Time value of Money

Objectives: After reading this chapter, you should be able to

1. Understand the concepts of time value of money, compounding, and discounting.
2. Calculate the present value and future value of various cash flows using proper mathematical
formulas.

The time value of money is a basic financial concept that holds that money in the present is worth
more than the same sum of money to be received in the future. Thus a dollar ($) today is worth more
than a dollar ($) in the future (all things being equal)

There are basically three reasons that justify this concept:

1. Individuals generally or in most cases prefer present consumption than future consumption. To
induce people to postpone their present consumption you have to offer them more in the future.
Therefore the value of cash flows will decrease as the preference for current consumption increases.

2. Inflation decreases the value of currency over time. Therefore, the value of future cash flows
decreases as expected inflation increases.

3. If there is any uncertainty (risk) associated with cash flows in the future, the less that cash flows
will be valued. Therefore, the value of future cash flows decreases as the uncertainty in the cash flows
increases.

Discounting and Compounding

- The mechanism for factoring in these elements is the discount rate. The discount rate is the
rate at which present and future cash flows are traded off.
1. Preference for current consumption ( Greater consumption = High discount rate)
2. Expect inflation (Higher Inflation – High discount rate)
3. Uncertainty in the future cash flows (Higher Risk – High discount rate)
- Higher discount rate leads to lower value for future cash flows in the future.
- The discount rate is also an opportunity cost. Since it captures the returns that an individual
would have made on the best opportunity of equivalent risk.
- Discounting future cash flows converts into cash flows in the present value dollars. Just a
discounting converts future cash flows into present cash flows.
- Compounding converts present cash flows into future cash.

Present value Principles

Principle 1: Cash flows at different points in time cannot be compared or aggregated

- All cash flows have to be brought to the same point in time, before comparisons and
aggregations are made and that point in time can be today (present value) or future (future
value)

Principle 2: A good investment rule will be based on upon not only how much to get in cash flows
from an investment but when you get those cash flows.

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Time lines of cash flows

- The best way to visualize cash flows is on a time line where you list out how much you get
and when.
- In a timeline, today is specified as ‘time 0’ and each is shown as a period

Cash Flows

$100 $100 $100 $100

0 1 2 3 4

Years

A Time Line for Cash Flows: $ 100 in Cash Flows Received at the End of Each of Next 4 years (Annuity)

There are five types of cash flows

- Simple cash flows,
- Annuities,
- Growing annuities
- Perpetuities
- Growing perpetuities
Most assets represent combinations of these cash flows. Thus, a conventional bond is a combination
of an annuity (coupons) and a simple cash flow (face value at maturity). A stock may be a
combination of a growing annuity and a growing perpetuity.

A simple cash flow is a single cash flow in a specified future time period. The single cash flows can
be in different forms such as simple interest or compounding interest.

- Simple interest is that is paid (earned) on only the original amount, or principal, borrowed
(lent). The dollar amount of simple interest (SI) is a function of three variables:
i) The original amount borrowed (lent) or Principal (Po), The interest rates (i) per time
period; and the number of time periods (n) for which the principal is borrowed (lent)
SI = Po(i)(n)
For example: Assoume that you deposit $100 in a savings account paying 8% simple interest and keep
it for 10 years. At the end of 10 Years, the amount of interest accumulated is determined as follows:
SI = 100(0.08)(10)
= $80.00

Compound Interest

 Compound interest (or compounding interest) is interest calculated on the initial

principal, which also includes all of the accumulated interest from previous periods on
a deposit or loan.
 Compound interest is calculated by multiplying the initial principal amount by one
plus the annual interest rate raised to the number of compound periods minus one.

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  Interest can be compounded on any given frequency schedule, from continuous to
daily to annually.
 When calculating compound interest, the number of compounding periods (t) makes a
significant difference.

Time Value of Money: Know this terminology and notation

FV Future Value (1+i)t Future Value Interest Factor [FVIF]

PV Present Value 1/(1+i)t Present Value Interest Factor [PVIF]

i or r Rate per period

t or n # of time periods
t
(1+i) Interest factor

Present values
At times, it is necessary to find the present value of a sum of money available in the future. To do
that we write equation as follows: PV = FV/ (1 + r)n
FV = the future value of a sum of money
PV = the present value of the same amount
r = the interest rate, or the growth rate per period
n = number of periods of growth

A single cash flow of $1,000.00 will be received in 5 years. For this cash flow, the appropriate
discount rate / period are 6.0%. What is the present value of this single cash flow?

= 1000/1.06^5
= $747.26

Practice questions (due 21/09/2020):

1. Ruth Mumba deposits $15 000 today and she is expecting $35 000 in 6 years’ time.
What is the implied annual rate of return?
2. Find the present value of $10,000 to be received at the end of 10 periods at 8% per
period.
3. If you deposit $10 in an account that pays 5% interest, compounded annually. How much will
you have at the end of (i) 10 years, (ii) 50 years and (iii) 100 years?
4. Calculate the amount of interest on $8,700.00 when earning 3.25 percent per annum for three
years.

Future Values
Future value (FV) is a measure of how much a series of regular payments will be worth at some
point in the future, given a specified interest rate.

FV = PV (1+r)n

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 FV = the future value of a sum of money
PV = the present value of the same amount
r = the interest rate, or the growth rate per period
n = number of periods of growth

A single cash flow of $747.26 is available now (in period 0). For this cash flow, the appropriate
discount rate / period is 6.0%. What is the period 5future value of this single cash flow?

= 747.26(1+.06)5
==
$1000.00

Practice Questions:

1. A single cash flow of $1,032.47 is available now (in period 0). For this cash flow, the
appropriate discount rate / period is 2.9%. What is the period 5 future value of this single cash
flow?
2. You are planning to invest $2,500 today for three years at a nominal interest rate of 9 percent
with annual compounding. What would be the future value of your investment?
3. Assume you want to invest $1000 in savings account that compounds annually at 6%
and you want to withdraw your savings in 15 months. What will be the future value?

4. You are scheduled to receive $13,000 in two years.  When you receive it, you will
invest it for six more years at 8 percent per year.  How much will you have in eight
years?

Frequency of compounding

FV = PV (1 + r)n
The above expression is valid for annual compounding. If we do the compounding quarterly, the
amount of interest credited will be only at the rate r/4, but there will also be 4n compounding
periods in n years. Similarly, for monthly compounding, the interest rate is r/12 per month and
the compounding occurs 12n times in n years. Thus, the above equation becomes:
FV = PV (1 + r/12)12n

The frequency of compounding affects the future and present values of cash flows. The stated interest
rate can deviate significantly from the true interest rate
For example, a 10% annual interest rate, if there is semi-annual compounding, works out to--‐
Effective Interest Rate = 1.052-1 = .1025 or
10.25%

Frequency Rate t Formula Effective Annual rate

Annual 10% 1 r 10.00%
Semi-annual 10% 2 (1+r/2)2-1 10.25%
Quarterly 10% 4 (1+r/4)4-1 10.38%
Monthly 10% 12 (1+r/12)12-1 10.47%
daily 10% 365 (1+r/365)365-1 10.5156%
Continuously 10% er-1 10.5171
(e = 2.71828)

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Assume a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would
be the amount of interest? In this case, it would be: $10,000 [(1 + 0.05)3 – 1] = $10,000 [1.157625 –
1] = $1,576.25.

Practice Questions.

1. Assume you want to invest $1000 in savings account that compounds annually at 6% and
you want to withdraw your savings in 15 months. (i) What will be the future value? What
will be the future value the interest is compounded (ii) Semi-annual, (iii) monthly (iv)
daily.
2. a) At the end of three years, how much is an initial deposit of $100 worth, assuming an
annual compound interest rate of (i) 100%? (ii) 10%? (iii) 0%
b) At the end of three years, how much is an initial $100 deposit worth, assuming a quarterly
compounded annual interest of (i) 100%? (ii) 10 %,(ii) 0%
c) Why do answers differ to 2 (b) differ from those to 2(a)?
3. Suppose you were to receive $1000 at the end of 10 years. If the opportunity rate is
10%, what is the present value of this amount if interest is compounded (a)
annually, (b) quarterly? (c) Continuous compounding.

Annuities

An annuity is a constant cash flow that occurs at regular intervals for a fixed period of time.

 Annuities are insurance contracts that promise to pay you regular income either
immediately or in the future.
 You can buy an annuity with a lump sum or a series of payments.
 Annuities come in three main varieties—fixed, variable, and indexed—each with its
own level of risk and pay-out potential.
 Fixed annuities are insurance contracts that pay a guaranteed rate of interest on the
account owner's contributions.
 Variable annuities, by contrast, pay a rate that varies according to the performance of
an investment portfolio chosen by the account owner.
 An indexed annuity is a type of annuity contract that pays an interest rate based on the
performance of a specified market index, such as the S&P 500. Indexed annuities give buyers
an opportunity to benefit when the financial markets perform well, unlike fixed annuities,
which pay a set interest rate regardless.
 The income you receive from an annuity is taxed at regular income tax rates, not long-
term capital gains rates, which are usually lower.

