Personal Financial Management

The Time Value

of Money

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The Time Value of Money

 Interest
 Simple Interest
 Future Value and Present Value
 Compound Interest
 Effective Annual Yield
 Inflation

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Interest
If we borrow an amount of money today, we will
repay a larger amount later. The increase in value is
known as interest. Money gains value over time.
The amount of a loan or a deposit is called the
principal. The interest is usually computed as a
percent of the principal. This percent is called the rate
of interest (or the interest rate, or simply the rate).
The rate of interest is assumed to be an annual rate
unless otherwise stated.
Interest
Interest calculated only on principal is called simple
interest. Interest calculated on principal plus any
previously earned interest is called compound
interest.

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Simple Interest

If P = principal, r = annual interest rate, and

t = time (in years), then the simple interest I
is given by
I = Prt.

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Example: Finding Simple Interest

Find the simple interest paid to borrow $4800

for 6 months at 7%.
Solution
I = Prt = $4800(.07)(6/12) = $168.

6 months is 6/12 of a year.

Future and Present Value

In the last example, the borrower would have to repay

$4800 + $168 = $4968.
The total amount repaid is called the maturity value
(or the value) of the loan. We will refer to it as the
future value, or future amount. The original
principal, denoted P, can also be thought of as present
value.
Future Value for Simple Interest

If a principal P is borrowed at simple interest

for t years at an annual interest rate of r, then
the future value of the loan, denoted A, is
given by
A = P(1 + rt).
Example: Future Value for Simple
Interest

Find the future value of $460 in 8 months, if the

annual interest rate is 12%.

Solution
  8 
A  P 1  rt   $460 1  .12     $496.80.
  12  
Example: Present Value for Simple
Interest
If you can earn 6% interest, what lump sum must
be deposited now so that its value will be $3500
after 9 months?
Solution
A  P 1  rt 
  9 
3500  P 1  .06   
  12  
$3500
P  $3349.28
1.045
Compound Interest

Interest paid on principal plus interest is

called compound interest. After a certain
period, the interest earned so far is credited
(added) to the account, and the sum
(principal plus interest) then earns interest
during the next period.
Compounding Period

Interest can be credited to an account at time

intervals other than 1 year. For example, it can
be done semiannually, quarterly, monthly, or
daily. This time interval is called the
compounding period (or the period).

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Future Value for Compound Interest

If P dollars are deposited at an annual interest

rate of r, compounded m times per year, and the
money is left on deposit for a total of n periods,
then the future value, A (the final amount on
deposit), is given by
n
 r
A  P 1   .
 m
Example: Future Value for
Compound Interest

Find the future value of $8560 at 4% compounded

quarterly for 8 years.
Solution
P = $8560, r = 4% = .04, m = 4. Over 8 years
n = 8m = 8(4) = 32.

n 32
 r  .04 
A  P 1    $8560 1    $11,769.49.
 m  4 
Example: Present Value for
Compound Interest
What amount must be deposited today, at 5%
compounded monthly, so that it will be $18,000 in
20 years?
Solution
240
 .05 
$18000  P 1  
 12 
$18000
P 240
 $6635.60
 .05 
1  
 12 
Effective Annual Yield
Savings institutions often give two quantities when
advertising the rates. The first, the actual
annualized interest rate, is the nominal rate (the
“stated” rate). The second quantity is the equivalent
rate that would produce the same final amount, or
future value, at the end of 1 year if the interest
being paid were simple rather than compound. This
is called the “effective rate,” or the effective
annual yield.
Effective Annual Yield

A nominal interest rate of r, compounded m

times per year, is equivalent to an effective
annual yield of
m
 r
Y  1    1.
 m
Example: Effective Annual Yield
What is the effective annual yield of an account
paying a nominal rate of 4.2%, compounded monthly?

Solution
12
 .042 
Y  1    1  .0428  4.28%
 12 
 Comparin the Effective Rate of Two
Investments

Which saving account is a better

investment : 6% compounded quarterly or
6.2% compounded semiannually?

 Annuities
An annuity is a savings investment for
which an individual or business makes the
same payment each period (i.e. annually,
semiannually, quarterly) into a compound –
interest account where the interest does
not change during the term of the
investment.
Annuities are set up by individuals to pay
for college expenses, vacations, or
retirement.
The payment are made at the end of the
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
Example
Find the future value of an annuity when
the payment is $800 semiannually the
interest rate is 5% compounded
semiannually and the term is 4 years


Example
Supposed you always dreamed of opening
your own business. And suppose a financial
planner estimates that you should need a
$35,000 initial investment to start a
business and you plan to save that amount
over the course of 5 years by investing in
an annuity that pays 7.5% compounded
weekly. How much do you need to invest
each week?

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Inflation
In terms of the equivalent number of goods or services
that a given amount of money will buy, it is normally
more today than it will be later. In this sense, the
money loses value over time. This periodic increase in
the cost of living is called inflation.
Unlike account values under interest compounding,
which make sudden jumps at certain points, price levels
tend to fluctuate gradually over time. It is appropriate,
for inflationary estimates, to use a formula for
continuous compounding.
Inflation
Inflation in an economy usually is expressed as a
monthly or annual rate of price increases, estimated by
government agencies in a systematic way. In the
United States, the Bureau of Labor Statistics publishes
consumer price index (CPI) figures, which reflect the
prices of certain items purchased by large numbers of
people
Future Value for Continuous
Compounding

If an initial deposit of P dollars earns

continuously compounded interest at an
annual rate r for a period of t years, then the
future value, A is given by

A  Pe . rt
Example:
Suppose that a cup of your favorite coffee is
$1.25. If the inflation rate persists at 2% over
time, find the approximate cost of the coffee
in 25 years.

Inflation Proportion

For a consumer product or service subject to

average inflation,

Price in year A CPI in year A


Price in year B CPI in year B
Example: Inflation
If your mother paid $3,000 in tuition in 1980 at the
same college that you will be attending and paying
$9,300 in 2005, compare the school’s tuition increase
to inflation over that same period of time.
Solution
Let x represent what we expect the tuition to be in
2005 if it had increased at the average rate since 1980.
Price in year 2005 CPI in year 2005

Price in year 1980 CPI in year 1980
Example: Inflation
Solution (continued)
x 195.3
 x  $7110.44.
$3000 82.4
Now compare with the actual 2005 tuition.
$9300
 1.30
$7128.64
Tuition at the school increased approximately 30%
more than the average CPI-U rate.
Rule of 70

An estimation of the years to double, which is the

number of years it takes for the general level of
prices to double for a given annual rate of inflation,
is given by
70
years to double  .
annual inflation rate
Example:
Estimate the number of years to double for an annual
inflation rate of 2.1%

Solution
70
Years to double   33.33
2.1

With an inflation rate of 2.1%, prices would double

in about 34 years.