Melicher, R. W., & Norton, E. A. (2013).

Introduction to Finance:Markets,Investments and

Financial Management. John Wiley & Sons.
FUNDAMENTALS OF FINANCE
FIN501

TIME VALUE OF MONEY

LECTURE TOPIC 4

1
LECTURE OUTLINE
 Understand what is meant by the time value of money.
 Comprehend the concept of simple interest.
 Comprehend the process of compounding.
 Construe discounting to determine present values.
 Find interest rates and time requirements for problems involving compounding or
discounting.
 Understand the meaning of ordinary annuities.
 Find interest rates and time requirements for problem involving annuities.
 Calculate annual annuity payments.
 Deduce compounding and discounting calculations using time intervals that are less
than one year.
 Apprehend the difference between the annual percentage rate and effective annual
rate.

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 TIME VALUE OF MONEY
Is the math of finance whereby interest is earned by saving or
investing money. Money can grow over time if we can save
(invest)it and earn a return on our savings (investment)
Example
 Lets begin with a saving account illustration. Assume you have $1000 to save or
invest – this is your principal.
 The present value(PV) of a savings or investment is its amount or value today.
For our example, this is your $1000
 A bank offers to accept your savings for one year and agrees to pay you an 8%
interest rate for use of your $1000. This amounts to $80 in interest (0.08 x
$1000).
 The total payment by the bank at the end of the year is $1080 ($1000 principal
plus $80 interest).
 This $1080 is referred to as the future value (FV).
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Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 TIME VALUE OF MONEY CONT’D
 The future value of a savings amount or investment is its
value at a specified time or date in future. In general terms we
have:
 FV= PV + ( PV X Interest rate)
 Or

 FV = PV x (1+ Interest rate)

 In our example, we have

 FV = $1000 + ($1000 x 0.08) = $1080

Or
FV = $1000 x (1+0.08) = $1080

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
TIME VALUE OF MONEY - SIMPLE INTEREST
 Lets now assume your $1000 investment remains on
deposit for two years but that the bank pays only
simple interest, which is interest earned only on the
investment’s principal. That is we have

FV = PV x [1 + (interest rate x number of periods)

 For our example this becomes

◦ FV = $1000 x [1 + (.08 x 2)] = $1160

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
SIMPLE INTEREST
 Thus Simple interest is interest calculated on the original
or principal sum borrowed.

EXAMPLE : Company A borrows $20,000 from Company

B for a period of 1 year at the simple interest rate of 6%.
What interest is owed at the end of the Year?
Interest = Pin
= $20,000 * 0.06 * 1
= $1200.00
6

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 SIMPLE INTEREST
 Present values of a single sum could be calculated
using the FV formula and making the PV the subject
of the formula as follows:

 FV = PV x [1+(interest rate x No. of periods)

 PV = FV/[1+ (interest rate x no. of periods)

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
COMPOUND INTEREST
 Compound interest involves earning interest on interest plus
the principal or initial investment. The compounding
concept is expressed as:

 FVn = PV (1 + r)n
Where : FV is the future value
PV is the present value
r is the interest rate
n is the number of periods

Using time lines

 A time line is a diagrammatic representation of cash flows
either received or paid or both.
 A time line may look like this, where PV equals present value
(value at time zero) and FV is the future value at the end of 8
the denominated time periods:
Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 FUTURE VALUE OF A SINGLE SUM
 EXAMPLE
Bingo Paperbacks is a bookshop. The partnership which owns
the store is saving to buy new shelving so that the business can
display its 10,000 titles more effectively. Bingo has saved
$20,000 this year and can invest the funds at 7% per annum at
the compound interest rate. What amount will they have at
the end of 5 years?
The inputs are : PV = $20000; r = 7% and; n = 5.
 using the formula : FVn= PV (1 + r)n
= 20 000(1 + 0.07)^5
= $28,051

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 FUTURE VALUE OF A SINGLE SUM
EXAMPLE
Bingo Paperbacks saved $20,000 this year and
invests the fund at 7% per annum compounded
monthly. What amount will they have at the
end of 5 years?

The inputs are : PV = $20000; r = 0.07/12 and; n = (12 x 5) = 60

using the formula : FVn = PV (1 + r)n
= 20 000(1 + 0.07/12)60
= $28,352.51
10

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial

Management. John Wiley & Sons.
 PRESENT VALUE OF A SINGLE SUM
 The FV equation may be manipulated so that it
will give the PV of a future sum by making the PV
the subject of the formula as below:

We rearrange FVn = PV (1 + r)n to get PV = FVn /(1 +r)n

Where :PV is the present value

FV is the future value
r is the interest rate
n is the number of periods in years.

