TIME VALUE OF MONEY CONCEPTS

Introduction

The concept of the time value of moneyis an integral concept in

the study of financial management. This is the focus of this unit
which you have to study now before you proceed to other topics.
The discussion may appear to be very "technical", however, you
are advised to make an effort to grasp the concepts that are
covered in this unit as they will come up from time to time in our
study of the other topics.

For example, you need the concepts covered in this unit in order
to study Capital Budgeting, Valuation of Shares, the Cost of
Capital and many other issues covered in corporate financial
management. Additionally, most of the concepts covered in this
unit will come in handy in your advanced studies of the subject.

Time Value of Money

The notion that money has a time value is one of the most basic
concepts in finance and investment analysis. Making decisions
today regarding future cash flows requires understanding that
the value of money does not remain the same throughout time.

A dollar today is worth less than a dollar sometime in the future

for two reasons.

Reason No. 1: Cash flows occurring at different points in time

have different values relative to any one point in time.
One dollar one year from now is not as valuable as one dollar
today. After all, you can invest a dollar today and earn interest so
that the value it grows to next year is greater than the one dollar
today. This means we have to take into account the time value of
money to quantify the relation between cash flows at different
points in time.

Reason No. 2:Cash flows are uncertain. Expected cash flows

may not materialize.
Uncertainty stems from the nature of forecasts of the timing
and/or the amount of cash flows. We do not know for certain
when, whether, or how much cash flows will be in the future.
This uncertainty regarding future cash flows must somehow be
taken into account in assessing the value of an investment.

Translating a current value into its equivalent future value is

referred to as compounding. Translating a future cash flow or
value into its equivalent value in a prior period is referred to as
discounting. We are going to deal with e basic mathematical
techniques used in compounding and discounting.

An investment of money has different values on different dates.

The adjustment in time value is a function of the following
factors:time, inflationrate, risk.

A lender will need compensation from a borrower for delaying

payment and this compensation will be determined by above
three factors. This compensation is the interest rate, which
represents the opportunity cost of funds.Let’s now discuss the
following:

 Future Value
 Present Value
 Simple Interest
 Simple Discount
 Compound Interest

Simple Interest
Remark: Interest is the price paid for the use of borrowed
money.

Interest is paid by the party who uses or borrows the money to

the party who lends the money. Interest is calculated as a
fraction of the amount borrowed or saved (principal amount) over
a certain period of time. The fraction, also known as the interest
rate, is usually expressed as a percentage per year, but must be
reduced to a decimal fraction for calculation purposes. For
example, if we’ve borrowed an amount from the bank at an
interest rate of 12% per year, we can express the interest as:

12% of the amount borrowed

or 12/100 of the amount borrowed

or 0,12× the amount borrowed.

When and how interest is calculated result in different types of

interest.

For example, simple interest is interest that is calculated on the

principal amount that was borrowed

or saved at the end of the completed term.

Remark:Simple interest is interest that is computed on the

principal for the entire term of the loan, and is therefore due at the
end of the term. It is given by
I = Prt
Where;
I-is the simple interest (in $) paid at the end of the term for the use
of the money
P - is the principal or total amount borrowed (in $) which is subject
to interest (P is also known as the present value (PV ) of the loan)
r- is the rate of interest, that is, the fraction of the principal that
must be paid each period (say, a year) for the use of the principal
(also called the period interest rate)
t - is the time in years, for which the principal is borrowed
NB: Interest is earned only on the original investment; no interest
is earned on interest

Example

Suppose you have $10 000 to invest in a bank savings account at

a simple interest of 20% per annum. How much will you have at
the end of the year?

Given that I=Prt

I = 10000×0.20×1

I =$2000 is the interest due (I) Simple

Interest

Therefore Total amount dueS=Interest+Principal Payment

=2000+10000

= 12000

Remark:The amount or sum accumulated of Future Value (S) (also

known as the maturityvalue, accrued principal) at the end of the
term t, is given by

S = Principal value + Interest

S=P+I

S = P + Prt

S = P(1 + rt).

Remark:The date at the end of the term on which the debt is to be

paid is known as the due date or maturity date.

Example

Suppose you deposit $10000 today in an account that pays

simple interest of 20% per annum. How much will you have at
the end of3 years?
 S =P (1+rt)

S= 10000(1+20%×3)

S =10000(1+0.20×3)

=$16000

Example

You borrow $18 000 for a simple rate of 22% per annum for 125
days. How much will you have to pay to the lender?
125
t= 365 ………note that t- is always in years so set it as a
fraction of number of days in a year.

P=18000

r =0.22

so applying , S=P (1+rt)

S=18000(1+0.22×125/365)

S=$19356

This is the Future Value of the amount to be paid to the lender.

Practice Questions

1. Calculate the simple interest and sum accumulated for $5

000 borrowed for 90days at 15% per annum. ($5 185)
2. Calculate the sum accumulated at the end of 3 years, 4
months and 17 days on a deposit of$20 000 and an interest
rate of 18.27% per year.

Present Values [discounting]

Sometimes we not only consider the basic formula I = Prtbut also
turn it inside out and upside down, as it were, in order to obtain
formula for each variable in terms of the others. Of particular
importance is the concept of present value P or PV, which is
obtained from the basic formula for the sum or future value S,
namely

S = P(1 + rt)

Dividing by the factor (1 + rt) gives

S
P=
1+rt
.
How do we interpret this result? We do this as follows: P is the
amount that must be borrowed now to accrue to the sum S, after
a term t, at interest rate r per year. As such it is known as the
present value of the sum S.

Remark:Discounting is a process of moving the future value of an

obligation/investment back to the present/today.
S
For Simple Interest = P= ( 1+ rt)

S
For Compound Interest= P= n
( 1+ i)

Example
A promissory note with a future value of $12000, simple interest
rate is 12% per annum is sold 3 months prior to its due date.
What is the Present Value on the day it is sold?
S=$12000 r=0.12 t=3/12

S
Given that , P= ( 1+ rt)

12000
Then PV =
(1+0.12 ×3 /12)
 = $11 650
Remark:A promissory note is a written promise by a debtor (called
the maker of the note) to pay a creditor (called the payee) a stated
sum of money (the so-called “maturity value”) on a specific date
(the due date), and stating a specific rate of interest. Such notes
can be bought and sold, that is, they are negotiable. Obviously
with such transactions it is the present value of the note that
counts.

