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The Time Value of Money

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  1. 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 UT Department of Finance

  2. 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 UT Department of Finance

  3. 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 UT Department of Finance

  4. 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. UT Department of Finance

  5. 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 UT Department of Finance

  6. 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 UT Department of Finance

  7. 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 = UT Department of Finance

  8. 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 UT Department of Finance

  9. 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 UT Department of Finance

  10. 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 UT Department of Finance

  11. 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 UT Department of Finance

  12. 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”. UT Department of Finance

  13. 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] UT Department of Finance

  14. 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. UT Department of Finance

  15. 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 UT Department of Finance

  16. 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 UT Department of Finance

  17. 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 UT Department of Finance

  18. 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 = UT Department of Finance

  19. 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 UT Department of Finance

  20. 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? UT Department of Finance

  21. (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 UT Department of Finance

  22. 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 UT Department of Finance

  23. 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 UT Department of Finance

  24. 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 = UT Department of Finance

  25. 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 UT Department of Finance

  26. 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 UT Department of Finance

  27. 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 UT Department of Finance

  28. 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 UT Department of Finance

  29. 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 UT Department of Finance

  30. 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 UT Department of Finance

  31. 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 UT Department of Finance

  32. 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 UT Department of Finance

  33. 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 UT Department of Finance

  34. 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 UT Department of Finance

  35. 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 UT Department of Finance

  36. 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 UT Department of Finance

  37. 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? UT Department of Finance

  38. 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? UT Department of Finance

  39. 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. UT Department of Finance

  40. 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. UT Department of Finance

  41. Possible Answers - Problem 2 • $400 • $431.01 • $452.56 Need a Hint? UT Department of Finance

  42. 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 UT Department of Finance

  43. 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%. UT Department of Finance

  44. Possible Solutions - Problem 3 • $1,000 • $921.37 • $1021.37 Need a Hint? UT Department of Finance

  45. 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 UT Department of Finance

  46. Congratulations! • You obviously understand this material. Now try the next problem. • The Interactive Exercises are found on slide #37. UT Department of Finance

  47. 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. UT Department of Finance

  48. 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. UT Department of Finance

  49. 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). UT Department of Finance