Chapter 5: Time Value of Money

Principles of Managerial Finance by

Gitman and Zutter
 Future Value vs. Present Value
• Time line – a horizontal line on which time
zero appears at the leftmost end and future
periods are marked from left to right; can be
used to depict investment cash flows.

• Note to the teacher: illustrate timeline with

compounding and discounting
Future Value vs. Present Value cont
• The future value technique uses
compounding to find the future value of each
cash flow at the end of the investment’s life
and then sums these values to find the
investment’s future value.
• The present value technique uses discounting
the find the present value of each cash flow at
time zero and then sums these values to find
the investment’s value today.
 Basic Patterns of Cash Flow
• 1. Single amount – a lump-sum amount either
currently held or expected at some future
date.
• 2. Annuity – a level periodic stream of cash
flow.
• 3. Mixed stream – a stream of cash flow that is
not an annuity; a stream of unequal periodic
cash flows that reflect no particular pattern.
 Single Amounts – Future Value
• Future value – is the value at a given future
date of an amount placed on deposit today
and earning interest at a specified rate.
• Compound interest – interest that is earned
on a given deposit and has become part of the
principal at the end of a specified period.
• Principal – the amount of money on which
interest is paid.
 Single Amounts – Future Value
• The future value depends on the interest rate
and the number of periods that money is
invested.
• The higher the interest rate, the higher the
future value
• The longer the period of time, the higher the
future value.
 Single Amounts - Present Value
• Present value – the current peso value of a future
amount – the amount of money that would have
to be invested today at a given interest rate over
a specified period to equal the future amount.
• Discounting cash flows – the process of finding
present values;
• The inverse of compounding interest.
 Single Amounts - Present Value cont
• Instead of finding the future value of present
pesos invested at a given rate, discounting
determines the present value of a future
amount, assuming an opportunity to earn a
certain return on the money.
• This annual rate of return is variously referred
to as the discount rate, required rate, cost of
capital, and opportunity cost.
 Single Amounts – Present Value
• The higher the discount rate, the lower the
present value
• The longer the period of time, the lower the
present value.
 Annuities
• Annuity – a stream of equal periodic cash
flows over a specified time period.
• These cash flows can be inflows of returns
earned on investments or outflows of funds
invested to earn future returns.
 Types of Annuities
• 1. Ordinary annuity – an annuity for which the
cash flow occurs at the end of each period.
• 2. Annuity due – an annuity for which the cash
flow occurs at the beginning of each period.
 Ordinary Annuity vs. Annuity Due
• Ordinary Annuity
• Year annuity due
• 0 P0 P1,000
• 1 1,000 1,000
• 2 1,000 1,000
3 1,000 1,000
• 4 1,000 1,000
• 5 1,000 0
• ------- -------
• Totals P5,000 P5,000
 Annuities
• The annuity due would have a higher future
value than the ordinary annuity because each
of its five annual cash flows can earn interest
for 1 year more than each of the ordinary
annuity’s cash flows.
• In general, the value (present or future) of an
annuity due is always greater than the value
of an otherwise identical ordinary annuity.
 Comparison of Annuity Due with
Ordinary Annuity Future Value cont
• Because the cash flow of the annuity due
occurs at the beginning of the period rather
than at the end (that is, each payment comes
one year sooner in the annuity due), its future
value is greater.
 Finding the Present Value of a
Perpetuity
• Perpetuity – an annuity with an infinite life –
in other words, an annuity that never stops
providing its holder with a cash flow at the
end of each year.
 Example
• Ross Clark wishes to endow a chair in finance
at his alma mater. The university indicated
that it requires P200,000 per year to support
the chair, and the endowment would earn
10% per year.

• PV = P200,000 / 10% = P2,000,000

 Mixed Streams
• Mixed stream – a stream of unequal periodic
cash flows that reflect no particular pattern.
 Future Value of a mixed Stream
• We determine the future value of each cash
flow at the specified future date and then add
all the individual future values to find the total
future value.
 Present Value of a Mixed Stream
• We determine the present value of each
future amount and then add all the individual
present values together to find the total
present value.
 Compounding Interest More
Frequently than Annually
• Semiannual compounding – compounding of
interest over two periods within the year.
• Quarterly compounding – compounding of
interest over four periods within the year.
• The more frequently interest is compounded,
the greater the amount of money
accumulated. This is true for any interest rate
for any period of time.
 Continuous Compounding
• Continuous compounding – compounding of
interest an infinite number of times per year
at intervals of microseconds.
 Example
• Present value = P100
• Annual rate of interest, compounded
• continuously = 8%
• Number of years = 2

