The Time Value of Money

 Time Value of Money Concept

 Future and Present Values of single payments
 Future and Present values of periodic payments
(Annuities)
 Present value of perpetuity
 Future and Present values of annuity due
 Annual Percentage Yield (APY)

Slide 1
 The Time Value of Money Concept
 We know that receiving $1 today is worth more
than $1 in the future. This is due to opportunity
costs
 The opportunity cost of receiving $1 in the future
is the interest we could have earned if we had
received the $1 sooner

Slide 2
 The Future Value
 Future Value equation:
Future Value for one period
FV1  PV0 1  i 
1

Future Value for two periods

FV2  PV0 1  i 1  i 
Future Value for three periods
FV3  PV0 1  i 1  i 1  i 
Future Value general formulation
FVn  PV0 1  i 
n
Slide 3
 Future Value – Single Sums
 If you deposit $100 in an account earning 6%,
how much would you have in the account after 1
year?
 Mathematical Solution:

FVn = $1 x (1 + i)n
FVn = $100 x (1 + 0.06)1
FVn = $106

Slide 4
 Future Value – Single Sums (Continued)
Calculator Solution (TI BA II PLUS)
N Number of periods
I/Y Interest per Year
P/Y Payment per Year
C/Y Compounding per Year
PV Present Value
PMT PayMenT (Periodic and Fixed)
FV Future Value
MODE END for ending and BGN for beginning
N I/Y P/Y PV PMT FV MODE
1 6 1 -100 0 106
Slide 5
 Future Value – Single Sums (Continued)
 If you deposit $100 in an account earning 6%,
how much would you have in the account after 5
years?
N I/Y P/Y PV PMT FV MODE
5 6 1 -100 0 133.82
Mathematical Solution:
FVn = $1 x (1 + i)n
FVn = $100 x (1 + 0.06)5
FVn = $133.82
Slide 6
 Future Value – Single Sums (Continued)
 If you deposit $100 in an account earning 6% with
quarterly compounding, how much would you
have in the account after 5 year?
N I/Y P/Y PV PMT FV MODE
20 6 4 -100 0 134.69
Mathematical Solution:
FVn = $1 x (1 + i)n
FVn = $100 x (1 + 0.06/4)5x4
FVn = $134.69
Slide 7
 Future Value – Single Sums (Continued)
 If you deposit $100 in an account earning 6% with
monthly compounding, how much would you have
in the account after 5 year?
N I/Y P/Y PV PMT FV MODE
60 6 12 -100 0 134.89
Mathematical Solution:
FVn = $1 x (1 + i)n
FVn = $100 x (1 + 0.06/12)5x12
FVn = $134.89
Slide 8
 Future Value – Single Sums (Continued)
 If you deposit $1,000 in an account earning 8%
with daily compounding, how much would you
have in the account after 100 year?
N I/Y P/Y PV PMT FV MODE
36,500 8 365 -1000 0 2,978,346.07
Mathematical Solution:
FVn = $1 x (1 + i)n
FVn = $1,000 x (1 + 0.08/365)100x365
FVn = $2,978,346.07
Slide 9
 The Present Value
 Present Value equation:
Present Value (today) of any future cash flow (payment) :
FVn
PV0 
1  i n
Present Values are additive that is
after finding the present value of
payments made in the future you can
add them together.

Slide 10
 Present Value – Single Sums (Continued)
 If you receive $100 one year from now, what is
the PV of that $100 if your opportunity cost is
6%?
N I/Y P/Y PV PMT FV MODE
1 6 1 -94.37 0 100
Mathematical Solution:
PV0 = $1 / (1 + i)n
PV0 = $100 / (1 + 0.06)1
PV0 = -$94.34
Slide 11
 Present Value – Single Sums (Continued)
 If you receive $100 five year from now, what is
the PV of that $100 if your opportunity cost is
6%?
N I/Y P/Y PV PMT FV MODE
5 6 1 -74.73 0 100
Mathematical Solution:
PV0 = $1 / (1 + i)n
PV0 = $100 / (1 + 0.06)5
PV0 = -$74.73
Slide 12
 Present Value – Single Sums (Continued)
 If you sold land for $11,933 that you bought 5
years ago for $5,000, what is your annual rate of
return?
N I/Y P/Y PV PMT FV MODE
5 19 1 -5,000 0 11,933
 Mathematical Solution:
1 1

