Time Value of Money

• The concept of the time value of moneyis an

integral concept in the study of financial
management
• you need the concepts covered in this unit in
order to study Capital Budgeting, Valuation of
Shares, the Cost of Capital and many other
issues covered in corporate financial
management.
 Time value of money
• The notion that money has a time value is one
of the most basic concepts in finance and
investment analysis.
• Making decisions today regarding future cash
flows requires understanding that the value of
money does not remain the same throughout
time.
• A dollar today is worth less than a dollar
sometime in the future for two reasons.
 Time value of money
• Reason No. 1: Cash flows occurring at
different points in time have different values
relative to any one point in time.
• One dollar one year from now is not as
valuable as one dollar today.
• you can invest a dollar today and earn interest
so that the value it grows to next year is
greater than the one dollar today.
 Time value of money
• This means we have to take into account the
time value of money to quantify the relation
between cash flows at different points in time.
• Reason No. 2:Cash flows are uncertain.
Expected cash flows may not materialize.
• Uncertainty stems from the nature of forecasts
of the timing and/or the amount of cash flows.
We do not know for certain when, whether, or
how much cash flows will be in the future.
 Time value of money
• Translating a current value into its equivalent
future value is referred to as compounding.
• Translating a future cash flow or value into its
equivalent value in a prior period is referred to
as discounting.
• An investment of money has different values
on different dates. The adjustment in time
value is a function of the following
factors:time, inflationrate, risk.
 Time value of money

• A lender will need compensation from a

borrower for delaying payment and this
compensation will be determined by above
three factors.
• This compensation is the interest rate, which
represents the opportunity cost of funds.
 Time value of money
• Let’s now discuss the following:
• Future Value
• Present Value
• Simple Interest
• Simple Discount
• Compound Interest
 Simple interest
• Remark: Interest is the price paid for the use
of borrowed money.
• Interest is paid by the party who uses or
borrows the money to the party who lends
the money.
• Interest is calculated as a fraction of the
amount borrowed or saved (principal amount)
over a certain period of time.
 Simple interest
• Interest is calculated as a fraction of the amount
borrowed or saved (principal amount) over a certain
period of time.
• if we’ve borrowed an amount from the bank at an interest
rate of 12% per year, we can express the interest as:
• 12% of the amount borrowed
• or 12/100 of the amount borrowed
• or 0,12× the amount borrowed.
• When and how interest is calculated result in different
types of interest.
 Simple Interest
• Simple interest is interest that is computed on the principal for the
entire term of the loan, and is therefore due at the end of the term. It is
given by
• I = Prt
• Where;
• I-is the simple interest (in $) paid at the end of the term for the use of
the money
• P - is the principal or total amount borrowed (in $) which is subject to
interest (P is also known as the present value (PV ) of the loan)
• r- is the rate of interest
• t - is the time in years, for which the principal is borrowed
• NB: Interest is earned only on the original investment; no interest is
earned on interest
 Simple interest
• Example
• Suppose you have $10 000 to invest in a bank
savings account at a simple interest of 20% per
annum. How much will you have at the end of
the year?
• Given that I=Prt
• I=Prt
• I = 10000×0.20×1
• I =$2000
 Simple interest
• Therefore Totaamountdue
• S=Interest+Principal Payment
• =2000+10000
• = 12000
• Remark:The amount or sum accumulated of Future Value (S) (also known
as the maturityvalue, accrued principal) at the end of the term t, is given
by
• S = Principal value + Interest
• S=P+I
• S = P + Prt
• S = P(1 + rt).
• Remark:The date at the end of the term on which the debt is to be paid is
known as the due date or maturity date.
 Simple interest
• Suppose you deposit $10 000 today in an
account that pays simple interest of 20% per
annum. How much will you have at the end of
3 years?
• S =P (1+rt)
• S= 10000(1+20%×3)
• S =10000(1+0.20×3)
 Simple interest
• =$16000
•
• Example
• You borrow $18 000 for a simple rate of 22% per
annum for 125 days. How much will you have to
pay to the lender?
• t=………note that t- is always in years so set it as
a fraction of number of days in a year.
• P=18000
 Simple interest
• P=18000
• r =0.22
•
• so applying , S=P (1+rt)
• S=18000(1+0.22×125/365)
• S=$19356
 Present value
• Present Values [discounting]
• Of particular importance is the concept of
present value P or PV, which is obtained from
the basic formula for the sum or future value
S, namelyS = P(1 + rt)
•
• Dividing by the factor (1 + rt) gives
 Present Value
• S = P(1 + rt)
•
• Dividing by the factor (1 + rt) gives
 Simple interest
• Remark:Discounting is a process of moving the
future value of an obligation/investment back
to the present/today.
• For Simple Interest
• A promissory note with a future value of
$12000, simple interest rate is 12% per annum
is sold 3 months prior to its due date. What is
the Present Value on the day it is sold?
 Simple interest
• S=$12000 r=0.12 t=3/12
•
• Given that ,
•
•
• Then
• = $11 650
 Simple interest
• Time lines
• A time line is a useful way of representing
interest rate calculations graphically. Time
flow is represented by a horizontal line.
Inflows of money are indicated by an arrow
from above pointing to the line, while
outflows are indicated by a downward
pointing arrow below the time line.
 Time line
• t- term
• r =Interestrate
• P or PV
• FV or S= P(1 +rt)
• Remember that
•
• FV or Sum accumulated (S) = Principal + Interest received that is
• S = P + Prt
• = P(1 + rt)
• or equivalently
• Future value = Present value + Interest received.
 Time value of money
• Counting days
•
• The convention is that to determine the exact number of days
between the two relevant term dates,
• we includethe day the money is deposited or lent and
excludethe day the moneyis repaid (or withdrawn).
• The reasoning behind this is the simple fact that if you deposit
money on the 12th of June and withdraw it on the 13th of
June, there is only one day between the two dates, not two.
• However, when a security is issued and held until maturity, we
include the day on which itwas issued.
 Time value of money
• Practice Exercise
• Determine the number of days between 19
March and 11 September.
 Simple discount

