BBC406 Fundamentals of

Finance
Week 3 Time Value of Money 1

Learning Objectives
At the end of this chapter, you should be
able to:
Discuss the role of time value in finance and the
use of various calculation techniques
Understand the concept of future value and
present value and the components involved in
the calculations
Understand ordinary annuity and an annuity
due, in both present value and future value
calculations, as well as the concept of perpetuity

Learning Objectives (cont.)

Understand the calculation of
effective annual rate (EAR), annual
percentage rate (APR) and annual
percentage yield (APY)
Calculate other components in time
value of money such as periods,
interest rate and loan amortization

Introductions
Time is the friend of the wonderful company,
the enemy of the mediocre Warren Buffet.
Time is Money !!

Questions to Ask
If RM1 today is worth more than RM1
tomorrow, so what is our RM1 after today?

Important Concepts

Perpetuitie
s

Present Value

Future Value

Annuities

Payment

Interest/Discoun
t Rate

Important Rules
RULE 1: A Dollar Today and a Dollar in one year
are not equivalent.
RULE 2: To Calculate a cash flows future value,
you must compound it.
RULE 3: To calculate the value of a future cash
flow at an earlier point in time, we must
discount it
RULE 4: To calculate the value of a series of
payments in perpetuity, we must discount
them to present value

Introduction
Finance and financial planning deal with the
value of money over time.
Managing funds, be it in the form of
investment or borrowing over a specified
period of time, is referred as time value of
money.
In finance, the focus is on economic gains and
not accounting gains.

Time Value of Money

Time value of money relates to the concept
that a sum of money today is worth more than
the same sum in the future.
Lenders perspectives
Borrowers perspectives
Interest rates
periods

Future Value of a Single

Amount
Future value utilizes the concept of compounding.
FV1 = PV0 + Interest payment
where:
FV1 is the future value at the end of the first period (year
1)
PV0 is the present value of the amount being saved or
invested today

Example: Using the above formula, suppose you

deposit RM1,000.00 today and the bank offers a 7%
interest rate per annum. If you plan to save your money
for 3 years, the calculation is as follows:

Future Value Mathematical

Expression

Future Value Financial Table

Future Value Financial

Calculator

Eg3.1: Future Value

Lets say Sam deposits $200 for a year in an
account that pays 6% per year. At the end of the
year, he will have:

Eg3.2: Future Value

Multiple Period
If Sam closes out his account after
3 years, how much money will he
have accumulated? How much of
that is the interest-on-interest
component? What about after 10
years?

Eg3.3: Future Value Inflation

Lets say that you have seen your
dream house, which is currently listed
at $300,000, but unfortunately, you are
not in a position to buy it right away
and will have to wait at least another 5
years before you will be able to afford
it. If house values are appreciating at
the average annual rate of inflation of
5%, how much will a similar house cost
after 5 years?

Compounding
Frequency of calculating interest
Compounding (frequency of interest
calculation) can be done:
annually (once a year)
semi-annually (twice a year)
quarterly (four times a year)
monthly (twelve times a year)
daily (365 times a year)
continuously

Compounding (cont.)

Present Value of a Single

Amount
Present value is the current value of a given future cash
flow.
The present value tells us the amount of money needed
today in order to obtain a desired amount after a period of
time.
Example is given below:

Present Value Formula

Present Value Financial Table

The present value of RM10,000 in the above
example can also be found by multiplying the
amount by the present value interest factor
which can be referred to in the financial tables.
Example: The present value interest factor
(PVIF) is interest factor for 3 years (period 3)
and 6% (interest rate) it is 1.910. Thus, the
formula using Table 3 is as follows:
PV0 = FV (PVIF r, n) [r = 6%, n = 3]
= 10000 0.8396
= 8,396.00

Present Value Financial

Calculator (cont.)

Eg3.4: Present Value Discounting

Lets say you just won a jackpot of
$50,000 at the casino and would like to
save a portion of it so as to have
$40,000 to put down on a house after 5
years. Your bank pays a 6% rate of
interest. How much money will you
have to set aside from the jackpot
winnings?

Methods of Solving Future Value

Problems
Method 1: The formula method
Time-consuming, tedious

Method 2: The financial calculator approach

Quick and easy

Method 3: The spreadsheet method

Most versatile

Method 4: The use of Time Value tables:

Easy and convenient but most limiting in scope

Tips 1: Timeline
When solving time value of money problems,
especially the ones involving multiple periods
and complex combinations (which will be
discussed later) it is always a good idea to draw
a time line and label the cash flows, interest
rates and number of periods involved.

Timeline

Tips 2: One Equation

Any time value problem involving
lump sums -- i.e., a single outflow
and a single inflow--requires the
use of a single equation consisting
of 4 variables i.e. PV, FV, r, n

When can we use the TVM?

Calculating the amount of saving required for
retirement
Determining future value of an asset
Calculating the cost of a loan
Calculating growth rates of cash flows
Calculating number of periods required to
reach a financial goal.

Eg3.5: Retirement Savings

You have planned to have a retirement fund of
$2,000,000. The bank is offering you a fixed
deposits for forty years at 6.0%. What is the
initial deposits that you need to make today to
reach the retirement fund of $2,000,000 at the
end of forty years?

Eg3.6: Valuing Assets

In 1867, Sam purchased a land for the sum of
$7,200,000, or about 2 cents per acre. What
would it cost today if the land were exactly the
same condition as it was 140 years ago and the
prevailing interest rate over this time were 4%?

