Time Value of Money

 Time Value of Money (TVM) means the value of money is different

in different time periods.

Why Time is such an important element?

 TIME allows the opportunity to postpone consumption and earn

Interest hence, the value of Money is more today than in the future
due to its potential earning capacity.

 Factors that attributes to the individual’s time preference for money:

 Inflation (Purchasing Power)
 Available Investment Opportunities
 Individuals Consumption preference
 Risk (future is uncertain and risky)
Three Rules of Time Travel

• Financial decisions often require combining cash

flows or comparing values. Three rules govern these
processes.

2-2
 Time Value of Money

Example: If you have $100 today, versus an option to receive $100

after 3 years, what would you prefer?

Time line

A rational person will always choose to receive money today as the

funds can be invested and can earn interest on it.
 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).
Real Interest Rate
 Types of Interest
 Simple Interest
Formula SI = P0(i)(n)
SI: Simple Interest
P0: Principal amount (t=0)
i: Interest Rate per Period
n: Number of Time Periods

Example:
Assume that you deposit $1,000 in an account earning 7% simple interest for 2 years. What
is the accumulated interest at the end of the 2nd year?

SI = P0(i)(n)
= $1,000 (7.00%) (2)
= $140
 Types of Interest
Compound Interest
Formula CI = P0(in)
CI: Compound Interest
P0: Principal amount (t=0)
i: Interest Rate per Period
n: Number of Time Periods

Example:
Assume that you deposit $1,000 at a compound interest
rate of 7% for 2 years.
 Types of Interest
 Compound Interest
Example:
Assume that you deposit $1,000 at a compound interest rate of 7% for 2 years.

0 1 2
7%
$1,000

FV2
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(1.07)2 = $1,144.90
An EXTRA amount of $4.90 was earned in Year 2 with compound over simple interest.
 Lump Sum Payment

Lump Sum is a single payment/ amount invested today or

received at future date.

Present Value/ Future Value Factors:

FVn = PV0 * (1+r)n

PV0 = FVn / (1+r)n

 Annuity
An annuity is a series of Single payments made at fixed time periods.
Examples:
 Installment Loans
 Student Loan Repayment
 Mortgage Loan
 Car Loan
 Retirement – old system

Types of Annuities:
 Ordinary Annuity: Payments or receipts occur at the end of each
period.

 Annuity Due: Payments or receipts occur at the beginning of each

period.
 Growing Annuity
Growing annuity is used to describe a series of payments
that grow at a constant rate.
CF 1
PV of Growing Perpetuity =
r-g
where CF1= Cash flow next year
r = Market rate interest
g = Constant Growth rate

What is the present value of a cash flow stream that pays $105,000 at the
end of this year, and grows at5% per year forever?
PV of growing = 105,000 = 3,500,000
0.08 -0.05 
= 105,000 = 3,500,000
0.03
 Annuity
Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Annuity
Parts of an Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
 PV of an Annuity
 Ordinary Annuity: Payments or receipts occur at the end of each
period.

 Annuity Due: Payments or receipts occur at the beginning of each

period.

Where:
P = PV
PMT = payments (cash flows)
r = interest rate
n = number of years
Examples:
1. What is the value of the following Ordinary Due?
 Payment Amount: PKR 100,000/-
 Number of Years: 20 Years
 Interest Rate: 8.00% per year

Solution:

The payment amount will be multiplied by Annuity discounting factor.

PV = 100,000 * (1-(1/(1+0.08)20))/0.08
PV = 100,000 * 9.818

PV = 981,815/-
Examples:
2. What is the value of the following Annuity Due?
 Payment Amount: PKR 100,000/-
 Number of Years: 20 Years
 Interest Rate: 8.00% per year

Solution:

The payment amount will be multiplied by Annuity discounting factor.

