The Time Value of Money

Chapter 8

Learning Objectives
The time value of money and its
importance to business.
The future value and present value of a
single amount.
The future value and present value of
an annuity.
The present value of a series of uneven
cash flows.
2

The Time Value of Money

Money grows over time when it earns
interest.
Therefore, money that is to be received
at some time in the future is worth less
than the same dollar amount to be
received today.
Similarly, a debt of a given amount to
be paid in the future is less burdensome
than that debt to be paid now.
3

Future Value of a Lump Sum

Suppose that you have $100 today and plan
to put it in a bank account that earns 8% per
year.
How much will you have after 1 year? 5? 15?
After one year:
$100 x (1.08)1
= $108
After five years:
$100 x 1.08 x 1.08 x 1.08 x 1.08 x 1.08 = $146.93
$100 x (1.08)5
= $146.93
After fifteen years:
$100 x (1.08)15 = $317.22
n
Equation: FV = PV (1 + k)
4

Future Value of a Lump Sum

Graph of the Effect of Compounding
$1000
900

k = 8%

800
700
600

k = 4%

500
400
300
200
0

k = 0%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year

Present Value of a Lump Sum

Value today of an amount to be received
or paid in the future.
1
PV = FVn x
(1 + k)n
Example: Expect to receive $100 in one year. If we
can invest at 10%, what is it worth today?
0

PV = 100 = 90.90
(1.10)1

$100

Present Value of a Lump Sum

Value today of an amount to be received
or paid in the future.
1
PV = FVn x
(1 + k)n
Example: Expect to receive $100 in EIGHT years. If
we can invest at 10%, what is it worth today?
0

PV = 100 = 46.65
(1.10)8

8
$100

Present Value of a Lump Sum

Graph of the Effect of Discounting
$100
90

k = 0%

80
70
60

k = 5%

50
40
30
20
0

k = 10%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year

Financial Calculator Solution - PV

Previous Example: Expect to receive
$100 in EIGHT years. If we can invest at
100 = 46.65
10%, what isUsing
it worth
today?
PV =
Formula:
8
(1+.10)

Calculator Enter:
N =8
I/YR = 10
FV = 100
CPT PV = ?

- 46.65

I/YR

8 10

PV

PMT

FV

100
9

Financial Calculator Solution - FV

Previous Example: You invest $200 at
10%. How much is it worth after 5
Using Formula: FV = $200 (1.10)5 = $322.10
years?
Calculator Enter:
N
= 5
I/YR = 10
PV = -200
CPT FV = ?

322.10

I/YR

PV

PMT

5 10 -200

FV

?
10
10

Annuities
An annuity is a series of equal cash
flows spaced evenly over time.
For example, you pay your landlord an
annuity since your rent is the same
amount, paid on the same day of the
month for the entire year.
Jan

Feb
$500

Mar
$500

Dec
$500

$500

$500

11

Future Value of an Annuity

You deposit $100 each year (end of
year) into a savings account.
How much would this account have in it
at the end of 3 years if interest were
earned at a rate of 8% annually?
0

$0

$100

$100

$100

12

Future Value of an Annuity

You deposit $100 each year (end of year) into a
savings account.
How much would this account have in it at the
end of 3 years if interest were earned at a rate
0
1
2
3
of 8%
annually?
$0

$100
$100(1.08)2

$100
$100(1.08)1

$100
$100(1.08)0

$100.00
$108.00
$116.64
$324.64
13

Future Value of an Annuity

0

$0

$100
$100(1.08)2

$100
$100(1.08)1

$100
$100(1.08)0

$100.00
$108.00
$116.64
$324.64
n

FVA = PMTx( (1+k) - 1 )

k

3
(1+.08)
-1
= 100
.08
= 100(3.2464) = 324.64

14

Future Value of an Annuity

Calculator Solution
0

$0

$100

Enter:
N =3
I/YR = 8
PMT = -100
CPT FV = ?

$100

$100

324.64
N

I/YR

PV

PMT

FV

-100 ?

15

Present Value of an Annuity

How much would the following cash
flows be worth to you today if you could
earn 8% on your deposits?
0

$0

$100

$100

$100

16

Present Value of an Annuity

How much would the following cash
flows be worth to you today if you could
earn 8% on your deposits?
0

$0

$100
$100/(1.08)1

$100

$100

$100 / (1.08)2

$100 / (1.08)3

$92.60
$85.73
$79.38
$257.71
17

Present Value of an Annuity

How much would the following cash
flows be worth to you today if you could
earn 8% on your deposits?
0

$0

$100
$100/(1.08)1

$92.60
$85.73
$79.38
$257.71

$100

$100

$100 / (1.08)2

$100 / (1.08)3

PVA = PMTx(

1-

1
(1+k)n ) = 100(2.5771) =
k
257.71
18

Present Value of an Annuity

Calculator Solution
0

$0

$100

Enter:
N =3
I/YR = 8
PMT = 100
CPT PV = ?

$100

$100

-257.71
N

I/YR

PV

PMT

100

FV

19

Annuities and Annuities Due

An annuity is a series of equal cash
payments spaced evenly over time.
Ordinary Annuity: The cash payments
occur at the END of each time period.
Annuity Due: The cash payments occur
at the BEGINNING of each time period.

