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Open Educational Resources Kingsborough Community College

2022

ECO 2200: Module 3 - 5

Dorina Tila

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Time Value of Money
Module 3 through Module 5
Module 5: Outline
• Why do interests exist?
• Risks associated with lending money [Review again when looking at bonds]
• Future Value
• What is FV
• Calculating FV
• Compounding
• Types of Interest rates
• Nominal
• Periodic
• effective
• Present Value
• What is PV
• Calculating PV
• Discounting
• Amortization
• Other
• Finding I & N
• Annuities
• Rates of Return
TIME TO THINK
• Why are lenders willing to charge
interest when lending money?

OR

• Why are borrowers willing to pay

interest when borrowing money
 TIME TO THINK - QUESTION
$100 deposited at the bank

0 Interest = 0% 1

100 100

• Would you lend $100 today if you receive $100

next year?

• Why?
1. Satisfaction from Consumption

You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 100

• Do you get satisfaction from consumption?

• You sacrifice consumption for one year because you
lent money.
• Do you feel you should be compensated for this
“sacrifice”?
 2. Obsolescence or loss of value
over time: Inflation Rate = 4%
You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 100
Bike costs $100 Bike costs $104

• Inflation is an overall increase in prices.

• If a bike costs $100, would it be $100 or $104 after
a year at inflation rate of 4%?
• Would you win or lose @ nominal interest rate =0%
• Interest rate = 4%, interest rate= 10%?
 2.a Obsolescence or loss of value
over time: Inflation Rate = 4%
You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 100
Bike costs $100 Bike costs $104

• Inflation R = 4%
• Nominal interest R = 0%
• Real interest R = Nominal Interest R – Inflation R
• -4% = 0% - 4%
• Lender @ a loss in real terms
 2.b Obsolescence or loss of value
over time: Inflation Rate = 4%
You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 104
Bike costs $100 Bike costs $104
• Inflation R = 4%
• Nominal interest R = 4%
• Real interest R = Nominal Interest R – Inflation R
• 0% = 4% - 4%
• Lender indifferent regarding solely on value of money (but
remember that is not all --- you sacrificed other things)
 2.c Obsolescence or loss of value
over time: Inflation Rate = 4%
You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 110
Bike costs $100 Bike costs $104
• Inflation R = 4%
• Nominal interest R = 10%
• Real interest R = Nominal Interest R – Inflation R
• 6% = 0% - 4%
• Lender @ a profit in real terms (solely regarding value
of money: inflation)
 3. Probability of Default

You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 100

• Are you sure the borrower will pay you back the full amount and on
time?
• Think about increasing “deposit” when you rent an apartment.
• Should you be compensated for the default risk you are taking? [E.g.,
1% of borrowers default --- would you increase interest rate by 1%? -
-- [For more future reading: Risk Aversion]
• Wouldn’t you want to be compensated (interest rate addition) due
to such potential risk?
 4. Expectation of future rates?

You lend $100 for 1 year @ interest =3%

May May, 2021
$100 $110
Interest = 3%

April $100 April $103

2021 2022
• What if you expect that demand for “money” increases next
month?
• Demand increase for bikes would increase price of bikes.
Demand for money, would increase interest rates.
• Risk of alternative investments or change in rates
• Wouldn’t you want to be compensated (interest rate addition)
due to such potential risk?
 5. Liquidity

You lend $100 for 1 year @ interest =0%

0 Interest = 0% 1

100 100

• Liquid: Able to use immediately for purchase of goods and

services without additional cost
• Most liquid: Money
• You need to use the money in the middle of the year (personal
reasons… you breach the loan contract)
• Wouldn’t you want to be compensated (interest rate addition)
due to such potential risk?
 TIME TO THINK - QUESTION
• We will come back to these slides when we look at bonds.

• Do you know what a bond is?

• Does it have to do with borrowing and lending money?

• Pause and come back to these question.

• Next slides: We will look at lending in general and

understand Future Value (FV) and Present Value (PV).
I. Future Value
Future Value (FV) means the nominal value ($)
that you will receive at the end of the period
based on your principal and terms of the loan.

FV is expected to be higher than the initial

investment or principal.

This is due to time value of money.

I. Future Value (n=1)

$100 deposited at the bank

0 1
I0%

100 110

• Would you lend $100 today if you receive 10%

interest rate?
• What is the amount you receive at the end of the
year?
• Future Value of $100 @ interest =10% is $110
I. Future value (n=2)

$100 deposited at the bank

0 1 2
I0% I0%

100 FV at year 2?

• What is Future Value at the end of year 2?

