MK 1 Time Value of Money
MK 1 Time Value of Money
MK 1 Time Value of Money
Money
Muamar Nur Kholid, SE., Ak., M.Ak., CA., ACPA
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed
(lent).
Simple Interest Formula
Formula SI = P0(i)(n)
= $1,000(.07)(2)
= $140
Simple Interest (FV)
What is the Future Value (FV) of the deposit?
FV = P0 + SI
= $1,000 + $140
= $1,140
Future Value is the value at some future time of a
present amount of money, or a series of
payments, evaluated at a given interest rate.
Simple Interest (PV)
What is the Present Value (PV) of the previous
problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a future
amount of money, or a series of payments,
evaluated at a given interest rate.
Why Compound Interest?
20000
10% Simple
15000 Interest
10000 7% Compound
Interest
5000 10% Compound
Interest
0
1st Year 10th 20th 30th
Year Year Year
Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2 years.
0 1 2
7%
$1,000
FV2
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000 deposit
over the first year.
This is the same amount of interest you would
earn under simple interest.
Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07) =
$1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)(1.07)
= P0 (1+i)2 =$1,000(1.07)2
= $1,144.90
You earned an EXTRA $144.90 in Year 2 with
compound over simple interest.
General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.
0 1 2 3 4 5
10%
$10,000
FV5
Story Problem Solution
Calculation based on general formula:
FVn = P0 (1+i)n
FV5 = $10,000 (1+ 0.10) 5
= $16,105.10
Calculation based on Table I:
FV5 = $10,000(FVIF10%5)
= $10,000(1.611)
= $16,110 [Due to Rounding]
Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years. Let’s
examine the process to determine how much you
need to deposit today at a discount rate of 7%
compounded annually.
0 1 2
7%
$1,000
PV0
PV1
Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2
= $873.44
0 1 2
7%
$1,000
PV0
General Present
Value Formula
PV0 = FV1 / (1+i)1
PV0 = FV2 / (1+i)2
etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
Valuation Using Table II
PVIFi,n is found on Table II at the end of the book.
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Using Present Value Tables
PV2 = $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Story Problem Example
Agus wants to know how large of a deposit to
make so that the money will grow to $10,000 in 5
years at a discount rate of 10%.
0 1 2 3 4 5
10%
$10,000
PV0
Story Problem Solution
Calculation based on general formula:
PV0 = FVn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Calculation based on Table I:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
Types of Annuities
0 1 2 3
0 1 2 3
$1,145
$1,225
FVAD3 = $1,000(1.07)3 + $3,440 = FVAD3
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440
Valuation Using Table III
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
PVA3 = $1,000/(1.07)1 +
$2,624.32 = PVA3 $1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
Hint on Annuity Valuation
The present value of an ordinary
annuity can be viewed as occurring at
the beginning of the first cash flow
period, whereas the future value of an
annuity due can be viewed as
occurring at the end of the first cash
flow period.
Valuation Using Table IV
PVAn = R (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Overview of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 n-1 n
i% . . .
R R R R
R: Periodic
PVADn Cash Flow
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
PV0
How to Solve?
1. Solve a “piece-at-a-time” by
discounting each piece back to t=0.
2. Solve a “group-at-a-time” by first
breaking problem into groups of annuity
streams and any single cash flow groups.
Then discount each group back to t=0.
“Piece-At-A-Time”
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
“Group-At-A-Time” (#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV0 of Mixed Flow [Using Tables]
General Formula:
FVn = PV0(1 + [i/m])mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FVn,m: FV at the end of Year n
PV0: PV of the Cash Flow today
Impact of Frequency
Julie Miller has $1,000 to invest for 2 Years at an annual
interest rate of 12%.
Annual FV2 = 1,000(1+ [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2)(2)
= 1,262.48
Impact of Frequency
Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+ [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+[.12/365])(365)(2)
= 1,271.20
Effective Annual Interest Rate
(1 + [ i / m ] )m - 1
BWs Effective
Annual Interest Rate
Basket Wonders (BW) has a $1,000 CD at the bank.
The interest rate is 6% compounded quarterly for 1
year. What is the Effective Annual Interest Rate
(EAR)?
EAR = ( 1 + 6% / 4 )4 - 1
= 1.0614 - 1 = .0614 or 6.14%!
Steps to Amortizing a Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.
Amortizing a Loan Example
Julie Miller is borrowing $10,000 at a compound
annual interest rate of 12%. Amortize the loan if
annual payments are made for 5 years.
Step 1: Payment
PV0 = R (PVIFA i%,n)
$10,000 = R (PVIFA 12%,5)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Amortizing a Loan Example
End of Payment Interest Principal Ending
Year Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000