The Time Value of Money

Prof. Ron Romero

Basic Business Finance 2

The Time Value of Money

 Time Value

• Process of expressing
–the present in the future
(compounding)
–the future in the present
(discounting)
 Time Value

• Payments are either

–a single payment
–a series of equal payments
(an annuity)
 Time Value

• Time value of money problems

may be solved by using
–Interest tables
–Financial calculators
–Software
 Variables for Time Value of
Money Problems

• PV = present value
• FV = future value
• PMT = annual payment
• N = number of time periods
• I = interest rate per period
 Financial Calculators
• Express the cash inputs (PV, FV,
and PMT) as cash inflows and
cash outflows

• At least one of the cash variables

must be
–an inflow (+)
–an outflow (-)
 Future Value
• Future value of $1 takes a single
payment in the present into the
future

• General equation for the future

value of $1:

P0(1 + i)n = Pn
 Future Value Formula
• General equation for the future
value of

FV = PV(1 + i)n
PV = Present Value
r = rate of return
n = number of periods
 Future Value Illustrated

• PV = -100
• I=5
• N = 20
• PMT = 0
• FV = ?
 Future Value Illustrated

• PV = -100
• I=5
• N = 20
• PMT = 0
• FV = ?

• = 265.33
 Greater Terminal Values

• Higher interest rates

• Longer time periods

• Result in greater terminal values

Greater Terminal Values
 Present Value
• Present value of $1 brings a
single payment in the future
back to the present
• General equation for the present
value of $1:
P0 = Pn
(1+i)n
 Present Value Illustrated

• FV = 100
• I=6
• N=5
• PMT = 0
• PV = ?
 Present Value Illustrated

• FV = 100
• I=6
• N=5
• PMT = 0
• PV = ?

• = -74.73
 Lower Present Values

• Higher interest rates

• Longer time periods

• Result in lower present values

Lower Present Values
 Annuities - Future Sum

• Future sum of annuity takes a

series of payments into the future

• Payments may be made

–at the end of each time period
(ordinary annuity)
–at the beginning of each
time period (annuity due)
 FV Time Lines

•Ordinary annuity
0 1 2 3
Year
Payment - $100 100 100
 FV Time Lines

•Annuity due
0 1 2 3
Year
Payment $100 100 100 -
 Future Value of an
Ordinary Annuity Illustrated
• PV = 0
• PMT = -100
• I=5
• N=3
• FV = ?
 Future Value of an
Ordinary Annuity Illustrated
• PV = 0
• PMT = -100
• I=5
• N=3
• FV = ?

• = 315.25
 Greater Terminal Values

• Higher interest rates

• Longer time periods

• Result in greater terminal values

Greater Terminal Values
 Present Value of an Annuity

• The present value of an annuity

brings a series of payments in the
future back to the present
 Present Value of an
Ordinary Annuity Illustrated
• FV = 0
• PMT = 100
• I=6
• N=3
• PV = ?
 Present Value of an
Ordinary Annuity Illustrated
• FV = 0
• PMT = 100
• I=6
• N=3
• PV = ?

• = -267.30
 Annuities - Present Value
• Higher interest rates result in
lower present values

• But longer time periods

increases the present value
(because more payments are
received)
Annuities - Present Value
Additional Time Value Illustrations

• The following is a series of

problems or questions that
use the time value of money.
 Illustration 1

• You deposit $1,000 in an account

at the end of each year for
twenty years. What is the total
amount in the account if you
earn 6 percent annually?
 Future Value of an
Ordinary Annuity
• The unknown: FV
• The givens:
–PV = 0
–PMT = -1,000 The answer:
–N = 20
–I = 6
 Future Value of an
Ordinary Annuity
• The unknown: FV
• The givens:
–PV = 0
–PMT = -1,000 The answer:
$36,786
–N = 20
–I = 6
 Interpretation
• For an annual cash payment of
$1,000, you will have $36,786
after twenty years

• Of the $36,786
–$20,000 is the total cash outflow
–$16,786 is the earned interest
 Illustration 2

• What is the present value of (or

required cash outflow to
purchase) an ordinary annuity of
$1,000 for twenty years, if the
rate of interest is 6 percent?
 Present Value of an Annuity
• The unknown: PV
• The givens:
–FV = 0
–PMT = 1,000 The answer:
–N = 20
–I = 6
 Present Value of an Annuity
• The unknown: PV
• The givens:
–FV = 0
–PMT = 1,000 The answer:
$11,470
–N = 20
–I = 6
 Interpretation
• For a present payment of $11,470,
the individual will annually receive
$1,000 for the next twenty years

