Dr.

Axel Grossmann

FINC 3131
Chapter 4
1st Handout
Time Value of Money (Basics)

I) Introduction to Time Value of Money

Single Payments (Lump Sum Payments)
=

Single amount either currently held or expected at some future

date.

Present Value (PV)

The current dollar amount of future cash flows. It is found by

discounting future cash flows.

Future Value (FV)

The value of cash flows at a given future date. It is found by

applying compound interest

Simple Interest

When interest is not earned on prior interest

Compounding

Compound Interest
(Compounding)

When interest is earned on prior periods interest

The impact of compounding becomes more pronounced with
longer periods!

Discounting

The process of finding present values (the inverse of compounding

interest).

Opportunity cost

The rate of return you could earn on an alternative investment with

similar risk

Annuity

A stream of equal periodic cash flows

Ordinary Annuity =

Cash flows occur at the end of each period

Annuity Due

Cash flows occur at the beginning of each period

The Time Line:

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

II) Future and Present Value

A) Future Value and Compounding
Example:
Initial Investment (PV):

$100 Lump sum

Interest Rate (I):

5%

Over 3 years (N):

3 years

Simple Interest

Compound Interest
There are four ways of solving TVM problems:

1) Step-by-Step:
1

100

x 1.05

105

x 1.05

110.25

x 1.05

2) Formula:

3) Financial Calculator:
PV
FV
N
I
PMT

=
=
=
=
=

-100
?
3
5
0

Solve for future value CPT FV =

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

Table: Value of $100 at 5% over 100 years

Simple Interest
Year

Beginning Amount

Interest Earned

Ending Amount

100

105

105

110

110

115

115

120

120

125

10

200

150

100

595

600

Simple Interest

FV

Simple Interest after 10 years

FV

PV + (PV x I x N)

Compound Interest
Year

Beginning Amount

Interest Earned

Ending Amount

100.00

5.00

105.00

105.00

5.25

110.25

110.25

5.51

115.76

115.76

5.79

121.55

121.55

6.08

127.63

10

155.13

7.76

162.89

100

12523.93

626.20

13150.13

Compound Interest

FV PV 1 I

Compound Interest after 10 years

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

The Future Value of $1 (Future Value Interest Factor)

Assuming compounding interest, the future value depends on the interest rate and the time
period.

Ross, Westfield, Jordan Essentials of Corporate Finance 8e, page 101

Future value factors

Ross, Westfield, Jordan Essentials of Corporate Finance 8e, page 101

Example:
The future value factor is 1 I N
At 5% interest and 5 years:
Assume you invested a $100 at 5%, 5 years ago. Calculate the future value!
In class examples

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

Example 1:
In 1626, Peter Minuit bought all of Manhattan Island for about $24 in goods from the
Indians. Was that a good or bad deal for the Indians?
Assume the Indians could have sold the goods for $24 and invested the money at
10% till today?
N = 2013 1626 = 387

Assume the Indians could have sold the goods for $24 and invested the money at
5% till today?

Example 2:
You had a grand grandfather who deposited $1 ($10, $100) 100 years ago at 10%
interest for you. How much would you receive today?

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

B) Present Value and Discounting

Example:
An investment pays $1100 in 3 years. What would you be willing to pay for the bond if
banks are currently paying 5% interest for securities with similar risk (opportunity cost)?
Payment at end of period (FV):

$1100 Lump sum

Interest Rate (I):

5%

Over 3 years (N):

3 years

1) Step-by-Step:
1

/ 1.05
/ 1.05
/ 1.05

1,100

1,047.62

997.73

2) Formula:

3) Financial Calculator:
PV
FV
N
I
PMT

=
=
=
=
=

?
1,100
3
5
0

Solve for present value CPT PV =

Dr. Axel Grossmann

FINC 3131
Chapter 4
1st Handout

The Present Value of $1 (Present Value Interest Factor)

Ross, Westfield, Jordan Essentials of Corporate Finance 8e, page 108

Present value factors

Ross, Westfield, Jordan Essentials of Corporate Finance 8e, page 108

Example:
The present value factor is

1 I N

Assume you will receive $1100 at 5% in 3 years. What is the investment worth to you today?