Chapter Introduction to Finance

Lawrence J. Gitman
5 Jeff Madura

Time Value
of Money
 Learning Goals

Discuss the role of time value in finance and the use

of computational aids to simplify its application.
Understand the concept of future value and its
calculation for a single amount; understand the
effects on future value and the true rate of interest
of compounding more frequently than annually.
Understand the concept of present value, its calculation
for a single amount, and the relationship of present
to future cash flow.

Copyright 2001 Addison-Wesley 5-1

 Learning Goals

Find the future value and present value of an ordinary

annuity, the future value of an annuity due, and the
present value of a perpetuity.
Calculate the present value of a mixed stream
of cash flows, describe the procedures involved in:
Determining deposits to accumulate to a future sum
Loan amortization
Finding interest or growth rates

Copyright 2001 Addison-Wesley 5-2

 The Role of Time Value in Finance

Most financial decisions involve costs

and benefits that are spread out over time.
Time value of money allows comparison
of cash flows from different periods.
Question
Would it be better for a company to invest $100,000 in a product
that would return a total of $200,000 in one year, or one that
would return $500,000 after two years?
Answer
It depends on the interest rate!

Copyright 2001 Addison-Wesley 5-3

 Basic Concepts

Future Value
Compounding or growth over time
Present Value
Discounting to todays value
Single cash flows and series of cash flows can
be considered
Time lines are used to illustrate these relationships

Copyright 2001 Addison-Wesley 5-4

 Computational Aids

Use the equations

Use the financial tables
Use financial calculators
Use spreadsheets

Copyright 2001 Addison-Wesley 5-5

 Computational Aids

Copyright 2001 Addison-Wesley Figure 5.1 5-6

 Computational Aids

Copyright 2001 Addison-Wesley Figure 5.2 5-7

 Computational Aids

Copyright 2001 Addison-Wesley Figure 5.3 5-8

 Computational Aids

Copyright 2001 Addison-Wesley Figure 5.4 5-9

 Simple Interest

With simple interest, you dont earn interest

on interest.
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125

Copyright 2001 Addison-Wesley 5-10

 Compound Interest

With compound interest, a depositor earns

interest on interest!
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

Copyright 2001 Addison-Wesley 5-11

 Time Value Terms

PV0 = present value or beginning amount

k = interest rate
FVn = future value at end of n periods
n = number of compounding periods
A = an annuity (series of equal
payments or receipts)

Copyright 2001 Addison-Wesley 5-12

 Four Basic Models

FVn = PV0(1+k)n = PV(FVIFk,n)

PV0 = FVn[1/(1+k)n] = FV(PVIFk,n)

FVAn = A (1+k)n - 1 = A(FVIFAk,n)

k

PVA0 = A 1 - [1/(1+k)n] = A(PVIFAk,n)

k
Copyright 2001 Addison-Wesley 5-13
 Future Value Example

Algebraically and Using FVIF Tables

You deposit $2,000 today at 6% interest.
How much will you have in 5 years?

$2,000 x (1.06)5 = $2,000 x FVIF6%,5

$2,000 x 1.3382 = $2,676.40

Copyright 2001 Addison-Wesley 5-14

 Future Value Example

Using Microsoft Excel

You deposit $2,000 today at 6% interest.
How much will you have in 5 years?

Microsoft Excel Function

= FV(interest, periods, pmt, PV)
= FV(.06, 5, , 2000)

Copyright 2001 Addison-Wesley 5-15

 A Graphic View of Future Value

Copyright 2001 Addison-Wesley Figure 5.5 5-16

 Compounding More Frequently
Than Annually
Compounding more frequently than once a year results
in a higher effective interest rate because you are
earning on interest on interest more frequently.
As a result, the effective interest rate is greater
than the nominal (annual) interest rate.
Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.

