FINANCIAL MANAGEMENT

(MBA 622)

CHAPTER THREE

THE TIME VALUE OF MONEY

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 3.1 Compound Interest &
Future Value
─ Simple Interest
─ Interest paid (earned) on only the original amount
borrowed (lent)
─ Formulae: I=P×i×n
─ Future Value (Terminal Value)
─ Value at some future time of a present amount of
money, or a series of payments, evaluated at a
given interest rate
─ The future value of an amount for any simple
interest rate:
FV = P + I = P + (P × i × n)
= P [ 1 + (i × n)]
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 …. Cont’d
─ Present Value
─ The current value of a future amount of money, or a
series of payments, evaluated at a given interest
rate
─ Formulae: Rearrangement of the previous formulae
FV = PV [ 1 + (i × n)] → PV = FV/ [ 1 + (i × n)]
─ COMPOUND INTEREST
─ Implies that interest paid (earned) on a loan (an
investment) is periodically added to the principal
─ Interest is earned on interest as well as the initial
principal
─ Formulae for a single future amount:
FV = P × (1 + i)n
Future-Value Interest Factor
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 Illustration: 3.1

─ Suppose Mr. X deposited Br. 2,500 today in his

savings account that compounds interest
annually.
─ The interest rate is 8%.
─ He wishes to find the future value of his deposits
at the end of the 5th year.
─ Computation of the Future Value:
FV = P × (1 + i)n
= Br. 2,500 × (1 + 0.08)5
= Br. 2,500 × (1.08)5
= Br. 2,500 × (1.4693)
= Br. 3,673.32
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 3.2 Compound Interest with
Non-Annual Periods
─ When compounding occurs more than once in a
year
─ Possible compounding timings:
─ Semi-annually
─ Quarterly
─ Monthly
─ Weekly
─ Daily
─ Formulae for a single future amount can be rearranged
as:
FV = P × (1 + i/m)mn
Where, m = No. of times compounding
occurs during a year
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 Illustration: 3.2

─ Suppose Mr. X’s savings account compounds

interest quarterly.
─ What would be the future value of his deposits at
the end of the 5th year?
─ Computation of the Future Value:
FV = P × (1 + i/m)mn
= Br. 2,500 × [1 + (0.08 ÷ 4)]4 × 5
= Br. 2,500 × (1 + 0.02)20
= Br. 2,500 × (1.02)20
= Br. 2,500 × (1.48595)
= Br. 3,714.87

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 3.3 Present Value

─ In the FV techniques, we move money forward in

time since we know how much to begin with
─ Now, in PV techniques, we pull in money to its
current value: the reverse direction
─ PV is just the current value of a future sum
─ What is done is nothing other than inverse
compounding
─ In compounding, we used the interest rate and
initial investment
─ Here, we will use the discount rate and attempt
to determine the present value of future cash flows

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 ……. Cont’d

─ To determine the initial investment or the PV of a

single sum, both sides of the FV formulae would
be divided by the FV Interest Factor, (1 + i)n to
result at:
PV = FV × 1/(1 + i)n
Present-Value Interest Factor
─ Alternatively, PV can be computed as follows:
PV = FV × (1 + i) – n

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 Illustration: 3.3

─ If Mr. X wants to receive Br. 500 ten years from

today in an account that compounds interest
annually with a discount rate of 6%, how much
should he deposit now?
─ Computation of the Present Value:
PV = FV × (1 + i) - n
= Br. 500 × (1 + 0.06)-10
= Br. 500 × (1.06)-10
= Br. 500 × (.5584)
= Br. 279.20

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 3.4 Annuities- Ordinary &
Annuity Due
− Annuity
− A series of equal payments for a specified number
of periods.
− Basic Types of Annuities: Ordinary Annuity and
Annuity Due
− Ordinary Annuity:
− An annuity in which the payments occur at the end
of each period
− Annuity Due:
− An annuity in which the payments occur at the
beginning of each period.

