Personal Finance Notes

Time value of money concepts

Introduction

Time value of money concepts are required whenever we are dealing with the analysis and
valuation of financial transactions. Specifically, our concern is with the cash flows that occur
over time in relation to financial decisions. These cash flows are associated with the
purchase and sale of financial securities and the entering into of financial contracts.

As noted in this course, three elements are central to our analysis of time value of money
problems: cash flows, risk‐adjusted returns and time. The connection between each cash
flow in future times (its future value (FV) or accumulated sum (S)) and its present value (PV)
(in some cases referred to as the principal (P)—the cash flow’s current, or time zero,
equivalent value—is made through the rate (r) (e.g., an interest rate) at which funds may
either be invested or borrowed over the relevant time period (t or T).

For simplicity, in this course we mainly use Excel to solve our time value of money problems.
And, with the problems we mainly focus on, there are 5 possible variables of concern in our
most commonly‐used Excel functions. These are: RATE (the r per time period (e.g., day,
month, year)), NPER (the number of time periods; i.e., the no. of days, months, years), PMT
(the payment made in each time period, which will be 0 for single sum calculations), PV (the
present value, if we want to know the current dollar value), and FV (the future value, if we
want to know in terms of future dollar sums). If we know any 4 out of the 5 of these values,
then there is a formula in Excel that allows us to solve for the remaining value (i.e., =PV, =FV,
=RATE, =PMT, =NPER). So, the choices are very limited, and you must work out for which one
of these 5 values you are attempting to get a solution. Finally, in most calculations that we
deal with, one of PV, FV or PMT will equal 0, as a result of the problem being considered.

Cash flow conventions and time diagrams

Because our use of time value of money methods involves applications to the cash flows that
arise from investing and the lending and borrowing of money, our analyses of these
situations is assisted by the adoption of several conventions. One of these is that cash
inflows will be regarded as having a positive (+) sign, whilst cash outflows will be regarded as
having a negative (‐) sign. For example, if you borrow $1,000, this provides you with a cash
inflow, that we would designate by writing +$1,000. If you then repaid this sum plus a
hundred dollars interest at the end of one year, we would designate the resultant cash
outflow by writing ‐$1,100.

To further assist us in the analysis of lending and borrowing, we use diagrams that allow us
to explicitly introduce the dimension of time to the treatment of cash flows. Our convention
is to draw cash inflows—a positive cash flow; that is, a cash flow to us—above a horizontal

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time line showing when they occur. Cash outflows—a negative cash flow; that is, a cash flow
away from us—are drawn below this horizontal line.

To illustrate, consider a loan of $1,000, repaid by a sum of $1,100 (including $100 interest)
after one year. From the borrower’s viewpoint these cash flows are represented as follows:

+$1,000

Year 1

-$1,100

From the lender’s viewpoint the cash flows are, of course, algebraically opposite in sign. So,
the cash flows from the same loan are represented in the following way:

+$1,100

Year 1

-$1,000

Note also, that while we have included in the above diagram ‘+’ and ‘‐‘ signs in front of the
cash inflows and cash outflows, respectively, this is often ignored. If a line in the diagram is
below the horizontal line, then by convention it is a cash outflow; if above, a cash inflow.

To extend the analysis to multiple time periods, suppose that you borrow $200—a cash
inflow of $200 (+$200)—then repay that amount at the end of each of two years through
equal instalments of $110—successive cash outflows of $110 (2  ‐$110). This is represented
in a time diagram as:

+$200

Year 1 Year 2
-$110 -$110

Incidentally, does this example imply that the interest rate on the loan is 5% per annum? The
answer is no, although this might appear to be the case.

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It is true that $20 total interest has been paid on a debt of $200, spread over two years (10%
total interest based on the value of the principal, divided into two components of 5%). Using
one scale for measuring the cost of interest—as a flat rate over the life of the loan—the rate
is expressed as 5% pa. However, observe that the first repayment of $110 will repay part of
the debt, so the original amount borrowed—$200—will not continue to be owed after the
first payment. Note also, that since all the funds and interest will be repaid by the end of the
second year, that the FV of this loan is zero.

In fact, the actual interest rate implied in this series of cash flows—the interest rate that
results in the cash outflows having the same total time‐zero value as the time zero cash
inflow—is 6.5965% (using Excel, =RATE(2,‐110,200,0)).

