Time Value of Money

Time Value
 You got the Best Student award from your
University.
 You have the option of taking Rs.140,000
now or Rs.25000 per year for five years.
 Which should you take?
 The answer comes through taking into
consideration the time value of money.
“The Time Value of Money”

 A rupee in hand today is worth more than a

dollar promised at sometime in the future.
Why ????
 Risk and Uncertainty
 Inflation
 Consumption
 Investment opportunities
Cash Flow Time Lines
 The first step is visualizing the cash flows by
drawing a cash flow time line.
 Time lines show when cash flows occur.
 Time 0 is now.

0 1 2 3 4 5
Cash Flow Time Lines
 Outflows are listed as negatives.
 Inflows are positive.
 State the appropriate “interest rate,” which
represents your opportunity costs

0 1 2 3 4 5
8%

$250K $250K $250K $250K $250K

Future Value
 Future value is higher than today, because if I
had the money I would put it to work, it
would earn interest.
 The interest could then earn interest.
 Compounding: allowing interest to earn interest
on itself.
Future Value - Example
 If you invest 1,000 today at 8% interest per
year, how much should you have in five years
(in thousands).
0 1 2 3 4 5
8%

Principal -1
Interest 0.08 0.0864 0.0933 0.1008 0.1088
Prev. Interest 0.00 0.0800 0.1664 0.2597 0.3605
Total 1.08 1.1664 1.2597 1.3605 1.4693
Future Value
 For one year, the future value can be defined
as:

Future Value Year 1  Present Value + Interest

FV1  PV  PV  i
FV1  PV 1  i 
Future Value
 The second year, the future value can be
stated as follows:

FV2  FV1  FV1  i

 FV1 1  i 
 
 PV 1  i  1  i   PV 1  i 
2
Future Value
 Therefore, the general solution to the future
value problem is:

FVn  PV 1  i 
n


 PV FVIFi ,n 
 PV  Future Value Interest Factor 
Future Value
 Interest can be seen as 4.5

the opportunity growth 4 i=15%

3.5
rate of money.

Future Value of $1
3
i=10%
2.5
2
i=5%
1.5
1 i=0%

0.5
0
0 5 10 15
Periods
Present Value
 Present value is the value in today’s dollars of
a future cash flow.
 If we are interested in the present value of
$500 delivered in 5 years:

0 1 2 3 4 5
8%

PV=? $500
Present Value
 The general solution to this problem follows
from the solution to the future value problem:

FVn  PV 1  i 
n

FVn  1 
 PV   FVn  n 
1  i   1  i  
n
Present Value
 Since the discount rate 1.2

is the opportunity cost, 1 i=0%

Present Value of $1
the present value 0.8
represents what I i=5%
0.6
would have to give up
0.4 i=10%
now to get the future
i=15%
value specified. 0.2

0
0 5 10 15
Periods
Interest Rates
 If we know the amount we need at time n and
the amount we can invest at time zero, then
we must only solve for the interest rate.

0 1 2 3 4 5
?%

$100 $500
Interest Rates
 Solving for interest rates algebraically:

FVn  PV 1  i 
n

FVn
 1  i 
n

PV
1
 FVn  n

   1 i
 PV 
1
 FVn  n

  1  i
 PV 
Interest Rates - Example
0 1 2 3 4 5
?%

$100 $500
1
 500  5

  1  i
 100 

5
1
5
 1  13797
.  1  0.3797  i  37.97%
Time Periods
 If the present value, future value and interest
rate are known, but the number of time
periods is not. Then n can be found
algebraically:
FVn  PV 1  i 
n

ln( FVn )  ln( PV )  n ln[(1  i )]

ln( FVn )  ln( PV )
n
ln[(1  i )]
Time Periods - Example
 If we use the last example of investing $100, we
want $500 in future, and the current market
interest is 8%, n can be found:

ln( 500)  ln( 100)

n  20.9124
ln( 1.08)
Annuities
 Definition: A series of equal payments at a
fixed interval.
 Two types:
 Ordinary annuity: Payments occur at the end of
each period.
 Annuity due: Payments occur at the beginning of
each period.
Ordinary Annuity
 Example is a regular payment of $100 for five
years earning 8% interest.

0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

FV=?

What is the future value?

Ordinary Annuity – Future Value
 The future value of an ordinary annuity can be
found as follows:
n 1
FVAn  PMT  1  i 
t 0

Without derivation
 1  i n  1
FVAn  PMT  
 i 
Ordinary Annuity - Example
0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

 1  0.08  1 5
FVAn  100 
 0.08 
 586.66
Annuity Due
 Example is a regular payment of $100 for five
years earning 8% interest.

0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

FV=?

What is the future value?

Annuity Due – Future Value
 The future value of an annuity due can be found by
noticing that the annuity due is the same as an
ordinary annuity, with one more compounding
period:

 1  i   1n

FVAn  PMT   1  i 
 i 
Annuity Due - Example
0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

 1  0.085  1 
FVAn  100  1  0.08
 0.08 
 633.59
Ordinary Annuity - Present Value
 Example is a regular payment of $100 for five
years earning 8% interest.

0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

PV=?

What is the present value?

Ordinary Annuity - Present Value
 The present value of an ordinary annuity can be
found as follows:
n


1
PV  PMT
t 1
1  i  t

Without Derivation
 1 
 1  1  i  n 
PV  PMT  
 i 
 
Ordinary Annuity - Example
0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

 1 
 1  1  0.08 5 
PV  100      399.27
 0.08 
 
 
Annuity Due - Present Value
 Example is a regular payment of $100 for five
years earning 8% interest.

