GCAP 3166: Financial

Planning
Lecture 2a: Time
Value of Money

1
 Time Value of Money
The time value of money is a fundamental idea in
Finance that the money that one has now is worth
more than the money one will receive in the future
because money can earn interest or be invested.

2
 Time Value of Money

0 Interest Rate t
Present Value Future Value

Future value is a sum of money received or paid

in the future after earning interest.
Present value is the value today of a future cash
flow.
Discounting is the process of reducing the future
values to present values.
3
 Simple Interest
Under simple interest, interest is computed on the
original principal only.
Simple interest is used on short term investments –
often of duration less than 1 year.

4
 Simple Interest
Simple Interest Formula

0 r t
PV FV
FV = PV(1+ rt)
where FV = future value
PV = present value/principal
r = annual simple interest rate
t = time in years

5
 Simple Interest
Example 1: Find the total amount due on a loan of $800 at
9% annual simple interest at the end of 4 months.
4
0 r = 0.09 t  yr
12
PV=800 FV = ?

FV PV (1  rt )
4
FV 800[1  0.09( )]
12
FV 800(1.03)
FV $824

6
 Compound Interest
Compound interest refers to interest earned on
interest.

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 Compound Interest
Example 2: You deposit $1000 in a bank that pays an
interest rate of 6% per year on deposits. How much
will the bank owe you at the end of the 3 years?
Answer: $1191.2
1 year 1 year 1 year
0 1 2 3
Deposit FV1 PV0 (1  rt ) FV2 1060[1  0.06(1)] FV3 1123.6[1  0.06(1)]
PV0 1000 FV1 1000[1  0.06(1)] FV2 1060(1.06) FV3 1123.6(1.06)
FV1 1000(1.06) FV2 1123.6 FV3 1191.2
FV1 1060
1060 is made up of principal The interest earned in year 1
(1000) and interest (60). (60) is earning interest in
year 2.

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 Compound Interest
Compound Interest Formula

0 i 1 i 2 ………… n
PV FV

FV = PV(1+ i)n
where FV = future value
PV = present value/principal
i = interest rate per period

n = total number of periods

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 Example of Compound
Interest
Example 2: You deposit $1000 in a bank that pays an
interest rate of 6% per year on deposits. How much
will the bank owe you at the end of the 3 years?

0 i = 0.06 1 i = 0.06 2 i = 0.06 n=3

PV 1000 FV ?

FV = PV(1+ i)n
FV =1000(1 + 0.06)3
FV = 1191.02

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 Compound Interest
Future Value of $1000 Invested
at 8% and 10% per year
50000

45000

40000

35000 30913
Future Values ($)

30000

25000

20000

15000
11918 15968
10000

5000

0
0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425262728293031323334353637383940

Years

i = 8% i = 10%

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 Future Value of an Annuity
An annuity is any sequence of equal periodic
payments with finite maturity.
If payments are made at the end of each time interval,
then the annuity is called an ordinary annuity.
The futures value, of an annuity is the sum of all
payments plus all interest earned.

0 1 2 3 4
PMT PMT PMT PMT
FV

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 Example of Future Value of an
Annuity
Example 3: You are setting aside $3000 at the end of
every year in order to buy a car. If your savings earn
interest of 8% a year, how much will they be worth at
the end of 4 years?

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 Example of Future Value of an
Ordinary Annuity
Example 3:

1 year 1 year 1 year 1 year

0 i = 0.08 1 yr i = 0.08 2 yr i = 0.08 3 yr i = 0.08 4 yr
3000 3000 3000 3000
t=1 FV 30001  0.08
FV 3240

t=2 FV 30001  0.08

2

FV 3499.2

t=3 FV 30001  0.08

3

FV 3779.14

FVOA = $13518.34
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 Future Value of an Annuity
Formula for Future Value of an Ordinary Annuity

 1  i n  1 
FVOA PMT  

 i 

where FVOA = future value of ordinary annuity

PMT = periodic payments
i = interest rate per period
n = number of payments (periods)

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 Example of Future Value of an
Annuity
Example 3:
1 year 1 year 1 year 1 year
0 i = 0.08 1 yr i = 0.08 2 yr i = 0.08 3 yr i = 0.08 4 yr
3000 3000 3000 3000
FVOA = ?
 1  i n  1 
FVOA PMT  

 i 
 1  0.084  1 
FVOA 3000 

 0 . 08 
FVOA $13518.34
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 Example of Future Value of an
Annuity
Example 4: You will retire in 50 years time. You believe
that you will need to accumulate $500000 by your
retirement date in order to support your desired
standard of living. How much must you save at the end
of each year between now and your retirement to meet
that future goal assuming that interest rate is 10% per
year?

