Chapter 2 – Time value of money

Objectives
▪ Understand the role of time value of money in finance and understand the concept of
compound interest.
▪ Use your financial calculator to determine:
• The future value of a single amount invested today;
• The future value of an annuity;
• The present value of a single future amount;
• The present value of an annuity;
• The present value of a perpetuity;
• The present value of a cash flow growing at a constant rate over a time period;
• The present value of uneven cash flow streams.
▪ Define and calculate an annual effective rate.
▪ Distinguish between nominal and real interest rates.
▪ Establish the factors that determine the term structure of interest rates.
▪ Apply time value of money principles to real world problems and the valuation of bonds
 Time value of money

▪ The TVM concept is that money you have now is worth more than the same
amount in the future, due to its potential earning capacity, in the form of
interest.

▪ It is a fundamental principle to all aspects of financial management and serve

as an essential tool for both corporate and personal finance decision making.

▪ It can be used to compare investment alternatives and to solve problems

involving loans, mortgages, leases, savings, and annuities.
 TVM Timeline
▪ The timing of cash flows is very important in TVM calculations.

▪ A timeline visually represents a stream of cash flows at different points in time.

 Financial calculator
▪ Another important tool for the time value calculations is a financial calculator
and understanding how to use the financial calculator.

A few important points to note, regarding your financial calculator:

▪ Timing of cash flows – your calculator is set to automatically read cash flows as
taking place at the end of period.
▪ The “PMT” – function is automatically set to be read as “0”
▪ The “P/YR” – function is automatically set to be read as “1”

*NB: Important to always clear calculator memory – otherwise stored data can
influence calculations
 TVM calculations
With the time value of money, you can calculate the following values IF the other four
values are given:

▪ The future value of an amount of cash which will have accrued by a given date
resulting from earlier lump-sum or periodic investments. (FV)

▪ The present value of an investment at the beginning of a period, sometimes referred to

as the principal sum. (PV)

▪ The interest rate on a sum of money invested or borrowed, expressed as a decimal

fraction. (i)

▪ The period of investments made, or instalments are paid. (PMT)

▪ The number of periods for which the investment/loan is to receive interest. (N)
 Example 1
Single amount, single period:

You have R 1000 savings available to invest, you decide to invest the money at a local
bank at an annual interest rate of 6% for a period of 1 year.

What is the total amount of your investment at the end of year 1?

 Example 1 - Solution

PV = R -1 000 FV = ?

n=1
pmt = 0
i = 6%
p/yr = 1
Calculator = end mode
 Example 1 - Solution
Solution:

▪ The future value of your investment at the end of the year will be R 1 060.00, which
is the capital amount invested of R 1 000.00 plus the interest earned for the year
being R 60 (R 1 000 * 6%). It follows that the present value of your R 1 060.00 you
expect to receive at the end of the year is only R 1 000.00.

If you are to compute the future value on a financial calculator, the keystrokes would
be as follow:

PV = R - 1 000 (negative as the investment is an outflow of cash)

I/PYR = 6%
N=1
PMT = 0
P/YR = 1
FV = The unknown variable, you want to compute = R 1 060.00.
 Example 3
Single amount, multiple periods, non-annual compounding interest.

You have R 1 000 savings available to invest, you decide to invest at a local
bank at an annual interest rate of 6% for a period of 1 year, compounded
quarterly.

What is the total amount of your investment at the end of year 1?

 Example 3 - Solution
The future value of your investment at the end of the year will be R 1 061.36, which is
the capital amount invested of R 1 000.00 plus the interest earned for the periods
being: Period 1 - R 15 (R 1 000 * 1.5%) + Period 2 - R 15.23 (R 1 015 *1.5%) +
Period 3 – R 15.45 (R 1 030.23 *1.5%) + Period 4 – R 15.69 (R 1 045.68 * 1.5%).

*The 1.5% is the annual interest rate of 6% converted to quarterly interest rates.

If you are to compute the future value on a financial calculator, the keystrokes
would be as follow:
▪ PV = R - 1 000 (negative as the investment is an outflow of cash)
▪ I/PYR = 6%
▪ N =4
▪ PMT =0
▪ P/YR =4
▪ FV = The unknown variable, you want to compute = R 1 061.36

*Note the value of “N” and the value of the “P/YR”.

 Interest rates
▪ An interest rate is the cost stated as a percent of the amount borrowed for a time
period, usually one year.

▪ The prevailing market rate is composed of the real rate of interest that compensates
lenders for postponing their own spending during the term of the loan and;

▪ The inflation premium to offset the possibility that inflation may erode the value of
the money during the term of the loan. (real rate = nominal rate – inflation).

