Time Value of Money

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Time Value Topics
■ Future value (Compounding)
■ Present value (Discounting)
■ Rates of return
■ Annuity
■ Perpetuity
■ Amortization

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 Time Value of Money
• The time value of money (TVM) is the concept that money
available at the present time is worth more than the identical
sum in the future due to its potential earning capacity.
• Time value of money is the difference between an amount
of money in the present and that same amount of money in
the future. Having money now is more valuable than
having money later.
• The present amount is called the present value, the future
amount is called the future value, and the
appropriate rate that relates the two amounts is called
the discount rate.
• Future value (FV) is the value of a current asset at a future
date based on an assumed rate of growth. 
• There are two ways of calculating the future value (FV) of
an asset: FV using simple interest and FV using compound
interest.
Time lines show timing of
cash flows.

0 1 2 3
I%

CF0 CF1 CF2 CF3

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.
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• To illustrate, consider the following diagram, where PV represents
$100 that is in a bank account today and FV is the value that will be in
the account at some future time (3 years from now in this example):
• The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as
years or months. Time 0 is today, and it is the beginning of Period 1;
Time 1 is one period from today, and it is both the end of Period 1
and the beginning of Period 2; and so on. In our example the periods
are years, but they could also be quarters or months or even days.
Note again that each tick mark corresponds to both the end of one
period and the beginning of the next one. Thus, if the periods are
years, the tick mark at Time 2 represents both the end of Year 2 and
the beginning of Year 3.
• Cash flows are shown directly below the tick marks, and the relevant
interest rate is shown just above the time line. Unknown cash flows,
which you are trying to find, are indicated by question marks. Here
the interest rate is 5%; a single cash outflow, $100, is invested at
Time 0; and the Time-3 value is unknown and must be found.
• In this example, cash flows occur only at Times 0 and 3, with no flows
at Times 1 or 2. We will, of course, deal with situations where multiple
cash flows occur. Note also that in our example the interest rate is
constant for all 3 years. The interest rate is generally held constant,
but if it varies then in the diagram we show different rates for the
different periods.
 Use Four Different Procedures To Solve
Time Value

We can use four different procedures to solve time value.

These methods are described next.
1.Step-by-step approach using time line
2.Formula approach
3.Use a financial calculator.
4.Use a spreadsheet.
 Step-by-Step Approach

The time line itself can be modified and used to find the FV of $100
compounded for 3 years at 5%, as shown below:
 Formula Approach

In the step-by-step approach, we multiplied the amount at the

beginning of each period by (1 + I) = (1.05). Notice that the value at
the end of Year 2 is

If N = 3, then we multiply PV by (1 + I) three different times, which is

the same as multiplying the beginning amount by (1 + I)3. This
concept can be extended, and the result is this key equation:

We can apply Equation 4-1 to find the FV in our example:

 FV of an initial $100 after
3 years (I = 5%)

0 1 2 3
5%

10 FV = ?
0Finding FVs (moving to the right
on a time line) is called compounding.

10
After 1 year

FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.05)
= $105.00

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After 2 years

FV2 = FV1(1+I) = PV(1 + I)(1+I)

= PV(1+I)2
= $100(1.05)2
= $110.25

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After 3 years

FV3 = FV2(1+I)=PV(1 + I)2(1+I)

= PV(1+I)3
= $100(1.05)3
= $115.76

In general,
FVN = PV(1 + I)N
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We start with $100 in the account, which is shown at t = 0. We
then multiply the initial amount, and each succeeding beginning-of-
year amount, by (1 + I) = (1.05).
• You earn $100(0.05) = $5 of interest during the first year, so the
amount at the end of Year 1 (or at t = 1) is

• We begin the second year with $105, earn 0.05($105) = $5.25 on

the now larger beginning-of-period amount, and end the year with
$110.25. Interest during Year 2 is $5.25, and it is higher than the
first year’s interest, $5, because we earned $5(0.05) = $0.25
interest on the first year’s interest. This is called “compounding,”
and interest earned on interest is called “compound interest.”
• This process continues, and because the beginning balance is
higher in each successive year, the interest earned each year
increases.
• The total interest earned, $15.76, is reflected in the final balance,
$115.76.
 Compounding $$

■ Compounding is the process of determining the

future value (FV) of a cash flow or a series of cash
flows. The compounded amount, or future value, is
equal to the beginning amount plus interest earned.
Characteristics:
■ Growing Money to accumulate value in future
■ Solve for Future Value (FV)
■ Mathematical process (multiply)
 After 4 years
■ PV = $100
■N=4
■ i = 5%
■ FV = ? = $121.55

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After 4 years, but different
compounding per year
Semi-annual Quarterly
■ PV = $100 ■ PV = $100
■ N = 4 yrs x 2 = 8 time ■ N = 4 yrs x 4 = 16 time
period period
■ i = 5% / 2 = 2.5% per time ■ i = 5% / 4 = 1.25% per time
period period
■ FV = ? = ■ FV = ? =

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 Discounting $$
■ Present value (PV) is the current value of a future sum of
money or stream of cash flows given a specified rate of
return.
■ Discounting is the process of finding the present value (PV)
of a future cash flow or a series of cash flows; discounting is
the reciprocal, or reverse, of compounding.
■ The present value of a cash flow due N years in the future is
the amount which, if it were on hand today, would grow to
equal the given future amount.
Contt…..
Characteristics:
■Money needed today to accumulate x$
value in future
■Solve for Present Value (PV)
■Mathematical process (divide)
 What’s the PV of $110 due in
1 year if I/YR = 10%?

