Chapter Five Time Value of Money

This is one of the most important chapter which leads to better understanding of finance. The
concepts we will discuss in this chapter will be used in coming all chapter in this workbook as
well as in rest of the subjects you will study relevant to financial matters.

A rupee in hand today is worth more than a rupee to be received in the future because,
if you had it now, you could invest it, earn interest, and end up with more than one
dollar in the future. The process of going from today’s values, or present values (PVs),
to future values (FVs) is called compounding.

Basic terms:

PV = present value, or beginning amount, assume January 1 as present time.

R = interest rate investor can get per year. The interest earned is based on the balance at the
beginning of each year, and we assume that it is paid at the end of the year. You can also use
term like “I” or “k” as used by various authors.

FV = future value, or ending amount, of your account at the end of n years.

N or n = number of periods involved in the analysis.

Future Value:

The following formula will be used to calculate future value of any deposit.

FV = PV ( 1 + r )n

Illustration No.1

Suppose you have Rs.5000 today that you decided to deposit in bank
account and bank offered rate is 6%. Now question is how much you have in
account after one year?

For this purpose you will calculate future value of this amount.

N=1

PV = Rs.5000

Rate = 6% FV = PV ( 1 + r )n

FV = Rs. 5300

In Rs.5300, interest amount is Rs.300 and your own investment is Rs.5000

Illustration No.2

What is the future value of Rs.5,000 invested today if it earns 10% interest for two years?

Since you are depositing for two years, we assume that compounding interest will be applied i.e.
whatever interest you will earn at the end of first year will remain in your account and bank will
compute interest in the second you on the total amount including interest. To calculate it by
formulae we keep ‘N’ as 2 to get answer.

PV = Rs. 5000

N=2

Rate = 10%

FV = PV ( 1 + r )n

Future Value = Rs. 6050

Illustration No.3

What is the future value in eight years if you deposit Rs.3000 in two years and
Rs.5000 at the end of five years? Assume an annual compound rate of 8.5%.

You are depositing two amount at different time while bank rate is same i.e. 8.5% for both
deposit. First calculate future value of Rs.3000 by taking N = 6 and then calculate future value of
another amount Rs.5000 by taking N = 3. When you get future value of both amounts, add it to
get your final answer.

PV at the end of 2 years = Rs.3000

N= 6
Rate= 8.5%
FV = Rs.4894.4

PV at the end of 5 years = Rs.5000

N=2
Rate = 8.5%
FV = Rs.5886

So total amount in account at the end of 8th year will be = Rs.10780.4

Present Value:
Suppose you need Rs. 110,000 after one year while bank offered rate is 10%.
You are interested to know how much you should deposit to get your
required amount. For this kind of question you can use Future value formula
to find PV. The process to come to PV from future value is called discounting
and the rate that we use is generally called ‘discount rate’.

PV = FV ( 1 + r )-n

Important note:

Remember you can use future value formula to calculate any missing
information like FV, PV, n and ‘r’.

Effective Annual Rate

Sometimes compounding interval is not assumed on annual basis but rather

half yearly, quarterly or monthly basis.

Illustration No.4
Suppose investor deposit Rs. 100,000 for one year and bank offered rate is
10%. Now apply this information to following separate cases:

(a) Bank offered 10% rate per annum and interest will be calculated at
the end of year i.e. compounding annually. How much investor has
in account after one year?

PV = 100,000
N =1
r = 10%

FV = PV ( 1 + r )n

So total amount in investor account will be Rs.110,000.

(b)Now suppose bank offered rate is 10% per annum but compounding
on half yearly basis. It means bank will give 5% interest after six
months, this interest will remain in account and added in deposit
amount, later on 5% interest will be computed at year end on total
amount. Now total amount in account will be higher than case (a)
above.

So bank offered rate is 10% per annum but compounding half yearly
is actually giving you more amounts. If you convert this amount in
 the form of rate, this rate will be higher than offered rate of 10%
and we call it ‘effective annual rate’ (EAR).

PV = 100,000
N =1
r = 10%(compounding half yearly)

where m is the number of periods per year

In this question ‘m’ is equal to 2, because compounding is on half
yearly basis.

