Chapter 3: The Time Value of Money

I. FUTURE VALUES AND COMPOUND INTEREST

A. Cash flows occurring in different time periods are not comparable
unless adjusted for time value.
B. The future value is the amount to which an investment will grow
after earning interest. (See slide 3-21)
C. Future value = investment x (1+r)t.
D. The expression, (1+r)t, refers to compound interest or interest
earned on interest at the rate, r, for t periods. An investment of
$100 for five years at 6 percent interest compounded annually
would be (See slide 3-12).
E. $100 x (1.06)5 = $133.82, with the $33.82 representing the
accumulated interest.
F. If the $100 investment above earned 6 percent simple interest, or
annual interest on the original investment, the sum of the original
$100 plus accumulated simple interest would be(See slide 3-20)
$100 x .06 x five years = $30.00. Note that with compound interest
an additional $3.82 is earned in the five year period. See (See slide
3-24)for arithmetic and graphic analyses, respectively.
II. PRESENT VALUE
A. The value today of a future cash flow is called the present value.
The present value computation solves for the original investment at
a certain rate when one knows the future value. The present value
is the reciprocal of the future value calculation. (See slide 3-32)
Present value x (1+r)t = future value, while the present value = 1/
(1+r)t x future value. See Figure 3.3 for a graphical interpretation of
this relationship.
B. The interest rate used to compute present values of future cash
flows is called the discount rate. This will be an important variable
when value determination is studied in the next chapter.
C. Present values are directly related to the future cash flows and
inversely related to the discount rate, r, and time, t. The higher the
future cash flows, the higher the PV; the higher the discount rate
and longer the term, the lower the PV.
D. The expression, 1/(1+r)t, is called a discount factor, which is the PV
of a $1 future payment. (See slide 3-31) Discount factors for whole
number discount rates and years, are calculated and available for
use in Tables 3.3.
E. Cash flows occurring at different time periods are not comparable
for financial decision making. The cash flows must be time
adjusted, at an appropriate discount rate, usually to the "present"
for comparison, summation, or other analysis.
F. Finding the interest rate:
 In the expression, PV = FV(1+r)t, when the PV, FV, and t are
known, (1+r) may be solved arithmetically.
  The discount rate calculated is also called the annual
interest rate, growth rate, and internal rate of return,
depending on the situation.
III. MULTIPLE CASH FLOWS (See slide 3-35)
A. A future stream of cash flows associated with an investment may
be compared or summed if adjusted to a common time period,
usually the present.
B. The multiple cash flows may be the same amount and be equally
spaced over the term (called an annuity), may be an annuity with
cash flows assumed to be received forever (called a perpetuity), or
the future cash flow stream may be unequal
C. The key point is that when discounted to the present, all future cash
flows are standardized for comparison, for summing, and other
analysis, such as net present value studied later.
IV. PERPETUITIES AND ANNUITIES
A. How To Value Perpetuities (See slide 3-37)
 The present value of a never ending equal stream of cash
flows is called perpetuity.
 The PV of a perpetuity is equal to the periodic cash flow
divided by the appropriate discount rate, or PV (perpetuity) =
cash payments/r.
B. How To Value Annuities:
 An annuity is an equally spaced level stream of cash flows,
such as $50 per year for ten years.
 The present value of annuity is the difference between the
PV of the cash flows in perpetuity less the PV of the cash
flows beyond the relevant annuity period. Arithmetically, the
PV of a t year annuity is: (See slide 3-42)
 where C represents the annuity cash flows per period and r
is the appropriate discount rate. The bracketed quantity in
the formula above is called an (See slide 3-43) annuity
factor. Table 3.4 shows annuity factors with varied whole
number r and t.
 A financial calculator refers to annuity cash flows as
payments.
 A loan amortization problem uses the same expression
above, solving for C, now the monthly or quarterly payments.
The adjustment of annual to more frequent compounding or
payments is to multiply the annual t by the number of
payments per year and divide the r by the same number
C. Future and present value of an annuity
 The future value sum of a series of consecutive, equal
payments is called the future value of an annuity (See slide
3-45)
  The present value sum of a series of consecutive, equal
payments is called the present value of an annuity,
calculated by multiplying the future value of annuity, above,
by (1 +r)t
 With an ordinary annuity the cash flows (PMT or payments
key in a financial calculator) are assumed to flow at the end
of the period. An annuity due assumes the cash flows occur
at the beginning of the period. (See the BGN or DUE key on
your financial calculator).
II. INFLATION AND THE TIME VALUE OF MONEY

A. Inflation is an overall general rise in the price level for goods and
services
B. In the time value of money analysis above, interest rates were
assumed to be "real" rates, and the cash flows over the time line
were assumed to have the same purchasing power. With inflation
the purchasing power of cash flows over a time line declines at the
rate of inflation.
C. Real versus Nominal Cash Flows
 One measure of inflation is the Consumer Price Index (CPI).
The annualized percentage increases in the CPI are a
measure of the rate of inflation.
 Consumers and investors are concerned about the real
value of $1 or the purchasing power of the dollar or
investment return in a period of time.
D. Inflation and Interest Rates
 Actual dollar prices or interest rates are called nominal
dollars or interest rates. Bonds, loans, and most financial
contracts are quoted in nominal interest rates.
 Nominal rates, adjusted for inflation in a period, are real
interest rates, or the rate at which the purchasing power of
an investment.
 The real rate of interest is calculated as
 The approximate real rate is the nominal rate minus the
inflation rate. (See slide 3-48)
E. What Fluctuates: Real or Nominal Rates?
 Investors and lenders include expected inflation rates in
nominal rates to compensate for the loss of purchasing
power.
 Nominal rates include expected real rates of return plus
expected inflation rates.
F. Valuing Real Cash Payments
 Since nominal rates include real rates plus expected
inflation, discounting nominal future cash flows by nominal
rates will give the same answer as discounting real,
 expected inflation adjusted cash flows by the real interest
rate.
 Current dollar cash flows must be discounted by the nominal
interest rate; real cash flows must be discounted by the real
interest rate.
G. Providing For Retirement
 Expected inflation is a significant variable in retirement
planning, tuition savings plans, choice of vocation, or any
long-term financial planning. Even a low rate of inflation can
have a major negative effect on people who will receive
relatively fixed nominal income or returns.
 The actual purchasing power rate of return (real rate) on an
investment is the nominal expected rate of return, 1+r,
divided by 1 + the expected inflation rate. With high inflation,
the realized real rate may be negative.
H. Real or Nominal?
 Most financial analyses in this text will assume nominal rates
and will discount nominal cash flows. When one set of cash
flows are presented in real term, such as the social security
cash flows, then nominal cash flows and rates must be
adjusted to compare, contrast, and mix the cash flows. As
noted above, do not mix nominal and real or you will have-
garbage!
II. ANNUALLY COMPOUNDED INTEREST RATES VERSUS ANNUAL
PERCENTAGE RATES
A. The effective annual interest rate (See slide 3-52) is the period rate
annualized using compound interest. If the one-month rate is 1
percent, the effective annual rate is 12 percent to the twelfth power
for there are twelve months in a year. Thus, (1.01)12 -1 = .1268 or
12.68 percent. The exponent used is the number of periods in one
year.
B. The annual percentage rate (APR) is the period rate times the
number of periods to complete a year or the interest rate that is
annualized using simple interest. In the case above the one-month
rate of 1 percent times the number of months in a year equals
12.68 percent. This is the APR.

To convert an annual percentage rate to an effective annual rate, divide

the APR by the number of annual interest periods and annualize that
period rate. In this example it is 1.012 -1 = .1268 or 12.68 percent.