Topic Two

Financial Mathematics/Time Value of Money

Part 1
 Overview
 Distinguish between simple and compound interest.
 Calculate the present value and future value of a
single amount for both one period and multiple
periods.
 Calculate the present value and future value of
multiple cash flows.
 Calculate the present value and future value of
annuities.
 Time Value of Money
• Receiving $1 today is worth more than $1 in the
future
• The opportunity cost of $1 in the future is the
interest we could have earned on $1 if received
earlier
Today Future
 Compounding & Discounting
• Compounding
 Translating $1 today into its equivalent
future value

• Discounting
 Translating a future $1 into its equivalent
present value today
 Compounding & Discounting
End End End End
0 1 2 3 4

PV FV

• Future value (FV) is the amount an investment is worth

after one or more periods (the amount it has grown to).

• Present value (PV) is the current value of the future

cash-flows of an investment (the amount in today’s
dollars).
 Time Value Terminology
• The number of “interest paying” time periods between
the present value and the future value is represented by
‘n’.
• The rate of interest for discounting or compounding is
called ‘r’.
 n and r need to be consistent. If interest is paid monthly
the number of periods n has to be worked out in terms of
months
 All (single sum) time value questions involve four
values: PV, FV, r and n. Given three of them, it is
always possible to calculate the fourth.
Future Value of A Single Sum Example
You invest $100 in a savings account that earns 10%
interest per annum (compounded) for three years.

 Calculating FV the “long” way:

After one year: $100  (1.10) = $110
After two years: $110  (1.10) = $121
After three years: $121  (1.10) = $133.10
 Future Value of A Single Sum
• For one period:
FV1 = PV ( 1 + r ) = PV ( 1 + r ) 1
For two periods:
FV2 = PV ( 1 + r ) ( 1 + r ) = PV ( 1 + r ) 2
For n periods:
FVn = PV ( 1 + r ) n

In general, the future value, FVt of a single amount invested today

at r % for n periods is: FVn  PV 1  r 
n

• The expression (1 + r)n is the future value interest factor for a single
sum (FVIF).
 Future Value of A Single Sum:
Compound Versus Simple Interest
• Assume you make a deposit into a bank account.

 If the Bank pays you simple interest the interest payment

each period will be the same and will be the interest rate
times the initial amount.

 If the bank pays you compound interest you will receive

interest payments not just on the initial amount but also on
previous interest payments.
Comparing Simple And Compound Interest
• Simple interest refers to interest earned only on the
original capital investment amount.
FV = PV(1 + r n)

• Compound interest refers to interest earned on

both the initial capital investment and on the
interest reinvested from prior periods.
FV = PV(1 + r ) n
 In finance it is almost always compound interest
that is used.
 Comparing Simple And Compound Interest
• Example: $100 invested at 10% p.a. for 3 years
Simple interest: FV3 = 100(1+(0.10 x 3))
FV3 = 100(1.30)
FV3 = $130.00
Interest earned = $30.00

Compound interest: FV3 = 100(1.10)3

FV3 = 100(1.331)
FV3 = $133.10
Interest earned = $33.10
 The extra $3.10 is from compounding, i.e. earning interest
on interest.
 Future Value of A Single Sum Example
• What will $1,000 amount to in 5 years’ time if interest is 12% per annum, compounded annually?
 n = 5 (interest is calculated 5 times), r = 0.12:

•

FV  $1,000 1  0.125
Now assume interest is 12% per annum, compounded monthly.
Always remember that n is the number of compounding periods, not the number of years.
• n = 5yrs x 12 = 60 (interest is calculated 60 times),
•
 $1,000 (1.7623)
r = 0.12/12 = 0.01 (i.e. 1% per month)

 $1, 762.30

FV  $1,000 1  0.0160
 $1,000 (1.8167)
 $1,816.70
 Future Value of A Single Sum Example

• Difference in values = $1,816.70 - $1,762.30 =

$54.40

 The difference in values is due to the larger number

of periods in which interest can compound.

