The Time Value of Money

Time Value of Money (TVM) is the

foundation of Corporate Finance
Hence, it is critical that you understand the
TVM concepts
In order to work the problems in this
module, you should have the use of a
financial calculator such as Hewlett Packard
17B II or a spreadsheet such as Excel
1

The Time Value of Money

What is the Time Value of Money?
Compound Interest
Future Value
Present Value
Frequency of Compounding
Annuities
Multiple Cash Flows
Bond Valuation
2

The Time Value of Money

Which would you rather have -- $1,000 today or
$1,000 in 5 years?
Obviously, $1,000 today.
today
Money received sooner rather than later allows
one to use the funds for investment or
consumption purposes. This concept is referred
to as the TIME VALUE OF MONEY!!
MONEY
3

Why TIME?
TIME allows one the opportunity to
postpone consumption and earn INTEREST
NOT having the opportunity to earn interest
on money is called OPPORTUNITY COST

How can one compare amounts

in different time periods?
One can adjust values from different time
periods using an interest rate.
Remember, one CANNOT compare
numbers in different time periods without
first adjusting them using an interest rate.
5

Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest
earned, this is called compound interest.
FV = Principal + (Principal x Interest)
= 2000 + (2000 x .06)
= 2000 (1 + i)
= PV (1 + i)
Note: PV refers to Present Value or Principal

Future Value (Graphic)

If you invested $2,000 today in an account that
pays 6%
6 interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?

6%

$2,000
FV
7

Future Value (Formula)

FV1 = PV (1+i)n

= $2,000 (1.06)2
= $2,247.20

FV = future value, a value at some future point in time

PV = present value, a value today which is usually
designated as time 0
i = rate of interest per compounding period
n = number of compounding periods
Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =
8

Future Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
2

I%Yr

2000 +/-

PV

FV

2,247.20

Future Value Example

John wants to know how large his $5,000
deposit will become at an annual compound
interest rate of 8% at the end of 5 years.
years

8%

$5,000

FV5
10

Future Value Solution

Calculation based on general

formula: FVn = PV (1+i)n
FV5 = $5,000 (1+ 0.08)5
= $7,346.64

11

Future Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
5

I%Yr

5000 +/-

PV

FV

7,346.64

12

Double Your Money!!!

Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
We will use the Rule-of-72.

13

The Rule-of-72
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
14

Present Value
Since FV = PV(1 + i)n.
PV = FV / (1+i)n.
Discounting is the process of translating a
future value or a set of future cash flows
into a present value.
15

Present Value (Graphic)

Assume that you need to have exactly $4,000 saved 10
years from now. How much must you deposit today
in an account that pays 6% interest, compounded
annually, so that you reach your goal of $4,000?

6%

10

$4,000
PV0
16

Present Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
10

I%Yr

4000

FV

PV

-2,233.57

18

Present Value Example

Joann needs to know how large of a deposit to make
today so that the money will grow to $2,500 in 5
years. Assume todays deposit will grow at a
compound rate of 4% annually.

4%

5
$2,500

PV0
19

Present Value Solution

Calculation based on general

formula:
PV0 = FVn / (1+i)n
PV0 = $2,500/(1.04)5
= $2,054.81

20

Present Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM

I%Yr

2,500 +/-

FV

PV

2,054.81

21

Finding n or i when one

knows PV and FV
If one invests $2,000 today and has
accumulated $2,676.45 after exactly five
years, what rate of annual compound
interest was earned?

22

(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
5

2000 +/-

PV

2,676.45

FV

I%Yr

6.00

23

Frequency of Compounding
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0:

PV of the Cash Flow today

24

Effects of Multiple
Compounding Periods
General equation: PVn = FV (1 + i/m)nm
Example with semiannual compounding
Multiply years by 2 to get total periods.
Divide discount rate by 2 to get periodic rate.
Divide annual payment by 2 to get periodic pmt.

Many cash flows occur throughout year.

Use daily compounding: PV0 = FV (1 + i/365)365n
Or approximate assuming mid-year cash flows, multiplying
sum of PV of end-of-year cash flows by (1+i)1/2.
25

Frequency of Compounding
Example
Suppose you deposit $1,000 in an account that
pays 12% interest, compounded quarterly. How
much will be in the account after eight years if
there are no withdrawals?
PV = $1,000
i = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
26

Solution based on formula

FV= PV (1 + i)n
= 1,000(1.03)32
= 2,575.10

27

Future Value, Frequency of

Compounding (HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
32

I%Yr

1000 +/-

PV

FV

2,575.10

28

Annuities

An Annuity represents a series of equal

payments (or receipts) occurring over
a specified number of equidistant
periods.

Examples of Annuities Include:

Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
29

Example of an Ordinary
Annuity -- FVA
0

End of Year

7%
$1,000

$1,000

FVA3 = $1,000(1.07)2 + $1,000(1.07)1 +

$1,000(1.07)0 = $3,215
If one saves $1,000 a year at the end of every year
for three years in an account earning 7% interest,
compounded annually, how much will one have
at the end of the third year?

$1,000
$1,070
$1,145

$3,215 = FVA3

30

Future Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
1,000 +/-

PMT

I%Yr

FV

3,214.90

31

Example of an Ordinary
Annuity -- PVA
0

End of Year

7%
$1,000

$1,000

$1,000

$934.58
$873.44
$816.30
$2,624.32 = PVA3

PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 +

$1,000/(1.07)3 = $2,624.32
If one agrees to repay a loan by paying $1,000 a year at
the end of every year for three years and the discount
rate is 7%, how much could one borrow today?
32

Present Value
(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
Choose Fin, then TVM
1,000

PMT

I% Yr

PV

-2,624.32

33

Multiple Cash Flows Example

Suppose an investment promises a cash flow of
$500 in one year, $600 at the end of two years and
$10,700 at the end of the third year. If the
discount rate is 5%, what is the value of this
investment today?

5%

$500

$600 $10,700

PV0
34

Multiple Cash Flow Solution

0

5%
$500

$600 $10,700

$476.19
$544.22
$9,243.06

$10,263.47 = PV0 of the Multiple

Cash Flows
35

Multiple Cash Flow Solution

(HP 17 B II Calculator)
Exit until you get Fin Menu.
2nd, Clear Data.
FIN

CFLO

Flow(0)=?

Input

Flow(1)=?

500

Input

# Times (1) = 1

Input

Flow(2)=?

600

Input

# Times (2) = 1

Input

Flow(3)=?

10,700

Input

Exit
Calc
5

I%

NPV
36

Bond Valuation Problem

Find todays value of a coupon bond with a
maturity value of $1,000 and a coupon rate of
6%. The bond will mature exactly ten years from
today, and interest is paid semi-annually. Assume
the discount rate used to value the bond is 8.00%
because that is your required rate of return on an
investment such as this.
Interest = $30 every six months for 20 periods
Interest rate = 8%/2 = 4% every six months
37

Bond Valuation Solution

(HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data

FIN

TVM

30

PMT

1000

FV

I% YR

20

PV

-864.09

30

30

20
30
1000
38

Problem #1
You must decide between $25,000 in cash
today or $30,000 in cash to be received two
years from now. If you can earn 8% interest
on your investments, which is the better
deal?

39

Possible Answers - Problem 1

$25,000 in cash today
$30,000 in cash to be received two years f
rom now
Either option O.K.

Need a Hint?
40

Solution (HP 17 B II Calculator)

Problem #1
Exit until you get Fin Menu.
2nd, Clear Data
Choose FIN, then TVM
2

I%YR

30,000

FV

PV

-25,720.16

Compare PV of $30,000, which is $25,720.16

to PV of $25,000. $30,000 to be received 2
years from now is better.
41

Problem #2
What is the value of $100 per year for four
years, with the first cash flow one year from
today, if one is earning 5% interest,
compounded annually? Find the value of
these cash flows four years from today.

42

Possible Answers - Problem 2

$400
$431.01
$452.56

Need a
Hint?
43

Solution (HP 17 B II Calculator)

Problem #2
Exit until you get Fin Menu.
2nd, Clear Data
Choose FIN, then TVM

100

PMT

I% YR

FV

431.01

FVA=100(1.05)3 + 100(1.05)2 + 100(1.05)1 + 100(1.05)0

100

100

100

100
44

Problem #3
What is todays value of a $1,000 face value
bond with a 5% coupon rate (interest is paid
semi-annually) which has three years
remaining to maturity. The bond is priced
to yield 8%.

