Time value of money

A dollar in hand today is worth more than a dollar to be received in the future because if
you had the money now, you could invest it, earn interest, and end up with more than one
dollar in the future. Process of converting a value stated as a current $ amount, termed the
present value (PV), to a future value (FV) is called compounding.

When interest is earned on the interest earned in prior periods, we call it compound
interest.
If interest is earned only on the principal, we call it simple interest.
The total interest earned with simple interest is equal to the principal multiplied by the
interest rate times the number of periods: PV(I)(N).
Future value is equal to principal plus the interest: FV = PV + PV(I)(N).
For example, suppose you deposit $100 for 3 years and earn simple interest at an annual
rate of 5%.
Your balance at the end of 3 years would be:
FV = PV + PV(I ) (N) = $100 + $100 x (5%) x (3) = $100 + $15 = $115

PRESENT VALUES
The process of finding present values is called discounting.
Discounting simply is the reverse of compounding—that is, rather than adding interest to a
current amount to determine its future value, we take interest out of a future amount to
determine its present value. Consequently, if we solve for PV in Equation 4–1, we have an
equation that can be used to solve for the present value of a future dollar amount:

Relationship between FV & PV

Finding present values is called discounting, and as previously noted, it is the reverse of
compounding.
If you know the PV, you can compound to find the FV; or if you know the FV, you can
discount to find the PV.

ANNUITIES
If payments occur at the end of each period, then we have an ordinary annuity e.g.
payments on mortgages, car loans, and student loans
If payments are made at the beginning of each period, then we have an annuity due e.g.
rental lease payments, life insurance premiums, lottery.
Ordinary Annuity Cash Flow
Time Line (Alice’s Deposits)

Annuity Due Cash Flow

Time Line (Alvin’s Deposits)

TIME LINE SOLUTION:

Future Value of an Ordinary Annuity

Future Value of an Annuity Due

Present Value of an Ordinary Annuity

Present Value of an Annuity

PERPETUITIES
Most annuities call for payments to be made over some finite period of time—for example,
$100 per year for 3 years. However, some annuities go on indefinitely, or perpetually. These
perpetual annuities are called perpetuities.
Present value of a perpetuity is found by applying following equation:

Everything else equal, when the interest rate changes, the value of an investment changes
in an opposite direction.

UNEVEN CASH FLOW STREAMS

The definition of an annuity states constant amount i.e. annuities involve payments that are
the same or constant for every period.
However, most important decisions involve uneven, or non-constant, cash flows. For
example, common stocks typically pay an increasing stream of dividends over time, and
fixed asset investments such as new equipment normally do not generate constant cash
flows.
We use the term cash flow (CF) to denote a cash flow series in general, which includes both
uneven cash flows and annuities.
When all cash flows in a series are equal, CF1 = CF2 = CF3 =. . . CFn,= PMT, which represents
an annuity. When all cash flows in a series are non-constant, it represents an uneven cash
flow stream (CF)
To find the present value (PV) of an uneven cash flow stream, we must sum the PVs of the
individual cash flows included in the stream. The PV is found by applying this general
present value equation, which is simply a series of PV solutions to Equation 4–2:

The future value of an uneven cash flow stream, sometimes called the terminal value, is
found by compounding each payment to the end of the stream and then summing the
future values.
We generally are interested in present value of an asset’s cash flow stream than in the
future value because the present value represents today’s value, which we can compare
with the price of the asset.

So far we have assumed that interest is compounded annually. This is called annual
compounding.
Suppose deposited $100 in a bank that pays a 6% annual interest rate, but paid every 6
months, called semiannual compounding. Note that FIs pay interest more often than every
six months; often interest is paid on a daily basis.

To find the future value, we must make two adjustments:

1. Convert the annual interest rate to a rate per period, which is called the periodic rate &
2. Convert the number of years to the total number of interest payments during the life
of the investment.
3. The FV is larger under semiannual compounding than with annual compounding. The
first interest payment is sooner & interest is compounded more often. Quarterly
payments will generate more.

Everything else equal, the greater the number of compounding periods per year, the
greater the effective rate of return on an investment.

If we are to properly compare the returns that are earned on investments with different
compounding periods, we need to put them on a common basis.
This requires us to distinguish between the simple (or quoted) interest rate and the
effective annual rate (EAR):
The simple, or quoted, interest rate (rSIMPLE) in our example is 6%. The simple rate is also
called the annual percentage rate, or APR.

If interest is computed once each year EAR = APR. But, if compounding occurs more than
once per year then EAR>APR

To find the effective annual rate if the simple rate is 6% & interest is paid semiannually, we
find the following result:

If a loan is to be repaid in equal periodic amounts (monthly, quarterly, or annually), it is

said to be an amortized loan.

Loan Amortization Schedule