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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 ...
• 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

## • The value of TIME in compounding

Time Value of Money
Which would you prefer:

## • TIME VALUE TO MONEY!!

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

## 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:

## - 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
\$1,000 for the next 3 years. You can earn 5% interest on this
- 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

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….

## - This is the key technique to value costs &

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