W2 Time Value of Money
W2 Time Value of Money
W2 Time Value of Money
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1
The Time Value of Money
• What a difference between Tk.1 today and Tk.1 in a
year’s time?
• Factors change the value of money
– Interest cost
– Inflation
– Other risks to materialise the money
2
Simple Interest
In its most basic form, interest is calculated by multiplying
principal (amount invested) by rate (percent of interest)
multiplied by time (number of periods the interest is
calculated). This is called simple interest.
I=Prt
Example: A Tk.1,000 deposit at 8% per year for three years'
simple interest: I = (1000)(.08)(3) = 240
Expressed as a formula:
FV = P(1 + rt)
FV = (1000)+(1000)(.08)(3) = Tk.1240
Future Value: Less than a year
Note: Usually simple interest is used in financial
institutions for interest periods of less than one year.
If the rate is expressed as an annual rate (normal
practice), then the time period (t) must be a fraction of
a year.
FV
PV = (1+rt)
Discount and Present Value (PV): Example
Repeating the discount basic formula (simple interest):
FV
PV = (1+rt)
Example: If the bank loans out Tk.10,000 for 90
days at 8% simple interest, the PV is:
PV = 10000 / [1 + (.08)(90/365)]
= 10000/ 1.019726
= Tk.9,806.56
Compound Interest (1):
Compound Interest: If interest is left in the account to
accumulate for a longer period (usually longer than
one year), interest is earned and credited for a given
period, the new sum of principal + interest must now
earn interest for the next period, etc.
FV
FV = P(1 + r)n PV = (1+r) n
Compound Interest (2): Example
Suppose we invest our original Tk.1,000 for 3 years at
8%, compounded quarterly.
(The rate per quarterly period is 8% / 4 or 2%. The number of periods
(n) is 3 x 4 = 12 quarterly periods.)
FV = P(1 + r)n
FV = 1000 x [1+0.02)12 = Tk.1,268.24
If we wanted to know how much we'd have to invest
now (PV) at 8% compounded quarterly to earn
Tk.10,000 in 3 years:
PV = 10000 / (1.02)12 = Tk.7,884.93
Compound Interest (3): Use of Table
FV 100,000
PV 0
Rate 0.0066667 8% / 12
Nper 120 10 yrs x 12
=PMT Tk.546.61
Annuities (5): Example
Illustration (2): When Joe retires on his 65th birthday,
his retirement fund carries a balance of Tk.240,000. If
Joe transfers this balance into a fund earning 8% to pay
him or his heirs Tk.2,000 per month until the fund is
exhausted, how long can this annuity last?
FV 0
PV -240,000
Pmt 2,000
Rate 0.006667 8% / 12
=NPER 242.2195
Approx 242 months—just over 20 years! (Assuming 8% is
consistent and there is no risk of loss of principal!)
Amortization (Mortgages) (1):
Finally, if we take out a long term loan, such as a
mortgage, or a car loan based on the true APR, the
interest expense is calculated for each month based
on the unpaid balance of the loan.
A fixed monthly payment is computed from which is
first deducted the monthly interest, and the balance is
applied to reduce principal. The new interest is then
recalculated the next month based on the lower
principal.
This generates a schedule of all loan payments,
interest and principal applied, and outstanding balance
called an amortization schedule.
Amortization (Mortgages) (2):
In the early months of an amortization schedule, much
(perhaps most) of the monthly payment goes toward
interest because the unpaid balance is so large. As the
principal is paid down, more and more of each payment
is applied toward principal.
Example: in a 30 year Tk.100,000 home mortgage at 9%, the
required monthly payment is Tk.804.63 (round up 1 cent)
PV -100,000
Nper 360 (30 yrs)
Rate 0.0075 9% / 12
FV 0
=PMT Tk.804.62
Annuity calculation
A Father is planning a savings program to put his daughter through
University. His daughter is now 13 years old. She plans to enroll at
the University in 5 years, and it should take her 4 years to complete
her education. Currently, the cost per year (for everything- food,
clothing, tuition, books, transportation, and so forth) is Tk.100,000,
but a 5 percent inflation rate in these costs is forecasted. The
daughter recently received Tk.50,000 from her grandfather’s estate;
this money, which is invested in a bank account paying 9% interest
compounded annually, will be used to help meet the costs of the
daughter’s education. The rest of the costs will be met by money
the father will deposit in the savings account. He will make equal
deposits to the account in each year from now until his daughter
starts university. These deposits will also earn 9 % interest.
If the first deposit is made today, how large must each deposit be in
order to put the daughter through university?
Solution:
Universi Current Cost Years from Inflation Cash Required*
ty Year now
1 100000 5 (1.05)5 127630
2 100000 6 (1.05)6 134010
3 100000 7 (1.05)7 140710
4 100000 8 (1.05)8 147750