Chapter 6

Time Value of Money

Time Value of Money
The idea that money available at the
present is worth more than the same
amount in the future due to its potential
earning capacity
This core principle of finance holds that,
provided money can earn interest, any
amount of money is worth more the
sooner it is received.



Present Value of a Single
Amount
In present value calculations, future cash
amounts are discounted back to the present
time.
(Discounting means removing the interest
that is imbedded in the future cash amounts.)
As a result, present value calculations are
often referred to as a discounted cash flow
technique.


Components of a Present Value
(PV) calculation:
Present value amount (PV)
Future value amount (FV)
Length of time before the future amount
occurs (n)
Interest rate used for discounting the
future value amount (i)

Frequency of Compounding
The following table reflects a single
amount invested for one year and earning
an annual interest rate of 12%

When
Compounding
Occurs This
Often
Number of periods, n,
during a 1-year time
span
Interest rate, i,
(per period , n)
Annually 1 12%
Semiannually 2 6%
Quarterly 4 3%
Monthly 12 1%
Calculating the Present Value (PV)
of a single amount
Let's assume we are to receive $100 at
the end of two years. How do we calculate
the present value of the amount, assuming
the interest rate is 8% per year
compounded annually?
The present value formula for a single
amount is:
PV = FV x [ 1 (1 + i)
n
]
Using the present value formula, the
solution is:
PV = FV x [ 1 (1 + i)
n
]
PV = $100 x [ 1 (1 + 0.08)
2
]
PV = $100 x [ 1 (1.08)
2
]
PV = $100 x [ 1 1.1664 ]
PV = $100 x [0.8573388] >PV factor
PV = $85.73

Future Value of a Single
Amount
Knowing how much what got now given a
compounded interest rate.
It is the value of an amount that is allowed
to grow at a given rate over a period of
time.
Four Variables in the Future Value
calculations:
PV Present Value of amount
FV Future value of Amount
n Number of time periods that interest
will be added and compounded
i Interest rate for the time period n.
FV = PV (1 + i)
n

Calculating Future Value of a single
amount
You make a single deposit of $100 today.
It will remain invested for 4 years at 8%
per year compounded annually. What will
be the future value of your single deposit
at the end of 4 years?
FV = PV x (1 + i)
n

FV = $100 x (1 + .08)
4

FV = $136


Exercises
Paul makes a single deposit today of $200. The deposit will
be invested for 3 years at an interest rate of 10% per year
compounded semi-annually. What will be the future value of
Pauls account at the end of 3 years?
FV = PV x (1 + i)
n

FV = $200 x (1 + .05)
6

FV = $268.02

What is the length of time involved if a future amount of
$5,000 has a present value of $1,000, and the time value of
money is 8% compounded annually?
FV = PV x (1 + i)
n

5,000 = $1,000 x (1 + .08)
?

N = 21
Base on the table, the future value factor in 21 years (n) is 5.03383
closer to P5,000 at a rate of 8%.


Exercises

What is the annual interest rate necessary to discount a future
amount of $10,000 to a present value of $7,300 over a four-
year period, assuming the interest is compounded annually?

FV = PV x (1 + i)
n

10,000 = 7,300 x (1 + ?)
4

i = 8%

Base on the table, the present value factor in 4 years (n) is .73503
closer to P7,300 at a rate of 8%.




What is the present value of a security which promises to pay
you 5,000 in 20 years? Assume that you can earn 7 percent if
you were to invest in other securities of equal risk.
If you deposit 10,000 in a bank account which pays 10 percent
interest annually, how much money will be in your account after
5 years?
What is the current value of a CD that will pay $100 in 3 years if
the prevailing interest rate is 5% compounded annually?
An airplane ticket cost 500 today and it is expected to increase
at a rate of 5% per year compounded annually. Determine the
number of years it will take for the 500 airplane ticket to have a
future cost of 700?
Lorenzo put 600 today in an account that earns an annual rate
of 8% compounded semiannually. How many years will it take
Lorenzos single investment of 600 to have a future value of
900?
ANNUITIES
An annuity is the payment or receipt of equal
cash flows per period for a specified amount
of time.
An ordinary annuity is one in which the
payments of receipts occur at the end of
each period.
An annuity due is one in which payments or
receipts occur at the beginning of each
period.


