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Pharmacoeconomics & Health Outcomes

The time value of money:


Compounding Interest & Discounting

Leon E. Cosler, R.Ph., Ph.D.


Associate Professor of Pharmacoeconomics
Albany College of Pharmacy
MATH ...
Road Map
• Discuss the time value of money
- Saving money for the future
• Compounding interest
- Single amount
- Multiple amounts

- Today’s value of future resources


• Discounting
- Single amounts
- Multiple amounts

• Describe the use of discounting methods

• The value of TIME in compounding


Time Value of Money
Which would you prefer:

• $10,000 today or $10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is

• TIME VALUE TO MONEY!!


Time Value of Money
Why is TIME such an important element in
your decision?

TIME allows you the opportunity to postpone


consumption and earn INTEREST.
INTEREST
Compounding Interest….

Future Values of a single investment


Today you put $100 in a savings account
earning 5% annually, how much do you have
after year 1 ?

Now Year 1
$100 ???
Compounding Interest….

Future Values of a single investment


How much do you after year 5 ?
Now Year 1 Year 2 Year 3 Year 4 Year 5
$100 ##### ##### ##### ##### ????

• Formula:

- FV= C0 x (1+r)T
Present Value of Future Cash…
(single cash flow )
You have a savings bond which will pay you
$100, 3 years from now. Using a discount
rate of 5%, what’s it worth today?

When calculating present values; the interest


rate is often called the discount rate. Often,
these terms are interchangeable.

Now Year 1 Year 2 Year 3 Year 4 Year 5


? $ 100.00
The time value of money….
Present Value of Future Cash…
( single cash flow )
• Formula:

- C0= FV/ (1+r)^T

- PV= FV/ (1+r)^T


Compounding Interest….

Future Values of multiple cash flows


- Commonly referred as annuities…
You save $100 annually earning 5% interest.
How much do you have on 01/01/2010 ?

12/31/2007 12/31/2008 12/31/2009


$0.00 $0.00 $0.00
$100 $105.00 110.25
$110.25
$100 105.00
$105.00
$100.00
????
Compounding Interest….

Future Values of multiple investments


- Commonly referred as annuities…
- Calculate year by year
- or –
n
- Formula: FV = PMT * [ ( ( 1 + i )
–1)/i]
- ( I do NOT recommend using the formula…)
Using the formulas are tricky

The fine print says the formula works for deposits


made at the end of the year…
• So the value of $100 annually x 3 years @ 5%
should look like this:
FV = PMT * [ ( ( 1 + i ) n – 1 ) / i ]

Year 1 Year 2 Year 3


1/1/2007 12/31/2007 1/1/2008 12/31/2008 1/1/2009 12/31/2009

Starting Balance: $0.00 $100.00 $205.00


You save: $100.00 $100.00 $100.00
You earn: $0.00 $5.00 $10.25
Ending Balance: $100.00 $205.00 $315.25
Compounding Interest….
Present Values of multiple cash flows
- Your rich uncle promises to help you with college by given you
$1,000 for the next 3 years. You can earn 5% interest on this
money in your savings account.
- Your uncle asks you if you’d prefer to have him write a check
TODAY for all of this gift.
- How much do you ask for ???
1/1/2008 1/1/2009 1/1/2010 1/1/2011
????
$1,000 $1,050.00 $1,102.50
$1,000 $1,050.00
$1,000

- (ask me about the big Lotto lie…)


Compounding Interest….

Future Values of multiple investments


- Commonly referred as annuities…
- Calculate year by year
- or –

2723.25
Compounding Interest….

Future Values of multiple investments


- Commonly referred as annuities…
- Calculate year by year
- or –

1/1/2008 1/1/2009 1/1/2010 1/1/2011

$952.38
952.38 $1,000 $1,050.00 $1,102.50
907.03
$907.03 $1,000 $1,050.00
863.84
$863.84 $1,000
$2,723.25
2723.25
The value of TIME in compounding
• You need to save for your retirement !
You deposit $6,000 ($500 per month) once at the start of
each year, and you only earn interest on the last day of
the next year.
• Assume you will earn 6% interest on your money each
year.
• How much will you have after 30 years ?
The value of TIME in compounding
• Now assume you don’t start saving for your retirement right away.
15 years have passed, and you’ve saved nothing.
Because you now feel guilty about not having a retirement account;
you start saving DOUBLE the amount ($1000 per month = $12,000 per
year).
You save this amount for 15 years; assume you earn the same 6%.
• How much will you have after 30 years ?
The time value of money….

Present Value ( repeated cash flows )

- This is the key technique to value costs &


benefits which exceed 1 year!
That’s ALL for Today !