Chapter 5

The Time Value

of Money

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All rights reserved.
 Learning Objectives

1. Explain the mechanics of compounding, that

is how money grows over a time when it is
invested.
2. Discuss the relationship between
compounding and bringing the value of
money back to present.
3. Understand Annuities.

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 Learning Objectives

4. Determine the future or present value of a

sum when there are nonannual
compounding periods.
5. Determine the present value of an uneven
stream of payments and understand
perpetuities.
6. Explain how the international setting
complicates the time value of money.

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 Principle Applied
in this Chapter

Principle 2:
Money has a time value

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 The Time Value of Money

Which would you rather have -- $1,000

today or $1,000 in 5 years?
Obviously, $1,000 today.
We say that money has a time value
because that money can be invested with the
expectation of earning a positive rate of
return

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 How can one compare amounts in
different time periods?

One can adjust values from different time

periods using an interest rate.
Timelines

PV FV

0 1 2 3 4 5
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 1.1 Simple Interest

Interest is earned only on principal.

Example: Compute simple interest on $100
invested at 6% per year for three years.
1st year interest is
2nd yearinterest is ..
3rd year interest is ..
Total interest earned: $.........

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 1.2 Compound Interest

Compounding is when interest is earned

on the principal and interest earned so
far).

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 1.2 Compound Interest

Example: Compute compound interest on

$100 invested at 6% for three years with
annual compounding.
1st year interest is.Principal now is ..
2nd year interestis. Principal now is .
3rd year interest is .Principal now is $.........
Total interest earned: $..........

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 1.3 Future Value
The FV tells us what something (assets or liability) will
be worth at a future date.
The FV answer the question how much will it will be
worth then
FVN = PV (1 + r)n
FVN = the future of the investment at the end of n years
r = the annual interest (or discount) rate
n = number of years
PV = the present value, or original amount invested at the beginning of
the first year

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 Future Value Example

Example: What will be the FV of $100 in

2 years at interest rate of 6%?
FV2 =

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 How to Increase the
Future Value?

Future Value can be increased by:

Increasing number of years of
compounding (N)
Increasing the interest or discount rate (r)
Increasing the original investment (PV)

See example on next slide

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 Changing R, N, and PV

a. You deposit $500 in bank for 2 years. What is the FV

at 2%? What is the FV if you change interest rate to
6%?
FV at 2% = 500*(1.02)2 = $520.2
FV at 6% = 500*(1.06)2 = $561.8
b. Continue the same example but change time to 10
years. What is the FV now?
FV = 500*(1.06)10= $895.42
c. Continue the same example but change contribution
to $1500. What is the FV now?
FV = 1,500*(1.06)10 = $2,686.27
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 2. Present Value
Present value reflects the current value of a
future payment or receipt.

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 6% 5 10
PV0
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 Present Value

PV = FVn {1/(1 + r)n}

Where FVn = the future value of the investment at the

end of n years
n = number of years until payment is received
r = the interest rate
PV = the present value of the future sum of money

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 PV example

What will be the present value of $500 to be

received 10 years from today if the discount
rate is 6%?
PV =

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 Intrayear Compounding
Interest

Intrayear compounding Interest: is when

Interest is compounded more frequently than
one time per year. This means that are multiple
compounding periods per year.

For example :some Interest rates are

compounded semi-annually( times per
year), monthly (times per year).

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 Compounding Period Rate

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 Annuity
An annuity is a series of equal dollar
payments for a specified number of years.
payments occur at the end of each period.

Examples of Annuities Include:

Student Loan Payments
Car Loan Payments
Mortgage Payments
Retirement Savings

5-18
 FV Annuity - Example

What will be the FV of year annuity

compounded at ?
FV5 =

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 Table 5-1

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 FV of an Annuity Using
Equation

FVn = PMT {(1 + r)n 1/r}

FV n = the future of an annuity at the end of the nth year

PMT = the annuity payment deposited or received at the end of
each year

r = the annual interest (or discount) rate

n = the number of years

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 FV of an Annuity
Using Equation

We need to know the PV of different financial

instrument to compare them.

What will $500 deposited in the bank every

year for 5 years at 10% be worth?

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 Table 5-2

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 PV of Annuity
Using Equation

PV of Annuity = PMT {[1 (1 + r)1]}/r

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 Comparing PV to FV

Remember, both quantities must be present

value amounts or both quantities must be
future value amounts in order to be
compared.

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 Distinction between the FV of an
annuity and the PV of an annuity

The FV of an annuity equation answers the

question what will the payments or
receipts be worth then?
While the PV of an annuity Equation
answers the question what are the
payments or receipts worth now ?

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 Perpetuity

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 Perpetuity

If someone were to received $1000 per

moth forever , with an available interest
rate of 5%. What is the PV?

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