CHAPTER 2
Chapter outline
• Introduction
• Interest rates
• Future value and compounding of lump sums
• Compounding interest more frequently than annually
• Nominal and effective interest rates
• Present value and discounting
• More on present and future values
• Valuing annuities
• Perpetuities
• Amortising a loan
• Sinking funds
• Conclusion
Learning outcomes
By the end of this chapter, you should be able to:
• use various computation tools to analyse the role of time
value in finance
• calculate, interpret and explain the future value and
present value of single amounts or lump sums, and
investigate the relationship between them
• calculate, interpret and explain the future value and
present value of annuities (ordinary annuities, annuities
due and ordinary deferred annuities)
• calculate, interpret and explain the present value of a
perpetuity
Learning outcomes (cont.)
By the end of this chapter, you should be able to:
• calculate and interpret the present value and future
value of a mixed stream of cash flows
• determine deposits needed to accumulate a future sum,
calculate installments to amortise a loan and calculate
an interest rate or growth rate
• calculate the present value, future value, interest rate
and time period using discounting and compounding
principles.
Introduction
• The value of an investment depends on:
size
timing of cash flows
• The larger the cash inflows, and the sooner the
receipt of these cash flows, the more valuable
the investment
• Time value of money:
Cash flows to be received in the near future are more
valuable than ones to be received in the distant future
Interest rates
• Simple interest
Interest earned on the principal amount only –
interest earned is not reinvested
• Compound interest
All interest earned is reinvested together with
principal amount – interest is earned on original
principal as well as on interest that has been
reinvested
Sibusiso receives a R1 000 bonus. He invests the R1 000 in a
savings account that offers a simple interest rate of 10% p.a. for a
period of five years. How much money will Sibusiso have after
five years?
Example 4.1 Simple interest
Initial principal Interest
Year 1: 10% of R1 000 = R100
Year 2: 10% of R1 000 = R100
Year 3: 10% of R1 000 = R100
Year 4: 10% of R1 000 = R100
Year 5: 10% of R1 000 = R100
Initial principal: R1 000
Total interest earned over this period: R 500
Final amount after five years: R1 500
Sibusiso invests R1 000 in a savings account offering interest
at 10% p.a. but the interest earned will be reinvested. How
much money will Sibusiso have after five years?
Example 4.1 Compound interest
Initial Previous
Principal Interest Principal New amount
Year 1: 10% of R1 000,00 = R100,00 R1 000,00 R1 100,00
Year 2: 10% of R1 100,00 = R110,00 R1 100,00 R1 210,00
Year 3: 10% of R1 210,00 = R121,00 R1 210,00 R1 331,00
Year 4: 10% of R1 331,00 = R133,10 R1 331,00 R1 464,10
Year 5: 10% of R1 464,10 = R146,41 R1 464,10 R1 610,51
Initial principal: R1 000,00
Final amount after five years: R1 610,51
Total interest earned over this period: R 610,51
Future value and compounding of a
lump sum
• Future value (FV): determine accumulated value
of all cash flows at end of a project (T
n
)
• Present value (PV): discounts all cash flows to
start/beginning of a project (time zero, T
0
)
FV
n
= PV
0
× (1+i)
n
Example 4.2
Sibusiso invests his money for a period of one
year at an interest rate of 10%. What will the FV of
his investment be at the end of the year?
Example 4.3
Sibusiso invests his money for two years at 10%.
Calculate the FV of his investment after two years.
Compounding interest more frequently
than annually
• Interest often computed more frequently than
once a year
• Terminology for different frequencies of
compounding:
Nominal annual rate compounding annually (NACA)
Nominal annual rate compounding semiannually
(NACSA)
Nominal annual rate compounding quarterly (NACQ)
Nominal annual rate compounding monthly (NACM)
Semiannual, quarterly and monthly
compounding
• Formula when interest is compounded more
than once per period:
FV
n
= PV
0
×
• FV increases when frequency of compounding
the interest payments is increased
m n
m
i
1
×

.

