Chapter 4

The Time Value of Money

Learning Goals & Objective
1. Discuss the role of time value in finance, the use
of computational aids, and the basic patterns of
cash flow.
2. Understand the concept of future value and
present value, their calculation for single
amounts, and the relationship between them.
3. Find the future value and the present value of
both an ordinary annuity and an annuity due,
and the present value of a perpetuity.
Learning Goals & Objective
4. Calculate both the future value and the present value of
a mixed stream of cash flows.
5. Understand the effect that compounding interest more
frequently than annually has on future value and the
effective annual rate
of interest.
6. Describe the procedures involved in
◦ Determining deposits needed to accumulate to a
future sum
◦ Loan amortization
◦ Finding interest or growth rates
◦ Finding an unknown number of periods.
The Role of Time Value in Finance
Refers to the observation that is it better to
receive money sooner than later.
Because funds received today can be reinvested
to reach a greater value in the future
RM1 today is worth more than RM1 in the
future.
Inflation rate: persistently increase in general
price of goods and services reduce the
purchasing power of consumers
Basic Pattern of Cash Flow
1) Single Amount: A lump-sum amount
either currently held or expected at some
future date.

Example:
Damon plans to invest a single amount of
RM3000 into fixed deposit that provides
interest of 5%p.a. How much Damon
would have after 5 years.
 Basic Pattern of Cash Flow
2) Annuity: A level periodic stream of cash
flow.
Ordinary Annuity: A series of equal
payments made at the END of each period
over a fixed amount of time.
Example:
Damon plans to invest RM1000 at the end of
each month into fixed deposit with interest of
5%p.a. How much would Damon have after 5
years.
Basic Pattern of Cash Flow
Annuity Due: A series of equal payments made at
the BEGINNING of each period over a fixed
amount of time.
Example:
Damon plans to invest RM1000 at the beginning of
each month into fixed deposit with interest of
5%p.a. How much would Damon have after 5
years?
An annuity due will always be greater than an
ordinary annuity because interest will compound for
an additional period.
Basic Pattern of Cash Flow
3) Mixed Stream: A stream of unequal
periodic cash flows that reflect no particular
pattern.
Example:
Damon plans to invest RM1000, RM2000,
RM3000, RM4000, and RM5000 into fixed
deposit from year 1 to year 5 respectively.
How much would Damon have at the 5th
year.
Future Value
Determining what will be the value worth
at a specific future with an investment
amount made today.

Example:
Invest RM1000 now, how much you will
get after 5 years at the fixed interest rate
(5%). FV = PV (1+i)n
Present Value
Determining the value today of cash flow
(CF) to be received at a specific date in
the future.

Example:
You need RM1 million after 5 years, how
much you need to invest now.
PV = FV/(1+i)n
Future Value vs Present Value
• Suppose a firm has an opportunity to spend $15,000 today
on some investment that will produce $17,000 spread out
over the next five years as follows:

Year Cash flow

1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000

• Is this a wise investment?

• To make the right investment decision, managers need to
compare the cash flows at a single point in time.
Future Value vs Present Value:
Time Line
Future Value vs Present Value:
Compounding and Discounting

PV FV (compounding)
FV PV (discounting)
Future Value vs Present Value:
Financial Keys
Time Value of Money:
Terms
PV = present value
i = interest rate
FVn = future value at end of “n” periods
n = number of compounding periods
PMT = an annuity (series of equal payments
or receipts)
Time Value of Money: Refer to
interest factor
Four Basic Models table

• FVn = PV0(1+i)n = PV x (FVIFi,n)

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

• FVAn = PMT (1+i)n - 1 = Ax

(FVIFAi,n)
i

n
Future Value:
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.
Compound interest : Interest earned on both principal
amount and the interest earned in previous periods.
Future Value:
Single Amount: Mathematical & FVIF
Table
Example 1:

If Fred Moreno places RM100 in a saving account

paying 8% interest compounded annually, how
much will he have in the account at the end of one
year?

FV = PV (1 + i)n = PV (FVIFi,n)

=RM100 x (1.08)1 = RM100 (FVIF8%,1 )

=RM108 = RM108
Future Value:
Single Amount: FVIF Table
Future Value:
Single Amount: Mathematical & FVIF
Table
Example II:

Jane Farber places RM800 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.

FV = PV (1 + i)n = PV (FVIFi,n)
FV5 = RM800 (1 + 0.06)5 = RM800 (FVIF6%,5)

= RM1,070.40
Future Value:
Single Amount: FVIF Table
Future Value:
Single Amount: Graphical View

•Interest rate increase, the higher future value

•The longer the maturity the higher future value
Present Value:
Single Amount
Presentvalue is the current dollar value of a future
amount of money.
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.
Present Value:
Single Amount: Mathematical & PVIF
Table
Example 1:

Tan has an opportunity to receive RM300 one year

from now. If he can earn 6% on his investments,
what is the most he should pay now for this
opportunity?
PV = FV / (1 + i)n = FV (PVIF i, n )

= RM300 /(1 + 0.06)1 = RM300 x

= RM283.01 = RM283.01
Present Value:
Single Amount: PVIF Table
Present Value:
Single Amount: Mathematical & PVIF
Table
Example 11:

Lim wishes to find the present value of RM1,700

that will be received 8 years from now. Lim’s
opportunity cost is 8%.

