MONEY-TIME RELATIONSHIPS AND

EQUIVALENCE

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 LEARNING OUTCOME
• Money Time Value of Single (Payment) Cash Flow
• Understand the concept
• Able to solve related problems

• Money Time Value of Multiple (Payment) Cash Flow

• Understand the concept
• Able to solve related problems

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 1.0 REVIEW
• Time Value of Money

• Interest and Interest Rate

• Simple Interest and Compound Interest

• Cash Flow Diagram

• Economic Equivalent

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 1.1 TIME VALUE OF MONEY
Congratulations!!! You have won a cash prize! You have two
payment options:
A - Receive $10,000 now OR
B - Receive $10,000 in three years.

Which option would you choose?

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2 Dimensions of Money

• How much?

• When?

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Why we need to measure the time value of money?

• If you are on diet or body building, what kind of measurement

to chart your progress?

• The same principle goes for money. You need to chart how
well you are doing, how effective is your approach, is the
option A is better than the option B?, etc.

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Why will any time value of money do to you?

• It will tells you the value of money in different periods

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What is the RM10 worth in time period 3?

Today ?
RM10 RM ??

0 1 2 3 4
1 year ?

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Present Value (PV)
Future Equivalent Value (FV)

RM10 RM ??
(PV) (FV)

0 1 2 3 4

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Money, when invested, makes money.

Money today is worth more than money in the future.

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 1.2 INTEREST AND INTEREST RATE
 Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money (PTPTN)
• Difference between an ending amount of money and a beginning amount
of money

 Interest = amount owed now – principal

 Interest rate – Interest paid over a time period expressed as a percentage of

principal


 1.3 SIMPLE (NOMINAL) INTEREST
RATE
Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = (P)(n)(i) F = P [1+(i)(n)]

Example: $100,000 lent for 3 years at simple i = 10% per year. What is
repayment after 3 years?
Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

 1.4 COMPOUND (EFFECTIVE)
INTEREST RATE
Compound Interest
Whenever the interest charge for any interest period is based on the
remaining principal amount plus any accumulated interest charges up
to the beginning of that period.

That is, interest compounds over time

Interest = (principal + all accrued interest) (interest rate)
F = P [1+(i)] n
Interest for time period t is
 1.4 COMPOUND (EFFECTIVE)
INTEREST RATE
Example: For an investment of $500 at an interest rate of 8% p.a. for
four years, what would be the future value of this investment,
a) Assuming simple interest?
F = $500(1 + (4)(0.08)) = $660
a) Assuming compound interest?
F = $500(1 + 0.08)4 = $680.24
Example: How much would I need to invest in a savings account
yielding 6% interest p.a. to have $5000 in five years’ time?
P = F / (1+i)n = $5,000 / (1+0.06)5 = $3,736.29
 1.5 EFFECTIVE PERIODIC RATE (r)
Definition
The amount of interest made from one dollar after one period

Suppose I deposit RM1 today, and 6 months later I have RM1.05

What is the effective 6-month rate?

r = 5/100 =0.05 or 5%

RM1 RM1.05

0 1
 1.5 EFFECTIVE PERIODIC RATE (r) &
EFFECTIVE ANNUAL INTEREST
RATE (ia)
Definition
r = inom / m i a = [1 + (inom / m)]m – 1

Example: For the case of 12% p.a. compounded monthly,

inom = 0.12, m = 12 (months in a year), thus, r = 0.12/12 = 0.01 (or 1% / month)
Example: What is the effective annual interest rate for a nominal rate of 8% p.a.
when compounded monthly?
i a = (1+0.08/12)12 – 1 = 0.083 (or 8.3% / year)

Use i a instead of inom when comparing alternatives.

