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The Time Value of Money In order to work the problems in this module, the user should have the use of a business calculator such as the Hewlett Packard 17BII.

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the time value of money
The Time Value of Money
  • In order to work the problems in this module, the user should have the use of a business calculator such as the Hewlett Packard 17BII.
  • The author grants individuals a limited license to use this presentation. It is the sole property of the author who holds the corresponding copyrights. The user agrees not to reproduce, duplicate or distribute any copies of this presentation in any form.
  • The author would like to thank the Innovative Technology Center at The University of Tennessee which supported this project with a grant through the “Teaching with Technology Summer Institute.” She would also like to commend the teachers who helped her design the module.
  • If you have any comments or suggestions on how to improve this presentation, please e-mail the author at smurphy@utk.edu.
    • Copyright ©2000 Suzan Murphy
  • In order to work the problems in this module, the user should have the use of a business calculator such as the Hewlett Packard 17BII.
  • The author grants individuals a limited license to use this presentation. It is the sole property of the author who holds the corresponding copyrights. The user agrees not to reproduce, duplicate or distribute any copies of this presentation in any form.
  • The author would like to thank the Innovative Technology Center at The University of Tennessee which supported this project with a grant through the “Teaching with Technology Summer Institute.” She would also like to commend the teachers who helped her design the module.
  • If you have any comments or suggestions on how to improve this presentation, please e-mail the author at smurphy@utk.edu.
    • Copyright ©2000 Suzan Murphy

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the time value of money2
The Time Value of Money
  • What is the “Time Value of Money”?
  • Compound Interest
  • Future Value
  • Present Value
  • Frequency of Compounding
  • Annuities
  • Multiple Cash Flows
  • Bond Valuation

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the time value of money3
Obviously, $1,000 today.

Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the TIME VALUE OF MONEY!!

Which would you rather have -- $1,000 today or $1,000 in 5 years?

The Time Value of Money

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how can one compare amounts in different time periods
How can one compare amounts in different time periods?
  • One can adjust values from different time periods using an interest rate.
  • Remember, one CANNOT compare numbers in different time periods without first adjusting them using an interest rate.

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compound interest
When interest is paid on not only the principal amount invested, but also on any previous interest earned, this is called compound interest.

FV = Principal + (Principal x Interest)

= 2000 + (2000 x .06)

= 2000 (1 + i)

= PV (1 + i)

Note: PV refers to Present Value or Principal

Compound Interest

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future value graphic
Future Value (Graphic)

If you invested $2,000 today in an account that pays 6% interest, with interest compounded annually, how much will be in the account at the end of two years if there are no withdrawals?

0 1 2

6%

$2,000

FV

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future value formula
Future Value (Formula)

FV1 = PV (1+i)n = $2,000(1.06)2 = $2,247.20

FV = future value, a value at some future point in time

PV = present value, a value today which is usually designated as time 0

i = rate of interest per compounding period

n = number of compounding periods

Calculator Keystrokes: 1.06 (2nd yx) 2 x 2000 =

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future value hp 17 b ii calculator
Future Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

2

N

6

I%Yr

2000 +/-

PV

FV

2,247.20

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future value example
Future Value Example

John wants to know how large his $5,000 deposit will become at an annual compound interest rate of 8% at the end of 5 years.

0 1 2 3 4 5

8%

$5,000

FV5

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future value solution
Future Value Solution
  • Calculator keystrokes: 1.08 2nd yx x 5000 =
  • Calculation based on general formula:FVn = PV (1+i)nFV5= $5,000 (1+ 0.08)5 = $7,346.64

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future value hp 17 b ii calculator11
Future Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

5

N

8

I%Yr

5000 +/-

PV

FV

7,346.64

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slide12

Double Your Money!!!

Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?

We will use the “Rule-of-72”.

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slide13

The “Rule-of-72”

Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)?

Approx. Years to Double = 72/ i%

  • 72 / 12% = 6 Years
  • [Actual Time is 6.12 Years]

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present value
Present Value
  • Since FV = PV(1 + i)n.

PV= FV / (1+i)n.

  • Discounting is the process of translating a future value or a set of future cash flows into a present value.

