TIME VALUE OF MONEY

TAMK.
K. 02

MUSTARUDDIN, SE, MSi, PhD

1
 Time Value of Money

⚫ Future value
⚫ Present value
⚫ Rates of return
⚫ Amortization

2
 Time lines show timing of cash flows.

0 1 2 3
i%

CF0 CF CF2 CF
1 3

Tick marks at ends of periods, so Time 0 is today;

Time 1 is the end of Period 1; or the beginning of
Period 2.

3
Time line for a $100 lump sum due at the
end of Year 2.

0 1 2
i%
Year

10
0

4
Time line for an ordinary annuity of $100 for 3 years.

0 1 2 3
i%

10 10 10
0 0 0

5
Time line for uneven CFs -$50 at t = 0 and
$100, $75, and $50 at the end of Years 1
through 3.

0 1 2 3
i%

-50 10 50
0 75

6
What’s the FV of an initial $100 after 3
years if i = 10%?

0 1 2 3
10
%
100 FV =
?

Finding FVs is compounding.

7
After 1 year:

FV1 = PV + INT1 = PV +
PV(i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:

FV2 = PV(1 + i)2

= $100(1.10)2
= $121.00.

8
After 3 years:

FV3 = PV(1 + i)3

= 100(1.10)3
= $133.10.

In general,

FVn = PV(1 +
i)n.

9
 Four Ways to Find FVs

⚫ Solve the equation with a regular calculator.

⚫ Use tables.
⚫ Use a financial calculator.
⚫ Use a spreadsheet.

10
 Financial Calculator Solution

Financial calculators solve this equation:

FVn = PV(1 + i)n.

11
Here’s the setup to find FV:

INPUT
S3 10 -100 0
N I/YR PV PMT FV
OUTP
133.10
UT

Clearing automatically sets everything to 0, but for

safety enter PMT = 0.
Set: P/YR = 1,
END
12
 What’s the PV of $100 due in 3 years if
i = 10%?

Finding PVs is discounting, and it’s the reverse of

compounding.

0 1 2 3
10
%
PV = 100
?

13
Solve FVn = PV(1 + i )n for
PV:

PV = FVn / (1+i)n = FVn(1/(1+i)).n

⎛ 1 ⎞⎟ 3 ( PVIF )
PV = ⎜ =
⎝ 1.1 ⎠ i,n
$100 $100
= ( 0.751
0 ) =
$100 3 $75.13
. 14
 What’s the difference between an
ordinary annuity and an annuity due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT
Annuity Due
0 1 2 3
i%

PMT PMT PMT

15
What’s the FV of a 3-year ordinary
annuity of $100 at 10%?

0 1 2 3
10
%
10 10 10
0 0 0
110

121
FV =
331 16
⚫ Future Value of an Annuity

FVAn = PMT ((1+i)n - 1/i)

= PMT (FVIFAi,n)
= $100 ((1+0.10)3 - 1)/0.10)
= $100 (3.31) = $331

17
Future Value of Annuity (due)

FVAn (Due)= (1 + i)n - 1)

PMT ( )(1+i)
i

= 100 ((1+0.10)3 – 1)/0.10)(1.10)

= $364.10
or
FVAn(Due) = PMT(FVIFAi,n)(1+i)

18
 Financial Calculator Solution

INPUT
3 10 0 -100
S I/Y PM
N PV FV
OUTP R T
331.00
UT

Have payments but no lump sum PV, so enter 0 for

present value.

19
What’s the PV of this ordinary annuity?

0 1 2 3
10
%
10 10 10
90.91 0 0 0
82.64

75.13 = PV
248.68

20
INPUTS
3 10 100 0
PM
N I/YR PV FV
OUTPU T
T -248.69

Have payments but no lump sum FV, so enter 0 for future

value.

21
Find the FV and PV if the
annuity were an annuity due.

0 1 2 3
10%

100 100 100

FV(due) = $364.10…, PV (due) =

22
Present Value an Annuity (PVA)
1
1 ( 1 + i )n
PVAn = PMT ( - i )
= PMT (PVIFAi,n)

= $100((1 – 1/(1+0.10)3 )/(0.10)

= $100(2,486851991) = $248,685

23
⚫ Present Value of Annuity (Due)

PVAn (Due) = PMT ((1-(1/(1+i)n)/i))(1+i)

= $100((1-(1/(1+0.10)3 /0.10))(1+0.10)

= $100( 2.7355371901)

= $273.55

24
What is the PV of this uneven cash
flow stream?
0 1 2 3 4
10
% 10 300 300 -50
90.91 0
247.93
225.39

-34.15
530.08 = PV

25
What interest rate would cause $100 to
grow to $125.97 in 3 years?

$100 (1 + i )3 =
$125.97.
INPUT
3 -100 I/Y0 125.97 PM
S
N PV FV
OUTP R T
8%
UT

26
Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated I% constant? Why?

LARGER! If compounding is more

frequent than once a year--for example,
semiannually, quarterly,
or daily--interest is earned on interest
more often.

27
 0 1 2 3
10
%
10 133.1
0 Annually: FV3 = 100(1.10)3 = 0
133.10.
0 1 2 3
0 1 2 3 4 5 6
5%

10 134.0
Semiannually:
0 FV6 = 100(1.05)6 = 1
134.01.
28
We will deal with 3 different rates:

iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate.

EAR = EFF% = effective

rate
annual

29
⚫ iNom is stated in contracts. Periods per year (m)
must also be given.

⚫ Examples:
● 8%; Quarterly = 2%
● 8%, Daily interest (365 days) = 0.0219178%

30
⚫ Periodic rate = iPer = iNom/m, where m is number of
compounding periods per year. m = 4 for quarterly, 12
for monthly, and 360 or 365 for daily compounding.

⚫ Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.

31
⚫ Effective Annual Rate (EAR = EFF%):
The annual rate that causes PV to grow to the same FV as under
multi-period compounding.

Example: EFF% for 10%, semiannual:

FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.

EFF% = 10.25% because

(1.1025)1 = 1.1025.

Any PV would grow to same FV at 10.25% annually or 10%

semiannually.

32
⚫ An investment with monthly payments is
different from one with quarterly payments.
Must put on EFF% basis to compare rates of
return. Use EFF% only for comparisons.

⚫ Banks say “interest paid daily.” Same as

compounded daily.

33
How do we find EFF% for a nominal rate of
10%, compounded
semiannually?

EFF = {(1 + Inom/m)m - 1

Or use a financial calculator.

34
EAR = EFF% of 10%

EARAnnual = 10%.

EARQ = (1 + 0.10/4)4 – 1 = 10.38%.

EARM = (1 + 0.10/12)12 – 1 = 10.47%.

EARD(360) = (1 + 0.10/360)360 – 1 = 10.52%.

35
Can the effective rate ever be equal to the
nominal rate?
⚫ Yes, but only if annual compounding is used, i.e.,
if m = 1.

If m > 1, EFF% will always be greater than the nominal

rate.

36
When is each rate used?

iNom: Written into contracts, quoted by banks

and brokers. Not used in calculations or
shown on time lines.

37
FV of $100 after 3 years under 10% semiannual
compounding? Quarterly?

⎛ iNom ⎞ mn
F = PV ⎜ 1 + ⎟
⎝ m ⎠
V n .

⎛ 0.1 ⎞ 2x
F = ⎜1 + 0 ⎟
3 ⎝ 2 ⎠3
V $100
S
= $100(1.05)6 =
FV3Q =$134.01.
$100(1.025)12 =
$134.49.
38
What’s the value at the end of Year 3
of the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?

0 1 2 3 4 5 6 6-mos.
5% periods

10 10 10
0 0 0

39
⚫ Payments occur annually, but
compounding occurs each 6 months.

⚫ So we can’t use normal annuity valuation

techniques.

40
1st Method: Compound Each CF
0 1 2 3 4 5 6
5%
10 10 100.00
0 0 110.2
5121.5
5331.8
0
FVA3 = 100(1.05)4 + 100(1.05)2 + 100
= 331.80.

41
b. The cash flow stream is an annual
annuity. Find kNom (annual) whose
EFF% = 10.25%. In calculator,

EFF% = 10.25
P/YR = 1
NOM% = 10.25
c.
INPUT3 10.25 0 -100
S N I/YR PV PMT F
OUTP V
331.8
UT 0
42
What’s the PV of this stream?

0 1 2 3
5%

10 10 10
0 0 0
90.70
82.27
74.62
247.59

43
Amortization

Construct an amortization schedule

for a $1,000, 10% annual rate loan
with 3 equal payments.

44
 1
1
$1000 =PMT ( -
(1+0.10)
30.10 )
= PMT (2.48685)

PMT = $1,000/2.48685 = $402.11

45
 Step 1: Find the required payments.

0 1 2 3
10
%
-1,000 PMT PMT PMT

INPUT3 10 -1000 0
S N I/YR PV PMT F
OUTP 402.1 V
UT 1
46
Step 2: Find interest charge for Year 1.
INTt = Beg balt (i)
INT1 = $1,000(0.10) =
$100.

Step 3: Find repayment of principal in

Year 1.

Repmt = PMT – INT

= $402.11 – $100
= $302.11.

47
Step 4: Find ending balance after
Year 1.

End bal = Beg bal – Repmt

= $1,000 – $302.11 =
$697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.

48
 BEG PRIN END
YR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest declines. Tax implications.

 $
402.11
Interest

302.11

Principal Payments

0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
50
⚫ Amortization tables are widely used--for
home mortgages, auto loans, business loans,
retirement plans, etc. They are very
important!

⚫ Financial calculators (and spreadsheets) are

great for setting up amortization tables.

51
On January 1 you deposit $100 in an account that
pays a nominal interest rate of 10%, with daily
compounding (365 days).

How much will you have on October 1, or after 9

months (273 days)? (Days given.)

FV9mnt = $100 ( 1+ 0.10/365)273 = $107.47

52
 iPer = 10.0% / 365
= 0.027397% per day.

0 1 2 27
0.027397% ... 3

-10 FV =
0 ?
( 1.00027397 ) 27
F =
27 ( 3
V = $100 1.0776 ) =
3 $107.77.
$100 5
Note: % in calculator, decimal in equation.

53
 iPer = iNom/m
= 10.0/365
= 0.027397% per day.

INPUTS
273 -100 0
N I/Y PV PMT FV
OUTPU R 107.77
T

Enter i in one step.

Leave data in calculator.

54
Now suppose you leave your money in the bank for
21 months, which is 1.75 years or 273 + 365 = 638
days.
How much will be in your account at maturity?
Answer: Override N = 273 with N = 638.
FV = $119.10.

FV638 = 100 ( 1+ 0.10/365)638 =

55
iPer = 0.027397% per day.

0 365 638 days

... ...

-100 FV = 119.10

FV= $100(1 + .10/365)638

= $100(1.00027397)638
= $100(1.1910)
= $119.10.

56
1. Greatest Future Wealth

Find FV of $850 left in bank for

15 months and compare with
note’s FV = $1,000.

FVBank =
$850(1.00019178)456
= $927.67 in bank.
Buy the note: $1,000 > $927.67.

57
2. Greatest Present Wealth

Find PV of note, and compare

with its $850 cost:

PV= $1,000/(1.00019178)456
= $916.27.

58
3. Rate of Return

Find the EFF% on note and compare with

7.25% bank pays, which is your opportunity
cost of capital:

FVn = PV(1 +
i)n
$1,000 = $850(1 +
i)456
Now we must solve for i.

59
 INPUT 456 -850 0 1000
S
N I/YR PV PMT F
OUTP 0.035646% V
UT per day

Convert % to decimal:

Decimal = 0.035646/100 = 0.00035646.

EAR = EFF% = (1.00035646)365 – 1

= 13.89%.

60
Using interest conversion:

P/YR = 365.
NOM% = 0.035646(365) = 13.01.
EFF% = 13.89.

Since 13.89% > 7.25% opportunity cost,

buy the note.

61
Latihan Soal:
Anggap satu tahun dari sekarang, Anda akan menyetor $ 1.000 ke
dalam tabungan di bank anda dengan bunga 6 persen.
a. Jika bank membunga manjemukkan (coumponded) uang anda setiap
tahun, berapa banyak yang Anda miliki dalam rekening Anda empat
tahun dari sekarang?
b. Berapa uang anda empat tahun dari sekarang jika bank membunga
majemukkannya secara triwulanan ?
c. Misalkan Anda menyetor $ 1.000 dalam 4 pembayaran masing-masing $
250 pada Tahun 1, Tahun 2, Tahun 3, dan Tahun 4. Berapa banyak yang
akan Anda miliki di akun Anda di Tahun 4, berdasarkan bunga majemuk
tahunan 6 persen?
d. Misalkan Anda menyetor 4 pembayaran yang sama di akun Anda pada
Tahun 1, Tahun 2, Tahun 3, dan Tahun 4. Dengan asumsi tingkat bunga
6 persen, seberapa besar jumlah pembayaran Anda harus lakukan setiap
tahunnya untuk mendapatkan saldo akhir yang sama seperti Anda
dihitung pada bagian (a)?

62
EXERCISE 2:

a. LIONEL MESSI, as a professional foot-ball player has been signed to a

three-year $10 million contract at the foot-ball club in the Spain. The
details provide for an immediate cash bonus of $1 million. He is to receive
$2 million in salary at the end of first year, $3 million in the next, and $4
million at the end of the last year. Assuming a 10% percent discount rate, is
this package worth $10 million ? How much it is it worth?

b. You plan to make a series of deposits in a interest bearing account. You

will deposit Rp 1 million today, Rp 2 million in two years, and Rp8
million in five years. If you withdraw Rp 3 million in the three years and
Rp 5 million in seven years. How much you will you have after eight years
if the interest rate is 9 percent? What is the present value of these cash
flows?

63