College of Business and Behavioral Science

Clemson University

Class Notes
Chapter 5

Time Value of Money

Jared Smith
FIN 311: Financial Management I

Fundamental Idea: A dollar today is

worth more than a dollar tomorrow.
Question: How much more?
Example: How much must I promise to give you in
one year for you to give me $1,000 today?

Key Concepts and Skills

Be able to compute the future value of an
investment made today
Be able to compute the present value of cash to
be received at some future date
Be able to compute the return on an investment
Be able to compute the number of periods that
equates a present value and a future value given
an interest rate
Compute the future value of multiple cash flows
Compute the present value of multiple cash
flows
Compute loan payments
Find the interest rate on a loan
Understand how interest rates are quoted
Understand how loans are amortized or paid off

Definitions:
Cash flow: The excess of cash revenues over cash outlays in a
given period of time

Present value: The current value of one or more future cash

flows, discounted at some appropriate interest rate.

Future Value: The value to which a specific cash flow or

series of cash flows will grow on a given date in the future.

Interest Rate: The rate paid (or received if you are a creditor)
on borrowed money, expressed as a percentage of the sum
borrowed. [Indicates how fast money will grow]

Simple Interest: Interest paid only on the original principal,

not on the interest accrued.

Compound Interest: Interest computed on the accumulated

interest as well as on the original principal. [Includes interest on
the interest]

Examples:
1 - Investing for a single period
If you invest $1,000 in a savings account at 6% per
year, how much will you have in one year?

Formula:

2 Investing for more than one period

If you then leave all the money in the bank for one
more year, how much will you have at the end of two
years?

Formula:

And again, at the end of three years how much would

you have?

Formula:

How much would you have at the end of 3 years

using simple interest?

General Formula:
The general formula for calculating the future value
of cash flows after t periods (with compound
interest):

FV = PV*(1+r)

Note that there are four variables in the equation:

1) PV present value
2) FV future value
3) r rate of interest per period (expressed as a
decimal)
4) t number of periods
We can solve for any one of these four variables
given values for the other three.

I. Solving for FV (PV, r, and t are known)

If we know the present value of a cash flow, the interest rate per period, and the number
of periods, but we want to calculate the future value, we can simply plug the numbers
into the equation above:

FV = PV*(1+r)t
Examples:
1) Over the summer you were able to save $10,000.
If you invest the money in an account that pays
5% per year how much will you have in 10 years?

b) How much will you have in 30 years?

c) How much will you have in 30 years if you

receive 10% interest?

II. Solving for PV (FV, r, and t are known)

When we calculate the PV of some future amount, we are discounting that future
amount.
If we know the future value of a cash flow, the interest rate per period, and the
number of periods, but we want to calculate the present value, we need a different
form of the same equation. Solving for PV yields:

PV = FV*(1/(1+r))t
Or equivalently,

PV = FV*(1+r)-t
Derivation:

Examples:
2) In five years you want to have $25,000 to use as a
down payment on a house. How much would you
need to invest today if you can lock in an interest
rate of 10%?

3) You want to buy a new car when you finish

Graduate School 4 years from now. The current
price of the car is $40,000. You estimate the price
will rise with inflation (2%) for the next few
years. How much must you invest today if you
receive 8% interest?

III. Solving for r (PV, FV, and t are known)

If we know the present value of a cash flow, the future value of the cash flow, and
the number of periods, but we want to calculate the interest rate per period, we need
yet another form of the same equation. Solving for r yields:

r = (FV/PV)1/t 1
Derivation:

Examples:
4) Vincent Van Goghs Sunflowers was sold at an
auction in 1987 for approximately $36 million. It
had sold in 1889 for $125. At what discount rate is
$125 the present value of $36 million, given a 98year time span?

5) Suppose you have a 1-year old son and you want

to provide $75,000 in 17 years towards his college
education. You currently have $10,000 to invest.
What interest rate must you earn to have the
$75,000 you need?

IV. Solving for t (PV, FV, and r are known)

If we know the present value of a cash flow, the future value of the cash flow, and
the interest rate per period, but we want to calculate the number of periods, we need
the final form of the same equation. Solving for t yields:

t = ln(FV/PV) / ln(1+r)
Derivation:

Examples:
6) You inherit $50,000 on your 20th birthday. If you
invest the $50,000 and earn 10% per year on your
investment, at what age will you have
accumulated $1 million?

