Financial Management

Unit 4
Time Value of Money

Today Future

1
 Learning Objectives
1. Construct an appropriate cash flow timeline
using information from a given scenario
2. Discuss compounding, discounting, future
value, and present value
3. Compute the future value of some
beginning amount
4. Compute the present value of a single
payment to be received in the future

2
 Learning Objectives
5. Determine either future values (FV),
present values (PV), number of periods, or
interest rate for a single sum equation if the
other three variables are known
6. Calculate the future value or present value
of an annuity
7. Explain the difference between an ordinary
annuity, an annuity due, and a perpetuity
8. Calculate the present value of perpetuity
3
 Learning Objectives
9. Demonstrate how to find the present and
future value of an uneven series of cash
flows
10. Distinguish among the following interest
rates: Nominal (or Quoted) rate, Periodic
rate, and Effective (or Equivalent) Annual
Rate
11. Solve time value of money problems that
involve fractional time periods
12. Use time value of money (TVM) tables 4
 Agenda
• Time lines
• Future value
• Present value
• Annuities
• Perpetuities
• Uneven cash flow streams
• Frequent compounding

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Main concept of time value of
money

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We know that receiving $1 today is worth
more than $1 in the future. This is due to
OPPORTUNITY COSTS.
The opportunity cost of receiving $1 in the
future is the interest we could have earned
if we had received the $1 sooner.
Today Future

7
 Time lines show timing of cash flows.

0 1 2 3
10%

CF0 CF1 CF2 CF3

=-10,000

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
 Time lines show timing of cash flows.

0 1 2 3
10%

CF0 CF1 CF2 CF3

=-10,000

Negative Cash Flows represent outflows

(payments that we are to make)
 Time lines show timing of cash flows.

0 1 2 3
10%

CF0 CF1 CF2 CF3

=-10,000

Positive Cash Flows represent inflows

(payments that we are to receive)
 Four Ways to Find PVs or FVs

• Use a regular calculator to solve the

equation.
• Use financial tables.
• Use a financial calculator.
• Use a spreadsheet.
Translate $10,000 today into its equivalent
in the future (COMPOUNDING).

Today Future

?
Amount gets larger as
compound interest is added
12
 Translate $10,000 in the future into its
equivalent today (DISCOUNTING).

Today Future

Amount gets smaller as

compound interest is removed
13
 If you deposit $10,000 in an account earning
10%, how much would you have in the account
after 3 years?

0 1 2 3
10%

$10,000 FV = ?

Finding FVs is compounding.

 How much money would you accept now, in
exchange for $10,000 three years from now,
given an opportunity cost of 12%?
You will deposit this money in
an account earning 12% for it
to grow to $10,000 in 3 years.

0 1 2 3
12%

PV = ? $10,000

Finding PVs is discounting

(opposite of compounding)
Present Values Future Values
• Moving Cash flows • Moving Cash flows
backward in time forward in time
(DISCOUNTING) (COMPOUNDING)

• How much would I

invest now for it to grow • If I invest this PV
to the Future Value amount now, it will grow
(FV) in n years to this Future Value
(FV) in n years

𝐹𝑉
𝑃𝑉 =
(1 + 𝑖)! 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)!
Solving for i and n 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)!

17
The Four TVM Variables
 In 1958 the average tuition for one year at an Ivy
League school was $1,800. 30 years later, in 1988, the
average cost was $13,700. What was the growth rate
in tuition over the 30-year period?
l T abl es
Financia using
Solution

19
 In 1958 the average tuition for one year at an Ivy
League school was $1,800. 30 years later, in 1988,
the average cost was $13,700. What was the growth
rate in tuition over the 30-year period?
atical
Solution
Mathem

20
 Jill currently has $300,000 in a brokerage account.
The a/c pays 10% int. How many years will it take for
her to have $1M in the a/c?
l T abl e s
Financia using
Solution

