LECTURE NOTES | TIME VALUE OF MONEY | GRC
TIME VALUE OF MONEY AND INTEREST RATES
In this topic, we look at the technical details of how interest rates affect
the value of financial securities by reviewing time value of money
concepts. For example, interest rates have a direct and immediate
effect on the value of virtually all financial securities—that is, interest
rates affect the price or value the seller of a security receives and the
buyer of a security pays in organized financial markets.
Time Value of Money
▪ Time value of money is the basic notion that a dollar received
today is worth more than a dollar received at some future date.
 This is because a dollar received today can be invested and its
value enhanced by an interest rate or return such that the
investor receives more than a dollar in the future.
 Also with the concept of inflation, people normally choose to
spend now rather than in the future. (Example, with the P5 that
we have today, we can buy 3 candies. Let’s say that there is a
hyperinflation and we project that our P5 next month can buy
2 candies only. Normally, we choose to buy today because our
P5 is worth 3 candies rather than the value of 2 candies next
month. Review concept of inflation please. If you do not buy
the candies now, alkansi ka og 1 candy by next month diba.
So this concept forces you to spend now rather than in the
future because you’re 1 candy richer.)
o But what if you do not really need the candies now?
To compensate you for delaying consumption (i.e.,
saving), you are paid a rate of interest by those who
wish to consume more today than their current
resources permit (users of funds). (So since you do
not really wish nor need to spend, you would rather
invest your money at an interest rate more than
enough to cover inflation para dili ka alkansi (refer to
previous notes in nominal interest rate, inflation and
real interest rate). In a layman’s perspective, let us say
that you have a friend who needs P5 today and
promises to pay you P10 next month. In your analysis,
you would think: “If I use my P5 today, I’ll get three
candies. But, if I let my friend borrow this P5 that I
have, I’ll get P10 next month and by then I would get
4 candies kay because of inflation P5:2candies and
since ni earn man ka og interest na P5, then I can buy
4. Or, if you would but 3 candies now, you get to
spend around P7.50, mas mahal kaysa sa P5 last
month but since you earned interest, you’re still P2.50
richer.)
▪ So you get to ask, in the perspective of your
friend, why would he be willing to pay P10
next month in exchange of P5 today? There
are a lot of factors. It could be that he has an
emergency (see the danger of not setting
aside emergency fund so as early as now, start
saving na mo for rainy days) or he has a
positive problem where he can invest the P5
and earn more. Example mag business siya
which gives him a return of P20 next month.
 The time value of money concept specifically assumes that
any interest or other return earned on a dollar invested over
any given period of time (e.g., two, three, four, . . . years) is
immediately reinvested—that is, the interest return is
compounded. This is in contrast to the concept of simple
interest, which assumes that interest returns earned are not
reinvested over any given time period.
o compound interest-interest earned on an investment is
reinvested.
o simple interest-interest earned on an investment is not
reinvested.

Example 2–5 Calculation of Simple and Compounded
Interest Returns
CALCULATION OF SIMPLE INTEREST RETURN
Suppose you have $1,000 to invest for a period of two years.
Currently, default risk-free one-year securities (such as those issued
by the U.S. Treasury) are paying a 12 percent interest rate per year, on
the last day of each of the two years over your investment horizon.
If you earn simple annual interest on this investment, or you do not
reinvest the annual (12 percent) interest earned, the value of your
investment at the end of the first year is:
With simple interest, the $120 in interest earned in year 1 is not
reinvested in year 2. Rather, you take the $120 in interest out of the
investment account and hold it until the end of year 2. Only the
original $1,000 investment is carried forward and earns interest in year
2. Thus, the value at the end of the two-year investment horizon is:
LECTURE NOTES | TIME VALUE OF MONEY | GRC
CALCULATION OF COMPOUNDED INTEREST RETURN
If, instead, the annual interest earned is reinvested immediately after
it is received at 12 percent (i.e., interest is compounded), the value of
the investment at the end of the first
year is:
Notice that after the first year of the two-year investment horizon, you
have $1,120 whether the investment earns simple or compounded
interest. With compounded interest, however, the $120 in interest
earned in year 1 is reinvested in year 2. Thus, the whole $1,120 is
carried forward and earns interest in year 2. In this case, the value of
the investment at the end of the two-year investment horizon is:
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

The above illustrates the value of the investment over the two-year
investment horizon using compounded interest. By compounding
interest using time value of money principles, an investor increases his
or her return compared to the simple interest return. In the example
above using a two-year investment horizon, a 12 percent annual
interest rate, and an initial investment of $1,000, the investment is
worth $1,254.40 at the end of two years under compounded returns
rather than $1,240 using simple interest to calculate returns.

