STUDY UNIT 2:

Time value of money - Single

investments

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Study unit outcomes
After studying this study unit you should be able to:
• Derive the formula to calculate the final value of an investment
(future value) given a single investment amount, the nominal interest
rate and the number of compounding periods.
• Calculate the future value of an investment given a single interest
rate.
• Calculate the present value from a future value for discrete
compounded interest.
• Use EXCEL to calculate all the above-mentioned problems.

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 Recap of what we learnt in Study unit 1
For a single once of payment of C at the start of the period:
Simple interest
Simple
FV = C (1 + in) interest rate

Compound interest
Effective annual Nominal
interest rate interest rate
( p) ( p)
i i
FV = C (1 + i ) = C (1 +
n
) = C (1 +
np
) np

p p
Future value Present value
Effective periodic
interest rate

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Important terminology
Time value of money:
The accumulated/discounted amount of an amount of money after interest
growth was added/removed.

Present value:
The once off amount that needs to be invested at the beginning of the
investment period to accumulate the amount at the end of the investment
period

Future value:
The sum of original the cash flow and all the interest additions made during
the investment period.

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Proof – Simple interest formula (Recap)
Assume that an amount 𝐶 is invested for a specific period at a simple interest rate 𝑖 per year.
Prove that the accumulated value (𝐹𝑉) after 𝑛 years is: 𝐶(1 + 𝑛𝑖)

Period Amount at start of Cash flow Interest Amount at end

period
1 𝐶 𝑖𝐶 𝐶 + 𝑖𝐶 = 𝐶(1 + 𝑖)
2 𝐶(1 + 𝑖) 𝑖𝐶 𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝐶(1 + 2𝑖)
3 𝐶(1 + 2𝑖) 𝑖𝐶 𝐶 + 𝑖𝐶 + 𝑖𝐶 + 𝑖𝐶 = 𝐶(1 + 3𝑖)

𝑛 𝐶(1 + (𝑛 − 1)𝑖) 𝑖𝐶 𝐶(1 + 𝑛𝑖)

∴ 𝐹𝑉 = 𝐶(1 + 𝑛𝑖)

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Proof – Compound interest formula – annual interest rate
(Recap)
Assume that an amount 𝐶 is invested for a specific period at an effective annual interest rate 𝑖 per
year.
Prove that the accumulated value (𝐹𝑉) after 𝑛 years is:𝐶(1 + 𝑖)𝑛

Period Amount at start of Cash flow Interest Amount at end

period
1 𝐶 𝑖𝐶 𝐶 + 𝑖𝐶 = 𝐶(1 + 𝑖)
2 𝐶(1 + 𝑖) 𝐶 1+𝑖 𝑖 𝐶(1 + 𝑖) + 𝐶(1 + 𝑖)𝑖 = 𝐶(1 + 𝑖)2
3 𝐶(1 + 𝑖)2 𝐶(1 + 𝑖)2 𝑖 𝐶(1 + 𝑖)2 + 𝐶(1 + 𝑖)2 𝑖 = 𝐶(1 + 𝑖)3

𝑛 𝐶(1 + 𝑖)𝑛−1 𝐶(1 + 𝑖)𝑛−1 𝑖 𝐶(1 + 𝑖)𝑛

∴ 𝐹𝑉 = 𝐶(1 + 𝑖)𝑛

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 Calculating effective periodic interest (Recap)
Effective interest rate
An investor deposits R100 into an account that earns 5% 𝑭𝑽 = 𝑪(𝟏 + 𝒓)𝒏𝒑 𝑭𝑽 = 𝑪(𝟏 + 𝒊)𝒏
interest semi-annually. Determine the future value
Effective periodic interest rate Effective annual interest rate
(accumulated value ) in the account at the end of a two-
𝒊(𝒑) 𝟏𝟐𝟏, 𝟓𝟓𝟎𝟔
year period. 𝒓 = 𝟓% 𝒑𝒆𝒓 𝒉𝒂𝒍𝒇 𝒚𝒆𝒂𝒓 = 𝒊= − 𝟏 = 𝟏𝟎, 𝟐𝟓%
𝒑 𝟏𝟎𝟎

100 +5 +5.25 +5.5125 +5.7881

NB: Effective interest rate is always used in calculations.

0
0.5 1 1.5 2
Nominal interest rate
Nominal interest is a quoted rate (implicit per year).Interest
𝒕 𝟎 𝟎. 𝟓 𝟏 𝟏. 𝟓 𝟐 is earned more often than once per year.
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 105 110.25 115.7625 121.5506
𝒂𝒄𝒄𝒐𝒖𝒏𝒕 𝒊(𝒑) 𝒏𝑝
𝑭𝑽 = 𝑪(𝟏 + )
𝒑

