Chapter 5

The Time Value

of Money—
The Basics

1
 Slide Contents

• Learning Objectives
• Principles Applied in this Chapter
• 5.1 Using Timelines to Visualize Cash Flows
• 5.2 Compounding and Future Value
• 5.3 Discounting and Present Value
• 5.4 Making Interest Rates Comparable
• Key Terms
Learning Objectives

1. Construct cash flow timelines to organize your analysis of

problems involving the time value of money.
2. Understand compounding and calculate the future value of cash
flows using mathematical formulas, a financial calculator, and an
Excel spreadsheet.
Learning Objectives (cont.)

3. Understand discounting and calculate the present value of cash

flows using mathematical formulas, a financial calculator and an
Excel spreadsheet.

4. Understand how interest rates are quoted and know how to make
them comparable.
 Principles Applied in this Chapter
Principle 1: Money Has a Time Value.
5.1 USING TIMELINES TO VISUALIZE
CASHFLOWS
Using Timelines to Visualize Cashflows

• A timeline identifies the timing and amount of a stream of payments

– both cash received and cash spent - along with the interest rate
earned.

• A timeline is typically expressed in years, but it could also be

expressed as months, days or any other unit of time.
Time Line Example
i=10%

Years 0 1 2 3 4

Cash flow -$100 $30 $20 -$10 $50

The 4-year timeline illustrates the following:

• The interest rate is 10%.
• A cash outflow of $100 occurs at the beginning of the first year (at time
0), followed by cash inflows of $30 and $20 in years 1 and 2, a cash
outflow of $10 in year 3 and cash inflow of $50 in year 4.
5.2 COMPOUNDING AND FUTURE
VALUE
 Compounding and Future Value
Time value of money calculations involve Present value (what a cash
flow would be worth to you today) and Future value (what a cash flow
will be worth in the future).
 Compound Interest and Time
Example: Suppose that you deposited $500 in your savings account that
earns 5% annual interest. How much will you have in your account after
two years? After five years?

•FV2 = PV(1+i)n = 500(1.05)2 = $551.25

 Compound Interest and Time
YEAR PV or Interest Earned (5%) FV or
Beginning Value Ending
Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $26.25 $551.25
3 $551.25 $551.25*.05 =$27.56 $578.81
4 $578.81 $578.81*.05=$28.94 $607.75
5 $607.75 $607.75*.05=$30.39 $638.14

Using Equation 5-1a: FV = PV(1+i)n

= 500(1.05)5 =
$638.14
Figure 5.1 Future Value and Compound Interest Illustrated
(Panel A) Calculating Compound Interest
Figure 5.1 Future Value and Compound Interest Illustrated
(cont.)
(Panel B) The Power of Time
Figure 5.1 Future Value and Compound Interest Illustrated
(cont.)
(Panel C) The Power of the Rate of Interest
 Applying Compounding to Things Other
Than Money
Example A DVD rental firm is currently renting 8,000 DVDs per year. How
many DVDs will the firm be renting in 10 years if the demand for DVD
rentals is expected to increase by 7% per year?

•Using Equation 5-1a,

• FV = 8000(1.07)10 = 15,737.21 DVDs
 CHECKPOINT 5.2:
CHECK YOURSELF

Calculating the FV of a Cash Flow

What is the FV of $10,000 compounded at 12% annually for 20
years?
 Step 1: Picture the Problem
i=12%

Years
0 1 2… 20
Cash flow -$10,000

Future
Value=?
Step 2: Decide on a Solution Strategy
This is a simple future value problem. We can find the future value using
Equation 5-1a.
Step 3: Solve

