Time Value of Money

The Interest rate

Which would you prefer 10,000 today or
10,000 in 5 years?

Obviously, 10,000 today

You already recognize that there is TIME VALUE

TO MONEY!!
 Why is TIME such an important
element in your decision?

TIME allows you the opportunity to postpone

consumption and earn INTEREST.
 Compound Interest
Assume that you deposit 1,000 at a compound
interest rate of 7% for 2 years.

0 1 2
7%
1,000
FV2
 Future Value at end of year 1
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.
 Future Value at end of year 2
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 compound
over simple interest.
 FV formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
 Using Table
FVIFi,n is found on Table at the end of the book.
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
 Numerical
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
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]
If you place 1000 in the fixed deposit of a bank
at 5 % interest rate, how much shall it grow at
the end of three years?

FVn = P0 (1+i)n
FV5 = 1000 (1+ 0.05)3
= 1000 * 1.1576
= 1157.60
If you deposit 55,000 in the fixed deposit of a
bank at 10 % interest rate, how much shall it
grow at the end of four years?

FVn = P0 (1+i)n
FV5 = 55000 (1+ 0.1)4
= 55000 * 1.4641
= 80525.50
 Finding PV from a FV
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
 PV Formula

PV0 = FV2 / (1+i)2 = 1,000 / (1.07)2

= FV2 / (1+i)2 = 873.44

0 1 2
7%
1,000
PV0
 PV using Table
PVIFi,n is found on Table 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
 Practical situation
Alia 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
 Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = 10,000 / (1+ 0.10)5
= 6,209.21
Calculation based on Table:
PV0 = 10,000 (PVIF10%, 5)
= 10,000 (.621)
= 6,210.00 [Due to Rounding]
 Annuities
An Annuity represents a series of equal payments
(or receipts) occurring over a specified number of
equidistant periods.
 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.
 Examples of Annuities
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
 Ordinary Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3

100 100 100

Today Equal Cash Flows
Each 1 Period Apart
 Annuity Due
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

100 100 100

Today Equal Cash Flows

Each 1 Period Apart
 Ordinary annuity PVA
0 1 2 3 4
7%

1,000 1,000 1,000

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
= 2,624.32
 Annuity Due Future Value
0 1 2 3 4
7%
1,000 1,000 1,000 1,070

1,145
1,225

FVAD3 = 1,000(1.07)3 + 3,440 = FVAD3

1,000(1.07)2 + 1,000(1.07)1
= 1,225 + 1,145 + 1,070
= 3,440
 Annuity Due - PV
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
1,000.00 1,000 1,000
934.58
873.44

2,808.02 = PVADn

PVADn = 1,000/(1.07)0 + 1,000/(1.07)1 +

1,000/(1.07)2 = 2,808.02
 Annuity Simple way to compute
Instead of computing one by one as in the
previous slide the PV can be calculated by
multiplying the annuity amount with the sum of
discount factor.
0 1 2 3 4
7%
1 1,000 1,000
0.9345
0.8734
1,000 * 1.8079 = 1807.90
1.8079 = Present value annuity factor
 Test yourself
What would be the PV annuity factor for 4
years, 10% rate of interest?
0.909 + 0.826 + 0.751 + 0.683 = 3.169

What would be the PV annuity factor of an

annuity due for 4 years, 10% rate of interest?
1+ 0.909 + 0.826 + 0.751 + 0.683 = 3.487
Calculate the present value of Rs.1000
(a) Received one year from now
(b) Received at the end of three years
(c) Received at the end of five years
Assuming a 5 % rate of interest.

(a) Received one year from now = 952.38

(b) Received at the end of three years = 863.83
(c) Received at the end of five years = 783.52
Calculate the future value of Rs.1000
(a) One year from now
(b) At the end of three years
(c) At the end of five years
Assuming a 10 % rate of interest.

(a) One year from now = 1100

(b) At the end of three years = 1331
(c) At the end of five years = 1610.51
Your father has promised to give you 1,00,000
in cash on your 25th birthday. Today is your 18th
birthday. He wants to know
(a) If he makes annual payments into a fund
after one year, who much each have to be if
the fund pays 8%?
Your father has promised to give you 1,00,000 in
cash on your 25th birthday. Today is your 18th
birthday. He wants to know
(a) If he makes annual payments into a fund after
one year, who much each have to be if the fund
pays 8%?
19th to 25th = 7 years
FV = Annuity * (FVAF,8%, 7 years)
1,00,000 = Annuity * 8.923
Or Annuity = 1,00,000 / 8.923 = 11207.24

He will have to pay 11207.24 into the fund

annually
 Recap
PV of a single cash flow
FV of a single cash flow
PV of an annuity
FV of an annuity
 Steps to Solve Time Value of Money
Problems
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
 Mixed Cash Flows Example
Aalia will receive the set of cash flows below.
What is the Present Value at a discount rate of
10%.

0 1 2 3 4 5
10%
600 600 400 400 100
PV0
 How to solve?

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 Mixed Flow
End of Topic