2-1

Chapter 2
Time Value of Money

 Future value
 Present value
 2-2

The
The Interest
Interest Rate
Rate

Which would you prefer -- $10,000

today or $10,000 in 5 years?
years
Obviously, $10,000 today.
today

You already recognize that there is TIME VALUE

TO MONEY!!
MONEY

Because present is in hand whereas future is

distant and hazy.
 2-3

Why
Why TIME?
TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
INTEREST
 2-4

Time Value of Money

 The principles of time value analysis

have many applications, ranging
from setting up schedules for paying
off loans to decisions about whether
to acquire new equipment.
 2-5

Types
Types of
of Interest
Interest

 Simple Interest
Interest paid (earned) only on the original
amount, or principal, borrowed (lent).
 Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
 2-6

Simple
Simple Interest
Interest Formula
Formula

Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 2-7

Simple
Simple Interest
Interest Example
Example

 Assume that you deposit $1,000 in an

account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?

SI = P0(i)(n)
= $1,000(.07)(2)
= $140
 2-8

Simple
Simple Interest
Interest (FV)
(FV)

 What is the Future Value (FV)

FV of the
deposit?
FV = P0 + SI
= $1,000 + $140
= $1,140
 Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
 2-9
When the time is given in months, or
Days then
 When the time is given in
days, there are two
different varieties of
simple interest in use:
 2-10

Continue,…

 The general practice in Canada is to use

exact interest, whereas the general practice
in the United States and in international
business transactions is to use ordinary
interest (also referred to as the Banker’s
Rule).
 2-11

EXAMPLE

 A loan of $15 000 is taken out. If the interest

rate on the loan is 7%, how much interest is
due and what is the amount repaid if
 a) The loan is due in seven months;
 b) The loan was taken out on April 7 and is
due in seven months?
 2-12

Continue,…

 A): We have P = 15 000, r = 0.07 and since

the actual date the loan was taken out is
not given, we use t = 7/12.

FV= P+I = 15000 + 612.50 = 15612.50

 2-13

Continue,…

 B): Since a date is given when the loan was

actually taken out, we must use days. Seven
months after April 7 is November 7. Using
the table on the inside back cover, we find
that April 7 is day 97 and November 7 is day
311. The exact number of days between the
two dates is 311 − 97 = 214. Thus, t=214/365
 2-14

Con,..

FV= P + I = 15000+615.52 = 15615.52

 2-15

Time lines show timing of cash flows.

0 1 2 3
i%

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1; or
the beginning of Period 2.
 2-16

Time line for a $100 lump sum due at

the end of Year 2.

0 1 2 Year
i%

100
 2-17

Time line for an ordinary annuity of

$100 for 3 years.

0 1 2 3
i%

100 100 100

 2-18

Time line for uneven CFs: -$50 at t = 0

and $100, $75, and $50 at the end of
Years 1 through 3.

0 1 2 3
i%

-50 100 75 50
 2-19

What’s the FV of an initial $100 after 3

years if i = 10%?

0 1 2 3
10%

100 FV = ?

Finding FVs (moving to the right

on a time line) is called compounding.
 2-20

After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = FV1(1+i) = PV(1 + i)(1+i)
= PV(1+i)2
= $100(1.10)2
= $121.00.
 2-21

After 3 years:
FV3 = FV2(1+i)=PV(1 + i)2(1+i)
= PV(1+i)3
= $100(1.10)3
= $133.10.
In general,

FVn = PV(1 + i)n.

 2-22

Example: Assume that one year

from now, you will deposit
$1,000 into a savings account
that pays 8 percent.
If the bank compounds interest
annually, how much will you
have in your account four years
from now?
 2-23

What’s the PV of $100 due in 3 years if

i = 10%?

Finding PVs is discounting, and it’s

the reverse of compounding.

0 1 2 3
10%

PV = ? 100
 2-24

Solve FVn = PV(1 + i )n for PV:

n
FVn  1 
PV = n = FVn  
 1+ i
1+ i

3
 1 
PV = $100  
 1.10 
= $100 0.7513  = $75.13.
 2-25
Calculating PV incase of interest payment
Problem: How much I have to deposit today to earn 500$
interest after two years if the bank charges 10 % interest
compounded annually?

