Topic 2

Financial Mathematics/Time Value of Money

Part 1

Overview
In this lecture we will:
Discuss the time value of money concept;
Learn about simple interest;
Learn about compounding and discounting;
Learn about compound interest;
Calculate the present value and future value of a single
amount for both one period and multiple periods;
Calculate the present value and future value of multiple
cash flows; &
Calculate the present value and future value of annuities;
RMIT University2008

BAFI1008 Business Finance

Time Value of Money

Receiving $1 today is worth more than $1 in the

future
The opportunity cost of $1 in the future is the
interest we could have earned on $1 if received
earlier
Today

RMIT University2008

BAFI1008 Business Finance

Future

Time Value Terminology

For a single sum time value problem there are four variables that have to be
taken into account:
n - The number of interest paying time periods between a present value and
a future value;
R - The rate of interest for discounting or compounding;
Note - n and r need to be consistent - if interest (r) is paid monthly the
number of periods n has to be worked out in terms of months (we will see
example of this later on which will help to explain it);
PV0 Present value the price/value of the asset/investment now (at time
period zero (T0))
FVn Future value the price/value of the asset/investment at some future
specified time (Tn)
All single sum time value questions involve four values: PV, FV, r and n given three of the values it is always possible to calculate the unknown
fourth value.

Future Sum With Simple Interest

If the Bank pays you simple interest on a deposit the interest payment each period
will be the same and will be the interest rate times the initial amount.
Simple interest refers to interest earned only on the original capital investment
amount.
The formula for the future value of a single sum calculated with simple interest is:
FVn = PV(1 + (r x n))
Example: $100 invested at 10% p.a. simple interest for three years
1.FV3 = $100(1+(0.10 x 3))
2.FV3 = $100(1.30)
3.FV3 = $130.00
Therefore, interest earned = $30.00

RMIT University2008

BAFI1008 Business Finance

Compounding and Discounting

Compounding

Translating $1 today into its equivalent future value.

Discounting
Translating a future $1 into its equivalent present value today.
Timeline

0
T0
PV0

RMIT University2008

1
T1

2
T2

BAFI1008 Business Finance

3
T3

4
T4
FV4

Compound Interest
If the bank pays you compound interest you
will receive interest payments not just on the
initial amount but also on previous interest
payments.
Compound interest refers to interest earned
on both the initial capital investment and on
the interest reinvested from prior periods (i.e.
earning interest on interest).
In finance compound interest is usually used.

RMIT University2008

BAFI1008 Business Finance

Single Sums:
Future Value of A Single Sum
Example: Future value of a single sum
You invest $100 in a savings account that earns 10% p.a. interest
(compounded) for three years.
Calculating FV the long way:
1. After one year:

$100 (1.10) = $110

2. After two years: $110 (1.10) = $121

3. After three years: $121 (1.10) = $133.10
Calculating FV the short way (preferred):

FV of a single amount invested today at r % for n periods is:

FVn = PV0(1+r)n
The expression (1 + r)n is the future value interest factor (FVIF) for a single
sum.

RMIT University2008

BAFI1008 Business Finance

Single Sums:
Future Value of A Single Sum
FV3 = 100(1.10)3
Timeline

1.FV3 = 100(1.331)
2.FV3 = $133.10

$100

T0

Interest earned = $33.10

$133.10

T1

PV0

T2

T3
FV 3

Notice:
Interest earned with compounding $33.10;
Interest earned with simple interest $30.00;
Difference $3.10 - due to compounding
(i.e. interest on interest).
RMIT University2008

BAFI1008 Business Finance

Single Sums:
Future Value of A Single Sum
Example: Future value of a single sum
What will $1,000 amount to in five years time if interest is 12% p.a. compounded annually?
n = 5 (interest is calculated 5 times), r = 0.12:
1. FV5

= $1,000(1.12)5

2. FV5

= $1,000(1.7623)

3. FV5

= $1,762.30

Now assume interest is 12% per annum, compounded monthly.

