CHAPTER 5

TIME VALUE OF MONEY

The time value of money (TVM) is a fundamental concept in finance that refers to the idea
that a dollar today is worth more than a dollar in the future. This concept is based on the
principle that money has the potential to earn interest or generate returns over time, so a
certain amount of money today is considered more valuable than the same amount of money
in the future.
There are several key components to understanding the time value of money:
1. Future Value (FV): This represents the value of money at a specified future point in
time, based on a certain interest rate or rate of return. The future value can be
calculated using formulas such as compound interest formulas.
2. Present Value (PV): Present value is the current worth of a future sum of money,
discounted back to its present value using an appropriate discount rate. It reflects the
amount of money that would need to be invested today at a given rate of return to
equal a future sum of money.
3. Interest Rates: Interest rates play a crucial role in TVM calculations. They represent
the cost of borrowing money or the return on investment. Higher interest rates
generally mean that money grows faster over time, leading to higher future values and
lower present values.
4. Time Periods: The time period refers to the length of time over which money is
invested or borrowed. TVM calculations consider the time value of money over
different time periods, adjusting for the effects of compounding or discounting.
5. Compounding: Compounding refers to the process of earning interest on both the
initial principal and the accumulated interest from previous periods. Compound
interest leads to exponential growth of money over time.
6. Discounting: Discounting is the process of calculating the present value of future cash
flows by applying a discount rate. It involves reducing the value of future cash flows
to reflect their current worth.
Simple interest is a type of interest that is calculated only on the principal amount of a loan or
investment. It does not take into account any interest that has been previously earned or paid.
The formula for calculating simple interest is:
Simple Interest
Simple interest refers to the interest that is calculated only on the original principal
amount of a loan or investment. It does not take into account any interest that has been
accumulated or paid previously. This type of interest is straightforward and easy to
calculate, making it suitable for situations where interest is not compounded over time.
Simple Interest=P×r×t
Where:
Simple Interest= Simple Interest = Total amount of interest earned or paid
P = Principal amount (the initial amount of money)
r = Annual interest rate (expressed as a decimal)
t = Time period (usually in years)
The simple interest formula assumes that the interest is not compounded; that is, the interest
earned or paid remains constant each year based on the original principal amount. This is
different from compound interest, where interest is calculated on both the principal and any
previously earned interest.

Question 1: Sarah deposited $5,000 in a savings account with an annual interest rate of
4%. How much simple interest will she earn after 3 years?
Answer: Using the simple interest formula
Simple Interest
=Simple Interest=P×r×t, where
P = $5,000,
r=0.04
t=3
Simple Interest = $5,000 *0.04 * 3 = $600
Sarah will earn $600 in simple interest after 3 years.
Question 2: A loan of $8,000 is borrowed at an annual interest rate of 6%. How much
simple interest will be paid after 4 years?

Simple Interest=P×r×t,= $1,920

$1,920 in simple interest will be paid after 4 years.

Question 3: Tom invested $3,500 in a fixed deposit with an annual interest rate of 5%.
How much simple interest will he earn after 2 years?

Answer: Using the simple interest formula

Simple Interest
Simple Interest=P×r×t
= $350
Tom will earn $350 in simple interest after 2 years.

Question 4: A student borrowed $2,500 from a friend and agreed to pay back with 8%
annual interest after 1 year. How much interest will the student pay?
Answer: Using the simple interest formula
Simple Interest=P×r×t,
=$200
The student will pay $200 in interest after 1 year.
Compound interest
Simple interest refers to the interest that is calculated only on the original principal amount of
a loan or investment. It does not take into account any interest that has been accumulated or
paid previously. This type of interest is straightforward and easy to calculate, making it
suitable for situations where interest is not compounded over time.

