THE TIME VALUE OF MONEY

Dr. Çiğdem AKBAŞ

Introduction to Corporate Finance
Introduction
• Money has time value.
• This simply means that it is better to
have $1 today than to receive $1 in the
future. The logic of this claim is
straightforward – if you have $1 in hand
today, you can invest it and earn interest,
which means that you will have more
than $1 in the future.
• Thus, the time value of money is a
financial concept recognising that the
value of a cash receipt (or payment)
depends not just on how much money
you receive, but also on when you
receive it.
• A simple example illustrates the essence of the
time value of money.
• Suppose you have $100 today, and you can put
that sum into an investment that pays 5%
interest per year. If you invest $100 now, by
the end of one year you will earn $5 in interest
(0.05 × $100 = $5). Your $100 initial
investment will have grown to $105 in one
year ($5 in interest plus the original $100
investment).
• In a sense, then, receiving $100 now is
equivalent to receiving $105 in one year.
Whether you receive $100 now and invest it at
5%, or whether you have to wait a year to
receive $105, you wind up with the same
amount of cash.
• In this case, we would say that $105 is the
future value of $100 invested for one year at
5%. More generally, the future value is the
value of a cash receipt or payment as at some
future date.
• We can reframe the above example to illustrate
another dimension of the time value of money.
• Suppose you have no money today, but you
expect to receive $105 in one year. Suppose
also that a bank is willing to lend you money,
charging an interest rate of 5%.
• How much would they lend you today if you
promise to pay them the $105 that you will
receive next year? From the calculations
above, you can probably guess that the answer
is $100. The bank will give you $100 today in
exchange for a payment next year of $105.
Here, $100 is the present value of $105 to be
received in one year when the interest rate is
5%.
• More generally, the present value is just the
value of a future cash receipt or payment in
terms of today’s dollars.
THE CONCEPT OF FUTURE
VALUE
• We can calculate the future value of an investment made
today by applying either simple interest or compound
interest over a specified period of time.
• Simple interest is interest paid only on the initial principal
of an investment. Principal is the amount of money on
which the interest is paid. To demonstrate, if the
investment in our previous example pays 5% simple
interest, then the future value in any year equals $100 plus
the product of the annual interest payment and the number
of years. In this case, its future value would be $110 after
two years [$100 + (2 × $5)], $115 in three years [$100 + (3
× $5)], $120 at the end of the fourth year [$100 + (4 × $5)],
and so on.
• Compound interest is interest earned both on the initial
principal and on the interest earned in previous periods. To
demonstrate compound interest, assume that you have the
opportunity to deposit $100 into an account paying 5%
annual interest. After one year, your account will have a
balance of $105. This sum represents the initial principal of
$100 plus 5% ($5) in interest. This future value is
calculated as follows:
• Future value after one year = $100 × (1 + 0.05) = $105
• If you leave this money in the account for another year, the
investment will pay interest at the rate of 5% on the new principal
of $105. In other words, you will receive 5% interest both on the
initial principal of $100 and on the first year’s interest of $5. At the
end of this second year, there will be $110.25 in your account,
representing the principal at the beginning of year 2 ($105) plus 5%
of the $105, or $5.25, in interest.1
• The future value at the end of the second year is computed as
follows:
• It is important to recognise the difference in
future values resulting from compound
versus simple interest. Although the
difference between the account balances for
simple versus compound interest in this
example ($110 versus $110.25) seems rather
trivial, the difference grows exponentially
over time.
• With simple interest, this account would have
a balance of $250 after 30 years [$100 + (30
× $5)];
• With compound interest, the account balance
after 30 years would be $432.19.
 • Because financial analysts routinely use compound interest, we
THE EQUATION generally use compound rather than simple interest.
FOR FUTURE • Equation 3.1 gives the general algebraic formula for calculating
VALUE the future value, at the end of n periods, of a lump sum invested
today at an interest rate of r% per period:
EXAMPLE
• You have an opportunity to invest $100 cash
in a bank savings account that pays 6% annual
interest. You would like to know how much
money you will have at the end of five years.
• Substituting PV = $100, r = 0.06, and n = 5
into Equation 3.1 gives the future value at the
end of year 5:
• FV = $100 × (1 + 0.06)5 = $100 × (1.3382) =
$133.82
• Your account will have a balance of $133.82 at
the end of the fifth year, so your investment
grew by $33.82.
 PRESENT VALUE OF A LUMP SUM
RECEIVED IN THE FUTURE
• So far we have examined how to project the amount of cash that
builds over time as an initial investment earns interest. Now we
reverse that focus, asking what an investor would pay today in
exchange for receiving a lump-sum payment at some point in the
future. In other words, we want to know the present value of the
future cash flow.
• In finance, we use the term discounting to describe the process of
calculating present values. The technique of discounting helps us to
answer this question: If I can earn r% on my money, then what is the
most I would be willing to pay now for the opportunity to receive FV
dollars n periods from today?
• Suppose an investment will pay you $300 one year
from now. How much would you be willing to
spend today to acquire this investment if you can
earn 6% on an alternative investment of equal risk?
To answer this question, you must determine how
many dollars you would have to invest at 6% today
in order to have $300 one year from now. Let PV
equal this unknown amount, and use the same
notation as in our discussion of future value:

• The present value of $300 one year from today is

$283.02 in today’s dollars. That is, $283.02 invested
today at a 6% interest rate would grow to $300 at
the end of one year. Therefore, today, you would be
willing to pay no more than $283.02 for an
investment that pays you $300 in one year.
 THE EQUATION FOR PRESENT VALUE

• We can find the present value of a lump sum mathematically by solving Equation 3.1 for PV. In other words,
the present value (PV) of some future amount (FV) to be received n periods from now, assuming an
opportunity cost of r, is given by Equation 3.2:
• Australis NZ Pty Ltd manufactures tennis racquets with leased machines.
Their leases run for five years, which corresponds to the useful life of the
equipment. Part of their standard lease agreement dictates that at the end of the
lease, Australis NZ must remove the old equipment, and fulfilling that
requirement costs Australis NZ about $1,200 per machine. Managers at
Australis NZ want to know the present value of this cost so that they can add it
to the list of up-front fees
• that they charge when they sign a new lease with a client. Assuming that the
relevant discount rate is 7%, what is the present value of a $1,200 payment
that occurs five years in the future?
• Substituting FV = $1,200, n = 5, and r = 0.07 into Equation 3.2 yields the
following:
• Figure 3.3 provides a time line illustrating
the cash flows in this example
A GRAPHIC VIEW OF PRESENT VALUE

• Figure 3.4 illustrates the relationship

between the present value of a future lump
sum, the discount rate and the ‘waiting time’
before the future lump sum is paid.
• For investors who expect to receive cash in
the future, Figure 3.4 contains two
important messages.
• First, the present value of a future cash
payment declines the longer investors must
wait to receive it.
• Second, the present value declines as the
discount rate rises. Note that for a discount
rate of 0%, the present value always equals
the future value ($1). However, for any
discount rate greater than zero, the present
value falls below the future value.
 • Equations 3.1 and 3.2 are just two ways of writing a mathematical
ADDITIONAL relationship linking the present and future value of cash flows to each other
APPLICATIONS and to the interest rate and investment horizon. In many situations, the
objective is not to find the present or future value of a cash payment, but
INVOLVING LUMP SUMS instead to answer a question about the interest rate or the investment horizon.
The series of examples that follows illustrates other kinds of problems that
can be solved by using some form of Equation 3.1.
A final example illustrates how
you might use to make a wise
decision when confronted with
different options for borrowing
money to purchase a consumer
durable good.
FUTURE VALUE OF CASH
FLOW STREAMS

• Financial managers frequently need to evaluate

streams of cash flows that occur in future periods.
Though this is mechanically more complicated than
computing the future or present value of a single
cash flow, the same basic techniques apply.
• Two types of cash flow streams are possible: the
mixed stream and the annuity.
• A mixed stream is a series of unequal cash flows
reflecting no particular pattern.
• An annuity is a stream of equal periodic cash flows
over a stated period of time.
FINDING THE FUTURE • The future value of any stream of cash flows
VALUE OF A MIXED measured at the end of a specified year is merely the
sum of the future values of the individual cash flows
STREAM at that year’s end. This future value is sometimes
called the terminal value. The following example
demonstrates such a calculation.
 • Before looking at future-value computations for annuities,
we distinguish between the two basic types of annuities: the
ordinary annuity and the annuity due.
• An ordinary annuity is an annuity for which the payments
occur at the end of each period, whereas an annuity due is
one for which the payments occur at the beginning of each
period.
TYPES OF • To demonstrate these differences, assume that you wish to
ANNUITIES choose the better of two annuities as a personal investment
opportunity. Both are five-year, $1,000 annuities. Annuity A
is an ordinary annuity, and annuity B is an annuity due.
Although the amount of each annuity totals $5,000, the
timing of the cash flows differs; each cash flow arrives one
year sooner with the annuity due than with the ordinary
annuity. As you might expect (given the core principle of
the time value of money), for any positive interest rate, the
future value of an annuity due is always greater than the
future value of an otherwise identical ordinary annuity.
Why? Because you receive the first cash flow today in the
annuity due, giving you a longer time to earn interest.
FINDING THE FUTURE
VALUE OF AN ORDINARY • The future value of an ordinary annuity can be calculated using the
ANNUITY same method demonstrated earlier for a mixed stream.
Sometimes consumers know
that they want to accumulate a
certain amount of money by
making regular deposits into a
savings account. In this
situation, the uncertainty is not
the future value of the annuity,
but rather the amount of time
needed to accumulate that
future value.
FINDING THE
FUTURE VALUE OF
AN ANNUITY DUE • We can convert the equation for the future value of
an ordinary annuity, Equation 3.4, into an
expression for the future value of an annuity due,
denoted FV (annuity due). To do so, we must take
into account that each cash flow of an annuity due
earns an additional year of interest. Therefore, we
simply multiply Equation 3.4 by (1 + r), as shown
in Equation 3.5:
• Equation 3.5 demonstrates that the future value of an
annuity due always exceeds the future value of a similar
ordinary annuity (for any positive interest rate) by a factor
of 1 plus the interest rate. We can check this by comparing
the results from the two different five-year vacation savings
plans presented earlier. We determined that, given a 7%
interest rate, after five years the value of the ordinary
annuity was $5,750.74, and that of the annuity due was
$6,153.29. Multiplying the future value of the ordinary
annuity by 1 plus the interest rate yields the future value of
the annuity due:
• FV (annuity due) = $5,750.74 × (1.07) = $6,153.29
PRESENT VALUE OF CASH
FLOW STREAMS