Finding PVs is discounting, it’s reverse of

compounding.

0 1 2 3
10%

PV = ? 110
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Solve FVN = PV(1 + I ) for PV N

FVN N
1
PV = = FVN
(1+I)N 1+I

1
110
PV =
1.10
PV= $100
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 What’s the PV of $100 due in
3 years if I/YR = 10%?

Finding PVs is discounting, and it’s the

reverse of compounding.

0 1 2 3
10%

PV = ? 10
0 22
Solve FVN = PV(1 + I ) for PV N

FVN N
1
PV = = FVN
(1+I)N 1+I

3
1
PV =
$100 1.10
= $100(0.7513) =
$75.13 23
What’s the PV of $110 due in 1
year if I/YR = 10%?
Annual Discounting Semi-annually
■ FV = $110 ■ FV = $110
■ N = 1 yr ■ N = 1 yr x 2 = 2 time
■ i = 10% period
■ PV = ? = ■ i = 10% / 2 = 5.0% per time
period
■ PV = ? =

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Cash Flow signs
Investing $ today
■ Outlay (invest) $ today in
present to earn greater
return in the future.
■ Earn interest (revenue),
plus principal
■ PV = <->
■ FV = +
Borrowing $ today
■ Take in (borrow) $ today
in present to use now,
then repay with interest
in the future.
■ Pay interest (expense),
plus principal
■ PV = +
■ FV = <->
Periods or Interest Rate unknown

Solve for N Solve for i

■ Invest $100 today ■ Deposit $100 today. You
earning 10% & need need $148.45 in 4 years.
$146.41. How long will it What’s the annual
take interest rate if the money
is compounded quarterly?
Solve for Interest Rate

0 1 2 3
?%

- 2
FV = PV(1 + I) N
1
$2 = $1(1 + I)3
(2)(1/3) = (1 + I)
1.2599 = (1 + I)
I= 0.2599 =
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25.99%
 Ordinary Annuity vs. Annuity Due

■ If the payments are equal and are made at fixed intervals,

then we have an annuity. For example, $100 paid at the end of
each of the next 3 years is a 3-year annuity.
■ Ordinary Annuity: If payments occur at the end of each
period, then we have an ordinary (or deferred) annuity.
Payments on mortgages, car loans, and student loans are
generally made at the ends of the periods and thus are
ordinary annuities.
■ Annuity Due: If the payments are made at the beginning of
each period, then we have an annuity due. Rental lease
payments, life insurance premiums, and lottery payoffs (if you
are lucky enough to win one!) are examples of annuities due.
Ordinary Annuity vs. Annuity
Due

Ordinary Annuity
0 1 2 3
I%

$100=PMT $100 $100

Annuity Due
0 1 2 3
I%

$100=PMT $100 $100

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What’s the FV of a 3-year
ordinary annuity of $100 at 5%?

0 1 2 3
5%

10 10 10
0 0 0110
121
FV = 315.25
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 FV Annuity Formula
■ As you can see from the time line diagram,
with the step-by-step approach we apply the
following equation with N = 3 and I = 5%:

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FV Annuity Formula

■ The future value of an annuity with N

periods and an interest rate of I can be
found with the following formula:
(1+I)N-1
= PMT
I
(1+0.05)3-1
= $100 =$315.25
0.05
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What’s the PV of this ordinary
annuity?

0 1 2 3
10%

10 10 10
90.91 0 0 0
82.64
75.13
248.69 = PV 33
PV Annuity Formula
■ The present value of an annuity with N
periods and an interest rate of I can be
found with the following formula:
1 1
= PMT −
I I (1+I)N
1 1
= $100 − = $248.69
0.1 0.1(1+0.1)3
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Find the FV and PV if the
annuity were an annuity due.

0 1 2 3
10%

100 100 100

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Retirement problem for you

Scenario Solution
■ Want to retire in 35 years ■ Pmt = $2500
■ Deposit (invest) $2500 ■ N= 35
year into an S&P 500 ■ i = 12.1%
Index fund (which ■ FV = ? = $1,104,853
returns 12.1% annually)
■ How much will you have
■ $2500/yr x 35 yrs =
to retire on in 35 years?
$87,500 total cash outlay
■ How much cash did you
have to outlay in total to
accumulate that much?
Retirement problem for your friend
the slacker
Scenario Solution
■ Want to retire with you in ■ Pmt = $2500
35 years, but is ski bum & ■ N= 20
fails to save his 1st 15 years
■ i = 12.1%
■ Deposit (invest) $2500 year
into an S&P 500 Index fund ■ FV = ? = $182,231
(which returns 12.1%
annually) ■ $2500/yr x 20 yrs =
■ How much will you have to $50,000 total cash outlay
retire on in 35 years?
■ How much cash did you
■ $1,104,853 vs. $182,231
have to outlay in total to
accumulate that much?
Perpetuity
■ A consol, or perpetuity, is simply an annuity
whose promised payments extend out
forever. Since the payments go on forever,
you can’t apply the step-by-step approach.
However, it’s easy to find the PV of a
perpetuity with the following formula: