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• Time Value of Money • • Money can “make” money if Invested Centers around an interest rate

7

TIME VALUE OF MONEY & INTEREST FORMULAS

The change in the amount of money over a given time period is called the time value of money

Interest Rate

INTEREST - MANIFESTATION OF THE TIME VALUE OF MONEY. THE AMOUNT PAID TO USE MONEY. IT REPRESENTS THE GROWTH OF CAPITAL PER UNIT PERIOD.

INVESTMENT

INTEREST = VALUE NOW - ORIGINAL AMOUNT

Economic Equivalence

•Economic Equivalence •Two sums of money at two different points in time can be made economically equivalent if: •We consider an interest rate and, •No. of Time periods between the two sums

Equality in terms of Economic Value

LOAN

INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT

RENTAL FEE PAID FOR THE USE OF SOMEONE ELSES MONEY…EXPRESSED AS A %

Equivalence Illustrated

RM20,000 is received here

**Simple and Compound Interest
**

•Two “types” of interest calculations •Simple Interest

T=0

t = 1 Yr

•Compound Interest •Compound Interest is more common worldwide and applies to most analysis situations

RM21,800 paid back here

RM20,000 now is economically equivalent to RM21,800 one year from now IF the interest rate is set to equal 9%/year

**Simple and Compound Interest
**

Simple Interest • Calculated on the principal amount only • In a multiperiod situation with simple interest: •The accrued interest does not earn interest during the succeeding time period •Normally, the total sum borrowed (lent) is paid back at the end of the agreed time period PLUS the accrued (owed but not paid) interest. •Simple Interest is:

(principal)(interest rate)(time) RMI = (P)(i)(n)

Compound Interest

• To COMPOUND – stop and compute the associated interest and add it to the unpaid balance. •When interest is compounded, the interest that is accrued at the end of a given time period is added in to form a NEW principal balance. •That new balance then earns or is charged interest in the succeeding time period •Interest then “earns interest”

**Compound Interest: Interest:
**

• Assume: •P = RM1,000

Example

Interest formulas

1. F/P and P/F Factors 2. P/A and A/P Factors 3. F/A and A/F Factors 4. P/G and A/G Factors

**• i = 5% per year compounded annually (C.A.) •N = 3 years P=RM1,0 00
**

1 I1=RM50.00 I2=RM52.50 2 3

Owe at t = 3 years: RM1,000 + 50.00 + 52.50 + 55.13 = RM1157.63

5. Effective Interest Rate

P=Present value, F=Future Value, A=Annual equivalent amount, i=Interest Rate, n=No. of interest periods,

I3=RM55.13

**1.Single-payment Compound Amount 1.SingleF/P Factor To find F given P
**

Fn = P(F/P,i%,n) = P(1+i)n Fn

**Example- F/P Analysis ExampleExample: P= RM1,000;n=3;i=10% What is the future value, F?
**

F = ??

0

1

2

3

…………. Compound forward in time P0 n

P=RM1,00 0

i=10%/year

F3 = RM1,000[F/P,10%,3] = RM1,000[1.10]3 = RM1,000[1.3310] = RM1,331.00

**2.Single-Payment Present Worth Amount 2.SingleP/F Factor To find P given F
**

P = F(P/F,i%,n) = F(1+i)-n Fn

Example – P/F Analysis

Assume F = RM100,000, 9 years from now. What is the present worth of this amount now if i =15%?

F9 = RM100,000

i = 15%/yr

0 1 2 3

…………

8

9

**…………. n P P/F factor brings a single future sum back to a specific point in time.
**

P= ?? P0 = RM100,000(P/F, 15%,9) = RM100,000(1/(1.15)9) = RM100,000(0.2843) = RM28,430 at time t = 0

**3.Equal-Payment Series Compound Amount 3.EqualF/A Factor To find F given A
**

(1 i ) F = A (F/A, i, n)= A i

n

Example

Formosa Plastics has major fabrication plants in Texas and Hong Kong. It is desired to know the future worth of RM1,000,000 invested at the end of each year for 8 years, starting one year from now. 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 in 8 years is

1

RM F

…………..

0

N

RM A per period

Find RM F given the RM A amounts

F = l000(F/A,14%,8) = 1000( 13.23218) = RM13,232.80 = 13.232 million 8 years from now.

**4.Equal-Payment Series Sinking Fund 4.EqualA/F Factor
**

A = F (A/F, i, n)= F

Example

How much money must Carol deposit every year starting, l year from now at 5.5% per year in order to accumulate RM6000 seven years from now?

Solution The cash How diagram from Carol's perspective fits the A/F factor. A= RM6000 (A/F,5.5%,7) = 6000(0.12096) = (A/F,5.5%,7) 6000(0.12096) RM725.76 per year The A/F factor Value 0f 0.12096 was computed using the A/F factor formula

i (1 i ) n 1

R M F N

0

……… ….. RM A per period

Find RM A given the Future amt. – RM F

5.Equal-Payment Series Present Worth Amount 5.EqualP/A Factor Desire an expression for the present worth – P of a stream of equal, end of period cash flows – A

**6.Equal-Payment Series Capital Recovery Amount 6.EqualA/P Factor
**

A P( A / P, i, n) P

P

(1 i)n 1 P A (P/A,i, n) A i(1 i)n

P = ??

0 1 2 3 n-1 n 0

i(1 i)n (1 i)n 1

1

2

3

n-1

n

Find RM P given the RM A amount

A = given

Find RMA given the RM P amount

A = ??

7.Arithmetic Gradient

Increasing uniform series

A1+(n-2)G A1+(n-1)G

7.Arithmetic Gradient

• P/G Factor To find P given G

P

A( P / A, i, n) G( P / G, i, n) A (1 i) n 1 (1 i)n in 1 G i(1 i) n i 2 (1 i) n

A1+2G A1+G

• A/G Factor To find A given G

A A1 G( A / G, i, n) A1 G (1 i)n in 1 i(1 i) n i

0

1

2

3

n-1

N

This represents a positive, increasing arithmetic gradient

Gradient Example

• Consider the following cash flow

RM3 00 RM4 00 RM5 00

Gradient Example

•PW(10%) of the base annuity = RM100(P/A,10%,5) •PBase = RM100(3.7908)= RM379.08 •Not Finished: We need the PW of the gradient component and then add that value to the RM379.08 amount •Calculating or looking up the P/G,10%,5 factor yields the following:

RM1 00

0 1

RM2 00

2

3

4

5

•Pt=0 = RM100(6.8618) = RM686.18 for the gradient PW •Total PW(10%) = RM379.08 + RM686.18 •Equals RM1065.26

Present Worth Point is here! And the G amt. = RM100/period

Find the present worth if i = 10%/yr; n = 5 yrs

**8.Nominal and Effective Interest
**

Nominal Interest Rate, r: r: An interest rate that does not include any consideration of compounding Format: “r% per time period, t” t” Ex: 5% per year” year” 1.5% per month for 12 months Same as: (1.5%)(12) = 18% per 12 months Effective Interest Rates, ia: An interest rate taking into account the effect of any compounding during the year Format: “r% per time period, compounded ‘m’ times a year. ‘m’ denotes or infers the number of times per year that interest is compounded. Ex: 18% per year, compounded monthly

EIR Notation

r = the nominal interest rate per year. m = the number of compounding periods within the year.

i = the effective interest rate per compounding period (r/m)

ia = effective interest rate per year

ia = (1 + r/m)m - 1 = (1 + i)m - 1.

•Remember: Always apply the Effective Interest Rate in solving problems.

Example

If a savings bank pays 1.5% interest per 3 months, what are the nominal and effective interest rates per year?

Solution Nominal interest rate r = 4 x 1.5% = 6% Effective interest rate per year ia = (1+r/m)m-1 = (1+.06/4)4-1

Example

A person deposits RM100 into a bank that pays 5% interest, compounded semiannually. How much would be in the saving account at the end of one year?

Solution 5% interest, compounded semiannually, means that the bank pays 2.5% every 6 months. Thus, the initial amount P=RM100 would be credited with .025(100)=RM2.50 interest at the end of 6 months, or P P + Pi = 100+100(.025) = RM102.50

= 6.1%

The RM102.50 is left in the saving account; at the end of the 2nd 6-month period, the interest earned is .025(102.50)=RM2.56, for a total in the account at the end

Example

(cont’)

Example

A person invests a sum of RM5000 in a bank at a nominal interest rate of 12% for 10 years. The compounding is quarterly. Find the maturity amount of the deposit after 10 years. Solution: M=4, r = 12% ia = (1+.12/4)4 - 1 = 12.55% F = P(1+ia)n = 5000(1+.1255)10= RM16,308.91

The RM102.50 is left in the saving account; at the end of the 2nd 6-month period, the interest earned is 6.025(102.50)=RM2.56, for a total in the account at the end (P + Pi) (P + Pi)+ i (P + Pi) = P(1+i)2 =100(1+.025)2 =RM105.06

We saw that RM100 left in the saving account for one year increased to RM105.06, so the interest paid was RM5.06. the effective interest rate per year , ia , is RM5.06/RM100 = .0506 =5.06%

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