FIN1001 PERSONAL FINANCE AND THE SOCIETY

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• Be able to compute the future value of an investment
made today
• Be able to compute the present value of cash to be
received at some future date
• Be able to compute the return and length of an
investment
• Be able to find the future and present value for
different compounding periods

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 Time Value of Money
• A dollar received today worth more than a dollar
received five years from now
• Because today’s dollar can be saved or invested
and earn some kind of returns, such as interest
• The time value of money involves two
components: future value and present value

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 Time Value of Money
• Present Value
– the current value of an asset (or stream of
assets) that will be received in the future.
– Value at t=0 on a timeline
• Future Value
– the value of an asset at the end of a particular
time period in the future
– “Later” money on a timeline

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 Time Value of Money
• Interest rate – “exchange rate” between
earlier money and later money
– Discount rate for finding the present value of
some future amounts
– Rate of return of your savings or investment
– Cost of borrowing loans

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4.1a Simple vs Compound Interest
• Simple interest – interest is earned only on the
original principal
• Compound interest – interest is earned on BOTH
principal and interest previously received
• Example 1:
You put $10,000 into your savings account in a bank
that gives you 10% interest per year. What is the
value of the savings after 2 years?

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4.1a Simple vs Compound Interest –
Example 1
With simple interest calculation:
• In the 1st year, interest earned on principal
=
• In the 2nd year, interest earned on principal
=
• Value of savings after two years
= Principal + total interest earned
=

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4.1a Simple vs Compound Interest –
Example 1
With compound interest calculation:
• In the 1st year: interest earned on principal
=
• In the 2nd year, interest earned on both principal &
interest received previously
=

• Value of savings after two years

= Principal + total interest earned
=
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 4.1a Effects of Compounding
• Effects of compounding:
▪ The extra _____ comes from the interest of
______ earned in the first year.
▪ The effect of compounding is small for a small
number of periods, but it increases as the
number of periods increases.
▪ Compounding is the basis of ALL time value of
money considerations
▪ Most people leave the interest earned in the
account so that it will earn additional interest
on it.
▪ Compound interest is always assumed in time
value of money calculations.
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4.1b Future Values: General Formula

• 𝑭𝑽 = 𝑷𝑽 𝟏 + 𝒓 𝒕

▪ FV = future value
▪ PV = present value
▪ r = periodic interest rate, expressed as a decimal
▪ t = number of periods
• Future value interest factor = (1 + r)t

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 4.1b Future Values – Example 2
• Suppose your grandpa’s grandpa deposited $100 at
5% interest 200 years ago. How much would the
investment be worth today?
▪ 𝐹𝑉 =
• What is the effect of compounding?
▪ By simple interest:
FV =
▪ Compounding added $ to the value of
the investment!!

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 4.1b Future Values:
Two Important Relationships
1. For a given interest rate:
 The longer the time period, the higher the
future value
 For a given r, as t increases, FV increases
2. For a given time period:
 The higher the interest rate, the larger the
future value
 For a given t, as r increases, FV increases

FV = PV(1 + r)t
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 4.1c Compounding Frequency
• The effect of compounding depends on the frequency with
which interest is paid and the periodic interest rate that is
applied.
• The table shows some common compounding periods and
how many times per year interest is paid for them.
Compounding Periods Times per year (n)
Annually 1
Semi-annually 2
Quarterly 4
Monthly 12
Daily 365
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4.1c Compounding Frequency – Example 3
• Suppose you have $5,000 to invest for 15 years.
There are 3 options for your investment:
– Bank A: 8.8% interest compounded annually
– Bank B: 8.7% interest compounded semiannually
– Bank C: 8.6% interest compounded monthly
• Which bank should you choose?
Step 1: Find the periodic interest rate (r)
Step 2: Find the number of periods (t)
Step 3: Compute the future value (FV)

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4.1c Compounding Frequency – Example 3
Bank A: 8.8% interest compounded annually
• The annual interest rate
r=
• The total number of years
t=
• Future value of your investment
FV =