FV = 110,250

So total amount in investor account will be Rs.110,250. When we

convert this information in effective rate, this rate will be 10.25%. In
similar pattern, if we increase number of compounding intervals in a
year, we will get more future amount, hence effective annual rate
will be on higher side as compared to annual rate offered by bank.
This annual offered rate is called APR (annual percentage rate) and
we use term EAR (effective annual rate) for actual rate that we
received.

Annuities

Series of payment with finite time period is called annuity. It may be

classified as:

(a) Annuity Due

Suppose you are saving Rs.100 each year for five years. This amount is
treated as annuity. If first amount deposited today, it would be treated as
‘annuity due”.

(b)Ordinary Annuity
Annuity that starts at the end of year is called ordinary annuity. If question is
not helping to identify, assume ‘ordinary

Illustration No.5
 An investor deposited Rs.5000 each year for next five years. Bank
offered rate is 6%. How much amount investor will accumulate at the end of
fifth year?

PMT = We use this symbol for annuity payment.

All other symbols will remain same as discussed earlier in single amount
condition.

Now
Pmt = Rs.5000
N =5
R = 6%
FV = ?
FV = Pmt [ ( 1 + r )n –1 ] / r

Answer: Rs. 28,185

Illustration No.6

An investor deposited Rs.8000 each year for next five years. Bank
offered rate is 7%. What would be its present value?

Now
Pmt = Rs.8000
N =5
R = 7%
PV = ?

PV = Pmt [ 1 – ( 1 + r )-n ] / r

Answer: Rs. 32,801

Illustration No.7
 An investor deposited Rs.8000 each year for next five years. First
payment starts today. Bank offered rate is 7%. What would be its future
value at the end of fifth year?

This is annuity due case. Formulae will be slightly changed and total value
will be higher than ordinary annuity.

Now
Pmt = Rs.8000
N =5
R = 7%
FV = ?
FV = Pmt [ ( 1 + r )n –1 ] / r *(1+r)

or

FV = ordinary annuity * ( 1 + r )

Answer: Rs. 49,226

Illustration No.8

An investor deposited Rs.8000 each year for next five years. First
payment starts today. Bank offered rate is 7%. What would be its present
value?

This is annuity due case. Formulae will be slightly changed and total value
will be higher than ordinary annuity.

Now
Pmt = Rs.8000
N =5
R = 7%
PV = ?
PV = Pmt [ 1 – ( 1 + r )-n ] / r *(1+r)

Or
PV = ordinary annuity *( 1 + r )

Answer: Rs. 35,097

Loan Amortization

When a business man borrows fund from bank, it is possible that he can ask
the banker that he is willing to pay whole loan with interest in fixed
installment basis. We assume that interest rate is fixed and loan duration is
also set by banker, in this case bank will use annuity concept to calculate
loan installment. This loan installment may be divided on yearly basis or
quarterly basis as planned by business man. When all installment paid by
business man, whole loan with interest will be finished.

This whole exercise is presented in the form of loan amortization table that
presented here.

Illustration No.9
You borrow Rs.50,000 from bank on which rate of interest is 15% per annum.
You asked the banker that you will pay whole loan with interest in 5 years
and requested to make fixed installment of the whole loan and interest.

This fixed installment is actually “annuity” because it meets all the

characteristics of annuity. We can calculate it with the help of annuity
formulae.

PV = Rs.50,000
N= 5
R = 15%
Pmt = ?

Loan Amortization Table

Year Installment Interest Principle Unpaid bal

1 14915.78 7500 7415.778 42584.22

2 14915.78 6387.633 8528.144 34056.08

3 14915.78 5108.412 9807.366 24248.71

4 14915.78 3637.307 11278.47 12970.24

5 14915.78 1945.536 12970.24 0

Remember that actual interest payment will decline as you will pay
installments and actual loan payment will increase.
Perpetuity:
Series of cash flow forever is called ‘perpetuity’.

Because a perpetuity has an infinite number of cash flows, we can’t compute

its value by discounting each one. We can use a simple formula to calculate present value of a
perpetuity.

