Topic 2

Financial Mathematics/Time Value of Money

Part 1
 Overview
 In this lecture we will:
Discuss the time value of money concept;
Learn about simple interest;
Learn about compounding and discounting;
Learn about compound interest;
Calculate the present value and future value of a single
amount for both one period and multiple periods;
Calculate the present value and future value of multiple
cash flows; &
Calculate the present value and future value of annuities;

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 Time Value of Money
• Receiving $1 today is worth more than $1 in the
future
• The opportunity cost of $1 in the future is the
interest we could have earned on $1 if received
earlier

Today

 Future

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 Time Value Terminology
 For a single sum time value problem there are four variables that have to be
taken into account:
 n - The number of interest paying time periods between a present value and
a future value;
 R - The rate of interest for discounting or compounding;
 Note - n and r need to be consistent - if interest (r) is paid monthly the
number of periods n has to be worked out in terms of months (we will see
example of this later on which will help to explain it);
 PV0 – Present value – the price/value of the asset/investment now (at time
period zero (T0))
 FVn – Future value – the price/value of the asset/investment at some future
specified time (Tn)
 All single sum time value questions involve four values: PV, FV, r and n -
given three of the values it is always possible to calculate the unknown
fourth value.
 Future Sum With Simple Interest
 If the Bank pays you simple interest on a deposit the interest payment each period
will be the same and will be the interest rate times the initial amount.
 Simple interest refers to interest earned only on the original capital investment
amount.
 The formula for the future value of a single sum calculated with simple interest is:
FVn = PV(1 + (r x n))
Example: $100 invested at 10% p.a. simple interest for three years
1.FV3 = $100(1+(0.10 x 3))
2.FV3 = $100(1.30)
3.FV3 = $130.00
Therefore, interest earned = $30.00

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 Compounding and Discounting
 Compounding
 Translating $1 today into its equivalent future value.

 Discounting
Translating a future $1 into its equivalent present value today.

Timeline

0 1 2 3 4
T0 T1 T2 T3 T4
PV0 FV4

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 Compound Interest
If the bank pays you compound interest you
will receive interest payments not just on the
initial amount but also on previous interest
payments.
Compound interest refers to interest earned
on both the initial capital investment and on
the interest reinvested from prior periods (i.e.
earning interest on interest).
In finance compound interest is usually used.

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 Single Sums:
Future Value of A Single Sum
 Example: Future value of a single sum
You invest $100 in a savings account that earns 10% p.a. interest
(compounded) for three years.
 Calculating FV the “long” way:
1. After one year: $100  (1.10) = $110
2. After two years: $110  (1.10) = $121
3. After three years: $121  (1.10) = $133.10
Calculating FV the “short” way (preferred):
• FV of a single amount invested today at r % for n periods is:
FVn = PV0(1+r)n
1.The expression (1 + r)n is the future value interest factor (FVIF) for a single
sum.

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 Single Sums:
Future Value of A Single Sum
FV3 = 100(1.10)3
Timeline

• FV3 = 100(1.331)
$100 $133.10
• FV3 = $133.10 T0 T1 T2 T3
PV0 FV3
Interest earned = $33.10
Notice:
1.Interest earned with compounding $33.10;
2.Interest earned with simple interest $30.00;
3.Difference $3.10 - due to compounding
(i.e. interest on interest).

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 Single Sums:
Future Value of A Single Sum

 Example: Future value of a single sum

 What will $1,000 amount to in five years’ time if interest is 12% p.a. compounded annually?
 n = 5 (interest is calculated 5 times), r = 0.12:
1. FV5 = $1,000(1.12)5
2. FV5 = $1,000(1.7623)
3. FV5 = $1,762.30

 Now assume interest is 12% per annum, compounded monthly.

 Always remember that n is the number of compounding periods, not the number of years.
1. n = 5yrs x 12 months per year = 60 (i.e. interest is calculated 60 times).
2. r = 0.12 p.a./12 months per year = 0.01 (i.e. interest rate is 1% per month).
3. FV60 = $1,000(1.01)60
4. FV60 = $1,000(1.8167)
5. FV60 = $1,816.70
6. Difference ($1,816.70 - $1,762.30 = $54.40) is due to compounding more often over entire
investment period (i.e. 60 times @ 1% v. 5 times @ 12%).
7. Future values also depend critically on the assumed interest rate - the higher the interest rate, the
greater the future value.