The time value of money concept can be used to convert cash flows
earned over an investment horizon into a value at the end of the
investment horizon. This is called the investment’s future value (FV)
and is the same as that in the compounded return example above.
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

Conversion of present values into the future values

Alternatively, the time value of money concept can be used to convert

the value of future cash flows into their current or present values (PV)
(i.e., future dollars converted into their equivalent present value or
current dollars).

Two forms of time value of money calculations are commonly used in

finance for security valuation purposes: the value of a lump sum and
the value of annuity payments.
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

LUMP SUM V. ANNUITY PAYMENT

A lump sum payment is a single cash payment received at the

beginning or end of some investment horizon (e.g., $100 at the
beginning of the sixth year or $100 at the end of five years). here you
need to be conscious that there is a big difference in your investment
is it states beginning of the fifth year or end of five years
Annuity payments are a series of equal cash flows received at fixed
intervals over the entire investment horizon (e.g., $100 a year received
each year for five years). In actual practice, “annuity” payments can
be paid more frequently than once a year—so that the term annuity
really means a constant payment received at equal intervals throughout
an investment horizon (e.g., twice, three times, . . . a year). So in
annuity, you can pay (invest) daily, monthly, quarterly, semi-annually
and annually.
Lump Sum Valuation
Present Value of a Lump Sum.
The present value function converts cash flows received over a future
investment horizon into an equivalent (present) value as if they were
received at the beginning of the current investment horizon. (It
actually answers the question, “If I need $10,000 at the end of 6
periods, given this interest rate, how much should I invest today at
year zero?”)
Present value ( PV ) of a lump sum received at the end of the
investment horizon, or future value ( FV ):
where
PV =Present value of cash flows
FVt = Future value of cash flows (lump sum) received in
t periods
r = Interest rate earned per period on an investment
(equals the nominal annual interest rate, i, divided by the
number of compounding periods per year (e.g., daily, weekly,
monthly, quarterly, semiannually)
t = Number of compounding periods in the investment
horizon (equals the number of years in the investment horizon
times the number of compounding periods per year)
(Don’t be confused because other finance books use different letters
or symbols to represent these variables but these are just the same.)

This is done by discounting future cash flows back to the present using
the current market interest rate. The present value of an investment is
the intrinsic value or price of the investment.
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

Calculation of Present Value of a Lump Sum
You have been offered a security investment such as a bond that will
pay you $10,000 at the end of six years in exchange for a fixed
payment today. If the appropriate annual interest rate on the
investment is 8 percent compounded annually, the present value of this
investment is computed as follows:
If the annual interest rate on the investment rises to 12 percent, the
present value of this investment becomes:
rates is one of the most fundamental relationships in finance and is
evident in the swings that occur in financial asset prices whenever
major changes in interest rates arise.
Note also that as interest rates increase, the present values of the
investment decrease at a decreasing rate. The fall in present value is
greater when interest rates rise by 4 percent, from 8 percent to 12
percent, compared to when they rise from 12 percent to 16 percent—
the inverse relationship between interest rates and the present value of
security investments is neither linear nor proportional.
Finally, from this example notice that the greater the number of
compounding periods per year (i.e., semiannually versus annually),
the smaller the present value of a future amount.

If the annual interest rate on the investment rises to 16 percent, the

present value of this investment becomes:

Finally, if the annual interest rate on the investment of 16 percent is

compounded semiannually (that is, you will receive t=(6x2)=12 total
interest payments, each calculated as r=(16 percent / 2) = 8 percent
times the principal value in the investment, where r in this case is the
semiannual interest payment) rather than annually, the present value
of this investment becomes:

Notice from the previous examples that the present values of the
security investment decrease as interest rates increase. This is because
as interest rates increase, fewer funds need to be invested at the
beginning of an investment horizon to receive a stated amount at the
end of the investment horizon. This inverse relationship between the
value of a financial instrument—for example, a bond—and interest

Future Value of a Lump Sum.
The future value of a lump sum equation translates a cash flow
received at the beginning of an investment period to a terminal (future)
value at the end of an investment horizon (e.g., 5 years, 6 years, 10
years, etc.).
Future value ( FV ) of a lump sum received at the beginning of the
investment horizon:
Calculation of Future Value of a Lump Sum
You plan to invest $10,000 today in exchange for a fixed payment at
the end of six years. If the appropriate annual interest rate on the
investment is 8 percent compounded annually, the future value of this
investment is computed as follows:
If the annual interest rate on the investment rises to 12 percent, the
future value of this investment becomes:
If the annual interest rate on the investment rises to 16 percent, the
future value of this investment becomes:
LECTURE NOTES | TIME VALUE OF MONEY | GRC
Finally, if the annual interest rate on the investment of 16 percent is
compounded semiannually rather than annually (i.e., r =16%/2= 8%
and t= 6 x2= 12), the future value of this investment becomes:
Notice that the future value of an investment increases as interest rates
increase. As interest rates rose from 8 percent to 12 percent, the
(future) value of the investment of $10,000 for six years rose by
$3,869.49 (from $15,868.74 to $19,738.23). As rates rose from 12
percent to 16 percent, the (future) value of the investment rose
$4,625.73 (from $19,738.23 to $24,363.96). Note also that as interest
rates increase, future values increase at an increasing rate. This is
because as interest rates increase, a stated amount of funds invested at
the beginning of an investment horizon accumulates to a larger amount
at the end of the investment horizon. This is due to the compounding
of interest returns. By contrast, as stated earlier, as interest rates
increase, the present value of an investment decreases at a decreasing
rate. These nonlinear relationships are illustrated in Figure 2–15.
Finally, notice that as the number of compounding periods per year
increases, the future value of a present amount increases.
Relation between Interest Rates and Present and Future Values
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

Annuity Valuation Calculation of Present Value of an Annuity

You have been offered a bond that will pay you $10,000 on the last
Present Value of an Annuity. day of every year for the next six years in exchange for a fixed
payment today.

If the appropriate annual interest rate on the investment is 8 percent,

the present value of this investment is computed as follows:

The present value of an annuity equation converts a finite series of

constant (or equal) cash flows received on the last day of equal
If the investment pays you $10,000 on the last day of every quarter for
intervals throughout the investment horizon into an equivalent
the next six years (i.e., r= 8%/4=2% and t= 6x4 = 24) the present value
(present) value as if they were received at the beginning of the
of the annuity becomes:
investment horizon. The time value of money equation used to
calculate this value is illustrated in Figure 2–16 and is represented as
follows:

Present value ( PV ) of an annuity stream ( PMT ) received in the

future:
If the annuity is paid on the first day of each quarter, an extra interest
payment would be received for each $10,000 payment. Thus, the time
value of money equation for the present value of an annuity becomes:
which can be reduced to the simpler equation:

The present value of this investment becomes:

 LECTURE NOTES | TIME VALUE OF MONEY | GRC

Present Value of $10,000 Received on the Last Day of Each

Quarter for Six Years (i.e., t = 6x 4 = 24 )
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

Future Value of an Annuity.

If the investment pays you $10,000 on the last day of every quarter for
The future value of an annuity equation converts a series of equal cash the next six years (i.e., r = 8%/4 = 2% and t = 6 x 4 = 24), the future
flows received at equal intervals throughout the investment horizon value of the annuity becomes:
into an equivalent future amount at the end of the investment horizon.

Future value ( FV ) of an annuity payment stream received over an

investment horizon:

which can be reduced to the simpler equation:

Calculation of the Future Value of an Annuity

You plan to invest $10,000 on the last day of every year for the next
six years. If the interest rate on the investment is 8 percent, the future
value of your investment in six years is computed as follows:
 LECTURE NOTES | TIME VALUE OF MONEY | GRC

ANNUITY DUE In the first calculation example above, the EAR on the 16 percent
If the annuity is paid on the first day of each quarter, an extra interest simple return compounded semiannually (i.e., r =16%/2 =8% and c=
payment would be earned on each $10,000 investment. Thus, the time 2) is computed as:
value of money equation for the future value of an annuity becomes:

and in another calculation above, the EAR on the 8 percent simple

return compounded quarterly (i.e., r= 8%/4= 2% and c=4) is computed
Thus, the future value of this investment becomes: as:

Thus, for each dollar invested at the beginning of the year, at 16

percent (compounded semiannually) and 8 percent (compounded
Effective Annual Return quarterly), respectively, you would have earned $0.1664 and $0.0824
at the end of the year.
The annual interest rate, i , used in the time value of money equations
in the calculation examples above is the simple (nominal or 12-month) Accordingly, the EAR provides a more accurate measure of
interest rate on the securities. annual returns in time value of money calculations.
However, if interest is paid or compounded more than once per year,
the true annual rate earned or paid will differ from the simple annual
rate.

The effective or equivalent annual return ( EAR ) is the return earned

or paid over a 12-month period taking any within-year compounding
of interest into account. Specifically, the EAR can be written as
follows:

where c number of compounding periods per year.