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TOPIC 2

The Time Value of money

Comments

In some courses and textbooks, this topic is also called Financial

Mathematics

Time value of money is about calculating future and present value of money.

In this topic you will learn how to calculate

1) Compound interest / future value

1a) Effective interest rates

1b) The rule of 72

2) Present value

3) Future value of annuity

4) Present value of annuity

Time value of money is the foundation of half of this course. Topics like

Capital budgeting (Topic 3 & 4) and Cost of capital (Topic 5 & 6) will be

based on your knowledge of this topic.

Mastery of this topic is thus essential for successful completion of BFN402

1) COMPOUND INTEREST

Characteristics

Only one investment at the beginning of year 1. Both principal and interest

earned will earn interest. The future value is required.

Example:

What is the future value of RM1,000 invested in Fixed Deposit with a Bank at

10% for 4 years

Yr

1

Principal

At start of year

RM1,000

Interest

Principal

At end of year

2

3

4

updated yeap31/7/2013, 22/3/2004

Using Formula

FV = P ( 1+r ) n

P is Present value or Principal

r is the interest rate per annum and

n is the number of periods

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There exist compound value tables that you can refer to for the FV factor. In

DBS we shant be referring them.

1a) EFFECTIVE INTEREST RATE

This is the effective interest rate earned where the investment is

compounded more than once a year.

deposit that is compounded every 3 months?

Using Formula

Effective r =

E(r) = ( 1 + (r / m)) m - 1

m is the number of times interest is compounded in 1 year

Exercise

What is the effective interest rate of a fixed deposit that pays 3% pa for a 6

month tenure?

1b) THE RULE OF 72

Rule of 72 is a method of estimating how many years for a given amount of

interest or the amount of interest for a given number of years; it would take to

double a sum of money.

The answers derived using the rule of 72 are merely rough estimates.

Example 1: if your investment can earn 12% per annum, how many years

would it take to double your investment?

The approximate number

of years required

72

12

6 years

Example 2: if you plan to double your investment in 4 years, what is the rate

of return you should be aiming for?

The approximate required

rate of return

72

4

18%

Exercise

If inflation is 6%, estimate the number of years it would take prices to quadruple

(4 times).

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Updated yeap22/3/2004

This is the reverse of compound value. Present value means value now.

We are concern with finding the value now of a sum of money receivable in

the future.

Using Formula

PV

FV

(1+r)n

There exist present value tables that you can refer to for the PV factor. In

DBS we shant be referring them.

Example:

Find the value now (present value) of a sum RM 1,464.10 receivable at the end

of 4 years. The applicable interest for the period is 10%.

3) FUTURE VALUE OF ANNUITY

This involves not 1 sum of investment as above but a series of investments/

payments each invested at a specific point of time. I.e. every month end,

year-end etc. All such investments shall earn compound interest. We are to

calculate the future value of such a scheme.

Example

How much would Mr Tan have if he were to invest RM1,000 in a fixed deposit a/c

on 31st December every year for the next 5 years. Interest to be calculated at

7% throughout the period.

Updated yeap22/3/2004

Year

1

Principal

At start

Interest

earned

Annuity

Invested

Principal

At end

2

3

4

5

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Using Formula

FV = A ( 1 + r ) n - 1

r

Where A is the Annuity amount.

You will note that the annuity amount is invested at the end of each period.

This is called ordinary annuity.

There exist future value of annuity tables that you can refer to for the FV

annuity factor. In DBS we shant be referring them.

Here we are interested in finding out how much the Annuity scheme is worth

in one lump sum now. With this one lump sum, we can invest (earning

compound interest) now and upon maturity will still end up with the same FV

amount as the annuity scheme.

annuity) . The loan amount is the PV.

Using Formula

PV = A

or

PV = A

1 - ( 1 + r )- n

r

Updated yeap22/3/2004

1

1 - (1+r)n

r

There exist PV of annuity tables that you can refer to for the PV annuity

factor. In DBS we shant be referring them.

Example

Mr Tan is seeking a loan of RM$4,100.20 from BHL Bank as a down payment of

moulding machine for his factory. The tenure of the loan is 5 years and the

applicable interest rate is 7%. Repayment shall be a fixed sum at the end of

each year. What is the amount of repayment?

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Note

If you take the PV of RM4,100.20 and you compound interest it at 7% and 5

years, what will you get?

Exercises

1) You invest RM2,000 in Public Bank fixed deposit a/c which pays interest of

3.25% yearly. How much would you have in your a/c at the end of 3 years?

2) If I have RM148,643.65 and I am able to invest it at 10% consistently for 20

years; How much will I have in my account at the end of 20 years?

3) Mrs Sim placed RM10,000 in CIMB Bank fixed deposit a/c. The interest rate

is 3.5% pa. How much will she have in 6 years time?

