THE TIME VALUE

OF MONEY
Introducti
on
This chapter explores the
fundamental concept of the time
value of money, a crucial
principle in financial management
and investment decisions. It
highlights the importance of
understanding how the timing of
cash flows affects their value.
Learning
Outcomes
After studying this chapter, you
should be able to:
Understand the concepts of future value and
present value.
Know the calculation of single amounts, and
the relationships between them.
Find the future value and the present value
of both an ordinary annuity and an annuity
due, and find the present value of a
perpetuity.
Calculate both the future value and the
present value of a mixed stream of cash
flows.
Know how to compute intraperiod
 Lesson 1: Future
Value vs Present
Value

Future value Present value

 is a techniques  is a techniques
typically measure measure cash flows at
cash flows at the end the start of a project’s
of a project’s life. life (time zero).
 it’s refers to the cash  is just like cash in hand
you will receive at a today.
given future date.
 Lesson 1: Legal Forms
of Business
Organizations

TOOLS USED IN TIME

VALUE OF MONEY
COMPUTATION
 FINANCIAL
FINANCIA CALCULATOR
L TABLES S
Financial tables Financial calculators also
include various can be used for time value
future and computations. Generally,
financial calculators include
present value
numerous preprogrammed
interest factors financial routines for quick
that simplify time and efficient time value
value computations.
calculations.
 FINANCIAL
COMPUTERS AND
CALCULATOR SPREADSHEETS
S
Financial calculators also
can be used for time value It also offer
computations. Generally, built-in functions
financial calculators include for time value
numerous preprogrammed calculations,
financial routines for quick allowing for
and efficient time value flexible and
computations. automated
calculations.
 Basic
Patterns of
Cash Flow
The cash flow—both inflows and
outflows—of a firm can be described
by its general pattern. It can be
defined as a single amount, an
annuity, or a mixed stream.
 Single
Amount
Annuity
A lump-sum
amount either
currently held or A level periodic
expected at some stream of cash flow.
future date. For our purposes,
we’ll work primarily
with annual cash
flows.
Annuity Mixed
Stream
A level periodic
stream of cash flow.
A stream of cash
For our purposes,
flow that is not an
we’ll work primarily
annuity; a stream of
with annual cash
unequal periodic
flows.
cash flows that
reflect no particular
pattern.
 Lesson 2: Single
Amounts
Future Value
of a Single
Amount
The future value (FV) of a single amount is the value
of a present single amount at a given interest rate over
a specified future period of time. This is done by
applying the compound interest which is the interest
that is earned on a given initial principal and such
interest has become part of the principal at the end of a
specified period. The compounding here can be
annually, semi-annually, quarterly, monthly, weekly,
daily, or even continuously.
The Equation
for Future
Value
Future value of a single amount is calculated
using the formula:
FVn=PV(1+i)n

FVn =future value at the end of period n

PV =initial principal, or present value
i =annual rate of interest paid.
n =number of periods (typically years) that the
money is left on deposit
Exampl
e:
Suppose you put 10,000 in a saving
account with the interest of 8% and keep
it there for 5 years. What would the future
value at the end of year 5?
Before applying the formula above, let’s go through the
concept of compounding interest at the end of each year
separately. So the future value at the end of each year comes
from the principal plus interest at that given year. The principal
and interest will become a new principal for next year and so
on.
Exampl
e: Thus, we can calculate the future value at the end of each
year as follows:

Future value at the end of year 1 = 10,000 × (1+0.08) =

$10,800

The principal and interest of $10,800 become a new

principal for year two.

FV at the end of year 2 = 10,800 × (1+0.08) = $11,664

FV at the end of year 3 = 11,664 × (1+0.08) = $12,597.12
FV at the end of year 4 = 12,597.12 × (1+0.08) =
$13,604.89
Finally, the FV of year 5 = 13,604.89 × (1+0.08) =
$14,693.28
Exampl
e: Now let’s use the formula to calculate the
future value of a single amount.
FVn=PV(1+i)n

FV = 10,000 × (1+0.08)5 =
$14,693.28

The future value interest factors at an

interest of 8% over 5 year-time are 1.4693.

Therefore, the FV = 10,000 × 1.4693 =

$14,693
Another Example for
the Equation of
Future Value
Jane Farber places $800 in a savings account
paying 6% interest compounded annually. She
wants to know how much money will be in the
account at the end of 5 years.
Substituting PV =$800, i=0.06, and n =5 to give the
amount at the end of year 5.