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present value graphic
Present Value (Graphic)

Assume that you need to have exactly $4,000saved 10 years from now. How much must you deposit today in an account that pays 6% interest, compounded annually, so that you reach your goal of $4,000?

0 5 10

6%

$4,000

PV0

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present value hp 17 b ii calculator
Present Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

10

N

6

I%Yr

4000

FV

PV

-2,233.57

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present value example
Present Value Example

Joann needs to know how large of a deposit to make today so that the money will grow to $2,500in 5 years. Assume today’s deposit will grow at a compound rate of 4% annually.

0 1 2 3 4 5

4%

$2,500

PV0

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present value solution
Present Value Solution
  • Calculation based on general formula: PV0 = FVn / (1+i)nPV0= $2,500/(1.04)5 = $2,054.81
  • Calculator keystrokes: 1.04 2nd yx 5 = 2nd 1/x X 2500 =

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present value hp 17 b ii calculator19
Present Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

5

N

4

I%Yr

2,500 +/-

FV

PV

2,054.81

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finding n or i when one knows pv and fv
Finding “n” or “i” when one knows PV and FV
  • If one invests $2,000 today and has accumulated $2,676.45 after exactly five years, what rate of annual compound interest was earned?

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hp 17 b ii calculator
(HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

5

N

2000 +/-

PV

2,676.45

FV

I%Yr

6.00

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frequency of compounding
Frequency of Compounding

General Formula:

FVn = PV0(1 + [i/m])mn

n: Number of Years

m: Compounding Periods per Year

i: Annual Interest Rate

FVn,m: FV at the end of Year n

PV0: PV of the Cash Flow today

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frequency of compounding example
Frequency of Compounding Example
  • Suppose you deposit $1,000 in an account that pays 12% interest, compounded quarterly. How much will be in the account after eight years if there are no withdrawals?

PV = $1,000

i = 12%/4 = 3% per quarter

n = 8 x 4 = 32 quarters

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solution based on formula
Solution based on formula:

FV= PV (1 + i)n

= 1,000(1.03)32

= 2,575.10

Calculator Keystrokes:

1.03 2nd yx 32 X 1000 =

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future value frequency of compounding hp 17 b ii calculator
Future Value, Frequency of Compounding (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

32

N

3

I%Yr

1000 +/-

PV

FV

2,575.10

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annuities
Annuities
  • An Annuity represents a series of equal payments (or receipts) occurring over a specified number of equidistant periods.
  • Examples of Annuities Include:

Student Loan Payments

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

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example of an ordinary annuity fva
FVA3 = $1,000(1.07)2 + $1,000(1.07)1 + $1,000(1.07)0=$3,215

If one saves $1,000 a year at the end of every year for three years in an account earning 7% interest, compounded annually, how much will one have at the end of the third year?

Example of an Ordinary Annuity -- FVA

End of Year

0 1 2 3 4

7%

$1,000 $1,000 $1,000

$1,070

$1,145

$3,215 = FVA3

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future value hp 17 b ii calculator28
Future Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

1,000 +/-

PMT

3

N

7

I%Yr

FV

3,214.90

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example of anordinary annuity pva
PVA3 = $1,000/(1.07)1 + $1,000/(1.07)2 +

$1,000/(1.07)3 =$2,624.32

If one agrees to repay a loan by paying $1,000 a year at the end of every year for three years and the discount

rate is 7%, how much could one borrow today?

Example of anOrdinary Annuity -- PVA

End of Year

0 1 2 3 4

7%

$1,000 $1,000 $1,000

$934.58

$873.44

$816.30

$2,624.32 = PVA3

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present value hp 17 b ii calculator30
Present Value (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

Choose Fin, then TVM

1,000

PMT

3

N

7

I% Yr

PV

-2,624.32

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multiple cash flows example
Multiple Cash Flows Example

Suppose an investment promises a cash flow of $500 in one year, $600 at the end of two years and $10,700 at the end of the third year. If the discount rate is 5%, what is the value of this investment today?

0 1 2 3

5%

$500 $600 $10,700

PV0

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multiple cash flow solution
Multiple Cash Flow Solution

0 1 2 3

5%

$500 $600 $10,700

$476.19

$544.22

$9,243.06

$10,263.47 = PV0of the Multiple Cash Flows

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multiple cash flow solution hp 17 b ii calculator
Multiple Cash Flow Solution (HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data.

