Time Value of Money (TVM)

FIN 3010 Financial Management 1

Time Value of Money The concept of Time Value of Money (TVM) is fundamental in the study of finance The basic idea of TVM is that a dollar (Ringgit) today is worth more than a dollar (Ringgit) to be received in the future Why is the value of RM1 today > value of RM1 in the future?
Risk (Probability of receipt of future dollars) Personal preference for current consumption Investment opportunities forgone (returns on dollars invested today not available to future dollars)

Concepts of Present Value and Future Value

Assuming no risk and no personal preference, in each of the following choices, which would you prefer?
RM1,000 today or RM1,000 in a years time? RM999 today or RM1,000 in a years time? RM500 today or RM1,000 in a years time? RM3,456.78 today or RM3,789.01 in a years time? RM11,111.11 today or RM12,222.22 in a years time? RM8,361 today or RM9,275 in a years time?

Concepts of Present Value and Future Value (2)

To make informed decisions, the choices above can be converted so that they are both measured at the same point in time Either today (present value) or in the future (future value) Using the last choice as an example, assuming an investment opportunity giving the rate of return of 10%, RM8,361 today is worth RM8,361 in present value terms, and RM9,275 in a year is worth RM8,432 in present value terms (or in other words, in todays terms) This method of bringing a future cash flow into a present value is called discounting The alternative way RM8,361 today will be worth RM9,197 in a years time, while of course, RM9,275 in a years time is worth exactly that in a years time This method of bringing a present (current day) cash flow into the future, representing it as a future value, is called compounding

Discounting and Compounding

Whichever method is used, the decision would be the same RM9,275 in years time is worth more than RM8,361 today The concepts of discounting and compounding in the form of a diagram:

Exponential Effect of Compound Interest If you put RM100 into a savings account that pays 5% interest for a period of 20 years, how much money will you have at the end of the 20 years?
5% x RM100 = RM5 per year Total interest = RM5 x 20 years = RM100 Total money at the end of 20 years = RM100 (principal) + RM100 (interest) = RM200 Or would there be more in the savings account? RM265.33? Interest earned after one year will also earn interest on the subsequent years (interest on interest)

Illustration of Compounding Interest

With compound interest, interest also earns interest Year 1: 5% of $100.00 Year 2: 5% of $105.00 Year 3: 5% of $110.25 Year 4: 5% of $115.76 Year 5: 5% of $121.55 = $5.00 + $100.00 = $5.25 + $105.00 = $5.51 + $110.25 = $5.79 + $115.76 = $6.08 + $121.55 = $105.00 = $110.25 = $115.76 = $121.55 = $127.63

Computational Notes Common Computational Tools

Financial tables Financial calculators Spreadsheet Software

In financial mathematics, there are 3 basic patterns of cash flow

A single amount An annuity A mixed stream

Future Value of a Single Amount Start with an initial amount today (present value) The amount is invested over a period of time The investment gives a certain fixed and constant rate of return The task is to find the value of this investment at the end of the period of investment

Example 1
Ahmad places RM800 in a savings account that pays 6% interest. He would like to know how much will be in that account at the end of 5 years The formula FV = PV x (1 + i)n Solving it arithmetically, FV = PV x (1 + i)n FV = RM800 x (1 + 0.06)5 FV = RM1,070.58 Solving it using the financial table, (1+i)n = Future Value Interest Factor (FVIF), which can be obtained from table A-1 Look up Period = 5, and Interest Rate of 6%, and you will get 1.338 FV = PV x (1 + i)n FV = PV x FVIF FV = RM800 x 1.338 = RM1,070.40

Present Value of a Single Amount Begin a targeted amount in the future (future value) An amount (to be calculated) would be invested over a period of time The investment gives a certain fixed and constant rate of return The task is to find the value of the amount to be invested now, that will give the targeted amount in the future

Example 2
Siti would like to have RM5,000 in 4 years time. She has the opportunity to invest in a scheme that guarantees her 7% annual returns. How much must she invest today in order for her to get the RM5,000 she wants at the end of 4 years? The formula PV = FV / (1 + i)n Solving it arithmetically, PV = FV / (1 + i)n PV = RM5,000 / (1 + 0.07)4 PV = RM3,814.48 Solving it using the financial table, 1 / (1 + i)n = Present Value Interest Factor (PVIF), which can be obtained from table A-2 Look up Period = 4, and Interest Rate of 7%, and you will get 0.763 PV = FV / (1 + i)n PV = FV x PVIF PV = RM5,000 x 0.763 PV = RM3,815