\

+
Sibusiso invests his money for a period of two years at an
interest rate of 10%, compounded semiannually. What will
the FV of his investment be at the end of this period?
FV
4
= PV
0
×
m n
m
i
1
×

.

\

+
= R1 000 ×
2 2
2
0,10
1
×

.

\

+
= R1 000 × (1,05)
4
= R1 000 × 1,216
= R1 215,51
Example 4.6
Continuous compounding
• Interest sometimes computed continuously
FV
n
= PV
0
× e
i × n
Let’s reconsider Sibusiso’s deposit of R1 000 in the
savings account for a period of two years at an annual
interest rate of 10%, but let’s now assume that the interest
is compounded continuously. Calculate the FV.
Using the formula:
FV
2
= PV
0
× e
i × n
= R1 000 × 2,7183
0,10 × 2
= R1 221,40
Nominal and effective interest rates
• Nominal (stated) interest rate: contractual
annual percentage rate of interest charged by a
lender or promised by a borrower
• Effective (true) annual rate: annual rate of
interest actually paid or earned.
Effective annual rate includes effects of compounding
frequency; nominal rate does not
EAR =
1
m
i
1
m
÷

.

\

+
Example 4.10
• What is the effective annual rate of interest if
an annual nominal rate of 8% is compounded
quarterly?
Using the formula:
EAR =
=
= (1,02)
4
− 1
= 0,0824
= 8,24%
1
m
i
1
m
÷ 
.

\

+
1
4
8%
1
4
÷

.

\

+
Present value and discounting
• Present value (PV)
Amount of money invested today at given interest rate
for specified period to equal future amount
• Alternatively: PV is amount today that is
equivalent to future payment that has been
discounted by appropriate interest rate
• Since money has time value: PV of future amount is
worth less longer you have to wait to receive it
• Process of finding PVs: discounting
Present value and discounting
• PV
Amount of money that would have to be invested today
at given interest rate over specified period to equal future
amount
PV
0
=
( )
n
n
i 1
FV
+
Example 4.11
Fikile wishes to find the current value (PV) of an
amount of R1 700 that will be received eight years
from now, assuming that the annual interest rate
is 8%.
Using the formula:
PV = FV × (1 + i)
n
= R1 700 × (1,08)
8
= R1 700 × 0,5402
= R918,46
More on present and future values
• Determining an interest rate
Sometimes necessary to calculate the return on
investment
• Calculating the number of periods
Sometimes necessary to work out the number of time
periods for an initial investment to accumulate to a
given FV
Valuing annuities
• Annuity
Series of equal payments (cash outflows) or receipts
(cash inflows) occurring over specified time period
Consists of constant payments made at regular
intervals (monthly, quarterly, annually, etc.)
• Two types of annuities
Ordinary annuity (or annuity in arrears): payments or
receipts occur at the end of each period
Annuity due (or annuity in advance): payments occur
at the start of each period
Example 4.14
You deposit R2 000 at the end of each of the next five
years in an account that pays 10% interest p.a. What
will the FV of your account be after five years?
Example 4.14
FVA = PMT ×
( )
(
(
¸
(
¸
÷ +
i
i 1 1
n
Using the formula:
FVA = PMT ×
( )
(
(
¸
(
¸
÷ +
i
i
n
1 1
= R2 000 ×
( )
(
(
¸
(
¸
÷
0,10
1 1,10
5
= R2 000 × 6,1051
= R12 210,20
FV of an annuity due
• Annuity due: each payment occurring is moved
ahead one period in order to convert the cash
flow stream into an ordinary annuity
Achieved by multiplying PMT by (1+i)
Resulting cash flows of R5 300 (5 000 × 1,06) at the
end of each period are similar to the cash flows of
R5 000 at the beginning of each period
Example 4.19
T
0
T
1
T
2
T
3
T
4
T
5
R5 000 R5 000 R5 000 R5 000 R5 000
R5 300 R5 300 R5 300 R5 300 R5 300
FVA = PMT × (1 + i) ×
( )


.

\

÷ +
i
i
n
1 1
= R5 000 × 1,06 ×
( )


.

