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# Chapter 4 - Time Value of Money

## SEEM2440A/B Chapter 4 - Time value of money

Money-time relationships
Money has a time value because it can earn interest (or profit)
over time.
Simple interest:
Total interest is linearly proportional to the amount of loan
(principal), the interest rate, and the number of interest periods.

I = (P)(N)(i)

I : total interest
P : principal
N : number of interest periods
i : interest rate per interest period.

## Example 4.1: You borrowed \$10,000 for 3 years at a simple

interest rate of 10%. How much will you repay at the end of 3rd
year?
I = (10, 000)(3)(0.1) = \$3, 000. You need to pay \$13,000.
SEEM2440A/B Chapter 4 - Time value of money
Compound interest:
Suppose the interest accumulates as follows:
Period, p Amount owed Interest amount Amount owed
at the start of p for p at the end of p
1 \$10,000 \$1,000 \$11,000
2 \$11,000 \$1,100 \$12,100
3 \$12,100 \$1,210 \$13,310

## You would repay \$13,310. Total interest payment would be

\$13,310-\$10,000=\$3,310>\$3,000 (interest in simple interest
calculation).
Interest accumulates over the earned interests in the previous
periods. More common than simple interest.

## Generalize: Future equivalent of \$10,000 (P) at the end of 3 (N)

periods is P(1 + i)N = \$10, 000(1.1)3 .

## SEEM2440A/B Chapter 4 - Time value of money

Economic equivalence

## When comparing the alternatives, we should consider:

the interest rate
the amounts of money involved
the timing of the monetary receipts or expenses
the manner in which the interest (or profit) is paid
Back to the example with compound interest:
\$10,000 now is equivalent to \$11,000 one year from now, and it
is equivalent to \$12,100 two years from now under the fixed
compound interest rate of 10%. One should be indifferent
between the following three alternatives:
2 Pay/receive \$11,000 one year from now
3 Pay/receive \$12,100 two years from now

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.2 (3 plans for repayment of \$10,000 in three years
at 10% per year)
You owe \$10,000 to your credit card company. You have 3
plans to pay the balance back:

## Plan 1: Pay interest due at end of each year and principal at

end of third year.
Year Amount owed Interest Principal payment Total pmnt.
1 10,000 1,000 0 1,000
2 10,000 1,000 0 1,000
3 10,000 1,000 10,000 11,000
Total: 3,000 13,000

## SEEM2440A/B Chapter 4 - Time value of money

Plan 2: Pay principal and interest in one payment at the end of
third year.
Year Amount owed Interest Principal payment Total pmnt.
1 10,000 1,000 0 0
2 11,000 1,100 0 0
3 12,100 1,210 10,000 13,310
Total: 3,310 13,310

## Plan 3: Pay off the debt in 3 equal end-of-year payments.

Year Amount owed Interest Principal payment Total pmnt.
1 10,000 1,000 3,021 4,021
2 6,979 697.9 3,323 4,021
3 3,656 365.6 3,656 4,021
Total: 2,063.5 12,063

Plan 1,2 and 3 are all equivalent at the compound interest rate
of 10%! (Why? You can answer it at the end of this chapter.)

## SEEM2440A/B Chapter 4 - Time value of money

Cash-flow diagrams
i = effective interest rate per interest period
N = number of compounding periods
P = the present sum of money
F = future sum of money
A = end-of-period cash flows in a uniform series for a specified
number of periods, starting at the end of first period and
continuing through the last period.
In a cash-flow diagram:
horizontal line represents time scale,
arrows represent cash flows. Downward arrows represent
expenses (negative cash flows or cash outflows) and
upward arrows represent receipts (positive cash flows or
cash inflows).
The cash-flow diagram is dependent on the point of view.
In the course, without explicitly mention, the company’s
(investor’s) point of view will be taken.
SEEM2440A/B Chapter 4 - Time value of money
General setting

Beginning of
period 1
End of period 1 F

0
1 2 3 N-1 N

i % per period

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.3

Show the cash flow diagrams for Plans 2 and 3 from the credit
card company’s viewpoint. Identify i, P, F, A.