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 Future Value of A Single Sum
Future value of $100
Interest Rate
Number of 5% 10% 15% 20%
periods
1 $105.00 $110.00 $115.00 $120.00
2 $110.25 $121.00 $132.25 $144.00
3 $115.76 $133.10 $152.09 $172.80
4 $121.55 $146.41 $174.90 $207.36
5 $127.63 $161.05 $201.14 $248.83

 For a given number of periods, the higher the interest rate the higher the
future value.
 For a given interest rate, the more compounding periods the greater the
future value.

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 Present Value of A Single Sum
 Present value of a single amount discounted back to today at r % for
n periods is:
PV0 = FVn(1+r)-n
or
PV0 = FVn
(1+r)n
• The expression (1 + r)-n is the present value interest factor (PVIF) for a single
sum.

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 Present Value of A Single Sum
 Example: Present value of a single sum
If you will receive $1,000 in three years’ time what is its PV if your opportunity
cost/discount rate/interest rate is 10% p.a.?
 Calculating PV the “long” way:
Timeline
Yr 3: $1,000 (1.10)-1 = $909.09
Yr 2: $909.09 (1.10)-1 = $826.45
Yr 1: $826.45 (1.10)-1 = $751.32
$751.32 $826.45 $909.09 $1,000.00
T0 T1 T2 T3

 Calculating FV the “short” way: PV0 FV 3

• PV of a single future amount

discounted back to today at r % for n periods is:
 PV0 = FVn(1+r)-n
 PV0 = $1,000(1.10)-3
 PV0 = $1,000(0.7513)
 PV0 = $751.30

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 Present Value of A Single Sum
Your rich grandmother promises to give you
$10,000 in 10 years’ time. If interest rates are
12% per annum how much is this gift worth
today?
PV0 = FVn(1+r)-n
PV0 = $10,000(1.12)-10
PV0 = $10,000(0.3220)-3
PV0 = $3,220.00

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 Present Value of A Single Sum
Present value of $100
Interest Rate
Number of
periods 5% 10% 15% 20%
1 $95.24 $90.91 $86.96 $83.33
2 $90.70 $82.64 $75.61 $69.44
3 $86.38 $75.13 $65.75 $57.87
4 $82.27 $68.30 $57.18 $48.23
5 $78.35 $62.09 $49.72 $40.19

 For a given number of periods, the higher the interest rate the lower the
present value.
 For a given interest rate, the greater the number of discounting periods
the lower the present value.

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 Single Sums: Problem Variations
In general the problems that students will confront in this
course will either involve working out present values or
future values.
 However, it is of course possible to also want to work out
n if given PV, FV and r. It is quite a common problem to
want to know how long it will take an investment to grow
from its PV to its FV at a given interest rate.
 It is also possible to work our r given n, PV and FV. It is
quite a common problem to want to know what the rate of
return on an asset is when it grows from PV to FV over a
given period of time.

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 Single Sums: Problem Variations

 Example: Solving for the unknown rate of return (r)

You currently have $100 available for investment for a 21
year period. At what annual interest rate must you invest
this amount in order for it to be worth $500 at maturity?
 Remember, given any three factors in the present value or
future value of a single sum formula, the fourth factor can
be solved.

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 Single Sums: Problem Variations
 Example: Solving for the unknown rate of return (r)
Since we know both the PV and FV (and n), we can use either the PV or the
FV of a single sum formula to find the unknown interest rate (r).