PV for a perpetuity = cash flow/discount rate

For example, an investment offers a perpetual cash flow of Rs.5000 every year. The return
you require on such an investment is 10 percent. What is the value of this investment?

The value of this perpetuity is:

Perpetuity PV= C/r = 5000/.10 = Rs. 50,000

So this person should invest Rs.50,000 to get perpetual cash inflow of Rs.5000.

Nominal rate

Nominal rate is generally called “quoted rate” that we use in business transactions and in
financial activities. It is assumed that inflation is already included in nominal rate. We are
interested to calculate real rate offered by economy, this rate may be calculated as follows:

Illustration No.
Nominal rate in economy is 12% while inflation is 7%. What should be real rate in economy?

1+ real rate = 1+nominal/1+inflation

So real rate is 4.7%.

1. Your grandfather has offered you a choice of one of the three alternatives: $ 5,000 now; $ 1,000 a
year for eight years; or $12,000 at the end of eight years, assuming you could earn 15 percent
annually, which alternative should you choose?

2. You need $30,750 at the end of eight years, bank is offering you 12 percent interest on your deposit
(compounded annually). How much amount should you deposit?
3. Brain Hirt started business on January 1, 2000. Every year he plans to deposit Rs.2500 in his bank
account, which earns 8 percent annually. First payment will start at the end of year 2000. On
December 31, 2005, he used the entire balance in his bank account to invest in a certificate of
deposit at 12 percent annually. How much will he have on December 31, 2010?

4. On January 1, 2010, Mr. Strong bought 100 shares of stock for $13 per share. On December 31,
2012, he sold the stock for $20.50 per share. What is his annual rate of return?
5. Donald Johnson has just given an insurance company $20,000. In return, he will receive an annuity
of $1,800 for 20 years. At what rate of return must the insurance company invest this $20,000 in
order to make the annual payments?

6. Mary Mills has retired after 35 years with the Electric Company her total pension funds have an
accumulated value of $300,000, and her life expectancy is 18 more years. Her pension fund manager
assumes that she can earn an 8 percent return on her assets. What will her yearly annuity be for the
next 18 years?
7. You wish to retire in 20 years, at which time you want to have accumulated enough money to
receive an annuity of $12,000 for 25 years after retirement. During the period before retirement you
can earn 8 percent annually, while after retirement you can earn 10 percent on your money. What
are your annual contributions to the retirement fund to allow you to receive the $12,000 annuity?

8. If you borrow $9,725 and are required to repay the loan in five equal annual installments of $2,500,
what is the interest rate associated with the loan?
9. If your uncle borrows $50,000 from the bank at 10 percent interest over the eight-year life of the
loan, what equal annual payments must be made to discharge the loan, plus pay the bank its
required rate of interest (round to the nearest dollar)? How much of his first payment will be
applied to interest? To principle? How much of his second payment will be applied to each?

Amortization Schedule

10. If investors are to earn a 4 percent real interest rate, what nominal interest rate must they earn if
the inflation rate is:
a. zero
b. 4 percent
c. 6 percent
11. Perpetuities. A local bank will pay you $100 a year for your lifetime if you deposit $2,500 in the bank
today. If you plan to live forever, what interest rate is the bank paying?

12. Perpetuities. A property will provide $10,000 a year forever. If its value is $125,000, what must be
the discount rate?

13. Perpetuities. A local bank advertises the following deal: “Pay us $100 a year for 10 years and then
we will pay you (or your beneficiaries) $100 a year forever.” Is this a good deal if the interest rate
available on other deposits is 8 percent?
14. Jim Thomas borrows $70,000 at 12 percent interest toward the purchase of a
home. His mortgage is for 30 years.

a. How much will his annual payments be? (Although home payments are usually on monthly
basis, we shall do our analysis on an annual basis for ease of computation. We get reasonably
accurate answer.

b. How much interest will he pay over the life of the loan?

c. How much should he be willing to pay to get out of a 12 percent mortgage and into a 10 percent
mortgage with 30 years remaining on the mortgage? Assume that current interest rates are 10
percent. Disregard taxes.
15. Your younger sister, Susie, will start college in five years. She has just informed your parents that
she wants to go to Collegiate U., which will cost $ 8,000 per year for four years (assumed to come at
the end of end year). Anticipating Susie’s ambitions, your parents started investing $ 1,000 per year
five years ago and will continue to do so for five more years.