Solve Using a Mathematical Formula

FV = $10,000(1.12)20
= $10,000(9.6463)
= $96,462.93
Step 3: Solve (cont.)
Solve Using a Solve Using an Excel
Financial Calculator Spreadsheet
N = 20
I/Y = 12% =FV(rate,nper,pmt, pv)
PV = -10,000 =FV(0.12,20, 0,-10000)
PMT = 0
= $96,462.93
FV = $96,462.93
 Step 4: Analyze
If you invest $10,000 at 12%, it will grow to$96,462.93 in 20 years.
Compound Interest with Shorter
Compounding Periods
Banks frequently offer savings account that compound interest every
day, month, or quarter.
More frequent compounding will generate higher interest income and
lead to higher future values.
Table 5-2 The Value of $100 Compounded at Various Non-
Annual Periods and Various Rates
 CHECKPOINT 5.3:
CHECK YOURSELF

Calculating Future Values Using

Non-Annual Compounding Periods
If you deposit $50,000 in an account that pays an annual
interest rate of 10% compounded monthly, what will
your account balance be in 10 years?
 Step 1: Picture the Problem

i=10%
Months
0 1 2… 120
Cash flow -$50,000

FV of $50,000
Compounded for
120 months
@ 10%/12
Step 2: Decide on a Solution Strategy

This involves solving for future value of $50,000. Since the interest is
compounded monthly, we will use equation 5-1b.
 Step 3: Solve
Using a Mathematical Formula Using a Financial Calculator

FV = PV (1+i/12)m*12 N = 120
I/Y = .833%
= $50,000 (1+0.10/12)10*12 PV = -50,000
= $50,000 (2.7070) PMT = 0

= $135,352.07 FV = $135,352
Step 3: Solve (cont.)

Using an Excel Spreadsheet

=FV(rate,nper,pmt, pv)

=FV(0.00833,120, 0,-50000)

= $135,346.71
Step 4: Analyze

• More frequent compounding leads to a higher FV as you are earning

interest more often on interest you have previously earned.

• If the interest was compounded annually, the FV would have been

equal to only $129,687.12
• $50,000 (1.10)10 = $129,687.12
5.3 DISCOUNTING AND PRESENT
VALUE
The Key Question

• What is value today of cash flow to be received in the future?

• The answer to this question requires computing the present value

(PV) i.e. the value today of a future cash flow, and the process of
discounting, determining the present value of an expected future
cash flow.
 The Mechanics of Discounting Future Cash
Flows

• The term in the bracket is known as the Present Value Interest Factor
(PVIF).

• PV = FVn × PVIF
Figure 5.2 The Present Value of $100 Compounded at
Different Rates and for Different
Time Periods
 CHECKPOINT 5.4:
CHECK YOURSELF
Solving for the PV of a Future Cash Flow
What is the present value of $100,000 to be received at the end of 25
years given a 5% discount rate?
Step 1: Picture the Problem
i=5%
Years
0 1 2… 25
Cash flow $100,000

Present
Value =?
Step 2: Decide on a Solution Strategy

Here we are solving for the present value (PV) of $100,000 to be

received at the end of 25 years using a 5% interest rate. We can solve
using equation 5-2.
 Step 3: Solve
Using a Mathematical Formula Using a Financial Calculator
N = 25
PV I/Y = 5
= $100,000 [1/(1.05)25) PMT = 0
= $100,000 [0.2953]
FV = 100,000
= $29,530

PV = -$29,530
Step 4: Analyze

Once you’ve found the present value, it can be compared to other

present values. Present value computation makes cash flows that
occur in different time periods comparable so that we can make good
decisions.
 Two Additional Types of Discounting
Problems
Solving for: (1) Number of Periods; and
(2) Rate of Interest

(1): How long will it take to accumulate a specific amount in the future?
• It is easier to solve for “n” using the financial calculator or Excel rather than mathematical
formula. (See checkpoint 5.5)
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 are able to generate an annual return of 9%, it will take 8
years (=72/9) to double the value of investment.
 CHECKPOINT 5.5:
CHECK YOURSELF

Solving for Number of Periods, n

How many years will it take for $10,000 to grow to $200,000 given a
15% compound growth rate?
 Step 1: Picture the Problem
i=15%