• Year 1: 100 + 10%*100 = $110
• Year 2: 110 + 10%*110 = $121
I. Future Value (n=3)

$100 deposited at the bank

0 1 2 3
I0% I0% I0%

100 FV at year 3?

• What is Future Value at the end of year 3?

• Year 1: 100 + 10%*100 = $110
• Year 2: 110 + 10%*110 = $121
• Year 3: 121 + 10%*121 = $133
I. Future Value @ interest 10%

After 1 year:
• FV1 = PV(1 + i) = $100(1.10) = $110
After 2 years:
• FV2 = PV(1 + i)2 = $100(1.10)2 = $121
After 3 years:
• FV3 = PV(1 + i)3 = $100(1.10)3 = $133
After N years (general case):
• FVN = PV(1 + I)N
I. Calculator – Solving for FV (i=10%)

• FV equation (i=10%)
• Requires 4 inputs into calculator and will solve for
the fifth.
• (Set to P/YR = 1 and END mode.)
INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

• Excel: =FV(rate,nper,pmt,pv,type)
• Excel: =FV(0.1,3,0,-100,1)
TIME TO THINK
• In these examples, did you earn interest on
interest?
• Did you earn interest on $10 during year 2?
• Did you earn interest on $21 during year 3?

Example
• Year 1: 100 + 10%*100 = $110
• Year 2: 110 + 10%*110 = $121
• Year 3: 121 + 10%*121 = $133

• What is “compound”?
I. Future Value (n=3)

$100 deposited at the bank

0 1 2 3
5% 5% 5%

100 FV at year 3?

• What is Future Value at the end of year 3?

• Year 1: 100 + 5%*100 = $105
• Year 2: 105 + 5%*110 = $110.25
• Year 3: 110.25 + 5%*121 = $115.76
I. Future Value (n=3)
• In these examples, did you earn interest on
interest?
• Did you earn interest on $5 during year 2?
• Did you earn interest on $10.25 during year 3?

Example
• Year 1: 100 + 5%*100 = $105
• Year 2: 105 + 5%*5 = $110.25
• Year 3: 110.25 + 5%*5 = $115.76

• What is the FV of $100 after 3 years under 5%

semiannual compounding?
• Quarterly compounding?
I. Future Value (n=3)
• What is the FV of $100 after 3 years under 4%
semiannual compounding? Quarterly compounding?

MN
 INOM 
FVN = PV1 + 
 M 

23
 0.04 
FV3S = $1001 + 
 2 
FV3S = $100(1.02) 6 = $112.62

FV3Q = $100(1.01)12 = $112.68

I. FV - COMPOUNDED
Compounded Annually Not Compounded
Year 1: 105 = 100 * (1+5%) = 100 + 5 Year 1: 105 = 100 * (1+5%) = 100 + 5

Year 2: 110.25 = 100* (1+5%)* (1+5%) Year 2: 110 = 100* (1+5%) + 5

• Interest is paid one a year

(annually)
• Interest is paid on interest
(compounded)

• Year 2: (100 + 5) * (1+5%) = 100 *

(1+5%) + 5* (1+5%)

• FV = PVN * (1 + I)N
• Excel: =FV(0.05,10,0,-100,1) • FV (n=10, no interest on interest) =
• N=10 years = 100 + 5*10 = $150
• FV = $162.89
• Excel: =FV(0.05,30,0,-100,1) • FV (n=30, no interest on interest) =
• N=30 years = 100 + 5*30 = $250
• FV = $432.19
I. Future Value @ interest 5%

After 1 year:
• FV1 = PV(1 + i) = $100(1.05) = $105
After 2 years:
• FV2 = PV(1 + i)2 = $100(1.05)2 = $110.25
After 3 years:
• FV3 = PV(1 + i)3 = $100(1.05)3 = $115.76
After N years (general case):
• FVN = PV(1 + I)N
I. Calculator – Solving for FV (i=5%)

• FV equation - (i=5%)
• Requires 4 inputs into calculator and will solve for
the fifth.
• (Set to P/YR = 1 and END mode.)
INPUTS 3 5 -100 0
N I/YR PV PMT FV
OUTPUT 115.76

• Excel: =FV(rate,nper,pmt,pv,type)
• Excel: =FV(0.05,3,0,-100,1)
TIME TO THINK
• Does is matter how often you get paid the
interest
Example
• 10% paid semi-annual (5% in Jun and 5% in Dec)
• 10% paid annually (10% in Dec)

• Which is your choice? Why?