 Effective Periodic Rate

r = 18% per year, compounded CP-ly

CP m i% Effective rate, i a
Year 1 18 (1.18)1 - 1= 18%
6 months 2 9 (1.09)2 - 1= 18.81%
Quarter 4 4.5 (1.045)4 - 1= 19.25%
Month 12 1.5 (1.015)12 - 1= 19.562%
Week 52 0.35 (1.0035)52 - 1= 19.68%

i a= (1 + i)m - 1
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 1.6 CASH FLOW DIAGRAMS / TABLE NOTATION
r = effective interest rate per interest period
i =nominal interest rate or APR
t = number of compounding periods (e.g., month, quarter, years)
PV = present sum of money; the equivalent value of one or more cash flows at the
present time reference point
FV = future sum of money; the equivalent value of one or more cash flows at a
future time reference point
A = end-of-period cash flows (or equivalent end-of-period values ) in a uniform
series continuing for a specified number of periods, starting at the end of the first
period and continuing through the last period
G = uniform gradient amounts -- used if cash flows increase by a constant amount
 CASH FLOW DIAGRAM NOTATION

1
1 2 3 4 5=t

1 Time scale with progression of time moving from left to right; the numbers represent
time periods (e.g., years, months, quarters, etc...) and may be presented within a time
interval or at the end of a time interval.
 CASH FLOW DIAGRAM NOTATION

1
1 2 3 4 5=t
PV =$8,000 2
1 Time scale with progression of time moving from left to right; the numbers represent
time periods (e.g., years, months, quarters, etc...) and may be presented within a time
interval or at the end of a time interval.

2 Present expense (cash outflow) of $8,000 for lender.

 CASH FLOW DIAGRAM NOTATION
A = $2,524 3
1
1 2 3 4 5=t
PV =$8,000 2
1 Time scale with progression of time moving from left to right; the numbers represent
time periods (e.g., years, months, quarters, etc...) and may be presented within a time
interval or at the end of a time interval.

2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

 CASH FLOW DIAGRAM NOTATION
A = $2,524 3
1
1 2 3 4 5=t
P =$8,000 2 4 i,r = 10% per year
1 Time scale with progression of time moving from left to right; the numbers represent
time periods (e.g., years, months, quarters, etc...) and may be presented within a time
interval or at the end of a time interval.

2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

4 Interest rate of loan.

 CASH FLOW DIAGRAM NOTATION
A = $2,524 3 5
1
1 2 3 4 5=t
P =$8,000 2 4 i,r = 10% per year
1 Time scale with progression of time moving from left to right; the numbers represent
time periods (e.g., years, months, quarters, etc...) and may be presented within a time
interval or at the end of a time interval.

2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

4 Interest rate of loan. 5 Dashed-arrow line indicates

amount to be determined.
 1.6 Economic Equivalence
Different sums of money at different times may be equal in
economic value at a given rate $106

Year

0 1
Rate of return = 6% per year

$100 now $100 now is economically equivalent to $106 one year from now,
if the $100 is invested at a rate of 6% per year.
Use interest rate i and time t in upcoming relations to move money
(values of P, F and A) backwards and forwards between time periods t
= 0, 1, …, n to make them equivalent (not equal) at the rate i
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Established when we are indifferent between a future payment, or a series
of future payments, and a present sum of money .
Considers the comparison of alternative options, or proposals, by reducing
them to an equivalent basis, depending on:
interest rate;
amounts of money involved;
timing of the affected monetary receipts and/or expenditures;
manner in which the interest , or profit on invested capital is paid and
the initial capital is recovered.

