CHAPTER 5

Time Value of Money

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 CHAPTER 5
Time Value of Money
■ Future value
■ Present value
■ Annuities
■ Perpetuities
■ Other Compounding Periods
■ Comparing Interest Rates

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 Example
• Suppose you invest $15000 today on some investment
that will produce $17000 over the next 5 years.
• Is this a wise investment?

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 Time Value Of Money
• The idea that money available at the present time
is worth more than the same amount in the
future due to it’s potential earning capacity.
• The basis for this idea is that no rational entity
keeps money idle.
• Thus, provided if money can earn interest, any
amount of money is worth more the sooner it is
received.

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 Time lines

0 1 2 3
i%

CF0 CF1 CF2 CF3

⚫ First step is to construct a timeline which helps to

visualize what is happening.
⚫ Show the timing of cash flows.
⚫ Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period
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Future Value and Present Value
⚫ Future Value is the amount to which a cash flow or
series of cash flows will grow over a period of time
when compounded at a given interest rate.
⚫ Present Value is the value today of a future cash
flow or series of cash flows.
⚫ Compounding is the arithmetic process of
determining the future value of a series of cash flow
when compound interest is applied
⚫ Discounting is the opposite process of
compounding

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 Basic Patterns of Cash flow
• Single Amount
– A lump-sum amount either currently held or
expected at some future date. e.g. $1000 today or
$650 to be received at the end of 10 years
• Annuity
– A level periodic stream of cash flow
• Mixed Stream
– A stream of cash flow that is not annuity. A stream
of unequal periodic cashflow

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 What is the future value (FV) of an initial $100
after 3 years, if I/YR = 10%?

• Compound Interest is when interest is earned on

prior periods’ interest amount.
• FV can be solved by using the arithmetic, financial
calculator, and spreadsheet methods.

0 1 2 3
10%

100 FV = ?
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 Solving for FV:
The arithmetic method
⚫ After 1 year:
◦ FV1 = PV ( 1 + i ) = $100 (1.10)
= $110.00
⚫ After 2 years:
◦ FV2 = PV ( 1 + i )2 = [$100(1.10)] (1.10)
= $100 (1.10)2 =$121.00
⚫ After 3 years:
◦ FV3 = PV ( 1 + i )3
= [$100(1.10)(1.10)] (1.10)
= $100 (1.10)3
= $133.10
⚫ After n years (general case):
◦ FVn = PV ( 1 + i )n

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Using the FV table

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 What is the present value (PV) of $100 due in 3
years, if I/YR = 10%?

• Finding the PV of a cash flow or series of cash

flows when compound interest is applied is called
discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.

0 1 2 3
10%

PV = ? 100
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 Solving for PV:
The arithmetic method
• Solve the general FV equation for PV:
– PV = FVn / ( 1 + i )n

– PV = FV3 / ( 1 + i )3
= $100 / ( 1.10 )3
= $75.13

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Using the PV table

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 Annuities

⚫ So far the discussion is based on a one-time

lump sum payment that increases or
decreases due to compound interest.
⚫ However a lot of assets provide fixed
periodic payments. These are called annuities.
⚫ Thus annuities are a series of equal payments
at fixed intervals for a specified number of
periods

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Ordinary Annuity and Annuity Due
• An annuity whose payments occur at the end of
each period is called ordinary annuity

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

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Ordinary Annuity and Annuity Due

• An annuity whose payments occur at the

beginning of each period is called annuity
due.
Annuity Due
0 1 2 3
i%

PMT PMT PMT

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What is the difference between an ordinary annuity
and an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

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 Future Value of Ordinary Annuity
• What is the future value of an investment
agreement where you will be given $100 at the
end of each year for a 3 year period?
• It is always assumed in annuities that after each
payment is received it is invested at the current
interest rate.

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Future Value of Ordinary Annuity

0 1 2 3
10%

100 100 100

100 (1.10)
100 (1.10)(1.10)
Total = $331.00
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 Future Value of Ordinary Annuity

• FVA = 100[(1.103 – 1)/1]

= $331.00

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Using the FVA Table

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Future Value of Annuity Due
0 1 2 3
10%

100 100 100

100 (1.10)
100 (1.10)(1.10)
100 (1.10)(1.10)(1.10)
Total = $364.1

• FVAdue = $331 (1.10)

= 364.1
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Using the FVAdue Table

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 Present Value of Ordinary Annuity
• What is an investment agreement that pays $100
at the end of each year for a 3 year period worth
now?
• It is the sum of the present values of all the
individual cash flows.

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 Present Value of Ordinary Annuity

0 1 2 3
10%

100 100 100

$100/(1.10)
$100/(1.10)(1.10)
$100/(1.10)(1.10)(1.10)
Total = $248.69

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 Present Value of Ordinary Annuity

• PVA = $100 [(1-(1/1.103))/1]

= $248.69

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Using the PVA table

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 Present Value of Annuity Due

0 1 2 3
10%

100 100 100

$100/(1.10)
$100/(1.10)(1.10)
Total = $273.55

• PVAdue = PVAordinary (1+I)

• PVAdue = $248.69 (1.10) = $273.55
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Using PVAdue Table

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 Perpetuities
• Perpetuities are annuities that continue forever.
• A stream of equal payments at fixed intervals
expected to continue forever.
• PV of Perpetuity = PMT/i

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Uneven Cash Flows

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 Other Compounding Periods
• So far assumption was annual compounding.
This is the arithmetic process of determining
final value of a cash flow or series of cash flows
when interest is added once a year.
• Sometimes interest can be added more than
once a year, like semiannual or quarterly
compounding.

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 Other Compounding Periods
• Same methods or formula can be applied but
with new rate and period.

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 Comparing Interest Rates
• Nominal Interest Rates are the quoted interest rates often at
Annual Percentage Rate.
• Effective Annual Rate is the annual interest rate actually being
earned as opposed to the quoted rate when compounding is done
non-annually.
– Also known as “Equivalent Annual Rate”
– It is the rate that would produce the same future value under annual
compounding as would frequent compounding at a given nominal rate.

– M = number of payments per year

– INOM = Annual Percentage Rate or Nominal rate

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