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Time Value of Money:

One of the most fundamental concepts in finance is that money has a time value. That is
to say that money in hand today is worth more than money that is expected to be received in the
future. The reason is straightforward: A dollar that you receive today can be invested such that you
will have more than a dollar at some future time. This leads to the saying that we often use to
summarize the concept of time value: A dollar today is worth more than a dollar tomorrow."

How to Think About Time Value of Money Problems


One of the biggest obstacles to correctly solving time value of money problems is
identifying the cash flows and their timing. On this page I will offer some tips that I hope will be
helpful.

There are Always Five Variables


Every time value of money problem has five variables: Present value (PV), future value
(FV), number of periods (N), interest rate (i), and a payment amount (PMT). In many cases, one of
these variables will be equal to zero, so the problem will effectively have only four variables. You will
always know the values of all but one of these, and it is that missing value for which you will be
solving.
Present Value
Any value that occurs at the beginning of the problem (or the beginning of a part of the
problem) is a present value. The key is that the present value occurs before any other cash
flows. Usually, when a present value is given, it will be surrounded by words indicating that
an investment happens today.
Future Value
The future value is usually the last cash flow. Obviously, it is a cash flow that occurs at some
time period in the future. The future value is a single cash flow. If it occurs more than once,
then it is probably an annuity payment.
Annuity Payment
An annuity payment is a series of two or more equal payments that occur at regular time
periods. Each payment, if taken alone, is a future value, but the key point is that the annuity
payment is a recurring payment. That is, there are more than one of them in a row.
Interest Rate
The interest rate is the growth rate of your money over the life of the investment. It is usually
the only percentage value that is given. However, some problems will have different interest
rates for different time frames.

For example, problems involving retirement planning will often give pre-retirement and
post-retirement interest rates. Frequently, when you are being asked to solve for the interest
rate, you will be asked to find the compound average annual growth rate (CAGR).
Number of Periods
The number of periods is the total length of time that the investment will be held. Typically, it
is given as a number of years, though it will often need to be adjusted to some other time
scale. For example, if you are told that the investment pays interest quarterly (4 times per
year) then you must adjust N so that it reflects the total number of quarterly (not annual) time
periods.

NOTE: The interest rate, number of periods, and annuity payment variables must all agree on the
length of a time period (a day, a week, a month, a year, etc). That is, i is always the interest rate
per period, N is always the total number of periods, and PMT is always the amount of the
payment per period. Very often, it is necessary to make adjustments to the values given in a
problem. For example, interest rates are usually given as annual rates. However, if payments
occur monthly, then the interest rate must be adjusted to a monthly rate (typically by dividing the
annual rate by 12). Similarly, the number of years would have to be changed to the number of
months.

Draw a Time Line


Even after you have successfully identified the cash flows, it can be difficult to track the timing of
the cash flows in your head. This is where time lines are so important. A time line is a graphical
representation of the size and timing of the cash flows.

When you are first learning to solve time value problems, drawing time lines is a very good idea.
In the picture above, you can easily see that the problem consists of a five-year $100 annuity
(PMT), and a $1,000 cash flow (FV) that occurs at the end of the investment. The time line
helps you to see exactly when each cash flow occurs, and therefore how many periods it needs
to be moved (either forward or backwards in time). As the problems that you are solving
become more complex, the importance of drawing time lines increases.

Simple vs. Compound Interest


You can see the power of compound interest in that last example. If we were dealing with
simple interest (i.e., you do not earn interest on top of interest) then you would have earned only
$80 in interest over the 10-year period. However, with compound interest, you have actually
earned $115.89 in interest. So, compounding added an extra $35.89 over 10 years. It gets even
better over longer time frames and/or with higher interest rates.
To see this even better take a look at the following chart, which shows the difference between
compound and simple interest over long periods. Notice how the future value grows
exponentially with compound interest. The dotted line shows the difference in future values over
30 years.

EFFECTIVE vs NOMINAL RATE OF RETURN


The interval at which is paid also has an effect on the final result. As an alternative to
interest being paid annually it may be paid monthly, quarterly or half yearly. The more frequently
the interest is compounded with a year, the higher the end result.
The rate of interest which is payable more frequently than yearly is called nominal rate of
interest, while the actual rate of interest is called the effective rate of interest.
The formula for converting nominal rate into an effective rate is as follows:
Effective rate= [(1+i/m)^m]-1
While i=nominal rate
M=no.of compounding periods in a year
EXAMPLE:

If nominal rate is 10% and compounding is quarterly,


Effective rate is=(1+10%/4)^4-1=10.38.
Des: Go to CNVR menu
N=No. of compounding in a year=4
I=10
EPF=SOLVE=10.38

The Rule of 72
The Rule of 72 is an often useful tool that can be used to approximate how long it will take to
double your money at a particular interest rate:
Years to double money = 72 interest rate
So, using the rule we can see that at 8% it will take about 9 years to double your money:
Years to double money = 72 8% = 9 years:

