IBF-Time Value of Money

In simpler terms, future value represents the total amount that an investment or sum of money
will grow to, including both the original amount invested and the interest or returns it
generates over time.
The formula to calculate future value (FV) is:
FV = PV * (1 + r)^n
Where: FV = Future Value
PV = Present Value or the initial investment amount
r = Interest rate or rate of return per period
n = Number of periods (usually expressed in years)
The future value calculation takes into account the time value of money, recognizing that
money today is worth more than the same amount in the future due to the potential for
investment and earning returns.
Q.Let's say you have $1,000 that you want to invest in a savings account that offers an
annual interest rate of 5%. You plan to leave the money invested for 3 years.
To calculate the future value (FV), you can use the formula mentioned earlier:
FV = PV * (1 + r)^n
Where: PV = $1,000 (initial investment) r = 5% (interest rate per year) n = 3 years
Plugging the values into the formula, we get:
FV = $1,000 * (1 + 0.05)^3 FV = $1,000 * (1.05)^3 FV = $1,000 * 1.157625 FV ≈ $1,157.63
Therefore, the future value (FV) of your $1,000 investment after 3 years at a 5% annual
interest rate would be approximately $1,157.63.
This means that if you leave your money in the savings account for 3 years, you can expect it
to grow to around $1,157.63 by the end of the period, considering the interest earned. The
future value calculation allows you to estimate the growth of an investment over time and
assess its potential value in the future.
Present Value
In other words, present value represents the value of a future cash flow or investment at the
present moment, accounting for the time value of money. It allows for the comparison of cash
flows or investments that occur at different points in time.
The formula to calculate present value (PV) is:
PV = FV / (1 + r)^n
Where: PV = Present Value FV = Future Value or the expected sum of money in the future r
= Interest rate or rate of return per period n = Number of periods (usually expressed in years)
The present value calculation takes into consideration the concept of discounting, recognizing
that the value of money decreases over time due to inflation and the opportunity cost of not
having the money available for other investments.
By calculating the present value, you can determine the amount of money that needs to be
invested today to achieve a desired future value, or evaluate the attractiveness of an
investment opportunity based on its present value compared to its future value.

Q.Suppose you have been offered a financial investment opportunity that promises to
pay you $1,500 at the end of 5 years. However, you want to assess the present value of
this future payment to determine its worth in today's terms, considering the time value
of money.
Let's assume a discount rate of 6% per year, which represents the rate of return you could
earn on an alternative investment with similar risk.
To calculate the present value (PV), you can use the formula mentioned earlier:
PV = FV / (1 + r)^n
Where: FV = $1,500 (future payment) r = 6% (discount rate per year) n = 5 years
Plugging in the values into the formula, we get:
PV = $1,500 / (1 + 0.06)^5 PV = $1,500 / (1.06)^5 PV = $1,500 / 1.338225 PV ≈ $1,120.69
Therefore, the present value (PV) of the $1,500 future payment, discounted at a 6% annual
rate, is approximately $1,120.69.
This means that in order for the future payment of $1,500 to be considered of equal value in
today's terms, you would need to invest approximately $1,120.69 today at a 6% annual rate of
return.
The present value calculation allows you to evaluate the attractiveness of an investment or
assess the worth of a future cash flow by considering the time value of money. It helps in
making informed financial decisions by comparing the present value of different cash flows
or investments occurring at different points in time.
Finding the Interest Rate when pv and fv are given
Q.Suppose you have invested $5,000 in a savings account, and after 3 years, the account
has grown to $6,500. You want to calculate the interest rate earned on this investment.
To find the interest rate, you can rearrange the present value formula to solve for the interest
rate (r):
PV = FV / (1 + r)^n
In this case, PV = $5,000, FV = $6,500, and n = 3 years.
The formula can be rewritten as:
(1 + r)^n = FV / PV
Substituting the given values, we have:
(1 + r)^3 = $6,500 / $5,000 (1 + r)^3 = 1.3
To isolate the (1 + r), we take the cube root of both sides:
1 + r = ∛1.3 1 + r ≈ 1.0914
Subtracting 1 from both sides, we get:
r ≈ 0.0914
Converting the decimal to a percentage, the interest rate is approximately 9.14%.
Therefore, the interest rate earned on the investment is approximately 9.14% over the 3-year
period.
By using the present value formula and rearranging it to solve for the interest rate, you can
determine the rate of return on an investment when the present value and future value are
known.
Annuity: An annuity refers to a series of equal cash flows or payments received or paid at
regular intervals over a specified period. It involves a predictable stream of payments that can
occur either in the form of receiving payments (referred to as receiving an annuity) or making
payments (referred to as paying an annuity). Annuities are commonly used in financial
planning, retirement savings, and insurance.