Nominal interest rate

(𝟐)
𝒊 = 𝟓% + 𝟓% = 𝟏𝟎% per year

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 Proof – Compound interest formula – periodic interest rate
𝑖 (𝑝)
Assume that an amount 𝐶 is invested for a specific period at an effective periodic interest rate
𝑝
𝑖 (𝑝) 𝑛𝑝
per period. Prove that the accumulated value (𝐹𝑉) after 𝑛 years is:𝐶(1 + )
𝑝
Period Amount at start of period Cash flow Interest Amount at end
1 𝐶 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝)
𝐶 𝐶+ 𝐶 = 𝐶(1 + )
𝑝 𝑝 𝑝
2 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 2
𝐶(1 + ) 𝐶 1+ × 𝐶(1 + ) + 𝐶(1 + )× = 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝 𝑝 𝑝 𝑝
3 𝑖 (𝑝) 2 𝑖 (𝑝) 2 𝑖 (𝑝) 𝑖 (𝑝) 2 𝑖 (𝑝) 2 𝑖 (𝑝) 𝑖 (𝑝) 3
𝐶(1 + ) 𝐶(1 + ) × 𝐶(1 + ) + 𝐶(1 + ) × = 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝 𝑝 𝑝 𝑝

𝑛𝑝 𝑖 (𝑝) 𝑛𝑝−1 𝑖 (𝑝) 𝑛𝑝−1 𝑖 (𝑝) 𝑖 (𝑝) 𝑛𝑝

𝐶(1 + ) 𝐶(1 + ) × 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝

𝑖 (𝑝) 𝑛𝑝
∴ 𝐹𝑉 = 𝐶(1 + )
𝑝
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 Calculating effective interest over total period
An investor deposits R100 into an account that earns 5% Effective interest rate
interest semi-annually. Determine the future value
(accumulated value ) in the account at the end of a two- 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 =
year period. 𝑷𝑽
Effective 2 year interest rate
𝟏𝟐𝟏. 𝟓𝟓𝟎𝟔 − 𝟏𝟎𝟎
100 +5 +5.25 +5.5125 +5.7881 = 𝟐𝟏, 𝟓𝟓%
𝟏𝟎𝟎

NB: Effective interest rate is always used in calculations.

0
0.5 1 1.5 2

𝒕 𝟎 𝟎. 𝟓 𝟏 𝟏. 𝟓 𝟐
𝑻𝒐𝒕𝒂𝒍 𝒊𝒏
100 105 110.25 115.7625 121.5506
𝒂𝒄𝒄𝒐𝒖𝒏𝒕

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 Proof – Relationship between effective and nominal interest rate
𝑖 (𝑝)
Suppose 𝑖 (𝑝) is the nominal interest rate per year, but is compounded p times a year. Thus is the
𝑝
𝑖 (𝑝) 𝑝
effective interest per period. Show that the effective annual interest rate is given by: 𝑖 = (1 + ) −1
𝑝
Let 𝐶 be invested at the beginning of the investment period:
Period Amount at start of period Cash flow Interest Amount at end
1 𝐶 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝)
𝐶 𝐶+ 𝐶 = 𝐶(1 + )
𝑝 𝑝 𝑝
2 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 𝑖 (𝑝) 2
𝐶(1 + ) 𝐶 1+ × 𝐶(1 + ) + 𝐶(1 + )× = 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝 𝑝 𝑝 𝑝
3 𝑖 (𝑝) 2 𝑖 (𝑝) 2 𝑖 (𝑝) 𝑖 (𝑝) 2 𝑖 (𝑝) 2 𝑖 (𝑝) 𝑖 (𝑝) 3
𝐶(1 + ) 𝐶(1 + ) × 𝐶(1 + ) + 𝐶(1 + ) × = 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝 𝑝 𝑝 𝑝

𝑝 𝑖 (𝑝) 𝑝−1 𝑖 (𝑝) 𝑝−1 𝑖 (𝑝) 𝑖 (𝑝) 𝑝

𝐶(1 + ) 𝐶(1 + ) × 𝐶(1 + )
𝑝 𝑝 𝑝 𝑝
𝑖 (𝑝) 𝑖(𝑝)
𝑖 (𝑝) 𝐹𝑉−𝑃𝑉 𝐶(1+ 𝑝 )𝑝 −𝐶 𝐶[(1+ 𝑝 )𝑝 −1] 𝑖 (𝑝) 𝑝
∴ 𝐹𝑉 = 𝐶(1 + 𝑝
)𝑝 ∴𝑖= 𝑃𝑉
= 𝐶
= 𝐶
= (1 + 𝑝
) −1

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 Example
For the next four years a bank account will earn interest as follows:
• During the first nine months the effective annual interest rate is 7.12%.
• For the following year and a half the interest rate is 7.65% per year, compounded halfyearly.
• For the next five quarters the nominal interest rate is 7.8% per year, compounded monthly.
• For the remaining period the interest rate is 1.92% effective per quarter.
(i) If an investor wants an amount of R50,000 in his bank account at the end of the four-year period, calculate
how much he will need to invest into the bank account now.
(ii) Use your answer in (i) and calculate the equivalent effective interest rate that is applicable over the four-year
period.
(iii) Use your answer in (i) and calculate the equivalent annual effective interest rate that is applicable over the
four-year period.
−3 −1.25(12) −2
 i ( 2)   i (12)   i ( 4)  FV = C (1 + i )
n

