Time Value of Money Stepen Ross

Chapter Five
First Principles of Valuation:

The Time Value of Money
Copyright  2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan 5-1
Slides prepared by Sue Wright
Konsep Time Value of Money (TVM)
• TVM = suatu konsep penentuan nilai uang yg
diakibatkan oleh perubahan waktu.
• Mana yg lebih bernilai : Rp 1 juta yg diterima
sekarang atau Rp1 juta yg akan diterima satu
tahun mendatang?
• Jawabannya cukup jelas, yaitu Rp 1 juta yg
diterima sekarang tentunya lebih bernilai.
• Perubahan nilai waktu uang yg diakibatkan oleh
perubahan waktu bisa dipengaruhi juga oleh inflasi,
peruhan harapan, kurs valas, dsb.

Cont ...
• Inilustrasi semacam itu merupakan contoh nilai
waktu uang (time value of money).
• Kenapa time value of money (TVM) itu penting?
• Setidaknya ada dua alasan kenapa demikian?
• Pertama, risiko pendapatan di masa mendatang
lebih tinggi dibandingkan dengan pendapatan saat
ini.
• Kedua, ada biaya kesempatan (opportunity cost)
pendapatan masa mendatang.
• Jika pendapatan diterima sekarang, kita bisa
menginvestasikan pendapatan tersebut (misal pada
tabungan), dan akan memperoleh bungan
tabungan.
• Nilai waktu uang merupakan konsep sentral dalam
manajemen keuangan.
• Ada beberapa pakar yg mengatakan bahwa pada
dasarnya Manajemen Keuangan merupakan
aplikasi konsep nilai waktu uang (time value of
money).
• Pemahaman nilai waktu uang sangat penting dalam
studi manajemen keuangan.
• Banyak keputusan dan teknik dalam manajemen
keuangan yang memerlukan pemahaman nilai
waktu uang.
• Seperti biaya modal, analisis keputusan investasi,
(capital budgeting), analisis alternatif dana,
penilaian surat berharga, merupakan contoh dan
teknik analisis yg memerlukan pemahaman TVM.
Chapter Organisation
5.1 Future Value and Compounding
5.2 Present Value and Discounting
5.3 More on Present and Future Values
5.4 Present and Future Values of Multiple Cash Flows
5.5 Valuing Equal Cash Flows: Annuities and Perpetuities
5.6 Comparing Rates: The Effect of Compounding Periods
5.7 Loan Types and Loan Amortisation
5.8 Summary and Conclusions

Chapter Objectives
• Distinguish between simple and compound interest.
• Calculate the present value and future value of a single amount
for both one period and multiple periods.
• Calculate the present value and future value of multiple cash
flows.
• Calculate the present value and future value of annuities.
• Compare nominal interest rates (NIR) and effective annual
interest rates (EAR).
• Distinguish between the different types of loans and calculate the
present value of each type of loan.

Time Value Terminology
0 1 2 3 4
PV FV
• Future value (FV) is the amount an investment is worth after

one or more periods.
• Present value (PV) is the current value of one or more future

cash flows from an investment.

Time Value Terminology
• The number of time periods between the present

value and the future value is represented by ‘t’.
• The rate of interest for discounting or

compounding is called ‘r’.
• All time value questions involve four values: PV,

FV, r and t. Given three of them, it is always
possible to calculate the fourth.
Interest Rate Terminology
• Simple interest refers to interest earned only on the

original capital investment amount.
• Compound interest refers to interest earned on

both the initial capital investment and on the
interest reinvested from prior periods.

Future Value of a Lump Sum
You invest $100 in a savings account that earns 10 per cent

interest per annum (compounded) for three years.
After one year: $100  (1 + 0.10) = $110

After two years: $110  (1 + 0.10) = $121
After three years: $121  (1 + 0.10) = $133.10

• The accumulated value of this investment at the end of three years can be split
into two components:
– original principal $100
– interest earned $33.10 (pendapatan dari bunga majemuk_componding
interest)
– Bungan biasa = P . i . n =
– Bunga thn 1 = 100 x (1,1) = $10
– Bunga thn 2 = 100 x (1,1) = $10
– Bunga thn 3 = 100 x (1,1) = $10
– Total pendapatan bunga= $30
• Using simple interest, the total interest earned would only have been $30. The
other $3.10 is from compounding.
• Kalau kita pake perhitungan bunga biasa (simple interest) maka pendapatan
bunga selama 3 tahun di atas hanya dapat $30

• In general, the future value, FVt, of $1 invested

today at r per cent for t periods is:
FVt  $1  1  r 
t
• FV = PV (1 + i) n
• The expression (1 + r)t is the future value interest
factor (FVIF). Refer to Table A.1.