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 Example of Future Value of an
Annuity
Example 4:
0 1 2 i = 0.10 …………… 50
PMT PMT PMT
FVOA = 500000
 1  i   1 
n
FVOA PMT  

 i 
 1  0.150  1 
500000 PMT  

 0 .1 
500000 PMT (1163.91)
PMT $429.59
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 Future Value of an Annuity
Due
An annuity due is an annuity with beginning- of –
period payments.

0 1 2 3 4
PMT PMT PMT PMT
FVAD

Future value of = Future value of * (1 + i)

annuity due of ordinary annuity

FVAD = FVOA(1+i)
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 Example of Present Value of an
Annuity
Example 5: How much should you deposit in an account
paying interest at a rate of 6% per year in order to
withdraw $5000 a year (end of year) for the next 3
years? (After the last payment is made, no money is to
be left in the account.)

Recall: FV PV 1  i 
n

FV
PV 
(1  i ) n

20
 Example of Present Value of an
Annuity
Example 5:

1 year 1 year 1 year

0 i = 0.06 1 yr i = 0.06 2 yr i = 0.06 3 yr
5000 5000 5000
5000 t=1
PV  4716.98
1  0.06
5000 t=2
PV  4449.98
1  0.062
5000 t=3
PV  4198.10
1  0.063

PVOA = $13365.06
21
 Present Value of an Annuity
Formula for Present Value of an Ordinary Annuity

 1  1  i  n 
PVOA PMT  

 i 
where PVOA = present value of ordinary annuity
PMT = periodic payments
i = interest rate per period
n = number of payments (periods)

22
 Example of Present Value of an
Annuity
Example 5: using the formula

1 year 1 year 1 year

0 i = 0.06 1 yr i = 0.06 2 yr i = 0.06 3 yr
5000 5000 5000

 1  1  i  n 
PVOA PMT  

 i 
 1  1  0.06  3 
PVOA 5000 

 0 . 06 
PVOA $13365.06
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 Amortization
Amortizing a debt means that the debt is retired
in a given length of time by equal periodic
payments that include compound interest.
Now
0 1 2 ……………… n
PVOA PMT PMT PMT

Taking a Cash Cash Cash Cash

loan inflow outflow outflow outflow

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 Example of Amortization
Example 6: A family decides to purchase a house for
$125000. The house is to be financed by paying a 20%
down payment and signing a 30-year mortgage that is
repaid in equal monthly repayments. The interest rate
of the mortgage loan is 1% a month. What is the
monthly mortgage payment?

25
 Example of Amortization
Initial loan = (0.8)(125000) = $100000
n = (30)(12) = 360
i = 0.01
0 1 2 ………. 360
PVOA = 100000 PMT PMT PMT
 1  1  i  n 
PVOA PMT  

 i 
 1  1  0.01 360 
100000 PMT  

 0 . 01 
100000 PMT (97.22)
26 PMT $1028.61
 Present Value of an Annuity
Due

0 1 2 3 4
PMT PMT PMT PMT
PVAD

Present value of = Present value of * (1 +

i)
annuity due of ordinary annuity

PVAD = PVOA(1+i)
27
 Computing Interest Rate per
Period
When requesting an interest rate quote from a bank,
the bank may quote the annual rate r and the number
of compounding periods (m).
Example: 12% a year compounded quarterly
We can easily compute the interest rate per period as
follow:

where m if the number of compounding period in a

year.

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 Effective Annual Interest
Rates
We cannot compare different annual interest rate r
with different compounding periods m directly.
The annual interest rates with different
compounding periods need to be converted to
effective annual interest rates for comparison.