• Simple Discount
• Remark: is interest calculated on the face
(future) value of a term and paid at the
beginning of the investment term.You will
receive interest in advance
• Previously, we emphasised the interest that
has to be paid at the end of the term for
which the loan (or investment) is made.
 Simple discount
• The discount on the sum S is then simply the difference between the future and
present values. Thus the discount (D) is given by
•
• D = S − P.
• The discount D is also given by
•
• D = Sdt
•
• (compare to the formula for simple interest I = Prt) where d= simple discount rateand
the discounted (or present) value of S is
•
• P=S−D
• = S − Sdt
• P= S(1 − dt)
•
 Simple discount
• or
•
• Present Value = Future Value − Future Value ×
discount rate × time.
•
• PV = FV − FV × d × t
• = FV (1 − dt)
 Simple discount
• Example
• Suppose the government floats Treasury bills
of face value $10 at a discount of 10%. Lisa
wants to subscribe and has $10. The tenure of
the TB is 1 year. How much does Lisa Pay now
and how much will she get at the end of 1
year.
 Simple Discount
• When Lisa subscribes to the issue she pays $9 and at the end of the
tenure she will get $10 from Treasury.
• Discounted Value = S (1-dt) or (S-D)
• Discount = Sdt
• = 10× 0.10×1
• =$1
• Therefore PV given above is P=S-D = $10-$1
• = $9
• Or better still, Discounted Value = S (1-dt)
• = 10 (1-0.10×1)
• = $9
• Which is the amount paid by Lisa to be paid back $10 in one years’ time.
 Simple discount
• Example
• A customer signs a promissory note agreeing
to pay $100000 in 3 months’ time. He then
decides to discount the note with a bank at a
discount rate of 22%. How much will he
receive from the bank now?
 Equivalent Simple Interest
• Equivalent Simple Interest Rate
• It establishes a relationship between Simple
Discount and Simple Interest.
 Simple discount
• Example
• Determine the discount, discount value and the
equivalent simple interest rate on a loan of
$35000 due in 9months with a discount rate of
26%?
• S= $35 000 d= 26% t= 9/12
• ⟹Discount (D) =Sdt
• =35000×0.26× 9/12
• = $6 825
 Simple discount
• ⇒ Discounted Value (PV) =S-D or S (1-dt)
• =35000-6825
• =$28175
• The discounted value is $28175. In order to determine
the equivalent interest rate r,we note that 28 175 is the
price now and that 35 000 is paid back nine months later.
•
• I=S−P
• = 35000 – 28 175
• = 6825
 Equivalent Simple interest
• The interest is thus 6825. The question can thus be rephrased as follows:
What simple interest rate, when applied to a principal of $ 28 175 , will
yield $6825 interest in nine months?
• But remember
•
• I = Prt
• and with substitute we get
•
• 6825 = 28 175 ×r × 9/12
• If we make r subject , we get
•
• r = 0.32298
• =32%
 Payment of interest at different dates
• Payments and obligations of different dates
•
• The value of a sum of money is determined by the date
at which it is paid or received
• Example
• If you owe $2000 to be paid in 10months time at an
interest of 27%. How much would you pay?
• Given that S=P (1+rt)
• =20000 (1+0.27×10/12)
• =$24500
• Example
• Suppose you owe $100000 to be paid 4months
from now,
• $120000 to be paid 7months from now. You then
negotiate to pay all the amounts owed 10months
from now.
• How much will you eventually pay? (Use a simple
interest rate of 22% for the evaluation purpose)
• Time line presentation is as follows;
• New Obligation
• S ($100000for 6 months ) =P(1+rt)
• =100000(1+0.22×6/12)
• =$111000