Example—Future Value of a Lump
Sum
• What will $1000 amount to in five years time if interest is 12 per cent per annum, compounded annually?
•
•

FV  $1000 1  0.12
5

From the example, now assume interest is 12 per cent per annum, compounded monthly.
Always remember that t is the number of compounding periods, not the number of years.
 $1000  1.7623
 $1 762.30
FV  $1000 1  0.01
60
 $1000  1.8167
 $1816.70
Interpretation
• The difference in values is due to the larger

number of periods in which interest can compound.
• Future values also depend critically on the

assumed interest rate—the higher the interest rate,
the greater the future value.

Future Values at Different Interest
Rates
Number of Future value of $100 at various interest rates

periods
5% 10% 15% 20%
1 $105.00 $110.00 $115.00 $120.00
2 $110.25 $121.00 $132.25 $144.00
3 $115.76 $133.10 $152.09 $172.80
4 $121.55 $146.41 $174.90 $207.36
5 $127.63 $161.05 $201.14 $248.83

Future Value of $1 for Different
Periods and Rates

Present Value of a Lump Sum
You need $1000 in three years time. If you can earn 10 per
cent per annum, how much do you need to invest now?
Discount one year: $1000 (1 + 0.10) –1 = $909.09

Discount two years: $909.09 (1 + 0.10) –1 = $826.45
Discount three years: $826.45 (1 + 0.10) –1 = $751.32
PV = FV (1 + i)-n
PV = 1000 (1 + 0,10) -3
PV = 1000 (1,1)-3
PV = 1000 (0,75132)
PV = 751, 32

Interpretation
• In general, the present value of $1 received in t periods of

time, earning r per cent interest is:
PV  $1  1  r 
t
$1

1  r  t
• The expression (1 + r)–t is the present value interest factor

(PVIF). Refer to Table A.2.

Example—Present Value of a Lump
Sum
Your rich grandmother promises to give you $10 000 in 10 years

time. If interest rates are 12 per cent per annum, how much is
that gift worth today?
PV  $10 000  1  0.12

10
 $10 000  0.3220

 $ 3220

Present Values at Different Interest
Rates
Number of Present value of $100 at various interest rates

periods
5% 10% 15% 20%
1 $95.24 $90.91 $86.96 $83.33
2 $90.70 $82.64 $75.61 $69.44
3 $86.38 $75.13 $65.75 $57.87
4 $82.27 $68.30 $57.18 $48.23
5 $78.35 $62.09 $49.72 $40.19

Present Value of $1 for Different
Periods and Rates
Present
value
of $1 ($)
r = 0%
1.00
.90
.80
.70
r = 5%
.60
.50
r = 10%
.40
.30 r = 15%
.20 r = 20%
.10
Time
1 2 3 4 5 6 7 8 9 10 (years)

Solving for the Discount Rate
• You currently have $100 available for investment for a 21-year period. At what interest rate must you
invest this amount in order for it to be worth $500 at maturity?
• FV = PV (1 + i)n
• PV = FV/(1 + i)n
• PV = FV (1 + i)-n
• 100 = 500 (1 + i) -21
• i = [FV/PV)1/n - 1
• i = [500/100)1/2]1 - 1
• i = [(5)1/21] - 1
• i = [(5)0,047619] - 1
• i = [1,07965314] - 1
• i = 0,07965314 x 100%
• i = 7,97%
• Given any three factors in the present value or future value equation, the fourth factor can be solved.
r can be solved in one of three ways:
• Use a financial calculator
• Take the nth root of both sides of the equation
• Use the future value tables to find a corresponding value. In this example, you need to find the r for
which the FVIF after 21 years is 5 (500/100).

Pembuktian
• FV = PV (1 + i)n
• FV = 100 (1 + 0,0797)21
• FV = 100 (1,0797)21
• FV = 100 (5,0045)
• FV = 500, 45 (Pembulatan angka)
• FV = $500 ---- terbukti betul
Kalau PV = FV/(1 +i)n
PV = 500 / (1 + 0,0797)^21
PV = 500/ (1,0797)^21
PV = 500/5,0045
PV = 99,91 ---- dibulatkan menjadi PV = 100
terbuktui
Dari soal tadi, bukti bahwa n = 21
thn?
• n = (Log S – Log P)/Log (1 +i)

• n = (Log FV – Log PV)/ Log (1 + i)
• = (Log 500 – Log 100)/ Log 1,0797)
• = (2,698 – 2)/0,0333
• n = 0,698/0,0333
• n = 20,96096 ---- dibulatkan menjadi 21 thn
(tebukti)
• =

The Rule of 72
• The ‘Rule of 72’ is a handy rule of thumb that states:

If you earn r per cent per year, your money will double in
about 72/r per cent years.
• For example, if you invest at 6 per cent, your money will

double in about 12 years.
• This rule is only an approximate rule.

