Project Cost / Finance Management

MSPM Bahria University

Lecture: 10
Time Value of Money
Outline
 Meaning of Time Value
 Simple Interest
 Compound Interest
Time Value of Money (TVM)

 The time value of money (TVM) is the concept

that money you have now is worth more than
the identical sum in the future due to its
potential earning capacity. 
Time Value of Money
 Basic Problem:
– How to determine value today of cash flows that are expected in the
future?
 Time value of money refers to the fact that a dollar in hand today
is worth more than a dollar promised at some time in the future
 Which would you rather have -- $1,000 today or $1,000 in 5
years?
 Obviously, $1,000 today.
today
 Money received sooner rather than later allows one to use the
funds for investment or consumption purposes. This concept is
referred to as the TIME VALUE OF MONEY!!
MONEY
 TIME allows one the opportunity to postpone consumption and
earn INTEREST.
INTEREST
Simple Interest

 Simple interest is interest that is paid (earned)

on only the original amount, or principal,
borrowed (lent).

– where SI = simple interest in dollars

– P0 = principal, or original amount borrowed (lent) at time period 0
– i = interest rate per time period
– n = number of time periods
Simple Interest

 For example, assume that you deposit $100 in

a savings account paying 8 percent simple
interest and keep it there for 10 years. At the
end of 10 years, the amount of interest
accumulated is determined as follows:
Compound Interest

Compound interest (or compounding interest) is

interest calculated on the initial principal, which
also includes all of the accumulated interest of
previous periods of a deposit or loan.
– it is calculated by multiplying the initial principal
amount by one plus the annual interest rate raised
to the number of compound periods minus one
 Compound Interest Formula
  
CI = P [(1 + i)n – 1]
Where P = Principal Amount, i = nominal annual
interest rate in percentage terms, and n =
number of compounding periods.
This simplified formula assumes that interest is
compounded once per period, rather than
multiple times per period.
Compound Interest Example

 Take a three-year loan of $10,000 at an

interest rate of 5% that compounds annually.
What would be the amount of interest?
 Solution=
 In this case, it would be: $10,000 [(1 + 0.05)3 –
1] = $10,000 [1.157625 – 1] = $1,576.25.
Compounding Periods

 Annually= Once a year

 Biannually/semi annually= twice a year
 Bimonthly = every two months
 Monthly = 12 times in a year
 Quarterly = 4 times in a year
 Weekly = 52 times in a year
 Daily = 365 times in a year
Compound formula II

 Compound interest (or compounding interest)

is interest calculated on the initial principal,
which also includes all of the accumulated
interest of previous periods of a deposit or
loan.
Compound formula

 The formula for compound interest, including

principal sum, is:
A = P (1 + i/t) (nt)
– A = the future value of the investment/loan, including interest
– P = the principal investment amount (the initial deposit or loan amount)
– i = the annual interest rate (decimal)
– t = the number of times that interest is compounded per unit t
– n = the time the money is invested or borrowed for
Let's look at an example

If an amount of $5,000 is deposited into a savings account at an

annual interest rate of 5%, compounded monthly, the value of the
investment after 10 years can be calculated as follows...
P = 5000.
i = 5/100 = 0.05 (decimal).
t = 12.
n = 10.
If we plug those figures into the formula, we get the following:
A = 5000 (1 + 0.05 / 12) (12 * 10) = 8235.05.
So, the investment balance after 10 years is $8,235.05.