Time lines
A time line is a useful way of representing interest rate
calculations graphically. Time flow is represented by a horizontal
line. Inflows of money are indicated by an arrow from above
pointing to the line, while outflows are indicated by a downward
pointing arrow below the time line.

For a simple interest rate calculation, the time line is as follows:

P or PV
t- term

r
=Interestra
te

FV or S= P(1 +rt)

At the beginning of the term, the principal P (or present value) is

deposited (or borrowed) – that is, it is entered onto the line. At the
end of the term, the amount or sum accumulated, S (or future
value) is received (or paid back). Note that the sum accumulated
includes the interest received.

Remember that

FV or Sum accumulated (S) = Principal + Interest received that is

 S = P + Prt
= P(1 + rt)
or equivalently
Future value = Present value + Interest received.

Negotiable Certificates of Deposit (NCDs).

The concept of simple interest is often applied to financial

instruments found on the moneymarket ( the short-term market ).
An important instrument on this market is the
negotiablecertificate of deposit (NCD). NCDs arise when banks
solicit large deposits from investors for a fixed period of time
during which the money cannot be withdrawn. The investor is
then given a certificate which is negotiable. This means that the
investor can sale or negotiate the certificate in the money market
at any stage before the maturity date of the deposit.

The amount invested is the nominal, or face value of the

instrument upon which interest is calculated at the period of the
deposit using simple interest. To find out how this interest is
calculated, let us look at the following example.

S=P+I
S = P ( 1+ rt )

Example

Suppose on 1 May 2012, you purchase an NCD with a maturity

date of 31 July, 2012, a face value of $1 000 000 and an interest
rate of 34.65% that is payable on maturity. How much will you
receive on the maturity date?

We have already seen that S = P (1 + rt ), therefore the maturity

value, S, is going to be :
 S = 1 000 000 (1 + 0.3465 x 91 / 365 ) = $1 086
387.67

Note that, when a security is issued for the first time, it is issued
on the primary market.Subsequently, it starts trading on the
secondary market, on which it acquires a value which may not
necessarily be equal to the face value. NCDs are traded in the
secondary market on a yield basis, that is the price is determined
on the basis of a yield. When calculating the market value, or the
consideration to be paid when the NCD is being negotiated, we
need to know the number of days remaining to maturity.

Counting days

The convention is that to determine the exact number of days

between the two relevant term dates, we includethe day the
money is deposited or lent and excludethe day the moneyis
repaid (or withdrawn). . The reasoning behind this is the simple
fact that if you deposit money on the 12th of June and withdraw
it on the 13th of June, there is only one day between the two
dates, not two.However, when a security is issued and held until
maturity, we include the day on which itwas issued.

Let us look at the following example.

Example
Calculate the number of days between 25 May and 17 August.
You must remember that some months have 31 days while others
have 30 days. You should be able to get the number of days by a
simple count of your fingers:

Month Days
May (including 25 May) 7
June 30
July 31
August (excluding 17 August) 16
Total 84 days

Now, let’s look at the following examples.

Example

On 1 May 2012 you purchase an NCD with a maturity date of 31

July 2012, nominal value of $1 000 000 and an interest rate of
34.65%. Subsequently, on that same day, the yield on similar
securities falls to 33%. You then decide to sell the NCD. How
much should you expect?

Since we have seen that S= P (1+rt ), we can deduce that the

consideration, or market value, P, is given by the following
relationship:

P = S/( 1 + rd )

Where:S is the maturity value,

dis the days remaining to maturity,
ris the yield per year.

Therefore, the consideration, P, will be equal to:

P =1 087 336.99
(1 + 0.33 x 91 /365)

P = 1 087 336.99
1.082273973
P = $1 004 678.13

Practice Exercise
 1. On 1 May 2012, you purchase an NCD with a maturity date
of 31 July 2012, nominalvalue of $1 000 000 and an
interest rate of 34.65%. On 18 June 2012 you then sell
theNCD at a yield of 32% pa. How much do you receive?
2. Determine the number of days between 19 March and 11
September.
3. Suppose an investor wishes to purchase a treasury bill (with
a par value, that is face value, of $100 000) maturing on 2
July 2012 at a discount rate of 16,55% per annum and with
a settlement date of 13 May 2012. What would the required
price be (this is present or discount value – also referred to
as the consideration)? What is the equivalent simple interest
rate of the investment?

You can see from these examples and the exercise that you have
done, that the values of anNCD increases when the market yield
decreases relative to the interest rate.

Simple Discount

Remark: is interest calculated on the face (future) value of a term

and paid at the beginning of the investment term.You will receive
interest in advance

Previously, we emphasised the interest that has to be paid at the

end of the termfor which the loan (or investment) is made. On the
due date, the principal borrowedplus the interest earned is paid
back.

In practice, there is no reason why the interest cannot be paid at

the beginning ratherthan at the end of the term. Indeed, this
implies that the lender deducts the interestfrom the principal in
advance. At the end of the term, only the principal is thendue.
Loans handled in this way are said to be discounted and the
interest paid inadvance is called the discount. The amount then
advanced by the lender is termed thediscounted value. The
discounted value is simply the present value of the sum to bepaid
back and we could approach the calculations using the present
value technique as before.

Expressed in terms of the time line of the previous section, this

meansthat we are given S and asked to calculate P.

P or PV
t- term

d= discount rate

S=

The discount on the sum S is then simply the difference between

the future and present values. Thus the discount (D) is given by

D = S − P.

The discount D is also given by

D = Sdt

(compare to the formula for simple interest I = Prt) where d=

simple discount rateand the discounted (or present) value of S
is

P=S−D
= S − Sdt
P= S(1 − dt)

or
Present Value = Future Value − Future Value × discount rate ×
time.

PV = FV − FV × d × t
= FV (1 − dt)

(compare to the formula for the accumulated sum or future value

for simple interest)

S = P(1 + rt).

