WARNING

This collection of slides provides an idea of the course

structure and key words.

It is NOT intended to substitute the readings required

by the instructor.

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 KET307
FINANCIAL MANAGEMENT
Nguyen Manh Hiep

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 CHAPTER 2
THE TIME VALUE OF MONEY

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 In this chapter

I.
• WHAT IS INTEREST RATE

II.
• COMPOUNDING

III.
• DISCOUNTING

IV
• SOME EXERCISES
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 I. INTEREST RATE
Interpretation of Interest Rate
▪ A dollar on hand is preferred to a dollar received
in the future (it’s an assumption).
▪ To induce people to invest their money,
investments must offer additional benefit (i.e., risk
free rate).
▪ Investments are risky. Minor additional benefit is
not enough. There must be a risk premium.
 I. INTEREST RATE
Interpretation of Interest Rate
Interest Rate [or (Required) Rate of Return]
= Risk Free Rate
+ Risk Premium
(+ Inflation Premium)
Risk free rate: Preference for cash on hand versus
future income.
 I. INTEREST RATE
Interpretation of Interest Rate
▪ Inflation premium: maintain the same level of
purchasing power.
▪ Risk free rate + risk premium: increase in
purchasing power.
▪ Given expected cash-flow from the assets,
determining the rate of returns is the same as
setting the price.
 I. INTEREST RATE
Interpretation of Interest Rate
▪ Each person requires different rate of returns on
the same assets, based on their level of risk
tolerance. Highly risk-adverse investors required
higher returns.
▪ However, many financial assets are traded in the
markets. Their prices (and rates of return) are set
at the equilibrium of demands and supplies or at
arbitrage-free prices. The rates of return set by
the market are called the market rates of return.
 I. INTEREST RATE
Some formulas
 II. COMPOUNDING
Compounding
0

▪ Compounding is the process of calculating future

value from present value.
▪ Future value is the amount of money an
investment will grow to at some date in the future
by earning interest at some compound rate.
 II. COMPOUNDING
Example: Tuan Bach deposits VND1 billion into a one-
year savings account earning an interest rate of 10%.
▪ How much does he have at the end of the 1st year?
▪ Tuan Bach is absent-minded and forgets about the
savings account. At the end of the third year, she
suddenly recalls. If interest rate doesn’t change, how
much can she withdraw from her account?
▪ What if Tuan Bach deposited VND1 billion into a six-
month savings account earning an interest rate of
10%?
 II. COMPOUNDING
Example: Tuan Bach has been depositing VND50
million into a savings account on every birthdays since
his daughter Mai Linh was born. The interest rate is
5%, compounded annually. How much money will be
in the account on Mai Linh’s 20th birthday immediately
before Tuan Bach makes the deposit on that day?
 II. COMPOUNDING
Example: Tuan Bach has been depositing VND50
million into a savings account on the day his daughter
Mai Linh was born. The interest rate is 5%,
compounded annually. Since then, on every birthday
of Mai Linh, he deposited to the saving account an
amount 10% more than the previous year.
How much money will be in the account on Mai Linh’s
20th birthday immediately before Tuan Bach makes
the deposit on that day?
 II. COMPOUNDING
Example: Tuan Bach has been depositing VND50
million into a savings account on the day his daughter
Mai Linh was born. The interest rate is 5%,
compounded semi-annually. Since then, on every
birthday of Mai Linh, he deposited to the saving
account an amount 10% more than the previous year.
How much money will be in the account on Mai Linh’s
20th birthday immediately before Tuan Bach makes
the deposit on that day?
 III. DISCOUNTING
Discounting
0

▪ Discounting is the process of calculating the

present value future cash flows.
 III. DISCOUNTING
Example: Tuan Bach wants to put aside a saving for his
dream trip to France next year. The trip will cost
VND100 million. The interest rate on one year saving
account at the bank is 5%. How much does he have to
save now?
If he decides to travel in two years, how much money he
must put into the saving account now?
 III. DISCOUNTING
Example: Tuan Bach wants to save for his daughter Mai
Linh future marriage. He decides to put an equal
amount of saving into a bank account on every
birthday of Mai Linh since she is born. The interest
rate is 5%, compounded annually. Tuan Bach
estimates that the cost of marriage will be 1 billion,
and that Mai Linh will get married on her 22nd
birthday, on which day no saving will me made, and all
will be withdrawn.
What is the saving amount that Tuan Bach has to make
on each of Mai Linh’s birthday?
 III. DISCOUNTING
Example: Tuan Bach wants to save for his daughter Mai
Linh future marriage. He decides to put an amount of
saving into a bank account on every birthday of Mai Linh
since she is born. The saving amount deposited at one
birthday will be increased by 10% from the last. The
interest rate is 5%, compounded annually. Tuan Bach
estimates that the cost of marriage will be 1 billion, and
that Mai Linh will get married on her 22nd birthday, on
which day no saving will me made, and all will be
withdrawn.
What is the saving amount that Tuan Bach has to make on
the day Mai Linh is born? And on Mai Linh’s 12th birthday?
 III. DISCOUNTING
Example: Tuan Bach wants to save for his daughter Mai
Linh future marriage. He decides to put an amount of
saving into a bank account on every birthday of Mai Linh
since she is born. The saving amount deposited at one
birthday will be increased by 10% from the last. The
interest rate is 5%, compounded semi-annually. Tuan
Bach estimates that the cost of marriage will be 1 billion,
and that Mai Linh will get married on her 22nd birthday, on
which day no saving will me made, and all will be
withdrawn.
What is the saving amount that Tuan Bach has to make on
the day Mai Linh is born? And on Mai Linh’s 12th birthday?
 IV. EXERCISES
Example: Today, Tuan Bach’s daughter Mai Linh is
born. Tuan Bach wants to save for her 4-year
university education in the US when she gets 18. The
cost of studying in the US is currently VND 2 billion
per year and is expected to increase by 5% each year.
He decides to put an amount of saving into a bank
account on every birthday of Mai Linh until she is 21,
with the amount in any year 10% higher than the last.
The interest rate is 5%, compounded annually.
How much does Tuan Bach need to put into the bank
today?
 IV. EXERCISES
Example: When Tuan Bach purchased his apartment, he
took out a VND500 million, 30-year mortgage with an
interest rate of 6% per year. Payments are made in 30
equal installments at the end of each year. Now, it is the
end of the 12th year, and Tuan Bach has just made the
12th payment. Tuan Bach has now decided to pay the
mortgage off by repaying the outstanding balance.
Calculate:
▪ the annual payment Sophie has to make each year.
▪ the amount Sophie has to pay at the end of 12th year to
payoff the mortgage.
▪ the total of interest payments during the past 12 years.
 IV. EXERCISES
Example
▪ Tuan Bach is a freelancer and is now 40 years old. He has no
retirement insurance. He now decides to save for retirement
at the age of 60. He expects to live until 80 years old.
▪ He estimate that at the beginning of the first year when he
retires, he will need to withdraw from his saving account an
amount of VND120 million to spend on his daily needs. Then,
the amount withdrawn each year will need to be increased by
10% to compensate for inflation.
▪ The interest rate on the saving account is now 10% but is
expected to fall to 5% after he retires.
▪ Calculate the amount Tuan Bach needs to save at the
beginning of each year for his retirement.
End of Chapter 2

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