CHAPTER 2

TIME VALUE OF MONEY

 Time Value Of Money
Basic Principle : A dollar received today is worth more
than a dollar received in the future.

• This is due to opportunity costs. The opportunity cost

of receiving $1 in the future is the interest we could
have earned if we had received the $1 sooner.

• This concept is so important in understanding

financial management (investment, stock & bond
valuation etc..)

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 If we can measure this opportunity cost,
we can:
Translate $1 today into its equivalent in the future
(compounding) – Future Value
Today Future

?
Translate $1 in the future into its equivalent today
(discounting)- Present Value
Today Future

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 Future Value (FV)
Compound interest occurs when interest paid
on the investment during the first period is added
to the principal; then, during the second period,
interest is earned on this new sum.

• Compounding is the process of determining the

Future Value (FV) of cash flow.

• The compounded amount (Future Value) is

equal to the beginning amount plus interest
earned.

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 Future Value (FV)
For example : If we place RM 1000 in a savings
account paying 5% interest compounded annually.
How much will it be worth at the end of each year ?
RM 1000 5% 5% 5% 5% 5%

0 1 2 3 4 n..

• Year 1 = RM1000 (1.05) = RM1050.00

• Year 2 = RM1050.00 (1.05) = RM1102.50
• Year 3 = RM1102.50 (1.05) = RM1157.63
• Year 4 = RM1157.63 (1.05) = RM 1215.51
• etc……
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 Future Value (FV)
Formula of Future Value (FV) :

FVn = PV (1+i)n or FVn = PV (FVIFi,n)

where;
FVn = the FV of the investment at the end of n year
n = the number of years
i = the annual interest rate
PV = original amount invested at beginning of the
first year
**(1+i) is also known as compounding factor.

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 Future Value (FV)
For example : If we place RM1,000 in a savings
account paying 5% interest compounded annually.
How much will our account accrue in 4 years?
PV=RM1,000, i =5% & n=4 years.

a) FVn=PV (1+i)n b) FVn = PV (FVIFi,n)

FV4=1,000 (1+0.05)4 FV4 = PV (FVIF5%,4)
=1,000 (1.2155) =1,000 (1.2155)
=RM1,215.50 =RM1,215.50

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 Example:
If Adam invests RM10,000 in a bank where it will earn 6% interest
compounded annually. How much will it be worth at the end of
a) 1 year and b) 5 years?

Compounded for 1 year

a) FV1= $10000 (1+0.06)1 b) FV1 = PV (FVIF6%,1)
= $10000 (1.06)1 = $10000 (1.0600)
= $10,600.00 = $10,600.00

Compounded for 5 year

a) FV5 = $10000 (1+0.06)5 b) FV5 = PV (FVIF6%,5)
= $10000 (1.06)5 = $10000 (1.3382)
= $13,380.00 = $13,382.00

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 Compound Interest With Non-annual
Periods
Non-annual periods : not annual compounding but
occurs semiannually, quarterly, monthly…

If compounding semiannually :
FV = PV (1 + i/2)n x 2 or FVn = PV (FVIFi/2,nx2)

If compounding quarterly :
• FV = PV (1 + i/4)n x 4 or FVn = PV (FVIFi/4,nx4)

If compounding monthly :
• FV = PV (1 + i/12)n x 12 or FVn = PV (FVIFi/12,nx12)

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 PRESENT VALUE (PV)
Present value is the current value of futures sum
Finding Present Values (PVs) is called discounting

We can calculate PV by using this equation :

• PV = FVn or PV = FVn (PVIFi,n)

(1+i )n

**[ 1/(1+i)n ] is also known as discounting factor.

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 PRESENT VALUE (PV)
For example : What is the PV of $800 to be received
10 years from today if our discount rate is 10%.

PV = 800/(1.10)10
= $308.43

or

PV = $800 (PVIF 10%,10yrs)

= $800 (0.3855)
= $308.40

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 Hint for single sum problems:
In every single sum future value and present
value problem, there are 4 variables: FV, PV, i,
and n

When doing problems, you will be given 3

of these variables and asked to solve for the
4th variable.

Keeping this in mind makes “time value”

problems much easier!
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 PV with Multiple, Uneven Cash
Flows
For example: What is the PV of an investment that
yields $300 to be received in 2 years and $450 to be
received in 8 years if the discount rate is 5%?