Example

Suppose the government floats Treasury billsof facevalue $10 at

a discount of 10%. Lisa wants to subscribe and has t $10. The
tenureof the TB is 1 year. How much does Lisa Pay now and how
much will she get at the end of 1 year.

Solution

When Lisa subscribes to the issue she pays $9 and at the end of
the tenure she will get $10 from Treasury.

Discounted Value = S (1-dt) or (S-D)

Discount = Sdt

= 10× 0.10×1

=$1

Therefore PV given above is P=S-D = $10-$1

= $9

Or better still, Discounted Value = S (1-dt)

= 10 (1-0.10×1)

= $9
Which is the amount paid by Lisa to be paid back $10 in one
years’ time.

Example

A treasury bill with a tenure of 90 days and a face value of $100

000 is issued at a discount of 18%. At what consideration is it
being issued?

PV=S (1-dt)

PV=100000[1-(0.18×90/365)]

PV=$95561

Example

A customer signs a promissory note agreeing to pay $100000 in 3

months’ time. He then decides to discount the note with a bank
at a discount rate of 22%. How much will he receive from the
bank now?

PV=S (1-dt)

PV=100000[1-(0.22×3/12)]

PV=$94500

The person receives $94500 from the bank now.

NB. Money-market instruments that are traded on a discount

basis are bankers’ acceptances(referred to as BAs) and treasury
bills. The value appearing on the acceptanceor bill, the so-called
“face value”, is what the owner thereof will receive on the
maturitydate. On the other hand, the price paid is the present
value, which is calculatedas described above using the current
rate as set by the market.

Practice Question
Suppose that a discount security has a nominal value of $1000
but is issued at $945 with a tenor of 90 days. Calculate the
discount rate, d.

Equivalent Simple Interest Rate

It establishes a relationship between Simple Discount and Simple

Interest. The calculation of the discount rate is based on the
assumption that the security is held to its full tenor. If an
investor buys a security, he may not necessarily hold it to its full
tenor. The investor may opt to sell the security before it matures.
The yield will be the difference between what the investor gets
when he sells the security and what he paid for it. This is also
called the equivalent simple interest rate. When a note is
discounted, the interest rate which is equivalent to the discount
rate will be greater than the actual discount rate. This difference
arises from the fact that the Discount Rate is calculated on the
Face Value whereas Interest is calculated on the Present Value.

Example

Determine the discount, discount value and the equivalent

simple interest rate on a loan of $35000 due in 9months with a
discount rate of 26%?

S= $35 0000 d= 26% t= 9/12

⟹Discount (D) =Sdt

=35000×0.26× 9/12

= $6 825
⇒ Discounted Value (PV) =S-D or S (1-dt)

=35000-6825

=$28175

The discounted value is $28175. In order to determine the

equivalent interest rate r,we note that 28 175 is the price now
and that 35 000 is paid back nine months later.

I=S−P
= 35000 – 28 175
= 6825

The interest is thus 6825. The question can thus be rephrased as

follows: What simple interest rate, when applied to a principal of
$ 28 175 , will yield $6825 interest in nine months?
But remember

I = Prt
and with substitute we get

6825 = 28 175 ×r × 9/12

If we make r subject , we get

r = 0.32298
=32%
Thus the equivalent simple interest rate is 32 % per annum.

NB
Note the considerable difference between the interest rate of 32%
and the discountrate of 26%. This emphasises the important fact
that the interest rate and thediscount rate are not the same
thing. The point is that they act on differentamounts,and at
different times – the former acts on the present value, whereas
the latter actson the future value.

Practise Question.

1. Determine the Discounted Value on a promissory note of

$3000 due in 8months at a discount rate of 15%. What is
the equivalent Simple Interest rate?
2. A bank’s simple discount rate is 18%. If you sign a
promissory note to pay$4 000 in six months’ time, how
much would you receive from the bank now?
What is the equivalent simple interest rate?
3. Determine the simple interest rate that is equivalent to a
discount rate of
(a) 12% for three months
(b) 12% for nine months
Hint: Let S = 100 and use the appropriate formula to set up
anequation forr.

Cardinal Rules of Time Value

Remark:A particular investment has different values on different

dates. This is linked through the Future Value and Present Value
by applying relevant interest rates whether simple or compound.

For example, $1 000 today will not be the same as $1 000 in six-
months’ time. In fact, if the prevailing simple interest rate is 16%
per annum, then, in six months, the $1 000 will have
accumulated to $1 080.

⇒ 1 000 × (1 + 0,16× 1/2) = 1 080

On the other hand, three months ago it was worth less – to be

precise, it was worth $961,54.
 PV = 1 000
1 + 0,16×3/4
= 961,54

Represented on a time line, these statements yield the following

picture:

916.54
$1 000
t=3/12 t=6/12

16%
now

1 080
1 000

This is summarised as below:

1. To move money forward(determining the Face Value)

a. Where simple interest is applicable you inflate the relevant
sum by multiplying (1+rt)
b. Where compound interest is applicable you inflate by (1+i)n
2. When you want to move money backwards(determining the
present value)
a. Where simple interest is applicable, wedeflate by (1+rt)
b. Where compound interest is applicable you deflate the
relevant sum by (1+i)n

The point is that the mathematics of finance deals with dated

values of money. This fact is fundamental to any financial
transaction involving money due on different dates. In principle,
every sum of money specified should have an attached date.

Practice Question
Jack borrows a sum of money from a bank and, in terms of the
agreement, must pay back $1 000 nine months from today. How
much does he receive now if the agreed rate of simple interest is
12% per annum? How much does he owe after four months?
Suppose he wants to repay his debt at the end of one year. How
much will he have to pay then?

Interest and date values

Payments and obligations of different dates

The value of a sum of money is determined by the date at which

it is paid or received

Example

If you owe $2000 to be paid in 10months time at an interest of

27%. How much would you pay?

Given that S=P (1+rt)

=20000 (1+0.27×10/12)

=$24500

Example

If you want $20000 today, how much should you have invested
done 5months ago at the same interest rate of 27%.

