Introduction to Finance

Topic 4
The Time Value
of Money

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Learning Objectives
5.1 Explain the mechanics of compounding, and
bringing the value of money back to the present.
5.2 Understand annuities.
5.3 Determine the future or present value of a sum
when there are nonannual compounding periods.
5.4 Determine the present value of an uneven stream
of payments and understand perpetuities.

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Compound Interest, Future, and
Present Value

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Using Timelines to Visualize Cash
Flows
Timeline of cash flows

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Simple Interest
• Interest is earned only on principal.
• Example: Compute simple interest on $100 invested
at 6% per year for three years.
– 1st year interest is $6.00
– 2nd year interest is $6.00
– 3rd year interest is $6.00
– Total interest earned: $18.00

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Compound Interest (1 of 2)
• Compounding is when interest paid on an investment
during the first period is added to the principal; then,
during the second period, interest is earned on the
new sum (that includes the principal and interest
earned so far).

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Compound Interest (2 of 2)
• Example: Compute compound interest on $100
invested at 6% for three years with annual
compounding.
– 1st year interest is $6.00 Principal now is $106.00
– 2nd year interest is $6.36 Principal now is $112.36
– 3rd year interest is $6.74 Principal now is $119.10
– Total interest earned: $19.10

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Future Value
• Future Value is the amount a sum will grow to in a certain
number of years when compounded at a specific rate.

FVN PV 1  r 
n

• FVN = the future of the investment at the end of “n” years

• r = the annual interest (or discount) rate
• n = number of years
• PV = the present value, or original amount invested at the
beginning of the first year

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Future Value Example
• Example: What will be the FV of $100 in 2 years at
interest rate of 6%?

FV2 PV 1  r  $100 1  0.06 

2 2

$100 1.06 
2

$112.36

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How to Increase the Future Value?
• Future Value can be increased by:
– Increasing number of years of compounding (N)
– Increasing the interest or discount rate (r)
– Increasing the original investment (PV)
• See example on next slide

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Changing R, N, and PV
a. You deposit $500 in bank for 2 years. What is the FV at 2%?
What is the FV if you change interest rate to 6%?
FV at 2% 500 1.02  $520.20
2

FV at 6% 500 1.06  $561.80

2

b. Continue the same example but change time to 10 years.

What is the FV now?
FV 500 1.06  $895.42
10

c. Continue the same example but change contribution to

$1,500. What is the FV now?
FV 1,500 1.06  $2,686.27
10

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Figure 5-1 $100 Compounded at 6
Percent Over 20 Years

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Figure 5-2 The Future of $100 Initially Deposited
and Compounded at 0, 5, 10, and 15 Percent (1 of 2)

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Figure 5-2 The Future of $100 Initially Deposited
and Compounded at 0, 5, 10, and 15 Percent (2 of 2)
• Figure 5-2 illustrates that we can increase the FV by:
– Increasing the number of years for which money is
invested; and/or
– Investing at a higher interest rate.

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Computing Future Values using
Calculator or Excel
• Excel Function for FV: = FV(rate, nper, pmt, pv)

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Present Value (1 of 2)
• Present value reflects the current value of a future
payment or receipt.

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Present Value (2 of 2)
 1 
PV FVn  n 
 1  r  

FVn = the future value of the investment at the end of n

years
n = number of years until payment is received
r = the interest rate
PV = the present value of the future sum of money

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PV Example
• What will be the present value of $500 to be received
10 years from today if the discount rate is 6%?
 1 
PV $500  10 
 1  0.06  
 1 
$500  
 1.791 
$500 0.558 
$279.00

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Using Excel
• Excel Function for PV: = PV(rate,nper,pmt,fv)

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Let’s Try
• Abdullah is depositing his monies RM25,000 in Bank
Muamalat. The profit rate is 5%. Compute Abdullah’s total
deposit after 5, 10 and 15 years.
• Jonathan is expecting a lump-sum pension amount of
RM120,000 at his retirement 30 years from now. Assuming
that the rate is 6%, what is the value of his pension money
now?
• Abdurrahman has RM45,000 in his pocket now and he
expect to grow the amount to RM50,000 in 2 years. What
will be the deposit rate for Abdurrahman in order for him to
achieve this?

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Annuities

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Annuities
• An annuity is a series of equal dollar payments for a
specified number of years.
• Ordinary annuity payments occur at the end of each
period.

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FV of Annuity
Compound Annuity
• Depositing or investing an equal sum of money at the
end of each year for a certain number of years and
allowing it to grow.

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FV Annuity - Example
What will be the FV of a 5-year, $500 annuity compounded
at 6%?

FV5 $500 1  0.06   $500 1  0.06   $500 1  0.06 

4 3 2

 $500 1.262   $500 1.191  $500 1.124   $500 1.090 

 $500 $631.00  $595.5  $562.00  $530.00  $500
$2,818.50

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Table 5-1 Growth of a 5-Year, $500
Annuity Compounded at 6 Percent

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FV of an Annuity – Using the
Mathematical Formulas (1 of 2)
  1  r n  1 
FV PMT   
 r 
 
FVn  the future of an annuity at the end of the nth year
PMT = the annuity payment deposited or received at
the end of each year
r = the annual interest (or discount) rate
n = the number of years

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FV of an Annuity – Using the
Mathematical Formulas (2 of 2)
• What will $500 deposited in the bank every year for 5
years at 6% be worth?
  1  r n  1 
• ​FV PMT   
 r 
 
$500 5.637 
$2,818.50

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FV of Annuity: Changing PMT, N,
and r (1 of 2)
1. What will $5,000 deposited annually for 50 years be
worth at 7%?
− FV = $2,032,644
− Contribution = $250,000 (= 5000×50)
2. Change PMT = $6,000 for 50 years at 7%
− FV = $2,439,173
− Contribution = $300,000 (= 6000×50)

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FV of Annuity: Changing PMT, N,
and r (2 of 2)
3. Change time = 60 years, $6,000 at 7%
− FV = $4,881,122
− Contribution = $360,000 (= 6000×60)
4. Change r = 9%, 60 years, $6,000
− FV = $11,668,753
− Contribution = $360,000 (= 6000×60)

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Present Value of an Annuity
• Pensions, insurance obligations, and interest owed on
bonds are all annuities. To compare these three types
of investments we need to know the present value
(PV) of each.

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Table 5-2 Illustration of a 5-Year, $500 Annuity
Discounted to the Present at 6 Percent

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PV of Annuity – Using the
Mathematical Formulas

PV of Annuity PMT
 
 1  1  r  1 
 
r
500 4.212 
$2,106

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Annuities Due (1 of 2)
• Annuities due are ordinary annuities in which all
payments have been shifted forward by one time
period. Thus, with annuity due, each annuity payment
occurs at the beginning of the period rather than at the
end of the period.

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Annuities Due (2 of 2)
• Continuing the same example: If we assume that $500
invested every year for 5 years at 6% to be annuity due,
the future value will increase due to compounding for one
additional year.
  1  r n  1 
• ​FV5 annuity due  PMT   

 r 
 
500 5.637 1.06 
$2,987.61
(versus $2,818.80 for ordinary annuity)

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Amortized Loans (1 of 2)
• Loans paid off in equal installments over time are
called amortized loans.
Example: Home mortgages, auto loans.
• Reducing the balance of a loan via annuity payments
is called amortizing.

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Amortized Loans (2 of 2)
• The periodic payment is fixed. However, different
amounts of each payment are applied toward the
principal and interest. With each payment, you
owe less toward principal. As a result, the amount
that goes toward interest declines with every
payment (as seen in Figure 5-4).

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Figure 5-4 The Amortization Process

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Amortization Example
• Example: If you want to finance a new machinery with
a purchase price of $6,000 at an interest rate of 15%
over 4 years, what will your annual payments be?

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Finding PMT – Using the
Mathematical Formulas
• Finding Payment: Payment amount can be found by solving
for PMT using PV of annuity formula.

PV of Annuity PMT
 1  1  r 
4

r

6,000 PMT
1  1  0.15  
4

0.15
6,000 PMT 2.855 
6,000
PMT 
2.855
$2,101.59

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Table 5-3 Loan Amortization Schedule Involving
a $6,000 Loan at 15 Percent to be Repaid in 4
Years

Interest Repayment of the

portion of the principal portion of the Outstanding loan Balance
Year Annuity Annuitya Annuityb After the Annuity Payment
0 0 0 0 $6,000.00
1 $2,101.59 $900.00 $1,201.59 4,798.41
2 2,101.59 719.76 1,381.83 3,416.58
3 2,101.59 512.49 1,589.10 1,827.48
4 2,101.59 274.12 1,827.48 Blank

a
The interest portion of the annuity is calculated by multiplying the outstanding loan balance at the
beginning of the year by the interest rate of 15 percent. Thus, for year 1 it was $6,000 × 0.15 = $900.00,
for year 2 it was $4,798.41 × 0.15 = $719.76, and so on.
b
Repayment of the principal portion of the annuity was calculated by subtracting the interest portion of
the annuity (column 2) from the annuity (column 1).

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Making Interest Rates Comparable

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Making Interest Rates Comparable
• We cannot compare rates with different compounding
periods. For example, 5% compounded annually is
not the same as 5% percent compounded quarterly.
• To make the rates comparable, we compute the
annual percentage yield (APY) or effective annual rate
(EAR).

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Quoted Rate versus Effective Rate (1 of 2)
• Quoted rate could be very different from the effective rate if
compounding is not done annually.

• Example: $1 invested at 1% per month will grow to


$1.126825 $1.00 1.01
12

in one year. Thus even

though the interest rate may be quoted as 12%

compounded monthly, the effective annual rate or APY is
12.68%.

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Quoted Rate versus Effective Rate (2 of 2)

Where m = number of compounding periods

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Table 5-4 The Value of $100
Compounded at Various Intervals (1 of 2)
For 1 year at r percent

r= 2% 5% 10% 15%
Compounded annually $102.00 $105.00 $110.00 $115.00

Compounded semiannually 102.01 105.06 110.25 115.56

Compounded quarterly 102.02 105.09 110.38 115.87

Compounded monthly 102.02 105.12 110.47 116.08

Compounded weekly (52) 102.02 105.12 110.51 116.16

Compounded daily (365) 102.02 105.13 110.52 116.18

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Table 5-4 The Value of $100
Compounded at Various Intervals (2 of 2)
For 10 years at r percent

r= 2% 5% 10% 15%
Compounded annually $121.90 $162.89 $259.37 $404.56

Compounded semiannually 122.02 163.86 265.33 424.79

Compounded quarterly 122.08 164.36 268.51 436.04

Compounded monthly 122.10 164.70 270.70 444.02

Compounded weekly (52) 122.14 164.83 271.57 447.20

Compounded daily (365) 122.14 164.87 271.79 448.03

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Finding PV and FV with Nonannual
Periods
• If interest is not paid annually, we need to change the
interest rate and time period to reflect the nonannual
periods while computing PV and FV.
– r = stated rate/# of compounding periods
– N = # of years×# of compounding periods in a year
• Example: If your investment earns 10% a year, with
quarterly compounding for 10 years, what should we use
for “r” and “N”?
0.10
r  0.025 or 2.5%
4
N 10 4 40 periods
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The Present Value of an Uneven
Stream and Perpetuities

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The Present Value of an Uneven
Stream
• Some cash flow stream may not follow a
conventional pattern. For example, the cash flows
may be erratic (with some positive cash flows and
some negative cash flows) or cash flows may be a
combination of single cash flows and annuity (as
illustrated in Table 5-5).

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Table 5-5 The Present Value of an Uneven
Stream Involving One Annuity Discounted to the
Percent: An Example

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Table 5-6 Determining the Present Value of an
Uneven Stream Involving One Annuity Discounted
to the Present at 6 Percent: An Example

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Perpetuity (1 of 2)
• A perpetuity is an annuity that continues forever.
• The present value of a perpetuity is given by
PP
PV 
r
• PV = present value of the perpetuity
• PP = constant dollar amount provided by the
perpetuity
• r = annual interest (or discount) rate

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Perpetuity (2 of 2)
• Example: What is the present value of $2,000
perpetuity discounted back to the present at 10%
interest rate?

2000

0.10
$20,000

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Table 5-7 Summary of Time Value of
Money Equation

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Key Terms
• Amortized loan • Effective annual rate
(EAR)
• Annuity
• Future value
• Annuity due
• Future value factor
• Annuity future value
factor • Ordinary annuity
• Annuity present • Present value
value factor
• Present value factor
• Compound annuity
• Perpetuity
• Compound interest
• Simple interest
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Copyright

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