

(Excel function: = fv (12%/4,5*4, 0, -5000) = 9030.50)

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Example 9: Another example of compounding at other frequencies:

Wilkins Micawber has just received $20,000 and he is thinking of saving it for his retirement that
is 15 years away. First National Bank offers 7% interest on a 15-year deposit, compounded
annually. Second National Bank gives 6.9% annually but compounds it monthly. What should
Micawber do?

This example essentially compares two compounding frequencies and examines which one is
more lucrative. Micawber starts with a deposit of $20,000 today. Obviously, we need to find the
value of such a deposit 15 years later. So, we need to find FV. Since there are two different
compounding frequencies, we need to find FV for each of them and compare them.

So he should put his money in the Second National Bank.

(Excel function: FV for First National Bank = fv (7%,15,0, -20000) = 55180.63

FV for Second National Bank = fv (6.9%/12,15*12,0, -20000) = 56135.48)

Example 10: Another example of finding the interest rate:

An investment offers triple your money in 24 months (don’t believe it?!). What rate per three
months are you being offered?

This example is a little bit confusing. First, we don’t have any specific PV and FV. But we know
the ratio of FV to PV (triple leads to a ratio of 3). Second, it is asking what rate per three months.
Hence, this suggests that the compounding frequency is every 3 months. I must agree that this
compounding frequency is very elusive and can often be neglected at first sight.

Now that we have quarterly compounding, we need to adjust the time period correspondingly. 24
months amounts to 8 quarterly compounding times. So, T = 8 in this case.

Following equation (2’), we have:

(Excel function approach: = rate (8,0, -1,3) = 14.72%)

Example 11: Another example of finding the number of periods:

You can earn 0.45 percent per month at your bank. If you deposit $1,500, how many years must
you wait until your account has grown to $3,600?

This example is compounding per month. In other words, period is defined as a month and period
rate is monthly rate, which is given by 0.45%. Obviously $1,500 is our PV and $3,600 is our FV.
All we need to find is T, number of periods.

Following equation (2’), we have:

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 Notice here that T is the total number of periods. Remind ourselves carefully that period in this
example is MONTH! So, the above 194.99 is essentially in terms of total number of months. Not
surprisingly, the number of years should be given by 194.99/12 = 16.25 years!

Alternatively, if you want to make the final T in years directly, you can try:

(Excel function: = nper (0.45%,0, -1500,3600) =194.99 (months))