Time Value of Money

FIN 4333 - Financial Management
Time Value of Money
(Adair Chaps 5, 6, 7)
 Future Value
 Present Value
 Rates of Return
 Loan Amortization
1
Time Value of Money:
Future Value
 A Dollar Today is Worth More than a

Dollar Tomorrow - Interest can be Earned
 Future Value = The Amount an
Investment Will Grow to Over a Period of
Time
 For One Period: FV = PV*(1+i)
 Invest $100 @ 10% for 1 year
 FV = $100 * (1.1) = $110
 Compounding = Earning Interest on
Interest (Reinvesting the Interest)
 Invest $100 @ 10% for 3 years
 FV = $100 * (1.1) * (1.1) * (1.1)
 FV = $100 * (1.1)3
 FV = $100 * 1.331 = $133.10
 General Formula: FV = PV*(1+i)n
2
Future Value: Multiple Cash Flows
How much will you have in exactly 5 years if you
deposit $2,000 per year into an account paying
10 percent annual interest? Each deposit is
made at the end of the period.
0 1 2 3 4 5
Time
(years)
$2,000 $2,000 $2,000 $2,000 $2,000.00

x 1.1
2,200.00
x 1.12
2,420.00
x 1.13
2,662.00
x 1.14
2.928.20
Total future value $12,210.20
 Ordinary Annuity Future Value Formula
 (1  i ) n  1
FVA  Pmt   
 i 
3
Time Value of Money:
Present Value
 If You Need a Certain (Known) Amount of

Money in the Future, How Much do you
Need to Invest Today?
 Present Value = The Current Value of
Future Cash Flows Discounted at the
Appropriate Rate
 For One Period: PV = FV / (1+i)
 Discounting = the Opposite of

Compounding - Finding the Present Value
of Some Future Amount
 General Formula: PV = FV / (1+i)n
 What is the Value Today of $133.10 to be

Received in 3 years if r = 10%?
 PV = $133.10 / (1.1)3
 PV = $133.10 / 1.331 = $100
4
Present Value: Multiple Cash Flows
How much would you pay to receive $2,000 per

year for 5 years? Your relevant interest rate is 10
percent. Each payment is made at the end of the
period.
0 1 2 3 4 5
Time
(years)
$2,000 $2,000 $2,000 $2,000 $2,000
x 1 / 1.1
$1,818.18
x 1 / 1.12
1,652.89 x 1 / 1.13
1,502.63 x 1 / 1.14
1,366.03 x 1 / 1.15
1,241.84
Total present value
$7,581.57
 Ordinary Annuity Present Value Formula
 1 
1 
 (1  i ) n 
PVA  Pmt   
 i 
 
5
How Long Does it Take?
If you deposit $1,000 today in an account paying
10%, how long does it take to grow to $2,000?
FV  PV (1  i ) n
$2,000  $1,000  (1.10) n

$2,000
(1.10)  n
2
$1,000
ln(1.10) n  n ln(1.10)  ln 2
ln 2 0.6931
n   7.27 years
ln(1.10) 0.0953
6
What is the Rate?
Assume the total cost of a college education will
be $60,000 when your child enters college in 10
years. You have $10,000 to invest today. What
rate of interest must you earn on your investment
to cover the cost of your child’s education?
FV  PV (1  i ) n
$60,000  $10,000  (1  i )10
$60,000
(1  i ) 
10
6
$10,000
(1  i )  61 10
r  61 10  1  1.1962  1
 0.1962  19.62%
7
Perpetuities and Annuities Due
 Perpetuities
 Cash Flows Are Perpetual
Pmt
 PPV 
i
 Find PV of Investment that Pays $500
per year Forever; r = 8%
PV = $500 / 0.08 = $6,250
 Annuities Due
 Ordinary Annuities Have Cash Flows at
the END of Each Period
 An Annuity Due Has Cash Flows at the
BEGINNING of Each Period
 Value Annuity Due =
Value Ordinary Annuity *
(1+i)
8
Growing Perpetuities and Annuities
(Constant % Growth Rate)
 Growing Perpetuities
 Cash Flows Are Perpetual and Grow at
a Constant Rate.
Pmt1
 PVGP 
ig
 Growing Annuities
 Cash Flows Grow at a Constant Rate for
a Specified Period of Time.
 1 1 1 g  
n
 PVGA  Pmt1     
 i  g i  g  1  i  
 (1  i ) n  (1  g ) n 
 FVGA  Pmt1  
 i  g 
9
Growing Perpetuities and Annuities
(Constant $ Growth)
Gradient Series Annuities

