Lecture 3: The Time Value of Money

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The learning outcomes

At the end of this session you should be able to:

▪ Understand the concept of the time value of money
▪ Differentiate between types of interest rate
▪ Be able to calculate a Future Value (FV) and Present Value (PV)
▪ Understand and be able to use financial tables
▪ Calculate the present values of multiple cash flows, annuities and
perpetuities
▪ Cope with non-standard annuities and perpetuities
▪ Distinguish between real and nominal cash flows and interest rates
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The timeline

Date 0:
Date 1:
Date 2:
Example: Suppose you must pay tuition of $10,000 per year for the next two years. Your tuition
payments must be made in equal installments at the start of each semester. What is the timeline of
your tuition payments?
5-4

Assuming today is the start of the first semester, your first payment occurs at date 0
(today). The remaining payments occur at semester intervals. Using one semester as the
period length, we can construct a timeline as follows:
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Future and Present Values

❑ Capital markets allow for the movement of money over time

❑ Several ways to receive money in the future
A one off payment e.g. inheritance, lottery win
A regular stream of payments e.g. salary, interest

▪ The Future Value (FV) is the actual amount you get, that is the
number of pounds you receive in your hand, at the future date –
i.e. the cash flow
▪ This differs from the Present Value (PV) which is what that future
cash flow is worth TODAY
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Indifference

Receive money
today Receive money in the future

Present Value Future Value

PV FV
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Interest rates

❑ Many investments pay interest. The rate of interest (r) can be:
▪ Fixed – stays the same for the whole life of the investment
▪ Variable – can change during the life of the investment
❑ There are two basic types of interest rates:
▪ Simple Interest: Interest is earned ONLY on the original investment
▪ Compound Interest: Interest is earned on the original investment AND on any interest already
earned in previous periods
 Simple Interest Rates

Example

Interest earned at a simple interest rate of 8% pa

for four years on a principal balance of £200

Year 0 1 2 3 4
Interest Earned 16 16 16 16
Cumulative Value 200 216 232 248 264

8
 Compound Interest Rates

Example
Interest earned at an annual compound interest
rate of 8% for four years on a principal balance of
£200.

Year 0 1 2 3 4
Interest Earned 16 17.28 18.66 20.16
Cumulative 200 216 233.28 251.94 272.10
Value 9
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Compounding & Future Values

Rather than work out the interest year by year we can use a simple
formula to work out the FV

t
FV = C  (1 + r )
Example
What is the future value of £200 received today if it earns compound interest at
8% per year for four years?

4
FV = £200 (1 + 0.08) = £272.10
The Composition of Interest over Time
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Future Values with Compounding

7000

6000 0%
5%
5000 10%
FV of £100

4000 15%
Interest Rates
3000

2000

1000

0
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
Number of Years
Wheat and the
chessboard
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❑ Question 1: How much would £120 be worth in 9 years if it was invested today at a
compound interest rate of 7%?

❑ Question 2: Suppose £350 were to be invested for 10 years at a compound

interest rate of 9%, how much interest would be earned:
▪ Just in Year 3 alone?
▪ In total by the end of Year 3?
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❑ Question 1: How much would £120 be worth in 9 years if it was invested today
at a compound interest rate of 7%?

Answer:

FV = C x (1 + r)t

Here we have: C = 120, r = 0.07, t = 9

Hence: FV = 120 x (1 + 0.07)9 = 120 x 1.8385 =
£220.62
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❑ Method One:

At the end of Yr 2, total value would be:

= 350 x (1+0.09)2 = £415.835

Interest earned in Yr 3 = £415.835 x 0.09 = £37.425

❑ Method Two:

At the end of Yr 2, total value would be:

= 350 x (1+0.09)2 = £415.835
At the end of Yr 3, total value would be:
= 350 x (1+0.09)3 = £453.26
Interest earned in Yr 3 = 453.26 – 415.835 = £37.425