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4.1c Compounding Frequency – Example 3
Bank B: 8.7% interest compounded semiannually
• The semiannual interest rate
r=
• The total number of semiannual periods
r=
• Future value of your investment
=

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4.1c Compounding Frequency – Example 3
Bank C: 8.6% interest compounded monthly
• The monthly interest rate
=
• The total number of months
=
• Future value of your investment
=
Decision:
The future value of the investment in Bank___ is
the greatest ➔ Choose Bank ___
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 4.2 Present Values
• How much do I have to invest today to have some
amount in the future?
▪ 𝑭𝑽 = 𝑷𝑽 𝟏 + 𝒓 𝒕

𝑭𝑽
▪ Rearrange to solve for 𝑷𝑽 = 𝒕
𝟏+𝒓
• When we talk about discounting, we mean finding
the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

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 4.2 Present Values – Example 4a

• Suppose you need $30,000 in one year for the down

payment on a new car. If you can earn 6.5% annually,
how much do you need to invest today?

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Example 4b: What if you buy the new car
three years later?

Finding PVs is discounting, and it’s the reverse of

compounding.
0 1 2 3
6.5%

PV = ? 30,000

PV = FV(1+r)-t =

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 4.2 Present Values – Example 5
• You want to begin saving for your graduation trip in
Europe and you estimate that it will need $50,000 in
3 years. If you feel confident that you can earn 1%
per month, how much do you need to invest today?

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 4.2 Present Values – Example 6
• Your parents set up an education fund for you 15
years ago that is now worth $364,248.246. If the
fund earned 9% per year, how much did your
parents invest?

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 4.2 Present Values:
Two Important Relationships
1. For a given interest rate:
 The longer the time period, the lower the
present value
 For a given r, as t increases, PV decreases
2. For a given time period:
 The higher the interest rate, the lower the
present value
 For a given t, as r increases, PV decreases
FV
PV =
(1 + r ) t
 4.2 Present Values:
Two Important Relationships

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4.3 The Basic PV Equation - Refresher
𝑭𝑽
𝑷𝑽 = 𝒕
𝟏 + 𝒓

• There are four parts to this equation

– PV, FV, r, and t
– If we know any three, we can solve for the
fourth

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 4.3 Discount Rate
• Often, we will want to know what the implied rate
of return is in an investment
• Rearrange the basic PV equation and solve for r

𝑭𝑽 = 𝑷𝑽 𝟏 + 𝒓 𝒕
𝟏
𝑭𝑽 𝒕
𝒓= –𝟏
𝑷𝑽

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 4.3 Discount Rate – Example 7
• You are looking at an investment that will pay
$50,000 in 3 years if you invest $40,000 today.
What is the implied rate of return?

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 4.3 Discount Rate – Example 8

• Suppose you are offered an investment that will

allow you to double your money in 5 years. You
have $5,000 to invest. What is the implied rate of
return?

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4.4 Finding the Number of Periods
• Start with basic equation and solve for t
(remember your logs?!)

𝑭𝑽 = 𝑷𝑽 𝟏 + 𝒓 𝒕

𝑭𝑽
ln
𝒕= 𝑷𝑽
ln 𝟏 + 𝒓

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 4.4 Number of Periods – Example 9

• You want to purchase a new car and you are willing

to pay $180,000. If you can invest at 8% per year
and you currently have $100,000, how long will it
be before you have enough money to pay cash for
the car?

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4.4 Number of Periods – Example 10

• How long does it need to take to double your

investment which gives 10% rate of returns
annually?

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 Rule of 72
• For a given rate of return, the approximate time it
takes to double your money is given by 72/r%.
• For example, $1 invested at 10% would take
approximately 7.2 years to turn into $2. In reality, it
will take 7.2725 years to double.
• Q: You have been an investment that promises to
double your money every 15 years. What is the
approximate rate of return on the investment?
• A: From the rule of 72, the rate of return is given
approximately by 72/r% = 15, so the rate is
approximately ____%. Verify that the exact answer is
_____________________. 37
Table 4.4

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