Time Value of Money

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 Agenda
Time Lines
Future Values
Present Values
Solving for Interest Rate and Time
Future Value of an Annuity
Present Value of an Annuity
Perpetuities
Uneven Cash Flow Streams
Semiannual and Other Compounding Periods
Comparison of Different types of interest rates
Fractional Time Periods
Amortized Loans
Partial Amortization
 What is Time Value?
We say that money has a time value because that money can be
invested with the expectation of earning a positive rate of return.
In other words, a peso received today is worth more than a peso
to be received tomorrow
That is because todays peso can be invested so that we have
more than one peso tomorrow
The statements above are not true in all cases. Denmark for
example, imposed a 0.2% rate on bank deposits in 2012.
Although rare, the imposition of negative interest rates are
possible especially in an attempt to encourage spending in
depressed economies.
 If you have P10,000 today, and you
deposit it in the bank, how much will
you most likely receive in 10 years?

a. P9,500
a. P9,500
b. P14,000
b. P10,000
c. P14,000
c. P10,000
 Timelines
An important tool used in the time value of money analysis

A graphical representation used to show the timing of cash flows

A timeline is a graphical device used to clarify the timing of the

cash flows for an investment

Each tick represents one time period

PV FV

0 1 2 3 4 5

Today
 Future Value
The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum
today
Terms:
PV present value, or beginning amount in your account
i interest rate the bank pays on the account per year
INT amount of interest you earn during the year (aka
discount rate, opportunity cost rate)
FV future value or ending amount of your account at the
end of n years
n number of periods involved in the analysis
 Future Value
Simple Annual Interest
Q: Today, Peter invested P1,000 for 5 years with
simple annual interest of 10%. How much is its
future value?
A: FV = PV x [1 + (i*n)]
FV = P1,000 x [1 + (10%*5)]
FV = P1,000 x 1.5
FV = P1,500
 Future Value
Interest compounded
Q: Today, Peter invested P100 for 3 years at 10%,
compounded annually. How much is its future
value?

A: FV = PV (1+i)
0 1 2 3

100 FV = ?

After 1 year : FV = PV (1+i)^1 = 100 (1+10%)^1 = 110

After 2 years: FV = PV (1+i)^2 = 100 (1+10%)^2 = 121
After 3 years: FV = PV (1+i)^3 = 100 (1+10%)^3 = 133.10
 Agenda
Future Value
Present Value
Annuities
Rates of Return
Amortization
 If you need to have P10,000 in 10
years, how much will you likely
have to invest today?

a. P7,000
b. P10,000
c. P12,000
 Present Value
The value today of a future cash flow or series
of cash flows.
Represents the amount that needs to be
invested to achieve some desired future value.
FVN
PV
1 i
N
 Present Value: An Example
Suppose that your five-year old daughter has just announced
her desire to attend college. After some research, you
determine that you will need about $100,000 on her 18th
birthday to pay for four years of college. If you can earn 8%
per year on your investments, how much do you need to
invest today to achieve your goal?
N = 13; I = 8%; PV = ?; PMT = 0; FV = 100,000

100 ,000
PV $36,769.79
1.08
13
 Solving for Interest and Time
I = (FV/PV)^1/n 1
Sample problem
You can buy a security at a price of $78.35, and it
will pay you $100 after 5 years. How much is the
interest rate youd earn if you bought the
security?
I = (100/78.35)^(1/5) 1 = 5%
 Solving for Interest and Time
N = ln (FV/PV) / ln (1+i)
Sample problem
Mr. Amos invested P60,000 in stocks at a 10%
interest rate compounded semi-annually. How
many years did it take Mr. Amos for his investment
to reach P100,000?
N = ln (100,000/60,000) / ln (1 + 5%)
N = 10.47 / 2 = 5.24 years
 Annuities
An annuity is a series of payments of an equal amount at
fixed intervals for a specified number of periods.
Annuities are very common:
Rent
Mortgage payments
Car payment
Pension income
The timeline shows an example of a 5-year, $100 annuity
Annuity = equal PMT
100 100 100 100 100

0 1 2 3 4 5
 Annuities
Ordinary (Deferred) Annuity
An annuity whose payments occur at the end of
each period.
Annuity Due
An annuity whose payments occur at the
beginning of each period.