• S ($120 000for 3 months) =P(1+rt)

• =120000(1+0.22×3/12)
• =$126600
• ⇒Therefore Total obligation owing will be (Obligation 1 + Obligation 2)
• = (111000+126600)
• =$237600
•
• Suppose you offered to pay $20000 now in
part settlement of the debt, this amount
cannot simply be deducted from the amount
($237600). The $20000 must be extended
• P=20 000 S ?? @10
months
• Given that S= P(1+rt) ; S@ 10 months=
20000(1+0.22×10/12)
• S=$23667
• What he owes $237600 less what he paid
$23667 (time value adjusted) gives what he
has to pay to level off the debt(X).
• Their fore Final payment (X) =$237600-$23667
• X=$213933
•
• Example
•
• Lisa owes Tracy $5000 due in 3months and $2000
due in 6months. Lisa offers to pay $3000
immediately, ifshe can pay the balance in one year.
Tracy agrees that they use simple interest rate of
16% per annum. They also agreed that the $3000
paid now will also be subject to the same rate of
16% for evaluation purposes. How much will Lisa
pay at the end of the year?
• Compound Interest
• Compound interest arises when, in a
transaction over an extended period of time,
interest due at the end of a payment period is
not paid, but added to the principal.
Thereafter, the interest also earns interest,
that is, it is compounded.
• S (FV) =P (1+i)n
• PV=S/ (1+i) n

• Example
• Find the present value of $170000 which
should be received at the end of 8years when
the interest rate is 22.67% compounded once
a year.
•
•
• PV=170000/ (1+0.2267)8
• PV=$33154
•
 Compounding
• Compounding More than Once a Year
•
• Perhaps you have noticed that we have been
careful to use the phrase “compounded
annually” in the above examples and
exercises. This is because the compound
interest earned depends a lot on the intervals
or periods over which it is compounded.
• S ≡ the accrued amount, also known as the future value
• P ≡ the initial principal, also known as the present value
• i≡jm/m, the annual interest rate compounded m times
per year
• n≡ t × m, = number of compounding periods
• t≡ the number of years’ of investment
• m≡ the number of compounding periods per year
• jm≡ the nominal interest rate per year
 compounding
• The above equation is same as: S=P (1+i)n
• Where i= jm/m
• n=tm
•
• Example
• Find the future value of $40 000 deposited into an account that earns
12.62% per annum for 6 years, compounded:
• Once per year
• Semi-annually
• Quarterly
• Monthly
• Daily
Payment of Obligations at different dates

• Example
• If you want $20000 today, how much should
you have invested done 5months ago at the
same interest rate of 27%.
• The above examples are represented in a time
line as following:
• NB YOU ARE LOOKING FOR THE PRESENT
VALUE NOW
Payment of obligations at different dates
 Nominal and Effective Annual Rates

• Remark:In cases where interest is calculated more than

once a year, the annual rate quoted is the Nominal rate.