Always remember that n is the number of compounding periods, not the number of years.
n = 5yrs x 12 months per year = 60 (i.e. interest is calculated 60 times).
r = 0.12 p.a./12 months per year = 0.01 (i.e. interest rate is 1% per month).
FV60 = $1,000(1.01)60
FV60 = $1,000(1.8167)
FV60 = $1,816.70
Difference ($1,816.70 - $1,762.30 = $54.40) is due to compounding more often over entire
investment period (i.e. 60 times @ 1% v. 5 times @ 12%).
Future values also depend critically on the assumed interest rate - the higher the interest rate, the
greater the future value.

RMIT University2008

BAFI1008 Business Finance

10

Future Value of A Single Sum

For a given number of periods, the higher the interest rate the higher the
future value.
For a given interest rate, the more compounding periods the greater the
future value.

RMIT University2008

BAFI1008 Business Finance

11

Present Value of A Single Sum

Present value of a single amount discounted back to today at r % for
n periods is:
PV0 = FVn(1+r)-n
or
PV0 = FVn
(1+r)n
The expression (1 + r)-n is the present value interest factor (PVIF) for a single
sum.

RMIT University2008

BAFI1008 Business Finance

12

Present Value of A Single Sum

Example: Present value of a single sum
If you will receive $1,000 in three years time what is its PV if your opportunity
cost/discount rate/interest rate is 10% p.a.?
Calculating PV the long way:
Yr 3:

$1,000 (1.10)-1 = $909.09

Yr 2:

$909.09 (1.10)-1 = $826.45

Yr 1:

Timeline

$826.45 (1.10)-1 = $751.32

$751.32

$826.45

T0

Calculating FV the short way:

PV0

T1

$909.09
T2

$1,000.00
T3
FV 3

PV of a single future amount

discounted back to today at r % for n periods is:
PV0 = FVn(1+r)-n
PV0 = $1,000(1.10)-3
PV0 = $1,000(0.7513)
PV0 = $751.30

RMIT University2008

BAFI1008 Business Finance

13

Present Value of A Single Sum

Your rich grandmother promises to give you
$10,000 in 10 years time. If interest rates are
12% per annum how much is this gift worth
today?
PV0 = FVn(1+r)-n
PV0 = $10,000(1.12)-10
PV0 = $10,000(0.3220)-3
PV0 = $3,220.00

RMIT University2008

BAFI1008 Business Finance

14

Present Value of A Single Sum

For a given number of periods, the higher the interest rate the lower the
present value.
For a given interest rate, the greater the number of discounting periods
the lower the present value.

RMIT University2008

BAFI1008 Business Finance

15

Single Sums: Problem Variations

In general the problems that students will confront in this
course will either involve working out present values or
future values.
However, it is of course possible to also want to work out
n if given PV, FV and r. It is quite a common problem to
want to know how long it will take an investment to grow
from its PV to its FV at a given interest rate.
It is also possible to work our r given n, PV and FV. It is
quite a common problem to want to know what the rate of
return on an asset is when it grows from PV to FV over a
given period of time.

RMIT University2008

BAFI1008 Business Finance

16

Single Sums: Problem Variations

Example: Solving for the unknown rate of return (r)
You currently have $100 available for investment for a 21
year period. At what annual interest rate must you invest
this amount in order for it to be worth $500 at maturity?
Remember, given any three factors in the present value or
future value of a single sum formula, the fourth factor can
be solved.

RMIT University2008

BAFI1008 Business Finance

17

Single Sums: Problem Variations

Example: Solving for the unknown rate of return (r)
Since we know both the PV and FV (and n), we can use either the PV or the
FV of a single sum formula to find the unknown interest rate (r).
A. PV of a single sum

B. FV of a single sum

PV0 = FVn(1+r)-n

FVn = PV0(1+r)n

1. 100 = 500(1+r)-21

1. 500 = 100(1+r)21

2. 100/500 = (1+r)-21

2. 500/100 = (1+r)21

3. 0.20 = (1+r)-21

3. 5 = (1+r)21

4. (0.20)1 = (1+r)-21

4. (5)1 = (1+r)21

5. (0.20)1/-21 = (1+r)-21/-21

5. (5)1/21 = (1+r)21/21

6. (0.20)-0.04762 = 1+r

6. (5)0.04762 = 1+r

7. 1.0797 = 1+r

7. 1.0797 = 1+r

8. 1.0797-1 = 1+r-1

8. 1.0797-1 = 1+r-1

9. 0.0797 = r = 7.97% p.a.