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Example:
I borrow $1,000, $1,200, and $1,500 from a bank (at 8% p.a. effective interest rate) at the end of years
1, 2, and 3, respectively. At the end of year 5, I make a payment of $2,000, and at the end of year 7, I
pay off the loan in full.

a) Construct the cash flow diagram.

b) Determine the amount of final payment.
c) Determine the amount of interest paid to the bank.
d) Compare the amount repaid based on the end of year 1.
Example:
I borrow $1,000, $1,200, and $1,500 from a bank (at 8% p.a. effective interest rate) at the end of years
1, 2, and 3, respectively. At the end of year 5, I make a payment of $2,000, and at the end of year 7, I
pay off the loan in full. $1,500
a) $1,000
$1,200
F = P [1+(i)] n

5 6 7

0 1 2 3 4 Years

For withdrawals (loan),

b) F6 = ($1000)(1+0.08)6 = $1,586.87
F5 = ($1200)(1+0.08)5 = $1,763.19 $2,000 X
F4 = ($1500)(1+0.08)4 = $2,040.73
Total withdrawals = $5,390.79
Interest paid to bank,
For repayments, c) Withdrawals = $1000 + $1200 + $1500 = $3,700
F2 = – ($2000)(1+0.08)2 = – $2,332.80 Repayments = – $2000 – $X
F0 = – ($X)(1+0.08)0 = – $X Solving for X, 0 = $3700 – $2000 – $X, X = $1,700
Total repayments = – $2,332.80 – $X Interest paid = $3058 – $1700 = $1,358
Solving for X,
0 = $5,390.79 – $2,332.80 – $X
X = $3,057.99 ≈ $3,058
Example:
I borrow $1,000, $1,200, and $1,500 from a bank (at 8% p.a. effective interest rate) at the end of years
1, 2, and 3, respectively. At the end of year 5, I make a payment of $2,000, and at the end of year 7, I
pay off the loan in full. $1,500
$1,200
$1,000
5 6 7

0 1 2 3 4 Years

d) Compare the amount repaid based

on the end of year 1.
$2,000 X
F0 = $1000
F–1 = ($1200)(1+0.08)–1 When cash flows occur at different times,
F–2 = ($1500)(1+0.08)–2 each cash flow must be brought forward
F–4 = – ($2000)(1+0.08)–4
F–6 = – ($X)(1+0.08)–6 (or backward) to the same point in time
and then compared.
Solving for X,
0 = $1000 + ($1200)(1+0.08)–1 + ($1500)(1+0.08)–2 – ($2000)(1+0.08)–4 – ($X)(1+0.08)–6
X ≈ $3,058 ( same answer as before!)
 QUIZ
1. A company has extra funds to invest for future capital expansion. If
the selected investment pays simple interest, what interest rate would
be required for the amount to grow from RM60,000 to RM90,000 in
5 years?

2. Construct a cash flow diagram for the following cash flows: RM25,000
outflow at time 0, RM9,000 per year inflow in years 1 through 5 at an
interest rate of 10% per year, and an unknown future amount in year 5.

3. Construct a cash flow diagram that represents the amount of money

that will be accumulated in 15 years from an investment of RM40,000
now at an interest rate of 8% per year.

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 2.0 RELATING PRESENT AND FUTURE
EQUIVALENT VALUES OF SINGLE
(PAYMENT) CASH FLOWS

Refers to moving a single dollar amount up and down the time line.

Let’s derive the relationship between PV and FV

Examples of Single Cash Flow

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Lets assume you deposit RM100 with a bank today who state they
will pay you 10% interest in one year.

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How many ringgits will you have in one year?

RM100 (PV) RM ? (FV)

0 1
i = 10% or r?

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 RM100 RM 110

0 1
i = 10%
r = 0.1
How do you get RM110?

Future Value (FV) = RM100 + RM100(0.1)=RM110

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 RM100 RM 110

0 1
i = 10%
r = 0.1
FV = RM100 + RM100(0.1)=RM110
FV = RM100 (1+0.1)=RM110

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RM100
RM 110

0 1
i = 10%
r = 0.1
FV = RM100 (1+0.1)=RM110

What does it means?

It means when we move RM100 forward 1 time period, we multiple

the initial value (present value) with (1+0.1).
 FV = RM100(1+0.1)

RM100 RM 110

0 1
i = 10%
r = 0.1
What would you multiply the PV (RM100) if you want to move it
over 2 time period?

