Interest and the Time

Value of Money
Engr. M. Cabal
Objectives: to understand the effect of time on the value of money and compute interest based
on different conditions

Time Value of Money

When an individual or a company desires to invest an amount of capital in a long-term
project, the effect of time on the value of that capital needs to be considered. The
longer the life of the project, the more important will be the considerations of the time
value of money. Other factors that affect the outcome of investment projects are
inflation, taxes, and risk.

Sources of Capital
There are, in general, two sources of capital needed to make an investment. Capital can
be obtained either from the investor’s own funds or from a lender. Wherever capital is
obtained, there is a cost associated with the use of the funds. If they are obtained from
a lender, the cost of capital is the interest rate at which the funds are loaned to the
investor. If the investor chooses to use his own funds for the required capital, then the
cost is called the opportunity cost of capital.
INTEREST CONCEPTS

SIMPLE INTEREST
The amount of interest earned by an investment (for example, a single
principal deposit in a savings account) is called simple interest
COMPOUNDINTEREST

Compounded interest is computed by applying the interest rate to the

remaining unpaid principal plus any accumulated interest. One could
consider it as “the interest earns interest.”

NOMINAL,EFFECTIVE,AND CONTINUOUS INTEREST RATES

The nominal interest rate is the percentage increase in money you pay the
lender for the use of the money you borrowed. Nominal interest rate is the
interest rate before taking inflation into account, in contrast to real interest
rates and effective interest rates.
The effective interest rate is the real return on a savings account or any
interest-paying investment when the effects of compounding over time are
taken into account. The more frequent the compounding periods, the
higher the rate. It also reflects the real percentage rate owed in interest on
a loan, a credit card, or any other debt.

In the limiting case of continuous compounding, the effective rate is given

by:
CASH FLOW DIAGRAMS

The construction of a cash flow diagram, sometimes referred to as a time line,

will greatly aid in the analysis of an investment opportunity. The cash flow
diagram is a way of accounting for all cash incomes and outflows at their
appropriate position in time. That is, in general terms, the cash flow for any
particular period is the income received during that period minus the expenses
incurred during that same period.

A horizontal line is drawn which represents the length of time (life) of the
investment opportunity (project). The interest periods are then marked off and
labeled above the line. At the extreme left of the time line is time zero (or, as will
be defined in the next section, the Present). Time zero represents the time when
the first cash flow is made for this project. Time zero is, therefore, defined by
each project and not by a specific calendar date. Time zero can also be
interpreted as the beginning of time period 1. All cash flows are then placed
beneath the time line, corresponding to the position in time (or interest periods)
in which they occurred. Negative cash flows (expenses exceeding revenues) are
given a minus sign.
In the time line illustrated below, CF1, CF2, etc., represent the cash flows occurring at the end of interest period 1, 2,
etc.

Example:
Consider the example of a 3-year auto loan from the view of the lender. The lender provides $20,000 to the client (a
negative cash flow for the lender) at month 0 at an interest rate of 0.5% per month. In exchange, the lender receives
$608 per month from the client over the next 36 months. The resulting cash flow diagram would be:
set of notations that will be used:

P = Present sum of money. The present (time zero) is defined as any point from which the analyst wishes
to measure time.

F = Future sum of money. The future is defined as any point n that is greater than time zero.

A = Annuity. This is a uniform set of equal payments that occur at the end of each interest period from one
to n.

G = Uniform gradient. This is a series of payments that uniformly increase or decrease over the life of the
project.

i = Compound interest rate per period.

n = Total number of compounding periods in the cash flow diagram.