▪ In general, the interest rate, is influenced by three main variables which are:
• The time value of money (preferring it now rather than later)
• The risk of capital repayment
• Expected inflation
 Interest rates
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who
doesn't, pays it.” – Albert Einstein

▪ Compounding interest is the addition of interest to the principal sum of a loan or

deposit, or in other words, interest on interest. It is the result of reinvesting interest,
rather than paying it out.

▪ Interest rates takes two forms namely the nominal interest rate (also referred to as
simple interest) and effective interest rate.

• The nominal interest rate does not take into account the compounding period, the
interest is computed only on the original amount borrowed.

• The effective interest rate does take the compounding period into account, interest
is calculated each period on the original amount borrowed plus all interest
accumulated to date.
 Interest rates
Interest rates quoted by three banks:
• Bank X: 15%, compounded daily
• Bank Y: 15.5%, compounded quarterly
• Bank Z: 16%, compounded annually

Which bank would you borrow from and which bank would you invest with?

365
 0.15  Calculator: 365 (x : y)
Effective Rate Bank X = 1 + - 1 = 16.18%
365 
15 2nd Func EFF

4
 0.155  4 (x : y) 15.5 2nd Func
Effective Rate Bank Y = 1 + - 1 = 16.42%
 4  EFF
1
 0.16 
Effective RateBank z = 1 + - 1 = 16% 1 (x : y) 16 2nd Func
 1  EFF
 Example 6
Work through examples 4 & 5 in the notes before attempting example 3:

An amount of R 10 000 was deposited into a savings account which pays interest
of 10% per annum, compounded monthly. If periodic withdrawals of R 5 00 are
made at the end of every quarter, what will the savings account balance be at
the end of two years?
 Example 6 - Solution

▪ Because the interest is compounded monthly and the cash flows occur quarterly, you
must convert the interest compounding period to match the period of the cash flows.

▪ NB: you cannot convert the cash flows to match the interests’ compounding period,
then the interest will not be calculated accurately.

▪ A method to convert the compounding period of the interest to match the period of
the cash flows is to calculate the effective interest rate per annum, and then convert
the annual effective interest rate again to a quarterly nominal interest rate.
 Example 6 - Solution
1. Converting the annual nominal rate compounding to an annual effective interest
rate is: 12 (x,y ) 10 2ndF →EFF = 10.47%.

2. Converting the annual effective interest rate to a nominal interest rate

compounding quarterly 4 (x,y ) 10.47% 2ndF →APR = 10.08%.

3. Now solve the problem by calculating the future value of the savings at the end of
two years.

PV = R - 10 000 (negative as the investment is an outflow)

I/PYR = 10.08%
N = 8 (4 quarters per year for 2 years)
PMT = 500 (positive as the period withdrawals is an inflow)
P/YR = 4 (4 quarters per year)
FV = The unknown variable, you want to compute = R 7 831.91
 Annuities vs Perpetuities

▪ Annuities are a series of payments/receipts of a fixed amount, for a specific period.

• Annuities can further be split between:

- “ordinary annuities” - cash flow occurs at the end of the period and;
- “annuities due” - cash flow occur at the beginning of the period.

▪ Perpetuities is also a series of payments/receipts of a fixed amount, however there is

no end date (into perpetuity).
 Example 7

If, Mr. A want to retire from his job, and receive a monthly annuity for the next 5 years.
Calculate how much must Mr. A invest currently at a 12% annual interest rate to receive
an ordinary monthly annuity of R 10 000 per month.

Solution:
FV =R0
I/PYR = 12%
N = 60 (5*12)
PMT = 10 000 (cash inflow)
P/YR = 12
PV = The unknown variable, you want to compute = R 449 550.38
 Example 8

If, Mr. A want to retire from his job, and receive an annual annuity for the next 5
years. Calculate how much must Mr. A should invest now at a 12% annual interest
rate to receive an ordinary annual annuity of R 10 000 per year growing at a
consistent rate of 6% per year.
 Example 8 - Solution
To solve this problem, you can either discount the cash flows individually at the
discount rate of 12% (which is very time consuming).

It would be best to use the NPV function on your calculator.

Timeline:
 Example 8 - Solution
NPV keystrokes on calculator:

▪ 0 ENT/DATA
▪ 10 000 ENT/DATA
▪ 10 600 ENT/DATA
▪ 11 236 ENT/DATA
▪ 11 910.16 ENT/DATA
▪ 12 624.77 ENT/DATA
▪ 2ndF CASH 12 ENT/DATA COMP = R 40 109.15.