The Time Value of Money

The Concept of Interest

─ COMPOUND INTEREST
─ Implies that interest paid (earned) on a loan
(an investment) is periodically added to the
principal
─ Interest is earned on interest as well as the
initial principal
─ Formulae for a single future amount:
FV = P × (1 + i)n
Future-Value Interest Factor 2
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The Concept of Interest
─ Simple Interest
─ Interest paid (earned) on only the original amount
borrowed (lent)
─ Formulae: I=P×i×n
─ Future Value (Terminal Value)
─ Value at some future time of a present amount of
money, or a series of payments, evaluated at a given
interest rate
─ The future value of an amount for any simple interest
rate:
FV = P + I = P + (P × i × n)
= P [ 1 + (i × n)]
 The Concept of …
─ Present Value
─ The current value of a future amount of money, or a
series of payments, evaluated at a given interest rate
─ Formulae: Rearrangement of the previous formulae
FV = PV [ 1 + (i × n)] → PV = FV/ [ 1 + (i × n)]
─ COMPOUND INTEREST
─ Implies that interest paid (earned) on a loan (an
investment) is periodically added to the principal
─ Interest is earned on interest as well as the initial
principal
─ Formulae for a single future amount:
FV = P × (1 + i)n 5

Future-Value Interest Factor

 Illustration: 3.1
─Suppose Mr. X deposited Br. 2,500 today in his
savings account that compounds interest annually.
─The interest rate is 8%.
─He wishes to find the future value of his deposits at
the end of the 5th year.
─Computation of the Future Value:
FV = P × (1 + i)n
= Br. 2,500 × (1 + 0.08)5
= Br. 2,500 × (1.08)5
= Br. 2,500 × (1.4693)
6
= Br. 3,673.32
 Compound Interest with Non-Annual
Periods
─ When compounding occurs more than once in a year
─ Possible compounding timings:
─ Semi-annually
─ Quarterly
─ Monthly
─ Weekly
─ Daily
─ Formulae for a single future amount can be
rearranged as:
FV = P × (1 + i/m)mn 7
Where, m = No. of times compounding occurs
during a year
Illustration: 3.2
─Suppose Mr. X’s savings account compounds
interest quarterly.
─What would be the future value of his deposits at
the end of the 5th year?
─Computation of the Future Value:
FV = P × (1 + i/m)mn
= Br. 2,500 × [1 + (0.08 ÷ 4)]4 × 5
= Br. 2,500 × (1 + 0.02)20
= Br. 2,500 × (1.02)20
= Br. 2,500 × (1.48595)
8
= Br. 3,714.87
Present Values
─In the FV techniques, we move money forward in time
since we know how much to begin with
─Now, in PV techniques, we pull in money to its
current value: the reverse direction
─PV is just the current value of a future sum
─What is done is nothing other than inverse
compounding
─In compounding, we used the interest rate and initial
investment
─Here, we will use the discount rate and attempt to
determine the present value of future cash flows 9
Present Values…
─To determine the initial investment or the PV of a
single sum, both sides of the FV formulae would
be divided by the FV Interest Factor, (1 + i)n to
result at:
PV = FV × 1/(1 + i)n
Present-Value Interest Factor
─Alternatively, PV can be computed as follows:
PV = FV × (1 + i) – n
10
Illustration: 3.3
─If Mr. X wants to receive Br. 500 ten years from
today in an account that compounds interest
annually with a discount rate of 6%, how much
should he deposit now?
─Computation of the Present Value:
PV = FV × (1 + i) - n
= Br. 500 × (1 + 0.06)-10
= Br. 500 × (1.06)-10
= Br. 500 × (.5584)
= Br. 279.20
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Annuities: Ordinary & Annuity Due
−Annuity
−A series of equal payments for a specified
number of periods.
−Basic Types of Annuities: Ordinary Annuity and
Annuity Due
−Ordinary Annuity:
−An annuity in which the payments occur at the
end of each period
−Annuity Due:
−An annuity in which the payments occur at the 12
beginning of each period.
Future Value of an Ordinary Annuity
−The aggregated sum of the future value of each
individual payment on the final rent day
−Illustration 3.4: FVOA
Assume that Mr. X wants to provide his son for a college
education by depositing Br. 500 at the end of each year for
the next five years in a bank where he will earn 6% interest.
How much will he have at the end of five years?
−Using the FV formulae for each stream of
payments,
FV5 = 500(1.06)4 + 500(1.06)3 + 500(1.06)2 + 500(1.06) + 500
= 500(1.262) + 500(1.191) + 500(1.124) + 500(1.06) + 500
= 631.00 + 595.50 + 562.00 + 530.00 + 500.00 13
= Br. 2,818.50
Future Value of an Ordinary…
− Future Value of an Ordinary Annuity, FVOA
[(1 + i)n – 1] FV Interest Factor for
FVOA = R
i an Annuity
−For the previous Illustration:
[(1 + 0.06)5 – 1]
FVOA = 500 ×
0.06
[(1.06)5 – 1]
= 500 ×
0.06
0.3382
= 500 ×
0.06
= 500 × 5.6371 14
= Br. 2,818.55
Future Value of an Annuity Due
−The total amount on deposit one period after the
final rent
[(1 + i)n – 1]
FVAD = R (1 + i)
i