Future Value of an Ordinary
Annuity (FV
OA
)
The Future Value of an Ordinary Annuity (FVoa)
is the value that a stream of expected or promised
future payments will grow to after a given number of
periods at a specific compounded interest.

The Future Value of an Ordinary Annuity could be
solved by calculating the future value of each
individual payment in the series using the future value
formula and then summing the results. A more direct
formula is: FVoa = PMT [((1 + i)
n
- 1) / i]

FVoa = PMT [((1 + i)
n
- 1) / i]
Where:
FVoa = Future Value of an Ordinary
Annuity
PMT = Amount of each payment
i = Interest Rate Per Period
n = Number of Periods
What amount will accumulate if we deposit $5,000 at
the end of each year for the next 5 years? Assume an
interest of 6% compounded annually.
PV = 5,000
i = .06
n = 5
FVoa = PMT [((1 + i)
n
- 1) / i]
= 5,000 [((1 + .06)
5
- 1) / .06]
= 5,000 [ (1.3382255776 - 1) /.06 ]
= 5,000 (5.637092) >FVoa factor
= 28,185.46


Find the future value at time 5 of a $100 annuity that is to be
received annually over the next 5 years if the interest rate equals
10%
FVoa = PMT [((1 + i)
n
- 1) / i]
= 100 [((1 + .10)
5
- 1) / .10]
= 100 [ (1.61051 - 1) /.10 ]
= 100 (6.10510) >FVoa factor
= 610.51




In practical problems, you may need to
calculate both the future value of an
annuity (a stream of future periodic
payments) and the future value of a single
amount that you have today.
Example:
You are 40 years old and have accumulated $50,000 in
your savings account. You can add $100 at the end of
each month to your account which pays an interest rate
of 6% per year. Will you have enough money to retire in
20 years?

You can treat this as the sum of two separate
calculations:
the future value of 240 monthly payments of
$100 Plus
the future value of the $50,000 now in your account.

PMT = $100 per period
I = .06 /12 = .005 Interest per period
(6% annual rate / 12 payments/yr
n = 240 periods (12 x 20)
FVoa = 100 [ (3.3102 - 1) /.005 ]
= 100 (462.04)
= 46,204

PV = 50,000 Present value (the amount
you have today)
i = .005 Interest per period
n = 240 Number of periods
FV = PV (1+i)
240

= 50,000 (1.005)
240

= 50,000 (3.3102044)
= 165,510.22

FVoa = 100 [ (3.3102 - 1) /.005 ]
= 100 (462.04)
= 46,204
+
FV = PV (1+i)
240

= 50,000 (1.005)
240

= 50,000 (3.3102044)


= 165,510.22
= After 20 years you will have accumulated
$211,714.22 (46,204 + 165,510.22)


Future Value of an Annuity Due
(Fv
ad
)
The Future Value of an Annuity Due
is identical to an ordinary annuity except
that each payment occurs at the
beginning of a period rather than at the
end. Since each payment occurs one
period earlier, we can calculate the
present value of an ordinary annuity and
then multiply the result by (1 + i).
FVad = FVoa (1+i)
FVad = FVoa (1+i)
Where:
FVad = Future Value of an Annuity Due
FVoa = Future Value of an Ordinary
Annuity
i = Interest Rate Per Period

What amount will accumulate if we deposit $5,000 at the
beginning of each year for the next 5 years? Assume
an interest of 6% compounded annually.
PV = 5,000
i = .06
n = 5
FVoa = PV (1+i)
n
FVoa = 5,000 (1+.06)
5

= 5,000 (5.63709)


