FIN 3331

Managerial Finance
Lecture 5

Time Value of money

Prepared by: Dang Thi Thuy
3 November 2011

Lecture outline

How time value of money works and its

importance.

Calculate present value (PV) and future value

(FV) of lump sums.

Different types of annuities, calculate their PV,

FV.

Introduction to the Time Value

of Money

A dollar today is worth more than a dollar

received in future

In most economies we expect a return on

money or capital related to the productivity of

things capital can buy

This is the fundamental source of the real

returns (not just inflationary increases)

The required returns are cumulatively known as

the opportunity cost of capital

Present value & Future value

Present value (PV): value today of a future cash
flow or series of cash flows, beginning amount.
Future value (FV): amount of a cash flow orr series
of cash flow will grow over a period of time
when the cash flow is compounded at an
interest rate; ending amount.
Time line: tool used in time value analysis,
illustrate cash flows and their timing.
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Example of PV, FV and Time line

You invest $5,000 with interest rate of 5% p.a. for 3
year. FV = ?
PV = $5,000; r = 5% p.a.
Time line:

FV = value of your $5,000 in next 3 years

= 5,000 * (1+0.05)3 = $5,788.125
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Simple interest
Simple interest is used when there is only
a single time period involved.
E.g.: You borrow $1000 and agree to pay
12% interest in 1 years time. Calculate
interest & principal payments?
Interest owned = 0.12 *1000 = $120
Total payment = 120 + 1000 = $1120

PV and FV of a single payment

FV: future cash sum equivalent to a
specified amount today.
PV: cash equivalent to an amount to be paid
or received at some future date.
Assume principal (P) is borrowed today at
interest rate I, repayment after t period.
What would be FV?
FV = P(1+it)
Know FV, PV = ?
PV = P = FV/(1+it)

Example
Using simple interest:
Calculate As payment of a loan of $10,000
after 1 year, & after 6 months, interest at
8% per annum.

A promises to pay %500,000 in 6 months

time at the rate of 14% p.a. How much has
A borrowed?
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Compound Interest
Is the interest calculated each period on a principal
amount & on any interest earned on the investment up
to that period.
E.g.: You borrow $1000 and agree to pay 12% interest in
2 years time. Calculate interest & principal payments?
Interest year 1 = 1000 * 0.12 = 120
Interest year 2 = (1000+120) * 0.12 = 134.4
Total payment = 120 + 134.4 = $1254.4
=1000 * (1+0.12)2 = $1254.4

PV and FV using compound interest

Using compound interest, we have:
S = P(1+r)n
S is the future sum or FV
P is principal of PV
r is interest rate
n is number of periods

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Example
Using compound interest:
Calculate As payment of a loan of $10,000
after 1 year, & after 6 months, interest at
8% per annum.

A promises to pay %500,000 in 6 months

time at the rate of 14% p.a. How much has
A borrowed?
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PV & FV over Multiple Periods of

Time

General formula for PV and FV across multiple periods:

PV = FV / (1+r)N
FV = PV (1+r)N
N is the number of periods between FV and PV
If FV and PV are known the rate of return (r) can be
found by the formula:
r = (FV/PV) 1/N 1

Annuity
Definition: a series of equal payments/cash
flows at fixed intervals for a specified number
of period.
E.g.: monthly rental payments, mortgages
payments.
2 kinds of annuity:
- Ordinary annuity, also called annuity
- Annuity due

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Annuity
-

Ordinary annuity/or annuity:

payments/cash flows occur at the end of
each period.

Annuity due: payments/cash flows occur

at the beginning of each period.

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Examples:

Ordinary annuity

Annuity due

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PV & FV of an Ordinary Annuity

1 1/(1+r)
PV = PMT -----------------

r
(1+r) 1
FV = PMT ----------------N

r
PMT is the equal amount of payments occurring at end
the of each consecutive equal length period of time

N is the number of payments

r is the interest rate per period to time, compounded at
the end of each period.

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Example

Find PV of an ordinary annuity of $5000

for 4 years at 8% per year.

A intends to save $200 every month and

the interest rate is 8.4%per year. How
much would A have saved at the end of
year 2?
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PV & FV of an Annuity Due

PMT

PV = PMT + -----r

1
1- ------------N-1
(1+r)

FV = FV of Annuity * (1+r)

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Example of Annuity Due

A has been promised seven payments of
$1000 every month with the first one to
occur immediately. Calculate the PV of the
annuity due if the interest rate is 0.5% per
month?
Hint: Start with drawing a time line

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Future value of annuity due

In order to calculate future value of an
annuity due we use two stages approach.
A can save $200 per month but intends to
start saving today (at beginning of each
month). If interest rate is 0.7% per month.
How much A save in two year time?

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Future value of annuity due

Step 1: Calculate PV of annuity with
PMT = $200
r = 0.7% per month
n = 24
Step 2: Calculate FV of annuity due by the
formula:
FV = FV of Annuity * (1+r)
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Perpetuity

Perpetuity can be defined as an ordinary

annuity with the cash flows to continue forever.

PV =

PMT
------------

Example: Consol is a perpetual bond issued by

r
the British
government to consolidate past
debts

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Tutorial questions

Problems: 5-1, 5-2, 5-3, 5-7, 5-9, 5-10, 514, 5-15, 5-16 pg. 153-154 in text book.

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