Annuities
An annuity is a stream of equal periodic cash flows, over a specified period of time There are two types of annuities Ordinary Annuity cash flow occurs at the end of each period Annuity Due cash flow occurs at the beginning of each period

Future Value of an Ordinary Annuity

An amount will be invested periodically at the end of each period This investment will occur over a specific time period The investment gives a certain fixed and constant rate of return The task is to find the value of this investment at the end of the period of investment

Example 3
Johan saves RM5,000 at the end of each year. He places his savings into an investment instrument that gives a constant 8% return. He does this for 10 years. How much will he have at the end of the 10 years? Solving it using the financial table, FVannuity = PMT x FVIFannuity Future Value Interest Factor (FVIF) for an annuity can be obtained from table A-3 Look up Period = 10, and Interest Rate of 8%, and you will get 14.487 FVannuity = PMT x FVIFannuity FVannuity = RM5,000 x 14.487 FVannuity = RM72,435

Present Value of an Ordinary Annuity

There is a periodic cash flow occurring at the end of each period These cash flows are invested over a specific time period The investment gives a certain fixed and constant rate of return The task is to find the value of this investment now (present value)

Example 4
An investment instrument will provide cash flows of RM4,000 at the end of each year for the next 5 years. The return on invested funds is 7%. What is the present value of this investment? Solving it using the financial table, PVannuity = PMT x PVIFannuity Present Value Interest Factor (PVIF) for an annuity can be obtained from table A-4 Look up Period = 5, and Interest Rate of 7%, and you will get 4.100 PVannuity = PMT x PVIFannuity PVannuity = RM4,000 x 4.100 PVannuity = RM16,400

Future Value of an Annuity Due

An amount will be invested periodically at the beginning of each period This investment will occur over a specific time period The investment gives a certain fixed and constant rate of return The task is to find the value of this investment at the end of the period of investment

Example 5
Lim sets aside RM2,000 at the beginning of each year. He places this amount into an investment instrument that gives a constant 7% return. He does this for 6 years. How much will he have at the end of the 6 years? Solving it using the financial table, FVannuity due = PMT x FVIFannuity x (1 + i) Future Value Interest Factor (FVIF) for an annuity can be obtained from table A-3 Look up Period = 6, and Interest Rate of 7%, and you will get 7.153 FVannuity due = PMT x FVIFannuity x (1 + i) FVannuity due = RM2,000 x 7.153 x (1.07) FVannuity due = RM15,307.42 The future value of an annuity due is always greater than the future value of an otherwise identical ordinary annuity

Present Value of an Annuity Due

There is a periodic cash flow occurring at the beginning of each period These cash flows are invested over a specific time period The investment gives a certain fixed and constant rate of return The task is to find the value of this investment now (present value)

Example 6
An investment instrument will provide cash flows of RM4,000 at the beginning of each year for the next 5 years. The return on invested funds is 7%. What is the present value of this investment? Solving it using the financial table, PVannuity due = PMT x PVIFannuity x (1 + i) Present Value Interest Factor (PVIF) for an annuity can be obtained from table A-4 Look up Period = 5, and Interest Rate of 7%, and you will get 4.100 PVannuity due = PMT x PVIFannuity x (1 + i) PVannuity due = RM4,000 x 4.100 x (1.07) PVannuity due = RM17,548 The present value of an annuity due is always greater than the present value of an otherwise identical ordinary annuity

Present Value of a Perpetuity A perpetuity is an annuity with an infinite life It is an annuity that continuously (with no ending) gives a cash flow at the end of each period The task is to find the present value of this perpetuity

Example 7 An investment vehicle will provide its beneficiary a periodic (annual) cash flow of RM2,500, continuously with no end. The investment will earn a return of 5%. What is the value of this investment vehicle? Solving it arithmetically, PVperpetuity = PMT / i PVperpetuity = RM2,500 / 0.05 PVperpetuity = RM50,000

Present Value of a Mixed Stream

In an annuity, the cash flow stream is that of equal periodic cash flows However, at times, the cash slow stream may not be equal across the period, or in other words, there is no particular pattern of cash flows This is called a mixed stream

Example 8
A company has been offered the opportunity to receive the following mixed stream of cash flows over the next 3 years End of year Cash flow 1 2 RM2,000 RM3,700

3 RM1,500 If the required rate of return is 10%, what is the present value of this opportunity? Solving it using the financial table (table A-2), Determine the present value of each future cash flow Add the individual present values to give the total present value Year 1 2 3 Cash flow RM2,000 RM3,700 RM1,500 PVIF 0.909 0.826 0.751 Present value RM2,000 x 0.909 = RM1,818.00 RM3,700 x 0.826 = RM3,056.20 RM1,500 x 0.751 = RM1,126.50 RM6,000.70