Future Value of Multiple Cash Flows
• You deposit $1000 now, $1500 in one year, $2000 in two

years and $2500 in three years in an account paying 10 per
cent interest per annum. How much do you have in the
account at the end of the third year?
• You can solve by either:
– compounding the accumulated balance forward one
year at a time
– calculating the future value of each cash flow first and
then totalling them.

Solutions
• Solution 1
– End of year 1: ($1000  1.10) + $1500 = $2600
– End of year 2: ($2600  1.10) + $2000 = $4860
– End of year 3: ($4860  1.10) + $2500 = $ 846
• Solution 2
$1000  (1.10)3 = $1331
$1500  (1.10)2 = $1815
$2000  (1.10)1 = $2200
$2500  1.00 = $2500
Total = $7846

Solutions
Future value calculated by compounding forward one period at a time
0 1 2 3 4 5
Time
(years)
$0 $ 0 $2200 $4620 $7282 $10 210.20
0 2000 2000 2000 2000 2000.00
x 1.1 x 1.1 x 1.1 x 1.1 x 1.1
$0 $2000 $4200 $6620 $9282 $12 210.20
Future value calculated by compounding each cash flow separately

0 1 2 3 4 5
Time
(years)
$2000 $2000 $2000 $2000 $2000.0

x 1.1
2200.0
x 1.12
2420.0
x 1.13
2662.0
x 1.14
2928.2
Total future value $12 210.20
Figures 5.6/5.7 — Calculation of FV for Multiple Cash Flow Stream

Present Value of Multiple Cash Flows
• You will deposit $1500 in one year’s time, $2000 in two years
time and $2500 in three years time in an account paying 10
per cent interest per annum. What is the present value of
these cash flows?
• You can solve by either:

– discounting back one year at a time
– calculating the present value of each cash flow first and
then totalling them.

Solutions
• Solution 1
– End of year 2: ($2500  1.10–1) + $2000 = $4273
– End of year 1: ($4273  1.10–1) + $1500 = $5385
– Present value: ($5385  1.10–1) = $4895
• Solution 2
$2500  (1.10) –3 = $1878
$2000  (1.10) –2 = $1653
$1500  (1.10) –1 = $1364
Total = $4895

Solutions
Present value
0 1 2 3 4 5 calculated by
discounting each
$1000 $1000 $1000 $1000 $1000 Time cash flow separately
x 1/1.06 (years)
$ 943.40
x 1/1.062
890.00
x 1/1.063
839.62
x 1/1.064
792.09
x 1/1.065
747.26
$4212.37 Total present value

r = 6%
Present value
0 1 2 3 4 5 calculated by
discounting back one
$4212.37 $3465.11 $2673.01 $1833.40 $ 943.40 $ 0.00 Time period at a time
0.00 1000.00 1000.00 1000.00 1000.00 1000.00 (years)
$4212.37 $4465.11 $3673.01 $2833.40 $1943.40 $1000.00
Total present value = $4212.37

r = 6%
Figures 5.8/5.9 — Calculation of PV for Multiple Cash Flow Stream

Annuities
• An ordinary annuity is a series of equal cash flows

that occur at the end of each period for some fixed
number of periods.
• Examples include consumer loans and home

mortgages.
• A perpetuity is an annuity in which the cash flows

continue forever.

Present Value of an Annuity
1  1/ 1  r  t 
PV  C   
 
 r 
C = equal cash flow
• The discounting term is called the present value

interest factor for annuities (PVIFA). Refer to
Table A.3.

• Example 1
You will receive $500 at the end of each of the
next five years. The current interest rate is 9
per cent per annum. What is the present value
of this series of cash flows?
PV  $500  
1  1/ 1.09 5 

 
 0.09 
 $500  3.8897
 $1 944.85
• Example 2
You borrow $7500 to buy a car and agree to
repay the loan by way of equal monthly
repayments over five years. The current
interest rate is 12 per cent per annum,
compounded monthly. What is the amount of
each monthly repayment?
1  1/ 1.01 60 
$7 500  C   
 
 0.01 
C  $7 500  39.1961
 $191.35
Future Value of an Annuity
FV  C 
  1  r   1
t
r
• The compounding term is called the future value
interest factor for annuities (FVIFA). Refer to Table
A.4.