\

÷
0,06
1 1,06
5
= R5 000 × 1,06 × 5,637
= R29 876,59
What amount will accumulate if you deposit R5 000 at
the beginning of each year for the next five years in an
account with an interest of 6% compounded annually?
PV of an ordinary annuity
• PVA: current value of a stream of expected or promised future
payments that have been discounted to a single equivalent value
today
PVA = PMT ×
( )
(
(
¸
(
¸
+ ÷
÷
i
i
n
1 1
Example 4.20
Suppose you need an investment that will pay R2 000 at
the end of every year for the next five years at an annual
interest rate of 10%. How much should you invest today?
Using the formula:
PVA = PMT ×
( )
(
(
¸
(
¸
+ ÷
÷
i
i
n
1 1
= R2 000 ×
( )
(
(
¸
(
¸
÷
÷
0,10
1,10 1
5
= R2 000 × 3,7908
= R7 581,57
Example 4.22
What amount must you invest today at 6% interest
compounded annually so that you can withdraw R5 000 at
the beginning of each year for the next five years?
Using the formula:
PVA = PMT × (1+i) ×
( )
(
(
¸
(
¸
+ ÷
÷
i
i
n
1 1
= 5 000 × (1,06) ×
( )
(
(
¸
(
¸
÷
÷
0,06
1,06 1
5
= R22 325,53
Mixed stream of cash flows
• Annuity based on equal payments over a
number of periods
• During capital budgeting cash flows from initial
investment usually not in form of annuity
• Unequal cash flows will probably be generated
over project lifetime
In some cases, positive as well as negative cash flows
may occur
Mixed cash flow stream
Not possible to use annuity formulae and calculator
solutions
Example 4.24
As a reward for taking care of your uncle he makes the
following payments into your account over a period of five
years:
Year Cash flow
1 R5 000
2 R5 000
3 R6 000
4 R6 000
5 R1 000
Assuming an interest rate of 10% per annum, calculate the
PV of the cash flows.
T
0
T
1
T
2
T
3
T
4
T
5
R5 000 R5 000 R6 000 R6 000 R1 000
× 1,1
1
4 545,45
× 1,1
2
4 132,23
× 1,1
3
4 507,89
× 1,1
4
4 098,08
× 1,1
5
620,92
17 904,57
Example 4.24
The calculation can also be computed with a
financial calculator by using the cash flow function
(Cf
i
):
Input Function
0 Cf
i
5 000 Cf
i
5 000 Cf
i
6 000 Cf
i
6 000 Cf
i
1 000 Cf
i
10 i
NPV = R17 904,58
Example 4.24
Perpetuities
• Perpetuity: annuity in which periodic payments
begin on a fixed date and continue indefinitely
(perpetual annuity)
• Three types of perpetuities:
Ordinary perpetuity: payments made at the end of
the stated periods
Perpetuity due: payments made at the beginning of
the stated periods
Growing perpetuity: periodic payments grow at a
given rate (g)
Perpetuities
• Formula used to calculate the PV of an ordinary
perpetuity (PV
∞
):
PV
∞
=
• Formula used to calculate the PV of a growing
perpetuity:
PV
∞
=
i
PMT
g i÷
PMT
Conclusion
• A lump sum refers to a single payment or receipt of cash
at a specific point in time. A distinction was made
between initial cash flows (occurring at time zero, i.e.
now) and future cash flows that occur somewhere in
future.
• An annuity can be defined as a stream of equal, periodic
cash flows over a specified period of time, in equally
spaced time intervals. These payments are usually
annual, but can occur at other intervals, such as
monthly (e.g. bond payments). Annuity formulae allow
complex problems to be resolved in a systematic
manner.
Conclusion (cont.)
• A perpetuity is a perpetual stream of constant or
constantly growing cash flows.
• A mixed cash stream consists of nonconstant cash
flows, where different cash flows occur every period.
• The FVs and PVs of lump sum amounts, annuities and
mixed cash flows can be calculated by making use of
formulae, financial tables or a financial calculator.