FIN

CFLO

Flow(0)=?

0

Input

Flow(1)=?

500

Input

# Times (1) = 1

Input

Flow(2)=?

600

Input

# Times (2) = 1

Input

Flow(3)=?

10,700

Input

Exit

Calc

5

I%

NVP

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slide34

Bond Valuation Problem

Find today’s value of a coupon bond with a maturity value of $1,000 and a coupon rate of 6%. The bond will mature exactly ten years from today, and interest is paid semi-annually. Assume the discount rate used to value the bond is 8.00% because that is your required rate of return on an investment such as this.

Interest = $30 every six months for 20 periods

Interest rate = 8%/2 = 4% every six months

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slide35

Bond Valuation Solution

(HP 17 B II Calculator)

Exit until you get Fin Menu.

2nd, Clear Data

FIN

TVM

30

PMT

1000

FV

4

I% YR

20

N

PV

-864.09

0 1 2 ……….… 20

30 30 30

1000

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welcome to the interactive exercises
Welcome to the Interactive Exercises
  • Choose a problem; select a solution
  • To return to this page (slide 37), use Power Point’s Navigation Menu
  • Choose “Go” and “By Title”

1

2

3

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problem 1
Problem #1

You must decide between $25,000 in cash today or $30,000 in cash to be received two years from now. If you can earn 8% interest on your investments, which is the better deal?

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possible answers problem 1
Possible Answers - Problem 1
  • $25,000 in cash today
  • $30,000 in cash to be received two years from now
  • Either option O.K.

Need a Hint?

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slide39

Solution (HP 17 B II Calculator)

Problem #1

Exit until you get Fin Menu.

2nd, Clear Data

Choose FIN, then TVM

2

N

8

I%YR

30,000

FV

PV

-25,720.16

Compare PV of $30,000, which is $25,720.16 to PV of $25,000. $30,000 to be received 2 years from now is better.

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problem 2
Problem #2
  • What is the value of $100 per year for four years, with the first cash flow one year from today, if one is earning 5% interest, compounded annually? Find the value of these cash flows four years from today.

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possible answers problem 2
Possible Answers - Problem 2
  • $400
  • $431.01
  • $452.56

Need a Hint?

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slide42

Solution (HP 17 B II Calculator)

Problem #2

Exit until you get Fin Menu.

2nd, Clear Data

Choose FIN, then TVM

100

PMT

4

N

5

I% YR

FV

431.01

FVA=100(1.05)3 + 100(1.05)2 + 100(1.05)1 + 100(1.05)0

0 1 2 3 4

100 100 100 100

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problem 3
Problem #3
  • What is today’s value of a $1,000 face value bond with a 5% coupon rate (interest is paid semi-annually) which has three years remaining to maturity. The bond is priced to yield 8%.

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possible solutions problem 3
Possible Solutions - Problem 3
  • $1,000
  • $921.37
  • $1021.37

Need a Hint?

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slide45

Solution (HP 17 B II Calculator)

Problem #3

Exit until you get Fin Menu.

2nd, Clear Data

FIN

TVM

25

PMT

1000

FV

4

I% YR

6

N

PV

921.37

0 1 2 ……….… 12

25 25 25

1000

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congratulations
Congratulations!
  • You obviously understand this material. Now try the next problem.
  • The Interactive Exercises are found on slide #37.

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comparing pv to fv
Comparing PV to FV
  • Remember, both quantities must be present value amounts or both quantities must be future value amounts in order to be compared.

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how to solve a time value of money problem
How to solve a time value of money problem.
  • The “value four years from today” is a future value amount.
  • The “expected cash flows of $100 per year for four years” refers to an annuity of $100.
  • Since it is a future value problem and there is an annuity, you need to solve for a FUTURE VALUE OF AN ANNUITY.

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valuing a bond
Valuing a Bond
  • The interest payments represent an annuity and you must find the present value of the annuity.
  • The maturity value represents a future value amount and you must find the present value of this single amount.
  • Since the interest is paid semi-annually, discount at HALF the required rate of return (4%) and TWICE the number of years to maturity (6 periods).

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