Copyright 2001 Addison-Wesley 5-17

 Compounding More Frequently
Than Annually
For example, what would be the difference in future
value if I deposit $100 for 5 years and earn 12% annual
interest compounded (a) annually, (b) semiannually,
(c) quarterly, and (d) monthly?

Annually: 100 x (1 + .12)5 = $176.23

Semiannually: 100 x (1 + .06)10 = $179.09
Quarterly: 100 x (1 + .03)20 = $180.61
Monthly: 100 x (1 + .01)60 = $181.67

Copyright 2001 Addison-Wesley 5-18

 Compounding More Frequently
Than Annually

Copyright 2001 Addison-Wesley 5-19

 Continuous Compounding
With continuous compounding the number
of compounding periods per year approaches infinity.
Through the use of calculus, the equation thus becomes:

FVn (continuous compounding) = PV x (ekxn)

where e has a value of 2.7183

Continuing with the previous example, find the future value of the
$100 deposit after 5 years if interest is compounded continuously.

FVn = 100 x (2.7183).12x5 = $182.22

Copyright 2001 Addison-Wesley 5-20

 Nominal and Effective Rates

The nominal interest rate is the stated or contractual

rate of interest charged by a lender or promised by
a borrower.
The effective interest rate is the rate actually paid
or earned.
In general, the effective rate is greater than the nominal
rate whenever compounding occurs more than once
per year.
EAR = (1 + k/m)m - 1

Copyright 2001 Addison-Wesley 5-21

 Nominal and Effective Rates

For example, what is the effective rate of interest

on your credit card if the nominal rate is 18% per
year, compounded monthly?

EAR = (1 + .18/12)12 - 1
EAR = 19.56%

Copyright 2001 Addison-Wesley 5-22

 Present Value

Present value is the current dollar value of a future

amount of money.
It is based on the idea that a dollar today is worth more
than a dollar tomorrow.
It is the amount today that must be invested at a given
rate to reach a future amount.
It is also known as discounting, the reverse
of compounding.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return,
and the cost of capital.
Copyright 2001 Addison-Wesley 5-23
 Present Value Example

Algebraically and Using PVIF Tables

How much must you deposit today in order to have
$2,000 in 5 years if you can earn 6% interest
on your deposit?

$2,000 x [1/(1.06)5] = $2,000 x PVIF6%,5

$2,000 x 0.74758 = $1,494.52

Copyright 2001 Addison-Wesley 5-24

 Present Value Example

Using Microsoft Excel

How much must you deposit today in order
to have $2,000 in 5 years if you can earn
6% interest on your deposit?

Microsoft Excel Function

=PV(interest, periods, pmt, FV)
=PV(.06, 5, , 2000)

Copyright 2001 Addison-Wesley 5-25

A Graphic View of Present Value

Copyright 2001 Addison-Wesley Figure 5.6 5-26

 Annuities

Annuities are equally-spaced cash flows of equal size.

Annuities can be either inflows or outflows.
An ordinary (deferred) annuity has cash flows
that occur at the end of each period.
An annuity due has cash flows that occur
at the beginning of each period.
An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will
compound for an additional period.

Copyright 2001 Addison-Wesley 5-27

 Annuities

Copyright 2001 Addison-Wesley Table 5.1 5-28

 Future Value
of an Ordinary Annuity
Using the FVIFA Tables
An annuity is an equal annual series of cash flows.
Example
How much will your deposits grow to if you deposit $100
at the end of each year at 5% interest for three years?

FVA = 100(FVIFA,5%,3) = $315.25

Year 1 $100 deposited at end of year = $100.00

Year 2 $100 x .05 = $5.00 + $100 + $100 = $205.00
Year 3 $205 x .05 = $10.25 + $205 + $100 = $315.25

Copyright 2001 Addison-Wesley 5-29

 Future Value
of an Ordinary Annuity
Using Microsoft Excel
An annuity is an equal annual series of cash flows.
Example
How much will your deposits grow to if you deposit $100
at the end of each year at 5% interest for three years?

