LECTURE 2

Time Value of Money

Brooks, (2013) Chapters

3, 4

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 Learning Objectives

1. Calculate future values and understand compounding.

2. Calculate present values and understand discounting.
3. Calculate implied interest rates and waiting time from the
time value of money equation.
4. Apply the time value of money equation.
5. Explain the Rule of 72, a simple estimation of doubling
values.
6. Calculate future and present values for Annuities
7. Distinguish between the different types of loan repayments:
discount loans
interest-only loans
amortized loans

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 3.1 Future Value and
Compounding Interest
The value of money at the end of the stated
period is called the future or compound
value of that sum of money.
Determines the attractiveness of alternative
investments
Figures out the effect of inflation on the future
cost of assets, such as a car or a house.

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 3.1 (A) The Single-Period
Scenario
FV = PV + PV x interest rate, or
FV = PV(1+interest rate)
(in decimals)

Example 1: Lets say John deposits $200 for a

year in an account that pays 6% per year. At
the end of the year, he will have:

FV = $200 + ($200 x .06) = $212
= $200(1.06) = $212

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 3.1 (B) The Multiple-Period
Scenario
FV = PV x (1+r)n
Example 2: If John closes out his account after 3 years,
how much money will he have accumulated? How much of
that is the interest-on-interest component? What about
after 10 years?

FV3 = $200(1.06)3 = $200*1.191016 = $238.20,
where, 6% interest per year for 3 years = $200 x.06 x 3=$36
Interest on interest = $238.20 - $200 - $36 =$2.20

FV10 = $200(1.06)10 = $200 x 1.790847 = $358.17

where, 6% interest per year for 10 years = $200 x .06 x 10 =
$120
Interest on interest = $358.17 - $200 - $120 = $38.17

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 3.1 (C) Methods of Solving
Future Value Problems
Method 1: The formula method
Time-consuming, tedious
Method 2: The financial calculator
approach
Quick and easy
Method 3: The spreadsheet method
Most versatile
Method 4: The use of Time Value tables
Easy and convenient but maybe limiting in scope

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 3.1 (C) Methods of Solving Future
Value Problems (continued)
Example 3: Compounding of Interest

Lets say you want to know how much money you
will have accumulated in your bank account after 4
years, if you deposit all $5,000 of your high-school
graduation gifts into an account that pays a fixed
interest rate of 5% per year. You leave the money
untouched for all four of your college years.

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 3.1 (C) Methods of Solving Future
Value Problems (continued)
Example 3: Answer
Formula Method:
FV = PV x (1+r)n$5,000(1.05)4=$6,077.53

Time value table method:

FV = PV(FVIF, 5%, 4) = 5000*(1.215506)=6,077.53,
where (FVIF, 5%,4) = Future value interest factor listed
under the 5% column and in the 4-year row of the Future
Value of $1 table.

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 3.1 (C) Methods of Solving Future
Value Problems (continued)

Example 4: Future Cost due to Inflation

Lets say that you have seen your dream
house, which is currently listed at $300,000,
but unfortunately, you are not in a position
to buy it right away and will have to wait at
least another 5 years before you will be able
to afford it. If house values are appreciating
at the average annual rate of inflation of 5%,
how much will a similar house cost after 5
years?

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 3.1 (C) Methods of Solving Future
Value Problems (continued)
Example 4 (Answer)

PV = current cost of the house = $300,000;

n = 5 years;
r = average annual inflation rate = 5%.
Solving for FV, we have
FV = $300,000*(1.05)(1.05)(1.05)(1.05)(1.05)
= $300,000*(1.276282)
= $382,884.5

So the house will cost $382,884.5 after 5 years

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 3.2 Present Value and
Discounting
Involves discounting the interest that would have
been earned over a given period at a given rate of
interest.
It is therefore the exact opposite or inverse of
calculating the future value of a sum of money.
Such calculations are useful for determining todays
price or the value today of an asset or cash flow that will
be received in the future.
The formula used for determining PV is as follows:
PV = FV x 1/(1+r)n

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 3.2 (A) The Single-Period
Scenario

When calculating the present or discounted

value of a future lump sum to be received
one period from today, we are basically
deducting the interest that would have
been earned on a sum of money from
its future value at the given rate of
interest.
i.e. PV = FV/(1+r) since n = 1
So, if FV = 100; r = 10%; and n =1;
PV = 100/1.1=90.91

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 3.2 (B) The Multiple-Period
Scenario

When multiple periods are involved

The formula used for determining PV is as
follows:
PV = FV x 1/(1+r)n
where the term in brackets is the present
value interest factor (PVIF) or the
relevant rate of interest and number of
periods involved, and is the reciprocal of
the future value interest factor (FVIF)

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 3.2 Present Value and
Discounting (continued)

Example 5: Discounting Interest

Lets say you just won a jackpot of $50,000
at the casino and would like to save a
portion of it so as to have $40,000 to put
down on a house after 5 years. Your bank
pays a 6% rate of interest. How much
money will you have to set aside from the
jackpot winnings?

