# Foundations of Finance

Lecture 2

The Time Value of Money:

An Introduction to Financial Mathematics

1. Lecture Overview

This week will provide you with an introduction to financial

mathematics. The lecture is designed to ensure you have the

tools necessary to calculate the value of financial

instruments later in the course. Today’s lecture will

consider:

– Why a dollar received today is worth more than a dollar received

any time after today; and,

– How to calculate what a dollar received at some time in the

future is worth today.

Assumptions

• No uncertainty

• Perfect competition

• No frictions

• Capital flows relatively easily

Terminology

• Single and multiple cash flows

• PV=present value ($)

• FV=future value ($)

• n=# of periods (days (365), weeks (52),

fortnights (26), months (12), years)

• r = interest rate (%; > 0)

• Timeline

Time value of money: single cash flow

• Example 1: Suppose a bank pays 10% p.a.

interest. You are given the choice between

two plans. Plan A, you receive $100 today.

Plan B, you receive $100 one year from now.

• How can we compare these choices?

2.1 Future Value of a Single Cash Flow

Example 2: How much does $100 become after 2 years

earning an interest rate of 10%?

FV single cash flow: multiple periods

Year Future value

0 100 F

1 110 F(1+r)

2 121 F(1+r)(1+r)=F(1+r)²

n

r F FV ) 1 ( + =

2.1 Future Value of a Single Cash Flow

Solution Using Compound Interest Calculations:

Future Value = F

0

(1 + r)

n

FV = $100 (1 .1)

2

= $121

2.1 Future Value of a Single Cash Flow

Solution:

This question is asking us to calculate the future value (ie the

worth of the asset at some future date). The answer to this

question depends on whether we use simple interest or

compound interest calculations:

– Simple Interest: The amount of interest paid is only a function

of the initial principal invested (ie if the principal doesn’t

change then, given a constant interest rate, the interest paid

each period will be the same); and,

– Compound Interest: Interest in successive periods is calculated

based on the principal as well as on interest earned in previous

periods (ie interest is earned on interest).

2.1 Future Value of a Single Cash Flow

Solution Using Simple Interest Calculations:

Future Value = Principal + interest

FV = F

0

+ F

0

r

s

n

= F

0

(1 + r

s

n)

= $100 (1 + [0.1*2])

= $120

Comparing the two answers, we can see the future value using

compound interest is $1 more than if we use simple interest.

Why? Because, with the compound interest, interest in the

second period included an amount earned on the interest we

were paid in the first period (ie in the second period, we earned

10% interest on the $10 interest from the first period, or an

extra $1).

Simple and compound interest

• What is the value of $100 invested at 10%

compounded annually for 100 years?

Solution: 1, 378,061.234

• What is the value of $100 invested at 10% p.a.

simple interest, for 100 years?

Solution: $1,100

From now on we will only use compound

interest

Future value: single cash flow

• Example 3: Pat deposits $500 in the bank today.

What is the value of Pat’s investment after 10 years if

the investment earns 7% interest?

Future value: single cash flow

• Example 4: Rebecca has $100,000 to invest and

she has narrowed down her decision to two

investments. Option A returns 60% p.a. for 4 years,

but the maximum investment she can make is

$10,000. Option B returns 12% p.a. for 4 years and

Rebecca can invest the whole $100,000. Which

option produces the best result for Rebecca and

what is the benefit over the lesser option? Assume

the $90,000 left from A is placed in a non interest

bearing bank deposit.

• OPTION A: returns $155,536

• OPTION B: returns $157,352

2.2 Present Value of a Single Cash Flow

Using the time value of money idea, we know that we would

have to put an amount less than $1 in the bank in order to

receive $1 from the investment in the future. Exactly how

much less than $1 we would need to deposit in the bank

initially depends on:

– How long we are going to leave it there; and,

– How much interest we will earn in the mean time.

Consider the following example.