• A. PV of a single sum • B. FV of a single sum

• PV0 = FVn(1+r)-n • FVn = PV0(1+r)n

• 1. 100 = 500(1+r)-21 • 1. 500 = 100(1+r)21

• 2. 100/500 = (1+r)-21 • 2. 500/100 = (1+r)21
• 3. 0.20 = (1+r)-21 • 3. 5 = (1+r)21
• 4. (0.20)1 = (1+r)-21 • 4. (5)1 = (1+r)21
• 5. (0.20)1/-21 = (1+r)-21/-21 • 5. (5)1/21 = (1+r)21/21
• 6. (0.20)-0.04762 = 1+r • 6. (5)0.04762 = 1+r
• 7. 1.0797 = 1+r • 7. 1.0797 = 1+r
• 8. 1.0797-1 = 1+r-1 • 8. 1.0797-1 = 1+r-1
• 9. 0.0797 = r = 7.97% p.a. • 9. 0.0797 = r = 7.97% p.a.

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 Single Sums: Problem Variations

 Example: Solving for the unknown rate of return (r)

If you sell land for $11,933 (FV) that you bought five
years ago (n) for $5,000 (PV), what is your annual rate of
return?
Using the same method as in the previous example you
will find that the rate of return (r) is equal to 19% p.a.

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 Single Sums: Problem Variations
 Example: Solving for the unknown rate of return (n)
Suppose you placed $100 in an account that pays interest of 9.6% p.a.,
compounded monthly. How long will it take for your account to grow to $500?
 note: r = 0.096/12 = 0.008 (i.e. 0.8% per month)
Since we know both the PV and FV (and r), we can use either the PV or the
FV of a single sum formula to find the unknown number of investment periods
(n). To get the answer we must use natural logs (the ln button on your
calculator).
• A. PV of a single sum • B. FV of a single sum

• PV0 = FVn(1+r)-n • FVn = PV0(1+r)n

• 1. 100 = 500(1.008)-n • 1. 500 = 100(1.008)n

• 2. 100/500 = (1.008) -n • 2. 500/100 = (1.008)n

• 3. 0.20 = (1.008)-n • 3. 5 = (1.008)n

• 4. ln(0.20) = -nln(1.008) • 4. ln(5) = nln(1.008)

• 5. -1.6094 = -n(0.007968) • 5. 1.6094 = n(0.007968)

• 6. -1.6094/0.007968 = -n • 6. 1.6094/0.007968 = n

• 7. -202 = -n = 202 months • 7. 202 = n = 202 months

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 Single Sums: Problem Variations
 Hint For Single Sum Problems
There are only 4 variables: FV, PV, r, and n.
You will always be given three variables and
asked to solve for the fourth.
This hint makes solving single sum time-value
problems much easier.

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 Multiple Uneven Cash-Flows
 Example: Future Value of Multiple Uneven Cash-Flows
 You deposit $1,000 now, $1,500 in one year, $2,000 in two years and $2,500 in three years in an
account paying interest of 10% p.a. How much will you have in the account at the end of the third
year?
 As each of the cash-flows is of a different value you must first calculate the future value of each
cash flow individually as a single sum and then total the future values.

 FVn = PV0(1+r)n
Timeline
 $1,000(1.10)3 = $1,000(1.331) = $1 331
 $1,500(1.10)2 = $1,500(1.21) = $1 815
 $2,000(1.10)1 = $2,000(1.10) = $2 200

 $2 500(1.00) = = $2 500 T0 T1 T2 T3

 Total = $7 846 $1,000 $1,500 $2,000 $2,500

$1,331
$1,815
$2,200
$2,500
$7,846

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 Multiple Uneven Cash-Flows
 Example: Present Value of Multiple Uneven Cash-Flows
 You deposit $1,500 in one year, $2,000 in two years and $2,500 in three years in an account
paying interest of 10% p.a. What is the present value of these cash flows?
 As each of the cash-flows is of a different value you must first calculate the present value of each
cash-flow individually as a single sum and then total the present values.
 PV0 = FVn(1+r)-n
 $1,500(1.10)-1 = $1,500(0.9091) = $1,364 Timeline

 $2,000(1.10)-2 = $2,000(0.8264) = $1,653

 $2,500(1.10)-3 = $2,500(0.7513) = $1 878

 Total = $4 895 T0 T1 T2 T3

$1,500 $2,000 $2,500

$1,364

$1,653

$1,878

$4,895

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 Annuities

 What is an Annuity? A series of constant/fixed cash-flows

(payments or receipts) ocurring at regular intervals, e.g. a
superannuation/pension payment.
 Types of Annuities:
 Ordinary annuity;
 Annuity due;
 Deferred annuity;
 Perpetuity; &
 Growing perpetuity.