(i)C = PV = 50, 000 (1 + i ) −9 12

1 +  1 +  1 +  (ii) i=
FV − PV (iii)
 2   12   4  50, 000 = 37062.56 (1 + i )
4
PV
 0.0765   7.8% 
−3 −1.25(12)
50, 000 − 37062.56 1
= 50, 000 (1.0712 ) (1 + 0.0192 ) =
−0.75 −2
1 +  1 +  i=
 50, 000  4
 2   12  37, 062.56  −1
= 34.9070%  37062.56 
= 50, 000  0.949723  0.893499  0.9073886  0.962678
i = 7.7727%
= R37, 062.56

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 Example
.
Five independent investments 𝐶1 , 𝐶2 , 𝐶3 , 𝐶4 and 𝐶5 are made into a savings account
at times 𝑡1 , 𝑡2 , 𝑡3 , 𝑡4 and 𝑡5 respectively. Assume that nominal interest rate is
100𝑖%, compounded 𝑝 times per year. Calculate the total value of the payments at
time t where 𝑡1 < 𝑡 < 𝑡2 < 𝑡3 < 𝑡4 < 𝑡5 .
i ( p ) p (t −t1 )
V1 = C1 (1 + )
p
i ( p ) − p ( t2 − t ) i ( p ) p ( t − t2 )
V2 = C2 (1 + )  V2 = C2 (1 + )
p p
i ( p ) p ( t − tk )
Vk = Ck (1 + )
p
5
i ( p ) p ( t − tk )
Vtotal =  Ck (1 + )
k =1 p

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 Example
The following investments is made into an investment account:
.
• R5,000 at the beginning of the first year.
• R8,000 at the end of the second year.
• R3,000 at the start of year four.
The interest for these investments are as follows:
5% pa, compounded monthly, during the first two years, 1.5% per quarter
effectively during year 3 and 4 and 5.5% pa effectively for year five.
Determine the accumulated amount of all the payments at the end of year five.
i ( p ) pn i ( p ) pn i ( p ) pn i ( p ) pn
FV5000 = C (1 + ) (1 + ) (1 + i) n
FV8000 = C (1 + ) (1 + i ) n
FV3000 = C (1 + ) (1 + i ) n
p p p p
5% (12)(2) = 8, 000(1 + 1.5%)(4)(2) (1 + 5.5%)1 = 3, 000(1 + 1.5%)(4)(1) (1 + 5.5%)1
= 5, 000(1 + ) (1 + 1.5%) (4)(2)
(1 + 5.5%)1

12 = 9,507.60 = 3,359.22
= 6,565.84
NFV = 6,565.84 + 9,507.60 + 3,359.22 = 19, 432.66

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In EXCEL or any other programming language
Create a template for calculating FV, C, interest rates (all forms), and n.
Use the Exercises in the following slides to test your answers.

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 Exercise 1
R50,000 is invested for a period of 10 years. Determine the accumulated
amount (FV) at the end of the 10 year period if:
(i) The simple interest rate is 5% per annum. (R75,000)
(ii) The simple interest rate is 1.3% per quarter. (R76,000)
(iii) The effective annual interest rate is 5% pa. (R81,444.73)
(iv) The nominal interest rate is 5% pa, compounded monthly. (R82,350.47)
(v) The effective semi-annual interest rate is 2.5%. (R81,930.82)

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 Exercise 2
RX is invested for a period of 8 years and accumulates to R60,000. Determine
the value of X (PV) if:
(i) The simple interest rate is 6% per annum. (R40,540.54)
(ii) The effective annual interest rate is 7% pa. (R34,920.55)
(iii) The nominal interest rate is 6.5% pa, compounded quarterly. (R35,820.64)
(iv) The effective monthly interest rate is 0.5%. (R37,171.43)

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 Exercise 3
An investment accumulates to double the original amount in 6 years time.
Determine the:
(i) The simple annual interest rate on this investment. (16.6667%)
(ii) The effective annual interest rate on this investment. (12.2462%)
(iii) The nominal interest rate, compounded weekly, on this investment.
Assume 52 weeks in a year. (R11.5653%)
(iv) The effective daily interest rate on this investment. Assume 365 days per
year. (0.0317%)

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 Exercise 4
An investment made on 1 July 2018 accumulates to at least 1.5 times the
original amount in n years time. Determine the value of n as well as the date
of the last day of the investment period if:
(i) The simple quarterly interest rate is 5%. (2,5 years 31 Dec 2020)
(ii) The effective annual interest rate is 4%. (11 years 30 Jun 2029)
(iii) The nominal interest rate, compounded monthly, is 4.5%. (9.0333 years
31 July 2027)

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To do
• Read Study unit 2 of the study guide.
• You will now be able to do Problem 2.1 from the study guide.
• Assignment 2 – due one week from today
• Do Tutorial 2 before the Tutorial class

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