Chapter 3

Time Value of
Money

Why TIME?
Why is TIME such an important element in your decision?
TIME allows you the opportunity to postpone consumption and
earn INTEREST.
INTEREST

The time value of money is the value of money

figuring in a given amount of interest earned over a
given amount of time.

Basic Time Value Concepts

The time value of money is the relationship

between time and money.
According to the present value of money concept,
a dollar earned today is worth more than a dollar
earned in the future.
This concept is used to choose among alternative
investment proposals.

The Interest Rate

Which would you prefer -- $10,000 today or
$10,000 in 5 years?
years
Obviously, $10,000 today.
today
You already recognize that there is TIME VALUE
TO MONEY!!
MONEY

Variables in Interest
Computations

Principal: The amount borrowed or invested

Interest rate: A percentage of the
outstanding principle.
Time: the number of years or fractional
portion of a year that principal is outstanding.

Basic Time Diagram

Types of 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).

Simple and Compound

Interests

Simple interest is determined on the principal

only.
principal x interest rate (%) x time
Compound interest is determined on:
the principal, and any interest earned (and not
withdrawn).
Compound interest is the typical computation
applied in most time value applications.

Simple Interest (FV)

What is the Future Value (FV)

FV of the deposit?
FV

= P0 + SI
= $1,000 + $140
= $1,140
Future Value is the value at some future time of a
present amount of money, or a series of payments,
evaluated at a given interest rate.

Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at a compound
interest rate of 7% for 2 years.
years

7%

$1,000
FV2

Future Value
Single Deposit (Formula)
FV1

= P0 (1+i)1 = $1,000 (1.07)

= $1,070
Compound Interest
You earned $70 interest on your $1,000 deposit over
the first year.
This is the same amount of interest you would earn
under simple interest.

Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
FV2 = FV1 (1+i)1
=
P0 (1+i)(1+i) = $1,000(1.07)(1.07)
= P0 (1+i)2
$1,000
2
= $1,000(1.07)
$1,000
= $1,144.90
You earned an EXTRA $4.90 in Year 2 with compound over
simple interest.

General Future Value Formula

FV1
FV2

= P0(1+i)1
= P0(1+i)2
.
.
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or
FVn = P0 (FVIFi,n) -- See Table I

Valuation Using Table I

FVIFi,n is found on Table I
at the end of the book.

Period
1
2
3
4
5

6%
1.060
1.124
1.191
1.262
1.338

7%
1.070
1.145
1.225
1.311
1.403

8%
1.080
1.166
1.260
1.360
1.469

Using Future Value Tables

FV2
= $1,000 (FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Period
6%
7%
8%
1
1.060
1.070
1.080
2
1.124
1.145
1.166
3
1.191
1.225
1.260
4
1.262
1.311
1.360
5
1.338
1.403
1.469

Simple Interest (PV)

What is the Present Value (PV)

PV of the previous
problem?

The Present Value is simply the $1,000 you originally

deposited. That is the value today!
Present Value is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate.

Present Value Single Deposit

(Graphic)
Assume that you need $1,000 in 2 years. Lets examine
the process to determine how much you need to deposit
today at a discount rate of 7% compounded annually.

7%

$1,000
PV0

PV1

Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 = FV2 / (1+i)2
= $873.44

7%

$1,000
PV0

General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
.
.
.
etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or
PV0 = FVn (PVIFi,n) -- See Table II

Valuation Using Table II

PVIFi,n is found on Table II
at the end of the book.

Period
1
2
3
4
5

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

Using Present Value Tables

PV2 = $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]

Period
1
2
3
4
5

6%
.943
.890
.840
.792
.747

7%
.935
.873
.816
.763
.713

8%
.926
.857
.794
.735
.681

Ordinary Annuities
and Annuities Due

An annuity is a series of equal payments at equal time

intervals
An ordinary annuity assumes the first payment
occurs at the end of the first year
An annuity due assumes the first payment occurs at
the beginning of the first year

Annuity Computations
An annuity requires that:

the periodic payments or receipts (rents)

always be of the same amount,

the interval between such payments or

receipts be the same, and

the interest be compounded once each interval.