 Future values also depend critically on the assumed

interest rate - the higher the interest rate, the greater
the future value.
 Future Value of A Single Sum
Future value of $100
Interest Rate
Number of 5% 10% 15% 20%
periods
1 $105.00 $110.00 $115.00 $120.00
2 $110.25 $121.00 $132.25 $144.00
3 $115.76 $133.10 $152.09 $172.80
4 $121.55 $146.41 $174.90 $207.36
5 $127.63 $161.05 $201.14 $248.83

For a given number of periods, the higher the interest rate

the higher the future value.
For a given interest rate, the more compounding periods the
greater the future value.
 Present Value of A Single Sum

PV  FV 1  r  -n

or
FV
PV 
1  r n

1  r 
-n
is the present value interest factor for a single sum (PVIF)
 Present Value of A Single Sum Example
If you will receive $1,000 in three years’ time what is its PV if your
opportunity cost/discount rate/interest rate is 10% p.a.?
Can do it the long way, period by period:
Yr 3: $1,000 (1.10)-1 = $909.09
Yr 2: $909.09 (1.10)-1 = $826.45
Yr 1: $826.45 (1.10)-1 = $751.32

0 1 2 3

$1,000
$909.09
$826.45
$751.32
 Present Value of A Single Sum
Application of The Formula
You will receive $1,000 in three years’ time. What is its PV if
your opportunity cost is 10% p.a.?
PV  FV 1  r  -n

PV0  1,000 1.10 -3

PV0  1,000(0.7513)
PV0  $751.30
Present Value of A Single Sum Example

Your rich grandmother promises to give you

$10,000 in 10 years’ time. If interest rates are 12%
per annum how much is this gift worth today?

PV0  $10,000 1  0.12 10

PV0  $10,000 (0.3220)

PV0  $3,220
 Present Value Of A Single Sum
Present value of $100
Interest Rate
Number of
periods 5% 10% 15% 20%
1 $95.24 $90.91 $86.96 $83.33
2 $90.70 $82.64 $75.61 $69.44
3 $86.38 $75.13 $65.75 $57.87
4 $82.27 $68.30 $57.18 $48.23
5 $78.35 $62.09 $49.72 $40.19
For a given number of periods, the higher the interest rate
the lower the present value.
For a given interest rate, the greater the number of
discounting periods the lower the present value.
 Problem Variations: Single Sum Problems

In general the problems that students will confront in this course
will either involve them in working out present values or future
values.

However, it is of course possible to also want to work out n if given

PV, FV and r. It is quite a common problem to want to know how
long it will take something to grow from its PV to its FV at a given
interest rate.

It is also possible to work our r given n, PV and FV. It is quite a

common problem to want to know what the rate of return on an asset

is when it grows from PV to FV over a given period of time

Solving For The Unknown Rate of Return (r)

Example
• You currently have $100 available for investment
for a 21 year period. At what annual interest rate
must you invest this amount in order for it to be
worth $500 at maturity?

 Remember, given any three factors in the present

value or future value of a single sum formula, the
fourth factor can be solved.
 Solving for the Unknown Rate of Return (r)
Example 1 (cont.)
Since we know both the PV and FV (and n), we can use either the PV or
the FV of a single sum formula to find the unknown interest rate (r).

• A. PV of a single sum • B. FV of a single sum

• PV0 = FVn(1+r)-n • FVn = PV0(1+r)n
• 1. 100 = 500(1+r)-21 • 1. 500 = 100(1+r)21
• 2. 100/500 = (1+r)-21 • 2. 500/100 = (1+r)21
• 3. 0.20 = (1+r)-21 • 3. 5 = (1+r)21
• 4. (0.20)1 = (1+r)-21 • 4. (5)1 = (1+r)21
• 5. (0.20)1/-21 = (1+r)-21/-21 • 5. (5)1/21 = (1+r)21/21
• 6. (0.20)-0.04762 = 1+r • 6. (5)0.04762 = 1+r
• 7. 1.0797 = 1+r • 7. 1.0797 = 1+r
• 8. 1.0797-1 = 1+r-1 • 8. 1.0797-1 = 1+r-1
• 9. 0.0797 = r = 7.97% p.a. • 9. 0.0797 = r = 7.97% p.a.
Solving For The Unknown Rate of Return (r)
Example
If you sell land for $11,933 that you bought five years ago for
$5,000, what is your annual rate of return?

