Time Value of Money

Simple vs. Compound Interest

Capital and Investment

The term capital refers to wealth in the form of money

or property that can be used to produce more wealth.
In this regard, it is recognized that a dollar today is
worth more than a dollar one or more years from now
because of the interest (or profit) it can earn.
Therefore, money has a time value.

Required Rate of Return 2

If you would know the value of money,
go and try to borrow some.

—Benjamin Franklin
Time Value of Money
Money has value, and if money remains un-invested
(like in a large bottle), value is lost.

Money changes in value not only because of interest

rates and inflation (or deflation) and currency exchange
rates also cause money to change in value.

Required Rate of Return 4

Interest Rates
1. It has already been discussed in length that how interest are
decided and managed by Central bank.

2. There are two ways in which interest is computed.

1. Simple Interest
2. Compound Interest

Required Rate of Return 5

Simple Interest
When the total interest earned or charged is linearly proportional to
the initial amount of the loan (principal), the interest rate, and the
number of interest periods for which the principal is committed, the
interest and interest rate are said to be simple.
Interest = P x N x i
= principal amount x no. of years x interest rate

Required Rate of Return 6

Compound Interest

Whenever the interest charge for any interest period (a year, for
example) is based on the remaining principal amount plus any
accumulated interest charges up to the beginning of that period, the
interest is said to be compound.

Required Rate of Return 7

Example
Mr. A got a loan of Rs 1,000 from XYZ Bank for three years at
interest rate of 10%. Compute how much Mr. A will have to
pay at the end of term period. Assume nothing will be paid to
bank before end of three years.

If Simple Interest is used:

Interest Expense = 1,000 x 3 x 10% = 300
Total Future Value = 1,000+300 = 1,300

Required Rate of Return 8

Example
If Compound Interest is used:
Period Amount owed at Interest amount for Amount owed at End
beginning of Period the Period of Period
1 1,000 1,000*10% = 100 1,100
2 1,100 1,100*10% = 110 1,210
3 1,210 1,210*10% =121 1,331

Interest Expense = 100+110+121 = 331

Total Future Value = 1,000+331 = 1,331
Future Value =

Required Rate of Return 9

Example
Important point to remember is

Simple Interest is theoretical concept

whereas Compound interest is actually used all across the

globe.

Required Rate of Return 10

Compounding “twice a year”
If Compound Interest is used:
Period Amount owed at Interest amount for the Amount owed at
beginning of Period Period End of Period
1 1,000.00 1,000*10%/2 = 50 1,050
2 1,050.00 1,050*10%/2 = 52.50 1,102.50
3 1,102.50 1102.5*10%/2=55.125 1,157.625
4 1,157.625 1157.625*10%/2 = 57.88 1,215.506
5 1,215.506 1215.506*10%/2 = 60.77 1,276.282
6 1,276.282 1276.282*10%/2 = 63.81 1,340.096

Future Value = = 1340.096

Required Rate of Return 11

Example
Compounding twice a year

Compounding quarterly a year

Compounding monthly

Compounding daily

Compounding ‘m’ times a year

Required Rate of Return 12

Economic Equivalence

Interest rate 10% Period 3 years

Principal/Present Value Economic Future Value

Rs, 1,000 Equivalence Rs. 1,331

Required Rate of Return 13

Economic Equivalence
To find future value when Principal amount (present value)
is given

To find present value when future value is given

Required Rate of Return 14

Problem:
You have just invested a one-time amount of $5,000 in a stock-based mutual
fund. This fund should earn (on average) 9% per year over a long period of time.
How much will your investment be worth in 35 years?

P=5000, i=9%, N=35 years

5000 * 20.4139
F = 102,070

Required Rate of Return 15

Problem:
You just inherited $10,000. While you plan to squander some of it away, how
much should you deposit in an account earning 5% interest per year if you’d like
to have $10,000 in the account in 10 years??

F=10,000, i=5%, N=10 years

P = 10,000 / 1.6289
P = 6,139

Required Rate of Return 16

Problem:
In 1885, first class postage for a one ounce letter cost $0.02. The same
postage in 2007 costs $0.41. What compounded annual increase in the
cost of first class postage has been experienced over this period of time?

F=$0.41, P= $0.02, N=2007-1885=122 years, i=?

i = 0.025 or 2.5%

Required Rate of Return 17