Chapter 4: The Role of Time Value in To make the right investment decision,

Finance managers need to compare the cash flows

at a single point in time.
Most financial decisions involve costs &
benefits that are spread out over time. Figure 5.1 Time Line

Time value of money allows comparison of

cash flows from different periods.

Question: Your father has offered to give

you some money and asks that you Figure 5.2 Compounding and Discounting
choose one of the following two
alternatives:

– $1,000 today, or

– $1,100 one year from now.

What do you do?

The answer depends on what rate of Basic Patterns of Cash Flow

interest you could earn on any money you The cash inflows and outflows of a firm
receive today. can be described by its general pattern.
For example, if you could deposit the The three basic patterns include a single
$1,000 today at 12% per year, you would amount, an annuity, or a mixed stream:
prefer to be paid today.

Alternatively, if you could only earn 5% on

deposited funds, you would be better off if
you chose the $1,100 in one year.

Future Value versus Present Value

Suppose a firm has an opportunity to

spend $15,000 today on some investment
Future Value of a Single Amount
that will produce $17,000 spread out over
the next five years as follows: Future value is the value at a given future
date of an amount placed on deposit
today and earning interest at a specified
rate. Found by applying compound
interest over a specified period of time.

• Compound interest is interest that is

earned on a given deposit and has
Is this a wise investment? become part of the principal at the end of
a specified period.
• Principal is the amount of money on money will be in the account at the end of
which interest is paid. five years.

Personal Finance Example

If Fred Moreno places $100 in a savings

account paying 8% interest compounded
annually in 1 year, how much will he have
at the end of 1 year?

Figure 5.4 Future Value Relationship

If Fred were to leave this money in the

account for another year, how much
would he have at the end of the second
year?

• We use the following notation for the Present Value of a Single Amount
various inputs:
• Present value is the current dollar value
of a future amount—the amount of
money that would have to be invested
today at a given interest rate over a
specified period to equal the future
• The general equation for the future amount.
value at the end of period n is • It is based on the idea that a dollar today
FV n = PV × (1 + r) n is worth more than a dollar tomorrow.

• Discounting cash flows is the process of

finding present values; the inverse of
compounding interest.

• The discount rate is often also referred

to as the opportunity cost, the discount
rate, the required return, or the cost of
capital.

Future Value of a Single Amount:

Personal Finance Example
The Equation for Future Value
Paul Shorter has an opportunity to receive
Jane Farber places $800 in a savings
$300 one year from now. If he can earn
account paying 6% interest compounded
6% on his investments, what is the most
annually. She wants to know how much
he should pay now for this opportunity?
Present Value of a Single Amount:

The Equation for Present Value

Figure 5.5 Present Value Relationship
The present value, PV, of some future
amount, FV n, to be received n periods
from now, assuming an interest rate (or
opportunity cost) of r, is calculated as
follows:

Annuities
Ordinary Calculator An annuity is a stream of equal periodic
cash flows, over a specified time period.
Paul Shorter has an opportunity to receive
These cash flows can be inflows of returns
$300 one year from now. If he can earn
earned on investments or outflows of
6% on his investments, what is the most
funds invested to earn future returns.
he should pay now for this opportunity?
$283.02 – An ordinary (deferred) annuity is an
annuity for which the cash flow occurs at
PV of 1
the end of each period.
Press “[Link]”
– An annuity due is an annuity for which
Press “Divide” button TWICE the cash flow occurs at the beginning of
Press “equal” button equivalent to the each period.
number of periods – An annuity due will always be greater
Present Value of a Single Amount: than an otherwise equivalent ordinary
annuity because interest will compound
The Equation for Future Value for an additional period.
Pam Valenti wishes to find the present
value of $1,700 that will be received 8
years from now. Pam’s opportunity cost is Personal Finance Example
8% Fran Abrams is choosing which of two
annuities to receive. Both are 5-year
$1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due.
Fran has listed the cash flows for both
annuities as shown in Table 5.1 on the Press “equal” button equivalent to (one
following slide. minus the number of periods) Ex: 10 yrs,
to press it (1-10) 9 times
Note that the amount of both annuities
totals $5,000. Deduct the constant number “1”

Table 5.1 Comparison of Ordinary Divide it with the rate

Annuity and Annuity Due Cash Flows
Personal Finance Example
($1,000, 5 Years)
Fran Abrams wishes to determine how
much money she will have at the end of 5
years if he chooses annuity A, the ordinary
annuity and it earns 7% annually. Annuity
A is depicted graphically below:

Finding the Future Value of an Ordinary

Annuity
Finding the Present Value of an Ordinary
• You can calculate the future value of an
Annuity
ordinary annuity that pays an annual cash
flow equal to CF by using the following • You can calculate the present value of an
equation: ordinary annuity that pays an annual cash
flow equal to CF by using the following
equation:

• As before, in this equation r represents

the interest rate and n represents the
number of payments in the annuity (or • As before, in this equation r represents
equivalently, the number of years over the interest rate and n represents the
which the annuity is spread). number of payments in the annuity (or
equivalently, the number of years over
Ordinary Calculator
which the annuity is spread).
Future value of Ordinary Annuity
Present Value of ordinary annuity
Press “[Link]”
Press “[Link]”
Press “multiply” button TWICE
Press “divide” button TWICE
Press “equal” button and “M+” equivalent
to number of periods

Press “MR” • FV AD= (FV OA) X (1+R)

Finding the Present Value of an Ordinary • =5750.74 X (1.07)= 6153.29
Annuity (cont.)
• As before, in this equation r represents
Braden Company, a small producer of the interest rate and n represents the
plastic toys, wants to determine the most number of payments in the annuity (or
it should pay to purchase a particular equivalently, the number of years over
annuity. The annuity consists of cash flows which the annuity is spread).
of $700 at the end of each year for 5
Ordinary Calculator
years. The required return is 8%.
Future Value of Annuity Due

Press “[Link]”

Press “multiply” button TWICE

Press “equal” button equivalent to (one

minus the number of periods) Ex: 10 yrs,
to press it (1-10) 9 times
Table 5.2 Long Method for Finding the
Deduct the constant number “1”
Present Value of an Ordinary Annuity
Multiply it with the constant number “1”
plus the rate ([Link])

Finding the Present Value of an Annuity

Due

• You can calculate the present value of an

ordinary annuity that pays an annual cash
flow equal to CF by using the following
equation:

Finding the Future Value of an Annuity

Due

• You can calculate the present value of an

annuity due that pays an annual cash flow • As before, in this equation r represents
equal to CF by using the following the interest rate and n represents the
equation: number of payments in the annuity (or
equivalently, the number of years over
which the annuity is spread).

Ordinary Calculator

Present Value of Annuity Due

Press “[Link]”

Press “divide” button TWICE

Press “equal” button and “M+” equivalent

to (one minus number of periods) Ex: 10
yrs, to press it (1-10) 9 times

Press “MR”

Add the constant number “1”

Finding the Present Value of a Perpetuity

• A perpetuity is an annuity with an

infinite life, providing continual annual
cash flow.

• If a perpetuity pays an annual cash flow

of CF, starting one year from now, the
present value of the cash flow stream is

PV = CF ÷ r

Personal Finance Example

Ross Clark wishes to endow a chair in

finance at his alma mater. The university
indicated that it requires $200,000 per
year to support the chair, and the
endowment would earn 10% per year. To
determine the amount Ross must give the
university to fund the chair, we must
determine the present value of a $200,000
perpetuity discounted at 10%.

PV = $200,000 ÷ 0.10 = $2,000,000