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 3.2 Present Value and
Discounting (continued)
Example 5 (Answer)
FV = amount needed = $40,000
N = 5 years; Interest rate = 6%;
PV = FV x 1/ (1+r)n
PV = $40,000 x 1/(1.06)5
PV = $40,000 x 0.747258
PV = $29,890.33 Amount needed to be set
aside today

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 3.2 (C) Using Time Lines

When solving time value of money

problems, especially the ones involving
multiple periods and complex combinations
(which will be discussed later) it is always a
good idea to draw a time line and label the
cash flows, interest rates and number of
periods involved.

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 3.2 (C) Using Time Lines
(continued)

FIGURE 3.1 Time lines of growth rates (top) and discount

rates (bottom) illustrate present value and future value.

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 3.3 One Equation and Four
Variables
Any time value problem involving lump sums -- i.e., a
single outflow and a single inflow--requires the use of
a single equation consisting of 4 variables i.e. PV, FV,
r, n
If 3 out of 4 variables are given, we can solve for the
unknown one.
FV = PV x (1+r)n solving for future value
PV = FV X [1/(1+r)n] solving for present value
r = [FV/PV]1/n 1 solving for unknown rate
n= [ln(FV/PV)/ln(1+r)] solving for number of periods

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 3.4 Applications of the Time
Value of Money Equation
Calculating the amount of saving required
for retirement
Determining future value of an asset
Calculating the cost of a loan
Calculating growth rates of cash flows
Calculating number of periods required to
reach a financial goal.

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 3.5 Doubling of Money: The Rule of
72 (works well for r=4%-30%)

The Rule of 72 estimates the number of

years required to double a sum of money at
a given rate of interest.
For example, if the rate of interest is 9%, it would
take 72/9 8 years to double a sum of money
Can also be used to calculate the rate of
interest needed to double a sum of money
by a certain number of years.
For example, to double a sum of money in 4
years, the rate of return would have to be
approximately 18% (i.e. 72/4=18).

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 4.1 Future Value of Multiple Payment
Streams

With unequal periodic cash flows, treat

each of the cash flows as a lump sum and
calculate its future value over the relevant
number of periods.
Sum up the individual future values to
get the future value of the multiple payment
streams.

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 Figure 4.1 The time line of a
nest egg

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 4.1 Future Value of Multiple
Payment Streams (continued)
Example 1: Future Value of an Uneven Cash
Flow Stream:
Jim deposits $3,000 today into an account that pays
10% per year, and follows it up with 3 more
deposits at the end of each of the next three years.
Each subsequent deposit is $2,000 higher than the
previous one. How much money will Jim have
accumulated in his account by the end of three
years?

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 4.1 Future Value of Multiple Payment
Streams (Example 1 Answer)

FV = PV x (1+r)n
FV of Cash Flow at T0 = $3,000 x (1.10)3 = $3,000 x 1.331= $3,993.00
FV of Cash Flow at T1 = $5,000 x (1.10)2 = $5,000 x 1.210 = $6,050.00
FV of Cash Flow at T2 = $7,000 x (1.10)1 = $7,000 x 1.100 = $7,700.00
FV of Cash Flow at T3 = $9,000 x (1.10)0 = $9,000 x 1.000 = $9,000.00
Total = $26,743.00

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 4.2 Future Value of an Annuity
Stream

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 4.2 Future Value of an Annuity
Stream (continued)

Example 2: Future Value of an Ordinary

Annuity Stream
Jill has been faithfully depositing $2,000 at the end
of each year since the past 10 years into an account
that pays 8% per year. How much money will she
have accumulated in the account?