Using the same method as in the previous example you will find
that the rate of return (r) is equal to 19% p.a.
Solving For The Unknown Number of Investment Periods (n)

 Suppose you placed $100 in an account that pays

interest of 9.6% p.a., compounded monthly. How
long will it take for your account to grow to $500?

 note: r = 0.096/12 = 0.008 (i.e. 0.8% per month)

 Solving For The Unknown Number of Investment Periods (n)
Since we know both the PV and FV (and r), we can use either the PV or the
FV of a single sum formula to find the unknown number of investment
periods (n). To get the answer we must use natural logs (the ln button on
your calculator)

• A. PV of a single sum • B. FV of a single sum

• PV0 = FVn(1+r)-n • FVn = PV0(1+r)n
• 1. 100 = 500(1.008)-n • 1. 500 = 100(1.008)n
• 2. 100/500 = (1.008)-n • 2. 500/100 = (1.008)n
• 3. 0.20 = (1.008)-n • 3. 5 = (1.008)n
• 4. ln(0.20) = -nln(1.008) • 4. ln(5) = nln(1.008)
• 5. -1.6094 = -n(0.007968) • 5. 1.6094 = n(0.007968)
• 6. -1.6094/0.007968 = -n • 6. 1.6094/0.007968 = n
• 7. -202 = -n = 202 months • 7. 202 = n = 202 months
 Hint For Single Sum Problems
 There are only 4 variables: FV, PV, r, and n.
 You will always be given three variables and
asked to solve for the fourth.

 This hint makes solving single sum time-

value problems much easier.
 Multiple Uneven Cash-Flows
Future Value of Multiple Uneven Cash-Flows
Example
• You deposit $1,000 now, $1,500 in one year, $2,000 in
two years and $2,500 in three years in an account
paying interest of 10% p.a. How much will you have
in the account at the end of the third year?

 As each of the cash-flows is of a different value you

must first calculate the future value of each cash flow
individually as a single sum and then total the future
values.
 Solution
End End End
0 1 2 3

$1,000 $1,500 $2,000 $2,500

$2,200

$1,815

$1,331
1,000(1.10)3 = 1,000(1.331) = 1 331
$7,846
1,500(1.10)2 = 1,500(1.21) = 1 815
2,000(1.10)1 = 2,000(1.10) = 2 200
2 500(1.00) = 2 500
Total = $7 846
 Present Value of Multiple
Uneven Cash-Flows Example
• You deposit $1,500 in one year, $2,000 in two years and
$2,500 in three years in an account paying interest of 10%
p.a. What is the present value of these cash flows?

 As each of the cash-flows is of a different value you must

first calculate the present value of each cash-flow
individually as a single sum and then total the present
values.
 Solution
End End End
0 1 2 3

$1,500 $2,000 $2,500

$1 364
$1 653
$1 878
$4 895
1,500(1.10)-1 = 1,500(0.9091) = 1,364
2,000(1.10)-2 = 2,000(0.8264) = 1,653
2,500(1.10)-3 = 2,500(0.7513) = 1 878
Total = $4 895
 Types of Annuities
 Ordinary annuities

 Annuities due

 Deferred annuities

 Perpetuities

 Growing perpetuities
 Types of Annuities
• An ordinary annuity is a series of constant cash flows that occur at the
end of each period for some fixed number of periods commencing at
the end of the first period (i.e. at T1)

0______1_______2 _____ 3 _____ 4____ 5__

$$ $$ $$ $$
Examples include consumer loans and home mortgages.

• An annuity due is a series of constant cash flows that occur at the start
of each period for some fixed number of periods, commencing at the
beginning of the first period (i.e. at T0).
0______1_______2 _____ 3_____ 4_____5__
$$ $$ $$ $$
Examples include paying rent in advance or uni fees in advance
 Types of Annuities
• A deferred annuity is a series of constant cash flows that occur at the
end of each period for some fixed number of periods commencing some
future period after period one (e.g commencing at T3 (the end of the
third period)).
Examples include a lump sum pension plan.

