5/26/2021

1. TIME VALUE OF MONEY (TVM)

CHAPTER 3:
What is the value to you today of $100 paid to you in the
TIME VALUE OF MONEY future?

Given the choice between $100 today and $100 next year,
most people would choose $100 today.

Objective
Explain the concept of time value of money
and interest rate
How we link the present to the future
Provide examples of real life
applications

TIME VALUE OF MONEY WHAT IS AN INTEREST RATE?

$100 today is worth more than the - Why do lenders charge interest?
expectation of $100 next year because: The existence of alternatives means that lenders
a bank would pay interest on the $100 face an opportunity cost.
inflation makes next year’s $100 less valuable than Borrowers rent resources from lenders. Interest is
today’s
the rent.
uncertainty of receiving next year’s $100
A dollar one year from now is worth less than a
dollar today.
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WHAT IS AN INTEREST RATE? 2. FUTURE VALUE AND PRESENT VALUE

The interest rate is the percent rate charged, or paid, How can we compare payments at different
by a lender to a borrower for the use of credit. This dates?
is usually expressed as an annual percentage of
the principal
Calculate Interest rate by dividing the amount of interest
by the amount of principal

2.1. FUTURE VALUE FUTURE VALUE: ONE YEAR

The value on a future date of an investment Future Value =

made today. Initial Payment + Interest

FV = PV + PV x i
If you invest $100 today at 10 percent interest
= PV (1+i)
per year, in one year you will have $110.
$110 = $100 + $100x(0.1)
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FUTURE VALUE : SIMPLE INTEREST FUTURE VALUE: SIMPLE INTEREST

Simple interest is calculated on the original principal Simple Interest = PV * i * n
only. Accumulated interest from prior periods is not -> FV = PV + PV * i * n
used in calculations for the following periods.
= PV * (1 + i*n)
Simple interest is normally used for a single period of
less than a year, such as 30 or 60 days where:
PV = principal (original amount borrowed or
loaned)
i = interest rate for one period
n = number of periods

$2968.00
•$2926.00
•$3178.00
•$2884.00

SIMPLE INTEREST: EXAMPLES EXAMPLES

1. You deposit $1000 into a saving account with simple 3. What is the future value of a loan of
interest rate of 4%/year for 5 years. How much $2800 to be repaid in 8 months at an
interest will you earn at the end of the 5-year period? annual interest of 9%?
How much money is in your account (if you don’t
withdraw the interest) a. $2968

b. $2926
2. You borrow $10,000 for 60 days at 5% simple interest c. $3178
per year (assume a 360 day year). Calculate FV?
d. $2884
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Rebecca wants to

EXAMPLES FUTURE VALUE: COMPOUND INTEREST

4. You want to borrow $500 and you ask your friend to lend Compound interest is calculated each period on
you this amount, offering to pay him back $548 in 9 months. the original principal and all interest
What is the annual interest rate for this short term loan?
a. 20% accumulated during past periods.
b. 8.25% Although the interest may be stated as a yearly rate,
c. 12.8% the compounding periods can be yearly,
d. 16.5%
semiannually, quarterly, or even continuously.

FUTURE VALUE: COMPOUND INTEREST COMPOUND INTEREST: TWO YEARS

FV = PV + PV * i FV = $100+$100(0.1)+$100(0.1) + $10(0.1)
=$121
-> FV = PV + PV * i
Present Value of the Initial Investment
= PV * (1+i)
+ Interest on the initial investment in the 1st Yr
+ Interest on the initial investment in the 2nd Yr
+ Interest on the Interest from the 1st Yr in the 2nd Yr
$110 = $100 * (1 + 0.1)
= Future Value in Two Years
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VALUE OF $5 INVESTED COMPOUND INTEREST

Assume that the interest rate is 10% p.a, with Future value of an investment of PV
an investment of $5 at 10% we obtain in n years at interest rate i
FVn = PV * (1+i)n
1 Year $5*(1+0.10) $5.5
(Remember: The interest rate is
2 years $5.5*(1+0.10) $6.05 measured is a decimal so if 5%, i = .05)
3 years $6.05*(1+0.10) $6.655

4 Years $6.655*(1+0.10) $7.3205

FUTURE VALUE: CAUTION EXAMPLE

Time (n) & interest rate (i) You deposit 1500 USD on a saving account at the
must be in same time units rate of 7.5% per year, compounded monthly.
What will you receive after 3 years?
If i is at annual rate, then n must be in years.