The nature of interest

Interest is both a charge to the borrower for the use of money, and a return to a lender for
foregoing current consumption. For our purposes, an interest rate will be considered as a
measure (or scale) of the cost of money.

Simple interest

Simple interest (i) is where the amount of interest (I) is calculated on the original sum
invested or borrowed—this sum being the principal (P). That is, compounding of interest—
the payment of interest on interest already accumulated (see below) does not occur. Thus,
the amount of interest paid is in direct or linear proportion to the time over which the
money is borrowed and the interest rate itself. Usually, time is expressed in years (t), or
fractions of years. Thus, if the simple interest rate per year (per annum) is denoted by the
symbol r, the amount of interest to be paid after t years is given by:

𝐼 𝑃 𝑟 𝑡. Eqn. 1

Because of the characteristic that interest is directly proportional to time, this expression is
also valid for fractions of a year.

Simple interest is mainly used for short‐term transactions, where absence of compounding
doesn’t matter a great deal. Business examples include interest calculated on Bills and
Promissory Notes. Consumer applications are for instruments such as bank deposits.

If we invest or borrow P (the principal) at a rate of interest r for t years, the interest paid will
total P  r  t. Thus, the sum to which the original principal P will accumulate, including
interest, will be P + (P  r  t), which simplifies to

𝑆 𝑃1 𝑟 𝑡 . Eqn. 2

S is the accumulated sum.

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Example 1: How much would you repay on a loan of $1,000 at simple interest of 10% per
annum if you repay the debt in full, including interest, after two years?

This requires us to determine to what sum the $1,000 will accumulate.

S = 1,000[1 + (r  t)] = 1,000[1 + (0.10  2)] = 1000(1.2) = $1,200

The converse of the accumulated sum is the concept of present value (PV or P). This may be
defined as the sum of money that if exchanged ‘now’ (i.e., at the present time), is equivalent
to the receipt of S, in t years’ time, when the available rate of interest is r. By rearrangement
of the above equation, we obtain:

𝑃 . Eqn. 3

Example 2: You wish to accumulate a fund of $1,200 after two years. How much (i.e., what
PV or ‘value’) would you need to deposit now, if you can earn 10% per annum simple
interest?
$ ,
𝑃𝑉 $1,000.
.

Example 3: You can invest $20,000 in a bank fixed deposit for 90 days at 6.2% per annum.
Calculate the amount of interest that you will earn?
Here t = 90/365 = 0.246575 years, so we have:

I = P  r  t = $20,000  0.06  0.246575 = $295.89

Compound interest
Unlike simple interest, the amount of compound interest paid (or received) is not in direct or
linear proportion to the principal. Rather, interest is accumulated every compounding
period, through its addition to the original principal. Then, the amount of the next interest
payment is calculated on the sum of principal and interest accumulated to this date. That is,
interest is paid on the previous amounts of interest that have been added to the principal, as
well as the principal itself. This process is then repeated at the next compounding date.

For example, it is implicit from an earlier example that at 10% per annum (abbreviated as
p.a.) simple interest, $1,000 will grow to $1,100 after one year, $1,200 after two years and
$1,300 after three years. In contrast, at 10% per annum compound interest, $1,000 will grow
to $1,100 after one year but to $1,210 after two years and $1,331 after three years:

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Compounded and simple values accumulated

from $1,000 at 10% per annum

1600
Compound
1500

Simple
1400
$
1300

1200

1100

1000
0 1 2 3 4 5
Year

Compound interest is said to exhibit exponential behaviour, which means that the
accumulated sum is increasing at an increasing rate. We can see from the above graph that
the amount of interest is increasing each year—$100 to $110 to $121. Further, the size of
the increase in the dollar amount of the interest payment is itself becoming greater from
one year to the next—$10 ($110 ‐ $100) to $11 ($121 ‐ $110), and so on.

In order to be exact when discussing compound interest, we must employ some terminology
and symbols with clearly defined meanings.

The rate of interest is usually denoted i per period, compounded m times per annum (m
represents the number of compounding periods per year). Alternatively, this same rate i may
be expressed as a nominal rate per annum j defined as j = m x i. To add further precision, the
interest rate (j) can be written with the subscript character m. That is, the symbol jm reads as
‘the nominal interest rate is j p.a. (again, per annum), compounded m times per annum’
(meaning at a rate per period of i, compounded m times per year, where i = j/m)

To sum up:

𝑗 𝑚 𝑖 𝑜𝑟

𝑖 . Eqn. 4

Example 4: If j4 = 8% p.a., what is the rate of compound interest per quarter?

