Financial Institution

Zaheer Swati 1

Unit 3

TIME VALUE OF MONEY & INTEREST
3.1 Time Value of Money
A dollar in hand today is worth more than a dollar in hand tomorrow. Why is that?
I could buy something today and thus get the use today of what I buy
I could invest today and gain the return fromthat investment
I could avoid the loss of value due to inflation in costs
I could lend the money today and gain the interest on that loan

3.2 The Interest
Interest rates are among the most closely watched variables in the economy
Its movements are reported almost daily by the media
An interest rate is simply the price of money
Compensation to lender for foregoing other useful investment
Equilibriumprice at which demand and supply of fund meet


The intersection between demand and supply represents the equilibriumcost of borrowing funds, k*
This (k*) is called the pure or real rate of interest. This is the interest rate resulting purely as a result of the
interaction between the supply and demand for funds
Its important to note that interest rates are determined by many other factors besides the real rate of interest

3.3 Why is there interest on a loan?
There needs to be a return, given the value today vs. tomorrow
The loss of value fromthe other potential uses must be recognized
There are risks that the loan may not be repaid.


Interest
Rate (k
d
)
DEMAND
SUPPLY
k*
Q*
Quantity of
Funds
Financial Institution


Zaheer Swati 2

Unit 3

3.4 The Relevant Variables for TVM
o The initial amount lent, called the principal amount (P)
o The time period of the loan (n)
o The interest rate (i)
o Frequency of compounding or discounting

3.5 Type of Interest
There are two types of interest, simple and compound
Simple interest is applied to the initial amount, called the principal, for a given time period for interest
If the period of the loan is greater than the time period for interest, the simple interest will be repeated, at the same
amount, and accumulate during successive time periods for interest until the end of the time period of loan
Compound interest is applied to the initial sum, plus any previous accumulated interest that has not been paid, for
each successive time period for interest
The rationale for compound interest is that the interest is in fact money that should be in hand at the end of the time
period for interest, i.e., at the time it is due. Therefore, if that interest is not received, it is, in effect, also lent and
therefore should also bear interest


Formula



Example 3.1: What is the future amount that will be available in four years if Rs. 8,000 is invested at 12% per year
simple interest now?

Solution












SI
n
=P +(P * i * n)


SI
n
=P +(P * i * n)
SI
4
=8,000 +(8,000 * 0.12 * 4)
SI
5
= Rs. 11,840
FV
n
=PV (1 +i)
n

Formula for
Compound Interest
Financial Institution


Zaheer Swati 3

Unit 3

Example 3.2: What is the future amount that will be available in four years if Rs. 8,000 is invested at 12% per year
compound interest now?


Solution








Example 3.3: Calculate simple interest and compound interest assuming that principal amount is Rs. 10,000; interest rate
is 9% for three years. What is the amount difference between compound and simple interest?



Year

Simple I nterest Calculation

Compound I nterest Calculation
Simple Interest
Calculation
Simple
Interest
Accumulated
Year-end
Balance
Compound
Interest
Calculation
Compound
Interest
Accumulated
Year-end
Balance
Yr 1 Rs. 10,000 * 9% Rs. 900 Rs. 10,900 Rs. 10,000 * 9% Rs. 900 Rs. 10,900
Yr 2 10,000 * 9% 900 11,800 10,900 * 9% 981.00 Rs. 11,881.00
Yr 3 10,000 * 9% 900 12,700 11,880.10 * 9% 1069.29 Rs. 12,950.29
Total Rs. 2,700 Rs. 2,950.29

Difference = 2,950.29 - 2,700 = Rs. 250.29












FV
n
=PV (1 +i)
n

FV
4
=PV (1 +0.12)
4

FV
4
=
Continuous
Compound
Simple
Financial Institution


Zaheer Swati 4

Unit 3

3.6 Different Compounding Cycles or Intra Year Compounding
o The value of lump sumamount (one time cash flow) at some future time evaluated at a given interest rate assuming
that compounding takes place more than one time in a year (Intra Year)
o Interest rate reduced while periods of time increase by frequency of compounding (m) i.e. i/mand n*m







Example 3.4: You have Rs. 9,000 to deposit. ABC Bank offers 12 percent per year compounded monthly, while King
Bank offers 12 percent but will only compound annually. How much will your investment be worth in 10 years at each
bank?
Solution: ABC Bank 9,000 (1 +0.12/12)
10* 12
Answer: Rs. 29,703.48
King Bank 9,000 (1 +0.12)
10
Answer: Rs. 27,952.63
Variance Rs. 1,750.85