Years
0 1 2… N =?
Cash flow -$10,000
$200,000

We know FV,
PV, and i and
are solving for
N
 Step 2: Decide on a Solution Strategy
In this problem, we are solving for “n”. We know the interest rate, the
present value and the future value. We can calculate “n” using a financial
calculator or an Excel spreadsheet.
 Step 3: Solve
• Using a Financial Calculator • Using an Excel
I/Y = 15 Spreadsheet
PMT = 0
PV = -10,000 N = NPER(rate,pmt,pv,fv)
FV = 200,000
= NPER(.15,0,-10000,200000)
N = 21.4 years

= 21.4 years
Step 4: Analyze

It will take 21.4 years for $10,000 to grow to $200,000 at an annual

interest rate of 15%.
Solving for the Rate of Interest

(2): What rate of interest will allow your investment to grow to a

desired future value?

We can determine the rate of interest using mathematical equation,

the financial calculator or the Excel spread sheet.
CHECKPOINT 5.6:
CHECK YOURSELF

Solving for the Interest Rate, i

At what rate will $50,000 have to grow to reach $1,000,000
in 30 years?
 Step 1: Picture the Problem
i=?%

Years
0 1 2… 30

Cash flow -$50,000 $1,000,000

We know FV, PV
and N and are Solving
for “interest rate”
Step 2: Decide on a Solution Strategy

Here we are solving for the interest rate. The number of years, the
present value, the future value are known. We can compute the
interest rate using mathematical formula, a financial calculator or an
Excel spreadsheet.
 Step 3: Solve
Using a Mathematical Formula Using an Excel Spreadsheet
I = (FV/PV)1/n - 1
= (1000000/50000)1/30 - 1
= (20)0.0333 - 1 =Rate (nper, pmt, pv, fv)
= 1.1050 - 1 =Rate(30,0,-50000,1000000)
= .1050 or 10.50%
=10.50%
Step 4: Analyze

You will have to earn an annual interest rate of 10.50 percent for 30
years to increase the value of investment from $50,000 to $1,000,000.
5.4 MAKING INTEREST RATES
COMPARABLE
Annual Percentage Rate (APR)

The annual percentage rate (APR) indicates the interest rate paid or
earned in one year without compounding. APR is also known as the
nominal or quoted (stated) interest rate.
Calculating the Interest Rate and Converting
it to an EAR
We cannot compare two loans based on APR if they do not have the
same compounding period.
To make them comparable, we calculate their equivalent rate using an
annual compounding period. We do this by calculating the effective
annual rate (EAR)
CHECKPOINT 5.7:
CHECK YOURSELF

Calculating an EAR
What is the EAR on a quoted or stated rate of 13 percent
that is compounded monthly?
 Step 1: Picture the Problem

i= an annual rate of 13% that is compounded monthly

Months
0 1 2… 12

Compounding periods
are expressed in months
(i.e. m=12) and we are
Solving for EAR
Step 2: Decide on a Solution Strategy

Here we need to solve for Effective Annual Rate (EAR). We can

compute the EAR by using equation 5-4
Step 3: Solve

EAR = [1+.13/12]12 - 1
= 1.1380 – 1
= .1380 or 13.80%
Step 4: Analyze

• There is a significant difference between APR and EAR (13.00%

versus 13.80%).

• If the interest rate is not compounded annually, we should compute

the EAR to determine the actual interest earned on an investment or
the actual interest paid on a loan.
To the Extreme:
Continuous Compounding
• As m (number of compounding period) increases, so does the EAR.
When the time intervals between when interest is paid are infinitely
small, we can use the following mathematical formula to compute
the EAR.
• EAR = (e quoted rate ) – 1
• Where “e” is the number 2.71828
Continuous Compounding (cont.)

• Example What is the EAR on your credit card with continuous

compounding if the APR is 18%?

• EAR = e.18 - 1
= 1.1972 – 1
= .1972 or 19.72%
Key Terms

• Annual Percentage Rate (APR)

• Compounding
• Compound Interest
• Discounting
• Discount Rate
• Effective Annual Rate (EAR)
• Future Value
Key Terms (cont.)

• Future Value Interest Factor

• Nominal or Stated Interest Rate
• Present Value
• Present Value Interest Factor
• Simple Interest
• Timeline