TIME VALUE OF MONEY
KOH HO THONG
MBA, BBA (Hons), DHE (Accounting)
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Contents
Time Line
Future Value
Present Value
Future Value Of Ordinary Annuity
Future Value Of Annuity Due
Present Value Of Ordinary Annuity
Present Value Of Annuity Due
Perpetuity
Compounding And Discounting More Than Once A Year
Continuous Compounding And Discounting
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Time Value Terminology
0 1 2 3 4
PV FV
Future value (FV) is the amount an investment is
worth after one or more periods.
Present value (PV) is the current value of future
cash flows of an investment.
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Time Value Terminology
The number of time periods between the present
value and the future value is represented by ‘t’.
The rate of interest for discounting or
compounding is called ‘r’.
All time value questions involve four values: PV,
FV, r and t. Given three of them, it is always
possible to calculate the fourth.
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Future Value of a Cash Flow
At the end of year n for a sum
compounded at interest rate i is
FVn = PV0 ( 1 + i )n Formula
In Table 1 in the text, ( FVIFi,n ) shows
the future value of $1 invested for n
years at interest rate i FVIFi,n = ( 1 + i )n
When using the table,
FVn = PV0 ( FVIFi,n )
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Future Value
6
Future Value
7
Future Value
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Exercise
1. Assume that you keep RM5,555 in the
savings account at Affin Bank with an interest
rate of 15% per year for 5 years. How much
potential return will you obtain at the end of the 5
year period?
2. If you keep RM4,321 in the savings account at
Maybank with an interest rate of 7% per year for
2 years, how much potential return will you
obtain at the end of the 2 years period?
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Present Value
10
Present Value
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Present Value
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Exercise
1. Assume that you are given the opportunity to
purchase a low risk security that promised a
payment of RM127.63 at the end of the period of
5 years with an interest rate offer of 5% per year.
How much is the present value for RM127.63?
2. You plan to accumulate savings money in the
bank for RM6,213 in a period of 5 years from
now. How much savings must you make now if
the interest rate offered by the bank is 12% per
year?
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Annuities
An ordinary annuity is a series of constant
cash flows that occur at the end of each
period for some fixed number of periods.
Examples include consumer loans and
home mortgages.
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Future Value of Ordinary Annuity
Ordinary annuity is annuity that occurs at
the end of each period
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Future Value of Ordinary Annuity
Danon Company deposited RM5,000 at
the end of each year for a period of 3
years consecutively in an account that
pays a yearly interest of 10 percent. What
is the future value of that annuity?
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Future Value of Annuity Due
Sometimes we face a situation where the
payment of annuity is at the beginning of a
period, for example, the beginning of each
month or year.
This type of annuity is known as annuity
due where it is different from ordinary
annuity as ordinary annuity is paid at the
end of a period.
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Future Value of Annuity Due
Danon Company deposited RM5,000 at
the beginning of each period for 3 years
consecutively in the account that pays
yearly interest of 10 percent. How much is
the future value for that annuity?
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Exercise
1. Assume you had deposited RM100 into the
bank at the beginning of the year for 3 years in
the savings account that gives 5% interest rate.
How much can be obtained at the end of the
third year?
2. Mr. Yeoh deposited RM10,000 into the bank
on 31st December each year for 5 years at an
interest rate of 10%. How much can he obtain at
the end of the fifth year?
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Present Value of Ordinary Annuity
Payment of annuity promises a return rate
(investment in bonds) and cash flow (cash
flow resulting from investment in
equipment and plant).
Therefore, it is important for a finance
manager to know the value of the
investment at the present time.
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Present Value of Ordinary Annuity
Taming Company expects to receive
RM3,000 at the end of each year for 3
consecutive years. How much is the
present value for that annuity if it is
discounted at the rate of 6% per year?
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Present Value of Annuity Due
Taming Company expects to receive
RM3,000 at the beginning of each year for
consecutive 3 years. How much is the
present value of that annuity if it is
discounted at the rate of 6% per year?
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Exercise
You are offered an annuity payment of
RM100 at the end of each year for 3 years
and is deposited into the bank. The
interest rate offered is 5% per year. How
much is the present value of that annuity
payment?
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Perpetuities
The future value of a perpetuity cannot be
calculated as the cash flows are infinite.