9. 0.0797 = r = 7.97% p.a.

RMIT University2008

BAFI1008 Business Finance

18

Single Sums: Problem Variations

Example: Solving for the unknown rate of return (r)
If you sell land for $11,933 (FV) that you bought five
years ago (n) for $5,000 (PV), what is your annual rate of
return?
Using the same method as in the previous example you
will find that the rate of return (r) is equal to 19% p.a.

RMIT University2008

BAFI1008 Business Finance

19

Single Sums: Problem Variations

Example: Solving for the unknown rate of return (n)
Suppose you placed $100 in an account that pays interest of 9.6% p.a.,
compounded monthly. How long will it take for your account to grow to $500?
note: r = 0.096/12 = 0.008 (i.e. 0.8% per month)
Since we know both the PV and FV (and r), we can use either the PV or the
FV of a single sum formula to find the unknown number of investment periods
(n). To get the answer we must use natural logs (the ln button on your
calculator).
A. PV of a single sum

B. FV of a single sum

PV0 = FVn(1+r)-n

FVn = PV0(1+r)n

1. 100 = 500(1.008)-n

1. 500 = 100(1.008)n

2. 100/500 = (1.008)-n

2. 500/100 = (1.008)n

3. 0.20 = (1.008)-n

3. 5 = (1.008)n

4. ln(0.20) = -nln(1.008)

4. ln(5) = nln(1.008)

5. -1.6094 = -n(0.007968)

5. 1.6094 = n(0.007968)

6. -1.6094/0.007968 = -n

6. 1.6094/0.007968 = n

7. -202 = -n = 202 months

7. 202 = n = 202 months

RMIT University2008

BAFI1008 Business Finance

20

Single Sums: Problem Variations

Hint For Single Sum Problems
There are only 4 variables: FV, PV, r, and n.
You will always be given three variables and
asked to solve for the fourth.
This hint makes solving single sum time-value
problems much easier.

RMIT University2008

BAFI1008 Business Finance

21

Multiple Uneven Cash-Flows

Example: Future Value of Multiple Uneven Cash-Flows
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 interest of 10% p.a. How much will you have in the account at the end of the third
year?
As each of the cash-flows is of a different value you must first calculate the future value of each
cash flow individually as a single sum and then total the future values.
FVn = PV0(1+r)n
Timeline

$1,000(1.10)3 = $1,000(1.331) = $1 331

$1,500(1.10)2 = $1,500(1.21) = $1 815
$2,000(1.10)1 = $2,000(1.10) = $2 200
$2 500(1.00) =

= $2 500

Total = $7 846

T0

$1,000

$1,500

T1

$2,000

T2

T3

$2,500
$1,331

$1,815
$2,200
$2,500
$7,846

RMIT University2008

BAFI1008 Business Finance

22

Multiple Uneven Cash-Flows

Example: Present Value of Multiple Uneven Cash-Flows
You deposit $1,500 in one year, $2,000 in two years and $2,500 in three years in an account paying
interest of 10% p.a. What is the present value of these cash flows?
As each of the cash-flows is of a different value you must first calculate the present value of each
cash-flow individually as a single sum and then total the present values.
PV0 = FVn(1+r)-n
$1,500(1.10)-1

= $1,500(0.9091) = $1,364

$2,000(1.10)-2

= $2,000(0.8264) = $1,653

$2,500(1.10)-3

= $2,500(0.7513) = $1 878

Total = $4 895

Timeline

T0

T1
$1,500

T2
$2,000

T3
$2,500

$1,364
$1,653
$1,878
$4,895

RMIT University2008

BAFI1008 Business Finance

23

Annuities
What is an Annuity? A series of constant/fixed cash-flows
(payments or receipts) ocurring at regular intervals, e.g. a
superannuation/pension payment.
Types of Annuities:
Ordinary annuity;
Annuity due;
Deferred annuity;
Perpetuity; &
Growing perpetuity.

RMIT University2008

BAFI1008 Business Finance

24

Annuities
Ordinary annuity - A series of constant cashflows occurring at the end of each period for
some fixed number of periods and commencing
at the end of the first period (i.e. commencing
at T1).

