Topic 2

Time Value of Money

 Important Terms
• Present Value (PV)
• Future Value (FV)
• Compound interest
• Simple interest
• Annuities
• Perpetuities
• Nominal Interest rate (NIR)
• Effective Interest rate (EAR)
 Time Value of Money
• A dollar in hand today is worth more than a dollar
promised at some time in future
• Interest can be earned while you wait….so a dollar today
would grow to more than a dollar later
• The trade-off between money now and later depends on
the rate you can earn by investing
 Time Value Terminology
• Future value (FV) is the amount an investment is worth after one
or more periods.

• Present value (PV) is the amount that corresponds to today’s

value of a promised future sum.

• The number of time periods between the present value and the
future value is represented by N

• The rate of interest for discounting or compounding is

called I/Y

• All time value questions involve four values: PV, FV, I/Y and N.
Given three of them, it is always possible to calculate the fourth.
 Time Value Terminology
• Compounding is the process of accumulating interest
in an investment over time to earn more interest.

• Interest on interest is earned on the reinvestment of

previous interest payments.

• Discount rate is the interest rate that reduces a given

future value to an equivalent present value.

• Compound interest is calculated each period on the

principal amount and on any interest earned on the
investment up to that point.

• Simple interest is the method of calculating interest in

which, during the entire term of the loan, interest is
computed on the original sum borrowed.
 SHARP EL 735S
• Reset
2ndF Alpha 1 0

• Memory Clear
2ndF Alpha 0 0

• No of decimals
Set Up 0 0 (TAB) is pressed, DIG(0-9)? Press 4

(if you want 4 decimal points to avoid any rounding off

errors)
 Symbols and Meanings
• Present Value (PV)
• Future Value (FV)
• No of time periods (n)
Always on the same base
• Rate of interest (I/Y) or I
• Payment (PMT)
• Nominal Interest rate (NIR)…..see APR
• Effective Interest rate (EAR)….see EFF
• Amortisation AMRT function
 Future Value of a Lump Sum
You invest $100 in a savings account that earns 10 per cent interest per
annum (compounded) for 3 years. How much do you have after 3 years?

Calculate Future value (FV) using calculator:

Press 100
Press +/- button i.e we input that as a negative since it’s an
outflow
Press PV
Press 10 I/Y
Press 3 N
Press COMP FV

Answer: $133.10 is the amount that I have after 3 years

 Compounding….reinvesting interest
• $100 invested @10% amounts to $110 after one period
• $100 invested @10% amounts to $121 after two periods

• Or simply $110 that we got after period one being

reinvested @10% for one more period

110 x 10% = $11 interest earned

• Hence by end of period2, the bank has $121

• Or simply 100 +/- PV, 2n, 10 I/Y, COMP FV

Answer: $121
Future values of $100 at 10%
 Example—Future Value of a Lump Sum
• What will $1000 amount to in five years time if
interest is 6 per cent per annum, compounded
annually?
FV  $1000 1  0.06
5

 $1000  1.3382
 $1338.22
• From the example, now assume interest is 6 per
cent per annum, compounded monthly.
• Always remember that t is the number of
compounding periods, not the number of years.
FV  $1000 1  0.005
60

 $1000  1.3489
 $1348.90
 Interpretation
• The difference in values is due to larger number of
periods in which interest can compound

• The higher the interest rate, higher the future value

 Example—Present Value of a Lump Sum

Your rich grandmother promises to give you $100,000

in 10 years time. If interest rates are 12 per cent per
annum, how much is that gift worth today?

Use calculator to get PV:

100000 FV
10 N
12 I/Y
COMP PV

Answer: $32,197.32 is the worth of the gift today

 Determining the Discount Rate
• You currently have $100 available for investment for a
21-year period. At what interest rate must you invest
this amount in order for it to be worth $500 at maturity?

To determine the discount rate (I/Y) in this example, a

financial calculator is used.
100 +/- PV (outflow…neg. sign)
21 N
500 FV (what you need in future)
COMP I/Y (round off to 2 decimals)

Answer: 7.97%
(Cross check!!)
 The Rule of 72
• The ‘Rule of 72’ is a handy rule of thumb that
states:

– If you earn r per cent per year, your money will

double in about 72/r per cent years

• For example, if you invest at 8 per cent, your

money will double in about 9 years i.e. 72/8

• This rule is only an approximate rule.

 Finding the Number of Periods
• You have been saving up to buy a new car. The
total cost will be $10 000. You currently have
$8000. If you can earn 6% on your money, how
long will you have to wait?

• To determine the number of periods (N) in this

example, a financial calculator is used.

8000 +/- PV
10000 FV
6 I/Y
COMP N

Answer: I will have to wait for 3.83 years

 Future Value of Multiple Cash Flows

• You deposit $1000 now, $1500 in one year, $2000 in

two years and $2500 in three years in an account
paying 10 per cent interest per annum. How much
do you have in the account at the end of the third
year?

• You can solve by :

– Using a time line
– calculating the future value of each cash flow
first and then totaling them…… USE
CALCULATOR !!
 Future Value of Multiple Cash Flows (Using
calculator)
TIME LINE:

1000 yr1 1500 yr 2 2000 yr3 2500 yr4 beg or end of yr3

1000 +/- PV, 3 N, 10 I/Y COMP FV = $1331

1500 +/- PV, 2 N, 10 I/Y COMP FV = $1815
2000 +/- PV, 1 N, 10 I/Y COMP FV = $2200
2500 invested in the last year = $2500

Total amount at the end of 3rd year = $7846

 Present Value of Multiple Cash Flows
• You will deposit $1500 in one year’s time,
$2000 in two years time and $2500 in three
years time in an account paying 10 per cent
interest per annum. What is the present
value of these cash flows?