FV = RM100(1+0.1) ?

RM100

0 1 2
i = 10%
r = 0.1
 FV = RM100(1+0.1)(1+0.1)=RM100(1+0.1)2 =R M121

RM100 RM110 RM121

0 1 2

i = 10%
r = 0.1
FV = RM100(1+0.1)2

FV = PV(1+0.1)2
FV = PV (1+r)t FV = PV (1+i)n

FV = Future Value of money

PV = Present Value of money
r = effective period rate
t = number of time periods
SINGLE CASH FLOW FORMULA
PV FV

0 1 t

FV = PV (1+r)t

The only single cash flow formula that exist

You can move cash flows forwards or backwards in time
r and t must be correspond or match
General approach in solving single cash flow problem.
1. Interpret the problem by drawing a cash flow time line diagram
2. Solve the problem
Problem 2.1
A bank pays 12% compounded quarterly. What is the equivalent 6
month effective rate (r) ?.

How do we know that 12% is not an effective rate? If not stated by the
bank, by convention the interest rate is the APR (nominal or Annual
Percentage Rate).
A bank pays 12% compounded quarterly. What is the equivalent 6
month effective rate (r).

rq = 0.12/4 = 0.03

0 One quarter 1 2 3 4

i = 12%
A bank pays 12% compounded quarterly. What is the equivalent 6
month effective rate (r).

rq = 0.12/4 = 0.03

RM1 RM1.03

0 One quarter 1 2 3 4

i = 12%
Now the problems says what is the effective 6 month rate?

The amount of interest made from RM1 after one 6 month period

RM1 RM1.03 RM ?

0 One quarter 1 2 3 4

i = 12%
RM1 RM1.03 (FV) RM ?

0 One quarter 1 One quarter 2 3 4

FV = PV(1+r)t
FV = 1(1+rq)t
FV = 1(1+0.03)2 =1.0609

So what is the effective 6 month rate?

0.0609 or 6.09%
Problem 2.2
A bank pays 12% compounded quarterly. What is the equivalent
monthly effective rate (r) ?.

rq = 0.12/4 = 0.03

RM1 RM1.03

0 One quarter 1 2 3 4

i = 12%
 So what is the effective 1 month rate?

The amount of interest made from RM1 after 1 month period.

rq = 0.03
RM1 RM1.03

0 1 2 3 month

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 So what is the effective 1 month rate?

The amount of interest made from RM1 after 1 month period.

rq = 0.03
RM1 RM1.03
rm rm rm
0 1 2 3 month

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 So what is the effective 1 month rate?

The amount of interest made from RM1 after 1 month period.

rq = 0.03
RM1 RM1.03
rm rm rm
0 1 2 3 month

FV = PV(1+r)t
1.03 = 1(1+rm)3
rm = 0.0099 or 0.99%

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Problem 2.3
You inherit RM10,000 that is payable in 6 months. What is the equivalent
value 3 month and 1 year from today? Assume a bank pays 12%
compounded monthly.

RM ? RM10,000 RM ?

0 3 6 9 12 month
1st, we need to calculate the effective monthly rate
rm = 0.12/12 = 0.01 or 1%

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 RM10,000 RM ?

0 3 6 9 12 month

FV = PV(1+r)t
What is the future value of RM10,000 at time t=12?

FV = PV(1+r)t
FV = 10,000(1+rm)6
FV = 10,000(1+0.01)6
FV = 10,615.2
You inherit RM10,000 that is payable in 6 months. What is the equivalent
value 3 month and 1 year from today? Assume a bank pays 12%
compounded monthly.
RM ? RM10,000

0 3 6 9 12 month

Move backward in time, called discounting

What is the value of RM10,000 at time t=3?

