Week 3 Wealth Time and Money

MCD2170 Foundations of Finance

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 Learning Objectives
 Explain the concept of time value of money and its importance;
 Explain the concept of future value (FV);
 Demonstrate use of future value in making financial decisions;
 Explain the concept of present value (PV) and how it relates to future
value;
 Demonstrate use of present value in making financial decisions;
 Define simple and compound interest;
 Explain the benefits of compounding;
 Explain the concept of Effective Annual Rate (EAR);
 Demonstrate use of calculator to solve financial problems
Motivation for Wealth, Time & Money
Wealth, Time & Money is the 1st in a series of 3 weeks that introduces financial
mathematics.

 Financial math is about Valuation.

 Value is defined as the worth of an asset, the total of what the
asset can earn over the period held. The worth of an asset
typically comes from net income in the future and terminal value.
 The first step in establishing value is to establish the components of cash flow
streams (money streams) that arise from financial products and real assets.
– Examples of financial products: loans, shares, bonds.
– Examples of real assets: Real estate and equipment (that represent
investable, tangible projects).
 Motivation (cont.)
 The value established could be a present value or a future value.

 Value is termed by a number of names; including fundamental value, true

value, intrinsic value and economic value.
 Value is important because it is used to make buying and
selling decisions of financial products and real assets.
 Value needs to be distinguished from the concept of “Price”.
– The price of a financial product or real asset is what it trades at in a
market as a function of its supply and demand.
– The value of an asset is only one of the many factors that influences
the supply and demand of the asset and hence its price.

* Subject link: Price as a function of supply and demand is developed further in

Microeconomics
 Motivation (cont.)
 The comparison between “Value” and “Price” provides a good
justification for buying and selling decision
– If Value < Price, asset is termed ‘over-priced”, a buyer wouldn’t
buy but a seller would sell.

– If Value > Price, asset is termed ‘under-priced”, a buyer would buy

but a seller wouldn’t sell.

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 Time Value of Money
The time at which money is earned or paid affects its value
or cost.
 Money received or earned today, is greater in value to the
recipient than if received at a later date.
 Money paid today is greater in cost to the payer, than if paid
at a later date.
This is intuitively true, would you prefer to receive $1,000 now
or wait 10 yrs. to receive the $1,000. As $1000 today is worth
more than $1000 10 years later.
“ A dollar today is worth more than a dollar tomorrow. ”
 Using timelines to visualize cash flows
 Drawing a time line can help to clearly identify the timing of when money is received or
paid.
– Timeline starts at time 0, which means Now / Present
– Timeline ends at the end of holding period
– Time periods are usually identified on the top of the timeline
– The dollar amount of the cash flow received or paid at each time period is shown
below the timeline
– Positive values represent cash inflows and cash outflows are indicated by negative
numbers

Year 0 Year 1 Year 2 Year 3

-$1,000 $1500 $500 $600

Present Value
 Interest – simple vs. compound
 Interest is a direct measure for the time value of money. It is the price of
using money over time.
 Interest is the compensation (reward) that investors (lenders) require
for deferring consumption from the borrowers. It is considered an
expense to the borrower and income for the lender.
 Interest is the investor's required rate of return.
 Required rate of return can be simple or compounded
– Simple interest is that the interest is earned only on principal.
– Compound interest is when interest paid on an investment during
the first period is added to the principal; then, during the second
period, interest is earned on the new sum (that includes the
principal and interest earned so far).

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 Example- simple & compound interest
E.g.: You’ve opened a bank account for three years with an initial deposit of $100,000 and interest at 10% p.a.
 Calculate the simple interest earned for 3 years
 Calculate the compound interest earned for 3 years with annual compounding

Year 0 Year 1 Year 2 Year 3

-$100,000
(Deposit)
 Simple interest on $100,000 invested at 10% per year for three years
– 1st year interest is $10,000
– 2nd year interest is $10,000
– 3rd year interest is $10,000
– Total interest earned: $30,000

 Compound interest on $1000 invested at 10% for three years with annual compounding.
– 1st year interest is $10,000 Principal now is $110,000
– 2nd year interest is $11,000 Principal now is $121,000
– 3rd year interest is $12,100 Principal now is $133,100
– Total interest earned: $33,100

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 Effect of Compounding

Principal $100,000 Interest 10%

Year Opening Balance Interest Closing Balance

1 $100,000 $10,000 $110,000
2 $110,000 $11,000.0 $121,000.0
1
3 $121,000.0 $12,100.0 $133,100.0
 Benefits of Compounding
Future value of $1 with compound interest
8

7
10%
6

5
Future value of $1

4
5%
3

2
2%
1
0%

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years

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 Time Value of Money
 Given that money has different value dependent on the
time it is earned or paid, three central rules arise:
− Money can be only be combined and compared
if earned at the same time period.
− Moving money forward in time to establish a
value is called compounding.
− Moving money backward in time to establish a
value is called discounting.