45

Possible Solutions - Problem 3

$1,000
$921.37
$1021.37

Need a hint?
46

Solution (HP 17 B II Calculator)

Problem #3
Exit until you get Fin Menu.
2nd, Clear Data

FIN

TVM

25

PMT

1000

FV

I% YR

PV

921.37

25

25

12
25
1000
47

Congratulations!
You obviously understand this material!!

48

Comparing PV to FV
Remember, both quantities must be present
value amounts or both quantities must be
future value amounts in order to be
compared.

49

How to solve a time value of

money problem
The value four years from today is a
future value amount.
The expected cash flows of $100 per year
for four years refers to an annuity of $100.
Since it is a future value problem and there
is an annuity, you need to solve for a
FUTURE VALUE OF AN ANNUITY.
50

Valuing a Bond
The interest payments represent an annuity and
you must find the present value of the annuity.
The maturity value represents a future value
amount and you must find the present value of this
single amount.
Since the interest is paid semi-annually, discount at
HALF the required rate of return (4%) and TWICE
the number of years to maturity (6 periods).
51

Applications of Present
Value Techniques
Deposits to accumulate a future sum
Useful for calculating a childs education fund, a
retirement fund, etc.
Once you know the sum you wish to save, the
formula is:
PMT = [FVAn / FVIFAi,n]

Payments to amortize a loan or debt

obligation
PMT = [PVAn / PVIFAi,n]
52

Application: Mortgage Payments

Assume 30-year, $200,000 mortgage at

8% with monthly payments occurring
at the end of each month

Note: Monthly interest rate on loan = .08/12 = 0.0067

Monthly Payment = $200,000

0.0067
1
1(1.0067) 360

$1473.11

53

Application: Return to a Bank

A bank makes a $100,000 loan and will receive
payments of $805 each month for 30 years as
repayment. What is the rate of return to the
bank for making this loan?

54

Application: Return to a Bank

Set P/Y = 12
PMT
= $805
n

= 360

PV

= ($100,000)

FV

= $0

= 9%

55

Application: Accumulating a
Future Sum
An individual would like to purchase a
home in five (5) years. The individual will
accumulate enough money for a $20,000
down payment by making equal monthly
payments to an account that is expected to
earn 12% annual interest compounded
monthly. How much are the equal monthly
payments?
56

Application: Accumulating a
Future Sum
In the previous example, our saver
deposited
$244.89 x 60 = $14,693.40
Interest Earned was
$20,000 - $14,693.40 = $5,306.60

57

Application: Amortizing a Loan

Your company would like to borrow
$100,000 to purchase a piece of machinery.
Assume that you can make one payment at
the end of each year, the term is 15 years,
and interest rate is 7%. What is the amount
of the annual payment?

58

Application: Amortizing a Loan

Set P/Y = 1:
= $100,000
PV
n

= 15

FV

= $0

=7

PMT

= $10979.46

59

Application: Value of MBA

Earning $30,000/year before entering program and
tuition costs are $8,000/year. Expected salary of
$40,000 per year for 30 years after graduation. Cost
of fund is 8%.
PV of costs = $8,000 + $8,000/1.08 + $30,000 x PVIFA8%,2
yrs) = $68,905
PV of benefits = $10,000 x PVIFA8%,30 yrs = $112,578, which
must be discounted two more years: $112,578 / 1.082 =
$96,517
Present value of getting an MBA is = $96,517 - $68,905 =
$27,612
60

Present Value of a
Growing Annuity

Algebraic solution

1 g
1n

1 i

PVAn = PMT0 1 g

i - g

61

Application: Value of
Gold Mine
You have rights to mine for 20 years, expecting to extract
5,000 ounces of gold every year. The price per ounce is
currently $300, but is increasing at 3% per year. The
appropriate discount rate is 10%.

1.03 20
1
20
1.10
PV0 = $300 5,000 1.03

0.10 0.03

$16,145,980

62