The above examples are represented in a time line as following:

PV?t= 5/12 t=10/12

-5 0 10 months
 20000 FV?
S
Given that PV= (1+rt )

20000
PV= (1+0.27∗5 /12)

PV=$17977, 53

Example

Suppose you owe $100000 to be paid 4months from now,

$120000 to be paid 7months from now. You then negotiate to pay
all the amounts owed 10months from now. How much will you
eventually pay? (Use a simple interest rate of 22% for the
evaluation purpose)

Time line presentation is as follows;

T=6 months

T=3 months

r=22% PV=? 100 000 120 000

0 4 months 7 months 10 months

Future Value??

So we need to calculate the values of the new obligation

(t=6months for $100000 and t=3months for $120000) at a time
period 10months at a simple interest rate of 22%.

NB-For comparison purpose, all date values must be brought to

the same date. Only cashflows evaluated at the same date are
comparable.

New Obligation
 1) S ($100000for 6 months ) =P(1+rt)
=100000(1+0.22×6/12)
=$111000

2) S ($120 000for 3 months) =P(1+rt)

=120000(1+0.22×3/12)

=$126600

⇒Therefore Total obligation owing will be (Obligation 1 +

Obligation 2)

= (111000+126600)

=$237600

Suppose you offered to pay $20000 now in part settlement of the

debt, this amount cannot simply be deducted from the amount
($237600). The $20000 must be extended (evaluated for time
value at an appropriate rate) for 10months for comparison
purposes (inflating- finding the future value).Then find the final
amount needed to liquidate the resultant obligation.

Time value concept illustrated below in a timeline;

t=10 months

P=20 000 S ?? @10 months

Given that S= P(1+rt) ; S@ 10 months= 20000(1+0.22×10/12)

S=$23667

To find final owing, at the final due date, the Total obligations
should equal the Total payments.

Total Owing = Total Payments

 Total Owing =Part Payment + Final Payment (say
X to be determined)

⇒What he owes $237600 less what hepaid $23667 (time value

adjusted) gives what he has to pay to level off the debt(X).

Their fore Final payment (X) =$237600-$23667

X=$213933

From time to time a debtor may wish to replace a set of

financial obligations with a single payment on a given date. In
fact, this is one of the most important problems in financial
mathematics. It must be emphasised here that the sum of a set
of dated values due on different dates has no meaning. All dated
values must first be transformed to values due on the same
date(normally the date on which the payment that we want to
calculate is due). The process is simply one of repeated
application of the key rules of time value as the following example
illustrates:

Example

Lisa owes Tracy $5000 due in 3months and $2000 due in

6months. Lisa offers to pay $3000 immediately, ifshe can pay the
balance in one year. Tracy agrees that they use simple interest
rate of 16% per annum. They also agreed that the $3000 paid
now will also be subject to the same rate of 16% for evaluation
purposes. How much will Lisa pay at the end of the year?

Time Line

5000 t=9/12 r=0.16

2000t=6/12 r=0.16

0 3 6 12 months
3000 t=12/12 r=0.16 ????

Finding values of Obligation at Final Due Date

a) S(5000@ 12 months) =P (1+rt)r= 0.16 t=9/12

=5000(1+0.16×9/12)

=$5600

b) S(2000@ 12 months) =P (1+rt) r=0.16 t=6/12

=2000(1+0.16×6/12)

=$2160

Total obligations = (a) + (b)

=$5600+$2160

=$7760

Finding the values of Payments

S(3000@12 months) =P (1+rt) given r=016 t= 1 year

= 3000(1+0.16×1)

=$3480

At the Final duedate value ,which is 12 months;

Total obligation=Total payments ( i.e. part payments + final

payment[X])

This way we find what Lisa owes Tracy at the end of 12 months

⇒ 7760 = 3480+X

⇒ X=7760-3480

⇒X=$4280
Lisa owes $4 280.

Practice Questions

1. Noma owes 8 500 due in 10 months. For each of the

following cases, what single payment will repay her debt if
money is worth 15% simple interest per annum?
a) now
b) six months from now
c) in one year

2. LK owes AT $20 000 due in six months and $6 000 due in

11 months. LK offers to pay $10 000 immediately if he can
pay the balance in two year. AT agrees, on condition that
they use a simple interest rate of 18% per annum. They also
agree that for settlement purposes the $10 000 paid now
will also be subject to the same rate. How much will LK
have to pay at the end of the two years? (Take the
comparison date as one year from now!)

1. Mufaro must pay the bank $2 000 which is due in one year.
She is anxious to lessen her burden in advance and
therefore pays $600 after three months, and another $800
four months later. If the bank agrees that both payments
are subject to the same simple interest rate as the loan,
namely 14% per annum, how much will she have to pay at
the end of the year to settle her outstanding debt?

Compound Interest

Compound interest arises when, in a transaction over an

extended period of time, interest due at the end of a payment
period is not paid, but added to the principal. Thereafter, the
interest also earns interest, that is, it is compounded. The
amount due at the end of the transaction period is the
compounded amount or accrued principal or future value, and the
difference between the compounded amount and the original
principal is the compound interest. Essentially, the basic idea is
that interest is earned on interest previously earned.

Examples

You deposit $1000 at 10% per annum into a savings account,

how much will you have at the end of 4 years if interest is
compounded once per year.

Year/Period Beginning Interest Ending Interest

Amount factor amount
1 1000 0.1 1100 100
2 1100 0.1 1210 110
3 1210 0.1 1331 121
4 1331 0.1 1464,10 133,10
Compound 464,10
interest=

Compound Interest = Ending amount (1464.10)- Beginning

amount (1000) = 464.10

As shown in the example, compound interest in fact is just the

repeated application of simple interest to an amount that is
at each stage increased by the simple interest earned in the
previous period. It is, however, obvious that where the
investment term involved stretches over many periods, compound
interest calculations along the above lines can become tedious.

To remedy this we use a formula for calculating the amount

generated for any number of periods.

S (FV) =P (1+i)n
wheren, is number of periods and i, compound interest rate per
period and P is Present value

It also follows when that when given the future value amount S,
you can find the Present value ,P by the process of discounting
as follows;

PV=S/ (1+i)n

Example

Find the present value of $170000 which should be received at

the end of 8years when the interest rate is 22.67% compounded
once a year.