Since the subscript ‘4’ stands for m, i = j/m = 8/4% = 2% per quarter. This means interest is
compounded four times per year, at a rate of 2% per quarter.

Previously, the accumulated sum was defined as the sum of money (S) to which the principal
(P) will grow. Let’s now attach the subscript t to S. That is, St means the accumulated sum

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after t periods. Also, let’s use the symbol It to denote the amount of interest paid at the end
of period t. Now to derive an expression for St.

At the end of the first period, the accumulated sum S1 will equal P plus the first period’s
interest, I1. But I1 is equal to the principal times the rate of interest i. That is, I1 = P  i.

Summarising and simplifying (i.e., simplifying in the algebraic sense),

𝑆 𝑃 𝐼 𝑃 𝑃 𝑖 𝑃 1 𝑖 .

Similarly, we can reason

𝑆 𝑆 𝐼 𝑆 𝑆 𝑖 𝑆 1 𝑖 .

But we have shown:

𝑆 𝑃 1 𝑖 ,

so

𝑆 𝑃 1 𝑖 1 𝑖 𝑃 1 𝑖 .

Next,

𝑆 𝑆 𝐼 𝑆 𝑆 𝑖 𝑆 1 𝑖 𝑃 1 𝑖 1 𝑖 𝑃 1 𝑖 .

The pattern emerging is that each S’s subscript is equal to the exponent of (1 + i). That is,
more generally,

𝑆 𝑃 1 𝑖 . Eqn. 5

Note that, since i = j/m, the latter may be substituted for i in this equation.

𝑆 𝑃 1 . Eqn. 6

Example 5: How much will you have after 1½ years if interest is at 5% per half year (10% p.a.,
compounded twice annually) and you commence with $100? That is, how much will $100
accumulate to after 3 half years at 5% per half‐year?

S3 = 100(1 + 5%)3 = 100(1.05)3 = 100(1.1576) = $115.76.

You can solve this using Excel’s FV function (=FV(0.05,3,0,‐100)).

Before doing so, you should note that the accumulated sum St is represented by future value
(FV), whilst the principal P is represented by present value (PV), and that the cash‐flow
conventions are correctly adhered to (i.e., cash inflows at one point in time, require cash
outflows at another). So, to get the cash inflow of $115.76 in 1½ years, we need to have a
cash outflow (i.e., deposit or invest) $100 now.

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 Personal Finance Notes

Present value, PV (or P), is defined as the sum of money which, if exchanged ‘now’, would be
equivalent to receiving St at the end of t periods in the future, if interest is at i per period.
That is, if we know St, we can determine what sum invested or borrowed now, P, would
accumulate to that future value given that it could be invested or lent at i% per period.

𝑃 . Eqn. 7

The right‐hand side of the equation can also be written as:

𝑆 1 𝑖 , Eqn. 8

where the minus (‘‐‘) sign on the exponent (the t) indicates the inverse of the term in
brackets is to be used.

Dividing St by (l + i)t, which is equivalent to multiplying it by (l + i)‐t, is known as discounting

the sum St to its present value, PV. The quantity l/(l + i)t, or (l + i)‐t is thus called a discount
factor (DF). It is the discount factor that is used to convert a given accumulated sum to its
present value. In some books, it is identified by the symbol PVF (Present Value Factor), or
PVIF (Present Value Interest Factor).

Example 6: A loan was repaid by a lump sum (including interest) of $115.76, after 3 years. If
interest was at 5% per annum, how much was borrowed?
The relevant time‐diagram (from the viewpoint of the borrower) is given below.

+$100

Year 1 Year 2 Year 3

-$115.76

Solution by Excel =PV(0.05,3,0,‐115.76) = $100.

To solve for any component of a compound interest problem involving single sums, you need
to know 3 of the following 4 variables (PMT will be 0 in the case of single‐sum problems).
These are the: RATE (interest rate per period, i); NPER (the number of periods); PV (or P) (the
present value); and FV (or St) (the future value).

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We have shown how to calculate the FV and how to calculate the PV. If you need to know
the interest rate, i, given the other 3 values, you can use the RATE function in Excel. Or, to
find the no. of time periods, the NPER function.

