Lecture 3

Time Value of Money I

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 MONASH BUSINESS SCHOOL

Lecture Sources
i. Keown, A. J., Martin, J. D., and Petty, J. W. (2020).
Foundations of Finance. Tenth Edition. Pearson. (Chapter 5)
ii. Foundations of Finance Unit Reader BFF1001 (Custom
Edition EBook) compiled by Dr Jason Tze Jong Choo (2019).
(Chapter 2)
iii. Dahlquist, J., and Knight, R. (2022). Principles of Finance.
OpenStax. (Chapter 7) (Link)

2
 MONASH BUSINESS SCHOOL

Learning outcomes
1. Understand the concept of the time value of money (TVM).
2. Apply timelines to solve TVM problems and differentiate
simple and compound interest.
3. Compute the future value of a sum of money or cash flow.
4. Compute the present value of a sum of money or cash flow.
5. Understand additional TVM problems.
6. Compute the future or present value of a sum of money or
cash flow when there are non-annual compounding periods.

3
 Lecture 3
Time Value of Money I
Part 1:
Time Value of Money Concept

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Time Value of Money Concept

 Let’s say you have won a cash prize of RM10,000. You have two options:

Option 1: Receive RM10,000 now or today.

Option 2: Receive RM10,000 in 4 years.

Which option will you choose?

 The answer depends on your understanding of the time value of money (TVM).

5
 Time Value of Money Concept
 Time value of money (TVM) = a dollar received today is worth more than a dollar received at some
point in the future.
Reasons:
i. Inflation
• Inflation (rising prices) erodes purchasing power.
• What you can buy now for a dollar will not be equivalent to what that dollar will be able to
purchase one year or a few years from now.
• Example: the RM10,000 you receive today will be worth more than the RM10,000 that
you receive 4 years from now due to the possibility of inflation.
ii. Money received now can be saved or invested now to earn return  more money in future.
• Example: If you decide to take the RM10,000 in 4 years, you may be giving up an
opportunity to invest the RM10,000 and earn interest for 4 years – opportunity cost is the
interest that you could earn if you invested the money for 4 years. Opportunity cost is the
cost of making a choice in terms of the next best alternative that must be foregone.
iii. Risk
• Future payments of cash carry risks – e.g., default risk. > what's this ?
-

6
 Time Value of Money Concept
 TVM is based on the fact that it is possible to earn interest income on cash that is deposited in an
investment or interest-bearing account.
 Over time, interest is earned on amounts invested today (present value), which effectively means
that time will add value to the savings (future value).
 The longer the investment period, the more interest income will be generated.
 The higher the interest rate on the investment, the more the money will grow.
 There are two forms of valuation of money:
(i) Single or lump sum payment (cash outflow) and receipt (cash inflow)
(ii) Multiple payments (cash outflow) and receipts (cash inflow)
 The valuation of money can be further divided into two categories:
(i) Future value (FV) – what a cash flow will be worth in the future
(ii) Present value (PV) – what cash flow would be worth today
7
 Time Value of Money Concept
 Let’s say you have won a cash prize of RM10,000. You have two options:

Option 1: Receive RM10,000 now or today.

Option 2: Receive RM10,000 in 4 years.

Which option will you choose?

 You would choose Option 1 to receive the RM10,000 today.

 You can increase the future value of your money by investing and gaining interest over a period of
time – i.e., you will earn the principal amount (RM10,000) plus interest.

 If you select Option 2, then the payment you receive in 4 years (i.e., RM10,000) will be your future
value.

8
 Lecture 3
Time Value of Money I
Part 2:
Timeline and Compound Interest

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Using Timelines to Visualize Cash Flows
 Timeline = Linear representation of the timing of cash flows.
 A timeline identifies the timing and amount of a stream of cash flows – both cash received and
spent – along with the interest rate it earns.
Why why
Time
↑ ↑

End of End of
Period 1 & Period 3 &
Beginning Beginning
of Period 2 of Period 4

 Time periods can be expressed in years, months, and days.

 Negative cash flow = cash outflow
 Positive cash flow = cash inflow

10
 Using Timelines to Visualize Cash Flows
Example 1
Suppose you lend a friend RM100,000 today to help him finance a new Marry Brown fast-food
franchise, and in return, he promises to give you RM121,551 at the end of the fourth year. How can
this situation be represented in a timeline? The interest rate is 5% for one period (i.e., one year).