▪ Total Int. earned by end of Yr 3 = 453.26 – 350 = £103.26

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Interest Frequency

▪ So far we have assumed interest is paid only once a year

▪ If interest is paid annually i.e. in one go at the end of the year:
“Compounding” effect only kicks in the following year
Have to wait until Year 2 to start earning interest on the interest paid in Year 1
▪ What happens if interest is paid twice a year?
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Interest Frequency

❑ Suppose you invest £200 at 8% for one year, but received interest every 6
months
▪ After six months get 4% of £200
= 0.04 x 200 = 8 = £8
▪ For the following six months:
Receive interest on the original £200
Receive interest on the £8 interest
▪ So interest payment for second half of year:
= 0.04 x 208 = 8.32 = £8.32
▪ Total FV = £200 + £8 + £8.32 = £216.32
▪ Recall if interest paid annually FV= £216
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Interest Frequency

▪ For a given headline rate of interest, the more frequently interest is

compounded, the higher the FV will be

▪ £200 invested at 8% for 4 years will be worth

£272.10 if interest compounded annually
£273.71 if interest compounded half-yearly
£275.13 if interest is compounded monthly
£275.36 if interest is compounded weekly
£275.43 if interest is compounded instantaneously

▪ Thus more frequent compounding is:

Good for savers
Bad for borrowers
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Annual Percentage Rate (APR)

▪ APR is used to describe the true cost of borrowing money. It takes into account:
The headline interest rate
Interest frequency (e.g. monthly or annually)
Any initial fees for setting up the loan
Any other costs you HAVE to pay

▪ In the UK all lenders are forced to calculate APR in exactly the same way
This makes it easy to compare loans
[Link]

▪ Note, definitions may vary across countries:

The US APR is not the same as the UK APR
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▪ APR applied to borrowing money

▪ There is a similar convention for savings called the Annual

Equivalent Rate (AER)

▪ AER tells you the true rate of interest you will have received
by the end of the year. So takes into account:
How often interest is paid
Promotional offers that disappear after an initial period

▪ In the US, the equivalent figure is called the “Annual

Percentage Yield” or APY
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FVs & PVs

❑ Recall FVs are the values of cash flows at some point in the future e.g. If r = 10%
If you receive £100 in Yr 4
▪

Clearly it is worth £100 in Yr 4

If you receive £100 now
▪

It would be worth £100 x (1+0.1)4 = £146.41 in Yr 4

If you receive £100 next year
▪

It would be worth £100 x (1+0.1)3 = £133.1 in Yr 4

▪ PVs tell you what those FVs or cash flows are worth today
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Present Values

Future Value after t periods

PV = t
(1+ r)
C
Generally we write this as: PV = t
(1+ r)
C = the future value of cash flow to be received
r = interest rate (or often called the discount rate)
t = number of years
Note: For the remainder of this module, r will always refer to an annually compounded
interest rate unless otherwise stated
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Present Values

Example I
Assuming an interest rate of 9%, how much would £100 to be received in 1 years
time be worth today?

PV = 100
(1+ 0.09)1 = £91.74
Example II
Assuming an interest rate of 5%, how much would £350 to be received in 9 years
time be worth today?

PV = 350
9 = £225 .61
(1+ 0.05)
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Recall Lecture One?

▪ We said decisions involved three elements

Time, Money & Risk

C
PV = t
(1+ r)
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Discounting

▪ Working out PVs can take a long time!

▪ In Example II we had r = 5% and t =9. If we knew what £1 was worth in

this situation, working out what £350 was worth would be easy!

▪ “Discount Factors” tell us exactly that, and so can speed things up

They tell you what £1 to be received a certain number of years in the
future, is worth today given a certain interest rate
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A Discount Factor (DF)

DF = 1
(1+ r ) t

Once you have the discount factor, multiply it by the future cash flow to get
the PV

In Example II we had r = 5% and t =9 so

1
DF = = 0.6446
(1 + 0.05 )9

Hence PV is 350 x 0.6446 = £225.61

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Discount Tables

Year/Rate 1% 2% 3% 4% 5% 6%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584
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Future Value Tables

Year/Rate 1% 2% 3% 4% 5% 6%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908
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Activity 2

❑ Assuming an interest rate of 6%:

1. What would be the value in five years (i.e. the FV) of £153 received today

2. What would be the value today (i.e. the PV) of £270 to be received in three years
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PV of Multiple Cash Flows

▪ PVs are “additive”

▪ If you have multiple cash flows

Can find the PV of each cash flow and add together to get the total present value
e.g. Suppose we have one cash flow each year for three years

▪ In theory we can add as many cash flows as we want

C1 C2 C3
PV = 1 + 2 + 3
(1+ r ) (1+ r ) (1+ r )
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What Do PVs Tell Us?