20

Future Value of an Annuity Due

You deposit $100 each year at the
beginning of the year into a savings
account.
How much would this account have in it
at the end of 3 years if interest were
earned at a rate of 8% annually?
0

$100

$100

$100

21

Future Value of an Annuity Due

You deposit $100 each year (begin. of year)
into savings account.
How much would this account have in it at the
end of 3 years if interest were earned at a rate
0
1
2
3
of 8%
annually?
$100
$100(1.08)3

$100
$100(1.08)2

$100
$100(1.08)1

$108.00
$116.64
$125.97
$350.61

22

Future Value of an Annuity Due

You deposit $100 each year (begin. of year)
into savings account.
How much would this account have in it at the
end of 3 years if interest were earned at a rate
0
1
2
3
of 8%
annually?
$100
$100(1.08)3

$100
$100(1.08)2

n
(1+k)
- 1 )(1+k)
FVA = PMTx(
k
DUE

$100
$100(1.08)1

$108.00
$116.64
$125.97
$350.61

=100(3.2464)(1.08)= 350.61
23

Future Value of an Annuity Due

Calculator Solution
0

$100

$100

$100

Set Calculator to
Begin Mode
Enter:
N =3
I/YR = 8
PMT = -100
CPT FV = ?

350.61
N

I/YR

PV

PMT

FV

-100 ?

24

Present Value of an Annuity Due

How much would the following cash
flows be worth to you today if you could
earn 8% on your deposits?
0

$100
$100/(1.08)0

$100
$100/(1.08)1

$100
$100 / (1.08)2

$100.00
$92.60
$85.73
$278.33
25

Present Value of an Annuity Due

How much would the following cash
flows be worth to you today if you could
earn 8% on your deposits?
0

$100
$100/(1.08)0

$100.00
$92.60
$85.73
$278.33

$100
$100/(1.08)1

PVA = PMTx(
DUE

$100
$100 / (1.08)2

1-

1
(1+k)n

)(1+k)

= 100(2.5771)(1.08)
= 278.33
26

Amortized Loans
A loan that is paid off in equal amounts
that include principal as well as interest.
Solving for loan payments.
Solving for interest and principal paid.

27

Amortized Loans

You borrow $5,000 from your parents to purchase a used

car. You agree to make payments at the end of each year
for the next 5 years. If the interest rate on this loan is
6%, how much is your annual payment?
0

$5,000

$?

ENTER:
N =5
I/YR = 6
PV = 5,000
CPT PMT = ?

$?

$?

$?

$?

1,186.98
N

I/YR

PV

PMT

FV

6 5,000 ?

28

Amortized Loans
You borrow $20,000 from the bank to purchase
a used car. You agree to make payments at the
end of each month for the next 4 years. If the
annual interest rate on this loan is 9%, how
much is your monthly payment?
1
1(1.0075)48
$20,000 = PMT
.0075
1
1 - (1+k)n
PVA = PMTx(
) $20,000 = PMT(40.184782)
k
PMT = 497.70

29

Amortized Loans
You borrow $20,000 from the bank to purchase
a used car. You agree to make payments at the
end of each month for the next 4 years. If the
annual interest rate on this loan is 9%, how
much is your monthly payment?
ENTER:
N = 48
497.70
I/YR = 9
PV = 20,000
CPT PMT = ?
N
I/YR
PV
PMT
FV
Note:

N = 4 * 12 = 48

And set your P/Y to 12!!

48

20,000 ?

30

Perpetuities
A perpetuity is a series of equal
payments at equal time intervals (an
annuity) that will be received into
infinity.
PVP = PMT
k

31

Perpetuities
A perpetuity is a series of equal payments at
equal time intervals (an annuity) that will be
received into infinity.
Example: A share of preferred stock pays a
constant dividend of $5 per year. What is the
present value if k =8%?

PVP = PMT
k

If k = 8%: PVP = $5/.08 = $62.50

32

PV of Uneven Cash Flows

How much would the following cash flows be
worth to you today if you could earn 8% on
your deposits?
0

$7,000,000

$7,000,000
$1,851,852
$3,429,355
$4,762,993
$4,410,179
$21,454,380

$2,000,000

$4,000,000

$6,000,000

$6,000,000

$2mil/(1.08)1 $4mil/(1.08)2 $6mil /(1.08)3 $6mil /(1.08)4

33

Solving for k
Example: A $200 investment has grown to $230
over two years. What is the ANNUAL return on this
investment?

$200

$230
230 = 200(1+ k)2

FV = PV(1+ k)n

1.15 = (1+ k)2

1.15 = (1+ k)2
1.0724 = 1+ k
k = .0724 = 7.24%
34

Solving for k
Example: A $200 investment has grown to $230
over two years. What is the ANNUAL return on this
investment?
Enter known values:
N = 2
PMT
= 0
PV = -200
FV = 230
Solve for:
I/YR

7.24

= ?

I/YR

PV

-200

PMT

FV

230

35

Compounding more than Once per Year

$500 invested at 9% annual interest for
2 years. Compute FV.
Compounding

Frequency
$500(1.09)2 = $594.05 Annual
$500(1.045)4 = $596.26 Semi-annual
$500(1.0225)8 = $597.42 Quarterly
$500(1.0075)24 = $598.21 Monthly
$500(1.000246575)730 = $598.60 Daily

36

Continuous Compounding
Compounding frequency is infinitely
large.
Compounding period is infinitely small.
Example: $500 invested at 9% annual interest for
2 years with continuous compounding.

FV = PV x e
FV = $500 x e

.09 x 2

kn

= $598.61
37