FV5 =$800(1+0.06)5
=$800(1.338)
=$1,070.40
 Lesson 2: Single
Amounts
Present Value of a
Single Amount

Present value is the current

dollar value of a future amount—the
amount of money that would have
to be invested today at a given
interest rate over a specified period
to equal the future amount.
 Lesson 2: Single
Amounts
Present Value of
a Single Amount

The present value of a single amount is

defined as the current worth of a single
payment or series of payments to be
received at a later date, given a specific
adjustment for timing based on
assumptions about interest rates and
Exampl
e: The formula used to calculate the present value of a
single amount is:

In this formula, the following variables are defined

as:

PV = Present value of the amount

FV = Future value of the amount (amount to
be received in future)
i = Interest rate (in percentage terms)
n = Number of periods after which the
Exampl
e:
Suppose a company expects to receive
$8,000 after 5 years. Calculate the present
value of this sum if the current market
interest rate is 12% and the interest is
compounded annually.
In this example, the number of periods (n)
is 5 and the interest rate (i) is 12%.
Therefore, the present value (PV) is
calculated as follows:
Exampl
e: PV = FV x 1 / (1+i)n
= 8,000 x 1 / (1+0.12)5
= 8,000 x 1 / (1.12)5
= 8,000 x 1 / 1.7623
= 8,000 x 0.5674
= $4,540

According to these results, the amount of $8,000, which

will be received after 5 years, has a present value of
$4,540.

This example shows that if the $4,540 is invested today

at 12% interest per year, compounded annually, it will
grow to $8,000 after 5 years
 Lesson 3:
Annuities
What is
Annuity?
 is a stream of equal periodic cash flows, over a
specified time period.
 These cash flows are usually annual but can
occur at other intervals, such as monthly (rent,
car payments).
 The cash flows in an annuity can be inflows
(the $3,000 received at the end of each of the
next 20 years) or outflows (the $1,000 invested
 Type of
Annuities
Ordinary Annuity
Annuity Due
the cash
the cash flow
flow occurs
occurs at the
at the
end of each
beginning
period
of each
 The Difference Between an Annuity
Due and an Ordinary Annuity

The key difference between an annuity due and

an ordinary annuity is that the payments for an
annuity due are scheduled to be issued at the
beginning of each payment period, while the
payments for an ordinary annuity are scheduled for
the end of each period. This timing differential
causes another difference, which is that the earlier
payments for an annuity due give it a higher
present value than the present value of an ordinary
 Future Value of a
Ordinary
Annuity
An ordinary annuity is a series of payments made at the
end of each period in a series of payments. It has the
following characteristics:
 All payments are in the same amount (such as a series of
payments of $1,000).
 All payments are made at the same intervals of time (such
as once a month or quarter, over a period of a year).
 All payments are made at the end of each period (such as
payments being made only on the last day of the month).

Usually, payments made under the ordinary annuity

concept are made at the end of each month, quarter, or year,
though other payment intervals are possible (such as weekly
or even daily).
Future Value of a
Ordinary Annuity
The formula for calculating the future
value of an ordinary annuity (where a series
of equal payments are made at the end of
each of multiple periods) is:
P = PMT [((1 + r)n - 1) / r]
Where:
P = The future value of the annuity stream to
be paid in the future
PMT = The amount of each annuity payment
r = The interest rate
n = The number of periods over which
payments are made
Exampl
e:
The treasurer of ABC International expects
to invest $100,000 of the firm's funds in a
long-term investment vehicle at the end of
each year for the next five years. He expects
that the company will earn 7% interest that
will compound annually. The value that these
payments should have at the end of the five-
year period is calculated as:
P = $100,000 [((1 + .07)5 - 1) / .07]
P = $575,074
Exampl
e:
As another example, what if the interest on the
investment compounded monthly instead of
annually, and the amount invested were $8,000 at
the end of month? The calculation is:

P = $8,000 [((1 + .005833)60 -

1) / .005833]
P = $572,737

The .005833 interest rate used in the last

example is 1/12th of the full 7% annual interest
rate.
 Present Value of
a Ordinary
Annuity
An ordinary annuity is a series of
equal payments, with all payments
being made at the end of each
successive period. An example of an
ordinary annuity is a series of rent or
lease payments. The present value
calculation for an ordinary annuity is
used to determine the total cost of an
annuity if it were to be paid right now.
Present Value of
a Ordinary
Annuity
The formula for calculating the present
value of an ordinary annuity is:
P = PMT [(1 - (1 / (1 + r)n)) / r]

Where:
P = The present value of the annuity
stream to be paid in the future
PMT = The amount of each annuity payment
r = The interest rate
n = The number of periods over which
payments are to be made
Exampl
e:
ABC International has committed to a legal
settlement that requires it to pay $50,000 per
year at the end of each of the next ten years.
What would it cost ABC if it were to instead
settle the claim immediately with a single
payment, assuming an interest rate of 5%?
The calculation is:

P = $50,000 [(1 - (1/(1+.05)10))/.05]

P = $386,087
 Future Value of a
Annuity Due
An annuity due is a series of payments made
at the beginning of each period in the series.
Therefore, the formula for the future value of an
annuity due refers to the value on a specific
future date of a series of periodic payments,
where each payment is made at the beginning of
a period. Such a stream of payments is a
common characteristic of payments made to the
beneficiary of a pension plan. These calculations
are used by financial institutions to determine
the cash flows associated with their products.
 Future Value of a
Annuity Due
The formula for calculating the future value of an
annuity due (where a series of equal payments are
made at the beginning of each of multiple consecutive
periods) is:
P = (PMT [((1 + r)n - 1) / r])(1 + r)
Where:
P = The future value of the annuity stream to be
paid in the future
PMT = The amount of each annuity payment
r = The interest rate
n = The number of periods over which payments
are to be made
Exampl
e:
The treasurer of ABC Imports expects to
invest $50,000 of the firm's funds in a long-
term investment vehicle at the beginning of
each year for the next five years. He expects
that the company will earn 6% interest that
will compound annually. The value that these
payments should have at the end of the five-
year period is calculated as:
P = ($50,000 [((1 + .06)5 - 1) / .06])(1 +
.06)
 Present Value of
a Annuity Due
o The present value of an annuity due is used to derive
the current value of a series of cash payments that
are expected to be made on predetermined future
dates and in predetermined amounts. The calculation
is usually made to decide if you should take a lump
sum payment now, or to instead receive a series of
cash payments in the future (as may be offered if
you win a lottery).
o The present value calculation is made with a
discount rate, which roughly equates to the current
rate of return on an investment. The higher the
discount rate, the lower the present value of an
annuity will be. Conversely, a low discount rate
 Present Value of
a Annuity Due
The formula for calculating the present value of an
annuity due (where payments occur at the beginning of
a period) is:
P = (PMT [(1 - (1 / (1 + r)n)) / r]) x
(1+r)

Where:
P = The present value of the annuity stream to be
paid in the future
PMT = The amount of each annuity payment
r = The interest rate
n = The number of periods over which payments
Exampl
e:
ABC International is paying a third party
$100,000 at the beginning of each year for the
next eight years in exchange for the rights to
a key patent. What would it cost ABC if it were
to pay the entire amount immediately,
assuming an interest rate of 5%? The
calculation is:

P = ($100,000 [(1 - (1 / (1 + .05)8)) / .05])

x (1+.05)
P = $678,637
 Present Value of
a Perpetuity

Perpetuity can be defined as the

income stream that the individual gets
for an infinite time period and its
present value is arrived at by
discounting the identical cash flows
with the discounting rate. Here the
cash flows are infinite but its present
value amounts to a limited value.
Present Value of
a Perpetuity

The formula for calculating the

present value of a Perpetuity:
Exampl
e: An individual is offered a bond that
pays coupon payments of $10 per year
and continues for an infinite amount of
time. Assuming a 5% discount rate, the
formula would be written as:

After solving, the amount expected to

pay for this perpetuity would be $200.
 Lesson 4:
Mixed
Streams
Two basic types of cash flow streams are
possible: the annuity and the mixed stream.
Whereas an annuity is a pattern of equal periodic
cash flows, a mixed stream is a stream of unequal
periodic cash flows that reflect no particular pattern.
Financial managers frequently need to evaluate
opportunities that are expected to provide mixed
streams of cash flows. Here we consider both the
future value and the present value of mixed
 Future Value of a
Mixed Stream

The FV of a mixed stream cash

flow refers to the sum of the
expected future value of a stream of
unequal periodic cash flows over a
certain period of time at a given
interest rate.
 Present Value of
a Mixed Stream

The PV of a mixed stream cash

flow is the sum of the expected
current value of future periodic
unequal cash flow over a certain
period of time at a given discount
rate.
 Lesson 5:
Compounding Interest
More Frequently than
Annually
Interest is often compounded more
frequently than once a year. Savings
institutions compound interest
semiannually, quarterly, monthly,
weekly, daily, or even continuously. This
section discusses various issues and
techniques related to these more
 A General Equation for
Compounding More Frequently
Than Annually

The formula for annual compounding

(Equation 5.4) can be rewritten for use
when compounding takes place more
frequently. If m equals the number of
times per year interest is compounded,
the formula for annual compounding can
be rewritten as