CHAPTER 3

Miss Nur Hanis Mohd Mokhlis

TIME VALUE OF MONEY
1
Introduction
• Interest may be regarded as a reward paid by one person or
organization (the borrower) for the use of an asset which
refereed to as capital, belonging to another or organization
(the lender).

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Example
1. A bank will be expected to pay interest to its customers on
money held in their savings accounts
2. A company will be expected to pay interest to a bank on
money lent to it for a business project. 2
Introduction
In monetary terms,
• capital is referred to as principal.
• Total received by the lender after a period of time is called

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accumulated value
• Difference between the principal and the accumulated value is
called interest.

Note that we are assuming here that no other payments are

made or incurred (eg charges, expenses) 3
Introduction
EXAMPLE 1
A bank lends an individual RM 1,000. The individual has to pay
back the bank RM 1,200 in one year’s time. Determine the
capital, accumulated value and the interest that has been

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charged.

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Introduction
• If there is some risk of default (loss of capital / non-payment/
not able to pay back the loan), a lender would expect to be
paid a higher rate of interest than would otherwise be the
case.

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Introduction
• If there is some risk of default (loss of capital / non-payment/
not able to pay back the loan), a lender would expect to be
paid a higher rate of interest than would otherwise be the
case.

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EXAMPLE 2
If you lend money both to US government (by purchasing a fixed
interest security) and to a property developer, then you will
probably demand a higher rate of interest from the property
developer. 7
Interest – Simple Interest
• The essential feature of simple interest is that interest, once
credited to an account, does not itself earn further interest.

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• Suppose an amount C is deposited in an account that pays
simple interest at the rate of i = 100% per annum. Then after n
years, the deposit will accumulated to:

𝐶(1 + 𝑛𝑖)
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Interest – Simple Interest
EXAMPLE 3
An investor deposits RM 10,000 in a bank account that pays
simple interest at a rate of 5% pa. What will the deposit have
accumulated to after 3 years?

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Interest – Simple Interest
EXAMPLE 4
An investor puts RM5,000 in a savings account that pays 10%
simple interest at the end of each year. Compare how much the
investor would have after 6 years if the money was :

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1. Invested for 6 years
2. Invested for 3 years, then immediately reinvested for a
further 3 years.

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Interest – Simple Interest
• So under a simple interest arrangement, an investor can earn
more interest by withdrawing the capital and then
immediately reinvesting it. This is undesirable since it leads to
heavy and unnecessary additional expenses.

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• Hence we will now consider the case where interest does
itself earn interest.

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Interest – Compound Interest
• The essential feature of a compound interest is that interest
itself earns interest.
• Suppose an amount C is deposited in an account that pays
simple interest at the rate of 𝑖 = 100% per annum. Then

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after n years, the deposit will accumulated to:

𝐶 1+𝑖 𝑛

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Interest – Compound Interest
EXAMPLE 5
An investor deposits RM 10,000 in a bank account that pays
compound interest at a rate of 5% pa. What will the deposit
have accumulated to after 3 years?

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Interest – Compound Interest
EXERCISE 1
Find the accumulated value of RM5,000 at the end of 5 years
and 4 months invested at 9% per annum assuming compound
interest throughout.

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Simple vs Compound Interest

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Accumulation Factors
• 𝐴(𝑡1 , 𝑡2 ) defined to be the accumulation at time 𝑡2 of an
investment of 1 at time 𝑡1 for 𝑡1 ≤ 𝑡2 .
• Number 𝐴(𝑡1 , 𝑡2 ) known as accumulation factor, since the
accumulation at time 𝑡2 of an investment of 𝐶 at time 𝑡1 is by

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proportion:
𝐶𝐴(𝑡1 , 𝑡2 )
• 𝐴(𝑛) is often used as an abbreviation for the accumulation
factor 𝐴(0, 𝑛).
𝐴 𝑛 = 𝐴 0, 𝑛 = 1 + 𝑛𝑖 simple interest
𝐴 𝑛 = 𝐴 0, 𝑛 = 1 + 𝑖 𝑛 compound interest 21
Accumulation Factors
EXAMPLE 6
An investor deposited RM 10,000 in a bank account that paid
simple interest at a rate of 5% pa. After 3 years, it had
accumulated to RM 11,500. Find the accumulation factor from

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time 0 to time 3.

