TIME VALUE OF MONEY

CHAPTER 2

Time Value of Money

The Cost of Money is established and measured by an

interest rate, a percentage that is periodically applied
and added to an amount of money over a specified
length of time.

Economic Equivalence

Interest Formulas Single Cash Flows

Equal-Payment Series

Dealing with Gradient Series

Composite Cash Flows.

Time Value of Money

Money has a time value because it can earn more

money over time (earning power).
Money has a time value because its purchasing power
changes over time (inflation).
Time value of money is measured in terms of interest
rate.
Interest is the cost of having money available for use a cost to the borrower and an earning to the lender

Elements of Transactions involve Interest

1.

Initial amount of money in transactions involving debt or

investments is called the principal (P).

2.

The interest rate ( i ) measures the cost or price of money and is

expressed as a percentage per period of time.

3.

A period of time, called the interest period (n), determines how

frequently interest is calculated.

4.

A specified length of time marks the duration of the transactions

and thereby establishes a certain number of interest periods (N).

5.

A plan for receipts or disbursements (A n) that yields a particular

cash flow pattern over a specified length of time. [monthly equal
payment]

6.

A future amount of money (F) results from the cumulative effects

of the interest rate over a number of interest periods.
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EXAMPLE OF INTEREST TRANSACTION

Suppose that you apply for an

education loan of $30,000 from a bank
at a 9% annual interest rate. In addition
you pay a $300 loan origination fee
when the loan begins.
The bank offers two repayment plans,
one with equal payments made at the
end of every year for the next five
years (installment plan) and the other
with a single payment made after the
6
loan period of five years (deferment

Which Repayment Plan?

Table 2.1 Repayment plan offered by the lender
End of Year

Receipts

Payments
Plan 1

Year 0

$30,000.00

Plan 2

$300.00

$300.00

Year 1

$7,712.77

Year 2

$7,712.77

Year 3

$7,712.77

Year 4

$7,712.77

Year 5

$7,712.77

46,158.72

The amount of loan = $30,000 & origination fee = $300 &

interest rate = 9% APR
F = P (1 + i )N = P (1+0.09)5 = $30,000 x (1.09)5 = $46,158.72
7

Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example

i (1 i ) N
( A / P, i , N ) A P

N
(1 i ) 1

0.09(1 0.09) 5
A P (30,000)

5
(1 0.09) 1

i
( A / F , i, N ) A F

N
(1 i ) 1

A $46,158.72

$7,712.77

=
0.09

5
(1 0.09) 1 $7,712.77

Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example
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Methods of Calculating Interest

n 0: P
n 1 : F1 P (1 i )
n 2 : F2 F1 (1 i ) P (1 i ) 2
M
n N : F P (1 i ) N
10

11

12

13

Practice Problem
Problem Statement
If you deposit $100 now (n
now (n

0) and $200 two years from

2) in a savings account that pays 10% interest,

how much would you have at the end of year 10?

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Solution

10

$100(1 0.10)10 $100(2.59) $259

$100

$200

$200(1 0.10)8 $200(2.14) $429

F $259 $429 $688

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Economic Equivalence

What do we mean by economic equivalence?

Why do we need to establish an economic equivalence?
How do we establish an economic equivalence?

16

Economic Equivalence
How do we know, whether we should prefer to have $20,000
today and
$50,000 ten years from now, or $8,000 each year for the next
ten years?

Which option would you prefer?

17

Equivalence Calculation: A Simple example

Figure 2-4 Using compound interest to establish economic equivalence

18

Equivalence relation between P and F.

19

20

21

EXAMPLE 2.3

Equivalence Calculation

FIND: V3 (equivalent worth at n

Step 1:

3) and i

10%.