7) You want to buy a new house. You currently have

$15,000 and you figure you need to have a 10%
down payment plus an additional 5% of the loan
amount for closing costs. Assume the type of
house you want will cost about $150,000 and you
can earn 7.5% per year. How long will it be before
you have enough money for the down payment
and the closing costs?

Conceptual Interactions of Variables:

Holding the other 2 variables constant:
1. What happens to the PV when r increases?

2. What happens to FV when r increases?

3. What happens to PV when t increases?

4. What happens to FV when t increases?

Discounted Cash Flow Analysis (DCF)

DCF extends the work we did with the Time
Value of Money to incorporate multiple cash
flows
We will introduce several special patterns of cash
flows that have simple valuation formulas
For more general problems, valuation is done by
discounting each cash flow individually
Correctly accounting for the timing of the cash
flows is critical, although it is really just a matter
of bookkeeping

Multiple Cash Flows: Examples

1. As a bowling superstar you sign a 3 year contract
with a major shoe company. They agree to pay you
a signing bonus of $5 million plus $3 million at
the end of each of the next 3 years. The discount
rate is 8%.
a) What is the present value of the contract?

b)What is the end of contract value of the contract?

c) If you invest all of the proceeds at the time of

payment how much will you have in 10 years?

Key Insights:
Cash flows valued in the same period can be
added together
Once the cumulative value of the cash flows in
one period is determined, the multiple cash flows
can be treated as a single cash flow in that period
Systematically applying a timeline reduces the
complexity of the problem
Example 2:
Your broker calls you and tells you that he has this
great investment opportunity. If you invest $10,000
today, you will receive $4,000 in one year and $7,500
in two years. If you require a 15% return on
investments of this risk, should you make the
investment?

Example 3:
You are offered the opportunity to invest for your
retirement. If you invest you will receive payments of
$25,000 per year for 5 years. The first payment is
made 40 years from today. How much would you be
willing to invest today if you desire an interest rate of
12%?

Annuities and Perpetuities

Two commonly occurring cash flow patterns
are annuities and perpetuities.
Annuity: Finite series of equal payments that
occur at regular intervals
If the first payment occurs at the end of
the period, it is called an ordinary
annuity
If the first payment occurs at the
beginning of the period, it is called an
annuity due
Perpetuity: Infinite series of equal payments
that occur at regular intervals (an annuity
with an infinite life)

Perpetuity Valuation
If there were no Time Value of Money, a
perpetuity would have infinite value.
With a positive discount rate, the distant cash
flows are negligible in current value.
Therefore, the present value of a perpetuity
converges to a finite number.
Discounting each cash flow and adding them up
would be tiring since there are infinitely many.
Instead we have a very simple formula:

PVPerp

CF

Derivation:
PV CF /(1 r ) CF /(1 r ) 2 CF /(1 r ) 3
Multiply through by (1+r):

PV (1 r ) CF CF /(1 r ) CF /(1 r ) 2
PV (1 r ) CF PV
PV * r CF
PV CF / r
Exa
mples:
1. What is the value of an asset that pays $1,000 per
year in perpetuity if the interest rate is 5%?

2. What if the interest rate is 10%?

3. What if we assume the payments dont start until

10 years from now and rates are 10%?

Annuity Valuation
1 Knowledge of perpetuity valuation provides a shortcut to valuing
an annuity
2 Think of an annuity as two perpetuities: one beginning at time
zero, the other beginning when the annuity ends and for the
opposite amount
Consider a five year ordinary annuity:
Period:

Annuity:

CF CF CF CF CF

Perpetuity1:
Perpetuity2:

CF CF CF CF CF CF CF CF CF CF
0 0 0
0 0 -CF -CF -CF -CF -CF

10

Present Value of an Annuity

Under this approach, combining the present values of the two perpetuities yields
the present value of the annuity:

PV Annuity PV Perp .1 PV Perp .2

CF CF 1

r r 1 r
Finally,

CF
1
PV Annuity
1

k
r
1 r
k = the length of the annuity, # of
This formula is discounting cash flow #1

Payments

Examples:
1. You win $1,000,000 in the lottery. As a payoff, you have the choice between
receiving $40,000 per year for 25 years (beginning in one year), or receiving
a lump sum of $600,000 today. The current interest rate is 4.5%. Assuming no
difference in tax implications, which option do you choose?
PVA= 40k/ .045 [1-1/1.045^25
PMT= 40k

= 593,128.36

N= 25 Interest = 4.5 CPT PV

2. You are offered the opportunity to invest for youre your retirement. If you
invest you will receive payments of $25,000 per year for 5 years. The first
payment is made 40 years from today. How much would you be willing to invest
today if you desire an interest rate of 12%?