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 Understanding Value
 When money is compounded, a future value is obtained. A
single cash flow, compounded over time can be calculated by

 When money is discounted, a present value is obtained. A

single cash flow, discounted over time can be calculated by

Where:
FV - the accumulated future value at end of holding period
PV- the cash flow at time 0,
is the appropriate interest rate, and
the number of periods / payments

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 Future Value Interest factor (FVIF)
 is FVIF
 FVIF is the FV of 1 dollar at i% per annum after n
periods.
– It depends on the number of periods in which
interest can be compounded. The larger the
number of periods, the greater the future value.
– It also depends critically on the interest rate.
The higher the interest rate, the greater the
FVIF.

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 Present Value Interest Factor- PVIF
 PVIF: 1/(1 + i)n
 PVIF is the PV of 1 dollar at % per annum after n
periods
– Present value depends on the number of periods
in which interest can be discounted. The larger
the number of periods, the smaller the present
value.
– Present value also depends critically on the
assumed interest rate (discount rate) - the higher
the interest rate, the smaller the present value.

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 Four Important Cash Flow Patterns

 Single Sum or Lump Sum Cash Flow

 Mixed Stream or Multiple Cash Flow
 Annuities (covered in week 4)
 Perpetuities (covered in week 4)

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 Timeline: Cash flow patterns
I =10 %
0 1 2 3
CF0 CF2 CF3 n
CF1
If there is only CF0 then it is a case of a single Lump Sum Cash
Flow.
However, if there are CF0, CF1 , CF2, then it is referred to as
Multiple Cash Flows.
If multiple cash flows are all equal: CF0 = CF1 = CF2 = ... = CFn then
it is referred to as an Annuity.
If the annuity goes on forever (n  ∞ ) then it is known as a
Perpetuity
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 Calculations - Single Cash Flows
(Lump Sum Cash Flow Pattern)
Questions may require you to calculate the following
 FV given PV, Interest rate and Time
 PV given FV, Interest Rate and
 given FV, PV and
 n given FV, PV and

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 Example 1: Future Value of a Single Lump Sum
Suppose that you invested $1,000 in an investment bank today.
Assume also that you invest at a guaranteed fixed rate of 6.00% after
tax for a period of 5 years. How much will this amount grow to by the
time the investment account matures

FV = PV×(1 + )n
FV = $1000×(1.06)5 = $1,338.23

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 Example 2: How Long is the Wait?
If you deposit $5,000 today in an account paying 10%, how long
does it take to grow to $10,000?

The ‘Rule of 72’ (This rule is

only an approximation): If
you earn r% per year, your
money will double in about
72/r years.

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 Example 3: What Rate Is Enough?
Assume the total cost of a 3-year commerce university education
will be $100,000 when your child enters university in 20 years.
Assume you have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of your future
child’s education?

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 Example 4: Present Value Lump Sum
How much would you have to set aside today in order to
have $20,000 five years from now assuming the current
interest rate is 7.00%?

PV $20,000

0 1 2 3 4 5
$20,000
PV  5
 $14,259.72
(1.07)
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 Compounding with non-annual periods

 So far, compounding frequency has been assumed to

be annual. In reality compounding frequency may be
more than one in a year.
 The future value of an investment compounded m times
a year for years is:
 i  mn
FV  PV  1  
 m

– is the frequency of compounding in a period

– is the stated/quoted annual interest rate, and is
commonly called the annual percentage rate
(APR) or the nominal interest rate (NIR)
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 Nominal Interest Rates

 The nominal interest rate (NIR) is known as the stated, or

quoted, rate (e.g., 10% pa compounded annually)
 The NIR is simply equal to the interest rate charged per
period multiplied by the number of periods per annum
 For example, if a bank charges 1% per month on a car
loan, the NIR is 1% x 12 = 12%

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 Example 5: Compounding Frequency

A bank is offering 12 per cent interest compounded

quarterly, if you put $200 in an account, how much will you
have at the end of year 2?

4 2
 0.12 
FV  $200 1    $253.35
 4 
4 = m; m is the number of quarter per year

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 Effective Annual Rate (EAR)
 The EAR is the true interest rate expressed as if it were compounded
once per year:

m
 i 
EAR  1   1
 m

– the stated annual interest rate,

– the number of compounding periods in a year.

