The Time Value of Money

After complete this unit successfully, you should be able

to:
 
 Explain what the time value of money is and why it is
so important in the field of finance
 Explain the difference between simple and compound
interest rate and identify the factors that affect the
power of compounding.
 Explain the concept of future and present value, and
use the formulae to make business decisions.
 The Key Question!
 What would you prefer:
1. £100 today OR
2. £105 next year

Why? How to decide? What factors influence the

decision?

These are important questions in Finance. To

answer/solve these question we need an important
tool. This tool is: Time value of money.

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 Reasons for Money has Time Value
 TVM is based on the belief that people prefer
to consume goods today rather than wait to
consume similar goods tomorrow.
 Today’s money can be invested to earn interest
or spent.
 When there is monetary inflation, the value of
currency decreases over time.
 If there is any uncertainty (risk) associated
with the cash flow in the future, the less that
cash flow will be valued.

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 Future Value versus Present Value

 Financial decisions are evaluated either on

a future value basis or present value basis.
(compare, add, subtract ..)
 Future value measures what one or more cash
flows are worth at the end of a specified
period.
 Present value measures what one or more cash
flows that are to be received in the future will
be worth today (at t=0).

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 Example
Suppose you invest £1000 at 6% per annum
[Note: 6% means 6/100 or 6 ÷ 100, which is 0.06]
One year later you will have 1000 + (1000 x 0.06) or
(1000 x 1) + (1000 x 0.06).
Since 1000 is a common factor, this can be written as:
1000 x (1 + 0.06), i.e. 1000 x (1 + rate of interest)
1 + 0.06 = 1.06, so the amount one year later will be:
1000 x 1.06 = 1060
If invested for 2 years, it would be 1000 x 1.06 x 1.06
= 1000 x 1.062 = 1123.60.
If invested for 3 years, it would be:
1000 x 1.06 x 1.06 x 1.06 = 1000 x 1.063 = 1191.02
Thus, the future value of £1000 at 6% is:
1000 x 1.061 = £1060 after 1 year;
1000 x 1.062 = £1123.60 after 2 years;
1000 x 1.063 = £1191.02 after 3 years; and so on

Future Value (FV) is the amount that the

Present Value (PV) of an investment will
grow to over a number of time periods (n),
given a particular rate of interest (i).
PV x (1 + i)n = FVn
i.e. to find the future value of a present sum
of money, it should be multiplied by the
Future Value Factor (1 + i)n.
Future Value and Compounding
The Future Value Equation
The general equation to find the future
value is:
n
FVn  PV (1i) (5.1)
where:
FVn = future value of investment at the end of
period n
PV = original principal (P0) or present value
i = the rate of interest per period, which is
often a year
n = the number of periods
The term (1 + i)n is the future value factor, which can be
found in Future Value Factor table
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Exhibit 5.6: Future Value Factors

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As seen earlier, PV x (1 + i)n = FV
Re-arranging the above:
FV 1
PV = --------- OR FV x ---------
(1 + i)n (1 + i)n

To find the present value of a sum of money to be

received in the future, it should be divided by (1 + i) n
OR multiplied by the Present Value Factor, i.e.
1
---------
(1 + i)n

The higher the values of i (the interest rate) and n

(the number of periods), the lower will be the present
value.
Exhibit 5.8: Present Value Factors

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Why should we find the Present Value
of future cash flows?
• Since we can not compare or add/subtract cash flows at
different point in time together we need to convert cash
flow to a common point in time.
• Financial decisions are made in the present time.
• Your investment is being made in the present, but the
cash flows you get back will be in the future. Because of
the time value of money, future cash flows are not
comparable with a present cash flow (i.e. your
investment). To make them comparable, the present
value of the future cash flows has to be found
Exhibit 5.2: Future Value and Present
Value Compared

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Exhibit 5.4: How Compound Interest

Grows

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 Exhibit 5.5: Future Value of €1 – The
higher interest rate, the faster money will
grow

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Application: The power of compounding -
Stocks, Bonds and Bills

• Between 1926 and 1998, Ibbotson Associates found that

stocks on the average made about 11% a year, while
government bonds on average made about 5% a year.

• If your holding period is one year, the difference in end-of-

period values is small:
– Value of $ 100 invested in stocks in one year = $ 111
– Value of $ 100 invested in bonds in one year = $ 105
 Holding Period and Value
Figure 3.3: Effect of Compounding Periods: Stocks versus T.Bonds

$7,000.00

$ 100 invested in stocks, earning

$6,000.00 11% a year, is worth more than seen
times as much at the end of 40 years
than $ 100 invested in bonds, earning
5% a year.
$5,000.00

$4,000.00
Stocks
T. Bonds
$3,000.00

$2,000.00
The compounding effect increases
as the time horizon increases.

$1,000.00

$0.00

Compounding Periods
 Concept Check
• Most pension plans allow individuals to decide where their pensions
funds will be invested - stocks, bonds or money market accounts.
• Where would you choose to invest your pension funds?
 Predominantly or all equity
 Predominantly or all bonds and money market accounts
 A Mix of Bonds and Stocks
• Will your allocation change as you get older?
 Yes
 No
Frequency Compounding
Compounding More Frequently Than Once a
Year
The more frequently the interest payments
are compounded, the larger the future value
of €1 for a given time period.
FVn =PV×(1+i/m)m×n (5.2)

where: m = number of compounding

periods in a year

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 COMPOUNDING OF INTEREST
• The higher the values of i (the interest rate) and
n (the number of periods), the higher will be the
future value.
• The more frequently interest is applied in a year,
the higher will be the average annual interest
rate – this is called the Annual Equivalent Rate
or Effective Annual Rate (EAR).
• Since compound interest increases
exponentially, it is necessary to find the
geometric average (rather than the simple
arithmetic average) to determine the EAR.
 Annual Percentage Yield or
Effective Annual Rate (EAR)
When interest is applied more frequently
than annually, the EAR tells you what the
notional interest rate would be if it were
applied annually

 i m
EAR =  1 + ------  - 1
 m 
Where i = quoted annual interest rate, and
m = number of compounding periods per year
 Example of EAR
 The frequency of compounding affects the future and present values
of cash flows. The stated interest rate can deviate significantly from
the true interest rate –
• For instance, a 10% annual interest rate, if there is semiannual
compounding, works out to-
Effective Interest Rate = 1.052 - 1 = .10125 or 10.25%
Frequency Rate t Formula Effective Annual Rate
Annual 10% 1 10.00%
Semi-Annual 10% 2 (1+r/2)2-1 10.25%
Monthly 10% 12 (1+r/12)12-1 10.47%
Daily 10% 365 (1+r/365)365-1 10.5156%
Continuous 10% er-1 10.5171%
(e=the base of the natural logarithm =2.7183)
r m

EAR = (1 + m ) -1
 The Rule of 72
 Rule of 72 is used to determine the amount
of time it takes to double an investment.

 It says that the time to double your money

(TDM) approximately equals 72/i, where i is
expressed as a percentage.

 Rule of 72 is fairly accurate for interest

rates between 5% and 20%.

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