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

Today

End of
Period 2

End of
Period 3

$100

$100

$100

Equal Cash Flows

Each 1 Period Apart

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2

$100

$100

$100

Today

Beginning of
Period 3

Equal Cash Flows

Each 1 Period Apart

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

. . .

i%
R

R = Periodic
Cash Flow
FVAn = R(1+i)n-1 + R(1+i)n-2 +
... + R(1+i)1 + R(1+i)0

FVAn

n+1

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

$1,000

$1,000

7%
$1,000

$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
= $3,215

$3,215 = FVA3

Valuation Using Table III

FVAn

= R (FVIFAi%,n)

FVA3

= $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215

Period
1
2
3
4
5

6%
1.000
2.060
3.184
4.375
5.637

7%
1.000
2.070
3.215
4.440
5.751

8%
1.000
2.080
3.246
4.506
5.867

Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

n+1

. . .

i%
R

R
R = Periodic
Cash Flow

PVAn

PVAn = R/(1+i)1 + R/(1+i)2

+ ... + R/(1+i)n

Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period

$1,000

$1,000

7%
$934.58
$873.44
$816.30

$1,000

$2,624.32 = PVA3

PVA3 =

$1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32

Valuation Using Table IV

PVAn

= R (PVIFAi%,n)

PVA3

= $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624

Period
1
2
3
4
5

6%
0.943
1.833
2.673
3.465
4.212

7%
0.935
1.808
2.624
3.387
4.100

8%
0.926
1.783
2.577
3.312
3.993

Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

i%
R

FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
FVAn (1+i)

. . .

n-1

FVADn

Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

$1,000

$1,000

$1,070

7%
$1,000

$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440

$3,440 = FVAD3

Valuation Using Table III

FVADn
FVAD3

= R (FVIFAi%,n)(1+i)
= $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867

Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

PVADn

. . .

i%
R

n-1

R: Periodic
Cash Flow

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)

Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period

$1,000

$1,000

7%
$1,000.00
$ 934.58
$ 873.44

$2,808.02 = PVADn
PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +
$1,000/(1.07)2 = $2,808.02

Valuation Using Table IV

PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808

Period
1
2
3
4
5

6%
0.943
1.833
2.673
3.465
4.212

7%
0.935
1.808
2.624
3.387
4.100

8%
0.926
1.783
2.577
3.312
3.993

Frequency of
Compounding

Compounding refers to the frequency with which interest

is computed and added to the principal balance
The more frequent the compounding, the higher the
interest earned
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

Impact of Frequency
ALI has $1,000 to invest for 2 Years at an annual interest
rate of 12%.
Annual
FV2
= 1,000(1+
[.12/1])(1)(2)
1,000
= 1,254.40
Semi
FV2 = 1,000(1+
[.12/2])(2)(2)
1,000
= 1,262.48
Qrtly
FV2 = 1,000(1+
[.12/4])(4)(2)
1,000
= 1,266.77
Monthly
FV2 = 1,000(1+
[.12/12])(12)(2)
1,000
= 1,269.73
(365)(2)
Daily
FV2 = 1,000(1+[.12/365])
1,000
= 1,271.20

Discrete Versus
Continuous Intervals

Discrete compounding means we can count the

number of compounding periods per year
E.g., once a year, twice a year, quarterly, monthly,
or daily
Continuous compounding results when there is an
infinite number of compounding periods

Discrete Versus
Continuous Intervals (contd)

Mathematical adjustment for discrete compounding:

FV PV (1 R / m)

mt

R annual interest rate

m number of compounding periods per year
t time in years

Discrete Versus
Continuous Intervals (contd)

Mathematical equation for continuous

compounding:

FV PVe

Rt

e 2.71828