Time Value of Money

A dollar received today is

worth more than a dollar
received in the future

Chapter 7 1
 Compounding and Future Value
1. Simple Interest means interest is earned only
on the initial investment
2. Compound Interest means interest is earned
not only on the principal but also on the
interest earned earlier
3. FVn = PV(1 + i)n
where FV= Future value of investment at the
end of n years,
n= number of years compounding occurs
i= annual interest rate
PV=initial investment

Chapter 7 2
 Example
•If we place RM1000 in a savings account
paying 5% interest compounded annually, how
much will our account accrue to in 10 years?
•Answer:
•FV10 = 1000(1 + 0.05)10
= 1000(1.62889)
= RM1,628.89
Thus, at the end of 10 years, we will have
RM1,628.89 in our savings account.

Chapter 7 3
 Periodic Compounding: Compound
Interest with Nonannual Periods
• If we invest our money for 5 years at 8%
interest compounded semi annually, we are
really investing our money for 10 six-month
periods during which we receive 4%interest
each period.
• FVn = PV( 1 + i/m)mn where:
FVn = the future value of the investment at the end of n
years.
N= the number of years during which the compounding
occurs.
i= annual interest (discount) rate
PV = the present value or the original amount invested at
the beginning of the first year.
m= the number of times compounding occurs during
the year.

Chapter 7 4
 Example
• If we place RM100 in a savings account that
yields 12% compounded quarterly, by how
much will our investment grow at the end of 5
years?
• Answer:
• FV5 = RM100 (1 + 0.12/4)4x5
= RM100(1 + 0.03)20
= RM100 (1.8061)
= RM180.61
• The more frequently interest is compounded,
the greater the amount of money accumulated.

Chapter 7 5
 Continuous Compounding
• Compounding of interest an infinite number of
times per year at intervals of microseconds.
• FVn (continuous compounding) = PV x (ek x n)
• Example: A deposit of RM100 into an account
paying 8% annual interest compounded
continuously. Calculate the amount at the end of
year 2.
• FV2 = 100 x e0.08x 2
= 100 x 1.1735
= RM117.35

Chapter 7 6
 Present Value
• What is the value in today’s dollars of a sum of
money to be received in the future?
• Current value of future payment.
• PV = FVn (1/(1+ i)n) where
– PV = the present value of the future sum of
money
– FVn = the future value of the investment at
the end of n years.
– n= the number of years until the payment will
be received.
–i = the annual discount (interest) rate.

Chapter 7 7
 Example
• What is the present value of RM500 to be
received 10 years from today if our discount
rate is 6%?
• Answer:
• PV = RM500[ 1/(1+0.06)10]
= 500 (1/1.7908)
= RM500(0.5584)
= RM279.20
• Thus the present value of the RM500 to be
received in 10 years is RM279.20

Chapter 7 8
 Example
• What is the present value of an investment that
yields RM500 to be received in 5 years and
RM1000 to be received in 10 years if the
discount rate is 4%?
• Answer:
• PV = 500 [1/(1+0.04)5] + 1000[1/(1+ 0.04)10]
= 500(1/1.2167) + 1000(1/1.4802)
= 500(0.8219) + 1000(0.6756)
= 410.95 + 675.6
= RM1,086.55

Chapter 7 9
 Annuities
1. An annuity is a stream of equal annual cash
flows over a specified period of time. It can
be inflows or outflows.
2. Two basic types of annuities:
1. An ordinary annuity is an annuity for
which the cash flows occur at the end of
each period.
2. An annuity due is one for which the cash
flows occur at the beginning of each
period.

Chapter 7 10
 Future Value of Ordinary Annuity
• Assume that Sara owns an investment that will
pay her RM100 each year for 20 years. The
current interest rate is 15%. What is the FV of
this annuity?
1. Draw a timeline

10 10 100 100 100

0 0

0 1 2 3 …………………………. 19 20

?
Chapter 7 11
 FV of an Ordinary Annuity
1. Write out the formula using symbols:
FVAn = PMT x FVIFAi,n
FVAn = PMT x {[(1+i)n –1]/i}
2. Substitute the appropriate numbers:
FVA20 = RM100 x {[(1+0.15)20 –1]/0.15

3. Solve for the FV:

FVA20 = RM100 x 102.4436
= RM10,244.36

Chapter 7 12
Present Value of an Ordinary Annuity
• Assume that Sara owns an investment that will
pay her RM100 each year for 20 years. The
current interest rate is 15%. What is the PV of
this annuity?
• Draw a timeline

100 100 100 100 100

0 1 2 3 …………………………. 19 20

Chapter 7 13
 PV of an Ordinary Annuity
1. Write out the formula using symbols:
PVAn = PMT x PVIFAi,n
= PMT x {[1- 1/(1+i)n ]/i}
2. Substitute appropriate numbers:
PVA = RM100 x {[1-1/(1+ 0.15)20]/0.15}
3. Solve for the PV
PVA = RM100 X 6.2593
PVA = RM625.93

Chapter 7 14
 Future Value of Annuity Due
• FVn (annuity due) = PMT (FVIFAi,n)(1 + i)
• The FV of annuity due is larger than the
FV of ordinary annuity because we
compound the cash flows for one
additional year.