21
 Jill currently has $300,000 in a brokerage account. The
a/c pays 10% int. How many years will it take for her to
have $1M in the a/c?
atical
Solution
Mathem

22
 The Rule of 72
It determine the number of years it will take to
double the value of your investment.
N = 72/interest rate

For example, if you can generate an annual

return of 9%, it will take
72/9 = 8 years
to double the value of investment.
Annuity: a sequence of cash flows of
equal amount, occurring at equally
spaced (equidistant) intervals for a finite
number of periods.
Yearly, Semi-annually, Quarterly,
Monthly, Weekly, Daily,…

0 1 2 3 4
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 Types of Annuities
(Constant amount at constant intervals)

• Ordinary Annuity
– start at end of time period, eg. month,
quarter, year … eg. Home loan

• Annuity Due
– start at beginning of time period, eg. Rent
lease
25
 What’s the difference between an
ordinary annuity and an annuity due?

Ordinary Annuity: payments at END of each period

0 1 2 3
i%

PMT PMT PMT

0 1 2 3
i%

PMT PMT PMT

Annuity Due: payments at START of each period
 FV - Annuities

(1 + 𝑖)! −1
𝐹𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑀𝑇
𝑖

1+𝑖 !−1
𝐹𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 = 𝑃𝑀𝑇 (1 + 𝑖)
𝑖

27
 PV - Annuities

1
1−
(1 + 𝑖)!
𝑃𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑀𝑇
𝑖

1
1−
(1 + 𝑖)!
𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 = 𝑃𝑀𝑇 (1 + 𝑖)
𝑖
28
 Future Value - Annuity

If you invest $1,000 at the end of each year for the next 3
years, at 8%, how much would you have after 3 years?

$1000 $1000 $1000

lly
indiv ulate
i dua
C al c

0 1 2 3
$1000

FV = $1000(1.08)1 = $1080

FV = $1000(1.08)2 = $1166.40

Done for demonstration purposes.

Total FV = $3246.40
We only calculate individually if 29
the amounts are different.
 Future Value - Annuity

If you invest $1,000 at the end of each year for the next 3
years, at 8%, how much would you have after 3 years?
(1 + 𝑖)! −1
Formula

𝐹𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑀𝑇

𝑖
Annuity

30
 Future Value - Annuity

If you invest $1,000 at the end of each year for the next 3
years, at 8%, how much would you have after 3 years?
l T abl e s
Financia

31
 Present Value - Annuity
What is the PV of $1,000 at the end of each of the next 3
years, if the opportunity cost is 8%?

$1000 $1000 $1000

lly
indiv ulate
i dua
C al c

0 1 2 3

PV = $1000/(1.08)1 = $925.93

PV = $1000/(1.08)2 = $857.34

PV = $1000/(1.08)3 = $793.83

Total PV = $2,577.10

Done for demonstration purposes.

We only calculate individually if

the amounts are different. 32
 Present Value - annuity

What is the PV of $1,000 at the end of each of the next 3

years, if the opportunity cost is 8%?
1
1−
(1 + 𝑖)!
𝑃𝑉 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑃𝑀𝑇
Formula

𝑖
Annuity

33
 Present Value - annuity

What is the PV of $1,000 at the end of each of the next 3

years, if the opportunity cost is 8%?
l T abl e s
Financia

34
 Earlier, we examined this Ordinary Annuity

$1000 $1000 $1000

0 1 2 3

Using an interest rate of 8%, we find that:

• The Future Value (at Year 3) is $3,246.40.

• The Present Value (at Year 0) is $2,577.10.

35
 What about this annuity?

$1000 $1000 $1000

0 1 2 3
• Same 3-year time line,
• Same number of cash flows, but
• The cash flows occur at the beginning of
each year, rather than at the end of each
year.
• This is an “annuity due.”
36
 Future Value - annuity due

If you invest $1,000 at the beginning of each of the next 3

years at 8%, how much would you have at the end of year 3?