4) You have RM100,000. If you are able to invest it at a rate of 20% per annum,

how much will you have in 13 years?

5) What if you had being able to invest it at 40%. How much will you have in 7

years?

6) Bank A offers you 3.2% interest for its fixed deposit compounded monthly.

Alternatively Bank A is also offering 3.25 % interest for fixed deposit

compounded semi-annually. Which is the better deal?

7) Which is the better deal? Bank A which offers 3.3% pa for its fixed deposit or

Bank B that offers 3.25% compounded monthly?

8) Which is the better deal? A fixed deposit that pays 3.22% compounded

monthly or 3.32% compounded quarterly?

9) You invest RM2,000 for 2 years at 3.25% pa compounded quarterly. How

much would you have in your account at the end of 2 years?

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10)You invest RM1,000 in a fixed deposit account that pays 3.4% pa. The

maturity is in 6 months time but you will maintain the deposit for 3 years. How

much will you have at the end of 3 years?

11) Davids uncle promised to give him RM1,000 on his 21 st birthday which is in 3

years time. How much is this worth in todays money if inflation is 6%?

12)Mr Lim calculated that he will have RM500,000 when he retires in 10 years

time. How much is this worth in todays money if inflation is 6%?

13)How many years would it take to double your money if you can earn 12% pa?

Use the rule of 72.

14)How many years would it take to double your money if you can earn 3% pa?

Use the rule of 72.

15)How much interest do you need to earn if you want to double our money in 4

years time? Use the rule of 72.

16)How much interest do you need to earn if you want to double our money in 8

years time? Use the rule of 72.

17)Its 2014 and a regular bowl of Hokkien mee cost around RM3.50. If inflation

is really 6% how much would it costs in 24 years? Use the rule of 72.

18)Ryans father promised to give him RM150,000 when he turns 21 years old.

Ryan is 15 years old this year. Assume that the interest rate for fixed deposit

is constant at 8% pa for the next 6 years. How much does Ryans father need

to keep in fixed deposit now in order that his son can have RM150,000 in 6

years time.

19)Chooi Fun has a savings plan. She plans to save RM8,000 every year for 5

years. How much will he have if she can earn 3% every year?

20)Mr Loh would like to save RM5,000 every year for the next 10 years. How

much will he have then if he can get 3.2% pa?

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21)You are now 40 years old and would like to retire at 55 years age. At that time

you would like have at least RM500,000 on hand. How much must you save

now at the end of each year so that you will have this sum at the end of 15

years. You reckon that the average interest rate during this period would be

3%. p.a.

22)Mr Loh wants to borrow money to buy a house. His house cost RM500,000.

Mr Loh will pay a down payment of RM50,000; he intends to borrow the rest

via a 10 year 5.5% housing loan. If the bank requires a lump sum payment at

the end of every year, how much is his repayment?

23)An investor wants to buy a condominium in Kuala Lumpur. The seller is

asking for RM480,000. If the investor figures that he can collect RM45,900 at

the end of each year in rent and then sell the building after 7 years for

RM600,000, what should he offer to pay to yield a 16% return on the

investment.

24)You buy a house, which you finance for RM64,000. You agree to make 15

annual instalments. Interest on the loan is 10%. What is the amount of each

instalment?

25)You borrow RM3,400 for 4 years at 5%. Prepare a loan amortisation schedule

using the format below.

Year

Principal

At start

Repayment

Amount

Interest

paid

Principal

paid

Principa

l

At end

1

2

3

4

26)You borrow RM5,400 for 3 years at 5%. Prepare a loan amortisation schedule

using the format below.

Year

YeapCP

Principa

l

Repayment

Amount

Interest

paid

Page 7 of 8

Principa

l paid

Principal

At end

15/01/2016

At start

1

2

3

27)Rachel has RM100,000 in her EPF account now. She reckons that she will

earn an average of RM8,000 monthly for the next 20 years. EPF contribution

is about 20% of this amount every month. How much will she have in her

EPF when she retires in 20 years time if her EPF account earns 5.5% pa.

consistently.

Quick Test

1) If Mr Lee took a 20 year 5.5% RM100,000 housing loan that required

servicing only at the end of each year, how much would be his annual

repayment?

2) Mr Lee invested RM100,000 in a fixed deposit account that pays 3.25%

pa. The tenure is for 3 months. How much will he get in 1 years time.

3) Mr Lee is thinking of saving RM5,000 every year for the next 12 years.

Assuming a average interest rate of 3.25%, how much will Mr Lee have at

the end of 12 years.

4) Mrs Tan has RM50,000 now. She is going to save RM8,000 each year for

the next 4 years. For the 6 years thereafter, she will save RM10,000 a

year. How much will she have if the fixed deposit pays 3.25% pa.

Updated yeap 8/1/2014 ,31/7/2013, ,25/3/2013, 3/1/2012, 1/7/08, 22/3/2004

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