## SEEM2440A/B Chapter 4 - Time value of money

Solution

Plan 2 Plan 3

F = \$13,310 A= \$4,021

0 0
2 3=N 1 2 3=N
1
End of Year (EOY) End of Year (EOY)

P = \$10,000 P = \$10,000

Example 4.4

## You are analyzing a project with five-year life. The project

requires a capital investment of \$50,000 now, and it will
generate uniform annual revenue of \$6,000. Further, the
project will have a salvage value of \$4,500 at the end of the fifth
year and it will require \$3,000 each year for the operations.
Develop the cash-flow diagram for this project from the
investor’s viewpoint.

Solution

\$4,500

0 1 2 3 4 5

## \$3,000 \$3,000 \$3,000 \$3,000 \$3,000

End of Year (EOY)
\$50,000

## SEEM2440A/B Chapter 4 - Time value of money

Rules for performing calculations with cash flows

## Three Rules for performing arithmetic calculations with cash

flows:
1 Cash flows cannot be added or subtracted unless they
occur at the same point in time.
2 To move a cash flow forward in time by one time unit,
multiply the magnitude of the cash flow by (1 + i).
3 To move a cash flow backward in time by one time unit,
divide the magnitude of the cash flow by (1 + i).

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas relating P and F

0
1 2 … N−1 N
End of Period

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas relating P and F

F = P(1 + i)N .

## Notation: F = P(F/P, i%, N) where the factor in the

parentheses is read "find F given P at i% interest per
period for N interest periods".

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas relating P and F

0
1 2 … N−1 N
End of Period

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas relating P and F

 N
P = F 1+i 1
= F(1 + i)−N .

## Notation: P = F(P/F, i%, N) where the factor in the

parentheses is read "find P given F at i% interest per
period for N interest periods.

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.5: You deposit \$50,000 now in a savings account at
an interest rate of 8% per year. How much will you have in this
account at the end of fifth year? Assume the interest rate is
constant at 8% for the next five years.
Solution: P = 50, 000, i = 8% per year, N = 5
F = P(F/P, 8%, 5) = 50, 000(1 + 0.08)5 = \$73, 466

## Example 4.6: How much should you deposit in a savings

account now so that you will have \$100,000 in this account 6
years from now? Assume that the interest rate is 5% per year.
Solution: F = 100, 000, i = 5% per year, N = 6
P = F(P/F, 5%, 6) = 100, 000(1 + 0.05)−6 = \$74, 627

## SEEM2440A/B Chapter 4 - Time value of money

General setting with annuities (A)

A A A A A

0 N
1 2 3 N-1

i % per period

P F

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas relating P,F, and A

## Rule: Uniform (equal) receipts, A, at the end of each period for

N periods at an interest rate of i% per period, where the first
receipt occurs at the end of the first period and the last one
occurs at the end of the Nth period.
Finding F when A is given
Find the future equivalent at the end of Nth period of each cash
flow A. Then sum them up.
Future equivalent at the end of period N of the cash flow that
happens at the end of period 1: A(F/P, i%, N − 1)
Future equivalent at the end of period N of the cash flow that
happens at the end of period 2: A(F/P, i%, N − 2)
...........
Future equivalent at the end of period N of the cash flow that
happens at the end of period N: A(F/P, i%, 0)

## SEEM2440A/B Chapter 4 - Time value of money

F = A(F/P, i%, N − 1) + A(F/P, i%, N − 2) + ... + A(F/P, i%, 1) +
A(F/P, i%, 0)
⇒ F = A[(1 + i)N−1 + (1 + i)N−2 + ... + (1 + i)1 + (1 + i)0 ].
Note that
[(1 + i)N−1 + (1 + i)N−2 + (1 + i)N−3 + ... + (1 + i)1 + (1 + i)0 ] =
N−1 h in
1
(1 + i)N−1 (1+i)
P
n=0

## The last term comprises a geometric series of the form

ar0 + ar1 + ar3 + ... + arN−2 + arN−1 , where a = (1 + i)N−1 ,
r = (1 + i)−1 .