Example 3.5: If interest is compounded quarterly, how much will you have in a bank account?
(a) If you deposit today Rs. 8,000 at the end of 3 months, if the bank pays 5.0% APR?
Solution: 8,000 (1 + 0.05 / 4)
Answer: Rs. 8,100


(b) If you deposit today Rs. 10,000 at the end of 6 months, if the bank pays 9.0% APR?
Solution: 10,000 (1 + 0.09 / 4)
2

Answer: Rs. 10,455.06


(c) If you deposit today Rs. 80,000 at the end of 12 months, if the bank pays 8.0% APR?
Solution: 80,000 (1 + 0.08 / 4)
1* 4

Answer: Rs. 86,594.57


(d) If you deposit today Rs. 5,000 at the end of 24 months, if the bank pays 5.0% APR?
Solution: 5,000 (1 + 0.05 / 4)
2* 4

Answer: Rs. 5,522.43








FV
n
=PV (1 +i / m)
n * m
General Formula
Financial Institution


Zaheer Swati 5

Unit 3

3.7 Future value for stream of constant cash flows (Annuity)
If constant cash flows occur at the end of each period/year is called ordinary annuity for instance payment of car
loan, mortgage loan and student loan are examples of ordinary annuity
If payments or receipts are made at the beginning of each year/period, the annuity is an annuity due, rental payment
for apartment and life insurance payments are typical examples of this annuity

Constant Cash flow Stream for Ordinary Annuity












Example 3.6: You decide to work for next 20 years before an early-retirement. For your post-retirement days, you plan
to make a monthly deposit of Rs. 1,000 into a retirement account that pays 12% p.a. compounded monthly. You will
make the first deposit one month fromtoday. What will be your account balance at the end of 20 years?
Solution:
1,000 [
12 / 12 . 0
1 ) 12 / 12 . 0 1 (
12 * 20

]

Answer: Rs. 989,255.37


Constant Cash flow Stream for Ordinary Annuity











FVA
Due
=

CCF [
i
i
n
1 ) 1 (
] (1+i)
Annuity Due

0 1 2 3 4 5

Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000
0 1 2 3 4 5

Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000 Rs. 1,000
FVA
n
=

CCF [
i
i
n
1 ) 1 (
]
Ordinary Annuity
Financial Institution


Zaheer Swati 6

Unit 3

Example 3.7: Suppose you deposit Rs. 1,000 in an account at the start of each of the four years. If the account earns 12
percent annually, how much will be in the account at the end of fourth year?
Solution: 1,000 [
12 . 0
1 ) 12 . 0 1 (
4

] (1+0.12)
Answer: Rs. 5,352.85

Example 3.8: If you put Rs. 100 in the market at the end of every year for 20 years at 10%, how much would you end up
with? What if you put the Rs. 100 in at the beginning of every year?
Solution (a): 100 [
10 . 0
1 ) 10 . 0 1 (
20

]
Answer: Rs. 5,727.50


Solution (b): 100 [
10 . 0
1 ) 10 . 0 1 (
20

] (1+0.10)
Answer: Rs. 6,300.25


Example 4.9: You deposit Rs. 17,000 each year for 10 years at 7%. Then you earn 9% after that. If you leave the money
invested for another 5 years how much will you have in the 15th year?
Solution:
FVA
n
=

CCF [
i
i
n
1 ) 1 (
]
FVA
10
=

17,000 [
07 . 0
1 ) 07 . 0 1 (
10

]
FVA
10
= Rs. 234,879.62
FV
n
=PV (1 +i)
n
FV
5
=234,879.62 * (1 +0.09)
5

FVA
5
= Rs. 361,391.41


Example 3.10: Mr. Kazmi has decided to start saving for his post-retirement period. Beginning his 21
st
birthday has one
year fromnow. Kazmi plans to invest Rs. 2,000 each birthday into bank, investment earning a 9 percent compound
annually. He will continue his saving plan for ten years and then stop making payments. But his saving in bank will
continue to 6% for 35 more years. What is the present value of these cash flows?
Solution:
2,000 [
09 . 0
1 ) 09 . 0 1 (
10

] =Rs. 30,385.86

FV
35
=30,385.86 (1 +0.06)
35

FV
35
= 233,548.36

PV
45
=233,548.36/ (1+0.10)
45
Answer: Rs. 3,204.10