Time is more value than money.

You can get more money, but you

cannot get more time.Jim Rohn
SAJID MIR SHAIKH
2
Future value

Present Value

Ordinary Annuity and Annuity Due

Nominal Interest rate.

Effective Annual rate EAR)

Amortization
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3
What is The Time Value of Money?
A dollar received today is worth more than
a dollar received tomorrow

This is because a dollar received today
can be invested to earn interest
The amount of interest earned
depends on the rate of return that can
be earned on the investment.

Time value of money quantifies the value
of a dollar through time
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4
Basic Rules
The following are simple rules that you should
always use no matter what type of TVM problem
you are trying to solve:

1. Stop and think: Make sure you understand
what the problem is asking. You will get the
wrong answer if you are answering the wrong
question.

2. Draw a representative timeline and label the
cash flows and time periods appropriately.

3. Write out the complete formula using symbols
first and then substitute the actual numbers to
solve.
4. Check your answers using a calculator.

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TIME allows one the opportunity to
postpone consumption and earn
INTEREST.

NOT having the opportunity to earn interest
on money is called OPPORTUNITY
COST.

Why TIME?

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5
Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!
The Interest Rate
Which would you prefer -- $10,000 today or
$10,000 in 5 years?
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6
Types of Interest
o Compound Interest
o Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
o Simple Interest
o Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
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7
Simple Interest Formula
Formula SI = P
0
(i)(n)

SI: Simple Interest
P
0
: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
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8
SI = P
0
(i)(n)
= $1,000(.07)(2)
= $140
Simple Interest Example
Assume that you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?
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General Formula:
FV
n
= PV
0
(1 + [i/m])
mn

n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FV
n,m
: FV at the end of Year n
PV
0
: PV of the Cash Flow today
Frequency of Compounding
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10
11
The Millionaire
Game:
A Perfect
Metaphor For
Compound
Interest
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12
A: Answer A
C: Answer C
B: Answer B
D: Answer D
50:50
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
$1 Million
$500,000
$250,000
$125,000
$64,000
$32,000
$16,000
$8,000
$4,000
$2,000
$1,000
$500
$300
$200
$100
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Julie Miller has $1,000 to invest for 2 Years at an annual
interest rate of 12%.

Annual FV
2
= 1,000(1+ [.12/1])
(1)(2)

= 1,254.40
Semi FV
2
= 1,000(1+ [.12/2])
(2)(2)

= 1,262.48
Impact of Frequency
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13
Qrtly FV
2
= 1,000(1+ [.12/4])
(4)(2)

= 1,266.77

Monthly FV
2
= 1,000(1+ [.12/12])
(12)(2)

= 1,269.73

Daily FV
2
= 1,000(1+[.12/365])
(365)(2)

= 1,271.20
Impact of Frequency
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15
Time lines show timing of cash
flows.
CF
0
CF
1
CF
3
CF
2
0 1 2 3
i%
Tick marks at ends of periods.
Time 0 is today; Time 1 is the end of Period 1; or the beginning of
Period 2.

90% of getting a Time Value problem correct is setting up the
timeline correctly!!!
Interest Rate
Cash Flows
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16
100
0 1 2 Year
i%
Time line for a $100 lump sum due at the end of Year 2.
100 100 100
0 1 2 3
i%
Time line for an ordinary annuity of $100 for 3 years.
100 50 75
0 1 2 3
i%
-50
Time line for uneven CFs: -$50 at t = 0 and $100, $75, and $50 at
the end of Years 1 through 3.
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Translate Rs.1 today into its equivalent in the future
(compounding).






Translate Rs.1 in the future into its equivalent today
(discounting).
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17
18
FUTURE VALUE
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19
Single Sum - Future & Present Value
Assume can invest PV at interest rate i to receive future sum, FV
Similar reasoning leads to Present Value of a Future sum today.
1 2 3 0
FV
1
= (1+i)PV
FV
3
= (1+i)
3
PV
PV
FV
2
= (1+i)
2
PV
1 2 3 0
PV = FV
1
/(1+i)
FV
1

PV = FV
2
/(1+i)
2

FV
2

PV = FV
3
/(1+i)
3

FV
3

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Whats the FV of an initial Rs.1000
after 1 years if i = 10%?
FV = ?
0 1
10%
Finding FVs (moving to the right on a time line) is called compounding.
+
INTREST
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20
After 1 year:
FV
1
= PV + INT
1
= PV + PV (i)
= PV(1 + i)
= Rs.1000(1.10)
= Rs.1100.00.
After 2 years:
FV
2
= FV
1
(1+i) = PV(1 + i)(1+i)
= PV(1+i)
2
= Rs.1000(1.10)
2

= Rs.1210.00.
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21
After 3 years:
FV
3
= FV2(1+i)=PV(1 + i)
2
(1+i)
= PV(1+i)
3
= Rs.1000(1.10)
3

= Rs.1330.10.
In general,
FV
n
= PV(1 + i)
n
.

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Spreadsheet Solution
Use the FV function

= FV(Rate, Nper, Pmt, PV)

= FV(0.10, 3, 0, -1000) = 1330.10
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10%
Whats the PV of $100 due in 3
years if i = 10%?
Finding PVs is discounting, and its the reverse of
compounding.
100
0 1 2 3
PV = ?
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Solve FV
n
= PV(1 + i )
n
for PV:
( )
PV =
FV
1+i
= FV
1
1+i
n
n
n
n
|
\

|
.
|
( )
PV = $100
1
1.10

= $100 0.7513 = $75.13.
|
\

|
.
|
3
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Spreadsheet Solution
Use the PV function:

= PV(Rate, Nper, Pmt, FV)

= PV(0.10, 3, 0, 100) = -75.13
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Finding the Time to Double
20%
2
0 1 2 ?
-1
FV = PV(1 + i)
n

$2 = $1(1 + 0.20)
n

(1.2)
n
= $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
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Spreadsheet Solution
Use the NPER function: see
spreadsheet.