Solution

Timeline

PV?? t=8

0 8 years

170K
S
Given that PV = n
(1+i)

PV=170000/ (1+0.2267)8

PV=$33154

Practice Questions

1. What is the Present Value of the following yearly successive

cash flows given that the interest rate is 26.61% p.a
compounded once per year?
 CFs : $12000,$15000,$16900,$26950
n
Given∑ CF /(1+i)n=¿($40757, 37)
i=1

2. Find the compounded amount on $5 000 invested for ten

years at 7.5% per
annum compounded annually.
3. How much interest is earned on $9 000 invested for five
years at 8% per annum and compounded annually?

Compounding More than Once a Year

Perhaps you have noticed that we have been careful to use the
phrase “compounded annually” in the above examples and
exercises. This is because the compound interest earned depends
a lot on the intervals or periods over which it is compounded.
Financial institutions frequently advertise investment
possibilities in which interest is calculated at intervals of less
than a year, such as semi-annually, quarterly, monthly or even
on “daily balance”. What difference does this make? A few
examples should help us answer this question.

To find the Future Value when interest is paid more than once
per year we use the following relationship :
tm
jm
S=P (1+ )
m

Where S ≡ the accrued amount, also known as the future

value
P ≡ the initial principal, also known as the present
value
i≡jm/m, the annual interest rate compounded m times
per year
n≡ t × m, = number of compounding periods
t≡ the number of years’ of investment
 m≡ the number of compounding periods per year
jm≡ the nominal interest rate per year

The above equation is same as: S=P (1+i)n

Where i= jm/m

n=tm

Example

Find the future value of $40 000 deposited into an account that
earns 12.62% per annum for 6 years, compounded:

i. Once per year

ii. Semi-annually
iii. Quarterly
iv. Monthly
v. Daily

Solution
tm
jm
Given thatS=P (1+i)n or that S=P (1+ )
m

We will have the following results with t=6 ,P= $40 000 , jm
=0.1262 and changing value of m

i. S =40 000(1+0.1262/1)6 where m=1

ii. S =40 000(1+0.1262/2)6×2 where m=2

 =115 487.42

iii. S =40 000(1+0.1262/4)6×3 where m=3

=192 779.87

iv. S =40 000(1+0.1262/12)6×12 where m=12

=511 095.58

v. S =40 000(1+0.1262/365)6×365 where m=365

=14630 261.50

Other Formulasuseful in Time Value calculations

You don’t need to cram these but you can deduce them by
yourself by rearranging the above formulas for time value .

Check for yourself if you come up with these;

S
ln ⁡( )
P wherei can be replaced by jm/m
t=
mln ( 1+ i )

[ ]
1 /tm
S
jm=m ( ) −1
P

s
ln ⁡( )
p
n=
ln ⁡(1+i)

Practice Questions

1. How much time does it take for and investment will double
e.g. from 5 000 to 10 000 @ 10% compounded twice a year.?
 2. At what interest rate per annum must money be invested if
the accrued principal must treble in ten years?

Nominal and Effective Annual Rates

Remark:In cases where interest is calculated more than once a

year, the annual rate quoted is the Nominal rate.

Effective Annual Rate [EAR]

Is the actual interest earned per year calculated and expressed as

a percentage of the relevant principal This is the equivalent
annual rate of interest – that is, the rate of interestactually earned
in one year if compounding is done on a yearly basis.

Example

Calculate the [EAR] Effective Rate of Interest when the nominal

rate of interest is 15% per annum compounded on the following
basis:

I. Yearly
II. Semi-yearly
III. Quarterly
IV. Monthly
V. Daily

Solution

Given the following formula defined before;

tm
jm
S=P (1+i)n or that S=P (1+ )
m

I. Yearly case: assuming that P=100 , t=1 ,m=1

 tm
jm
S=P (1+ )
m
1∗1
015
S=100(1+ )
1
=115.00

Interest=Future Value(S)-Present Value (P)

=115-100=15
Interest 15
EAR= Principal = 100 ×100

=15%

EAR =15% yearly

II. Half yearly case : m=2 ,t=1, P=100

1∗2
015
S=100(1+ )
2

=115.56 semi-yearly

I=S-P

=115.56-100

=15.56
15.56
EAR= 100 ×100

=15.56%

III. Quarterly case : m=4 , t=1, P=100

1∗4
015
¿ 100(1+ )
4

=115.865 (1/4 yearly)

I=S-P

=115.865-100
 =15.87
15.87
EAR= 100 ×100

=15.87% (quarterly)

IV. Monthlycase : m=12, t=1 ,P=100

( )
1∗12
015
S=100 1+
12
=116.075

I =S-P

=116.075-100

=16.08
16.08
EAR= 100 ×100

=16.08 %

V. Daily Case :m=365 ,t=1 ,P=100

1∗365
015
S=100(1+ )
365
=116.179

I =S-P

=116.179-100

=16.179
16.18
EAR= 100 ×100
=16.18 %

From the above example you should note that, in order to

calculate the effective rate, we do not require the actual principal
involved. In fact, it is convenient to use P = 100, since the interest
calculated then immediately yields the effective rate as a
percentage.

The EARs formulation is as follows:

[( ) ]
m
jm
EAR∨ j eff = 1+ −1
m

The Effect of Increasing the number of Compounding times

per annum

As we increase the number of times the interest is paid in a year

implies that ,effectively we are increasing the interest rate or
return earned on an investment. Notice that the Future Value is
increasing as we increase m, the number of compounding times
p.a. The Future Value increases at an increasing rate then tails
off to a certain upper limiting value as m approaches positive
infinity ( as well the interest rate increases at an increasing rate
then tails off to a limiting value as m approaches positive
infinity). As m tendsto positiveinfinity, the EAR turns to an upper
limit.

What is the significance of this behaviour of EAR?

It protects the lender against the lender e.g. banks, in that the
return on an investment cannot be infinitesimally increased by
increasing the rate at which interest is earned per annum If such
a limiting value did not exist, it would have meant that the future
value of an investment (or debt) could be made arbitrarily large
by increasing the compounding frequency. If it does exist, we
know that there is an upper limit to the accrued value of an
investment or debt over a limited time period.

