MBA Prep Summer Tech

The Time Value of Money
In order to work the problems in this module, the user should have the use of a business calculator such as the Hewlett Packard 17BII. The author grants individuals a limited license to use this presentation. It is the sole property of the author who holds the corresponding copyrights. The user agrees not to reproduce, duplicate or distribute any copies of this presentation in any form. The author would like to thank the Innovative Technology Center at The Technology The University of Tennessee which supported this project with a grant through the Teaching with Technology Summer Institute. She would also like to Technology Summer Institute. She would also like to commend the teachers who helped her design the module. If you have any comments or suggestions on how to improve this presentation, please e-mail the author at smurphy@utk.edu. Copyright 2000 Suzan Murphy
August, 2000 UT Department of Finance

What is the Time Value of Money? Compound Interest Future Value Present Value Frequency of Compounding Annuities Multiple Cash Flows Bond Valuation

Which would you rather have -- $1,000 today or $1,000 in 5 years? Obviously, $1,000 today today. Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred MONEY!! to as the TIME VALUE OF MONEY
Why TIME?
TIME allows one the opportunity to postpone consumption and earn INTEREST. INTEREST NOT having the opportunity to earn interest on money is called OPPORTUNITY COST.
How can one compare amounts in different time periods?

One can adjust values from different time periods using an interest rate. Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.
Compound Interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest. FV = Principal + (Principal x Interest) = 2000 + (2000 x .06) = 2000 (1 + i) = PV (1 + i) Note: PV refers to Present Value or Principal
Future Value (Graphic)

If you invested $2,000 today in an account that
pays 6 interest, with interest compounded 6% annually, how much will be in the account at the end of two years if there are no withdrawals?
6%
$2,000
FV
Future Value (Formula)

FV1 = PV (1+i)n
FV = PV = i = n =
= $2,000 (1.06)2 = $2,247.20
future value, a value at some future point in time present value, a value today which is usually designated as time 0 rate of interest per compounding period number of compounding periods
Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =
August, 2000
UT Department of Finance
Future Value (HP 17 B II Calculator)

Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM 2 6 2000 +/FV N I%Yr PV 2,247.20
August, 2000
Future Value Example

John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at years. the end of 5 years
0
8% $5,000
FV5
Future Value Solution

Calculation based on general formula: FVn = PV (1+i)n FV5 = $5,000 (1+ 0.08)5 = $7,346.64 Calculator keystrokes: 1.08 2nd yx x 5000 =
August, 2000

August, 2000
Double Your Money!!!

Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?
We will use the Rule-of-72. Rule-of-72
August, 2000
The Rule-of-72
Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)? Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
August, 2000
Present Value
Since FV = PV(1 + i)n. PV = FV / (1+i)n. Discounting is the process of translating a future value or a set of future cash flows into a present value.
Present Value (Graphic)

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%
10
$4,000
PV0
Present Value (Formula)

PV0 = FV / (1+i)2 = $2,233.58 = $4,000 / (1.06)10
0 6%
10
$4,000
PV0
Present Value (HP 17 B II Calculator)

Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM 10 6 4000 PV N I%Yr FV
-2,233.57
August, 2000
Present Value Example

Joann needs to know how large of a deposit to make today so that the money will grow to $2,500 in 5 years. Assume todays deposit will grow at a compound rate of 4% annually.
0
4%
5
$2,500
PV0
Present Value Solution

Calculation based on general PV0 = FVn / (1+i)n formula: PV0 = $2,500/(1.04)5 = $2,054.81 Calculator keystrokes: 1.04 2nd yx 5 = 2nd 1/x X 2500 =

Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM
5 4 2,500 +/PV
N I%Yr FV 2,054.81
August, 2000
Finding n or i when one knows PV and FV

If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?
August, 2000
(HP 17 B II Calculator)
Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM 5 2000 +/2,676.45 I%Yr N PV FV 6.00
August, 2000
Frequency of Compounding
General Formula: FVn = PV0(1 + [i/m])mn
n: m: i: FVn,m: PV0:
August, 2000
Number of Years Compounding Periods per Year Annual Interest Rate FV at the end of Year n PV of the Cash Flow today
Frequency of Compounding Example

Suppose you deposit $1,000 in an account that pays 12% interest, compounded quarterly. How much will be in the account after eight years if there are no withdrawals? PV = $1,000 i = 12%/4 = 3% per quarter n = 8 x 4 = 32 quarters
Solution based on formula:

FV= PV (1 + i)n = 1,000(1.03)32 = 2,575.10 Calculator Keystrokes: 1.03 2nd yx 32 X 1000 =
Future Value, Frequency of Compounding (HP 17 B II Calculator)

August, 2000
Annuities
An
Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.
Examples of Annuities Include:
Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings
August, 2000
Example of an Ordinary Annuity -- FVA

End of Year
0 7%
1 $1,000
2 $1,000
3 $1,000 $1,070 $1,145
FVA3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0 = $3,215

If one saves $1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?
$3,215 = FVA3

Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM 1,000 +/3 7 FV PMT N I%Yr 3,214.90
August, 2000
Example of anOrdinary Annuity -- PVA

End of Year
0 7%
1 $1,000
2 $1,000
3 $1,000
$934.58 $873.44 $816.30 $2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 + $1,000/(1.07)3 = $2,624.32
If one agrees to repay a loan by paying $1,000 a year at the end of every year for three years and the discount rate is 7%, how much could one borrow today?

