FBF Lecture 2

TIME VALUE OF MONEY 1

Spring 2015

Lecture 2 Do List
2

explain the time value of money (TVM) concept

identify the differences between simple interest
and compound interest
be familiar with TVM terminology
calculate the future value of a single amount
calculate the present value of a single amount
calculate effective rates and distinguish them
from nominal rates
draw time lines to represent the DCF process
FBF Lecture 2

Spring 2015

Topic In Perspective
3

Last week
Three major financial management decisions
Cash flow is important
Financial markets

This week
Valuing cash flows at different periods
TVM is critical to this valuation
Future costs and benefits

TVM has applications throughout finance

Investment decision analysis
Financial markets
FBF Lecture 2

Spring 2015

Time value of money (TVM)

4

The financial manager makes decisions about

proposals with cash flows over long periods of
time
An important consideration is the timing of these
cash flows
The time value of money must be recognised

It is based on the fact that a dollar today is worth

more than a dollar tomorrow
Would you prefer $2 million today, or
$2 million in five years time?
FBF Lecture 2

Spring 2015

Example 1
5

You invest $1,000 in a bank today for a period of

one year
The bank will pay interest at a rate of 5% pa.
How much will you have in the bank next year?
Solution
Interest = $1000 x 5% (or 0.05) = 50
Add interest to the original investment
$1000 + 50 = 1050
FBF Lecture 2

Spring 2015

Variables
6

A dollar amount today,

present value

and an interest rate,

and a period of time,
gives a dollar amount in the future
future value

FBF Lecture 2

Spring 2015

Terminology
7

Time Value of Money has its own language:

PV
i
n
FV
PMT

= present value, or principal

= interest rate, later we use r
= number of periods, later we use t
= future value
= periodic payment

This week, we learn about applications that

require three variables to then determine a fourth
FBF Lecture 2

Spring 2015

Time Line
8

Interest for the period of time

start of period 1

start of period 2

end of period 1

end of period 2

Drawn as
|
0
FBF Lecture 2

|
1

|
2

|
3
Spring 2015

Simple Interest
9

Calculated on the original principal

Takes no account of changes in principal
Sometimes called Flat rate interest

Used in the valuation of short-term financial

instruments traded in the money market
Term is under 12 months
Bills of exchange

FBF Lecture 2

Spring 2015

Future value with simple interest

10

INT = PV i n
i = simple interest rate per year
n = number of years

FV = PV + INT
FV = future value at end of term
PV = principal value at beginning
INT = interest amount over the time period

FV = PV + PV i n

= PV(1 + i n)
FBF Lecture 2

Spring 2015

Present Value with simple interest

11

The formula can be rearranged to calculate

present values
PV = FV / (1 + i n)
This can also be used to price short-term
financial instruments
This is covered more in lecture 4

FBF Lecture 2

Spring 2015

Example 2
12

What is the future value of $100,000 invested for

180 days at 10% pa simple interest?
Solution
FV = PV(1 + i n)
FV

= 100,000(1 + 10%180/365)
= 100,000(1 + 0.0493)
= 104,930

Note the annual interest rate is adjusted for the number

of days the funds are invested during the year
FBF Lecture 2

Spring 2015

Compound Interest
13

Interest is added to the principal each period

Interest on interest
Called compounding

The compounding period can be any designated

length of time
yearly, half-yearly, monthly

Simple interest is calculated only on the original

amount
FBF Lecture 2

Spring 2015

Future Value
14

Applying the formula many times gives

FV = PV(1+i1)(1+i1)..... (1+i1)
which is equivalent to:
FV = PV(1 + i)n

where
i = the per period interest rate
n = the number of compounding periods
PV = the original principal
FBF Lecture 2

Spring 2015

Example 3
15

Mavis deposits $1,000 today in a savings

account that pays interest once a year.
How much will Mavis have in three years time if
the interest rate is 12% p.a.?
1000
|_______|________|________|
0
1
2
3

To answer the question you first need to identify

what information has been given
Interest rate; term; PV or FV
FBF Lecture 2

Spring 2015

Example 3: Using a table

16

YEAR

1
2
3

OPENING
BALANCE
1000.00
1120.00
1254.40

INTEREST
120.00
134.40
150.53

CLOSING
BALANCE
1120.00
1254.40
1404.93

Interest = Opening balance multiplied by interest

rate
i.e., 1,000 x 12% = 120.00
FBF Lecture 2

Spring 2015

Example 3: Using the formula

17

FV = PV ( 1 + i )n

= 1000(1 + 0.12)3

= 1404.93
Or, expressed another way

FV = 1000(1.12)(1.12)(1.12)

= 1120(1.12) (1.12)

= 1254.40(1.12)

= 1404.93
FBF Lecture 2

Spring 2015

Example 4
18

Freda deposits $5,317 today in a savings

account with an interest rate of 5% pa
What is the value of Freda's deposit in four years
time?
|______|_______|________|________|
0
1
2
3
4

What have you been asked to calculate?