 FV  n  11,933 
5
i   1 i   1  19%
 PV   5,000 
Slide 13
 Present Value – Single Sums (Continued)
 Suppose you placed $100 in an account that pays
9.6% interest, compounded monthly. How long
will it take for your account to grow to $500?
N I/Y P/Y PV PMT FV MODE
202 9.6 12 -100 0 500
 Mathematical Solution:
 FV 
ln    500 
ln  
n 
PV 
n  100   202 months.
 i
ln 1    0.096 
 m ln 1  
m : compoundin g frequency  12 
Slide 14
 Hint for Single Sum Problems
 In every single sum future value and present value
problem, there are 4 variables:
 FV, PV, i, and n
 When doing problems, you will be given 3 of
these variables and asked to solve for the 4th
variable
 Keeping this in mind makes “time value”
problems much easier!
Slide 15
Compounding and Discounting Cash Flow Streams
 Annuity: a sequence of equal cash flows,
occurring at the end of each period
 If you buy a bond, you will receive equal semi-
annual coupon interest payments over the life of
the bond
 If you borrow money to buy a house or a car, you
will pay a stream of equal payments

Slide 16
 Future Value – Annuity
 If you invest $1,000 each year at 8%, how much
would you have after 3 years?
N I/Y P/Y PV PMT FV MODE
3 8 1 0 -1000 3,246.40

 Mathematical Solution:
 1  i   1
n  1  0.083  1
FVn  PMT   FV3  $1,000 
 i   0.08 
FV3  $3,246.40
Slide 17
 Present Value – Annuity
 What is the PV of $1,000 at the end of each of the
next 3 years, if the opportunity cost is 8%?
N I/Y P/Y PV PMT FV MODE
3 8 1 2,577.10 -1000 0

 Mathematical Solution:
 1   1 
 1   1 
PV0  PMT 
1 i
n

 1  0.083 
 i  PV0  $1,000 
   0.08 
 
PV0  $2,577.10
Slide 18
 Perpetuities
 Suppose you will receive a fixed payment every
period (month, year, etc.) forever. This is an
example of a perpetuity
 You can think of a perpetuity as an annuity that
goes on

Slide 19
 Perpetuities (Continued)
We know the equation for PV as :
 1 
1  1  i n 
PV0  PMT  
 i 
 
1
If n gets large then the term approaches zero.
( 1  i) n

Therefore the PV equation reduces to

1 PMT
PV0  PMT   or PV0 
i  i Slide 20
 Perpetuities (Continued)
 What should you be willing to pay in order to
receive $10,000 annually forever, if you require
8% per year on the investment?
 PV = $10,000 / 0.08 = $125,000

Slide 21
 Future Value – Annuity Due
Annuity Due: The cash flows occur at the beginning of each
year, rather than at the end of each year
 If you invest $1,000 at the beginning of each of
the next 3 years at 8%, how much would you have
at the end of year 3?
N I/Y P/Y PV PMT FV MODE
3 8 1 0 -1000 3,506.11 BEGIN

 Mathematical Solution:
 1  i n  1  1  0.083  1
FV  PMT
n   3  $1,000 
(1  i ) FV  (1  0.08)
 i   0.08 
FV3  $3,506.11

Slide 22
 Present Value – Annuity Due
Annuity Due: The cash flows occur at the beginning of each
year, rather than at the end of each year
 What is the PV of $1,000 at the beginning of each
of the next 3 years, if your opportunity cost is 8%?
N I/Y P/Y PV PMT FV MODE
3 8 1 2,783.26 -1000 0 BEGIN

 Mathematical Solution:
 1   1 
  1  
1  0.08
 1 
PV0  PMT 
1 i
n
 (1  i ) PV0  $1,000
3
 (1.08)
 i   0.08 
   
PV0  $2,783.26

Slide 23
 Uneven Cash Flows
How do we find the PV of a cash flow stream when all of
the cash flows are different? (Use a 10% discount rate)
Period CF PVCF
0 -10,000 -10,000.00
1 2,000 1,818.15
2 4,000 3,305.79
3 6,000 4,507.89
4 7,000 4,781.09
Total 4,412.95

Slide 24
 Uneven Cash Flows
CF
CF0 -10000 ENTER

C01 2000 ENTER F01 1.00 ENTER

C02 4000 ENTER F02 1.00 ENTER

C03 6000 ENTER F03 1.00 ENTER

C04 7000 ENTER F04 1.00 ENTER

NPV 10 ENTER CPT 4,412.95

Slide 25
 Annual Percentage Yield (APY) or
Effective Annual Rate (EAR)
 Which is the better loan:
 8.00% compounded annually, or
 7.85% compounded quarterly?
 We can’t compare these nominal (quoted) interest
rates, because they don’t include the same number
of compounding periods per year!
 We need to calculate the APY

Slide 26
 Annual Percentage Yield (APY) or
Effective Annual Rate (EAR) (Continued)
m
 quoted rate 
APY  1   1
 m 
m is the compoundin g frequency

 Find the APY for the quarterly (m = 4) loan:

4
 0.0785 
APY  1    1  0.0808
 4 

 The quarterly loan is more expensive than the 8%

loan with annual compounding!
Slide 27
 Annual Percentage Yield (APY) or
Effective Annual Rate (EAR) (Continued)
 2nd ICONV
 NOM 7.85 ENTER (EFF)
 C/Y 4 ENTER (EFF)
 CPT 8.08

Slide 28