Interest payment = Future value – Present value

= PV (1+i)^n - PV
= PV{(1+i)^n – 1}
I = PV {(1+i)^n – 1}
PV = I / (1+i)^n – 1

PV = 500 / (1+0.1)^2 – 1
PV = 500 / (1.1)^2 -1
PV = 500 / 1.21 – 1
PV = 500 / 0.21
PV = 2380$
 2-26

Finding the Time to Double

0 1 2 ?
20%

-1 2
FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
 2-27

Finding the Interest Rate

0 1 2 3
?%

-1 2
FV = PV(1 + i)n
$2 = $1(1 + i)3
(2)(1/3) = (1 + i)
1.2599 = (1 + i)
i = 0.2599 = 25.99%.
 2-28

Annuity

An annuity is a series of equal payments made at fixed

intervals for a specified number of periods. For example,
$100 at the end of each of the next three years is a three-
year annuity. The payments are given the symbol PMT,
and they can occur at either the beginning or the end of
each period. If the payments occur at the end of each
period, as they typically do, the annuity is called an
ordinary, or deferred, annuity. Payments on mortgages,
car loans, and student loans are typically set up as
ordinary annuities. If payments are made at the
beginning of each period, the annuity is an annuity
due. Eg: Rental payments for an apartment, life insurance
premiums.
 2-29

What’s 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

PV FV
 2-30
What’s the FV of a 3-year ordinary
annuity of $100 at 10%?
=FV(0.1,3,100,0,0)

0 1 2 3
10%

100 100 100

110
121
FV = 331
 2-31

FV Annuity Formula
 The future value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
n
(1 i)  1
PMT
i
3
(1 0.10)  1
100 331.
0.10
 2-32

What’s the PV of this ordinary annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV
 2-33

PV Annuity Formula
 The present value of an annuity with n
periods and an interest rate of i can
be found with the following formula:
1
1-
(1  i)n
PMT
i
1
1- 3
(1  0.10)
100 248.69
0.10
PV (10%,3,100,0,0)
 2-34

Find the FV and PV if the

annuity were an annuity due.

0 1 2 3
10%

100 100 100

 2-35

PV and FV of Annuity Due

vs. Ordinary Annuity

 PV of annuity due:
 = (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56
 FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1
 2-36

Excel Function for Annuities Due

Change the formula to:

=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function
there are no other cash flows. The
fifth term tells the function that it is an
annuity due. A similar function gives
the future value of an annuity due:
=FV(10%,3,-100,0,1)
 2-37
What is the PV of this uneven cash
flow stream? A series of Un-equal payments made at fixed intervals for a
specified number of periods.

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
 2-38

 Input in “CFLO” register:

CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
 Enter I = 10%, then press NPV button to
get NPV = 530.09. (Here NPV = PV.)
 2-39

Spreadsheet Solution

A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
Excel Formula in cell A3:
=NPV(10%,B2:E2)
 2-40

Nominal rate (iNom)

 Stated in contracts, and quoted by banks
and brokers.
 Not used in calculations or shown on time
lines
 Periods per year (m) must be given.
 Examples:
8%; Quarterly
8%, Daily interest (365 days)
 2-41

Periodic rate (iPer )

 The rate of interest assessed (charged) on a loan or investment over a set time period when
compounding occurs more than once per year. (to add one thing to another).

 iPer = iNom/m, where m is number of

compounding periods per year. m = 4 for
quarterly, 12 for monthly, and 360 or 365 for
daily compounding.
 Used in calculations, shown on time lines.
 Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =
0.021918%.
 2-42

Will the FV of a lump sum be larger or

smaller if we compound more often,
holding the stated I% constant? Why?

LARGER! If compounding is more

frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.
 2-43
FV Formula with Different Compounding
Periods (e.g., $100 at a 12% nominal rate with
semiannual compounding for 5 years)
mn
 iNom 
FVn = PV  1 +  .
 m 
2x5
 0.12 
FV5S = $100  1 + 
 2 
= $100(1.06)10 = $179.08.
 2-44
FV of $100 at a 12% nominal rate for 5
years with different compounding
FV(Annual)= $100(1.12)5 = $176.23.
FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.
FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.
 2-45

Perpetuities

Most annuities call for payments to be made

over some finite period of time—for example,
$100 per year for three years. However, some
annuities go on indefinitely, or perpetually
(forever, for long period of time), and these are
called perpetuities.
Perpetuities can be illustrated by some British securities
issued after the Napoleonic Wars. In 1815, the British
government sold a huge bond issue and used the
proceeds to pay off many smaller issues that had been
floated in prior years to pay for the wars. Since the
purpose of the bonds was to consolidate past debts, the
bonds were called consols.
 2-46
The present value of a perpetuity is found by applying the
following formula:

 PV(perpetuity) = PMT/ I
 where PMT denotes payments and I
stand for interest rate.
 Suppose each consol promised to pay $100 per
year in perpetuity. (Actually, interest was stated
in pounds.) What would each bond be worth if the
opportunity cost rate, or discount rate, was 5
percent? The answer is $2,000:
 2-47

 PV(Perpetuity) = $ 100/0.05 = 2,000 if I = 5%

Suppose the interest rate rose to 10 percent; what
would happen to the consol’s value? The value
would drop to $1,000:
PV(perpetuity) = $100/0.1 = 1,000 if I = 10%