There are several formulas used to calculate compound interest, depending on the specific
scenario and the frequency of compounding. Here are the key formulas for compound
interest:
1. Annual Compound Interest: A=P×(1+r)^t
Where:
 A is the amount of money accumulated after t years, including interest.
 P is the principal amount (the initial amount of money).
 r is the annual interest rate (expressed as a decimal).
 t is the time period for which the money is invested or borrowed (usually in years).
2. Compound Interest with Multiple Compounding Periods per Year:
A=P×(1+r/n)^nt
 A is the amount of money accumulated after t years, including interest.
 P is the principal amount.
 r is the annual interest rate (expressed as a decimal).
 n is the number of compounding periods per year.
 t is the time period for which the money is invested or borrowed (usually in years).
Problem 1: Sarah invests $5,000 in a savings account with an annual interest rate of 5%,
compounded annually. How much will she have after 3 years?
Solution:
Using the compound interest formula for annual compounding:
A=P×(1+r) ^t

Where:
P = $5,000 (principal amount)
A = $5,000 \times (1 + 0.05)^3
A = $5,000 \times (1.05)^3
A = $5,000 \times 1.157625
A = $5,788.125
After 3 years, Sarah will have approximately $5,788.13 in her savings account.
Problem 2: Tom borrows $10,000 from a bank at an annual interest rate of 8%,
compounded quarterly. How much will he owe after 2 years?
Solution:
Using the compound interest formula for quarterly compounding:
A=P×(1+r/n)^nt
A = $10,000 1 + 0.02)^8
A = $10,000 *1.171661
A = $11,716.61
After 2 years, Tom will owe approximately $11,716.61 to the bank.
Problem 3: Emily invests $2,500 in a mutual fund with an annual interest rate of 6%,
compounded monthly. How much will her investment be worth after 5 years?
Where:
P = $2,500 (principal amount)
r=0.06
n=12 (monthly compounding)
t=5 years
A = $2,500 \times (1 + 0.005)^{60}
A = $2,500 \times 1.348858
A = $3,372.15
After 5 years, Emily's investment will be worth approximately $3,372.15.
The future value of a single amount
calculation is used to determine the value of an investment or sum of money at a specific
future date, taking into account compound interest. The formula for calculating the future
value (FV) of a single amount is:
FV=Pv×(1+r) ^t
Where:
FV is the future value of the investment or sum of money.
Pv is the principal amount (initial investment or sum of money).
r is the annual interest rate (expressed as a decimal).
t is the time period for which the money is invested or saved (usually in years).
Example:
Sarah invests $10,000 in a fixed deposit account with an annual interest rate of 6%. How
much will her investment be worth after 5 years?

Using the future value formula:

Pv = $10,000
r=0.06 (6% interest rate expressed as a decimal)
t=5 years
=10000(1+0.06) ^5
=10000(1.338225)
$13,382.25
After 5 years, Sarah's investment will be worth approximately $13,382.25.

The future value (FV) of an Annuity

The future value (FV) of an annuity refers to the total value of a series of equal payments or
receipts at a specified future point in time, assuming a certain interest rate. The formula to
calculate the future value of an annuity depends on whether the payments are made at the end
of each period (ordinary annuity) or at the beginning of each period (annuity due).
For an ordinary annuity, where payments are made at the end of each period, the formula to
calculate the future value (FV) is:
For example, if you have an annuity where you deposit $1,000 at the end of each year for 5
years with an annual interest rate of 5%, the future value can be calculated as:
=$1,000×(1+0.05)-1/.0.05

= $1,276.28

PRESENT VALUE
The present value (PV) of a single amount or a series of cash flows (such as an annuity)
represents the current worth of these future cash flows, discounted at a specific interest rate.
The formulas for calculating the present value of a single amount and an annuity are
different.

1. Present Value (PV) of a Single Amount: The formula to calculate the present value
of a single amount is:
Where:
 PV = Present Value of the single amount
 FV = Future Value of the single amount
 r = Interest rate per period
 n = Number of periods
For example, if you want to calculate the present value of $1,000 to be received in 5 years
with an annual interest rate of 5%, the calculation would be:
=783.53
2. Present Value (PV) of an Annuity: The formula to calculate the present value of an
ordinary annuity (where payments are made at the end of each period) is:

For example, if you want to calculate the present value of an annuity with $500 payments at
the end of each year for 10 years at an annual interest rate of 6%, the calculation would be:
=3,459.31