▪ The total PV of a set of cash flows tells us

The total value of all cash flows TODAY

▪ Investors will be indifferent between the set of cash flows and the total PV

▪ If you are receiving money

Want total PV to be as high as possible

▪ If you are paying money

Want total PV to be as low as possible
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PV of Multiple Cash Flows

Example
You treat yourself to a new car. The car dealer gives you the choice of paying £15,500
cash now, or making three instalment payments: £8,000 now and £4,000 at the end of
each of the next two years. If your cost of money is 8%, which do you prefer?

Present Value of instalments

4000 4000
= 8,000 + +
(1 + 0.08) (1 + 0.08)
1 2

PV = 8000 + 3703 .70 + 3429 .36 = £15,133 .06

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Moving Money Through Time

❑ To summarise:

▪ To move money forward in time i.e. to work out future values, we multiple by
(1+r) for each year
So amounts get bigger

▪ To move money back in time i.e. to work out present values, we divide by (1+r)
for each year
So amounts get smaller
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Example - Indifference

❑ If the interest discount rate is 12%

▪ Investor should be indifferent between
Receiving £500 in Year 4, and £317.76 now

£500
-4 years -2 years +1 year +3 years +5 years

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9
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Perpetuities & Annuities

Annuity
▪An annuity is an equally spaced stream of identical cash flows for a fixed
number of years
Perpetuity
▪A perpetuity is an equally spaced stream of identical cash flows that
never ends
▪ A standard annuity/perpetuity is one where the cash flows occur once a
year and start exactly one year from today
 Valuing an Annuity
Valuing an Annuity

▪ As an annuity is just a set of multiple cash flows

we can use the same method as before

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Example
Example

▪ Suppose an annuity will pay £100 per year for 8 years, starting next year. If
the interest rate is 6% what is it worth today i.e. what is its PV?

100 100 100

PV = + + ..... +
(1 + 0.06) (1 + 0.06)
1 2
(1 + 0.06)8

PV = 94.34 + 89.00 + 83.96 + ..... + 62.74 = £620.98

39
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Annuity Factors

Working out annuity values can also take a long time, so again we use a
short cut and can look up “Annuity Factors”

The annuity factor At,r% is simply the value of receiving £1 per year, starting
next year, for t years at an interest rate of r%

The PV of a standard annuity paying C per year is then just equal to C x the
Annuity Factor
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Annuity Tables

Year/Rate 1% 2% 3% 4% 5% 6%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601
 Annuity Factor Formula

The annuity factor At,r% in the tables is given by the formula:

1 1 
At ,r % = − 
 r r (1 + r ) 
t

Note: As you are given Annuity tables there is no need to remember this formula
unless you want to!

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 Annuity Example

In our previous example we had an annuity of £100 for 8 years at an interest

rate of 6%

100 100 100

PV = + + ... + = £620.98
1 + 0.06 (1 + 0.06)2
(1 + 0.06)8

Alternatively we could say that the Annuity Factor for A8years, 6% is 6.2098 (from
the annuity tables) and therefore:

PV = £100 x 6.2098 = £620.98

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 Perpetuities

A perpetuity is also a set of multiple cash flows

PV = C
(1+ r )1 + C
(1+ r ) 2 + C
(1+ r ) 3 + ...............
But as they never end cannot calculate it bit by bit. However, can show that if we
could add every single bit of a standard perpetuity, we would get the same answer
as that given by:

PV of perpetuity = C
r

C = Annual payment r = interest rate 44

45

Example - Perpetuity
You have won a competition where the prize is £50 a year for ever starting next year.
Interest rates are 7%. What is the PV of the prize?

