2.5 Time Value of Money
The time value of money (TVM) is one of the most fundamental concepts in finance: a dollar today is worth more than a dollar in the future because of its earning potential. Investment advisers use TVM concepts daily when analyzing investments and planning for client goals.
Why a Dollar Today Is Worth More
Earning Potential: Money today can be invested to earn returns
Inflation: Future dollars buy less due to rising prices
Risk: A promise of future money carries uncertainty
Opportunity Cost: Can't use future money for today's opportunities
Core Concepts
Present Value (PV)
Present value is the current worth of a future sum of money, discounted at a given rate.
Question it answers: "What is $10,000 received in 5 years worth today?"
Future Value (FV)
Future value is the value of a current sum of money at a future date, compounded at a given rate.
Question it answers: "What will $10,000 invested today be worth in 5 years?"
Key Formulas
Future Value Formula
FV = PV x (1 + r)^n
FV: Future Value
PV: Present Value
r: Interest rate per period
n: Number of periods
Example: $10,000 invested at 8% for 5 years:
- FV = $10,000 x (1.08)^5 = $10,000 x 1.469 = $14,693
Present Value Formula
PV = FV / (1 + r)^n
Example: What is $14,693 received in 5 years worth today at 8%?
- PV = $14,693 / (1.08)^5 = $14,693 / 1.469 = $10,000
The Rule of 72
A quick way to estimate how long it takes to double your money:
Years to Double approx. 72 / Interest Rate
4%: 72 / 4 = 18 years
6%: 72 / 6 = 12 years
8%: 72 / 8 = 9 years
10%: 72 / 10 = 7.2 years
12%: 72 / 12 = 6 years
The Rule of 72 works in reverse too: At what rate do you need to invest to double money in 10 years? 72 / 10 = 7.2%
Compounding Frequency
More frequent compounding results in higher effective returns:
Annual: 1 period per year. $10,000 at 8% for 1 Year: $10,800.00
Semi-annual: 2 periods per year. $10,000 at 8% for 1 Year: $10,816.00
Quarterly: 4 periods per year. $10,000 at 8% for 1 Year: $10,824.32
Monthly: 12 periods per year. $10,000 at 8% for 1 Year: $10,830.00
Daily: 365 periods per year. $10,000 at 8% for 1 Year: $10,832.78
Key Point: For the same stated (nominal) rate, more frequent compounding = higher effective annual rate (EAR).
Effective Annual Rate (EAR)
The effective annual rate converts any compounding frequency to an annual equivalent:
EAR = (1 + r/m)^m - 1
Where m = number of compounding periods per year
Example: 8% compounded monthly:
- EAR = (1 + 0.08/12)^12 - 1 = 8.30%
Annuities
An annuity is a series of equal payments at regular intervals. Investment advisers encounter annuities in retirement planning, loan analysis, and income products.
Types of Annuities
Ordinary Annuity: Payment Timing: End of each period. Example: Most loans, bonds
Annuity Due: Payment Timing: Beginning of each period. Example: Rent, insurance premiums
Key Difference: Annuity due payments occur one period earlier, so an annuity due is worth more than an otherwise identical ordinary annuity.
Annuity Applications
Retirement planning: TVM Concept Used: How much to save (PV of future need)
Loan payments: TVM Concept Used: Monthly payment calculation
Education funding: TVM Concept Used: Future cost of tuition
Income planning: TVM Concept Used: What can be withdrawn annually
Discount Rate Selection
The discount rate used in TVM calculations significantly affects results:
Risk-free rate: When Used: Government bonds, guaranteed payments
Required return: When Used: Investments with specific risk levels
Opportunity cost: When Used: Alternative investment returns
Inflation rate: When Used: Real purchasing power calculations
Important: Higher discount rates result in lower present values. A risky investment's cash flows should be discounted at a higher rate than a safe investment's cash flows.
In Practice: How Investment Advisers Apply This
Client planning applications:
- Calculate how much to save monthly for retirement
- Determine if a lump sum or annuity is more valuable
- Compare investment alternatives with different timing
- Evaluate whether early payment of debt makes sense
Investment analysis:
- Calculate present value of expected cash flows
- Compare bonds with different maturities
- Evaluate NPV of investment opportunities
On the Exam
The Series 65 exam tests your ability to:
1. Understand that a dollar today is worth more than a dollar tomorrow
2. Apply the Rule of 72 to estimate doubling time
3. Recognize that more frequent compounding increases effective returns
4. Distinguish between ordinary annuity and annuity due
5. Understand how discount rate affects present value
Common formats include Rule of 72 calculations and understanding compounding frequency effects.
Key Takeaways
- Time value of money: A dollar today is worth more than a dollar in the future
- Future value: FV = PV x (1 + r)^n - grows current money at a given rate
- Present value: PV = FV / (1 + r)^n - discounts future money back to today
- Rule of 72: Years to double = 72 / interest rate
- More frequent compounding = higher effective annual rate
- Ordinary annuity: Payments at end of period; Annuity due: Payments at beginning
- Higher discount rates result in lower present values