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Time Value of

Money

3-1

The Time Value of Money

Concept:

- States that the amount of

money today is different from

what it will be in the future.

3-3

The Time Value of Money

Simple Interest

Compound Interest

Amortizing a Loan

Compounding More Than

Once per Year

3-4

The Interest Rate

today or $10,000 in 5 years?

TIME VALUE TO MONEY!!

3-5

Why TIME?

element in your decision?

postpone consumption and earn

INTEREST.

3-6

Types of Interest

Simple Interest

Interest paid (earned) on only the original

amount, or principal, borrowed (lent).

Compound Interest

Interest paid (earned) on any previous

interest earned, as well as on the

principal borrowed (lent).

3-7

Simple Interest Formula

Formula SI = P0(i)(n)

SI: Simple Interest

P0: Deposit today (t=0)

i: Interest Rate per Period

n: Number of Time Periods

3-8

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?

SI = P0(i)(n)

= $1,000(.07)(2)

= $140

3-9

Simple Interest (FV)

What is the Future Value (FV) of the

deposit?

FV = P0 + SI

= $1,000 + $140

= $1,140

FutureValue is the value at some future

time of a present amount of money, or a

series of payments, evaluated at a given

interest rate.

3-10

Simple Interest (PV)

What is the Present Value (PV) of the

previous problem?

The Present Value is simply the

$1,000 you originally deposited.

That is the value today!

PresentValue is the current value of a

future amount of money, or a series of

payments, evaluated at a given interest

3-11

rate.

Future Value

Single Deposit (Graphic)

Assume that you deposit $1,000 at

a compound interest rate of 7% for

2 years.

0 1 2

7%

$1,000

FV2

3-13

Future Value

Single Deposit (Formula)

FV1 = P0 (1+i)1 = $1,000 (1.07)

= $1,070

Compound Interest

You earned $70 interest on your $1,000

deposit over the first year.

This is the same amount of interest you

would earn under simple interest.

3-14

Future Value

Single Deposit (Formula)

FV1 = P0 (1+i)1 = $1,000 (1.07)

= $1,070

FV2 = FV1 (1+i)1

= P0 (1+i)(1+i) = $1,000(1.07)(1.07)

= P0 (1+i)2 = $1,000(1.07)2

= $1,144.90

You earned an EXTRA $4.90 in Year 2 with

3-15

compound over simple interest.

General Future

Value Formula

FV1 = P0(1+i)1

FV2 = P0(1+i)2

etc.

FVn = P0 (1+i)n

or FVn = P0 (FVIFi,n) -- See Table I

3-16

Valuation Using Table I

FVIFi,n is found on Table I.

Period 6% 7% 8%

1 1.060 1.070 1.080

2 1.124 1.145 1.166

3 1.191 1.225 1.260

4 1.262 1.311 1.360

5 1.338 1.403 1.469

3-17

Using Future Value Tables

FV2 = $1,000 (FVIF7%,2)

= $1,000 (1.145)

= $1,145 [Due to Rounding]

Period 6% 7% 8%

1 1.060 1.070 1.080

2 1.124 1.145 1.166

3 1.191 1.225 1.260

4 1.262 1.311 1.360

5 1.338 1.403 1.469

3-18

Story Problem Example

Julie Miller wants to know how large her deposit

of $10,000 today will become at a compound

annual interest rate of 10% for 5 years.

0 1 2 3 4 5

10%

$10,000

FV5

3-19

Story Problem Solution

Calculation based on general formula:

FVn = P0 (1+i)n

FV5 = $10,000 (1+ 0.10)5

= $16,105.10

Calculation based on Table I:

FV5 = $10,000 (FVIF10%, 5)

= $10,000 (1.611)

= $16,110 [Due to Rounding]

3-20

Double Your Money!!!

double $5,000 at a compound rate

of 12% per year (approx.)?

3-21

The Rule-of-72

double $5,000 at a compound rate

of 12% per year (approx.)?

72 / 12% = 6 Years

[Actual Time is 6.12 Years]

3-22

Solving the Period Problem

Inputs 12 -1,000 0 +2,000

N I/Y PV PMT FV

Compute 6.12 years

investment that earns 12% annually

will double to $2,000 in 6.12 years.

Note: 72/12% = approx. 6 years

3-23

Present Value

Single Deposit (Graphic)

Assume that you need $1,000 in 2 years.

Lets examine the process to determine

how much you need to deposit today at a

discount rate of 7% compounded annually.

0 1 2

7%

$1,000

PV0 PV1

3-24

Present Value

Single Deposit (Formula)

= FV2 / (1+i)2 = $873.44

0 1 2

7%

$1,000

PV0

3-25

General Present

Value Formula

PV0 = FV1 / (1+i)1

PV0 = FV2 / (1+i)2

etc.

PV0 = FVn / (1+i)n

or PV0 = FVn (PVIFi,n) -- See Table II

3-26

Valuation Using Table II

PVIFi,n is found on Table II

at the end of the book.

Period 6% 7% 8%

1 .943 .935 .926

2 .890 .873 .857

3 .840 .816 .794

4 .792 .763 .735

5 .747 .713 .681

3-27

Using Present Value Tables

PV2 = $1,000 (PVIF7%,2)

= $1,000 (.873)

= $873 [Due to Rounding]

Period 6% 7% 8%

1 .943 .935 .926

2 .890 .873 .857

3 .840 .816 .794

4 .792 .763 .735

3-28

5 .747 .713 .681

Story Problem Example

Julie Miller wants to know how large of a

deposit to make so that the money will

grow to $10,000 in 5 years at a discount

rate of 10%.

0 1 2 3 4 5

10%

$10,000

PV0

3-29

Story Problem Solution

Calculation based on general formula:

PV0 = FVn / (1+i)n

PV0 = $10,000 / (1+ 0.10)5

= $6,209.21

Calculation based on Table I:

PV0 = $10,000 (PVIF10%, 5)

= $10,000 (.621)

= $6,210.00 [Due to Rounding]

3-30

Solving the PV Problem

Inputs 5 10 0 +10,000

N I/Y PV PMT FV

Compute -6,209.21

future value that will earn 10% annually

for 5 years requires a $6,209.21 deposit

today (present value).

3-31

Types of Annuities

An Annuity represents a series of equal

payments (or receipts) made at a fixed

interval for a specified number of

periods

Ordinary Annuity: Payments or receipts

occur at the end of each period.

Annuity Due: Payments or receipts

occur at the beginning of each period.

3-32

Examples of Annuities

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

3-33

Parts of an Annuity

(Ordinary Annuity)

End of End of End of

Period 1 Period 2 Period 3

0 1 2 3

Each 1 Period Apart

3-34

Parts of an Annuity

(Annuity Due)

Beginning of Beginning of Beginning of

Period 1 Period 2 Period 3

0 1 2 3

Each 1 Period Apart

3-35

Overview of an

Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 1 2 n n+1

i% . . .

R R R

R = Periodic

Cash Flow

FVAn

FVAn = R(1+i)n-1 + R(1+i)n-2 +

... + R(1+i)1 + R(1+i)0

3-36

Example of an

Ordinary Annuity -- FVA

Cash flows occur at the end of the period

0 1 2 3 4

7%

$1,070

$1,145

FVA3 = $1,000(1.07)2 +

$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3

= $1,145 + $1,070 + $1,000

= $3,215

3-37

Hint on Annuity Valuation

The future value of an ordinary

annuity can be viewed as

occurring at the end of the last

cash flow period, whereas the

future value of an annuity due

can be viewed as occurring at

the beginning of the last cash

flow period.

3-38

Valuation Using Table III

FVAn = R (FVIFAi%,n)

FVA3 = $1,000 (FVIFA7%,3)

= $1,000 (3.215) = $3,215

Period 6% 7% 8%

1 1.000 1.000 1.000

2 2.060 2.070 2.080

3 3.184 3.215 3.246

4 4.375 4.440 4.506

5 5.637 5.751 5.867

3-39

Solving the FVA Problem

Inputs 3 7 0 -1,000

N I/Y PV PMT FV

Compute 3,214.90

I/Y: 7% interest rate per period (enter as 7 NOT .07)

PV: Not relevant in this situation (no beg value)

PMT: $1,000 (negative as you deposit annually)

FV: Compute (Resulting answer is positive)

3-40

Overview View of an

Annuity Due -- FVAD

Cash flows occur at the beginning of the period

0 1 2 3 n-1 n

i% . . .

R R R R R

... + R(1+i)2 + R(1+i)1

= FVAn (1+i)

3-41

Example of an

Annuity Due -- FVAD

Cash flows occur at the beginning of the period

0 1 2 3 4

7%

$1,000 $1,000 $1,000 $1,070

$1,145

$1,225

2

$1,000(1.07) + $1,000(1.07) 1

= $3,440

3-42

Valuation Using Table III

FVADn = R (FVIFAi%,n)(1+i)

FVAD3 = $1,000 (FVIFA7%,3)(1.07)

= $1,000 (3.215)(1.07) = $3,440

Period 6% 7% 8%

1 1.000 1.000 1.000

2 2.060 2.070 2.080

3 3.184 3.215 3.246

4 4.375 4.440 4.506

5 5.637 5.751 5.867

3-43

Solving the FVAD Problem

Inputs 3 7 0 -1,000

N I/Y PV PMT FV

Compute 3,439.94

Complete the problem the same as an ordinary annuity

problem, except you must change the calculator setting

to BGN first. Dont forget to change back!

Step 1: Press 2nd BGN keys

Step 2: Press 2nd SET keys

Step 3: Press 2nd QUIT keys

3-44

Overview of an

Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 1 2 n n+1

i% . . .

R R R

R = Periodic

Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

3-45

Example of an

Ordinary Annuity -- PVA

Cash flows occur at the end of the period

0 1 2 3 4

7%

$934.58

$873.44

$816.30

$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +

$1,000/(1.07)2 +

$1,000/(1.07)3

= $934.58 + $873.44 + $816.30

3-46

= $2,624.32

Hint on Annuity Valuation

The present value of an ordinary

annuity can be viewed as

occurring at the beginning of the

first cash flow period, whereas

the future value of an annuity

due can be viewed as occurring

at the end of the first cash flow

period.

3-47

Valuation Using Table IV

PVAn = R (PVIFAi%,n)

PVA3 = $1,000 (PVIFA7%,3)

= $1,000 (2.624) = $2,624

Period 6% 7% 8%

1 0.943 0.935 0.926

2 1.833 1.808 1.783

3 2.673 2.624 2.577

4 3.465 3.387 3.312

5 4.212 4.100 3.993

3-48

Solving the PVA Problem

Inputs 3 7 -1,000 0

N I/Y PV PMT FV

Compute 2,624.32

I/Y: 7% interest rate per period (enter as 7 NOT .07)

PV: Compute (Resulting answer is positive)

PMT: $1,000 (negative as you deposit annually)

FV: Not relevant in this situation (no ending value)

3-49

Overview of an

Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 1 2 n-1 n

i% . . .

R R R R

R: Periodic

PVADn Cash Flow

= PVAn (1+i)

3-50

Example of an

Annuity Due -- PVAD

Cash flows occur at the beginning of the period

0 1 2 3 4

7%

$ 934.58

$ 873.44

$2,808.02 = PVADn

$1,000/(1.07)2 = $2,808.02

3-51

Valuation Using Table IV

PVADn = R (PVIFAi%,n)(1+i)

PVAD3 = $1,000 (PVIFA7%,3)(1.07)

= $1,000 (2.624)(1.07) = $2,808

Period 6% 7% 8%

1 0.943 0.935 0.926

2 1.833 1.808 1.783

3 2.673 2.624 2.577

4 3.465 3.387 3.312

5 4.212 4.100 3.993

3-52

Steps to Solve Time Value

of Money Problems

1. Read problem thoroughly

2. Create a time line

3. Put cash flows and arrows on time line

4. Determine if it is a PV or FV problem

5. Determine if solution involves a single

CF, annuity stream(s), or mixed flow

6. Solve the problem

7. Check with financial calculator (optional)

3-53

Present Value of

Unequal Cash Flow

0 1 2 3 4 5

10%

$600 $600 $400 $400 $100

$545.45

$495.87

$300.53

$273.21

$ 62.09

$1677.15 = PV0 of the Unequal Cash Flow

3-56

Unequal Cash Flow (#1)