Exit until you get Fin Menu. 2nd, Clear Data. Choose Fin, then TVM 1,000 3 7 PV PMT N I% Yr -2,624.32
August, 2000
Multiple Cash Flows Example

Suppose an investment promises a cash flow of $500 in one year, $600 at the end of two years and $10,700 at the end of the third year. If the discount rate is 5%, what is the value of this investment today?
0
5%
1
$500
$600 $10,700
PV0
Multiple Cash Flow Solution

0
$476.19 $544.22 $9,243.06
1
5% $500
$600 $10,700
$10,263.47 = PV0 of the Multiple Cash Flows

Multiple Cash Flow Solution (HP 17 B II Calculator)

Exit until you get Fin Menu. 2nd, Clear Data.
FIN Flow(0)=? Flow(1)=? Flow(2)=? Flow(3)=? Exit Calc 5 NVP
CFLO 0 500 600

10,700
Input Input Input Input # Times (1) = 1 # Times (2) = 1 Input Input
I%
Bond Valuation Problem

Find todays value of a coupon bond with a maturity value of $1,000 and a coupon rate of 6%. The bond will mature exactly ten years from today, and interest is paid semi-annually. Assume the discount rate used to value the bond is 8.00% because that is your required rate of return on an investment such as this.
Interest = $30 every six months for 20 periods Interest rate = 8%/2 = 4% every six months
Bond Valuation Solution (HP 17 B II Calculator)

Exit until you get Fin Menu. 2nd, Clear Data
FIN 30 1000 4 20 PV TVM PMT FV I% YR N -864.09
1
30
2
30
20
30 1000
August, 2000
Welcome to the Interactive Exercises

Choose a problem; select a solution To return to this page (slide 37), use Power Points Navigation Menu Choose Go and By Title
1 2 3
Problem #1
You must decide between $25,000 in cash today or $30,000 in cash to be received two years from now. If you can earn 8% interest on your investments, which is the better deal?
August, 2000
Possible Answers - Problem 1

$25,000 in cash today $30,000 in cash to be received two years from now Either option O.K.
Need a Hint?
Solution (HP 17 B II Calculator) Problem #1

Exit until you get Fin Menu. 2nd, Clear Data Choose FIN, then TVM
2 8 30,000 PV N I%YR FV -25,720.16
Compare PV of $30,000, which is $25,720.16 to PV of $25,000. $30,000 to be received 2 years from now is better.
Problem #2
What is the value of $100 per year for four years, with the first cash flow one year from today, if one is earning 5% interest, compounded annually? Find the value of these cash flows four years from today.
August, 2000
Possible Answers - Problem 2

$400 $431.01 $452.56
Need a Hint?

Exit until you get Fin Menu. 2nd, Clear Data Choose FIN, then TVM
100 4 5 FV PMT N I% YR 431.01
FVA=100(1.05)3 + 100(1.05)2 + 100(1.05)1 + 100(1.05)0
1
100
2
100
3
100
4
100
August, 2000
Problem #3
What is todays value of a $1,000 face value bond with a 5% coupon rate (interest is paid semi-annually) which has three years remaining to maturity. The bond is priced to yield 8%.
August, 2000
Possible Solutions - Problem 3

$1,000 $921.37 $1021.37
Need a Hint?

Exit until you get Fin Menu. 2nd, Clear Data
FIN 25 1000 4 6 PV TVM PMT FV I% YR N 921.37
1
25
2
25
12
25 1000
August, 2000
Congratulations!
You obviously understand this material. Now try the next problem. The Interactive Exercises are found on slide #37.
August, 2000
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.
August, 2000
How to solve a time value of money problem.

The value four years from today is a future value amount. The expected cash flows of $100 per year for four years refers to an annuity of $100. Since it is a future value problem and there is an annuity, you need to solve for a FUTURE VALUE OF AN ANNUITY.
Valuing a Bond
The interest payments represent an annuity and you must find the present value of the annuity. The maturity value represents a future value amount and you must find the present value of this single amount. Since the interest is paid semi-annually, discount at HALF the required rate of return (4%) and TWICE the number of years to maturity (6 periods).

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The Time Value of Money

The Time Value of Money

The Time Value of Money

How can one compare amounts in different time periods?

Future Value (Graphic)

Future Value (Formula)

= $2,000 (1.06)2 = $2,247.20

Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =

Future Value (HP 17 B II Calculator)

Future Value Example

Future Value Solution

Future Value (HP 17 B II Calculator)

Double Your Money!!!

We will use the Rule-of-72. Rule-of-72

Present Value (Graphic)

Present Value (Formula)

Present Value (HP 17 B II Calculator)

Present Value Example

Present Value Solution

Present Value (HP 17 B II Calculator)

Finding n or i when one knows PV and FV

Frequency of Compounding Example

Solution based on formula:

Future Value, Frequency of Compounding (HP 17 B II Calculator)

Example of an Ordinary Annuity -- FVA

3 $1,000 $1,070 $1,145

FVA3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0 = $3,215

Future Value (HP 17 B II Calculator)

Example of anOrdinary Annuity -- PVA

Present Value (HP 17 B II Calculator)

Multiple Cash Flows Example

Multiple Cash Flow Solution

$10,263.47 = PV0 of the Multiple Cash Flows

Multiple Cash Flow Solution (HP 17 B II Calculator)

CFLO 0 500 600

Bond Valuation Problem

Bond Valuation Solution (HP 17 B II Calculator)

Welcome to the Interactive Exercises

Possible Answers - Problem 1

Solution (HP 17 B II Calculator) Problem #1

Possible Answers - Problem 2

Solution (HP 17 B II Calculator) Problem #2

FVA=100(1.05)3 + 100(1.05)2 + 100(1.05)1 + 100(1.05)0

Possible Solutions - Problem 3

Solution (HP 17 B II Calculator) Problem #3

How to solve a time value of money problem.

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