• Note to teacher: use Excel,

• =b2*exp(b3*b4)
 Nominal and Effective Annual Rates
(EAR) of Interest
• Nominal (stated) annual rate – contractual
annual rate of interest charged by a lender or
promised by a borrower.
• Effective (true) annual rate (EAR) – the annual
rate of interest actually paid or earned.
 EAR cont
• 2 points:
• 1. Nominal and effective annual rates are
equivalent for annual compounding.
• 2. The effective annual rate increases with
increasing compounding frequency.
 APR vs APY
• Annual percentage rate (APR) – the nominal
annual rate of interest, found by multiplying the
periodic rate by the number of periods in one
year, that must be disclosed to consumers on
credit cards and loans as a result of “truth-in-
lending” laws.
• Annual percentage yield (APY) – the effective
annual rate of interest that must be disclosed to
consumers by banks on their savings products as
a result of “truth-in-savings laws”.
Special Applications of Time Value
• 1. Determining deposits needed to
accumulate a future sum
• 2. Loan amortization – the determination of
the equal periodic loan payments necessary to
provide a lender with a specified interest
return and to repay the loan principal over a
specified period.
• 3. Finding interest or growth rates
• 4. Finding an unknown number of periods
 Loan Amortization
• Loan amortization schedule – a schedule of
equal payments to repay a loan. It shows the
allocation of each loan payment to interest
and principal.
 ST5-1
• Delia Martin has P10,000 that she can deposit in
any of three savings accounts for a 3-year period.
Bank A compounds interest on an annual basis,
Bank B compounds interest twice each year, and
Bank C compounds interest each quarter. All
three banks have a stated annual interest rate of
4%.
 ST5-1 cont
• A. what amount would Ms. Martin have at the end of the
third year, leaving all interest paid on deposit, in each
bank?
• B. what effective annual rate (EAR) would she earn in each
of the banks?
• C. On the basis of your findings in parts A and B, which
bank should Ms. Martin deal with? Why?
• D. If a fourth bank (Bank D), also with a 4% stated interest
rate, compounds interest continuously, how much would
Ms. Martin have at the end of the third year? Does this
alternative change your recommendations in part C?
Explain why for why not.
 ST5-2

• Ramesh Abdul wishes to choose the better of two

equally costly cash flow streams: annuity X and
annuity Y. X is an annuity due with a cash inflow of
P9,000 for each of 6 years. Y is an ordinary
annuity with a cash inflow of P10,000 for each of
6 years. Assume that Ramesh can earn 15% on his
investments.
 ST5-2 cont
• A. On a purely subjective basis, which annuity
do you think is more attractive?
• B. Find the future value at the end of year 6
for both annuities.
• C. Use your finding in part B to indicate which
annuity is more attractive. Why? Compare
your finding to your subjective response in
part A.
 ST5-3
• You have a choice of accepting either of two 5-
year cash flow streams or single amounts. One
cash flow stream is an ordinary annuity, and the
other is a mixed stream. You may accept
alternative A or B – either as a cash flow stream
or as a single amount. Given the cash flow
stream and single amounts associated with each
, and assuming a 9% opportunity cost, which
alternative (A or B) and in which form (cash flow
stream or single amount) would you prefer?
 ST5-3 cont
• Cash flow stream
• End of year Alternative A Alternative B
• 1 P700 P1,100
• 2 700 900
• 3 700 700
• 4 700 500
• 5 700 300
• Single amount
• At time zero P2,825 P2,800
 ST5-4
• Judi Janson wishes to accumulate P8,000 by
the end of 5 years by making equal, annual,
end-of-year deposits over the next 5 years. If
Judi can earn 7% on her investments, how
much must she deposit at the end of each
year to meet this goal?
 4-1
• If you deposit $10,000 in a bank account that
pays 10% interest annually, how much will be
in your account after 5 years?
 4-2
• What is the present value of a security that
will pay $5,000 in 20 years if securities of
equal risk pay 7% annually?
 4-3
• Your parents will retire in 18 years. They
currently have $250,000, and they think they
will need $1 million at retirement. What
annual interest rate must they earn to reach
their goal, assuming they don’t save any
additional funds?
 4-4
• If you deposit money today in an account that
pays 6.5% annual interest, how long will it
take to double your money?
 4-6
• What is the future value of a 7%, 5-year
ordinary annuity that pays $300 each year? If
this were an annuity due, what would its
future value be?
 4-7
• An investment will pay $100 at the end of
each of the next 3 years, $200 at the end of
Year 4, $300 at the end ofYear 5, and $500
atthe end of Year 6. If otherinvestments of
equal risk earn 8% annually, what is this
investment’s present value? Its future value?
End of chapter 5