1+𝑖 !−1
Formula

𝐹𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 = 𝑃𝑀𝑇 (1 + 𝑖)

𝑖
Annuity

37
 Future Value - annuity due

If you invest $1,000 at the beginning of each of the next 3

years at 8%, how much would you have at the end of year 3?
l T abl e s
Financia

38
 Present Value - annuity due

What is the PV of $1,000 at the beginning of each of the

next 3 years, if your opportunity cost is 8%?

1
1−
(1 + 𝑖)!
Formula

𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 = 𝑃𝑀𝑇 (1 + 𝑖)

𝑖
Annuity

39
 Present Value - annuity due

What is the PV of $1,000 at the beginning of each of the

next 3 years, if your opportunity cost is 8%?
l T abl e s
Financia

40
 Perpetuities
• Annuities that continues forever
• Perpetual annuities

𝑃𝑀𝑇
𝑃𝑉 =
𝑖
Interest Rate (i) must
be stated as a decimal

41
 Perpetuities
Suppose you were offered $250 beginning in one year
and continuing forever. If you could earn 10% on your
investment, how much should you pay for this
perpetuity?

𝑃𝑀𝑇
𝑃𝑉 = =
𝑖

42
 Uneven Cash Flows
-$10,000 $1,000 $2,000 $4,000 $6,000

0 1 2 3 4
Find the present value of this cash flow stream, given
Formula

a 12% discount rate

43
 Uneven Cash Flows
-$10,000 $1,000 $2,000 $4,000 $6,000

0 1 2 3 4
l T abl e s

Find the present

value of this cash
Financia

flow stream, given

a 12% discount
rate

44
 Frequent Compounding
• Up to this point it has been assumed that
interest is earned annually (once per year).

• In many instances, interest is paid more

than once for the year (e.g. semi- annually,
quarterly etc.)

• FV of a lump sum will be larger if we

compound more than once per year (more
interest on interest) 45
 Nominal Interest Rate (inom)
• The nominal interest rate is the quoted or
stated rate.

• It is usually quoted per annum.

• This is the rate that is stated in contracts,

and quoted by banks and brokers, but the
compounding periods per year are usually
also given. 46
 Periodic Interest rate (iper)

The periodic interest rate is the rate that is

actually paid each compounding period

e.g. the rate that is paid quarterly or monthly if

there is quarterly or monthly compounding.

47
Periodic Interest rate (iper)

𝑖!:;
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑅𝑎𝑡𝑒 = 𝑖789 =
𝑚
m = # of compounding periods per year.

Annual compounding: m=1

Semi-Annual compounding: m=2
Quarterly compounding: m=4
Monthly compounding: m = 12

48
 Effective Annual Rate (EAR or
EFF or EAIR)
• The EAR is the annual rate that causes the
PV to grow to the same FV as under multi-
period compounding.

• It is useful to compare returns on

investments with different compounding
periods per year.

49
 Effective Annual Rate (EAR or
EFF or EAIR)

8
𝑖
𝐸𝐴𝐼𝑅 = 1 + −1
𝑚

If m > 1, EAIR will always be greater than the nominal

rate.

50
 Question
What is the future value of $100 in 3 years’ time
at an interest rate of 10% compounded semi-
annually? What is the nominal rate, periodic
rate and effective annual rate?

51
 Question
What is the future value of $100 in 3 years’ time
at an interest rate of 10% compounded semi-
annually? What is the nominal rate, periodic
rate and effective annual rate?

52
 Question
What is the future value of $100 in 3 years’ time at an
interest rate of 10% compounded semi-annually? What is
the nominal rate, periodic rate and effective annual rate?

53
 Question
What is the future value of $100 in 3 years’ time at an
interest rate of 10% compounded semi-annually? What is
the nominal rate, periodic rate and effective annual rate?

54
Future Value with Frequent
Compounding

55
 Question
What is the future value of $100 in 3 years’ time at an
interest rate of 10% compounded semi-annually? What is
the nominal rate, periodic rate and effective annual rate?

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