• Effective Annual Rate [EAR]

• Is the actual interest earned per year calculated and

expressed as a percentage of the relevant principal
• This is the equivalent annual rate of interest – that is,
the rate of interest actually earned in one year if
compounding is done on a yearly basis.
• Example
• Calculate the [EAR] Effective Rate of Interest
when the nominal rate of interest is 15% per
annum compounded on the following basis:
• Yearly
• Semi-yearly
• Quarterly
• Monthly
• Daily
• Solution
• Given the following formula defined before;
• S=P (1+i)n or that s=
•
• Yearly case: assuming that P=100 , t=1 ,m=1
•
• =115.00
• Interest=Future Value(S)-Present Value (P)
• =115-100=15
• EAR==×100
• =15%
• EAR =15% yearly
• Half yearly case : m=2 ,t=1, P=100
•
• =115.56 semi-yearly
• I=S-P
• =115.56-100
• =15.56
• EAR= ×100
• =15.56%
• Quarterly case : m=4 , t=1, P=100
•
• =115.865 (1/4 yearly)
• I=S-P
• =115.865-100
• =15.87
• EAR= ×100
• =15.87% (quarterly)
• Monthlycase : m=12, t=1 ,P=100

• =116.075
• I =S-P
• =116.075-100
• =16.08
• EAR= ×100
• =16.08 %
• Daily Case :m=365 ,t=1 ,P=100
• =116.179
• I =S-P
• =116.179-100
• =16.179
• From the above example you should note
that, in order to calculate the effective rate,
we do not require the actual principal
involved. In fact, it is convenient to use P =
100,
• The EARs formulation is as follows

• The Effect of Increasing the number of Compounding times

per annum
• As we increase the number of times the interest is paid in a
year implies that ,effectively we are increasing the interest
rate or return earned on an investment.
•
•
• Notice that the Future Value is increasing as
we increase m, the number of compounding
times p.a.
• The Future Value increases at an increasing
rate then tails off to a certain upper limiting
value as m approaches positive infinity
• What is the significance of this behaviour of
EAR?
• It protects the borrower against the lender e.g.
banks, in that the return on an investment cannot
be infinitesimally increased by increasing the rate
at which interest is earned per annum If such a
limiting value did not exist, it would have meant
that the future value of an investment (or debt)
could be made arbitrarily large by increasing the
compounding frequency.
• Continuous Compounding
•
• There is a limit regarding the effects of increasing m , on the
accumulated Future Value or EAR. The limit exists when m
is so large that it approaches infinity is equal to letter e
which is the base of a natural logarithm which is equal to
2.1782
• e=2.1782
• We can write the effective interest rate (as a percentage) as:
•
• Jeff= 100( ejm− 1).
• This is the effective interest rate when the number of compounding periods tends to infinity.
Therefore we will use the symbol J∞ to identify it, and now define
•
• J∞ = 100(ejm− 1).
• EAR for continuous compounding [ j∞]
•
• The case where interest is compounded an almost infinite number of times as continuous
compounding at a rate c, and to J∞ as the effective interest rate expressed as a percentage for
continuous compounding.
• Thus
• J∞ = 100(eC– 1)
• NB. Thus, finally, with continuous compounding at rate c and for principal P, we can deduce
that:
•
• The FV in one year is
• S = Pec.
•
• The FV in t years will then simply be
•
• S = Pect
• Derivation of usable Formulae involving continuous compounding
• Suppose that we have a sum P that we invest for one year, on the one hand, at a nominal
annual rate of jmcompounded m times per year and, on the other, at a continuous
compounding rate of c. In these two cases the sum accumulated in one year is then
respectively
•
• S=Pec.
•
• The question is: What must the continuous rate c be for these two amounts to beequal? It
must be
•
• ec=
• since the principal is the same in both cases.
• We can solve for c by taking the natural logarithm
• The question is: What must the continuous
rate c be for these two amounts to beequal? It
must be
•
• ec=
• since the principal is the same in both cases.
• We can solve for c by taking the natural
logarithm of both sides.
• [stages left here]
• This gives the following results
• c= m ln
• And