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The Principle of Consistency
• Now let 𝑡0 ≤ 𝑡1 ≤ 𝑡2 and consider an investment of 1 at time 𝑡0 .
• The proceeds at time 𝑡2 will be 𝐴(𝑡0 , 𝑡2 ) if one invests at time 𝑡0 for
term 𝑡2 − 𝑡0 , or 𝐴(𝑡0 , 𝑡1 ) 𝐴(𝑡1 , 𝑡2 ) if one invests at time 𝑡0 for term
𝑡1 − 𝑡0 and then, at time 𝑡1 , reinvests the proceeds for term 𝑡2 − 𝑡1 .

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• In a consistent market these proceeds should not depend on the
course of action taken by the investor. Accordingly, we say that
under the principle of consistency:

𝐴 𝑡0 , 𝑡𝑛 = 𝐴 𝑡0 , 𝑡1 𝐴 𝑡1 , 𝑡2 … 𝐴(𝑡𝑛−1 , 𝑡𝑛 )
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The Principle of Consistency
EXERCISE 2
RM4,600 is invested at time 0 and the proceeds at time 10 are
RM8,200.

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Calculate 𝐴 7,10 if 𝐴 0,9 = 1.8, 𝐴 2,4 = 1.1, 𝐴 2,7 = 1.32,
𝐴 4,9 = 1.45

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Present Value
• How much do we need to invest now to provide payments at a
later time?
• This amount is called present value (PV) or discounted value of
the payments.

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𝐶 𝑛
1
𝑃𝑉 = 𝑛 = 𝐶𝑣 𝑤ℎ𝑒𝑟𝑒 𝑣 =
1+𝑖 1+𝑖
It is the amount that is needed to be invested at time 0 at
compound interest rate 𝑖 to accumulate 𝐶 at time 𝑛.
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Present Value
EXAMPLE 7
An investor must make a payment of RM 5,000 in 5 years time,
the investor wishes to make provision for this payment by
investing a single sum now in a deposit account that pays 10%

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per annum compound interest. How much should be the initial
investment be?

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Discount Rates
• An alternative way of obtaining the discounted value of a
payment is to use discount rates.

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Discount Rates – Simple
Discount
• As similar to simple interest, the discount earned is not itself
subject to further discount.
• Suppose an amount 𝐶 is due after n years and a rate of simple
discount of 𝑑 per annum applies. Then the sum of money

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required to be invested now to amount to 𝐶 after 𝑛 years (ie
the present value of 𝐶):
𝐶(1 − 𝑛𝑑)

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Discount Rates – Simple
Discount
EXAMPLE 8
Discount RM 10,000 for 3 years using a simple discount rate of
5% pa.

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Discount Rates – Simple
Discount
• In normal commercial practice, d is usually encountered only
for periods of less than a year.
• 𝑑 also known as a rate of commercial discount.

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Discount Rates – Simple
Discount
EXAMPLE 9
An 8-month loan is repayable by a single payment of RM
100,000. If the loan is issued at a rate of commercial discount of
15% 𝑝𝑎, how much was initially lent to the borrower?

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Discount rates – Compound
(effective) discount
• Discount earned is subject to further discount.
• Suppose an amount 𝐶 is due after 𝑛 years and a rate of
compound (or effective) discount of 𝑑 per annum applies.
Then the sum of money required to be invested now to

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accumulate to 𝐶 after 𝑛 years (present value of 𝐶):

𝐶 1−𝑑 𝑛

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Discount rates – Compound
(effective) discount
EXAMPLE 10
Discount RM 10,000 for 3 years using a compound discount rate
of 5% pa.

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Discount Factors
• In the same way that the accumulation factor 𝐴(𝑛) gives the
accumulation at time 𝑛 of an investment of 1 at time 0, we
define 𝑣(𝑛) to be the present value of a payment of 1 due at
time 𝑛.