## SEEM2440A/B Chapter 4 - Time value of money

Note that the sum of the first N terms in a geometric series is:
N−1
P n a(1−rN )
ar = 1−r .
n=0
Therefore we have the following:
N−1 h in (1+i)N−1 − 1
1 (1+i)N −1
(1 + i)N−1 (1+i) (1+i)
P
= 1− 1
= i
n=0 (1+i)
We find:
h i
(1+i)N −1
F=A i

## SEEM2440A/B Chapter 4 - Time value of money

Finding A when F is given
h N
i
From F = A (1+i)i −1 ,

h i
i
A=F (1+i)N −1

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.7: You plan to deposit \$2,000 to your savings
account at the end of every month for the next 15 months
starting from the next month. If the interest rate you can earn is
2% per month how much money will accumulate immediately
after your last deposit at the end of the 15th month?
Solution: h per15month,
h A N= 2,i000, i = 2% i N = 15 months. F =?
(1+i) −1 (1.02) −1
F=A i = 2, 000 0.02 = \$34, 587

## Example 4.8: What uniform monthly amount should you deposit

in your savings account at the end of each month for the
following 10 months in order to accumulate \$75,000 at the time
of the 10th deposit? Assume that the interest rate you can earn
is 4% per month and the first deposit will be made next month.
Solution:
h F = 75, h per month,
i 000, i = 4% i N = 10 months. A =?
i 0.04
A = F (1+i)N −1 = 75, 000 (1.04)10 −1 = \$6, 247

## SEEM2440A/B Chapter 4 - Time value of money

Finding P when A is given
Given P = F(P/F, i%, N) and F = A(F/A, i%, N), we can derive
P = A(P/A, i%, N) as follows:

## P h= A(P/A,ii%, N) = [A(F/A, i%, N)](P/F, i%, N) ⇒

N
A (1+i)i −1 (1 + i)−N

h i
(1+i)N −1
P=A i(1+i)N

## Notation: P = A(P/A, i%, N).

Finding A when P is given
h N −1
i
From P = A (1+i)
i(1+i) N ,

h i
i(1+i)N
A=P (1+i)N −1

## Notation: A = P(A/P, i%, N).

SEEM2440A/B Chapter 4 - Time value of money
Example 4.9: How much should you deposit to your savings
account now at an annual interest rate of 10% to provide for 5
end-of-year withdrawals of \$15,000 each?
Solution:
h A N= 15, h per
i 000, i = 10% iyear, N = 5 years. P =?
(1+i) −1 (1.1)5 −1
P = A i(1+i)N = 15, 000 0.1(1.1)5 = \$56, 862

## Example 4.10: You plan to borrow a loan of \$100,000 which

you will repay with equal annual payments for the next 5 years.
Suppose the interest rate you are charged is 8% per year and
you will make the first payment one year after receiving the
loan. How much is your annual payment?
Solution:
h P =N 100, h per year,
i 000, i = 8% i N = 5 years. A =?
i(1+i) 0.08(1.08)5
A = P (1+i)N −1 = 100, 000 (1.08)5 −1 = \$25, 046

## SEEM2440A/B Chapter 4 - Time value of money

SEEM2440A/B Chapter 4 - Time value of money
Deferred annuities
Table 1: Ordinary annuities
Year 0 1 2 3 ... N
Cash flow - A A A ... A

## Table 2: Deferred annuities

Year 0 1 2 3 ... J J+1 J+2 ... N
Cash flow - - - - ... - A A ... A

## What is the present equivalent of the deferred annuity shown in

Table 2 as of time 0 (P0 )?

## What is the future equivalent of the deferred annuity shown in

Table 2 as of time N (FN )?

FN = A(F/A, i%, N − J)

Example 4.11

P0=?
5,000

## 4,000 ..…….. 4,000

2,000 …….. 2,000

6 7 8 9 10
0 1 2 3 4 5 11 12 13 14 15

i=10 % per
period

Solution

## P0 = 4000(P/A, 10%, 5) − 1000(P/A, 10%, 8)(P/F, 10%, 2) +

5000(P/F, 10%, 11) + 2000(P/A, 10%, 4)(P/F, 10%, 11)
= \$14, 729.

## Cash flow series that increases or decreases by a constant

amount (G) from one period to the next. See the cash flow
diagram in the next slide.

