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Time Value of Money: Debashis Saha, Assistant Professor, F & B, Jahangirnagar University
Time Value of Money: Debashis Saha, Assistant Professor, F & B, Jahangirnagar University
The time value of money (TVM) is the concept that suggests present
day money is worth less than money in the future because of its earning
power over time. A taka today is more valuable than a taka a year hence
Present Values
Of An Annuity
PVAt =A* {[1-(1+r)-t]/r}
Intra-year
Compounding 4
Debashis Saha, Assistant Professor, F
& B, Jahangirnagar University
Variables
where
r = rate of return
t = time period
n = number of time periods
A = constant periodic flow
CF = Cash flow (the subscripts t and 0 mean at time t
and at time zero, respectively)
PV = present value (PVA = present value of an annuity)
FV = future value (FVA = future value of an annuity)
Creating a Timeline
Annuity: A level periodic stream of cash flow. For our purposes, we’ll
work primarily with annual cash flows. Examples include either paying
out or receiving $800 at the end of each of the next 7 years.
❑ If the interest rate (or discount rate) is higher (say 9%), the PV
will be lower.
❑ PV = 5000*(1/(1.09)10) = 5000*(0.4224) =$2,112.00
❑ If the interest rate (or discount rate) is lower (say 2%), the PV
will be higher.
❑ PV = 5000*(1/(1.02)10) = 5000*(0.8203)
= $4,101.50
If the rate or periodic payment does change, then the sum of the future
value of each individual cash flow would need to be calculated to
determine the future value of the annuity. If the first cash flow, or
payment, is made immediately, the future value of annuity due
Debashis Saha, Assistant Professor, F
formula would be used. 24
& B, Jahangirnagar University
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.
To better understand the
difference between these
annuities, she has listed
their cash flows in Table.
Note that the amount of
each annuity totals $5,000.
The two annuities differ in
the timing of their cash
flows:
Debashis Saha, Assistant Professor, F
25
& B, Jahangirnagar University
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. It
represents deposits of $1,000 annually, at the end of each of the
next 5 years, into a savings account paying 7% annual interest.
This situation is depicted on the following time line:
The future value of annuity due formula calculates the value at a future date. The use of the
future value of annuity due formula in real situations is different than that of the present value
for an annuity due. For example, suppose that an individual or company wants to buy an
annuity from someone and the first payment is received today. To calculate the price to pay
for this particular situation would require use of the present value of annuity due formula.
However, if an individual is wanting to calculate what their balance would be after saving for 5
years in an interest bearing account and they choose to put the first cash flow into the
account today, the future value of annuity due27 would be used.
Debashis Saha, Assistant Professor, F
& B, Jahangirnagar University
Fran Abrams wanted to choose between an ordinary annuity
and an annuity due, both offering similar terms except for the
timing of cash flows. We calculated the future value of the
ordinary annuity in the example on page 164. We now will
calculate the future value of the annuity due, using the cash
flows represented by annuity B
Assume that Sally owns an investment that will pay her $100 each
year for 20 years. The current interest rate is 15%. What is the
PV of this annuity?
The formula shown has assumptions, in that it must be an ordinary annuity. These assumptions
are that
If the payment and/or rate changes, the calculation of the present value would need to be adjusted depending on the specifics.
If the payment increases at a specific rate, the present value of a growing annuity formula would be used.
If the first payment is not one period away, as the 3rd assumption requires, the present value of annuity due or present value of
deferred annuity may be used. An annuity due is an annuity that's initial payment is at the beginning of the annuity as opposed
to one period away. A deferred annuity pays the initial payment Debashis Saha, Assistant Professor, F
34 at a later time.
& B, Jahangirnagar University
Present Value of Annuity Due
Formula:
PV=
Weighted average
cost of capital
(WACC)