0______1_______2 _____ 3 _____ 4___ _ 5__

$$ $$ $$

• A perpetuity is a series of constant cash flows that occur at the end of

each period indefinitely (i.e. forever).
Examples include a scholarship fund available each year forever
(e.g. Rhodes Scholarship).
Calculating PV of An Ordinary Annuity The Long Way
What is the PV of receiving $1,000 at the end of each of the next 3
years if the opportunity cost is 8% p.a.?

The Long Way

Treating each cash-flow as a single sum and discounting each cash-
flow back to T0 individually, then summing the values:

PV ? 1000 1000 1000

0 1 2 3
PV0 = 1,000(1.08)-3 =793.83
PV0 = 1,000(1.08)-2 =857.34
PV0 = 1,000(1.08)-1 =925.93
PV0 = 2,577.10
Present Value of An Ordinary Annuity Using The PV
of An Ordinary Annuity Formula (i.e. the easy way)

1  1  r  n 
PV  PMT  
 r 

• PMT = the annuity payment

• The discounting term (value in the big square bracket) is called

the present value interest factor of the annuity (PVIFA).

 Note, the formula always assumes that it is an ordinary annuity.

Therefore, it provides the PV one period before the first
payment or receipt takes place.
 Present Value of An Ordinary Annuity Example

What is the PV of receiving $1,000 at the end of each of the

next 3 years if the opportunity cost is 8% p.a.?

1000 1000 1000

PV ?
0 1 2 3
1  1  r  n 
PV  PMT  
 r 
1  1.083 
PV0  1,000  
 0 .08 
PV0  1,0002.5771
PV0  $2,577.10
Present Value of An Ordinary Annuity Example
You will receive $500 at the end of each of the next 5
years. The current interest rate is 9% p.a. What is the
present value of this series of cash flows?

1 - (1.09) -5 
PV0  $500  
 0.09 
PV0  $500 [3.8897]
PV0  $1, 944.85
 Finding The Unknown PMT (Annuity Payment)

In the previous problems we were given:

n the number of investment periods,
r the discount/ interest rate per investment period, and
PMT the regular periodic annuity payment/receipt

and asked to calculate the PV of the ordinary annuity.

However, it is common to want to know PMT if given n, r

and PV. This is particularly so in instances of trying to work

out the regular periodic payments on a loan.

 Finding The Unknown PMT
(Annuity Payment)
• Using the previous numerical example:
PV0 = $1,944.85, r = 9% p.a., n = 5 years, PMT
=?
1  (1.09) 5 
1,944.85  PMT  
 0.09 
1,944.85  PMT 3.8897
1,944.85
PMT 
3.8897
PMT  $500
 Future Value of An Annuity
 1  r n - 1 
FVn  PMT  
 r 
• The compounding term (sqaure bracketed term) is
called the future value interest factor of the annuity
(FVIFA).

 The formula gives the FV at the time the last

payment/receipt is made.
 Future Value of An Annuity Example
If you invest $1,000 at the end of each of the next 3
years at 8% p.a., how much will you have after 3
years?
1000 1000 1000

0 1 2 3
 1  r n - 1  FV
FVn  PMT   33 ?
 r 
 (1.08) 3  1 
FV3  1,000 
 0 .08 
FV3  1,0003.2464
FV3  $3,246.40
 Future Value of An Annuity Example

What is the future value $200 deposited at the end of

every year for 10 years if the interest rate is 6% per
annum?
 1.0610 - 1 
FV10  $200  
 0.06 
FV10  $20013.181
FV10  $2,636.20
 General Approach To
Problem Solving
1. Draw a timeline
2. Determine what unknown the problem involves:
 r, n, PV, FV, PMT?
3. Identify the class of problem:
 single sum, multiple uneven cash-flow, annuity?
4. Recognise any ‘traps’ in the problem:
 annual interest rate and more than one
compounding period per year? Adjust r and n.