The present value of a perpetuity is calculated
as follows:
C
PV
r
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Perpetuities
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Exercise
Consider the perpetuity that pays RM100
per year, with an interest rate of 10%. How
much is the present value of this
perpetuity?
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Compounding And Discounting
More Than Once A Year
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Continuous Compounding And
Discounting
What is the future value for RM100 that is
invested now for 6 years with an interest
rate of 8 percent per year and
compounded continuously?
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Continuous Compounding And
Discounting
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Exercise
1. What is the future value for RM260 that
is invested now for 3 years at the interest
rate of 10 percent per year and
compounded continuously?
2. What is the present value for RM200
that will be received 5 years from now and
discounted continuously at the interest
rate of 6 percent per year?
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Exercise
3. Mr. Sarbat plans to invest RM3,000 a year in
the Pension Investment Scheme for a period of
15 years. Mr. Sarbat wants to know the result of
the RM3,000 investment at the beginning of
each year compared with the end of each year.
Calculate the value differences between the two
types of cash flow if the interest rate is 8 percent
per year.
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Exercise
4. Mas Joko Company is considering an
investment on a new machine that involves a
total purchase and assembly cost of RM30,000.
The usage of this new machine is expected to
generate a yearly cash flow for 5 consecutive
years: end of first year RM4,000, end of second
and third year RM5,000, end of fourth year
RM6,000 and end of fifth year RM8,000. If the
company requires a yearly 18% rate of return on
its investment, is it reasonable for the company
to continue with its investment?
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Exercise
5. Complete the present value for a series of indefinite
yearly payments of RM180, assuming that the interest
rate is
(a) 5 percent
(b) 10 percent
6. You have just won a puzzle contest where you were
offered two choice of prizes that is whether to accept
RM60,000 today or RM12,000 at the end of each year
for 5 consecutive years. If the cash flow is discounted at
a yearly rate of 12 percent and compounded twice a
year, which choice would you choose?
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Exercise
7. Mrs. Aimi plans to get a loan for a total of
RM6,000 at the interest rate of 10% from a kind-
hearted money lender. The money lender
agrees to receive a sum of payment for the
same amount at the end of each year for 4
years. What is the size of payment that Mrs.
Aimi must give to the money lender each year?
8. What is the present value for RM400 that will
be received in 7 years from now and discounted
continuously at the interest rate of 10 percent
per year?
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Tutorial Question
Naim and Nadiah are planning in sharing to buy a house 10
years from now with the expected price of RM100,000. Naim
will save RM5,000 every year in his account beginning a year
from now. His last annual savings will be made at the end of
the tenth year. Nadiah will deposit RM4,000 in the account
now and another RM8,000 four years from now.
They also plan to help Naim’s father (Mr. Roslee) who had
just retired and Nadiah’s sister (Nurul) who had just started
her studies in university. Naim will deposit a sum of money
into his father’s account to enable him to withdraw RM3,600
per year, starting a year from now until his father’s death.
While, Nadiah will deposit RM6,000 into Nurul’s account and
will only allow Nurul to withdraw the same amount every year
starting a year from now. As the period of her studies is four
years, Nurul will make four withdrawals.
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Tutorial Question
With the assumption that all the accounts will
pay an interest of 9%, compounded yearly,
answer the following questions:
(a) How much should be added by Naim and
Nadiah at the end of the tenth year to enable
them to buy the said house?
(b) How much is the amount that Naim must
deposit into his father’s account?
(c) How much is the amount that Nurul can
withdraw every year?
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Answer
Naim’s savings:
FV10 = RM5,000 (FVIFA 9%, 10)
= RM5,000 (15.193)
= RM75,965
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Answer
Nadiah’s savings:
FV10 = RM4,000 (FVIF 9%,10) +
RM8,000(FVIF9%,6)
= RM4,000 (2.3674) +
RM8,000 (1.6771)
= RM9,469.60 + RM1,341.68
= RM22,886.40
Total savings = RM75,965 + RM22,886.40 =
RM98,851.40
Therefore, amount need to be added=
RM100,000 – RM98,851.40 = RM1,148.60
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Answer
b. PV = RM3,600 I 0.09 = RM40,000
c. RM6,000 = A (PVIFA 9%,4)
A = RM6,000 / 3.2397
= RM1,852.02
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