FBF Lecture 2

Spring 2015

Example 4 Solution
19

What information have you been given?

PV = 5,317
i = 5%
n=4
FV = PV ( 1 + i )n
FV = 5,317 ( 1 + 0.05 )4 = $6,462.85

FBF Lecture 2

Spring 2015

Present Value
20

Rearranging the future value formula gives the

formula for the present value
PV = FV (1 + i)n
or

PV = FV(1 + i)-n
or

FV
PV
n
(1 i)
FBF Lecture 2

Spring 2015

Example 5
21

You own a bank fixed term deposit that

guarantees to pay you $230,000 in six years
time, however you are not prepared to wait.
What amount of cash would you receive today if
someone will buy the fixed term deposit today?
The buyer applies a discount rate of 20% pa
FV

0
FBF Lecture 2

6
Spring 2015

Example 5 Solution
22

What information have you been given?

FV = 230,000
i = 20%
n=6
PV = FV ( 1 + i )-n

= 230,000 (1 + 0.20)-6

= $77,026.53

FBF Lecture 2

Spring 2015

Example 6
23

You estimate that you will need $2,500,000 in 20

years to fund your retirement.
Your superannuation fund will generate a return
of 9% p.a.
What amount of money would you need to invest
today to have $2,500,000 when you retire?

FBF Lecture 2

Spring 2015

Example 6 Solution
24

What information have you been given?

FV = 2,500,000
i = 9%
n = 20
PV = FV ( 1 + i )-n

= 2,500,000 (1 + 0.09)-20

= $446,077.22

FBF Lecture 2

Spring 2015

Frequency of Compounding
25

Interest rates are normally quoted as per annum

But the compounding frequency is not always
annual
A nominal rate is the rate you can observe in the
market
If the compounding period is not annual the rate
must be qualified
16% p.a. compounded monthly
This nominal rate is not the same as 16% return pa
FBF Lecture 2

Spring 2015

Example 7
26

What is the compounding rate for each time

period for a 18% nominal annual interest rate
with monthly compounding?
Solution
The number of compounding periods each year
is 12
Rate per period = 18% 12 = 1.5%

FBF Lecture 2

Spring 2015

Effective Annual Rates (EAR)

27

An effective rate is an interest rate that

compounds annually
To convert a nominal rate to an effective rate
EAR = (1 + i)m - 1
where
m = number of compounding periods per year
i = interest rate per period

FBF Lecture 2

Spring 2015

Example 8
28

Which interest rate is higher?

12.5% annual interest rate, compounded halfyearly, or
12.3% annual interest rate compounding monthly

Convert both nominal rates to EARs

EAR = (1+ i)m - 1
EAR = (1 + i)m - 1
= (1+.0625)2 -1
= (1 + .01025)12 1
= 12.89%
= 13.02%
FBF Lecture 2

Spring 2015

Example 9
29

A company has the opportunity to buy an asset

today for $70,000
The company expects to be able to sell this
asset in three years for $87,500
The appropriate return is 9.5% pa.
Should the firm buy the asset?

FBF Lecture 2

Spring 2015

Example 9 Solution
30

70,000
87,500
|______|______|______|
0

i = 9.5%
PV= 87500/(1+0.095)3 = 66,644.71
The firm should not buy the asset

FBF Lecture 2

Spring 2015

Example 10
31

A forest company is offering investors an

opportunity to invest in a rubber plantation
The cost to invest is $6,000 in 2013
Projected returns from this investment are
$3,000 in 2016 and
$7,500 in 2021

The required return is 15%pa

Is it worth investing in this project?
(think in current day dollar terms PV)
FBF Lecture 2

Spring 2015

Example 10 Solution
32

-6000
3000
7500
|___|___|___|___|___|___|___|___|
13

14

15

16

17 18

19

20

21

i = 15%
PV3000 = 3000/(1+0.15)3 = 1972.55
PV7500 = 7500/(1+0.15)8 = 2451.76
Value in 2013 = $4,424.31
Not worth investing in this project
FBF Lecture 2

Spring 2015

Example 11
33

Bert and Beryl want to establish a fund that will

pay $10,000 to each of their two grandchildren,
Peter and Mary, when they turn 21.
Mary turns 21 in ten years time and Peter turns
21 in twelve-and-a-half years time.
If the funds interest rate is 8% pa. compounded
half-yearly, what amount should Bert and Beryl
deposit today?

FBF Lecture 2

Spring 2015

Example 11 Solution
34

$10,000
20

$10,000
25

i = 8%/2 = 4%
FV = $10,000 in both cases

PV of Marys payment = 10,000/(1.04)20

PV of Peters payment = 10,000/(1.04)25
PV = 4,563.87 + 3,751.17

= $8,315.04
FBF Lecture 2

Spring 2015