2.2 Present Value of a Single Cash Flow

Example 5:

What is the present value (PV) of receiving $110 1 year

from now if r = 10%?

PV requires looking back!

2.2 Present Value of a Single Cash Flow

Solution Using Compound Interest Calculations:

Present Value = FV

(1 + r)

n

PV = 110

(1.10)

= $100

Present value: single cash flow

Example 6: Suppose you will inherit $200,000, 3 years

from now and r = 10%. What is the value to you today?

PV = FV

(1 + r)

n

=

200,000

(1.1)ᵌ

= $150,262.9602

2.3 Future Value of Multiple Cash Flows

To calculate the future value of multiple cash

flows, we can simply employ the approach

discussed earlier. From this point, we will

discuss calculations using compound interest,

though it is important to note a simple interest

approach can also be employed.

2.3 Future Value of Multiple Cash Flows

Example:

You will make three bank deposits in the next 3 years, with the first

deposit to be made exactly 1 year from today. Further details of these

deposits are provided in the table below. Calculate the total value of

these deposits in exactly 3 years’ time given interest is paid at a rate of

10% per annum (calculated at the end of each year).

Time 1 year 2 years 3 years

Deposit

Amount

$100 $200 $500

2.3 Future Value of Multiple Cash Flows

Solution:

In answering this question, it is useful to draw a timeline:

We can see from the timeline that, in exactly 3 years’ time:

– The first deposit ($100) will have been in the bank for exactly two years;

– The second deposit ($200) will have been in the bank for exactly one year;

and,

– The third deposit ($500) will be deposited in the bank immediately before

the time at which we wish calculate the total value of the deposits.

t=0 t=1 t=2 t=3

Deposit $100 Deposit $200 Deposit $500

We want to calculate the total

value of the 3 deposits here.

2.3 Future Value of Multiple Cash Flows

Solution:

Given this, we can calculate the total value of these deposits in

exactly three years’ time as follows:

FV

3

= $100(1.1)

2

+ $200(1.1) + $500

= $121 + $220 + $500

= $841

2.3 Future Value of Multiple Cash Flows

Now, let’s say that the amounts we are to deposit are equal

in value. Let’s say we plan to deposit $100 at the end of

each year for the next 3 years. A finite number of cash flows

that are equal in value and are evenly spaced are called

annuities. There are 3 types of annuities, which we will

now consider in turn:

– Ordinary Annuities;

– Annuities Due; and,

– Deferred Annuities.

2.3.1 Future Value of Annuities

1) Ordinary Annuity

An ordinary annuity is one where the time between now and the

first cash flow is the same as the time separating each subsequent

cash flow. Diagrammatically, an ordinary annuity comprising n

cash flows of $F can be shown as:

An example of an ordinary annuity is the series of repayments

made on a bank loan.

$F $F $F $F $F

t=1 t=0 t=2 t=3 t=4 t=n …..…………..

…..…………..

Future value of an ordinary annuity

• Example: Peter deposits $100 at the end of

each year for 3 years at a rate of 10%. What is

the value of the annuity at the end of the 3

years?

1 2 3

Begin 0 100 210

Interest 0 10 21

Deposit 100 100 100

End 100 210 331

Future value of annuities

Year Cash flow Years to end Future value

0 0 3 0

1 F 2 F(1+r)²

2 F 1 F(1+r)

3 F 0 F

2.3.1 Future Value of Annuities

To find the future value of an annuity comprising n

cash flows of $F immediately following the last cash

flow, we can either compound each individual cash

flow, or we can apply the formula below:

What about if there are an infinite number of cash

flows?

(1 ) 1

n

n r

r

FV F

r

FS

(

+ ÷

=

(

¸ ¸

=

2.3.1 Future Value of Annuities

2) Annuity Due

An annuity due is one where the first cash flow occurs

immediately. However, the time between the first cash flow and

the second cash flow is the same as the time separating all

subsequent cash flows. Diagrammatically, an annuity due

comprising n cash flows of $F can be shown as:

An example of an annuity due is rent paid on a residential property.

