Time Value of

Money
Muamar Nur Kholid, SE., Ak., M.Ak., CA., ACPA

Semester Ganjil 2021/2022

 The Time Value of Money

 The Interest Rate

 Simple Interest
 Compound Interest
 Amortizing a Loan
 Compounding More Than Once per Year
 The Interest Rate

Which would you prefer -- $10,000 today

or $10,000 in 5 years?

Obviously, $10,000 today.

You already recognize that there is TIME

VALUE TO MONEY!!
 Why TIME?

Why is TIME such an important element

in your decision?

TIME allows you the opportunity to

postpone consumption and earn INTEREST.
 Types of Interest

 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)

SI: Simple Interest

P 0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
 Simple Interest Example
Assume that you deposit $1,000 in an account
earning 7% simple interest for 2 years. What is
the accumulated interest at the end of the 2nd
year?
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?

Future Value of a Single $1,000 Deposit

Future Value (U.S. Dollars)

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.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I
 Valuation Using Table I
FVIFi,n is found on Table I at the end of the book.
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Using Future Value Tables
FV2 = $1,000 (FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Story Problem Example
Julie Miller wants to know how large her deposit of
$10,000 today will become at a compound annual interest
rate of 10% for 5 years.

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

 An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
Ordinary Annuity: Payments or receipts occur
at the end of each period.
Annuity Due: Payments or receipts occur at the
beginning of each period.
 Examples of Annuities

• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
 Parts of an Annuity
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Parts of an Annuity
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .
R R R
R = Periodic
Cash Flow

FVAn = R(1+i)n-1 + R(1+i)n-2 + FVAn

... + R(1+i)1 + R(1+i)0
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
 Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as occurring
at the end of the last cash flow
period, whereas the future value of
an annuity due can be viewed as
occurring at the beginning of the
last cash flow period.
 Valuation Using Table III
FVAn = R (FVIFAi%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215
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 View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
i% . . .
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + FVADn

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070

$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

PVADn = R/(1+i)0 + R/(1+i)1 + ... + R/(1+i)n-1

= PVAn (1+i)
 Example of an
Annuity Due -- PVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%

$1,000.00 $1,000 $1,000

$ 934.58
$ 873.44
$2,808.02 = PVADn

PVADn = $1,000/(1.07)0 + $1,000/(1.07)1 +

$1,000/(1.07)2 = $2,808.02
Valuation Using Table IV
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
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
 Steps to Solve Time Value
of Money Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single CF, annuity
stream(s), or mixed flow
6. Solve the problem
7. Check with financial calculator (optional)
 Mixed Flows Example
Julie Miller will receive the set of cash flows
below. What is the Present Value at a discount
rate of 10%.

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]

$600(PVIFA10%,2) = $600(1.736) = $1,041.60

$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) = $100 (0.621) = $62.10
 “Group-At-A-Time” (#2)
0 1 2 3 4

$400 $400 $400 $400

$1,268.00
0 1 2 PV0 equals
Plus
$200 $200 $1677.30.
$347.20
0 1 2 3 4 5
Plus
$100
$62.10
 Frequency of Compounding

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

Effective Annual Interest Rate

The actual rate of interest earned (paid) after
adjusting the nominal rate for factors such
as the number of compounding periods per
year.

(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

[Last Payment Slightly Higher Due to Rounding]

 Usefulness of Amortization

1. Determine Interest Expense -- Interest

expenses may reduce taxable income of the firm.

2. Calculate Debt Outstanding -- The quantity of

outstanding debt may be used in financing the
day-to-day activities of the firm.