Chapter 6
Time Value of Money
Slide Prepared by:
Abdullah Al Yousuf Khan
Assistant Professor – IUBAT
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
6.1 INTRODUCTION
• Time value of money is a critical consideration in
financial and investment decisions.
• For example, compound interest calculations are
needed to determine future sums of money resulting
from an investment.
• Discounting, or the calculation of present value, which
is inversely related to compounding, is used to
evaluate future cash flow associated with capital
budgeting projects.
• There are plenty of applications of time value of money
in finance.
• The chapter discusses the concepts, calculations, and
applications of future values and present values.
6.2 FUTURE VALUES-COMPOUNDING
• A dollar in hand today is worth more than a
dollar to be received tomorrow because of the
interest it could earn from putting it in a
savings account or placing it in an investment
account.
• Compounding interest means that interest
earns interest.
6.2
• For the discussion of the concepts of
compounding and time value, let us define:
EXAMPLE 6.1
• George Jackson placed $1,0oO in a savings
account earning 8 percent interest
compounded annually. How much money will
he have in the account at the end of 4 years?
Fn=P(1+i)n
F4=$1,000(1+0.08)4=$1,000×FVIF8,4
From Appendix A, the FVIF for 4 years at 8 percent is
1.3605.
Therefore,
F4=$1,000(1.3605) = $1,360.50
EXAMPLE 6.2
• Rachael Kahn invested a large sum of money in
the stock of TLC Corporation. The company
paid a $3 dividend per share. The dividend is
expected to increase by 20 percent per year
for the next 3 years. She wishes to project the
dividends for years 1through 3.
Fn = P(l + i)n
F1 = $3(1 + 0.2)1 = $3(1.2000) = $3.60
F2 = $3(1 + 0.2)2= $3(1.4400) = $4.32
F3 = $3(1 + 0.2)3= $3(1.7280) = $5.18
Intra-year Compounding
• Interest is often compounded more frequently than once a
year. Banks, for example, compound interest quarterly,
daily, and even continuously. If interest is compounded m
times a year, then the general formula for solving for the
future value becomes
Fn=P(1+i/m)n.m=[Link]/m,n.m
• The formula reflects more frequent compounding (n.m) at a
smaller interest rate per period (i.m). For example, in the
case of semiannual compounding (m = 2), the above formula
becomes;
Fn=P(1+i/2)n.2=[Link]/2,n.2
Continuous Compounding
• As m approaches infinity, the term
Fn=P(1+i/m)n.m approaches ℮i.n , where ℮ is
approximately 2.71828, and F, becomes
Fn=P. ℮ i.n
• The future value increases as m increases.
Thus, continuous compounding results in the
maximum possible future value at the end of n
periods for a given rate of interest.
EXAMPLE 6.3
• Assume that P = $100, i = 12% and n = 3 years.
Then for
Future Value of an Annuity
• An annuity is defined as a series of payments
(or receipts) of a fixed amount for a specified
number of periods.
• Each payment is assumed to occur at the end
of the period.
• The future value of an annuity is a compound
annuity which involves depositing or investing
an equal sum of money at the end of each year
for a certain number of years and allowing it to
grow.
Future Value of Annuity
EXAMPLE 6.4
• Jane Oak wishes to determine the sum of
money she will have in her savings account at
the end of 6 years by depositing $1,000 at the
end of each year for the next 6 years. The
annual interest rate is 8 percent.
The ,is given in Appendix B as 7.336.
Therefore,
S6 = $1,000( )= $1,000(7.336) = $7,336
6.3 PRESENTVALUE-DISCOUNTING
• Present value is the present worth of future sums of
money. The process of calculating present values, or
discounting, is actually the opposite of finding the
compounded future value. In connection with
present value calculations, the interest rate i is called
the discount rate.
Recall that,
FVn= P.(l + i)n
Therefore,
EXAMPLE 6.5
• Ron Jaffe has been given an opportunity to
receive $20,000 6 years from now. If he can
earn 10 percent of his investments, what is the
most he should pay for this opportunity?
• To answer this question, one must compute
the present value of $20,000 to be received 6
years from now at a 10 percent rate of
discount. F6 is $20,000, i is 10 percent, which
equals 0.1, and n is 6 years. PVIF10,6 from
Appendix C is 0.5645.
