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Financial Management BBPW3103

Chapter 3 Time Value of Money

Concept of Compounding and Future Value


Compounding concept explains that RM1 today
is more valuable than RM1 in future through the investment activities to generate interest and subsequently multiple Among the reasons why the TVM make this alternative more valuable are: Individuals more interested use they money now compare in the future During the inflation period, the purchasing power of RM1 now more than the purchasing power of RM1 in the future Capital that be obtained now can be invested to generate a higher return in the future

Time Line
Refer to period of one investment. Time 0 (t0) refer to the present time, time
1 (t1) refer to the end of the first period and so forth.

Compounding Interest
Types of interest
Simple Interest : Interest that will be received based on the principal amount Compounding Interest : Interest that will be paid not only on the principal amount but also on any interest payable not withdrawn throughout the period

Compounding Interest (Cont)


Example 3.1 : If you invested RM100 in saving
account with the interest rate 10% per year, how much return will you received at the end of the first year. Return (F) = Principal (P) + Interest (i) = P + P(i) = P(1 + i) = RM100 ( RM100 x 10%) = RM100 + RM10 = RM110

Compounding Interest (Cont)


If the stated returns are not withdrawn from the saving
account, and the interest rate for the second and third year remained unchanged, how much return will you receive at the end of the second and third year? F2 = P(1 + i)2 = RM100(1 + 0.1)2 = RM121

F3 = P(1 + i)3 = RM100(1 + 0.1)3 = RM133.10

Compounding Interest (Cont)


When the saving period I extended to tn,
the total return that will obtained in the period (n) is Fn = P(1 + i)n

Calculating Future Value Using Schedule


The Future Value (FVn) equivalent to the
principal at the point of time equal 0 or the original principal amount (PV0) multiply with the future value factor stated in the schedule of Future Value Interest Factor (FVIFi,n) The formula of FV using the schedule is FVn = PV0 (FVIFi,n)

Calculating Future Value Using Schedule (Cont)


Example 3.2 : You invested RM2,000 in the
saving account at a yearly interest rate of 5% for the period of one year. Upon the completion of one year, how much return will your receive? FV1 = PV0(FVIFi,n) = RM2,000 (FVIF5% , 1) = RM2,000 (1.0500) = RM2,100.00

Calculating Future Value Using Schedule (Cont)


Example 3.3 : Assume you deposited RM2,000
in the saving account at a yearly interest 5% for the period 4 years. Upon the completion years, how much the return will you receive? FV4 = PV0(FVIFi,n) = RM2,000 (FVIF5% , 4) = RM2,000 (1.216) = RM2.432.00

Graphical Illustration of FV
There are 3 basic elements which sill
influenced the future value, these are
Principal (amount that was borrowed or invested) Time period (the number of frequency of interest payment) Interest rate payable or interest received

Graphical Illustration of FV (Cont)


To show the interest rate influenced the FV of
an investment, find the return for deposited RM100 at Bank A, B and C that offer interest rate 8%, 10% and 12% per year for 3 years. FV for Bank A FVA = PV0(FVIFi,n) = RM100 (FVIF8% , 3) = RM100 (1.2600) = RM126.00

Graphical Illustration of FV (Cont)


FV for Bank B
FVB = PV0(FVIFi,n) = RM100 (FVIF10% , 3) = RM100 (1.3310) = RM133.10 FV for Bank C FVC = PV0(FVIFi,n) = RM100 (FVIF12% , 3) = RM100 (1.4050) = RM140.50

Graphical Illustration of FV (Cont)


The correlation of FV, time period and
interest rate can be shown on the graph below

Concept of Discounting and Present Value (PV)


Used to ascertain the present value (PV0)
of principal value for sum of the money in the future (FVn) that is discounted at an interest rate (i) for the valuation period (n@t)

Calculation of PV
There are formula to calculate PV
PV0 = FV (1 + i)n Exmaple 3.4 : Assume you expect to received returns of RM2,500 a year from now. How much the present value if the discount rate is 8% per year PV0 = FV (1 + i)n = RM2,500 (1 + 0.08)1 = RM2,314.81

Calculation of PV (Cont)
What is the present value that you must invest if
your expect to received RM2,500 in the period 2 years and 3 years at a discount rate 8% per year? PV0 = FV (1 + i)n = RM2,500 (1 + 0.08)2 = RM2,143.35

PV0

= FV (1 + i)n = RM2,500 (1 + 0.08)3 = RM1,984.58

Calculation of PV Using Schedule


The way of PV using schedule is the same
with FV calculation. But calculation of PV is using Present Value Interest Factor (PVIF) The formula is PV0 = FV (PVIFi,n)

Calculation of PV Using Schedule (Cont)


Exmaple 3.5 : Assume you expect to
receive RM3,999 in 3 years from now. How much is the PV if the discount rate is 9% per year? PV3 = FV(PVIFi,n) = RM3,999 (PVIF9% , 3) = RM3,999 (0.772) = RM3,087.23

Calculation of PV Using Schedule (Cont)


Example 3.6 : You intend to accumulate saving
money at the bank for RM5,712 for the 4 years. How much saving you must make now if the interest rate is 10% per year? PV4 = FV(PVIFi,n) = RM5,713 (PVIF10% , 4) = RM5,713 (0.683) = RM3,901.98.