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
Future Value of an Ordinary Annuity
Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much will she have at
the end of three years?

Fva = 100 {[(1+5%)^3 1] / 5%}

Fva = 315.25
 Future Value of an Annuity Due
Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much will she have at the end of three
years?

Fvad = 100 {[(1+5%)^3 1] / 5%} (1+5%) = 331.01

Present Value of an Ordinary Annuity
Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much is the present
value of her payments?

Pva = 100 [1 (1/(1+5%)^3) / 5%]

Pva = 272.32
 Present Value of an Annuity Due
Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much is the present value of her
payments?

Pvad = {100 [1 [1/(1+5%)^(3-1)] / 5%} + 100

Pvad = 285.94
Ordinary Annuity Solving for Payment
when FV is known
Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the end of the year?

PMT = 50,000 / [(1+5%)^5 1] / 5% = 9,048.74

Annuity Due Solving for Payment when
FV is known
Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the beginning of the year?

PMTad = 50,000 / {[(1+5%)^5 1] / 5%} (1+5%)

PMTad = 8,617.85
Ordinary Annuity Solving for Payment
when PV is known
How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the end of the year, if the present value
is 10,000?

PMT = 50,000 / [(1 (1/(1+5%)^5 )/5%] / 5% = 2,309.75

Annuity Due Solving for Payment when
PV is known
How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the beginning of the year, if the present
value is 10,000?

PMTad = 10,000 / {[(1 (1/(1+5%)^(5-1) )/5%] / 5%} + 1

PMTad = 2,199.76
Ordinary Annuity Solving for N when FV
is known
Sharon plans to save P100 per year (first payment at
end of the year). Assuming that the interest is 5%, how
many years does it take for Sharon to accumulate
1,000?

N = ln[1 (1,000/-100)5%] / ln (1+5%) = 8.31 years

 Annuity Due Solving for N when FV is
known
Sharon plans to save P100 per year (first payment at
beginning of the year). Assuming that the interest is
5%, how many years does it take for Sharon to
accumulate 1,000?

Nad = {ln[(1,000 x 5%) / (100 x 1.05)] + 1} / ln (1+5%)

Nad = 7.98 years
Ordinary Annuity Solving for N when PV
is known
Sharon plans to withdraw P100 per year (first payment at
the end of the year) from her P1,000 savings. Assuming that
the interest is 5%, how many years will it take to exhaust
her savings?

N = - ln[1 (1000/100) 5%] / ln (1+5%) = 14.207 years

 Annuity Due Solving for N when PV is
known
Sharon plans to withdraw P100 per year (first payment at the
beginning of the year) from her P1,000 savings. Assuming that
the interest is 5%, how many years will it take to exhaust her
savings?

Nad = {- ln[1 + 5% (1 (1000/100)] / ln (1+5%)} + 1

Nad = 13.25 years
 Ordinary Annuity: Solving for I
when FV is known (CALC)
Frederick will be contributing P30,000 to his
girlfriends account as a sign of his love
every quarter starting next quarter. He
calculates that in 10 years, there will be
P1,500,000 in his girlfriends account if she
does not touch any of the deposit. How much
interest is the account earning if Fredericks
calculations are correct?
Annuity Due: Solving for I when FV
is known (CALC)
Frederick contributes P30,000 to his
girlfriends account as a sign of his love
every quarter starting at the beginning of this
quarter. He calculates that in 10 years, there
will be P1,500,000 in his girlfriends account if
she does not touch any of the deposit. How
much interest is the account earning if
Fredericks calculations are correct?
 Summary
Rules regarding annuity, ceteris paribus:
Ordinary Annuity Annuity Due

Future Value Lower Higher

Present Value Lower Higher

Payment Higher Lower

N Higher Lower

Interest Higher Lower

 Perpetuities
A stream of equal payments expected to
continue forever
PV (Perpetuity) = Payment / Interest rate
Suppose each consol (British government
perpetual bonds) promised to pay $100 in
perpetuity, if the discount rate or opportunity
cost rate is 5% and 10%:
PV (Perpetuity) = 100/5% = $2,000
PV (Perpetuity) = 100/10% = $1,000
 Uneven Cash Flow Stream
A series of cash flows in which the amount
varies from one period to the next
PMT = equal cash flows coming at regular
intervals
CF = uneven cash flows
Uneven Cash Flows: An Example (PV)
Assume that an investment offers the following cash
flows. If your required return is 7%, what is the maximum
price that you would pay for this investment?