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 Example 6: Effective annual rate
 You have $10,000 to invest for one year and the following choices
are offered by the banks in your area:
(a) 6% p.a., compounded annually;
(b) 5.90% p.a., compounded daily;
Which of the alternatives would you choose?

m 1
 i   0.06 
a) EAR  1    1  1    1  6.00%
 m  1 
m 365
 i   0.0590 
b) EAR  1    1  1    1  6.08%
 m  365 
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 Continuous Compounding
 Frequency of compounding (or discounting) within a period of time
approaches infinity (i.e., interest is charged so frequently that the time
between two periods approaches zero)
 Interest is compounded instantaneously, i.e.

i  n FV
FV  PV  e PV 
Where
e i n
= the number of periods
= the one-period interest rate
= 2.71828182846, a constant (base of natural
logarithms – also known as Euler’s constant)

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 Example 7: FV Continuous Compounding
You invest $1,000 in an account today. The interest is 10% p.a.,
compounded continuously. What will be the balance in the account at
the end of five years?

FV5  PV  ei n  $1,000 e 0.10(5)

 $1,000(1.64872)  $1,648.72

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 Example 8: PV Continuous Compounding
Suppose you want a balance of $1,000 at the end of five
years. If interest on the account is 10% p.a., compounded
continuously, how much must you deposit today?

PV  FV / e in
 $1,000 / e 0.10(5)
 $1,000 / 1.64872  $606.53

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 Calculations- Multiple Cash Flows
 The approach to calculating the future value (or present
value ) of a known mixed stream involves a two step
process.
− Step One: Calculate the future value (or PV) of each
future amount to be received at a comparable point in
time.
− Step Two: Sum all future values (or PV) at a
comparable point in time together to determine the
future value (or PV) of the known mixed stream.

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 Example 9: FV Mixed Stream

You deposit $1,000 now, $1,500 in one year, $2,000 in two

years and $2,500 in three years in an account paying 10%
interest per annum. How much do you have in the account
at the end of the third year?

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 Example 9 continued
• Step 1: Draw a time line for time comparability
FV3=1000(1.1)3 = $1331
FV3= 1500(1.1)2 = $1815

FV3= 2000(1.1)1 = $2200

-$1000 -$1500 -$2000 FV3 = $2500

0 1 2 3
3 years of growth 2 years of growth 1 year of growth Time comparable

Step 2: summing up
FV= $1331+$1815+$2200+$2500=$7,846
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 Example 10: PV Mixed Stream
You deposit $1,500 in one year, $2,000 in two years and $2,500
in three years in an account paying 10% interest per annum.
What is the present value of these cash flows?

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 Example 10 continued
Step 1: Draw a time line for time comparability
1878.29=PV0=2500÷(1.1)3
1652.89=PV0= 2000÷(1.1)2
1363.64=PV0= 1500÷(1.1)1

-$2000 -$2500
-$1500
0 1 2 3
Time comparable Discount back 1 Discount back 3
Discount back 2
year years years

Step 2: Summing up
$4,894.82
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 Yield / or return
 The Yield or Return of an asset is a widely used metric for relative
performance.
 It expresses the money earned by the asset, as a percentage of the
price paid for the asset, i.e. 𝑌𝑖𝑒𝑙𝑑= 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠/𝑃𝑟𝑖𝑐𝑒
 The money earned can be income, capital gains or a combination of
both.
 The percentage is usually expressed for a time period, e.g. % per
annum.
 The terms Yield and Return are interchangeable. Return is also called
the “Rate of return”

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 Various types of return
 Nominal return:
– Also known as the annual percentage return (APR).
 Effective return: e.g. EAR
– The return that includes the effect of compounding.
 Real return.
– The return that accounts for the erosion of purchasing power due
to inflation.
 Required rate of return
– The minimum return needed. WACC is an example of a RRoR.
– Commonly used as a discount rate in PV calculations.

 Expected rate of return

– The anticipated/forecasted return that will be earned on an asset.
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 Summary
 TVM implies that money has different values at different times. Money
received (paid) today, is greater in value (cost) to the recipient (payer)
than if received (paid) at a later date.
 Money can only be combined and compared if earned at the same
time period.
 Moving money forward in time to establish a value is called
compounding.
 When money is compounded, a future value is obtained. A single cash
flow, compounded over time can be calculated by
 Moving money back in time to establish a value is called discounting
 When money is discounted, a present value is obtained. A single cash
flow, discounted over time can be calculated by

9
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 Summary (cont.)
 Nominal return (i.e. nominal interest rate ) is the return most commonly
used when financial products are quoted; without the effect of
compounding and inflation.
 Effective return (i.e. EAR) is the return that includes the effect of
compounding.
– EAR is the true interest rate expressed as if it were compounded
once per year
 Real return (i.e. real interest rate) is the return that removes the effect
of inflation.

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