Topic  Time Value of

Money
2
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Construct a cash flow timeline;
2. Explain the compounding and discounting of a stream of cash flows;
3. Calculate the present and future values using the cash flow timeline
and equations;
4. Describe annuities and the difference between an ordinary
annuity and an annuity due;
5. Calculate the present and future values of an ordinary annuity
and an annuity due.
6. Explain perpetuities and the difference between level perpetuity
and growing perpetuity; and
7. Calculate the present value of level perpetuity and growing
perpetuity.

 INTRODUCTION
An organisation may have excess funds which it can invest in an array of
investments. It would like to determine how much returns the investments will
generate after a period of time. In other situations, the organisation may want to
build a new plant sometime in the future and it would like to determine how
much earnings it must retain to ensure it has sufficient cash when it is ready to
construct the new plant.
In this topic, we will first learn to construct a cash flow timeline to help us to visualize
the cash flows of an investment project. We will then explain what compounding is and
learn to calculate the future value of cash flows. In the third subtopic, we will look at
discounting and learn to calculate the present value of cash flows. Next, we will look at
annuities and the difference between an ordinary annuity and annuity due, and to
calculate their present and future values. In the last subtopic, we will review perpetuities
and determine the present value of a level perpetuity and growing perpetuity.

2.1 TIMELINE
A timeline is a time value analysis tool which will help us to visualise the cash
flows of an investment project. Timelines are useful to analyse complex financial
problems.

Let us assume we deposit RM100 in a bank account at an interest rate of five per
cent for three years. Figure 2.1 represents the timing of the cash flows of our
deposit.

Figure 2.1: The timing of cash flows of our deposit

In Figure 2.1, PV (present value) represents the RM100 we deposited in the bank,
and FV (future value) is the amount which will be in our account in three years.
The intervals between 0 and 1, 1 and 2, and 2 and 3 are periods which can be
years, quarters or months. Time 0 represents today and it is the beginning of
Period 1, while Time 1 is one period from today, and represents the end of Period
1 and the beginning of Period 2, and so on.

Cash flows are shown below the tick marks representing the period while the
interest rate is shown above the timeline. The cash flows which we want to find
out are represented with a question mark.
In our illustration, we have a single cash outflow of RM100, an interest rate of five
per cent, which is invested at Time 0, and we want to find the Time-3 value. In our
example, the interest is held constant at five per cent. However in real life, interest
rates may vary from period to period and it will be shown in the diagram for the
respective periods accordingly. Similarly in our example, while there are only two
cash flows in Times 0 and 3, and no cash flows in Times 1 and 2, there could be
multiple cash flows in real life.

SELF-CHECK 2.1

You deposit RM2,000 in a fixed deposit account which pays an interest

of four per cent annually. Using the timeline method, determine the
amount that you would have in the account after 3 years.

2.2 FUTURE VALUES

You will hear this maxim often in finance: a dollar in hand today is worth more
than a dollar to be received in the future. That is because if we had one dollar
now, we could invest it and earn interest, and therefore we will end up with more
than one dollar in the future.

Compounding is the term used to describe the process of moving forward

from the initial investment called the present value (PV) to future values
(FVs). In our example above, we invested RM100 in a bank account at five
per cent interest per annum. How much would we have at the end of Year 3?
We can use four different ways to find out the answer.

The following definitions are generally used in the time value of money
computations.

PV = Present value, or the beginning amount.

FVN = Future value of an investment after N periods. Our cash flow at the end
of Year 3 will be denoted as FV3.
CF1 = Cash flow. In our investment above, our initial investment will be negative
and the cash flows in Years 1, 2 and 3 will be positive. If you borrow money from
the bank, the first cash flow, which is the money the bank loans to you will be
positive, while your repayment of the loan will be negative.

I = Interest rate earned in a year, and sometimes it is denoted as „i‰. The

interest earned is based on the balance at the beginning of the period. We
assume the interest is paid at the end of the period unless it is stated
otherwise.

INT = Interest earned stated in the relevant currency. In our investment

mentioned earlier, interest will be earned in the Malaysian ringgit.

N = The number of period. In our investment above, N = 3.

2.2.1 Step-by-Step Approach

We can use the timeline to find the FV of the RM100 compounded for three
years at five per cent. We can modify the timeline presented earlier to find the
answer:

At N = 0, we start with our initial investment of RM100.