How much more will your parents have to invest each year for the next five years to have the
necessary funds for Susie’s education? Use 10 percent as the appropriate interest rate throughout
this problem (for discounting or compounding).
16. Retirement Savings. You believe you will need to have saved $500,000 by the time you retire in 40
years in order to live comfortably. If the interest rate is 6 percent per year, how much must you save
each year to meet your retirement goal?

17. Retirement Savings. How much would you need in the previous problem if you believe that you will
inherit $10,000 in 10 years?

18. Retirement Savings. You believe you will spend $40,000 a year for 20 years once you retire in 40
years. If the interest rate is 6 percent per year, how much must you save each year until retirement
to meet your retirement goal?
19. Retirement Planning. A couple thinking about retirement decide to put aside $3,000 each year in a
savings plan that earns 8 percent interest. In 5 years they will receive a gift of $10,000 that also can
be invested.

a. How much money will they have accumulated 30 years from now?
b. If their goal is to retire with $800,000 of savings, how much extra do they need to save every
year?
20. Retirement Planning. A couple will retire in 50 years; they plan to spend about $30,000 a year in
retirement, which should last about 25 years. They believe that they can earn 8 percent interest on
retirement savings.

a. If they make annual payments into a savings plan, how much will they need to save each year?
Assume the first payment comes in 1 year.
b. How would the answer to part (a) change if the couple also realizes that in 20 years, they will
need to spend $60,000 on their child’s college education?
Practice Questions: TVM

1. What is the future value of $2,000 invested today if it earns 10% interest for one year?

2. What is the future value of $2,000 invested today if it earns 10% interest for two years?

3. What is the future value of $6,000 invested today if it earns 8.5% interest for seven Years?

4. What is the future value of $6,000 invested today if it earns 8% for 10.5 years?

5. An investor deposits $100 into his credit union account that pays interest at the rate of 3.25%
per year (payable at the end of each year). He leaves the money and all accrued interest in the
account for 7 years. How much will he have at the end of the 7 years?

6. What is the future value in SEVEN years if you receive $300 in two years and $500 at the end
of five years? Assume an annual compound rate of 8.5%.
7. What is the value of $2000 after one year if bank compounding half yearly and offered rate is
10%. ( note: compare your answer with the answer of question no.1, give comments)

8. What is the value of $2000 after one year if bank compounding quarterly and offered rate is
10%. ( note: compare your answer with the answer of question no.1 and 7, give comments)

9. What is the value of $2000 after one year if bank compounding monthly and offered rate is
10%. ( note: compare your answer with the answer of question no.1,7 and 8 give comments)

10. What is the present value of $2,000 to be received 2 years from today when the annual
discount rate is 10%?

11. What is the present value of $500 to be received 10.5 years from today when the annual
discount rate is 8%?

12. What is the present value of $700 to be received in two equal installments ($350 each), two
years and five years from today, when the annual discount rate is 10%?

13. Suppose Capitol Federal Bancorp offers a certificate of deposit that pays $10,000 in five
years for exchange for $8,000 today. What interest rate is Capitol Federal Bancorp
offering?

14. Suppose Bank One offers a certificate of deposit that pays $5,000 in four years for exchange
for $4,000 today. What interest rate is Bank One offering?

15. How many years will take $10,000 to grow to $20,000 if bank offered rate is 10%.

16. How many years will take $25,000 to grow to $120,000 if bank offered rate is 18%.

17. Your grandfather placed $2,000 in trust fund for you. In 10 years the fund will be worth
$5,000. What is the compound annual rate of return on the trust fund?

18. Your rich aunt puts $35,000 into a bank account earning 4.00%. You are not to withdraw the
money until the balance has doubled. About how many years will you have to wait?
19. Sales of current year are 75,000 and sales of a company after four years is $375,000. What is
the rate of growth?

