Muhammad Shoaib Sajjad

The Time Value of Money

Learning Objectives

 Explain the mechanics of

compounding, which is how money
grows over a time when it is
invested.
 Be able to move money through time
using time value of money tables,
financial calculators, and
spreadsheets.
 Discuss the relationship between
compounding and bringing money
back to present.
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Learning Objectives

 Define an ordinary annuity and

calculate its compound or future
value.
 Differentiate between an ordinary
annuity and an annuity due and
determine the future and present
value of an annuity due.
 Determine the future or present value
of a sum when there are nonannual
compounding periods.
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Learning Objectives

• Determine the present value of an

uneven stream of payments

• Determine the present value of a

perpetuity.

• Explain how the international setting

complicates the time value of money.

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Principles Used in this
Chapter

• Principle 2 : The Time Value of

Money – A Dollar Received
Today Is Worth More Than a
Dollar Received in The Future.

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Simple Interest

Interest is earned on principal

$100 invested at 6% per year

1st year interest is $6.00
2nd year interest is $6.00
3rd year interest is $6.00
Total interest earned: $18.00

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Difference Between Simple and
Compound Interest Rate
• For example, a student obtains a simple interest loan
to pay one year of her college tuition, which costs
$18,000, and the annual interest rate on her loan is
6%. She repaid her loan over three years and the
amount of simple interest she paid was $3,240 =
$18,000 x 0.06 x 3. The total amount she repaid was
$21,240 = $18,000 + $3,240.

• For example, if the student introduced above obtained

a compound interest loan for college. The amount of
compound interest that would be paid is $3,438.29,
which is higher than the simple interest of $3,240. This
is because unlike the simple interest, the compound
interest accrues on both the principal and the
accumulated interest.

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Compound Interest

• When interest paid on an

investment during the first
period is added to the
principal; then, during the
second period, interest is
earned on the new sum.

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Compound Interest

Interest is earned on previously earned

interest

$100 invested at 6% with annual

compounding
1st year interest is $6.00 Principal is $106.00
2nd year interest is $6.36 Principal is $112.36
3rd year interest is $6.74 Principal is $119.11
Total interest earned: $19.11

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Future Value

- The amount a sum will grow in

a certain number of years when
compounded at a specific rate.

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Future Value

FV1 = PV (1 + i)
Where FV1 = the future of the investment at
the end of one year
i= the annual interest (or discount)
rate
PV = the present value, or original
amount invested at the beginning
of the first year

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Future Value

What will an investment be worth

in 2 years?

$100 invested at 6%
FV2= PV(1+i)2 = $100 (1+.06)2
$100 (1.06)2 = $112.36

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Future Value

• Future Value can be increased

by:
• Increasing number of years of
compounding
• Increasing the interest or
discount rate

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Future Value Using Tables

FVn = PV (FVIFi,n)
Where FVn = the future of the investment at
the end of n year
PV = the present value, or original
amount invested at the beginning
of the first year
FVIF = Future value interest factor or
the compound sum of $1
i= the interest rate
n= number of compounding periods
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Future Value

What is the future value of $500

invested at 8% for 7 years? (Assume
annual compounding)
Using the tables, look at 8% column, 7
time periods. What is the factor?
FVn= PV (FVIF8%,7yr)
= $500 (1.714)
= $857

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Future Value Using Calculators

Using any four inputs you will find the 5th.

Set to P/YR = 1 and END mode.
INPUTS OUTPUT

N 10 I/YR 6

PV -100

PMT 0

FV 179.10

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 Future Value Using Spreadsheets
Spreadsheets and the Time Value of Money

If we invest $500 in a bank where it will earn 8 percent compounded

annually, how much will it be worth at the end of 7 years?

rate (I) = 8%
number of periods (n) = 7
payment (PMT) = 0
present value (PV) = $500
type (0=at end of period) = 0

Future value = $856.91

Excel formula: FV = (rate, number of periods, payment, present value, type)

Entered in cell d13: = FV(d7,d8,d9,-d10,d11)

Notice that present value ($500) took a negative value
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Present Value

The current value of a future payment

PV = FVn {1/(1+i)n}
Where FVn = the future of the investment at
the end of n years
n= number of years until payment is
received
i= the interest rate
PV = the present value of the future sum
of money

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Present Value

What will be the present value of $500

to be received 10 years from today if
the discount rate is 6%?

PV = $500 {1/(1+.06)10}
= $500 (1/1.791)
= $500 (.558)
= $279

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Present Value Using Tables

PVn = FV (PVIFi,n)
Where PVn = the present value of a future sum of
money
FV = the future value of an investment at
the end of an investment period
PVIF = Present Value interest factor of $1
i= the interest rate
n= number of compounding periods

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Present Value

What is the present value of $100

to be received in 10 years if the
discount rate is 6%?
PVn = FV (PVIF6%,10yrs.)
= $100 (.558)
= $55.80

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Present Value Using Calculators

Using any four inputs you will find the 5th.

Set to P/YR = 1 and END mode.
INPUTS OUTPUT

N 10 PV -55.84
I/YR 6

PMT 0

FV 100.00

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Annuity

• Series of equal dollar payments

for a specified number of years.

• Ordinary annuity payments

occur at the end of each period

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Compound Annuity

• Depositing or investing an equal

sum of money at the end of
each year for a certain number
of years and allowing it to grow.