The present value of an annuity can be calculated by taking each cash flow and discounting it back to
the present, and adding up the present values. Alternatively, there is a short cut that can be used in the
calculation [A = Annuity; r = Discount Rate; n = Number of years]

Present value of Annuity = PvA = A [(1-(1/ (1+r) n)/r]

Example:
Assume you are the lucky winner of the $30 million state lottery. You can take prize money of either
as (a) 30 payments of $1 million per year starting today, or (b) $15 million paid today. If the interest
rates is 8%, which option should you take?

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Option A:
- You are required to find the present value of the payments to be received in 30 periods
including the one paid today. Therefore,

PVA = 1000000[(1-(1/(1+0.08)29)/0.08]
= $11.16 million
The total becomes $ 1 million (received today) plus Present value of $1 million to be received in 29
years period.

= $11.16 + 1 = $12.16 million

$12.16 million is compared with $15 million to be received today; therefore, it will be prudent to get
$15 million today.

Future value of annuity

The future value of an end-of-the- period annuity can also be calculated as follows-
( 1+ r ) n−1
FVA¿ A[ ]
r

This is the equation you would use to determine how much money you will accumulate at a future
point in time if you set aside a constant amount each period.

Thus, the future value of $1,000 at the end of each year for the next five years, at the end of the fifth
year is (assuming a 10% discount rate)

( 1+0.1 ) 5−1
= 1000 [ 0.1
]

( 1.10 ) 5−1
= 1000[ ]
0.1

= $ 6 105.10

An annuity pays $80.00 each period for 5 periods. For these cash flows, the appropriate discount rate
is 6.0%. What is the period 5 future value of this annuity?

= $450.96 (try to work it out to get this figure using the formula above)

Assume that you want to send your newborn child to a private college (when he gets to be 18 years
old). The tuition costs are $ 16000/year now and that these costs are expected to rise 5% a year for the
next 18 years. Assume that you can invest, after taxes, at 8%.
Step One: Calculate the growth of fees for the next 18 years the time the child will be going to
college:

= 1600*(1.05)18

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= $38 505.91

Step Two (Final Step): Find the future value of tuition fees at the time the child will be going to
school:
= 38505.91

Practice Questions:

1. An annuity pays $63.92 each period for 4 periods. For these cash flows, the appropriate
discount rate / period is 9.1%. What is the period 5 future value of this annuity?

2. An annuity pays $70 each period for 4 periods. For these cash flows, the appropriate
discount rate / period is 8 %. What is the future value of this annuity? You are
required to present your answer in excel using time line method, formula and function
method.
3. Calculate the future value of the following at a nominal interest rate of 12%: $800
invested at the end of each of the next 8 years, compounded annually.
4. You deposit $2000 at the end of each year into an account earning 6% interest compounded
annually. How much will you have in the account in 15 years?

Growing Annuity
A growing annuity is a cash flow growing at a constant rate for a specified period of time. A growing
annuity may sometimes be referred to as an increasing annuity. If A is the current cash flow, and g is
the expected growth rate, the time line for a growing annuity looks as follows

0 1 2 3 4 5 n

A(1+g)1 A(1+g)2 A(1+g)3 A(1+g)4 A(1+g)5 A(1+g)n

Present value of Growing Annuity

The present value of a growing annuity formula calculates the present day value of a series of future
periodic payments that grow at a proportionate rate

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Example Two

Assume Thobekile considered saving $10 000 per year for her retirement. Although $10 000 is the
most she can save in the year, she expects her salary to increase each year so that she will be able to
increase her savings by 5% per year. With this plan, if she earns 10% per year on her savings, how
much will Thobekile have saved at age 65 assume she is now 35years old?

= p/(r-g)*[1-(1+g/1+r)n]

PVGA = 10000/(0.10-0.05)[1-(1.05/1.10)30

= $ 150 463.15

Example Two (For Annuity Due)

Consider the example of a gold mine, where you have the rights to the mine for the next 20 years,
over which period you plan to extract 5,000 ounces of gold every year. The price per ounce is $300
currently, but it is expected to increase 3% a year. The appropriate discount rate is 10%. The present
value of the gold that will be extracted from this mine can be estimated as follows:

Step One: Find P; thus

P = 5000*300

= $1500 000

Step Two: Find the Present value

PV GAD = p/(r-g)*(1+g)*[1-(1+g/1+r)n]

= 1500000/( 0.10-0.03)*1.03[1 – (1+0.03)20/(1+0.10)20]

= $16 145 980.56

Practice Questions:

1. Assume you work for a pharmaceutical company that has developed a new drug. The patent
on the drug will last 17 years. You expect that the drug’s profits will be $2 million in its first
year and that this amount will grow at a rate of 5% per year for the next 17 years. Once the
patent expires, other pharmaceutical companies will be able to produce the same drug and

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 competition will likely drive profits to zero. What is the present value of the new drug if the
interest rate is 10% per year?