The cash flow diagrams that follow should help to define these sums of money.
INTEREST FORMULAS FOR DISCRETE COMPOUNDING

SINGLE PAYMENTS
The first formula to be derived allows the calculation of the equivalent future amount F, of a present sum,
P. Suppose P is placed in a bank account that earns i% interest per period. It will grow to a future amount,
F, at the end of n interest periods according to:

Derivation:
The factor (1 + 𝑖)𝑛 is frequently called the Single Payment Compound Amount Factor and is symbolized in
this text by (F/P )i,n. If one is given the amount of P, one uses the (F/P )i,n factor to find the equivalent
value of F. That is,

Similarly, if a future amount, F, is known and it is desired to calculate the equivalent present amount, P,

The factor (1 + 𝑖)−𝑛 is frequently called the Single Payment Present Worth Factor and is symbolized in
this text by (P/F )i,n. If one is given the amount of F, one uses the (P/F )i,n factor to find the equivalent
value of P. That is,
UNIFORM SERIES (ANNUITIES)
It is often necessary to know the amount of a uniform series payment, A, which would be equivalent to a
present sum, P, or a future sum, F. In the following formulas that relate P, F, and A, it is imperative that the
reader understands that: 1) P occurs one interest period before the first value of A; 2) A occurs at the end
of each interest period; and 3) F occurs at the same time as the last A (at time n).
The value of a future sum, F, of a series of uniform payments, each of value A, can be found by summing
the future worth of each individual payment. That is, treat each A as a distinct present value (but with a
different time zero) and use (F/P )i,n to calculate its contribution to the total F:

Multiplying both sides by (1+i) yields

Subtracting the first equation from the second yields

Solving for F in terms of A results in:

The term in the {} brackets is called the Uniform Series Compound Amount Factor and is symbolized by
(F/A)i,n. If one is given the amount of A, one uses the (F/A)i,n factor to find the equivalent value of F. That
is,

Rearranging and solving for A yields

The term in the { } brackets is called the Sinking Fund Factor and is symbolized by (A/F )i,n. If one is given
the amount of F, one uses the (A/F )i,n factor to find the equivalent value of A. That is,

Substituting

to

yields

which contains the Uniform Series Present Worth Factor, (P /A)i,n in the {} brackets
If one is given the amount of A, one uses the (P /A)i,n factor to find the equivalent value of P. That is,

Rearranging
and solving for A yields

The term in the { } brackets is called the Capital Recovery Factor and is symbolized by (A/P )i,n. If one is
given the amount of P, one uses the (A/P )i,n factor to find the equivalent value of A. That is,
UNIFORM GRADIENT
Without derivation, equations can be developed that relate the gradient, G, to an equivalent annuity, an
equivalent present sum, and an equivalent future sum:

The term in the { } brackets is symbolized by (A/G)i,n. If one is given the amount of G, one uses the (A/G)i,n
factor to find the equivalent value of A. That is,

The term in the { } brackets is symbolized by (P /G)i,n. If one is given the amount of G, one uses the (P/G)i,n
factor to find the equivalent value of P. That is,
The term in the { } brackets is symbolized by (F/G)i,n. If one is given the amount of G, one uses the (F/G)i,n
factor to find the equivalent value of F. That is,
Summary:
Examples:
1. If $10,000 is invested in a fund earning 15% compounded annually, what will it grow to in 10 years?

2. It is desired to accumulate $5,000 at the end of a 15-year period. What amount needs to be invested
if the annual interest rate is 10% compounded semi-annually? Assume the given interest rate is a
nominal rate and that the principal is compounded at 5% per period.

3. What interest rate, compounded annually, will make a uniform series investment (at the end of each
year) of $1,000 equivalent to a future sum of $7,442? The investment period is 5 years.
4. An individual wishes to have $6,000 available after 8 years. If the interest rate is 7% compounded
annually, what uniform amount must be deposited at the end of each year?

5. An individual wishes to place an amount of money in a savings account and, at the end of one month
and for every month thereafter for 30 months, draw out $1,000.What amount must be placed in the
account if the interest rate is 12% (nominal rate) compounded monthly?
Try this!
1. A principal of $50,000 is to be borrowed at an interest rate of 15%
compounded monthly for 30 years. What will be the monthly payment
to repay the loan?

2. An individual deposits $1,000 at the end of each year into an

investment account that earns 8% per year compounded monthly. What
is the balance in his account after 10 years?
Solution:

1.

2.
End.