Ordinary (Deferred) Annuity: An ordinary annuity, also known as a deferred annuity,

refers to a series of equal cash flows or payments where the payments occur at the end of
each period. In other words, the payments are made in arrears. For example, if you receive a
monthly payment for a period of 5 years, and the payments start at the end of the first month,
it would be considered an ordinary annuity.

Annuity Due: An annuity due is similar to an ordinary annuity in terms of a series of equal
cash flows or payments. However, in an annuity due, the payments occur at the beginning of
each period, as opposed to the end of the period in an ordinary annuity. For example, if you
receive a monthly payment for a period of 5 years, and the payments start immediately at the
beginning of the first month, it would be considered an annuity due.
The key difference between an ordinary annuity and an annuity due is the timing of the cash
flows or payments. In an ordinary annuity, the payments occur at the end of each period,
while in an annuity due, the payments occur at the beginning of each period.
 Annuity:

 A series of equal payments at fixed intervals for a specified number of periods.

 Ordinary (Deferred) Annuity:

 An annuity whose payments occur at the end of each period.

 Annuity Due:

 An annuity whose payments occur at the beginning of each period

Future Value of Ordinary Annuity

Future Value of Ordinary Annuity
The Future Value of an Ordinary Annuity represents the total value or accumulated amount
of a series of equal cash flows or payments received or paid at regular intervals over a
specified period, assuming those payments are invested and earn a certain interest rate.
The formula to calculate the future value of an ordinary annuity is:
FV = P * [(1 + r)^n - 1] / r
Where: FV = Future Value of the ordinary annuity P = Payment amount per period r =
Interest rate per period n = Number of periods
 (1 + r) represents the growth factor, accounting for the interest earned on each
payment.
 (1 + r)^n represents the compounding of interest over the number of periods.
 [(1 + r)^n - 1] calculates the sum of the interest factors over the periods, representing
the accumulation of the investment.
 P * [(1 + r)^n - 1] / r calculates the future value by multiplying the payment amount
per period by the accumulation factor, adjusted by the interest rate per period.
By using this formula, you can determine the future value of an ordinary annuity, which
represents the total amount that will be accumulated at the end of the specified period,
considering the regular payments and the interest earned on those payments.
Q.Suppose you plan to save $1,000 at the end of each year in an investment account that
earns an annual interest rate of 6%. You plan to make these payments for a period of 5
years. Now, let's calculate the future value of this ordinary annuity.
FV = P * [(1 + r)^n - 1] / r
Where: P = $1,000 (Payment amount per period) r = 6% or 0.06 (Interest rate per period) n =
5 years (Number of periods)
Plugging the values into the formula, we have:
FV = $1,000 * [(1 + 0.06)^5 - 1] / 0.06
Calculating the terms within the brackets first:
(1 + 0.06)^5 = 1.338225
Substituting this value back into the formula:
FV = $1,000 * (1.338225 - 1) / 0.06 FV = $1,000 * 0.338225 / 0.06 FV = $5,095.38
Therefore, the future value of this ordinary annuity, with annual payments of $1,000, an
interest rate of 6%, and a period of 5 years, is approximately $5,095.38.
This means that if you make regular annual payments of $1,000 into the investment account
for 5 years at a 6% annual interest rate, the account would accumulate to around $5,095.38 by
the end of the period, taking into account the compounding of interest.
Calculating the future value of an ordinary annuity helps you estimate the total amount that
will be accumulated over time, considering regular payments and the interest earned on those
payments.