• Many decisions in corporate finance require

financial managers to calculate the present values of
cash flow streams that occur over several years. In
this section, we show how to calculate the present
values of mixed cash flow streams and annuities.
We also demonstrate the present-value calculation
for a very important cash flow stream known as a
perpetuity.
FINDING THE PRESENT VALUE OF A MIXED STREAM
FINDING THE PRESENT VALUE OF AN ANNUITY DUE
ADVANCED APPLICATIONS OF
TIME VALUE

• The techniques we have studied thus far have

many different applications in business as well as
in personal finance. Some of those applications
involve compounding interest more frequently
than once per year. When interest compounds
more often, the stated interest rate on a loan or an
investment doesn’t always accurately measure the
true rate of return, or the effective rate of interest.
In this section, we relax the assumption
maintained so far that interest compounds once
per year, and we examine several additional
applications of the time value of money.
COMPOUNDING MORE
FREQUENTLY THAN ANNUALLY

• In many applications, interest compounds

more frequently than once a year. Financial
institutions compound interest semiannually,
quarterly, monthly, weekly, daily or even
continuously. This section explores how the
present-value and future-value techniques
change if interest compounds more than once a
year.
Semiannual Compounding
• The semiannual compounding of interest involves
two compounding periods within the year. Instead
of the stated interest rate being paid once per year,
one-half of the rate is paid twice a year.
• To demonstrate, consider an opportunity to deposit
$100 in a savings account paying 8% interest with
semiannual compounding. After the first six months,
your account grows by 4% to $104. Six months
later, the account again grows by 4% to $108.16.
Notice that after one year, the total increase in the
account value is $8.16, or 8.16% ($8.16 ÷ $100.00).
This return slightly exceeds the stated rate of 8%
because semiannual compounding allows you to
earn interest on interest during the year, increasing
the overall rate of return. Table 3.1 shows how the
account value grows every six months for the first
two years. At the end of two years, the account
value reaches $116.99.
Quarterly Compounding
• As the name implies, quarterly compounding
describes a situation in which interest
compounds four times per year. An investment
with quarterly compounding pays one-fourth of
the stated interest rate every three months.
• For example, assume that after further
investigation, you find an institution that pays
8% interest compounded quarterly. After three
months, your $100 deposit grows by 2% to
$102. Three months later, the balance again
increases 2% to $104.04. By the end of the
year, the balance reaches $108.24. Table 3.2
tracks the growth in the account every three
months for two years. At the end of two years,
the account is worth $117.17, which is greater
than the sum attained after two years with
semiannual compounding.
A General
Equation
 Continuous
Compounding
STATED VERSUS EFFECTIVE ANNUAL INTEREST RATES
CALCULATI
NG
DEPOSITS
NEEDED TO
ACCUMULA
TE A
FUTURE
SUM
LOAN AMORTISATION

• Loan amortisation refers to a situation in which a borrower pays down the principal (the
amount borrowed)
• on a loan over the life of the loan. Often, the borrower makes equal periodic payments.
For instance, with a conventional, 30-year home mortgage, the borrower makes the same
payment each month for 30 years until the mortgage is completely repaid. To amortise a
loan (that is, to calculate the periodic payment that pays off the loan), you must know the
total amount of the loan (the amount borrowed), the term of the loan, the frequency of
periodic payments and the interest rate.
• In terms of the time value of money, the loan amortisation process involves finding a
level stream of payments (over the term of the loan) with a present value (calculated at
the loan interest rate) equal to the amount borrowed. Lenders use a loan amortisation
schedule to determine these payments and the allocation of each payment to interest and
principal.
• For example, suppose that you borrow $25,000 at 8% annual interest for five years to
purchase a new car. To demonstrate the basic approach, we first amortise this loan
assuming that you make payments at the end of years 1 through 5. We then modify the
annual formula to compute the more typical monthly car loan payments. To find the size
of the annual payments, the lender determines the amount of a five year annuity
discounted at 8% that has a present value of $25,000. This process is actually the inverse
of finding the present value of an annuity.