Plot of EAR and m

EAR EAR curve

Number of compounding times,m

Continuous Compounding

There is a limit regarding the effects of increasingm , on the

accumulated Future Value or EAR. The limit exists whenm is so
large that it approaches infinity is equal toletter ewhich is
thebase of a natural logarithm which is equal to 2.1782

e=2.1782

( )
n
jm j
lim 1+ =e m

m→∞ m

We can write the effective interest rate (as a percentage) as:

Jeff= 100( ejm− 1).

This is the effective interest rate when the number of

compounding periods tends to infinity. Therefore we will use the
symbol J∞ to identify it, and now define

J∞ = 100(ejm− 1).
EAR for continuous compounding [ j∞]

The case where interest is compounded an almost infinite

number of times as continuous compounding at a rate c, and to
J∞ as the effective interest rate expressed as a percentage for
continuous compounding.
Thus
J∞ = 100(eC– 1)

NB. Thus, finally, with continuous compounding at rate c and for

principal P, we can deduce that:

The FV in one year is

S = Pec.

The FV in t years will then simply be

S = Pect

Derivation of usable Formulae involving continuous

compounding

Suppose that we have a sum P that we invest for one year, on the
one hand, at a nominal annual rate of jmcompounded m times
per year and, on the other, at a continuous compounding rate of
c. In these two cases the sum accumulated in one year is then
respectively

S=Pec.
m
jm
S=P (1+ )
m

The question is: What must the continuous rate c be for these
two amounts to beequal? It must be

m
c jm
e =(1+ )
m
since the principal is the same in both cases.

We can solve for c by taking the natural logarithm of both sides.

[stages left here]

This gives the following results

jm
c= m ln 1+ m ( )
And

( )
c
m
j m=m e −1

Remark:We use the above formulae to convert a continuous

compounded interest rate to an equivalent nominal interest rate
that is compounded periodically, or vice versa. The two rates
obtained in this way are equivalent in the sense that they will
yield the same amount of interest, or give rise to the same effective
interest rate.

Practice Questions

1. An investor buys a security that pays an interest of 20% per

annum compounded continuously. What is the EAR?
2. Suppose $12 000 was invested on 15 November 20X0 at a
continuous rate of 16%. What would the accumulated sum
be on 18 May 20X1? (Count the days exactly.)
3. You have two investment options:
(a) 1975% per annum compounded semi-annually
(b) 19% per annum compounded monthly
Use continuous rates to decide which is the better option.

Equations of Value
From time to time, a debtor (the guy who owes money) may wish
to replace his set of financial obligations with another set. On
such occasions, he must negotiate with his creditor (the guy who
is owed money) and agree upon a new due date, as well as on a
new interest rate. This is generally achieved by evaluating each
obligation in terms of the new due date, and equating the sum of
the old and the new obligations on the new date. The resultant
equation of value is then solved to obtain the new future value
that must be paid on the new due date.

It is evident from these remarks that the time value of money

concepts must play an important role in any such
considerations, even more so than they did in the simple interest
case, since the investment terms are generally longer in cases
where compound interest is relevant.

Example

You decide now that when you graduate in four years’ time you
are going to treat yourself to a car to the value of 20 000. If you
can earn 17% interest compounded monthly on an investment,
calculate the amount that you need to invest now.

Solution
[include time line presentation]
Example

An obligation of $50 000 falls due in three years’ time. What

amount will be needed to cover the debt if it is paid
(a) in six months from now
(b) in four years from now
if the interest is credited quarterly at a nominal rate of 12% per
annum?

Solution

[Draw the relevant time line.]

(a) To determine the debt if it is paid in six months (ie two
quarters), we must discount the debt back two-and-a-half-years
from the due date to obtain the amount due.

S = P (1 + i)n

P = S (1 + i)-n

with m = 4, t = 2,5 and jm = 0,12.

P = S (1 + i)-n
P=?????

= 37 204,70
The present value of the debt six months from now is $37
204,70.

(b) To determine the debt, if it is allowed to accumulate for one

year past the due date, we must move the money forward one
year to obtain.

S = P (1 + i)n
S=????

= 56 275,44
The future value of the debt four years from now is $56 275,44

As we noted above that we would concern ourselves here with

replacing one set of financial obligation with another equivalent
set. This sounds complicated, but is really just a case of applying
the above rules for moving money back and forward, keeping a
clear head and remembering that, at all times, the only money
that may be added together (or subtracted) is that with a common
date.

Example

Tenesmus Sithole foresees cash flow problems ahead. He

borrowed $10 000 one year ago at 15% per annum, compounded
semi-annually and due six months from now. He also owes $5
000, borrowed six months ago at 18% per annum, compounded
quarterly and due nine months from now. He wishes to pay $4
000 now and reschedule his remaining debt so as to settle his
obligations 18 months from today. His creditor agrees to this,
provided that the old obligations are subject to 19% per annum
compounded monthly for the extended period. It is also agreed
that the $4 000 paid now will be subject to this same rate of 19%
for evaluation purposes. What will his payment be in 18 months’
time?

Solution
Example

Solution
Self Test Problems

1) At what rate of simple interest will $600 amount to $654 in

nine months?

2) A promissory note dated 1 April 2006 for $1 500, borrowed at

16% per annum, which is due on 1 October 2006 is sold on 1July
2006. What is the maturity value of the note? What is the present
value on the date of sale?

3) The simple discount rate of a bank is 16% per annum. If a

client signs a note to pay $6 000 in nine months time, how much
will the client receive? What is the equivalent simple interest
rate?

4) Calculate the sum accumulated if a fixed deposit of $10 000 is

invested on 15 March 2003 until 1 July 2005 and interest is
credited annually on 1 July at 15.5% per annum.

5) You are quoted a rate of 20% per annum compounded semi-

annually. What is the equivalent continuous interest rate?

6) You have two investment options:

a. 19.75% per annum compounded semi-annually.

b. 19% per annum compounded monthly.
Use continuous rates to decide which the better investment
option is.

7) Determine the effective rates of interest if the nominal rate is

18% and interest is calculated:

a. Half-yearly.
b. Monthly.

