Time Value of Money

Shahin Maharramli
[email protected]
Definition of Time Value
"A dollar today is worth more than a dollar in the future.”

Explanation:
The concept of the Time Value of Money (TVM) is fundamental in finance and economics. It means that
money you have in your hand today is more valuable than the same amount received at a future date.
Why is this so?

Opportunity: You can invest today's money and earn interest, making it grow over time.
Inflation: Over time, money typically loses purchasing power due to rising prices.
Risk: There's uncertainty about future payments. You may not receive money promised in the future.
Why TVM is important?
Understanding the Time Value of Money (TVM) is crucial in finance and everyday financial decision-making
for several reasons:

1. Opportunity Cost
Money available today can be invested or saved to earn interest or generate returns.
Delaying receipt of money means losing out on potential earnings.
Example: If you invest $1,000 today at 5%, it becomes $1,050 in one year. Waiting one year to receive the
$1,000 costs you that $50 earned.
2. Inflation
Inflation reduces the purchasing power of money over time.
Money received in the future usually buys less than the same amount today.
Example: $100 today might buy more groceries than the same $100 five years from now.
3. Risk and Uncertainty
Future money carries the risk of non-payment or unexpected events.
Receiving money today eliminates uncertainty and provides security.
Example: A company promising payment in two years might go bankrupt, and the future payment may never
materialize.
Key terms to understand
"A dollar today is worth more than a dollar in the future.”

• Present Value (PV)

• Future Value (FV)
• Interest Rate (r)
• Compounding
• Discounting
Types of Interest
"A dollar today is worth more than a dollar in the future.”
•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).
Simple Interest rate Formula
•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?

•What is the Future Value (FV) of the deposit?

•FV = P0 + SI = $1,000 + $140 = $1,140

•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.
Future Value of Single Amount
(Compound Interest rate)
"A dollar today is worth more than a dollar in the future.”

• Measuring value of an amount that is allowed to grow at a given interest over a period of
time
• Assuming that the worth of $1,000 needs to be calculated after 4 years at a 10% interest
per year, we have:
1st year……$1,000 X 1.10 = $1,100
2nd year…...$1,100 X 1.10 = $1,210
3rd year……$1,210 X 1.10 = $1,331
4th year……$1,331 X 1.10 = $1,464
Future Value – Single Amount
A generalized formula for Future Value:

Where
FV = Future value
PV = Present value
i = Interest rate
n = Number of periods;

In the previous case, PV = $1,000, i = 10%, n = 4, hence;

Future Value of 1$ (Table)
Future Value – Single Amount
(Using Table)
• In determining future value, the following can be used:

Where FVIF = the interest factor

• If $10,000 were invested for 10 years at 8%, the future

value would be:
Present Value – Single Amount
"A dollar today is worth more than a dollar in the future.”

• A sum payable in the future is worth less today than the stated amount
• The formula for the present value is derived from the original formula for future value:

• The present value can be determined by solving for a mathematical solution to the
formula above, thus restating the formula as:
Present Value of 1$ (Table)
Understanding Annuities
•An annuity is a series of equal payments or receipts made at regular intervals over a specific period.

•Payments could be annual, semi-annual, quarterly, monthly, etc.

Types of Annuities:
Ordinary Annuity (Most common)
Payments occur at the end of each period.
Example: Loan repayments, mortgage payments.

Annuity Due
Payments occur at the beginning of each period.
Example: Rent payments, lease payments.
Why Annuities Matter
• Annuities help individuals and businesses plan for steady income or expenses;

• Essential in financial planning, retirement funds, and evaluating investment projects.

Example:
You deposit $1,000 each year into a savings account paying 5% interest annually.
After 3 years, you'll have:
• 1st deposit grows for 2 years.
• 2nd deposit grows for 1 year.
• 3rd deposit has no growth yet (end-of-year deposit).
Compounding Process for Annuity
• Future Value of an Annuity:
• "How much will I have in the future if I deposit regular equal payments, earning interest?"
Calculated by compounding each individual payment into the future and then adding up all of these payments.
Future Value of Single Amount
(Compound Interest rate)
A generalized formula for Future Value of Annuity:

Scenario: Suppose you deposit $1,000 annually into an account earning 5% interest per year. You do this
every year for 3 years. How much money will you have at the end of the third year?

After 3 years, you'll have $3,152.50.

Future Value of Annuity
Present Value of Annuity
The Present Value of an Annuity (PVA) tells you the amount of money you'd need today to
equal a series of future regular payments (annuities), considering a given interest rate.

It answers the question:

"How much money do I need to invest today to cover future periodic payments or
withdrawals?"
Present Value of Annuity
Scenario: You want to withdraw $1,000 at the end of each year for 5 years, and your
savings earn 4% annually. How much money must you have today?

You need approximately $4,451.80 today to cover these future withdrawals.

Present Value-Annuity
Exercises
1. Future Value (FV) Problem
You deposit $2,000 today in an account earning 6% annual interest. How much will you
have in the account after 4 years?
2. Present Value (PV) Problem
You plan to receive $5,000 three years from now. If the interest rate is 7%, how much is this
amount worth today?
3. Future Value of an Annuity (FVA) Problem
You deposit $1,500 at the end of each year for 5 years into a savings account that pays an
annual interest rate of 5%. How much will you have at the end of 5 years?
4. Present Value of an Annuity (PVA) Problem
You want to withdraw $2,000 at the end of each year for the next 6 years. The account
earns an annual interest rate of 4%. How much money must you deposit today to cover
these withdrawals?
Future Value of Single Amount
(Compound
Mixed Practice Problem
Interest rate)
You're considering two investment options:
Option A: Receive $10,000 today.
Option B: Receive $11,000 three years from today (assuming an annual interest rate of 3%).
Which option would you prefer based on present value?

Annuity Payment Calculation

You take a loan of $10,000 today at an annual interest rate of 8%, to be repaid in 4 equal
annual payments (end of each year). Calculate the amount of each annual payment.
Effective Annual Rate (EAR)
• The Effective Annual Rate (EAR) is the actual interest rate you earn or pay when interest
is compounded more frequently than once per year.
• EAR shows the true cost or benefit of an interest rate by accounting for compounding
within a year.
Effective Annual Rate Example
Suppose your bank offers a nominal interest rate of 12% per year compounded monthly.
What's the actual annual interest rate you'll earn?
Why is the Effective Annual Rate (EAR) Higher than
the Nominal Rate?
When interest is compounded more frequently (monthly, quarterly, or daily), you earn
interest not only on your original principal but also on the interest earned during the
year.
Nominal Interest Rate:
Represents interest earned only on the principal, without considering interest-on-interest
within the year.
Effective Annual Rate (EAR):
Reflects interest earned on both the original principal and the interest accumulated
throughout the year due to more frequent compounding. This effect is known as interest-
on-interest.
Why is the Effective Annual Rate (EAR) Higher than
the Nominal Rate?
Real vs. Nominal Interest Rates (Exact Formula)
Exact Formula (Fisher Equation):

Suppose your savings account offers a nominal interest rate of 6%, and the annual inflation rate is 2%.
Using the exact Fisher equation:

The exact real interest rate is approximately 3.92%, slightly lower than the 4% given by the simplified
approximation method.