Present value of mixed stream

Compounding More Frequently Than Annually

Interest is often compounded more frequently than once a year Interest can be compounded semiannually (twice a year), quarterly (four times a year), monthly (12 times a year), weekly, daily, and so on The method of calculating future value and present value of single amounts, annuities and mixed streams of cash flow can be adjusted to reflect such more frequent compounding The basic method i FV ! PV v (1  ) mvn m i represents the annual interest rate (usually the interest rate will be quoted in annual terms) m represents the number of times per year interest is compounded n represents the number of periods (years) Basically the method involves doing two additional things Dividing the (annual) interest rate with m Multiplying the number of periods (years) with m

Example 9
Aisya would like to find out the future value of RM100 invested at 8% interest compounded quarterly for 2 years The relevant parameters are: Present Value = RM100 Interest = 8% / 4 = 2% Periods = 2 years x 4 = 8 Future Value = ? Solving it using the financial table, Look up in table A-1, Period = 8, and Interest = 2%, and you will get 1.172 FV = PV x FVIF FV = RM100 x 1.172 = RM 117.20

Recap TVM Flowchart

Single amount or stream of cash flow? Stream of CF CF goes on forev er? Single amount Calcula te PV or FV? FV Example 1 PV Example 2

Equal cash flows?

yes

no

CF at beginnin g or end of period?

end

Calcula te PV or FV?

FV Example 3

PV yes no Calcula te PV or FV? FV Example 5 beginning

Example 4

Example 7

Example 8

PV Example 6

Compounding more frequently than annually?

yes

Example 9

Continuous Compounding
Recall the formula to calculate the FV of a Single Amount [with adjustments for compounding more frequently than annually]

i FV ! PV x 1  m

mxn

At times, compounding frequency is every microsecond In this case, m approaches infinity The formula is restated as,

F !

v (e )
Note : e is approximately 2.71828183

ivn

Example 10
Amy deposits RM1,000 into a savings account that pays interest at the rate of 2% compounded continuously. What will be the balance in her account after 3 years?

FV ! PV v (e ) FV ! RM1,000 v (e FV ! RM1,000 v e FV ! RM1,061.84

0.02 v 3

ivn

0.06

FV ! RM1,000 v 1.061837

The Problem with Differing Compounding Frequencies

Which is a better deal? Deposit interest rate of 2.5% compounded monthly, or 2.65% compounded annually? Personal loan at interest rate of 8.5% compounded monthly, or 8.4% compounded weekly? Investment scheme that returns 10% compounded annually, 9.75% compounded quarterly or 9.6% compounded weekly?
There is a need for a technique to make convenient comparisons

Nominal & Effective Rates Nominal annual rate

Stated or quoted rate which appears in contractual agreements Does not reflect compounding effects

Effective annual rate (EAR)

True or actual rate realized Takes into account the effects of compounding

i EAR ! 1  - 1 m
i .. nominal annual rate m compounding frequency

Example 11
What is the effective annual rate associated with an 8% nominal annual rate when interest is compounded annually, quarterly, monthly and weekly? 1 m Annually EAR ! 1  i - 1 ! 1  0.08 - 1 ! 0.08 ! 8.00%
m 1

Quarterly Monthly Weekly

i 0.08 EAR ! 1  - 1 ! 1  - 1 ! 0.0824 ! 8.24% 4 m

i 0.08 A ! 1  - 1 ! 1  - 1 ! 0.0830 ! 8.30% 12 i 0.08 EAR ! 1  - 1 ! 1  - 1 ! 0.0832 ! 8.32% 52 m
m 52

12

The Problem with Differing Compounding Frequencies - Revisit

Which is a better deal? EAR 2.53% Deposit interest rate of 2.5% compounded monthly, or 2.65% compounded annually? EAR 8.84% EAR 2.65% Personal loan at interest rate of 8.5% compounded monthly, or 8.4% compounded weekly? EAR 8.76% EAR 10% Investment scheme that returns 10% compounded EAR 10.11% annually, 9.75% compounded quarterly or 9.6% compounded weekly? EAR 10.07%

Using the Financial Calculator

There could be minor variations among various brands/models but the generic method is as follows,
There are 5 variables Number of periods, n Interest rate, i Present Value, PV Future Value, FV Periodic cash flow in an annuity, PMT In most cases, in each problem/calculation, only 4 variables will be affected First enter the value, then the variable To find the answer, press the unknown variable (preceded by the compute button in some calculator models