Future Value of $100 in 18 months at

5% annual interest rate is
FV = 100 x (1+.05)1.5

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Rate True value Rule of 72 Rule of 70 Rule of 69

1% 69.66 72.00 70.00 69.00

Invest $100 at 5% annual interest 3% 23.45 24.00 23.33 23.00

How until you have $200? 5% 14.21 14.40 14.00 13.80

7% 10.24 10.29 10.00 9.86

The Rule of 72:
9% 8.04 8.00 7.78 7.67
Divide the annual interest rate into 72
11% 6.64 6.55 6.36 6.27
So 72/5=14.4 years.
13% 5.67 5.54 5.38 5.31
1.0514.4 = 2.02
15% 4.96 4.80 4.67 4.60

17% 4.41 4.24 4.12 4.06

19% 3.98 3.79 3.68 3.63

21% 3.64 3.43 3.33 3.29

- 30% 2.64 2.40 2.33 2.30

2.2. PRESENT VALUE PRESENT VALUE: ONE YEAR

Present Value (PV) is the value today (in the
present) of a payment that is promised to be Solve the Future Value Formula for PV:
made in the future.
FV = PV x (1+i)
so
At a 5 percent interest rate, the present value of $105 one
year from now is $100. FV
PV 
Reverses the future value calculation (1  i )
Present Value = Future Value divided by
one plus interest rate
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PRESENT VALUE: ONE YEAR EXAMPLE PRESENT VALUE: GENERAL FORMULA

The picture can't be display ed.

$100 received in one year, i=5%

Present Value of payment received
n years in the future:
FV $100
PV    $95.24
(1  i ) 1.05 FV
PV 
Note: FV = PVx(1+i) = $95.24x(1.05) = $100 (1  i ) n

PRESENT VALUE: IMPORTANT PROPERTIES EXAMPLE: INTEREST RATE ON A LUMP SUM INVESTMENT

Present Value is higher: If you invest $15,000

1. The higher future value of the payment. for ten years, you
(FV bigger) receive $30,000. What i  n FV  1
is your annual return? PV
2. The shorter time period until payment. 30000 1
 10  1  10 2  1  210  1
(n smaller) 15000
 0.071773463
3. The lower the interest rate.
 7.18% (to the nearest basis point)
(i smaller)
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2.3. THE FREQUENCY OF COMPOUNDING –

NOMINAL AND EFFECTIVE INTEREST RATE THE FREQUENCY OF COMPOUNDING

18% per year compounded monthly is just code

You have a credit card that carries a rate of
interest of 18% per year compounded monthly.
What is the interest rate compounded annually?
That is, if you borrowed $1 with the card, what
would you owe at the end of a year?
for 18%/12 = 1.5% per month
All calculation must be expressed in terms of
consistent units

NOMINAL INTEREST RATE EFFECTIVE ANNUAL RATE (EAR)

A Nominal Interest Rate is an interest rate that EAR is an annual rate of interest when
does not include any consideration of compounding occurs more often than once a
compounding year
Also called Annual Percentage Rate (APR)
EAR = (1 + APR/
m)
m -1
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EFFECTIVE ANNUAL RATES OF AN APR OF 18% THE FREQUENCY OF COMPOUNDING

Note that as the frequency of compounding increases, so
A n n u al F re q u e n cy o f A n n u al
P e rc e n ta g e C o m p o u n d in g E f fe c t iv e R a te
does the effective annual rate. If we allow compounding to
ra te occur more and more frequent, the compounding period
1 8 1 1 8 .0 0
becomes shorter and shorter. Then m, the number of
1 8 2 1 8 .8 1 compounding periods increases. What occurs as the
1 8 4 1 9 .2 5 frequency of compounding rises to infinity?
1 8 1 2 1 9 .5 6
 k 
m

1 8 5 2 1 9 .6 8 EFF  Lim   1  m    1  e k  1
m    m  
1 8 3 6 5 1 9 .7 2  

THE FREQUENCY OF COMPOUNDING THE FREQUENCY OF COMPOUNDING

EAR = eAPR – 1
Where “APR” is the nominal rate of interest The effective annual rate that’s equivalent
compounded continuously. to an annual percentage rate of 18% is
This is the max. interest rate for any value of “APR”
then e 0.18 - 1 = 19.72%
compounded continuously. More precision shows that moving from
daily compounding to continuous
compounding gains 0.53 of one basis
point