Calculating the Future Value


If you were to invest a certain dollar amount today, it would grow to a larger
(hopefully!) value at some point in the future. The value at the future point in time is called
the future value. In order to calculate the future value we must know the rate at which the
investment will grow (called the interest rate or discount rate) and the length of time that the
investment will be held (number of periods).
Suppose that you invest $100 today at an interest rate of 8% per year and expect to
hold the investment for one year. How much will the investment be worth at the end of this
period? In other words, what is the future value?
grow at the rate of 8% per year for a period of one year. So, the future value is equal to
the present value plus the interest earned over the course of the year. In other words:
100 + 100 * 0.08 = 108
So, the future value will be $108 at the end of the year. We can express the above equation
algebraically as: In this problem, the $100 that is invested today is known as the present value,
and your investment will
FV1 = PV + PV * i

Example:

1) Jim makes a deposit of $12,000 in a bank account. The deposit is to earn


interest annually at the rate of 9 percent for seven years.
Solution: N = 7,
I = 9,
PV = 12,000,
PMT = 0 ,
P/Y = 1,
FV = $21,936.47

Calculating Present Value


The present value is the current value of a stream of cash flows. Thus the name: Present value
means "what is it worth right now?" To solve for the present value, we merely rearrange our
basic time value formula:
PV = FVN/(1 + i)N
So, to find the present value we take the future value and divide it by (1 + i)N where N is the
period where the future value is located. Note that since we are dividing the future value, the
present value will always be less than the future value.
EXAMPLE:
An investor can make an investment in a real estate development and receive an expected
cash return of 45,000 after six years. Based on a careful study of other Investment alternatives,
she believes that an 18 percent annual return compounded quarterly is a reasonable return to
earn on this investment. How much should she pay for it today?
SOLUTION: N = 6 4 = 24,
I = 18,
PMT = 0,
FV = 45,000.
P/Y = 4,
PV = $15,646.66.

Solving for i and N for Lump Sum Cash Flows


In the previous sections, we have seen how to calculate present values and future
values of lump sum cash flows. However, in many cases you may need to solve for the number
of periods or the interest rate. The purpose of this section is to show exactly how to do that.
It is important to remember that we are using the basic time value of money formula:
FVN = PV(1 + i)N
All that we need to do is to solve that equation, algebraically, to find either N or i. We will solve
for the interest rate first since it is a more common need and also a bit easier mathematically.
EXAMPLE1: Suppose you have the opportunity to make an investment in a real estate

venture that expects to pay investors 750 at the end of each month for the next eight
years. You believe that a reasonable return on your investment should be 17 percent
compounded monthly. What will be the final value?
SOLUTION: SET=END
N = 8 12 = 96,
I = 17,
PMT = 750,
P/Y = 12,
FV = 0 39,222.96.

EXAMPLE2:
Suppose you deposit 5,000 into an account earning 4 percent interest, compounded monthly.
How many years will it take for your account to be worth 7,500?
SOLUTION: PV = 5,000,
I = 4,
PMT = 0,
FV = 7,500
C/Y = 12,
N = 121.84, or 10.15 YEARS
EXAMPLE3:
You have just borrowed 10,000 and will be required to make monthly payments of 227.53 for the
next five years in order to fully repay the loan. What is the implicit interest rate on this loan?
SOLUTON: N = 5 12 = 60,
PV = 10,000,
PMT = 227.53,
FV = 0
P/Y = 12,
I = 13%

Calculating the Future Value of a Regular Annuity


As noted above, according to the principle of value additivity, we can treat an annuity as
a series of lump sum cash flows. Well, we have already seen how to calculate the future value
of a lump sum. All that we need to do is apply this formula to each of the cash flows individually,
and then sum the results:

Using the example shown in the time line (above), and a 9% per period interest rate, we get:
FVA = 100*(1.09)2 + 100*(1.09) + 100 = 327.81

EXAMPLE:
If one saves Rs.1000/- a year at end of every year for three years in an account earning 7% intrest,
compounding annually, how much will one have at the end of thried year?

SOLUTION:
N=3
I=7
PMT=-1000
FV=3215

Internal rate of return


The internal rate of return (IRR) is a rate of returnused in capital
budgeting to measure and compare the profitability of investments. It is also called
the discounted cash flow rate of return (DCFROR) or simply the rate of return
(ROR).[1] In the context of savings and loans the IRR is also called the effective interest
rate. The term internal refers to the fact that its calculation does not incorporate
environmental factors (e.g., the interest rate or inflation).
EXAMPLE:
What is the internal rate of return of an investment with the following cash
flows? n $
0 (1,000)
1 300
2 300
3 300
4 200
5 100
SOLUTION: goto CASH menu
I0= -1,000,
I1 = 300,
12 = 300,
I3 = 300,
I4 = 200,
I5 = 100,
solve for IRR

NET RESENT VALUE


In finance, the net present value (NPV) or net present worth (NPW)of a time
series of cash flows, both incoming and outgoing, is defined as the sum of the present
values (PVs) of the individual cash flows of the same entity.

EXAMPLE:
If suppose an investment promises a cash flow of Rs.500 in one year,Rs.600 at the end of
two years and Rs.10,700 at the end of thired year. If discount rate is 5%, what is the value of this
investment today?

SOLUTION:
I=5
FLOW=0=EXE
FLOW1= 500=EXE
FLOW2=600=EXE
FLOW3=10,700=EXE
ESE
NPV=SLOVE=10,263.47

BY

Arun Chowdary
CFP Practioner