Graphical Illustration of PV
Change of interest rate, time of period or
the return will changed of the present value. Example 3.7 : You intend to obtain return of RM1,000 in 3 years from Bank A, B and C that offer interest 8%, 10% and 12%. What id the principal value that should make?

Graphical Illustration of PV (Cont)


PVA = = = = = = = =
= = = =

FV(PVIFi,n) RM1,000 (PVIF8% , 3) RM1,000 (0.7938) RM793.80 FV(PVIFi,n) RM1,000 (PVIF10% , 3) RM1,000 (0.7513) RM751.30
FV(PVIFi,n) RM1,000 (PVIF12% , 3) RM1,000 (0.7118) RM711.80

PVB

PVC

Graphical Illustration of PV (Cont)

Single Cash Flow Money Value


Is a cash flow that only occurs once in the
period of valuation The FV of an amount of single cash flow invested presently will increase from time to time with the specific interest rate

Series Cash Flow Money Value


Is a series receiving or payments of cash
that occur throughout the valuation period. There are several categories of series of cash flow that is
Annuity Derivation Cash Flow Perpetuity

Annuity
Series of payments @ receiving of the same

amount at the same intervals through the period For example, Cash flow of RM5 that receive for every month is an example of Annuity Types of Annuity
Ordinary Annuity : Annuity occurs at the end of each period Annuity Due : Annuity at the beginning of the period

Annuity : FV of Ordinary Annuity


That occurs at the end of each period Future Value Annuity (FVA) is the number
of annuity payments at a specific amount (n) that will increase at a specific period based on a specific interest rate (i). The formula of the FVA is = A[(1 + i)n 1)] i OR = A(FVIFAi,n)

Annuity : FV of Ordinary Annuity (Cont)


Example 3.8 : You had deposited RM100 at the
end of each year for 3 years continuously in the account that pays a yearly interest rate 10%. How much the FV of the said annuity? FVA = A[(1 + i)n 1)] i = RM100[(1 + 0.1)3 -1] 0.1 = RM331

OR

= = = =

A(FVIFAi,n) RM100 (FVIFA10%,3) RM100(3.310) RM331

Annuity : FV of Ordinary Annuity (Cont)


Example 3.9 : Danon Company deposited
RM5,000 at the end of each year for 3 years consecutively in an account that pays a yearly interest rate of 10%. What is the FVA? FVA = A[(1 + i)n 1)] i = RM5,000[(1 + 0.1)3 -1] 0.1 = RM16,550

OR

= = = =

A(FVIFAi,n) RM5,000 (FVIFA10%,3) RM100(3.310) RM16,550

Annuity : FV of Annuity Due


The payment of annuity occurs at the
beginning of the period. For example, at the beginning of each month or each year. The formula for FV of Annuity Due is = [A][(1 + i)n 1)][1 + i] i OR = A(FVIFAi,n)(1 + i)

Annuity : FV of Annuity Due (Cont)


Example 3.10 : Danon Company deposited RM5,000 at
the beginning of each year for 3 years consecutively in an account that pays a yearly interest rate of 10%. What is the FVA? FVA = [A][(1 + i)n 1)][1 + i] i = RM5,000[(1 + 0.1)3 -1][1 + 0.1] 0.1 = RM18,205 OR = = = = A(FVIFAi,n)(1 + i) RM5,000 (FVIFA10%,3)(1 + 0.1) RM100(3.310)(1.10) RM18,205

Annuity : PV of Ordinary Annuity


Present value of ordinary annuity can be
obtained using the below formula PVA = A{1 [1 (1 + i)n]} I OR = A(PVIFAi.n) Example 3.11 : Taming Company expects to receive RM3,000 at the end of each year for 3 consecutive years. How in the present value for the annuity if the discount rate is 6% per year.

Annuity : PV of Ordinary Annuity (Cont)


PVA = A{1 [1 (1 + i)n]} I = RM3,000{1 [1 (1 + 0.06)3]} 0.06 = RM3,000[1 0.8396] 0.06 = RM481.1422 0.06 = RM8,019.04
OR = = = = A(PVIFAi.n) RM3,000 (PVIFA6%,3) RM3,000 (2.673) RM8,019.00

Annuity : PV of Annuity Due


The formula for PV of Annuity Due is (PVA)
= A{1 [1 (1 + i)n]} i x (1 + i) OR = A(PVIFAi.n)(1 + i) Example 3.12 : Taming Company expects to receive RM3,000 at the beginning of each year for 3 consecutive years. How in the present value for the annuity if the discount rate is 6% per year.

