Time value of money

Classes 1

Barbara Grabińska, Ph.D

Agenda
• Introduction

• Time value of money - essentials

• Time value of money – basic formulas

• Time value of money – calculations

Question to consider

Would you prefer to receive 10 000

PLN today or in one year time?

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 Time Value of Money

Time Value of Money

 A concept that takes into account the change in the
value of money over time;
 Application in the analysis of various payment
streams (e.g. savings, loans, capital annuities, cash
flows and investments);
 The time value of money represented by the interest
rate (r);

Future value and present value

• Future value (FV) – value received or

paid in the future or considered from the
point of view of some point in the future
• Present value (present, present) (PV) -
value received or paid today or
considered from today's point of view

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 Future value and present value

Calculation of future value (FV) of investment made

today
• How the investment made today will grow in the
future?

Calculation of present value (PV) of future cash

considerations (inflows and outflows)
• What a cash flow to be received in the future is
worth today?

Time Value of Money

• Capitalization – adding earning generated
over time to the initial value of investment
• Discounting – the process of calculation
present value (PV) of capital based on
future value

Future value

• Kapitalizacja prosta (Simple Interest)

FV  PV (1  nr )

FV – wartość przyszła (future value)

PV – wartość teraźniejsza (present value)
n – liczba lat (numer of years)
R- stopa procentowa (interest rate, rate of return)

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 Future value(2)

• Compound Interests
• Kapitalizacja złożona roczna

FV  PV (1  r ) n

• Kapitalizacja złożona częściej niż raz w roku

FV  PV (1  r / m) nm
m – liczba kapitalizacji w roku (compounding
frequency)

Future value(3)

• Kapitalizacja ciągła (Continuous Compounding)

FV  PV  enr
e – podstawa logarytmu naturalnego
(base of the natural logarithm (Euler’s
number~2,71828)

Time Value of Money

Example 1
The amount of PLN 1 000 is invested in a
bank deposit for a period of 2 years. The
interest rate on the deposit is 12%.
Calculate the future value for different
types of capitalization: simple, annual,
quarterly, continuous.

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 Effective interest rate(1)

Effective interest rate - this is the rate

that takes capitalization into account. It
allows you to compare investments with
different types of capitalization.

Effective interest rate (2)

• With capitalization more than once a year

ref  (1  r / m) m  1
• With continuous capitalization

ref  e r  1

Time Value of Money

Example 2
Determine the effective interest rates, with
a nominal rate of 8%, for capitalization:
annual, monthly, daily (assuming 365 days
in a year) and continuous.

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 Time Value of Money

Example 3
After the birth of the child, their parents
intend to invest the money in a deposit with
an interest rate of 7% per year, with the
interest compounded once a year. What
amount do they need to invest now so that
in 18 years the child will have PLN
400,000?

Nominal vs real interest rate

The real interest rate takes into account the

depreciation of money caused by inflation.

1  rn
rr  1
1 i
rn- nominal interest rate
rr- real interest rate
i– inflation rate

Nominal vs real interest rate

Example 4
The annual inflation rate was 3%. The
interest rate at which the bank charged
interest on deposits in current accounts was
1% per annum, and on term accounts 4.5%
per annum. What are the real rates in both
cases?

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 NET PRESENT VALUE NPV
Net Present Value (NPV) - the difference between
discounted net cash flows
and discounted capital expenditure.

n
ct
NPV  c0  
t 1 (1  r )t
c0 – initial investment/cash outlay on the project
ct – net cash flow generated by project at time „t”
r – required rate of return/cost of capital/opportunity cost of capital understood as
the percentage at which capital will be borrowed for a possible alternative use
n – life of the project (in years)

IRR (INTERNAL RATE OF RETURN)

NPV  0  investment project to be accepted

NPV< 0  investment project to be rejected

when NPV = 0  r = IRR (internal rate of return)

n
ct
c0  
t 1 (1  IRR )t

NET PRESENT VALUE NPV

Example 5
An investor is considering the purchase of a
machine for PLN 400000. Projected cash flows
(net of operating costs) will amount to: PLN
100000 after the first year, PLN 200000 after the
second year, and PLN 300000 after the third. The
cost of capital is 12%. What will be the NPV of
the investment? Will the investor undertake the
investment?

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 NET PRESENT VALUE NPV

Example 6
The entrepreneur is considering the modernization of the
production line, which is associated with a one-time outlay of
PLN 2 million. Estimated incremental cash flows obtained as a
result of this investment will amount to PLN 1,2 million, PLN 1
million, PLN 0,75 million, PLN 0,5 million and PLN 0,3 million,
respectively- at the end of the following years (from the first to
the fifth). The expected cost of capital increases by 0,5
percentage points each year - from 4% in the first year to 6%
in the last year. What is the NPV?

Internal rate of return (IRR)

Example 7
What will be the internal rate of return
on the investment related to: current
capital expenditure of PLN 1 million and
cash flows of PLN 0,5 million after the
first year and PLN 1 million after the
second year.

Time Value of Money

Example 8
As a result of the investment, we expect to
receive three cash flows: PLN 2 000 after
one year, PLN 2 500 after two years, and
PLN 2 800 after three years. The required
rate of return is variable and in subsequent
years amounts to: 8%, 8,5%, 9%. What is
the current value of this investment?

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 Time Value of Money
Example 9
The investment results in paying several amounts to a
bank deposit every three months (the first payment is
made in three months). The capitalization is quarterly,
and the interest rate on the deposit changes every
quarter and amounts to: 8%, 8,2%, 8,4%, 7,8%. The
following amounts are paid in successively: PLN 100,
PLN 300, PLN 200, PLN 250. Please calculate the future
value after one year.

Time Value of Money

Example 10
The investment results in receiving a certain
amount every month indefinitely (perpetual
annuity). The first amount received in a month
is PLN 100, and each subsequent amount
increases by 0,5% compared to the previous
one. The rate of return required by the
investor is 12%. What is the current value of
payments received?

Time Value of Money

Example 13
An investor placed PLN 20 000 on a five-year
term deposit. For the first two years, the
interest rate on the deposit was 10% per
annum (with semi-annual capitalization),
and for the next three years – 12% (with
quarterly interest capitalization). How much
will the account balance be after five years?

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 Time Value of Money
Example 14
What will be the account balance of an
investor who invested PLN 5 000 for eight
months? For the first half of the year, the
interest rate is 12% with quarterly
capitalization, and then 14% with monthly
capitalization.

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