25k.5 Years
PVA= 25k/.12 [1-1/1.12^5] = 90,119.41
This value is as of 39 on number line
90,119.4/1.12^39 = 1,084.17
FV/(1+r)^t

3. You are ready to buy a house and you have $40,000 for a down payment and
closing costs. Closing costs are estimated to be 4% of the loan value. You have
an annual salary of $72,000 and the bank is willing to allow your monthly
mortgage payment to equal 28% of your monthly income. The interest rate on
the loan is 6% per year with monthly compounding (0.5% per month) for a 30
year fixed rate loan. How much money will the bank loan you? How much can
you offer on the house?
PVA= 72k/12 X .28/.005 (1-1/1.005 = 280,209.91
CF
Offer= Loan + Down Payment, however the 40k is for down payment and
closing cost.
Down payment= Cash - Cash paid to closing cost

Offer= 280,209.91 + [40k - .04 (280,209.91)]

4. Finding the Payment: Suppose you want to borrow $20,000 for a new car.
You can borrow at 9% per year, compounded monthly (0.75% per month). If
you take a 4 year loan, what is your monthly payment?
Translate 9%/12 to .75% per month
PVA= CF/r (1-1/(1+r)^k
20k= CF/.0075 [1-1/1.0075^48]
CF=497.76
N=48
Interest= .75
PV=20k

5. Finding the number of payments: You are negotiating to purchase Panther

Surf & Ski, a successful retail store, from Ed, the current owner. The price is
$1,000,000 and Ed has agreed to fund the deal entirely with owner financing at
9% per year (0.75% per month). Your calculations indicate that the stores cash
flows can support monthly payments of $16,089. How long will it be before you
can payoff the loan?
PVA= CF/r [1-(1/1+r)^k]
1,000,000 = 16089/.0075 [1-(1/1.0075)^k]
.4662= 1-(1/1.0075)^k
(1/1.0075)^k=1-.4662
K ln(1/1.0075)= ln(1-.4662)

PV=1m
Interest= .75
PMT= 16089
K= 84 Months

Future Value of an Annuity

Future Value of an Annuity: The annuity valued at the end of the annuity.
To find the future value of the annuity, simply move the present value forward
by k periods:

FV Annuity PV Annuity 1 r k

CF 1 r k

r
Therefore,

1
1
k
1 r

CF
k
1 r 1
FV Annuity
r
k = the length of the annuity

Examples:
1. You deposit $500 from your paycheck into a money market account ever
month. How much will the account be worth in 10 years if the interest rate on
the account is 6% (0.5% per month)?
FVA= CF/r [(1+r)^k -1)]
= 500/.005 [(1.005)^120 -1] = 81,939.67
120=N .5 = Interest -500=PMT

2. Find the rate: You can afford save $10,000 per year for your retirement in 30
years. What interest rate will you need in order to have $2,000,000 when you
retire?
2,000,000 = 10000/r [(1+r)^30-1]
Interest rate= 11.025 %
2,000,000 = FV
10k= PMT
30= N
CPT= Interest rate

Annuity Due
An annuity due is like an ordinary annuity except the payments occur at the
beginning of each period.
An annuity due can be viewed as simply an ordinary annuity starting one
period earlier.