Annuity : PV of Annuity Due (Cont)


PVA = A{1 [1 (1 + i)n]} i x (1 + i) = RM3,000{1 [1 (1 + 0.06)3]} 0.06 x 1.06 = RM3,000[1 0.8396] 0.06 x 1.06 = RM481.1422 0.06 x 1.06 = RM8,500.18
OR = = = = A(PVIFAi.n) (1 + i) RM3,000 (PVIVA6%,3) (1 + 0.06) RM3,000 (2.673) (1.06) RM8,500.14

Non-Uniform Cash Flow


Involves a mixture of cash flow or cash
floe is irregular The calculation for future value and present value of an irregular cash flow is a combination concept of determining money value for single cash flow and annuity cash flow

FV of Derivation Cash Flow


Involves the determination of FV foe each of the

cash flow and subsequently totaling all the FV. The formula is FVn = Pt(1 + i)n-1 Example 3.13 : Bikin Fulus Company made a decision to deposit RM2,000 at the end of the 1st and 2nd year, withdrawing RM3,000 at the end of the 3rd year and depositing RM4,000 at the end of 4th year. How much is this future value cash flow at the end of the 4th year if the annual interest rate is 10% per year?

FV of Derivation Cash Flow (Cont)


FVn = Pt(1 + i)n-1 = (RM2,000)(1 + 0.1)4-1 + (RM2,000)(1 + 0.1)4-2 - (RM3,000)(1 + 0.1)4-3 + (RM4,000)(1 + 0.1)4-4 = RM5,782

PV of Derivation Cash Flow


Involves the determination of PV foe each of the

cash flow and subsequently totaling all the PV. The formula is PV0 = Pt[1 (1 + i)n] Example 3.14 : Bikin Fulus Company expects to receive RM1,000 at the end of 1st year and 2nd year, RM2,000 at the end of 3rd year and RM4,000 at the end of 4th year. How much is the present value cash flow if the yearly interest rate is 10% per year?

PV of Derivation Cash Flow (Cont)


PV0 = Pt[1 (1 + i)n] = RM1,000[1 (1 + 0.1)1] + RM1,000[1 (1 + 0.1)2] + RM2,000[1 (1 + 0.1)3] + RM4,000[1 (1 + 0.1)4] = RM5,970.22

Perpetuity
Is the annuity that have infinity period Cannot be used in decision making

because every investment have valuation period. The formula is PVp = P i

Perpetuity (Cont)
Sukehati Company issued securities that
promised a payment of RM100 per year at the yearly interest rate of 8% to the holders of that security. How much the present value for that cash flow? PVp = P i = RM100 0.08 = RM1,250

Compounding and Discounting More Than Once A Year


Sometimes, the payment or receiving of return

occurs more than once a year. For example, twice a year, quarterly and monthly. For this, the period (n) must times with the number of payment or receiving (m) and the interest rate (i) must be divided with the number of payment or receiving (m) as shown below: FV = PV x [1 + (i m)]nm OR = PV [FVIF(im)(nm)]

Compounding and Discounting More Than Once A Year (Cont)


Example 3.16 : The future value of RM1 now
for 6 years, using the interest rate of 10% per year with the different compounding frequencies
Nm 6x1=6 6x2= 12 6x4= 24 6 x 12 = 72 i/m 0.1 1 = 0.1 0.1 2 = 0.05 0.1 4 = 0.025 0.1 12 = 0.0083 FV RM1(1 + 0.1)6 = RM1.772 RM1(1 + 0.05)12 = RM1.796 RM1(1 + 0.025)24 = RM1.809 RM1(1 + 0.0083)72 = RM1.817

Compounding Once a year Twice a year Four times a year Every month

Compounding and Discounting More Than Once A Year (Cont)


Example 3.17 : The present value of RM1
received in 6 years from now, discounting at the interest rate of 10% per year with different discounting frequencies
Nm 6x1=6 6 x 2 = 12 6 x 4 = 24 6 x 12 = 72 i/m 0.1 1 = 0.1 0.1 2 = 0.05 0.1 4 = 0.025 0.1 12 = 0.0083 PV RM1 (1 + 0.1)6 = RM0.564 RM1 (1 + 0.05)12 = RM0.557 RM1 (1 + 0.025)24 = RM0.553 RM1 (1 + 0.0083)72 = RM0.550

Discounting Once a year Twice a year Four times a year Every month

Continuous Compounding and Discounting


Some cases of the time value of money,
interest must be compounded or discounted continuously or at each microsecond. The formula is FV = PV(ein) PV =FV (ein)

Continuous Compounding and Discounting (Cont)


Example 3.18 : What is the future value
for RM100 that is invested now for 6 years with an interest rate of 8% per year and compounded continuously? FV = PV(ein) = RM100(e(0.08)(6)) = RM161.61

Continuous Compounding and Discounting (Cont)


Example 3.19 : What is the present
value for RM161.61 that will received in 6 years from now with an interest rate of 8% per year and discounted continuously? PV =FV (ein) = RM161,61 (e(0.08)(6)) = RM100