𝑟 = 5%

0 1 2 3 4

−𝑅𝑀100,000 𝑅𝑀121,551

11
 Using Timelines to Visualize Cash Flows
Example 2
Suppose that you made an investment of RM40,000 today that returns nothing in one year, RM20,000
at the end of year 2, nothing in year 3 and RM40,000 at the end of year 4. The interest rate is 13.17%
for one period. How can this situation be represented in a timeline?

𝑟 = 13.17%
0 1 2 3 4

−𝑅𝑀40,000 𝑅𝑀0 𝑅𝑀20,000 𝑅𝑀0 𝑅𝑀40,000

12
 Simple Interest
 Interest is earned only on principal.
 Example 3: Compute simple interest on RM100 invested at 6% per year for three years.

Years Principal Interest Total Amount Received

1 RM100.00 RM6.00
2 RM100.00 RM6.00
3 RM100.00 RM6.00
Total principal and interest earned RM100.00 RM18.00 RM118.00

13
 Compound Interest
 Compounding is when interest paid on an investment during the first period is added to the
principal; then, during the second period, interest is earned on the new sum (i.e., the principal and
interest earned so far).
 Example 4: Compute compound interest on RM100 invested at 6% compounded annually for three
years.

Years Principal Interest Total Amount Received

1 RM100.00 RM6.00 RM106.00
2
3
RM106.00
RM112.36
↳ RM6.36
RM6.74
RM112.36
RM119.10
Total interest earned RM19.10 RM 337 46
.

14
 Lecture 3
Time Value of Money I
Part 3:
Single Cash Flow - Future Value

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Future Value (FV)
 Future value (FV) is the amount to which your cash flow will grow or a future dollar amount.
 FV calculates the movement of money forward in time - this process is called compounding.
𝑟
0 1 2 3 𝑛

𝐶 ???

Compounding
 Formula: Future value factor = the value of
𝒏
𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓) (1 + 𝑟) used as a multiplier to
calculate an amount’s FV.
FV = Future value of the cash flow at the end of “n” periods
PV = Present value or initial or original amount of cash flow invested at time 0
r = Interest rate per period
n = Number of periods
16
 Future Value (FV)
Example 5
You lend RM100 to your colleague for 2 years at an interest rate of 6% for one period (i.e., one year).
What is the future value?
𝑟 = 6%
Note:
0 1 2 $ = use 4 decimal places
% = use 6 decimal places
−𝑅𝑀100 × 1.06 𝑅𝑀106 × 1.06 𝑅𝑀112.36

Method 1: Mathematical Calculation Method 2: Financial Calculator Method 3: Excel Spreadsheet

𝐹𝑉 = 𝑃𝑉 × 1 + 𝑟 × (1 + 𝑟) HP10bII+ 6 𝑖/𝑦𝑟
𝐹𝑉 = 𝑅𝑀100 × 1 + 0.06 × (1 + 0.06)
2 𝑛
𝐹𝑉 = 𝑅𝑀112.3600 0 𝑝𝑚𝑡 >
- what's this ?

𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏 −𝑅𝑀100 𝑃𝑉
𝐹𝑉 = 𝑅𝑀100 × (1 + 0.06) 𝐹𝑉 𝑅𝑀112.3600
𝐹𝑉 = 𝑅𝑀100 × 1.123600
𝐹𝑉 = 𝑅𝑀112.3600
17
 Future Value (FV)
Example 6
You have won a cash prize of RM10,000. You decided to receive the money today and invest it in a
fixed deposit account for 4 years. The interest rate is 5% compounded annually. How much will you
receive at the end of 4 years?
𝑟 = 5%
0 1 2 3 4

−𝑅𝑀10,000 ???