You inherit RM10,000 that is payable in 6 months. What is the equivalent
value 3 month and 1 year from today? Assume a bank pays 12%
compounded monthly.
RM ? RM10,000

0 3 6 9 12 month
 RM 9705.9 RM10,000

0 3 6 9 12 month
 Single Payment Factors (F/P and P/F)
Single payment factors involve only P and F. Cash flow diagrams are as follows:

Formulas are as follows:

F = P(1 + i ) n P = F[1 / (1 + i ) n]
Terms in parentheses or brackets are called factors. Values are in tables for i and n values
Factors are represented in standard factor notation such as (F/P,i,n),
where letter to left of slash is what is sought; letter to right represents what is given

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 3.0 RELATING PRESENT AND FUTURE
EQUIVALENT VALUES OF MULTIPLE
(PAYMENT) CASH FLOWS

Some multiple cash flows examples (annuity and perpetuity)

Present value of a perpetuity (PVperp)
Present value of an annuity knowing PVperp formula
Present value of growth perpetuity

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What is Annuity?

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What is Annuity?
An annuity is a contract between you and an insurance company in which
you make a lump sum payment or series of payments and in return obtain
regular disbursements beginning either immediately or at some point in the
future. (A uniform series of cash transactions).

The goal of annuities is to provide a steady stream of income during

retirement.

Financial Product
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Equal cash flows between equal time periods over a finite period of time.

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Equal cash flows between equal time periods over a finite period of time.

multiple payment

RM100 RM100 RM100 RM100

0 1 2 3 4

Fn  A(1  i ) n 1  A(1  i ) n  2  A(1  i ) n 3  ...  A

 1  i n  1
Fn  A 
 i  © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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What is Perpetuity?

A financial instrument to produce a constant stream of identical cash

flows with no end.

Financial Product

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Annuity –
Equal cash flows between equal time periods over a finite period of time.

Perpetuity –
Equal cash flows between equal time periods over an infinite period of
time.

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 RM100 RM100 RM100
Annuity
0 1 2 3

RM100 RM100 RM100 RM100

Perpetuity
0 1 2 3 ∞
Is the cash flow diagram below an annuity?

RM100 RM100 RM100

0 1 2 3 4 5

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Is the cash flow diagram below a perpetuity?

RM100 RM100 RM100

0 1 2 3 ∞

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 Fn  A(1  i ) n 1  A(1  i ) n  2  A(1  i ) n 3  ...  A

 1  i n  1
Fn  A 
 i 

The equation is correct when the annuity starts

at the end of FIRST time period and NOT AT TIME ZERO.

RM100 RM100 RM100

0 1 2 3

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Uniform Series Involving P/A and A/P
The uniform series factors that involve P and A are derived as follows:
(1) Cash flow occurs in consecutive interest periods
(2) Cash flow amount is same in each interest period

The cash flow diagrams are:

A = Given A=?

0 1 2 3 4 5 0 1 2 3 4 5

P = Given
P=?
P = A(P/A,i,n) Standard Factor Notation A = P(A/P,i,n)
Note: P is one period Ahead of first A value
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Uniform Series Involving P/A and A/P

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 Example: Uniform Series Involving P/A
A chemical engineer believes that by modifying the structure of a certain water
treatment polymer, his company would earn an extra $5000 per year. At an interest
rate of 10% per year, how much could the company afford to spend now to just
break even over a 5 year project period?

(A) $11,170 (B) 13,640 (C) $15,300 (D) $18,950

The cash flow diagram is as follows: Solution:

A = $5000 P = 5000(P/A,10%,5)
= 5000(3.7908)
4 5
= $18,954
0 1 2 3
i =10% Answer is (D)
P=?
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Now, we are going to derive the Present Value of Perpetuity

We will derive a formula that will “crush” all the multiple cash values into
one equivalent value at a specific time period

RM100 RM100 RM100 RM100

0 1 2 3 ∞
For a given r (effective interest rate), there exist one single dollar value that is
mathematically equivalent with multiple cash flow.

