Time Value of Money

DR. mohamed sameh

Time Value of Money
 Basic Problem:
– How to determine value today of cash flows that are expected in the
future?
 Time value of money refers to the fact that a dollar in hand today
is worth more than a dollar promised at some time in the future
 Which would you rather have -- $1,000 today or $1,000 in 5
years?
 Obviously, $1,000 today.
today
 Money received sooner rather than later allows one to use the
funds for investment or consumption purposes. This concept is
referred to as the TIME VALUE OF MONEY!!
MONEY
 TIME allows one the opportunity to postpone consumption and
earn INTEREST.
INTEREST
 The Role of Time Value in Finance

• Most financial decisions involve costs & benefits

that are spread out over time.
• Time value of money allows comparison of cash
flows from different periods.

© Pearson Education 2013 4-3

Future Value and Compounding
 Future value refers to the amount of money an investment will grow to over some
length of time at some given interest rate
 To determine the future value of a single cash flows, we need:
 present value of the cash flow (PV)
 interest rate (r), and
 time period (n)

 FVn = PV0 × (1 + r)n

 Future Value Interest Factor at ‘r’ rate of interest for ‘n’ time periods
 Examples on computation of future value of a single cash flow
Future Value (Graphic)

If you invested $2,000 today in an account that

pays 6%
6 interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?

0 1 2
6%
$2,000
FV
Future Value (Formula)

FV1 = PV (1+r)n
= $2,000 (1.06)2
= $2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
r = rate of interest per compounding period
n = number of compounding periods

Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =

Future Value (Example)
 John wants to know how large his $5,000
deposit will become at an annual compound
interest rate of 8% at the end of 5 years.
years

0 1 2 3 4 5
8%
$5,000
FV5
Future Value Solution
 Calculation based on general formula: FVn = PV (1+r)n
 FV5 = $5,000 (1+ 0.08)5
 = $7,346.64

 Calculator keystrokes: 1.08 2nd yx x 5000 =


Present Value and Discounting
 The current value of future cash flows discounted at the appropriate
discount rate over some length of time period
 Discounting is the process of translating a future value or a set of future
cash flows into a present value.
 To compute present value of a single cash flow, we need:
 Future value of the cash flow (FV)
 Interest rate (r) and
 Time Period (n)


PV0 = FVn / (1 + r) n

 PVIF (r,n)
 Examples
Present Value (Graphic)

Assume that you need to have exactly $4,000 saved 10

years from now. How much must you deposit today in
an account that pays 6% interest, compounded annually,
so that you reach your goal of $4,000?

0 5 10
6%
$4,000
PV0
 Present Value
(Formula)
PV0 = FV / (1+r)10
= $4,000 / (1.06)10
= $2,233.58

0 5 10
6%
$4,000
PV0
Present Value Example

Joann needs to know how large of a deposit to make

today so that the money will grow to $2,500 in 5 years.
Assume today’s deposit will grow at a compound rate
of 4% annually.
0 1 2 3 4 5
4%
$2,500
PV0
Present Value Solution

 Calculation based on general

formula: PV0 = FVn / (1+r)n
PV0 = $2,500/(1.04)5
= $2,054.81

 Calculator keystrokes: 1.04 2nd yx 5 =

2nd 1/x X 2500 =
Frequency of
Compounding

General Formula:
FVn = PV0(1 + [r/m])mn

n: Number of Years
m: Compounding Periods per Year
r: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
Frequency of Compounding Example

 Suppose you deposit $1,000 in an account that pays

12% interest, compounded quarterly. How much will
be in the account after eight years if there are no
withdrawals?

PV = $1,000
r = 12%/4 = 3% per quarter
n = 8 x 4 = 32 quarters
Solution based on formula:

FV= PV (1 + r)n
=
1,000(1.03)32
=
2,575.10

Calculator Keystrokes:
1.03 2nd yx 32 X 1000 =
Present Value versus Future Value
 Present value factors are refers to future value factors
 Interest rates and future value are positively related
 Interest rates and present value are negatively related
 Time period and future value are positively related
 Time period and present value are negatively related
Self solution

problem1
If Fahmi Hamada places US$100 in a savings
account paying 8 percent interest compounded
annually, how much will he have at the end of 1
year?
Problem 2
Jannett Maher places US$800 in a savings account paying 6
percent interest compounded annually. She wants to know
how much money will be in the account at the end of five
years.

© Pearson Education 2011 18

Solution 1
Future value at end of year 1 = US$100  (1 + 0.08)
= US$108

Solution 2
Annuities
• Annuities are equally-spaced cash flows of equal
size.
• Annuities can be either inflows or outflows.
• An ordinary (deferred) annuity has cash flows that
occur at the end of each period.
• An annuity due has cash flows that occur at the
beginning of each period.
• An annuity due will always be greater than an
otherwise equivalent ordinary annuity because interest
will compound for an additional period.

© Pearson Education 2013 4-20

Annuity problem

Rasha 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 US$700 at the end of each year
for 5 years. The required return is 8
percent.
Annuity solution