Microsoft Excel Function

=FV(interest, periods, pmt, PV)
=FV(.06,5,100, )

Copyright 2001 Addison-Wesley 5-30

 Future Value of an Annuity Due

Using the FVIFA Tables

An annuity is an equal annual series of cash flows.
Example
How much will your deposits grow to if you deposit $100
at the beginning of each year at 5% interest for three years.

FVA = 100(FVIFA,5%,3)(1+k) = $330.96

FVA = 100(3.152)(1.05) = $330.96

Copyright 2001 Addison-Wesley 5-31

 Future Value of an Annuity Due

Using Microsoft Excel

An annuity is an equal annual series of cash flows.
Example
How much will your deposits grow to if you deposit $100
at the beginning of each year at 5% interest for three years.

Microsoft Excel Function

=FV(interest, periods, pmt, PV)
=FV(.06, 5,100, )
=315.25*(1.05)

Copyright 2001 Addison-Wesley 5-32

 Present Value
of an Ordinary Annuity
Using PVIFA Tables
An annuity is an equal annual series of cash flows.
Example
How much could you borrow if you could afford annual
payments of $2,000 (which includes both principal
and interest) at the end of each year for three years
at 10% interest?

PVA = 2,000(PVIFA,10%,3) = $4,973.70

Copyright 2001 Addison-Wesley 5-33

 Present Value of an Ordinary
Annuity
Using Microsoft Excel
An annuity is an equal annual series of cash flows.
Example
How much could you borrow if you could afford annual
payments of $2,000 (which includes both principal
and interest) at the end of each year for three years
at 10% interest?

Microsoft Excel Function

=PV(interest, periods, pmt, FV)
=PV(.10, 3, 2000, )

Copyright 2001 Addison-Wesley 5-34

Present Value of a Mixed Stream

Using Microsoft Excel

A mixed stream of cash flows reflects no particular pattern
Find the present value of the following mixed stream assuming
a required return of 9%.

Microsoft Excel Function

=NPV(interest, cells containing CFs)
=NPV(.09,B3:B7)

Copyright 2001 Addison-Wesley 5-35

 Present Value of a Perpetuity

A perpetuity is a special kind of annuity.

With a perpetuity, the periodic annuity or cash flow
stream continues forever.

PV = Annuity/k

For example, how much would I have to deposit today

in order to withdraw $1,000 each year forever if I can
earn 8% on my deposit?

PV = $1,000/.08 = $12,500

Copyright 2001 Addison-Wesley 5-36

 Loan Amortization

Copyright 2001 Addison-Wesley Table 5.7 5-37

 Determining Interest
or Growth Rates
At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
For example, you invested $1,000 in a mutual fund
in 1994 which grew as shown in the table below?

It is important to note
that although there are
7 years shown, there are
only 6 time periods
between the initial deposit
and the final value.

Copyright 2001 Addison-Wesley 5-38

 Determining Interest
or Growth Rates
At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Thus, $1,000 is the present value,

$5,525 is the future value,
and 6 is the number of periods.

Copyright 2001 Addison-Wesley 5-39

 Determining Interest
or Growth Rates
At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Copyright 2001 Addison-Wesley 5-40

 Determining Interest or Growth
Rates
At times, it may be desirable to determine the compound interest
rate or growth rate implied by a series of cash flows.
For example, you invested $1,000 in a mutual fund in 1994
which grew as shown in the table below?

Microsoft Excel Function

=Rate(periods, pmt, PV, FV)
=Rate(6, ,1000, 5525)

Copyright 2001 Addison-Wesley 5-41

 Using Microsoft Excel

The Microsoft Excel Spreadsheets used

in the this presentation can be downloaded
from the Introduction to Finance companion
web site: http://www.awl.com/gitman_madura

Copyright 2001 Addison-Wesley 5-42

Chapter Introduction to Finance
Lawrence J. Gitman
5 Jeff Madura

End of Chapter