Eg3.7: Loans
Hoo, a college student, needs to borrow $5,000
today for his tuition fee. He agrees to pay back
the loan in a lump-sum payment five years from
now, after he is out of college. The bank states
that the payment will need to be $7,012.76. If
John borrows the $5,000 from the bank, what
interest rate is he paying on his loan?

Eg3.8: Growth Rate

You are the planning commissioner for A town, a
growing city in the southwest. The city council
has estimated that the citys population will
increase very rapidly over twenty years,
reaching an estimated 250,000. Today, the
population is 94,222. What is the projected
growth rate of this city?

E.g3.9: Waiting to be rich

You aim to be a millionaire. Today, your financial
portfolio is worth $3,733.24. You determine that
you can earn 15% every year on your portfolio.
You do not plan to invest any additional money in
this portfolio, nor will you withdraw any funds
from it before it grows to $1 million. Given your
15% interest rate, how long will you have to wait
to become a millionaire if this investment
represents all your wealth?

Tip 3: Doubling of Money:

The Rule of 72
The Rule of 72 estimates the number of years
required to double a sum of money at a given
rate of interest.
For example, if the rate of interest is 9%, it would
take 72/9 8 years to double a sum of money

Can also be used to calculate the rate of

interest needed to double a sum of money by a
certain number of years.
For example, to double a sum of money in 4 years,
the rate of return would have to be approximately
18% (i.e. 72/4=18).

Annuities
An annuity is a series of equal payments made
at fixed intervals for a specified number of
periods.

Annuities
Each payment of an ordinary annuity belongs to the
payment at the end of the period.
The payment of an annuity-due refers to a payment period
starting beginning of the period.

Annuities (cont.)

Figure below illustrates the two types of annuity:

Ordinary Annuities
All annuities involve end-of-the-year receipts or
payments, therefore, they are categorized as
ordinary annuity.
Assuming current year is year 0, the first cash
receipt or payment starts at year 1.

Present Value of an Ordinary

Annuity
The present value of each payment
must be calculated by dividing each by 1
plus the discount rate raised to the
power of the number of periods
involved.
Suppose we want to find the present
value of RM50 received every year for
three years at a discount rate of 7%.
The calculation is shown in Figure below:

Present Value Ordinary

Annuities

E.g3.10: PV of Ordinary
Anuity
Abby has won a competition which pays her
$5,000 per year for 3 years, beginning one
year from today. Abby wants to know the
present value of the prize using a discount rate
of 7%.

Present Value Ordinary

Annuities (formula)

Present Value Ordinary

Annuities (financial
calculator)

Present Value Annuity

Due
The annuities are often paid with the first payment
starting at the beginning of the year- starting immediately
at year 0 is called an annuity due.
A sum of RM50 is paid every year for three years but the
first payment starts immediately.
The details are shown below:

Present Value Annuity Due (cont.)

E.g3.11: PV of Annuity Due

Abu has won a lottery of $1 million and will get
paid in 5 annual payments immediately, over a
period of 5 years. If Abus opportunity cost of
funds is 8%, what is the present value of his
jackpot?

Perpetuity
Payments of equal periodic cash flows are to be made till
infinity or forever is called a perpetuity.
Roslan has invested in a special government bond that provides
income on investment of RM100 per annum in perpetuity.
Determine the present value of this perpetual annuity if you are
told that the time value of money is 8% per annum.
Solution:
PV = PMT
r
= 100
0.08
= 1250 i.e. RM1,250

Future Value Annuity

The future value of an annuity
refers to the amount that we will
accumulate by making regular
payments at a given interest rate
over a specified period of time.
Figure below shows how the future
value is determined using an
interest rate of 9% and the yearly
payment is RM25:

Future Value Annuity

(cont. )

E.g3.12: FV of Ordinary
Annuity
Baker plans to put aside $5,000 per year so
that he can make a nice down payment on a
machine in 6 years time. If he makes the
payments at the end of each year and earns
8% on his deposits, how much will he have
accumulated at the end of 6 years?

Future Value Annuity Due

Payments are to begin immediately, NOT at
the end of the first period, we must therefore
calculate the future value of an annuity due.
As the last payment is made at the
beginning of the last period, the entire future
value of the annuity earns an extra years
interest by the end of the last period.
Similar to the present value of an annuity
calculation, to calculate the future value
multiply the future value of the annuity by 1
plus the interest rate.

FV Annuity Due

Refer to Figure below:

E.g3.13: FV of Annuity Due

Baker now plans to put aside $5,000 per year
starting now and still earns 8% on his deposits,
how much will he have accumulated at the end
of 6 years?

Effective Annual Rate

Effective annual rate (EAR)the rate has a
very significant impact on TVM
Contractual annual interest ratein FV and PV
calculations is called the nominal rate.
The formula to calculate EAR:

Effective annual rate

The effective annual rate or simply effective
rate may also be defined as the interest rate
on a loan or financial product restated from the
nominal interest rate as an interest rate with
annual compound interest payable in arrears.
In other words, it is the equivalent annual rate
after adjusting for the frequency of
compounding that occurs within a year. It is
used to compare the annual interest between
loans with different compounding terms (daily,
monthly, annually, etc)

Annual Percentage Rate

Annual percentage rate (APR) refers to the rate
obtained by multiplying the periodic short term
rate (e.g. semi-annually, quarterly, monthly, etc.)
by the number of periods in a year.
A rate that is stated in annual terms
Example: Suppose a bank is charging its credit
card holders 1.2% on a monthly basis, thus, in a
year the calculation will be:
1.2 12 = 14.4%.
This 14.4% is the APR.