University of Technology, Jamaica

Financial Management (FIN3001)

Unit 4: The Time Value of Money
Importance of time with respect to money
The time value of money is considered the most important concept in finance.
The time value of money is the process of calculating the value of an asset in the past, present or
future. It is based on the premise that the original principal will increase in value over time by
interest earned. This means that a dollar invested today is going to be worth more tomorrow.
We know that receiving $10,000 today is worth more than receiving $10,000 in the future. This
is due to opportunity costs. The opportunity cost of receiving $10,000 in the future is the interest
we could have earned if we had received the $10,000 sooner.
Time line concepts
Cash flow time lines are a very important tool that helps you to visualize the timing of cash flows
associated with a particular situation. A cash outflow is designated with a negative sign, while a
cash inflow is designated with a positive sign (in most cases the positive sign is implied). The
interest rate that is applied to the situation is given on the time line. A cash flow time line can be
illustrated as follows:

Time lines show timing of cash flows.

0 1 2 3
10%

CF0 CF1 CF2 CF3

=-10,000

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1;
or the beginning of Period 2.

According to this cash flow time line, $10,000 is invested today at 10% for a period of 3 years.
Future Value
If we know the value of an investment today, the time period of the investment and the interest
rate that we will earn, then we can calculate the future value of the investment. Translating the
$10,000 invested today into its equivalent in the future is known as compounding where both the
original investment and any interest previously earned by the investment earn additional interest
Problem 1:
If you deposit $10,000 in an account earning 10%, how much would you have in the account
after 3 years?
In general, FVn = PV(1 + i)n where PV = Present Value, FV = Future Value, i = interest rate
n = number of compounding periods
Using interest factor tables, the future value of an amount invested today equals the amount
originally invested multiplied by a multiple that is based on the interest rate earned, i, and the
amount of times interest is earned, n. This multiple, which equals (1 + i)n, is called the future
value interest factor for i and n, and is designated FVIFi,n; using this concept,
FVn = PV (1 + i)n = PV(FVIFi,n)
In our example,
FVn = PV(FVIFi,n) = 10,000 (FVIF10%,3) = 10,000 x 1.3310 = 13,310
Present Value
Present value is the value of an amount to be received (or paid) in the future stated in today’s
(present) dollars – i.e., the current value of a future amount. If we know the value of an
investment some time in the future, the time period of the investment and the interest rate that we
will earn, then we can calculate the present value of the investment. When we find the present

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value, PV, of an amount we are said to be discounting the future value to the present at the
opportunity cost rate, which is the rate that can be earned on an investment with equal risk. The
present value is therefore the opposite of the future value and if we have the opportunity to earn a
positive rate of return, then the present value must always be less than the future value.
Problem 2:
Assume that you need $10,000 in 3 years. How much do you need to deposit today at a discount
rate of 12% compounded annually?
Calculation Solve FVn = PV (1 + i)n for PV:
PV = FVn/(1 + i)n
= FVn [1/(1+i)]n
Alternatively, using interest factor tables:
PVn = FV (1 + i)n = FV(PVIFi,n)
In our example, PVn = FV(PVIFi,n) = 10,000 (PVIF12%,3) = 10,000 x 0.7118 = 7,118
Hints for solving single sum problems
§ In every single sum future value and present value problem, there are 4 variables:
§ FV, PV, i and n
§ When doing problems, you will be given 3 of these variables and asked to solve for the
4th variable.
§ Keeping this in mind makes time value problems much easier!
Problem 3:
In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later,
in 1988, the average cost was $13,700.
What was the growth rate in tuition over the 30-year period?
Problem 4:
Jill currently has $300,000 in a brokerage account. The account pays a 10 percent annual interest
rate. Assuming that Jill makes no additional contributions to the account, how many years will it
take for her to have $1,000,000 in the account?
Annuities
An annuity is referred to as a series of equal payments that are made at equally spaced intervals
– e.g. - $100 received each year for the next 5 years. An ordinary annuity is an annuity with
cash flows that occur at the end of the period, whereas an annuity due is an annuity with cash
flows that occur at the beginning of the period.
Ordinary Annuity
Ordinary annuity problems can be calculated using interest factor tables as follows:
FVA = PMT (FVIFA(i,n))
PVA = PMT (PVIFA(i,n))
Problem 5:
Today is your 23rd birthday. Your aunt just gave you $1,000. You have used the money to open
up a brokerage account. Your plan is to contribute an additional $2,000 to the account each year
on your birthday, up through and including your 65th birthday, starting next year. The account has
an annual expected return of 14 percent. How much do you expect to have in the account right
after you make the final $2,000 contribution on your 65th birthday?
Problem 6:
What is the present value of a 5-year ordinary annuity with annual payments of $200, evaluated at
a 15 percent interest rate?
Annuity Due
An annuity due has cash flows at the beginning of the period. Each payment will therefore earn
interest for one more period than if it were an ordinary annuity and the future value of an annuity
due will be greater, all else equal. Calculations are therefore always multiplied by a factor (1 + i)
Problem 7:
If you invest $1,000 at the beginning of each of the next 3 years at 8%, how much would you
have at the end of year 3?