Chapter 7 15
 Present Value of Annuity Due
• With present value of annuity due, we
receive cash flow 1 year earlier-that is, we
receive it at the beginning of each year.
• It is discounted back for one less period.
• PV(annuity due) = PMT(PVIFAi,n)(1+i)
• Present value of an annuity due is larger
than that of an ordinary annuity because
all cash flows are received earlier, and
these cash flows are discounted for 1 year
less.

Chapter 7 16
 Present Value of a Perpetuity
• A perpetuity is an annuity that
continues forever.
• PVP∞ = PMT x 1/I
• Ex: Compute the present value of a RM100
perpetuity discounted at 5%.
• Answer: PV = RM100/5%
= RM2,000

Chapter 7 17
 PV OF A Mixed Streams of Cash Flows
• Example: i = 6%

0 100 200 300 200 200 100 300 1000

94.34
178
251.88
145.82
149.46
70.50
199.52
627.41
1716.93

Chapter 7 18
 PV of Uneven Cash Flow
i= 6%
0 1 2 3 4 5 6 7

1000
100 200 200 200 200 0

94.34

693.02

653.80

0.00
665.10
1,413.24

Chapter 7 19
 Present Value of Uneven Cash Flow
Involving One Annuity Discounted At 6%
Year Cash flow Year Cash flow
1 500 6 500
2 200 7 500
3 -400 8 500
4 500 9 500
5 500 10 500
1. PV of RM500 received at the end of Y1 = 500(0.943) = 471.50
2. PV of RM200 received at the end of Y2 = 200(0.890) = 178.00
3. PV of RM400 outflow at end of Y3 = (400)(0.840) = - 336.00
4. Value at the end of Y3 of a RM500 annuity, Y4-Y10 =
500(5.582)= 2,791. PV of RM2,791 received at the end of Y3 =
2,791(0.840) = 2,344.44
5. Total PV = 471.50 + 178.00 – 336 + 2,344.44 = RM2,657.94

Chapter 7 20
 PV of Mixed Stream Involving 2 Annuities
Discounted At 5%
Year Cash flow Year Cash flow
1 200 6 -300
2 200 7 500
3 200 8 500
4 200 9 500
5 200 10 500
1. PV of annuity Y1-Y5 = 200(4.329) = RM865.80
2. PV of RM300 cash outflow = -RM300(0.746) = - RM223.80
3. Value at end of Y6 of annuity (Y7- Y10) = 500(3.546) =
RM1,773. PV of RM1,773 received at the end of Y6 =
RM1,773 (0.746) = RM1,322.66
4. Total PV = 865.80 – 223.80 + 1,322.66 = RM1,964.66

Chapter 7 21
Future Value of An Uneven Cash Flow
Stream
• The future value of an uneven cash flow stream
(sometimes called the terminal value) is found
by compounding each payment to the end of the
stream and then summing the future values.
• Example : i = 6%
0 1 2 3 4 5 6 7

100 200 200 200 200 0 1000

0
224.72
228.20
252.50
267.6
141.85
Chapter 7 22
2,142.92
 Loan Amortization
1. Refers to the computation of equal period
loan payments necessary to provide the
lender with a specified interest return and
repay the loan principal over a specified
period.
2. Involves finding the future payments, over
the term of the loan, whose present value at
the loan interest rate equals the amount of
initial principal borrowed.
3. A loan amortization schedule is used by
lenders to determine the payment amounts
and the allocation of each payment to
interest and principal.
Chapter 7 23
 Loan Amortization - Example
• You want to buy a car. You borrow RM60,000
to be repaid in 4 equal payments at the end
of each of the next 4 years, and the interest
rate that is paid to the lender is 15% on the
outstanding portion of the loan.
1. Compute the PMT:
– RM60,000 = PMT (PVIFA15%,4)
– RM60,000 = PMT(2.8547)
– PMT = RM60,000/2.8547
= RM21,017.97

Chapter 7 24
 Loan Amortization - Example
2. Compute the interest portion of the annuity by multiplying
the outstanding loan balance at the beginning of the year by
the interest rate of 15%.
1. For year 1, interest = RM60000 x 15% = RM9000.
2. For year 2,
interest = 15% x RM47,982.03 = RM7197.30
3. Calculate the repayment of the principal portion of the
annuity by subtracting the interest portion from the annuity.

Year Annuity Interest Repayment of Outstanding loan

principal balance after the
annuity payment
1 21,017.97 9000.00 12017.97 47982.03
2 21,017.97 7197.30 13820.67 34,161.36

3 21,017.97 5124.20 15,893.77 18,267.59

4 21,017.97 2740.14 18,267.59

Chapter 7 25