To calculate the interest earned in Year 1, we multiply the initial investment with
the interest rate is five per cent (1 + I) = (1.05). The value of the investment at
end of Year 1 is:

FV1 = PV + INT
= PV + PV (I)
= PV (1 + I)N
= RM100 (1 + 0.05)
= RM100 (1.05) = RM105
We begin Year 2 with an amount of RM105. In Year 2, this amount will further
earn an interest equal to RM105 (0.05) = RM5.25. At the end of Year 2, the value
of our investment will be RM110.25. Notice that the interest earned in Year 2 is
more than the interest earned in Year 1. We call this „compounding‰ and the
interest earned on interest is referred to as „compound interest‰.

In Year 3, we would earn RM110.25 (0.05) = RM5.51 interest. The value of our
investment at the end of Year 3 would be:

FV3 = RM110.25 (1.05) = RM115.76

The step-by-step approach shows how the compounding interest is calculated.

However, this approach can be tedious and time-consuming when the number of
years is large.

2.2.2 Formula Approach

To calculate the value of our investment at the end of a period, we multiply the
opening balance at the beginning of the period with (1 + I). Hence, the value of
our investment at the end of Year 2 would be:

FV2 = FV1 (1 + I)
= PV (1 + I) (1 + I)
= PV (1 + I)2
= RM100 (1.05)2 = RM110.25

We can now generalise the process with the following formula:

PVN = PV (1 + I)N 2.1

To calculate the value of the investment at the end of Year 3, apply the formula
above:

FV3 = RM100 (1.05)3 = RM115.76

We can use financial calculators and spreadsheets to solve time value problems. As a
business student, you are advised to familiarise yourself with using spread sheets to solve
financial calculations as it will be useful in your working environment, as well as in your
own personal financial planning.

2.2.3 Simple Interest and Compound Interest

Compound interest is the interest earned when an interest is earned on
interest. When an interest is earned only on the principal, we refer to it as
simple interest. To calculate the simple interest earned, multiply the principal
with the interest rate and the number of periods: PV (I) (N). The future value
is represented by the principal plus the interest: FV = PV + PV (I) (N).

Referring to our example earlier, if we invest RM100 for three years and earn a
simple interest of five per cent per annum, our balance at the end of Year 3 would
be:

FV = PV + PV (I) (N)
= RM100 + RM100 (5%) (3)
= RM100 + RM15 = RM115

You would notice that the total simple interest above is less than the compound
interest we calculated earlier. You should be aware of how the interest is paid for
an investment, whether it is simple interest or compound interest.

SELF-CHECK 2.2

You deposit RM2,000 into a fixed deposit account which will pay an
interest of four per cent, compounded annually. How much will you
have in the account after 3 years? (Answer: RM2,249.73)
2.2.4 Compounding Process in a Graphical Form
The importance of the interest rate in compounding is shown in Figure 2.2. As
the interest rates rise, so does the future value. The figure shows the
compounding effect on our RM100 investment at different interest rates.

Figure 2.2: Growth of RM100 at various interest rates and time periods

2.3 PRESENT VALUES

In the previous subtopic, we took the present value of our investment and
calculated its value at some point in the future. However, in financial
management, you would also come across situations where you want to know
how much you have to invest today to enable you to receive certain cash flows at
a certain point in the future. For example, let us say you plan to build a new plant
in five years which is expected to cost RM5 million. How much of your earnings
should you put aside from now, so that at the end of five years you will have
RM5 million? In other words, what is the value of the amount of money today
which you will receive in the future? The answer to the question can be obtained
by determining the present value of future cash flow through the process called
discounting.

In the previous subtopic, we looked at how a RM100 investment would grow to

RM115.76 in three years at an interest rate of five per cent. Hence, RM100 is the
present value of RM115.76 due in three years at a five per cent interest rate
By now you would have realised that discounting is the reverse of compounding.
Hence, if you know the FV, you can find the PV.

First, let us find the PV using the step-by-step method.

To find the FV, moving from the left to the right, we multiplied the initial amount
and each subsequent amount by (1 + I). To find the PV, we work from right to
left, dividing the future value and each subsequent amount by (1 + I). For
example, we can find the PV in Year 2 and Year 1 as follows,

PV2
FV3
 (1 
I)
RM115.76
PV2   RM110.25
(1  0.05)
RM110.25
PV1  (1  0.05)  RM105.00
However, as we noted earlier, the step-by-step method is not efficient when we
are dealing with periods extending to several years. An alternative to the step-by-
step method is the formula method.

Recall Equation 2.1, which we used to find the FV. We now solve the same
equation to find PV.