Method 1: Mathematical Calculation Method 2: Financial Calculator Method 3: Excel Spreadsheet

HP10bII+
5 𝑖/𝑦𝑟
𝑭𝑽 = 𝑷𝑽 𝒙 (𝟏 + 𝒓)𝒏
4 𝑛
𝐹𝑉 = 𝑅𝑀10,000 × (1 + 0.05) 0 𝑝𝑚𝑡
𝐹𝑉 = 𝑅𝑀10,000 × 1.21550625 −𝑅𝑀10,000 𝑃𝑉
𝐹𝑉 = 𝑅𝑀12,155.0625 𝐹𝑉 𝑅𝑀12,155.0625

18
 Relationship Between Variables
 Future value (FV) increases by:
(i) Increasing the interest rate (r)
(ii) Increasing number of periods of compounding (n)
(iii) Increasing the initial or original investment (PV)

 Change the interest rate (r):

Example 7:
You deposit $500 in the bank for 2 years. What is the FV at 2% compounded annually? What is the
FV if you change the interest rate to 6% compounded annually?

𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏

𝐹𝑉 𝑎𝑡 2% = $500 × (1 + 0.02) = $𝟓𝟐𝟎. 𝟐𝟎𝟎𝟎

𝐹𝑉 𝑎𝑡 6% = $500 × (1 + 0.06) = $𝟓𝟔𝟏. 𝟖𝟎𝟎𝟎

19
 Relationship Between Variables
 Change in number of periods (n)
Example 8:
Continue the same example but change the time to 10 years. What is the FV now?

𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏

𝐹𝑉 𝑎𝑡 6% = $500 × (1 + 0.06) = $𝟖𝟗𝟓. 𝟒𝟐𝟑𝟖

 Change in the value of the initial or original investment (PV)

Example 9:
Continue the same example but change the contribution to $1,500. What is the FV now?

𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏

𝐹𝑉 𝑎𝑡 6% = $1,500 × (1 + 0.06) = $𝟐, 𝟔𝟖𝟔. 𝟐𝟕𝟏𝟓

20
 Relationship Between Variables
 The figure below illustrates that we can increase the FV by:
(i) Increasing the number of periods (years) for which money is invested; and/or
(ii) Investing at a higher interest rate.

Source: Keown, A. J., Martin, J. D., and Petty, J. W. (2020). Foundations of Finance. Tenth Edition. Pearson.
21
 Lecture 3
Part 4
Time Value of Money I:
Single Cash Flow - Present Value

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Present Value (PV)
 Present value (PV) is the current value of a future cash flow or the fair value of a security.
 PV calculates the movement of money backwards in time - this process is called discounting.
𝑟
0 1 2 3 𝑛

??? 𝐶

Discounting
Present value factor = the value of
 Formula: 𝟏
𝑷𝑽 = 𝑭𝑽 × ( )
used as a multiplier to
(𝟏 + 𝒓)𝒏
calculate an amount’s PV.
PV = Present value or initial or original amount invested at time 0
FV = Future value of the cash flow at the end of “n” periods
r = Interest rate per period
n = Number of periods
23
 Present Value (PV)
Example 10
What is the present value of an investment that yields RM500 to be received in 2 years? The discount
(interest) rate is 6% for one year. 𝑟 = 6%
0 1 2

−𝑅𝑀444.9982 ÷ 1.06 𝑅𝑀471.6981 ÷ 1.06 𝑅𝑀500

Method 1: Mathematical Calculation Method 2: Financial Calculator Method 3: Excel Spreadsheet
𝑃𝑉 = 𝐹𝑉 ÷ 1 + 𝑟 ÷ (1 + 𝑟) HP10bII+
𝑃𝑉 = 𝑅𝑀500 ÷ 1 + 0.06 ÷ (1 + 0.06) 6 𝑖/𝑦𝑟

𝑃𝑉 = 𝑅𝑀444.9982 2 𝑛
𝟏 0 𝑝𝑚𝑡
𝑷𝑽 = 𝑭𝑽 ×
(𝟏 + 𝒓)𝒏 − 𝑅𝑀500 𝐹𝑉
1
𝑃𝑉 = 𝑅𝑀500 ×
(1 + 0.06) 𝑃𝑉 𝑅𝑀444.9982
𝑃𝑉 = 𝑅𝑀500 × 0.8899964
FV = PV x (1 + r)"
𝑃𝑉 = 𝑅𝑀444.9982 24