 Cash Flows Grow at a Constant $ Amount for
a Specified Period of Time.
 Total PV = PV Level Annuity + PV Gradient
 Find PV of Level portion of the annuity the

normal way.
 Use the following equation to find the present

value of the gradient portion of the annuity.
1  (1  ni)(1  i )  n 
PVGradient  $ Increase  2 
 i 
 Add the two portions together to get the total
PV.
10
Effective Annual Rates &
Compounding
 In general, if we let q be the quoted rate and m

be the number of periods, then the general
relationship between the quoted rate and the
effective rate is:
m
 inom 
EAR (or EFF %)  1   1
 m 
 The rate typically quoted on a loan agreement is

equal to the rate per period multiplied by the
number of periods. This rate is called the Annual
Percentage Rate (APR). The APR is thus a
quoted rate, not an effective rate!
 Continuous compounding:
EAR  einom  1
11
FV and PV with Rates Compounding
More Frequently Than 1x per Year
You deposit £1,000 into an account that pays 6
percent interest, compounded semi-annually.
How much will you have in 5 years?
 Method 1: use the periodic rate (e.g., inom/m =

0.06 / 2 = 0.03) with the total number of periods
(e.g., n * m = 5 * 2 = 10):
25
 0.06 
FV  £1,0001  
 2 
 £1,000(1.03)10
 £1,343.92
 Method 2: first, find the EAR, then use the EAR
as the rate with n equal to 5:
2
 0.06 
EAR  1    1  0.0609  6.09%
 2 
FV  £1,0001.0609  £1,343.92
5
12
Amortization
 Amortized Loans
 Principal + Interest Paid Throughout the
Life of the Loan
 Home Mortgages and Auto Loans Are
Amortized Loans
 Find Payment Using the Annuity Present
Value Equation:
 1 
1 
 (1  i ) n 
Loan Amt  Pmt   
 i 
 
Rearrange:
Pmt  Loan Amt

 1 
1 
 (1  i ) n 
 
 i 
 
Note: i = period rate

(monthly, etc)
n = # payments
13
Excel TVM Functions
To find the future value FV(Rate,Nper,Pmt,PV,Type)
To find the present value PV(Rate,Nper,Pmt,FV,Type)
Payment for an annuity PMT(Rate,Nper,PV,FV,Type)
Number of periods NPER(Rate,Pmt,PV,FV,Type)
Yield of an annuity RATE(Nper,Pmt,PV,FV,Type,Guess)
Present value of unequal CF NPV(Rate,Values)
To raise e to a power EXP(Number)
14

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FIN 4333 - Financial Management

Time Value of Money

 A Dollar Today is Worth More than a

$2,000 $2,000 $2,000 $2,000 $2,000.00

Total future value $12,210.20

 Ordinary Annuity Future Value Formula

 If You Need a Certain (Known) Amount of

 Discounting = the Opposite of

 What is the Value Today of $133.10 to be

How much would you pay to receive $2,000 per

 Ordinary Annuity Present Value Formula

$2,000  $1,000  (1.10) n

Gradient Series Annuities

 Total PV = PV Level Annuity + PV Gradient

 Find PV of Level portion of the annuity the

 Use the following equation to find the present

 In general, if we let q be the quoted rate and m

 The rate typically quoted on a loan agreement is

 Method 1: use the periodic rate (e.g., inom/m =

Pmt  Loan Amt

Note: i = period rate

To find the future value FV(Rate,Nper,Pmt,PV,Type)

To find the present value PV(Rate,Nper,Pmt,FV,Type)

Payment for an annuity PMT(Rate,Nper,PV,FV,Type)

Number of periods NPER(Rate,Pmt,PV,FV,Type)

Yield of an annuity RATE(Nper,Pmt,PV,FV,Type,Guess)

Present value of unequal CF NPV(Rate,Values)

To raise e to a power EXP(Number)

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