−Illustration 3.5: FVAD for Illustration 3.4

[(1 + 0.06)5 – 1]
FVAD = 500 × (1 + 0.06)
0.06
0.3382
= 500 × × (1.06)
0.06
= 500 × 5.6371 × 1.06
= Br. 2,987.66 15
Present Value of an Ordinary Annuity
−The discounted value of a series of future rents on
the date one period before the first rent is made

−Illustration 3.6: PVOA for Illustration 3.4

Using the PV formulae for each stream of
payments,
PV5 = 500(1.06)-1 + 500(1.06)-2 + 500(1.06)-3 + 500(1.06)-4 + 500(1.06)-5
= 500(.943) + 500(.890) + 500(.840) + 500(.792) + 500(.747)
= 471.50 + 445.00 + 420.00 + 396.00 + 373.50
= Br. 2,106.00

16
Present Value of an Ordinary…
−Present Value of an Ordinary Annuity, PVOA
[1 – (1 + i)-n] PV Interest Factor for
PVOA = R an Annuity
i

−For the previous Illustration:

[1 – (1 + 0.06)-5]
PVOA = 500 ×
0.06
[1 – (1.06)-5]
= 500 ×
0.06
0.2527
= 500 ×
0.06
= 500 × 4.2124 17
= Br. 2,106.18
Present Value of an Annuity Due
−The discounted value of a series of future rents on
the date the first rent is made
[1 – (1 + i)-n]
PVAD = R (1 + i)
i

−Illustration 3.7: PVAD for Illustration 3.6

[1 – (1 + 0.06)-5]
PVAD = 500 × (1 + 0.06)
0.06
0.2527
= 500 × × (1.06)
0.06
= 500 × 4.2124 × 1.06
18
= Br. 2,232.55
Present Value of Complex Streams
− Investment projects involving uneven cash flows over
several years
− Not only comparison of PVs of cash flows between
projects, but also the cash inflows and outflows within
a project is required.
− Illustration 3.8: Complex Stream of CFs @ d/f rates
Year Rates CFs Year Rates CFs
1 6% Br. 500 6 8% Br. 500
2 6 200 7 8 500
3 6 (400) 8 8 500
4 8 500 9 8 500
5 8 500 10 8 500
Perpetuities & Infinite Annuities
−Perpetuity
− An annuity that continues forever
− Every year from its establishment, such investment pays
the same amount
− Preferred Stock is the best example
−PV of a Perpetuity: PP
PV =
i

−Illustration 3.9: PV of a Perpetuity

− What is the value of a Br. 500 perpetuity discounted
back to the present at 8%?
− PV = Br. 500 ÷ .08
− PV = Br. 6,250
Making Interest Rates Comparable
−Comparing interest rates is important for making
intelligent investing or borrowing decisions
−Difficulty in comparison due to timing of
compounding
−Converting to some common compounding period
& then compare
−Nominal or Quoted Interest Rate
− The rate of interest stated on the contract
−Annual Percentage Yield (APY)
− The annual compound rate that produces the same
return as the nominal or quoted rate
Making Interest …
−Annual Percentage Yield (APY)
− Also called Effective Annual Rate (EAR)
− Computed using:
APY or EAR = (1 + Quoted Rate/m)m – 1
Where, m is the number of compounding
periods within a year
−Illustration 3.10: APY or EAR
− Borrowing money from a bank at 12% compounded
monthly. Convert it into APY or EAR.
APY or EAR = (1 + Quoted Rate/m)m – 1
= (1 + 0.12/12)12 – 1
= (1.01)12 – 1 = 1.1268 – 1
= 0.1268 = 12.68%
Chapter
Ends

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