Week 9-10

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Agenda
 Time value of money
 Interest Calculation: Simple interest vs compound interest
 Annual Percentage Rate (APR) or effective annual rate
 Present Value vs Future Value
 Net Present Value (NPV) and Internal Rate of Return (IRR)
 Annuities and Installment/Debt repayments

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Time value of money
Question:
Would you prefer to have $100 today or $100 after 1 year?
$100 today is worth more than $100 in a year time,
because:
1. We can at least earn some interest by putting
$100 into a bank account
2. Inflation may mean less purchasing power of
$100 in the future
3. May be you can’t get $100 after one year.
Question:
After you bought a product, would you prefer to pay $100
today or $100 after 1 year? 3
Present Value, Interest, Future Value
• Future Value = Present value + Required Compensation
– Present value = Initial Principal (P0) = the amount invested (or
borrowed) initially
– Interest rate (i) = as percentage of the principal/year
– Time (t) = period of time over which the money is lent/invested
(borrowed)
– Future value (Pt) = value of the money after a period of time

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Simple Interest
 The bank doesn’t compute interest on interest
 You get same and fixed interest value every year of your
investment

 Simple Interest: I = (P0 i) t

 Future Value: Pt = P0 + I = P0 + (P0 i t) = P0 (1+ i t)
 Present value: P0 = Pt / (1 + i t)
 A savings account of £10,000 earns simple interest at 5% per annum.
Calculate the future value of the account after 6 years.
 P6 = 10.000 (1+0.05*6) = 13.000

 Calculate the present value of £6000 that is expected to be received in

three years’ time with simple interest of 7.5% per annum.
 P0 = 6000/(1+0.075*3) = £ 4897.9

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Compound Interest
 Based on assumptions that after year 1, the bank
 (1) computes your interest,
 (2) adds it to the principal
 (3) next year there would be interest on the interest
We say the interest is compounding every year
 Future Value with compound interest:
Pt = P0 (1+ i)t
 Present Value with compound interest:
P0 = Pt / (1+ i)t
 (1+i)t is called the future value factor
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Simple vs. Compound
Invest $100 in 10% annual rate
2000

1500 Fc
Fs
F ($)

1000

500

0
0 5 10 15
Year 20 25 30

 What about 100 years?

 Simple interest = $__ every year, it becomes $_____
 Compounding = $_______
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Simple vs. Compound
Invest $100 in 10% annual rate
2000

1500 Fc
Fs
F ($)

1000

500

0
0 5 10 15
Year 20 25 30

 What about 100 years?

 Simple interest = $10 every year, it becomes $1,100
 Compounding = $ 1,378,061
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Tax
 Tax reduces the amount of interest received
 Simple Interest
 I = P0 ( i (1 - tax) t )
 Pt = P0 ( 1 + i (1 - tax) t )
 Compound Interest
 Pt = P0 ( ( 1 + i ( 1 – tax ) )t )
 Net Interest: I = Pt – P0
 I = P0 ( ( 1 + i ( 1 – tax ) )t - 1 )

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Compounding daily, monthly, quarterly
and semi annually
Calculate the future value of £6,500 to be received in two years’
time when the interest rate is 8% per annum, compounded
daily.

 Pt = P0 (1+ i/m)n m:convertion period / year

 Pt = 6,500(1+ 0.08/365)2(365) n:mxt
t : number of years
 Pt = 7627.7

Types of questions:
• Given P0, i, t calculate Pt
• Given Pt, i, t calculate P0
• Given Pt, P0 , i calculate t
• Given Pt, P0 , t calculate i
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Please Remember
 You ALWAYS need to make sure that the interest rate
and the time period match.
 If you are looking at annual periods, you need an annual
rate.
 If you are looking at monthly periods, you need a
monthly rate.

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Interest Calculation:
Simple interest vs compound interest
Question:
You save Rp 10,000,000 in a bank for three months. The bank
offers 10% per annum interest rate. Indonesian government
imposes a final tax for the interest income by 20%. After three
months, how much interest you get?
Simple Interest:
Net Interest=3/12*10%(1-20%)*10000000=Rp 200000
Compound interest monthly:
Month 1= 1/12*10%*(1-20%)*10000000 = Rp. 66,666.67
Month 2= 1/12*8%*(10000000+66666.67) = Rp. 67,111.11
Month 3= 1/12*8%*(1066666.67+67111.11) = Rp. 67,558.52
Total 3 months of interest= 201336
Net Interest= ((1+1/12*10%*(1-20%))^3)*10000000-10000000
= ((1+1/12*10%*(1-20%))^3-1)*10000000
= 201336 12
Interest Calculation:
Simple interest vs compound interest
Question:
You save Rp 10,000,000 in a bank for three months. The bank
offers 10% per annum interest rate. Indonesian government
imposes a final tax for the interest income by 20%. After three
months (compounding daily), how much interest you get?
Compound interest daily:
Assume the three months have 91 days,
Net Interest= ((1+1/365*10%*(1-20%))^91)*10000000-10000000
= ((1+1/365*10%*(1-20%))^91-1)*10000000
= Rp 201432
How long (months) the saving to double your money (assume
interest rate remains the same)?
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14
Annual Percentage Rate or effective annual rate
• Interest rates are usually cited as nominal rates of interest
expressed as per annum figures.
• Some bank offers different compounding frequency (daily,
monthly, quarterly, semi-annually).
• To compare different nominal rates and different
compounding periods use APR.
• If interest is compounded once a year at the APR rate, the
investment would yield exactly the same return, Pt, at the
end of t years, as it would if interest were compounded m
times per year at the nominal rate.

