Lecture 3

Time Value of Money

Topics Covered

 Future Values
 Present Values
 Multiple Cash Flows
 Perpetuities and Annuities
Future Values

Future Value - Amount to which an investment

will grow after earning interest.

Compound Interest - Interest earned on

interest.

Simple Interest - Interest earned only on the

original investment.
 Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100.
 Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned
Value 100
 Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned 6
Value 100 106
 Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a principal
balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130

Value at the end of Year 5 = $130

 Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five years on the
previous year’s balance.
 Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five years on the
previous year’s balance.

Interest Earned Per Year =Prior Year Balance x .06

Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five
years on the previous year’s balance.
Future Values

Future Value of $100 = FV

FV  $100  (1  r ) t
Future Values

FV  $100  (1  r ) t

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?
Future Values

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

FV  $100  (1  .06 )  $133 .82

5
 Future Values with Compounding

70 Interest Rates
60 0%
5%
50 10%
FV of $1

40 15%

30

20

10

0
10

12

14

16

18

20

22

24

26

28

30
0

Number of Years
Present Values

Present Value Discount Factor

Value today of a Present value of
future cash a $1 future
flow. payment.
Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Present Values

Present Value = PV

Future Value after t periods

PV = (1+ r) t
Present Values

Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on your
money, how much money should you set aside today in order
to make the payment when due in two years?
Present Values

Discount Factor = DF = PV of $1

DF  1
(1 r ) t

 Discount Factors can be used to compute the

present value of any cash flow.
Time Value of Money
(applications)

 The PV formula has many applications.

Given any variables in the equation, you can
solve for the remaining variable.

PV  FV  1
(1 r ) t
PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash now,
or make three payments: $8,000 now and $4,000 at the end of
each of the following two years. If your cost of money is 8%,
which do you prefer?
PV of Multiple Cash Flows

 PVs can be added together to evaluate

multiple cash flows.

PV  C1
(1 r ) 1  (1 r ) 2 ....
C2
Perpetuities & Annuities

Perpetuity
A stream of level cash payments that never
ends.

Annuity
Equally spaced level stream of cash flows for
a limited period of time.
Perpetuities & Annuities

PV of Perpetuity Formula

PV  C
r

C = cash payment
r = interest rate
Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?
Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?
Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?
Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?

PV  1, 000 , 000
( 1 .10 ) 3
 $751,315
Perpetuities & Annuities

PV of Annuity Formula

PV  C  1
r  1
r ( 1 r ) t 
C = cash payment
r = interest rate
t = Number of years cash payment is received
Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present value

of $1 a year for each of t years.

PVAF   1
r  1
r ( 1 r ) t 
Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to
make 3 annual installments of $4,000 per year.
Given a rate of interest of 10%, what is the price you
are paying for the car (i.e. what is the PV)?
Perpetuities & Annuities

Applications
 Calculation of periodic payments
– Mortgage payment
– Annual income from an investment payout
– Future Value of annual payments
Perpetuities & Annuities

Example - Future Value of annual payments

You plan to save $4,000 every year for 20 years and
then retire. Given a 10% rate of interest, what will be
the FV of your retirement account?
Perpetuity

A benefactor wishes to donate a sum for

research at the University. If the interest rate is
10 per cent and the aim of the donation is to
provide $100,000 every year, then the amount
that should be set aside today is:
Perpetuity

A benefactor wishes to donate a sum for

research at the University. If the interest rate is
10 per cent and the aim of the donation is to
provide $100,000 every year, then the amount
that should be set aside today is:
Present value of the perpetuity:
C 100,000
  $1,000,000
r 0.10
Growing Perpetuity

 The benefactor realises that there is a need to

account for growth in salaries, which he estimates at
4 per cent, starting in Year 1. Therefore instead of
providing $100,000 in year 1, he must provide 1.04 x
$100,000 in Year 1 and so on…
PV of a stream of Cash Flows

 Recall that the present value of a stream of

cash flows is:
Compound Interest and Present
Values

 When money is invested at compound interest, each interest

payment is reinvested to earn more interest in subsequent
periods.
 Continuous compounding means that payment is spread evenly
and continuously throughout a year.
 In general, an investment of $1 at a rate of r per annum
compounded m times a year amounts to at the end of the year
to:
m
  r 
1   
  m 
Continuous Compounding

 A General Equation for Compounding More

Frequently than Annually
Example of Continuous
Compounding

 Fred has found an institution that will pay him 8%

annual interest, compounded semi-annually. If he
leaves the money in the account for 24 months (2
years), he will be paid 4% interest compounded over
four periods.
Continuous Compounding

• A General Equation for Compounding More

Frequently than Annually
– Recalculate the example for the Fred Moreno example
assuming (1) semiannual compounding and (2)
quarterly compounding.
Continuous Compounding

 With continuous compounding the number of

compounding periods per year approaches
infinity.
 Through the use of calculus, the equation
thus becomes: rt
e
 Continuing with the previous example, find
the Future value of the $100 deposit after 5
years if interest is compounded continuously.
Examples

 Suppose you invest $1 at a continuously

compounded rate of 11 per cent (r=0.11) for
one year. What is the value at the end of the
period?
 Suppose the investment is over a period of
two years. What is the value of the final
investment?