= NPER(Rate, Pmt, PV, FV)

= NPER(0.10, 0, -1, 2) = 3.8

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Finding the Interest Rate
?%
2
0 1 2 3
-1
FV = PV(1 + i)
n

$2 = $1(1 + i)
3

(2)
(1/3)
= (1 + i)
1.2599 = (1 + i)
i = 0.2599 = 25.99%.
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Spreadsheet Solution
Use the RATE function:

= RATE(Nper, Pmt, PV, FV)

= RATE(3, 0, -1, 2) = 0.2599

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Cash flow / PMT.

Out flow=Deposit / Inflow=Receipt.

Consol

Terminal Valve= Fv of uneven cash flow.

Annual Compounding.

Quarterly, Monthly, Daily Compounding

Nominal Rate= APR
Types of Annuities
Ordinary Annuity: Payments or receipts occur at the end
of each period.
Annuity Due: Payments or receipts occur at the
beginning of each period.
An Annuity represents a series of equal payments (or
receipts) occurring over a specified number of
equidistant periods.
0 1 2 3 4
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Examples of Annuities
Student Loan Payments

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings
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Ordinary Annuity
PMT PMT PMT
0 1 2 3
i%
PMT PMT
0 1 2 3
i%
PMT
Annuity Due
Whats the difference between an ordinary
annuity and an annuity due?
PV FV
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Year end
Investment
(1.12)
2
R 112.00
R 125.44
R 337.44
(1.12)
1
2 3
R 100.00
1
R 100.00 R 100.00
0
Future value of an annuity (FVA) at 12%
What is the future value of an
Ordinary Annuity?
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35
FV Annuity Formula
The future value of an annuity with n periods and an
interest rate of i can be found with the following
formula:
44 . 337
12 .
100 =
+
=
+
=
0.12
1 ) 0 (1
i
1 i) (1
PMT
3
n
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Spreadsheet Solution
Use the FV function

= FV(Rate, Nper, Pmt, Pv)

= FV(0.12, 3, -100, 0) = 337.44
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Present Value of an Annuity
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38
100 100 100
0 1 2 3
12%
90.91
82.64
75.13
240.183 = PV
PV Annuity Formula
The present value of an annuity with n periods and an
interest rate of i can be found with the following
formula:
183 . 240
12 .
100 =
+
=
+
=
0.12
) 0 (1
1
1-
i
i) (1
1
1-
PMT
3
n
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Spreadsheet Solution
Use the PV function: see
spreadsheet.

= PV(Rate, Nper, Pmt, Fv)

= PV(0.12, 3, 100, 0) = -240.183
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Perpetuities
Suppose you will receive a fixed payment
every period (month, year, etc.) forever.
This is an example of a perpetuity.

You can think of a perpetuity as an
annuity that goes on forever.
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What should you be willing to pay in order to
receive $10,000 annually forever, if you
require 8% per year on the investment?
PMT $10,000
i .08

= $125,000
PV = =
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42
Find the FV and PV if the
annuity were an annuity due.
100 100
0 1 2 3
10%
100
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43
PV and FV of Annuity Due
vs. Ordinary Annuity
PV of annuity due:
= (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56

FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1
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Excel Function for Annuities Due

Change the formula to:

=PV(10%,3,-100,0,1)


The fourth term, 0, tells the function there are no
other cash flows. The fifth term tells the
function that it is an annuity due. A similar
function gives the future value of an annuity
due:

=FV(10%,3,-100,0,1)
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What is the PV of this uneven cash
flow stream?
0
100
1
300
2
300
3
10%
-50
4
90.91
247.93
225.39
-34.15
530.08 = PV
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Annual Effective Rate
1 -
m
Rn
1 Rate Effective
m
(

+ =
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Annual Effective Rate

Interest rates quoted by three banks:

Bank X: 15%, compounded daily

Bank Y: 15.5%, compounded quarterly

Bank Z: 16%, compounded annually

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48
Annual Effective Rate
16% 1 -
1
0.16
1 Rate Effective
16.42% 1 -
4
0.155
1 Rate Effective
16.18% 1 -
365
0.15
1 Rate Effective
1
z Bank
4
Y Bank
365
X Bank
=
(

+ =
=
(

+ =
=
(

+ =
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Can the effective rate ever be equal
to the nominal rate?
Yes, but only if annual compounding is used,
i.e., if m = 1.


If m > 1, EFF% will always be greater than the
nominal rate.
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50
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step
3)
5. Start again at Step 2 and repeat.
Steps to Amortizing a Loan
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Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV
0
= R (PVIFA
i%,n
)
$10,000 = R (PVIFA
12%,5
)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Amortizing a Loan Example
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Amortizing a Loan Example
End of
Year
Payment Interest Principal Ending
Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
[Last Payment Slightly Higher Due to Rounding]
i
Per
= 11.33463%/365
= 0.031054% per day.
FV=?
0 1 2 273
0.031054%
-100
Note: % in calculator, decimal in equation.
( )
( )
FV = $100 1.00031054
= $100 1.08846 = $108.85.
273
273
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54
55
ANY QUESTION
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