Take note of the following

Adjustments for compounding more frequently than annually PV & FV, PV & PMT, FV & PMT will have opposite signs BEGIN or END Clear memory before starting calculations

Example 12
Ahmad places RM800 in a savings account that pays 6% interest. He would like to know how much will be in that account at the end of 5 years. n 5 i% 6 PV 800 FV ? Answer : 1,070.58 PMT

Example 13
Siti would like to have RM5,000 in 4 years time. She has the opportunity to invest in a scheme that guarantees her 7% annual returns. How much must she invest today in order for her to get the RM5,000 she wants at the end of 4 years? n 4 i% 7 PV ? FV 5,000 Answer : 3,814.48 PMT

Example 14
Johan saves RM5,000 at the end of each year. He places his savings into an investment instrument that gives a constant 8% return. He does this for 10 years. How much will he have at the end of the 10 years? n 10 i% 8 PV FV ? PMT 5,000

Answer : 72,432.81

Example 15
An investment instrument will provide cash flows of RM4,000 at the beginning of each year for the next 5 years. The return on invested funds is 7%. What is the present value of this investment? n 5 BEGIN Answer : 17,548.85 i% 7 PV ? FV PMT 4,000

Example 16
Aisya would like to find out the future value of RM100 invested at 8% interest compounded quarterly for 2 years.

n 8

i% 2

PV 100

FV ? Answer : 117.17

PMT

Using the Spreadsheets TVM calculations can be made using built-in functions in most contemporary spreadsheet software For example, in Microsoft Excel, the following functions are available [Category : Financial] FV PV PMT NPER RATE

Beyond FV and PV
So far calculations were made to determine future value (FV) and present value (PV) n xx i% xx PV ? FV ? PMT xxx

TVM calculations could also involve determining the values of Periodic cash flow (PMT) Interest or growth rate (i%) Number of periods (n)

Calculating PMT Example 17

You would like to buy a house 5 years from now. You estimate that the down payment required at that time would be RM30,000. To accumulate this amount, you plan to make equal annual end-of-year deposits into an account which gives a return of 6%. How much is the required annual deposit?

n 5

i% 6

PV

FV 30,000

PMT ?

Answer : 5,321.89

Calculating PMT Example 18

You take a loan in the amount of RM6,000. The interest rate is 10% and you are required to repay the loan in equal annual end-of-year payments over a period of 4 years. You are told that this loan is amortized. What is the annual loan repayment amount?

n 4

i% 10

PV 6,000

FV

PMT ?

Answer : 1,892.82

Loan Amortization The previous example is an amortized loan, which is a method of loan repayment This method is commonly used in home loans The present value (PV) of the series of periodic cash flows or loan repayments (PMT) is the loan principal (amount borrowed) Each periodic repayment comprises two components interest and repayment of principal In earlier periods, a larger portion of the periodic repayment comprises interest vis--vis repayment of principal

Loan Amortization Schedule [1] [2] [3] [4] [5] Year-end Principal [1] [4] 4,707.18 3,285.08 1,720.77 0.03

Beginning Principal Year 1 2 3 4 6,000.00 4,707.18 3,285.08 1,720.77

Loan Payment

Apportionment of loan payment Interest 10% x [1] Principal [2] [3] 1,292.82 1,422.10 1,564.31 1,720.74

1,892.82 1,892.82 1,892.82 1,892.82

600.00 470.72 328.51 172.08

Calculating i% Example 19
Ali is offered a loan of RM2,000 which is to be repaid in equal annual end-of-year amounts of RM514.14 for the next 5 years. He would like to find out what the interest rate on this loan is. n 5 i% ? PV -2,000 FV PMT 514.14

Answer : 9.00%

Note the negative sign

Calculating i% Example 20
Sofiya invested RM3,000 in a unit trust scheme. After 8 years, she was told that her investment is worth RM6,500. What is the annual rate of growth of her investment?

n 8

i% ?

PV -3,000

FV 6,500

PMT

Answer : 10.15%
Note the negative sign

Calculating n Example 21
Abu would like to know how many years it would take for his savings of RM1,000, which would earn a return of 8% annually, to grow to RM2,500?

n ?

i% 8

PV -1,000

FV 2,500

PMT

Answer : 11.91 years

Note the negative sign

Calculating n Example 22
Sarah has borrowed RM25,000 at an annual interest rate of 11%. She was told that she had to make equal annual endof-year repayments of RM4,800. She would now like to know how long it would take for her to fully repay the loan. n ? i% 11 PV 25,000 FV PMT - 4,800

Answer : 8.15 years

Note the negative sign