Financial Management

Session -#
Time Value of Money

Time Value of Money

Would you prefer to have $1 million now or $1
million 10 years from now?
Of course, we would all prefer the money now!
This illustrates that there is an inherent monetary
value attached to time.

Time Value of Money

A dollar received today is worth more than a
dollar received tomorrow
The time value of money is a recognition that
money received today is worth more than an
equal amount of money received months or years
in the future:
Why TIME is such an important element in decision?
This is because a dollar received today can be invested
to earn interest
Cash flows for the future are uncertain
The amount of interest earned depends on the rate of
return that can be earned on the investment
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Time Value of Money

Compounding Technique
Translating a current value into its equivalent
future value is referred to as compounding.
Used to estimate the future value of money
FV is higher than the PV

Discounting Technique
Translating a future cash flow or value into its equivalent
value in a prior period is referred to as discounting.
Used to estimate the present value of money
PV is less than the future value

Time Value of Money

Time Value of Money, or TVM, is a concept that is
used in all aspects of finance including:

Bond valuation
Stock valuation
Accept/reject decisions for project management
Financial analysis of firms
And many others!

PV & FV
If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500.
In the one-period case, the formula for FV can be
written as:

FV = C0(1 + r)
Where C0 is cash flow today (time zero), and
r is the appropriate interest rate.

PV & FVContd

In the one-period case, the formula for PV can

be written as:
C1
PV
1 r
WhereC1 iscashflowatdate1,and
ristheappropriateinterestrate.
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FV for Multi-Period
The general formula for the future value of an
investment over many periods can be written
as:
FV = C0(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.

Exercise: FV
Suppose a stock currently pays a dividend of $1.10,
which is expected to grow at 40% per year for the
next five years.
What will the dividend be in five years?
FV = C0(1 + r)T
$5.92 = $1.10(1.40)5

Exercise: FV

Assume Joe has the same cash flow stream from his
investment but wants to know what it will be worth
at the end of the fourth year
1. Draw a timeline:
$100

$300

$500

$1000

4
$1000

i = 10%

?
?

?
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Exercise: PV

What is the PV of this uneven cash flow stream?

We can always treat each CF as a separate lump sum,

discount each CF to PV separately, and sum up the PVs

$100

$300

10%

3
$300

4
-$50

90.91
247.93
225.39
-34.15
$530.08 = PV
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The
Compounding an investment m times a year for T years
provides for future value of wealth:

FV C0 1
m

mT

If you invest $50 for 3 years at 12% compounded

semi-annually, what amount will you expect at the
end of 3 years?

.12
FV $50 1

23

$50 (1.06) $70.93

6

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Continuous Compounding
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C0erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal to
2.718.
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The Power of Compound Interest

A 20-year-old student wants to save $3 a day for her
retirement. Every day she places $3 in a drawer. At
the end of the year, she invests the accumulated
savings ($1,095) in a brokerage account with an
expected annual return of 12%.
How much money will she have when she is 65 years
old?
If she sticks to her plan, she will have $1,487,261.89 when
she is 65.

What if she sticks to the plan but returns compounded

on daily basis?
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The Power of Compound InterestContd

If you dont start saving until you are 40 years old,
how much will you have at 65?
If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $146,000.59 at
age 65. This is $1.3 million less than if starting at age
20.
Lesson: It pays to start saving early.

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The Power of Compound InterestContd

How much must the 40-year old deposit annually to
catch the 20-year old?
To find the required annual contribution, enter the
number of years until retirement and the final goal of
$1,487,261.89, and solve for PMT.

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The Power of Compound InterestContd

If you invest $1000 for a year @10% rate of annual
interest, what will be the value after the end of the
year, if interest is compounded yearly, half-yearly,
Quarterly.
Frequency No.
Future value
Yearly
1
1100
Half-yly
2
1102.5
Qtly
4
1103.81
Monthly
12
1104.71
Weekly
52
1105.06
Daily
365
1105.16
Continuous
1105.17
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Simplifications
Perpetuity
A constant stream of cash flows that lasts forever

Growing perpetuity
A stream of cash flows that grows at a constant rate forever

Annuity
A stream of constant cash flows that lasts for a fixed
number of periods

Growing annuity
A stream of cash flows that grows at a constant rate for a
fixed number of periods

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Perpetuity
A constant stream of cash flows that lasts forever
C

C
C
C
PV

2
3
(1 r ) (1 r ) (1 r )
C
PV
r
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Exercise: Perpetuity
What is the value of a bond that promises to pay 15
every year for ever?
The interest rate is 10-percent.

15

15

15

15
PV
150
.10
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Growing Perpetuity
A growing stream of cash flows that lasts forever
C

C(1+g)

C (1+g)2

C
C (1 g ) C (1 g )
PV

2
3
(1 r )
(1 r )
(1 r )
2

C
PV
rg
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Exercise: Growing Perpetuity

The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever. If the
discount rate is 10%, what is the value of this
promised dividend stream?
$1.30

$1.30(1.05)

$1.30 (1.05)2

$1.30
PV
$26.00
.10 .05
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Annuity
A constant stream of cash flows with a fixed maturity
C

C
C
C
C
PV

2
3
T
(1 r ) (1 r ) (1 r )
(1 r )
C
1
PV 1
T
r (1 r )
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Exercise: Annuity
If you can afford a $400 EMI for car loan, how much
car loan can you afford if interest rates are 7% for 36month?
$400

$400

$400

$400

36

$400
1
PV
$12,954.59
1
36
.07 / 12 (1 .07 12)
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Exercise: AnnuityContd
What is the present value of a four-year annuity of
$100 per year that makes its first payment two years
from today if the discount rate is 9%?
4

PV1
t 1

$297.22

$100
$100
$100
$100
$100

$323.97
1
2
3
4
t
(1.09) (1.09) (1.09) (1.09) (1.09)

$323.97

$100

$327 .97
PV
$297 .22
0
1.09

$100

$100

$100

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Exercise: AnnuityContd
Whats the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?
Compound each cash flow

Payments occur annually, but compounding occurs

every 6 months.
Cannot use normal annuity valuation techniques.

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Exercise: AnnuityContd
Whats the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?
0

5%

100

100

100
110.25
121.55
331.80

FV3 = $100(1.05)4 + $100(1.05)2 + $100

FV3 = $331.80
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Growing Annuity
A growing stream of cash flows with a fixed maturity
C

C(1+g)

C (1+g)2

C(1+g)T-1

C
C (1 g )
C (1 g )
PV

T
2
(1 r )
(1 r )
(1 r )

T 1

1 g
C

PV
1
r g (1 r )

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Exercise: Growing Annuity

A defined-benefit retirement plan offers to pay
$20,000 per year for 40 years and increase the annual
payment by 3% each year. What is the present value
at retirement if the discount rate is 10%?
$20,000

$20,000(1.03) $20,000(1.03)39

40

40

$20,000
1.03
PV
$265,121.57
1
.10 .03 1.10
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Exercise: Growing Annuity

You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?

$8,500 (1.07) 2
$8,500 (1.07) 4
$8,500 (1.07)
$8,500 (1.07) 3
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0
1
$34,706.26

5
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What Is a Firm Worth?

Conceptually, a firm should be worth the present
value of the firms cash flows.
The tricky part is determining the size, timing, and
risk of those cash flows.

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Thank You!

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