• What is “compound”?
I. FV – Compounded annually
$110 due in one year
0 1
I0%

PV=100 FV= ?

• What is the future value of $100 if:

• Annual Nominal interest rate = 10%
• Interest paid annually

• FV = 100 * (1+ 10%) = 110

I. FV – Compounded semi-annually
Principal = $100 I0%
0 1

PV=100 FV1= ? FV2= ?

• What is the future value of $100 if:

• Annual Nominal interest rate = 10%
• Interest paid twice a year (semi-annually)

• FV1 (6 months) = 100 * (1+10%/2) = 105

• FV2 (+6 months) = 105 * (1+10%/2) = 110.25
I. FV – COMPOUNDED m-times
Compounded Annually Compounded Semi-Annually
Year 1: 110 = 100 * (1+10%) Year 1: 105 = 100 * (1+5%) + 100*(1+5%)
*(1+5%) = 110.25

Year 2: 121 = 100* (1+10%)* (1+10%) Year 2: 121.55 = 110.25* (1+5%)*(1+5%)

• Interest is paid once a year • Interest is paid m times a year

• FV = PVN * (1 + I)N • FV = PVN * (1 + I/m)m*N
• N: years, m: times compounded

• Excel: =FV(0.10,10,0,-100,1) • Excel =FV(0.1/2,10*2,0,-100,1)

• N=10 years • N= 10 years paid 2 times a year
• FV = $259.37 • FV=$265.33

• Excel: =FV(0.1,30,0,-100,1) • Excel =FV(0.1/2,30*2,0,-100,1)

• N=30 years • N= 30 years paid 2 times a year
• FV = $1,744.94 • FV=$1,867.92

Assignment: Compound it Daily for 10 years

II. Interest Rates
Principal = $100 I0%
0 1 2

PV=100 FV1= ? FV2= ?

• Quoted Rate INominal

• Annual nominal interest rate = 10%
• Ignores compounding
• Stated as 10% quarterly, semiannually, daily, etc.
• Periodic Rate INominal /m
• m compounded times per year
• E.g., 5% periodic rate annually
II. Effective Interest Rate
Quoted Rate Periodic Rate
Compounded Annually Compounded m times annually

INominal INominal /m
Year 1: 110 = 100 * (1+10%) Year 1: 105 = 100 * (1+5%) + 100*(1+5%)
*(1+5%) = 110.25

Effective rate = (110.25-100)/100 =

Effective rate = (110-100)/100 = 10%
10.25%

• Interest is paid once a year • Interest is paid m times a year

• Excel =EFFECT(nominal_rate,npery)
• Effective rate = (1 + INOM/m)m – 1
• Semiannual =EFFECT(0.1,2) = 10.25%
• Quarterly =EFFECT(0.1,4) = 10.38%
• Daily =EFFECT(0.1,365) = 10.52%
Question: Find effective rate for quoted rate 4%, daily, quarterly, and semiannually.
 TIME TO THINK
• Why is Effective Interest Rate important?

• Can we compare these loans?

• Which one would you choose?
• @ reported interest rate 5.00% compounded annually
• @ reported interest rate 4.97% compounded semiannual
• @ reported interest rate 4.96% compounded quarterly
• @ reported interest rate 4.95% compounded daily
 TIME TO THINK
• Why is Effective Interest Rate important?

• Can we compare these loans?

• – Need to find Effective Rates

Reported Rates Effective Rates Excel Formula

5.00% 5.000% =EFFECT(0.05,1)
4.97% 5.032% =EFFECT(0.0497,2)
4.96% 5.053% =EFFECT(0.0496,4)
4.95% 5.074% =EFFECT(0.0495,365)
 II. Effective Interest Rates
• Effective return varies between same investments, using
the same nominal rate, but different compounding
intervals.

Effective Effective
Annual Annual Reported Excel Formula
Rates Rates Rates
EARANNUAL 5.00% 5.00% =EFFECT(0.05,1)
EARSEMIANNUALLY 5.06% 5.00% =EFFECT(0.05,2)
EARQUARTERLY 5.09% 5.00% =EFFECT(0.05,4)
EARDAILY (365) 5.13% 5.00% =EFFECT(0.05,365)
II. Use of Different Interest Rates
Interest Use
Rates
• Written into contracts, quoted by banks and brokers.
INOM
• Not used in calculations or shown on time lines.

• Used in calculations and shown on time lines.