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1
𝑣 𝑛 =
𝐴(𝑛)

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Discount Factors
𝑛 𝑛
𝑣 𝑛 = 1−𝑑 ;𝐴 𝑛 = 1+𝑖

1 1 𝑛
𝑣 𝑛 = = = 𝑣
1+𝑖 𝑛

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𝐴(𝑛)
1 1
𝐴 𝑛 = =
𝑣(𝑛) 1−𝑑 𝑛

So regardless whether we’re given interest or discount rates, we

could calculate both accumulation and present values. 40
Discount Factors
EXERCISE 3
1. Given an investment of RM1,000 find the accumulation after 5 years
using:
a) Simple discount of 8% pa

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b) Compound discount of 8% pa
c) Compound interest of 8% pa

2. Given payment of RM2,000 due in 4 years time, calculate the

present value using :
a) Simple interest of 3% pa
b) Simple discount of 3% pa 41
c) Compound interest of 3% pa
Effective Rates of Interest and
Discount
• Effective rates are compound rates that have interest paid
once per unit time either at the end of the period (effective
interest) or at the beginning of the period (effective discount).
• This distinguishes them from nominal rates where interest is

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paid more frequently than once per unit time.

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Effective Rates of Interest
• An investor will lend an amount 1 at time 0 in return for a
repayment of 1 + 𝑖 at time 1. Hence we can consider i to be
the interest paid at the end of the year. Accordingly i is called
the rate of interest (or the effective rate of interest) per unit

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time.
• Denoting the effective rate of interest during the 𝑛th period
by 𝑖𝑛 :
𝐴 𝑛 = 1 + 𝑖𝑛 𝐴(𝑛 − 1)
𝐴 𝑛 − 𝐴(𝑛 − 1)
𝑖𝑛 = 43
𝐴(𝑛 − 1)
Effective Rates of Interest
• If 𝑖 is the compound rate of interest:
𝐴 𝑛 = 1 + 𝑖 𝑛 and 𝐴 𝑛 − 1 = 1 + 𝑖 𝑛−1

𝑛
1+𝑖 − 1 + 𝑖 𝑛−1

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𝑖𝑛 = 𝑛−1 = 1+𝑖 −1=𝑖
1+𝑖
• Since this is independent of n, we see that the effective rate of
interest is identical to the compound rate of interest we met
earlier.
• Effective rate of interest is identical to the compound rate of
interest. 44
Effective Rates of Interest
EXAMPLE 11
An investor’s bank balance at various times was as follows:
1 JAN 2012 1 JUL 2012 I JAN 2013

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RM3,000 RM3,100 RM3,300

Calculate:
(i) Effective six-monthly rate between 1 Jan 2012 and 1 Jul 2012.
(ii) Effective annual rate between 1 Jan 2012 and 1 Jan 2013 45
Effective Rate of Discount
• We can think of compound discount as an investor lending an
amount 1 − 𝑑 at time 0 in return for a repayment of 1 at
time 1. The sum of 1 − 𝑑 may be considered as a loan of 1
(to be repaid after 1 unit of time) on which interest of amount

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d is payable in advance.
• Accordingly 𝑑 is called the rate of discount (or the effective
rate of discount) per unit time.
𝐴 𝑛 − 𝐴(𝑛 − 1)
𝑑𝑛 =
𝐴(𝑛)
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Effective Rate of Discount
EXERCISE 4
Show that effective rate of discount, 𝑑𝑛 is equal to compound
discount 𝑑

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Equivalent Rates
• Two rates of interest and/or discount are equivalent if a given
amount of principal invested for the same length of time
produces the same accumulated value under each of the
rates.

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Equivalent Rates
EXAMPLE 12
Find the effective annual interest rate that is equivalent to a
simple interest rate of 3% pa over 4 years.

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Equivalent Rates
𝑣 =1−𝑑
1 𝑖
𝑑 =1−𝑣 =1− = = 𝑖𝑣
1+𝑖 1+𝑖

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