8) A small businessman borrowed some money from the bank

under the following conditions:

 $500 000 to be paid after 3 months from the date of the

loan.
 $800 000 to be paid one 1 year from the date of the loan.
  $900 000 to be paid 1 year 6 months from the date of the
loan.
The businessman has found things to be tough this year and
fails to make any payments.
 6 months from now he makes a payment of $300 000.
 9 months later he pays $250 000.
The bank accepts this arrangement provided that the balance
is to be paid on the last date as agreed. If simple interest is
charged at 22% per year, how much is to be paid by the
businessman? Illustrate in a time line.

9) A lender quotes an interest rate on loans at 22% per annum

with continuous compounding, but interest is actually paid
quarterly. Find the amount of interest on a loan of $250 000 after
1 year.

10) Compare the amounts accumulated on a principal of $10 000

if invested from 10 March 2003 to 1 July 2005 at 16.5% per
annum compounded semi-annually, and credited on 1 July and 1
July, if:

a. Simple interest is used for the odd period and compound

interest for the rest of the term.

11) Paul owes Winston $1 000 due in 3 years and $8 000 due in
5 years. He wishes to reschedule his debt so as to pay two sums
on different dates, one say X, in one year and the other, which is
twice as much (i.e. 2X), five years later. Winston agrees provided
that the interest rate is 18% per annum compounded quarterly.
What are Paul’s payments? Illustrate in a time line.

12) Determine the future value of an annuity after five payments

of $600 each, paid annually at an interest rate of 10% per
annum.

13) Mrs. Dudley decides to save for her daughter’s higher

education and, every year from the child’s first birthday onwards,
puts away $1 200. If she receives 11% interest annually, what
will the amount be after her daughter’s 18th birthday?

14) Determine the amount and the present value of an ordinary

annuity with payments of $200 per month for five years at 18%
per annum compounded monthly. What is the total interest paid?

15) Suppose the annuity just described above is not an ordinary

annuity but an annuity due. What would the amount and
present value be then, and what would be the interest paid?

16)Peter Penniless owes Wendy Worth $5 000 due in two years

from now, and $3 000 due in five years from now. He agrees to
pay $4 000 immediately and settle his outstanding debt
completely three years from now. How much must he pay then if
they agree that the money is worth 12% per annum compounded
half-yearly?

CHAPTER 3

ANNUITIES

Annuities
An annuity is a series of equal payments made at fixed intervals
for a specified number of periods. For example, a promise to pay
$ 1 000 a year for 3 years is a 3-year annuity. There are two
types of annuities : annuity due and ordinary (deferred) annuity.

Diagram for Ordinary Annuity

R R R R R R R

FV
If the payments are made at the end of each period, that is, they
are made at the same time that interest is credited, it is an
ordinary annuity. If the payments are made at the beginning of
each period, the annuity is known as an annuity due.

Diagram for Ordinary due

R R R R R R R

FV

If the payments begin and end on a fixed date, the annuity is

known as an annuitycertain. On the other hand, if the payments
continue for ever, the annuity is knownas perpetuity.

The FV of an annuity is the sum of all payments made and the

accumulated interest at the end of the term.

The PV is the sum of payments, each discounted to the beginning

of the term, that is, the sum of the present value of all payments.

Future Value of an Ordinary Annuity

Example
Suppose you deposit $ 100 at the end of each year for 3 years in
a savings account thatpays 5% interest per year, how much will
you have at the end of 3 years?

In this example, each payment is compounded out to the end of

period n, and the sum ofthe compounded payments is the future
value of the annuity

Timeline presentation of the problem:

100 100 100

0 1 2 3

100
105
110.25315.
25

Thus, the future value of the annuity = [100 (1.05) 2 + 100 (1.05)1
+ 100] = $315.25.

You should notice that this type of calculation becomes tedious if

the investment term spans over a very long period of time, so we
engage a formula, the derivation of which shall be beyond the
scope of this course/module.

Future Value Interest Factor Annuity [FVIFA]

The future value of an annuity of $1 for a period of n years at an

interest rate of i is given by the following formula:

( 1+i )n−1
FVIFA n , i%=
i
 ( 1+0 . 05 )3 −1
FVIFA 3, 5%=
0 . 05
For the above example;
= 3.1525

To find the FV, we multiply the FVIFA by the size of periodic

payment

FV= 3.1525×100 = 315.25

Generally, The FV of an ordinary annuity is given by the following

formulation;

(1+i )n −1
FV OD =[ ]×R
i
Where iis interest rate i per payment interval,

R is annuity payment amount per period

n is the number of payment intervals of the annuity

NB.
The annual interest rate jmcompounded m times per year jm/mis
denoted by i [i= jm/m]
While the number of interest compounding periods tm is denoted
by n.

As such;

[ ]
( )
tm
jm
1+ −1
m
FV OD= ∗R
jm
m

Practice Questions
1. Mrs Thodes decides to save for her daughter’s higher
education and, every year, from the child’s first birthday
onwards, puts away $1 200. If she receives 11% interest
annually, what will the amount be after her daughter’s 18th
birthday?
 2. What is the accumulated amount (future value) of an
annuity with a payment of $600 four times per year and an
interest rate of 13% per annum compoundedquarterly at the
end of a term of five years?

Future Value of an Annuity Due.

If the $100 payments had been made at the beginning of each

year, this would be an annuity due and the time line would look
as shown below :

100 100 100

0 1 2 3

105
110.25115.
76

331.01

Thus, the future value of the annuity due is [100 (1.05) + 100
(1.05)2 + 100 (1.05)3 ] = $331.01.

Since the payments occur earlier, more interest is also earned,

thus the future value of an annuity due is larger ($331,01) than
that of an ordinary annuity ($315.25).

To get the future value of an annuity due we compound the

future value of an ordinary annuity by an extra period.

Future value of annuity due [FVAD] = R× FVIFAOD (1+i)

In our example, the future value of the annuity due is 100
(3.1525) (1.05) = $331.01.

Present Value of an Ordinary Annuity.

Remark: The present value of an annuity is the amount of money

that must be invested now, at i percent, so that n equal periodic
payments may be withdrawn without any money being left over at
the end of the term of n periods.

