FIN 5134: Financial Management and Practices

W2 Lecture 02: Time Value of Money

Dr. M. Anwar Ullah, FCMA

Southeast University Bangladesh
Faculty of Business
MBA Program: Summer 2016

anwarullah@hotmail.com Or anwar2023@yahoo.com.sg

1
 The Time Value of Money
• What a difference between Tk.1 today and Tk.1 in a
year’s time?
• Factors change the value of money
– Interest cost
– Inflation
– Other risks to materialise the money

• For example: the annual interest rate is 10%, I lend you

Tk.1 today and will get back after 1 year, how much worth
of that Tk.1 in a year’s time?
– ? x (1+10%) = Tk.1
– ? = Tk.0.91

• 10% is called “cost of capital”; “?” is called the “discount

factor”

2
 Simple Interest
In its most basic form, interest is calculated by multiplying
principal (amount invested) by rate (percent of interest)
multiplied by time (number of periods the interest is
calculated). This is called simple interest.
 
I=Prt
 
Example: A Tk.1,000 deposit at 8% per year for three years'
simple interest: I = (1000)(.08)(3) = 240

So, a Tk.1000 deposit at 8% simple interest for three years

earns Tk.240 interest.
 Future Value

The future value (FV) of a simple interest calculation is

derived by adding the original principal back to the interest
earned.

Tk.1,000 + Tk.240 = Tk.1,240

Expressed as a formula:
FV = P(1 + rt)
FV = (1000)+(1000)(.08)(3) = Tk.1240
 
 Future Value: Less than a year
Note: Usually simple interest is used in financial
institutions for interest periods of less than one year.
If the rate is expressed as an annual rate (normal
practice), then the time period (t) must be a fraction of
a year.

Example: we invest Tk.10,000 in an 8%, 90-day

certificate of deposit (CD). Our total proceeds at the
end of the CD period are:
 
FV = P(1 + rt)
FV = 10,000 x [1+ (.08)(90/365)] = Tk.10,197.26
 Discount and Present Value (PV)
Often, if a bank or other financial institution loans a
sum for a short term, the lender will prefer to calculate
the interest up front and loan out the discounted
principal, or principal minus interest to be earned.

The interest to be paid up front on a loan is called

Discount and the discounted principal, or the actual
amount loaned is called the Present Value (PV)

FV
PV = (1+rt)

 
Discount and Present Value (PV): Example
Repeating the discount basic formula (simple interest):

FV
PV = (1+rt)
 
Example: If the bank loans out Tk.10,000 for 90
days at 8% simple interest, the PV is:
 
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= Tk.9,806.56
 Compound Interest (1):
Compound Interest: If interest is left in the account to
accumulate for a longer period (usually longer than
one year), interest is earned and credited for a given
period, the new sum of principal + interest must now
earn interest for the next period, etc.

To distinguish from simple interest, we use "n" to refer

to the number of "periods" in which the interest is
compounded and added to principal.

FV
FV = P(1 + r)n PV = (1+r) n
 Compound Interest (2): Example
Suppose we invest our original Tk.1,000 for 3 years at
8%, compounded quarterly.
(The rate per quarterly period is 8% / 4 or 2%. The number of periods
(n) is 3 x 4 = 12 quarterly periods.)
 
FV = P(1 + r)n
FV = 1000 x [1+0.02)12 = Tk.1,268.24
 
If we wanted to know how much we'd have to invest
now (PV) at 8% compounded quarterly to earn
Tk.10,000 in 3 years:
 
PV = 10000 / (1.02)12 = Tk.7,884.93
 Compound Interest (3): Use of Table

Because raising interest factors to an exponent of "n"

was a difficult calculation before calculators, some
mathematicians used logarithmic functions to calculate
the exponent factor.

Financial professionals acquired Tables of these

functions, so that either of the above problems could be
calculated simply by looking up a FV factor (or to
discount, a PV factor) based on the interest rate and
number of compounding periods and multiplying the
principal by the interest factor.
 Annuities (1):
An annuity is an interest bearing account into which
we make, or we receive, payments of an equal
amount each period until the annuity ends.

If the payment is made on the last day of each period,

it is an ordinary annuity. (This is most typical and
what we will illustrate.)