Present Value of Ordinary Annuity

The Present Value of an Ordinary Annuity refers to the current value or the discounted
amount of a series of equal cash flows or payments received or paid at regular intervals over
a specified period. It represents the amount of money that needs to be invested today to
generate those future cash flows or payments, assuming a certain discount rate.
The formula to calculate the present value of an ordinary annuity is:
PV = P * [1 - (1 + r)^(-n)] / r
Where: PV = Present Value of the ordinary annuity P = Payment amount per period r =
Discount rate per period n = Number of periods
 (1 + r)^(-n) represents the discount factor, reflecting the present value of each future
payment.
 1 - (1 + r)^(-n) calculates the discounted sum of the payment present values over the
periods.
 P * [1 - (1 + r)^(-n)] / r calculates the present value by multiplying the payment
amount per period by the discounted sum, adjusted by the discount rate per period.
By using this formula, you can determine the present value of an ordinary annuity, which
represents the amount of money that needs to be invested today to generate the expected
future cash flows or payments.
Q.Suppose you are considering an investment opportunity that promises to pay you
$1,500 at the end of each year for a period of 5 years. You want to assess the present
value of this ordinary annuity, given a discount rate of 8%.
Using the formula provided earlier:
PV = P * [1 - (1 + r)^(-n)] / r
Where: P = $1,500 (Payment amount per period) r = 8% or 0.08 (Discount rate per period) n
= 5 years (Number of periods)
Plugging the values into the formula, we have:
PV = $1,500 * [1 - (1 + 0.08)^(-5)] / 0.08
Calculating the terms within the brackets first:
(1 + 0.08)^(-5) ≈ 0.680583
Substituting this value back into the formula:
PV = $1,500 * [1 - 0.680583] / 0.08 PV = $1,500 * 0.319417 / 0.08 PV = $5,991.34
Therefore, the present value of this ordinary annuity, with annual payments of $1,500, a
discount rate of 8%, and a period of 5 years, is approximately $5,991.34.
This means that to generate the expected future cash flows of $1,500 per year for 5 years,
given a discount rate of 8%, you would need to invest approximately $5,991.34 today. The
present value calculation allows you to assess the current worth of future cash flows and
helps in making investment decisions based on their present value.

 Perpetuity:

A stream of equal payments at fixed intervals expected to continue forever

Loan Amortization
Loan amortization refers to the process of gradually paying off a loan over time through
regular, scheduled payments. It involves breaking down the total loan amount into a series of
smaller, equal payments, typically made on a monthly basis, that cover both the principal (the
original loan amount) and the interest charges.
Amortization is based on the principle of gradually reducing the outstanding loan balance
over the loan term. With each payment, a portion goes towards paying down the principal,
reducing the overall amount owed, while another portion goes towards paying the interest
charges accrued on the remaining balance.
The loan amortization process typically involves the following key components:
1. Loan Terms: This includes the initial loan amount, the interest rate, and the loan term
(the duration over which the loan will be repaid).
2. Monthly Payments: The total loan amount is divided by the number of monthly
payments over the loan term, resulting in equal monthly installments.
3. Principal and Interest Allocation: With each payment, a portion goes towards
reducing the principal balance, while the remaining portion covers the interest charges
for that period. The interest portion decreases over time as the outstanding balance
reduces.
4. Amortization Schedule: An amortization schedule provides a detailed breakdown of
each payment, showing the allocation between principal and interest, the remaining
loan balance after each payment, and the total interest paid over the loan term.
As the loan progresses, the proportion of each payment that goes towards reducing the
principal increases, while the interest portion decreases. By the end of the loan term,
assuming all payments are made as scheduled, the loan balance will be fully paid off.
Loan amortization allows borrowers to repay their loans in manageable installments over
time, ensuring a gradual reduction in the outstanding balance. It also provides transparency
by showing how each payment contributes to the reduction of principal and the payment of
interest.