Compounding to find FV: FVN = PV (1  2.1

I)N

FV
Discounting to find PV: PV 2.2
= (1  I)N

Substituting the values in Equation 2.2, we obtain:

RM115.76
PV   RM100
(1  0.05)N

You can also calculate the present values by using the financial calculator or
 SELF-CHECK 2.3

Let us say you purchase a risk-free bond which promises to pay

RM2,249.73 in 3 years. If the risk-free interest rate is four per cent, how
much is the bond worth today? (Answer: RM2,000)

How much will it be worth if the bond matures in five years and the
risk- free interest is six per cent? (Answer: RM1,681.13)

2.3.1 Discounting Process in a Graphical Form

The present value of a sum to be received in the future decreases and approaches
zero as the payment date is extended further into the future. As shown in Figure
2.3, the higher the interest rate, the faster the present value falls. This is because
the present value interest factor is inverse of the future value interest factor.

Figure 2.3: Present value of RM100 at various interest rates and time perio
Finding the Interest Rate and Number of Years
We have familiarised ourselves with Equations 2.1 and 2.2, and used them to find
PV and FV. There are four variables in the equations and if we know any three of
them, we can find the fourth.

Let us say we know the PV, FV and N, and we want to find I. For example, we
want to invest RM100 now and expect to generate returns of RM150 after 10
years (PV = RM100, FV = RM150, and N = 10 years), and we want to find the
rate of return. By using Equation 2.1 and reversing it:

PV(1  I)N  FV

RM100 (1  I)10  RM150

(1  I)10  RM150 /

RM100 (1  I)10  1.5

1  I  1.5(1/10)
1  I  1.0414
I  1.0414  1
I  0.0414  4.14%
2.3

You can also calculate the interest rate (I) and number of years (N), by using the
financial calculator or spreadsheets.

2.4 ANNUITIES
In the previous subtopics, we looked at cash flows involving single payments.
However, often we deal with investments with a series of inflows such as
coupons from a bond, as well as a series of payments (outflows) such as home
mortgages and auto loans. When payments of equal amounts are made at fixed
intervals, we call it an annuity. For example, if we obtain a five-year auto loan,
we would pay a fixed sum every month, say RM1,000, for the next five years to
the bank. We would call it a five-year annuity. Remember that two things must
hold for an annuity: it must have constant payments and a fixed number of
periods.
If the payments are made at the end of the period, then we will call it ordinary or
deferred annuity. Since payment of home mortgages and auto loans are generally
settled at the end of the periods, they are ordinary annuities.

On the hand, if payments are made at the beginning of the period, then it is called
annuity due. Generally, since rental lease payments and insurance premiums are
made at the beginning of the period, they are due annuity.

In the financial market, ordinary annuities are more common, and therefore
unless it is clearly stated, when we come across an „annuity‰, we would assume
payments are made at the end of the period.

Let us assume that we make an annual payment of RM100 for a three-year period
at five per cent. The timelines for the ordinary annuity and annuity due will look
as follows:

Take note that with annuity due, each payment is shifted to the left by one year.
Since we are making annual payments (cash outflow), they are shown with minus
signs.

ACTIVITY 2.1

1. Explain why an annuity due has a higher present value than an

ordinary annuity.

2. If the present value of an ordinary annuity is given to you, what is

the easiest way to find the corresponding annuity due?
Future Value of an Ordinary Annuity
Let us look at ordinary annuity timeline from the previous subtopic, where we
make payments of RM100 at the end of each year for three years at an interest
rate of five per cent. Figure 2.4 shows how to calculate the future value of the
ordinary annuity, FVAN, graphically.

Figure 2.4: Future value of an ordinary annuity

Recall how we calculate the compounding interest. In Figure 2.4, we compound

each payment to Year 3, and then add those compound values to find the
annuityÊs FV. However, if the annuity extends too many years, it would be
tedious and time- consuming to find the future value using the timeline. Using the
step-by-step approach in the diagram, we can produce the equation below.

FVAN  PMT (1  I)N1  PMT (1  I)N2  PMT (1  I)N3

Substituting the values N = 3, I = 5%, we obtain:

2 1 0
FVAN  RM100 (1.05)  RM100 (1.05)  RM100 (1.05)
FVAN  RM315.25

Hence, we can generalise the future value of an annuity as follows:

FVAN  PMT (1  I)N1  PMT (1  I)N2  PMT (1  I)N3  PMT (1  I)0

The future value of an annuity is as follows:

(1  1)N 1 
FVAN  PMT    2.4
 I I 
By substituting the values, we find the future value of the annuity to be RM315.25.
 1  0.053
FVA3  RM100 1
  RM315.25

  0.05 0.05 
 

You can also solve the annuity problems with a financial calculator or spread
sheets.