29
 GCAP 3166: Financial
Planning
Lecture 2b:
Determining a Saving
Schedule

30
 Reference:
Personal Finance - An Integrated Planning Approach, Frasca,
8th Edition
Chapter 2 (pg. 35 to 40)

31
 Determine the concrete goals
Case: The Steele Family
The Steeles – Arnold (37), Sharon (35), Nancy (9) and
John (7) – are a typical middle-class American family.
Arnold and Sharon have identified 4 specific goals
they want to achieve in the future:
1. Providing 4 years of college education to Nancy and
John, with Nancy starting 8 years from the present
and John starting 2 years after Nancy. The current
annual cost for a college education is $12000.

32
 Determine the concrete goals
2. Add a greenhouse to the home 18 years in the future.
The greenhouse would cost $40000 to install today.

3. Taking a European vacation 20 years in the future.

The current cost of a European vacation is $10000.

4. Accumulate a retirement nest egg 28 years in the

future. Arnold and Sharon would like to have
$100000 in today’s purchasing power to use in a
variety of ways at retirement.

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 Determine a Saving Schedule
Arnold and Sharon have approached you to help them to
come up with a saving plan to enable them to meet
their objectives.

34
 Determining a Saving
Schedule
Step 1: Determine the cost of the activity if it is taken
today (Already done).

Step 2: Adjust the cost to reflect inflation. The inflated

amount can be determined using the compounding
process with the inflation rate, working the same way as
the interest rate.

Step 3: Determine a saving schedule (Trial and error).

Step 4: Monitor the progress

35
 Determining a Saving
Schedule
Assume that the inflation rate over the planning period
will be 3% per year while college costs are presumed
to increase at a 6% rate per year.
Goals Years until Amount Expected
Goal is Required ($) Inflation Rate
Achieved (Today’s Cost) (%)
1. Nancy starts college
Year 1 8 12000 6
Year 2 9 12000 6
2. John joins Nancy at college
Year 3 10 12000 + 12000 6
Year 4 11 24000 6
3. Nancy finishes college
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 Determining a Saving
Schedule
Goals Years until Amount Expected
Goal is Required ($) Inflation Rate
Achieved (Today’s Cost) (%)
3. Nancy finishes college
Year 5 12 12000 6
Year 6 13 12000 6
4. John finishes college
5. Greenhouse 18 40000 3
6. Vacation 20 10000 3
7. Retirement 28 100000 3
Total 246000

37
 Determining a Saving
Schedule
Step 2: Adjust the cost to reflect inflation.
a. The Steele family requires $12000 eight years from now
with an expected inflation rate (for college) of 6%.

0 1 2 Inflation rate = 0.06 …………… 8

12000 Inflated amount = ?

Inflated amount = $12000x(1.06)8 = $19126

b. Repeat the same process for each relevant year.

38
 Determining a Saving
Schedule
Goals Years until Amount Expected Inflated
Goal is Required ($) Inflation Amount
Achieved (Today Cost) Rate ($)
(%)
1. Nancy starts college
Year 1 8 12000 6 19126
Year 2 9 12000 6 20274
2. John joins Nancy at college
Year 3 10 24000 6 42980
Year 4 11 24000 6 45559
3. Nancy finishes college

39
 Determining a Saving
Schedule
Goals Years until Amount Expected Inflated
Goal is Required ($) Inflation Amount
Achieved (Today Cost) Rate ($)
(%)
3. Nancy finishes college
Year 5 12 12000 6 24146
Year 6 13 12000 6 25595
4. John finishes college
5. Greenhouse 18 40000 3 68097
6. Vacation 20 10000 3 18061
7. Retirement 28 100000 3 228793
Total 246000 492632

40
 Determining a Saving
Schedule
Step 3: Determine a saving schedule.
Saving Plan 1: Determine the required saving amount
each year by using the annuity (FVOA) formula.
The Steele family needs $19126 in 8 years time.
Assuming that the Steeles will earn 8% per year on
their saving, determine the amount they need to
deposit at the end of each year to meet this goal.