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 Annuities
 Ordinary annuity - A series of constant cash-  Annuity due - A series of constant cash-flows
flows occurring at the end of each period for occurring at the start of each period for some
some fixed number of periods and commencing fixed number of periods and commencing at the
at the end of the first period (i.e. commencing beginning of the first period (i.e. commencing
at T1). at T0).

Timeline
Timeline

T0 T1 T2 T3 T0 T1 T2 T3

• $100 $100 $100 $100 $100 $100

• Examples include mortgage repayments (payment

• Examples include paying rent or uni. fees in
annuity) and superannuation/pension payments
advance.
(receipt annuity).

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 Annuities
 Deferred annuity - A series of constant cash- • Perpetuity - A series of constant cash-flows
flows occurring at the end of each period for occurring at the end of each period indefinitely
some fixed number of periods and commencing (i.e. forever).
some future period after period one (e.g
commencing at T3 (the end of the third
period)).

Timeline Timeline

T0 T1 T2 T3 T4 T5 T0 T1 T2 T3 .....……… T∞
$100 $100 $100
$100 $100 $100 $100

• Examples include a lump sum pension plan.

• Examples include a scholarship fund available
each year forever (e.g. Rhodes Scholarship).

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 Annuities

 Future value of an ordinary annuity:

 1  r  n - 1 
 FVn  PMT  r

 

• The compounding term (sqaure bracketed term) is called

the future value interest factor of the annuity (FVIFA).
The formula gives the FV at the time the last
payment/receipt is made.

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 Annuities
 Example: Future Value of An Ordinary Annuity
If you invest $1,000 at the end of each of the next 3 years at 8% p.a., how
much will you have after 3 years?

Timeline
 1  r  n - 1 
FVn  PMT  
 r 
 (1.08) 3  1
FV3  $1,000 
T0 T1
$1,000
T2
$1,000
T3
$1,000  0 .08 
FV3  $1,000 3.2464
FV3 = $3,246.40

FV3  $3,246.40

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 Annuities
 Present value of an ordinary annuity:

1  1  r   n 
 PV0  PMT  
 r 

• PMT = the annuity payment

• The discounting term (value in the big square bracket) is
called the present value interest factor of the annuity
(PVIFA).
 Note, the formula always assumes that it is an ordinary
annuity and it provides the PV one period before the
first payment or receipt takes place, i.e. it provides PV
at T0.

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 Annuities
 Example: Present Value of An Ordinary Annuity
What is the PV of receiving $1,000 at the end of each of the next 3 years if the
opportunity cost is 8% p.a.?

Timeline 1  1  r   n 
PV0  PMT  
 r 
1  1.08 3 
PV0  $1,000 
T0 T1
$1,000
T2
$1,000
T3
$1,000
 0.08 
PV0 = $2,577.10
PV0  $1,000 2.5771
PV0  $2,577.10

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 Annuities
 Finding an unknown PMT
• In the previous problems we were given:
n the number of investment periods;
r the discount/ interest rate per investment period; &
PMT the regular periodic annuity payment/receipt,

 and asked to calculate the PV of the ordinary annuity.

 However, it is common to want to know PMT if given n, r and PV.

This is particularly so in instances of trying to work out the regular
periodic payments on a loan.

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 Annuities
 Finding an unknown PMT
• Using the previous numerical example:
PV0 = $2,577.10, r = 8% p.a., n = 3 years, PMT = ?

1  (1.08) 3 
$2,577.10  PMT  
 0. 08 
$2,577.10  PMT  2.5771
$2,577.10
PMT 
2.5771
PMT  $1,000

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 Future Values & Present Values:
Single Sums, Multiple Uneven Cash-Flows, &
Annuities

1. Draw a timeline
2. Determine what unknown the problem involves:
r, n, PV, FV, PMT?
3. Identify the class of problem:
single sum; multiple uneven cash-flow; annuity?
4. Recognise any ‘traps’ in the problem:
Annual interest rate and more than one
compounding period per year? Adjust r and n.

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