Time Value of Money

Family Economics & Financial Education

Time Value of Money

Time value of money -- Money to be paid out or received in the future is not equivalent to money paid out or received today

The Time Value of Money

Which would you rather have -- `1,000 today or Rs 1,000 in 5 years? Obviously, `1,000 today. Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Why TIME?
TIME allows one the opportunity to postpone consumption and earn INTEREST. NOT having the opportunity to earn interest on money is called OPPORTUNITY COST.

Compounding Interest
Compounding interest -- Earning interest on interest Make your money work for you
Developed because compounding interest causes money to make money Rs1,000 Invested Compounded Annually at 10% Interest Rate 1 Year Rs1,104.71 2 Years Rs1,220.39

Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest. FV = Principal + (Principal x Interest) = 2000 + (2000 x .06) = 2000 (1 + i) = PV (1 + i) Note: PV refers to Present Value or Principal FV refers to Future Value or Amount

Double Your money!!!

Quick! How long does it take to double Rs5,000 at a compound rate of 12% per year (approx.)?

We will use the Rule-of-72.

The Rule-of-72
Quick! How long does it take to double Rs5,000 at a compound rate of 12% per year (approx.)?

Approx. Years to Double = 72 / i%

= 72 / 12% = 6 Years [Actual Time is 6.12 Years]

Problem #1
You must decide between Rs25,000 in cash today or Rs 30,000 in cash to be received two years from now. If you can earn 8% interest on your investments, which is the better deal?

Possible Answers - Problem 1

Rs25,000 in Cash today Rs30,000 in cash to be received two years from now Either option is OK

Need a Hint?

Problem #2
What is the value of Rs100 per year for four years, with the first cash flow one year from today, if one is earning 5% interest, compounded annually? Find the value of these cash flows four years from today.

Possible Answers - Problem 2

Rs400 Rs431.01 Rs452.56

Simple Interest
Simple interest -- Interest earned on the principal investment
Principal -- The original amount of money invested or saved

Amount invested x annual interest rate x number of years = interest earned

Ex. 1,000 x 0.10 x 2=Rs200
Rs1,000 Invested at 10% Simple Interest Rate 1 Year Rs1,100.00 2 Years Rs1,200.00

Three Factors Affecting the Time Value Calculations Time Amount invested Interest rate

Annuities
An

Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.

Examples of Annuities Include:

Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

Example of an Ordinary Annuity -- FVA

End of Year

0 7%

1 $1,000

2 $1,000

3 $1,000

$934.58 $873.44 $816.30 $2,624.32 = PVA3 FVA3 = Rs1,000(1.07)2 + Rs1,000(1.07)1 + Rs1,000(1.07)0 = Rs3,215
If one saves Rs1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?

Multiple Cash Flows Example

Suppose an investment promises a cash flow of Rs500 in one year, Rs600 at the end of two years and Rs10,700 at the end of the third year. If the discount rate is 5%, what is the value of this investment today?

5%

Rs500 PV0

Rs600 Rs10,700

Multiple Cash Flow Solution

0
Rs476.19 Rs544.22 Rs9,243.06

1
5% 500

Rs600 Rs10,700

Rs10,263.47 = PV0 of the Multiple Cash Flows

Time
The earlier an individual invests, the more time their investment has to compound interest and increase in value

A Little Goes a Long Way

Sally Saver puts away Rs3,000 per year in her IRA account earning 10% - she does this for 10 years then stops. Sally accumulates Rs1,239,564 by the age of 65.
Ed Uninformed waits until he is 28. He must contribute Rs3,000 to his IRA account earning 10% for 38 years. Ed accumulates Rs1,102,331 by the age of 65

Amount Invested
Investing only a small amount a month is better than not investing at all
Ex. At 8% interest, invested at age 17, one dollar per day will become $17,865.52 by age 65

The larger the amount invested the greater return a person will earn Always pay yourself first
Savings should be a fixed expense

Amount Invested continued

70-20-10 Rule
70% Spent 20% Saved 10% Invested

Flexible expenses can be decreased in order to increase the amount a person is able to invest

The Costs Adds Up

Investing at age 18 at 8% interest until age 65. Item Daily cup of coffee at Rs2.50 Eating lunch out 5 days per week at a cost of Rs5Rs10 each time
Daily can of soda or chips at $1.00 each or both a can of pop and chips $2.00 Daily candy at Rs1.00

Average Yearly Expense Rs912.50 Rs1,300.00-Rs2,600.00

Future Value Rs38,704.46 Rs55,140.60 Rs1,10281.21

$15,481.78 $30,963.57

$365.00 $730.00

Rs365.00

Rs15,481.78

Interest Rate
The percentage rate paid on the money invested or saved Higher interest=more money earned
Rs1,000 Invested Compounded Monthly Interest Rate 4% 6% 1 Year Rs1,040.74 Rs1,061.68 5 Years Rs1,221.00 Rs1,348.85 10 Years Rs1,490.83 Rs1,819.40

Risk
A higher interest rate generally has a greater risk
Risk -- The uncertainty of the outcome of an investment

Fixed Interest Rate

Fixed interest rate -- The rate will not change for the lifetime of the investment Having a savings or investment plan with a fixed interest rate guarantees a specific return but can provide a moderate risk
If the average interest rates rise, the amount a person earns from this type of investment will not increase

Inflation
Another consideration with interest rates is ensuring the interest rate is higher than the rate of inflation
Inflation -- The steady rise in the general level of prices Ex. If an individual has money invested at 4% interest and the inflation rate is 4%, the individuals wealth will stay the same

Time Value of Money Calculations

Present value
PV=(FV)(1+i)-N

Future value
FV=(PV)(1+i)N

Financial calculators may be used to complete these calculations.

HP 17 B II Calculator FINANCIAL CALCULATOR

Calculation Components
Present value (PV) -- How much money a person

has today
Future value (FV) How much money a person

expects to have in the future Interest rate (i) The percentage rate paid on the money invested or saved Time (N) -- Length of investment
Calculated by the number of compounding periods (daily, monthly, or annually)

Review
Compounding interest earns interest on interest Increased time=more interest earned Higher principle=more interest earned Higher interest rate=more interest earned