41
 Determining a Saving
Schedule
0 1 2 i = 0.08 …………… 8
PMT PMT PMT
FVOA = 19126

 1  i n  1 
FVOA PMT  

 i 
 1  0.088  1 
19126 PMT  

 0 . 08 
19126 PMT (10.6366)
PMT $1798
42
 Determining a Saving
Schedule
Table 1: Annual Saving
Goals Years until Amount Inflated Required
Goal is Required ($) Amount Annual
Achieved (Today Cost) ($) Saving ($)
1. Nancy starts college
Year 1 8 12000 19126 1798
Year 2 9 12000 20274 1624
2. John joins Nancy at college
Year 3 10 24000 42980 2967
Year 4 11 24000 45559 2737
3. Nancy finishes college

43
 Determining a Saving
Schedule
Goals Years until Amount Inflated Required
Goal is Required ($) Amount Annual
Achieved (Today Cost) ($) Saving ($)
3. Nancy finishes college
Year 5 12 12000 24146 1272
Year 6 13 12000 25595 1191
4. John finishes college
5. Greenhouse 18 40000 68097 1818
6. Vacation 20 10000 18061 395
7. Retirement 28 100000 228793 2400
Total 246000 492632 16202

44
 Determining a Saving
Schedule
Saving Plan 1
Summing the required annual savings for all the
activities gives a total required annual savings of
$16202.
However, this is not an amount that have to be saved
each year over the next 28 years.
As each goal is achieved, the need to save for it can be
eliminated.
(Refer to Table 2 from attached handout)

45
 Determining a Saving
Schedule
Saving Plan 1 (refer to Saving Plan 1 from the attached
excel printout)
We are assuming end-of-year deposits. Hence deposit in the
current year will not be earning any interest in that year.
The interest is based on the ending balance in the previous
year.
Year 1 Year 2
0 1 2 i = 0.08 ……………
Deposit 16202 Deposit 16202
Interest = 0 Interest = (0.08)(16202) = 1296
Ending Balance Ending Balance = 16202 + 1296 + 16202
= 16202 = 33700

46 Note: Deposit refers to new deposit and interest is calculated on the previous balance.
 Determining a Saving
Schedule
Saving Plan 1 (refer to Saving Plan 1 from the attached excel
printout)

Interest Earned = 0.08*(Previous year Ending Balance)

Ending Balance = Previous year Ending Balance

+ Current year Deposit
+ Current year Interest Earned
- Current year Withdrawals

47
 Determining a Saving
Schedule
Problem with Saving Plan 1

The saving plan requires the most savings in the early

years when both Arnold and Sharon incomes are
probably lower than what they will be in future years.

48
 Determining a Saving
Schedule
Saving Plan 2: Arnold and Sharon can start with an
initial annual saving of $8000 (around 10% of their
pretax incomes) and then increase it by $1000 every 4
years.

Refer to Saving Plan 2 from the attached excel printout.

49
 Determining a Saving
Schedule
Problem with Saving Plan 2

There are negative ending balances for a number of

years. This implies that the Steeles would have to
borrow to make up for the shortages and would have to
pay interests for the loans.

50
 Determining a Saving
Schedule
Saving Plan 3:
Arnold and Sharon are unable to increase their saving
above the 10% of income target.
Fortunately, the Steeles have accumulated some
investments that are worth approximately $30000.
$18000 of the $30000 can be transferred to the saving
account related to their goal-planning activity
immediately.

51
 Determining a Saving
Schedule
Saving Plan 3 (refer to Saving Plan 3 from the attached
excel printout)

Year 1 Year 2
0 1 2 i = 0.08 ……………
Deposit 18000 Deposit 8000 Deposit 8000
Interest Interest = (0.08)(27440) = 2195
= (0.08)(18000) Ending Balance = 8000 + 2195 + 27440
=1440 = 37635
Ending Balance
= 8000 + 1440 + 18000
= 27440

52 Note: Deposit refers to new deposit and interest is calculated on the previous balance.
 Determining a Saving
Schedule
Step 4: Monitor the progress
The usefulness of the goal planning (saving plan)
depends to a large extent on the validity of the
assumptions embedded in the plans.
Main assumptions:
1. Inflation rates of 3% and 6%
2. Interest rate of 8%
The above rates may change over the plan life.

53
 Determining a Saving
Schedule
Step 4: Monitor the progress
Constant monitoring of the progress toward achieving
the goals is required to ensure a quick respond to
changes in the financial environment.

54