$100(1+0.1)3+ $80(1+0.1)2+$120(1+0.1)1+$150

= $511.90
Step 2:

$200(1+0.1)-1+ $100(1+0.1)-2 = $264.46

Step 3:

V3= $511.90 + $264.46 = $776.36

Figure 2-6 Equivalent worth calculation at n

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Interest Formulas for Single Cash Flows

Compound Amount Factor

Figure 2-7 Compounding process: Find F, given P, i, and N

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Interest Rate Factors (10 %)

24

Example 2.4 If you had $1,000 now and invested it at 7%

interest compounded annually,
how much would it be
worth in 8 years?

Figure 2-8 Cash flow diagram

Given: P = $1,000,

i = 7 %, and N = 8 years;

Find: F

F = $1,000 (1+0.07)8 = $1,718.19 or using this

F = P (F/P, i, N) factor notation together with table value
F = $1,000 (1.7182) = $1,718.19

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Present -Worth Factor

26

Example 2.5
A zero coupon (installment) bond is a popular variation
on the bond theme for some investors. What should be
the price of an eight year (maturity) zero-coupon with a
face value (future value) of $1,000 if similar, nonzero
coupon bonds are yielding 6% annual interest?

Figure 2-10 Cash flow diagram

Given: F = $1000,
Find: P

i = 6%, and N = 8 years

P = $1,000 (1+0.06)-8 = $1,000 (0.6274) = $627.40

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Example 2.6
Suppose you buy a share of stock for $10 and sell it for $20; your
profit is thus $10. it takes five years to gain this profit, what would
be the rate of return on your investment?
Given: P

$10, F

$20

$20 and

$10 (1+ i )5

1+ i =
= 1.14869
0.1487 = 14.87%

5 years,

$2 = (1+ i )5

Find: i
=

(F / P, i, 5)

1.14869 1

0.14869 or

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Example 2.7
You have just purchased 200 shares of GE stock at $15
per share. You will sell the stock when its market price
doubles. If you expect the stock price to increase 12%
per year, how long do you expect to wait before selling
the stock?
Given: P

$3,000,

$6,000 and

P (1+ i )N

(1.12) N

Log 2

log 2 / log 1.12

i = 12%,

P (F/P, i, N) 6,000
=

Find: N

$3,000 (1+ 0.12)N

N log 1.12

solve for N

gives
N

0.301 / 0.049

6.116 6.12 years

Figure 2-12 Cash flow diagram

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Practice Problem

$1,000
$500

A
Given: i

10%,

Find: C that makes the

two cash flow streams
to be indifferent

B
0

30

Approach
Step 1:

$1,000

Select the base period to use,

say n = 2

Step 2:

$500

A0

Find the equivalent lump sum

value at n = 2 for both A and B.

Step 3:
Equate both equivalent values
and solve for unknown C.

B
0

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Solution
For A:
$1,000
V2 $500(1 0.10) 2 $1, 000(1 0.10) 1
$1, 514.09

For
V B:

$500

C (1 0.10) C

2.1C

2.1C C:
$1, 514.09
To Find
C $721

B
0

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Practice Problem
$1,000
$500

At what interest rate

would you be
indifferent between
the two cash flows?

$502
$502

$502

B
0

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Approach

Step 1:

$1,000

Select the base period to

compute
$500
the equivalent value (say, n
A
= 3)

$502
$502

Step 2:

$502

Find the net worth of each

at n = 3.
B
0

2
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Establish Equivalence at n

Option A : F3 $500(1 i ) 3 $1, 000

Option B : F3 $502(1 i ) 2 $502(1 i ) $502

Option A : F3 $500(1.08) 3 $1, 000

Find the solution

by trial and error, say i = 8%
$1, 630
Option B : F3 $502(1.08) 2 $502(1.08) $502
$1, 630

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Practice Problem

You want to set aside a lump sum amount

today in a savings account that earns 7%
annual

interest

to

meet

future

investment in the amount of $10,000 to

be incurred in 6 years.

How much do you need to deposit today?

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Solution
$10,000
F = $10,000;

N = 6 years;

i = 7 %;

Find P

0
6

P $10, 000(1 0.07) 6

$10, 000( P / F , 7%, 6)
$6, 663

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