Time Value of Money

Personal Finance Basics

part 1

BOGDAN SZAFRAŃSKI, PHD, MBA

Learning Goals
LG 1 Discuss the role of time value in finance, the use of
computational tools, and the basic patterns of cash
flow.
LG 2 Understand the concepts of future value and present
value, their calculation for single cash flow amounts,
and the relationship between them.
LG 3 Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.

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5.1 The Role of Time Value in Finance
(1 of 5)

• Time Value of Money

– Refers to the observation that it is better to receive money
sooner than later
• Future Value Versus Present Value
– Suppose that a firm has an opportunity to spend $15,000
today on some investment that will produce $17,000 spread
out over the next 5 years as follows:
Year Cash flow
1 $−4,400
2 $ 5,000
3 $ 4,000
4 $ 3,000
5 $ 2,000
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5.1 The Role of Time Value in Finance
(2 of 5)

• Future Value Versus Present Value

– Is this investment a wise one?
– Timeline
 A horizontal line on which time zero appears at the leftmost
end and future periods are marked from left to right; can be
used to depict investment cash flows

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Figure 5.1 Timeline

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5.1 The Role of Time Value in Finance
(3 of 5)

• Future Value Versus Present Value

– To make the correct investment decision, managers must
compare the cash flows depicted in Figure 5.1 at a single
point in time
– Compounding
 Used to find the future value of each cash flow at the end of an
investment’s life
– Discounting
 Used to find the present value of each cash flow at time zero

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Figure 5.2 Compounding and Discounting

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5.1 The Role of Time Value in Finance
(4 of 5)

• Computational Tools
– Financial Calculators
– Electronic Spreadsheets
– Cash Flow Signs
 To provide a correct answer, financial calculators and
electronic spreadsheets require that a calculation’s relevant
cash flows be entered accurately as cash inflows or cash
outflows
 Cash inflows are indicated by entering positive values
 Cash outflows are indicated by entering negative values

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Figure 5.3 Calculator Keys

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5.1 The Role of Time Value in Finance
(5 of 5)

• Basic Patterns of Cash Flow Mixed Cash Flow Stream

– Single Amount Year A B

 A lump-sum amount either 0 −$3,000 −$ 50

currently held or expected at 1 100 50
some future date 2 800 −100
– Annuity 3 1,200 280
 A level periodic stream of cash 4 1,200 −60
flows 5 1,400 Blank
– Mixed Stream 6 300 Blank
 A stream of cash flows that is
not an annuity

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5.2 Single Amounts (1 of 7)
• Future Value of a Single Amount
– The Concept of Future Value
 Future Value
– The value on some future date of money that you invest
today
 Compound Interest
– Interest that is earned on a given deposit and has become
part of the principal at the end of a specified period
 Principal
– The amount of money on which interest is paid

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Personal Finance Example 5.1 (1 of 2)
If Fred Moreno places $100 in an account paying 8% interest
compounded annually (i.e., interest is added to the $100
principal 1 time per year), after 1 year he will have $108 in
the account. That’s just the initial principal of $100 plus 8%
($8) in interest. The future value at the end of the first year is
Future value at end of year 1 = $100 × (1 + 0.08) = $108
If Fred were to leave this money in the account for another
year, he would be paid interest at the rate of 8% on the new
principal of $108. After 2 years there would be $116.64 in the
account. This amount would represent the principal after the
first year ($108) plus 8% of the $108 ($8.64) in interest.

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Personal Finance Example 5.1 (2 of 2)
The future value after 2 years is
Future value after 2 years = $108 × (1 + 0.08)
= $116.64
Substituting the expression $100 × (1 + 0.08) from the first-
year calculation for the $108 value in the second-year
calculation gives us
Future value after 2 years = $100 × (1 + 0.08) × (1 + 0.08)
= $100 × (1 + 0.08)2
= $116.64

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5.2 Single Amounts (2 of 7)
• Future Value of a Single Amount
– The Equation for Future Value
 FVn = future value after n periods
 PV0 = initial principal, or present value when time = 0
 r = annual rate of interest
 n = number of periods (typically years) that the money remains
invested

FVn  PV0  (1  r )n (5.1)

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Personal Finance Example 5.2
Jane Farber places $800 in a savings account paying 3%
interest compounded annually. She wants to know how
much money will be in the account after 5 years. Substituting
PV0 = $800, r = 0.03, and n = 5 into Equation 5.1 gives the
future value after 5 years:
FV5 = $800 × (1 + 0.03)5 = $800 × (1.15927) = $927.42
We can depict this situation on a timeline as follows:

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Personal Finance Example 5.3 (1 of 5)
In Personal Finance Example 5.2, Jane Farber places $800 in
her savings account at 3% interest compounded annually and
wishes to find out how much will be in the account after 5 years.
Calculator use We can use a financial
calculator to find the future value directly.
First enter –800 and depress PV; next
enter 5 and depress N; then enter 3 and
depress I/Y (which is equivalent to “r” in our
notation); finally, to calculate the future
value, depress CPT and then FV. The
future value of $927.42 should appear on
the calculator display as shown at the left.
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Personal Finance Example 5.3 (2 of 5)
Remember that the calculator differentiates inflows from outflows
by preceding the outflows with a negative sign. For example, in
the problem just demonstrated, the $800 present value (PV),
because we entered it as a negative number, is considered an
outflow. Therefore, the calculator shows the future value (FV) of
$927.42 as a positive number to indicate that it is the resulting
inflow. Had we entered $800 present value as a positive number,
the calculator would show the future value of $927.42 as a
negative number. Simply stated, the cash flows—present value
(PV) and future value (FV)—will have opposite signs.
(Note: In future examples of calculator use, we will use only a
display similar to that shown on the previous slide. If you need a
reminder of the procedures involved, review the previous slide.)
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Personal Finance Example 5.3 (3 of 5)
Spreadsheet use Excel offers a mathematical function that
makes the calculation of future values easy. The format of
that function is FV(rate,nper,pmt,pv,type). The terms inside
the parentheses are inputs that Excel requires to calculate
the future value. The terms rate and nper refer to the interest
rate and the number of time periods, respectively. The term
pv represents the lump sum (or present value) that you are
investing today.

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Personal Finance Example 5.3 (4 of 5)
For now, we will ignore the other two inputs, pmt and type,
and enter a value of zero for each. The following Excel
spreadsheet shows how to use this function to calculate the
future value.

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Personal Finance Example 5.3 (5 of 5)
Changing any of the values in cells B2, B3, or B4
automatically changes the result shown in cell B5 because
the formula in that cell links back to the others. As with the
calculator, Excel reports cash inflows as positive numbers
and cash outflows as negative numbers. In the example
here, we have entered the $800 present value as a negative
number, which causes Excel to report the future value as a
positive number. Logically, Excel treats the $800 present
value as a cash outflow, as if you are paying for the
investment you are making, and it treats the future value as
a cash inflow when you reap the benefits of your investment
5 years later.

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5.2 Single Amounts (3 of 7)
• Future Value of a Single Amount
– A Graphical View of Future Value
 Figure 5.4 illustrates how the future value of $1 depends on
the interest rate and the number of periods that money is
invested
 It shows that (1) the higher the interest rate, the higher the
future value, and (2) the longer the money remains invested,
the higher the future value

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Figure 5.4 Future Value Relationship

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