• Given;
F6 = $20,000
i = 10%
n = 6 years
Present Value of Mixed Streams of Cash
Flows
• The present value of a series of mixed
payments (or receipts) is the sum of the
present value of each individual payment.
• We know that the present value of each
individual payment is the payment times the
appropriate PVIF.
EXAMPLE 6.6
• Candy Parker has been offered an opportunity
to receive the following mixed stream of
revenue over the next 3 years:
Year Revenue
1 $1,000
2 2,000
3 500
• If she must earn a minimum of 6 percent on
her investment, what is the most she should
pay today?
Year Revenue ($) x PVIF = Present Value
1 1,000 0.943 $943
2 2,000 0.890 1,780
3 500 0.840 420
$3,143
Present Value of an Annuity
• Interest received from bonds, pension funds, and insurance
obligations all involve annuities.
• To compare these financial instruments, we need to know the
present value of each.
• The present value of an annuity (Pn) can be found by using the
following equation:
Present Value of an Annuity
Perpetuities
• Some annuities go on forever. Such annuities
are called perpetuities. An example of a
perpetuity is preferred stock which yields a
constant dollar dividend indefinitely. The
present value of a perpetuity is found as
follows:
Applications of Future Values and
Present Values
• Deposits to Accumulate a Future Sum (or
Sinking Fund).
• Amortized Loans.
• Annual Percentage Rate (APR)
• Rate of Growth.
• Bond Values.
Sinking Fund
• An individual might wish to find the annual
deposit (or payment) that is necessary to
accumulate a future sum.
• To find this future amount (or sinking fund) we
can use the formula for finding the future
value of an annuity.
Sinking fund amount= A= S/PVIFAi,n
Sinking Fund
• Mary Czech wishes to determine the equal annual end-of-year
deposits required to accumulate $5,O00 at the end of 5 years
when her son enters college. The interest rate is 10 percent.
The annual deposit is:
• In other words, if she deposits $819 at the end of each year for
5 years at 10 percent interest, she will have accumulated
$5,000 at the end of the fifth year.
Loan Amortization
• If a loan is to be repaid in equal periodic
amounts, it is said to be an amortized loan.
Examples include auto loans, mortgage loans,
and most commercial loans. The periodic
payment can easily be computed as follows:
Amount of loan =A= P/PVIFA
Amortization
• Jeff Balthness has a 40-month auto loan of
$5,000at a 12 percent annual interest rate. He
wants to find out the monthly loan payment
amount.
• So, to repay the principal and interest on a
$5,000, 12 percent, 40-month loan, Jeff
Balthness has to pay $152.28 a month for the
next 40 months.
Amortization Schedule
• Assume that a firm borrows $2,000 to be
repaid in three equal installments at the end of
each of the next 3 years. The bank wants 12
percent interest. Compute the amount of each
payment.
Amortization Schedule
Annual Percentage Rate (APR)
• Different types of investments use different compounding
periods.
• For example, most bonds pay interest semiannually; banks
generally pay interest quarterly.
• If an investor wishes to compare investments with different
compounding periods, he or she needs to put them on a
common basis.
• The annual percentage rate (APR), or effective annual rate, is
used for this purpose and is computed as follows:
Rate of Growth
• Assume that the Geico Company has earnings
per share of $2.50 in 19x1,and 10years later
the earnings per share has increased to $3.70.
The compound annual rate of growth of the
earnings per share can be computed as
follows:
Bond Value
• Bonds call for the payment of a specific
amount of interest for a stated number of
years and the repayment of the face value at
the bond’s maturity. Thus, a bond represents
an annuity plus a lump sum.
• Its value is found as the present value of this
payment stream. The interest is usually paid
semiannually.
Bond Valuation
Bond Valuation
• Assume there is a 10-year bond with a 10
percent coupon, paying interest semiannually
and having a face value of $1,0o0. Since
interest is paid semiannually, the number of
periods involved is 20 and the semiannual cash
inflow is $10012 = $50.
Assume that investorshave a required rate of
return of 12 percent for this type of bond.
Then, the present value (V) of this bond is: