Week 5 6

The Islamia University of Bahawalpur
Department of Finance- IBMAS
Time Value of Money

Course Instructor: Dr. Amna Noor
The Role of Time Value in Finance

• Most financial decisions involve costs & benefits that
are spread out over time.
• Time value of money allows comparison of cash
flows from different periods.
• Question: Your father has offered to give you some
money and asks that you choose one of the following
two alternatives:
– $1,000 today, or
– $1,100 one year from now.
• What do you do?
• The answer depends on what rate of interest

you could earn on any money you receive
today.
• For example, if you could deposit the $1,000
today at 12% per year, you would prefer to be
paid today.
• Alternatively, if you could only earn 5% on
deposited funds, you would be better off if you
chose the $1,100 in one year.
Basic Concepts
• Future Value: compounding or growth over
time
• Present Value: discounting to today’s value
• Single cash flows & series of cash flows can be
considered
• Time lines are used to illustrate these
relationships
Computational Aids
Time Line
Compounding and Discounting

Computational Aids
Financial Tables
Basic Patterns of Cash Flow
• The cash inflows and outflows of a firm can be described by its general
pattern.
• The three basic patterns include a single amount, an annuity, or a mixed
stream:
Simple Interest
• With simple interest, you don’t earn interest on
interest.
• Year 1: 5% of $100 = $5 + $100 = $105
• Year 2: 5% of $100 = $5 + $105 = $110
• Year 3: 5% of $100 = $5 + $110 = $115
• Year 4: 5% of $100 = $5 + $115 = $120
• Year 5: 5% of $100 = $5 + $120 = $125
Compound Interest
• With compound interest, a depositor earns interest on interest!
• Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
• Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
• Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
• Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
• Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
Time Value Terms

• PV0 = present value or beginning amount
• i = interest rate
• FVn = future value at end of “n” periods
• n = number of compounding periods
• A = an annuity (series of equal payments
or receipts)
Four Basic Models

• FVn = PV0(1+i)n = PV x (FVIFi,n)
• PV0 = FVn[1/(1+i)n] = FV x (PVIFi,n)
• FVAn = A (1+i)n - 1 = A x (FVIFAi,n)

i
• PVA0 = A 1 - [1/(1+i)n] = A x (PVIFAi,n)

i
Future Value of a Single Amount

• Future Value techniques typically measure cash flows at the end
of a project’s life.
• Future value is cash you will receive at a given future date.
• The future value technique uses compounding to find the future
value of each cash flow at the end of an investment’s life and
then sums these values to find the investment’s future value.
• We speak of compound interest to indicate that the amount of
interest earned on a given deposit has become part of the
principal at the end of the period.
Future Value of a Single Amount: Using FVIF Tables
• If Fred Moreno places $100 in a savings account

paying 8% interest compounded annually, how much
will he have in the account at the end of one year?
$100 x (1.08)1 = $100 x FVIF8%,1

$100 x 1.08 = $108
Practice Question
• Jane Farber places $800 in a savings account paying
6% interest compounded annually. She wants to know
how much money will be in the account at the end of
five years.
FV5 = $800 X (1 + 0.06)5 = $800 X (1.338) = $1,070.40

Future Value of a Single Amount:
A Graphical View of Future Value
Future Value
Relationship
Present Value of a Single Amount

• Present value is the current dollar value of a future amount of
money.
• It is based on the idea that a dollar today is worth more than a
dollar tomorrow.
• It is the amount today that must be invested at a given rate to
reach a future amount.
• Calculating present value is also known as discounting.
• The discount rate is often also referred to as the opportunity cost,
the discount rate, the required return, or the cost of capital.
Example: Present Value of a Single Amount
• Paul Shorter has an opportunity to receive $300 one

year from now. If he can earn 6% on his investments,
what is the most he should pay now for this
opportunity?
$300 x [1/(1.06)1] = $300 x PVIF6%,1
$300 x 0.9434 = $283.02
Practice Question
• Pam Valenti wishes to find the present value of
$1,700 that will be received 8 years from now.
Pam’s opportunity cost is 8%.
PV = $1,700/(1 + 0.08)8 = $1,700/1.851 = $918.42

Present Value of a Single Amount: A Graphical

View of Present Value
Present Value
Relationship
Annuities
• Annuities are equally-spaced cash flows of equal size.
• Annuities can be either inflows or outflows.
• An ordinary (deferred) annuity has cash flows that occur at the
end of each period.
• An annuity due has cash flows that occur at the beginning of
each period.
• An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound for
an additional period.
Types of Annuities
• Fran Abrams is choosing which of two annuities to
receive. Both are 5-year $1,000 annuities; annuity A is
an ordinary annuity, and annuity B is an annuity due.
Fran has listed the cash flows for both annuities as
shown in Table on the following slide.
Note that the amount of both annuities total $5,000.

Table : Comparison of Ordinary

Annuity and Annuity Due Cash Flows ($1,000, 5 Years)
Example: Future Value of an Ordinary Annuity

• Fran Abrams wishes to determine how much money she
will have at the end of 5 years if he chooses annuity A,
the ordinary annuity and it earns 7% annually. Annuity
a is depicted graphically below:
Future Value of an Ordinary Annuity: Using the FVIFA

Tables
FVA = $1,000 (FVIFA,7%,5)

= $1,000 (5.751)
= $5,751
Present Value of an Ordinary Annuity

• Braden Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular
annuity. The annuity consists of cash flows of $700 at the end
of each year for 5 years. The required return is 8%.
Present Value of an Ordinary Annuity

Future Value of an Annuity Due:

Using the FVIFA Tables
• Fran Abrams now wishes to calculate the future value
of an annuity due for annuity B in Table Recall that
annuity B was a 5 period annuity with the first annuity
beginning immediately.
FVA = $1,000(FVIFA,7%,5)(1+.07)
= $1,000 (5.751) (1.07)
= $6,154
Present Value of an Annuity Due
• In the earlier example, we found that the value of

Braden Company’s $700, 5 year ordinary annuity
discounted at 8% to be about $2,795. If we now
assume that the cash flows occur at the beginning of the
year, we can find the PV of the annuity due.
PVA = $700 (PVIFA,8%,5) (1.08)
= $700 (3.993) (1.08)
= $3,018.40
Present Value of a Perpetuity

• A perpetuity is a special kind of annuity.
• With a perpetuity, the periodic annuity or cash flow stream continues
forever.
PV = Annuity/Interest Rate
• For example, how much would I have to deposit today in order to

withdraw $1,000 each year forever if I can earn 8% on my deposit?
PV = $1,000/.08 = $12,500
Future Value of a Mixed Stream

Future Value of a Mixed Stream of Cash Flows

Present Value of a Mixed Stream

• Frey Company, a shoe manufacturer, has been offered an
opportunity to receive the following mixed stream of cash
flows over the next 5 years.
Present Value of a Mixed Stream

• If the firm must earn at least 9% on its investments,
what is the most it should pay for this opportunity?
• This situation is depicted on the following time line.
Present Value of a Mixed Stream of Cash Flows

Compounding Interest More Frequently Than

Annually
• Compounding more frequently than once a year results
in a higher effective interest rate because you are
earning on interest on interest more frequently.
• As a result, the effective interest rate is greater than the
nominal (annual) interest rate.
• Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.
Example
• Fred Moreno has found an institution that will pay him 8%
annual interest, compounded quarterly. If he leaves the
money in the account for 24 months (2 years), he will be paid
2% interest compounded over eight periods.
Future Value from Investing $100 at 8% Interest Compounded

Quarterly over 24 Months (2 Years)
Future Value at the End of Years 1 and 2 from

Investing $100 at 8% Interest, Given Various
Compounding Periods
Compounding Interest More Frequently Than

Annually (cont.)
• A General Equation for Compounding More Frequently than

Annually
• 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:
FVn (continuous compounding) = PV x (eixn)
where “e” has a value of 2.7183.
• Continuing with the previous example, find the Future value

of the $100 deposit after 5 years if interest is compounded
continuously.
• With continuous compounding the number of

compounding periods per year approaches infinity.
• Through the use of calculus, the equation thus becomes:
FVn (continuous compounding) = PV x (eixn)

where “e” has a value of 2.7183.
FVn = 100 x (2.7183).08x2 = $117.35

Nominal & Effective Annual Rates of Interest
• The nominal interest rate is the stated or contractual rate of

interest charged by a lender or promised by a borrower.
• The effective interest rate is the rate actually paid or earned.
• In general, the effective rate > nominal rate whenever
compounding occurs more than once per year
• Fred Moreno wishes to find the effective annual rate associated

with an 8% nominal annual rate (i = .08) when interest is
compounded (1) annually (m=1); (2) semiannually (m=2); and
(3) quarterly (m=4).
Special Applications of Time Value:

Deposits Needed to Accumulate to a Future Sum
Example:
Suppose you want to buy a house 5 years from now and
you estimate that the down payment needed will be
$30,000. How much would you need to deposit at the
end of each year for the next 5 years to accumulate
$30,000 if you can earn 6% on your deposits?
PMT = $30,000/5.637 = $5,321.98


Loan Amortization
($6,000 Principal, 10% Interest, 4-Year Repayment Period)

Interest or Growth Rates
• At times, it may be desirable to determine the compound interest rate or
growth rate implied by a series of cash flows.
Ray Noble wishes to find the rate of interest or growth

reflected in the stream of cash flows he received from a
real estate investment over the period from 2002 through
2006 as shown in the table on the following slide.
PVIFi,5yrs = PV/FV = ($1,250/$1,520) = 0.822
PVIFi,5yrs = approximately 5%

Finding an Unknown Number of Periods
• At times, it may be desirable to determine the number of time periods needed
to generate a given amount of cash flow from an initial amount.
Ann Bates wishes to determine the number of years it will take for her initial
$1,000 deposit, earning 8% annual interest, to grow to equal $2,500. Simply
stated, at an 8% annual rate of interest, how many years, n, will it take for Ann’s
$1,000 (PVn) to grow to $2,500 (FVn)?
PVIF8%,n = PV/FV = ($1,000/$2,500) = .400
PVIF8%,n = approximately 12 years

Summary of Key Definitions, Formulas, and Equations for Time
Value of Money

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The Islamia University of Bahawalpur

Department of Finance- IBMAS

Time Value of Money

The Role of Time Value in Finance

• The answer depends on what rate of interest

Compounding and Discounting

Time Value Terms

Four Basic Models

• PV0 = FVn[1/(1+i)n] = FV x (PVIFi,n)

• FVAn = A (1+i)n - 1 = A x (FVIFAi,n)

• PVA0 = A 1 - [1/(1+i)n] = A x (PVIFAi,n)

Future Value of a Single Amount

Future Value of a Single Amount: Using FVIF Tables

• If Fred Moreno places $100 in a savings account

$100 x (1.08)1 = $100 x FVIF8%,1

FV5 = $800 X (1 + 0.06)5 = $800 X (1.338) = $1,070.40

Present Value of a Single Amount

Example: Present Value of a Single Amount

• Paul Shorter has an opportunity to receive $300 one

PV = $1,700/(1 + 0.08)8 = $1,700/1.851 = $918.42

Present Value of a Single Amount: A Graphical

Note that the amount of both annuities total $5,000.

Table : Comparison of Ordinary

Example: Future Value of an Ordinary Annuity

Future Value of an Ordinary Annuity: Using the FVIFA

FVA = $1,000 (FVIFA,7%,5)

Present Value of an Ordinary Annuity

Present Value of an Ordinary Annuity

Future Value of an Annuity Due:

Present Value of an Annuity Due

• In the earlier example, we found that the value of

Present Value of a Perpetuity

• For example, how much would I have to deposit today in order to

Future Value of a Mixed Stream

Future Value of a Mixed Stream of Cash Flows

Present Value of a Mixed Stream

Present Value of a Mixed Stream

Present Value of a Mixed Stream of Cash Flows

Compounding Interest More Frequently Than

Future Value from Investing $100 at 8% Interest Compounded

Future Value at the End of Years 1 and 2 from

Compounding Interest More Frequently Than

• A General Equation for Compounding More Frequently than

• A General Equation for Compounding More Frequently

• Continuing with the previous example, find the Future value

• With continuous compounding the number of

FVn (continuous compounding) = PV x (eixn)

FVn = 100 x (2.7183).08x2 = $117.35

Nominal & Effective Annual Rates of Interest

• The nominal interest rate is the stated or contractual rate of

• Fred Moreno wishes to find the effective annual rate associated

Special Applications of Time Value:

PMT = $30,000/5.637 = $5,321.98

Special Applications of Time Value:

Special Applications of Time Value:

Ray Noble wishes to find the rate of interest or growth

PVIFi,5yrs = PV/FV = ($1,250/$1,520) = 0.822

Special Applications of Time Value:

PVIF8%,n = PV/FV = ($1,000/$2,500) = .400

PVIF8%,n = approximately 12 years

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