=

28,185.45
FVad = 28,185.45 (1 + .06)
= 29,876.59


Present Value of an Ordinary
The Present Value of an Ordinary
Annuity (PVoa) is the value of a stream of
expected or promised future payments
that have been discounted to a single
equivalent value today. It is extremely
useful for comparing two separate cash
flows that differ in some way.
PVoa = PMT [(1 - (1 / (1 + i)
n
)) / i]

PVoa = PMT [(1 - (1 / (1 + i)
n
)) / i]
PVoa = Present Value of an Ordinary
Annuity
PMT = Amount of each payment
i = Discount Rate Per Period
n = Number of Periods

Example 1:
What amount must you invest today at 6%
compounded annually so that you can
withdraw $5,000 at the end of each year for
the next 5 years?
PMT = 5,000
i = .06
n = 5
PVoa = 5,000 [(1 - (1/(1 + .06)
5
)) / .06]
= 5,000 (4.212364)
= 21,061.82

Example 2:
A computer dealer offers to lease a system to
you for $50 per month for two years. At the
end of two years, you have the option to buy
the system for $500. You will pay at the end
of each month. He will sell the same system
to you for $1,200 cash. If the going interest
rate is 12%, which is the better offer?
You can treat this as the sum of two separate
calculations:
the present value of an ordinary annuity of 24
payments at $50 per monthly period Plus
the present value of $500 paid as a single
amount in two years.
PMT = 50 per period
i = .12 /12 = .01 Interest per period (12% annual rate / 12
payments per year)
n = 24 number of periods
PVoa = 50 [ (1 (1/(1.01)
24
)) / .01]
= 50 [(1- (1 / 1.26973)) /.01]
= 1,062.17
+
FV = 500 Future value (the lease buy out)
i = .01 Interest per period
n = 24 Number of periods
PV = FV [ 1/ (1 + i)
n
]
= 500 (1/1.26973 )
= 393.78
The present value (cost) of the lease is $1,455.95 (1,062.17 +
393.78). So if taxes are not considered, you would be $255.95
better off paying cash right now if you have it.

Find the present value of a $100 annuity
that is to be received annually over the
next 5 years if the interest rate equals 10%
PVoa = PMT [(1 - (1 / (1 + i)
n
)) / i]
= 100 [(1 - (1 / (1 + .10)
5
)) / .10]
= 100 (3.79079)
= 379.08


Present Value of an Annuity Due
(Pv
ad
)
The Present Value of an Annuity Due
is identical to an ordinary annuity except
that each payment occurs at the
beginning of a period rather than at the
end. Since each payment occurs one
period earlier, we can calculate the
present value of an ordinary annuity and
then multiply the result by (1 + i).
PVad = PVoa (1+i)

PVad = PVoa (1+i)
Where:
PV-ad = Present Value of an Annuity Due
PV-oa = Present Value of an Ordinary
Annuity
i = Discount Rate Per Period

What amount must you invest today a 6%
interest rate compounded annually so that
you can withdraw $5,000 at the beginning
of each year for the next 5 years?
PMT = 5,000
i = .06
n = 5
PVoa = 21,061.82
PVad = 21,061.82 (1.06) = 22,325.53
1. What is the future value of a 5 year ordinary annuity which
promises to pay you 300 each year assuming an interest of 7
percent? What is its future value of annuity due?
2. Find the present value of the following ordinary annuity: 400 per
year for 10 years at 10 percent. Identify the present value of
annuity due.
3. You have a coin you wish to sell. A potential buyer offers to
purchase the coin from you in exchange for a series of three annual
payments of $50 starting one year from today. What is the current
value of the offer if the prevailing rate of interest is 7% compounded
annually?
4. You plan to deposit $100 into a savings account at the end of each
month for the next 5 years. a) At 3% compounded monthly, how
much will you have accumulated at the end of 5 years? b) How
much difference would it make if the payments were made at the
beginning of the month rather than at the end?
5. Suppose you win a lottery that entitles you to receive $500 per
month for the next 20 years. If money is worth 6% compounded
monthly, what is the present value of this annuity?