## SEEM2440A/B Chapter 4 - Time value of money

Cash flows in arithmetic gradient series

(N-1)G
(N-2)G

3G
2G
G

0 1 2 3 4 N-1 N

i% per period

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas

## Finding F when G is given

F = G(F/P, i%, N − 2) + 2G(F/P, i%, N − 3) + 3G(F/P, i%, N −
4) + ... + (N − 1)G(F/P, i%, 0) ⇒
F = G[(1 + i)N−2 + 2(1 + i)N−3 + 3(1 + i)N−4 + ... + (N − 1)(1 + i)0 ]
(1)
Multiply both sides of the expression in (1) with (1 + i):
F(1+i) = G[(1+i)N−1 +2(1+i)N−2 +3(1+i)N−3 +...+(N−1)(1+i)1 ]
(2)
Subtract (1) from (2):
Fi = G[(1 + i)N−1 + (1 + i)N−2 + (1 + i)N−3 + ... + (1 + i)1 − (N − 1)]
F = Gi [(1 + i)N−1 + (1 + i)N−2 + (1 + i)N−3 + ... + (1 + i)1 + 1] − GN
i

h i
G (1+i)N −1 GN G GN
F= i i − i ⇒F= i (F/A, i%, N) − i .

## SEEM2440A/B Chapter 4 - Time value of money

Finding P when G is given
We know the formula to find F given G, and the formula to find
P given F. We can use these formulas to find (P/G, i%, N) as
follows:
 h N
i 
P = Gi (1+i)i −1 − GN
i (P/F, i%, N)
Recall (P/F, i%, N) = (1 + i)−N
Hence,
 h i
1 (1+i)N −1 N
P=G i i(1+i)N
− (1+i)N
.

## SEEM2440A/B Chapter 4 - Time value of money

Finding A when G is given
We know the formula to find F given G, and the formula to find
A given F. We can use these formulas to find (A/G, i%, N) as
follows:
A = Gi (F/A, i%, N) − GN

i (A/F, i%, N)
⇒ A = Gi − GNi (A/F, i%, N)
(A/F, i%, N) = (1+i)i N −1
Hence,
h i
1 N
A=G i − (1+i)N −1
.

Example 4.12

18,000

16,000
14,000
12,000
10,000

0 1 2 3 4 5

## i=10% per period

a) P=? b) A=?

0 1 2 3 4 5 0 1 2 3 4 5

## SEEM2440A/B Chapter 4 - Time value of money

Solution

\$18,000

\$16,000
\$14,000
\$12,000
\$10,000
0 1 2 3 4 5

\$8,000
\$6,000
\$10,000
\$4,000
+ \$2,000

0 1 2 3 4 5 0 1 2 3 4 5

Solution

## P = 10000(P/A, 10%, 5) + 2000(P/G, 10%, 5)

= \$51, 631.
A = P(A/P, 10%, 5)
= 51631.47(A/P, 10%, 5)
= \$13, 620.

## Cash flow series that increases or decreases by a constant

percentage (f ) from one period to the next. See the cash flow
diagram in the next slide.
A −A
Note that Ak = (1 + f )Ak−1 and f = kAk−1k−1 , where f is the
constant rate of change.

## SEEM2440A/B Chapter 4 - Time value of money

Cash flows in geometric gradient series

i% per period

0 1 2 3 4 N-1 N

A1
A2=(1+f)A1

A3=(1+f)2A1

A4=(1+f)3A1

AN-1=(1+f)N-2A1

AN=(1+f)N-1A1

## SEEM2440A/B Chapter 4 - Time value of money

Interest formulas

## Derive the expression for the present equivalent (P) of the

geometric series.
Use the previously derived formulas (A/P,i%,N) and (F/P,i%,N)
to find A and F, respectively.