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 4.2 Future Value of an Annuity
Stream (continued)
Example 2 Answer

Future Value of Payment One = $2,000 x 1.089 = $3,998.01

Future Value of Payment Two = $2,000 x 1.088 = $3,701.86
Future Value of Payment Three = $2,000 x 1.087 = $3,427.65
Future Value of Payment Four = $2,000 x 1.086 = $3,173.75
Future Value of Payment Five = $2,000 x 1.085 = $2,938.66
Future Value of Payment Six = $2,000 x 1.084 = $2,720.98
Future Value of Payment Seven = $2,000 x 1.083 = $2,519.42
Future Value of Payment Eight = $2,000 x 1.082 = $2,332.80
Future Value of Payment Nine = $2,000 x 1.081 = $2,160.00
Future Value of Payment Ten = $2,000 x 1.080 = $2,000.00
Total Value of Account at the end of 10 years$28,973.13

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 4.2 Future Value of an Annuity
Stream (continued)

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 4.3 Present Value of an Annuity

To calculate the value of a series of equal

periodic cash flows at the current point in time,
we can use the following simplified formula:
1
1
1 r n

PV PMT
r
The last portion of the equation, is the
Present Value Interest Factor of an Annuity (PVIFA).

Practical applications include figuring out the nest egg needed

prior to retirement or lump sum needed for college
expenses.
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 FIGURE 4.4 Time line of present
value of annuity stream.

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 4.3 Present Value of an Annuity
(continued)

Example 3: Present Value of an

Annuity.
John wants to make sure that he has saved up
enough money prior to the year in which his
daughter begins college. Based on current
estimates, he figures that college expenses will
amount to $40,000 per year for 4 years (ignoring
any inflation or tuition increases during the 4
years of college). How much money will John need
to have accumulated in an account that earns 7%
per year, just prior to the year that his daughter
starts college?

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 4.3 Present Value of an Annuity
(continued)

Example 3 Answer
Using the following equation:

1
1
n
1 r
PV PMT
r

1. Calculate the PVIFA value for n=4 and r=7%3.387211.

2. Then, multiply the annuity payment by this factor to get
the PV,
PV = $40,000 x 3.387211 = $135,488.45

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 4.4 Annuity Due and Perpetuity

A cash flow stream such as rent, lease, and

insurance payments, which involves equal periodic
cash flows that begin right away or at the beginning
of each time interval is known as an annuity due.

Figure 4.5 An ordinary annuity versus an annuity

due.

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 4.4 Annuity Due and Perpetuity

PV annuity due = PV ordinary annuity x (1+r)

FV annuity due = FV ordinary annuity x (1+r)
PV annuity due > PV ordinary annuity
FV annuity due > FV ordinary annuity
Can you see why?

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 4.4 Annuity Due and Perpetuity
(continued)
Example 4: Annuity Due versus Ordinary
Annuity
Lets say that you are saving up for retirement
and decide to deposit $3,000 each year for the
next 20 years into an account which pays a rate
of interest of 8% per year. By how much will
your accumulated nest egg vary if you make
each of the 20 deposits at the beginning of the
year, starting right away, rather than at the end
of each of the next twenty years?

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 4.4 Annuity Due and Perpetuity
(continued)
Example 4 Answer
Given information: PMT = -$3,000; n=20; i= 8%; PV=0;

FV PMT
1 r 1
n

FV ordinary annuity = $3,000 * [((1.08)20 - 1)/.08]

= $3,000 * 45.76196
= $137,285.89
FV of annuity due = FV of ordinary annuity * (1+r)
FV of annuity due = $137,285.89*(1.08) = $148,268.76

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 4.4 Annuity Due and Perpetuity
(continued)
Perpetuity
A Perpetuity is an equal periodic cash flow
stream that will never cease.
The PV of a perpetuity is calculated by using
the following equation:

PMT
PV
r

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 4.4 Annuity Due and Perpetuity
(continued)
Example 5: PV of a perpetuity
If you are considering the purchase of a consol that
pays $60 per year forever, and the rate of interest
you want to earn is 10% per year, how much money
should you pay for the consol?
Answer:
r=10%, PMT = $60; and PV = ($60/.1) = $600
$600 is the most you should pay for the consol.

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 4.5 Three Loan Payment
Methods

Loan payments can be structured in one of 3

ways:
1) Discount loan
Principal and interest is paid in lump sum at end
2) Interest-only loan
Periodic interest-only payments, principal due at end.
3) Amortized loan
Equal periodic payments of principal and interest

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 4.5 Three Loan Payment
Methods (continued)
Example 6: Discount versus Interest-only versus
Amortized loans

Roseanne wants to borrow $40,000 for a period of 5 years.

