Time Value of Money

Course: Business Finance-1 Session No: 13,14 Instructor: Sana Tauseef

Cash figures at different time periods are not directly comparable

Which would you prefer to get -- $10,000 today or $10,000 in 5 years? Which would you prefer to pay -- $10,000 today or $10,000 in 5 years?

There are some important terminologies which we should be familiar with

Future Value is the value at some future time of a present amount of money, evaluated at a given interest rate. Present Value is the current value of a future amount of money, evaluated at a given interest rate. Compounding is the process of calculating the future value from a given present value Discounting is the process of calculating the present value from a given future value
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In finance, we always use compound interest

Simple Interest
Interest paid (earned) on only the original amount, or principal, borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).
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Assume that you deposit $1,000 in an account earning 7% for 2 years. What is the future value at the end of the 2nd year
if compound interest is earned?? if simple interest is earned??

Present and future values can be calculated using equations or tables

General Future Value Formula: FVn = P0 (1+i)n or FVn = P0 (FVIFi,n) -- See FVIF Table
General Present Value Formula: PV0 = FVn / (1+i)n or PV0 = FVn (PVIFi,n) -- See PVIF Table
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Financial calculators can be used to solve the TVM problems

Use the highlighted row of keys for solving any of the FV, PV, FVA, PVA, FVAD, and PVAD problems
N: I/Y: PV: PMT: FV: Number of periods Interest rate per period Present value Payment per period Future value

CLR TVM: Clears all of the inputs into the above TVM keys

Financial calculators can be used to solve the TVM problems

Inputs
N

7
I/Y

-1,000
PV

0
PMT FV

Compute
N: I/Y: PV: PMT: FV:

1,144.90

2 Periods (enter as 2) 7% interest rate per period (enter as 7 NOT .07) $1,000 (enter as negative as you are investing) Not relevant in this situation (enter as 0) Compute (Resulting answer is positive)

Annuity is a series of equal payments (or receipts) occurring over a specified number of equidistant periods Ordinary Annuity: Payments or receipts occur at the end of each period. Annuity Due: Payments or receipts occur at the beginning of each period.

Examples of annuities include

Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

10

What is the future value of an annuity with an equal payment of $1,000 for 3 years if the interest rate is 10% and if:
the payments are made at the end of each year?? the payments are made at the beginning of each year??

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PV and FV of annuities can be calculated using financial calculator

Inputs
N

3
I/Y

7
PV

-1,000
PMT FV

Compute
N: I/Y: PV: PMT: FV:

3,214.90

3 Periods (enter as 3 year-end deposits) 7% interest rate per period (enter as 7 NOT .07) Not relevant in this situation (no beg value) $1,000 (negative as you deposit annually) Compute (Resulting answer is positive)