Chapter 3:

The Time Value of Money:

An introduction to
financial mathematics

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 Learning Objectives
✮ Understand and solve problems
involving simple interest and
compound interest, including
accumulating, discounting and making
comparisons using the effective
interest rate.
✮ Value, as at any date, contracts
involving multiple cash flows.
✮ Distinguish between different types of
annuity and calculate their present
and future values.
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Learning Objectives (cont.)
✮ Apply your knowledge of annuities to
solve a range of problems, including
problems involving principal-and-
interest loan contracts.
✮ Distinguish between ordinary and
general annuities and make basic
calculations involving general
annuities.

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 Fundamental Concepts
✮ Cash flows ✮ Interest rate
✮ Rate of return  Special case of rate of
return (used when the
C1 – C0 financial agreement is
r =
C in the form of debt).
where 0
✮ Time value of money
C1 = cash inflow at time 1
 Money received now
C0 = cash outflow at time can be invested to
0 earn additional cash
r = rate of return per (interest).
period

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 Time Value of Money
✮ An investment decision will involve
an outlay of cash made in one period
with the expectation of cash inflows
in future periods. As a significant
amount of time may elapse between
the outflow of cash and the
subsequent inflows, the significance
of this time should be considered. To
ignore differences in the timing of
cash flows is to ignore the
importance of the time value of
money.
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 Simple Interest
✮ Typically used when there is only a
single time period.
✮ Interest is calculated on the original
sum invested.
✮ Interest = Principal (P ) x number of periods (t )
x r
✮ Where ‘S ’ is the lump sum payable:
S = P + Prt
S = P (1 + rt )

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 Present Value
✮ Present cash equivalent of an amount
to be paid or received at some future
date, calculated using simple interest.
✮ Formula:
S
P =
(1 + rt )
where P = present value
S = payment at future date
r = applicable interest rate
t = number of periods before
payment
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 Compound Interest
✮ Compounding involves accumulating
interest on previous interest
payments.
✮ This means that previous interest
payments generate further interest.
✮ This earning of interest on interest is
one of the key differences between
simple interest and compound
interest.

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Compound Interest (cont.)
✮ Formula:
 The sum (S ) accumulated after n periods
is:
S = P (1 + i ) n
where i = rate per period
n = number of periods

The present value of a future sum is:

P =
S
(1 + i ) n

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 Nominal and Effective
Interest Rates
✮ Nominal rate
 Quoted interest rate where interest is
charged more frequently than the time
period specified in the interest rate.

✮ Effective rate
 Interest rate where interest is charged at
the same frequency as the interest rate
quoted.

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Nominal and Effective Interest
Rates (cont.)
✮ Distinction important when interest is
compounded over a period different from
that expressed by the interest rate e.g. more
than once a year. The effective interest rate
can be calculated:

i = (1 + j/m) m
– 1

where j = nominal rate per period

m = number of compounding periods
which occur during a single nominal
period
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Example: Effective Annual
Interest Rate
✮ Calculate the effective annual
interest rates corresponding to 12 per
cent p.a., compounding:
(a) semi-annually.
Solution: Using equation 3.6

m 2
 j  0.12 
i = 1 +  − 1 = 1 +  − 1 = (1 .06 ) 2
− 1 = 12.36%
 m  2 

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Example: Effective Annual
Interest Rate (cont.)
✮ Calculate the effective annual
interest rates corresponding to 12 per
cent p.a., compounding:
(b) quarterly.
Solution: Using equation 3.6

m 4
 j  0.12 
i = 1 +  − 1 = 1 +  − 1 = ( 1. 03) 4
− 1 = 12.5509%
 m  4 

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Example: Effective Annual
Interest Rate (cont.)
✮ Calculate the effective annual
interest rates corresponding to 12 per
cent p.a., compounding:
(c) monthly.
Solution: Using equation 3.6

m 12
 j  0.12 
i = 1 +  − 1 = 1 +  − 1 = ( 1. 01) 12
− 1 = 12.6825%
 m  12 

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Example: Effective Annual
Interest Rate (cont.)
✮ Calculate the effective annual
interest rates corresponding to 12 per
cent p.a., compounding:
(d) daily.
Solution: Using equation 3.6