## P = A1 (P/F, i%, 1) + A2 (P/F, i%, 2) + ... + AN (P/F, i%, N)

Note that (P/F, i%, N) = (1 + i)−N and Ak = (1 + f )k−1 A1 ,
2 ≤ k ≤ N.
Hence,
P = A1 (1 + i)−1 +(1 + f )(1 + i)−2 + ... + (1 + f )N−1 (1 + i)−N

   2  N−1
⇒ P = A1 (1 + i)−1 1 + 1+f 1+i + 1+f
1+i + ... + 1+f
1+i

## SEEM2440A/B Chapter 4 - Time value of money

N−1
(1−xN )
xn =
P
Using the summation formula 1−x , when x 6= 1, we
n=0
can derive the following
 expression:
1+f
(Note that x = 1+i , and x 6= 1 reduces to i 6= f )

(
A1 [1−(P/F,i%,N)(F/P,f %,N)]
i−f 6 i
f =
P=
A1 N(P/F, i%, 1) f =i

## Note that f can be negative. For example, when f = −0.1,

(F/P, f %, N) = (1 − 0.1)N .

Example 4.13

## (Blank&Tarquin) Chemical Engineers at a Coleman Industries

plant in the Midwest have determined that a small amount of a
newly available chemical additive will increase the water
repellency of Coleman’s tent fabric by 20%. The plant
superintendent has arranged to purchase the additive through
a 5-year contract at \$7,000 per year, starting 1 year from now.
He expects the annual price to increase by 12% per year
thereafter for the next 8 years. Additionally, an initial investment
of \$35,000 was made now to prepare a site suitable for the
contractor to deliver the additive. Use i=15% per year to
determine the equivalent total present worth of all these cash
flows.

Solution

0 1 2 … 5 6 … 13

\$7,000(1.12)
\$7,000
\$35,000

\$7,000(1.12)8

Solution

## 35, 000 + 7, 000(P/A, 15%, 4) +

7,000[1−(P/F,15%,9)(F/P,12%,9)]
0.15−0.12 (P/F, 15%, 4) = \$83, 232.

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.14

10,000
9,500
9,000

8,500
8,000
7,500
7,000

0 1 2 3 4 5 6 7 8 9

2,000
2,500
X X X X

## X/3 X/3 X/3

0 1 2 3 4 5 6 7 8 9

X=?

Solution

## [10, 000(P/A, 10%, 7) − 500(P/G, 10%, 7)](P/F, 10%, 2) − 2, 000 =

X(P/A, 10%, 7) − 2X
3 (P/A, 10%, 3) + 2, 500(P/F, 10%, 9).

## [10, 000(4.8684) − 500(12.763)](0.8264) − 2, 000 =

X(4.8684) − 2X3 (2.4869) + 2, 500(0.4241)

⇒ X = 9, 935.8

Example 4.15

## Suppose that the parents of a young child decide to make

annual deposits into a savings account, with the first deposit
being made on the child’s 5th birthday and the last deposit
being made on the 15th birthday. Then, starting on the child’s
18th birthday, four end-of-year withdrawals will be made at the
amounts of \$2,000, \$2,400, \$2,800, and \$3,200, respectively. If
the effective annual interest rate is 8% during this period of
time, what are the annual deposits in years 5 through 15?

Solution

## A= [2,000 (P/A,8%,4) + 400 (P/G,8%,4)] (P/F,8%,2) (A/F,8%,11)

= [2, 000(3.3121)+400 (4.650)] (0.8573) (0.0601) = \$437.14

## SEEM2440A/B Chapter 4 - Time value of money

Nominal and effective interest rates

You are given two 1-year fixed deposit saving plans. The
interest rate of the two plans are:
Plan 1: 12% per year (compounded annually).
Plan 2: 12% per year compounded monthly.

## SEEM2440A/B Chapter 4 - Time value of money

In Plan 1, the interest rate "12% per year" is known as the
effective interest rate per year, the same as the one we use
before.

## In plan 2, the interest rate "12% per year compounded monthly"

is known as the nominal interest rate per year with the
compounding period 1 month (or compounding frequency 12).

## SEEM2440A/B Chapter 4 - Time value of money

In general, the nominal and effective interest rates are related
by
!M
r(M)
i= 1+ −1 (NOM-EFF)
M
where
i: effective interest rate per period;
r(M) : nominal interest rate per period with compounding
frequency M.