PV = 100,000 * ((1-(1/(1+0.08)20))/0.08) * (1.08)

PV = 100,000 * 9.818 * 1.08
PV = 100,000 * 10.6036

PV = 1,060,360/-
 PV of an uneven cash flow stream
0 1 2 3 4
10%

300/(1.10) 100 300 300 -50

90.91
300/(1.10)2
247.93
300/(1.10)3
225.39
-50/(1.10)4
-34.15
530.08 = PV

For uneven cash flows, an annuity formula does not apply, and the
value is calculated by individually discounting/ compounding all cash
 FV of an Annuity
FV of an annuity is calculated by compounding each
individual payment into the future and then adding up all
these payments.

Ordinary Annuity:

Annuity Due:
Examples:
3. A 20-year-old student wants to start saving for retirement. She plans to save $1 a
day. Every day, she puts $1 in her drawer. At the end of the year, she invests the
accumulated savings ($365) in an online stock account. The stock account has an
expected annual return of 10%.

How much money will she have when she is 65 years old?

Solution:

FV = 365 * (((1+0.10)45-1)/0.10)
FV = 365 * 718.90

FV = $ 262,400/-

She will grow her investment to $ 262,400/- at the time of retirement.

Examples:
4. A 20-year-old student wants to start saving for retirement. She had $365 in savings
and plans to save $1 a day. At the end of the year, she invests the accumulated savings
($365) in an online stock account. The stock account has an expected annual return
of 10%.
How much money will she have when she is 65 years old?

Solution:

FV = 365 * (((1+0.10)45-1)/0.10) * (1.10)

FV = 365 * 790.79

FV = $ 288,640/-

With additional savings of 1 year, her investments will increase to $ 288,640/- at

the time of retirement.
 Impact of Compounding frequency
General Formula: FVn = PV * (1+r/m)(m*n)

Example: Hamza has PKR 1,000 to invest for 2 Years at an annual interest rate of
12%

Annual: FV2 = 1,000 * (1+ [0.12/1])(1)(2) = 1,254.40

Semi-Annual: FV2 = 1,000 * (1+ [0.12/2])(2)(2) = 1,262.48

Quarterly: FV2 = 1,000 * (1+ [.12/4])(4)(2) = 1,266.77

Monthly: FV2 = 1,000 * (1+ [.12/12])(12)(2) = 1,269.73

Daily: FV2 = 1,000 * (1+[.12/365])(365)(2) = 1,271.20

 Impact of Compounding frequency
Annuity Formulas:
 PV of ordinary annuity:
PV = PMT * ((1-(1/(1+r/m)(m*n))/(r/m)

 PV of Annuity Due:
PV = PMT * ((1-(1/(1+r/m)(m*n))/(r/m) * (1+r/m)

 FV of Ordinary Annuity:
FV = PMT * (1+r/m)(m*n)-1)/(r/m)

 FV of Annuity Due:
FV = PMT * (1+r/m)(m*n)-1)/(r/m) * (1+r/m)

Where m is the number of compounding periods per year.

 Perpetuity
Perpetuities are assets with a constant stream of cashflow
each year with no end.

PV = Present Value
C = Cash Flow
R = interest rate
Examples:
 British Government has sold such type of securities during the war with France
by the name of Consol Bonds which will pay investors s steady stream of
interest forever.
 In Pakistan, several banks have issued TIER-1 capital TFCs which have no
maturity and will provide cash flows every year, unless called by the issuer.
However, the cash flows are not fixed.
 Classification of Interest Rates
Nominal rate (iNOM) – also called the quoted or state rate.
An annual rate that ignores compounding effects.
iNOM is stated in contracts. Periods must also be given,
e.g. 8% Quarterly or 8% Daily interest.

Periodic rate (iPER) – amount of interest charged each

period, e.g. monthly or quarterly.
iPER = iNOM / m, where m is the number of compounding
periods per year. m = 4 for quarterly and m = 12 for
monthly compounding.
 Classification of Interest Rates
Effective (or equivalent) annual rate (EAR = EFF%) –
the annual rate of interest being earned, taking into account
compounding.
EFF% for 10% semiannual investment:
EFF% = ( 1 + iNOM / m )m – 1
= ( 1 + 0.10 / 2 )2 – 1
= 10.25%

An investor would be indifferent between an investment

offering a 10.25% annual return and one offering a 10%
annual return, compounded semiannually.
Corporate Valuation & Time Value of Money
Time Value of Money Review - Concept Questions

1-What are the four basic parts (variables) of the time-value of

money equation?