Perpetuity
Perpetuity is a constant cash flow at regular intervals forever. The present value of perpetuity is

PV of Perpetuity = A/r

Where A is the Annuity and r is the rate

A Console bond is a bond that has no maturity and pays a fixed coupon. Assume that you have a
coupon console bond of $60. The value of this bond, if the interest rate is 9%, is as follows:
Value of Console Bond

=$60/.09
=$667

Practice Questions:

1. An investor purchasing a British consol is entitled to receive annual payments from the
British government forever. What is the price of a consol that pays $250 annually if the next
payment occurs one year from today? The market interest rate is 5.6 percent.
2. A project yields an annual benefit of $100 per year, starting immediately and continuing
forever. What is the present value of the benefits if the interest rate is 5 percent?
3. How much is $100 at the end of each year forever at 10% interest worth today?

Growing Perpetuity
A growing perpetuity is a cash flow that is expected to grow at a constant rate forever. The present
value of a growing perpetuity is‐

= CF1
(r-g)
where:
CF1 is the expected cash flow next year,
g- is the constant growth rate and
r - is the discount rate.

Example

Assume you planned to donate money to your alma mater to fund annual $30 000 graduation party.
While the $30 000 could be adequate for next year, students estimate that the party’s cost will rise by
4% per year thereafter. To satisfy their request, how much do you need to donate now if the interest
rate is 8%?

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= 30000/(0.08-0.04)

= $750 000

Practice Questions:

1. A firm's profits are expected to be 1,000 this year, and then to rise by 2% each year after that
(forever). The interest rate is 5%. What is the value of the firm?
2. Consider the valuation of a share of common stock that is expected to pay $2 dividend
per share at the end of the year. It is expected that the dividends will grow at a rate of
10% based on assessment of the riskiness of the common stock; the investor’s
required rate of return is 15%. Compute the value of the stock.

Loan Amortisation (next chapter)

Amortization is an accounting technique used to periodically lower the book value of a loan
or intangible asset over a set period of time. In relation to a loan, amortization focuses on
spreading out loan payments over time.

Loan Amortization is the process of spreading out a loan into a series of fixed payments. The
loan is paid off at the end of the payment schedule.

An amortized loan is a type of loan that requires the borrower to make scheduled, periodic
payments that are applied to both the principal and interest.

Key Terms:

- Principal

- Interest rate

- Term Length

- Payment frequency

Principal

- It refers to amount borrowed or the initial balance which is the original amount
borrowed or initial loan amount

Interest Rate

- It represents the cost of borrowing money

- Almost always given on an annual basis

- Determines the expense paid by the Borrower or interest earned by the lender

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Term length

- It refers to the length of the loan

- A 20 year mortgage loan has 20 year term length

- If it is paid on time, principal on loan balance will reach zero after 20 years

- Loan will be paid off when principal is zero.

Payment Frequency

- It refers to how often payments are regularly scheduled.

- Annual payment frequency: scheduled payment occur annually

Loan amortisation table

- It is a schedule of regular payments that must be made by borrower to pay off the loan
on time.

Formula

P = R [1-(1+r)-n]
r
Where:

P- is the principal
R- represent the periodic payments
n- number of periods
r – applicable rate

Example
Let’s assume you have been given the following information:

Principal $100 000, Interest rate 6%, the loan is paid annually for 30 years.
Required calculate the periodic payment for this loan. You are further required to draw an
amortisation table.

100,000 = R[ (1.06-10)/0.06]

= 13, 586.80 (rounding error)

Payment Number Payment Principal Interest Balance

-
£13,586.8 £6,000.0 £92,413.2
1 0 £7,586.80 0 0
2 £13,586.8 £8,042.00 £5,544.7 -

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 £84,371.2
0 9 0
-
£13,586.8 £5,062.2 £75,846.6
3 0 £8,524.52 7 8
-
£13,586.8 £4,550.8 £66,810.6
4 0 £9,036.00 0 8
-
£13,586.8 £4,008.6 £57,232.5
5 0 £9,578.15 4 3
-
£13,586.8 £3,433.9 £47,079.6
6 0 £10,152.84 5 8
-
£13,586.8 £2,824.7 £36,317.6
7 0 £10,762.01 8 7
-
£13,586.8 £2,179.0 £24,909.9
8 0 £11,407.74 6 3
-
£13,586.8 £1,494.6 £12,817.7
9 0 £12,092.20 0 3
£13,586.8
10 0 £12,817.73 £769.06 £0.00

Return and Risk Analysis

Return

- It refers to income received from an investment plus any change in market price,
usually expressed as a percentage of the beginning market price of the investment.

For example buy for $100 a security that would pay $7 in cash to you and be worth
$106 one year later. The return would be:

= $7+$6)/100

= 13%

Risk

- Refers to variability of returns from those that are expected.

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