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Compound Annuity

FV5 = $500 (1+.06)4 + $500 (1+.06)3

+$500(1+.06)2 + $500 (1+.06) + $500

= $500 (1.262) + $500 (1.191) +

$500 (1.124) + $500 (1.090) +
$500
= $631.00 + $595.50 + $562.00 +
$530.00 + $500
= $2,818.50

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Illustration of a 5yr $500 Annuity
Compounded at 6%

0 1 2 3 4 5
6%

500 500 500 500 500

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Future Value of an Annuity

FV = PMT {(FVIFi,n-1)/ i }
Where FV n= the future of an annuity at
the end of the nth years
FVIFi,n= future-value interest factor or sum of
annuity of $1 for n years
PMT= the annuity payment deposited or
received at the end of each year
i= the annual interest (or discount) rate
n = the number of years for which the
annuity will last

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Compounding Annuity

What will $500 deposited in the bank

every year for 5 years at 10% be
worth?
FV = PMT {(FVIFi,n-1)/ i }
Simplified this equation is:
FV5 = PMT(FVIFAi,n)
= $500(5.637)
= $2,818.50
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Future Value of an Annuity
Using Calculators
Using any four inputs you will find the 5th.
Set to P/YR = 1 and END mode.
INPUTS OUTPUT

N 5 FV -2,818.55

PV 0

I/YR 6

PMT 500

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Present Value of an Annuity

• Pensions, insurance obligations,

and interest received from
bonds are all annuities. These
items all have a present value.
• Calculate the present value of
an annuity using the present
value of annuity table.

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Present Value of an Annuity

Calculate the present value of a $500

annuity received at the end of the
year annually for five years when the
discount rate is 6%.
PV = PMT(PVIFAi,n)
= $500(4.212)
= $2,106

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Present Value of Ordinary Annuity Due
If you would like to determine today's value of a future
payment series, you need to use the formula that
calculates the present value of an ordinary annuity.

This is the formula you would use as part of a bond

pricing calculation. The PV of an ordinary annuity
calculates the present value of the coupon payments
that you will receive in the future.

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 Ordinary Annuity & Annuity Due
• Payments are required at the end of each period.
For example, straight bonds usually pay coupon
payments at the end of every six months until
the bond's maturity date.
• Payments are required at the beginning of each
period. Rent is an example of annuity due. You
are usually required to pay rent when you first
move in at the beginning of the month, and then
on the first of each month thereafter.
• Since the present and future value calculations
for ordinary annuities and annuities due are
slightly different, we will first discuss the
present and future value calculation for ordinary
annuities.
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Future Value of Annuity

To calculate the future value of the annuity, we

have to calculate the future value of each cash
flow. Let's assume that you are receiving
$1,000 every year for the next five years, and
you invested each payment at 5%. The
following diagram shows how much you would
have at the end of the five-year period:

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Amortized Loans

• Loans paid off in equal

installments over time
– Typically Home Mortgages
– Auto Loans

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Payments and Annuities

If you want to finance a new

machinery with a purchase
price of $6,000 at an interest
rate of 15% over 4 years, what
will your payments be?

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Future Value Using Calculators

Using any four inputs you will find the 5th.

Set to P/YR = 1 and END mode.
INPUTS OUTPUT

N 4 PMT -2,101.59

PV 6,000

I/YR 15
FV 0

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Amortization of a Loan

• Reducing the balance of a loan via

annuity payments is called
amortizing.
• A typical amortization schedule
looks at payment, interest, principal
payment and balance.

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Amortization of 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
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Amortization of 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

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Amortization Schedule

Yr. Annuity Interest Principal Balance

1 $2,101.58 $900.00 $1,201.58 $4,798.42

2 $2,101.58 719.76 1,381.82 3,416.60

3 $2,101.58 512.49 1,589.09 1,827.51

4 $2,101.58 274.07 1,827.51

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Compounding Interest with
Non-annual periods
If using the tables, divide the percentage by
the number of compounding periods in a
year, and multiply the time periods by the
number of compounding periods in a year.
Example:
8% a year, with semiannual compounding for
5 years.
8% / 2 = 4% column on the tables
N = 5 years, with semiannual compounding
or 10
Use 10 for number of periods, 4% each
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Perpetuity

• An annuity that continues forever is

called perpetuity
• The present value of a perpetuity is
PV = PP/i
PV = present value of the perpetuity
PP = constant dollar amount
provided by the of perpetuity
i = annuity interest (or discount
rate)
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The Multinational Firm

• Principle 1- The Risk Return Tradeoff – We

Won’t Take on Additional Risk Unless We
Expect to Be Compensated with Additional
Return
• The discount rate is reflected in the rate of
inflation.
• Inflation rate outside US difficult to predict
• Inflation rate in Argentina in 1989 was
4,924%, in 1990 dropped to 1,344%, and in
1991 it was only 84%.

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 Practious Questions
Q1. Mathew deposits $10,000 in an investment fund that
promises annual interest of 8%, paid semi-annually.
How much will he have at the end of 10 years?

Q2. If your friend requires you to repay $6,500 after two

years on a loan amount of $5,000, what is the implied
rate of interest being charged by your friend?

Q3. You are expecting your CD to mature in 10 years with

a maturity value of $7,890. What is the present value of
this investment if the discount rate is 3%?

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Questions
Q4. You wish to accumulate $1 million in 40 years.
How much should you save every year if you are able
to earn an average annual return of 7%?

Q5. A $1,000 bond that pays interest of 5% in

perpetuity will have the following present value if
the discount rate is 6%.

Q6. You are planning to get a 5-year loan and are

expecting to get an approval for the loan at an
annual interest rate of 6%. If you can afford a
monthly payment of $350, how much loan should you
apply for?

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 Questions
Q7. If you are able to save $150 every month and invest
it in an investment fund that earns a n average annual
return of 6%, how much will the fund be worth at the
end of 50 years?

Q8. An investment that yields $1,000 in 4 years and

$3,000 in 6 years, based on a discount rate of 5%,
what would be Present Value

Q9. If your original investment of $10,000 grows to

$15,000 in 10 years, what would be the implied rate
of return ?

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