Example

Suppose an investor has the following alternatives : a three year

annuity of $1 000.00 or a lump sum payment today. What must
the lump sum payment be to make it equivalent to the annuity if
the interest rate is 10% ?

If the payments come at the end of each year, the annuity is an

ordinary annuity and the time line will look as shown below :

1000 1000 1000

0 1 2 3

909.10
826.40
751.302 486.80

Thus, the present value of the annuity is given by :

[ (1 000 ) / (1.10) + (1 000 ) / (1.10) 2 + (1 000 )(1.10)3] = $2
486.80
This is the present value of three payments of $1 000 each
deposited at the end of each year.

Present Value Interest Factor Annuity , (PVIFAOD)

The present value of an annuity of $1 for a period of n years at an

interest rate of i is given

by the following formula:

( 1+i )n −1
PVIFA OD =
i ( 1+i )n

Where iis interest rate i per payment interval,

R is annuity payment amount per period

n is the number of payment intervals of the annuity

NB.
The annual interest rate jmcompounded m times per year jm/m
is denoted by i [i= jm/m], while the number of interest
compounding periods tm is denoted by n.[tm=n]

To find the PV of the annuity , we can make use of the formula:

Multiply the PVIFA by the periodic payment,R. So we have;

PVOD=PVIFAOD× R

PV OD =
[
( I +i )n −1
i (1+i )n ]×R

or where interest is earned more than once

 [ ]
( ) −1 ∗R
tm
jm
1+
m
PV OD =

m (
1+ )
tm
jm jm
m

For the above example, this would be;

PV OD =
[ ( 1+0 .10 )3−1
0 .10 ( 1+0 . 10 )3 ]
×1000

= $2 486.80

Present Value of an Annuity Due

We can establish a relationship between the present value of an

annuity due and an ordinary annuity, namely

PV (of annuity due with n periods)= firstpayment +PV ( of ordinary

annuity with (n − 1) periods)

Thus the present value of an annuity due is given by

Present Value of Annuity[PVAD] = R× PVIFAOD (1+i)

Example

If the monthly rental on a building is $1 200 payable in advance,

what is the equivalent yearly rental? Interest is charged at 12%
per annum compounded monthly. How much interest is paid?

Solution
What the question in fact asks is: What rental must be paid as a
lump sum at the beginning of the year instead of monthly
payments? In other words, this is a present value-type
calculation. There is one payment at the beginning but not at the
end. This means that the first payment does not have to be
discounted and that the remaining 11 payments form an
ordinary annuity. Thus the equivalent yearly rental (ER) is given
by

ER = First payment + Present value of remaining 11

payments

Solution:
[use timeline]
Or use the following relationship

Present Value of Annuity[PVAD] = R× PVIFAOD (1+i)

Working:
Summary

1. Present Value of Ordinary Annuity [PVOD] = R× PVIFAOD

2. Present Value of Annuity Due [PVAD] = R× PVIFAOD (1+i)
3. Future Value of Ordinary Annuity[FVOD] = R× FVIFAOD
4. Future Value of Annuity Due [FVAD] = R× FVIFAOD (1+i)

Annuity Payment Date differs from Interest Payment Date

In practice the payment of interest does not to coincide exactly

with the annuity payment date. When the two does not coincide,
it presents practical difficulties on deciding which interest rate to
use for which period since they differ. If this happens we have to
make use of the concept of continuous compounding as noted
earlier in our discussions, to convert the mismatching interest
rate through continuous compounding to make the interest
payment date (IPD) and the annuity payment date (APD) coincide.
[ i.e. marry/match/coincide IPD and APD}.

What we will be doing is to replace the specified interest rate and

period with an equivalent interest rate that corresponds to the
period of the payments.

Example
An investor makes a payment of $10 000 at the end of every 4
months for the next 6 years. Calculate the Future Value of the
payments if interest is compounded semi-annually at 19.5%.

Timeline presentation

XXXX
Lets establish notation here:

mi(The frequency of Interest Payment) = 2

mp(frequency of annuity payment) = 3

We see mi ≠ mp thus giving the need to convert the semi- annually

compounded rate to be applicable to the periods of annuity
payment ie every 4 months

Step 1
Convert the semi-annual compounding of interest to three time
per year to coincide with the frequency of payments per year of
annuity. We go through the equivalent continuous effective rate.

Jm= 0.195 mi =2
We know that ;

(
c=mln 1+
jm
m )
(
c=2 ln 1+
0. 195
2 )

= 18.60697%
Step 2
Is to calculate the equivalent nominal rate, jm , to the continuous
rate calculated in step 1 , coinciding with mp =3.

We also know that;

( )
c
m
j m=m e −1

Given c = 18.60697% and mp=3

We will have;

( )
0.1860
3
j m=3 e −1
=19.1961%
This rate is an annual equivalent nominal rate compounded 3
times p.a , which makes now applicable to the period of
payement which is also 3 time p.a.

Step 3
We can now aplly this rate to find the Future value of the
investment as follows.

FVOD = R× FVIFAOD

[ ] ( )
tm
jm
1+ −1
m
FV OD= ∗R
jm
m
Thus;

[ ( )
]
3 ×6
0.1919
1+ −1
3
FV OD= ×10 000
0.1919
3

= $320 923.78
, which is the FV of the investment.
Alternative method to find the Equivalent Periodic Nominal
Rate

We can use the following formula

[( ) ]
m
jm n
j n=n 1+ −1
m
, jn compounded n times, equivalent to jm compounded m times

n- is where you want to go ie the frequency of payment

m- is the where you are coming from ie the frequency of interest
compounding

Try use the formulae and see if you get the same coincided
periodic nominal rate.

Practice Questions

1. Calculate the present value of an annuity that provides $1

000 per year forfiveyears if the interest rate is 12,5% per
annum.
2. Max puts $3 000 down on a second-hand car and contracts
to pay the balance in 24 monthly instalments of $400 each.
If interest is charged at a rate of 24% per annum, payable
monthly, how much did the car originally cost when Max
purchased it? How much interest does he pay?
3. Determine the present value of an annuity with semi-annual
payments of $800 at 16% per year compounded half-yearly
and with a term of ten years.