$F $F $F $F $F $F

…..…………..

…..…………..

t=0 t=1 t=2 t=3 t=4 t=n-1

2.3.1 Future Value of Annuities

3) Deferred Annuity

A deferred annuity is one where the first cash flow occurs at some

time in the future, but the time between now and the first cash flow

does not equal the time separating each subsequent cash flow.

Diagrammatically, a deferred annuity comprising n cash flows of $F

that commences in m periods can be shown as:

An example of a deferred annuity is a “buy now pay later” scheme

often promoted by retail outlets.

$F $F $F $F

…..………….. …..…………..

…..…………..

…..………….. t=0 t=m

t=m+1

t=m+2 t=m+n-1

2.3.1 Future Value of Annuities

Example:

Calculate the future value in 3 periods’ time of an ordinary

annuity comprising 3 payments of $500. These payments

are made at the end of each period, and the interest rate is

8% per period.

2.3.1 Future Value of Annuities

Solution:

Approach 1: Compounding each cash flow individually

Approach 2: Using the Future Value of an Annuity Formula

2

500(1.08) 500(1.08) 500

$1, 623.20

FV = + +

=

3

(1.08) 1

500

0.08

$1, 623.20

FV

(

÷

=

(

¸ ¸

=

Future value of ordinary annuity

• Example: John is 40 years old and has

accumulated $100,000 in his retirement fund.

He can add $1200 at the end of each year to

the account which is returning 6%. Will he

have enough to retire on in 20 years, given he

estimates he needs $500,000?

2.4 Present Value of Multiple Cash Flows

When calculating the present value of multiple

cash flows, we can either:

– Discount each cash flow individually and sum the

resultant values to calculate the present value; or,

– In the cash of identical evenly spaced cash flows,

we can use the present value of an annuity

formula.

2.4 Present Value of Multiple Cash Flows

Example

I expect to receive the following cash flows over the next four

years.

What is the present value of these cash flows given they are

received at the end of the relevant year and the interest rate is 10%

p.a?

Time 1 year 2 years 3 years 4 years

Cash Flow $300 $290 $500 $580

2.4 Present Value of Multiple Cash Flows

Solution

While the cash flows are evenly spaced, they are not of the same

dollar value. Therefore, they are not an annuity and, in order to

calculate their present value, we must discount them individually

before summing them.

2 3 4

300 290 500 580

(1.10) (1.10) (1.10) (1.10)

$1, 284.20

PV = + + +

=

2.4.1 Present Value of Annuities

The formula used to calculate the present value

of an annuity differs based on the type of annuity

being considered. Let’s consider each type of

annuity in turn.

2.4.1 Present Value of Annuities

1) Ordinary Annuity

Recall that an ordinary annuity is one where the time between

now and the first cash flow is the same as the time separating each

subsequent cash flow. To calculate the present value of an

ordinary annuity comprising n cash flows of $F, we use the

following equation:

2

...........

(1 ) (1 ) (1 )

1 (1 )

n

n

n r

F F F

PV

r r r

r

F

r

FA

÷

= + + +

+ + +

( ÷ +

=

(

¸ ¸

=

2.4.1 Present Value of Annuities

Ordinary Annuity Example

The present value of an ordinary annuity comprising 10 annual cash

flows of $500 each is calculated as follows given an interest rate of

10% p.a. :

10

1 (1 )

1 (1.10)

500

0.10

$3, 072.28

n

r

PV F

r

÷

÷

( ÷ +

=

(

¸ ¸

( ÷

=

(

¸ ¸

=

2.4.1 Present Value of Annuities

2) Annuity Due

Recall that an annuity due is one where the first cash flow occurs

immediately. To calculate the present value of an annuity due

comprising n cash flows of $F, we use the following equation:

2 1

( 1)

1

...........

(1 ) (1 ) (1 )

1 (1 )

n

n

n r

F F F

PV F

r r r

r

F F

r

F FA

÷

÷ ÷

÷

= + + + +

+ + +

( ÷ +

= +

(

¸ ¸

= +

2.4.1 Present Value of Annuities

Annuity Due Example

The present value of an annuity due comprising 10 annual cash flows of $500

each is calculated as follows given an interest rate of 10% p.a.

When we compare this with the present value of the ordinary annuity from

Slide 29, we see the present value of the annuity due is higher. Why?

( 1)

9

1 (1 )

1 (1.10)

500 500

0.10

$3, 379.51

n

r

PV F F

r

÷ ÷

÷

( ÷ +

= +

(

¸ ¸

( ÷

= +

(

¸ ¸

=

2.4.1 Present Value of Annuities

The reason:

• payments made under an ordinary annuity occur at the end of

the period while payments made under an annuity due occur

at the beginning of the period.

• The PV is larger under the annuity due because all the

payments are made earlier. In other words, they are all closer

to the "present" so they are subject to less discounting.

2.4.1 Present Value of Annuities

3) Deferred Annuity

Recall that a deferred annuity is simply an annuity that

commences as some time in the future. To calculate the present

value of a deferred annuity that commences in m periods and

comprises n cash flows of $F, we use the following:

1

1 (1 )

(1 )

n

m

r

F

r

PV

r

÷

÷

( ÷ +

(

¸ ¸

=

+

2.4.1 Present Value of Annuities

Deferred Annuity Example

The present value of a deferred annuity commencing in 5 years

that comprises 10 annual cash flows of $500 each is calculated as

follows given an interest rate of 10% p.a. :

What about if there are an infinite number of cash flows?

10

4

1 (1.10)

500

0.10

(1.10)

$2, 098.41

PV

÷

( ÷

(

¸ ¸

=

=

2.4.2 Present Value of Perpetuities

A perpetuity is a series of equally spaced cash flows of same dollar

value that continues on forever. As with annuities, perpetuities

can be broken into three types based on the time until the first

cash flow occurs, namely:

– Ordinary Perpetuities;

– Perpetuities Due; and,

– Deferred Perpetuities.

2.4.2 Present Value of Perpetuities

1) Ordinary Perpetuity

Ordinary Perpetuity: The time between now and the first cash flow

is the same as the time separating subsequent cash flows. The

only difference between an ordinary perpetuity and an ordinary

annuity is that, in the case of the ordinary perpetuity, cash flows

continue forever. The present value of an ordinary perpetuity

comprising individual cash flows of $F is calculated as:

F

PV

r

=

2.4.2 Present Value of Perpetuities

Ordinary Perpetuity Example

The present value of an ordinary perpetuity that comprises annual

cash flows of $500 each is calculated as follows given an interest

rate of 10% p.a.:

500

0.1

$5, 000

PV =

=

• Example: At what interest rate would you be

indifferent to a perpetuity paying 2,000,000

p.a. and a one off payment of 40,000,000?

• Solution:

At a 5% interest rate you are indifferent. If the

interest rate is above 5% the immediate

onetime payment is better; because future

cash flows are less valuable. If the r is below

5%, the perpetuity payment is better, because

future cash flows are more valuable.

2.4.2 Present Value of Perpetuities

2) Perpetuity Due

Perpetuity Due: The first cash flow occurs immediately. The only

difference between a perpetuity due and an annuity due is that, in

the case of the perpetuity due, cash flows continue forever. The

present value of an annuity due comprising individual cash flows of

$F is calculated as:

F

PV F

r

= +

2.4.2 Present Value of Perpetuities

Perpetuity Due Example

The present value of a perpetuity due that comprises annual cash

flows of $500 each is calculated as follows given an interest rate of

10% p.a.:

500

500

0.1

$5, 500

F

PV F

r

= +

= +

=

2.4.2 Present Value of Perpetuities

3) Deferred Perpetuity

Deferred Perpetuity: A perpetuity that commences some time in the

future, but the time between now and the first cash flow does not

equal the time separating each subsequent cash flow. The only

difference between a deferred perpetuity and a deferred annuity is

that, in the case of the deferred perpetuity, cash flows continue

forever. The present value of a deferred annuity commencing in m

periods and comprising individual cash flows of $F is calculated as:

1

(1 )

m

F

r

PV

r

÷

(

(

¸ ¸

=

+

2.4.2 Present Value of Perpetuities

Deferred Perpetuity Example

The present value of a deferred perpetuity that commences in 4 years

and comprises annual cash flows of $500 each is calculated as follows

given an interest rate of 10% p.a.:

1

3

(1 )

500

0.1

(1.10)

$3, 756, 57

m

F

r

PV

r

÷

=

+

=

=

3. Interest Rates for Time Value of Money

Calculations

In time value of money calculations, it is very important to ensure

that each piece of information included in calculations is expressed in

terms of the time frame. Consider the following examples.

Example 1:

When calculating the present value of a single cash flow, if the

number of periods (n) is expressed in terms of the number of years till

the cash flow is received, then the interest rate (r) used must also be

expressed as a rate applied once a year. In the case of a single cash

flow, n and r could also be expressed as semi-annual figures, etc and

the answer would be the same.

3. Interest Rates for Time Value of Money

Calculations

Example 2:

When calculating the present value of an annuity / perpetuity,

both n and r must be expressed in terms of the same time as the

period between each cash flow. So, if cash flows are monthly, n

should represent the number of months and r should be the

monthly interest rate.

We already know how to convert n from the number of years to

the number of months, but how do you convert r from an annual

rate to a monthly rate? Use the Interest Rate Wheel. Before we

look at the wheel, let’s familiarize ourselves with some interest

rate terminology.

3. Interest Rates for Time Value of Money

Calculations

First, consider the difference between annual effective, annual nominal and

periodic interest rates:

– Annual effective interest rate: An interest rate where the frequency of

charging / payment matches the period specified by the interest rate. In other

words, the rate is quoted annually and is applied annually;

– Annual nominal interest rate: An interest rate where interest is charged more

frequently than the time period specified in the interest rate. For example,

12% p.a. compounded monthly is an example of a nominal interest rate; and,

– Periodic interest rate: The rate of interest applied per compound period in the

case of a nominal interest rate. For example, if the interest rate is 12%

compounded semi-annually, the periodic (6 month) interest rate is 12%/2 =

6%.

3. Interest Rates for Time Value of Money

Calculations

How do we know which rate to use?

Recall the earlier discussion on using information in the

equations that is expressed in terms of the same time

frame. More specifically:

– Use an annual effective rate to calculate future or present

value when:

• You have an annuity / perpetuity with annual cash flows. Here,

you must also have n expressed in terms of number of years; or,

• You have multiple uneven cash flows / a single cash flow and

you have expressed n in terms of the number of years.

3. Interest Rates for Time Value of Money

Calculations

– Use a periodic interest rate to calculate future or present value

when:

• You have an annuity / perpetuity with cash flows paid less than

annually. Here, the periodic rate must be expressed as frequently

as the cash flows. For example:

– If you have an annuity paid monthly, you must use a monthly

periodic interest rate and a monthly value of n; and,

– If you have an annuity paid quarterly, you must use a quarterly

period interest rate and a quarterly value of n.

• You have multiple uneven cash flows / a single cash flow and you

want to use a value of n calculated based on the same period as the

period rate. For example;

– If you have n expressed in terms of months, use a monthly period

rate; and,

– If you have n expressed in terms of days, use a daily periodic rate.

– NB: It doesn’t matter what period you use, as long as r and n are

both calculated based on this period.