• Xxxxxxxxx to put formula module pge 58

• Jm=m(e^c/m)-1)
• Remark:We use the above formulae to convert
a continuous compounded interest rate to an
equivalent nominal interest rate that is
compounded periodically, or vice versa.
• The two rates obtained in this way are
equivalent in the sense that they will yield the
same amount of interest, or give rise to the
same effective interest rate.
• Equations of Value
•
• From time to time, a debtor (the guy who
owes money) may wish to replace his set of
financial obligations with another set. On such
occasions, he must negotiate with his creditor
(the guy who is owed money) and agree upon
a new due date, as well as on a new interest
rate.
• It is evident from these remarks that the time
value of money concepts must play an
important role in any such considerations,
• even more so than they did in the simple
interest case, since the investment terms are
generally longer in cases where compound
interest is relevant.
• Example
• You decide now that when you graduate in
four years’ time you are going to treat yourself
to a car to the value of 20 000.
• If you can earn 17% interest compounded
monthly on an investment, calculate the
amount that you need to invest now.
• An obligation of $50 000 falls due in three
years’ time. What amount will be needed to
cover the debt if it is paid
• (a) in six months from now
• (b) in four years from now
• if the interest is credited quarterly at a
nominal rate of 12% per annum?
• (a) To determine the debt if it is paid in six months (ie
two quarters), we must discount the debt back two-
and-a-half-years from the due date to obtain the
amount due.
•
• S = P (1 + i)n
•
• P = S (1 + i)-n
•
• with m = 4, t = 2,5 and jm = 0,12.
• P = S (1 + i)-n
• P=?????
•
•
•
• = 37 204,70
• The present value of the debt six months from now is $37 204,70.
•
• (b) To determine the debt, if it is allowed to accumulate for one
year past the due date, we must move the money forward one
year to obtain.
• S = P (1 + i)n
• S=????
•
•
• = 56 275,44
• The future value of the debt four years from
now is $56 275,44
•
• As we noted above that we would concern ourselves here with
replacing one set of financial obligation with another
equivalent set.
• Example

• Tenesmus Sithole foresees cash flow problems ahead. He

borrowed $10 000 one year ago at 15% per annum,
compounded semi-annually and due six months from now. He
also owes $5 000, borrowed six months ago at 18% per
annum, compounded quarterly and due nine months from
now. He wishes to pay $4 000 now and reschedule his
remaining debt so as to settle his
• obligations 18 months from today. His creditor
agrees to this, provided that the old
obligations are subject to 19% per annum
compounded monthly for the extended
period. It is also agreed that the $4 000 paid
now will be subject to this same rate of 19%
for evaluation purposes. What will his
payment be in 18 months’ time?
• Solution
 Annuities

• An annuity is a series of equal payments made

at fixed intervals for a specified number of
periods. For example, a promise to pay $ 1 000
a year for 3 years is a 3-year annuity. There are
two types of annuities : annuity due and
ordinary (deferred) annuity.
•
• Diagram for Ordinary Annuity
• Diagram for Ordinary Annuity
• To insert diagram
• If the payments are made at the end of each
period, that is, they are made at the same time
that interest is credited, it is an ordinary
annuity.
• If the payments are made at the beginning of
each period, the annuity is known as an
annuity due.
• Diagram for Ordinary due
• To insert diagram
• If the payments begin and end on a fixed date, the annuity
is known as an annuitycertain. On the other hand, if the
payments continue for ever, the annuity is knownas
perpetuity.
•
• The FV of an annuity is the sum of all payments made and
the accumulated interest at the end of the term.
•
• The PV is the sum of payments, each discounted to the
beginning of the term, that is, the sum of the present value
of all payments.
• Future Value of an Ordinary Annuity
•
• Example
• Suppose you deposit $ 100 at the end of each year for
3 years in a savings account thatpays 5% interest per
year, how much will you have at the end of 3 years?
•
• In this example, each payment is compounded out to
the end of period n, and the sum ofthe compounded
payments is the future value of the annuity
• Timeline presentation of the problem:
• Future Value Interest Factor Annuity [FVIFA]
•
• The future value of an annuity of $1 for a
period of n years at an interest rate of i is
given by the following formula:
FVIFA n,i % 