Simple annuities

Introduction
The tools developed in the previous section apply to the FV, or PV, of a single sum of money
at compound interest. An annuity involves a stream of these single sums (or payments).
Usually, the payments are of equal amount, denoted by the symbol R (or, in Excel, by PMT)
with these payments being made over equal time intervals over the life (or maturity) of the
annuity. A typical example of an annuity is a housing or car loan—the first repayment is
generally required on the last day of the month in which the loan is advanced, then at
monthly intervals thereafter.

Most annuities of the types described above are members of a set known as simple
annuities. These annuities are such that interest compounding or charging occurs at the
same frequency as the payments. For example, interest being charged (compounded)
monthly on a loan for which the payments are also made on a monthly basis. However,
there are also general annuities, which feature interest compounding at a frequency that
differs from that of the annuities’ stream of payments.

Accumulated sum of a simple ordinary annuity

First, we will develop a mathematical expression to value St, in this case being the
accumulated sum of a stream of payments of $R each time period. This may be achieved by
finding the accumulated sum at time t of each individual payment, adding these to obtain
the total accumulated sum of the annuity, then simplifying this result. Looking at the first R,
it will accumulate interest for one less than t periods (since it was deposited at the end of
the first period), so its accumulated sum will be R x (l + i)t‐1. The second payment will
accumulate to R x (l + i)t‐2, and so on.

The annuity’s accumulated sum, St, forms the following series. The series is obtained by
adding up the accumulated sums of each of the respective payments of R, and calculating
the FV of each given the number of time periods over which it will accumulate interest, and
the interest rate per period:

𝑆 𝑅 1 𝑖 𝑅 1 𝑖 ... 𝑅 1 𝑖 𝑅 1 𝑖 𝑅.

Multiplying both sides of the equation by (l + i) we obtain:

𝑆 1 𝑖 𝑅 1 𝑖 𝑅 1 𝑖 ... 𝑅 1 𝑖 𝑅 1 𝑖 𝑅 1 𝑖

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so
𝑆 1 𝑖 𝑅 1 𝑖 𝑅 1 𝑖 𝑅 1 𝑖 ... 𝑅 1 𝑖 𝑅 1 𝑖
𝑅 1 𝑖 𝑅 1 𝑖 .

Subtracting the first of the equations that have just been written from the second:

𝑆 1 𝑖 𝑆 𝑅 1 𝑖 𝑅,

since all other terms cancel out.

Expanding the LHS of the equation and simplifying its RHS we obtain:

𝑆 𝑆𝑖 𝑆 𝑅 1 𝑖 1
so
𝑆 𝑅 . Eqn. 9

If the payment amount, R, in equation 9 is $1, then the equation simplifies to:

𝑆 . Eqn. 10

That is, this is an expression for the accumulated sum of $1 per period, or the Future Value
Annuity Factor (FVAF) for t periods at rate i per period.

Example 7: Use equation 9 to find the accumulated sum of $100 at the end of each year for 3
years if i = 10% per annum.
Here R (PMT) = $100, t (NPER) = 3, i (RATE) = 0.10 (10%). Substituting in equation 9:

1 0.1 1
𝑆 100
0.1
𝑆 $331.

Confirming this, using Excel’s FV function, =FV(0.1,3,‐100,0) = $331. Note that this time PMT
is not zero (but, PV is!).

Example 8: Confirm the answer in Example 7 by summing the future values of the respective
individual payments.
This leads to the following time diagram:

100(1.1)2
100(1.1)
100
100 100 100
0 1 2 3

So, S3 = 100 (1.1)2 + 100 (1.1) + 100 = 121+ 110+ 100 = $331.
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 Personal Finance Notes

We now present another simple illustration of a ‘real world’ kind which combines the
accumulated sum of a single amount with that of an annuity.

Example 9: The Prime Minister opened a savings account with a deposit of $300.
Subsequently deposits of $200 are made quarterly, interest being paid at j4 = 8%. If a silk suit
costs $1,200, by how much would the Prime Minister be ‘short’ of the requisite sum, after a
year?
It should be clear that the shortfall will be the difference between $1,200 and the
accumulated sum of the above savings pattern. The accumulated sum of the initial deposit
is:

$300 x (1.02)4 = $324.73.

The accumulated sum of the subsequent annuity is:

1 0.02 1
𝑆 200
0.02
𝑆 $824.32.

So, savings will total $1,149.05. Thus, the shortfall is $50.95.

We can consider the Excel solution. Its inputs are:

PV PMT NPER RATE

‐300 ‐200 4 0.02

=FV(0.02,4,‐200,‐300) = $1,149.05. Note that this time, as there was an initial deposit, that
PMT is not 0.