If the payment is made on the first day of each period,

it is an annuity due. (not as common) MS Excel
identifies the two types as "0" or blank=ordinary; "1"
=annuity due.
 Annuities (2):
Some annuities have no "fixed" ending date, but rather
continue for the life of the recipient. These are usually
called life annuities and the payment is calculated for a
number of periods based on life expectancy.

A perpetuity is an annuity with no ending date. (An

example of a perpetuity is an endowed scholarship,
where only interest is paid out as scholarship funds and
the endowment principal remains invested "forever" or in
perpetuity.)
 Annuities (3):

A sinking fund is a fund in which a regular annuity

payment is made to accumulate to a future value to be
used for some future purpose, such as paying off a
bond issue or some other obligation.
 
Before calculators, polynomials and logarithmic
functions were used to calculate annuity tables for
financial use. Now, we can simply use spreadsheet
financial functions, usually using =PV, =FV, or =PMT in
Excel and now inserting payment information where
applicable.
 Annuities (4): Example
Illustration (1): We need to accumulate a sinking fund of Tk.100,000 in
ten years (120 months) to pay off a note payable. If we can invest our
funds at 8% compounding monthly, how much must we deposit per
month?

FV 100,000
PV 0

Rate 0.0066667 8% / 12
Nper 120 10 yrs x 12

=PMT Tk.546.61
 Annuities (5): Example
Illustration (2): When Joe retires on his 65th birthday,
his retirement fund carries a balance of Tk.240,000. If
Joe transfers this balance into a fund earning 8% to pay
him or his heirs Tk.2,000 per month until the fund is
exhausted, how long can this annuity last?
FV 0
PV -240,000
Pmt 2,000
Rate 0.006667 8% / 12

=NPER 242.2195
Approx 242 months—just over 20 years! (Assuming 8% is
consistent and there is no risk of loss of principal!)
 Amortization (Mortgages) (1):
Finally, if we take out a long term loan, such as a
mortgage, or a car loan based on the true APR, the
interest expense is calculated for each month based
on the unpaid balance of the loan.
A fixed monthly payment is computed from which is
first deducted the monthly interest, and the balance is
applied to reduce principal. The new interest is then
recalculated the next month based on the lower
principal.
This generates a schedule of all loan payments,
interest and principal applied, and outstanding balance
called an amortization schedule.
 Amortization (Mortgages) (2):
In the early months of an amortization schedule, much
(perhaps most) of the monthly payment goes toward
interest because the unpaid balance is so large. As the
principal is paid down, more and more of each payment
is applied toward principal.
Example: in a 30 year Tk.100,000 home mortgage at 9%, the
required monthly payment is Tk.804.63 (round up 1 cent)
PV -100,000
Nper 360 (30 yrs)
Rate 0.0075 9% / 12
FV 0

=PMT Tk.804.62
Annuity calculation
A Father is planning a savings program to put his daughter through
University. His daughter is now 13 years old. She plans to enroll at
the University in 5 years, and it should take her 4 years to complete
her education. Currently, the cost per year (for everything- food,
clothing, tuition, books, transportation, and so forth) is Tk.100,000,
but a 5 percent inflation rate in these costs is forecasted. The
daughter recently received Tk.50,000 from her grandfather’s estate;
this money, which is invested in a bank account paying 9% interest
compounded annually, will be used to help meet the costs of the
daughter’s education. The rest of the costs will be met by money
the father will deposit in the savings account. He will make equal
deposits to the account in each year from now until his daughter
starts university. These deposits will also earn 9 % interest.
If the first deposit is made today, how large must each deposit be in
order to put the daughter through university?
Solution:
Universi Current Cost Years from Inflation Cash Required*
ty Year now
1 100000 5 (1.05)5 127630
2 100000 6 (1.05)6 134010
3 100000 7 (1.05)7 140710
4 100000 8 (1.05)8 147750

*Using Table A-1

PV = 127630 + 122940 + 118440 + 114090 = 483100.

However cash that will be there from grandfather’s estate:
FV = 50000[FVIF 9%, 5] = 76930. (Using Table A-1)
Hence cash still required = 483100 – 76930 = 406170.
Hence Annuity Payments:
A[FVIF 9%, 5] + A[FVIFA 9%, 5]** = 406170
A (1.539) + A (5.98) = 406170
A (1.539 + 5.98) = 406170
A (7.519) = 406170
Hence A = 54000.

**Using Table A-2