Time Value of Money

Introduction to Business Finance (Fall 2012) 1

Cash figures at different time periods
are not directly comparable…

Which would you prefer to get -- $10,000

today or $10,000 in 5 years?

Which would you prefer to pay -- $10,000

today or $10,000 in 5 years?

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There are some important terminologies
which we should be familiar with…

Future Value is the value at some future time of a

present amount of money, evaluated at a given
interest rate.
Present Value is the current value of a future amount
of money, evaluated at a given interest rate.
Compounding is the process of calculating the future
value from a given present value
Discounting is the process of calculating the present
value from a given future value

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In finance, we always use compound
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).

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 Assume that you deposit $1,000 in
an account earning 7% for 2 years.
What is the future value at the end
of the 2nd year…
– if compound interest is earned??
– if simple interest is earned??

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Present and future values can be
calculated using equation, table or
financial calculator…
Future Value Formula:
FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See FVIF Table

Present Value Formula:

PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See PVIF Table

Introduction to Business Finance (Fall 2012) 6

Financial calculators can be used to
solve the TVM problems…
Use the highlighted row of keys
for solving any of the FV, PV, FVA,
PVA, FVAD, and PVAD problems

N: Number of periods
I/Y: Interest rate per period
PV: Present value
PMT: Payment per period
FV: Future value
CLR TVM: Clears all of the inputs
into the above TVM keys

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 Financial calculators can be used
to solve the TVM problems…

Inputs 2 7 -1,000 0
N I/Y PV PMT FV

Compute 1,144.90

N: 2 Periods (enter as 2)
I/Y: 7% interest rate per period (enter as 7 NOT .07)
PV: $1,000 (enter as negative as you are investing)
PMT: Not relevant in this situation (enter as 0)
FV: Compute (Resulting answer is positive)

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Annuity is a series of equal payments
(or receipts) occurring over a specified
number of equidistant 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.

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Examples of annuities include…

• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings

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 What is the future value of an
annuity with an equal payment of
$1,000 for 3 years if the interest rate
is 10% and if:
 the payments are made at the end of
each year??
 the payments are made at the
beginning of each year??

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Present and future value of an ordinary
annuity can be calculated using equation,
table or financial calculator…

Future Value of annuity Formula:

FVAn = PMT * (((1+i)n -1)/i)
or FVAn = PMT (FVIFAi,n) -- See FVIFA Table

Present Value Formula:

PVA0 = PMT * ((1- (1+i)n )/i)
or PVA0 = PMT (PVIFAi,n) -- See PVIFA Table

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 Financial calculators can be used to
solve the TVM problems…
Inputs 3 10 0 -$1000 $3310
N I/Y PV PMT FV

Compute

N: 3 Periods (enter as 3)
I/Y: 10% interest rate per period (enter as 10 NOT .10)
PV: Not relevant in this situation (enter as 0)
PMT: $1,000 (enter as negative as you are investing)
FV: Compute (Resulting answer is positive)

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Unlike an annuity, in some cases,
future cash flows vary in size…

• Discounting and compounding of multiple cash

flows can not be done using a formula or a table.

• PV of multiple cash flows = the sum of the present

values of the individual cash flows.

• FV of multiple cash flows at a common point in

time = the sum of the future values of the
individual cash flows at that point in time.

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Perpetuity is an annuity with an
infinite number of cash flows…

PMT PMT PMT

PV    
(1  i ) (1  i ) (1  i )
1 2 3

PMT
PV 
i

Find the present value of a perpetuity of

$270 per year if the interest rate is 12%
per year??

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Loan Amortization Schedule shows how a
loan is paid off over time…

Amortization tables are widely used for home

mortgages, auto loans, business loans, retirement
plans, etc.
It breaks down each payment into the interest
component and the principal component.

Construct an amortization schedule for a

Rs.10,000, 10% annual rate loan with 4 equal
annual payments.

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Investments with different compounding
intervals provide different effective
returns…

Effective annual rate (EAR) is the annual rate of

interest actually being earned, accounting for
compounding.
To compare investments with different compounding
intervals, you must look at their effective returns.
For the same nominal rate, the effective rate increases
as the compounding frequency increases.

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