20. Consider an APR of 12% with monthly compounding. What is the EAR ( effective annual rate)?

21. Consider an APR of 13.5% with quarterly compounding. What is the EAR ( effective
annual rate)?

22. Consider an EAR of 13.75% with quarterly compounding. What is the APR ( annual
percentage rate)?

23. Consider an EAR of 18.25% with monthly compounding. What is the APR ( annual
percentage rate)?

24. Suppose you save $4,000 per year at the end of each year for 3 years and earn 5% interest per
year. How much will you have at the end of 3 years?

25. Suppose you save $4,000 per year at the end of each year for 10 years and earn 8.5% interest
per year. How much will you have at the end of 10 years?

26. Suppose you save $4,000 per year at the beginning of each year for 3 years and earn 5%
interest per year. How much will you have at the end of 3 years? Compare this answer with
question no. 24 and give comments.

27. Suppose you save $4,000 per year at the beginning of each year for 10 years and earn 8.5%
interest per year. How much will you have at the end of 10 years? Compare this answer with
question no. 25 and give comments.

28. A person deposited Rs.5000 at the end of six months in each of the next five years. Bank
offered rate is 10%. Calculate how much he has at the end of five years.

29. A person saved Rs.2500 at the end of each month in the next three years. Bank offered rate
is 12.25%. Calculate how much he has at the end of three years.

30. Suppose you save $4,000 per year at the end of each year for 30 years and earn 5% interest
per year. How much will you have at the end of 30 years?
31. Suppose you save $500 per year at the end of each year for 20 years and earn 8.25% interest
per year. How much will you have at the end of 20 years?

32. Suppose you save $1,000 per year at the end of each year for 15 years and earn 8.25% interest
per year. How much will you have at the end of 15 years?

33. Suppose you save $1,000 per year at the end of each year for 15 years and earn 7.49% interest
per year. How much will you have at the end of 15 years?

34. Suppose you save $2,000 per year at the beginning of each year for 15 years and earn 7.49%
interest per year. How much will you have at the end of 15 years?

35. Suppose you save $1,000 per year at the beginning of each year for 15 years and earn 7.49%
interest per year. How much will you have at the end of 15 years?

36. Suppose you save $1,000 per year at the beginning of each year for 3 years and earn 5%
interest per year. What is the present value of this annuity

37. Suppose you save $500 per year at the end of each year for 15 years and earn 8.25% interest
per year. What is the present value of this annuity?

38. Suppose you can save $100 per year at the end of each year for 10 years and earn 5.45%
interest per year. However, you cannot start saving for four years. How much will you have at
the end of 14 years?

39. Suppose that the constant and perpetual cash flow is $1,000 and the discount rate is 8%. What
is the value of this perpetuity?

40. Suppose that the constant and perpetual cash flow is $1,000 and the discount rate is 10%.
What is the value of this perpetuity?

41. Suppose you can save $200 per year at the end of each year for 15 years and earn 7.49%
interest per year. However, you cannot start saving for five years. What is the present value of
this annuity?

42. What are the annual payments for a 4-year $4,000 loan if the interest rate is 9% per year?
Make up a loan amortization schedule.
43. You are planning to take a car, its cash price is Rs.800,000. Bank is offering seven year monthly
payment plan at 18%. How much monthly installment will be offered by bank?

44. Suppose you are accepting bank offer as given in Q No.43 but want to amortize whole loan in
five years. What monthly installment will be offered by bank?

45. Suppose you are planning to accept bank offer as given in Q No.43 but instead of monthly
payment plan, you are interested in quarterly installment. Compute the amount you will pay
after each quarter.

46. Suppose you are planning to take this car through bank loan but you already have saving of
Rs.150,000 which you paid to bank as down payment and rest you are agree on monthly
installment at 18%. Compute monthly payment.

47. Repeat Q No.43 to Q No.46 assuming bank is following annuity due condition.

48. Consider the following future value problem. The respective cash flows for t = 0, 1, 2, and 3
are $3,000, $2,000, $8,000, and $5,000 and the discount rate is ten percent. What is the future
value at t = 4?

49. You are offered a signing bonus of $2,000,000 or a future payment of $2,500,000 at the end of
three years from now. If you can earn 7% on invested funds, would you take the signing bonus
or wait for the future payment?