FV = PV
-

(1 + r)"
 Present Value (PV)
Example 11
Your firm has just sold a piece of property for RM500,000, but under the sales agreement, it will not
receive the RM500,000 until 10 years from today. What is the present value of RM500,000 to be
received 10 years from today if the discount rate is 6% for one period?
𝑟 = 6%
0 1 2 … 10

??? 𝑅𝑀500,000

Method 1: Mathematical Calculation Method 2: Financial Calculator Method 3: Excel Spreadsheet

𝟏 HP10bII+ 6 𝑖/𝑦𝑟
𝑷𝑽 = 𝑭𝑽 ×
(𝟏 + 𝒓)𝒏 10 𝑛
1 0 𝑝𝑚𝑡
𝑃𝑉 = 𝑅𝑀500,000 ×
(1 + 0.06)
−𝑅𝑀500,000 𝐹𝑉
𝑃𝑉 = 𝑅𝑀279,197.3885 𝑃𝑉 𝑅𝑀279,197.3885
25

↓
 Relationship Between Variables
 Present value (PV) decreases by:
(i) Increasing the interest rate (r) Note: Present value (PV)
decreases (increases) by the
(ii) Increasing number of periods (n)
decreasing (increasing)
future value.
 Change the interest rate (r):
Example 12:
What is the PV of $500 to be received 2 years from today if the discount rate is at 2% per period?
What is the PV if you change the interest rate to 6% for one period?
𝟏
𝑷𝑽 = 𝑭𝑽 ×
(𝟏 + 𝒓)𝒏
$500
𝑃𝑉 𝑎𝑡 2% = = $𝟒𝟖𝟎. 𝟓𝟖𝟒𝟒
(1 + 0.02)

$500
𝑃𝑉 𝑎𝑡 6% = = $𝟒𝟒𝟒. 𝟗𝟗𝟖𝟐
(1 + 0.06)

26
 Relationship Between Variables

 Change the number of periods (n):

Example 13:
Continue the same example but change the time to 10 years. What is the PV now?
𝟏
𝑷𝑽 = 𝑭𝑽 ×
(𝟏 + 𝒓)𝒏

$500
𝑃𝑉 𝑎𝑡 6% = = $𝟐𝟕𝟗. 𝟏𝟗𝟕𝟒
(1 + 0.06)

27
 Relationship Between Variables
 The figure below shows that the PV is lower if:
(i) Time period is longer; and/or
(ii) Interest rate is higher.

Source: Keown, A. J., Martin, J. D., and Petty, J. W. (2020). Foundations of Finance. Tenth Edition. Pearson.
28
 Lecture 3
Time Value of Money I
Part 5:
Single Cash Flow – Additional
Time Value of Money Problems

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Solving for the Number of Periods (n)

Example 14
If you deposit RM5,000 today in an account paying 10% per period how long will it take for this
deposit to grow to RM10,000?
𝑟 = 10%
𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏
0 1 2 … ??? 𝑅𝑀10,000 = 𝑅𝑀5,000 × (1 + 0.10)
𝑅𝑀10,000
𝑅𝑀5,000 𝑅𝑀10,000 = (1.10)
𝑅𝑀5,000
2 = (1.10)
𝑙𝑛 2 = (𝑛) ln(1.10)
𝐼𝑛(2)
=𝑛
𝐼𝑛(1.10)
𝟕. 𝟐𝟕𝟐𝟓 𝒚𝒆𝒂𝒓𝒔 = 𝒏

30
 The Rule of 72
 The Rule of 72 can be used to find out approximately how long it will take to double your money.
 The formula for the rule of 72 is expressed as follows:

𝟕𝟐
𝒀𝒆𝒂𝒓𝒔 𝒇𝒐𝒓 𝒂𝒏 𝒂𝒎𝒐𝒖𝒏𝒕 𝒕𝒐 𝒅𝒐𝒖𝒃𝒍𝒆 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 (𝒓)

 It is important to note that the interest rate (r) should be expressed as a whole number or integer (e.g., 5%
and not 0.05).
 If you can invest at r% per annum, it will take you approximately 72/r to double your money.
 Example 15: Rena has invested RM1,000 (PV) at 6% per annum and wants to know approximately how long
it will take for her money to grow to RM2,000 (FV).
72
𝑌𝑒𝑎𝑟𝑠 𝑓𝑜𝑟 𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑑𝑜𝑢𝑏𝑙𝑒 = ≈ 𝟏𝟐 𝒚𝒆𝒂𝒓𝒔
6
 Rena will need 12 years for her RM1,000 to become RM2,000 at an investment rate of 6%.
 If Rena’s account earns an interest rate of 9%, then it will take 8 years (72/9) for her money to double.

