Professional Documents
Culture Documents
2015@FM I CH 3 - Time Vlue of Money
2015@FM I CH 3 - Time Vlue of Money
1
This birr 121 has four parts. The first part is the birr 100 original principal. The second part is
the birr 10 in interest you earned in the first year, and the third part is another birr 10 you earn in
the second year, for a total of birr 120. The last birr 1 you end up with (the fourth part) is interest
you earn in the second year on the interest paid in the first year: birr 10 × 0.10 = birr 1.
This process of leaving your money and any accumulated interest in an investment for more than
one period, thereby reinvesting the interest, is called compounding. Compounding the interest
means earning interest on interest, so we call the result compound interest. With simple
interest, the interest is not reinvested, so interest is earned each period only on the original
principal.
We now take a closer look at how we calculated the birr 121 future value. We multiplied birr
110 by 1.1 to get birr 121. The birr 110, however, was birr 100 also multiplied by 1.1. In other
words:
Birr 121 = birr 110 × 1.1
= (birr 100 × 1.1) × 1.1
= birr 100 × (1.1 × 1.1)
= birr 100 × 1.1 2
= birr 100 × 1.21
At the risk of overstating the obvious, let’s ask: How much would our birr 100 grow to after
three years? Once again, in two years, we’ll be investing birr 121 for one period at 10 percent.
We’ll end up with birr 1.10 for every birr we invest, or birr 121 × 1.1 = birr 133.10 total. This
birr 133.10 is thus:
Birr 133.10 = birr 121 × 1.1
= (birr 110 × 1.1) × 1.1
= (birr 100 × 1.1) × 1.1 × 1.1
= birr 100 × (1.1 × 1.1 × 1.1)
= birr 100 × 1.1 3
= birr 100 × 1.331
You’re probably noticing a pattern to these calculations, so we can now go ahead and state the
general result. As our examples suggest, the future value of birr 1 invested for t periods at a rate
of r per period is this:
Future value = birr 1 × (1 +r) t
The expression (1+r) t is sometimes called the future value interest factor (or just future value
factor) for birr 1 invested at r percent for t periods and can be abbreviated as FVIF (r, t).
In our example, what would your birr 100 be worth after five years? We can first compute the
relevant future value factor as follows:
(1 +r) t= (1 +0.10)5=1.15= 1.6105
Your birr 100 will thus grow to:
Birr 100 × 1.6105 = birr 161.05
The growth of your birr 100 each year is illustrated in Table 3.1. As shown, the interest earned in
each year is equal to the beginning amount multiplied by the interest rate of 10 percent.
2
Table 3.1 Future Value of birr 100 at 10 percent
Year Beginning Beginning Compound Total Interest Ending
Amount Amount Interest Earned Amount
1 birr100.00 Birr 10 Birr 0.00 Birr 10.00 Birr 110.00
2 110.00 10 1.00 11.00 121.00
3 121.00 10 2.10 12.10 133.10
4 133.10 10 3.31 13.31 146.41
5 146.41 10 4.64 14.64 161.05
Total birr Total birr Total birr 61.05
50 11.05 Interest
simple compound
interest interest
In Table 3.1, notice the total interest you earn is birr 61.05. Over the five-year span of this
investment, the simple interest is birr 100 × 0.10 = birr 10 per year, so you accumulate birr 50
this way. The other birr 11.05 is from compounding.
Notice how the simple interest is constant each year, but the amount of compound interest you
earn gets bigger every year. The amount of the compound interest keeps increasing because more
and more interest builds up and there is thus more to compound.
Future values depend critically on the assumed interest rate, particularly for long-lived
investments. Notice the future value of birr 1 after 10 years is about birr 6.20 at a 20 percent rate,
but it is only about birr 2.60 at 10 percent. In this case, doubling the interest rate more than
doubles the future value.
To solve future value problems, we need to come up with the relevant future value factors. There
are several different ways of doing this. In our example, we could have multiplied 1.1 by itself
five times. This would work just fine, but it would get to be very tedious for, say, a 30-year
investment.
Fortunately, there are several easier ways to get future value factors.
Alternatively, you can use a table that contains future value factors for some common interest
rates and time periods. Table 3.2 contains some of these factors. To use the table, find the
column that corresponds to 10 percent. Then look down the rows until you come to five periods.
You should find the factor that we calculated, 1.6105.