RM100 RM100 RM100 RM100 RM X

0 1 2 3 ∞
0 1

Rephrase -For a given r, there exists a dollar value at time 0 in which you are
theoretically indifferent between all the RM100 values that go on forever and
one value (RM X) at t=0
Imagine that you are given RM100 today. You deposit it in a bank and the
effective annual interest rate is 10% (r= 0.1).

RM 100

0 1

How much cash would you have in 1 year?

Single cash flow problem

RM 100 RM 110

0 1
3.1 The Present Value of Perpetuity
RM 100 RM 110

0 1

Say at t=1, you spend RM10 and leave RM100 sitting in the bank
RM 100 RM 100
Remains in the bank
0 1

RM 100 RM 10
Spend
0 1
RM 100 RM 100 RM ?

1 2

What will the remaining RM100 at t=1 grow into at t=2 ?

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RM 100 RM 100 RM 110

1 2

What will the remaining RM100 at t=1 grow into at t=2 ?

Another single cash flow problem

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Say at t=2, you want to repeat what you did at t=1.

RM 100 RM 100
Remains in the bank
0 1 2

RM 10 RM 10
Spend
0
1 2

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So, what does it means ?

RM 100
r = 0.1
0 1

RM 10 RM 10
Your spending
0
1 2

The RM100 at t=0 has provided RM10 spending at time 1 and 2

Given r=0.1, could RM100 provide RM10 of spending indefinitely ?

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 Therefore, with r = 0.1, RM100 at time 0 provides a cash flow stream of
RM10 beginning at time 1 forever

RM10 RM10 RM10 RM10 RM 100

0 1 2 3 ∞
= 0 1
r = 0.1

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 RM10 RM10 RM10 RM10 RM 100

0 1 2 3 ∞
= 0 1
r = 0.1

Notice that

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 RM10 RM10 RM10 RM10 RM 100

0 1 2 3 ∞
= 0 1
r = 0.1

Also

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 The Present Value of Perpetuity

C C C C PVperp

0 1 2 3 ∞
= 0 1
r
Where:
C is the repeated cash flow
r is the effective periodic rate
PVperp is the present value of Perpetuity

Where the solution is one time period

prior to the first “C”.
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 C C C C PVperp

0 1 2 3 ∞
= -1 0 1 2
r

Once we have crushed the multiple cash flows into a single value, we can use a
single cash flow principles to move that value anywhere on the time line.

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Problem 3.1
You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

What would be your 1st step?

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You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

Draw a cash flow time line diagram

What do the periods have to be ?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

1-89
You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

Draw a cash flow time line diagram

What do the periods have to be ?

Monthly
When we will start to receive the monthly RM100?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

1-90
You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

Draw a cash flow time line diagram

What do the periods have to be ?

Monthly
When we will start to receive the monthly RM100?
After 6 months
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-91
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

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1-92
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

Now, what is the next step ?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

To calculate the effective periodic rate.

For what time period ?
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-94
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

To calculate the effective periodic rate.

Effective monthly rate

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1-95
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

We need to convert it into the effective monthly rate.

What type of interest rate published by the bank?

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1-96
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

We need to convert it into the effective monthly rate.

What type of interest rate published by the bank?
Nominal or APR, unless stated

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

1-97
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

RM100 RM100 RM100 RM ?

= 0 1
0 1 5 6 7 ∞

We need to convert it into the effective monthly rate.

What type of interest rate published by the bank?
Nominal or APR, unless stated
Therefore, we need to convert the effective monthly rate from the given
nominal rate.
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1-98
You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

1st calculate the quarterly effective rate

RM1 RM1.02

0 1 Quarter 1

Then what’s next ?

