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BMFP 3582 Chapter 7 Time Value of Money (Present & Annual Woth)R

# BMFP 3582 Chapter 7 Time Value of Money (Present & Annual Woth)R

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05/09/2014

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TIME VALUE OF MONEYTIME VALUE OF MONEYINTEREST FORMULASINTEREST FORMULAS
7

Time Value of MoneyTime Value of Money
Time Value of Money
Money can “make”money if Invested
Centers around an
interest rate
The change in the amount of money over agiven time period is called thetime value of money
Interest RateInterest Rate
INTERESTINTEREST--MANIFESTATION OF THE TIMEMANIFESTATION OF THE TIME VALUE OF MONEY. THE AMOUNT PAID TO VALUE OF MONEY. THE AMOUNT PAID TOUSE MONEY. IT REPRESENTS THE GROWTHUSE MONEY. IT REPRESENTS THE GROWTHOF CAPITAL PER UNIT PERIOD.OF CAPITAL PER UNIT PERIOD.
INVESTMENTINVESTMENT
INTEREST = VALUE NOWINTEREST = VALUE NOW--ORIGINAL AMOUNTORIGINAL AMOUNT
LOANLOAN
INTEREST = TOTAL OWED NOWINTEREST = TOTAL OWED NOW--ORIGINAL AMOUNTORIGINAL AMOUNT
RENTAL FEE PAID FOR THE USE OF SOMEONEELSES MONEY…EXPRESSED AS A %
Economic EquivalenceEconomic Equivalence
Economic Equivalence
Two sums of money at two different pointsin time can be made economicallyequivalent if:
We consider an interest rate and,
No. of Time periods between the twosums
Equality in terms of Economic Value
Equivalence IllustratedEquivalence Illustrated
T=0t = 1 Yr
RM20,000 now is economically equivalent toRM21,800 one year from now IF the interest rate isset to equal 9%/year
Simple and Compound InterestSimple and Compound Interest
Two “types”of interest calculations
Simple Interest
Compound Interest
Compound Interest is more commonworldwide and applies to most analysissituations

Simple Interest
Calculated on the principal amount only
In a multiperiodsituation with simple interest:
The accrued interest does not earn interest duringthe succeeding time period
Normally, the total sum borrowed (lent) is paidback at the end of the agreed time period PLUS theaccrued (owed but not paid) interest.
Simple Interest is:
(principal)(interest rate)(time)(principal)(interest rate)(time)RMI = (P)(i)(n)RMI = (P)(i)(n)
Simple and Compound InterestSimple and Compound InterestCompound InterestCompound Interest
To
COMPOUND
–stop and compute theassociated interest and add it to the unpaidbalance.
When interest is compounded, the interest that isaccrued at the end of a given time period is addedin to form a NEW principal balance.
That new balance then earns or is chargedinterest in the succeeding time period
Interest then “earns interest”
Compound InterestCompound Interest
::
ExampleExample
Assume:
P = RM1,000
i = 5% per year compounded annually (C.A.)
N = 3 years
II
22
=RM52.50=RM52.50II
11
=RM50.00=RM50.001 2 3
P=RM1,0P=RM1,00000
II
33
=RM55.13=RM55.13
Owe at t = 3 years:RM1,000 + 50.00+ 52.50 + 55.13= RM1157.63

Interest formulasInterest formulas
1.F/P and P/F Factors2.P/A and A/P Factors3.F/A and A/F Factors4.P/G and A/G Factors5.Effective Interest Rate
P=Present value, F=Future Value, A=Annual equivalent amount,P=Present value, F=Future Value, A=Annual equivalent amount,i=Interest Rate, n=No. of interest periods,i=Interest Rate, n=No. of interest periods,
1.Single1.Single--payment Compound Amountpayment Compound Amount
F/P FactorF/P FactorTo find F given PTo find F given P
P
0
F
n
n

………….
Compound forward in time
F
n
= P(F/P,i%,n) = P(1+i)
n
ExampleExample--F/P AnalysisF/P Analysis
Example: P= RM1,000;n=3;i=10%Example: P= RM1,000;n=3;i=10%
What is the future value, F?What is the future value, F?
0 1 2 3
P=RM1,00P=RM1,0000F = ??F = ??
i=10%/yeari=10%/year
F
3
= RM1,000[F/P,10%,3] = RM1,000[1.10]
3
= RM1,000[1.3310] = RM1,331.00

2.Single2.Single--Payment Present Worth AmountPayment Present Worth Amount
P/F FactorP/F FactorTo find P given FTo find P given F
PF
n
n

………….
P/F factor brings a singleP/F factor brings a singlefuture sum back to a specificfuture sum back to a specificpoint in time.point in time.
P = F(
P/F,i%,n
) = F(1+i)
-n
ExampleExample – –P/F AnalysisP/F Analysis
Assume F = RM100,000, 9 years from now. What is Assume F = RM100,000, 9 years from now. What isthe present worth of this amount now if i =15%?the present worth of this amount now if i =15%?
0 1 2 3 8 9
…………
F
9
=RM100,000
P= ??i = 15%/yr

P
0
= RM100,000(P/F, 15%,9) =RM100,000(1/(1.15)
9
)= RM100,000(0.2843) = RM28,430at time t = 0

3.Equal3.Equal--Payment Series Compound AmountPayment Series Compound Amount
F/A FactorF/A FactorTo find F given ATo find F given A
0

…………..N
RM A per periodRM A per periodRMF
Find RM F given theFind RM F given theRM A amountsRM A amounts
F = A (F = A (
F/A, i, n F/A, i, n
)= A)= A
ii
n
1)1(

ExampleExample
Formosa Plastics has major fabrication plants inFormosa Plastics has major fabrication plants inTexas and Hong Kong. It is desired to know theTexas and Hong Kong. It is desired to know thefuture worth of RM1,000,000 invested at the end of future worth of RM1,000,000 invested at the end of each year for 8 years, starting one year from now.each year for 8 years, starting one year from now.The interest rate is assumed to be 14% per year.The interest rate is assumed to be 14% per year.
A = RM1,000,000/yr; n = 8 yrs, i = 14%/yr
Solution:Cash flows are indicated in RM1000 units. The F value in8 years is
F =
l000
(F/A,14%,8)
=1000( 13.23218) = RM13,232.80= 13.232million 8 years from now.
4.Equal4.Equal--Payment Series Sinking FundPayment Series Sinking Fund
A/F Factor A/F Factor
RM A per periodRM A per period
0

…………..N
MF
Find RM A given theFind RM A given theFuture amt.Future amt. – –RM FRM F
(1)1
n
ii F
A = F ( A = F (
A/F, i, n  A/F, i, n
)=)=
ExampleExample
How much money must Carol deposit everyHow much money must Carol deposit everyyear startingyear starting
,,
l year from now at 5.5% perl year from now at 5.5% peryear in order to accumulate RM6000 sevenyear in order to accumulate RM6000 sevenyears from now?years from now?
SolutionSolution
The cash How diagram from Carol's perspective fits theThe cash How diagram from Carol's perspective fits the A/F factor. A/F factor.
A= RM6000 ( A= RM6000 ( A/F,5.5%,7 A/F,5.5%,7) = 6000() = 6000(0.120960.12096) =) =RM725.76RM725.76per yearper year
The A/F factor Value 0f 0.12096 was computed usingThe A/F factor Value 0f 0.12096 was computed usingthe A/F factor formulathe A/F factor formula