BUSINESS

FINANCE

Week 5 and 6
Time Value of Money

Ayesha Ashraf
Department of Commerce
University of Sahiwal
 Learning Objectives
• To know why time value of money is important?
• To understand what is time line ?
• To describe and understand future value of money along with practice
questions.
• To describe and understand present value of money along with practice
questions.
• To understand the concept of annuity in context of FV and PV.
 Why Time?

Which would you prefer -- $10,000 today or $10,000 in 5 years?

Why is TIME such an important element in your decision?
 Cont.…
• TIME allows us the opportunity to postpone consumption and earn
INTEREST.
• Type of Interest
Simple interest
• Interest paid (earned) on only the original amount, or principal,
borrowed (lent).
Compound interest
• Interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent).
 Time lines
• Graphical representation used to show the timing of cash flows.
Outflow
• A cash deposit, cost, or amount paid. It has a minus sign.
Inflow
• A cash receipt.
0 I%
1 2 3

CF0 CF1 CF2

 Future Value
• Future Value is the value at some future time of a present amount of
money, or a series of payments, evaluated at a given interest rate.
• The amount to which a cash flow will grown over a given period of time
when compounded at a given interest rate.
 For 1 year
• FV=PV(1 + I)
• In general,
• FVN = PV(1 + I)N
 Question
• PV = $100
• i = 10%
• N=2
• FV = ?
 Question FV (simple interest)
• Assume that you deposit $1,000 in an account earning 7% simple
interest for 1 year. What is the interest at the end of year?
• = P0(i)(n)
• = $1,000(.07)(1)
• = $70
FV = P0 + SI
= $1,000 + $70
= $1,070
 Question FV (simple interest)
• Assume that you deposit $1,000 in an account earning 7% simple
interest for 2 years. What is the accumulated interest at the end of the
2nd year?
• = P0(i)(n)
• = $1,000(.07)(2)
• = $140
FV = P0 + SI
= $1,000 + $140
= $1,140
 FV of Single Deposit
• Assume that you deposit $1,000 at a compound interest rate of 7%
for 2 years.

FV1 = P0 (1+i)1
= $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000 deposit over the first year.
This is the same amount of interest you would earn under simple interest
 Question (Cont’d)
FV1 = P0 (1+i)1
= $1,000 (1.07)
= $1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)(1.07)
= P0 (1+i)2 = $1,000(1.07)2 = $1,144.90

You earned an EXTRA $4.90 in Year 2 with compound over simple interest.
FV of an Initial $100 after 3 years (I = 10%)

0 1 2 3
10%

100 FV = ?
Finding FVs (moving to the right on a time line)
is called compounding.

12
 After 1 year

FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.10)
= $110.00

13
 After 2 years

FV2 = FV1(1+I) = PV(1 + I)(1+I)

= PV(1+I)2
= $100(1.10)2
= $121.00

14
 After 3 years

FV3 = FV2(1+I)=PV(1 + I)2(1+I)

= PV(1+I)3
= $100(1.10)3
= $133.10

15
 Question

1. You have Rs.20,000 on hand that you plan to use to purchase a

cell phone after 3 years. The phone supposed to pay 4 percent
interest annually.
a. How much money will you have when it matures?
b. What if the interest rate increase from 4 to 10 percent?
2. Miss Hira wants to know how large her deposit of $10,000
today will become at a compound annual interest rate of 10% for
5 years.
 Question (Cont’d)
1. Assume you deposit $10,000 today in an account that pays 6
percent interest. How much will you have in five years?
2. Suppose you have just celebrated your 19th birthday. A rich
uncle has set up a trust fund for you that will pay you
$150,000 when you turn 30. If the relevant discount rate is 9
percent, how much is this fund worth today?
3. You’ve been offered an investment that will double your
money in 10 years. What rate of return are you being offered?
 Guess..
• Assume that you need $1,000 in 2 years. How much you need
to deposit today at a discount rate of 7% compounded annually.
• Present Value is the current value of a future amount of
money, or a series of payments, evaluated at a given interest
rate.
 Present Value
Present Value (PV)
• The value today of a future cash flow or series of cash flows.
Opportunity Cost Rate
• The rate of return on the best available alternative investment of
equal risk.
Discounting
• The process of finding the present value of a cash flow or a
series of cash flows; discounting is the reverse of compounding.
 Solving for Interest Rate and Time

Solving for i
• Suppose we buy a security at a price of Rs.10,000, and it will
pay us Rs.1000000 after five years. Here we know PV, FV, and
n, and we can find i.
Solving for n
• Suppose we buy a security at a price of Rs.10,000, and it will
pay us Rs.100000 at 10% rate. Here we know PV, FV, and i,
and we can find n.
 Questions
• What’s the PV of 11000 due in 1 year if I/Yr = 10%?
• Emerson Cammack wishes to purchase an contract that will pay
him 70,0000 after 20 years at 6% compound interest rate. What
is the PV of contract?
• Invest 10000 today earning 10% & need 150000. How long
will it take?
• Deposit 15000 today. You need 1000000 in 4 years. What’s
the annual interest rate if the money is compounded yearly?
 Question
• You estimate that you will need about 80,000 to buy a gadget in
8 years. You have about 35000 now. If you can 20% per year,
will you make it? At what rate will you just reach your goal?
 Suppose…
• How much will you have at the end of 10 year if your boss
withholds and invest 10000 at the end of next 10 years by
guaranteeing you a 10% annual rate of return?
FUTURE VALUE OF AN ANNUITY
 Future Value of An Annuity
Annuity
• A series of payments of an equal amount at fixed intervals for a
specified number of periods.
– E.g. 2000000 at the end of each of the next 10 years is a 10-year annuity.
• Ordinary (Deferred) Annuity
– Car Loan Payments
• Annuity Due
– Life insurance premiums
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

Today $100 $100 $100

 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
 Formula
• FVAn = R(1+i)n-1 + R(1+i)n-2 + R(1+i)n-3 + R(1+i)0
• Where
– FVAn =The future value of an annuity over n periods.
– R=PMT= Fixed payments
 Question
• If you deposit $100 at the end of each year for three years in a
savings account that pays 5 percent interest per year, how much
will you have at the end of three years?
• If you deposit $7500 at the end of each year for three years in a
savings account that pays 3 percent interest per year, how much
will you have at the end of three years?
PRESENT VALUE OF AN ANNUITY
 Present Value of an Annuity

• PVAn
The present value of an annuity of n periods.

– Present Value Interest Factor for an Annuity (PVIFAi,n)

The present value interest factor for an annuity of n periods discounted at i percent.
 Questions
• What amount today deposited in a bank account paying 3%
annually would allow you to withdraw 7500 at the end of each
of the next three years?
• How would you answer the proceeding question change if now
you wanted to withdraw 3750 at the end of the each of next
three year?
• What if you still wanted to withdraw 7500 at the end of the
next three years but with 6% interest rate?
 Reference
For further reading see the book
• Brigham, E. F. (2015). Fundamentals of financial management.
 Questions
• In case of any query contact me at: [email protected]
• You can also ask questions via Google Classroom
Thank you