2.4.1 Future Value of an Annuity Due

Recall that in an annuity due, each payment is made one period earlier.
Hence, the payments will earn an interest for an additional period. To
calculate the future value of an annuity due, we multiply the Equation 2.4
result by (1 + I):

FVAdue  FVAordinary (1  1) 2.5

For the annuity due, FVAdue RM315.25 (1.05) = RM331.01

SELF-CHECK 2.4

1. Using the timeline method, find out the present value of the
annuities due in subtopic 2.4.2. Did you get the same answer?

2. You plan to purchase a new car five years from now. You deposit
RM2,500 per year into a fixed deposit account which pays four
per cent interest, and you make the first deposit at the end of this
year. How much will you have in the deposit account after five
years? (Answer: RM13,540.81)

3. Referring to the above scenario, if you make the first deposit

immediately, how much will you have in the deposit account after
five years? (Answer: RM14,082.44)
 TOPIC 2 TIME VALUE OF MONEY  29

2.4.3 Present Value of an Ordinary Annuity

Recall how we calculate the present value of a series of cash flows. In Figure 2.5,
the present value of an ordinary annuity is calculated.

Figure 2.5: Present value of an ordinary annuity

To find the PV of the annuity, we discount each cash payment back to Time 0.
We then total up the discounted values. The above is simple and straightforward,
but imagine how tedious and time-consuming it would be if the annuity is for
many years.

We can apply the following formula to find the PVA. Notice that the equation
mirrors the step-by-step method we used earlier.

PVAN  MT
PMT (1   PMT 2.6
 (1  I)2 (1  I)N
I)1

We can summarise the above formula as follows:

1 1 
PVAN  PMT   
1 I (1  I)N
 
 1 1 
PVA3  PMT     RM272.32
0.05 0.05 (1  0.05)3
 
Present Value of an Annuity Due
Remember that in an annuity due, the payment occurs one period earlier.
Therefore, we will discount the payments for one less period.

To find the annuity due, we first find the value of the annuity due, and then
multiply the result of Equation 2.6 with (1 + I):

PVAdue  PVAordinary (1  1)

PVAdue  RM272.32 (1.05)  RM285.94

SELF-CHECK 2.5
1. You have an ordinary annuity with 10 payments of RM100 and
the applicable interest rate is 4%. What would the PVA be,
assuming it was an ordinary annuity? (Answer: RM811.09)
2. What would the PVA be if you were dealing with an annuity due?
(Answer: RM843.53)

2.5 PERPETUITIES
We looked at an investment with single payment at a fixed point in time, and the
relationship between the present value and future value. However, there are
investments which will promise to provide returns forever. An investment which
promises to pay returns perpetually or has no maturity is called a perpetuity.

A perpetuity is simply an annuity which has no maturity or whose promised

payments extend out forever. There are two types of perpetuities: level perpetuity
and growing perpetuity. In a level perpetuity, the payments are constant over time
while in a growing perpetuity, the payments grow at a constant rate from period
to period over time.

ACTIVITY 2.2

Explain the difference between level perpetuity and growing perpetuity.

 Present Value of a Level Perpetuity

We can determine the PV of a level perpetuity by dividing the constant

payment by the discount rate, as shown in the following formula:
PMT
PV of a level perpetuity 
I
Let us say we hold a bond which promises to pay RM100 per annum perpetually,
and the prevailing interest rate at the time of issue was five per cent. The present
value of the bond will be:
RM100
PV of a bond   RM2,000
0.05However, if the interest rate increases to 7.5 per cent,
then the value of the bond will fall to RM1,333:
RM100
PV of a bond   RM1,333
0.075

What would the value of the bond be if the interest rate decreases to 2.5 per cent?
The value of the bond will rise to RM4,000:
RM100
PV of a bond   RM4,000
0.075
Present Value of a Growing Perpetuity
If you are holding a growing perpetuity, then you will receive periodic cash flow
which grows at a constant rate each period. For example, let us say you hold a
growing perpetuity which makes its first payment of RM100 and its payments are
assumed to grow at five per cent per year. Using the compound effect, you know the
payment you receive in Year 2 will be RM100 (1.01) = RM105, and the payment in
Year 3 will be RM100 (1.05) (1.05) = RM110.25, and so on.
The formula to calculate the present value of a growing perpetuity is as follows:
PMTperiod 1
PV of a growing perpetuity
 Ig

Where PMTperiod 1 is the payment made in

the first period and g is the rate of growth
of the payment from period to period