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Chapter 4

The time value

of money

PowerPoint to accompany:

Learning Objectives

Explain the mechanics of compounding: how money

grows over time when it is invested

money

Discuss the relationship between compounding (future

value) and bringing money back to the present (present
value)

Calculate the effective annual rate of interest and then

explain how it differs from the nominal or stated interest
rate

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Learning Objectives

(contd)

Define an ordinary annuity and calculate its future value

and present value

Apply the annuity present value model to the process of

loan amortisation

Understand the notion of a general annuity and the

concept of equivalent interest rates

Deal with complex cash flows and deferred annuities

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Learning Objectives

(contd)

Determine how bond values change in response to

changing interest rates

Formulate multi-part and non-standard problems

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Compound interest is where interest paid on an

investment during the first period is added to the
principal, and during the second period interest is
earned on the original principal plus the interest earned
during the first period

Money invested at compound interest accumulates at an

increasing rate each period: exponential behaviour

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The periodic rate of compound interest, i, is defined by

the following equation:
i/jm

(4.1)

where m is the number of times that interest is

compounded each year, and j is the annual rate of
compound interest or the nominal annual rate

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(contd)

The total number of compounding periods, n, is given

by the following equation:
(4.2)

where interest is compounded m times per year for t

periods

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Future value
Investing a sum of money (present value) at compound
interest results in a future value
Future Value (FV)
\$1418.52
i = 6% per half year

Present Value (PV)

\$1000.00

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Computing the future value

The future value at the end of the nth period, FVn, can
be determined using the following equation:
FVn = PV(1 + i)n

(4.3)

FV can also be computed using financial tables, a

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The future value interest factor (FVIFi,n) is the

future value of \$1 for n periods at i%

If \$PV is invested or borrowed today, its future value

can be found by multiplying PV by the FVIF as follows:
FVn = PV(FVIFi,n)

10

(contd)

(4.4)

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(contd)

tables, however:

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(e.g. there is no value for i=6.2%; nor for n=240)

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Moving money through time with

the aid of a financial calculator (p.86)

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Using a Sharp EL-735 calculator (or most other financial calculators):

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Moving money through time with

the aid of a financial calculator (contd)

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mode

To select two decimal places (for displaying dollars

and cents), press 2ndF, then TAB, followed by 2

To clear the calculator between successive problems,

press 2ndF, then C/CE

The answers obtained using a financial calculator will

be more accurate than those obtained using tables

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Using spreadsheets for time-valueOf-money problems (p.87)

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The table below shows some of the functions used with Microsoft
Excel when moving money through time:

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Present value

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The present value is the current value of a sum of

money representing a future payment that is discounted
at an appropriate interest rate to reflect the time value
of money and other factors

The discount rate is the interest rate that converts a

future value to the present value

The discount factor is the quantity that converts a

particular future sum of money to its present value

Discounting is the process of converting a future value

to its present value

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.4: Computing the

present value (pp.88-89)

To determine an unknown PV, the following equation is

used:
PV = FVn / (1 + i)n

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(4-5)

To reach a savings target of \$3,000 after two years at

8% p.a. compounded quarterly, how much would we
have to invest today?

Substitute FV=\$3000, i =2% per quarter and n = 8
quarters (two years) into Equation 4-5:
PV = \$3,000 / (1.02)8 = \$3,000 / 1.17166
= \$2,560.47

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Example 4.4: Computing the

present
value (pp.88-89) (contd)
To determine an unknown PV, the following equation can
also used:
PV = FVn(PVIFi,n) (4-6)

To reach a savings target of \$3,000 after two years at 8%

p.a. compounded quarterly, how much would we have to
invest today?

Substitute FV=\$3000, i =2% per quarter and n = 8
quarters (two years) into Equation 4-6:
PV = FVn (PVIFi,n) =
\$3,000 (PVIF2%,8)
=

17

\$2559.00

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number
of
periods,
n
(p.90)

To determine an unknown n, the following equation is

used:
n = log(FV/PV) / log(1 + i)

(4-7)

How many months did it take to repay a loan of \$300 if

the sum repaid was \$358.84 at an interest rate of 12%
p.a. compounded monthly?

n = log(358.84 / 300) / log1.01
= log1.19613 / log1.01
= 18 months

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Example 4.6: Solving for the

interest
rate,
i
(p.90-1)
To determine an unknown i, the following equation is used:
i = (FV/PV)1/n - 1

(4-8)

The investment has grown to a sum of \$12,668. The interest

was compounded quarterly. Has the investment earned at
least 12% p.a.?

i = (\$12 668/\$10 000)1/8 - 1
= (1.2688).125 1
= 3% per quarter = nominal rate of 12% p.a

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Example 4.7: Making interest rates

comparable (p.91)

To determine the effective annual interest rate (EAR),

the following equation is used:
EAR = (1 + j/m)m 1

(4-9a)

What is the effective annual rate if 12% p.a. is

compounded twice per year?

