TVM1

Time Value of Money
1
Outline
 Understand what is meant by "the time value of money."

 Understand the relationship between present and future
value.
 Describe how the interest rate can be used to adjust the
value of cash flows – both forward and backward – to a
single point in time.
 Calculate both the future and present value of:
 an amount invested today (lump sum);
 a stream of equal cash flows (an annuity)
 a stream of uneven cash flows.
2
Time Value of Money
 Which would you prefer -- $10,000 today or
$10,000 in 5 years?
years
Obviously, $10,000 today.

today
You already recognize that there is
TIME VALUE TO MONEY!!

MONEY
3
Time Value of Money
Why is TIME such an important

element in your decision?
TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
INTEREST
Interest Example (FV)
 Assume that you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest
at the end of the 2nd year?
 FV = PV ( 1+i) n
 FV = 1,000 ( 1.07) 2 = $1,144.9
 How much interest did you earn?

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.
6
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2
years.
years
0 1 2
7%
$1,000
FV2
Interest Example (PV)
 What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
 Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
PV of a Lump Sum (Example)
Ayfer Yılmaz wants to know how large of a
deposit to make so that the money will grow to
$10,000 in 5 years at a discount rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
PV of a Lump Sum (Solution)
 Calculation based on general formula:
PV0 = FVn / (1+i)n

PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of periods, consecutively.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Example of an Ordinary Annuity
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA0 PVA0 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
Formulas for PV and FV of
Annuities
13
Uneven Cash Flows Example
Ayfer Yılmaz will receive the set of cash
flows below. What is the Present Value at
a discount rate of 10%.
10%
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
Uneven Cash Flows Example
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
What is the FV of this CF stream at t=5?
PV of a Perpeuity
Stream of Cash Flows that Never Terminates
0 1 2 3 4
10%
$600 $600 $600 $600 $600
PV = CF / i
PV = 600/0.10 = $6,000
Steps for Solving TVM Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF,
annuity stream(s), or mixed flow
6. Solve the problem
The Impact of Compounding
 Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated i% constant?
 Why?
18
The Impact of Compounding
(Answer)
 LARGER!
 If compounding is more frequent than

once a year--for example, semiannually,
quarterly, or daily--interest is earned on
interest more often.
19
$100 at a 12% nominal rate with
semiannual compounding for 5 years
m*n
INOM
FVN = PV 1 +
n
2x5
0.12
FV5 = $100 1 +
2
= $100(1.06)10 = $179.08
20
FV of $100 at a 12% nominal rate for
5 years with different compounding
FV(Ann.) = $100(1.12)5 = $176.23

FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19
21
Effective Annual Rate (EAR)
 The EAR is the annual rate that the
investor effectively earns in a year.
n
İAPR
EAR = 1 +
n
22
Effective Annual Rate Example
 Example: Invest $1 for one year at 12%,
semiannual:
FV = PV(1 + Iapr/N)N
FV = $1 (1.06)2 = $1.1236.
 EAR% = 12.36%, because $1 invested for

one year at 12% semiannual compounding.
23
EAR for a Nominal Rate of
12% (APR)
EARAnnual = 12%.
EARS = 2 p/yr = 12.36%.
EARQ = 4 p/yr = 12.55
EARM = 12 p/yr = 12.68%.
EARD(365) = 365 p/yr = 12.75%. 24

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Time Value of Money

 Understand what is meant by "the time value of money."

Obviously, $10,000 today.

You already recognize that there is

TIME VALUE TO MONEY!!

Why is TIME such an important

TIME allows you the opportunity to

 FV = 1,000 ( 1.07) 2 = $1,144.9

 How much interest did you earn?

CF0 CF1 CF2 CF3

PV0 = FVn / (1+i)n

 If compounding is more frequent than

FV(Ann.) = $100(1.12)5 = $176.23

 EAR% = 12.36%, because $1 invested for

EARS = 2 p/yr = 12.36%.

EARQ = 4 p/yr = 12.55

EARM = 12 p/yr = 12.68%.

EARD(365) = 365 p/yr = 12.75%. 24

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