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Problem 8:
What is the PV of $1,000 at the beginning of each of the next 3 years, if your opportunity cost is
8%?
Perpetuities
A perpetuity is an annuity that continues forever i.e. a perpetual annuity. The present value of
perpetuities can be computed using the following equation:
PVP = PMT/i
Problem 9:
Suppose you were offered the opportunity to receive $250 beginning in one year and continuing
forever. If you could earn 10% on your investments, how much should you pay for this
perpetuity?
Uneven Cash Flow Streams
Unlike an annuity, an uneven cash flow stream consists of cash flows that are not all the same
(equal), so we cannot use the annuity equations here. To determine the PV or FV of uneven cash
flow streams, we must compute the PV or FV of each individual cash flow and sum the resulting
values.
Problem 10:
You are given the following cash flows. What is the present value
(t = 0) if the discount rate is 12 percent?
0 12% 1 2 3 4 Periods
| | | | |
-10,000 1,000 2,000 4,000 6,000

Frequent Compounding
Up to this point, we have assumed that interest is earned (computed) annually. In many
instances, interest is computed more than once a year – i.e., interest compounds during the year.
For example, bonds generally pay interest semi-annually or quarterly. Most financial institutions
compute interest more frequently perhaps monthly or even daily.
The FV of a lump sum will be larger if we compound more often. If compounding is more
frequent than once a year, then interest is earned on interest more often. Lenders will therefore
prefer compounding to be done more often, while borrowers will prefer compounding to be
done less often.
Problem 11:
What is the future value of $100 in 3 years’ time at an interest rate of 10% compounded semi-
annually? What is the nominal rate, periodic rate and effective annual rate?
Nominal Interest rate (inom)
The nominal interest rate is the quoted or stated rate. It is usually quoted per annum. This is the
rate that is stated in contracts, and quoted by banks and brokers, but the compounding periods
per year are usually also given.
Periodic Interest rate (iper)
The periodic interest rate is the rate that is actually paid each compounding period e.g. – the rate
that is paid quarterly or monthly if there is quarterly or monthly compounding.
This rate is used in calculations and is the one shown on timelines.
Periodic rate = iper = inom/m
Where m= number of compounding periods per year.
If inom has annual compounding, then iper = inom/1 = inom

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 Period m – No of compounding periods
Annual 1
Semi-annual 2
Quarterly 4
Monthly 12
Daily 365

Effective Annual Rate (EAR or EFF or EAIR)

The EAR is the annual rate that causes the PV to grow to the same FV as under multi-period
compounding. It is useful to compare returns on investments with different payment
periods/compounding periods per year.
EAIR = [1 + (k/m)]m -1
If m > 1, EFF% will always be greater than the nominal rate. If annual compounding is used, i.e.
m=1, then the EFF would be equal to the nominal rate.

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