The lender offers her a choice of three payment structures:
1)Pay all of the interest (10% per year) and principal in one lump sum at
the end of 5 years;
2)Pay interest at the rate of 10% per year for 4 years and then a final
payment of interest and principal at the end of the 5th year;
3)Pay 5 equal payments at the end of each year inclusive of interest and
part of the principal.

Under which of the three options will Roseanne pay the least interest
and why? Calculate the total amount of the payments and the amount
of interest paid under each alternative.

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 4.5 Three Loan Payment
Methods (continued)
Method 1: Discount Loan.
Since all the interest and the principal is paid at the
end of 5 years we can use the FV of a lump sum
equation to calculate the payment required, i.e.
FV = PV x (1 + r)n
FV5 = $40,000 x (1+0.10)5
= $40,000 x 1.61051
= $64, 420.40
Interest paid = Total payment - Loan amount
Interest paid = $64,420.40 - $40,000 = $24,420.40

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 4.5 Three Loan Payment
Methods (continued)
Method 2: Interest-Only Loan.
Annual Interest Payment (Years 1-4)
= $40,000 x 0.10 = $4,000
Year 5 payment
= Annual interest payment + Principal payment
= $4,000 + $40,000 = $44,000
Total payment = $16,000 + $44,000 = $60,000
Interest paid = $20,000

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 4.5 Three Loan Payment
Methods (continued)

Method 3: Amortized Loan.

n = 5; I = 10%; PV=$40,000; FV = 0;CPT PMT=$10,551.86
Total payments = 5*$10,551.8 = $52,759.31
Interest paid = Total Payments - Loan Amount
= $52,759.31-$40,000
Interest paid = $12,759.31
Loan Type Total Payment Interest Paid
Discount Loan $64,420.40 $24,420.40
Interest-only Loan $60,000.00 $20,000.00
Amortized Loan $52,759.31 $12,759.31

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 4.6 Amortization Schedules

Tabular listing of the allocation of each loan

payment towards interest and principal reduction
Helps borrowers and lenders figure out the payoff
balance on an outstanding loan.

Procedure:
1)Compute the amount of each equal periodic
payment (PMT).
2)Calculate interest on unpaid balance at the end of
each period, minus it from the PMT, reduce the loan
balance by the remaining amount,
3)Continue the process for each payment period, until
we get a zero loan balance.

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 4.6 Amortization Schedules
(continued)

Example 7: Loan amortization schedule.

Prepare a loan amortization schedule for the
amortized loan option given in the previous
example. What is the loan payoff amount at
the end of 2 years?

PV = $40,000; n=5; i=10%; FV=0;

CPT PMT = $10,551.89

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 4.6 Amortization Schedules
(continued)
Year Beg. Bal Payment Interest Prin. Red End. Bal

1 40,000.00 10,551.89 4,000.00 6,551.89 33,448.11

2 33,448.11 10,551.89 3,344.81 7,207.08 26,241.03

3 26,241.03 10,551.89 2,264.10 7,927.79 18,313.24

4 18,313.24 10,551.89 1,831.32 8,720.57 9,592.67

5 9,592.67 10,551.89 959.27 9,592.67 0

The loan payoff amount at the end of 2

years is $26,241.03
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 4.9 Important Points about the
TVM Equation
1. Amounts of money can be added or subtracted
only if they are at the same point in time.
2. The timing and the amount of the cash flow are
what matters.
3. It is very helpful to lay out the timing and amount
of the cash flow with a timeline.
4. Present value calculations discount all future cash
flow back to current time.
5. Future value calculations value cash flows at a
single point in time in the future

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 4.9 Important Points about the
TVM Equation (continued)

6. An annuity is a series of equal cash payments at

regular intervals across time.
7. The time value of money equation has four
variables but only one basic equation, and so you
must know three of the four variables before you
can solve for the missing or unknown variable.
8. There are four basic methods to solve for an
unknown time value of money variable:
(1) Using equations and calculating the answer;
(2) Using the TVM keys on a calculator;
(3) Using financial functions from a spreadsheet.
(4) Using Tables with FVIF & PVIF

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 4.9 Important Points about the
TVM Equation (continued)

9. There are 3 basic ways to repay a loan:

(1) Discount loans,
(2) Interest-only loans, and
(3) Amortized loans.

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