1  i  1
n

i
 
1  0.05  1
For the above example;
FVIFA3,5% 
3

0.05
= 3.1525
To find the FV, we multiply the FVIFA by the size of periodic payment
• To find the FV, we multiply the FVIFA by the
size of periodic payment
• FV= 3.1525×100 = 315.25
• Generally, The FV of an ordinary annuity is
given by the following formulation;
FVOD [

1  i
n
1
] R
i
• Where iis interest rate i per payment interval,
• R is annuity payment amount per period
• n is the number of payment intervals of the annuity
• NB.
• The annual interest rate jmcompounded m times per year
jm/mis denoted by i [i= jm/m]
• While the number of interest compounding periods tm is
denoted by n.
• As such;
• Example
• Suppose you deposit $ 100 at the end of each year for 3
years in a savings account thatpays 5% interest per year,
how much will you have at the end of 3 years?

• For the above example;

• = 3.1525
• NB.
• The annual interest rate jmcompounded m
times per year jm/mis denoted by i [i= jm/m]
• While the number of interest compounding
periods tm is denoted by n.
• As such;
• Practice Questions
• 1. Mrs Thodes decides to save for her
daughter’s higher education and, every year,
from the child’s first birthday onwards, puts
away $1 200. If she receives 11% interest
annually, what will the amount be after her
daughter’s 18th birthday?
• Future Value of an Annuity Due.
•
• If the $100 payments had been made at the
beginning of each year, this would be an
annuity due and the time line would look as
shown below :
• Thus, the future value of the annuity due is [100 (1.05)
+ 100 (1.05)2 + 100 (1.05)3 ] = $331.01.
•
• Since the payments occur earlier, more interest is also
earned, thus the future value of an annuity due is larger
($331,01) than that of an ordinary annuity ($315.25).
•
• To get the future value of an annuity due we compound
the future value of an ordinary annuity by an extra
period.
• Future value of annuity due [FVAD] = R×
FVIFAOD (1+i)
• In our example, the future value of the
annuity due is 100 (3.1525) (1.05) = $331.01.
• Present Value of an Ordinary Annuity.
•
• Remark: The present value of an annuity is the
amount of money that must be invested now,
at i percent, so that n equal periodic payments
may be withdrawn without any money being
left over at the end of the term of n periods.
• Example
•
• Suppose an investor has the following
alternatives : a three year annuity of $1
000.00 or a lump sum payment today. What
must the lump sum payment be to make it
equivalent to the annuity if the interest rate is
10% ?
• Present Value Interest Factor Annuity ,
(PVIFAOD)
•
• The present value of an annuity of $1 for a
period of n years at an interest rate of i is
given
•
• by the following formula:
 PVIFAOD 