m 365
 j  0.12 
i = 1 +  − 1 = 1 +  − 1 = 12.7475%
 m  365 

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 Real Interest Rates
✮ The real interest rate is the interest rate
after taking out the effects of inflation.
✮ The nominal interest rate is the interest
rate before taking out the effects of
inflation.
 The real interest rate i * can be found
for a corresponding nominal interest
rate i and an expected inflation rate p
asi follows:
* = – 1
1 + i
PPT1 + p
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Continuous Interest Rates
✮ Continuous interest is a method of
calculating interest in which interest is
charged so frequently that the time
period between each charge
approaches zero.
✮ Continuous interest is an example of
exponential growth: S = Pe jn

where S = future sum

P = principal
j = continuously compounding interest
rate per period
n = number of periods
e = 2.71828182846
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 A Generalisation:
Geometric Rates of Return
✮ The rate of return between two dates,
measured by the change in value
divided by the earlier value.

✮ The average of a sequence of

geometric rates of return is found by a
process that resembles compounding.

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 A Generalisation: Geometric
Rates of Return (cont.)
✮ Average geometric rate of return is
also referred to as the average
compound rate of return.
1
Pn  n
i =
P 
 −1
 0 
Where Pn = final value or price
P0 = initial value or price
n = number of periods
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Valuation of Contracts with
Multiple Cash Flows
✮ Value additivity
 Cash flows occurring at different times
cannot be validly added.
 Only cash flows occurring at the same time
can be added.
 Therefore, it is necessary to convert
multiple cash flows into a single equivalent
cash flow.
 Cash flows can be carried either forward in
time (accumulated) or back in time
(discounted).
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 Valuation of Contracts
With Multiple Cash Flows
(cont.)
✮ Where a cash flow of C dollars occurs
on a date t, the value of that cash
flow at a valuation date t * is given
by:

Vt * = Ct (1 + i )t * - t

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 Valuation of Contracts
With Multiple Cash Flows
(cont.)
✮ Measuring the rate of return
 Where there are n cash inflows Ct (t = 1,
..., N), following an initial outflow of C0 ,
the internal rate of return is that value of r
that solves the equation:
n
Ct
∑(1 + r )
t =1
t
−C 0 = 0

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Example: Internal Rate of Return
✮ Consider 3 cash flows:
✮ –$1000 today
✮ +$1120 in 1 year
✮ +$25 in two years
✮ What is the average rate of return on the
initial investment of $1000, taking into
account compounding, that is, the IRR?
✮ The IRR is the r that satisfies the following
equation:
1120 25
+ −1000 =0
(1 +r ) (1 +r )2

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 Example: Internal Rate
of Return (cont.)
✮ The answer can be solved for precisely as
the equation is a quadratic equation.
✮ Alternatively, and more generally, trial and
error can be used, substituting different
values for r.
✮ In practice this would be done with a
computer, using something like Excel or
Lotus.
1120 25
+
✮ The IRR = 14.19 per cent2 − 1000
(1 + 0.1419) (1 + 0.1419)
= $980.82 + $19.17 − $1000 = 0

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 Annuities
✮ An annuity is a stream of equal cash
flows, equally spaced in time.

✮ We consider four types of annuities:

✮ Ordinary annuity
✮ Annuity due
✮ Deferred annuity
✮ Ordinary perpetuity

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 Ordinary Annuities

✮ Annuities in which the time period from

the date of valuation to the date of the
first cash flow is equal to the time
period between each subsequent cash
flow.
✮ Assume that the first cash flow occurs
at the end of the first time period:

0 1 2 3 4 5 6
$C $C $C $C $C $C
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Valuing Ordinary Annuities
✮ Future value

S ( n, i ) =
(1 +i )
n
−1
i
 Using the future value of annuity
tables, values of S(n,i ) for
different values of n and i can be
found.
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 Example: Ordinary
Annuities
✮ Starting with his next monthly salary,
Harold intends to save $200 each
month. If the interest rate is 8.4 per
cent per annum, payable monthly,
how much will Harold have saved
after 2 years?
Solution: Monthly interest rate is
0.4/12=0.7%. Using equation 3.28, Harold’s
C
savings will amount
S= [i (1 + i ) − 1]
to:n

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 Example: Ordinary
Annuities (cont.)
Solution: Substituting the values we
have.