Example—Future Value of an
Annuity
What is the future value of $200 deposited at the
end of every year for 10 years if the interest rate is
6 per cent per annum?
1.06 10  1
 
FV  $200  
0.06
 $200  13.181
 $2636.20

Perpetuities
• The future value of a perpetuity cannot be

calculated as the cash flows are infinite.
• The present value of a perpetuity is calculated as

follows:
C
PV 
r

Comparing Rates
• The nominal interest rate (NIR) is the interest rate

expressed in terms of the interest payment made
each period.
• The effective annual interest rate (EAR) is the

interest rate expressed as if it was compounded
once per year.
• When interest is compounded more frequently than

annually, the EAR will be greater than the NIR.
Calculation of EAR
m
 NIR 
EAR  1    1
 m 
m = number of times the interest is compounded

Comparing EARS
• Consider the following interest rates quoted by three banks:
– Bank A:15%, compounded daily
– Bank B:15.5%, compounded quarterly
– Bank C:16%, compounded annually

Comparing EARS
365
 0.15 
EAR Bank A  1    1  16.18%
 365 
4
 0.155 
EAR Bank B  1    1  16.42%
 4 
1
 0.16 
EAR Bank C  1   1  16%
 1 

Comparing EARS
• Which is the best rate? For a saver, Bank B offers

the best (highest) interest rate. For a borrower,
Bank C offers the best (lowest) interest rate.
• The highest NIR is not necessarily the best.
• Compounding during the year can lead to a

significant difference between the NIR and the
EAR.

Types of Loans
• A pure discount loan is a loan where the borrower
receives money today and repays a single lump sum in
the future.
• An interest-only loan requires the borrower to only pay

interest each period and to repay the entire principal at
some point in the future.
• An amortised loan requires the borrower to repay parts of

both the principal and interest over time.

Amortisation of a Loan
Year Beginning Total Interest Principal Ending

Balance Payment Paid Paid Balance
1 $5000.00 $1285.46 $450.00 $835.46 $4164.54
2 $4164.54 $1285.46 $374.81 $910.65 $3253.89
3 $3253.89 $1285.46 $292.85 $992.61 $2261.28
4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33
5 $1179.33 $1285.46 $106.13 $1179.33 $0.00
Totals $6427.30 $1427.30 $5000.00


Time Value of Money Stepen Ross

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Chapter Five

First Principles of Valuation:

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

• Future value (FV) is the amount an investment is worth after

• Present value (PV) is the current value of one or more future

Copyright  2004 McGraw-Hill Australia Pty Ltd

• The number of time periods between the present

• The rate of interest for discounting or

• All time value questions involve four values: PV,

• Simple interest refers to interest earned only on the

• Compound interest refers to interest earned on

Copyright  2004 McGraw-Hill Australia Pty Ltd

You invest $100 in a savings account that earns 10 per cent

After one year: $100  (1 + 0.10) = $110

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

• In general, the future value, FVt, of $1 invested

Copyright  2004 McGraw-Hill Australia Pty Ltd

• The difference in values is due to the larger

• Future values also depend critically on the

Copyright  2004 McGraw-Hill Australia Pty Ltd

Number of Future value of $100 at various interest rates

1 $105.00 $110.00 $115.00 $120.00

2 $110.25 $121.00 $132.25 $144.00

3 $115.76 $133.10 $152.09 $172.80

4 $121.55 $146.41 $174.90 $207.36

5 $127.63 $161.05 $201.14 $248.83

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Discount one year: $1000 (1 + 0.10) –1 = $909.09

Copyright  2004 McGraw-Hill Australia Pty Ltd

• In general, the present value of $1 received in t periods of

• The expression (1 + r)–t is the present value interest factor

Copyright  2004 McGraw-Hill Australia Pty Ltd

Your rich grandmother promises to give you $10 000 in 10 years

PV  $10 000  1  0.12

 $10 000  0.3220

Copyright  2004 McGraw-Hill Australia Pty Ltd

Number of Present value of $100 at various interest rates

1 $95.24 $90.91 $86.96 $83.33

2 $90.70 $82.64 $75.61 $69.44

3 $86.38 $75.13 $65.75 $57.87

4 $82.27 $68.30 $57.18 $48.23

5 $78.35 $62.09 $49.72 $40.19

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

• n = (Log S – Log P)/Log (1 +i)

Copyright  2004 McGraw-Hill Australia Pty Ltd

• The ‘Rule of 72’ is a handy rule of thumb that states:

• For example, if you invest at 6 per cent, your money will

• This rule is only an approximate rule.

Copyright  2004 McGraw-Hill Australia Pty Ltd

• You deposit $1000 now, $1500 in one year, $2000 in two

Copyright  2004 McGraw-Hill Australia Pty Ltd

Copyright  2004 McGraw-Hill Australia Pty Ltd

Future value calculated by compounding each cash flow separately

$2000 $2000 $2000 $2000 $2000.0

Total future value $12 210.20

Figures 5.6/5.7 — Calculation of FV for Multiple Cash Flow Stream