PV AnnuityDue PVOrdinaryAn nuity 1 r

Example:
1. You win $1,000,000 in the lottery. As a payoff, you have the choice between
receiving $40,000 per year for 25 years (with the 1st payment today), or
receiving a lump sum of $600,000 today. The current interest rate is 4.5%.
Assuming no difference in tax implications, which option do you choose?
Copy off Bens sheet

40k= PMT 25=N 4.5= Interest CPT= PV

PV= 40k/.045 [1-1/1.045^25] X (1.045) =

Or Like this
PVA= 40k/.045 [1-1/1.045^24]+40k = 619,819.13

EAR and APR

Different accounts have different compounding periods: daily, weekly, monthly,
yearly, continuous
How do we compare these different rates?
Effective Annual Rate (EAR): The actual yearly rate paid (or received) after
accounting for compounding that occurs during the year
To compare two alternative investments with different compounding
periods you need to use the EAR
Period Rate: The actual rate paid after accounting for compounding that occurs
during a period (i.e. week, month, and year)
Annual Percentage Rate (APR): The period rate times the number of periods per
year. The APR is the quoted rate for certain account and loans.
To calculate the period rate use the APR (period must match compounding
period):

Period rate = APR / Number of periods per year

NEVER divide the EAR by the number of periods per year it will NOT
give you the period rate!

Examples:
1. What is the APR if the monthly rate is 0.5%?
2. What is the APR if the semiannual rate is 0.5%?
3. What is the semiannual rate if the APR is 12% with monthly compounding?

Key Insights:
In (3), You CANNOT simply divide the above APR (based on monthly
compounding) by 2 to get the semiannual rate. You need an APR based on
semiannual compounding to find the semiannual rate!
You ALWAYS need to make sure that the interest rate and the time period
match.
If you have an APR based on monthly compounding, you must use monthly

periods or adjust the interest rate appropriately if you have payments other
than monthly.

Calculating EAR and APR

The formula for calculating EAR from the quoted rate is:

EAR 1
m

* q is the quoted rate

m is the number of compounding periods per year

The formula for calculating APR from EAR is:

APR m 1 EAR

1m

* m is the number of compounding periods per year

Examples:
1. Suppose you can earn 1% per month on an investment. What is the APR?
How much are you effectively earning?

2. Alternatively, if you can earn 3% per quarter what is the APR? How much are
you effectively earning?

3. If you want to earn an effective rate of 12% and you are looking at an account
that compounds on a monthly basis, what must the APR be?

4. You must choose between two savings accounts. The first pays 5.25% with
daily compounding. The second pays 5.3% with semiannual compounding.
Which do you choose?

5. You buy a new computer system for $3,500 and the store allows you to make
monthly payments. The loan period is 2 years and the interest rate is 18%
with monthly compounding. What is your monthly payment?

6. If instead in the previous example, the EAR based on monthly compounding

is 18% what is your monthly payment?

7. An investment account has an APR of 10.4% based on weekly compounding.

What is the effective semi-annual rate?

b. What is the EAR (effective annual rate)?

Continuous Compounding
Frequently, investments or loans are compounded continuously.
In this special case:
q

EAR e 1
* q is the quoted rate

Examples:
1. What is the effective annual rate of 7% compounded continuously?

2. You invest 100,000 for one year at a rate of 15%. What is the difference in
value between annual and continuous compounding?

Summary:
Why do we need to calculate equivalent cash flows at different times?
A dollar today is not the same as a dollar tomorrow. Therefore, we cannot add money
values in different time periods. We must calculate equivalent values at the same time
to add them.
We can now find a single cash flows equivalent value at any given time. Essentially, we
can move a cash flow to any point on a time line:
0

PV

t
FV

PV: Present value

FV: Future value
t:
Number of time periods between PV & FV
r:
Rate of interest

Value multiple cash flows by summing the values in a common period

Identify and value annuities

 Identify and value perpetuities

Compound over different time horizons and switch between EAR and APR

Loan Types:
Pure Discount Loans: Repayment is in one lump sum
Interest Only Loans: Pays only the interest each period and then the entire
principal is paid in a lump sum at the end.
Amortized Loans: Part of the loan principal is paid off over time. The
specific structure depends on the individual contract

Examples:
1. You buy a new house for $300,000. You put 10% down and borrow $270,000
at 6% (based on monthly compounding) with monthly payments (at the end of
the period) for 30 years.
a What are the monthly payments for an amortized mortgage with equal
monthly payments?

b How much interest is paid over the life of the loan?

c How much is owed after 10 years?

Some Suggested HW Problems:

4, 6, 7, 10, 12, 15, 19, 22, 24, 30, 31