0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

PV=?

What is the present value?

Annuity Due - Present Value
 The future value of an annuity due can be found as
follows:
n1


1
PV  PMT
t 0
1  i  t

Without Derivation
 1  
 1    
1 i
n

PV  PMT    1  i 
 i  

   

Annuity Due - Example
0 1 2 3 4 5
8%

$100 $100 $100 $100 $100

 1  
 1  5  
   1  0.08 
1  0.08   43121
PV  100
    
.
0.08
  
  
Annuities - Finding Interest Rate
 Interest rates cannot be solved directly.
 Calculators search for the correct answer
(there is only one correct answer).
 It guesses and then iteratively goes higher or
lower.
Perpetuities
 What would you have to pay to be paid
$2,000 per year forever (given a market rate
of 8%)?

PV  i   PMT
PMT $2,000
PV    $25,000
i 0.08
Uneven Cash Flow Streams
 If payments are irregular or come at irregular
intervals, we can still find the PV (or FV).
 Take the present value (or future value) of
individual payments and sum them together.
Uneven Cash Flows - Example
0 1 2 3 4 5
8%

$100 $200 $300 $400 $500

$ 92.59
$171.47
$238.15
$294.01
$340.29
$1,136.51 = Present Value
Uneven Cash Flow - Example
0 1 2 3 4 5
8%

$100 $200 $300 $400 $500

$432.00
$349.92
$251.94
$136.05
Future Value = $1,669.91

$1,136.51 = Present Value

Finding Interest Rate
 As with annuities, interest rates for uneven
cash flow streams cannot be solved directly.
 Calculators search for the correct answer,
called an IRR (there may be more than one
correct answer).
 It guesses and then iteratively goes higher or
lower.
Compounding
 The more often one compounds interest, the
faster it grows.
0 1 2 3 4 5
8% Annual

-$100 $146.93

0 1 2 3 4 5 6 7 8 9 10 Semi-
4%
Annual
-$100 $148.02
Compounding
 Why is there a difference in future value?
 Because interest is earned on itself faster!
 How would you adjust to compound monthly?
 How would you make an adjustment in
annuities?
Effective Annual Rate
 To convert the other compounding periods to
an effective annual compounding rate (EAR)
use the following formula:

m
 i
EAR   1    1
 m
m  Compounding periods / year
Effective Annual Rate - Example
 8% monthly compounding loan is equal to
what in effective annual rate?

12
 0.08 
EAR   1   1
 12 
 1083
.  10
.  0.083  8.3%
Fractional Time Periods
 If you invest $100 for nine months at an EAR
of 8%, how does one calculate the future
value?
 The same way one did before.

FV  PV 1  i 
n

where n =# of compounding periods

FV  1001  0.08  1001059419  $105.94
0.75
.
Amortized Loans
 A loan with equal payments over the life of
the loan is called an amortized loan.
 Loan mathematics are the same as an annuity.
 Loan amounts are the present value.
 Periodic loan payments are the payments.
Amortized Loans
 The present value of a monthly loan uses the
annuity formula adjusted for monthly payments:


1
Loan  PMT
 
nm
t 1 1 i m
Without Derivation
 1 
 1
  
nm

 1 i m 
Loan  PMT  
i
 m 
 
 
Amortized Loans
 Payments on a given loan can be found by solving
for PMT in the previous equation:

Loan
PMT 
 1 
 1
  
nm
 i
 1 m 
 i 
 m 
 
 
Amortized Loans - Example
 What is the payment on a 30 year loan of
$150,000?

150,000
PMT   1100
, .65
 1 
1 
  
3012

 1  0.08
12 
 0.08 
 12 
 
 
Amortization Schedules
 Amortization schedules show how much of
each payment goes toward principal and how
much toward interest.
 The easiest way of calculating one by hand is
by calculating the outstanding loan balance
month-by-month, and then taking the
difference in loan balance from month to
month as the principal portion of the payment.
Amortization Schedules
 The portion in the amortized loan formula that
says n×m can be interpreted as months
remaining.
 So to find the part of the first $1,100.65 that is
paid toward the principal one would realize
that at the beginning one had all $150,000
outstanding.
Amortization Schedules
 After the first month, one has 359 payments left.
Therefore the loan principal outstanding is:

 1 
1 
  
359

 1  0.0812 
Loan  1100
, .65   149,899.35
 0.08 
12
 
 
Amortization Schedules
 The difference in principal outstanding is the
part of the payment that went toward
principal. In this instance, 150,000-
149,899.35=$100.65
 The rest of the payment went toward interest.
In this instance that would be 1,100.65-
100.65=$1,000.
Amortization Schedules
$1,200
$1,000

$800
Interest
$600
Principal
$400

$200
$0
1 6 11 16 21 26 31
Years
Different Types of Interest
 Simple Interest (i or isimple) - The rate we have
used thus far to calculate interest.
 Periodic Interest (i or iperiodic) - The interest
paid over a certain period.
isimple
i periodic 
m
For Example: 8% compounded monthly
0.08
i periodic   0.6666%
12
Different Types of Interest
 Effective Annual Rate (EAR): Described
earlier as the rate that would be charged to get
the same compounded annual rate.
 Annual Percentage Rate (APR):

isimple
APR  i periodic  m   m  isimple
m