PV = FV / (1 + i)n = FV (PVIF i, n )

PV = RM1,700/(1 + 0.08)8 = RM1,700 x (PVIF8%,8)

PV = RM918.42
Present Value:
Single Amount: PVIF Table
PresentValue:
Single Amount: Graphical View

Interest rate increase, the lower present value

The longer the maturity the lower present value
Annuities:
Ordinary vs Annuity Due
Jennifer 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. Jennifer has listed the cash
flows for both annuities as shown:
Annuities: Future Value
Ordinary Annuity
Jennifer wishes to determine how much money she will
have if she chooses annuity A (deposit $1000 annually, at
the end of each of the next 5 years), the ordinary annuity
and it earns 7% annually. Annuity A is depicted graphically
below:

This analysis can be depicted on a time line as follows:

Annuities: Future Value
Annuity Due
• You can calculate the future value of an annuity due that
pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
Annuities: Future Value
Annuity Due
Jennifer wishes to determine how much money she
will have if she chooses annuity B (deposit $1000
annually, at the beginning of each of the next 5
years), the ordinary annuity and it earns 7%
annually. Annuity B is depicted graphically below:

FVa = $1000 x [(1+0.07)5 – 1]/0.07 x (1+0.07) =

$6153.29
Annuities: Present Value
Ordinary Annuity
• You can calculate the present value of an ordinary
annuity that pays an annual cash flow equal to CF by
using the following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
Annuities: Present Value
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%.

This analysis can be depicted on a time line as follows:

Annuities: Present Value
Annuity Due
• You can calculate the present value of an annuity due
that pays an annual cash flow equal to CF by using the
following equation:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
Annuities: Present Value
Annuity Due
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 beginning of each year
for 5 years. The required return is 8%.

PVa = $700/0.08 x [1-1/(1+0.08)5] (1+0.08)

= $3018,49
Present Value of a Perpetuity
Annuity which continues forever
PV = CF ÷ r

For example, how much would I have to deposit

today in order to withdraw RM1,000 each year
forever if I can earn 8% on my deposit?

PV = RM1,000/0.08 = RM12,500
Future Value:
Mixed Stream
RM564.64
RM1,036.00
RM594.05
RM436.00
RM300.00
RM2,930.69

RM400 800 500 400 300 I/Y = 9%

0 1 2 3 4 5

4 3 2 1 0
Present Value:
Mixed Stream

RM400 800 500 400 300

0 1 2 3 4 5

1 2 3 4 5
RM366.96
RM673.36
RM386.10
RM283.36
RM194.97
RM1,904.75

I/Y = 9%
 Future Value:
Deferred Annuity
You are expected to deposit RM20,000 per year at
the end of year 2, 3, 4, 5 and 6 for an investment.
How much would you receive at the end of Year 8 if
the compound rate is 20%?
RM20,000 20,000 20,000 20,000 20,000

0 1 2 3 4 5 6 7 8

RM214,318.08
 Present Value:
Deferred Annuity
You are expected to receive RM20,000 per year at
the end of year 4, 5, 6, 7 and 8 from an
investment. How much you should invest now if
you require a 20% rate of return?
RM20,000 20,000 20,000 20,000 20,000

0 1 2 3 4 5 6 7 8

RM34,613
Effective Annual Rate (EAR)
Which is the better loan:
8% compounded annually,
or
7.85% compounded quarterly?
We can’t compare these nominal (quoted) interest
rates, because they don’t include the same number
of compounding periods per year!
We need to calculate the EAR.
Effective Annual Rate (EAR)

EAR = (1+ m )
Quoted rate m
- 1
Find the EAR for the quarterly loan:

EAR = ( .0785
1+ 4 4
- 1 )
= .0808, or 8.08%

The quarterly loan is more expensive than the 8% loan

with annual compounding!
Nominal & Effective
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.
Compounding Interest:
More Frequently than Annually
Compounding more frequently than once a year
results in a higher effective interest rate because
you are earning interest on interest more
frequently.
In general, the effective rate > nominal rate
whenever compounding occurs more than once
per year
Furthermore,the effective rate of interest will
increase the more frequently interest is
compounded.
Compounding Interest:
More Frequently than Annually
A General Equation for Compounding More
Frequently than Annually
Compounding Interest:
More Frequently than Annually

You decide to invest RM1,000 and earned 6%,

how much would you earn after 3 years with
interest compounded quarterly?

PV = 1,000
I = 0.06/4
n = 3x4 = 12
FV3 = 1,000 (1.015)12
= RM1,195.62
Compounding Interest:
More Frequently than Annually
You decide to invest RM1,000 and earned 6%, how
much would you earn after 3 years with interest
compounded monthly?

PV = 1,000
I = 0.06/12
n = 3*12

FV3 = 1,000 (1.005)36

= RM1,196.68
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) = PV0 (ein)

where “e” has a value of 2.7183.

Continuous Compounding

Find the future value of the RM1,000 deposit

after 5 years if interest is 8% compounded
continuously.

FVn = 1,000 x (2.7183).08x5 = RM1,491.83