100 200 300

0 1 2 3 4 5

100 200 300

PV 513.04
1.07 1.07 1.07
1 2 3
 Uneven Cash Flows: An Example (FV)
Terminal Value = The future value of an uneven cash flow stream
Suppose that you were to deposit the following amounts in an
account paying 5% per year. What would the balance of the
account be at the end of the third year?

300 500 700

0 1 2 3 4 5

FV 3001.05 5001.05 700 1,555.75

2 1
 Non-annual Compounding
We could assume that interest is earned semi-annually,
quarterly, monthly, daily, or any other length of time
The only change that must be made is to make sure that the
rate of interest is adjusted to the period length
Non-annual Compounding (cont.)

Suppose that you have $1,000 available for investment.

After investigating the local banks, you have compiled the
following table for comparison. In which bank should you
deposit your funds?

Bank Interest Rate Compounding

First National 10% Annual
Second National 10% Monthly
Third National 10% Daily
Non-annual Compounding (cont.)

We can find the FV for each bank as follows:

FV 1,000110
. 1,100
1
First National Bank:

12
0.10
Second National Bank: FV 1,000 1 1,104 .71
12
365
0.10
Third National Bank: FV 1,000 1 1,10516
.
365
Obviously, you should choose the Third National Bank
 Continuous Compounding

There is no reason why we need to stop increasing the

compounding frequency at daily
We could compound every hour, minute, or second
We can also compound every instant (i.e., continuously):

F Pe rt

Here, F is the future value, P is the present value, r is the annual rate of
interest, t is the total number of years, and e is a constant equal to
about 2.718
Continuous Compounding (cont.)

Suppose that the Fourth National Bank is offering to pay

10% per year compounded continuously. What is the
future value of your $1,000 investment?

0 .10 1
F 1,000 e 1,10517
.
This is even better than daily compounding
The basic rule of compounding is: The more frequently interest is
compounded, the higher the future value
Continuous Compounding (cont.)

Suppose that the Fourth National Bank is offering to pay

10% per year compounded continuously. If you plan to
leave the money in the account for 5 years, what is the
future value of your $1,000 investment?

0 .10 5
F 1,000e 1,648.72
 Different Rates
Nominal (Quoted, Stated, Annual Percentage) Interest Rate
The rate charged by banks and other financial institutions
For example, 6% compounded quarterly, 5% compounded monthly
Effective (Equivalent Annual) Rate
The annual rate of interest actually being earned
EAR = (1+iNOM/m)^m 1
If payment is only once a year, EAR = nominal rate
Periodic Rate
Rate charged by a lender or paid by a borrower each period
iPER = iNOM/m
If Nominal rate is quoted at 18%, payable monthly, periodic rate is 18%/12 or 1.5%
If payment is only once a year, Nominal rate = periodic rate.

Landbank charges 10% interest rate, compounded quarterly. How much is the
nominal, EAR, and periodic rate?
Nominal = 10%, EAR = 10.38%, Periodic = 2.5%
 Different Rates Sample Problem 1
Marga Bank offers an investment security with
a 7.5 percent nominal annual return,
compounded quarterly. Margas competitor,
Felice Bank, is offering a similar security that
bears the same risk and same effective rate of
return. However, Felices security pays
interest monthly. What is the nominal annual
return of the security offered by Felice?
 Different Rates Sample Problem 2
If it were evaluated with an interest rate of 0
percent, a 10-year regular annuity would have
a present value of $3,755.50. If the future
(compounded) value of this annuity, evaluated
at Year 10, is $5,440.22, what effective annual
interest rate must the analyst be using to find
the future value?
 Fractional Time Periods
If you deposit $100 in a bank that uses daily
compounding and pays a nominal rate of 10% with a
365 days, how much is the FV after 9 months?
N = 365 x 9/12 ; I = 10% / 365 ; PV = 100
FV = PV x [(1 + i)^n] = 100 x [(1 + 0.000273973)^274] =
107.79
You borrow $100 that charges 10% simple interest but
you borrow only for 274 days. How much interest do
you owe?
Interest owed = 100 x 10% x 274/365 = $7.51
 Amortized Loans
A loan that is repaid in equal payments over its life.
If a firm borrows $1,000 and the loan is to be repaid in 3 equal
payments at the end of each of the next three years, and the
lender charges 6% on the loan balance, how much is the
periodic payment? Construct the loan amortization schedule.
N = 3; I = 6%; PV = 1000; PMT = ?; FV = 0