2-What does the term compounding mean?

3-Define a growth rate and a discount rate. What is the difference

between them?

4-What happens to a future value as you increase the interest

(growth) rate?
Time Value of Money Review - Concept Questions

5-What happens to a present value as you increase the discount

rate?

6-What happens to a future value as you increase the time to the

future date?

7-What happens to the present value as the time to the future value
increases?

8-Is the present value always less than the future value?
Time Value of Money Review - Concept Questions

9-What is the difference between an ordinary annuity and an

annuity due?

10-What does the amortization schedule tell you about a loan

repayment?

11-What does it mean that the current principal balance of a loan

being repaid as an amortized loan is the present value of the future
payment stream?

12-If you increase the number of payments on an amortized loan,

does the payment increase or decrease? Why or why not?
Time Value of Money Review - Concept Questions

13- If you increase the interest rate on an amortized loan, does the
payment increase or decrease? Why or why not?

14-If you won the lottery and had the choice of the lump-sum payoff or
the annuity payoff, what factors would you consider besides the
implied interest rate (indifference interest rate) in selecting the payoff
style?
 Questions:
1. What is the future value of the following annuity due?
 Payment amount = $100
 Payment frequency = annual
 Number of payments = 20
 Interest rate = 8% per year

A. $2,000.00
B. $4,576.20
C. $4,942.29

Correct Answer: C
 Questions:
2. Which of the following statements is TRUE?  (Assume that the
yearly cash flows are identical for both annuities and that the common
interest rate is greater than zero.)

A. The present value of an annuity due is greater than the present

value of an ordinary annuity.
B. The present value of an ordinary annuity is greater than the
present value of an annuity due.
C. The future value of an ordinary annuity is greater than the future
value of an annuity due.
D. Both B and C are correct.

Correct Answer: A
 Questions:
3. Julie is 30 years old and want to save for her retirement. She
approaches an investment advisor who provides two retirement plans
with equal annual payments to be made till retirement.

A. If she starts investing today, she will make an annual payment of

$10,000 per year.
B. If she starts investing at 45, she will make an annual payment of
$20,000

Calculate the value of both annuities (ordinary) at the time of

retirement, if the interest rate is 5%. Indicate what decision should she
make.
Answer:
C. 664,388
D. 661,319
 Questions:
4. Starting on her 30th birthday, a women invests every year on her
birthday in an account that grows at an annual effective interest rate of
7%. What should be the annual payment if she wants this fund to grow
to $300,000 on her 65th birthday?

Solution:

Formula: FV = P * ((1+r)n-1)/r

300,000 = P * 138.24
300,000/ 138.24 = P

P = 2170.19
 Questions:
5. A four-year lease agreement requires payments of $10,000 at the beginning of
every year. If the interest rate is 6.00% compounded monthly, what is the cash value
of the lease?

Solution:
The rate is compounded Monthly, so the annualized rate applicable on the payments
will be:

EAR: (1+0.06/12)^12-1 = 6.17%

Solving for the Annuity:

PV = 10,000 * (1-((1/(1+0.0617)4)/0.0617 * (1+0.0617)

PV = 10,000 * 3.45 * 1.0617

PV = 36,647/-
 Questions:
1. What deposit made at the beginning of each year will accumulate
to $120,000 at 8% at the end of 10 years?

2. Laura wants to accumulate $150,000 in her bank account by

depositing $1,000. If interest on the account is 5% compounded
quarterly, for how long does Laura have to deposit the money?

3. James deposited $150 at the beginning of each month for two years
into his savings account. For the next four years he did not make
any more deposits, leaving the money in the account. The bank
charges 4% interest compounded monthly. What will the balance
be after 12 years?