• The $11,470 is an immediate cash

outflow

• The $1,000 annual payment to be

received is a cash inflow
 Illustration 3

• You buy a stock for $10 and

expect the price to increase 9
percent annually. After 10 years,
what is the anticipated price of
the stock?
 Future Value of $1
• The unknown: FV
• The givens:
–PV = 10
–PMT = 0 The answer:
–N = 10
–I = 9
 Future Value of $1
• The unknown: FV
• The givens:
–PV = 10
–PMT = 0 The answer:
–N = 10 $23.67
–I = 9
 Interpretation

• A $10 stock will be worth $23.67

after 10 years if its price grows
9% annually.
 Illustration 4

• What is the cost of a stock that

was sold for $23.67, held for 10
years and whose value
appreciated 9 percent annually?
 Present Value of $1
• The unknown: PV
• The givens:
–FV = 23.67
–PMT = 0 The answer:
–N = 10
–I = 9
 Present Value of $1
• The unknown: PV
• The givens:
–FV = 23.67
–PMT = 0 The answer:
$10
–N = 10
–I = 9
 Interpretation

• $23.67 received after ten years is

worth $10 today if the rate of
return is 9 percent.
 Interpretation of Future and
Present Values
These two problems are the same:

• In the first case the $10 is

compounded into its future value
($23.67)

• In the second case the future value

($23.67) is discounted back to its
present value ($10)
 Illustration 5

• A stock was purchased for $10

and sold for $23.67 after 10 years.
What was the return?
Future Determination of the Interest Rate

• The unknown: I
• The givens:
–PV = 10
–PMT = 0 The answer:
–N = 0
–FV = 23.67
Future Determination of the Interest Rate

• The unknown: I
• The givens:
–PV = 10
–PMT = 0 The answer:
–N = 0 9%
–FV = 23.67
 Interpretation

• The yield on a $10 investment

that was sold after 10 years for
$23.67 is 9%.
 Illustration 6

• If an investment pay $50 a year

for 10 years and repays $1,000
after 10 years, what is this
investment worth today if you can
earn 6 percent?
Determination of Present Value
• The unknown: PV
• The givens:
–FV = 1,000
–PMT = 50 The answer:
–I = 6
–N = 10
Determination of Present Value
• The unknown: PV
• The givens:
–FV = 1,000
–PMT = 50 The answer:
$926
–I = 6
–N = 10
 Interpretation

• If you collect $50 a year for 10

years and receive $1,000 after 10
years, those cash inflows are
currently worth $926 at 6
percent.
 Illustration 7

• Time value is used to determine

a loan repayment schedule such
as a mortgage.
 Loan Repayment Schedule
• Amount borrowed (PV) = $80,000
• Interest rate (I) = 8%
• Term of the loan (N) = 25 years
• No future value since loan is
repaid
• Amount of the annual payment =
$7,494.30
Loan Repayment Schedule
Principal Balance
Pmnt Interest Repayment Owed
1 $6,400.00 $1,094.15 $78,905.85
2 6,312.47 1,181.68 77,724.17
. . . .
. . . .
. . . .
25 555.13 6,939.17 .00
 Illustration 8

• You have $170,000 and spend

$36,000 a year. If you earn 8%
annually, how long will your
funds last?
 Determination of
Number of Years

• The unknown: N
• The givens:
–PV = 170,000
–I = 8 The answer:
–FV = 0
–PMT = -36,000
 Determination of
Number of Years

• The unknown: N
• The givens:
–PV = 170,000
–I = 8 The answer:
6.2 years
–FV = 0
–PMT = -36,000
 Interpretation

• If you have $170,000 and earn 8

percent annually, you can spend
$36,000 per year for
approximately 6 years and 2
months.
 Non-annual Compounding

• More than one interest payment

a year

• More frequent compounding

 Non-annual Compounding

• Multiply number of years by

frequency of compounding

• Divide interest rate by frequency

of compounding
 Non-annual Compounding
Illustration
• What is the future value of $100 that
pays 8 percent compounded
quarterly for five years?
 Answer

• FV = $100 (1+0.08/4) 5x4

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 Answer

• FV = $100 (1+0.08/4) 5x4

= $100 (1+0.02)20
 Answer

• FV = $100 (1+0.08/4) 5x4

= $100 (1+0.02)20
= $148.59
Periods less than One Year

• Same variables as in all time

value problems except N < 1.
 Illustration

• What is the return on an

investment that costs $98,543
and pays $100,000 after 45
days?
 Determination of Return

• The unknown: I
• The givens:
–PV = -98,543
–N = 0.1233 The answer:
–FV = 100,000
–PMT = 0
 Determination of Return

• The unknown: I
• The givens:
–PV = -98,543
–N = 0.1233 The answer:
12.64%
–FV = 100,000
–PMT = 0
 Interpretation

• $98,543 invested for 45 days

grows to $100,000 at 12.64
percent.
Fin