•
IPER • If M = 1, INOM = IPER = EAR.

• Used to compare returns on investments with

different payments per year.
EAR
• Used in calculations when annuity payments don’t
match compounding periods.
MODULE 5
• The following material will be covered
during Module 5.
• You are welcome to get an early start.
 TIME TO THINK
• What if you are given the Future Value and
need to calculate the value it currently has
[Present Value], assuming an interest rate
(opportunity cost of money).

• How much do you need to invest today to get

$110 next year @ a rate of 10%?
II. Present Value (PV)
Future Value (FV) means the nominal value ($)
that you will receive at the end of the period
based on your principal and terms of the loan.
FV = PVN * (1 + I)N Example: 105 = 100 * (1+5%)

Things to think about in future modules:

• Note that FV is nominal value and is not adjusted for inflation.
• Would it be comparable?

Present Value (PV) means the current value of

future sums of money (FV) given a specified rate
of return

PV = FVN /(1 + I)N Example: 100 = 105/ (1+5%)

II. Present Value (PV)
$110 due in one year
0 1
I0%

PV=? FV= $110

• What is the present value of future stream of

money, e.g., $110 received in one year @ 10%
interest rate?
• The PV shows the value of cash flows in terms of
today’s purchasing power.
• Finding the PV of a cash flow or series of cash flows
is called discounting (the reverse of compounding).
II. Solving for PV
• Solves FV equation for PV @ i=10% & FV = $110
• Similar to FV. Now, there are different input
information and are solving for a different variable
(solving for PV, given FV).

INPUTS 1 10 0 110
N I/YR PV PMT FV
OUTPUT -100

• Excel: =PV(rate,nper,pmt,fv,type)
• Excel: = PV(0.1,1,0,110,1)
• PV of future stream of $110 in one year is $100.
II. Solving for PV
• Solves FV equation for PV @ i=10% & FV = $110
• Similar to FV. Now, there are different input information
and are solving for a different variable (solving for PV,
given FV).

INPUTS 2 10 0 121
N I/YR PV PMT FV
OUTPUT -100

• Excel: =PV(rate,nper,pmt,fv,type)
• Excel: = PV(0.1,2,0,121,1)
• PV of future stream of $121 in two years discounted
annually at 10% is $100.
Reminder: Future Value (n=3)

$100 deposited at the bank

0 1 2 3
I0% I0% I0%

100 FV at year 3?

• What is Future Value at the end of year 2?

• Year 1: 100 + 5%*100 = $105
• Year 2: 110 + 5%*110 = $110.25
• Year 3: 121 + 5%*121 = $115.76
I. Future Value @ interest 5%

After 1 year:
• FV1 = PV(1 + i) = $100(1.05) = $105
After 2 years:
• FV2 = PV(1 + i)2 = $100(1.05)2 = $110.25
After 3 years:
• FV3 = PV(1 + i)3 = $100(1.05)3 = $115.76
After N years (general case):
• FVN = PV(1 + I)N
 Mirroring: Present Value (n=3)
How much should you deposit at the bank, so after 3 years
you receive 115.76 (at 5% interest rate paid annually)?

0 1 2 3
5% 5% 5%

PV=? FV1= 105 FV2= 110.25 FV3= 115.76

• What is PV if you receive 115.76 at end of 3rd year?

• PV (year 3): 115.76 /(1 + 5%) = $110.25
• PV (year 2): 110.25/(1 + 5%) = $105
• PV (year 1): 105/(1+5%) = $100
• OR PV = FV3 /(1 + i)3 =115.76 /(1 + 5%)3 = $100
II. Solving for PV
• Solves FV equation for PV @ i=10% & FV = $110
• Similar to FV. Now, there are different input information
and are solving for a different variable (solving for PV,
given FV).

INPUTS 3 5 0 115.76
N I/YR PV PMT FV
OUTPUT -100

• Excel: =PV(rate,nper,pmt,fv,type)
• Excel: = PV(0.05,3,0,115.76,1)
• PV of future stream of $115.76 in three years
discounted annually at 5% is $100.
I. Present Value @ interest 5%

PV of FV after 1 year:
• PV= FV1 /(1 + i) = $105/(1.05) = $100
PV of FV after 2 years:
• PV= FV2 /(1 + i)2 = $110.25/(1.05)2 = $100
PV of FV after 3 years:
• PV= FV3 /(1 + i)3 = $115.76/(1.05)3 = $100
PV of FV after N years (general case):
• PV = FVN /(1 + I)N or PMT/I for Perpetual Annuity
 Example 1 [Annuity]
• If Besa is 25 years old and invests $1,000 every
year until she is 65 years old.
• Interest Rate (compounded annually) is 10%.
• How much money will she have then?

INPUTS 40 10 0 -1000
N I/YR PV PMT FV
OUTPUT 442,592

• Excel: =FV(.1,40,-1000,0,0)
 Example 2 [Annuity]
• Emma is 25 years old.
• She wants to have $1 million by the time she is
65 years old.
• Interest Rate (compounded annually) is 10%.
• How much money should she pay annually?
INPUTS 40 10 0 1000000
N I/YR PV PMT FV
OUTPUT -2,259.41
• Excel: =FV(.1,40,0, 1000000,0)
 Example 3 [Annuity]
• Julia is 20 years old.
• She wants to have $1 million by the time she is
65 years old.
• Interest Rate (compounded annually) is 10%.
• How much money should she pay annually?
INPUTS 45 10 0 1000000
N I/YR PV PMT FV
OUTPUT -1,391
• Excel: =FV(.1,45,0, 1000000,0)
 Optional: Loan Amortization
• The FV = 0 because the reason for amortizing
the loan and making payments is to retire the
loan.
INPUTS 3 4 -1000 0
N I/YR PV PMT FV
OUTPUT 360

• Excel: =PMT(.04,3,-1000,0,0)

• Amortization tables are widely used for home

mortgages, auto loans, business loans,
retirement plans, etc.
I. PV – Discounted (n = 10 years)
Discounted Annually
(10 years, receive FV = 1000,
interest rate 10% once a year)
Year 1: 110 = 100 * (1+10%) = 100 + 10
Year 2: 121 = 100* (1+10%)* (1+10%)
• Interest is received once a year
• PVN = FV / (1 + I)N
• N: years, discounted annually
• Excel: =FV(0.10,10,0,-100,1)
• N=10 years
• FV = $259.37
• Excel: =FV(0.1,30,0,-100,1)
• N=30 years
• FV = $1,744.94
Assignment: Compound it Daily for 10 years
Discounted Semi-annually
(10 years, receive FV = 1000,
interest rate 10% twice a year)
Year 1: 105 = 100 * (1+5%) (1+5%) * (1+5%) (1+5%)
= 100 + 10
Year 2: 121.55 = 100*(1+5%)(1+5%) (1+5%) (1+5%)
• Interest is received m times a year
• PVN = FV/ (1 + I/m)m*N
• N: years, m: times discounted
• Excel =FV(0.1/2,10*2,0,-100,1)
• N= 10 years paid 2 times a year
• FV=$265.33
• Excel =FV(0.1/2,30*2,0,-100,1)
• N= 30 years paid 2 times a year
• FV=$1,867.92
I. Calculator – Solving for PV
• Solves the general FV equation for PV.
• Exactly like solving for FV, except we have different
input information and are solving for a different
variable.

INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90

• Excel: =PV(rate,nper,pmt,fv,type)
 I. FV – COMPOUNDED m-times
Compounded Annually Compounded Semi-Annually
Year 1: 110 = 100 * (1+10%) = 100 + 10 Year 1: 105 = 100 * (1+5%) + 100*(1+5%)
*(1+5%) = 100 + 10

Year 2: 121 = 100* (1+10%)* (1+10%) Year 2: 121.55 = 100*(1+5%)(1+5%) (1+5%) (1+5%)

• Interest is paid once a year • Interest is paid m times a year

• FV = PVN * (1 + I)N • FV = PVN * (1 + I/m)m*N
• N: years, m: times compounded

• Excel: =FV(0.10,10,0,-100,1) • Excel =FV(0.1/2,10*2,0,-100,1)

• N=10 years • N= 10 years paid 2 times a year
• FV = $259.37 • FV=$265.33

• Excel: =FV(0.1,30,0,-100,1) • Excel =FV(0.1/2,30*2,0,-100,1)

• N=30 years • N= 30 years paid 2 times a year
• FV = $1,744.94 • FV=$1,867.92

Assignment: Compound it Daily for 10 years

I. Present Value – Compounded
Semi-annually
$110 due in one year
0 1
I0%

PV=? FV= 110

• What is the present value of $110 due in one year

(@ 10% interest rate)?
• The PV shows the value of cash flows in terms of
today’s purchasing power.
• Finding the PV of a cash flow or series of cash flows
is called discounting (the reverse of compounding).