31
 Solving for the Interest Rates (r)
Example 16
Assume the total cost of a 3-year commerce university education will be RM100,000 when your child
enters university in 20 years. Assume you have RM5,000 to invest today. What rate of interest must
you earn on your investment to achieve the goal?
𝑟 =? ? ? 𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏
0 1 2 … 20 𝑅𝑀100,000 = 𝑅𝑀5,000 × (1 + 𝑟)
𝑅𝑀100,000
𝑅𝑀5,000 𝑅𝑀100,000 = (1 + 𝑟)
𝑅𝑀5,000
20 = (1 + 𝑟)
×
(20) = 1 + 𝑟
1.161586 = 1 + 𝑟
1.161586 − 1 = 𝑟
𝟎. 𝟏𝟔𝟏𝟓𝟖𝟔 = 𝒓
𝟏𝟔. 𝟏𝟓𝟖𝟔% = 𝒓
32
 Lecture 3
Time Value of Money I
Part 6:
Making Interest Rates
Comparable

BFW1001 Foundations of Finance

Lecturer: Sheena Sara Suresh Philip, Ph.D.
 Making Interest Rates Comparable
 The interest rates can also have different compounding periods per year (e.g., monthly, quarterly,
semi-annually, and daily). The one period is not always one year or compounded annually or once a
year.

One period Number of compounding periods per year (m)

1 week 52
1 month 12
2 months 12 / 2 = 6
3 months (1 quarter) 12 / 3 = 4
6 months (semi-annual) 12 / 6 = 2
90 days (360 days in a year) 360 / 90
90 days (365 days in a year) 365 / 90

Table: Length of one period and compounding periods per year

34
 Making Interest Rates Comparable
 We cannot compare interest rates with different compounding periods. For example, 5%
compounded annually (i.e., once a year) is not the same as 5% compounded quarterly (i.e., 4 times
a year).
 To make the interest rates comparable, we need to understand the (i) nominal interest rate and (ii)
equivalent effective annual rate (EAR).
 Nominal interest rate is the interest rate that indicates the amount of interest earned or paid in 1
year without adjusting for compounding.
 Nominal interest rate also refers to the quoted or stated interest rate or annual percentage rate -
the interest rate that was stated by the bank, lender or credit card company.
𝐍𝒐𝒎𝒊𝒏𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒓𝒎 = 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒑𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 𝒓 × 𝑵𝒐. 𝒐𝒇 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅𝒔 𝒑𝒆𝒓 𝒚𝒆𝒂𝒓 (𝒎)

 Interest rate per period (𝑟) includes interest rate per year, per month, per quarter, every 6 months
or per week. If the nominal interest rate is known and you want to find the interest rate per period
or effective 1-period interest rate (r), then: 𝒓𝒎
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 𝒑𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 𝒓 =
𝒎
35
 Making Interest Rates Comparable
 Example 17: If the interest rate per month is 0.5% (r = 0.005), then the nominal interest rate is:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟 = 𝑟 × 𝑚 = 0.005 × 12 = 0.06
The r = 0.005 and m = 12 (i.e., 12 months per year). The nominal interest rate is quoted as 6% per
annum compounded monthly (i.e., 12 times a year).
 Example 18: If the interest rate per quarter is 1.5% (r = 0.015), then the nominal interest rate is:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟 = 𝑟 × 𝑚 = 0.015 × 4 = 0.06

The r = 0.015 and m = 4 (i.e., 4 quarters per year). The nominal interest rate is quoted as 6% per
annum compounded quarterly (i.e., 4 times a year).
 Example 19: If the semi-annual interest rate is 3% (r = 0.03), then the nominal interest rate is:

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟 = 𝑟 × 𝑚 = 0.03 × 2 = 0.06

The r = 0.03 and m = 2 (i.e., semi-annual). The nominal interest rate is quoted as 6% per annum
compounded semi-annually (i.e., 2 times a year).