Pt  P0 (1  i / m)
m
mt  i 
APR  1    1
 m
Pt  P0 (1  APR) t (1+i/m)mt=(1+APR)t
(1+i/m)m=1+APR
APR=(1+i/m)m-1 15
Annual Percentage Rate or effective annual rate
Some bank offers different nominal rates of interest (usually per
annum) which different compounding frequency (daily, monthly,
quarterly, semi-annually). To make comparisons which banks
offer higher interest rate, we can calculate their APR.
Question:
Find the APR on a loan corresponding to 14% compounded daily,
monthly, and semi-annually. APR=(1+i/m)m-1
Compounded daily: APR=(1+1/365*14%)^365-1=15.02%
Compounded monthly: APR=(1+1/12*14%)^12-1=14.93%
Compounded semi-annually: APR=(1+1/2*14%)^2-1=14.49%
If you save money in a bank , you will choose a bank with higher
APR (assume with similar risk!). On the other hand, if you
borrow money from a bank, you will choose a bank with smaller
APR. 16
Future value (FV)
FV=PV(1+i/m)m.t
Where:
FV=Future Value
PV=Present Value
i=interest rate per annum (net, after tax)
t=number of years m=compounding frequency/year
Question:
You save Rp 10,000,000. at a bank for two years. For this saving the
bank offers a 10% per annum (excluded interest tax 20%). If the interest
compounded daily, how much you will get after two years?
Solution:
PV = Rp 10,000,000. i = 10%(1-20%)= 8% per annum
m = 365 and t = 2
FV = Rp 10,000,000(1+8%/365)365(2) = Rp 11,734,902.98
Thus, after two years you will get Rp 11,734,902.98
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Present Value (PV)
PV=FV/(1+i/m)m.t
Where:
PV=Present Value
FV=Future Value
i=interest rate per annum (net, after tax)
t=number of years m=compounding frequency/year
Question:
Suppose, you need Rp. 12,000,000 in next two years to travel. If a bank
offers a fix interest rate 10% per annum (compounded monthly,
excluded interest tax 20%) for two years, how much money you should
deposit now?

Solution:
FV = Rp 12,000,000. i = 10%(1-20%)= 8% per annum. m = 12 t = 2
PV = 12,000,000/(1+8%/12)12(2) = Rp 10,231,156.51
Thus, you should deposit Rp 10,231,156.51 now.
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You save $ 3500. For this saving the bank offers a 3.9%
per annum (excluded interest tax 20%).
If the interest compounded monthly, how many
months (round up) you will save until your saving
account balance become $ 4500?
PV=3500 I=3.9%*0.8
FV=4500
4500=3500*(1+3.9%*0.8/12)^X
4500/3500=(1+3.9%*0.8/12)^X
Ln(4500/3500)=X*Ln(1+3.9%*0.8/12)
X=Ln(4500/3500)/Ln(1+3.9%*0.8/12)
X=96.79=97

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Net Present Value (NPV)
NPV is the difference between the present value of cash inflows
and the present value of cash out.
Decision criteria in investing a project:
NPV >0  Invest or NPV <0 Don’t invest
Ct
NPV  t 1
t n
 C0
Where: (1  i) t

Ct = net cash inflow during the period t

C0 = initial investment
i = discount rate (required rate of return or weighted average cost of capital)
t = from year 1 one to year n
Example:
A project needs an initial investment of $400,000. The expected of the next net
cash flow at the end of next 4 years are $120,000, $130,000, $140,000 and
$200,000 respectively. You require a minimum return of 15% to take the
project.
Calculate the NPV. Go or no go with the project? 20
NPV - Problem
Year Cash Flows ($) Present Value of return in year 1
0 -400,000 P0 = 120000/(1+0.15)1 = 104,347.83
Present Value of return in year 2
1 120,000 P0 = 130000/(1+0.15)2 = 98,298.68
2 130,000 Present Value of return in year 3
3 140,000 P0 = 140000/(1+0.15)3 = 92,052.27
Present Value of return in year 4
4 200,000 P0 = 200000/(1+0.15)4 = 114,350.65

NPV = 104,347.83 + 92,298.68 + 92,052.27 + 114,350.65 – 400,000

NPV = 9049.43

You should GO with the project.

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Internal Rate of Return (IRR)
• When NPV>0, we know that the project gives a return more
than the required. When we want to know the return of the
project, IRR is used.
• Accept the project if the IRR greater than the required of return
(or WACC)
• The IRR calculation needs iteration as no simple formula
available.
Ct
0  t 1
t n
 C0
(1  IRR) t

Example:
A project needs an initial investment of $400,000. The expected of the next net
cash flow at the end of next 4 years are $120,000, $130,000, $140,000 and
$200,000 respectively. You require a minimum return of 15% to take the
project.
Calculate the IRR. Go or no go with the project? Hints: use Gsheet (IRR formula)
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Calculating IRR & NPV with Excel

=IRR(B3:B7)

=NPV(0.15;B4:B7)+B3

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 Annuities and Installment/Debt repayments
The term annuity is a series of fixed payments over a specified period of time.
Examples of annuities are regular deposits to a savings account, monthly
home mortgage payments and monthly insurance payments.
Formula for Ordinary Annuity (fixed amount paid at the end of each period)
Vanu = Ao((1+i/m)n-1)/(i/m)
Vo = Ao(1-(1+i/m)-n)/(i/m)
Where:
• i=interest rate per annum (net, after tax)
• m=number of periods per year
• n=number of periods.
• Ao=fixed amount paid at the end of each period
• Vanu=future value of the annuities
• Vo=present value of the annuities
Question:
A bank offers a fix saving interest rate 10% per annum (compounded monthly,
excluded interest tax 20%) for two years. If you save every end of month Rp
1,000,000 each for 18 months, how much you get money after 18 months.
Question:
Similar question except … you save every beginning of month… 24