Topic 3

Time
Time Value
Value of
of
Money
Money
 The Time Value of Money
 The Interest Rate
 Simple Interest
 Compound Interest
 Amortizing a Loan
 Compounding More Than
Once per Year
 The Interest Rate

Which would you prefer -- $10,000

today or $10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!
Why TIME PREFERENCE?
1. Uncertainty of future cash

2. Subjective preference for present

consumption

3. Speculation: opportunity to
postpone consumption and earn
INTEREST.
 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).
 Simple Interest Formula

Formula SI = P0(r)(n)
SI: Simple Interest
P0: Deposit today (t=0)
r: Interest Rate per Period
n: Number of Time Periods
 Simple Interest 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(r)(n)
= $1,000(.07)(2)
= $140
 Simple Interest (FV)
 What is the Future Value (FV) of the
deposit?
FV = P0 + SI
= $1,000 + $140
= $1,140
 Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
 Simple Interest (PV)
 What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
 Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
 Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
0 1 2
7%
$1,000
FV2
 Future Value
Single Deposit (Formula)
FV1 = P0 (1+r)1 = $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
 Future Value
Single Deposit (Formula)
FV1 = P0 (1+r)1 = $1,000
(1.07)
= $1,070
FV2 = FV1 (1+r)1

= P0 (1+r)(1+r) = $1,000(1.07)
(1.07) = P0 (1+r)2
= $1,000(1.07)2
 General Future
Value Formula
FV1 = P0(1+r)1
FV2 = P0(1+r)2
etc.

General Future Value Formula:

FVn = P0 (1+r)n
or FVn = P0 (FVIFr,n) -- See Table A1
 Example
Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.

0 1 2 3 4 5
10%
$10,000
FV5
 Solution
 Calculation based on general formula:
FVn = P0 (1+r)n
FV5 = $10,000 (1+ 0.10)5
= $16,105.10
 Calculation based on Table I:
FV5 = $10,000 (FVIF10%, 5)
= $10,000 (1.611)
= $16,110 [Due to
Rounding]
 Double Your Money!!!

Quick! How long does it take to

double $5,000 at a compound rate
of 12% per year (approx.)?

We will use the “Rule-of-72”.

 The “Rule-of-72”

Quick! How long does it take to

double $5,000 at a compound rate
of 12% per year (approx.)?

Approx. Years to Double = 72 / r%

72 / 12 = 6 Years
[Actual Time is 6.12 Years]
 Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
7%
$1,000
PV0 PV1
 Present Value
Single Deposit (Formula)

PV0 = FV2 / (1+r)2 = $1,000 / (1.07)2

= FV2 / (1+r)2 = $873.44

0 1 2
7%
$1,000
PV0
 General Present
Value Formula
PV0 = FV1 / (1+r)1
PV0 = FV2 / (1+r)2
etc.

General Present Value Formula:

PV0 = FVn / (1+r)n
or PV0 = FVn (PVIFr,n) -- See Table A2
 Example
Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a discount
rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
 Solution
 Calculation based on general formula:
PV0 = FVn / (1+r)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
 Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
 Types of Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity: Payments or receipts
occur at the end of each period.
 Annuity Due: Payments or receipts
occur at the beginning of each period.
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
 Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+r) n-1
+ R(1+r) + n-2

... + R(1+r)1 +
R(1+r)0
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$3,215 = FVA3
$1,000(1.07) + $1,000(1.07)
1 0

= $1,145 + $1,070 + $1,000

= $3,215
 Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
 Valuation Using Table A33
FVAn = R (FVIFAr%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215)
= $3,215
 Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+r)1 + R/(1+r)2
+ ... + R/(1+r)n
 Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +

$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
 Valuation Using Table IV
PVAn = R (PVIFAr%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624)
= $2,624
 Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
R R R R

R: Periodic
PVADn Cash Flow

PVADn = R/(1+r)0 + R/(1+r)1 + ... + R/(1+r)n-1

= PVAn (1+r)
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 +
$1,000/(1.07)1 +
2
 Valuation Using Table IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) =
$2,808
 Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF,
annuity stream(s), or mixed flow
6. Solve the problem
 Mixed Flows Example
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%.

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
 How to Solve?

1. Solve a “piece-at-a-time” by
discounting each piece back to
t=0.
2. Solve a “group-at-a-time” by first
breaking problem into groups of
annuity streams and any single cash
flow groups. Then discount each
group back to t=0.
 “Piece-At-A-Time”

0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
 “Group-At-A-Time” (#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
$600(PVIFA10%,2) = $600(1.736) = $1,041.60
$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) = $100 (0.621) = $62.10
 OTHER CASES
1. Deferred annuity
2. Growing annuities
3. Perpetuities
4. Growing perpetuities
 Frequency of
Compounding
General Formula:
FVn = PV0(1 + [r/m])mn
n: Number of Years
m: Compounding Periods per
Year r: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
 Impact of Frequency
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+ [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+
[.12/2])(2)(2) = 1,262.48
 Impact of Frequency
Qrtly 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
Continuos FV2 = 1000e(0.12)(2) =1271.25
 Effective Annual
Interest Rate
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ r / m ] )m - 1
 BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or
6.14%!
 Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (r% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step
3)
5. Start again at Step 2 and repeat.
 Amortizing a Loan Example
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV0 = R (PVIFA r%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
 Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000

[Last Payment Slightly Higher Due to Rounding]

 Usefulness of Amortization

1. Determine Interest Expense

-- Interest expenses may
reduce taxable income of the
2.firm.
Calculate Debt Outstanding --
The quantity of outstanding
debt may be used in financing
the day-to-day activities of the
firm.