EAR = (1 + 12/2)2 1
= (1.06)2 1
= 12.36% (greater than the nominal
interest rate!)

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Simple interest:

is not compounded: interest is only paid on the original

principal borrowed or invested

SI = P x r x t

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where P = principal, r = interest rate and t = time

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Annuities

An annuity is a series of equal dollar payments

for a specified number of periods

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e.g. payments on a housing loan, pension receipts

from a superannuation pension fund or interest
payments on bonds

An ordinary annuity is an annuity whose

payments are made at the end of each period

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annuity

The future value of an ordinary annuity can be

calculated using the following equation:
[(1+ i) n -1]
FVn = PMT
i

(4.11)

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Future value of an ordinary

annuity: Table 4.3 (p.95) (contd)

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Example 4.9: Future value of an

ordinary annuity (p.96) (contd)

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What is the FV of an annuity of \$100 per quarter for one

and a half years if the interest rate is 8% per annum
compounded quarterly? As remarked in relation to Table
4.3, this means the annuity has the following features:
PMT = \$100 per quarter, n = 6 quarters, and i = 2% per
quarter (.02 as a decimal)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

annuity (contd)

To determine the payment amount of an annuity the

following equation is used:

i(FV )
PMT =
(1+ i) -1
n

To determine the number of annuity periods the

following
equation is used:
n = log[{FV.i/PMT} + 1]
log(1 + i)

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(4.13)

(4.14)

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rate

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rearrange Equation 4-12 and use FVIFA tables:

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annuity

The present value of an ordinary annuity can

be calculated using the following equation:
(4-15)

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Example 4.12: Present value of an

ordinary annuity (p.98) (contd)

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What is the PV of an annuity of \$100 per quarter for one

and a half years if the interest rate is 8% per annum
compounded quarterly?

The annuity has the following features: PMT = \$100 per

quarter, n = 6 quarters, and i = 2% per quarter (.02 as a
decimal)

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442539174/Petty/Financial Management/6th edition

Example 4.12: Present Value of an

Ordinary Annuity (p.98) (contd)

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This PV amount is correct as is shown in Table 4.4

(p.100)

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(p.100)

Term loans are amortised in equal instalments over a

specified number of periods (terms)

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annuity (contd)

(4.17)

To determine the number of annuity periods:

n = -log[1 - (PV.i/PMT)]
log(1 + i)

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(4.18)

The annuity interest rate is found by trial and error

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Annuity due

Annuity due is an annuity where payments are made at

the beginning of each period

(4.20)

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Or:

PVdue = PMT(1 + PVIFAi,n 1)

(4.21)

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Ordinary annuity versus annuity

due: Figure 4.4 (p.105)

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As Figure 4.4 shows, the timing of the payments in these

two types of annuity differ:

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Perpetuity

To determine the present value of a perpetuity, the

following equation is used:
PV = PMT/i

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(4.22)

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irregular

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To determine the PV of an irregular cash flow,

the PV of each individual cash flow are added

To determine the overall FV of unequal cash

flows, the FV of the sum of the PV of each
individual cash flow is calculated

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Bond valuation

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A bond:

pays the owner of the security a predetermined

amount of interest each year (coupons) and a
principal amount at maturity

Bond prices change in response to interest rate

changes in financial markets

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acquisition

bond:

Thus, the bond price can be given by:

[1- (1 + i) -n ]
FVn
PV PMT

i
(1 + i) n

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(4.23)

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If the investors yield increased from 10% to

12%, the PV would be lower

If the investors yield decreased to 8% from

10%, the price (PV) would be higher

Bond prices decrease as bond yields increase

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Solving multi-part and nonstandard problems

1. Draw a timeline
Identify what is known and needs to be known

2. Determine what unknown(s) the problem involves

3. Identify the class of problem

4. Identify any traps in the problem

5. Formulate the problem

Which equation to use? How to set up spreadsheet?

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material

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Almost all business decisions involve cash flows that

occur in different time periods

A dollar today is not worth the same as in a years time,

so cash flows need to be valued in such a way that they
are comparable

Financial managers require an understanding of the

time value of money to ensure profitable investments