PV = $300(PVIF5%,2) + $450(PVIF5%,8)
= $300(0.907) + $450(0.677)
= 272.10 + 304.65
= $576.75

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 ANNUITY
An annuity is a series of equal payments for a
specified numbers of years.

100 100 100 100 100

0 1 2 3 4

There are 2 types of annuities*:

- ordinary annuity
- annuity due

*in finance, ordinary annuities are used much more frequently

than are annuities due

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 Ordinary Annuity
Ordinary Annuity is an annuity which the payments
occur at the end of each period.

a) Present Value of Annuity (PVA)

Present Value of Annuity (PVA) can be calculated
by using these equations:

PVAn = PMT / (1+i)n or PVAn = PMT (PVIFAi,n)

For example: Find the PV of $500 received at the end

of each year of the next 3 years discounted back to
the present at 10%?

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 Ordinary Annuity
Solutions:
a) PVA3 = (500/1.10)1 + (500/1.10)2 +
(500/1.10)3
= 454.55 + 413.22 + 375.66
= $ 1243.43

OR

b) PVA3 = 500 (PVIFA10%,3)

= 500 (2.487)
= $ 1243.50

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 Ordinary Annuity
b) Future Value of Annuity (FVA)
Compound Annuity / Future Value of Annuity (FVA)
can be calculated by using these equations :

FVAn = PMT (1+ i)n or FVAn = PMT (FVIFAi,n)

For example : We are going to deposit $15,000 at the

end of each year for the next 5 years in a bank where
it will earn 9% interest. How much will we get at the
end of 5 years?

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 Ordinary Annuity
Solutions:
a) At the end of 5 years, we will get…
FVA5 = 15000(1.09)4 + 15000(1.09)3 +15000(1.09)2
+ 15000(1.09)1 +15000
= 21173.72 +19425.44 + 17821.50 + 16350 +
15000
= $89,770.66
OR
b) By using FVIFA table
FVA5 = 15000 (FVIFA9%,5)
= 15000 (5.9847)
= $89,770.50

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 Annuity Due
Annuity Due is an annuity in which the payments
occur at the beginning of each period.

a) Future Value of Annuity Due (FVAD)

FVADn = PMT (FVIFAi,n) (1+i)

b) Present Value of Annuity Due (PVAD)

PVADn = PMT (PVIFAi,n) (1+i)

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 Annuity Due
For example (FVAD): We are going to deposit
$1,000 at the beginning of each year for the
next 5 years in a bank where it will earn 5%
interest. How much will we get at the end of 5
years?

FVADn = PMT (FVIFAi,n) (1+i)

= 1000 (5.526) (1 + 0.05)
= $5802.30

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 Annuity Due
For example (PVAD) : Find the PV of $500
received at the beginning of each year of
the next 5 years discounted back to the
present at 6%?

PVADn = 500 (PVIFA6%,5) (1+0.06)

= 500 (4.212) (1 + 0.06)
= $2,232.36

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 Amortized Loan
Amortized loan is a loan that paid off in equal
installments.

To determine the installment (payment) we can use

this formula :
PMT = Loans
PVIFAi,n

Each installment consists partly of interest and

partly of repayment of principal. This breakdown is
given in the amortization schedule.

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 Amortized Loan
For example: Daniel wants to accumulate
RM75,000 by the end of five (5) years. Assume
that the fund will earn an interest at 9.5%
compounded annually.

PMT = $75000/ PVIFA9.5%,5

= $10000 / 6.0446
= $ 12,407.73

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 Loan Amortization Schedule
Beginning Annual Interest Accumulated
Year Balance Deposit Generated Amount
(1) (2) (3) (1)+(2)+(3)=(4)

1 0 12,407.73 0 12,407.73

2 12,407.73 12,407.73 1,178.74 25,994.20

3 25,994.20 12,407.73 2,469.45 40,871.38

4 40,871.38 12,407.73 3,882.78 57,161.89

5 57,161.89 12,407.73 5,430.38 75,000

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 Perpetuity
Perpetuity is an annuity that continues forever.

The equation representing the present value of

annuity:
PV = PP
i

where,
PV= PV of the perpetuity
PP= Constant dollar amount provided by perpetuity
i = interest rate

25 SITI AISHAH BINTI KASSIM (FM2)

 THE END

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