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You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

2nd calculate the monthly effective rate

rm rm rm
RM1 RM1.02

0 1 month 1 2 3 months

Single cash flow problem

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1-100
You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
2nd calculate the monthly effective rate
rm rm rm
RM1 RM1.02

0 1 month 1 2 3 months

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You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
2nd calculate the monthly effective rate
rm rm rm
RM1 RM1.02

0 1 month 1 2 3 months

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You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
2nd calculate the monthly effective rate
rm rm rm
RM1 RM1.02

0 1 month 1 2 3 months

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 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
What is the value of perpetuity today?
What is the value of perpetuity one year from today ?
RM100 RM100 RM100 PVperp

= 0 1
0 1 5 6 7 ∞

Can we apply the perpetuity formula ?

Where the solution is one time period

prior to the first “C”.
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
What is the value of perpetuity today?
What is the value of perpetuity one year from today ?
RM100 RM100 RM100 PVperp

= 0 1
0 1 5 6 7 ∞

For what time period the RM15,000 solution is true ?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.
What is the value of perpetuity today?
What is the value of perpetuity one year from today ?
RM100 RM100 RM100 PVperp RM 15,100

= 0 5
0 1 5 6 7 ∞

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

 PVperp RM 15,100

0 5

The solution that we are looking for is at t=0

Therefore, use single cash flow formula to calculate the PVperp at t=0
 You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ?

RM100 RM100 RM100 RM14609

= 0 1
0 1 5 6 7 ∞

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You receive a perpetuity beginning 6 months from today of RM100 every
month. A bank pays 8% compounded quarterly.

What is the value of perpetuity today?

What is the value of perpetuity one year from today ? TRY ON YOUR
OWN

Single Cash Flow problem: the answer is RM 15,813.77

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3.2 The Present Value of Annuity
We will derive it based on knowing the present value of a perpetuity
formula.
RM100 RM100 RM100 RM X
=
0 1 2 3 0 1

Again, we will derive a formula that will “crush” all the multiple cash
values into one equivalent value at a specific time period

As in the case of perpetuity, for a given r, there exists a dollar value at time 0 in
which you are theoretically indifferent between the RM100 annuity and a single
value (RM X) at t=0
 RM100 RM100 RM100 RM ?

=
0 1 r = 0.1 2 ∞ 0 1

RM100 RM100 RM100 RM1000

=
0 1 r = 0.1 2 ∞ 0 1
 RM100 RM100 RM100 RM100 RM1000

=
0 1 r = 0.1 2 3 ∞ 0 1

Say we want to derive the formula for annuity of RM100 at time =1 and time =2
i.e. 2 periods annuity
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

The perpetuity above (A) can be split into two parts B and C
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100
C
3 ∞
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100
C
3 ∞
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100
C
3 ∞

Is C is a perpetuity ?
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100
C
3 ∞

Is C is a perpetuity ?
Therefore, we can apply the present perpetuity formula to C
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100 RM1000

C =
3 ∞ 0 1 2

Is C is a perpetuity ?
Therefore, we can apply the present perpetuity formula to C
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100 RM1000

C =
3 ∞ 0 1 2

Now B is annuity, and we want to solve it.

What is the relationship between A, B and C ?
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100 RM1000

C =
3 ∞ 0 1 2
Therefore; A = B + C
Hence; B = A – C
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100 RM1000

C =
3 ∞ 0 1 2

Can we subtract value of time=2 from t=0?

Cannot because both of them are not in the same term.
So, what should we do to enable us to proceed ???
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100
B
0 1 2

RM100 RM100 RM1000

C =
3 ∞ 0 1 2

Hence the present of an annuity today is the present value of perpetuity today
minus the value of perpetuity tomorrow that is discounted to today.
 RM100 RM100 RM100 RM100 RM1000
A =
0 1 r = 0.1 2 3 ∞ 0 1

RM100 RM100 RM173.55

B =
0 1 2 0 1

RM100 RM100 RM1000

C =
3 ∞ 0 1 2
Where t represent the number of cash flows in the annuity