PV = 50
0.07 = £714.29
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Activities 3

❑ Assuming an interest rate of 6% calculate:

1. PV of a four year annuity of £50 per year where first payment is received one
year from today

2. PV of a perpetuity of £50 per year where first payment is received one year from
today
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Activities 3 answer

❑ Assuming an interest rate of 6% calculate:

1. PV of a four year annuity of £50 per year where first payment is

received one year from today
50 50 50 50
PV = 1 +
(1+0.06) 2 +
(1+0.06) 3 +
( 1+0.06)4 = 173.26
( 1+0.06)

2. PV of a perpetuity of £50 per year where first payment is received one

year from today

50
PV = 0.06
= 833.33
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Timing of Cash Flows

▪ Remember the annuity factors and C/r formula are for STANDARD annuities
and perpetuities
i.e. first cash flow must be one year away

▪ In practice, cash flows may start today, or they may not start for 3 years, or 6
years, or 20 years

▪ In these cases we may need to work out the total value in stages
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Timing is Everything

▪ Example: What is the present value of £100 per year for ever, starting in 3
years time, if the interest rate is 7%?
▪ This looks like a perpetuity, but the timing is wrong. We can get round this in
two ways
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Method One

▪ Start by valuing a standard perpetuity and then add or subtract any extra or missing
payments
▪ If the payments started in one year we could say
PV = C / r = 100/0.07 = £1428.57
▪ Here cash flows only start in Year 3, i.e. we miss out on the cash flows in Year 1 and
Year 2
£100 received in Yr 1 has a PV of £100/1.07 = £93.46
£100 received in Yr 2 has a PV of £100/1.072 = £87.34
▪ Thus total PV of our cash flows is:
1428.57 – 93.46 – 87.34 = £1247.77
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Method Two

❑ Value the cash flows at an easy point in time and then move that value to
the present time

❑ For our cash flows, it is easy to value them in Year 2.

▪At this point, cash flows now start one year away
So we can use the C/r formula
▪In Yr 2 the cash flows have a total value of
C/r = 100/0.07 = £1428.57

❑ But that is the value in two years time. We want the value today, so we
need to discount it by two years i.e. divide by (1+r) twice

▪ Thus present value = 1428.57/1.072 = £1247.77

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Nominal v Real Cash Flows

❑ Two types of cash flow:

▪ Nominal cash flows: No inflation adjustment

▪ Real cash flows: With adjustment for inflation

Nominal cash flows = real cash flows x (1 + i)

where i = the general rate of inflation as a decimal
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Nominal v Real Interest Rates

❑ Two types of interest rate:

▪ Nominal interest rates includes the general rate of inflation

It is almost always the nominal interest rate that is quoted

▪ Real interest rates do not include inflation:

But would compensate the investor for time and risk

▪ Approximately: nominal rate ~ real rate + rate of inflation

More precisely: (1 + rN) = (1 + rR) x (1 +i)

where: rN = nominal rate of interest; rR = real rate of interest, i = inflation rate
54

Nominal v Real cash Flows

▪ Must always use either:

Real rates and real cash flows
Nominal rates and nominal cash flows
Never mix the two!

▪ Example
What is the PV of a real cash flow of £10,000 in 6 years if the nominal rate
of interest is 7.1% and the general rate of inflation is 2%?
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Nominal v Real cash Flows

▪ Use real cash flows and real interest rate

Real cash flow = £10,000
1 + rR = (1+rN)/(1+i) =1.071/1.02 = 1.05
So real interest rate = rR= 5%
PV = 10,000 / (1.05)6 = £7,462

▪ Use nominal cash flows and nominal rates

Nominal cash flow = 10,000 x 1.026
So nominal cash flow = £11,262
Nominal interest rate = 7.1%
PV = 11,262 / (1.071)6 = £7,462
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CONCLUSIONS

▪ The Time Value of Money is a crucial concept in finance:

Make sure you try the seminar questions and the lecture activities

You must get to grips with it in order to understand the remainder of the course!

Putting in some extra effort here will save you a whole lot of time and effort later in the
module