3. Interest Rates for Time Value of Money Calculations

I In nt te er re es st t R Ra at te e W Wh he ee el l

Annual Effective Rate

(1 ) 1

n

e p

r r = + ÷

1/

(1 ) 1

n

p e

r r = + ÷

Periodic Rate (1 ) 1

n n

e

r

r

n

= + ÷

1/

[(1 ) 1]

n

n e

r n r = + ÷ Periodic Rate

n

p

r

r

n

=

n p

r r n = ×

Annual Nominal Rate

Where: r

e

= annual effective rate

r

n

= nominal annual rate

r

p

= periodic rate (eg monthly, quarterly, etc)

n = number of compounding periods per annum

3. Interest Rates for Time Value of Money

Calculations

Examples

• Calculate the annual effective interest rate given an interest rate

of 12% p.a. compounded quarterly.

4

(1 ) 1

0.12

(1 ) 1

4

0.1255

12.55% . .

n

n

e

r

r

n

p a

= + ÷

= + ÷

=

=

3. Interest Rates for Time Value of Money

Calculations

Examples (Continued)

3. Calculate the monthly periodic interest rate given an interest rate of

9% p.a compounded monthly.

0.09

12

0.0075

0.75%

n

p

r

r

n

=

=

=

=

3. Interest Rates for Time Value of Money

Calculations

Examples (Continued)

• Calculate the 6 month interest rate (semi-annually, which is a

periodic interest rate) given an interest rate of 10% p.a.

compounded annually.

1/

1/ 2

(1 ) 1

(1.10) 1

0.0488

4.88%

n

p e

r r = + ÷

= ÷

=

=

3. Interest Rates for Time Value of Money

Calculations

Examples (Continued)

• Calculate the monthly periodic interest rate given an interest rate of

12% p.a. compounded quarterly.

Step1: to find the annual effective interest rate

4

(1 ) 1

0.12

(1 ) 1

4

0.1255

12.55% . .

n

n

e

r

r

n

p a

= + ÷

= + ÷

=

=

3. Interest Rates for Time Value of Money

Calculations

Step 2: To calculate the monthly periodic interest rate given the

annual effective interest rate is 12.55%.

In answering questions ask yourself

• Single or multiple cash flow?

• PV or FV?

• Is time period between cash flows

same/different to quoted time period of

interest compounding?

Examples

1. Calculate the future value of $1000 invested

today for a period of 20 years at an interest

rate of 10% compounded daily? How and

why would your answer differ if interest was

compounded quarterly?

Solution A:

• Single cash flow

• FV

• n = 20 x 365

• rᵨ = .10/365

• FV = 1,000

= $7,387.03

365 20

)

365

10 . 0

1 (

x

+

Solution B: interest is compounded quarterly

FV = 1,000

= $7,209.57

The value is less because there is less

compounding.

4 20

)

4

10 . 0

1 (

x

+

• Example:

What is the PV of a perpetuity paying

$15/month, beginning next month, if the

effective annual interest rate is a constant

12.68% p.a.?

• Solution:

• Step 1: convert annual effective interest rate

to a periodic rate (use interest rate wheel)

= about 1%

• Step 2: Apply PV of perpetuity formula

PV = 15/.01= $1500

1 ) 1 (

/ 1

÷ + =

n

e p

r r

• Jordan has successfully applied for a home

loan. Calculate how much he is borrowing

given the terms of the loan are as follows:

• Monthly repayments are $1,000

• The loan is taken over 25 years

• The interest rate is fixed at 10% p.a. compounded

quarterly

Solution:

We need to calculate the PV of all the repayments to work out how much will

be borrowed. The payments are evenly spaced and equal amounts so use

ordinary annuity formula. But cash flows occur at a different interval to

the interest compounding.

Step 1: calculate (0.103812)

Step 2: calculate monthly rate: (0.008264)

Step 3: use PV of annuity formula; n = 12 x 25

Answer: $ 110, 752.65

e

r

p

r

Next Week….

Next week we will apply the financial

mathematics we have learnt in today’s lecture to

valuing shares in a company.