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 …. Cont’d
− Future Value of an Ordinary Annuity, FVOA
− The aggregated sum of the future value of each
individual payment on the final rent day
− Illustration 3.4: FVOA
Assume that Mr. X wants to provide his son for a college
education by depositing Br. 500 at the end of each year
for the next five years in a bank where he will earn 6%
interest. How much will he have at the end of five years?
Using the FV formulae for each stream of payments,
FV5 = 500(1.06)4 + 500(1.06)3 + 500(1.06)2 + 500(1.06) + 500
= 500(1.262) + 500(1.191) + 500(1.124) + 500(1.06) + 500
= 631.00 + 595.50 + 562.00 + 530.00 + 500.00
= Br. 2,818.50

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 …. Cont’d
− Future Value of an Ordinary Annuity, FVOA
[(1 + i)n – FV Interest Factor for
1] an Annuity
FVOA = R
i
− For the previous Illustration:
[(1 + 0.06)5
500 – 1]
FVOA =
× 0.06

500 [(1.06)5 – 1]
=
× 0.06
0.33
500 82
=
×
0.06
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 …. Cont’d
− Future Value of an Annuity Due, FVAD
− The total amount on deposit one period after the final
rent
[(1 + i)n –
FVAD 1] (1 +
R
= i i)
− Illustration 3.5: FVAD for Illustration 3.4
[(1 + 0.06)5 –
500 1] (1 +
FVAD =
× 0.06 0.06)

0.33
500 82 ×
=
× (1.06)
0.06
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 …. Cont’d
− Present Value of an Ordinary Annuity, PVOA
− The discounted value of a series of future rents on the
date one period before the first rent is made

− Illustration 3.6: PVOA for Illustration 3.4

Using the PV formulae for each stream of payments,
PV5 = 500(1.06)-1 + 500(1.06)-2 + 500(1.06)-3 + 500(1.06)-4
+ 500(1.06)-5
= 500(.943) + 500(.890) + 500(.840) + 500(.792) + 500(.747)
= 471.50 + 445.00 + 420.00 + 396.00 + 373.50
= Br. 2,106.00

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 …. Cont’d
− Present Value of an Ordinary Annuity, PVOA
[1 – (1 + PV Interest Factor for
i)-n] an Annuity
PVOA
R
= i
− For the previous Illustration:
[1 – (1 +
500 0.06)-5]
PVOA =
× 0.06

500 [1 – (1.06)-5]
=
× 0.06
0.25
500 27
=
×
0.06
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 …. Cont’d
− Present Value of an Annuity Due, PVAD
− The discounted value of a series of future rents on the
date the first rent is made
[1 – (1 + i)-
PVAD n
] (1 +
R
= i i)
− Illustration 3.7: PVAD for Illustration 3.6
[1 – (1 +
500 0.06)-5] (1 +
PVAD =
× 0.06 0.06)

0.25
500 27 ×
=
× (1.06)
0.06
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= 500 × 4.2124 × 1.06
 3.5 Present Value of Complex
Stream
− Investment projects involving uneven cash flows
over several years
− Not only comparison of PVs of cash flows between
projects, but also the cash inflows and outflows
within a project is required.
− Illustration 3.8: Complex Stream of CFs @ d/f
rates
Year Rates CFs Year Rates CFs
1 6% Br. 500 6 8% Br. 500
2 6 200 7 8 500
3 6 - 400 8 8 500
4 8 500 9 8 500
5 8 500 10 8 500
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 3.6 Perpetuities & Infinite Annuities
− Perpetuity
− An annuity that continues forever
− Every year from its establishment, such investment
pays the same amount
− Preferred Stock is the best example
− PV of a Perpetuity: PP
P
=
V i
− Illustration 3.9: PV of a Perpetuity
− What is the value of a Br. 500 perpetuity
discounted back to the present at 8%?
− PV = Br. 500 ÷ .08
− PV = Br. 6,250

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 3.7 Making Interest Rates
Comparable
− Comparing interest rates is important for making
intelligent investing or borrowing decisions
− Difficulty in comparison due to timing of
compounding
− Converting to some common compounding
period & then compare
− Nominal or Quoted Interest Rate
− The rate of interest stated on the contract
− Annual Percentage Yield (APY)
− The annual compound rate that produces the same
return as the nominal or quoted rate
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 ….. Cont’d
− Annual Percentage Yield (APY)
− Also called Effective Annual Rate (EAR)
− Computed using:
APY or EAR = (1 + Quoted Rate/m)m – 1
Where, m is the number of
compounding periods within
a year
− Illustration 3.10: APY or EAR
− Borrowing money from a bank at 12% compounded
monthly. Convert it into APY or EAR.
APY or EAR = (1 + Quoted Rate/m)m – 1
= (1 + 0.12/12)12 – 1
= (1.01)12 – 1 = 1.1268 – 1
= 0.1268 = 12.68%
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 End of Chapter Three!

THANK YOU
For
Your
ATTENTION!

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