Example 10: A financial adviser has attempted to sell you an investment product which,
based on past performance, is expected to earn a return of 12% p.a. However, you have
discovered that there is a joining fee of $4 per $100 invested as well as an annual
administration fee of $1 per $100 originally invested. If you plan to collect the proceeds of
the investment after 5 years, what will be your rate of return? (Annual income is reinvested,
and the annual administration fee is deducted at the end of each year).

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The relevant time diagram, from the investor’s viewpoint is:

+$St

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
-$100

However, as concerns the managers of the investment product, they will only be investing
$96 (= $100 ‐ $4) and they will be deducting an annuity of $1, at the end of each year, from
your account. Thus, using Excel, your payoff will be:

=FV(0.12,5,0,‐96) minus =(FV(0.12,5,‐1,0))

= $169.18 ‐ $6.35 = $162.83.

Now, returning to the investor, an outlay of $100 is expected to return $162.83 immediately
after 5 years have elapsed. In terms of the rate of return (i), this is given by using Excel’s
RATE function. We have =RATE(5,0,‐100,162.83) = 0.1024 (10.24% p.a.). Thus, we can
conclude that the effect of the various charges is to reduce the investor’s expected return to
about 10% p.a.

Finally, if one wishes to be doubly sure about the sum to which the investment is expected
to accumulate, a schedule can be drawn‐up as in the following table:

Year Opening balance + Interest ‐ Fee Closing balance

1 96.00 11.52 ‐1.00 106.52

2 106.52 12.78 ‐1.00 118.30

3 118.30 14.20 ‐1.00 131.50

4 131.50 15.78 ‐1.00 146.28

5 146.28 17.55 ‐1.00 162.83

Present Value of a Simple Ordinary Annuity

The present value (PV) of a simple ordinary annuity is the sum of money which, if exchanged
‘now’, is equivalent to t payments of $R each, at the end of each period, with interest
compounded at i per period. The present value represents, for example, the amount of a
loan which is subsequently repaid by instalments of $R at the end of each period. Our first

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task is to develop an expression for PV. Of course, we could consider the series of discounted
cash flows from which PV is derived, but there is a simpler way. Remembering that:

𝑃 , and that

𝑆 , it must be that

𝑃 .

Dividing the numerator and denominator by (1 + i)t gives:

𝑃 . Eqn. 11

Example 11: Find the present value of an annuity of $100 at the end of each of 3 periods if i =
10%.
Here, R = 100, t = 3, i = 0.10 (10%). Using equation 11:

100 1 1 0.1
𝑃 $248.69.
0.1

Using Excel the solution is found as =PV(0.1,3,‐100,0), giving $248.69. Note that FV is 0 in this
case.

Example 12: You obtained a personal loan which was repaid by regular, monthly instalments
of $50 for two years, followed by a lump‐sum payment of $200 a month later. Interest was
at j12 = 18% p.a. (or 1.5% per month). How much was borrowed?
The sum borrowed is the present value of the subsequent cash flows, which are now shown
on a time diagram:

+$P

0 1 2 23 24 25

-$50 -$50 -$50 -$50

-$200

The solution of this problem requires determination of the total present value (PV) of the
annuity ($50 per month for 24 months) plus the present value of the final, single payment of

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$200. Using Excel =PV(0.015,24,‐50,0) plus =PV(0.015,25,0,‐200), so PV = $1,001.52

$137.84 $1,139.36.

Notice that the relevant term (NPER) differs in the respective equationsꟷthe annuity is 24
months, whereas the $200 payment occurs after 25 months.

A credit foncier loan is an application of a simple ordinary annuity. A credit foncier loan has
equal periodic repayments which ‘amortise’ the loan (reduce the balance to zero) over the
term of the loan. These payments include an interest component as well as a principal‐
reduction component.

Perpetuities
A perpetuity is a perpetual annuity—the payments continue to infinity. The simplest form of
perpetuity features perpetual payments (R dollars each) at the end of each period forever.
Its present value is:

𝑃 . Eqn. 12

Example 13: You expect a share to pay a dividend of $1.00 at the end of each year, in
perpetuity. If you require an interest rate (rate of return) equal to 8% p.a. on this
investment, how much would you be willing to pay for the share now (i.e., what is its PV?).
.
𝑃𝑉 $12.50.
.

This answer makes sense, because a dividend of $1.00 each year represents 8% of $12.50.

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