11

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 PRESENT VALUE OF A SINGLE SUM
EXAMPLE
Bingo Paperbacks gets the quote for the sort of shelving it
wants and decides to build an extension as well. The partners
think they can afford to do the work now, estimated cost is
$60,000, in 3 year’s time. How much do they need to have now
to fund this expense if they can earn 6% per annum,
compounded monthly.

Solution
 FV = $60000; k = 0.06/12 and; n = 3*12.

PV = FVn / (1 +r)n
= 60000/ (1 +0.06/12)^36
12
= 50,138.70
Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 FUTURE AND PRESENT VALUE OF
SEVERAL EQUAL SUMS
 An annuity is a series of equal cash flows that are
evenly spaced over time.
 There are 4 types of annuities:
i. Ordinary annuity – where the payments flow at
the end of each even-length period
ii. Annuity due – where the first payment is
received on the day of valuation/beginning of
each period.
iii. Deferred annuity - where the first payment is
deferred for a period greater than the
subsequent even-length periods
iv. Perpetuity – where the cash flows continue
forever
13

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 ORDINARY ANNUITY
 An ordinary annuity is a series of equal cash flows
which are evenly spaced over time and are
received at the end of each period.
 Present and future value of ordinary annuity

14

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 PRESENT VALUE OF ORDINARY ANNUITY
EXAMPLE : Find the present value of an ordinary annuity
that pays $10,000 per year for 5 years at 6%.
 SOLUTION

The inputs are as: C = $10000; k = 6% and; n = 5.

15

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 FUTURE VALUE OF ORDINARY ANNUITY
EXAMPLE : Find the future value of an ordinary annuity
that pays $20,000 per year for 18 years at 8%.
SOLUTION
The inputs as : C = $20000; k = 8% and; n = 18.

16

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial

Management. John Wiley & Sons.
 ANNUITY DUE
 An annuity whose payments occur at the beginning
of each period.
 An annuity due is only an ordinary annuity with an
extra payment added on the front end of the series of
cash flows.
 Future value of annuity due

17

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 FUTURE VALUE OF ANNUITY DUE
SOLUTIONEXAMPLE : Find the future value of a
$60,000 per year annuity for 21 years at 5 percent
assuming that payments are made at the beginning of
each year.

The inputs are : C = $60000; k = 5% and; n = 21.

18

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 PRESENT VALUE OF ANNUITY DUE
 The equation for calculating the PV of an annuity
due is:

EXAMPLE : Find the Present value of a $60,000 per year annuity for 21
years at 5 percent assuming that payments are made at the beginning of
each year.
SOLUTION: The inputs are : C = $60000; k = 5% and; n = 21

19

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 DEFERRED ANNUITY
 A deferred annuity has its first payment made
after several periods have elapsed.
 The equation for calculating the PV of an
annuity due is:

20

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 DEFERRED ANNUITY
EXAMPLE : Calculate the present value of an annuity that
pays $60,000 per year for 21 years at 5 percent assuming
that the first payment is made after 2 years.
SOLUTION
The inputs are : C = $60000; k = 5%; n = 21 and; b = 2.

21

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 PERPETUITY

A perpetuity is a series of regular equal payments

that continue forever.
 The equation for calculating PV of a perpetuity is:

EXAMPLE : Boon’s Best Bakery Co issues 10% $2 preference

shares that pay a 20 cents dividend per share for as far
future as anyone cares to analyze. What should be the
current price of each share, given a discount rate of 5%?
SOLUTION The inputs are : C = $0.2 and; k = 5%.

22

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 PRESENT VALUE AND FUTURE VALUE OF
UNEQUAL SUMS
A stream of unequal amounts is not an
annuity and cannot be manipulated by the
use of annuity equations.
 Thus, any problem with different amounts
must be solved using the single-sum
equations for either the FV or PV, as
required.

23

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 PRESENT VALUE OF UNEVEN CASH FLOW STREAMS
 Is found as the sum of PV’s of individual cash flows of the stream.