• You can solve by :

– Using a time line….(similar to FV calculation)
– Calculating the present value of each cash flow
first and then totaling them.
Present Value of Multiple Cash Flows (Using
calculator)

1500 FV, 1 N, 10 I/Y, COMP PV = $1363.64

2000 FV, 2 N, 10 I/Y, COMP PV = $1652.89
2500 FV, 3 N, 10 I/Y, COMP PV = $1878.29

PV of cashflows today = $4894.82

 Annuities
• An ordinary annuity is a series of equal
cash flows that occur at the end of each
period for some fixed number of periods.

• Examples include consumer loans and

home mortgages.

• A perpetuity is an annuity in which the

cash flows continue forever.
Present Value of an Annuity

 
1  1/ 1  r t 
PV  C   
 r 
C = equal cash flow

• The discounting term is called the

present value interest factor for
annuities (PVIFA).
• Example 1
You will receive $1000 at the end of each of the
next ten years. The current interest rate is 6 per
cent per annum. What is the present value of this
series of cash flows? (Refer to Annuity Table at
back of textbook and look under 6% and across
10 years to get the Annuity factor 7.3601)
 
1  1/ 1.0610 
PV  $1 000   
 0.06 
 $1 000  7.3601
 $7 360.10
 Finding the Rate for an Annuity
• You have a loan of $5000 repayable by instalments of
$745.15 at the end of each year for 10 years. What rate is
implicit in this 10 year annuity?
• To determine the discount rate (I/Y) in this example, a
financial calculator is used.
5000 PV
0 FV ……(everything is paid off)
10 N
745.15 +/- PMT
COMP I/Y

Answer: The rate for this annuity is 8%

 Finding the number of payments for an
Annuity
• You have $2000 owing on your credit card. You can only
afford to make the minimum payment of $40 per month. The
interest rate on the credit card is 1 per cent per month. How
long will it take you to pay off the $2000.

• To determine the number of payments (N) in this example, a

financial calculator is used.
2000 PV
0 FV
40 +/- PMT
1 I/Y
COMP N

Answer: 69.66 months or 69.66/12 = 5.81 years

 Future Value of an Annuity

FV  C 
1  r   1
t

• The compounding term is called the future

value interest factor for annuities (FVIFA).
Example—Future Value of an Annuity

What is the future value of $1000 deposited at the

end of every year for 20 years if the interest rate is 6
per cent per annum? (Look up under 6% and across
20 years to get Future value annuity factor of
36.786)

FV  $1 000 
(1.06) 20

1
0.06
 $1 000  36.7856
 $36 785.60
 Perpetuities
• The future value of a perpetuity cannot be calculated as
the cash flows are infinite.
• The present value of a perpetuity is calculated as follows:
C
PV 
r
• Best example: Preference shares (need to pay preference
dividends perpetually)

• Incase of Preference shares,

C = pref. dividend
r = market rate
PV = market value of Pref. share
 Comparing Rates
• The Nominal Interest Rate (NIR) is the interest
rate expressed in terms of the interest payment
made each period.

• The Effective Annual Interest Rate (EAR) is the

interest rate expressed as if it was compounded
once per year.

• When interest is compounded more frequently

than annually, the EAR will be greater than the
NIR
 Nominal Interest Rate (NIR)
• Banks, consumer durable companies ‘quote’ rates; hence
Quoted/ Stated rate
• Lenders compute NIR as

Interest rate per period x no. of periods in a year

• Example: If a bank charges 1.2% per month on car loans,

the NIR = 1.2 x 12 months = 14.4 %

• NIR is NOT actual cost to customer; EAR is !!

 Example: NIR TO EAR

10% compounded semi-annually is quoted rate

The actual rate you earn/ pay is the Effective rate of 10 %
compounded semi-annually

• Use of calculator to convert from NIR to EAR

 Convert from NIR to EAR
• 10% compounded semi-annually

2 [x,y] 10 2ndF EFF

We type 2 because it’s compounded semi-

annually…. 2 semi-annual periods in one year
10 – NIR given
Answer: Effective rate is 10.25%

• 16% compounded monthly

12 [x,y] 16 2ndF EFF

Answer: Effective rate is 17.23%
 Comparing EARS
• Consider the following interest rates quoted by three
banks; which is the best one if you are the borrower?

– Bank A: 8.3%, compounded daily

– Bank B: 8.4%, compounded quarterly

– Bank C: 8.5%, compounded annually

 Solution
• Compare EARs
EAR (Bank A) = 8.65%
EAR (Bank B) = 8.67%
EAR (Bank C) = 8.50%

• As a borrower, you prefer the one with the lowest EAR i.e.
Bank C
 Types of Loans

• An interest-only loan requires the borrower to

only pay interest each period and to repay the
entire principal at some point in the future.

• An amortised loan requires the borrower to

repay parts of both the principal and interest
over time.
 Summary and Conclusions
• For a given rate of return, the value at some point in the
future of an investment made today can be determined by
calculating the future value of that investment.
• The current worth of a future cash flow or series of cash
flows can be determined for a given rate of return by
calculating the present value of the cash flow(s) involved.
• It is possible to find any one of the four components
(PV, FV, I/Y, N) given the other three.
• A series of constant cash flows that arrive or are paid at
the end of each period is called an ordinary annuity.
• For financial decisions, it is important that any rates are
converted to effective rates before being compared.