1  i  1
n

i 1  i 
• n
• Where iis interest rate i per payment interval,
• R is annuity payment amount per period
• n is the number of payment intervals of the annuity
• NB.
• The annual interest rate jmcompounded m times per year jm/m
• is denoted by i [i= jm/m], while the number of interest
compounding periods tm is denoted by n.[tm=n]
•
• To find the PV of the annuity , we can make use of the formula:
Multiply the PVIFA by the periodic payment,R. So we have;
• PVOD=PVIFAOD× R
  I  i   1
n
PVOD  n 
R
 i 
1  i  
  1  0.10   1 
3
VOD  3
1000
 0.101  0.10  
1
1
• Present Value of an Annuity Due
• We can establish a relationship between the
present value of an annuity due and an ordinary
annuity, namely
•
• PV (of annuity due with n periods)=
firstpayment +PV ( of ordinary annuity with (n −
1) periods)
•
• Thus the present value of an annuity due is given by
•
• Present Value of Annuity[PVAD] = R× PVIFAOD (1+i)
•
• Example
• If the monthly rental on a building is $1 200 payable
in advance, what is the equivalent yearly rental?
Interest is charged at 12% per annum compounded
monthly. How much interest is paid?
• Solution
• What the question in fact asks is: What rental must be paid
as a lump sum at the beginning of the year instead of
monthly payments? In other words, this is a present value-
type calculation. There is one payment at the beginning but
not at the end. This means that the first payment does not
have to be discounted and that the remaining 11 payments
form an ordinary annuity. Thus the equivalent yearly rental
(ER) is given by
•
• ER = First payment + Present value of remaining 11 payments
• ER = First payment + Present value of
remaining 11 payments
• Or use the following relationship
•
• Present Value of Annuity[PVAD] = R× PVIFAOD
(1+i)
•
• Working:
• Summary
•
• Present Value of Ordinary Annuity [PVOD] = R× PVIFAOD
• Present Value of Annuity Due [PVAD] = R× PVIFAOD (1+i)
• Future Value of Ordinary Annuity[FVOD] = R× FVIFAOD
• Future Value of Annuity Due [FVAD] = R× FVIFAOD (1+i)
•
• Annuity Payment Date differs from Interest Payment Date
•
• Annuity Payment Date differs from Interest
Payment Date
• In practice the payment of interest does not to
coincide exactly with the annuity payment
date. When the two does not coincide, it
presents practical difficulties on deciding
which interest rate to use for which period
since they differ.
• What we will be doing is to replace the
specified interest rate and period with an
equivalent interest rate that corresponds to the
period of the payments.
• Example
• An investor makes a payment of $10 000 at the
end of every 4 months for the next 6 years.
Calculate the Future Value of the payments if
interest is compounded semi-annually at 19.5%.
• Lets establish notation here:
• mi(The frequency of Interest Payment) = 2
mp(frequency of annuity payment) = 3
•
• We see mi ≠ mp thus giving the need to convert the semi- annually
compounded rate to be applicable to the periods of annuity payment
ie every 4 months
•
• Step 1
• Convert the semi-annual compounding of interest to three time per
year to coincide with the frequency of payments per year of annuity.
We go through the equivalent continuous effective rate.
• Step 1
• Convert the semi-annual compounding of
interest to three time per year to coincide
with the frequency of payments per year of
annuity. We go through the equivalent
continuous effective rate.
• Jm= 0.195 mi =2

 jm 
c m ln  1  
 m 
  0.195 
c 2 ln  1  
 2 
• Step 2 = 18.60697%
• Is to calculate the equivalent nominal rate, jm ,
to the continuous rate calculated in step 1 ,
coinciding with mp =3.
•
• We also know that;
  c

j m m e  1
m

 
• Given c = 18.60697% and mp=3
• We will have;
 0.1860

j m 3 e 3
 1
 
• =19.1961%
• This rate is an annual equivalent nominal rate
compounded 3 times p.a , which makes now
applicable to the period of payement which is
also 3 time p.a.
• Step 3
• We can now aplly this rate to find the Future
value of the investment as follows.
• FVOD = R× FVIFAOD
• = $320 923.78
• , which is the FV of the investment
• Alternative method to find the Equivalent
Periodic Nominal Rate
•
• We can use the following formula
  m

  jmn 
j n n  1   1
 m  
 
• jn compounded n times, equivalent to jm compounded m
times
•
• n- is where you want to go ie the frequency of payment
• m- is the where you are coming from ie the frequency of
interest compounding
•
• Try use the formulae and see if you get the same
coincided periodic nominal rate.
•
• If this happens we have to make use of the
concept of continuous compounding as noted
earlier in our discussions, to convert the
mismatching interest rate through continuous
compounding to make the interest payment
date (IPD) and the annuity payment date
(APD) coincide. [ i.e. marry/match/coincide
IPD and APD}.