PV=CF1[1/(1+k)1+CF2[(1/(1+k)2+----+CFn[(1/(1+k)n

= CF (PVIF ) (using table)

t it
EXAMPLE: Calculate the present value of an Investment that
promises to pay you $100 in year 1, $300 in year 2, $200 in year 3,
$200 in year 4 and $1000 in year 5 discounted at 6 percent.
PV = CF1[1/(1+k)1 + CF2[1/(1+k)2 + CF3[1/(1+k)3 + CF4[1/(1+k)4+
CF5[1/(1+k)5
= 100(1/(1+0.06)1 + 300(1/(1+0.06)2+200(1/(1+0.06)3+200(1/(1+0.06)4
+ 1000(1/(1+0.06)5
= $94.34 + $267.00 + $167.92 + $158.42 + $747.26
24
= $1434.94
Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 FUTURE VALUE OF UNEVEN CASH FLOW STREAMS
 Also known as the Terminal Value.
 Found by compounding each payment to the end of the stream and
then summing the future values.
FVn = CFt(1+k)n-1 + CFt(1+k)n-2 + ------+ CFn(1+k)0
= CF (FVIF
t i,n-t
)
(using tables)

EXAMPLE : Calculate the future value of an Investment that promises

to pay you $100 after year 1, $300 after year 2, $200 after year 3, $200
after year 4 and $1000 after year 5 discounted at 6 percent.
SOLUTION
FVn = CF1(1+k)5-1 + CF2(1+k)5-2 + CF3(1+k)5-3 ---+ CF4(1+k)5-4 + CF2(1+k) 5-5
= 100( 1+0.06)4 + 300(1+0.06)3 +200(1+0.06)2
+ 200(1+0.06)1 + 1000(1+0.06) 0
= $126.25 + $357.30 + $224.72+ $212.00 + $1000
25
= $1920.27
Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial
Management. John Wiley & Sons.
 SOLVING CASH FLOW PROBLEMS

 A few steps to follow when solving cash flow

problems are:
 draw a time line and insert the cash flows.
 identify what component of the required
information is unknown.
 decide the class of problem and apply the
appropriate equation.
 write down the equation(s), manipulate them
so that the unknown value is on the left-hand
side, insert the values as given and solve. 26

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 APR VERSUS EAR
 The Annual Percentage Rate (APR) is determined
by multiplying the interest rate charged per period
(r) by the number of periods in a year (n) :

APR = r x n
 Example a car loan that charges interest of 1% per
month has as APR of 12% (i.e 1% x 12 months)
 An unpaid credit card balance that incurs interest
charges of 1.5% per month has an APR of 18% (i.e
1.5% x 12)
27

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 APR VERSUS EAR CONT’D
 However, the APR misstates the true interest rate
as it ignores the effect of periodic compounding.
 The effective interest rate (EAR) sometimes called
the annual effective yield measures the true interest
rate where compounding occurs more frequently
than once a year.
 Calculating the annual effective rate:

EAR= (1 + r)n – 1
 Where : r is the rate charged per period and n is
the number of periods per year. 28

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management. John
Wiley & Sons.
 APR VERSUS EAR CONT’D
 In cases where APR is known, EAR can be calculated as
follows:
Step 1: formula for APR = r x n
Step 2 : divide n on both sides of the equation
Step 3 : APR/n = r

Once r is calculated use this in the formula for EAR

to get the effective annual rate.

29

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
 APR VERSUS EAR CONT’D
EXAMPLE
Suppose a credit card is advertised at APR of 6% which is
assessed monthly. Calculate the EAR?
Step 1: formula for APR = r x n  0.06 = r x 12
Step 2 : divide n on both sides of the equation
Step 3 : APR/n = r  0.005 = r
Once r is calculated use this in the formula for EAR to get the
effective annual rate.
EAR= (1 + r)n – 1  (1 + 0.005)12 – 1 = 0.061677
EAR = 6.17%

30

Melicher, R. W., & Norton, E. A. (2013). Introduction to Finance:Markets,Investments and Financial Management.
John Wiley & Sons.
END OF LECTURE EXERCISE
1 .The price of a Microwave is advertised as $3,000 for a
zero deposit and full payment to be exactly made after two
years. The same model is available now at another dealer
for $2900. Which deal will you opt for, if money can earn
8% simple interest per annum?

31
END OF LECTURE EXERCISE
2. What would be the future value of $7,455 invested
annually for nine years beginning every year from now if
the annual interest rate is 19 percent?


32
END OF LECTURE EXERCISE
3. If Binal borrowed $500 000 today at 6% compounding
monthly, how much must he repay at the end of each
month starting this month to pay off the loan in 6 years?

33
END OF LECTURE EXERCISE
4. Find the Present value of a $60,000 per year investment
for 21 years at 5 percent assuming that regular payments
are made at the beginning of each year.

34
END OF LECTURE EXERCISE
5. A credit card advertisement states that the annual
percentage rate is 21 percent. If the credit card requires
quarterly payments, what is the effective annual rate of
interest on the loan?

35
END OF LECTURE EXERCISE
6. What is the present value of $359,000 that is to be
received at the end of 23 years, the discount rate is 11
percent, and semiannual discounting occurs?

36
THE END