The Time Value of Money

CHAPTER 2

What is Time Value?

We say that money has a time value because that money can be invested with the expectation of earning a positive rate of return In other words, a dollar received today is worth more than a dollar to be received tomorrow That is because todays dollar can be invested so that we have more than one dollar tomorrow

The Terminology of Time Value

Present Value - An amount of money today, or the current value of a future cash flow Future Value - An amount of money at some future time period Period - A length of time (often a year, but can be a month, week, day, hour, etc.) Interest Rate - The compensation paid to a lender (or saver) for the use of funds expressed as a percentage for a period (normally expressed as an annual rate)

Abbreviations
y y y y

PV - Present value FV - Future value Pmt - Per period payment amount N - Either the total number of cash flows or the number of a specific period i - The interest rate per period

Timelines
y A timeline is a graphical device used to clarify the timing of the cash flows for an investment y Each tick represents one time period

PV 0 Today 1 2 3 4

FV 5

Calculating the Future Value

Suppose that you have an extra $100 today that you wish to invest for one year. If you can earn 10% per year on your investment, how much will you have in one year? -100 0 ? 1 2 3 4 5

Calculating the Future Value (cont.)

Suppose that at the end of year 1 you decide to extend the investment for a second year. How much will you have accumulated at the end of year 2? -110 ? 0 1 2 3 4 5

Generalizing the Future Value

Recognizing the pattern that is developing, we can generalize the future value calculations as follows:

If you extended the investment for a third year, you would have:

Compound Interest
y

Note from the example that the future value is increasing at an increasing rate In other words, the amount of interest earned each year is increasing
Year 1: $10 Year 2: $11 Year 3: $12.10

The reason for the increase is that each year you are earning interest on the interest that was earned in previous years in addition to the interest on the original principle amount

Compound Interest Graphically

Future Value

The Magic of Compounding

On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly purchased Manhattan from the Indians for $24 worth of beads and other trinkets. Was this a good deal for the Indians? This happened about 371 years ago, so if they could earn 5% per year they would now (in 1997) have:

$1,743,577 ,261.65 = 24(1.05) 371

If they could have earned 10% per year, they would now have:

$54,562,89 8,811,973, 500.00 = 24(1.10) 371

Thats about 54,563 Trillion dollars!

The Magic of Compounding (cont.)

The Wall Street Journal (17 Jan. 92) says that all of New York city real estate is worth about $324 billion. Of this amount, Manhattan is about 30%, which is $97.2 billion At 10%, this is $54,562 trillion! Our U.S. GNP is only around $6 trillion per year. So this amount represents about 9,094 years worth of the total economic output of the USA! At 5% it seems the Indians got a bad deal, but if they earned 10% per year, it was the Dutch that got the raw deal Not only that, but it turns out that the Indians really had no claim on Manhattan (then called Manahatta). They lived on Long Island! As a final insult, the British arrived in the 1660s and unceremoniously tossed out the Dutch settlers.

Calculating the Present Value

So far, we have seen how to calculate the future value of an investment But we can turn this around to find the amount that needs to be invested to achieve some desired future value:

Present Value: An Example

Suppose that your five-year old daughter has just announced her desire to attend college. After some research, you determine that you will need about $100,000 on her 18th birthday to pay for four years of college. If you can earn 8% per year on your investments, how much do you need to invest today to achieve your goal?

Annuities
y

An annuity is a series of nominally equal payments equally spaced in time Annuities are very common:
Rent Mortgage payments Car payment Pension income

The timeline shows an example of a 5-year, $100 annuity

The Principle of Value Additivity

How do we find the value (PV or FV) of an annuity? First, you must understand the principle of value additivity:
The value of any stream of cash flows is equal to the sum of the values of the components

In other words, if we can move the cash flows to the same time period we can simply add them all together to get the total value

Present Value of an Annuity

We can use the principle of value additivity to find the present value of an annuity, by simply summing the present values of each of the components:

Present Value of an Annuity (cont.)

Using the example, and assuming a discount rate of 10% per year, we find that the present value is:

62.0 68.3 9 75.1 0 82.6 3 90.9 4 1 379.0 8

100 0 1

100 2

100 3

100 4

100 5

Present Value of an Annuity (cont.)

Actually, there is no need to take the present value of each cash flow separately We can use a closed-form of the PVA equation instead:

Present Value of an Annuity (cont.)

We can use this equation to find the present value of our example annuity as follows:

This equation works for all regular annuities, regardless of the number of payments

The Future Value of an Annuity

We can also use the principle of value additivity to find the future value of an annuity, by simply summing the future values of each of the components:

The Future Value of an Annuity (cont.)

Using the example, and assuming a discount rate of 10% per year, we find that the future value is:

146.41 133.10 121.00 110.00

100 0 1

100 2

100 3

100 4

100 5

= 610.51 at year 5

The Future Value of an Annuity (cont.)

Just as we did for the PVA equation, we could instead use a closed-form of the FVA equation:

This equation works for all regular annuities, regardless of the number of payments

The Future Value of an Annuity (cont.)

We can use this equation to find the future value of the example annuity:

Annuities Due
y

Thus far, the annuities that we have looked at begin their payments at the end of period 1; these are referred to as regular annuities A annuity due is the same as a regular annuity, except that its cash flows occur at the beginning of the period rather than at the end
100 100 1 100 100 2 100 100 3 100 100 4

5-period Annuity Due 100 5-period Regular Annuity

100 5

Present Value of an Annuity Due

We can find the present value of an annuity due in the same way as we did for a regular annuity, with one exception Note from the timeline that, if we ignore the first cash flow, the annuity due looks just like a four-period regular annuity Therefore, we can value an annuity due with:

Present Value of an Annuity Due (cont.)

Therefore, the present value of our example annuity due is:

Note that this is higher than the PV of the, otherwise equivalent, regular annuity

Future Value of an Annuity Due

To calculate the FV of an annuity due, we can treat it as regular annuity, and then take it one more period forward:

Pmt 0

Pmt 1

Pmt 2

Pmt 3

Pmt 4 5

Future Value of an Annuity Due (cont.)

The future value of our example annuity is:

Note that this is higher than the future value of the, otherwise equivalent, regular annuity