Tables such as 3.2 are not as common as they once were because they predate inexpensive
calculators and are available only for a relatively small number of rates. Interest rates are often
quoted to three or four decimal places, so the tables needed to deal with these accurately would
be quite large. As a result, the real world has moved away from using them. These tables still
serve a useful purpose. To make sure you are doing the calculations correctly, pick a factor from
the table and then calculate it yourself to see that you get the same answer. There are plenty of
numbers to choose from.
3
Table 3.2 Future Value Interest Factors
Number of Periods Interest Rate
5% 10% 15% 20%
1 1.0500 1.1000 1.1500 1.2000
2 1.1025 1.2100 1.3225 1.4400
3 1.1576 1.3310 1.5209 1.7280
4 1.2155 1.4641 1.7490 2.0736
5 1.2763 1.6105 2.0114 2.4883
The effect of compounding is not great over short time periods, but it really starts to add up as
the horizon grows. To take an extreme case, suppose one of your more prudent ancestors had
invested birr 5 for you at a 6 percent interest rate 200 years ago. How much would you have
today? The future value factor is a substantial 1.06 200 = 115,125.90 (you won’t find this one in a
table), so you would have birr 5 × 115,125.90 = birr 575,629.52 today. Notice that the simple
interest is just birr 5 × 0.06 = birr 0.30 per year. After 200 years, this amounts to birr 60. The rest
is from reinvesting. Such is the power of compound interest!
4
Present values for multiple periods
Suppose you need to have birr 1,000 in two years. If you can earn 7 percent, how much do you
have to invest to make sure you have the birr 1,000 when you need it? In other words, what is the
present value of birr 1,000 in two years if the relevant rate is 7 percent?
Based on your knowledge of future values, you know the amount invested must grow to birr
1,000 over the two years. In other words, it must be the case that:
Birr 1,000 = PV × 1.07 × 1.07
= PV × 1.07 2
= PV × 1.1449
Given this, we can solve for the present value:
Present value = birr 1,000/1.1449 = birr 873.44
Therefore, birr 873.44 is the amount you must invest to achieve your goal.
As you have probably recognized by now, calculating present values is quite similar to
calculating future values, and the general result looks much the same. The present value of birr 1
to be received t periods into the future at a discount rate of r is:
PV = birr 1 × [1/ (1+ r) t] = birr 1/ (1+ r) t
The quantity in brackets, 1/ (1 + r) t, goes by several different names. Because it’s used to
discount a future cash flow, it is often called a discount factor. With this name, it is not
surprising that the rate used in the calculation is often called the discount rate. We will tend to
call it this in talking about present values. The quantity in brackets is also called the present
value interest factor (or just present value factor) for birr 1 at r percent for t periods and is
sometimes abbreviated as PVIF (r, t). Finally, calculating the present value of a future cash flow
to determine its worth today is commonly called discounted cash flow (DCF) valuation.
To illustrate, suppose you need birr 1,000 in three years. You can earn 15 percent on your
money. How much do you have to invest today? To find out, we have to determine the present
value of birr 1,000 in three years at 15 percent. We do this by discounting birr 1,000 back three
periods at 15 percent. With these numbers, the discount factor is:
1/ (1+0.15)3= 1/1.5209 =0.6575
The amount you must invest is thus:
Birr 1,000 × .6575 = birr 657.50
We say that birr 657.50 is the present or discounted value of birr 1,000 to be received in three
years at 15 percent.
There are tables for present value factors just as there are tables for future value factors,and you
use them in the same way (if you use them at all). Table 3.3 contains a small set.
Table 3.3 present value interest factors
Number of Periods 5% 10% 15% 20%
1 .9524 .9091 .8696 .8333
2 .9070 .8264 .7561 .6944
3 .8638 .7513 .6575 .5787
4 .8227 .6830 .5718 .4823
5 .7835 .6209 .4972 .4019
In Table 3.3, the discount factor we just calculated (.6575) can be found by lookingdown the
column labeled “15%” until you come to the third row.
5
3.4 Future value of an annuity
An annuity is a sequence of equal, periodic payments. The payments may be made weekly,
monthly, quarterly, semi-annually, annually or for any fixed period of time. The time between
successive payments is called the payment period for an annuity. Each payment is called
periodic payment or periodic rent, and it is denoted by R. The time from the beginning of the
first payment period to the end of the last period is called the term of an annuity. If payments
are made at the end of each time interval, then the annuity is called an ordinary annuity. If
payments are made at the beginning of the payment period, it is called an annuity due.
