Lecture 1 Time Value of Money

Financial Mathematics
Time Value of Money

AQ004-3.5-2-FMTS Time Value of Money

Introduction to the time value of money
Effective rates of interest
Nominal Rates of Interest
Effective and Nominal Rates of Discount
Force of Interest
Topic & Structure of the lesson
Slide 2 (of 28)
At the end of this topic, YOU should be
able to:
Understand the concept of the time value of money.
Perform calculations related with simple and compounded
interest.
Differential effective and nominal rates of interest/discount.
Perform calculations related with effective and nominal
rates of interest/discount.

Learning Outcomes
Slide 3 (of 28)
If you have mastered this topic, you should be able to use the following
terms correctly in your assignments and exams:
(Prepare your own list)

Key Terms you must be able to use
Slide 4(of 28)
In order to estimate the value of a firms
projects and assets, its managers must
compare the benefits and costs.
This comparison is complicated by the fact
that they occur
at different points in time
in different currencies, or
with different risks
Introduction
Slide 5 (of 28)
In general, money today is not the same as
money in one year.
If you have $1 today, you can invest it (for example, in
a bank account) and end up with more than $1 in one
year.
We call the difference in value between money
today and money in the future the time value of
money.

Slide 6 (of 28)
Time Value of Money (TVM) is a concept that is
used in all aspects of finance including:
Bond valuation
Stock valuation
Accept/reject decisions for project management
Financial analysis of firms

Slide 7 (of 28)
1. Simple Interest
2. Compounded Interest
Types of Interest
Simple interest
At simple interest, the interest is computed on the original principal
during the whole time, or term, of the loan, at the stated annual rate
of interest.
The simple interest I on principal P for t years at annual rate r is
given by,

and the amount A is given by,

Types of Interest
Slide 8 (of 28)
t r P I =
( ) rt P t P
I P A
+ = + =
+ =
1 Pr
Where,

P = principal / the present value of A / the discounted value of A
I = simple interest
A = amount / accumulated value of P / maturity value of P
r = rate of interest per year (the ratio of the interest earned)
t = time in years
Example
Suppose we invest $500 at the beginning of year 1 in an
account that pays simple interest at 6% p.a., how much is
in the account at the end of 5 years ?

Slide 9 (of 69)
Solution
650 $ 150 500 I P A
150 $
5 06 . 0 00 5 P I
= + = + =
=
= = t r
$650 A
5) 0.06 (1 500 A
) R P(1 A
=
+ =
+ = t
OR
Quick Review Question
Slide 13 (of 28)
3. A loan of RM3,000 was made into an account
that earns 5% p.a. simple interest. What is the
maturity value of loan in 18 months from now?

4. If you want to accumulate $4,000, 30 months
from now, how much must you deposit now, if
you can earn 2.5% p.a. simple interest?
Slide 13 (of 28)
Compound interest
If the interest due is added to the principal at the end of
each interest period and thereafter earns interest is said
to be compounded.
The sum of the original principal and total interest is
called the compound amount or accumulated value.
The difference between the accumulated value and the
original principal is called the compounded interest.

Slide 11 (of 28)
Types of Interest
Slide 8 (of 28)
The accumulated values A for compounded
interest is,

Where,

P = principal / the present value of A / the discounted
value of A
A = amount / accumulated value of P / maturity value of P
r = rate of interest per year (the ratio of the interest
earned)
t = time in years
m = number of interest periods per year / the frequency of
compounding

mt
m
r
P A
|
.
|
\
|
+ = 1
Example
Suppose we deposit $500 at the beginning of year 1 in
an account that pays compound annually at 6% p.a.
how much is in the account at the end of 5 years ?

Slide 12 (of 69)
( )
$669.11
0.06 1 500
1
5
=
+ =
|
.
|
\
|
+ =
A
A
m
r
P A
mt
Solution

Slide 13 (of 28)
1. Find the accumulated amount on $1000 at 6%
interest compounded monthly after 5 years.

2. Suppose a man invested $1500 in an account at
15% compounded quarterly. How much money
does that man have at the end of10 years?
3. Suppose Mr. Robert needs RM250000 in
his account for his children's college
education,

a) if Mr. Robert expects to earn an average
return of 12%, compounding four times a
year and he has deposited RM50000 today
in his account, how many years will it take
for Mr. Robert to meet his goal? (Round
your answer to two decimal points.)
4. Suppose Mr. Robert needs RM250000
in his account for his children's college
education,

b) if Mr. Robert is determined to meet his
goal in ten years time and he has deposited
RM50000 this morning, what is the desired
return compounded annually in order to
meet his goal? (Give your answer in term of
percentage and round it to two decimal
points.)
Slide 22 of 29
Changes in the rate of interest
If the rate of interest changes during the
period of an investment, the compounding
formula would be as follow:

3 3
t
3
3
1
2 2
t
2
2
1
1 1
t
1
1
1 P A
m
m
i
m
m
i
m
m
i
|
|
.
|
\
|
+
|
|
.
|
\
|
+
|
|
.
|
\
|
+ =
z y x
i i i P A ) (1 ) (1 ) (1
3 2 1
+ + + =
Example
An investment of $8000 is made now to earn
10% p.a. compounded annually for 3 years
and the 8% p.a. in subsequent years. Find
the sum at the end of 5 years?
Example
Find the accumulated value of RM5000 at
the end of 5 years if the interest is 8% p.a.
compounded quarterly for the first two years,
12% p.a. compounded semi annually for the
next two years and 12% p.a. compounded
monthly for the following year.
Example
First two years, interest rate of 8%
compounded quarterly, the following
three years interest rate change to
6% compounded semi annually. Find
the future value of RM3,000 invested
today.
Slide 25 of 29
Simple Discount
Simple Discount at an Interest Rate
Simple Discount at a Discount Rate
In discounting at simple interest, means, the
difference, D = A P is called the simple
discount (on A) at an interest rate (r).
We may interpret D either as the interest I
on P which when added to P gives A, or as
the true discount on A which when
subtracted from A gives P.
Simple Discount at an
Interest Rate
Find the present value at 12% simple
interest of $1000 due in 5 months. What is
the true discount?