0 1 2 3 4 5

10%

$600 $600 $400 $400 $100

$1,041.60

$ 573.57

$ 62.10

$1,677.27 = PV0 of Mixed Flow [Using Tables]

$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57

$100 (PVIF10%,5) = $100 (0.621) = $62.10

3-57

Frequency of

Compounding

General Formula:

FVn = PV0(1 + [i/m])mn

n: Number of Years

m: Compounding Periods per Year

i: Annual Interest Rate

FVn,m: FV at the end of Year n

PV0: PV of the Cash Flow today

3-60

Impact of Frequency

Julie Miller has $1,000 to invest for 2

Years at an annual interest rate of

12%.

Annual FV2 = 1,000(1+ [.12/1])(1)(2)

= 1,254.40

Semi FV2 = 1,000(1+ [.12/2])(2)(2)

= 1,262.48

3-61

Impact of Frequency

Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)

= 1,266.77

Monthly FV2 = 1,000(1+ [.12/12])(12)(2)

= 1,269.73

Daily FV2 = 1,000(1+[.12/365])(365)(2)

= 1,271.20

3-62

Effective Annual

Interest Rate

Effective Annual Interest Rate

The actual rate of interest earned

(paid) after adjusting the nominal

rate for factors such as the number

of compounding periods per year.

(1 + [ i / m ] )m - 1

3-63

BWs Effective

Annual Interest Rate

Basket Wonders (BW) has a $1,000

CD at the bank. The interest rate

is 6% compounded quarterly for 1

year. What is the Effective Annual

Interest Rate (EAR)?

EAR = ( 1 + 6% / 4 )4 - 1

= 1.0614 - 1 = .0614 or 6.14%!

3-64

Steps to Amortizing a Loan

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.

3-65

Amortizing a Loan Example

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

PV0 = R (PVIFA i%,n)

$10,000 = R (PVIFA 12%,5)

$10,000 = R (3.605)

R = $10,000 / 3.605 = $2,774

3-66

Amortizing a Loan Example

End of Payment Interest Principal Ending

Year 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

3-67

Usefulness of Amortization

Interest expenses may reduce

taxable income of the firm.

2. Calculate Debt Outstanding --

The quantity of outstanding

debt may be used in financing

the day-to-day activities of the

3-68

firm.

Annual Percentage rate

Annual return is the return an

investment provides over a period of

time, expressed as a time-

weighted annual percentage.

The rate of annual return is measured

against the initial amount of the

investment and represents a geometric

mean rather than a simple arithmetic

mean.

3-69

Formula

APR = (1 + r/m)m-1.0

Where:

r = nominal rate

m = number of compounded

period in a year

3-70

Example

compounded quarterly, the APR

is?

3-71

Sample Problems

savings account earning 7%

interest compounded annually.

How much money will he

accumulate after 5 years?

3-72

Lackie Tyan invested a large

sum of money in ZZZ

Corporation. The company pays

a P3 dividend per share. The

dividends are expected to

increase by 15% per

year for the next 3 years. Lackie

3-73

wants to project the dividends

Bessie wants to determine the

sum of money she will have in

her savings account at the end

of 7 years by depositing P2,000

at the end of each year for the

next 7 years. The annual interest

rate is 9%.

3-74

Bessie wants to determine the

sum of money she will have in

her savings account at the end

of 5 years by depositing P1,000

at the beginning of each year for

the next 5 years. The annual

interest rate is 8%.

3-75

Value of Compounded

Interest

opportunity to receive P50,000

10 years from now. If he can earn

15% on his investment

compounded annually, what is

the most he should pay yo

benefit from This opportunity?

3-76

Future & Present values

the equal annual, end of the year

deposit required to accumulate

P15,000 at the end of 10 years

when her son enter college. The

interest rate is 12%.

3-77

Amortized Loan

auto loan at 12% annual interest

rate. She wants to finds out how

much the monthly payment

should be?

3-78

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