Timeline

Timeline

T0

Annuity due - A series of constant cash-flows

occurring at the start of each period for some
fixed number of periods and commencing at the
beginning of the first period (i.e. commencing
at T0).

T1

T2

T3

$100

$100

$100

Examples include mortgage repayments (payment

annuity) and superannuation/pension payments
(receipt annuity).

RMIT University2008

T0

T1

$100

$100

T2

T3

$100

Examples include paying rent or uni. fees in

advance.

BAFI1008 Business Finance

25

Annuities
Deferred annuity - A series of constant cashflows occurring at the end of each period for
some fixed number of periods and commencing
some future period after period one (e.g
commencing at T3 (the end of the third
period)).
Timeline

T0

Perpetuity - A series of constant cash-flows

occurring at the end of each period indefinitely
(i.e. forever).

Timeline

T1

T2

T3

T4

T5

$100

$100

$100

T0

T1
$100

Examples include a lump sum pension plan.

RMIT University2008

T2
$100

T3 ..... T
$100

$100

Examples include a scholarship fund available

each year forever (e.g. Rhodes Scholarship).

BAFI1008 Business Finance

26

Annuities
Future value of an ordinary annuity:

1 r n - 1

FVn PMT

The compounding term (sqaure bracketed term) is called

the future value interest factor of the annuity (FVIFA).
The formula gives the FV at the time the last
payment/receipt is made.

RMIT University2008

BAFI1008 Business Finance

27

Annuities
Example: Future Value of An Ordinary Annuity
If you invest $1,000 at the end of each of the next 3 years at 8% p.a., how
much will you have after 3 years?
Timeline

T0

T1
$1,000

T2
$1,000

T3
$1,000
FV3 = $3,246.40

1 r n - 1
FVn PMT

(1.08) 3 1
FV3 $1,000

0
.
08

FV3 $1,000 3.2464

FV3 $3,246.40

RMIT University2008

BAFI1008 Business Finance

28

Annuities
Present value of an ordinary annuity:

1 1 r n
PV0 PMT

PMT = the annuity payment

The discounting term (value in the big square bracket) is
called the present value interest factor of the annuity
(PVIFA).
Note, the formula always assumes that it is an ordinary
annuity and it provides the PV one period before the
first payment or receipt takes place, i.e. it provides PV
at T0.
RMIT University2008

BAFI1008 Business Finance

29

Annuities
Example: Present Value of An Ordinary Annuity
What is the PV of receiving $1,000 at the end of each of the next 3 years if the
opportunity cost is 8% p.a.?

1 1 r n
PV0 PMT

Timeline

T0

T1
$1,000
PV0 = $2,577.10

T2
$1,000

T3
$1,000

1 1.08 3
PV0 $1,000

0.08

PV0 $1,000 2.5771

PV0 $2,577.10

RMIT University2008

BAFI1008 Business Finance

30

Annuities
Finding an unknown PMT
In the previous problems we were given:
n the number of investment periods;
r the discount/ interest rate per investment period; &
PMT the regular periodic annuity payment/receipt,

and asked to calculate the PV of the ordinary annuity.

However, it is common to want to know PMT if given n, r and PV.
This is particularly so in instances of trying to work out the regular
periodic payments on a loan.

RMIT University2008

BAFI1008 Business Finance

31

Annuities
Finding an unknown PMT
Using the previous numerical example:
PV0 = $2,577.10, r = 8% p.a., n = 3 years, PMT = ?

1 (1.08) 3
$2,577.10 PMT

0
.
08

$2,577.10 PMT 2.5771

$2,577.10
PMT
2.5771
PMT $1,000

RMIT University2008

BAFI1008 Business Finance

32

Future Values & Present Values:

Single Sums, Multiple Uneven Cash-Flows, &
Annuities
1. Draw a timeline
2. Determine what unknown the problem involves:
r, n, PV, FV, PMT?
3. Identify the class of problem:
single sum; multiple uneven cash-flow; annuity?
4. Recognise any traps in the problem:
Annual interest rate and more than
compounding period per year? Adjust r and n.

RMIT University2008

BAFI1008 Business Finance

one

33