Example
Solution
We have A = 1000, r = 0.12, t = 5/12

The true discount is D = A P
( )
38 . 952 $
12
5
12 . 0 1
1000
1
=
|
.
|
\
|
+
=
+
=
rt
A
P
62 . 47 $ 38 . 952 1000 = = D
The discount rate, (d) for a year is the ratio of the
discount D for the year to the amount A on which
the discount is given.
The simple discount D on an amount A, also
called bank discount, for t years at the discount
rate d is calculated by means of the formula,

and the discounted value, or proceeds, P of A is,
Simple Discount at a
Discount Rate
Adt D=
) 1 ( dt A Adt A D A P = = =
Find the present value at 12% simple
discount of $1000 due in 5 months. What is
the simple discount?

Example
We have A = 1000, d = 0.12 and t = 5/12

The simple discount is D = A P
Solution
( )
( )
950 $
12
5
12 . 0 1 1000
1
=
(
|
.
|
\
|
=
= dt A P
50 $ 950 1000 = = D
Nominal Rates of Interest
Nominal rates of interest is an interest
rate that does not include any
consideration of compounding.
This rate is often referred to as the
Annual Percentage Rate (APR).
r = interest rate per period x number of periods
Slide 14 (of 28)
Annual Effective Interest Rate is the actual
rate of interest earned (paid) after adjusting
the nominal rate for factors such as the
number of compounding periods per year.
It is commonly expressed on an annual basis
as the effective annual interest, i
eff
.
This rate is often referred to as the Annual
Percentage Yield (APY).
Effective Rates of Interest
Slide 15 (of 28)
Effective Interest Rates (Any Time Period)
Effective Interest Rate equals the nominal
interest rate, if the interest rate period and
the compounding period are equal.

Effective Rate of Interest:

Where,
r = nominal interest rate per payment period
m = number of compounding periods per
payment period.
Slide 22 (of 28)
1 1
|
.
|
\
|
+ =
m
eff
m
r
i

What is the future value of $100 worth
after 1 year if a bank pays 12% interest
per year compounded semiannually?

Effective rate per payment period
=(1 + 0.12/2)^2 1 = 0.1236 = 12.36%
FV = $100 (1+0.1236) = $112.36
Slide 23 (of 28)
Terminology
Payment Period, Tp - Length of time during which cash
flows are not recognized except as end of period cash
flows.
Compounding Period (CP or interest period), Tc - Length
of time between compounding operations.
Interest Rate Period, T - Interest rates are stated as %
per time period. T is the time period.
Compounding frequency, m - the number of times that
compounding occurs within the time period of T.
Slide 16 (of 28)
Nominal Rates:
Format: r % per time period T
Ex: 5% per 6-months (r = 5%, T = 6 months)

Effective Interest Rates:
Format: r % per time period T, compounded m
times in time period T.
Ex: 18% per year, compounded monthly
(r = 18%, T = 1 year, CP = 1 month, m = 12)
Slide 17 (of 28)

The following are nominal rate statements:

Nominal Rate (r) Time Period (t) Compounding Period (CP)

1) 12% interest per year, compounded monthly.

2) 12% interest per year, compounded quarterly.

3) 3% interest per quarter, compounded monthly.

What are the corresponding effective annual interest
rates?
Slide 19 (of 28)
Corresponding effective annual interest rates:

Let compounding frequency, m, be the number of
time the compounding occurs within the time
period, t.
1) 12% interest per year, compounded monthly.
m = 12
Effective rate per CP, i
CP
= r/m = 1% (per month).

Effective annual rate, i
e
= ________________

Slide 20 (of 28)
Corresponding effective annual interest rates:

2) 12% interest per year, compounded quarterly.
m = 4
CP
= r/m = _____________

Effective annual rate , i
e
= _____________________

3) 3% interest per quarter, compounded monthly.

m = _____

CP
= __________________

Effective annual rate, i
e
= ___________________________

Slide 21 (of 28)
Effective and Nominal Rates of Discount
Interest is the rent paid by a borrower. It is usually
expressed as a percentage of the amount borrowed for a
specific time period.

The Discount Rate appears to be the same. However it
is the change in value with time. A sum of money if
loaned to a borrower who pays interest over a period of
time will increase by the amount of interest paid. If the
process is run in reverse then the amount will decrease.
The rate of decrease is referred to as the discount rate.

Effective rate per payment period = (1 r/m)
m
1

Slide 24 (of 28)

Slide 25 (of 28)
Force of Interest
The interest rate expressed as a
continuously compounded rate is called
the force of interest.

The annual force of interest is simply 12
times the monthly force of interest.

Slide 26 (of 28)
Q & A
Question and Answer Session
Slide 27 (of 28)
Annuities
What we will cover next
Slide 28 (of 28)

Lecture 1 Time Value of Money

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Time Value of Money

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