The amount (future value) of an ordinary annuity is the sum of all payments plus all interests
earned.
A=
Example: Newly married couples are both working and decide to have Birr 10,000 at the end of a
year for a down payment on a home. The account earns 12% compound annually. How large a
down payment will they have saved in three years?
Solution
R = Birr 10,000
n = 3 years.
i= 12%
Compound interest = A - R(n)
A =?
= 33,744 - 30,000
= 3,744 Birr
Example: A person deposits Birr 500 at the end of a year for 10 years in to an account that pays
6% compounded annually.
Solution:
R = Birr 500
n = 10years = 500×13.1807
i = 6% = Birr 6,590.40
A10 =?
Example 19: What is the PV of an annuity if the size of each payment is Birr 200 payable at the
end of each year for 10years and the interest rate is 8% compounded annually?
Using the above formula; the PV of the former example is computed as:
R = Birr 200
6
i = 8% = 200 (6.7100814)
n = 10yr = Birr 1,342.016
P =?
Example 20 How much should you deposit in an account paying 6% compounded annually in
order to be able to withdraw Birr 1000 every year for the next 12 years?
Solution.
R = Birr 1000
n= 12years = 1000(8.38385)
i = 6% = Birr 8383.85
PV =?
7
Plugging in the numbers from our lottery example under perpetuities.
We could find the PV of each individual cash flow using the numerical and then sum these
values to find the present value of the stream. Here is what the process would look like:
8
Future Value of an Uneven Cash Flow Stream
The future value of an uneven cash flow stream (sometimes called the terminal value) is found
by compounding each payment to the end of the stream and then summing the future values:
The future value of our illustrative uneven cash flow stream is $2,124.92:
Example: Mr.X has found an institution that will pay him 8% interest. If he leaves his birr 100 in
this account for 5 years,
Future Value
FV =
1. For semiannual compounding:
FV =100 ×12.0061 = 1,200.61
2. For quarterly compounding:
FV = 100 × 24.297369 = 2429.7369
3. For monthly compounding?
9
Present value
In the EAR equation, iNom/m is the periodic rate, and m is the number of periods per year. For
example, suppose you could borrow using either a credit card that charges 1 percent per month
or a bank loan with a 12 percent quoted nominal interest rate that is compounded quarterly.
Which should you choose?
To answer this question, the cost rate of each alternative must be expressed as an EAR:
Thus, the credit card loan is slightly costlier than the bank loan. This result should have been
intuitive to you—both loans have the same 12 percent nominal rate, yet you would have to make
monthly payments on the credit card versus quarterly payments under the bank loan.The EAR
rate is not used in calculations. However, it should be used to compare the effective cost or rate
of return on loans or investments when payment periods differ, as in the credit card versus bank
loan example.
@ Nominal rate
This is the rate that is quoted by banks, brokers, and other financial institutions. So, if you talk
with a banker, broker, mortgage lender, auto finance company, or student loan officer about
rates, the nominal rate is the one he or she will normally quote you. However, to be meaningful,
the quoted nominal rate must also include the number of compounding periods per year. For
10
example, abank might offer 6 percent, compounded quarterly, on CDs, or a mutual fund might
offer 5 percent, compounded monthly, on its money market account.
The nominal rate on loans to consumers is also called the Annual PercentageRate (APR). For
example, if a credit card issuer quotes an annual rate of 18 percent, this is the APR.
Nominal annual rate =iNom = (Periodic rate) (m). Here iNom is the nominal annual rate and m is
the number of compounding periodsper year.
To illustrate, consider a finance company loan at 3 percent per quarter:
Nominal annual rate = iNom = (Periodic rate) (m) = (3%) (4) = 12%,or
Periodic rate = iNom/m = 12%/4 = 3% per quarter.
If there is only one payment per year, or if interest is added only once a year, then m = 1, and the
periodic rate is equal to the nominal rate.
To illustrate use of the periodic rate, suppose you invest $100 in an account that pays a nominal
rate of 12 percent, compounded quarterly. How much would you have after two years?
For compounding more frequently than annually, we use the following modification
FV = $l00 (1 + 0.03)8
= $126.68.
11