S=
$200
0.007
(1.007 ) − 1
24
[ ]
= $200 × 26.03492507
= $5206.99

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Valuing Ordinary Annuities
✮ Present value

1 1 
P = A( n, i ) = 1 − n 
i  (1 + i ) 
✮ Using the present value of annuity
tables, values of A (n,i ) for
different values of n and i can be
found.
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 Example: Ordinary
Annuities
✮ Find the present value of an ordinary
annuity of $5000 per annum for 4
years if the interest rate is 8 per cent
per annum by:
(a) Discounting each individual cash flow.
C C C C
P= + + +
1 + i (1 + i ) 2
(1 + i ) (1 + i ) 4
3

$5000 $5000 $5000 $5000

= + + +
1.08 (1.08) 2
(1.08) (1.08) 4
3

= $16560.63
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 Example: Ordinary
Annuities (cont.)
✮ Find the present value of an ordinary
annuity of $5000 per annum for 4
years if the interest rate is 8 per cent
per annum by:
(b) Using equation 3.19.
C  1  $5000  1 
P= 1 − n
= 1 − 4
i  (1 + i )  0.08  (1.08) 
= $5000 × 3.31212684
= $16560.63

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 Example: Ordinary
Annuities (cont.)
✮ Find the present value of an ordinary
annuity of $5000 per annum for 4
years if the interest rate is 8 per cent
per annum by:
(c) Using Table 4 of Appendix A.
P = CA( n, i )
= $5000 × 3.3121
= $16560.50

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 Annuity Due
✮ An annuity where the first cash flow is
to occur immediately:
0 1 2 3 4 5 6
$C $C $C $C $C $C $C

✮ An annuity due of n cash flows is

simply an ordinary annuity of (n – 1)
cash flows, plus an immediate cash
flow of C.

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 Annuity Due (cont.)
✮ The present value of an annuity due

P = C (1 + A( n −1, i ) )
where P = present value
C = periodic cash flow
i = interest rate per period
n = number of cash flows

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 Deferred Annuity

✮ Annuity in which the first cash flow is to

occur after a time period that exceeds
the time period between each
subsequent cash flow:

0 1 2 3 4 5 6 7 8
$C $C $C $C $C
$C

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 Deferred Annuity (cont.)
✮ Present value of a deferred annuity:
C
P= A( n, i )
(1 + i ) k −1

where C = cash flow per period

i = interest rate per period
n = number of cash flows
k = number of time periods until
the first cash flow

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 Ordinary Perpetuity
✮ An ordinary annuity where the cash
flows are to continue forever:
0 1 2 3 4 5 6 ... ∞

$C $C $C $C $C $C ... $C
✮ The present value of an ordinary
perpetuity:
P =C i
where C = cash flow per period
i = interest rate per period

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 Principal-and-Interest
Loans
✮ An important application of annuities is
to loans involving a sequence of equal
cash flows, each of which is sufficient
to cover the interest accrued since the
previous payment and to reduce the
current balance owing.
✮ Such loans can be referred to as:
 principal-and-interest loans
 credit foncier loans
 amortised loans
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 Principal-and-Interest
Loans (cont.)
✮ Balance owing at a given date
 Equals the present value of the then
remaining repayments
✮ Loan term required
 Solving for the required loan term n:

log[ C ( C − Pi ) ]
n=
log(1 + i )
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 Principal-and-Interest
Loans (cont.)
✮ Changing the interest rate
 In some loans (usually called variable
interest rate loans) the interest rate can
be changed at any time by the lender.
 Two alternative adjustments can be
made:
 The lender may set a new required
payment which will be calculated as if the
new interest rate is fixed for the remaining
loan term.
 The lender may allow the borrower to
continue making the same repayment and,
instead, alter
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new interest rate.
 General Annuities
✮ Annuity in which the frequency of
charging interest does not match the
frequency of payment; thus,
repayments may be made either more
frequently or less frequently than
interest is charged.
✮ Link between short period interest
rate (iS) and long period interest rate
i = (1 + i )
m
(iL)
L S −1
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 Summary
✮ Fundamental concepts in financial
mathematics include rates of return,
simple and compound interest.
✮ Valuation of cash flows:
✮ Present value of a future cash flow
✮ Future value of a current
payment/deposit.
✮ Annuities are a special class of
regularly spaced fixed cash flows.

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