## SEEM2440A/B Chapter 4 - Time value of money

Example 4.16

You own a credit card which has a nominal interest rate of 15%
per year, compounded monthly. a) What is the effective annual
interest rate? b) Suppose your balance as of today (year 0) is
\$10,000. How much will you owe to the credit card company at
the end of 3 years if you do not make any payments during 3
years?
Solution: 12
a) i = 1 + 0.15
12 − 1 = 16.07%
b) Use formula (F/P,i%,N). We can use effective annual interest
rate of i% and N=3.
P(F/P, i%, N) = 10, 000(F/P, 16.07%, 3) = 15, 637
Alternatively, we can use interest rate per month 0.15
12 = 0.0125
and N=3(12)=36.
P(F/P, i%, N) = 10, 000(F/P, 1.25%, 36) = 15, 639

## SEEM2440A/B Chapter 4 - Time value of money

Continuous compounding

## What if M (number of compounding periods) → ∞. What is the

effective (continuous) interest rate?
r M

We know that i = 1 + M − 1.
r M

lim i = lim 1 + M − lim 1
M→∞ M→∞ p M→∞
Recall: lim 1 + p1 = e (natural logarithm base)
p→∞
M
Let r =p
h pr i h p ir
⇒ i = lim 1 + 1p − 1 = lim 1 + 1p −1
p→∞ p→∞
⇒ i = er − 1
We can obtain the interest formulas relating P,F,A, by using the
relation i = er − 1.

## SEEM2440A/B Chapter 4 - Time value of money

SEEM2440A/B Chapter 4 - Time value of money
Payment Period and Compounding Period

## Payment Period (PP) and Compounding Period (CP) of cash

flow:
Type 1: PP = CP (Done!)
Type 2: PP > CP
Type 3: PP < CP

## SEEM2440A/B Chapter 4 - Time value of money

Type 2: PP > CP

The strategy in this case is to find the effective interest rate per
PP by using the relation (NOM-EFF).

Example 4.17: For the past 7 years, a quality manager has paid
\$500 every 6 months for the software maintenance contract of
a LAN. What is the equivalent amount after the last payment, if
these funds are taken from a pool that has been returning 10%
per year compounded quarterly?

## SEEM2440A/B Chapter 4 - Time value of money

Solution

PP = 6 months; CP = 3 months.

## The effective interest rate per 6-month i is given by

0.05 2
 
i= 1+ − 1 = 0.05063.
2

## The equivalent amount after the last payment

= 500(F/A, 5.063%, 14) = \$9, 842.

## SEEM2440A/B Chapter 4 - Time value of money

Type 3: PP < CP; Case 1

## Under the above assumption, the strategy is similar to the case

of Type 2 by finding the effective interest rate per PP. Different
from Type 2, we cannot apply the relation of the nominal and
effective interest rates in (NOM-EFF) directly. The detailed
treatment can refer to Example 4.18 below.

Example 4.18

## Suppose you make \$500 monthly deposits to a tax-deferred

retirement plan that pays interest at a rate of 10% per year
compounded quarterly. Compute the balance at the end of 10
years.

## SEEM2440A/B Chapter 4 - Time value of money

Solution

PP = 1 month; CP = 3 months.

## The effective interest rate per 1 month i is given by

10% 1/3
 
i= 1+ − 1 = 0.826%
4

## The balance at the end of 10 years =

\$500(F/A, 0.826%, 120) = \$101, 907.89.

## SEEM2440A/B Chapter 4 - Time value of money

Type 3: PP < CP; Case 2

## Assumption: Interperiod cash flows earn no interest.

In this case,
Deposits (negative cash flows) are all regarded as
deposited at the end of the compounding period.
Withdrawals (positive cash flows) are all regarded as
withdrawn at the beginning of the compounding period.

Example 4.19

## Consider Example 4.18 again. Suppose that money deposited

during a quarter (the compounding period) will not earn any
interest. Compute the balance at the end of 10 years.

Solution

Months
0 3 6 … 120

A = \$500

Quarters
0 1 2 … 39 40

A = \$1,500

Solution

## The effective interest rate per quarter = 10%

4 = 2.5%.
A = 3(\$500) = \$1, 500 per quarter.
So,
F = \$1, 500(F/A, 2.5%, 40) = \$101, 103.83.