PMT = 1,000 / [(1 (1/(1+6%)^3)/6%] / 6% = 374.11

 Balloon Loan
A long-term loan, often a mortgage, that has
one large payment due upon maturity.
Advantage: very low interest payments,
requiring very little capital outlay during the
life of the loan.
Disadvantage: An undisciplined borrower will
be in trouble because he has to make a large
single payment upon maturity.
Partial Amortization: Balloon Loans
A house is worth $200,000, and a bank agrees to lend the
potential home buyer $175,000 secured by a mortgage on the
house. However, the buyer only has $5,000 and he is unable
to make the full $25,000 downpayment. The seller may take a
note of 20k, 8% interest rate and payments at the end of the
year based on a 20 year amortization schedule but with loan
maturing at the end of the 10th year.
N = 20; I = 8%; PV = 20,000; PMT = ?
Annual PMT of the note = 2,037.04
 Additional Problem 1:
To save money for a new house, you want to begin
contributing money to a brokerage account. Your plan is to
make 40 contributions to the brokerage account. Each
contribution will be for $1,500. The first contribution will
occur today and then every quarter, you will contribute
another $1,500 to the brokerage account. Assume that the
brokerage account pays a 6 percent return with annual
compounding. How much money do you expect to have in
the brokerage account in ten years (Quarter 40)? How much
money do you expect to have in the brokerage account in
Quarter 39?
 Additional Problem 2:
Today you opened up a local bank account. Your plan is make
five $1,000 contributions to this account. The first $1,000
contribution will occur today and then every six months you
will contribute another $1,000 to the account. (So your final
$1,000 contribution will be made two years from today). The
bank account pays a 6 percent nominal annual interest, and
interest is compounded monthly. After two years, you plan to
leave the money in the account earning interest, but you will
not make any further contributions to the account. How
much will you have in the account 8 years from today?
 Additional Problem 3
Erika and Kitty, who are twins, just received $30,000 each for their 25th
birthday. They both have aspirations to become millionaires. Each plans to
make a $5,000 annual contribution to her early retirement fund on her
birthday, beginning a year from today. Erika opened an account with the
Safety First Bond Fund, a mutual fund that invests in high-quality bonds
whose investors have earned 6% per year in the past. Kitty invested in the
New Issue Bio-Tech Fund, which invests in small, newly issued bio-tech
stocks and whose investors have earned an average of 20% per year in the
funds relatively short history.
Requirement 1: If the two womens funds earn the same returns in the
future as in the past, how old will each be when she becomes a millionaire?
Requirement 2: How large would Erikas annual contributions have to be for
her to become a millionaire at the same age as Kitty, assuming their
expected returns are realized?
Requirement 3: Is it rational or irrational for Erika to invest in the bond fund
rather than in stocks?
 Additional Problem 4
Your father, who is 60, plans to retire in 2 years, and he expects
to live independently for 3 years. He wants a retirement income
that has, in the first year, the same purchasing power as $40,000
has today. However, his retirement income will be a fixed
amount, so his real income will decline over time. His retirement
income will start the day he retires, 2 years from today, and he
will receive a total of 3 retirement payments.

Inflation is expected to be constant at 5 percent. Your father has

$100,000 in savings now, and he can earn 8 percent on savings
now and in the future. How much must he save each year,
starting today, to meet his retirement goals?
 Additional Problem 5:
You recently purchased a 20-year investment
that pays you $100 at t = 1, $500 at t = 2, $750
at t = 3, and some fixed cash flow, X, at the
end of each of the remaining 17 years. You
purchased the investment for $5,544.87.
Alternative investments of equal risk have a
required return of 9 percent. What is the
annual cash flow received at the end of each
of the final 17 years, that is, what is X?
Thank you for listening!