36
 Making Interest Rates Comparable
 Nominal interest rate does not help much when the rates being compared are not compounded for
the same number of periods per year.
• For example, the nominal interest rate of 8.084% (i.e., compounded annually) and 7.85% (i.e.,
compounded quarterly) are not comparable because they have different compounding
frequencies.
 Nominal interest rates with different compounding periods can be compared using the equivalent
effective annual rate (EAR).

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 Making Interest Rates Comparable
 Equivalent effective annual rate (EAR) refers to the annual compound rate that produces the same
returns as the nominal interest rate when money is compounded on a nonannual basis - provides
the true rate of return.
𝒎
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 (𝒓𝒎 )
𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝑨𝒏𝒏𝒖𝒂𝒍 𝑹𝒂𝒕𝒆 (𝑬𝑨𝑹) = 𝟏+ −𝟏
𝑵𝒐. 𝒐𝒇 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅𝒔
𝒑𝒆𝒓 𝒚𝒆𝒂𝒓 (𝒎)

 Example 20: The nominal interest rate of a loan in Bank A is 8.0841% (i.e., compounded annually),
and the loan in Bank B is 7.8500% (i.e., compounded quarterly). Which loan do you prefer?
 You first need to convert the rates to the same number of compounding periods (i.e., annual rate).

0.0785
𝐸𝐴𝑅 = 1 + − 1 = 0.080841 or 8.0841%
4

 You should be indifferent because both banks offer the same EAR.
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 Making Interest Rates Comparable
 If interest is not paid annually, we need to change the interest rate and time period to reflect the
nonannual periods while computing the future value (FV) and present value (PV) of money.
𝒓𝒎
𝒓=
# 𝒐𝒇 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅𝒔 (𝒎)

𝒏 = # 𝒐𝒇 𝒚𝒆𝒂𝒓𝒔 𝒙 # 𝒐𝒇 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝒑𝒆𝒓𝒊𝒐𝒅𝒔 (𝒎)

 Example 21: If your investment earns 10% a year, with quarterly compounding for 10 years, what is
the “r” and “n”?
0.10
𝑟= = 0.025 = 2.5%
4
𝑛 = 10 × 4 = 40 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

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 Making Interest Rates Comparable
Example 22
If Rafiq places RM100 in a savings account with a nominal interest rate of 12% compounded quarterly,
what will his investment grow to at the end of 5 years?
PV = RM100
𝑟 = 3%
r = 0.12 / 4 = 0.03 0 1 2 3 … 20
n = 5 x 4 = 20
FV = ??? −𝑅𝑀100 ???

𝑭𝑽 = 𝑷𝑽 × (𝟏 + 𝒓)𝒏
= 𝑅𝑀100 × (1 + 0.03)

= 𝑹𝑴𝟏𝟖𝟎. 𝟔𝟏𝟏𝟏

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 Making Interest Rates Comparable
Example 23
Melissa would like to deposit an amount of money today to achieve a savings target of RM1,000 in 5
years. She will deposit her money in a savings account paying a nominal interest rate of 8%, and the
investment is compounded semiannually (i.e., 2 times a year).

𝑟 = 4%
FV = RM1,000 0 1 2 3 … 10
r = 0.08 / 2 = 0.04
n = 5 x 2 = 10 ??? 𝑅𝑀1,000
PV = ???
𝟏
𝑷𝑽 = 𝑭𝑽 ×
(𝟏 + 𝒓)𝒏
1
𝑃𝑉 = 𝑅𝑀1,000 × = 𝑹𝑴𝟔𝟕𝟓. 𝟓𝟔𝟒𝟐
(1 + 0.04)

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 MONASH BUSINESS SCHOOL

Recommended Reading
i. Keown, A. J., Martin, J. D., and Petty, J. W. (2020).
Foundations of Finance. Tenth Edition. Pearson. (Chapter 5)
ii. Foundations of Finance Unit Reader BFF1001 (Custom
Edition EBook) compiled by Dr Jason Tze Jong Choo (2019).
(Chapter 2)
iii. Dahlquist, J., and Knight, R. (2022). Principles of Finance.
OpenStax. (Chapter 7) (Link)

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MONASH
BUSINESS